The Anthropology of the Boardroom

It would be natural to start this 2011 Foreword with a précis of the many dramatic regulatory developments newly affecting directors of publicly traded corporations beginning in 2011. Those changes, are, in fact, important to review and are summarized below. But with so much attention understandably focused on external requirements and pressures, it might be better to start first with a less highlighted and yet more central topic — namely, you, the director.

At the end of the day, the recent reforms deservedly catch headlines because they shift or channel some of the regulatory tides buffeting governance activity. But at the beginning of each day, the ability of the board to address those issues while running a successful business depends on you and your fellow directors. This suggests that we begin with recent developments concerning how you inform yourself as a director, how you deal with hidden burdens of the directorship, and how, as this Handbook describes in detail, you undertake the collectivity of tasks and human interactions, practices and rituals that together comprise what I call the anthropology of the boardroom.

F.1 Informing Yourself — Getting the Message at the Right Time and in the Right Place

The information that directors receive in preparation for board or committee meetings, at meetings and between meetings is now largely conveyed electronically by e-mail and attachments. Some corporations have gone paperless, transmitting materials solely via e-mail and/or on secure websites, and even issuing directors iPads (or the equivalent) on which to view that content. For inside directors who are members of management, this protocol involves little change and is essentially a seamless transition from part paper/part electronic to all “e.” But for outside directors, there are several risks which should be identified and avoided.

While paper documents can be mailed to a chosen physical address, protected from review by others, and secured from inadvertent or advertent misuse, electronic documents may not offer the same safeguards.

Furthermore, most outside directors still utilize their own personal (if retired) or day job (where they are executives) e-mail addresses, rather than the “.com” address of the company for which they are an outside director. Outside directors prefer this, of course, because they are much more likely to check their personal or day-job e-mail on a regular basis. However, this creates risks that can be avoided without inconvenience. First, let’s look at some risks that you may face as an outside director:

• If you are employed by another company, that company owns the
  e-mail system that your e-mail address resides on; the company where you are an outside director does not own that system or have access to it.
• Your employer has its own e-mail retention protocols, which may vary from those at the company where you serve as an outside director or from your own retention habits on your personal account.
• Attorney-client privileged information sent to your work address could be accessed by others who own and have access to that system, which could jeopardize the company where you serve as an outside director. Although this risk may seem remote, consider the fact that most large corporations conduct routine e-mail surveillance using risk-factor-driven search terms, and perform intrusive ex parte inspections of e-mails and attachments to ensure that they are in compliance with federal rules and regulations. If you receive an e-mail and/or attachment labeled “confidential” or “attorney-client privileged” from the company where you are a director, the label may trigger your employer’s e-mail surveillance system, and the e-mail and attachments may be automatically routed to your employer’s compliance arm, which will likely result in a call to you from compliance about a matter that is none of your employer’s business.
• The company on which you serve as an outside director may need to retrieve your outside director e-mail communication, for example if you are involved in a decision that is challenged in court. If those e-mails are stored on your employer’s system or on servers belonging to the company that administers your personal e-mail account, you must prevail on those entities to retrieve your outside director communications.

Companies can mitigate these risks by creating in-house e-mail addresses for their outside directors and instructing them to use only those addresses for director business. However, while this avoids the risks outlined above, it introduces a new one: significant delays in communication if outside directors fail to routinely check their different e-mail accounts.

For that reason, best practice for communicating with directors is to provide outside directors with a separate in-house e-mail address, but also to send an e-mail to the director’s work or personal address to alert the director that he or she has a new message in the director’s account. The protocol can be fine-tuned so that an outside director only receives alerts when the communications are board-related. Routine press updates from the company’s investor relations department can continue going to the director’s work or personal e-mail.

F.2 Informing Others — Avoiding Director Conflict of Interest

Director conflicts of interest continue to challenge even the most sophisticated companies. Two particular problem areas are directors’ charitable giving and directors’ personal dealings with other companies.

F.2.1 Directors and Charitable Giving

Director conflicts of interest arising out of charitable giving occur when one (or more) directors(s) provide significant support (personally or through the corporations they lead) to charities that are also supported by other companies that they direct. For example, let’s say that senior executives of Company A lend their company’s support to Charity X, which also enjoys strong support from Company B. As it turns out, one of the senior executives at Company A is also an outside director of Company B. Herein lies the potential conflict of interest: Is such charitable giving the result of director cross-favors that could materially impact independence of judgment of an outside director who is on an audit or compensation committee or otherwise needs, as all directors do, to make judgments solely on their merits without undue influence of others?

It is important to understand that such situations are not conflicts of interest by default. The expression “people give to people” is a truism, and it is common practice for charities to enlist corporate leaders to solicit their contacts to give to the charity.

However, boards must strengthen their protocols for collecting data about potential director cross-giving in order to identify and avoid conflicts of interest. Such data collection can be accomplished by improving the questionnaires that directors already complete about stock ownership and business ties.

Prior to each proxy season and annual meeting, directors receive a questionnaire that asks about stock ownership in the company they direct and about any business ties they have to that company or compensation from it other than as a director. In addition to this information, director questionnaires should also include questions about the relationships among the directors themselves. For example, which charities did they (or their employers) significantly support that year? To the directors’ knowledge, does the corporation that he or she directs also significantly support any of those same charities? (This can also be checked separately.) Have there been discussions with other directors about giving?

The point is not to interdict requests among directors to support charities, but rather to create a database from which the board can assess whether any potential conflict could raise an appearance of lack of independence of any directors as a result of “favors” given by one director to another, or “favors” owed.

F.2.2 Overlapping Opportunities

The second area of hidden conflict of interest for directors, that of dealing with overlapping interests at multiple corporations, is often misunderstood. In fact, many corporations have developed conflict-of-interest reference guides for their directors that are incorrect.

Let’s say that you are a director of Company A and are approached by someone from Company B who is seeking to interest Company A in buying Company B. However, you are an outside director at Company C as well, and Company C might also be interested in acquiring Company B.

Company A’s reference guide states that you do not have to disclose the matter to Company C, because the guidance assumes that since you received the information about Company B in your capacity as director of Company A, you have no obligation to share the information with Company C, even if Company C could also make the acquisition and be interested in Company B. However, that assumption is incorrect. You have as much of a duty to Company C as you do to Company A. I emphasize this because although this issue has been addressed for years on pages10-11 of this Handbook, some company guidelines still don’t offer proper guidance.

In the example given, even though you learned of an opportunity in your capacity as director of Company A, without full disclosure to the board of Company C, on which you also sit, and consent by its disinterested directors, you would need to recuse yourself from any business decision by Company A to pursue an opportunity that could also be pursued by Company C. Again, dealing with director conflicts of interest starts with disclosure — here, disclosure to the board of Company A of your need for recusal or disclosure of your need to seek permission from Company A’s board to seek approval to proceed from Company C’s board.

F.3 The Dodd-Frank Act’s Whistleblower Provisions

Having re-tooled your e-mail protocol, having fashioned a questionnaire that sorts out director charitable giving so that you remain beyond reproach, and having reviewed the often-overlooked issue of corporate opportunities that overlap businesses you lead or direct, let’s now review the new layers of regulation that you as a director need to be familiar with as a result of the extraordinary Dodd-Frank Act of 2010.

