2012 Proxy Season Developments: SEC Legal Bulletin and ISS Guidelines

Editor’s Note: James Morphy is a partner at Sullivan & Cromwell LLP specializing in mergers & acquisitions and corporate governance. This post is based on a Sullivan & Cromwell publication.

As issuers and shareholders look ahead to the 2012 proxy season, they should be aware of recent publications by the SEC’s Division of Corporation Finance with regard to Rule 14a-8 process issues and Institutional Shareholder Services with regard to potential voting recommendations on shareholder proposals.

SEC Staff Legal Bulletin No. 14F, issued on October 18, 2011, provides important new guidance on a number of topics that have led to confusion in recent years among issuers and shareholders participating in the Rule 14a-8 shareholder proposal process, including proof of share ownership for beneficial owners, submission of revised proposals, and withdrawal of a proposal submitted by multiple proponents.

On the same day, ISS, the influential proxy advisory firm, released proposed updates to its proxy voting guidelines for 2012. The proposed updates address topics such as company responses to last year’s say-on-pay votes and say-on-pay frequency votes, evaluation of executive pay practices, and recommendations on proxy access proposals. The proposed changes to the policy on evaluating executive pay include a new methodology that uses quantitative one-, three- and five-year comparisons of pay and stock performance together with a qualitative review, as needed.

SEC Staff Legal Bulletin No. 14F Relating to Rule 14a-8

Staff Legal Bulletin No. 14F (“SLB 14F”) [1] clarifies a number of process issues that have caused significant confusion – and often significant debate in no-action requests – relating to Rule 14a-8 shareholder proposals. These changes should help streamline and improve the process from the standpoint of both companies and shareholders.

Proof of Ownership by Beneficial Owners – Change in Staff Position

Rule 14a-8(b) provides that in order to be eligible to submit a shareholder proposal for inclusion in the company’s proxy materials, a shareholder must have continuously held at least $2,000 in market value or 1% of the company’s securities entitled to be voted at the shareholder meeting for at least one year by the date the shareholder submits the proposal. Rule 14a-8(b)(2)(i) provides that shareholders who hold their shares through an intermediary (as is true for the vast majority of public company shareholders) can provide proof of share ownership by submitting a written statement from the “record” holder of the securities.

The question of who is a record holder for these purposes has been a source of considerable uncertainty and a focus of litigation, no-action requests and prior guidance by the SEC’s Division of Corporation Finance (the “Division”). [2] Technically, the record holder of most public company shares is Cede & Co., the nominee of The Depository Trust Company (“DTC”). The actual public shareholders are beneficial owners of an interest in DTC’s holdings, through a securities intermediary that is a participant in the DTC system. In certain cases, a beneficial owner of a company’s shares may have engaged an introducing broker to purchase securities and the introducing broker will have engaged a clearing broker to execute the purchase. The introducing broker is typically not a DTC participant and the clearing broker typically is. The Division previously required companies to accept proof of ownership letters from introducing brokers for Rule 14a-8 purposes, even where the broker was not a DTC participant. In this situation, the company is not able to verify the positions against its own or its transfer agent’s records or against DTC’s listing of securities positions.

In SLB 14F, the Division reversed its prior position and takes the view that for Rule 14a-8(b)(2)(i) purposes, only DTC participants should be viewed as record holders of securities that are deposited at DTC. The Division stated that the transparency of DTC participants’ positions in a company’s securities will provide greater certainty to beneficial owners and to companies that proof of ownership has been established. The Division reiterated its view that Rule 14a-8(b)(2)(i) does not require a shareholder to obtain proof of ownership from DTC or Cede & Co.

If a beneficial owner’s broker or bank is not a DTC participant, shareholders would provide two proof of ownership statements – one from the shareholder’s broker or bank and one from the DTC participant confirming the broker or bank’s ownership – essentially demonstrating a chain of ownership back to DTC. [3]

A company may request from DTC a securities listing position that identifies the DTC participants having positions in the company’s securities and the number of securities held by each DTC participant on any specific date. This allows the company to verify, to some extent, the proponent’s statement of ownership indirectly through the DTC participant. If a proponent fails to provide proof of ownership from a DTC participant and the company intends to request no-action relief on that basis, the company must provide a notice of defect to the proponent pursuant to Rule 14a-8(f)(1) that describes the proof required by SLB 14F. If the proponent then fails to provide proof of ownership from a DTC participant, the company may request no-action relief from the staff to exclude the proposal.

The Division also provided guidance on two common errors made by shareholders when submitting proof of ownership to companies. Rule 14a-8(b) requires that shareholders must verify ownership of the requisite amount of shares for the one-year period preceding and including the date on which the shareholder submits the proposal. According to the Division, two common mistakes made by shareholders are (i) submitting proof of ownership that speaks of a date before the date of submission (for example, proof of ownership may be dated the day prior to the date of submission, which is not in technical compliance with the rule) and (ii) failing to confirm continuous ownership for a full one-year period. The Division provided suggested language that securities intermediaries could use in their proof of ownership letters to meet the technical requirements of Rule 14a-8(b).

