Pre-Flight Checklist: 2014 Update

In this year’s Foreword, Dougherty differentiates the need for directors to focus on their core mission of informed oversight and vigilance rather than merely reacting to the constant influx of “daily corporate governance commentary,” and explores other front-burner issues, such as the marked increase in SEC enforcement actions and other recent SEC initiatives; the continuing trend of class action suits as de facto settlement instruments; proxy advisory firm priorities for directors; and new guidance from the Public Company Accounting Oversight Board (PCAOB) that recommends that audit committee directors discuss internal auditing deficiencies with their auditors.

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When you prepare to fly in a small plane, you can’t help but watch over the pilot’s shoulder as that epauletted left arm reaches for a coffee-stained, laminated card tucked into the nook between the instrument panel and the sloping cockpit ceiling. While your pilot dutifully reads through the smudged list and scans various gauges, buttons and levers, thoughts and questions come to mind. You wonder if the plane could possibly be as ancient as the crumpled card, or whether this valued checklist ever gets updated as FAA rules evolve, or whether the small air carrier will ever buy a new plane. Once in the air, you sit back and dismiss these interesting questions—until the very next flight.

As a director, it is helpful to review a checklist of recent developments on a regular basis, and compare it to your company’s own practices. Yet, in that regard, you know that you need to be careful.

There are so very many “daily,” “weekly,” “monthly,” and “special” updates from the burgeoning “corporate governance online consultancy” that you might think that director principles are as ephemeral as mayflies, or that understanding the latest proxy advisory service priority item is congruent with a director’s mission.

In reality, the director’s mission of informed oversight, vigilance and energetic development of a collective vision for the enterprise has more to do with demonstrating enduring fundamentals (fostering innovation, manifesting integrity) than reacting to daily corporate governance commentary.

Your role is well-suited to a yearly pre-flight check that melds the new with the tried and true. The following sections of this Foreword address a list of 2014 updates (in order of personal interest) as prelude to the updated chapters that follow. Safe flight.

The SEC Surge

The SEC’s budget in 1988 was $135.2 million. In 2013, it was $1.26 billion. Although much media attention has focused on whether particular individuals are enforcement targets, the fact is that SEC enforcement actions have burgeoned. With over $10 billion in disgorgement and penalties collected by the SEC from 2002-2007 alone, nearly 1,300 companion criminal convictions from 2002-2008 (including 200 CEOs) and with more than 90 percent of managers who were identified as culpable by government enforcers losing their jobs in that 2002-2008 period, the SEC enforcement surge is underrecognized. The SEC also acts as a surrogate for private class action lawsuits, using penalties or disgorgement powers to compensate allegedly defrauded private investors. Under the Sarbanes-Oxley Act enforcement authority, in 2009 alone, more than $2 billion was paid to investors. Under the Dodd-Frank Act, this SEC surge continues unabated now that the SEC’s Whistleblower rules are well into their implementation phase following adoption last year. (See Chapter 4, Section 4.1.6.)

The Class Action Scourge

Meanwhile, securities class actions continue to be de facto private settlement instruments in which trials rarely occur and in which one set of shareholders effectively pays another. From 1996 through 2013, of the 4,226 securities class actions filed, according to National Economic Research Associates, only 14 were tried to verdict, with no verdicts in 2012 and no trials at all in 2013 . During those years, settlements totaled more than $79.5 billion according to the same study. Settlements are funded at about a 70 percent/30 percent rate by insurers and companies, with indemnification of individual defendants in settlement being the norm. (See Chapter 7.)

Much Ado About Something

This year, the U.S. Supreme Court will hear oral argument in the Halliburton case. That appeal asks the high court to overrule (or curtail) its own 1988 decision (Basic Inc. v. Levinson), which opened the floodgates of private securities class actions against issuers, officers, directors, auditors and other advisers. The question is whether investors who buy shares in the stock market may bring federal securities fraud claims even if they did not read and rely on the allegedly misleading statement (which a four justice plurality allowed in the 1988 Basic decision) so long as they bought in an “efficient” market and presumably relied on market price to reflect the challenged company data. Today, investors can sue for federal securities fraud concerning most exchange-traded securities without having to even have been aware of, or have glanced at, the challenged company disclosure. If the Supreme Court now recants or curtails this preferred status, the flood-tide of securities class action settlements may begin to ebb later in 2014.

Other SEC Initiatives

Beyond the SEC Surge, the Class Action Scourge and Much Ado About Something, be mindful of some quieter but no less important initiatives by the SEC’s Division of Corporate Finance. The proliferating use of non-GAAP financial measures has caught SEC attention, especially the need to explain why items are included or excluded from non-GAAP data points. Non-GAAP figures such as EBITDA (which depart from Generally Accepted Accounting Principles (GAAP)) tend to exclude costs that could distract from highlighting a particular aspect of the business. Where certain costs associated with employee retirement plans (e.g. deferred benefit plan adjustments) or acquisitions (layoff charges) are excluded from presentations, the SEC has taken the view that explanation of the reasoning for doing so is needed, not merely inclusion of the full GAAP numbers themselves. Non-GAAP versus GAAP profit measure differentials are significant: in 2012, for tech companies in the S&P index, non-GAAP earnings exceeded GAAP reported earnings by more than $40 billion according to The Analyst’s Accounting Observer online research service. Consequently, it is important for directors to see (and the proxy statement to explain) how various non-GAAP measures are defined.