Importantly, the SEC has postponed, for the moment, implementation of the two most intrusive measures in the Dodd-Frank Act, namely its “proxy access” paradigm and its “whistleblower” provisions. Dodd-Frank Act proxy access will now likely apply for the 2012 proxy season unless overturned by court challenges to the SEC’s implementive authority. Whistleblowing à la Dodd-Frank only awaits final SEC rulemaking. Let’s look first at the brave new whistleblower world that Dodd-Frank will open up. Fasten your seatbelt.

The SEC’s currently proposed rules set out a comprehensive procedure through which potential whistleblowers may submit information to the SEC and apply for award payments. The Act and the SEC encourage whistleblowers to come forward with high-quality information about potential violations of U.S. securities laws. A bounty of at least 10 percent and no more than 30 percent of the ultimate SEC sanction is offered. That could be millions of dollars.

It must be noted that the proposed SEC rules attempt to address some of the operational challenges and perverse incentives inherent in a program that offers substantial government payments for internal compliance information. However, they do so with limited success. In their current form, the proposed rules raise numerous concerns for corporations, including the impact of the proposed rules on maintaining effective corporate compliance programs.

F.3.1 Description of the SEC’s Proposed Dodd-Frank Act Whistleblower Rules

The SEC’s proposed rules begin by establishing the requirements that a whistleblower must meet in terms of the type and timing of the information provided to the SEC. A whistleblower may be eligible for an award where he or she voluntarily provides original information to the SEC that leads to the successful enforcement of a federal court or administrative action in which the SEC obtains monetary sanctions totaling more than $1 million. The proposed rules specify that, for purposes of calculating whether a Commission action exceeds $1 million, the term “action” means a single captioned judicial or administrative proceeding. Additionally, when determining whether the $1 million threshold has been reached, the SEC will not consider sanctions that the whistleblower is ordered to pay, or that are ordered against an entity whose liability is based substantially on conduct the whistleblower directed, planned, or initiated.

If a whistleblower’s original information leads to a successful action in which the Commission obtains monetary sanctions exceeding $1 million, the whistleblower will also be eligible for recoveries in “related actions” that are based on the same original information and are brought by the U.S. Attorney General, the SEC, the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, a national securities exchange, a registered securities association, a registered clearing agency, the Municipal Securities Rulemaking Board or a state attorney general in a criminal case.

The proposed rules provide that whistleblowers will not receive amnesty. Providing information to the SEC and assisting in an investigation and enforcement action will not preclude the SEC from bringing an action against a whistleblower based on their own conduct. In appropriate cases, however, the SEC will take the individual’s cooperation into account pursuant to its Policy Statement Concerning Cooperation by Individuals in Investigations and Related Enforcement Actions.

The proposed rules include several detailed definitions that expand on the foregoing standards, including:

• Whistleblower: An individual who provides the SEC with information relating to a potential violation of the securities laws. Companies and other entities are not eligible to be whistleblowers. Whistleblowers may submit information to the SEC anonymously. A whistleblower proceeding anonymously is required to be represented by an attorney, whose name and contact information will be submitted to the SEC, and anonymous whistleblowers will ultimately need to verify their identity to the SEC in order to claim an award.

Several categories of persons are not eligible for awards, including persons (i) convicted of a criminal violation related to the SEC action or a related action, (ii) who obtained the information through the performance of an audit that is subject to the requirements of Section 10A of the Exchange Act (i.e., most publicly traded U.S. corporations) and (iii) who make false statements in their whistleblower submission.

• Voluntarily: To receive an award, a whistleblower must provide the SEC with information before he or she (or his or her representative) receives any request, inquiry, or demand from the SEC, other governmental authorities, self-regulatory organizations, or the Public Company Accounting Oversight Board (PCAOB). The whistle­blower’s documents or information will not qualify if the employer already has been requested by the SEC to provide those materials, unless the employer fails to provide the documents or information to the requesting authority in a timely manner.
• Original information: To receive an award, a whistleblower submission must be (i) derived from independent knowledge or independent analysis, (ii) not already known to the SEC from any other source (unless the whistleblower is the original source) and (iii) “not exclusively derived” from certain public sources (unless the whistleblower is a source of the information). “Independent knowledge” means factual information that is “not derived from publicly available sources.” A person need not have direct, first-hand knowledge of potential violations to be considered to have “independent knowledge.” “Independent analysis” means a person’s own analysis, which is defined as the “examination and evaluation of information that may be generally available, but which reveals information not generally known or available to the public.”
• As a means to limit issues with “tainted” information, certain information is specifically excluded from the definition of “original information,” including that which is obtained (i) subject to the attorney-client privilege; (ii) as a result of a legal representation; (iii) through an engagement required under the securities laws by an independent public accountant; (iv) because of the person’s legal, compliance, audit, supervisory or governance responsibilities to an entity and the information was communicated to the person with the expectation they would take reasonable steps to cause the entity to respond appropriately, unless the entity did not disclose the information to the SEC in a reasonable time or proceeded in bad faith; (v) otherwise because of a company’s legal, compliance, audit or other similar processes; or (vi) in a way that violates federal or state criminal law.
• Information that leads to successful enforcement: A whistle­blower will be credited with providing information that led to a successful enforcement if (i) the information caused the SEC to commence an examination, open an investigation, reopen a closed investigation or inquire about new or different conduct, and the
  information significantly contributed to the action’s success, or (ii) the information was about conduct that was already under investigation, and it would not otherwise would have been obtained and was essential to the success of the action.

The proposed SEC rules restate Section 21F’s provision that if the SEC determines that an award is merited, the award must be at least 10 percent and no more than 30 percent of the monetary sanctions collected by the SEC and certain other authorities. It is possible that more than one whistleblower may receive an award in connection with the same or related actions. In that case, each whistleblower will be given an individual percentage award, but the total amount given to all whistleblowers as a group will still be between 10 percent and 30 percent.

The proposed rules set out criteria that the SEC will consider when determining the amount of an award. These include:

• The significance of the information provided to the success of the SEC action;
• The degree of assistance provided by the whistleblower;
• The SEC’s programmatic interest in deterring securities laws violations; and
• Whether the award otherwise enhances the SEC’s ability to enforce federal securities laws.

The proposing release also states that the SEC will use its discretion in setting whistleblower award amounts to encourage the utilization of internal corporate compliance procedures. Specifically, the proposing release states that the SEC expects to give credit to whistleblowers who first report potential violations internally, rather than reporting directly to the SEC in the first instance. Nevertheless, internal reporting is not a requirement in order to receive a whistleblower award above the 10 percent statutory minimum, and whistleblowers will not be penalized for not availing themselves of internal reporting opportunities for fear of retaliation or for other legitimate reasons.

In addition to the award criteria listed above, the proposed rules include other provisions intended to support corporate compliance programs by allowing a whistleblower to preserve his or her position vis-à-vis the SEC while giving them time to report potential violations through internal company procedures. If a whistleblower provides information to a person with legal, compliance, audit, supervisory or governance responsibilities for an entity, or to an entity’s legal, compliance, audit or other similar functions for identifying and addressing potential non-compliance, and then submits the same information to the SEC within 90 days, the SEC will consider that they provided information as of the date of the original disclosure to the company.

