Making Capitalism Sustainable: Three Steps for CEOs

Business leaders have a unique opportunity.

Today over half of Millennials claim to reject capitalism. Left unaddressed, public discontent and other challenges facing capitalism could reach a tipping point, resulting in damage to the system that has created the greatest level of freedom and prosperity the world has ever seen. Backlash could encourage governments to become even more directive, imposing greater controls through a stricter tax and regulatory environment that would diminish the ability of companies to effectively produce goods, services, and innovations that benefit all of society.

Businesses need to adjust to societal demands rather than wait for government to react. In their roles as both the chief decision-makers and public face of their companies, business leaders have a unique opportunity and responsibility to steer capitalism towards greater sustainability.

While no silver bullet exists, CEOs can take the following steps:

First, they can lead companies for the benefit of all stakeholders, including customers, employees, owners, communities, and environment. The notion of “shareholders only” no longer is enough. CEOs should drive greater diversity in management teams and boards of directors. Today women earn more degrees than men and comprise about half the workforce, yet hold only one in five Fortune 500 board seats. A company-led approach can stave off regulatory solutions, like quotas, that boardrooms face in other countries like Finland and Denmark. If nominating committees adopt an “every other one” strategy, in which they appoint women to every other vacant seat, women would comprise a third of Fortune 500 board seats in just a few years and, in turn, would help support greater diversity in management.

Second, amid rising economic inequality, which now approaches the record levels of the 1930s, CEOs can increase investment in their employees’ education. Recently JP Morgan Chase made headlines by raising their minimum wage and committing to a greater investment in education to help employees climb the economic ladder. The company will focus more on training entry-level employees and will partner with organizations for career-focused education. Other CEOs have a compelling rationale to follow suit: as the economy places an increasing premium on knowledge, company performance increasingly will depend on education.

Finally, those at the helm can build trust by fighting crony capitalism. From no-bid contracts to regulatory loopholes to tax carve-outs, crony deals rightly lend support to the notion that the system favors the well-connected few over the many. Sustainable capitalism relies on fair competition on an impartial playing field in the marketplace, not in the lobbies of Congress. Executives should reassess the objectives of their political giving, and vocalize the need for the business community at large to refrain from opportunities that would lead to an artificial leg up in the marketplace.

Capitalism boasts a track record of unmatched prosperity. But if its challenges remain unsolved, dissatisfaction could lead to an economic environment that leaves both companies and the greater society less prosperous.


Steve Odland is CEO of the Committee for Economic Development and former CEO of Office Depot Inc. and AutoZone Inc. Follow him and CED on Twitter: @SteveOdland, @CEDUpdate.

https://www.directorsandboards.com/articles/singlemaking-capitalism-sustainable-three-steps-ceos

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CEO Pay Ratio And Employees

August 4, 2016

By Dan Marcec, Director of Content & Marketing Communications, Equilar

335:1.    276:1.    247:1.    71:1.

Those figures represent alternative ways to calculate the ratio of CEO to worker pay in the U.S.—a ratio that every public company will be required to report for its own workers in 2018. Since the SEC passed this measure one year ago as a continuation of mandates from the Dodd-Frank legislation, the CEO Pay Ratio has become a lightning rod for discussion around executive pay.

The pay ratio is controversial for different reasons to different constituents. In the corporate governance universe, executive compensation professionals and the shareholders who vote on executive pay have debated the ratio’susefulness as a means to help them evaluate CEO pay. Companies are concerned about the costs involved—by some estimates, it will cost public companies a collective $1.3 billion to comply with the rule in its first year, and about half that amount every year thereafter. Meanwhile, opponents of what they describe as exorbitant CEO pay have said they would use the ratio to shame companies publicly.

Caught in the middle, HR departments will be assigned the daunting task of communicating this delicate information to company employees, and handling the influx of inevitable questions about what job is the median, how that compares across departments, and quite possibly, why the CEO gets paid so much. Undoubtedly they are asking how can they best communicate their own company’s ratio and educate employees on what it means.

Determining the CEO Pay Ratio

What makes the pay ratios reported by various sources thus far so vastly different? The largest of these figures cited above—335:1—is according to the AFL-CIO Executive Pay Watch. This accounts for the average reported total compensation for S&P 500 CEOs vs. the average for nonsupervisory workers in the U.S.

The smallest of these figures—71:1—was calculated by PayScale, which provides on-demand compensation data and software, comparing median cash compensation for 168 of the highest-paid CEOs in the annual Equilar 200 study to cash compensation of the median employee for those companies. This included all employee levels from individual contributor to executive level.

These differences reflect the fact that while companies will be required to provide disclosure of their CEO pay ratios beginning in 2018 public filings, there is some flexibility in the SEC rule that allows a company to select its methodology for identifying its median employee and that employee’s compensation.

The question remains how the ratio should be calculated to create the most direct comparison between how CEOs and employees are paid.

Executive vs. Employee Pay Strategies

It’s difficult to draw a direct comparison from executive to employee pay for several reasons. The AFL-CIO Executive Pay Watch included all reported CEO pay, which factors in equity compensation such as stock and options awards, while PayScale’s employee survey exclusively tracks salary information and thus compares more directly to the cash components of CEO pay in the form of salary and annual bonus.

On paper and in practice, stock and options make up a vast majority of CEO pay. Equity accounted for 68% of the reported compensation for the CEOs included in the Equilar 200 study used for the PayScale comparison. In other words, on average, less than one-third of these CEOs’ compensation was earned in cash. At the same time, CEO compensation reported in annual proxy statements often includes dollar values that are not paid in that year, because a significant portion of CEO pay is contingent on future performance. The ultimate value of those awards may be less or more than the reported numbers had indicated.

Meanwhile, non-executive employees may or may not receive company equity as part of their compensation. Even if employees do receive stock or options, they are less likely to be certain about the present value of their equity, and thus self-reported data may not fully capture the amount they ultimately realize as something tangible—even if it were accounted for in the pay ratio. As a result, survey data better reflects cash compensation, and an apples-to-apples comparison measuring the gap between CEO pay and their employees can help to normalize some of these discrepancies.

The highest-paid CEO on the Equilar 200 list—Dara Khosrowshahi of Expedia—provides a useful example of the differences between how pay is structured for CEOs versus most employees, and moreover, how that compensation is reported to the SEC.

In 2015, Khosrowshahi received stock options valued at more than $90 million on the day the award was granted. However, he will only realize that value if he hits aggressive performance goals. On top of that, the company has said it will not award him any more equity compensation until 2020. According to PayScale’s survey, the ratio of CEO pay—including equity—to the median employee would be nearly 1,000-to-1 at Expedia in 2015. In any other year, it would likely fall far closer to the 39:1 ratio shown in PayScale’s study, which represents the amount of cash Khosrowshahi took home in 2015.

Employee Perception of Executive Pay

The alternative ways to calculate the CEO pay ratio reflect another reality: While the figure may appear similarly across companies to the public, it will be calculated differently at every company. A new piece of information, never before disclosed by a majority of companies, will become publicly available—the median employee’s pay—and inevitably half of the company will fall below that mark.

So whether a particular company’s ratio is 335:1 or 71:1, HR departments will have to come up with detailed communications plans to address how the median employee was determined and why the ratio is what it is, especially if the figure may appear out of step compared to industry competitors.

To appraise employee sentiment on CEO pay, PayScale conducted a survey soliciting more than 22,000 responses on whether employees knew what their CEO’s compensation was, and if so, the degree to which they thought it was fair.

Overall, the findings showed more than half of employees were not aware of their CEO’s compensation (55%), and among those that did, nearly 80% believed it was appropriate. Meanwhile, more than half of respondents who felt that their CEO is overcompensated also reported that it negatively affects their view of the company (57%).

Unsurprisingly, employees at higher levels in their companies have more knowledge about and more readily approve of CEO compensation than employees at lower levels. In other words, the perception of the CEO’s compensation and its impact on the respondent’s opinion of the company is directly related their job level, according to the survey.

Though these responses may not be unexpected, they underscore the value of transparency in setting expectations about the forthcoming ratio and its influence on employee morale. If employees are surprised by revelations in the news or from a union advocate, they’re likely to be less informed than if it comes straight from the source.

Ultimately, CEOs are paid very differently than employees, and the data suggests that workers who understand the nuances are more receptive to learning more about why. HR departments and other internal communicators have the opportunity to gather information and data now so they can accurately tell their company’s story and dampen the noise from external parties that may try to tell that story for them.

For more information on PayScale’s employee survey, please visit www.payscale.com/data-packages/ceo-pay .

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Corporate Culture and the Role of Boards

July 22, 2016

Corporate Culture

          The Financial Reporting Council has published a report on Corporate Culture and the Role of Boards that is as applicable to U.S. companies as it is to U.K. companies—indeed, it is applicable to all market economy companies.

          The report starts with the premise that corporate culture is the crucial element in how a company performs.  “A strong culture will endure in times of stress and mitigate the impact.  This is essential in dealing effectively with risk and maintaining resilient performance.”

          The report makes the following key points:

  1. Recognize the Value of Culture.  A healthy corporate culture is a valuable asset, a source of competitive advantage and vital to the creation and protection of long-term value.  It is the board’s role to determine the purpose of the company and ensure that the company’s values, strategy and business model are aligned to it.  Directors should not wait for a crisis before they focus on company culture.
  2. Demonstrate Leadership.  Leaders, in particular the chief executive, must embody the desired culture, embedding this at all levels and in every aspect of the business.  Boards have a responsibility to act where leaders do not deliver.
  3. Be Open and Accountable.  Openness and accountability matter at every level.  Good governance means a focus on how this takes place throughout the company and those who act on its behalf.  It should be demonstrated in the way the company conducts business and engages with and reports to stakeholders.  This involves respecting a wide range of stakeholder interests.
  4. Embed and Integrate.  The values of the company need to inform the behaviors which are expected of all employees and suppliers.  Human resources, internal audit, ethics, compliance, and risk functions should be empowered and resourced to embed values and assess culture effectively.  Their voice in the boardroom should be strengthened.
  5. Align Values and Incentives.  The performance management and reward system should support and encourage behaviors consistent with the company’s purpose, values, strategy and business model.  The board is responsible for explaining this alignment clearly to shareholders, employees and other stakeholders.
  6. Assess, Measure and Engage.  Indicators and measures used should be aligned to desired outcomes and material to the business.  The board has a responsibility to understand behavior throughout the company and to challenge where they find misalignment with values or need better information.  Boards should devote sufficient resource to evaluating culture and consider how they report on it.
  7. Exercise Stewardship.  Effective stewardship should include engagement about culture and encourage better reporting.  Investors should challenge themselves about the behaviors they are encouraging in companies and to reflect on their own culture.

Martin Lipton

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SEC Issues New Guidance on Non-GAAP Measures

May 20, 2016

The SEC Issues New Cautionary Guidance on Non-GAAP Financial Measures

By Andrew R. Brownstein
David A. Katz
Edward J. Lee
Sabastian V. Niles

          This week, the SEC’s Division of Corporation Finance released updated Compliance and Disclosure Interpretations (C&DIs) addressing non-GAAP financial measures.  The updated C&DIs impact certain practices that have been widely used by public companies and underscore the SEC’s recently heightened focus on how non-GAAP financial measures are used, including concerns expressed by SEC Chair White,  SEC Chief Accountant Schnurr, SEC Deputy Chief Accountant Bricker and other senior SEC officials, as well as PCAOB Chair Doty, regarding a perceived overemphasis on non-GAAP financial information in the public markets.

The updated C&DIs address a range of issues, including: what kinds of practices could be misleading; presenting corresponding GAAP measures with “equal or greater prominence” when required; prohibited per share presentations; and handling income tax items related to a given measure.  Per the C&DIs, examples of potentially misleading non-GAAP measures include: excluding normal, recurring cash operating expenses necessary to operate an issuer’s business; presenting measures inconsistently between periods without appropriate disclosure; adjusting non-GAAP measures for non-recurring charges but not for non-recurring gains during the same period; and substituting individually-tailored revenue recognition and measurement methods for GAAP.

With respect to “equal or greater prominence,” the C&DIs highlight several situations where, in the SEC’s view, a non-GAAP measure used in documents filed with the SEC or in earnings releases furnished with a Form 8-K would likely be impermissibly more prominent than the most directly comparable GAAP measure.  These include, among others: omitting comparable GAAP measures from headlines or captions; presenting a non-GAAP measure ahead of the comparable GAAP measure (including in a headline or caption); presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font) that emphasizes non-GAAP over the comparable GAAP measure; presenting a full income statement of non-GAAP measures; describing non-GAAP measures (e.g., “record performance,” or “exceptional”) without an equally prominent description of the comparable GAAP measure; and excluding a quantitative reconciliation to the most directly comparable GAAP measure for forward-looking information (e.g., guidance or outlook) due to the “unreasonable efforts” exception of Regulation S-K, without disclosing that fact and identifying the information that is unavailable and its probable significance in an equally prominent location.

While non-GAAP financial measures will undoubtedly continue to be important and useful for companies and investors alike, management teams and audit committees of companies that disclose non-GAAP financial measures should carefully review the new C&DIs and consider whether to adjust their practices and disclosures in response to these updates and, more generally, to the SEC’s increased scrutiny of how non-GAAP measures are used and presented.

Andrew R. Brownstein
David A. Katz
Edward J. Lee
Sabastian V. Niles

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Questioning the ISS Study on the Impact of Board Leadership Structures on CEO Pay

By Lizanne Thomas, Jones Day

•  ISS did not provide transparency into its backup information and data.

• ISS seemingly overlooked the reality that a company’s performance has a more statistically significant impact on CEO pay than board leadership.

• ISS was quick to connect some dots but failed to connect them with the kind of precision that is expected of corporate America.

Institutional Shareholder Services (“ISS”) published a report in March 2016 arguing that CEO compensation is impacted by companies’ board structures. More specifically, ISS argues that CEOs of companies with boards chaired by an “insider” have higher compensation than CEOs of companies with boards chaired by an “outsider.”

Given ISS’s orientation toward one-size-fits-all corporate governance scorecards—and the fine print found on the last page of the report (warning readers that the information may not be accurate and that anyone who relies on the information does so at his or her own risk), we decided to dig into the report’s findings before accepting its conclusion. We think that our caution was warranted.

Generally, the report does not provide much transparency into its underlying data, which makes it difficult to analyze. Our requests for the backup information received no response. Nonetheless, we were able to use the data included in the report to rerun some of the calculations.

The report separates S&P 500 companies into four board categories—those chaired by: (i) an individual deemed by ISS to be an “insider,” (ii) the CEO of the company, (iii) an individual deemed by ISS to be an “affiliated outsider,” and (iv) an individual deemed by ISS to be an “independent outsider.” The report then concludes that:

• The average total compensation of CEOs in the insider and combined role categories is higher than the average total compensation of CEOs in the affiliated outsider and independent outsider categories, and

• Therefore, board structure has a significant impact on CEO pay.

Although the ISS report does not identify the companies it assigned to each of these categories, ISS does provide the identity of four companies in the “insider” category, and describes the compensation of these CEOs as being high outliers. Removing these so-called outliers from the “insider” category reduces the average total compensation for the “insider” category from $15.6 million to $11.8 million. In short, when the outliers are removed from the “insider” category, the resulting “insider” category’s average annual compensation is reduced by almost 25 percent and is almost equal to the average annual compensation of the “affiliated outsider” category.

We reviewed the proxies of the so-called “outliers” and discovered a few facts relevant to the conclusions drawn that were not mentioned by ISS:

• One outlier’s stock price increased 1600 percent over the five-year period ended December 31, 2014.

• Another outlier’s revenues almost doubled since its CEO took leadership and 98 percent of the CEO’s 2014 compensation was put at risk with stringent performance based measures.

• A third outlier decreased its then-CEO’s compensation three years in a row, and ultimately split the CEO position into two roles in response to shareholder feedback obtained in outreach efforts.

We believe that our findings demonstrate the danger in trying to adopt a one-size-fits-all approach to corporate governance and compensation practices. Public company boards and compensation committees use many types of information when making compensation decisions (feedback received through direct shareholder outreach efforts, performance measures, long-term strategies, etc.). Any report that attempts to identify a single reason for compensation variances among public company CEOs will, in our view, inevitably fail to account for valid variances.

Two of the so-called outliers, for example, adhered to ISS’s top corporate governance compensation policy—creating a meaningful link between pay and performance—by providing a large portion of their executives’ compensation packages in the form of performance-based/at-risk awards. The compensation packages of those CEOs have proven to create an effective incentive to maximize the value of their respective companies, as evidenced by the companies’ strong performances. Yet the strong performances, which resulted in high compensation, are not taken into account in ISS’s analysis.

The report also fails to acknowledge that a company’s revenue has a more statistically significant impact on CEO pay than does the category applicable to the company’s chair. In addition to testing the impact of the identity of the board chair on CEO pay, the report also analyzed the impact of:

• Three-year “indexed” total shareholder return of the company versus the S&P 500,

• Company revenues (averaged over the three-year period),

• The CEO’s tenure, and

• Whether there was a change in CEO during the course of the three years.

According to the report, in order to be statistically significant, the t-statistic of a variable must be greater than 2 or less than -2. Of the five variables tested, only two of the variables had t-statistics that were statistically significant: the chair code at -2.53 and the company revenue code at 5.36—more than two-and-a-half times greater. Any student of statistics would not “bury the lede” by focusing on a variable of lesser significance.

The authors of the ISS report nonetheless jump to the conclusion that “insiders” are not the best monitors of shareholder interests in the boardroom. This conclusion is unsupported as well as unfair, particularly given that, under stock exchange rules, CEO pay is set solely by independent directors and may not be set by “insiders.” In fact, CEO chairs cannot even serve on compensation committees. In our experience, compensation committees work hard to ensure an appropriate level of pay and linkage to performance. To blindly follow ISS’s conclusion would require shareholders to oust from the board the very leaders who have made many of these companies attractive investments in the first place and who have carefully applied the very principles that ISS espouses.

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SEC Grants No-Action Relief on Proxy Access Proposals

SEC Grants No-Action Relief on Proxy Access Proposals

Companies that have previously adopted mainstream proxy access bylaws received a vote of confidence from the SEC earlier this month when the agency issued 18 no-action letters on February 12th, 15 of which allowed the company to exclude related shareholder proposals on the basis of “substantial implementation” under Rule 14a-8(i)(10) of the Securities Exchange Act of 1934. Each of these companies successfully asserted that its proxy access bylaw fulfilled the “essential objective” of the shareholder proposal and, as a result, that the company had substantially implemented the proposal.  These recent no-action letters provide the first important guidance on how proxy access proposals will fare under Rule 14a-8(i)(10) following the issuance of SEC Staff Legal Bulletin 14H in October  2015 which severely limits the ability for companies to exclude shareholder proposals, including proxy access proposals, on the basis that they conflicted with management proposals under Rule 14a-8(i)(9).

Each of the 15 companies had received shareholder proposals after adopting a “3/3/20/20” proxy access bylaw permitting shareholders who continuously own 3% of shares outstanding for a 3-year period to nominate up to 20% of the board (and at least 2 directors).  Under the bylaws, no more than 20 shareholders can aggregate their shares to reach the 3% ownership threshold.  This version of proxy access is consistent with the minimum standard articulated by ISS in itsDecember FAQ.

The excluded shareholder proposals would have permitted shareholders who continuously own 3% of shares outstanding for a 3-year period to nominate up to 25% of the board (and at least 2 directors).  Typically, the proposals had no shareholder aggregation limit and also prohibited additional restrictions that did not apply to other board nominees.

Differences between company bylaws and shareholder proposals on director nominee caps and shareholder aggregation limits did not prevent the SEC from concluding that the proposals had been substantially implemented.  The companies had adopted modestly more restrictive director nominee caps (up to 20% of the board and at least 2 directors) than the shareholder proposals (up to 25% of the board and at least 2 directors).  In addition, in what was shaping up to be a potentially more significant point of contention, the company bylaws stipulated that no more than 20 shareholders could aggregate their shares to nominate a candidate, while the shareholder proposals typically had no shareholder aggregation limits.

Notably, the SEC Staff granted no-action relief even in situations where the proxy access bylaw contained eligibility restrictions for proxy access candidates that may not apply to other director nominees, including a candidate

  • who is nominated using the company’s advance notice provisions,
  • who receives third-party compensation,
  • who is not independent under applicable listing standards,
  • whose election would cause the company to be in violation of its charter documents or applicable regulations,
  • who is an officer or director of a competitor, as defined in Section 8 of the Clayton Antitrust Act of 1914,
  • whose business or personal interests within the preceding ten years would place them in a conflict of interest with the company or any of its subsidiaries such that it would cause them to violate any fiduciary duties of directors,
  • who is named subject of a pending criminal proceeding (excluding traffic violations and other minor offenses) or who has been convicted in such a criminal proceeding,
  • who is subject to any order of the type specified in Rule 506(d) of Regulation D promulgated under the Securities Act of 1933, as amended, and
  • who does not receive at least 25% of the votes cast in favor of the candidate’s election at a prior annual meeting.

While these eligibility restrictions provide important protections for the adopting companies, it remains to be seen whether ISS and investors will find them problematic notwithstanding the SEC’s finding of substantial implementation.

In the three instances when the SEC denied no-action relief, the companies required 5% vs 3% ownership of shares outstanding in order for shareholders to avail themselves of proxy access.

In the wake of these no-action letters, companies considering proxy access are likely to gravitate toward the models contained in the successful no-action letters, continuing the convergence of proxy access terms during the 2016 proxy season.  Proxy access adopters are expected to maintain a brisk pace, as companies now face a reduced risk of having bylaws challenged by shareholder proponents.

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Forum Selection Bylaw Upheld

By William Savitt, David E. Shapiro, Anitha Reddy

April 8, 2016

Forum-Selection Bylaws — Another Brick in the Wall

The Superior Court of California for the County of Los Angeles has added to a growing judicial consensus that forum-selection bylaws adopted in conjunction with public-company mergers will be enforced to direct transaction-related litigation to a single board-designated forum. RealD Inc. is a Delaware-chartered, California-headquartered corporation. When the company’s board of directors approved a merger agreement with Rizvi Traverse Management LLC, a California-based private equity firm, it also adopted a bylaw requiring that any fiduciaryduty litigation involving the company be brought in the courts of Delaware. A stockholder plaintiff nevertheless sued in California, claiming that RealD’s directors breached their fiduciary duties in approving the merger and that other parties aided and abetted that breach. Arguing that California was a more convenient forum, that no duplicative litigation was pending in Delaware (or anywhere else), and that claims against third-party defendants should not be subject to the RealD bylaw, the plaintiff urged the court to ignore the bylaw and allow his case to proceed. The California court refused. Finding that “litigating in Delaware will be reasonable and fair” and that “Delaware courts have special expertise in corporate matters,” the court rejected the plaintiff’s assertion that confining his suit to a Delaware forum would be inequitable. Forum-selection bylaws have proved resilient against attack, withstanding challenges in New York, Texas, California and several other jurisdictions. Deal planners should continue to consider and refine the state of the art in such bylaws, which are becoming an established tool to reduce the risk of opportunistic stockholder litigation.

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Incentive For Long-Term Investment Is Broken

March 14, 2016

Succeeding in the New Paradigm for Corporate Governance

By Martin LiptonSabastian V. NilesSara J. Lewis

          Recognizing that the incentive for long-term investment is broken, leading institutional investors are developing a new paradigm for corporate governance that prioritizes sustainable value over short-termism, integrates long-term corporate strategy with substantive corporate governance and requires transparency as to director involvement.  We believe that the new paradigm can reduce or even eliminate the outsourcing of corporate governance and portfolio oversight to ISS and activist hedge funds.