Lastly, note that the SEC published its report on how companies may use social media channels to disseminate company information, rather than relying merely on an old fashioned corporate press release. (See: http://www.sec.gov/litigation/investreport/34-69279.pdf.)

Proxy Advisory Firm 2014 Focus List

I do not want to suggest that proxy advisory firm agendas are irrelevant to director duties. I merely observe that corporate governance begins and prospers from within, and that there exists no empirical evidence that any of the advisory firm hot buttons (staggered boards, say-on-pay micro-metricsmithing, withhold vote protocols, and so on) are well-correlated with superior long-term financial performance. After a decade’s advisory firm onslaught of shareholder proposal recommendations, only ten percent of S&P 500 companies now have staggered boards; shareholder rights plans (except those plans adopted in medias res of a takeover and having limited duration) are disfavored; and compensation committee time devoted to parsing changing advisory firm methodologies is reaching headache levels.

For 2014, proxy advisory firm priorities include:

• Most importantly, for shareholder meetings that take place after February 1, 2014, the ISS proxy advisory firm will recommend to shareholders that they vote against or withhold votes from individual director nominees, committee members or full board nominee slates, if the board failed to act upon any precatory shareholder proposal that received a majority of shares cast in the prior year—just one year (not two successive years, as in the past). Moreover, ISS intends to respond to any board that less than fully implemented any such shareholder suggestions by assessing such factors as: the board’s reasoning for not fully implementing the suggestion(s); the board’s dialogue with shareholders; the subject matter of the proposal (one would hope so!); prior shareholder votes, if any, and so on. If your company’s 2013 proxy had a shareholder proposal that garnered a majority of votes cast, be mindful. And if you have precatory shareholder proposals in 2014 (or subsequently), be mindful that a majority “precatory” vote today can become a “recommendation against” director(s) who opposed it tomorrow.
• Almost three-quarters of say-on-pay proposals received 90 percent or better shareholder support in 2013, little changed from 2012. One phenomenon worth mention is the number of companies that criticized advisory firms’ mistakes in summarizing their company’s compensation parameters, especially for incentive compensation. Perhaps committees should test their proposed summaries for clarity with a consultant, or look for a peer’s compensation dashboard or chart that seems especially readable.
• Note that ISS still does not consider stock options to be “performance-based compensation” (unless accompanied by a performance-based vesting schedule). The option has no value unless the stock price increases. (Of course, a sizeable buy-back program might be a counter-example.)
• In any event, executive compensation plan presentation in proxy materials (using graphs, tables, charts, bullet points) is an evolving art. Be on the lookout for new 2014 peer company formats and assess their ease of understanding.

Stock Exchange Listing Update

In November 2013, Nasdaq proposed for the 2014 proxy season a change to mirror the NYSE requirement that a compensation committee member for a Nasdaq listed company must qualify as an independent director under Nasdaq’s general independence standards. (See Chapter 3.)

PCAOB Update

In October 2013, the Public Company Accounting Oversight Board (PCAOB) issued new guidance suggesting to audit committee directors that they discuss with their auditors any deficiencies in the auditors’ own methods of internal controls audits that the PCAOB identified in its review of the audit firm. That way, the audit committee members can learn about audit method issues that their audit team, or firm have addressed with the PCAOB, and whether any issues raised by the PCAOB with the audit firm relate to the methods used to audit the company’s financial statement and internal controls. (See: http://pcaobus.org/StandardsQandA/10-24-2013-SAPA-11.pdf.)

Director Nomination Criteria

Lastly, boards that have faced shareholder activists have been leading initiatives to adopt new bylaws that protect the confidentiality of company information from being passed on to others, such as the activist who nominated insurgent directors. Such bylaws provide that each proposed director nominee must acknowledge that he or she will follow board policies, including those protecting the confidentiality of company information, and specifically prohibiting disclosure to shareholders who nominate a director candidate. Relatedly, some bylaws have restricted compensation that can be received for service as a director to fees paid by the company, so that entities sponsoring a nominee may not also pay that director if elected in connection with service on the board. ISS has scrutinized such bylaws for overbreadth (e.g., if applied to a nominee not yet elected).

Completing the Metaphor (Seat Back Pocket)

Having reviewed that checklist, it remains the case that great pilots have sound vision and constant vigilance, all checklists aside. Sure they refer to the lists. (And the best ones amend them.) As a director, you are most valuable if you help senior management develop its corporate vision and you vigilantly oversee key processes. After all, you were elected director at this company because you have led or enabled other firm(s) to achieve exceptional status. And keep in mind that this Handbook has two characteristics: it tries to succinctly remind you of the key elements of your director role, and, physically, it fits well inside the airplane seat pocket in front of you, in that bigger airplane you take to travel to your board meeting.

As asset bubbles effervesce, as the Federal Reserve balance sheet parabolically morphs, and as exchange rates wobble, 2014 will challenge boards to keep management focused on innovation and on execution while attending to the increased demands of the SEC, ISS, exchanges, PCAOB, activist investors and others.