Submission of Revised Proposals – Change in Staff Position

SLB 14F addresses questions that the Division has received regarding revisions to a shareholder proposal (including the supporting statement). The Division previously indicated, in Staff Legal Bulletin No. 14, that if a shareholder submits a revised proposal before the company submits a no-action request, the company could choose to reject the revised proposal. It was not clear from this guidance, however, whether it mattered if the revision was submitted before or after the Rule 14a-8 deadline (generally, 120 days prior to the anniversary of the mailing of the prior year’s proxy statement) or whether new proof of ownership would be needed.

In SLB 14F, the Division has changed its position on revisions, and now provides that a company may not exclude a revised proposal so long as the revision is received prior to the 120-day deadline. However, if the company receives the revised proposal after the 120-day deadline, the Division will not require the company to accept the revised proposal. [4]

If the company chooses not to accept a revised proposal received after the deadline, it must treat the revised proposal as a second proposal and submit a notice to the Division of its intention to exclude the revised proposal. The company may cite Rule 14a-8(e) (which addresses the deadline for submitting proposals) as the reason for excluding the revised proposal.

When companies have received revised proposals, it has been common for them to argue in their noaction request to the Division that new proof of ownership should be required on the date of the revision, since the revision is the version of the proposal that the proponent is seeking to include in the proxy materials. However, in SLB 14F, the Division makes clear that a shareholder who submits a revised proposal is not required to provide new proof of ownership provided that the shareholder submitted adequate proof at the time of the initial proposal. On the other hand, if a shareholder does not provide adequate proof at the time of the initial proposal, then the shareholder may not submit any additional proposals for the same meeting at a later date, even if the shareholder proves ownership as of that later date.

Withdrawal of Proposals Submitted by Multiple Proponents – Change in Staff Position

It has been common in recent years for a shareholder proposal to have one lead filer and a number of “co-filers” who lend their support. This can put companies in a difficult position if an agreement is reached with the lead filer to withdraw the proposal, but it is not clear whether that lead filer has authority to withdraw the proposal or otherwise act on behalf of the co-filers. This question arises for the Division when a company seeks to withdraw a pending no-action request due to the withdrawal of the proposal.

In SLB 14F, the Division provides that a letter from the lead filer that includes a representation that the lead filer is authorized to withdraw the proposal on behalf of each proponent is sufficient to prove that the lead filer is withdrawing on behalf of each proponent. Previously, in Staff Legal Bulletin No. 14C, the Division required the company to demonstrate that each proponent designated a lead filer and the lead filer was authorized to act on behalf of all proponents. This requirement incentivized companies to attempt to obtain evidence of this authorization separately from each proponent. Under the revised guidance, companies may rely on the representation from the lead filer. This change should ease the administrative burden on companies dealing with multiple proponents.

Use of E-Mail to Deliver the Division’s Rule 14a-8 No-Action Responses

The Division also announced that they will now e-mail their responses to Rule 14a-8 no-action requests rather than sending hard copies via regular mail. In the past, it often took several days for companies and shareholders to receive the Division’s responses (either through regular mail or through the posting on the SEC’s website, often on a delayed basis), which created difficulties for companies dealing with proxy printing deadlines. SLB 14F notes that companies and proponents should include the appropriate e-mail contact information in any correspondence sent to the Division.

ISS 2012 Draft Policy Updates

On October 18, 2011, Institutional Shareholder Services (“ISS”) released the 2012 draft updates to its proxy voting guidelines for comment by investors and issuers. Issuers should consider the proposed updates, including any impact they may have on the expected level of support for the directors or the company’s say-on-pay proposal in 2012. Comments are due by October 31. [5]

Company Response to 2011 Say-On-Pay Vote

ISS proposed to recommend votes on compensation committee members and the current year say-on-pay proposal on a case-by-case basis if the company’s prior year say-on-pay proposal received “significant opposition” from the votes cast. This case-by-case analysis would take into account several factors, including an evaluation of the company’s outreach efforts to major institutional investors, the company’s response to the issues that influenced the prior year’s vote, the meaningfulness and comprehensiveness of the company’s disclosure and ISS’s analysis of other compensation actions of the company. ISS indicated that this higher level of scrutiny would be placed on companies where the say-on- pay proposal received the support of less than 50% of votes cast, and sought comment as to whether a support level of less than 70% should warrant an explicit response from the company to address concerns.

Company Response to 2011 Say-On-Pay Frequency Vote

ISS proposed to recommend votes against all incumbent directors if the board implements a say-on-pay vote on a less frequent basis than a frequency that received 50% or more of the votes cast. If a frequency received a plurality (but less than 50%) of the votes cast, and the board implements a say-on-pay vote less frequently, then ISS proposes to determine whether to vote against all incumbent directors on a case-by-case basis. The factors that ISS proposes to consider in this case-by-case analysis include the board’s rationale for its choice (which should demonstrate how a less frequent vote is beneficial to shareholders), whether ISS has specific concerns with the company’s compensation practices, the support level of the company’s say-on-pay proposal and the difference between the frequency adopted and the frequency supported by shareholders.

