Preparing for the 2014 Proxy and Annual Reporting Season

The following post comes to us from Laura Richman, counsel at Mayer Brown LLP, and is based on a Mayer Brown Legal Update.

While the proxy and annual reporting season for calendar year public companies typically heats up in the winter, by autumn preparations for the 2014 season should be underway. The following key issues for the upcoming season are discussed below:

  • Current Say-on-Pay Considerations
  • Say-When-on-Pay
  • Compensation Committee Independence and Compensation Consultants
  • NYSE Quorum Requirement Change
  • Pending Dodd-Frank Regulation
  • Proxy Access
  • Specialized Disclosures
  • SEC Interpretations Impacting Reporting
  • Iran Sanctions Disclosure
  • XBRL
  • PCAOB Audit Committee Communications Requirements
  • Director and Officer Questionnaires
  • E-proxy

Current Say‐on‐Pay Considerations

Public companies now have three years of mandatory say-on-pay voting experience and proxy disclosure precedents to draw upon when drafting say-on-pay proposals for their proxy statements. The say-on-pay requirement makes a clear, user-friendly explanation of compensation very valuable. The compensation discussion and analysis (CD&A) section of the proxy statement, which often begins with an executive summary of the executive compensation program, is a key component of the say-on-pay process. Some companies also have used proxy statement summaries and supporting text within the say-on-pay section of the proxy statement to succinctly highlight the reasons why they believe their executive compensation programs should be approved.

In addition to the proxy disclosure that is part of the say-on-pay proposal itself and the general requirements to explain compensation decisions in the CD&A, companies specifically need to discuss in the CD&A the extent to which compensation decisions were impacted by the results of the say-on-pay vote. There are now two years of precedents for this specific CD&A disclosure that companies may wish to review, both from a disclosure perspective and to benchmark what actions comparable companies have taken in response to say-on-pay votes in terms of shareholder engagement and compensation changes. Compensation committees should be reminded of this reporting obligation so that their deliberations can, if they so choose, specifically address the results of the say-on-pay advisory vote. However, because the say-on-pay vote is non-binding, compensation committees are not compelled to take any actions in response to the shareholder advisory vote.

Before filing the proxy statement and commencing the proxy solicitation, companies should be satisfied that the various sections of the proxy statement adequately explain executive compensation and make the case for approval.

If desired, however, separate additional proxy materials, focusing only on the say-on-pay vote, may be prepared and filed with the Securities and Exchange Commission (SEC) as additional definitive proxy soliciting materials. For example, in the event that a proxy advisory firm recommends that its clients vote against a company’s executive compensation, the company may want to prepare letters, presentations or scripts, further explaining its compensation decisions and rebutting the report containing the negative recommendation. Companies do not have to prepare special materials to respond to a negative say-on-pay proxy recommendation, but any such materials a company wishes to use must be filed with the SEC as additional definitive proxy soliciting materials.

A negative recommendation on executive pay from a proxy advisor will not necessarily result in a failed say-on-pay vote. There are precedents for companies receiving majority approval for their say-on-pay proposals even when a proxy advisory firm recommends votes against them, but it is likely that a negative recommendation will at least result in a lower percentage of approval. A say-on-pay proposal receiving significant opposition may have consequences for the company even if the advisory proposal is approved by a majority of the votes cast. For example, if a say-on-pay proposal is approved by less than 70% of the votes cast, ISS has in the past taken that fact into consideration in the subsequent year to determine whether or not to recommend a vote against the management say- on-pay proposal and the election of compensation committee members. In making its decision, ISS has indicated it will consider the company’s response, including engagement with major institutional investors, whether the issues are recurring or isolated, the company’s ownership structure and whether the say-on-pay vote received the support of less than 50% of the votes cast.

Shareholders, for the most part, approved their companies’ executive compensation proposals in 2013, often by wide margins. Of the Russell 3000 companies that held say-on pay votes between January 1, 2013 and September 2, 2013, 91% had their proposals passed with over 70% approval; 77% had approval rates of over 90%; and only 2.45% had their say-on-pay proposal fail. [1]

Companies should be aware that there have been several waves of litigation arising out of say-on- pay and proxy compensation disclosure. In the first wave, lawsuits were filed against a number of companies and their boards of directors where say-on-pay proposals failed to garner majority approval, alleging breaches of fiduciary duty. Subsequently there were suits alleging insufficient compensation disclosures in the proxy statements, seeking to enjoin the shareholder vote unless the company provided additional compensation disclosures. There have also been lawsuits challenging specific compensation actions, for example, based on failure to comply with Section 162(m) of the Internal Revenue Code. In addition to filed lawsuits, plaintiffs’ law firms have also announced “investigations” of executive compensation at a number of companies.

Even if plaintiffs are unsuccessful with their executive pay-related lawsuits, the costs of litigation can be expensive and may hurt the reputations of the defending companies and their compensation committee members and they may also be distracting to management. While many of these suits failed to prevail on the merits, there have been some victories for the plaintiffs, so public companies need to be aware of the potential for compensation-related lawsuits to be brought in connection with the 2014 proxy season. Compensation disclosures should be prepared, and compensation decisions should be made, with care, especially for companies that anticipate resistance to their say-on-pay proposals.

Outreach to key investors can be an important element of a successful say-on-pay vote. Before the proxy season gets fully underway, it would be worthwhile for the investor relations department to contact any large shareholders that voted against executive compensation at the last annual meeting to discuss the reasons for the negative vote. In order to avoid potential violations of the proxy rules, this dialogue should deal with the investor’s concerns, and should not involve any solicitation for the upcoming say-on-pay vote.

Say-When-on-Pay

Because the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) only requires companies to hold an advisory vote on the frequency of say-on-pay proposals (often called a “say-when-on-pay” vote) once every six years, it is likely that few companies will include a say-when-on-pay proposal in their 2014 proxy statements.