Based on a series of statements by these investors over the past few years, we offer practical options for companies to consider as they adjust to the new paradigm and decide what and how to communicate.  Each company should make its own independent decision as to content, persons, venues and intensity of its communications and what adjustments, if any, to its strategy and operations may be appropriate to meet the expectations of investors who have embraced the new paradigm.

What to Communicate

          Lead with the Strategy.  In the new paradigm, the company’s long-term strategy, its implementation and the company’s progress in achieving it take center stage.  Check-the-box governance fades into the background.  Define the company and its vision, explain key drivers of strategy and business outcomes and articulate how a portfolio of businesses and assets fit together and are reviewed.  Discuss key risks and mitigation methods and share how the company evaluates whether the strategy remains viable as the business environment, competitive landscape and regulatory dynamic change.  Discuss how a business model has transformed, and if the company is in the midst of a strategic transformation or a well-conceived turnaround plan that requires time to execute, explain it.

          Confirm Board Involvement in the Strategy.  The company should also explicitly describe how the board has actively reviewed long-term plans and that it is committed to doing so regularly.  Proactively share with these investors how directors are integrated into strategic planning, exercise robust oversight and test and challenge both strategy and implementation.  In the new paradigm, be clear and direct about the board’s role in guiding, debating and overseeing strategic choices.

          Make the Case for Long-Term Investments, Reinvesting in the Business for Growth and Pursuing R&D and Innovation.  The company should clearly explain how such investments are reviewed and articulate why and how they matter to long-term growth and value creation.  For investments that will take time to bear fruit, acknowledge that and explain their importance, timing and progress.

          Describe Capital Allocation Priorities.  This also includes discussing the board’s process for reviewing and approving capital allocation policies.  Where return of capital is a pillar of the company’s value creation framework, demonstrate thoughtfulness about the timing, pacing and quantum of buybacks and/or dividends and an awareness of relative tradeoffs.  If maintaining an investment-grade or fortress balance sheet is a priority, clarify why.

          Explain Why the Right Mix of Directors Is in the Boardroom.  Present the diverse skills, expertise and attributes of the board as a whole and of individual members and link those to the company’s needs and risks.  Be transparent about director recruitment processes that address future company and board needs.  Disclose the policy for ensuring that board composition and practices evolve with the needs of the company, including views on balance, tenure, retaining institutional knowledge, board refreshment and presence or absence of age or term limits.  Carefully explain procedures for increasing the diversity of the board and for ensuring that directors possess the skills required to direct the course of the company.  Discuss director orientation, tutorials and retreats for in-depth review of key issues.  Show that board, committee and director evaluations are substantive exercises that inform board roles, succession planning and refreshment objectives.

          Address Sustainability, Citizenship and ESG/CSR.  The company should integrate relevant sustainability and ESG matters into strategic and operational planning and communicate these subjects effectively.  Sharing sustainability information, corporate responsibility initiatives and progress publicly on the company’s website and bringing them to these investors’ attention are significant actions in the new paradigm.

          Articulate the Link Between Compensation Design and Corporate Strategy.  Describe how compensation practices encourage and reward long-term growth, promote implementation of the strategy and achievement of business goals and protect shareholder value.

          Discuss How Board Practices and Board Culture Support Independent Oversight.  Clearly articulate the actual practices and responsibilities of the lead director or non-executive chair, independent directors, committee chairs and the board as a whole in providing effective oversight, understanding shareholder perspectives, evaluating CEO performance and organizing themselves to ensure priorities are met.  Investor expectations are evolving in this regard, and the company should stay abreast of current expectations.

How to Communicate

          Periodic “Letters” to Investors.  Periodic “letters” to shareholders on behalf of the management and/or board focusing on the issues deemed important for satisfaction of the new paradigm are valuable.  Letters from management can articulate management’s vision and plans for the future, explain what the company is trying to achieve and discuss how it plans to win in the market.  Letters from the board can convey board-level priorities and involvement.  Depending on the circumstances, statements or letters may be separate, jointly signed by the CEO and the lead director or non-executive chair, come from particular committees as to matters within their ambit or be from the full board.

          Investor Days.  The company should use “Investor Days” to articulate a long-term perspective on company prospects and opportunities and provide “deep dives” into strategy, performance and capital allocation.  Challenges should also be candidly addressed and responsive initiatives outlined.  Deciding which long-term metrics, goals and targets should be shared is an area in active evolution.  All of the company’s major long-term investors, including “passive” investors and index funds, should be extended an invitation.  Key materials from a completed Investor Day can also be separately circulated to investors, including index funds.  The company may also invite directors to attend.  In certain cases, it may be useful for a director to participate in an Investor Day to validate and communicate board involvement and priorities.

          Quarterly Communications.  Quarterly earnings rituals remain, for now, a fact of life in the U.S.  Nevertheless, the company can place quarterly results in the context of long-term strategy and objectives, discuss progress towards larger goals and articulate higher priorities, all while eschewing quarterly guidance.

          Proxy Statements, Annual Reports, Other Filings and the Company’s Online Presence.  Proxy statements, annual reports/10-Ks, SEC filings, presentations and voluntary disclosures provide communication opportunities.  For example, the customary proxy section entitled “The Board’s Role in Risk Oversight” will ultimately evolve into section(s) covering “Board Oversight of Strategy and Risk.”  The company should present information online in readily accessible, user-friendly and well-organized formats.

          Investor Engagement.  Disciplined, direct and periodic two-way dialogue with institutional investors is advisable, supported by written communications and tailored presentations.  Opening channels of communication in advance of a crisis or activist challenge is extremely important.  Communicate engagement procedures and activity.  Prepare for director-level interactions with major shareholders and know when and how to involve director(s) – proactively or upon appropriate request – without encroaching upon management effectiveness.  Do not hesitate to reach out to investors, even during proxy season, if there is a matter of importance to discuss.  Coordinate internal outreach across the different categories of shareholders and have a superstar corporate governance executive and a superstar investor relations executive.

Martin Lipton

Sabastian V. Niles

Sara J. Lewis

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The New Paradigm for Corporate Governance

February 1, 2016

The New Paradigm for Corporate Governance, by Marty Lipton

Since I first identified a nascent new paradigm for corporate governance with leading major institutional investors supporting long-term investment and value creation and reducing or eliminating outsourcing to ISS and activist hedge funds, there has been a steady stream of statements by major investors outlining the new paradigm. In addition, a number of these investors are significantly expanding their governance departments so that they have in-house capability to evaluate governance and strategy and there is no need to outsource to ISS and activist hedge funds.

The following is a summary consolidation of what these investors are saying in various forums. Clearly articulated plans are necessary to gain and keep the support of these investors. A company should not leave an opening for an activist with a more attractive long-term plan. Board participation in the development and approval of strategy should be effectively communicated in letters to these investors, annual reports and proxy statements. The description should include the major issues debated by the board and how they were resolved. A company should recognize that ESG and CSR issues and how they are managed are important to these investors. A company should develop and communicate its procedures for engagement by management and directors with these investors. In addition, a company should facilitate direct engagement with directors by these investors who request it. A company should support national policies that are designed to achieve longterm value creation. A company should support major investment by government in infrastructure, a rational tax policy that encourages long-term strategies and other policies that encourage and support long-term growth on both a company and a macro basis. These investors do not favor stock repurchases at the expense of long-term investment. These investors recognize that there is no need for quarterly earnings guidance, if a company has a clearly articulated long-term strategy. These investors also recognize that quarterly guidance is inconsistent with the long-term investment strategies that they are encouraging.

In addition to the statements by, and actions of, these leading institutional investors, similar views are being expressed by The Conference Board, The Brookings Institution, The Aspen Institute, Focusing Capital on the Long Term (an organization formed to promote long-term investment), the chief economist of the Bank of England and numerous others. In addition, recent academic research has revealed the methodological fallacies in the so-called “empirical evidence” use by the academics who have argued that unrestrained attacks by activist hedge funds create longterm value for the targets of their attacks, thereby strengthening the ability of these institutions to refuse to support activist attacks on portfolio companies.

A recent article by Professor John Coffee of the Columbia Law School and the February 1, 2016 Letter from Larry Fink of BlackRock to the CEOs of the S&P 500 are must reads.

Martin Lipton

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409A SIX MONTH DELAY INCLUDES DIRECTORS

 

February 22, 2016
Caroline Hayday and Sasha Belinkie, of Cleary Gottlieb Steen & Hamilton LLP, recently wrote this article of interest:

It is well known that specified employees of publicly-traded companies must wait at least six months following a separation from service to receive payments of deferred compensation triggered by such separation. The six-month delay requirement must be set forth in the plan establishing the right to the payment of deferred compensation on or before the date the applicable individual first becomes a specified employee. Failure to do so, either as a matter of documentary or operational compliance, could result in the imposition of draconian penalty taxes and interest charges on the service provider under Section 409A of the Internal Revenue Code of 1986 (the “Code”).

What is perhaps less well known is that a non-employee director may also be considered a specified employee. A specified employee is defined by reference to Section 416(i) of the Code and includes “an employee who, at any time during the plan year, is”:

  • An officer whose annual compensation is greater than $170,000 (up to the lesser of 10% and 50 employees);
  • A 5% owner; or
  • A 1% owner receiving annual compensation of more than $150,000.
While there has been some discussion about directors who also hold (formally or informally) an officer position, very little attention has been given to the two ownership prongs of the definition and how they might trigger specified employee status for non-employee directors. On their face the two ownership prongs do not appear to apply to non-employee directors since they simply refer to “employees”; the preamble to the regulations, however, declined to accept the request by certain commenters to limit the universe of specified employees to common law employees. Section 416(i)(3) of the Code provides that self-employed individuals described in Section 401(c)(1) of the Code “shall be treated as an employee,” with Section 401(c)(1) defining a self-employed individual simply as an individual who has earned income from self-employment. Since Section 401(c)(1) addresses qualification of retirement plans in which non-employee directors do not commonly participate, the broad definition of employee may not have been focused on non-employee directors, but it does not specifically exclude them from its reach. The Internal Revenue Service generally considers directors fees to be self-employment income (and in fact the proposed Cafeteria Plan Regulations specifically call out directors as being self-employed individuals). Furthermore, Dan Hogans, one of the IRS architects of Section 409A, noted at a 2007 Steptoe & Johnson LLP audio-conference (memorialized in the annotated Section 409A regulations) both that the determination of who is a specified employee is by reference to the top-heavy rules and that directors could be picked up on the basis of share ownership.
Both 1% and 5% ownership of a public company are certainly a significant stake that may be uncommon among non-employee directors, although that level of ownership may be more likely among founders and long-time directors. Companies should also be aware that the ownership need only exceed the requisite threshold at any point in the year and such ownership is determined pursuant to the attribution rules of Section 318 of the Code. Section 318 of the Code sweeps in significantly more than the beneficial ownership rules applicable to public disclosure (e.g., unvested stock options regardless of whether they would vest in the relative short term). These rules may also require attribution of the ownership by partnerships and corporations, relevant for representatives of private equity, hedge fund and venture capital firms who serve on the board of a company in which such a firm holds a stake (although in practice these representatives may not receive compensation for the board service that is settled upon ceasing to be a board member, making designation as a specified employee effectively irrelevant).
Absent additional guidance to the contrary, public companies should consider making sure that their arrangements with their non-employee directors are in documentary compliance on this point, and including non-employee directors in their internal process around determining who their specified employees are and which payments may need to be delayed. For example, many companies provide for director awards that are settled at the time of departure from the board (e.g., restricted stock units that settle upon ceasing to be a board member and deferred fee arrangements) and thus, to the extent the departing director is a specified employee, settlement of those awards would almost certainly need to be delayed the requisite six months.
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Short Termism Destroys Long Term Shareholder Value

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2720248

This paper shows that an inflow of short-term institutional investors seems to pressure firms to cut R&D investment to report higher earnings and to generate positive earnings surprises, and also leads to temporary boosts in firm valuations. When these short-term investors subsequently leave, the reductions in R&D, higher earnings, and the increase in firm valuations are reversed. Our identification strategy exploits plausibly exogenous variation in the presence of short-term investors around Russell 2000 index inclusions, which are associated with a sharp temporary inflow of short-term institutions and a permanent increase in institutional ownership and analyst coverage.

 

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ISS Issues Executive Compensation Policies

http://www.issgovernance.com/file/policy/us-executive-compensation-policies-faq-21-jan-2016.pdf

In its latest update to compensation policies, ISS has highlighted three areas in particular:

  • FAQ #15 – Problematic Pay Practices and Equity Plans:ISS will now consider three-year average concentration ratios above 30% for the CEO or above 60% for the NEOs in aggregate as a signal that the equity plan is not broad-based;
  • FAQ #59 – Externally-Managed Issuers (EMIs):More detail on minimum levels of disclosure required to avoid the automatic ISS “against” recommendation; and
  • FAQ #61 – Subsequent event handling:More detail around how ISS will evaluate agreements or decisions in the current fiscal year (e.g. not in the year covered by the proxy statement – events subsequent to the fiscal year covered by the CD&A).

See the complete list of FAQ’s at the link above.

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Key Compensation Issues For 2016

January 8, 2016

Compensation Season 2016

          Boards of directors and their compensation committees will soon shift attention to the 2016 compensation season. Key considerations in the year ahead include the following:

1. Say-on-Pay. If a company anticipates a challenging say-on-pay vote with respect to 2015 compensation, it should proactively reach out to large investors, communicate the rationale for the company’s compensation programs and give investors an opportunity to voice any concerns. Shareholder outreach efforts, and any changes made to the compensation program in response to such efforts, should be highlighted in the proxy’s Compensation Disclosure and Analysis. ISS FAQs indicate that one possible way to reverse a negative say-on-pay recommendation is to impose more onerous performance goals on existing compensation awards and to disclose publicly such changes on Form 8-K, though the FAQs further note that such action will not ensure a change in recommendation. Disclosure of prospective changes to the compensation program will demonstrate responsiveness to compensation-related concerns raised by shareholders.

2. ISS. Management and compensation committees should understand the potential consequences of their decisions under applicable ISS policies, but should not waiver in their commitment to create a culture that attracts and retains talented personnel who will contribute to the long-term success of the company. The ISS position on a particular issue does not always serve the best interests of shareholders, and many large institutional shareholders have disclaimed ISS as a primary source of influence in favor of their own, internally generated policies. The most recent ISS pronouncements regarding executive compensation matters are summarized in our December 22, 2015 memorandum “ISS Publishes Updated FAQs Regarding 2016 U.S. Compensation Policies.”

3. New Dodd-Frank Regulations. Last year the SEC adopted final rules regarding pay ratio disclosure. Registrants must include the pay ratio disclosure for proxy statements filed in respect of the first fiscal year beginning on or after January 1, 2017. We continue to await final regulations regarding clawbacks, disclosure of pay for performance and disclosure of hedging by employees and directors. The SEC may finalize these rules as soon as early 2016.

4. Shareholder Activism and Change in Control Protections. Companies should ensure that they understand how their change in control protections function if an activist obtains a significant stake in the company or control of the board. Appropriate protections ensure that management will remain focused on shareholder interests during a period of significant disruption; inadequate protections can result in management departures at a time when stability is crucial. The best time to review these protections and ensure their adequacy is before an activist surfaces.

5. Equity Compensation Plan Matters. Companies should determine whether a share increase or new plan needs to be submitted to shareholders at this year’s annual meeting or whether the performance goals under their incentive plans require re-approval in order to preserve the plan’s exemption from tax code Section 162(m) and the continued deductibility of performance-based compensation. When seeking shareholder approval of an equity plan, companies should understand the likely voting recommendations of the proxy advisory firms, and consider whether additional plan changes or other steps will be required to ensure plan approval.

6. Compensation-Related Litigation. Set forth below are the principal categories of compensation-related litigation in recent years and some suggestions that may mitigate the likelihood of such actions.

  • Disclosure Regarding New or Amended Equity Plans. A robust description of the determination of the number of shares covered by a new or amended equity plan and the dilutive impact of the plan shares may reduce the likelihood of a lawsuit alleging inadequate disclosure.
  • Compliance with Plan Terms and/or Section 162(m). Care should be taken to administer plans in accordance with their terms, including applicable limits on share grants and cash incentive payments. Plans should be drafted to provide flexibility to grant non-deductible awards and should not commit to the preservation of deductibility, including when exercising administrative discretion. Proxy statements should include disclosure that highlights that flexibility and the possibility that even awards intended to be deductible may not be.
  • Director Equity Grant Limitations. Consider including in new or amended omnibus equity plans provisions specifying the precise amount and form of individual grants to directors or a meaningful director-specific individual award limit. These limits may help to avoid claims challenging the level of director compensation.

7. Excise Tax Exposure in M&A Transactions. M&A transactions may expose company employees to punitive taxes, including the 20% excise tax on golden parachute payments (Section 280G), the 15% excise tax on equity compensation awards in inversion transactions (Section 4985) and the 20% penalty tax on non-compliant deferred compensation (Section 409A). By planning ahead, companies may be able to mitigate or eliminate these tax exposures. Properly implemented non-compete arrangements and acceleration of taxable compensation into the year prior to a transaction closing may mitigate the 280G excise tax. An equity award cash out may avoid the application of the inversion excise tax.  And there is a robust corrections framework that allows companies to fix certain broken arrangements under Section 409A. Finally, where mitigation or remediation are impractical solutions to the application of one of these punitive taxes, make-whole arrangements may be appropriate.

8. Executive Succession. During the last twelve months, we have continued to witness a number of high profile CEO turnovers. Planning for succession of the CEO and other senior executives is critical for the long-term success and stability of any public corporation. The board should evaluate annually the status of future generations of company leadership, and the new year is a good time to highlight this priority item.

Michael J. Segal
Jeannemarie O’Brien
Adam J. Shapiro
Andrea K. Wahlquist
David E. Kahan

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ISS Publishes FAQs with Clarifications for 2016 Proxy Season

December 23, 2015

ISS Publishes FAQs with Clarifications for 2016 Proxy Season

          ISS recently published FAQs that clarify its approach on a variety of procedural and governance matters heading into the 2016 proxy season.  Among other things, the FAQs address ISS’s approach to evaluating board responsiveness to proxy access shareholder proposals that receive majority support.  As companies decide how to respond to the growing pressure to adopt proxy access, these FAQs indicate ISS’s position regarding responsiveness to precatory resolutions and certain “second level” proxy access design and drafting issues.

          Key Parameters of Proxy Access.  After a shareholder proposal seeking proxy access has passed, ISS may issue an adverse recommendation if the form of proxy access implemented or proposed by a company contains material restrictions that are more stringent than those included in the majority-supported proxy access shareholder proposal, including:

  • Ownership thresholds above three percent;
  • Ownership for more than three years;
  • Aggregation limits below 20 shareholders; and
  • A cap on nominees below 20 percent of the board.

Where the nominee cap or aggregation limit differs from that specifically stated in a shareholder proposal that received majority support, ISS will evaluate the differences on a case-by-case basis, taking into account (and expecting to see) disclosure regarding shareholder outreach efforts.  Most of the shareholder proxy access proposals that have previously passed asked companies to permit shareholders to “group” and aggregate shares they have individually held for 3 years in order to meet the 3% ownership threshold and were silent as to what a reasonable limit on aggregation would be; most (though not all) shareholder proponents have agreed to withdraw their proposals and major shareholders have been willing to support adopted proxy access bylaws where a company acts reasonably in selecting a group limit.  If shareholders passed a proxy access proposal with a 25% nominee cap, the company should be able to propose a 20% cap without receiving an adverse recommendation from ISS, assuming it can demonstrate in its proxy statement sufficient shareholder outreach and support.  The nomination cap is also an area where most shareholder proponents (and major shareholders) have been willing to show flexibility, and various approaches have emerged on the cap, including hybrid approaches that include both a percentage-based formulation and a numerical minimum or maximum.

          Restrictions or Conditions on Proxy Access Nominees.  On a range of “second-tier” issues that will have to be addressed as companies formulate proxy access bylaws to ensure that they are not abused, ISS will review proxy access implementation and restrictions on nominees on a case-by-case-basis.  ISS considers the following restrictions to be “especially problematic” and to “effectively nullify” the proxy access right:

  • Counting individual funds within a mutual fund family as separate shareholders for purposes of an aggregation limit; and
  • Imposing post-meeting ownership requirements for nominating shareholders.

In addition, ISS views the following restrictions as “potentially problematic,” especially when used in combination, in the context of evaluating board responsiveness to a shareholder-supported proxy access proposal:

  • Prohibiting resubmission of failed nominees in subsequent years;
  • Restricting third-party compensation of proxy access nominees (beyond requiring full disclosure of such arrangements);
  • Restricting the use of proxy access and proxy contest procedures for the same meeting;
  • How long and under what terms an elected shareholder nominee will count towards the maximum number of proxy access nominees; and
  • When the new proxy access right will be fully implemented and accessible to qualifying shareholders.

While these proxy access parameters are not generally inconsistent with the approach taken by the majority of companies that have recently implemented proxy access, this area is still in flux.  We would not expect ISS to issue withhold recommendations as a result of thoughtfully crafted and appropriate restrictions on the use of proxy access.  Companies evaluating proxy access should consider outreach with their shareholders, especially on areas where they may want to take a different position on certain limitations.  We also encourage companies implementing proxy access, whether preemptively or in response to the receipt or passage of a shareholder proposal, to do so in a measured fashion and to consult with counsel to distinguish between fundamental protections and those that might be considered inflammatory.

          Voting on Proxy Access Nominees.  ISS has also formulated a framework for evaluating proxy access nominees.  This set of criteria is in a sense broader than that used in evaluating directors in proxy contests and includes:

  • Nominee- and nominator-specific factors: the nominator’s rationale and critique of management or incumbent directors; the nominee’s qualifications and independence
  • Company-specific factors: the company’s performance relative to peers; background to the contested situation (if applicable); the board’s track record and responsiveness; director and nominee independence; the company’s governance profile; evidence of board entrenchment; current board composition (e.g., skill sets, tenure and diversity); ongoing controversies, if any
  • Election-specific factors: Whether the number of nominees exceeds the number of board seats; the voting standard for the election of directors

          Board Responsiveness to Passage of Independent Chair Proposals.  In evaluating board responsiveness to majority-supported independent chair proposals, ISS has stated that a policy that the company will adopt an independent chair structure upon the resignation of the current CEO would be considered responsive in the context of a company having previously lost the shareholder vote on an independent chair / separation of CEO-Chair proposal.  It will evaluate partial responses on a case-by-case basis, depending on the disclosure of shareholder input obtained through outreach, the board’s rationale and the facts and circumstances of the situation.  Board leadership structure remains an area where major institutional shareholders have shown flexibility where a company conducts effective outreach.

Andrew R. Brownstein
David M. Silk
David A. Katz
Trevor S. Norwitz
Sabastian V. Niles
S. Iliana Ongun

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Staggered Boards, Long-Term Investments and Long-Term Firm Value

December 3, 2015

Staggered Boards, Long-Term Investments and Long-Term Firm Value

          Recent econometric studies (“empirical evidence”) definitively rebut the position taken by the Harvard Law School Shareholder Rights Project (SRP) that classified boards are associated with lower firm value and inferior outcomes for shareholders. After correcting serious statistical and econometrical flaws in the studies put forth to support declassification, these new studies conclude that staggered boards result in long-term value creation:

  • A 2014 study, “Staggered Boards and Firm Value, Revisited” found that, when measured across the “time series,” firm value improves after firms stagger, and declinesafter firms destagger, with the effects stronger at firms seemingly more focused on the long-term. The study reinterprets traditional attacks against staggered boards, which purport to find a negative correlation in the “cross series” between staggered boards and firm value, by suggesting the decision to stagger is largely endogenous and related to ex ante, rather than ex post, lower firm value.
  • A 2014 study, “Board Destaggering: Corporate Governance Out of Focus?” found that activism, firm size, board size, prior performance, CEO tenure and governance arrangements influence decisions to destagger. After controlling for these endogenous factors, the study found that destaggering is associated with declines in long-term accounting performance and declines in R&D investment, “consistent with the reduced incentive horizon for directors following destaggering.”
  • A 2015 study, “Commitment and Entrenchment in Corporate Governance” found that “bilateral” protective arrangements that require shareholder approval – including staggered boards – are associated with increased firm value across the “time series.”
  • In addition, a 2015 study, “Do Staggered Boards Harm Shareholders?” contested the results of a 2013 study, “How Do Staggered Boards Affect Shareholder Value? Evidence from a Natural Experiment” that purported to find that staggered boards harm firm value, based on stock price reactions to court rulings. Based on the same sample and methods, the 2015 study found no statistically significant evidence that staggered boards harm firm value.