Evaluation of Executive Pay (Pay-For-Performance)

ISS proposed a new methodology for evaluating a company’s executive pay practices, including for purposes of determining whether to recommend a vote in favor of the company’s advisory say-on-pay proposal. Their proposal focuses on the extent to which executive pay reflect the principle of pay-for performance. ISS’s existing approach is to identify underperforming companies in terms of one- and three-year shareholder returns among a peer group, and then provide a qualitative analysis of other factors.

Their proposed new approach would continue to feature a quantitative analysis, followed as applicable by a further qualitative analysis. The quantitative analysis would have two features: one focusing on relative alignment of pay-for-performance and one focused on absolute alignment. The relative alignment analysis would evaluate companies within groups of 14-24 peers, selected on the basis of market capitalization, revenue (or assets for financial firms) and other factors, and would look at the degree of alignment between the company’s shareholder returns and CEO pay over one-year and three-year periods (with the three-year analysis given a 60% weight, and the one-year analysis a 40% weight). The relative analysis would also look to the multiple of the CEO’s total pay relative to the peer group median, though it is unclear how this would be integrated with the above multi-year analysis. The absolute alignment analysis would look at the alignment between the trend in the CEO’s pay and the company’s shareholder returns over a five-year period. The proposal indicates that relative alignment and absolute alignment “may be” weighted 50/50 in the quantitative analysis.

If the quantitative analysis demonstrates “weak” alignment, then ISS would use a further qualitative review to determine a final vote recommendation. The qualitative review would take into account a broad range of factors, including the use of performance-based awards, performance goals, peer group benchmarking and financial performance.

It is difficult to tell from the proposed policy update whether the ultimate policy would contain sufficient detail in terms of quantitative formulas and manner of qualitative review to allow companies any significant visibility into how particular year-end compensation decisions will be viewed under the policy.

Proxy Access

As described in our previous memoranda to clients, [6] Rule 14a-8 will be available for proxy access bylaw proposals in 2012. The SEC’s revisions to Rule 14a-8(i)(8) were not impacted by the judicial vacating of Rule 14a-11, the SEC’s mandatory proxy access rule, and went into effect in September 2011. The revised rules will allow shareholders to use a company’s proxy materials to propose proxy access bylaws and other election or nomination procedures. It remains to be seen how common shareholder proposals will be on this subject, whether they will be structured as precatory requests for board action or as binding bylaw amendments, the level of support they will receive, and how companies will respond to developments in this area.

ISS has proposed to evaluate shareholder proxy access proposals on a case-by-case basis, taking into account factors such as the proponent’s rationale for the proposal, the ownership thresholds proposed in the resolution, the maximum number of directors that shareholders may nominate and the method of determining which nominations should appear on the ballot if multiple shareholders submit nominations. Nothing in the proposed policy update provides any guidance on what specific terms ISS would view favorably or unfavorably in a proxy access proposal.

The draft policy update addresses only shareholder proposals in the area of proxy access. It does not address what recommendations ISS might make with respect to a management proposal asking shareholders to approve adoption of a proxy access provision. [7]

Other Matters

ISS’s draft policy update addresses a number of other changes in its policies for U.S. companies, including adopting a more rigorous analysis for the initial approval of equity plans under Section 162(m) of the Internal Revenue Code, strengthening ISS’s support for shareholder proposals requesting disclosure of a company’s political contributions and lobbying expenditures, and adding a policy to generally support proposals seeking disclosure of a company’s natural gas hydraulic fracturing (known as “fracking”) practices.


[1] SLB 14F is available on the SEC website at http://www.sec.gov/interps/legal.shtml.
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[2] In SLB 14F, the Division notes that two recent court cases held that a securities intermediary was not a record holder for purposes of Rule 14a-8(b) because it was not a DTC participant and did not appear on DTC’s listing of securities positions.
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[3] This is similar to the approach that would have applied under Rule 14a-11, the SEC’s mandatory proxy access rule that was judicially vacated earlier this year.
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[4] This position will also apply when a shareholder submits an initial proposal, and then submits a new proposal prior to the deadline. The Division previously permitted companies to exclude the new proposal as an impermissible second proposal under Rule 14a-8(c). However, the Division will now presume that the submission of the second proposal is a withdrawal of the first, unless the proponent affirmatively states that the second proposal is intended to be a new additional proposal.
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[5] The proposed policy updates are available at http://www.issgovernance.com/policy/2012comment.
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[6] See our memorandum, dated September 16, 2011, entitled “SEC Confirms That Rule 14a-8 Will Be Available for Proxy Access Bylaw Proposals in 2012“ and our memorandum, dated September 7, 2011, entitled “SEC to Allow Shareholders to Submit Proxy Access Proposals for 2012 Season.”
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[7] Based on existing Division interpretations, a company should be able to exclude a shareholder proposal relating to proxy access under Rule 14a-8(i)(9) if the company is including in the same proxy statement its own conflicting management proposal on proxy access for which it seeking shareholder approval.
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