However, any company that has a management- sponsored say-when-on-pay proposal in its proxy statement must disclose the policy it adopts regarding the frequency of say-on-pay votes— after taking into account the shareholder advisory say-when-on-pay vote—no later than 150 calendar days after the annual meeting, but at least 60 calendar days prior to the company’s deadline for submission of shareholder proposals under Rule 14a-8 for the next annual meeting. This disclosure would generally be accomplished in the Form 8-K reporting voting results pursuant to Item 5.07 (or in an amendment to that filing).

Compensation Committee Independence and Compensation Consultants

In June 2013, the SEC approved the compensation committee listing standards contemplated by Dodd-Frank and Rule 10C-1 under the Securities Exchange Act of 1934 (Exchange Act). The new listing standards establish independence requirements for compensation committee members and require compensation committees to consider factors relevant to potential conflicts of interest on the part of compensation consultants, legal advisers and other compensation advisers. The NYSE and Nasdaq rules are similar in many respects, but are discussed separately below for convenience.

NYSE Requirements

NYSE Compensation Committee Independence Requirements. The NYSE added new subsection (ii) to Section 303A.02(a) of the NYSE listed company manual to address the enhanced independence requirements for compensation committee members. This new independence rule specifies that, in addition to existing requirements to determine the independence of any director who will serve on the compensation committee, the board of directors must consider:

  • all factors specifically relevant to determining whether a director has a relationship to the listed company which is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member, including, but not limited to:
    • (A) the source of compensation of such director, including any consulting, advisory or other compensatory fee paid by the listed company to such director; and
    • (B) whether such director is affiliated with the listed company, a subsidiary of the listed company or an affiliate of a subsidiary of the listed company.

With respect to compensation, the accompanying commentary makes clear that the board “should consider whether the director receives compensation from any person or entity that would impair his ability to make independent judgments about the listed company’s executive compensation.” The rule does not expressly require consideration of indirect compensation, such as compensation paid to a family member or to a related entity, but such compensation may need to be considered to the extent that it is relevant to determining whether a director has a relationship that is material to his or her ability to be independent from management. Unlike the Nasdaq rules discussed below, the NYSE listing rule does not make receipt of any type of compensation a bar to serving on the compensation committee if the board is satisfied that such director meets the requirements for independence.

Similarly, affiliate status is not a bar to compensation committee independence under the NYSE listing standards. The commentary directs boards of directors to consider whether an affiliate relationship places a director under the direct or indirect control of the company or its senior management—or creates a direct relationship between the director and members of senior management—of a nature that would impair the director’s ability to make independent judgments about the listed company’s executive compensation.

NYSE Compensation Adviser Requirements. The NYSE added new subsection (c) to Section 303A.05 of the NYSE listed company manual to specify the rights and responsibilities of the compensation committee with respect to compensation advisers, which now must be addressed in the compensation committee charter. These provisions give the compensation committee the sole discretion to retain or obtain the advice of a compensation consultant, independent legal counsel or other adviser. When the compensation committee retains such an adviser, it is directly responsible for appointing, compensating and overseeing the adviser’s work. The company must provide for appropriate funding, as determined by the compensation committee, for payment of reasonable compensation to an adviser retained by the compensation committee.

The compensation committee may select a compensation consultant, legal counsel or other adviser only after considering all factors relevant to independence from management, including the following:

  • The provision of other services to the company by the person that employs the compensation adviser;
  • The amount of fees received from the company by the employer of the adviser, as a percentage of the total revenue of such employer;
  • The policies and procedures of the adviser’s employer that are designed to prevent conflicts of interest;
  • Any business or personal relationship of the adviser with a member of the compensation committee;
  • Any stock of the company owned by the adviser; and
  • Any business or personal relationship of the adviser or the adviser’s employer with an executive officer of the company.

The NYSE listing standard requires consideration of all factors relevant to compensation adviser independence, not just the six factors enumerated above. If there is a circumstance that is relevant to determining whether a compensation adviser is independent from management, the compensation committee would need to consider it, regardless of whether it is included among the specific factors mentioned in the listing standards.

The compensation committee is required to conduct the independence assessment for any compensation consultant, legal counsel or other adviser that provides advice to the compensation committee, other than:

  • In-house legal counsel; and
  • Any compensation consultant, legal counsel or other adviser whose role is limited to:
    • consulting on any broad-based plan that does not discriminate in scope, terms or operation, in favor of executive officers or directors of the listed company, and that is available generally to all salaried employees; or
    • providing information that either is not customized for a particular company or that is customized based on parameters that are not developed by the compensation consultant, and about which the compensation consultant does not provide advice.

In its order approving the NYSE’s amended listing standards, the SEC stated that it “anticipates that compensation committees will conduct such an independence assessment at least annually.”

When adopting Rule 10C-1, the SEC emphasized that compensation committees are required to conduct this conflict of interest assessment regardless of whether the compensation committee or management retained the adviser.

The NYSE commentary makes clear that the listing standards relating to compensation advisers do not require the compensation committee to act consistently with the advice or recommendation of any compensation adviser. Furthermore, the commentary states that the new listing standards do not require a compensation adviser to be independent. The requirement is that the compensation committee must consider the enumerated independence factors before selecting or receiving advice from a compensation adviser. However, after considering these independence factors, the compensation committee may select or receive advice from any compensation adviser it prefers, including ones that are not independent.

NYSE Effective Dates. The amended NYSE listing standards are effective, but NYSE listed companies have until the earlier of their first annual meeting after January 15, 2014, or October 31, 2014, to comply with the new compensation committee independence requirements.