The Dodd-Frank Act establishes retaliation protections for whistleblowers. The proposed rules state that these protections apply regardless of whether a whistleblower qualifies for an award. In addition, under the proposed rules, no person may impede a whistleblower from communicating with the SEC staff about a potential securities law violation. This includes enforcing or threatening to enforce a confidentiality agreement. Thus, under the proposed rules, alleged retaliation could expose a corporation to the risk of an SEC enforcement action, in addition to the usual risk that an employee will assert private claims.

Under the proposed rules, if a whistleblower is a director, officer, member, agent or employee of an entity represented by legal counsel and the individual has initiated communication with the SEC about a potential violation, the SEC staff may communicate directly with that person about the subject of the communication. The proposed rules assert that the staff need not seek the consent of the entity’s counsel for such communication.

F.3.2 Whistleblower Provision Concerns for Directors, Issuers and Other Securities Market Participants

Dodd-Frank’s enactment raised concerns about the impact of the new law’s whistleblower provisions, including the whistleblower program’s poten­tially deleterious effect on corporate compliance programs and the perverse incentives it may offer for individuals to circumvent such programs, or to approach the SEC with false, incomplete, or otherwise faulty information in an attempt to obtain a multi-million dollar award. Although the proposed rules attempt to address some of these concerns, in some instances they create new concerns. Directors should consider the following ways that the proposed rules could affect their corporation’s governance.

F.3.2.1 Concern: Will the Whistleblower Program Undermine Internal Corporate Compliance Programs?

The proposed SEC rules could cause whistleblowers to ignore internal compliance programs in favor of bringing their concerns directly to the SEC because of the tremendous potential monetary awards provided. Many companies established sophisticated internal corporate compliance programs in response to the Sarbanes-Oxley Act of 2002, which required public companies to establish procedures for the confidential receipt and treatment of complaints regarding accounting, internal controls, and auditing matters. Of course, regulated financial services firms are required to have extensive internal compliance programs. The SEC states that it recognizes the importance of these programs. Yet, the proposed rules do little to mitigate the threat to the effective operation of these programs inherent in the whistleblower award program.

The proposed rules provide certain incentives intended to support internal compliance programs, such as allowing whistleblowers to “keep their place in line” vis–à-vis the SEC if they first report concerns to a company compliance program, and crediting whistleblowers with reporting to internal programs when calculating award amounts. Further, in the proposing release, the SEC makes several statements expressing its disinclination to undermine effective compliance processes, and it expressly requests comments on how best to achieve this goal.

Nonetheless, the proposed rules do not address potential problems. For example, persons who are aware of potential misconduct might choose not to address it at a nascent stage, instead waiting to see if it grows into a more serious problem to potentially merit significant sanctions and a correspond­ingly large whistleblower award. Although the SEC has indicated that it will take this type of undesirable conduct into account when setting the amount of a whistleblower award, it is not disqualifying, and the promise of at least 10 percent of monetary sanctions collected by the SEC and other authorities may in some instances be enough to induce a whistleblower to let a problem worsen before reporting it.

In addition, the SEC’s attempts to support compliance programs through the new rules raise questions. For example, the proposed rules give whistle­blowers ninety days to report to the SEC after raising issues to a company compliance program. It is not clear what should happen if the company appropriately addresses the potential whistleblower’s concerns within the ninety-day period. May the whistleblower still report the conduct to the SEC? Should the company self-report all compliance issues to the SEC, no matter how unimportant, in order to forestall whistleblower reports? Should companies make regular, periodic self-reports to the SEC for the same pur­pose?

There are several ways in which the proposed rules could have more effectively ensured that internal compliance programs continue to play an integral role in responding to potential misconduct and to deter premature or unfounded whistleblower reports. The proposed rules could have required whistleblowers to report concerns to internal compliance programs before approaching the SEC, or required them to wait ninety days (or longer) before reporting to the SEC after invoking the internal compliance process. The rules could have imposed negative consequences on individuals —
in addition to the already proposed positive incentives — for not reporting concerns in the first instance to internal compliance programs, either by disqualifying such individuals from being considered whistleblowers, or at least by penalizing such persons, for example by mandating that they will be eligible to receive only the minimum award of 10 percent. Finally, as a requirement for making a whistleblower submission, the SEC could have required that a whistleblower certify or provide evidence to the SEC showing that a company failed to respond appropriately to a concern.

F.3.2.2 Concern: Will the Whistleblower Program Undermine Essential Relationships of Trust?

Another concern raised by the proposed rules is the incentive to whistle­blowing for individuals who are in positions of trust or otherwise are privy to company information, and the uncertainty this would create for companies. Under the proposed rules, attorneys, independent auditors, and personnel with compliance responsibilities face certain obstacles to reporting information to the SEC. These provisions provide some ability for companies to continue to rely on key advisors and processes while ameliorating the concern that those advisors will use sensitive information for their personal gain.

However, the proposed SEC rules would allow the SEC to communicate directly with employees and other personnel of entities represented by legal counsel, in contravention of established law requiring SEC staff to communicate with represented persons through or with the consent of their attorneys. If an officer or director chose not to inform his employer that he had made a whistleblower submission to the SEC, a company might not know that a member of the inner circle was sharing confidential information with the SEC for the sake of his own personal gain. This radical new approach could undermine companies’ confidence in the protections normally afforded by legal representation and force entities to reconsider the manner in which they share information with their own fiduciaries.

Additionally, the proposed SEC rules fail to address potential Fourth Amendment issues that may arise if a whistleblower employee provides information about his or her employer to the SEC. The Internal Revenue Service, which has implemented a similar whistleblower program, has issued guidance to its staff to minimize the likelihood that multiple contacts between the government and a whistleblower employee will result in an illegal search or seizure. The proposed rules contain no such limitation.

F.3.2.3 Concern: The Risk of Unfounded “Tips”

Issuers and other market participants should also be aware that the large financial motivations provided under Dodd-Frank could motivate individuals to make whistleblower submissions that are false or otherwise incorrect. In turn, these allegations could lead to expensive and distracting investigations, not to mention the possibility of unfounded and unfair enforcement actions by the SEC. The proposed rules address this concern in part by requiring whistleblowers to make declarations under oath, subject to the penalties of perjury, about the truthfulness of their statements. At least one Justice Department official has stated that whistleblowers who provide false information to the SEC will face criminal prosecution. In addition, persons who make false statements or use false documents in their dealings with the SEC are not eligible to be considered for a whistleblower award. These requirements, however, may not be robust enough to deter whistleblowers who are attracted by the possibility of multimillion dollar awards. The rules could more effectively deter false accusations by formally permitting affected parties the opportunity to respond to false or unfounded whistleblower allegations. The rules do not do so.

F.3.3 Other Issues Presented by the SEC’s New Whistleblower Program

The SEC’s primary goal in promulgating the proposed rules is to maximize submission of high-quality whistleblower information. As a result, it is possible that the SEC could gain more tips that lead it to open more investigations with greater underlying evidence than it has previously possessed, resulting in a more aggressive securities enforcement environment for companies. In that circumstance, companies would be prudent to ensure that their compliance systems are robust, so they can deter, detect, and adequately address misconduct before it gives rise to a whistleblower complaint to the SEC.

