Yearly Archives: 2022

Proposed Amendments to the Shareholder Proposal Rules

Posted by Marc S. Gerber, Richard J. Grossman, and Raquel Fox, Skadden, Arps, Slate, Meagher & Flom LLP, on
Thursday, August 11, 2022
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Marc S. Gerber, Richard J. Grossman, and Raquel Fox are partners at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on a Skadden memorandum by Mr. Gerber, Mr. Grossman, Ms. Fox, Brian V. Breheny, Ryan J. Adams, and Andrew T. Bond.

On July 13, 2022, the U.S. Securities and Exchange Commission (SEC), by a 3-2 vote, proposed amendments to the proxy rules that would narrow certain grounds under which companies may exclude shareholder proposals from their proxy statements. Specifically, the proposed amendments would modify the standards for exclusion under the “substantial implementation,” the “duplication” and the “resubmission” bases for exclusion under Rule 14a-8. Although presented as an effort to provide greater certainty and transparency to shareholder proponents and companies, the amendments (if adopted as proposed) likely would increase the number of shareholder proposals received by companies and make it less likely that proposals could be excluded.

Comments on the proposal are due by the later of 60 days following publication of the proposing release on the SEC’s website or 30 days following publication of the proposing release in the Federal Register, meaning that comments will be due no earlier than September 12, 2022. As the amendments are proposed rather than final rules, companies currently receiving shareholder proposals should continue to analyze those proposals under the existing rules.

Background

Pursuant to Rule 14a-8, a company must include a shareholder proposal in the company’s proxy materials unless the proposal falls under any one of thirteen substantive bases for exclusion or the proponent or proposal fails to satisfy the eligibility or procedural requirements of the rule. When a company intends to exclude a shareholder proposal from its proxy materials, the company typically requests no-action relief from the Staff of the SEC’s Division of Corporation Finance (Staff).

As described in our earlier post, the Staff took a number of positions during the 2022 proxy season that overturned long-standing no-action letter precedent. The proposed amendments would codify some of those positions and narrow three of the substantive bases available to companies to exclude proposals.

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Twitter v. Musk: Plaintiff’s Response to Defendant’s Counterclaim

Posted by Anna Restuccia (Harvard Law School), on
Wednesday, August 10, 2022
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This post provides the text of the response filed August 4, 2022, by Twitter, Inc. to Elon Musk’s counterclaim (discussed on the Forum here). This post is part of the Delaware law series; links to other posts in the series are available here.

Plaintiff Twitter, Inc. (“Twitter”), by and through its undersigned counsel, replies as follows to the Verified Counterclaims (the “Counterclaims”) of Elon R. Musk (“Musk”), X Holdings I, Inc., and X Holdings II, Inc. (each a “Defendant” and together, “Defendants” or the “Musk Parties”) as follows.

Introduction

Musk begins his answer to Twitter’s claims for breach of their merger agreement with more than ninety pages of counterclaims. According to Musk, he—the billionaire founder of multiple companies, advised by Wall Street bankers and lawyers—was hoodwinked by Twitter into signing a $44 billion merger agreement.

That story is as implausible and contrary to fact as it sounds. And it is just that—a story, imagined in an effort to escape a merger agreement that Musk no longer found attractive once the stock market—and along with it, his massive personal wealth—declined in value. After spending months looking for an excuse to get out of the contract, Musk claimed to terminate it, explaining his supposed reasons for doing so in a July 8 letter to Twitter. When Twitter sued to enforce its rights and exposed the weakness of those reasons, Musk spent weeks coming up with more supposed reasons—the Counterclaims—which offer up an entirely new set of excuses for his breach.

The Counterclaims are a made-for-litigation tale that is contradicted by the evidence and common sense. Musk invents representations Twitter never made and then tries to wield, selectively, the extensive confidential data Twitter provided him to conjure a breach of those purported representations. Yet Musk simultaneously and incoherently asserts that Twitter breached the merger agreement by stonewalling his information requests. As explained below and will be demonstrated at trial, the Counterclaims are factually inaccurate, legally insufficient, and commercially irrelevant:

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The Market for CEOs: Evidence from Private Equity

Posted by Paul A. Gompers (Harvard Business School), Steven N. Kaplan (University of Chicago), and Vladimir Mukharlyamov (Georgetown University), on
Wednesday, August 10, 2022
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Paul A. Gompers is Eugene Holman Professor of Business Administration at Harvard Business School; Steven N. Kaplan is the Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business; and Vladimir Mukharlyamov is Assistant Professor of Finance at the McDonough School of Business at Georgetown University. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance (discussed on the Forum here) by Lucian Bebchuk and Jesse Fried.