NASDAQ Requirements

Nasdaq Compensation Committee Requirements. Previously, Nasdaq did not require its listed companies to have a separate compensation committee—Nasdaq listing rules permitted executive compensation to be determined, or recommended to the board of directors, by a compensation committee consisting solely of independent directors or by independent directors constituting a majority of the board, with only independent directors voting. Under amended Rule 5605(d), Nasdaq requires listed companies to have a standing compensation committee, with a minimum of two members, each of whom are independent directors. The new listing rules also contain requirements for the charter of the compensation committee.

In addition to satisfying the general Nasdaq rules for director independence, Nasdaq Rule 5605(d)(2)(A) prohibits compensation committee members from accepting “directly or indirectly any consulting, advisory or other compensatory fee” from the company or any of its subsidiaries. For this purpose, compensatory fees do not include fees received as a director or board committee member, or fixed amounts under a retirement plan for prior service (as long as such compensation is not contingent upon continued service). Nasdaq’s position with respect to receipt of compensation is similar to the requirement of Exchange Act Rule 10A-3 with respect to audit committees, but, by prohibiting specific fees, it is more stringent than what is required for compensation committees by Rule 10C-1 or by the comparable NYSE listing standard.

Under Rule 5605(d)(2)(A), the board also will have to consider whether a director is affiliated with the company, a subsidiary of the company or an affiliate of a subsidiary of the company to determine whether such affiliation would impair the director’s judgment as a member of the compensation committee. However, affiliate status will not bar a determination of independence for a compensation committee member.

Nasdaq Compensation Adviser Requirements. Nasdaq Rule 5605(d)(3) gives the compensation committee the sole discretion to retain or obtain the advice of a compensation consultant, legal counsel or other adviser. It provides that the compensation committee is directly responsible for appointing, compensating and overseeing the work of any compensation consultant, legal counsel and other adviser it retains. The company must provide for appropriate funding, as determined by the compensation committee, for payment of reasonable compensation to a compensation consultant, legal counsel or any other adviser retained by the compensation committee.

Rule 5605(d)(3)(D) provides that the compensation committee may select, or receive advice from, a compensation consultant, legal counsel or other adviser to the compensation committee, other than in-house legal counsel, only after considering the following factors:

  • The provision of other services to the company by the employer of the compensation adviser;
  • The amount of fees received from the employer of the adviser, as a percentage of the total revenue of the employer;
  • The policies and procedures of the adviser’s employer that are designed to prevent conflicts of interest;
  • Any business or personal relationship of the adviser with a member of the compensation committee;
  • Any stock of the company owned by the adviser; and
  • Any business or personal relationship of the adviser or the adviser’s employer with an executive officer of the company.

In its order approving Nasdaq’s amended listing standards, the SEC stated that it “anticipates that compensation committees will conduct such an independence assessment at least annually.”

Unlike the corresponding NYSE listing standard which requires consideration of all relevant factors, Nasdaq only requires consideration of the six enumerated factors, without any requirement to consider any additional factors that might be relevant to compensation adviser independence.

The compensation committee is required to conduct the independence assessment with respect to any compensation adviser that provides advice to the compensation committee, other than in-house legal counsel. However, no independence assessment is required with respect to a compensation adviser that solely consults on any broad-based plan that does not discriminate in favor of executive officers or directors and that is available generally to all salaried employees, or that provides information that either is not customized for a particular issuer or is customized based on parameters that are not developed by the adviser, and about which the adviser does not provide advice.

When adopting Rule 10C-1, the SEC emphasized that compensation committees are required to conduct this conflict of interest assessment regardless of whether the compensation committee or management retained the adviser.

The compensation committee is not required to implement or act consistently with the advice or recommendations of any adviser. Nothing in the rule requires a compensation adviser to be independent; the rule only requires that the compensation committee consider the enumerated independence factors before selecting or receiving advice from a compensation adviser. After considering these independence factors, the compensation committee may select or receive advice from any compensation adviser it prefers, including ones that are not independent.

Nasdaq Effective Dates. Nasdaq listing standards relating to (i) the authority of a compensation committee to retain compensation consultants, legal counsel and other compensation advisers, (ii) the funding of such advisers and (iii) the compensation committee’s responsibility to asses the conflict of interest factors relating to such compensation advisers are effective. However, if the company does not yet have a compensation committee, these requirements will apply to the independent directors who determine, or recommend to the board for determination, executive officer compensation. Nasdaq companies must comply with the remaining provisions, including the compensation committee independence requirements, by the earlier of their first annual meeting after January 15, 2014, or October 31, 2014.

Nasdaq Certification Requirement. Nasdaq companies must certify their compliance with the new compensation committee rules to Nasdaq not later than 30 days after the applicable final implementation date. This is a new reporting requirement that Nasdaq companies will need to add to their corporate calendars. It is expected that Nasdaq will make the appropriate certification form for this purpose available by early 2014.

Disclosure of Compensation Consultant Conflicts of Interest

When it adopted Rule 10C-1, the SEC also expanded Item 407(e)(3) of Regulation S-K to require disclosure of compensation consultant conflicts of interest.

Item 407(e)(3)(iii) of Regulation S-K already required companies to disclose the role of compensation consultants in determining or recommending the amount or form of executive and director compensation. Companies must identify the consultants, state who retained the consultants, describe the nature and scope of the assignment and, in certain circumstances, disclose the aggregate fees paid to the consultants.

If any compensation consultants whose work must be disclosed pursuant to Item 407(e)(3)(iii) have a conflict of interest, Item 407(e)(3)(iv) requires disclosure of the nature of such conflict and how the conflict is being addressed, regardless of whether the compensation committee, management or any other board committee retained the consultant. In determining whether a conflict of interest exists for disclosure purposes, companies should consider the same factors that Rule 10C-1 requires compensation committees to consider when hiring compensation consultants, which are the same factors that the NYSE and Nasdaq rules discussed above specify.

Companies are not required to disclose potential conflicts of interest or of an appearance of a conflict of interest in their proxy statements. Disclosure is only required if a compensation consultant has an actual conflict of interest. Consulting on broad-based plans and providing non-customized benchmark data does not require conflict of interest disclosure under this rule.