          Concomitantly with the rise of the SRP, activist hedge funds have significantly grown in size and have piggybacked on the campaign against staggered boards and other governance “issues” as a lever to force firms into removing their takeover defenses, thus making them more vulnerable to short-termist pressures to deliver immediate shareholder returns. These attempts have been largely successful; over the last 10 years, the percentage of S&P 500 companies with classified boards has sharply declined from 47% to 10%, while at the same time S&P 500 companies have increased dividends and buybacks by 85% to nearly $1 trillion. This has been fueled by underinvesting in long-term growth and is in diametric opposition to the interests of institutional investors in long-term value creation, as evidenced by recent statements by Vanguard’s William McNabb, BlackRock’s Laurence Fink and State Street’s Ronald O’Hanley.

Hopefully these new studies will serve as a further wake-up call and make it clear that the recent trend of forcing companies to adopt one-size-fits-all governance “best practices” – at the expense of long-term investments and firm value – is misguided and must end.

Martin Lipton
Marshall Shaffer

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Hedge Fund Activism and Long-Term Firm Value

November 24, 2015

Hedge Fund Activism and Long-Term Firm Value

          A November 2015 article, Hedge Fund Activism and Long-Term Firm Value, by K.J. Martijn Cremers, Erasmo Giambona, Simone M. Sepe, and Ye Wang, is a very impressive econometric study showing that hedge fund activism more likely destroys long-term value, rather than creates it.  It shows that prior studies of the type Harvard Law School Professor Lucian Bebchuk relies on to validate his policy arguments supporting unfettered attacks by activist hedge funds do not warrant the credibility claimed for them.  Rather than summarize Hedge Fund Activism and Long-Term Firm Value, it can speak most definitively for itself:

“The ability of shareholders, especially activist hedge funds, to determine changes in corporate policies or firm control in the short-term complicates both managerial-decision making and the extent to which other stakeholders want to invest in their relationship with the firm. . . . In both cases, the result is a reduction in long-term firm value.  By enhancing shareholders’ ability to pressure directors and managers, hedge fund activism could thus exacerbate the shareholders’ limited commitment problem rather than acting as a beneficial corrective to managerial moral hazard.”

*          *          *

          “These results [which Bebchuk employs], however, need to be interpreted with caution, because the decision to target a particular firm at a particular time is an entirely discretionary choice by the activist hedge fund.  Hence, firms being targeted by hedge funds could potentially be substantially different from other firms, and this heterogeneity may be related to their subsequent performance rather than to the activist hedge fund campaign directly.  In order to better understand whether activist hedge funds tend to target a particular type of firms, we predict the determinants of activism through logit and Cox proportional hazard models.  These models suggest that prior firm performance is the key predictor of becoming a target in an activist hedge fund campaign.  Specifically, we find that firms are much more likely to become the target of hedge fund activism if they [have] been performing relatively poorly in the past one to five years – that is, hedge funds seem to primarily target relatively undervalued firms.”

“This result, in turn, raises the possibility that the increase in firm value documented by prior studies might be attributable to market mechanisms other than the intervention by activist hedge funds.  Indeed, in competitive markets, many different actors can intervene to turn things around at a relatively poorly performing company, including key employees, top executive management, directors, long-term shareholders, as well as other stakeholders like large customers or suppliers.  In order to address the possibility that other factors may explain the increase in firm value following hedge fund activism, we create a matched sample, where for each “target” firm that is targeted by an activist hedge fund we assign a “control” firm that has similar characteristics (using those characteristics that we document matter for being targeted) as the target firm in the year before the start of the target firm’s activist hedge fund campaign.”

*          *          *

          “[W]e find that when. . . long-term stakeholder relationships matter more to a hedge fund’s target, the targeted firms experience on average a more severe decline in Q in the three years after the intervention, relative to the firm value of the matched control firms.  Also in this case, our results are economically large and statistically significant.  For example, the group of firms in the industry with the most productive labor force that are targeted in hostile hedge fund campaigns have declined in value by 29.71% relative to the control firms in the three years after first being targeted, while the other firms targeted in hostile hedge fund campaigns declined in value by 7.75% relative to their control firms.”

“Our finds have significant implications for the current corporate governance debate, as they challenge the desirability of an indiscriminate expansion of shareholder rights.  While we recognize that managerial moral hazard or having entrenched managers and directors are concrete risks in corporate governance, our research suggests that facilitating the interventions of activist hedge funds might be an undesirable solution to address these risks.  Indeed, once one takes into account the full range of informational problems faced by shareholders – including both managerial moral hazard (or entrenchment) and the shareholder limited commitment problem – hedge fund activism may carry costs that seem to outweigh its potential benefits.  This also suggests that a desirable direction for future empirical research would be to investigate whether alternative corporate governance solutions exists that may better address the trade-offs posed by the multiple informational problems that imbue the shareholder-manager relationship.”

Other 2015 studies that reach the same conclusions are:

The Conference Board, Is Short-Term Behavior Jeopardizing the Future Prosperity of Business?

Yvan Allaire and Francois Dauphin, The Game of Activist Hedge Funds: Cui Bono?

John C. Coffee, Jr. and Darius Palia, The Wolf at the Door: The Impact of Hedge Fund Activism on Corporate Governance

Martin Lipton, Is Activism Moving In-House?

Martin Lipton

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Glass Lewis Announces 2016 Updates to Voting Policy Guidelines

Wachtell, Lipton, Rosen & Katz
(212) 403-1000 (Phone) | (212) 403-2000 (Fax)www.wlrk.comNovember 16, 2015

Glass Lewis Announces 2016 Updates to Voting Policy Guidelines

          Glass Lewis has released updated U.S. proxy voting guidelines for the 2016 proxy season.  Key areas of focus include:  (i) nominating committee performance; (ii) changing the Glass Lewis approach to exclusive forum provisions if adopted in the context of an initial public offering; (iii) director “overboarding;” (iv) evaluation of conflicting management and shareholder proposals when both are put to a vote of shareholders; and (v) withhold recommendations in the context of failures of environmental and social risk oversight.

         Nominating Committee Performance.  Beginning in 2016, Glass Lewis may consider recommending against the chairman of the nominating committee where a failure to ensure that the board has directors with relevant experience, either through director assessment or board refreshment, has contributed to a company’s poor performance.  Glass Lewis has not specified how it will define “poor performance” or how it will assess what contributed to such performance.  Nevertheless, we continue to believe that it is good practice for boards to engage in regular director evaluations and self-assessments.

          Exclusive Forum Provisions.  During the 2015 proxy season, Glass Lewis automatically recommended against the nominating committee chair at companies that adopted exclusive forum provisions prior to an initial public offering.  Beginning in 2016, Glass Lewis will no longer automatically recommend a “withhold” vote in such circumstances, but will instead weigh the presence of the exclusive forum provision in conjunction with the overall governance and shareholder rights profile of the newly public company.  At this time, Glass Lewis will continue automatically recommending against the chairman of the nominating committee when a company unilaterally adopts an exclusive forum provision without shareholder approval outside of a spin-off, merger or initial public offering.  We continue to believe that exclusive forum provisions have merit, but boards of directors need to understand the ramifications of implementing such provisions without shareholder approval.

          Overboarding.  Consistent with the recently announced proposed changes to ISS’s voting policies , Glass Lewis has lowered the number of board positions it views as acceptable:  (i) for executive officers with outside directorships, a limit of one outside public company directorship aside from their own; and (ii) for directors who are not executive officers, reducing the acceptable number of total public boards from the current six to five.  There will be a one-year grace period until 2017, during which time Glass Lewis would include cautionary language in research reports but would not recommend withhold votes for this reason.

          Conflicting Management and Shareholder Proposals.  In response to the SEC’s recent focus on the application of Rule 14a-8(i)(9), which allowed companies to exclude shareholder proposals that conflict with a management proposal, Glass Lewis has articulated how it will assess conflicting management and shareholder proposals.  Going forward, Glass Lewis will consider, among other factors, the nature of the underlying issue, the materiality of the differences between the terms of the shareholder proposal and the management proposal and the company’s overall governance profile, including its responsiveness to shareholders as evidenced by its response to previous shareholder proposals and its prior adoption of provisions enabling shareholder rights. 

          Environmental and Social Risk Oversight.  Glass Lewis expects to recommend against directors responsible for risk oversight where the board or management failed to sufficiently identify and manage a material social or environmental risk that did (or could) negatively affect shareholder value.  Consistent with past practice, Glass Lewis will also typically recommend against directors of companies with records of inadequate risk oversight (which would be assessed with the benefit of hindsight).

As companies and boards prepare for the 2016 proxy season, they should be mindful of the revised guidelines, but should not substitute such guidelines for their own independent judgments.

Andrew R. Brownstein            David M. Silk
David A. Katz                         Trevor S. Norwitz
Sabastian V. Niles                   S. Iliana Ongun

 

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ISS Announces Preliminary 2016 Voting Policy Updates

October 26, 2015

ISS Announces Preliminary 2016 Voting Policy Updates and Opens Comment Period

          Today, ISS announced it is considering changing its U.S. voting policies in three areas heading into the 2016 proxy season: (i) when a sitting CEO or a non-CEO director will be viewed as “overboarded” on account of service on multiple boards, (ii) unilateral board actions that reduce shareholder rights (with a focus on newly classified boards and supermajority voting provisions) and (iii) compensation disclosure at externally managed issuers .  Notably, the areas highlighted for change in the U.S. market do not address proxy access, “responsiveness” to majority-supported shareholder proposals or other current topics.  ISS is also proposing changes to non-U.S. policies, including with respect to Brazil, Canada, France, Hong Kong & Singapore, India, Japan, the Middle East & Africa and the U.K. & Ireland.

          Overboarding.  ISS is proposing lowering the acceptable number of board positions as follows:

1.  For CEOs with outside directorships, a limit of one outside public company directorship besides their own (with “Withhold” recommendations applying only to the CEOs’ outside boards); and

2.  For directors who are not the CEO, reducing the acceptable number of total public boards from the current six (the board under consideration plus five others) to a total of either: (a) five (the board under consideration plus four others) or (b) four (the board under consideration plus three others).

In all cases, there would be a proposed one-year grace period until 2017, during which time ISS would include cautionary language in research reports but would not recommend negative votes for this reason.

          Unilateral Board Actions.  ISS is anticipating generally issuing adverse vote recommendations for director nominees whenever the board of a post-IPO company unilaterally amends its governing documents to newly classify the board or establish supermajority vote requirements; such recommendations would continue until the unilateral action is reversed or ratified by a shareholder vote.  ISS is also considering whether or not to generally issue adverse recommendations if a pre-IPO board amends the company’s bylaws or charter prior to or in connection with the IPO to classify the board and establish supermajority vote requirements to amend the bylaws or charter. If this new policy were enacted, withhold recommendations would apply to director nominees at the annual meetings following completion of the IPO.  ISS also asks whether other board actions beyond self-classification and adopting new supermajority requirements should lead to adverse recommendations.

          Compensation at Externally Managed Issuers (EMIs).  ISS is proposing to generally recommend “Against” the say-on-pay proposal at EMIs (or the EMI’s compensation committee members, the compensation committee chair, or the entire board, as deemed appropriate, in the absence of a say-on-pay proposal on the ballot) “where a comprehensive pay analysis is impossible because the EMI provides insufficient disclosure about compensation practices and payments made to executives on the part of the external manager.”

          Comment Period, Timing and Other Potential Policy Changes. ISS will be seeking input on the updates outlined above using various channels, and formal written comments are due by November 9, 2015 (and may be submitted by e-mail to policy@issgovernance.com ).  ISS expects to release its final 2016 voting policies on November 18, and the final policies will apply to shareholder meetings taking place on or after February 1, 2016.  Note that in addition to releasing draft and final policies, ISS traditionally publishes new FAQs that clarify its positions and policies on various topics, and the final 2016 policies may feature significant changes beyond those outlined in today’s policy consultations and for which formal comment is being sought.

As always, neither boards nor investors should substitute ISS policies or pronouncements for their own independent, case-by-case, fiduciary judgments.

Andrew R. Brownstein
David M. Silk
David A. Katz
Sabastian V. Niles
S. Iliana Ongun

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ISS PUBLISHES ANNUAL POLICY SURVEY RESULTS

Summary by Veritas Executive Compensation Consultants

10/5/15

Last week, ISS announced its findings from the 2015-2016 annual ISS policy survey, the second key milestone in benchmark policy development.  This year, 109 institutional investors, 257 corporate issuers, and 20 consultants/advisors to companies participated in the survey.  The findings from the policy survey can be found here, and below is a synopsis of the policy survey results.  Here are the key takeaways:

  • Investors generally favor stricter “overboarding” thresholds for CEOs and other directors;
  • Investors support ISS’ current proxy access responsiveness policy;
  • Investors support broadening the list of items covered by “unilateral reductions in shareholder rights” and holding directors accountable until rights are fully restored;
  • Investors want clear reconciliation of adjustments used in non-GAAP compensation metrics;
  • Investors do not favor performance-based equity compensation for directors;
  • Investors want longer “cooling-off” periods for former executives and service providers before considering those directors to be independent;
  • Investors are increasingly skeptical about the benefits of renewing NOL pills; and
  • Investors seek disclosure by externally managed companies of the relevant compensation payments and practices of the external manager. 

 Over the next several weeks, ISS will continue its policy-making process for policies that will be effective February 1, 2016.  There are two approximate dates you should circle on your calendar concerning ISS policy development. The first is October 26, which is when ISS will publish certain draft 2016 policy updates and solicit comment.  Second, ISS anticipates releasing final benchmark policy updates for proxy season 2016 on November 18.

Below are more detailed notes on the results of the policy survey.  

2015-2016 ISS Policy Survey Results Synopsis:

Compensation-related survey questions:

1. Adjusted performance metrics:  How should non-GAAP or other adjusted performance metrics be viewed in a compensation performance metric, and what types of adjustments to reported or GAAP metrics are appropriate for compensation purposes?

a.  81% of investors agreed that adjusted metrics are sometimes acceptable, depending on the nature and extent of the adjustments and the degree to which disclosure of their purpose is transparent.  Of those 81%, two-thirds believe that non-GAAP metrics are acceptable as long as performance goals and results are clearly disclosed and reconciled with comparable GAAP metrics in the proxy statement, and the reasons for the adjustments are adequately explained.

2. Director compensation:  What types of equity compensation are appropriate for non-executive directors?  Are performance shares or stock options appropriate for director compensation?

a.  71% of investors believe that stock in lieu of cash for a director’s retainer or meeting fees is acceptable, but only 37% believe that performance-vesting equity is acceptable.

3. Externally-managed issuers:  How should ISS treat say-on-pay resolutions for externally-managed issuers where there is limited or no disclosure regarding executive compensation payments or practices?

a.  71% of investors surveyed indicated that ISS should recommend a vote against a say-on-pay proposal filed by an externally-managed issuer with minimal (or no) disclosure about executive compensation payments or practices on the part of the external manager.

 

Governance-related survey questions:

1. Overboarding:  What constitutes an acceptable number of directorships for directors, should there be restrictions placed on other classes of directors other than active CEOs (active CFOs and law firm partners, for instance), and should there be any exceptions? 

a.  For directors who are not sitting CEOs, 34% of investors believe that a four-directorship limit is appropriate; 18% believe that five is acceptable, and 20% believe that six (the status quo in ISS benchmark policy) is acceptable.  16% said “it depends/other” with a plurality suggesting a three-directorship limit.

b.  For sitting CEOs, 48% of investors believe that two seats (including the CEO’s own company) is an appropriate limit, while 32% believe that three total (the status quo in ISS benchmark policy) is appropriate.

2. Proxy access:  What restrictions in board-implemented proxy access rights, deviating from those requested in a majority supported shareholder proposal, would investors find problematic enough to potentially warrant an “against” or “withhold” vote for directors?

a.  Survey responses on proxy access are generally in line with the ISS benchmark voting policy adopted for 2015.

b.  72% of investors think ISS should issue negative recommendations impacting director elections if management adopts a higher-than-3% requirement, with that figure rising to 90% if the threshold exceeds 5%.  90% of investors surveyed believe negative recommendations are warranted if the ownership requirement exceeds 3 years.

c.  76% of investors surveyed believe negative directors recommendations are warranted if the aggregation limit is fewer than 20 shareholders.

d.  79% of investors believe that ISS should issue negative recommendations if a cap on nominees is less than 20% of the existing board size (rounded down).

3. Director accountability for unilateral bylaw amendments:  What unilateral bylaw amendments do investors find objectionable, and how long should directors be held accountable?

a.  Surveyed investors found a wide range of reductions in shareholder rights objectionable; those include classifying the board (92%), establishing supermajority voting requirements for charter/bylaw amendments (89%), diminishing the right to call special meetings or act by written consent (85%), adopting fee shifting (78%), implementing dissident director nominee compensation restrictions (77%), and increasing advance notice requirements (64%). 

b.  A majority of investors surveyed – 57% – believe that directors should be held accountable (through withhold vote recommendations) until shareholder rights are fully restored.

c.  ISS did not seek input on unilateral adoption of exclusive forum provisions. In a similar question on last year’s policy survey, institutions expressed the least concern about unilateral adoption of exclusive forum provisions of any of the actions on that list. 

4. Pre-IPO bylaw amendments:  How should boards of companies that have recently had their IPO be held accountable for shareholder rights-limiting bylaw amendments adopted before the IPO?

a.  A plurality of investors (48%) believe that a pre-IPO company should not adopt bylaw/charter amendments that negatively impact shareholders’ rights before becoming public, but a large minority (32%) believe pre-IPO companies should be free to adopt whatever provisions they deem appropriate, so long as they are clearly disclosed prior to the IPO.

5. Director independence for former executives:  When should the clock start on the 5-year cooling off period for former executives serving as directors to regain ISS’ “independent” designation, and should a cooling-off period also apply to former service providers to the company (outside counsel or auditor, for instance)?  

a.  A plurality (46%) of investors believe the 5-year clock should begin after the individual retires from the board as well as from all executive posts.

b.  82% of investors surveyed believe that former employees providing significant professional services to the company should also be subject to some cooling-off period.

6. Capital allocation and share buybacks:  What five-year historical financial metrics would investors find helpful in evaluating the appropriateness of certain capital allocation decisions (including share buybacks) made by the board?

a.  At least 85% of investors surveyed believe that additional information on share buybacks, dividends, capital expenditures, and cash balances would help assess capital allocation decisions, share buybacks, and the efficacy of board stewardship.

7. Net Operating Loss (NOL) poison pills:  How do investors believe companies should use NOL pills, what features would investors find broadly objectionable, and how often should they be renewed?

a.  Investor skepticism on NOL pills is growing.  21% believe that NOL pills should not be renewed or extended, 35% believe a duration of three years is too long between renewals, and 17% say it depends, while only 27% believe a three-year term is appropriate.  This is compared against companies, 61% of whom believe that three years is appropriate.

b.  Many investors believe that certain governance features present when a company proposes a poison pill could trigger them to vote against the pill; at least 75% of investors surveyed believe that those include (in decreasing order of objection) unequal voting rights, supermajority voting requirements, no ability to act by written consent or to call a special meeting, having a classified board, or a recent history of proxy contests.  

8. Controlled companies:  Do investors treat controlled companies differently than non-controlled companies for proxy voting or engagement purposes?

a.  56% of investors distinguish between controlled and non-controlled companies when making investment decisions and proxy voting decisions.

b.  91% of investors characterized their engagement with controlled companies as less constructive/productive than engagements with non-controlled companies.

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Managing Like An Activist Destroys Long Term Value

Attached and below is a recent memo from Wachtell Lipton:

September 18, 2015

A New Paradigm for Corporate Governance

          Recently, there have been three important studies by prominent economists and law professors, each of which points out serious flaws in the so-called empirical evidence being put forth to justify short-termism, attacks by activist hedge funds and shareholder-centric corporate governance.  These new studies show that the so-called empirical evidence omit important control variables, use improper specifications, contain errors and methodological flaws, suffer from selection bias and lack real evidence of causality.  In addition, these new studies show that the so-called empirical evidence ignore real-world practical experience and other significant empirical studies that reach contrary conclusions.  These new studies are:

For an earlier recognition of these defects in the so-called empirical evidence see, The Bebchuk Syllogism.

          These new studies provide solid support for the recent recognition by major institutional investors that while an activist attack on a company might produce an increase in the market price of one portfolio investment, the defensive reaction of the other hundreds of companies in the portfolio, that have been advised to “manage like an activist”, has the potential of lower future profits and market prices for a large percentage of those companies and a net large decrease in the total value of the portfolio over the long term.  Recognition of the Threat to Shareholders and the Economy from Attacks by Activist Hedge Funds and Some Lessons from BlackRock, Vanguard and DuPont—A New Paradigm for Governance

          Hopefully these new studies will enable and encourage major institutional investors to recognize that they are the last practical hope in reversing short-termism and taming the activist hedge funds.  Institutional investors should cease outsourcing oversight of their portfolios to activist hedge funds and bring activism in-house.  Short of effective action by institutional investors, it would appear that there is no effective solution short of federal legislation, which runs the risk of the cure being worse than the illness.  For an interesting attempt to legislate institutional investor focus on long-term rather than short-term performance see, European Commission Proposes to Moderate Short-termism and Reduce Activist Attacks

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DOJ New Requirements for Cooperation Credit

Attached and below is a recent memo from Wachtell Lipton Rosen & Katz:

DOJ Adopts New Requirements for Corporations Seeking Credit for Cooperation In an important development for corporations responding to federal investigations, the Department of Justice yesterday announced revisions to its Principles of Federal Prosecution of Business Organizations (“Principles”). The new policies, set out in a memorandum authored by Deputy Attorney General Sally Yates and sent to federal prosecutors across the nation, instruct prosecutors to focus their efforts to secure evidence against individuals responsible for corporate wrongdoing. The memorandum (accessible here) specifically encourages increased attention by DOJ attorneys on considering cases against individual wrongdoers, and also establishes additional guidelines that federal prosecutors and civil enforcement attorneys must follow in conducting and resolving corporate investigations. Perhaps most important under the new Principles, it is now DOJ policy that in order to qualify for any cooperation credit, a corporation must identify “all relevant facts relating to the individuals responsible for the misconduct.” Only if a company satisfies that threshold requirement will DOJ give the company credit for cooperation and assess the remaining elements of the company’s cooperative efforts (e.g., by weighing the timeliness and proactive nature of the company’s internal investigation, the diligence, thoroughness and speed of the investigation, etc.). In other words, as Ms. Yates explained in a speech following the announcement of the new policies, cooperation credit is now “all or nothing,” and there is “[n]o more partial credit for cooperation that doesn’t include information about individuals.” In some respects, this announced policy is more of a codification and strengthening of preexisting DOJ practice than a watershed announcement of a new direction in governmental policy. As we have previously observed, DOJ has for some time based cooperation credit on whether a corporation’s investigation assisted the government in identifying and prosecuting culpable employees. See our memorandum dated January 28, 2015. An important issue—which we hope is not overlooked as part of this heightened attention to potential individual culpability—is that assessing the actions and mental state of individuals is complex and making cases against corporate officers and employees is often difficult. As the Yates memorandum acknowledges, in the corporate setting, knowledge and responsibility are often diffuse, and proving an individual’s culpable intent can be challenging. The new Principles also require government attorneys on both the civil and criminal sides to coordinate with one another from the earliest stages of an investigation, and they encourage civil enforcement attorneys to levy parallel civil charges against individuals and corporations even when criminal charges are also brought. DOJ has made much greater use of civil enforcement tools, where the burden of proof is only a preponderance of the evidence (not the reasonable doubt standard applicable in criminal cases), in pursuing financial crisis era cases. The focus on civil enforcement tools in the Principles suggests that DOJ may make even greater use of this weapon in its arsenal.