Once a company is subject to an SEC investigation, under the proposed rules, employees who are within the scope of a subpoena or request for information that is directed to a company will not at that point be deemed to have “voluntarily” submitted information — and thus will not be eligible for a whistleblower award — unless the company is not timely in its response to the subpoena or request for information. This limitation demonstrates the importance of timely cooperation with SEC investigations and compliance with document requests and subpoenas, lest companies create new opportunities for whistleblower claims that would have otherwise been foreclosed.

Additionally, companies should note that, subject to certain exceptions, information that is obtained through attorney-client privileged communications is not “original,” and thus cannot be the basis of a whistleblower award. This limitation highlights the importance of maintaining privilege over communications with counsel, particularly in the context of internal investigations.

Companies also should consider the impact that the new whistleblower program will have on their ability to cooperate with government enforcement investigations. The proposing release states that, “in appropriate cases,” the SEC will reach out to companies against whom whistleblower complaints have been submitted to “give the company an opportunity to investigate the matter and report back.” The company’s actions in these circumstances will be considered in accordance with the Commission’s previous statement of policy for evaluating cooperation by companies. This guidance appears intended to address criticism that the whistleblower program will make it virtually impossible for companies to be “first in the door” to report potential misconduct to the government, undermining companies’ ability to receive cooperation credit.

Nevertheless, important questions remain. What are the “appropriate cases” in which the SEC will give companies an opportunity to conduct an investigation and report back? Undoubtedly, not all companies that are subject to whistleblower allegations will receive an opportunity to self-investigate and receive cooperation credit. Moreover, even if companies are able to receive credit for cooperating with the SEC, the whistleblower program could still inhibit their ability to receive full credit for cooperation in any related enforcement action by the Department of Justice. This is because federal sentencing guidelines offer full credit only if companies self-report “prior to the imminent threat of disclosure or government investigation.”

Finally, in addition to the foregoing concerns, companies should be aware that parties to civil litigation may attempt to use the SEC’s new whistleblower program as a vehicle for collateral attack. The SEC’s proposing release anticipates that violations of the securities laws may come to light through document discovery from a litigation opponent, and states that parties in receipt of such discovery can submit a whistleblower claim. Clearly, this presents the risk of additional fronts for battle in any litigation, and underscores that companies and their counsel will need to be cognizant to potential securities law violations even in the context of litigation that does not relate to securities issues.

F.3.4 Implementation of the Whistleblower Program

The SEC has stated that it expects to finalize the proposed rules in the first half of 2011.

The SEC’s Division of Enforcement is currently in the process of establishing a Whistleblower Office, and has posted a vacancy announcement for a senior officer to head that office. Additionally, the SEC has set aside more than $450 million in an Investor Protection Fund to provide funding for future whistleblower awards. However, as of the printing of this edition, full funding is on hold due to budget constraints.

F.4 Dodd-Frank Act Proxy Access — More Potential Instability

The Foreword to the 2010 edition of this Handbook covered the Proxy Access proposals extensively. In 2011, the SEC stands ready to implement proxy access once court challenges to SEC authority to promulgate proxy access rules are resolved. As a result, directors can expect proxy access to be in place for the 2012 proxy season.

Specifically, the Securities and Exchange Commission, by a 3-2 vote, has adopted “proxy access” — a set of far-reaching amendments to the proxy rules that provide stockholders of public companies an alternative means to nominate candidates for election to a company’s board of directors, and to have those nominees included in the company’s proxy materials (proxy statement and proxy card). The SEC’s proxy access rules allow stockholders (or groups of stockholders) holding at least three percent of the voting power of a company’s securities for at least three years to nominate candidates for up to 25 percent of a company’s total number of directors. Proxy access is expected to increase the leverage of activist and other stockholders in their interactions with corporate boards and is likely to result in a greater number of companies facing contested director elections.

In addition, the SEC adopted amendments to the proxy rules that permit stockholders to submit proposals under Exchange Act Rule 14a-8 providing for or requesting even greater access to include stockholder nominees in a company’s proxy statement — for example, additional access rights with lower stock ownership requirements and shorter holding periods, or the ability to include nominees for a greater percentage of board seats. This provision operates in only one direction, as stockholders may not propose more stringent requirements on proxy access than those provided by the SEC’s new rules.

F.4.1 Timing

The proxy access rules likely will become effective 60 days after resolution of court challenges, via announcement in the Federal Register, except that “smaller reporting companies” (generally, those with a public float below $75 million) will not become subject to proxy access until three years later. The deadline for eligible stockholders to submit access nominations under the new rules generally is 120 days before the anniversary of the mailing date of the prior year’s annual meeting proxy statement; for calendar-year companies, this deadline typically falls between mid-November and late December. Accordingly, proxy access will be in place for most companies (other than smaller reporting companies) for the 2012 proxy season.

F.4.2 Action Items

There are a number of steps that directors should consider taking this year. These steps may reduce the risk that a company will receive access nominations and better position a company to respond and react to the receipt of access nominations.

Stockholder Engagement: Boards of directors should review and, if necessary, enhance their engagement with major stockholders. As part of this effort, companies should understand their investors’ hot-button issues and consider their corporate governance and executive compensation practices in light of investor concerns. Where differences of opinion exist, commencing a thoughtful dialogue as part of constructive engagement may decrease the likelihood of the company becoming a target for access nominations.

Board Composition: Fundamentally, the board should ensure (typically as part of its annual self-evaluation process) that its directors have the necessary qualifications, skills and experience, as a group, to exercise effective oversight of management and the company’s business. Any perceived gaps in the skill sets of a board may present an opening for an access nomination. In addition, in considering optimal board size, a board may be aware of how board size impacts the number of access candidates that may be nominated. For example, a maximum of three access candidates may be nominated to a 12-member board, whereas a maximum of two access candidates may be nominated to an 11-member board.

Coordination with the Nominating/Corporate Governance Committee and the Board: Upon receipt of an access nomination, a company may have only a short window of time to determine whether to challenge the eligibility of the nomination. These decisions may require the nominating/corporate governance committee and the board to meet on short notice. As a result, calendars should be coordinated and directors should be alerted to the possibility of meeting shortly after the deadline for access nominations. Going forward, annual calendars may need to be revised to reflect potential meetings immediately following the access nomination deadline.

Review Bylaws and Board Policies: Companies should review their bylaws and other corporate governance documents to ensure that they function as intended in the event of an access nomination or the election to the board of access nominees. For example, companies should confirm that majority voting bylaws that contain a plurality voting standard in the event of an election contest define a contest so as to include any circumstance in which the number of candidates exceeds the number of board positions up for election. Companies also may want to refresh policies relating to the confidentiality of information provided to directors and authority to speak on behalf of the company.

Be Prepared: Companies should have a team ready to respond to an access nomination or other activist event. In addition to appropriate company personnel, the team generally should include legal advisors, financial advisors, proxy solicitors and a public relations firm.

A description of the SEC’s proxy access rules and related rule changes follows.

F.4.3 Rule 14a-11: Proxy Access for Director Nominations

The cornerstone of proxy access is the new Exchange Act Rule 14a-11, which provides that a stockholder or group of stockholders complying with the eligibility and other requirements of the rule can include the stockholder’s or group’s nominees for director in a company’s proxy materials. Rule 14a-11 applies to all companies that are subject to the SEC’s proxy rules, including registered investment companies and controlled companies, but excluding companies subject to the proxy rules solely because they have a class of registered debt. Proxy access does not apply to foreign private issuers as they are exempt from the proxy rules.