This conflict of interest disclosure is limited to compensation consultants; no disclosure is required with respect to other compensation advisers (such as outside legal counsel).

NYSE Quorum Requirement Change

Section 312.07 of the NYSE listed company manual establishes voting requirements for shareholder proposals where shareholder approval is a prerequisite to the listing of any additional or new securities, such as approval of certain issuances of stock or equity compensation plans. Previously, in addition to requiring approval by a majority of votes cast on the proposal, this listing standard required a quorum such that the total vote cast on the proposal represented over 50% in interest of all securities entitled to vote on the proposal. On July 11, 2013, the SEC approved a rule change to remove the mandated quorum. [2] Accordingly, Section 312.07, as amended, now reads:

Where shareholder approval is a prerequisite to the listing of any additional or new securities of a listed company, or where any matter requires shareholder approval, the minimum vote which will constitute shareholder approval for such purposes is defined as approval by a majority of votes cast on a proposal in a proxy bearing on the particular matter.

As a result of this change, companies including proposals in their proxy statements that are subject to the NYSE stockholder approval policy no longer have to disclose and calculate a separate quorum requirement for such agenda item. They can instead rely on the general requirements of their by-laws and governing law to determine if the required vote has been obtained.

Pending Dodd‐Frank Regulation

Proposed Pay Ratio Disclosure Rules. On September 18, 2013, the SEC proposed ray ratio disclosure rules pursuant to a Dodd-Frank mandate. [3] Pay ratio disclosure will not be required for the 2014 proxy season. The earliest that pay ratio disclosure is likely to be required is the 2016 proxy season (with respect to 2015 compensation.) However, public companies should familiarize themselves with the proposal and determine whether they want to submit comments to the SEC in an effort to shape the final rule.

Under the pay ratio proposal, public companies would have to disclose the median of the annual total compensation of all employees other than the chief executive officer, the annual total compensation of the chief executive officer and the ratio of these amounts. As proposed, smaller reporting companies, emerging growth companies and foreign private issuers would not be subject to the pay ratio disclosure requirement.

The proposed disclosure covers all employees of the company and its subsidiaries as of the last day of the prior fiscal year, including employees based outside of the United States, part-time employees, temporary employees and seasonal employees. Companies would be permitted to annualize the compensation of a full-time employee who did not work the entire year. However, for the purposes of the proposed rule, the compensation of temporary or seasonal workers may not be annualized; part-time employee compensation may not be measured on a full-time equivalent basis; and cost-of living adjustments may not be made for non-U.S. employees.

Although the proposal specifies that the median of the annual total compensation of all employees must be disclosed, the instructions to proposed Item 402(u) of Regulation S-K would permit companies flexibility to select a method for identifying the median employee that is appropriate to the size and structure of their businesses and compensation program. While companies would be permitted to identify the median based on total compensation regarding their full employee base, they alternatively may do so by using a statistical sample of their employee population. The proposed rules do not define the term median employee, but the proposing release explains that “identifying the median involves finding the employee in the middle.”

Companies could identify the median employee based on annual total compensation as determined under existing executive compensation rules. Alternatively, companies could identify the median employee based on any consistently used compensation measure, such as compensation amounts reported in its payroll or tax records, in which case they would then need to calculate the annual total compensation for that median employee in accordance with the SEC’s executive compensation rules.

Under the proposal, companies could use reasonable estimates to calculate annual total compensation or any element of such compensation. Reasonable estimates would also be permitted to calculate the annual total compensation of the median employee.

The only required narrative disclosure would be a brief, non-technical overview of the methodology used to identify the median, and any material assumptions, adjustments or estimates used to identify the median or to determine total compensation or elements of total compensation. Companies would have to clearly identify any estimated amounts. Additional disclosure, including additional ratios, would be permitted.

Pay-for-Performance. Dodd-Frank requires the SEC to adopt rules regarding pay-for- performance. Under these rules, companies will have to disclose material information that shows the relationship between executive compensation actually paid and the financial performance of the company, taking into account any change in the value of the company’s stock and the dividends paid by the company. The SEC has not yet proposed rules for this disclosure requirement and is not currently publishing a target time frame for such a proposal. It is unlikely that a rule on this subject could be proposed and finalized in time to impact the 2014 proxy season. However, it is important to monitor this rulemaking process, particularly since it is possible that the final disclosure requirements might influence upcoming decisions to be made by compensation committees.

Hedging. The SEC still needs to propose regulations to implement the Dodd-Frank requirement for companies to disclose whether employees and directors are permitted, directly or indirectly, to hedge the market value of securities granted as compensation. Companies are already required to disclose any policies regarding hedging the economic risk of owning company securities pursuant to Item 402(b)(2)(xiii) of Regulation S-K. Companies may wait until the SEC adopts final rules before adopting or amending a hedging policy that is designed to be responsive to the Dodd-Frank hedging requirement, although ISS’s position on hedging policies has prompted some companies to prohibit directors and executive officers (and sometimes employees in general) from engaging in hedging transactions with respect to such companies’ stock.

Clawbacks. Under Dodd-Frank, the SEC must direct stock exchanges to prohibit listing if a company does not develop a policy with respect to recovery of incentive-based compensation in certain circumstances. Unlike the comparable Sarbanes-Oxley Act provision, under Dodd- Frank, the clawback policy will need to cover both current and former executive officers, not just the chief executive officer and the chief financial officer. The Dodd-Frank clawback provision applies to any accounting restatement due to material non-compliance, whether or not the executive officer is responsible for the misconduct that led to the misstatement. This is another important area to follow closely, involving both SEC and stock exchange rulemaking. Companies may wait for the final rules before adopting or amending a clawback policy for the purposes of complying with this Dodd-Frank requirement (although some companies may choose to adopt some form of clawback provision before then, to the extent they perceive a corporate governance benefit from doing so).