A wide range of research examines the market for CEOs and executive mobility in public companies while largely ignoring the market for CEOs in private equity funded companies. The research on public companies typically finds low levels of mobility for CEOs, particularly recently. For example, Cziraki and Jenter (2021) study CEO changes at S&P 500 companies from 1993 and 2012 and find that internal promotions are much more common than external hires: 80% of new CEOs are insiders and 90% are either the hiring firm’s current executives, former executives, board members, or co-workers of its directors. Other work finds that external hires for public companies are generally less than 30% and never more than 50%, even when turnover is forced or performance related.

We augment the work on public company CEOs by studying the market for CEOs among larger U.S. companies (enterprise value greater than $1 billion) purchased by private equity firms between 2010 and 2016. We find that 71% of those companies hired new CEOs under private equity ownership. Almost 75% of the new CEOs are external hires with 67% being complete outsiders. The most recent experience of 69% of the outside CEOs was at a public company with 32% at an S&P 500 company. Almost 50% of the external hires have some previous experience at an S&P 500 company. These results are strikingly different from studies that look at public companies. The external CEOs also tend to have previous experience in the same industry as the hiring company.

Next, we estimate the compensation of the buyout firm CEOs. The median buyout in our sample earned 2.5 times on its equity investment. Companies with external CEOs appointed at the time of the buyout receive significant compensation. Using the performance of the buyouts and survey evidence on buyout equity incentives, we estimate that buyout firm CEOs earned compensation substantially greater than that of CEOs of similarly sized public companies and of comparable magnitude to compensation of S&P 500 CEOs.

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Second Circuit on Stating a Claim for Scheme Liability

Posted by Israel David, Samuel P. Groner, and Harrison D. Polans, Fried, Frank, Harris, Shriver & Jacobson LLP, on
Wednesday, August 10, 2022
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Israel David and Samuel P. Groner are partners and Harrison D. Polans is an associate at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on their Fried Frank memorandum.

On July 15, 2022, the U.S. Court of Appeals for the Second Circuit issued a decision holding that Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2d Cir. 2005)—in which the court previously held that misstatements and omissions alone do not suffice for scheme liability under Rule 10b-5(a) and (c) of the federal securities laws—continues to retain its vitality after the Supreme Court’s decision in Lorenzo v. SEC, 139 S. Ct. 1094 (2019). Some further conspiratorial-like act in furtherance of the “scheme” is required. In Lorenzo, the Supreme Court had held that an individual who knowingly disseminated a false statement but did not create it could be found liable under subsections (a) and (c) of Rule 10b-5, which are often referred to as the “scheme liability” subsections of Rule 10b-5.

In SEC v. Rio Tinto plc, et al., No. 21-2042, 2022 WL 2760323 (2d Cir. July 15, 2022), the Second Circuit affirmed the dismissal of scheme liability claims against a company and its senior officers relating to their alleged misstatements and omissions concerning the valuation of an exploratory coal mine the company had acquired in Mozambique. Applying Lorenzo, the court held that while “misstatements and omissions can form part of a scheme liability,” an “actionable scheme liability claim requires something beyond misstatements and omissions” (such as dissemination of those statements).

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Delaware and Caremark: An Update

Posted by Theodore N. Mirvis, David A. Katz, and Sabastian V. Niles, Wachtell, Lipton, Rosen & Katz, on
Tuesday, August 9, 2022
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Theodore N. Mirvis, David A. Katz, and Sabastian V. Niles are partners at Wachtell, Lipton, Rosen & Katz. This post is based on their Wachtell memorandum, and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Monetary Liability for Breach of the Duty of Care? (discussed on the Forum here) by Holger Spamann.

Recent Delaware decisions have reminded boards of directors of the obligation to make a good faith effort to put in place a compliance system designed to help ensure that their companies operate within the bounds of the law and that their products, services, and operations do not cause harm to consumers, community members, or the environment. That duty—famously associated with the Delaware Court of Chancery’s 1996 decision in Caremark—is a core responsibility of independent directors, working in concert with company management, that requires them to make a good faith effort to identify the key compliance risks the company poses to others and faces itself, and to put in place a reasonable oversight structure to address them.