Rule 14a-11 applies to the election of directors at an annual meeting (or a special meeting or an action by written consent in lieu of an annual meeting) unless applicable state law or a company’s governing documents (i.e., charter or bylaws) prohibit stockholders from nominating candidates for election to the board. The SEC notes that it is not aware of any state with such a prohibition. In the case of a company’s governing documents, such a prohibition would be unusual and may raise issues of enforceability under applicable state law. Such a prohibition also would be likely to provoke the ire of institutional and activist investors, as well as proxy advisory firms such as Institutional Shareholder Services (ISS). There is no mechanism for a company to “opt out” of proxy access.

F.4.4 Eligible Nominating Stockholders

The principal requirements for a stockholder or a group of stockholders to be eligible to nominate director candidates under Rule 14a-11 are:

• Three Percent: On the date that the nominating stockholder or group provides the requisite notice of nomination, the stockholder (individually) or the group (in the aggregate) must hold at least three percent of the total voting power of the company’s securities entitled to vote in the election of directors (that number of shares is referred to in this memorandum as the “minimum number of shares”);
• Three Years: The nominating stockholder or group must have held the minimum number of shares continuously for at least three years as of the date of its notice of nomination and must continue to hold at least the minimum number of shares through the date of the meeting at which directors will be elected;
• Proof of Ownership: The nominating stockholder or group must include in its notice of nomination proof of ownership of the minimum number of shares for the three-year holding period described above. If the nominating stockholder or each member of the group is not the registered holder of the securities, the proof may be in the form of written statements from the registered holders of the securities (or the brokers or banks through which the securities are held) or it may consist of previously filed Schedules 13D or 13G or Forms 3, 4 or 5 (which may be incorporated by reference into the notice of nomination);
• No Change of Control Intent: Neither the nominating stockholder nor any member of the group may be holding the company’s securities with the purpose or effect of changing control of the company or gaining a number of board seats in excess of the maximum number of board seats permitted by Rule 14a-11; and
• No Agreement With the Company: Neither the nominating stockholder nor any member of the group may have entered into an agreement with the company regarding the nomination.

In calculating the percentage of voting power held by the nominating stockholder or group, Rule 14a-11 requires that the stockholder or, in the case of a group, each member of the group, have both investment power and voting power with respect to the securities (whereas beneficial ownership requires only one or the other, but not both). This requirement is intended to limit the ability to use derivatives or other instruments that separate voting power from the economic risk of owning the securities in order to become eligible to make an access nomination. This method of calculating voting power also excludes securities that the holder merely has the right to acquire, such as securities underlying options that are currently exercisable but have not been exercised.

In addition, Rule 14a-11 provides that securities loaned to third parties are included in the calculation of voting power held only if the nominating stockholder or member of the group has the right to recall the loaned securities and will recall them upon notification by the company that any of the access nominees will be included in the company’s proxy materials. Borrowed securities or securities sold in a short sale are excluded from the determination of voting power held by the nominating stockholder or group.

A nominating stockholder or group will become ineligible, and its nominees excluded from the company’s proxy materials, if the stockholder or any member of the group submits any additional nominations to the company or participates in more than one proxy access nominating group with respect to the same company. The rule also provides for loss of eligibility in certain instances that are intended to avoid the possibility of a nominating stockholder or a member of a nominating group colluding or coordinating with a third party conducting a proxy contest for board seats at the same company.

F.4.5 Eligible Nominees

To be eligible, an access nominee must satisfy the objective independence standards of the securities exchange on which the company is listed (or in the case of an investment company, must not be an “interested person”). In addition, the nominee’s candidacy and, if elected, board membership must not violate applicable law (such as those laws governing board membership of companies in certain regulated industries).

Nominees do not have to satisfy any additional director qualification standards set forth in a company’s governing documents, although the nominating stockholder or group must disclose in its notice of nomination whether, to the best of its knowledge, the nominee meets any such qualifications.

Also, the nominee must not have entered into any agreement with the company regarding the nomination.

F.4.6 Number of Access Nominees

Nominating stockholders or groups may nominate candidates representing up to 25 percent of the total number of the company’s board of directors (rounded down to the closest whole number, but not less than one). This same calculation is applicable in the case of a staggered board in which one-third of the directors are elected each year, so that in any single year a majority of the class of directors standing for election (i.e., a majority of the one-third of the board) could face a challenge from access nominees. However, any access nominee previously elected to the staggered board whose term extends beyond the upcoming election of the directors will count towards the 25 percent limit.

In an attempt to keep proxy access from being an impediment to negotiations between companies and nominating stockholders or groups, the rules provide that an access nominee of an eligible nominating stockholder or group (with priority over other nominating stockholders or groups, as described below) whom a company agrees to include in its proxy materials as a company nominee would count towards the 25 percent limit, so long as the nominating stockholder or group filed its notice of nomination before beginning any discussion with the company about the nomination. In other words, settling with the nominating stockholder or group under those circumstances would not open the door to an alternative access nominee.

F.4.7 Priority among Multiple Nominating Groups

In a change from the “first to the mailbox” system proposed by the SEC in 2009, the final rules provide that if there are multiple nominating stockholders or groups, priority is given to the nominating stockholder or group holding the greatest percentage of voting power (based on the voting power percentages contained in the initial nomination notices). If that nominating stockholder or group nominated fewer than the maximum number of nominees permitted by Rule 14a-11, the company would include additional access nominees (up to the maximum number of nominees permitted by Rule 14a-11) nominated by the stockholder or group with the next highest percentage of voting power, and so on.

Where a company has received nominations from multiple stockholders or groups, the disqualification or withdrawal of a nominating stockholder or group of its nominee or its nominees opens the door to the access nominees of the nominating stockholder or group with the next highest percentage of voting power, unless the disqualification or withdrawal occurs after the company begins printing its proxy materials. If the company has begun printing its proxy materials by the time of a disqualification or withdrawal, the company does not have to include a substitute access nominee.

F.4.8 Notice of Nomination: Timing and Disclosure Requirements

A nominating stockholder or group must submit notice of the nomination to the company on new Schedule 14N, and file the Schedule 14N on the same day with the SEC via EDGAR (which will result in the notice becoming publicly available). The notice must be sent to the company and filed with the SEC no earlier than 150 days and no later than 120 days before the anniversary of the mailing date for the prior year’s annual meeting proxy statement (which, generally, will be the same deadline as the Rule 14a-8 deadline for submission of stockholder proposals for inclusion in the company’s proxy materials). As is the case with submission deadlines under Rule 14a-8 and under a company’s advance notice bylaws for the presentation of new business, the company is required to disclose in its proxy statement the deadline for proxy access nominations in connection with the following year’s meeting.