Proxy Access

The U.S. Court of Appeals for the District of Columbia vacated Rule 14a-11 under the Exchange Act, which was the SEC’s proxy access rule. This rule would have required public companies to include shareholder nominees for director in company proxy materials in certain circumstances. Although its proxy access rule was vacated, the SEC’s related amendment of Rule 14a-8 (the shareholder proposal rule) is effective. As amended, Rule 14a-8(i)(8) no longer provides a basis for companies to exclude from their proxy materials shareholder proposals to amend governing documents relating to nomination procedures implementing proxy access or disclosures relating to shareholder nominations, subject to specified exceptions in the rule.

As a result of the SEC’s proxy access rule being struck down, proxy access is now addressed, if at all, on a company-by-company basis through the shareholder proposal mechanism—a procedure sometimes referred to as private ordering. While nomination procedures no longer provide grounds to exclude proxy access shareholder proposals, other grounds for excluding shareholder proposals from an issuer’s proxy statement apply to proxy access proposals, when applicable.

During the 2012 proxy season, some proxy access proposals were successfully excluded because they (i) contained multiple proposals, (ii) described ownership requirements by cross- referencing SEC rules in a manner that made the proposal impermissibly vague or (iii) created conflicts with existing by-law provisions. While there was some expectation that the 2013 proxy season would see a flurry of proxy access proposals designed to respond to the issues that permitted companies to exclude proxy access proposals from proxy statements in 2012, relatively few proxy access proposals were submitted by shareholders for inclusion in 2013 proxy statements.

The proxy access shareholder proposals that were submitted in 2013 had varying ownership requirements for proxy access eligibility. One category of proposals required ownership of 1% of the company’s stock for one year. Another required either one or more holders to own between 1% and 5% of the company’s stock for two years or 50 or more holders to each own stock worth at least $2,000 with aggregate ownership for at least one year of between 0.5% and 5% of the company’s stock. A third had a 3% ownership threshold for three years, similar to the SEC rule that was struck down. Two proxy access shareholder proposals received majority support in 2012 (Nabors Industries and Chesapeake Energies) and two more in 2013 (Verizon Communications and CenturyLink). These four proposals that garnered majority approval in the last two proxy seasons each used the 3%/ three-year ownership threshold and holding period.

A company receiving a proxy access shareholder proposal for its 2014 proxy statement should promptly evaluate it for procedural deficiencies— such as being received after the deadline, being submitted by someone who does not meet the eligibility requirements, being too long or constituting multiple proposals—so that the company has time to comply with the steps necessary to seek exclusion of the proposal from its proxy statement on procedural grounds. The company should also analyze whether any of the non-procedural bases set forth in Rule 14a-8 provide an argument for exclusion of the specific proposal received.

If a company receives a proxy access shareholder proposal that is not excludable from its proxy statement on other grounds, it may want to consider including a management proxy access proposal in its proxy statement containing terms that it finds more acceptable. A shareholder proposal is excludable if it conflicts with a management proposal appearing in the same proxy statement. Before taking that step in response to a proxy access shareholder proposal, however, a company may want to assess with a proxy solicitor and/or its investor relations department what the likelihood would be for that shareholder proposal to be approved. If the proxy access shareholder proposal is not likely to garner sufficient support, the company may not want to offer a management proposal that is likely to be approved. Also, such companies should realize that even if they are able to exclude a proxy access shareholder proposal by including a management proposal on the same subject, shareholders in future years could submit proposals to amend the proxy access provisions so adopted.

Specialized Disclosures

Conflict minerals. As required by Dodd-Frank, the SEC adopted a final rule regarding disclosure of the use of conflict minerals originating in the Democratic Republic of the Congo or an adjoining country. The conflict minerals disclosure rule applies to any company that files reports with the SEC under Section 13(a) or Section 15(d) of the Exchange Act if conflict minerals are necessary to the functionality or production of a product manufactured or contracted to be manufactured by that company. The disclosure requirements apply to foreign private issuers, as well as to domestic issuers and to smaller reporting companies. There is no de minimis exception. The SEC’s conflict minerals rule recently survived a court challenge. Although the National Association of Manufacturers, the Chamber of Commerce and Business Roundtable have filed an appeal of the district court ruling, companies affected by the rule should not wait for the ultimate outcome, which may not come for a while and which ultimately may not overturn the SEC rule.

The centerpiece of the final conflict minerals rule is Form SD, a new form created specifically for specialized disclosures. Form SD, if required for conflict minerals disclosure, is prepared on a calendar year basis, regardless of a company’s fiscal year, and is due on May 31 of each year, commencing May 31, 2014. Depending on the factual circumstances, a company may be required to engage in supply chain due diligence, obtain an independent private sector audit relating to its due diligence and prepare a Conflicts Mineral Report as an exhibit to its Form SD filing. To be in a position to comply with the new rule by the required date of May 2014, public companies whose use of conflict minerals triggers the rule’s disclosure requirements need to move forward with their preparations to make this new annual filing, even though litigation is ongoing. Companies subject to the rule should implement conflict minerals disclosure controls and procedures relating to this rule.