The revised Principles underscore that any corporate internal review or response to a government-initiated probe must be carefully designed to maximize the opportunity for the corporation to receive appropriate credit for its cooperation. Where the evidence establishes that particular employees committed wrongdoing, the Yates memorandum makes it clear that those matters must be addressed forthrightly. But there will still be investigations in which the evidence does not support cases against all the individuals whom the government might wish to pursue. We expect that prosecutors will continue to recognize that there are cases in which individuals should not be charged, but the investigation must be conducted in a credible manner that enables the prosecutor to be comfortable in reaching that conclusion. In other words, we trust that fairness will remain as important as cooperation.

John F. Savarese Ralph M. Levene Wayne M. Carlin Jonathan M. Moses David B. Anders Scott Stevenson

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Shareholder Activism Has Gone Overboard

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SEC Adopts Rule for Pay Ratio Disclosure

SEC Adopts Rule for Pay Ratio Disclosure

Rule Implements Dodd-Frank Mandate While Providing Companies with Flexibility to Calculate Pay Ratio

FOR IMMEDIATE RELEASE
2015-160

Washington D.C., Aug. 5, 2015 —The Securities and Exchange Commission today adopted a final rule that requires a public company to disclose the ratio of the compensation of its chief executive officer (CEO) to the median compensation of its employees.  The new rule, mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, provides companies with flexibility in calculating this pay ratio, and helps inform shareholders when voting on “say on pay.”

“The Commission adopted a carefully calibrated pay ratio disclosure rule that carries out a statutory mandate,” said SEC Chair Mary Jo White.  “The rule provides companies with substantial flexibility in determining the pay ratio, while remaining true to the statutory requirements.”

The new rule will provide shareholders with information they can use to evaluate a CEO’s compensation, and will require disclosure of the pay ratio in registration statements, proxy and information statements, and annual reports that call for executive compensation disclosure.  Companies will be required to provide disclosure of their pay ratios for their first fiscal year beginning on or after Jan. 1, 2017.

The rule addresses concerns about the costs of compliance by providing companies with flexibility in meeting the rule’s requirements.  For example, a company will be permitted to select its methodology for identifying its median employee and that employee’s compensation, including through statistical sampling of its employee population or other reasonable methods.  The rule also permits companies to make the median employee determination only once every three years and to choose a determination date within the last three months of a company’s fiscal year.  In addition, the rule allows companies to exclude non-U.S. employees from countries in which data privacy laws or regulations make companies unable to comply with the rule and provides a de minimis exemption for non-U.S. employees.

The rule does not apply to smaller reporting companies, emerging growth companies, foreign private issuers, MJDS filers, or registered investment companies.  The rule does provide transition periods for new companies, companies engaging in business combinations or acquisitions, and companies that cease to be smaller reporting companies or emerging growth companies.

The rules will be effective 60 days after publication in the Federal Register.

# # #

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Risk Management and the Board of Directors

July 27, 2015

Risk Management and the Board of Directors

By Martin Lipton, Daniel A. Neff, Andrew R. Brownstein, Steven A. Rosenblum, Adam O. Emmerich, Sebastian L. Fain, David J. Cohen

I. INTRODUCTION

Overview

Corporate risk taking and the monitoring of risks have continued to remain front and center in the minds of boards of directors, legislators and the media, fueled by the powerful mix of continuing worldwide financial instability; ever-increasing regulation; anger and resentment at the alleged power of business and financial executives and boards, including particularly as to compensation during times of economic uncertainty, retrenchment, contraction, and changing dynamics between U.S., European, Asian and emerging market economies; and consistent media attention to corporations and economies in crisis. The reputational damage to companies and their boards that fail to properly manage risk is a major threat, and Institutional Shareholder Services now includes specific reference to risk oversight as part of its criteria for choosing when to recommend withhold votes in uncontested director elections. This focus on the board’s role in risk management has also led to increased public and governmental scrutiny of compensation arrangements and the board’s relationship to excessive risk taking and has brought added emphasis to the relationship between executive compensation and effective risk management. This overview highlights a number of issues that have remained critical over the years and provides an update to reflect emerging and recent developments.

As we have said before, the board cannot and should not be involved in actual day-to-day risk management. Directors should instead, through their risk oversight role, satisfy themselves that the risk management policies and procedures designed and implemented by the company’s senior executives and risk managers are consistent with the company’s strategy and risk appetite, that these policies and procedures are functioning as directed, and that necessary steps are taken to foster an enterprise-wide culture that supports appropriate risk awareness, behaviors and judgments about risk and that ensures that risk-taking beyond the company’s determined risk appetite is recognized and appropriately escalated and timely addressed. The board should establish that the CEO and the senior executives are fully engaged in risk management and should also be aware of the type and magnitude of the company’s principal risks that underlie its risk oversight. Through its oversight role, the board can send a message to management and employees that comprehensive risk management is neither an impediment to the conduct of business nor a mere supplement to a firm’s overall compliance program, but is instead an integral component of strategy, culture and business operations. In addition, the roles and responsibilities of different board committees in overseeing specific categories of risk should be reviewed to ensure that, taken as a whole, the board’s oversight function is coordinated and comprehensive. In that regard, PricewaterhouseCoopers’ 2014 Annual Corporate Directors Survey reported that 84% of directors believe there is a clear allocation of risk oversight responsibilities among the board and its committees, which represents a modest increase from the prior year, but over half of these directors suggested the clarity of the allocation of these responsibilities could still be improved.

In the wake of numerous high-profile cases over the recent years, risks related to cybersecurity and IT oversight continue to be issues that merit ever-increasing attention and oversight. As recent examples have highlighted, online security breaches, theft of personal data, proprietary or commercially sensitive information and damage to IT infrastructure are omnipresent threats and can have a significant financial and reputational impact on companies. The prevalence of these risks has been exacerbated by rapid innovations in cloud computing, data aggregation, mobile technology and social media, among others. Despite the increased attention this issue has gained recently, a survey report issued last year by PricewaterhouseCoopers indicated that a majority of directors still believe that their board should increase its focus on IT risks such as cybersecurity. In addition, boards should be mindful of potentially enhanced disclosure requirements for cybersecurity risks. Last year, the SEC reviewed public company disclosures relating to cybersecurity risks and issued comment letters to approximately 20 companies, and in June, Luis A. Aguilar, a Commissioner of the SEC, gave a speech at The New York Stock Exchange in which he emphasized that ensuring the adequacy of a company’s cybersecurity measures is an increasingly important part of a board’s risk oversight function.

The focus on risk management is a top governance priority of institutional investors. A PricewaterhouseCoopers survey report issued in 2014 indicated that risk management remains a top priority for investors, and a 2014-2015 National Association of Corporate Directors (NACD) survey revealed that risk oversight was one of the top five issues discussed with institutional investors. In exceptional circumstances, this scrutiny can translate into shareholder campaigns and adverse voting recommendations from ISS. ISS will recommend voting “against” or “withhold” in director elections, even in uncontested elections, when the company has experienced certain extraordinary circumstances, including material failures of risk oversight. In 2012, ISS clarified that such failures of risk oversight will include, among other things, bribery, large or serial fines or sanctions from regulatory bodies and significant adverse legal judgments or settlements. As a case in point, in connection with the ongoing FCPA investigation at Wal-Mart, ISS recommended voting against the chairman, CEO and audit committee chair “due to the board’s failure to adequately communicate material risk factors to shareholders, and to reassure shareholders that the board was exercising proper oversight and stewardship and would hold executives accountable if appropriate.”

Tone at the Top and Corporate Culture

The board and relevant committees should work with management to promote and actively cultivate a corporate culture and environment that understands and implements enterprise-wide risk management. Comprehensive risk management should not be viewed as a specialized corporate function, but instead should be treated as an integral, enterprise-wide component that affects how the company measures and rewards its success.

Of course, running a company is an exercise in managing risk in exchange for potential returns, and there can be danger in excessive risk aversion, just as there is danger in excessive risk-taking. But the assessment of risk, the accurate calculation of risk versus reward, and the prudent mitigation of risk should be incorporated into all business decision-making. In setting the appropriate “tone at the top,” transparency, consistency and communication are key: the board’s vision for the corporation, including its commitment to risk oversight, ethics and intolerance of compliance failures, should be communicated effectively throughout the organization. As noted in a 2014 speech by SEC Chairwoman Mary Jo White, “[e]nsuring the right ‘tone at the top’ . . . is a critical responsibility for each director and the board collectively.” Risk management policies and procedures and codes of conduct and ethics should be incorporated into the company’s strategy and business operations, with appropriate supplementary training programs for employees and regular compliance assessments.

II. THE RISK OVERSIGHT FUNCTION OF THE BOARD OF DIRECTORS

A board’s risk oversight responsibilities derive primarily from state law fiduciary duties, federal and state laws and regulations, stock exchange listing requirements, and certain established (and evolving) best practices, both domestic and worldwide.

Fiduciary Duties

The Delaware courts have taken the lead in formulating the national legal standards for directors’ duties for risk management. The Delaware courts have developed the basic rule under the Caremark line of cases that directors can only be liable for a failure of board oversight where there is “sustained or systemic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists,” noting that this is a “demanding test.” In re Caremark International Inc. Derivative Litigation, 698 A.2d 959, 971 (Del. Ch. 1996). Delaware Court of Chancery decisions since Caremark have expanded upon that holding, while reaffirming its fundamental standard. The plaintiffs in In re Citigroup Inc. Shareholder Derivative Litigation, decided in 2009, alleged that the defendant directors of Citigroup had breached their fiduciary duties by not properly monitoring and managing the business risks that Citigroup faced from subprime mortgage securities, and by ignoring alleged “red flags” that consisted primarily of press reports and events indicating worsening conditions in the subprime and credit markets. The court dismissed these claims, reaffirming the “extremely high burden” plaintiffs face in bringing a claim for personal director liability for a failure to monitor business risk and that a “sustained or systemic failure” to exercise oversight is needed to establish the lack of good faith that is a necessary condition to liability.

More recently, in Goldman Sachs Group, Inc. Shareholder Litigation, decided in October 2011, the court dismissed claims against directors of Goldman Sachs based on allegations that they failed to properly oversee the company’s alleged excessive risk taking in the subprime mortgage securities market and caused reputational damage to the company by hedging risks in a manner that conflicted with the interests of its clients. Chief among the plaintiffs’ allegations was that Goldman Sachs’ compensation structure, as overseen by the board of directors, incentivized management to take on ever riskier investments with benefits that inured to management but with the risks of those actions falling to the shareholders. In dismissing the plaintiffs’ Caremark claims, the court reiterated that, in the absence of “red flags,” the manner in which a company evaluates the risks involved with a given business decision is protected by the business judgment rule and will not be second-guessed by judges.

Overall, these cases reflect that it is difficult to show a breach of fiduciary duty for failure to exercise oversight and that the board is not required to undertake extraordinary efforts to uncover non-compliance within the company, provided a monitoring system is in place. Nonetheless, while it is true that the Delaware Supreme Court has not indicated a willingness, to date, to alter the strong protection afforded to directors under the business judgment rule which underpins Caremark and its progeny, boards should keep in mind that cases involving particularly egregious facts and circumstances and substantial shareholder losses could lead to a stricter standard, particularly at the trial court level. Companies should adhere to reasonable and prudent practices and should not structure their risk management policies around the minimum requirements needed to satisfy the business judgment rule.

Federal Laws and Regulations

Dodd-Frank. The Dodd-Frank Act created new federally mandated risk management procedures principally for financial institutions. Dodd-Frank requires bank holding companies with total assets of $10 billion or more, and certain other non-bank financial companies as well, to have a separate risk committee which includes at least one risk management expert with experience managing risk of large companies.

Securities and Exchange Commission. In 2010, the SEC added requirements for proxy statement discussion of a company’s board leadership structure and role in risk oversight. Companies are required to disclose in their annual reports the extent of the board’s role in risk oversight, such as how the board administers its oversight function, the effect that risk oversight has on the board’s process (e.g., whether the persons who oversee risk management report directly to the board as a whole, to a committee, such as the audit committee, or to one of the other standing committees of the board) and whether and how the board, or board committee, monitors risk.

The SEC proxy rules also require a company to discuss the extent to which risks arising from a company’s compensation policies are reasonably likely to have a “material adverse effect” on the company. A company must further discuss how its compensation policies and practices, including those of its non-executive officers, relate to risk management and risktaking incentives.

Industry-Specific Guidance and General Best Practices Manuals

Various industry-specific regulators and private organizations publish suggested best practices for board oversight of risk management. Examples include reports by the National Association of Corporate Directors (NACD)—Blue Ribbon Commission on Risk Governance and the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The 2009 NACD report provides guidance on and principles for the board’s risk oversight activities, the relationship between strategy and risk, and the board’s role in relation to particular categories of risk. These principles include understanding key drivers of success and risks in the company’s strategy, crafting the right relationship between the board and its standing committees as to risk oversight, establishing and providing appropriate resources to support risk management systems, monitoring potential risks in the company’s culture and incentive systems and developing an effective risk dialogue with management.

COSO published an internationally recognized enterprise risk management framework in 2004. The COSO approach presents eight interrelated components of risk management: the internal environment (the tone of the organization), setting objectives, event identification, risk assessment, risk response, control activities, information and communications, and monitoring. A COSO 2009 enterprise risk management release recommends concrete steps for boards, such as understanding a company’s risk philosophy and concurring with its risk appetite, reviewing a company’s risk portfolio against that appetite, and knowing the extent to which management has established effective enterprise risk management and is appropriately responding in the face of risk. In its 2010 progress report, COSO recommends that the board focus, at least annually, on whether developments in a company’s business or the overall business environment have “resulted in changes in the critical assumptions and inherent risks underlying the organization’s strategy.” By understanding and emphasizing the relationship between critical assumptions underlying business strategy and risk management, the board can strengthen its risk oversight role.

In June 2015, The Conference Board Governance Center published a report, The Next Frontier for Boards: Oversight of Risk Culture, that contains useful recommendations for board driven risk governance. Among other useful suggestions, the report suggests that boards receive periodic briefings (whether from chief internal auditors, outside subject matter experts or consulting firms) on board oversight of risk culture expectations.

With respect to cybersecurity risk management, the SEC has recently voiced its support of the Framework for Improving Critical Infrastructure Cybersecurity released by the National Institute of Standards and Technology (NIST) and indicated that as part of fulfilling their risk oversight function, boards should at a minimum work with management to ensure that corporate policies are in line with the Framework’s guidelines. The Framework includes a set of industry standards and best practices for managing cybersecurity risks, as well as encourages boards to think proactively with respect to cybersecurity threats with a view towards bolstering preparedness in the event of a cyberattack.

III. RECOMMENDATIONS FOR IMPROVING RISK OVERSIGHT

Risk management should be tailored to the specific company, but, in general, an effective risk management system will (1) adequately identify the material risks that the company faces in a timely manner; (2) implement appropriate risk management strategies that are responsive to the company’s risk profile, business strategies, specific material risk exposures and risk tolerance thresholds; (3) integrate consideration of risk and risk management into strategy development and business decision-making throughout the company; and (4) adequately transmit necessary information with respect to material risks to senior executives and, as appropriate, to the board or relevant committees.

Specific types of actions that the appropriate committees may consider as part of their risk management oversight include the following:

• review with management the company’s risk appetite and risk tolerance, the ways in which risk is measured on an aggregate, company-wide basis, the setting of aggregate and individual risk limits (quantitative and qualitative, as appropriate), the policies and procedures in place to hedge against or mitigate risks, and the actions to be taken if risk limits are exceeded;

• establish a clear framework for holding the CEO accountable for building and maintaining an effective risk appetite framework and providing the board with regular, periodic reports on the company’s residual risk status;

• review with management the categories of risk the company faces, including any risk concentrations and risk interrelationships, as well as the likelihood of occurrence, the potential impact of those risks, mitigating measures and action plans to be employed if a given risk materializes;

• review with management the assumptions and analysis underpinning the determination of the company’s principal risks and whether adequate procedures are in place to ensure that new or materially changed risks are properly and promptly identified, understood and accounted for in the actions of the company;

• review with committees and management the board’s expectations as to each group’s respective responsibilities for risk oversight and management of specific risks to ensure a shared understanding as to accountabilities and roles;

• review the company’s executive compensation structure to ensure it is appropriate in light of the company’s articulated risk appetite and risk culture and to ensure it is creating proper incentives in light of the risks the company faces;

• review the risk policies and procedures adopted by management, including procedures for reporting matters to the board and appropriate committees and providing updates, in order to assess whether they are appropriate and comprehensive;

• review management’s implementation of its risk policies and procedures, to assess whether they are being followed and are effective;

• review with management the quality, type and format of risk-related information provided to directors;

• review the steps taken by management to ensure adequate independence of the risk management function and the processes for resolution and escalation of differences that might arise between risk management and business functions;

• review with management the design of the company’s risk management functions, as well as the qualifications and backgrounds of senior risk officers and the personnel policies applicable to risk management, to assess whether they are appropriate given the company’s size and scope of operations;

• review with management the primary elements comprising the company’s risk culture, including establishing “a tone from the top” that reflects the company’s core values and expectation that employees act with integrity and promptly escalate non-compliance in and outside of the organization; accountability mechanisms designed to ensure that employees at all levels understand the company’s approach to risk as well as its risk-related goals; an environment that fosters open communication and that encourages a critical attitude towards decision-making; and an incentive system that encourages, rewards and reinforces the company’s desired risk management behavior;

• review with management the means by which the company’s risk management strategy is communicated to all appropriate groups within the company so that it is properly integrated into the company’s enterprise-wide business strategy;

• review internal systems of formal and informal communication across divisions and control functions to encourage the prompt and coherent flow of risk-related information within and across business units and, as needed, the prompt escalation of information to management (and to the board or board committees as appropriate); and

• review reports from management, independent auditors, internal auditors, legal counsel, regulators, stock analysts, and outside experts as considered appropriate regarding risks the company faces and the company’s risk management function, and consider whether, based on individual director’s experience, knowledge and expertise, the board or committee primarily tasked with carrying out the board’s risk oversight function is sufficiently equipped to oversee all facets of the company’s risk profile—including specialized areas such as cybersecurity—and determine whether subject-specific risk education is advisable for such directors.

In addition to considering the foregoing measures, the board may also want to focus on identifying external pressures that can push a company to take excessive risks and consider how best to address those pressures. In particular, companies have come under increasing pressure in recent years from hedge funds and activist shareholders to produce short-term results, often at the expense of longer-term goals. These demands may include steps that would increase the company’s risk profile, for example through increased leverage to repurchase shares or pay out special dividends, or spinoffs that leave the resulting companies with smaller capitalizations. While such actions may make sense for a specific company under a specific set of circumstances, the board should focus on the risk impact and be ready to resist pressures to take steps that the board determines are not in the company’s or shareholders’ best interest.

Situating the Risk Oversight Function

Most boards delegate oversight of risk management to the audit committee, which is consistent with the NYSE rule that requires the audit committee to discuss policies with respect to risk assessment and risk management. Financial companies covered by Dodd-Frank must have dedicated risk management committees. The appropriateness of a dedicated risk committee at other companies will depend on the industry and specific circumstances of the company. Boards should also bear in mind that different kinds of risks may be best suited to the expertise of different committees—an advantage that may outweigh any benefit from having a single committee specialize in risk management. To date, separate risk committees remain uncommon outside the financial industry. Regardless of the delegation of risk oversight to committees, the full board should satisfy itself that the activities of the various committees are coordinated and that the company has adequate risk management processes in place.

If the company keeps the primary risk oversight function in the audit committee and does not establish a separate risk committee or subcommittee, the audit committee should schedule time for periodic review of risk management outside the context of its role in reviewing financial statements and accounting compliance. While this may further burden the audit committee, it is important to allocate sufficient time and focus to the risk oversight role.

Risk management issues may arise in the context of the work of other committees, and the decision-making in those committees should take into account the company’s overall risk management system. Specialized committees may be tasked with specific areas of risk exposure. Banks, for instance, often maintain credit or finance committees, while energy companies may have public policy committees largely devoted to environmental and safety issues. Where different board committees are responsible for overseeing specific risks, the work of these committees should be coordinated in a coherent manner both horizontally and vertically so that the entire board can be satisfied as to the adequacy of the risk oversight function and the company’s overall risk exposures are understood, including with respect to risk interrelationships. It may also be appropriate for the committee charged with risk oversight to meet in executive session both alone and together with other independent directors to discuss the company’s risk culture, the board’s risk oversight function and key risks faced by the company.

The board should formally undertake an annual review of the company’s risk management system, including a review of board- and committee-level risk oversight policies and procedures, a presentation of “best practices” to the extent relevant, tailored to focus on the industry or regulatory arena in which the company operates, and a review of other relevant issues such as those listed above. To this end, it may be appropriate for boards and committees to engage outside consultants to assist them in both the review of the company’s risk management systems and also assist them in understanding and analyzing business-specific risks. But because risk, by its very nature, is subject to constant and unexpected change, boards should keep in mind that annual reviews do not replace the need to regularly assess and reassess their own operations and processes, learn from past mistakes, and seek to ensure that current practices enable the board to address specific major issues whenever they may arise. Where a major or new risk comes to fruition, management should thoroughly investigate and report back to the full board or the relevant committees as appropriate.

Lines of Communication and Information Flow

The ability of the board or a committee to perform its oversight role is, to a large extent, dependent upon the relationship and the flow of information between the directors, senior management, and the risk managers in the company. If directors do not believe they are receiving sufficient information—including information regarding the external and internal risk environment, the specific material risk exposures affecting the company, how these risks are assessed and prioritized, risk response strategies, implementation of risk management procedures and infrastructure, and the strengths and weaknesses of the overall system—they should be proactive in asking for more. Directors should work with management to understand and agree on the type, format and frequency of risk information required by the board. High-quality, timely and credible information provides the foundation for effective responses and decision-making by the board.

Any committee charged with risk oversight should hold sessions in which it meets directly with key executives primarily responsible for risk management, just as an audit committee meets regularly with the company’s internal auditors and liaises with senior management in – 9 – connection with CEO and CFO certifications for each Form 10-Q and Form 10-K. In addition, senior risk managers and senior executives should understand they are empowered to inform the board or committee of extraordinary risk issues and developments that need the immediate attention of the board outside of the regular reporting procedures. In light of the Caremark standards discussed above, the board should feel comfortable that “red flags” or “yellow flags” are being reported to it so that they may be investigated if appropriate.