In 2019, the Delaware Supreme Court’s decision in Marchand reminded boards that although the Caremark standard only requires a good faith effort to put in place and attend to a reasonable compliance structure, a plaintiff could state a claim against directors by pleading facts suggesting that the board failed to make any effort to ensure that a board-level system of oversight was in place to address a mission critical risk. In that case, the company’s sole business was to make ice cream and there was no board-level process for monitoring the safety of its products, which caused the death and illness of consumers in a listeria outbreak. Just last year, the Court of Chancery issued a high profile decision in the Boeing case, applying Marchand in the face of detailed fact pleadings suggesting that the company had no board-level process for overseeing the company’s effort to ensure the safety of its aircraft.

In those and other cases, the increasing use of books and records demands by plaintiffs to plead their claims has been illustrated. Because the Delaware courts have long made clear—including in Marchand and Boeing—that Caremark requires a good faith effort by the board, not perfection, and that the board will only face liability if the evidence demonstrates that a board has not made a good faith effort to fulfill its duties, plaintiffs have sought books and records to sustain their difficult burden to plead a viable claim. When these books and records do not reflect that a company had in place a board structure that attended to core business and legal risks, the plaintiffs cite to that lack of effort in an effort to plead a complaint that cannot be dismissed on motion.

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Hidden Gems: Do Compensation Disclosures Reveal Performance Expectations?

Posted by C. Edward Fee (Tulane University), Zhi Li (Chapman University), and Qiyuan Peng (University of Dayton), on
Tuesday, August 9, 2022
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C. Edward Fee is Professor of Finance at Tulane University Freeman School of Business; Zhi Li is Assistant Professor of Finance at Champan University George L. Argyros School of Business and Economics; and Qiyuan Peng is Assistant Professor of Finance at the University of Dayton. This post is based on their recent paper, forthcoming in Journal of Accounting and Economics.

Related research from the Program on Corporate Governance includes Stealth Compensation Via Retirement Benefits by Lucian A. Bebchuk and Jesse M. Fried.

Performance-based stock grant is an increasingly popular form of incentive pay for public firm CEOs in U.S. Under these grants, executives are expected to receive different levels of stock payments (“threshold,” “target,” or “maximum”), contingent on the firm’s meeting pre-specified hurdles by the end of the performance evaluation period. In 2006, the SEC announced new disclosure rules that require firms to report “unearned shares” from outstanding performance-based stock grants in their proxy statement. Unearned shares are the number of shares that executives are expected to receive conditional on whether the firm meets predetermined performance hurdles by the end of the evaluation period.

In our paper, Hidden Gems: Do Market Participants Respond to Performance Expectations Revealed in Compensation Disclosures?, forthcoming in the Journal of Accounting and Economics, we examine whether the disclosed “unearned shares” provide new information about a firm’s future performance. We believe the new disclosure contains forward-looking information for two reasons. First, firms often cite performance expectations over the evaluation period to justify the reported unearned shares. Second, past literature has shown that firms choose specific performance measures that reflect their strategic priorities. These performance criteria, which are often not fully disclosed to the public, may capture information related to CEO actions and firm performance over the long run. However, the disclosure might not be informative. For example, the compensation committee and other corporate insiders might not be able to correctly forecast future firm performance and plan payouts. Or the firm could be unwilling to truthfully reveal inside information. Or the performance-based grants might be poorly designed to be informative, such as the performance hurdles are set at unreasonably high (low) level or the performance measures used are unrelated to firm value. Hence, whether the disclosure of unearned shares is informative is an empirical question.

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Emerging Fraud Risks to Consider: ESG

Posted by Michael Brodsky and Amy Edwards, Deloitte, on
Tuesday, August 9, 2022
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Michael Brodsky is Managing Director and Amy Edwards is Audit & Assurance Senior Manager of the Fraud Risk Center, Deloitte & Touche LLP. This post is based on a Deloitte memorandum by Mr. Brodsky, Ms. Edwards, Krista Parsons, Maureen Bujno, and Kimia Clemente.

Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) by Lucian A. Bebchuk and Roberto Tallarita; For Whom Corporate Leaders Bargain (discussed on the Forum here) and Stakeholder Capitalism in the Time of COVID (discussed on the Forum here), both by Lucian Bebchuk, Kobi Kastiel, and Roberto Tallarita; Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock (discussed on the Forum here) by Leo E. Strine, Jr.; and Corporate Purpose and Corporate Competition (discussed on the Forum here) by Mark J. Roe.