Determining whether, and to what extent, a company is required to make conflict minerals disclosure involves a three-step process. The first step involves an analysis of whether a company is subject to the rule. If so, the second step is to conduct a reasonable country of origin inquiry to determine whether the conflict minerals originated in the Democratic Republic of the Congo or an adjoining country. Depending upon the outcome of that inquiry, the company may be required to proceed to the third step, which involves supply chain due diligence and may require the preparation of a Conflict Minerals Report. For more information regarding the conflict minerals disclosure rules, see our Legal Update dated September 5, 2012, entitled “US Securities and Exchange Commission Adopts Final Conflict Minerals Disclosure Rule.” [4]

]In May 2013, the SEC’s Division of Corporation Finance provided guidance on the conflict minerals rules in the form of frequently asked question. For a description of that guidance, see our Legal Update dated June 5, 2013, entitled “Securities and Exchange Commission Provides Guidance on Conflict Minerals and Resource Extraction Payments Disclosure.” [5]

Resource Extraction Payments Disclosure. The SEC adopted its resource extraction payments disclosure rule pursuant to the directive contained in Dodd-Frank, which added Section 13(q) to the Exchange Act. On July 2, 2013, the United States District Court for the District of Columbia vacated SEC Rule 13q-1, which required certain companies to disclose payments made to governments in connection with the commercial development of oil, natural gas or minerals. [6] This decision was rendered in American Petroleum Institute, et al. v. Securities and Exchange Commission and Oxfam America, Inc., Civil Action No. 12-1668.

The court vacated the SEC resource extraction payments disclosure rule because it found that the SEC made two substantial errors. According to the court:

  • The SEC misread Dodd-Frank as mandating public disclosure of the resource extraction payments reports, and
  • The SEC’s decision to deny any exemption for disclosures prohibited by foreign law was, given the limited explanation provided, arbitrary and capricious.

The court remanded the rulemaking to the SEC for further proceedings.

The SEC has announced that it will not appeal the court’s decision. Therefore, at the present time, there is no requirement to file a Form SD to report resource extraction payments. However, there have been recent media reports suggesting that the SEC is working on revised resource extraction payments disclosure rules. Issuers that were impacted by this Dodd-Frank regulatory requirement should continue to monitor developments in this rulemaking process for further developments.

SEC Interpretations Impacting Reporting

Cybersecurity. Although there are no current disclosures rules expressly relating to cybersecurity, the staff of the SEC’s Division of Corporation Finance (Staff) identified existing regulations that it believes can require disclosure of cybersecurity risks and cyber incidents in CF Disclosure Guidance: Topic No. 2, entitled “Cybersecurity.” [7] For example, the Staff stated that if the risk of cyber incidents is among the most significant factors that make an investment in the company’s securities risky, cybersecurity should be disclosed as part of risk factors. The cybersecurity risk disclosure would need to describe the nature of the material risks in this area and how each such risk affects the company. To place the risk in context, the company may need to disclose known or threatened cyber incidents.

According to the Staff’s cybersecurity disclosure guidance, cybersecurity risks and cyber incidents would need to be described in the management’s discussion and analysis if the costs or other consequences represent an event, trend or uncertainty that is reasonably likely to have a material effect on results of operations, liquidity or financial consideration, or cause reported financial information to be not indicative of future results or conditions. Management’s discussion and analysis disclosure would also be needed if it is reasonably likely that a cyber attack could lead to reduced revenues or increased protection costs, if material. If a company’s products, services, customers or supply relationships or competitive conditions are materially affected by cyber incidents, disclosure would be needed in the business section.

The Staff noted that litigation regarding a cyber incident may need to be disclosed. The Staff also identified situations that could require disclosures in financial statements prior to, during or after a cyber incident. If cyber incidents pose a risk to a company’s ability to record, process, summarize and report information required in SEC filings, the Staff suggested that management should consider whether there are any deficiencies in the company’s disclosure controls and procedures that need to be addressed.

After issuing its cybersecurity guidance, the Staff reviewed public company disclosures for compliance with this guidance and issued comments relating to cybersecurity matters to about 50 public companies of various sizes and industries. In issuing cybersecurity comments, the SEC not only reviewed disclosures contained in filed periodic reports, but, in some cases, based comments on other public information, such as material posted on the company’s website. [8]

According to a letter dated May 1, 2013 from SEC Chair Mary Jo White to Senator John D. Rockefeller IV, Chairman of the Senate Committee on Commerce, Science and Transportation, the Staff continues to prioritize cybersecurity disclosure as important and to issue comments in this area.

When preparing upcoming annual reports, it would be prudent for public companies to review the Staff’s cybersecurity guidance to determine whether cybersecurity is a topic that they need to address.

Sovereign Debt. In CF Disclosure Guidance: Topic No. 4, entitled “European Sovereign Debt Exposures,” [9] the Staff provided disclosure guidance directed at financial institutions regarding debt exposure in European countries experiencing a higher risk of default. The Staff indicated that such exposure should be provided separately by country, with sovereign and non-sovereign exposures segregated. The Staff also suggested that companies consider separately disclosing their gross unfunded commitments. Finally, the Staff suggested that companies provide information regarding hedges in order to present an amount of net funded exposure.

The guidance suggested specific items to be considered with respect to gross funded exposure (including countries, type of counterparty and categories of financial instruments), unfunded exposures, total gross exposures (funded and unfunded), effects of credit default protection to arrive at next exposure, other risk management disclosures and post-reporting date events. Companies with direct or indirect exposures to sovereign debt should review this guidance when preparing their upcoming annual reports.

Non-GAAP Financial Measures in CD&A. According to Instruction 5 to Item 402(b) of Regulation S-K, “[d]isclosure of target levels that are non-GAAP financial measures will not be subject to Regulation G and Item 10(e); however, disclosure must be provided as to how the number is calculated from the registrant’s audited financial statements.” In Regulation S-K compliance and disclosure interpretation number 118.08, the Staff made clear that this instruction is limited to CD&A disclosure of target levels that are non-GAAP financial measures. In May 2013, the Staff issued Regulation S-K compliance and disclosure interpretation number 118.09, extending this instruction to the disclosure of the actual results of the non-GAAP financial measure that is used as a target, provided that this disclosure is made in the context of a discussion about target levels.