Legal Compliance Programs

Senior management should provide the board or committee with an appropriate review of the company’s legal compliance programs and how they are designed to address the company’s risk profile and detect and prevent wrongdoing. While compliance programs will need to be tailored to the specific company’s needs, there are a number of principles to consider in reviewing a program. As noted earlier, there should be a strong “tone at the top” from the board and senior management emphasizing that non-compliance will not be tolerated. The compliance program should be designed by persons with relevant expertise and will typically include interactive training as well as written materials. Compliance policies should be reviewed periodically in order to assess their effectiveness and to make any necessary changes. There should be consistency in enforcing stated policies through appropriate disciplinary measures. Finally, there should be clear reporting systems in place both at the employee level and at the management level so that employees understand when and to whom they should report suspected violations and so that management understands the board’s or committee’s informational needs for its oversight purposes. A company may choose to appoint a chief compliance officer and/or constitute a compliance committee to administer the compliance program, including facilitating employee education and issuing periodic reminders. If there is a specific area of compliance that is critical to the company’s business, the company may consider developing a separate compliance apparatus devoted to that area.

Anticipating Future Risks

The company’s risk management structure should include an ongoing effort to assess and analyze the most likely areas of future risk for the company, including how the contours and interrelationships of existing risks may change and how the company’s processes for anticipating future risks are developed. Anticipating future risks is a key element of avoiding or mitigating those risks before they escalate into crises. In reviewing risk management, the board or relevant committees should ask the company’s executives to discuss the most likely sources of material future risks and how the company is addressing any significant potential vulnerability.

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The Changing Dynamics of Governance and Engagement

The attached article, Corporate Governance Update: The Changing Dynamics of Governance and Engagement, was published in the New York Law Journal on July 22, 2015.

July 23, 2015

Corporate Governance Update: The Changing Dynamics of Governance and Engagement

David A. Katz and Laura A. McIntosh

David A. Katz is a partner at Wachtell, Lipton, Rosen & Katz. Laura A. McIntosh is a consulting attorney for the firm. The views expressed are the authors’ and do not necessarily represent the views of the partners of Wachtell, Lipton, Rosen & Katz or the firm as a whole.

1 The Conference Board Governance Center White Paper, “What Is the Optimal Balance in the Relative Roles of Management, Directors, and Investors in the Governance of Public Corporations?” 2014, available at conference-board.org (subscription required).

As anticipated, the 2015 proxy season has been the “Season of Shareholder Engagement” for U.S. public companies. Activist attacks, high-profile battles for board seats, and shifting alliances of major investors and proxy advisors have created an environment in which shareholder engagement is near the top of every well-advised board’s to-do list. There is no shortage of advice as to how, when, and why directors should pursue this agenda item, and there is no doubt that they are highly motivated to do so. Director engagement is a powerful tool if used judiciously by companies in service of their strategic goals. As companies and their advisors study the lessons of the recent proxy season and look ahead, it is worth examining recent shifts in corporate governance dynamics. With an awareness of the general trends, and by taking specific actions as appropriate, boards can prepare and adapt effectively to position themselves as well as possible to achieve their strategic objectives.

Governance Dynamics Trends

Since 2000, the corporate environment has changed in many ways. A thoughtful white paper by The Conference Board discusses five of the most significant legal, social, and market trends during this time period that have contributed to the changing dynamics of corporate governance.1 These trends have been transformative, and, taken together, they are foundational to shareholder-director engagement today. The first is the increased influence of institutional investors. This is due primarily to the concentration of stock ownership in institutionally-held investment and savings accounts, and to a lesser extent to changes in voting rules and practices and proactive steps by institutional investors to influence corporate governance and direction. The second trend is a shift toward a purely commercial understanding of the purpose of a corporation. Though mid-20th century America generally agreed that a corporation had responsibilities to society as well as to its shareholders, in recent years the prevailing view held by many investors is that public corporations exist primarily to maximize shareholder value. Conflicting interpretations of this goal have produced a further debate as to whether the appropriate timeframe for doing so is the long- or short-term horizon.

The third trend is declining public trust in business and its leaders. Public confidence in corporate America plummeted with the collapse of Enron and WorldCom and the financial scandals that followed, and it was further undermined by the bankruptcies, bailouts, and stock market losses that accompanied the 2008-2009 financial crisis.

The fourth trend, largely a reaction to the third, is the expansion in federal regulations designed to increase the accountability of directors and senior management and provide shareholders with greater power. Federal regulations over the last decade and a half have, among other things, expanded the range of mandatory company disclosures, provided the U.S. Securities and Exchange Commission (SEC) with authority to introduce proxy access, diminished companies’ ability to exclude shareholder proposals from their proxy statements, required regular shareholder advisory votes on executive compensation, and identified shareholder fiduciary duties in certain types of proxy voting by some institutional investors.

This shift in the SEC’s focus recently was clearly articulated by SEC Commissioner Dan Gallagher in his last public speech as a Commissioner: “Part of the SEC’s tripartite mission is to protect investors. But too often, our concept of ‘investor protection’ reflects a prejudgment that a corporation is a democracy, where shareholders participate directly in the governance of the corporation.”2 Commissioner Gallagher went on to argue for a more traditional view of federal versus state regulation:

2 Securities and Exchange Commissioner Daniel M. Gallagher, “Activism, Short-Termism, and the SEC: Remarks at the 21st Annual Stanford Directors’ College,” June 23, 2015 (footnotes omitted), available at www.sec.gov/news/speech/activism-short-termism-and-the-sec.html.

3 Id.

4 See, e.g., David A. Katz & Laura A. McIntosh, “Corporate Governance Update: Important Proxy Advisor Developments,” Sept. 25, 2014, N.Y.L.J., available at corpgov.law.harvard.edu/2014/09/29/important-proxy-advisor-developments/

But, like the United States itself, a corporation can also be a republic, where shareholders elect directors, who in turn govern the corporation. The choice of a shareholder- or director-centric model is properly left to state law. The SEC increasingly has been disrespecting this distinction by interjecting opportunities for shareholder direct democracy into the securities laws. But the director-centric model is at least equally-well suited to the protection of investors, and so the SEC’s rules should provide enough flexibility to accommodate either approach.3

The fifth trend is the growing influence of proxy advisory firms. Proxy advisors successfully capitalized on the loss of public confidence in business leaders, the rise in share ownership of institutional investors, and the wide array of new regulations and governance requirements. Large investors turned to proxy advisors for guidance, smaller investors followed suit, and the soft power of proxy advisors has become disproportionately strong.4 Fortunately, over the last year or two, institutions and other large, influential investors have begun to distance themselves from proxy advisors. One factor in this reversal is the SEC’s issuance of Staff Legal -3- SLB 20 contained a number of elements that together have prompted institutional investors to take responsibility for their proxy votes rather than outsourcing them to advisors such as Institutional Shareholder Services Inc. (ISS). Some large institutional investors have created internal departments to handle much of the work they previously outsourced to proxy advisors. Investment advisors are evaluating and overseeing the work of their retained proxy advisory firms more closely. As Commissioner Gallagher might put it, institutional investors are starting to move from a “compliance mindset” on proxy voting to a “fiduciary mindset.”-4- -5-

Lipton, Rosen & Katz Client Memorandum, May 18, 2015, available at corpgov.law.harvard.edu/2015/05/18/winning-a-proxy-fight-lessons-from-the-dupont-trian-vote/.

14 Fink Letter, supra.

15 Id.

16 Society of Corporate Secretaries & Governance Professionals, “Role of Secretary,” 2015, available at www.governanceprofessionals.org/about/roleofsecretary

17 See Simon Osborne, “Rise of the Company Secretary,” Law Society Gazette, July 7, 2014, available at www.lawgazette.co.uk/law/practice-points/rise-of-the-company-secretary/5042026.fullarticle.

18 Andrew Kakabadse & Nada Korac-Kakabadse, “The Company Secretary: Building Trust Through Governance,” Institute of Chartered Secretaries and Administrators/Henley Business School, University of Reading, 2014, at 7.

19 See Goldstein, supra, at 18.

DuPont did exactly what investment community leaders such as Laurence Fink have encouraged corporations to do—“engage with a company’s long-term providers of capital; … resist the pressure of short-term shareholders to extract value from the company if it would compromise value creation for long-term owners; and, most importantly, … clearly and effectively articulate their strategy for sustainable long-term growth.”14 In his April 2015 letter to chief executives, Fink promised that “[c]orporate leaders and their companies who follow this model can expect our support.”15 In the DuPont-Trian proxy fight, he and a sufficient number of other institutional shareholders held up their end of the bargain.

Some institutional investors have expressed concerns regarding the rapid increase in director engagement and how they, as large shareholders whose attention is much in demand, will allocate their resources to engage meaningfully. There is some concern that companies with smaller market capitalizations may find it difficult to engage the attention of large shareholders, as these investors are likely to prioritize engagement with companies in which they have more significant investments. Smaller companies may need to seek engagement earlier in the proxy season (or before the proxy season) in order to obtain meaningful access to their institutional investors.

The Corporate Secretary

The preeminence of corporate governance and the rise of shareholder engagement have resulted in a fundamental shift in the role of the corporate secretary. As the Society of Corporate Secretaries and Governance Professionals has observed, “In recent years the Corporate Secretary has emerged as a senior, strategic-level corporate officer who plays a leading role in the company’s corporate governance.”16 In addition, many corporate secretaries have become, as one commentator put it, “the primary point of information and influence between the executive management and the board.”17 A 2014 U.K. study concluded that “[t]he role is changing: it is increasingly outward-focused (incorporating investor engagement and corporate communications), and not just about internal administration.”18 A 2014 ISS report found that when investors reach out to engage with boards, they most frequently contact the corporate secretary. The second-most frequent point of initial contact for investor-driven engagement is the board chair (or lead director), with the investor relations office a weak third.19 When it is the -6- -7-

Role of the Board

Corporate governance trends have wrought many significant changes in the management and oversight of U.S. corporations. The priorities and responsibilities of directors, investors, and senior executives have changed to varying degrees as all of the corporate actors adapt to new requirements, societal trends, and the increasingly interconnected corporate environment. Through mechanisms such as majority voting—which is becoming more widespread each year—shareholders are increasing the accountability of directors in annual elections. The hope is that these changing dynamics will have a beneficial effect. As Chief Justice Leo Strine of the Delaware Supreme Court has written:

[I]t is clear that stockholders have more tools than ever to hold boards accountable and the election process is more vibrant than ever. The election of more accountable boards should come with less tumult, not more. More accountable boards should be given more, not less, leeway to make decisions during their term. This does not mean that corporation law should strip stockholders of their substantive rights to vote on mergers or major asset sales. But it does mean that the costs of further distracting corporate managers from focusing on managing the business to generate profit would outweigh the benefits that come from more corporate referendums.24

24 Leo E. Strine, Jr. “One Fundamental Corporate Governance Question We Face: Can Corporations Be Managed For The Long Term Unless Their Powerful Electorates Also Act And Think Long Term?” 66 Bus. Law. 1, 23 (November 2010), available at http://www.ecgi.org/tcgd/2011/documents/Strine%20Fundmental%20Corp%20Gov%20Q%202011%20Bus%20L.pdf.

25 See, e.g., Del. Gen. Corp. L. § 141.

Perhaps one outcome of increased independent director engagement with shareholders will be a decline in corporate referenda, allowing directors to focus on creating value in the long term. To date, unfortunately, that has not been the case.

Though certain aspects of the role of the board may be changing, the fundamental role and responsibilities of the board hold constant. As a matter of state law, the board is charged with managing, or directing the management of, the affairs of the corporation.25 No matter how active or activist a company’s shareholders may become, their legal responsibilities extend only to the election of directors, votes on certain fundamental matters, and advisory votes on compensation. Some academics and activists argue that state law should be revised to expand the legal rights of shareholders; the merits of this suggestion are debatable, and in any event, it has not been implemented.

Shareholder influence likely will continue to grow, but the legal rights of shareholders remain limited, and the U.S. corporate model remains managerial and director-centric. Directors cannot allow their business judgment to be usurped or overly influenced by investors, advisors, or other board outsiders. Boards are encouraged to interact strategically with investors, to address their concerns, and to reinforce the company’s long-term goals, and at the -8-

same time to keep in mind that activism, corporate governance, and engagement change nothing about the fundamental fiduciary duties of directors.

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COMPENSATION PAID TO CONTROLLING SHAREHOLDERS SUBJECT TO BUSINESS JUDGMENT

EXECUTIVE COMPENSATION PAID TO CONTROLLING SHAREHOLDERS SUBJECT TO BUSINESS JUDGMENT REVIEW WHEN APPROVED BY AN INDEPENDENT COMMITTEE
July 20, 2015
Recently, Steve Quinlivan of Stinson Leonard Street LLP authored a piece on Dodd-Frank.com:
Members of the Dolan family hold 73% of the voting power of Cablevision Systems Corporation’s stock.  A shareholder commenced a derivative action regarding the executive compensation paid to Dolan family members serving as Executive Chairman and Chief Executive Officer and the Delaware Court of Chancery dismissed the claims.
In setting the compensation for the two family members that serve as Executive Chairman and Chief Executive Officer of Cablevision, the compensation committee used a peer group of 14 publicly traded companies.  The court, in analyzing the case, also looked to additional companies in Cablevision’s ISS peer group, for a total peer group of 26 companies.  18 members of the peer group had market capitalizations of over $10 billion and the average total revenue was $30.87 billion.  By comparison, Cablevision had a market capitalization of $4.39 billion and $19.58 billion in revenue.
Of the 17 peer companies with less than $30 billion in market capitalization, only two paid their CEO more than Cablevision paid its CEO.  The Executive Chairman earned more than 14 (of 17) CEOs at peer companies with a market capitalization below $30 billion.
The plaintiff claimed that the entire fairness standard should apply to review of the executive compensation rather than the business judgment rule.  The rational that was advanced was that transactions between controllers and a controlled company are reviewed under the entire fairness standard regardless of whether the transaction is approved by a committee or whether challenged in a merger or non-merger.
The Court agreed with the defendants’ analysis about the need to distinguish an independent committee’s compensation decisions from other matters warranting default entire fairness review. For example, major concerns in applying entire fairness review are informational advantages and coercion.  The Court noted the complaint does not support its allegations of leveraging control over the compensation committee with a factual basis to make that inference, and the Court did not believe the Executive Chairman and the CEO had a material informational advantage over the compensation committee about the value of their services. Additionally, the Court would not endorse the principle that every controlled company, regardless of use of an independent committee, must demonstrate the entire fairness of its executive compensation in court whenever questioned by a shareholder. Finally, the Court stated it was especially undesirable to make such a pronouncement here, where annual compensation is not a “transformative” or major decision.

 

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INVESTOR ACCESS TO INDEPENDENT DIRECTORS

July 14, 2015

Responding to Institutional Investor Requests for
Access to Independent Directors

          Recent statements by BlackRock, State Street, Vanguard and other institutional investors clearly articulate their expectation that companies should provide access to independent directors and should adopt a structure for regular investor/director communications.  In responding to these requests, there is a range of approaches that companies could adopt which, in each case, should be tailored to the specific circumstances of the company.  Indeed, institutional investors have specifically stated that they do not seek any particular method to ensure access to, and relationships with, directors.  However, they have made it clear that it will color their attitude toward the company if the company first begins to provide access to directors only after the company has been attacked by an activist.

          This memo outlines some alternatives to consider in constructing a shareholder relations program that will facilitate the development of meaningful long-term relationships with investors while also striking an appropriate balance between the roles of management and directors.  In the case of an activist attack or other contested situation, these alternatives would need to be supplemented by an intensive campaign with participation by directors.

  • The board could establish a Shareholder Relations Committee. This board committee could be available to receive communications from investors and meet with investors. In addition, it could oversee board and director evaluations, which have increasingly become an area of focus for institutional investors.
  • The Lead Director and two or three other independent directors could join the CEO and head of investor relations on annual visits to the top 10 to 15  investors. The scope and substance of the agenda for those visits could be tailored to take into account, among other things, the investor’s areas of focus and level of familiarity with the company (for example, the agenda for a meeting with the proxy team at an index fund may vary substantially from the agenda for a meeting with an active fund manager).
  • When setting up other routine meetings between the company’s CEO/CFO and top investors, the investor relations team could periodically offer to make two or three directors available to join the meeting and/or to meet privately with investors.
  • Directors could attend an Investor Day and arrangements could be made for them to meet with the company’s top investors.
  • Investors could be invited to the annual shareholders meeting and arrangements could be made for them to meet with directors.
  • The role of the Lead Director in facilitating communications with investors could be highlighted. In particular, investors could be provided with the Lead Director’s contact information and could be advised that the Lead Director will work to facilitate direct contact with board members in appropriate circumstances.
  • The Lead Director, Shareholder Relations Committee or the full board could issue an annual letter to investors that describes the “tone at the top” and ongoing initiatives to understand the perspectives of shareholders, develop long-term relationships and further enhance board functioning.
  • The shareholder relations program could be managed by the CFO and investor relations team, in consultation with the company’s CEO and general counsel.


Martin Lipton

Karessa L. Cain

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SEC Proposes Compensation Clawback Rules

Wachtell, Lipton, Rosen & Katz

July 2, 2015

SEC Proposes Compensation Clawback Rules

          The SEC yesterday proposed its long-awaited compensation clawback rules under the Dodd-Frank Act. The proposed rules would require public companies to adopt and enforce compensation recovery policies that recoup from executive officers incentive compensation resulting from specified accounting restatements. Failure to comply with these rules would result in delisting by the applicable exchange.

          Which companies would be covered? With very limited exceptions, the rules would apply broadly to all issuers with listed securities, including foreign private issuers, emerging growth companies, smaller reporting companies, controlled companies and issuers of listed debt whose stock is not also listed.

          Which individuals would be covered? The recovery policy would apply to an issuer’s current and former executive officers who served in that capacity at any time during the applicable look back period. Under the proposed rules, “executive officer” means the issuer’s president, principal financial officer, principal accounting officer, any vice-president in charge of a principal business unit, division or function and any other person (including executive officers of a parent or subsidiary) who performs similar policy-making functions for the issuer.

          What type of restatements would trigger application of the recovery policy? A restatement to correct an error that is material to previously issued financial statements would trigger application of the recovery policy. The determination regarding materiality would be based on facts and circumstances and existing judicial and administrative interpretations.

          How would the applicable look back period be determined? Incentive-based compensation received during the three completed fiscal years immediately preceding the date that a restatement is required to correct a material error would be subject to the recovery policy. Incentive-based compensation would be deemed received in the fiscal period during which the financial reporting measure specified in the incentive-based compensation award is attained, even if the payment or grant occurs before or after that period.

          What types of incentive-based compensation would be covered? Under the proposed rules, “incentive-based compensation” means any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure. “Financial reporting measures” include measures that are determined and presented in accordance with the accounting principles used in an issuer’s financial statements, as well as an issuer’s stock price and total shareholder return. Importantly, stock options and other equity awards that vest exclusively on the basis of service, without any performance condition, and bonus awards that are discretionary or based on subjective goals or goals unrelated to financial reporting measures, would not constitute incentive-based compensation.

          How would the recovery amount be determined? The recovery amount would equal the amount, calculated on a pre-tax basis, of incentive-based compensation received in excess of what would have been paid to the executive officer upon a recalculation of such compensation based on the accounting restatement. For incentive-based compensation that is not subject to mathematical recalculation based on the information in an accounting restatement (e.g., compensation based on stock price goals or total shareholder return), the recoverable amount may be determined based on a reasonable, documented estimate of the effect of the accounting restatement on the applicable measure.

For equity awards that are incentive-based compensation, if the shares or options are still held at the time of recovery, the recoverable amount would be the number of shares or options received in excess of the number that should have been received after applying the restated financial reporting measure. If options have been exercised, but the underlying shares have not been sold, the recoverable amount would be the number of shares underlying the excess options applying the restated financial measure. If shares have been sold, the recoverable amount would be the sale proceeds received by the executive officer with respect to the excess number of shares.

          Would the board have discretion whether to seek recovery? Board discretion would be very limited. An issuer would be required to recover compensation in compliance with its recovery policy except to the extent that pursuit of recovery would be impracticable because it would impose undue costs on the issuer or would violate home country law based on an opinion of counsel. Before concluding that pursuit is impractical, the issuer would first need to make a reasonable attempt to recover the incentive-based compensation. Finally, a board would be required to apply any recovery policy consistently to executive officers and an issuer would be prohibited from indemnifying any current or former executive officer for recovered compensation.

          What additional disclosure requirements would the new proposed rules impose? A listed U.S. issuer would be required to file its recovery policy as an exhibit to its Form 10-K. In addition, the proposed rules would require disclosure in an issuer’s annual proxy statement regarding the application of the recovery policy if, during the prior fiscal year, either a triggering restatement occurred or any balance of excess incentive-based compensation was outstanding. Required disclosure would include, for the prior fiscal year, (1) the names of individuals from whom the issuer declined to seek recovery, and (2) the name, and amount due from, each person from whom excess incentive-based compensation had been outstanding for 180 days or longer. In addition, any amounts recovered would reduce the amount reported in the applicable Summary Compensation Table column for the fiscal year in which the amount recovered initially was reported as compensation.

          When would the new rules become effective? The rules will not take effect for some time. There is a 60-day comment period applicable to the proposed rules. Thereafter the SEC must issue final rules. Once the final rules are published (the “SEC Publication Date”), each exchange will have 90 days to file proposed listing standards that must become effective within one year of the SEC Publication Date. Issuers would be required to adopt a compliant recovery policy no later than 60 days following the effective date of the applicable listing standards and to recover excess incentive-based compensation received on or after the SEC Publication Date if that compensation was based on financial information for any fiscal period ending on or after the SEC Publication Date. The additional proxy statement disclosures would apply immediately following the effective date of the applicable listing standards.

*        *        *        *        *        *

          Most public companies have adopted remuneration recovery policies and there is no meaningful disagreement that there are circumstances in which it is appropriate to recoup improperly awarded compensation. Recognizing that the statute does not leave much room for flexibility, the most troubling element of the proposed rules is that they impose a strict liability framework that strips a board of directors of discretion, continuing a trend that hampers a board’s ability to effectively direct a company.

Adam J. Shapiro
David E. Kahan

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ICGN GLOBAL GOVERNANCE PRINCIPLES

Global_Governance_Principles_2014

Posted here are the Global Governance Principles published by the International Corporate Governance Network, or ICGN. An investor-led organization of governance professionals, ICGN’s mission is to inspire and promote effective standards of corporate governance to advance efficient markets and economies world-wide. Established in 1995 and present in over 50 countries, the ICGN membership includes global investors with assets under management in excess of US$18 trillion.