In the event that the company did not hold an annual meeting during the prior year, or if the date of the annual meeting has changed by more than 30 days from the prior year, or if the company is holding a special meeting or acting by written consent to elect directors (in lieu of an annual meeting), nominations must be received a reasonable time before the company mails its proxy materials. That deadline must be set forth in a Form 8-K filed by the company within four business days of determining the anticipated meeting date. In addition to containing disclosures about the nominating stockholder or group and the access nominees comparable to the disclosure required in a proxy statement relating to a contested election, the notice on Schedule 14N must include the following:

• Disclosure of the amount of securities held by the nominating stockholder or group and the length of time those securities have been held (including the proof by which to determine that the ownership and duration of holding requirements have been satisfied);
• A statement of the intent of the nominating stockholder or members of the group to hold the minimum number of shares through the date of the meeting at which directors will be elected, and a statement of intent with respect to continued ownership after the election (which may be contingent on the results of the election);
• Disclosure as to whether, to the best knowledge of the nominating stockholder or group, the access nominees satisfy the director qualification standards, if any, contained in the company’s governing documents; and
• Certifications by the stockholder or each member of the group that, to such person’s knowledge, it is not holding the company’s securities with the purpose or effect of changing control of the company or gaining a number of seats on the board that exceeds the maximum number permitted under Rule 14a-11, and that the nominating stockholder or group and access nominees satisfy the requirements of Rule 14a-11.

Also, the Schedule 14N must include the website address on which the nominating stockholder’s or group’s soliciting material will be posted and may, at the option of the nominating stockholder or group, include a statement in support of each nominee, not to exceed 500 words per nominee.

Upon the filing and receipt of a Schedule 14N, these disclosures should be evaluated carefully by the company and its counsel to determine whether the nominating stockholder or group or access nominee is eligible under Rule 14a-11.

In the event that stockholders have additional proxy access rights under applicable state law or a company’s governing documents, a modified version of Schedule 14N is required to be filed with the SEC and transmitted to the company.

F.4.9 Excluding an Access Nominee

A company may exclude an access nominee if: (i) Rule 14a-11 is not applicable to the company; (ii) the nominating stockholder or group or access nominee failed to satisfy the eligibility requirements of Rule 14a-11; or (iii) the number of access nominees exceeds the maximum number of nominees permitted under Rule 14a-11. In addition, a company may exclude the statement in support of an access nominee or nominees if the statement exceeds 500 words per nominee. There is no exclusion of a nominee or a supporting statement on the basis that the Schedule 14N or the supporting state­ment is materially false or misleading, based on the SEC’s view that such disputes will be addressed through disclosure and/or litigation.

Where the company determines it has a basis to exclude an access nominee (including exclusion due to the fact that nominating stockholders or groups with priority resulting from higher percentages of voting power have nominated a full complement of access nominees) or to exclude a supporting statement, the following timeline and process applies:

• Within 14 days of the deadline for submitting access nominations, the company must notify a nominating stockholder or group (or its authorized representative) of the company’s determination to exclude a nominee or supporting statement and the company’s basis therefor.
• Within 14 days after receipt of the company’s notice, the nominating stockholder or group would have to respond to that notice and, if applicable, correct any eligibility or procedural deficiencies identified in that notice. Neither the composition of the nominating group nor the nominee(s) can be changed to cure any deficiency, other than reducing the number of nominees to comply with the 25 percent limit.
• No later than 80 days before the company files its definitive proxy materials with the SEC (and after providing the notice to the nominating stockholder or group described above and either receiving a response from the stockholder or group or allowing the 14-day period for such a response to expire without a response), the company must notify the SEC (with a copy to the nominating stockholder or group) of its intent to exclude the nominating stockholder’s or group’s nominee(s) or supporting statement and the basis for its determination. At this point, the company also may (but is not required to) seek the SEC staff’s concurrence via a no-action letter.
• Within 14 days of the nominating stockholder’s or group’s receipt of the company’s notice to the SEC, the nominating stockholder or group may submit a response to the SEC (with a copy to the company)
• If the company seeks the SEC staff’s views in a no-action letter, the company must provide the nominating stockholder or group with notice, promptly following receipt of the SEC staff’s no-action response, of whether it will include or exclude the access nominee(s).

As described above, the withdrawal or disqualification of a nominating stockholder or group or a nominee may result in inclusion of a nominee of the nominating stockholder or group with the next highest percentage of voting power. The SEC notes in the release that a company should seek no-action relief with respect to all nominees that it wishes to exclude at the outset and should assert all available bases for exclusion at that time.

F.4.10 Including an Access Nominee

If a company determines that it will include an access nominee in the company’s proxy materials, the company must notify the nominating stockholder or group not later than 30 days before the company files its definitive proxy materials with the SEC. As described below, this notification will permit the nominating stockholder or group to begin soliciting in favor of its nominees and against company nominees. Under the new rules, inclusion of access nominees in the company’s proxy materials will not trigger the requirement to file preliminary proxy materials.

A company that is including access nominees in its proxy statement will have to include in the proxy statement much of the information contained in the nominating stockholder’s or group’s Schedule 14N (including, if provided, the statements in support of the nominees). In addition, the company will be required to include additional company disclosure of the type typically included in a proxy statement for a contested election.

The rules also provide that the company’s proxy card must list the company nominees as well as the access nominees (and may clearly designate the different groups), but may not include a mechanism to vote for the company nominees as a group.

F.4.11 Access-Related Exemptions from the Proxy Rules

The SEC has created two new exemptions from the proxy rules – one for solicitations to form a nominating group under Rule 14a-11 and the other for solicitations by a nominating stockholder or group in favor of its Rule 14a-11 nominees and for or against company nominees. Neither exemption will apply in the case of solicitations relating to additional proxy access rights under state law or a company’s governing documents. A person soliciting to form a nominating group under Rule 14a-11 would not be eligible for this new exemption from the proxy rules if the person is holding company securities with the purpose or effect of changing control of the company or gaining more board seats than permitted under Rule 14a-11. Written communications subject to this exemption must be limited in scope to a statement of intent to form a nominating group, identification of potential nominees, the percentage of voting power held by the soliciting stockholder or group and how others may contact the soliciting stock­holder or group. Any such written communication must be filed with the SEC under cover of Schedule 14N on the date of first use. In the case of an oral communication relating to the formation of a nominating group, the soliciting person must file a Schedule 14N cover page (with the appropriate box on the cover page marked) with the SEC no later than the date of the first such communication. The SEC notes that this exemption is not exclusive, so, for example, a stockholder could rely on the “ten-person” soliciting exemption to form a nominating group without triggering a Schedule 14N filing prior to the actual nomination.

A nominating person or group may solicit in favor of its nominees to be included in the company’s proxy materials and for or against the company’s nominees without complying with the proxy rules so long as the soliciting party does not seek proxy authority or furnish a proxy card, and so long as any written materials contain a legend directing the reader to the company’s proxy statement and are filed with the SEC under cover of Schedule 14N on the date of first use. This exemption is available only after receiving notice from the company that the stockholder’s or group’s nominee will be included in the company’s proxy materials. A stockholder or group relying on this exemption may not rely on any other exemption from the proxy rules.

F.4.12 Liability

The nominating stockholder or group will be liable for any statement in its Schedule 14N or any other related communication that is false or misleading, regardless of whether that information is ultimately included in the company’s proxy statement. Companies will not be liable for information provided by the nominating stockholder or group that the company includes in its proxy statement.

F.4.13 Amendments to Rule 14a-8

SEC rules permit stockholder proposals to be excluded from company proxy statements for a variety of reasons. One such basis for exclusion has been proposals relating to director elections — the so-called “election exclusion” under Rule 14a-8(i)(8).