If non-GAAP financial measures are presented in CD&A or in any other part of the proxy statement for any purpose other than with respect to the disclosure of target levels, then those non-GAAP financial measures are subject to the requirements of Regulation G and Item 10(e) of Regulation S-K. For pay-related circumstances only, the Staff stated that it will not object if a registrant includes the required GAAP reconciliation and other information in an annex to the proxy statement, provided that the registrant includes a prominent cross- reference to such annex. If the non-GAAP financial measures are the same as those included in the Form 10-K that is incorporating the proxy statement’s executive compensation disclosures by reference, the Staff stated that it will not object if the registrant complies with Regulation G and Item 10(e) by providing a prominent cross-reference to the pages in the Form 10-K containing the required GAAP reconciliation and other information. [10]

Iran Sanctions Disclosure

The Iran Threat Reduction and Syria Human Rights Act of 2012 (ITRA) requires any company that is required to file annual or quarterly reports under Section 13(a) of the Exchange Act (which includes companies listed on a U.S. securities exchange) to disclose in those reports whether, during the period covered by the subject report, it or any affiliate has knowingly engaged in certain sanctionable activities relating to:

  • Development of Iran’s petroleum resources, production of refined petroleum products in or exportation of refined petroleum products from Iran, or development of Iran’s weapons of mass destruction (WMD) or other military capabilities, as described in Section 5(a) or (b) of the Iran Sanctions Act of 1996;
  • Financial institutions facilitating terrorist organizations or acts, sanctioned-party activities, WMD development or other prohibited activities in Iran as described in the Comprehensive Iran Sanctions, Accountability, and Divestment Act of 2010 (CISADA);
  • Financial institutions engaging in transactions benefitting the Iranian Revolutionary Guard Corps, as described in Section 104(d)(1) of CISADA;
  • Transfers of goods or technologies to Iran that are likely to be used to commit human rights abuses, as described in Section 105A of CISADA;
  • Transactions with terrorists whose property is blocked pursuant to Executive Order 13224;
  • Transactions with WMD proliferators whose property is blocked pursuant to Executive Order 13382; and
  • Transactions with the government of Iran as defined in Section 560.405 of Title 31 of the Code of Federal Regulations, without specific authorization of the government of the United States.

ITRA’s Disclosure Requirements. ITRA requires disclosure even when the actions did not violate any provision of U.S. law. There is no materiality threshold. The required disclosure must include a description of each such activity, specifying the nature and extent of the activity, the gross revenues and net profits attributable to the activity, if any, and whether the issuer or affiliate intends to continue the activity.

If an issuer is required to report this activity in its annual or quarterly report, it must also separately file with the SEC, at the same time it files its annual or quarterly report, a notice that such disclosure is contained in the report. Upon receiving such a notice, the SEC must promptly transmit the report to the President and to certain House and Senate committees. Upon being so notified, the President must initiate an investigation to determine whether the reported activities violate any Iran sanctions and accordingly penalties should be imposed as a result of the reported activities.

ITRA imposes disclosure obligations with respect to affiliates, not just entities controlled by a public company. The Division of Corporation Finance issued a compliance and disclosure interpretation specifying that, for the purposes of ITRA, “affiliate” is defined as it is in Rule 12b-2 under the Exchange Act, which covers any “person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the person specified.” Because such a broad definition applies, public companies may regularly need to determine whether any activities outside of their consolidated group are subject to disclosure under ITRA.

Because the activities identified above must be reported in annual reports, the disclosure will be subject to liability under Section 18 of the Exchange Act and covered by the chief executive officer and chief financial officer certifications. Therefore, public companies should consider whether they need to adopt a disclosure control designed to determine if any reportable activities by affiliates have occurred.

The disclosure obligation imposed by ITRA is an ongoing one, applicable both to annual and quarterly reports.

Precedent ITRA Disclosures. Precedent ITRA disclosure can now be found in both annual reports and quarterly reports filed with the SEC. [11] Many disclosures reported that the activities described were conducted by non-U.S. companies, such as subsidiaries, sister companies or other affiliates. The disclosures often emphasized that the activities conducted complied with applicable law.

Some ITRA disclosures specified that the activities described were initiated by a company prior to its acquisition by the reporting issuer or that the activities occurred prior to ITRA’s enactment. In many situations, issuers disclosed a decision to cease such activities. However, some companies stated an intention to continue activities to the extent permitted by applicable law.

The breadth of the affiliate requirement led some companies with significant shareholders to disclose activities conducted by other companies in which such shareholders also had a significant investment and/or board seats.

In some cases, the disclosure was accomplished by quoting the ITRA disclosure from the other company’s SEC filing. In other situations, the reporting company provided disclosures based on information received from its significant shareholder, or from the other company, noting if it had not been given specific information, such as with respect to revenues generated from the activities.

Because there is no specified location for the ITRA disclosure, companies have presented it as components of various items of the applicable report, including the business section, risk factors or legal proceedings in the applicable SEC report or separately in the “other information” item or at the end of part I of form 10-K.

XBRL

The staff of the SEC’s Division of Risk, Strategy, and Financial Innovation has published several observations from reviews of interactive financial data. These reports provide useful guidance regarding practices for implementing XBRL. In addition, both the Division of Corporation Finance and the Office of Interactive Disclosure have published FAQs, providing an ongoing resource. [12] The Office of Interactive Disclosure has updated its XBRL FAQs in 2013.

When XBRL rules first became mandatory, Item 406T of Regulation S-T provided a temporary exemption from liability for the interactive data files where there was a good faith attempt to comply with the rule and a prompt amendment upon the filer becoming aware of non-compliance. However, Item 406T was expressly made a temporary section and it expires on October 31, 2014. Therefore, it will not be available for filings in the upcoming annual reports. Item 406T had provided liability protection only for interactive date files submitted to the SEC less than 24 months after the electronic filer first was required to submit an interactive data file to the SEC, not taking into account any grace period. Companies providing interactive data should recognize that XBRL compliance errors could potentially give rise to liability under the same liability provisions as the SEC filing to which the interactive data files are submitted as an e-file.