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U.S. PROXY SEASON HALFTIME REPORT

U.S. PROXY SEASON HALFTIME REPORT
May 26, 2015
As we hit the halfway point for the 2015 U.S. proxy season, a number of trends related to governance practices are carrying through from recent years, an analysis of ISS Voting Analytics data shows.
Director Elections
Shareholders have largely endorsed directors standing for election in 2015, with average support levels of upwards of 96 percent, similar to last year. However, as is the case every year, a number of directors have not fared well at the ballot box. Fourteen directors have failed to receive majority support so far this season, compared with 12 board members at this time last year.
The lion’s share (12 of the 14) of year-to-date 2015 failed director votes have been at firms outside the Russell 3000 index. On a sector basis, most of the failed director elections have occurred at firms in the Technology Media and Telecom sector (with seven failed votes) and financial services firms (3 failed votes). Companies in the financial services sector topped last year’s list with the most failed director votes.
Drivers of Low Votes
The primary drivers of low director support come as no surprise to governance observers. Similar to prior years, affiliated directors on key committees, non-responsiveness to majority supported shareholder proposals or majority opposed directors and say on pay plans, unilaterally adopted poison pills, unilaterally adopted bylaw amendments, directors sitting on too many boards, and persistent pay-for-performance concerns are the major drivers of low shareholder support for directors.
Shareholder Proposals
Of roughly 950 resolutions submitted at almost 500 firms for the 2015 proxy season, 600 shareholder proposals have so far appeared on proxy ballots at close to 350 companies. In aggregate, about 18 percent of the proposals have been withdrawn and approximately 14 percent excluded from ballots with the SEC’s assent. Voting Analytics has average investor support for the approximately 190 shareholder resolutions where vote results are currently available at 33.5 percent support. Twenty eight (or roughly 15 percent) of these have received majority support, with proxy access proposals accounting for almost half of the majority votes. For context, these tallies compare with about 560 proposals at almost 330 companies in all of 2014, which received, on average, 32.7 percent support, and 83 of which received majority votes.
Governance Proposals Most Ubiquitous
Governance proposals account for half of all resolutions on ballots this year, followed by environmental and social (E&S) proposals with 37 percent of the total tally, and compensation proposals at 13 percent.
Governance proposals have received 43 percent average support of votes cast “for” and “against,” whereas shareholders have supported E&S and compensation resolutions by 22.6 percent and 33.4 percent on average, respectively. Governance proposals have also drawn 25 of the 28 majority votes thus far this year, with the remaining three majority votes for compensation resolutions. No E&S proposals have thus far received majority support, in contrast to this time last year when a lobbying disclosure proposal obtained majority support in early May. In 2014, seven E&S resolutions received majority support – six of which were opposed by boards.
Proxy Access Aplenty
In terms of volume, proxy access is the highest-profile shareholder proposal topic this proxy season, with 84 shareholder proposals on the ballot to date, or more than four times the number of proposals that appeared on ballot in 2014. Nearly all of the proxy access shareholder proposals are modeled on the 3 percent-for-three-years formulation featured in the SEC’s vacated proxy access rule. Voting Analytics data shows that access proposals have so far received 54.9 percent shareholder support at the 32 companies where vote results are available. Fourteen have received majority support.
The boards of seven companies have sponsored proxy access proposals that compete with the shareholder proposals on ballot, with terms that are more restrictive. Of the two dueling proposal vote outcomes available, investors voted down the board-sponsored 5 percent-for-three-years proposal at AES Corp. (Governance Quickscore: 2) which received just 36 percent support, favoring the 3 percent-for-three-years shareholder proposal with more than 66 percent support. At Exelon (Governance Quickscore: 6), however, shareholders did the exact opposite, and passed the 5 percent-for-three-years board proposal with more than 52 percent support, whereas the 3 percent-for-three-years shareholder proposal received 44 percent support.
Continued Calls for Independent Board Chairs
After proxy access, the next most frequently occurring shareholder resolution is that calling for an independent board chair, with 64 proposals on ballot so far this year. Average shareholder support for the 29 proposals for which vote results are available currently stands at 29.5 percent, down slightly from last year’s 31.1 percent average support. So far in 2015, no independent chair shareholder proposals have received majority votes – the proposal at Baxter International (Governance Quickscore: 10) came close, with 48.9 percent shareholder support. Last year, four independent chair proposals received majority support, two of which are on ballot again in 2015.
Management Say on Pay Update
As expected in 2015, management say-on-pay (MSoP) ballot volumes are down thanks to the dearth of biennial and triennial advisory votes falling in the 2015 calendar year. For the typical proxy voter, this should translate to a 10 percent year-over-year drop in MSoP ballot volumes. For many investors, this may turn out to be a false economy, however, since the focus simply shifts to the compensation committee and the election of directors. Levels of support have, however, remained relatively unchanged from last year, with average shareholder support for MSoP proposals at 92.3 percent. Eleven firms have so far received less than majority support, compared with 16 failed votes at this time last year. Most of this year’s failed votes have occurred at Russell 3000 firms and in the Industrials sector.
Roller Coaster Rides
A number of boards witnessed reversals of fortune with year-over-year support for say on pay increasing by 50 percentage points or more. Support at Sensient Technologies (Governance Quickscore: 1, Compensation Pillar Quickscore: 3) jumped to 98 percent in 2015 from 46 percent support in 2014, and at FirstMerit Corporation (Governance Quickscore: 2, Compensation Pillar Quickscore: 6), shareholders approved say-on-pay by a margin of 93 percent this year, up from 42 percent support last year.
Other companies experienced the opposite reversal of fortune. Walter Energy (Governance Quickscore: 3, Compensation Pillar Quickscore: 9) saw support for say on pay drop by nearly 70 percentage points, from 95 percent in 2014 to 28 percent this year. Shareholders also thumbed down pay at Schnitzer Steel (Governance Quickscore: 9, Compensation Pillar Quickscore: 8) this year, with just 24 percent support, down from 76 percent support in 2014, and, at Nuance Communication, (Governance Quickscore: 10, Compensation Pillar Quickscore: 10), where the say on pay vote just barely passed last year with 51 percent support, votes in favor dropped significantly in 2015, with just 14.6 percent support. – Edward Kamonjoh, ISS’ Head of U.S. Strategic Research Analysis and Studies
Veritas Executive Compensation Consultants, (“Veritas”) is a truly independent executive compensation consulting firm. 

 www.veritasecc.com, or contact CEO Frank Glassner via phone at (415) 618-6060, or via email at fglassner@veritasecc.com

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SEC ANNOUNCES NEW RULES ON EXECUTIVE COMPENSATION DISCLOSURE

SEC ANNOUNCES NEW RULES ON EXECUTIVE COMPENSATION DISCLOSURE
May 11, 2015
On April 29, the SEC announced that it had voted 3-2 in favor of proposing new rules requiring increased disclosure on the link between company performance and executive compensation. The proposed rules would implement a requirement mandated by Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. According to the SEC press release, the proposed rules would, “provide greater transparency and allow shareholders to be better informed when they vote to elect directors and in connection with advisory votes on executive compensation.”
What the Rules Would Do
If implemented as written, the new rules would require a new section in the compensation disclosure section of a company’s proxy or other relevant filing. The section would have to include a table showing the compensation paid to the company’s “principal executive officer,” as already disclosed in the summary compensation table; however, in the section that would be added under the proposed rules, this total compensation figure would be adjusted to reflect compensation “actually paid.” Amounts included in the summary compensation table for pension and equity awards would be adjusted. The table would also include the average compensation paid to the other named executive officers in the summary compensation table using the new methodology. The compensation disclosure would have to be for the previous five years.
The new rules would also require each company to include in the table its total shareholder return (TSR), using a specified definition of TSR, on an annual basis, also over a five-year look-back period. Additionally, the company would have to disclose TSR for each of the companies in its peer group, using the peers the company identified in either its stock performance graph or in its compensation discussion and analysis (CD&A).
Companies would also be required to tag the data interactively using eXtensible Business Reporting Language (XBRL).
Finally, using the information presented in the table, companies would have to describe the, “relationship between the executive compensation actually paid and the company’s TSR, and the relationship between the company’s TSR and the TSR of its selected peer group.” The company could fulfill this requirement through a narrative, a graphic representation showing the relationships, or some combination of the two.
Smaller reporting companies would only be required to provide the new disclosure for a three-year look-back period, and would not be required to disclose any peer TSR information.
Treatment of Pensions and Equity Awards
The difference between the amounts reported in the new disclosure table and the summary compensation table would stem from changes in the reporting of pension and equity award values. Pensions would be adjusted by subtracting the change in value to the pension, as reported in the summary compensation table, and then adding back the, “actuarially determined service cost for services rendered by the executive during the applicable year.”
To determine the disclosure in the new table, under the term “actually paid,” equity awards would not be disclosed until the day of vesting, and the value would be determined by fair value on the day of vesting, in addition to disclosing the fair value on the grant date. If the vesting date valuation assumptions are materially different from those in the company’s financial statements as of the grant date, then the company would be required to disclose the new fair value assumptions, as well.
Timing of New Rules
If the new rules receive final approval, all companies would have a phase in period. Most companies would be required to meet the new disclosure requirements in the next required filing, but they would only be asked to disclose the data with a three-year look-back period in the first relevant filing after the rules come into effect, adding a year of disclosure each subsequent filing for the next two filings, until the five-year look-back requirement is met.
Smaller companies would only be initially required to include two years’ of disclosure, adding the third year in the next relevant filing.
What the Rules Wouldn’t Do
As currently described, there are a few key points that the rules do not address.
Many companies craft long-term incentive plans with three year performance periods for payouts. The SEC rules require a five-year look-back period for comparing pay and performance, which may leave open some room for interpretation as to how the relationship between performance and pay over the disclosure period is best described effectively. This applies to options with three-year vesting periods, as well as performance-vesting awards with three-year performance periods.
Additionally, the performance period and pay period as required by the disclosure may not align, on an annual basis, with the company’s actual performance and pay periods, especially for companies with awards that do not vest at the calendar year end.
While the rules require the use of TSR as a performance metric, there is no requirement against using an additional performance metric, which some companies may find is more appropriate to their respective situation. Companies may choose to highlight pay for performance with other measures, such as earnings or return on invested capital, to draw attention to metrics believed to be more reflective of long-term performance and value creation.
Finally, the rules do not specify how companies would be required to treat the disclosure of compensation paid to multiple CEOs in a year where a company changed CEOs, and they also do not cover additional pay given in those years, either as part of the payments to the incoming or outgoing CEO.
Next Steps
If the rules receive approval from the Commission for publication, they will be published, and a 60-day comment period will open. 
P.S. – Let’s all keep in mind that there is a presidential election coming up shortly, and this is a hotly debated, and very unpopular subject……..
Veritas Executive Compensation Consultants, (“Veritas”) is a truly independent executive compensation consulting firm. 
We are independently owned, and have no entangling relationships that may create potentialconflict of interest scenarios, or may attract the unwanted scrutiny of regulators, shareholders, the media, or create public outcry.  
 
Veritas goes above and beyond to provide unbiased executive compensation counsel. Since we are independently owned, we do our job with utmost objectivity – without any entangling business relationships. 
 
Following stringent best practice guidelines, Veritas works directly with boards and compensation committees, while maintaining outstanding levels of appropriate communication with senior management. 
 
Veritas promises no compromises in presenting the innovative solutions at your command in the complicated arena of executive compensation. 
 
We deliver the advice that you need to hear, with unprecedented levels of responsive client service and attention. 
 

Visit us online at www.veritasecc.com, or contact our CEO Frank Glassner personally via phone at (415) 618-6060, or via email at fglassner@veritasecc.com. He’ll gladly answer any questions you might have. For your convenience, please click here for Mr. Glassner’s contact data, and click here for his bio.

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THE BOARDROOM STRIKES BACK

THE BOARDROOM STRIKES BACK 
April 27, 2015
This year’s proxy season is turning out to be more hostile than ever, as companies fight back against hedge fund activists.
Companies typically have their annual meetings in the late spring, like the blooming of tulips, and they attract hordes of shareholder activists looking for profits. The activists will often try to elect directors, making proxy season not a reminder of the warming spring but a clarion call for the barbarians at the gate.
Last year, the activists won a series of stunning victories at Darden Restaurants, Sotheby’s and the real estate investment trust now known as Equity Commonwealth, among others. In each case, the companies refused to bow to the activist agenda, preferring instead to try to prevent the activists from electing directors. Each company lost after spending millions of dollars, wasting both money and their boards’ reputations.
The losses actually came as no surprise. In 2014, activists had a 73 percent success rate in electing directors, according to FactSet’s corporate governance database, SharkRepellent. Given the odds, many, including me, predicted that this year’s proxy season would be all about settling as companies sought to avoid these types of bloody losses. This would be the year that shareholder activists dominated completely as companies ran for cover.
We were wrong.
The companies are fighting back. According to the proxy-advisory firm Institutional Shareholder Services and data from SharkRepellent, about 32 out of 78 contests will go to a vote in the second quarter of 2015 alone. This compares with 33 out of 92 contests for all of 2014. Well-known names like Tempur Sealy International, DuPont, MGM Resorts, Macerich and Shutterfly are all fighting proxy contests and refusing to settle with activists.
What explains the surprising, fighting turn?
In large part it is the unique circumstances of each company.
The investment firm H Partners Management, which says it is the largest shareholder of Tempur Sealy, is seeking the ouster of the company’s chief executive, Mark A. Sarvary, which leaves no room for compromise.
At DuPont, the board offered to settle with Nelson Peltz’s hedge fund, Trian Partners, by offering a board seat to one of its candidates. But Trian, which owns 2.7 percent of DuPont, has refused these overtures because it did not include a spot for Mr. Peltz himself. Instead, Trian has preferred to accuse DuPont, which has performed reasonably well, of a laundry list of lapses, including overspending, bad corporate governance and poor negotiating skills in selling assets. This is a fight that should have long been over, except it took a detour into the personal.
Personality often plays a big role in these battles, pushing parties to contest rather than settle. The fight at Wynn Resorts is not a traditional shareholder activist battle but an internecine one between Stephen A. Wynn, the chief executive, and his former wife, Elaine, who is seeking to remain on the board. The messy battle involves a divorce decree and the sale of shares, and it has devolved into nasty accusations of incompetence and sexism.
The trend toward fighting rather than fleeing extends to the exotic, with activists singling out REITs in particular this proxy season. The investment firm Land and Buildings has taken aim at Macerich and the Associated Estates Realty Corporation. Macerich is notable because it adopted a “just say no” defense to a hostile takeover bid by Simon Property, refusing to negotiate with the company, which later withdrew its offer. That Macerich is now the target of an activist is no surprise and should be a cautionary tale to any company that simply refuses to entertain a hostile bid.
The horrible shareholder governance that is all too common in REITs is also drawing non-hedge-fund activists in. Unite Here, a labor union that also seems to like shareholder activism, is taking aim at Hospitality Properties Trust and Ashford Hospitality Trust, seeking to elect directors to improve their corporate governance. The REITs, true to form, are resisting.
What is also noteworthy about the 30 or so contests that Institutional Shareholder Services pegs as the most hostile is that with the exception of Trian, none of the biggest shareholder hedge fund activists — like Greenlight, Pershing Square, Elliot, Jana or Third Point — are involved. Even the Wile E. Coyote of shareholder activism, Carl C. Icahn, is absent.
For the most part this is because companies settled quickly in the face of attacks by these giants. Pershing Square took aim at Zoetis at the end of last year, but the company settled almost immediately. Mr. Icahn settled with Gannett and Manitowoc soon after he announced his positions in those companies.
Meanwhile, Greenlight has mostly been shorting companies; Third Point is digesting Sotheby’s and focusing on Japan; and Jana has focused on campaigns to maximize shareholder value at Qualcomm and Hertz without proxy campaigns. Elliot has been silent, also perhaps focusing on its current investments.
Instead, newer or lesser-known funds are leading the activist charge. For example, a hedge fund coalition led by Harry J. Wilson, a member of the government task force that administered General Motors’ bailout, sought a stock buyback from the automaker, which capitulated quickly. Sarissa Capital Management, a three-year-old fund, is conducting a proxy contest at Ariad Pharmaceuticals, which makes cancer drugs. Meanwhile, Land and Buildings, which is six years old, is taking on MGM International in addition to the two REITs.
Companies may be fighting back precisely because these hedge funds are relative newcomers, thinking they have a better chance against lesser-known funds without the experience or reputation of the biggest ones. The urge to fight may also be because of a change in mood.
Some of the big institutional investors are starting to question the shareholder activism boom. Laurence D. Fink, chief executive of BlackRock, the world’s biggest asset manager, with $4 trillion, recently issued a well-publicized letter that criticized some of the strategies pushed by hedge funds, like share buybacks and dividends, as a “short-termist phenomenon.” T. Rowe Price, which has $750 billion under management, has also criticized shareholder activists’ strategies. They carry a big voice.
There has been at least one notable corporate victory so far. Biglari Holdings, the restaurant company, fought off a proxy battle from Groveland Capital, which held only 0.2 percent of the company. While the chief executive, Sardar Biglari, holds about 19 percent, giving the company a head start, its victory is all the more remarkable because the company is a symbol of bad governance. It paid Mr. Biglari $34.4 million last year, prompting recommendations against the management slate from I.S.S. and Glass Lewis, the other big proxy adviser.
The shifting landscape of shareholder activism perhaps signals a transition. With more players and money pursuing it, companies seem to be adopting a more nuanced strategy that takes into account the fact that not all activists are alike. Activism this year has also mostly been a midcap affair, with hedge funds taking aim at only three companies with market values of more than $10 billion — G.M., DuPont and Macerich. The bulk has focused on companies worth $2 billion or less.
For those who are a bit weary of the knee-jerk response of companies to buy back shares or pay dividends at the first sight of a shareholder activist, this may be a welcome development. To be sure, sometimes the goals of activists are worthwhile, but Mr. Fink may be right that companies are rushing too fast to embrace short-term payouts at the expense of long-term value.
Still, whether the hostility of spring becomes perennial remains to be seen. It will depend on how this year’s contests turn out and whether companies find that fighting the shareholder activists is worth it. Take a seat at the ring.
Veritas Executive Compensation Consultants, (“Veritas”) is a truly independent executive compensation consulting firm. 
We are independently owned, and have no entangling relationships that may create potentialconflict of interest scenarios, or may attract the unwanted scrutiny of regulators, shareholders, the media, or create public outcry.  
 
Veritas goes above and beyond to provide unbiased executive compensation counsel. Since we are independently owned, we do our job with utmost objectivity – without any entangling business relationships. 
 
Following stringent best practice guidelines, Veritas works directly with boards and compensation committees, while maintaining outstanding levels of appropriate communication with senior management. 
 
Veritas promises no compromises in presenting the innovative solutions at your command in the complicated arena of executive compensation. 
 
We deliver the advice that you need to hear, with unprecedented levels of responsive client service and attention. 
 

Visit us online at www.veritasecc.com, or contact our CEO Frank Glassner personally via phone at (415) 618-6060, or via email at fglassner@veritasecc.com. He’ll gladly answer any questions you might have. For your convenience, please click here for Mr. Glassner’s contact data, and click here for his bio.

 

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CII Opposes Automatic Accelerated Vesting Of Unearned Equity

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Unintended Consequences of Proxy Access Elections

Corporate Governance Update- The Unintended Consequences of Proxy Access Elections (dragged)

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Enhancing Audit Committee Transparency–EY

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2015 ISS U.S. Compensation Policies

http://www.issgovernance.com/file/policy/2015comprehensivecompensationfaqs.pdf

Above is the link to the new 2015 ISS document entitled 2015 U.S. Compensation Policies, Frequently Asked Questions.

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Engagement and Activism in the 2015 Proxy Season

January 29, 2015

Corporate Governance Update: Engagement and Activism in the 2015 Proxy Season

David A. Katz and Laura A. McIntosh∗

 

As the 2015 proxy season approaches, the dominant theme appears to be the interaction between directors and investors. Though, traditionally, there was little to no direct engagement, recent experience indicates that communication between these two groups is now on the rise, in some cases resulting in collaboration. This is potentially a beneficial development, particularly insofar as it may help companies and long-term investors work together to resist pressure from activist shareholders seeking short-term profits. In the current environment where activists and hedge funds appear to wield unprecedented financial and political leverage, and the influence of proxy advisors is as significant as it is controversial, the predominant trend seems to be “toward diplomacy rather than war.”1

Organizations such as the Shareholder-Director Exchange, which began last year to offer guidance to shareholders and boards on direct engagement, are promoting policies that may reduce the incidence, duration, and severity of contentious public disagreements. For many activist investors, however, controversy and not compromise is the goal, and these investors are likely to continue to engage in the more combative tactics of proxy fights, consent solicitations, withhold-vote campaigns, and proxy access proposals. More powerful than ever, these investors are using every tool at their disposal to discomfit their targets, and it seems no company is too big or too profitable to be immune from attack. The counter-current of high-profile activist aggression—particularly aimed at boards of directors— thus runs alongside the dominant theme of cooperation and engagement.

 

Direct Engagement on the Rise

Direct engagement between directors and shareholders traditionally has been rare, generally limited to annual meetings and proxy disclosures, and otherwise—particularly with respect to in-person interaction—occurring only in unusual circumstances. In recent years, however, as activism and shareholder rights have come to dominate the corporate governance landscape, communication with institutional investors has been understood as one of the more effective ways to address any simmering discontent and forestall issues before they become public controversies. Investor relations and communication primarily are handled by management and corporate officers, but recently there has been some momentum toward involving directors themselves. In December 2013, Mary Jo White, U.S. Securities and Exchange Commission chair, stated:

“Engagement with shareholders should mean more than just mailing out the annual proxy statement and conducting the annual meeting…. And the board of directors is—or ought to be—a central player in shareholder engagement.”2

White’s remarks quickly gained traction in the corporate governance arena. In July 2014, the Shareholder-Director Exchange—an organization that describes itself as “a working group of leading independent directors and representatives from some of the largest and most influential long-term institutional investors”3 —announced that it had sent a letter to the lead directors and corporate secretaries of every Russell 1000 company.4 The letter proposed that public company boards consider “adopting and clearly articulating a policy for shareholder-director direct engagement.”5

The signatory investor members of the Shareholder-Director Exchange represent over $10 trillion in assets under management and include prominent investment groups such as BlackRock, CalSTRS, and State Street Global Advisors. The letter cited the example of JP Morgan Chase & Co., which, in 2013, convened a group including board members and shareholders representing 40 percent of the shareholder base to discuss corporate governance issues. The Shareholder-Director Exchange has prepared a framework for direct engagement, the “SDX Protocol,” which was endorsed by JP Morgan Chase in its 2014 proxy.6

The SDX Protocol offers a 10-point set of guidelines for direct engagement between “longer-term” shareholders and directors. The Shareholder-Director Exchange emphasizes that the protocol is intended not to encourage the board to interfere with or usurp the investor relations function of management, but rather to consider direct engagement where doing so can be an effective aspect of the overall communications efforts of the company.7

The protocol advocates that boards adopt a clear policy for engagement (recommending a case-by case analysis of each decision to engage with a shareholder and suggesting that a board consider whether to post its policy on its website).8

Other points include identifying potential engagement topics, selecting participating directors, and planning and preparing for the engagement. The protocol sensibly recommends that companies review and update their policies annually and modify them to fit their own specific circumstances.9

Whether or not companies adopt the SDX Protocol, case-by-case decisions on director/investor engagement is something that public companies should consider. Direct engagement is not without its critics, who see a number of potential downsides of interaction. Legitimate objections include unfair access for large shareholders, potential management concerns about the undue influence of major shareholders on directors, and the inadvertent disclosure of information in violation of Regulation FD.10 Nonetheless, as the Shareholder-Director Exchange points out, “it is shortsighted for corporate boards to avoid engaging with their long-term investors when activists frequently meet with those same institutions to pursue corporate change.”11

 

The Politics of Activism

There is no question that shareholder activists have become more active, and

more successful in their activism, in recent years.12 With their unprecedented funds—reportedly close to $200 billion13—economically-motivated activists engage in more interventions, target larger companies, and enjoy significant support from traditional investors and political actors.14 According to a recent Credit Suisse report, there were 514 activist campaigns in 2014, the highest since the financial crisis, and a 20 percent increase over 2013.15 Activist shareholder interventions increased 88 percent between 2010 and 2013, while the average market capitalization of target companies increased to $8.2 billion in 2012 from $3.9 billion in 2011.16

The recently announced proxy fight for seats on the board of DuPont Co., initiated by long-time activist Nelson Peltz of Trian Fund Management, demonstrates that no company is too large to be targeted, and that outperforming the market does not insulate even a very large company from attack. The five largest companies ever engaged in activist proxy contests all were targeted within the last nine years—and in each case (other than DuPont, so far), the activists did achieve some elements of their strategic goals.17 In 2014, activists won a board seat in a record high of 73 percent of proxy fights, an increase from 63 percent in 2013.18

In addition, many activists have obtained board representation simply by threatening a proxy contest, as a number of companies have chosen to settle rather than bear the economic and reputational risks of a proxy fight. The introduction to the SDX Protocol lists a number of “red flags” that are likely to attract negative attention from activist organizations such as the Shareholder Rights Project at Harvard Law School.19

In recent years, the Shareholder Rights Project has operated to pressure public companies to declassify their boards of directors, and in nearly 100 cases—for better or worse—it has had the intended effect.20 The red flags cited by the SDX Protocol include both financial performance-related items such as shareholder return and corporate governance oriented items such as takeover defense plans. Based on the list, which is long and described as “growing,” the question for many companies is not whether they will experience the unwanted scrutiny of corporate gadflies and the unwelcome intrusions of activist investors, but when.