Introduction

Many audit committees are highly focused on the risk of financial statement fraud, but a case is growing for audit committees to expand their discussion of fraud risk to encompass a growing variety of environmental, social, and governance (ESG) issues. ESG-related topics increasingly appear on audit committee agendas and factor into financial reporting discussions, but they tend to arise less often in the context of discussions about fraud risk.

Investors continue to demonstrate interest in understanding risks related to ESG issues, which is helping fuel regulatory focus on reporting and disclosures. The SEC has already issued proposals to expand disclosures related to cybersecurity and climate issues, and further proposals are expected in areas such as human capital. These proposals are likely to significantly increase the scope of information that will be included in regulatory filings in the coming years.

In preparation for expected new reporting requirements, many companies are in the process of developing more robust ESG-related disclosure controls and procedures as well as internal control over financial reporting (ICFR). Some companies are developing ESG-related metrics for financial reporting and for incorporation into incentive compensation.

Ahead of these possible rule changes, fraud risk in this area should be top of mind for audit committees and a focal point in fraud risk assessments overseen by the audit committee. Many companies are currently providing information to investors that is not governed by the same types of controls present in financial reporting processes.

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Welcoming the Universal Proxy

Posted by Kai Liekefett, Derek Zaba, and Leonard Wood, Sidley Austin LLP, on
Monday, August 8, 2022
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Kai Liekefett and Derek Zaba are partners and Leonard Wood is senior managing associate at Sidley Austin LLP. This post is based on an Ethical Boardroom publication. Related research from the Program on Corporate Governance includes Universal Proxies (discussed on the Forum here) by Scott Hirst.

On 17 November 2021, the US Securities and Exchange Commission (SEC) adopted new Rule 14a-19 and amendments to existing rules under the Securities Exchange Act of 1934 to require the use of “universal” proxy cards in all non-exempt director election contests at publicly traded companies in the US.

The new rules contain only slight modifications from rules the SEC first proposed in October 2016. When the SEC reopened the public comment period in 2021, members of Sidley’s Shareholder Activism & Corporate Defense Practice sent a formal comment letter to the SEC regarding the proposed rules. We argued that the rules create the equivalent of “proxy access on steroids.” While comparable to the vacated Rule 14a-11, which allowed shareholders holding at least three per cent of a company’s outstanding shares for three years to put dissident directors on the company’s proxy statement, the Universal Proxy Rules confer substantially more significant rights to shareholders without any minimum ownership requirements (i.e. owning only one share for one minute will be sufficient). Unfortunately, the SEC proceeded to adopt these rules without meaningful safeguards against misuse.

The new rules will significantly change the methods by which proxy contests at public companies have been conducted for decades. Public advocates of shareholder activism have championed the adoption of the new rules. Their enthusiasm may reflect a premonition that the universal proxy rules will afford dissidents additional leverage when negotiating with boards and, ultimately, allow them to place more dissident candidates on boards. As such, we expect a significant increase in proxy contests and threats thereof once the universal proxy rules take effect for shareholder meetings after 31 August 2022. It is nothing less than the most dramatic change in the US proxy system in a generation.

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Does ESG Negative Screening Work?

Posted by Robert Eccles (Oxford University), Shivaram Rajgopal (Columbia University), and Jing Xie (Hong Kong Polytechnic University), on
Monday, August 8, 2022
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Robert Eccles is Visiting Professor of Management Practice at Oxford University Said Business School; Shivaram Rajgopal is Roy Bernard Kester and T.W. Byrnes Professor of Accounting and Auditing at Columbia Business School; and Jing Xie is Assistant Professor of Finance at Hong Kong Polytechnic University School of Accounting and Finance. This post is based on their recent paper.

Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) by Lucian A. Bebchuk and Roberto Tallarita; Does Enlightened Shareholder Value Add Value? (discussed on the Forum here) by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita; Companies Should Maximize Shareholder Welfare Not Market Value (discussed on the Forum here) by Oliver Hart and Luigi Zingales; and Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee (discussed on the Forum here) by Max M. Schanzenbach and Robert H. Sitkoff.