PCAOB Audit Committee Communications Requirements

In August 2012, the Public Accounting Oversight Board adopted Auditing Standard No. 16, Communications with Audit Committees and the SEC approved it in December 2012. Auditing Standard No. 16 superseded AU section 380, Communication With Audit Committees, and AU section 310, Appointment of the Independent Auditor. This new auditing standard is effective for audits of the 2013 fiscal year.

For further information about the new PCAOB audit committee requirements, see our Legal Update dated August 27, 2012 entitled “Public Accounting Oversight Board Pronouncements Regarding Communications with Audit Committees and PCAOB Inspection Information.” [13]

Director and Officer Questionnaires

Companies should include a question on their directors and officers questionnaires to determine if their directors or officers have any business or personal relationships with a compensation consultant retained, or proposed to be retained, by the company or the compensation committee.

Questions should be included in the directors and officers questionnaires to elicit information concerning the source of compensation committee members’ compensation and whether a compensation committee member is affiliated with the company, any subsidiaries of the company or any affiliate of a subsidiary of the company.

As a disclosure control with respect to ITRA, companies may want to add questions to their directors and officers questionnaires addressing the sanctionable activities identified by that act. Because the directors and officers may be construed as affiliates, the questions should ask about their activities, as well as what they know about company activities, with respect to Iran.

E-proxy

For the past five proxy seasons, companies have had the “e-proxy” option, pursuant to which they could use a notice and access procedure under which they could reduce mailing and printing costs by posting their proxy materials on an Internet site meeting the specifications set forth in Exchange Act Rule 14a-16 and sending shareholders a notice that the proxy materials were so available. Companies may also continue to use the traditional method of mailing full copies of proxy materials to shareholders or they may use a stratified approach relying on notice and access for certain shareholders and full delivery for other shareholders. Any shareholder who so requests is entitled to paper copies, even if the company otherwise uses the notice and access model.

Since it became available, e-proxy has been growing in popularity, especially among companies that have a large shareholder base and therefore stand to realize greater cost savings. One concern about its use is the requirement that the notice needs to go to shareholders, and the proxy materials must be filed and available on the Internet, at least 40 days prior to the meeting date. Some companies may find it difficult to meet this deadline, particularly if they have one or more proposals requiring a preliminary filing at least 10 days before the proxy materials are mailed or posted. If a company mails full proxy materials to all its shareholders, it has greater flexibility for its timetable for finalizing its proxy statement.

If a company plans to use the notice and access method for proxy materials, it should be sure all persons involved in the information-gathering process, including those responsible for compiling executive compensation and related person transaction disclosure, are informed of their deadlines in sufficient time to accommodate the e-proxy timetable.

Companies are not bound by a prior year’s choice of proxy delivery method. Therefore, even if a company has used the notice and access method in the past, it can choose to rely on full delivery of proxy materials in a year when it anticipates that it may have difficulty in finalizing the documents in time to meet the e-proxy deadline or when it is concerned about quorum or voting levels.

Retail voting generally has been lower when proxy materials have been delivered by notice and access as opposed to full printed copies being delivered to all shareholders. Under the e-proxy rules, companies can provide different methods of delivery to different shareholders. Therefore, as a partial solution to this problem, companies concerned about a decline in retail voting may stratify their proxy delivery methods, sending full proxy materials to retail shareholders holding a specified number of shares, and relying on notice and delivery for shareholders with smaller positions who may be less likely to vote in any event. A reminder mailing may be another way to boost the retail vote.

Endnotes:

[1] See Semler Brossy “2013 say on pay results,” September 4, 2013, available at http://www.semlerbrossy.com/wp-content/uploads/2013/09/SBCG-2013-Say-on-Pay-Report-2013-09-4.pdf.
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[2] See http://www.sec.gov/rules/sro/nyse/2013/34-69970.pdf.
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[3] Available at http://www.sec.gov/rules/proposed/2013/33-9452.pdf.
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[4] Available at http://www.mayerbrown.com/US-Securities- and-Exchange-Commission-Adopts-Final-Conflict-Minerals-Disclosure-Rule-09-05-2012.
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[5] Available at http://www.mayerbrown.com/files/Publication/583aae6d-7f47-4138-a4fc-be72d92650a4/Presentation/PublicationAttachment/0418c673-ab94-40c9-8aa1-c95203e98756/UPDATE-Corp_Conflict_Minerals_0613_V4.pdf.
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[6] The Court’s Memorandum Opinion is available at https://ecf.dcd.uscourts.gov/cgi-bin/show_public_doc?2012cv1668-51.
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[7] Available at http://www.sec.gov/divisions/corpfin/guidance/cfguidance-topic2.htm.
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[8] For example, Amazon, American International Group, Google, Eastman Chemical, Hartford Financial Services Group and Quest Diagnostics each received cybersecurity comments from the SEC during 2012.
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[9] Available at http://www.sec.gov/divisions/corpfin/guidance/cfguidance-topic4.htm.
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[10] See http://www.sec.gov/divisions/corpfin/guidance/regs-kinterp.htm.
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[11] It is relatively easy to locate precedent for these disclosures by searching for these notices on the SEC’s web site. For example, click on the advanced search page of the EDGAR full text search (http://searchwww.sec.gov/EDGARFSClient/jsp/EDGAR_MainAccess.jsp) and, select “IRANNOTICE” in the drop down menu of the form box to pull up the list of companies that filed such notices.
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[12] See http://www.sec.gov/divisions/corpfin/guidance/interactivedatainterp.htm and
http://www.sec.gov/spotlight/xbrl/staff-interps.shtml.
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[13] Available at http://www.mayerbrown.com/Public-Accounting-Oversight-Board-Pronouncements-Regarding-Communications-with-Audit-Committees-and-PCAOB-Inspection-Information-08-27-2012/.
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