As its profile rises, shareholder activism has become increasingly a socially charged issue, with some activists portraying themselves as Robin Hood-like characters in the corporate world21 and some populist politicians allying themselves with activist causes.22 This is heightened by an appeal to democratic values and an increasing focus on “shareholder rights,” rather broadly defined.23 For example, Institutional Shareholder Services (ISS) has announced that it will consider, for its revised Governance QuickScore 3.0 ratings, whether a board of directors has recently taken action that “materially reduces shareholder rights,” including eliminating the ability to call a meeting by written consent, lowering quorum requirements, classifying the board of directors, or increasing authorized capital. 24

Yet companies, boards, and other investors should keep in mind that shareholder activism is often merely a tactic in a self-interested investment strategy. Shareholder activists such as hedge funds typically are pursuing short-term financial gain at the expense of long-term shareholders and stakeholders. These funds welcome the support of academics and theorists who argue that disruption is good for the market; 25 however, a recent study by the Institute for Governance of Private and Public Organizations, after investigating these claims, found:

“[The] most generous conclusion one may reach from these empirical studies has to be that “activist” hedge funds create some short-term wealth for some shareholders as a result of investors who believe hedge fund propaganda (and some academic studies), jumping in the stock of targeted companies. In a minority of cases, activist hedge funds may bring some lasting value for shareholders but largely at the expense of workers and bond holders; thus, the impact of activist hedge funds seems to take the form of wealth transfer rather than wealth creation.”26

Activist hedge funds, in other words, keep their profits for themselves. Fortunately, investors can be and frequently are persuaded by a company’s management and directors to resist the initiatives of activist funds, even when the activists’ positions are backed by proxy advisory firms such as ISS and Glass Lewis. Investment managers such as BlackRock have made public statements in support of corporate America’s long-term strategic goals.27 BlackRock’s CEO recently wrote that “it is part of our collective role as actors in the global capital markets to challenge [the trend toward short-termism].”28 Despite the pressure to accede to activist demands, nonetheless it is the responsibility of the board of directors and the chief executive to, in the words of one Yale professor, “resist self-motivated activism that adds nothing.”29

 

The Proxy Battleground

The proxy statement continues to be the primary battleground for activist investors waging campaigns against their corporate targets. One source reports that in the 2014 proxy season, seeking boardroom representation was the most popular tactic, accounting for just over 40 percent of all activist interventions in the first half of last year.30 Meanwhile, proxy access proposals are surging in number this year, as activists attempt to enact so-called “private ordering” of proxy access in lieu of action by the SEC in this area. The New York City Comptroller has launched the “2015 Boardroom Accountability Project,” a national campaign for the widespread implementation of proxy access.31 The five pension funds of New York City are submitting precatory proxy access proposals simultaneously at 75 companies, chosen in order to spotlight the issues of climate change, board diversity, and CEO pay. The Boardroom Accountability Project’s requested proxy access bylaw would permit shareholders who own 3 percent of a company for 3 or more years the right to have their director candidates—up to one quarter of the board seats—listed in the company proxy. Since 2012, proxy access proposals with three percent/three year criteria have received shareholder approval at a rate of just over 50 percent.32

As with every shareholder proposal, proxy access proposals must meet certain formal and procedural requirements to be eligible for inclusion in the company proxy statement. Proxy access proposals have evolved in recent years, and their sponsors are often sophisticated investors, and as a result, most submissions are properly prepared. Without a procedural defect, these proposals can be difficult to exclude. The SEC has been unwilling to provide no-action relief on the exclusion of proxy access proposals on the basis of “substantial implementation,” meaning that the company has already adopted a form of proxy access with more stringent requirements.

This season, in the wake of a seemingly successful Whole Foods Market request—and in response to the large number of proxy access proposals submitted under the New York City initiative—numerous companies have submitted requests for exclusion under Rule 14a-8(i)(9), the rule that permits exclusion when there is a direct conflict with a management proposal on the same topic. However, reversing a December no-action letter stating that Whole Foods could exclude a proxy access proposal due to “direct conflict,” the SEC announced earlier this month that it would not, after all, provide no-action relief at this time with respect to any shareholder proposal on that basis. 33

The suspension of no-action relief is in effect pending a review of the “scope and application” of the rule.34 While no-action relief is not necessary for a company to exclude a shareholder proposal from its proxy materials, and while no-action letters are merely informal determinations with no binding effect, the SEC’s reversal of its no-action decision in this situation nonetheless is significant. The tortuous path of proxy access reform over the last decade is a reflection of its complexity and controversy.35 The SEC’s initial position on the Whole Foods proposal was consistent with prior determinations regarding Rule 14a-8(i)(9) on a wide range of governance topics, and its recent, unexpected action highlights the unusually high profile, and high stakes, of proxy access in the current environment. In our view, even if proxy access proposals are adopted, they are unlikely to have a meaningful impact, as hedge funds and other economically-motivated activists are much more likely to eschew proxy access due to its inherent limitations and instead bring the fight directly to the shareholders through a proxy contest. Proxy access is most likely to be utilized by special interests groups who cannot bear the cost of a proxy contest but want to have board representation to pursue their own agenda.

 

The 2015 Proxy Season

In 2015, public companies can expect an increase in both activist attention and the level of engagement expected by shareholders generally. Investors are eager for engagement. CMi2i, a capital markets research company based in the United Kingdom, recently surveyed global institutions managing over $6.7 trillion: 55 percent of respondents stated that they expect their level of engagement with portfolio companies to increase in 2015, while the remainder said that they expect it to remain the same.36 Only 13 percent of the respondents said that they do not have an active engagement policy with portfolio companies.37

Companies facing activist attacks, or considering a policy of direct engagement generally, should evaluate each situation on its own terms. Proactive and thoughtful communication with shareholders, whether involving the board directly or through traditional corporate channels, can be a powerful tool in promoting shareholders’ understanding and support of the company’s long-term strategy. Once an attack has commenced, effective, and possibly direct, communication with major shareholders may be crucial in gaining support for the board’s position versus that of the activist attackers. That said, the specifics of each situation will determine the best path of communication and engagement, and certainly any decision by boards to engage directly with shareholders should be made in close consultation with management and counsel.

Another recent phenomenon that occurred in 2014 and is likely to continue into 2015 is directly tied to the decrease in the number of public companies with staggered boards. In 2014, there were seven contests at companies with over $500 million in market capitalization that sought majority representation on the board of directors. 38 Given that ISS and shareholders appear to be more willing to support a change in the majority of the board, we could see an increase in activists seeking to take control of public companies without paying any premium for the shares. This should drive companies to engage more with their institutional shareholders to avoid this prospect.

The two themes of activism and engagement do, to a certain extent, overlap. One of the founders of the Shareholder-Director Exchange, a prominent corporate lawyer who also tried his hand at investment banking, has partnered with a former chief financial officer of JP Morgan Chase to start something new: “an activist hedge fund with a collaborative approach to management.” 39 As reported in the Wall Street Journal, the fund has begun with investments from more than a dozen current and former chief executive officers in addition to the founders.40

The fund expects to raise money from traditional investment groups such as pension funds and does not intend to launch proxy fights or release so-called “poison pen” letters. The inception of this fund is yet another signal that the lines between activism and mainstream investing are beginning to blur in today’s corporate environment. There is all the more reason for companies to be thoughtful in their engagement with investors and to take a long-term view of the future.

FOOTNOTES

∗ David A. Katz is a partner at Wachtell, Lipton, Rosen & Katz. Laura A. McIntosh is a consulting attorney for the firm. The views expressed are the authors’ and do not necessarily represent the views of the partners of Wachtell, Lipton, Rosen & Katz or the firm as a whole.

1 See Janet Dignan, “Proxy Season 2015: Meeting the Challenge,” CorporateSecretary.com, Nov. 25, 2014, available at www.corporatesecretary.com/articles/proxy-voting-shareholder-actions/12843/proxy-season-2015-meetingchallenge/.

2 U.S. Securities and Exchange Commission Chair Mary Jo White, “Remarks at the 10th Annual Transatlantic Corporate Governance Dialogue,” Dec. 3, 2013, available at http://www.sec.gov/News/Speech/Detail/Speech/1370540434901#.VLv9i_ldWvg.

3 The Shareholder-Director Exchange, “Introduction and Protocol,” February 2014, available at http://www.sdxprotocol.com/ (SDX Protocol).

4 PR Newswire, “Leading Public Company Directors and Representatives of Major Institutional Investors—United Under Shareholder-Director Exchange Banner—Announce New Steps Taken to Advance Growing Governance Movement,” July 22, 2014, available at www.prnewswire.com/news-releases/leading-public-company-directorsand-representatives-of-major-institutional-investors—united-under-shareholder-director-exchange-banner—announce-new-steps-taken-to-advance-growing-governance-movement-268085121.html.

5 The Shareholder-Director Exchange, Letter dated July 2, 2014, available at www.sdxprotocol.com/wpcontent/uploads/2014/07/SDX_Investor-Letter.pdf.

6 See id.

7 See SDX Protocol, supra note 3, at 4, 12.

8 See id. at 12.

9 See id. at 15.

10 See,e.g., Andrew Ross Sorkin, “Investors to Directors: Can We Talk?” NYTimes.com Dealbook, July 21, 2014, available at dealbook.nytimes.com/2014/07/21/investors-to-directors-can-we-talk/?_r=0.

11 See SDX Protocol, supra note 3, at 2.

12 See Linklaters.com, “Activist Investors Buoyed by Increased Success and Targeting Mid-Caps,” July 28, 2014 (finding that 60 percent of activist campaigns met their objectives in the first six months of 2014, compared to 56 percent throughout 2013), available at www.linklaters.com/News/LatestNews/2014/Pages/Activist-investorsbuoyed-increased-success-mid-caps.aspx#.

13 See “Top Activist Hedge Funds Close in on $200 Billion Mark; ValueAct Capital, Elliott Management & JANA Partners Lead the Way,” hedgetracker.com, Jan. 19, 2015, available at www.hedgetracker.com/article/Top-ActivistHedge-Funds-close-in-on-200-billion-mark-ValueAct-Capital-Elliott-Management-JANA-Partners-lead-the-way.

14 For further discussion of this topic, and of activism in corporate transactions, see Martin Lipton, “Dealing with Activist Hedge Funds,” Nov. 6, 2014, available at blogs.law.harvard.edu/corpgov/2014/11/06/dealing-with-activisthedge-funds-3/. See also David A. Katz & Laura A. McIntosh, “Corporate Governance Update: Shareholder Activism in the M&A Context,” NYLJ, March 27, 2014, available at www.wlrk.com/webdocs/wlrknew/WLRKMemos/WLRK/WLRK.23255.14.pdf.

15 Chris Young and Qin Tuminelli, “Activism Outlook for 2015” Credit Suisse (Jan. 25, 2015) (citing SharkRepellant).

16 See SDX Protocol, supra note 3, at 2 (citations omitted).

17 See Maureen Farrell, “The Largest Companies Ever Hit by Activist Proxy Fights,” WSJ.com MoneyBeat, Jan. 9, 2015, available at http://blogs.wsj.com/moneybeat/2015/01/09/the-largest-companies-ever-hit-by-activist-proxyfights/.

18 See Dana Mattioli & Liz Hoffman, “New Activist Hedge Fund Has CEO Backing,” WSJ.com, Jan. 20, 2015 (citing FactSet), available at www.wsj.com/articles/new-activist-hedge-fund-has-ceo-backing-1421730010.

19 See SDX Protocol, supra note 3, at 2-3.

20 See Shareholder Rights Project, “75% of 2014 Engagements Have Already Produced Agreements To Declassify: Towards Declassification at 100 S&P 500 and Fortune 500 Companies,” SRP News Alert, March 11, 2014, available at srp.law.harvard.edu/newsletters/3-11-2014_SRP_newsletter.shtml.

21 See, e.g., Robin Hood Investors Conference (founded by Carl Icahn), available at investors.robinhood.org/speaker/carl-icahn.

22 See, e.g., “Warren Pushes Exchanges on ‘One-Share, One Vote’ in Effort That Could Help Activist Hedge Funds,” MarketWatch, June 7, 2013, available at blogs.marketwatch.com/capitolreport/2013/06/07/warren-pushesexchanges-on-one-share-one-vote-in-effort-that-could-help-activist-hedge-funds/.

23 See, e.g., Institutional Shareholder Services, “Investors Indicate Little Tolerance for Unilateral Boardroom Adoption of Bylaw Amendments That Diminish Shareholder Rights, Study Finds,” Sept. 29, 2014, available at www.issgovernance.com/iss-releases-results-annual-global-voting-policy-survey/.

24 Institutional Shareholder Services, ISS Governance QuickScore 3.0: Overview and Updates, available by request at www.issgovernance.com.

25 See, e.g., Lucian Bebchuk et al., “The Long-Term Effects of Hedge Fund Activism,” Columbia L. R., June 2015 (forthcoming), available at papers.ssrn.com/sol3/papers.cfm?abstract_id=2291577.

26 Institute for Governance of Private and Public Organizations, “‘Activist’ Hedge Funds: Creators of Lasting Wealth? What Do the Empirical Studies Really Say?” July 2014, at 17, available at www.wlrk.com/docs/IGOPP_Article_Template2014_Activism_EN_v6.pdf.

27 See Larry Fink, Chairman & CEO, BlackRock, Letter of March 21, 2014, available at

online.wsj.com/public/resources/documents/blackrockletter.pdf.

28 Id.

29 Jeffrey Sonnenfeld, “Activism Inside Out,” ChiefExecutive.net, Jan./Feb. 2015, available at issuu.com/chiefexecutive/docs/jan_feb_2015 (citing HFR).

30 See Linklaters.com, supra note 12.

31 See City of New York, Office of the Comptroller, Boardroom Accountability Project, available at comptroller.nyc.gov/boardroom-accountability/.

32 For a more detailed discussion of proxy access proposals, see David A. Katz, “Proxy Access Proposals for the 2015 Proxy Season,” Nov. 7, 2014, available at blogs.law.harvard.edu/corpgov/2014/11/07/proxy-access-proposalsfor-the-2015-proxy-season/.

33 See David R. Fredrickson, Securities and Exchange Commission, Letter to Whole Foods Market, Inc., Jan. 16, 2015, available at www.sec.gov/divisions/corpfin/cf-noaction/14a-8/2015/jamesmcritchiecheveddenrecon011615- 14a8.pdf.

34 See Securities and Exchange Commission, Public Statement, “Statement from Chair White Directing Staff To

Review Commission Rule for Excluding Conflicting Proxy Proposals,” Jan. 16, 2015, available at www.sec.gov/news/statement/statement-on-conflicting-proxy-proposals.html#.VL5RHvldWvg.

35 The SEC proposed a proxy access rule in 2003 and in 2007 but did not approve a final rule until 2010. The rule was issued under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, became effective in November 2010, and then was vacated by the U.S. District Court for the District of Columbia in July 2011.

36 See CMi2i Annual Global Institutional Investor Survey, November 2014, available by request at www.cmi2i.com/.

37 Id. at 8.

38 Young & Tuminelli, supra note 15 (citing SharkRepellant and excluding hostile bids).

39 See Mattioli & Hoffman, supra note 18.

40 See id.

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Attacks by Activist Hedge Funds Threaten Shareholders and Economy

Martin Lipton Sabastian V. Niles Sara J. Lewis

December 22, 2014, January 23, 2015

UPDATED Recognition of the Threat to Shareholders and the Economy from Attacks by Activist Hedge Funds Again in 2014, as in the two previous years, there has been an increase in the number and intensity of attacks by activist hedge funds. Indeed, 2014 could well be called the “year of the wolf pack.” With the increase in activist hedge fund attacks, particularly those aimed at achieving an immediate increase in the market value of the target by dismembering or overleveraging, there is a growing recognition of the adverse effect of these attacks on shareholders, employees, communities and the economy. Noted below are the most significant 2014 developments holding out a promise of turning the tide against activism and its proponents, including those in academia. Already in 2015 there have been several significant developments that are worth adding, which are included in bold at the end.

• Several institutional investors voiced concerns about activism this year, including Laurence Fink of BlackRock – first in March lamenting the cuts to capital expenditures and increased debt used to fuel dividends and share buybacks, which he views as having the potential to “jeopardize a company’s ability to generate sustainable long-term returns,” and then in December stating that “[s]trategies pursued by activist investors ‘destroy jobs.’”

• Tim Armour of Capital Group criticized the recent wave of share buybacks, explaining that “[w]e think companies should be run for the long-term and do not think forced steps should be taken to maximize short-term profits at the expense of having thriving enterprise.”

• William McNabb of Vanguard spoke out against the standard activist playbook of aggressively criticizing companies once problems emerge and endorsed a more low-key approach of engagement between directors and shareholders aimed to prevent problems before they happen.

• James Montier of GMO Capital presented compelling empirical evidence that, as Jack Welch once said, shareholder value maximization is “the dumbest idea in the world,” and demonstrating that, ironically, it has not benefitted shareholders themselves.

• Even activists themselves began to acknowledge how outlandish some of their stunts are; Jeffrey Ubben of ValueAct, for example, who favors a more behind-the-scenes, constructive style of activism, likened certain recent actions by other activists to “greenmail,” called certain activist tactics “corrupt” and accused one activist in particular of simply “entertaining himself.”

• In December, the Conference Board released a must-read presentation entitled “Activists and Short Term Corporate Behavior” that compiles data demonstrating that capital investment by U.S. public companies has decreased (and is less than that of private companies), that shortterm pressures are increasing and that hedge fund activism results not in the creation of value but in transfers of value from employees and bondholders to shareholders.

• William Galston’s editorial in the Wall Street Journal, “‘Shareholder Value’ Is Hurting Workers: Financiers Fixated on the Short-Term Are Forcing CEOs into Decisions That Are Bad for the Country,” as the title suggests, warned that activism is harming workers (pointing to the recent break-up of Timken as a prime example) and that if short-termism prevails, “we won’t have the long-term investments in workers and innovation that we need to sustain a higher rate of growth.”

• Dominic Barton, the global managing director of McKinsey, and Mark Wiseman, the president and CEO of the Canada Pension Plan Investment Board, joined to author an article in the Harvard Business Review, “Focusing Capital on the Long Term,” which suggests practical steps that major asset owners such as pension funds, insurance firms and mutual funds can take to minimize the detrimental effects of increased pressure from financial markets and the resulting short-termism, which they believe has “far-reaching consequences, including slower GDP growth, higher unemployment, and lower return on investment for savers.”

• A federal court in California found “serious questions” as to whether Valeant and Pershing Square violated the federal securities laws in connection with their joint hostile bid for Allergan and thereby, as a practical matter, put an end to this scheme until the issue is resolved.

• SEC Commissioner Daniel Gallagher and former Commissioner (and current Stanford Law Professor) Joseph Grundfest argued that the push for board declassification by Harvard Law School’s Shareholder Rights Campaign, initiated by Professor Lucian Bebchuk, was not only based on shoddy scholarship, it actually violated federal securities law antifraud rules.

• SEC Commissioner Gallagher also called for much-needed reforms to Rule 14a-8 to “ensur[e] that activist investors don’t crowd out everyday and long-term investors” by repeatedly bringing costly shareholder proposals (notwithstanding prior failures) that have little or no connection to company value.

• The SEC took a step toward limiting uncritical reliance on proxy advisory firms by issuing guidance indicating that, to fulfill their fiduciary duties to clients, investment advisers must establish and implement measures reasonably designed both to provide sufficient ongoing oversight of proxy advisory firms and to identify and address such firms’ conflicts of interest and errors in their voting recommendations.

• Economics Professor William Lazonick argued that share buybacks can boost share prices in the short term but ultimately disrupt income equality, job stability and overall economic growth, and research by Barclays cited in a Financial Times article called “Buybacks: Money Well Spent?” provided empirical support showing that the “buyback bonanza” indeed contributed to slower growth, including lower earnings retention not reflected in price-to-book value.

• A paper by Dr. Yvan Allaire entitled “The Value of ‘Just Say No,’” and also memos by our firm (here and here), demonstrated that an ISS client note entitled “The IRR of No,” which argued that companies that had “just said no” to hostile takeover bids incurred profoundly negative returns, suffered from critical methodological and analytical flaws that undermined its conclusions.

• Dr. Allaire also presented sophisticated analyses contained in three papers (“Activist Hedge Funds: Creators of Lasting Wealth? What Do the Empirical Studies Really Say?”; “Hedge Fund Activism and Their Long-Term Consequences; Unanswered Questions to Bebchuk, Brav and Jiang”; and in 2015 “Still unanswered questions (and new ones) to Bebchuk, Brav and Jiang”), consistent with our firm’s earlier observations, offering a devastating critique of Professor Bebchuk’s research claiming to show that attacks by activist hedge funds did not destroy long-term value.

• The argument made by Professor Bebchuk, together with Professor Robert Jackson, that poison pills were unconstitutional was similarly dismissed (some would say derided) as the graspingat-straws argument that it was and one wholly inconsistent with existing case law.

• Delaware Supreme Court Chief Justice Leo Strine, Jr.’s Columbia Law Review article, “Can We Do Better By Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law,” persuasively argued against allowing investment funds to prevail over the carefully considered judgments of boards of directors and at the expense of the long-term interests of the ultimate beneficiaries whose assets such funds manage.

• In an article entitled “The Impact of Hedge Fund Activism: Evidence and Implications,” Columbia Law School Professor John Coffee, Jr. rejected the so-called empirical evidence that Professor Bebchuk uses to “prove” that activist attacks are beneficial, and proposed various potential reforms and private ordering techniques (such as a “window-closing” poison pill) that could help mitigate activism’s pernicious effects.

• In “How to Outsmart Activist Investors,” Professors William George and Jay Lorsch of the Harvard Business School advised companies on how to fend off activist challenges, writing that they “remain unconvinced . . . that hedge fund activism is a positive trend for U.S. corporations and the economy.”

• Leiden University Professor Pavlos Masouros, in his book entitled Corporate Law and Economic Stagnation: How Shareholder Value and Short-Termism Contribute to the Decline of the Western Economies, convincingly outlined the chain of political, economic and legal events that led to the shift from a “retain and invest” corporate strategy to a “downsize and distribute” mentality, and the consequent stagnation in GDP growth.

• Cornell University Law School Professor Lynn Stout also published a book that challenges the ideology of shareholder value maximization, the title of which speaks for itself: The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public.

• Oxford University Professor Colin Mayer’s Firm Commitment: Why the Corporation Is Failing Us and How to Restore Trust in It set forth a new paradigm for thinking about corporations, in part to solve the “increasing[] difficult[y] for directors to do anything other than reflect what is perceived to be in the immediate interests of their most influential, frequently short-term shareholders.”

• The Delaware Court of Chancery, in Third Point LLC v. Ruprecht, confirmed the legitimacy of the use of poison pills – not only in the face of an inadequate takeover offer – but also in response to an activist threat.

• State Street Global Advisors issued an issuer engagement protocol that is intended to enable State Street to better understand issuers’ business strategy, management and operations. Hopefully, this will result in State Street supporting issuers’ long-term investment goals and mitigate exposure to activists’ short-term demands.

• Vanguard reviewed their proxy voting and engagement efforts, emphasizing an approach to governance characterized by “quiet diplomacy focused on results,” in which voting decisions are made based on “its own analysis, not the recommendations of third parties” and direct discussions with companies are prioritized to “permit a more nuanced and precise exchange of views than the blunt instrument of a shareholder vote.”