Negative screening is broadly the process of finding and excluding stocks of companies, whose operations are seen as “unsustainable” from an environmental, social or a governance (ESG) standpoint (The U.S. SEC does not define a poor ESG stock. The European Sustainable Finance Disclosure Regulation (SFDR), on the other hand, defines a sustainability investment as “an investment in an economic activity that contributes to an environmental objective”). A popular version of negative screening, that is widely practiced by institutional investors sensitive to ESG considerations, is to exclude stocks of firms involved in the production of alcohol, tobacco, and gaming, and fossil-fuels such as coal and gas or oil (labeled as “sin stocks” or “excluded industries”). Reasons for exclusion vary and include moral values, the belief that this will put pressure on them to change or even put them out of business, or the conviction that the industry’s prospects are grim.

There is a relatively long literature suggesting that stock returns of sin stocks, traditionally covering alcohol, gaming, and tobacco, outperform the market (see Salaber 2007; Fabozzi, Ma, and Oliphant 2008; Hong and Kacperczyk 2009; Statman and Glushkov 2009; Durand, Koh, and Tan 2013). Hong and Kacperczyk (2009) identify firms in the alcohol, tobacco, and gaming industries as sin firms. Fabozzi, Ma, and Oliphant (2008) identify sin stocks as those classified in the six industries of alcohol, tobacco, defense, biotech, gaming, and adult services. Statman and Glushkov (2009) and Durand, Koh, and Tan (2013) define sin firms as ones operating in alcohol, tobacco, gaming, defence and weaponry industries. Following prior literature (e.g., Hong and Kacperczyk, 2009), we define a sin stock as a firm involved in the alcohol, gaming and tobacco industries. In addition, we also classify firms operating in weapons (gun industry) and carbon-intensive industries (i.e., coal and gas and oil) as sin stocks (Teoh et al., 1999). The intuition is that the investors who are willing to hold these screened investments expect a higher rate of return because of the social opprobrium attached to them and the exclusions they are facing from other investors which reduces the pool of capital available to them. However, relatively little is known about whether such negative screening by institutions impacts the valuation and fundamentals (e.g., operating, investing, and financing activities) of these companies. That is the question we study in this paper.

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SEC Reverses Aspects of Proxy Voting Advice Regulations

Posted by Marc Treviño and Bob Downes, Sullivan & Cromwell LLP, on
Monday, August 8, 2022
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Marc Treviño and Bob Downes are partners at Sullivan & Cromwell LLP. This post is based on a Sullivan & Cromwell memorandum by Mr. Treviño, Mr. Downes, Aaron Levine, Natasha Rygnestad-Stahl, and Jordan Voccola.

Summary

On July 13, the SEC voted 3 to 2 (Commissioners Peirce and Uyeda dissenting) to adopt amendments to the rules governing proxy voting advice provided by proxy advisory firms. The 2022 Final Rule rescinds two sections of the rules governing proxy voting advice adopted by the SEC in July 2020. The 2022 Final Rule rescinds Rule 14a-2(b)(9)(ii) and includes conditions to exemptions from the proxy rules’ information and filing requirements that required proxy advisory firms to (1) make their advice available to the companies subject to their advice at or before the time that they made the advice available to the proxy advisory firm’s clients and (2) provide their clients with a mechanism by which they could reasonably have been expected to become aware of any written statements regarding the proxy advisory firm’s proxy voting advice by registrants subject of the advice. The 2022 Final Rule also rescinds Note (e) to Rule 14a-9, which set forth examples of material misstatements or omissions related to proxy voting advice, specifically providing that failure to disclose material information regarding proxy voting advice could be misleading. The SEC has also rescinded certain supplemental guidance released in 2020, which was prompted, in part, by the adoption of the rescinded rules.

The 2022 Final Rule will be effective on September 19, 2022.

Background

In July 2020, the SEC adopted final rules regarding proxy voting advice provided by proxy advisory firms or proxy voting advice businesses (“PVABs”) (the “2020 Rules”). [1] The 2020 Rules comprised the following:

  • Rule 14a-2, which required PVABs to:
    • disclose conflicts of interest;
    • adopt and publicly disclose policies and procedures to provide proxy voting advice to registrants at or prior to dissemination to clients and to provide timely notice to clients of registrants’ responses;
  • Note (e) to Rule 14a-9, which clarified the applicability of the proxy rules’ antifraud provisions to proxy advice and added examples of when failure to disclose material information (e., the proxy advisor’s methodology, sources of information or conflicts of interest) regarding proxy voting advice could be considered misleading under Rule 14a-9; and
  • The definition of “solicitation,” which was amended to expressly include proxy voting advice and conditioned the availability of exemptions from the proxy rules’ information and filing requirements on proxy advisors meeting the above requirements.

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