The new rules amend Rule 14a-8(i)(8) to narrow the scope of the election exclusion and permit stockholders to make proposals requiring or seeking amendments to a company’s governing documents to establish additional bases for proxy access containing more liberal criteria for nominations than under Rule 14a-11 (for example, lower ownership thresholds or shorter holding periods). As described in the SEC’s release, a stockholder proposal relating to an additional proxy access nomination procedure no longer would be excludable (unless there was another basis on which to omit the proposal). On the other hand, a stockholder proposal to limit or restrict proxy access under Rule 14a-11 would be excluded as conflicting with the SEC’s proxy rules. In effect, new Rule 14a-11 operates as a floor, while revised Rule 14a-8(i)(8) leaves open the potential for stockholders to seek and advocate in favor of more expansive proxy access.

F.5 The Dodd-Frank Act Mandated Say-on-Pay Votes and Other Corporate Governance and Executive Compensation Changes

The Dodd-Frank Act also requires enhanced disclosure of executive compensation matters; imposes certain substantive requirements on public companies, such as requirements for nonbinding shareholder votes on executive compensation programs (“say-on-pay”); mandates the independence of compensation committee members; requires “clawbacks” of certain incentive compensation; and prohibits any incentive compensation arrangement by bank holding companies and certain other financial institutions that “encourages inappropriate risks.” These executive compensation provisions will compel public companies to adopt new approaches to both the disclosure and substance of their compensation practices.

F.5.1 Say-on-Pay

“Say-on-pay” refers to a non-binding shareholder advisory vote on a company’s compensation for executive officers as described in a company’s proxy statement. Proponents of say-on-pay view it as a mechanism for shareholders to express their views to a company’s board regarding the company’s executive compensation program. According to Institutional Shareholder Services (ISS), to date, approximately 70 U.S. companies have voluntarily adopted say-on-pay. Although many of those companies adopted a policy of holding say-on-pay votes on an annual basis, some companies, including Pfizer, Colgate-Palmolive and General Mills, adopted policies to hold say-on-pay votes every two years, and Microsoft adopted a policy to hold say-on-pay votes every three years. Although ultimately withdrawn, the United Brotherhood of Carpenters Pension Fund submitted shareholder proposals to 20 companies in 2009 seeking say-on-pay votes once every three years.

Now, Dodd-Frank requires annual meeting say-on-pay votes, with shareholders voting to determine if such votes will be held every one, two or three years and say-on-pay votes for merger-related compensation (sometimes referred to by proponents as “golden parachute” say-on-pay).

Annual Meeting Say-on-Pay Votes. The Act requires that, at a company’s first annual or other shareholder meeting (for which executive compensation disclosure is required by the proxy rules to be included in the proxy statement) occurring after the six-month anniversary of the date of enactment, shareholders be given two separate votes. The first is a non-binding vote to approve the compensation of executive officers as disclosed in the proxy statement. The second is a non-binding vote on whether future non-binding shareholder votes on executive compensation should take place every one, two or three years. The Act requires that companies hold a shareholder vote on the frequency of say-on-pay votes — i.e., whether say-on-pay votes should occur every one, two or three years — at least once every six years.

The annual meeting say-on-pay requirement does not require any SEC rulemaking. The SEC may adopt rules relating to annual meeting say-on-pay votes to address a number of topics. For example, companies that voluntarily have provided shareholders with a say-on-pay vote have been required to file preliminary proxy material with the SEC, with the attendant strains on their proxy season calendars. The SEC, however, amended the proxy rules in 2010 so that companies receiving TARP funds, and thereby required under the Emergency Economic Stabilization Act of 2008 to hold say-on-pay votes, were not required to file preliminary proxy material due to the inclusion of say-on-pay votes. The SEC likely will expand the circumstances under which a preliminary proxy filing is not required to include say-on-pay votes required under Dodd-Frank.

Another subject of likely SEC rulemaking relates to the existing requirement that for each item being voted on by shareholders (other than the election of directors), a proxy card must provide an opportunity for shareholders to specify by boxes a choice between approval or disapproval of, or abstention from, each matter to be acted upon. The SEC will need to create an exception to this rule in order for shareholders to vote on whether say-on-pay votes should be held every one, two or three years.

2010 Experience with Say-on-Pay. According to recent ISS data for the 2010 proxy season, say-on-pay votes received an average of 89.2 percent support at 128 companies (a combination of companies voluntarily providing say-on-pay votes and TARP companies required to provide say-on-pay votes), only slightly below the average support in 2009. There were notable exceptions, however. Motorola was the first U.S. company to fail to win majority support for a management say-on-pay vote, followed shortly after by Occidental Petroleum and KeyCorp. It remains to be seen what trends will develop and how making say-on-pay a regular occurrence will impact public company compensation practices going forward.

Related Provisions. The Act contains two other provisions that impact future say-on-pay voting results. The Act codifies the New York Stock Exchange rule prohibiting brokers from exercising discretionary voting authority — i.e., voting shares in the absence of instructions from beneficial owners — with respect to director elections, executive compensation or any other significant matter, as determined by SEC rulemaking. Proponents of this provision believe that it will remove discretionary authority for brokers to vote on say-on-pay proposals and will reduce the level of voting support for future say-on-pay votes. The second provision is a requirement that institutional investment managers that file Form 13F (i.e., investment managers exercising investment discretion over $100 million or more of U.S. public company equity and certain other securities) disclose at least annually how they voted on say-on-pay votes (including merger-related say-on-pay votes) with respect to the companies in whose shares they invest. It remains to be seen whether this additional disclosure will have any impact on the voting decisions of these institutional investment managers.

Merger-Related Say-on-Pay. The Act requires that, for any shareholder meeting occurring after the six-month anniversary of the date of enactment at which shareholders are being asked to approve an acquisition, merger, consolidation or sale or other disposition of all or substantially all of the assets of a company, the company:

• Include proxy disclosure in a “clear and simple form,” in accordance with rules to be adopted by the SEC, describing any agreements or understandings that the company or the other party to the transaction has with any of the company’s named executive officers concerning any type of compensation that is based on, or otherwise relates to, the transaction and the aggregate total of all such compensation that may be paid or become payable to the named executive officers; and
• Provide shareholders with a separate non-binding vote to approve those merger-related compensation agreements or understandings, unless those agreements or understandings previously have been the subject of an annual meeting say-on-pay vote (regardless of the outcome of such previous vote).

Although the choice as to the desired form of a business combination transaction — for example, a two-step transaction consisting of a tender offer followed by a back-end merger versus a one-step merger requiring a shareholder vote — can be influenced by a number of complex factors, it is possible that in certain circumstances the requirement to hold a merger-related say-on-pay vote if a transaction is structured as a merger requiring shareholder approval could tip the scale in favor of structuring the transaction as a tender offer.

F.5.2 Enhanced Independence for Compensation Committees and Their Advisors

Generally, compensation committee members for companies listed on a national securities exchange currently are required to meet the independence standards adopted by the exchange. Similar to the requirements under the Sarbanes-Oxley Act of 2002 for enhanced audit committee independence, Dodd-Frank required SEC rulemaking (within 360 days of the date of enactment) directing national securities exchanges to adopt listing standards (including exemptions for controlled companies and exceptions for foreign private issuers that do not have independent compensation committees) containing enhanced independence requirements for compensation committee membership and explicit authority for compensation committees to engage their own independent advisors.

Compensation Committee Membership. Under Dodd-Frank, the SEC is required to adopt rules directing national securities exchanges to require that listed company compensation committee members be independent, and that in determining the definition of “independence,” national securities exchanges are to consider (1) the source of compensation of a director, including any consulting, advisory or other compensatory fee paid by the company to the director and (2) whether the director is affiliated with the company, a subsidiary of the company or an affiliate of any subsidiary.

Independence of Advisors. Under the Act, a compensation committee will be able to select a compensation consultant, legal counsel or other advisor only after “taking into consideration” independence factors to be identified by the SEC. Although the requirement to take the independence factors into “consideration” suggests that the rules should not set forth any bright-line prohibitions, the rules could make it difficult as a practical matter to retain compensation consultants, legal counsel or other advisors that raise questions under the independence factors to be identified by the SEC.

Under the Act, the independence factors must include:

• The provision of other services to the company by the compensation consultant, legal counsel or other advisor;
• The amount of fees paid by the company as a percentage of total revenue of the compensation consultant, legal counsel or other advisor;
• The policies and procedures of the compensation consultant, legal counsel or other advisor that are designed to prevent conflicts of interest;
• Any business or personal relationship of the compensation consultant, legal counsel or other advisor with a member of the compensation committee; and
• Any stock of the company owned by the compensation consultant, legal counsel or other advisor.

Compensation Committee Authority. The Act provides that listed company compensation committees must have the authority to retain or obtain the advice of compensation consultants, independent legal counsel and other advisors, and that compensation committees shall be directly responsible for the appointment, compensation and oversight of the work of such consultants, counsel and other advisors. In addition, companies are required to provide appropriate funding for the compensation committee to pay the fees of compensation consultants, legal counsel and other advisors.

Disclosure. Pursuant to rules to be adopted by the SEC, any proxy statement for an annual meeting of shareholders occurring after July 2011 will be required to disclose (1) whether the compensation committee retained or obtained the advice of a compensation consultant and (2) whether the work of the compensation consultant raised any conflict of interest and, if so, the nature of the conflict and how the conflict was addressed.

F.5.3 Additional Executive Compensation Disclosures

Dodd-Frank mandated SEC rulemaking to require (1) disclosure of pay versus performance and (2) disclosure comparing CEO compensation to average employee compensation (referred to as internal pay ratio disclosure).

Pay Versus Performance Disclosure. The Act required annual meeting proxy disclosure that shows the relationship between (1) executive compensation actually paid and (2) the company’s financial performance, taking into account any change in value of the company’s shares and any dividends or distributions paid by the company. The Act provided that such disclosure may include a graphical representation of the information required to be disclosed.

Internal Pay Ratio Disclosure. The Act required the SEC to amend its executive compensation disclosure rules to require companies to disclose:

• The median of the annual total compensation of all company employees other than the CEO;
• The annual total compensation of the CEO (as set forth in the Summary Compensation Table); and
• The ratio of the two amounts.

In adopting rules to implement internal pay ratio disclosure, the SEC may address questions as to how companies should calculate annual total compensation of company employees other than the CEO including, for example, whether part-time, hourly or seasonal employees are included in the calculation.

F.5.4 Clawback Policies

Dodd-Frank directed the SEC to require the national securities exchanges to adopt listing standards so that listed companies must implement a policy to recoup executive compensation in the event of a financial restatement. Specifically, the policy must provide that if the company is required to prepare an accounting restatement due to material noncompliance of the company with any financial reporting requirement under the securities laws, the company will recover from any current or former executive officer who received incentive-based compensation (including stock options) during the three-year period preceding the restatement the amount of such incentive-based compensation that is in excess of what would have been paid to the executive officer under the restated financial statements.

This requirement reaches well beyond the clawback requirement in Sarbanes-Oxley, which applies only to a company’s CEO and CFO (although, as recently decided in SEC v. Jenkins, the misconduct requirement in the Sarbanes-Oxley clawback does not need to be the CEO’s or CFO’s misconduct), and beyond the clawback policies adopted by many companies, which only seek to recoup compensation from the person engaging in misconduct.

F.5.5 Disclosure Regarding Hedging

The Act required the SEC to amend the proxy rules to require annual meeting proxy disclosure as to whether company employees or members of the board of directors (or any designee of any such employee or board member) are permitted to purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars and exchange funds) that are designed to hedge or offset any decrease in the market value of company equity securities granted by the company as compensation to such employee or director or otherwise held directly or indirectly by such employee or director.

F.5.6 Chairman and CEO Disclosure

The Act required the SEC to adopt rules requiring annual meeting proxy disclosure of the reasons why the company has chosen the same person or different persons to serve as chairman of the board and as CEO. This requirement appears to be addressed by proxy rules already adopted by the SEC and put in place for the 2010 proxy season.

F.5.7 Provisions Applicable Only to Financial Institutions

The Act required various federal regulators (including the Federal Reserve, FDIC and Office of Thrift Supervision), no later than nine months after the date of enactment, to issue rules or guidelines that (1) prohibit “covered financial institutions” from having incentive compensation arrangements that encourage inappropriate risks by providing excessive compensation or that could lead to material financial losses and (2) require covered financial institutions to make disclosures to the applicable regulator regarding incentive compensation arrangements. Covered financial institutions include bank holding companies, registered broker-dealers, credit unions and investment advisors, but exclude financial institutions with assets of less than $1 billion.

In addition, the Act required the Federal Reserve to make rules requiring that (1) publicly traded nonbank financial institutions supervised by the Federal Reserve and (2) bank holding companies with at least $10 billion in assets establish a risk committee of the board of directors. The risk committee will oversee the company’s risk management practices, include the number of independent directors determined by the Federal Reserve and include at least one risk management expert.

F.6 Other Pressures on the Boardroom — ISS Issues Its 2011 Policy Updates

Institutional Shareholder Services (ISS), an influential proxy advisory firm, annually updates the policies that underlie its voting recommendations to its institutional investor clients.

Depending on a company’s shareholder base, an ISS voting recommendation can have a meaningful impact on the outcome of items submitted to a shareholder vote. ISS’s influence during the 2011 proxy season may be even greater than in prior years because, for the first time, all public companies will be holding advisory votes to approve executive compensation (say-on-pay votes) and on whether future say-on-pay votes should be held every one, two or three years (frequency votes).

Key changes or additions to ISS’s policies for the 2011 proxy season include the following:

• ISS will no longer consider a company’s prospective commitment to eliminate what ISS refers to as “problematic pay practices” as a way of preventing or reversing an ISS negative vote recommendation on say-on-pay votes or on re-election of compensation committee members;
• As anticipated, ISS will recommend in favor of annual say-on-pay votes rather than say-on-pay votes every two or three years;
• In analyzing executive compensation in connection with an annual meeting say-on-pay vote, ISS may give greater weight to its analysis of merger-related compensation arrangements when companies seek to satisfy the “say-on-golden parachute” vote by voluntarily including “golden parachute” disclosure in an annual meeting proxy statement; and

ISS will recommend against/withhold for directors when a company has failed to implement a shareholder proposal receiving a majority of votes cast in two out of the three previous years (rather than only when such votes occurred in two consecutive years).