• Two prominent former JP Morgan deal makers announced the formation of Hudson Executive Capital, which they described as a new type of activist hedge fund that will collaborate with companies and their boards. The announcement stated that Hudson will -4- not conduct proxy fights or issue poison-pen letters. Their goal appears to be to have Hudson recognized as a traditional merchant bank and not an activist hedge fund.

• Well-known Yale School of Management Professor Jeffrey Sonnenfeld in an article in the January/February issue of Chief Executive said, “Vigilant CEOs have a right, and even a duty, to resist self-motivated activism that adds nothing. It’s worth noting that it wasn’t so very long ago that investors who resorted to such antics were called by the less salubrious term ‘green mailers.’”

• Guhan Subramanian, a Professor at both Harvard Law School and Harvard Business School and a long-time protégé-colleague of Lucian Bebchuk, has written an article for the March issue of the Harvard Business Review advocating a new form of corporate governance that reflects a need to “return to first principles rather than meander toward ‘best practices.’” His first principle is that “Boards Should Have the Right to Manage the Company for the Long Term.” His other recommendations are (1) replacing quarterly earnings guidance with long-term goals, (2) accepting staggered boards if they can be overcome by a shareholder-approved takeover bid, (3) accepting exclusive forum bylaws, (4) instituting meaningful board evaluation but no director age or term limits, and (5) giving shareholders an “orderly” voice.

We hope that the growing recognition of the analytical and methodological defects in the socalled empirical evidence put forward to justify activist hedge fund attacks by Professor Bebchuk and his cohorts and the growing recognition, not just in the business community, but in academia as well, of the serious threat of activism and short-termism to employees, communities and the economy will result in further action by responsible institutional investors to deny support to activist hedge funds and will also result in legislative, regulatory and judicial actions to dampen their abuses and lessen substantially their impact.

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Do Scholars Have A Duty To Maximize Shareholder Value?

January 15, 2015

Do Scholars Have a Duty to Maximize Shareholder Value? *

By Peter Tunjic

If Lucian Bebchuk still thinks he’s “mainly a kind of of ivory tower academic”, his record as a shareholder activist better get ready for a long fight.

Considered one of America’s leading scholars in law and economics, the director of Harvard’s Program on Corporate Governance has a reputation for aggressively championing the cause of big shareholders and their attacks on public companies.

Bechuk might insist he’s living a life of the mind, but he can’t run away from the pin striped shadow cast by his papers – “The Case for Increasing Shareholder Power“. “The Costs of Entrenched Boards“, “The Myth of the Shareholder Franchise“, “The Myth that Insulating Boards Serve Long term Value“, “The Long Term Effects of Hedge Fund Activism” “Toward a Constitutional Review of the Poison Pill“.   You don’t have to share the professor’s obvious intellect,  to appreciate his radical corporate governance agenda.

To a critical eye, the target of Bebchuk’s econometric research might seem as predictable as his findings.   Delivering the good news to Bill Ackman, Carl Icahn and their fellow hedge fund managers.  First, the fact that they’re the good guys and second, the “proof”  needed to convince institutional investor and policy makers to dismantle the corporate defenses that stand in the way of the activist’s latest business strategy.

The Professor has even invited his students to join him in the pursuit of greater shareholder power.

The Shareholder Rights Project was established by the Harvard Law School Program on Institutional Investors to “contribute to education, discourse, and research related to efforts by institutional investors to improve corporate governance arrangements at publicly traded firms.”  Omitted from the project’s benign mission was to change real world  election policies to reflect their professor’s research and their client’s commercial objectives.

In 2014, the Shareholder Rights Project at Harvard boasted that more than 60% of companies that received their proposal agreed to move to annual elections.  Opening the door to investor business strategies harder to execute when directors have staggered tenure.

Unexpectedly for a project sponsored by a lauded professor and an elite university, the Shareholder Rights Project actively prosecuted the investor’s agenda despite a substantial body of academic research that was contradictory to their claims in support of annual elections.   An omission that now has an SEC Commissioner and Stanford law professor publicly questioning whether Harvard violated US Federal Securities Law by not disclosing the full body of evidence.

Whether Harvard broke the law is probably moot.  If the critics of the Gallagher- Grundfest paper get their way, it is they who will be answering the questions.   But no judge can decide the question so obviously begged by the Shareholder Rights Project at Harvard –  Why is a professor and the world’s most famous university, presumably committed to principles of objectivity and intellectual integrity, pushing the interests of big investors on to their students, regulators and public companies? 

THE IVORY TOWER ON WALL STREET

The Ivory tower moved into Wall Street forty years ago and the neighborhood has never really looked back.

The head of the Chicago School of Economics arrived with an unlikely promise – liberation from the tyranny of the free market.   No longer would investors need to justify their value to corporations.   In the future directors and managers would willingly yield their firm’s interests to Wall Street based on his remarkable academic discovery –  the duty to maximize their profits.

Better news was to come in 1976.   Rochester finance professors Michael Jensen and William Meckling published the “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure”.    Relying on the same discredited assumptions as Milton Friedman 6 years earlier,  their paper set out a practical guide to increasing shareholder wealth by paying managers in securities.

In what is arguably the best example of commercialization of research by a university, companies like IBM turned Jensen and Meckling’s math into their mantra.   James Montier writes “IBM’s mission statement was outlined by Tony Watson (the son of the founder) and was based on three principles…1) respect for individual employees, 2) a commitment to customer service and 3) achieving excellence.  By the early 1990’s not only had IBM had been transformed to fit its new found functions as the creator of shareholder value but so to had business schools.

Though executives are portrayed as the beneficiaries of this revolution, Bebchuk himself, leading the attack on executive remuneration, the real winner was the investment industry and the industrial complex it spawned.

At the time their findings were first published,  US Corporate equities as a percentage of US GDP was around 32%  it’s now  123% . Jensen and Meckling’s research had managed to do for the investment industry what performance enhancing drugs had done for the 1976 Olympics.

Since then, producing leaders perfectly sympathetic to the needs of Wall Street has arguably become the goal of business school.  Investors, the opportunistic beneficiaries of an education system that inexplicably tilts the playing field in their direction.  For more on the relationship between education and shareholder value read here.

Even today, Wall Street can still count on having strategic friends in high places.

A decade ago activist hedge funds held around US$12 billion under management.  That figure is now estimated to be over $US200 billion.  Activism has become an asset class in its own right with pension funds piling into activist business models over the targets of their attacks – Apple, Microsoft, Sony, DuPont, and PepsiCo.

Quick to assist hedge fund activists prove they’re running benign businesses worthy of encouragement are a group of academics led once again by Professor Bebchuk.  In the paper titled “The Long-Term Effects of Hedge-Fund Activism”, the Professor and others considered nearly 2,000 activist interventions by activist funds from 1994 to 2007.  Claiming triumphantly that based on their analysis:

Empirical studies show that attacks on companies by activist hedge funds benefit, and do not have an adverse effect on, the targets over the five-year period following the attack.

Only anecdotal evidence and claimed real-world experience show that attacks on companies by activist hedge funds have an adverse effect on the targets and other companies that adjust management strategy to avoid attacks.

Empirical studies are better than anecdotal evidence and real-world experience.

Therefore, attacks by activist hedge funds should not be restrained but should be encouraged.

I suggest a follow up study that considers whether this type of  research creates value for activist hedge funds.   Anecdotal evidence suggests a correlation between the publication of such papers and the growing fortunes of fund managers.

The Financial Post reports that activists are the fastest growing in the hedge fund industry.  Another report indicates activist funds have earned an annual return after fees of about 20% on average, compared to 8% for all hedge funds and 13% for the stock market since 2009.  Not to re-mention the explosive growth in funds under management.   Then there are the non financial measures of value such as the radical makeover from green mailers to democratic capitalists.

As far as I’m aware, of the hundreds of corporate governance studies in the last forty years, none have considered the effect of academic activism on Wall Street’s value.    Perhaps it’s time we knew the other side of the truth.

THE WORST WAY TO CREATE THE FUTURE

Peter Drucker said, “the best way to predict the future is to create it”.  He was referring to business managers, but he could equally have been referring to his academic colleagues in economics and law.

When Friedman and his fellow economists put shareholders in the center of the corporate universe encircled by all other stakeholders, they crossed the line from disinterested scholars pursuing the truth to the co-creators of the truth.  It is no accident of nature that:

“Corporations are almost universally conceived as economic entities that strive to maximize value for shareholders”

Bebchuk builds on this foundation of double hermeneutics and takes it a step further.   He wants to create the future in the image of his own research.

Not content to inquire into how managers maximize shareholders value in line with predictions,  the impatient professor feels compelled to give activist hedge funds the research ammunition and soldiers to breach the defenses of their public company prey.

Bebchuk even demands that his critics yield before his paper work:

Wachtell should engage with the evidence, not use the “opinions of wise people with considerable experience” to run away from it. To be a constructive contributor to policy debates, Wachtell should stop asserting that the professed beliefs of its partners or clients should serve as the factual premises of policymaking.

Friedrich von Hayek warned us about economists saying things like “Empirical studies are better than anecdotal evidence and real-world experience”.  In his1974 Nobel Memorial Lecture the famous economist and philosopher outlined the danger posed by scientific pretensions in the analysis of social phenomena.  Blaming those who use the  “pretense of knowledge” in their research as the reason why “as a profession we have made a mess of things”.

Donald Campbell expressed a similar fear:

“if we present our resulting improved truth-claims as though they were definitive achievements comparable to those in the physical sciences, and thus deserving to override ordinary wisdom when they disagree, we can be socially destructive.”

A warning that grows more ominous when the line between true scholarship and economic advocacy becomes blurred.

Who should policy makers believe as they are incredulously called to increase the opportunities for shareholders to make money under cover of decreasing the opportunities for managerial self interest?  Bebchuk who says trust in my data or the Nobel Laurette who warned us to never trust an economist who says trust in my data.

THE SCHOLAR’S DUTY

If the conclusion were not absurd, I’d think that Milton Friedman and all those who have stood on his shoulders had lost their mind and were under the mistaken impression that they too were under a duty to maximize shareholder value. Scholars do not owe a duty to shareholders.

In 1837  Ralph Waldo Emerson delivered to Harvard’s Phi Beta Kappa Society what is now referred to as “The American Scholar” speech.   The speech, considered by Oliver Wendell Holmes, Sr. to be America’s “Intellectual Declaration of Independence”  sets out the obligations that come with scholarship.

Howard Mumford Jones recounts the duty –  “The Scholar, said Emerson, is Man Thinking; and the principal instruments of his education are three – nature, books and action.  From nature rightly understood, he will learn that the laws of the universe are also the laws of the human mind.  The office of books is not to create book-worms but independent souls.  The life of action is not to be swallowed up in business, but to translate intellect into character.   And the final object of education is that the soul may be weaned from a passive clinging to what has been said and done in the world and prefer a vigorous intellectual independence”.

Two hundred years on and the focus is back on Harvard and its Shareholder Rights Project.

Witness as senior corporate and securities law professors from Boston University, Chicago, Columbia, Cornell, Duke, George Washington, Georgetown, Harvard, Michigan, New York University, Northwestern, Stanford, Texas, UCLA, Vanderbilt, Virginia and Yale defend students who tell half truths and seek to silence those who pursue the truth:

We are thirty-four senior professors from seventeen leading law schools whose teaching and research focus on corporate and securities law. We write to respectfully urge SEC Commissioner Daniel M. Gallagher, and his co-author Professor Joseph Grundfest, to withdraw the allegations, issued in a paper released last month (described on the Forum here), that Harvard and the Shareholder Rights Project (SRP), a clinic at its law school, violated the securities laws by assisting institutional investors in submitting shareholder proposals to declassify corporate boards.

In the last in this series, I asked whether corporate governance was groupthink masquerading as a paradigm.  This Statement of Thirty-Four Senior Corporate and Securities Law Professors Urging Commissioner Gallagher and Professor Grundfest to Withdraw Their Allegations against Harvard and the SRP is bad timing for those who protest my thesis.

The seventh sign of group-think is that members are under pressure not to express arguments against any of the group’s views.   Social pressure is applied to members who stand up and question the group’s judgement. The eighth and last sign of group think is the emergence of self-appointed “mindguards”.  Individual members take it upon themselves to protect the group and the leader from information that is problematic or contradictory to the group’s cohesiveness, view, and/or decisions.

Is this is what is to become of the American Scholar?  Self appointed arbiters of merit who invite comparison to a psychological condition.

Do those, like Yale Professor Jonathan Macey, who led the assault on the Gallagher- Grundfest paper, not see the problem?  By defending shareholders from managers and attacking those who stand in their way, like Lynn Stout and now the Commissioner and his co-author, he is choosing to side with one industry over the rest of the economy.

The concept of accountability is central to corporate governance.  I have little doubt that most people think that directors and managers have a mythical duty to maximize shareholder value.

Now, in this centenary year of the 1915 Declaration of Principles being published by the American Association of University Professors, both the duty and the accountability of the scholar are at risk of becoming a myth too:

Since there are no rights without corresponding duties, the considerations heretofore set down with respect to the freedom of the academic teacher entail certain correlative obligations….. The liberty of the scholar within the university to set forth his conclusions, be they what they may, is conditioned by their being conclusions gained by a scholar’s method and held in a scholar’s spirit; that is to say, they must be the fruits of competent and patient and sincere inquiry, and they should be set forth with dignity, courtesy, and temperateness of language. The university teacher, in giving instructions upon controversial matters, while he is under no obligation to hide his own opinion under a mountain of equivocal verbiage, should, if he is fit in dealing with such subjects, set forth justly, without suppression or innuendo, the divergent opinions of other investigators; he should cause his students to become familiar with the best published expressions of the great historic types of doctrine upon the questions at issue; and he should, above all, remember that his business is not to provide his students with ready-made conclusions, but to train them to think for themselves, and to provide them access to those materials which they need if they are to think intelligently.

The AAUP’s 1915 Principles go on to describe to whom the duty is owed.   The drafters were unequivocal.  The scholar’s duty then, as it remains now, is owed to the community at large:

The responsibility of the university teacher is primarily to the public itself, and to the judgment of his own profession; and while, with respect to certain external conditions of his vocation, he accepts a responsibility to the authorities of the institution in which he serves, in the essentials of his professional activity his duty is to the wider public to which the institution itself is morally amenable. 

A message that is repeated on the AAUP’s website today: http://american%20association%20of%20university%20professors/

The university is a public good, not a private profit-making institution, and corporations or business interests should not dictate teaching or research agendas“.

Reading these principles and reflecting on much of the state of corporate governance research it is clear that scholarship takes more than just rigorous empirical inquiry.

The integrity of truth in every field of university research, including corporate governance, depends on the allegiance of the professor to the public as a whole and their accountability to their duties.   Namely, the scholar’s rigorous method and, what sadly seems to have been forgotten in the pursuit of shareholder value, the scholar’s spirit.

* A work in progress….

 

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Recognition of the Threat to Shareholders and the Economy from Attacks by Activist Hedge Funds

By
Martin Lipton
Sara J. Lewis

Recognition of the Threat to Shareholders and the Economy from Attacks by Activist Hedge Funds

          Again in 2014, as in the two previous years, there has been an increase in the number and intensity of attacks by activist hedge funds.  Indeed, 2014 could well be called the “year of the wolf pack.”

With the increase in activist hedge fund attacks, particularly those aimed at achieving an immediate increase in the market value of the target by dismembering or overleveraging, there is a growing recognition of the adverse effect of these attacks on shareholders, employees, communities and the economy.  Noted below are the most significant 2014 developments holding out a promise of turning the tide against  activism and its proponents, including those in academia.

  • Several institutional investors voiced concerns about activism this year, including Laurence Fink of BlackRock – first in March lamenting the cuts to capital expenditures and increased debt used to fuel dividends and share buybacks, which he views as having the potential to “jeopardize a company’s ability to generate sustainable long-term returns,” and then in December stating that “[s]trategies pursued by activist investors ‘destroy jobs.’”
  • Tim Armour of Capital Group criticized the recent wave of share buybacks, explaining that “[w]e think companies should be run for the long-term and do not think forced steps should be taken to maximize short-term profits at the expense of having thriving enterprise.”
  • William McNabb of Vanguard spoke out against the standard activist playbook of aggressively criticizing companies once problems emerge and endorsed a more low-key approach of engagement between directors and shareholders aimed to prevent problems before they happen.
  • James Montier of GMO Capital presented compelling empirical evidence that, as Jack Welch once said, shareholder value maximization is “the dumbest idea in the world,” and demonstrating that, ironically, it has not benefitted shareholders themselves.
  • Even activists themselves began to acknowledge how outlandish some of their stunts are; Jeffrey Ubben of ValueAct, for example, who favors a more behind-the-scenes, constructive style of activism, likened certain recent actions by other activists to “greenmail,” called certain activist tactics “corrupt” and accused one activist in particular of simply “entertaining himself.”
  • In December, the Conference Board released a must-read presentation entitled “Activists and Short Term Corporate Behavior” that compiles data demonstrating that capital investment by U.S. public companies has decreased (and is less than that of private companies), that short-term pressures are increasing and that hedge fund activism results not in the creation of value but in transfers of value from employees and bondholders to shareholders.
  • William Galston’s editorial in the Wall Street Journal, “‘Shareholder Value’ Is Hurting Workers: Financiers Fixated on the Short-Term Are Forcing CEOs into Decisions That Are Bad for the Country,” as the title suggests, warned that activism is harming workers (pointing to the recent break-up of Timken as a prime example) and that if short-termism prevails, “we won’t have the long-term investments in workers and innovation that we need to sustain a higher rate of growth.”
  • Dominic Barton, the global managing director of McKinsey, and Mark Wiseman, the president and CEO of the Canada Pension Plan Investment Board, joined to author an article in the Harvard Business Review, “Focusing Capital on the Long Term,” which suggests practical steps that major asset owners such as pension funds, insurance firms and mutual funds can take to minimize the detrimental effects of increased pressure from financial markets and the resulting short-termism, which they believe has “far-reaching consequences, including slower GDP growth, higher unemployment, and lower return on investment for savers.”
  • A federal court in California found “serious questions” as to whether Valeant and Pershing Square violated the federal securities laws in connection with their joint hostile bid for Allergan and thereby, as a practical matter, put an end to this scheme until the issue is resolved.
  • SEC Commissioner Daniel Gallagher and former Commissioner (and current Stanford Law Professor) Joseph Grundfest argued that the push for board declassification by Harvard Law School’s Shareholder Rights Campaign, initiated by Professor Lucian Bebchuk, was not only based on shoddy scholarship, it actually violated federal securities law antifraud rules.
  • SEC Commissioner Gallagher also called for much-needed reforms to Rule 14a-8 to “ensur[e] that activist investors don’t crowd out everyday and long-term investors” by repeatedly bringing costly shareholder proposals (notwithstanding prior failures) that have little or no connection to company value.
  • The SEC took a step toward limiting uncritical reliance on proxy advisory firms by issuing guidance indicating that, to fulfill their fiduciary duties to clients, investment advisers must establish and implement measures reasonably designed both to provide sufficient ongoing oversight of proxy advisory firms and to identify and address such firms’ conflicts of interest.
  • Economics Professor William Lazonick argued that share buybacks can boost share prices in the short term but ultimately disrupt income equality, job stability and overall economic growth, and research by Barclays cited in a Financial Times article called “Buybacks: Money Well Spent?” provided empirical support showing that the “buyback bonanza” indeed contributed to slower growth, including lower earnings retention not reflected in price-to-book value.
  • A paper by Dr. Yvan Allaire entitled “The Value of ‘Just Say No,’” and also memos by our firm (here and here), demonstrated that an ISS client note entitled “The IRR of No,” which argued that companies that had “just said no” to hostile takeover bids incurred profoundly negative returns, suffered from critical methodological and analytical flaws that undermined its conclusions.
  • Dr. Allaire also presented a sophisticated analysis contained in two papers (“Activist Hedge Funds: Creators of Lasting Wealth? What Do the Empirical Studies Really Say?” and “Hedge Fund Activism and Their Long-Term Consequences; Unanswered Questions to Bebchuk, Brav and Jiang”), consistent with our firm’s earlier observations, offering a devastating critique of Professor Bebchuk’s research claiming to show that attacks by activist hedge funds did not destroy long-term value.
  • The argument made by Professor Bebchuk, together with Professor Robert Jackson, that poison pills were unconstitutional was similarly dismissed (some would say derided) as the grasping-at-straws argument that it was and one wholly inconsistent with existing case law.
  • Delaware Supreme Court Chief Justice Leo Strine, Jr.’s Columbia Law Review article, “Can We Do Better By Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law,” persuasively argued against allowing investment funds to prevail over the carefully considered judgments of boards of directors and at the expense of the long-term interests of the ultimate beneficiaries whose assets such funds manage.
  • In an article entitled “The Impact of Hedge Fund Activism: Evidence and Implications,” Columbia Law School Professor John Coffee, Jr. rejected the so-called empirical evidence that Professor Bebchuk uses to “prove” that activist attacks are beneficial, and proposed various potential reforms and private ordering techniques (such as a “window-closing” poison pill) that could help mitigate activism’s pernicious effects.
  • In “How to Outsmart Activist Investors,” Professors William George and Jay Lorsch of the Harvard Business School advised companies on how to fend off activist challenges, writing that they “remain unconvinced . . . that hedge fund activism is a positive trend for U.S. corporations and the economy.”
  • Leiden University Professor Pavlos Masouros, in his book entitled Corporate Law and Economic Stagnation: How Shareholder Value and Short-Termism Contribute to the Decline of the Western Economies, convincingly outlined the chain of political, economic and legal events that led to the shift from a “retain and invest” corporate strategy to a “downsize and distribute” mentality, and the consequent stagnation in GDP growth.
  • Cornell University Law School Professor Lynn Stout also published a book that challenges the ideology of shareholder value maximization, the title of which speaks for itself:  The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public.
  • Oxford University Professor Colin Mayer’s Firm Commitment: Why the Corporation Is Failing Us and How to Restore Trust in It set forth a new paradigm for thinking about corporations, in part to solve the “increasing[] difficult[y] for directors to do anything other than reflect what is perceived to be in the immediate interests of their most influential, frequently short-term shareholders.”
  • The Delaware Court of Chancery, in Third Point LLC v. Ruprecht, confirmed the legitimacy of the use of poison pills – not only in the face of an inadequate takeover offer – but also in response to an activist threat.

We hope that the growing recognition of the analytical and methodological defects in the so-called empirical evidence put forward to justify activist hedge fund attacks by Professor Bebchuk and his cohorts and the growing recognition, not just in the business community, but in academia as well, of the serious threat of activism and short-termism to employees, communities and the economy will result in further action by responsible institutional investors to deny support to activist hedge funds and will also result in legislative, regulatory and judicial actions to dampen their abuses and lessen substantially their impact.
Martin Lipton
Sara J. Lewis

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Thoughts On Activism

By Martin Lipton, Steven A. Rosenblum and Karessa L. Cain

Wachtell, Lipton, Rosen & Katz
(212) 403-1000 (Phone) | (212) 403-2000 (Fax)
www.wlrk.com

Companies today are more vulnerable to activist attacks than ever before. Over the past decade or so, several trends have converged to foster an environment that is rife with opportunities for activists to extract value. These include the steady erosion of takeover defenses, the expansion of the ability of shareholders to pressure directors, the increasingly impatient and short-termist mindset of Wall Street, and a regulatory disclosure regime that is badly in need of modernization to reflect the current realities of rapid stock accumulations by activists, derivative securities and behind-the-scenes coordination among activist hedge-funds and investment-manager members of “wolf packs.”

          The number of activist attacks has surged from 27 in 2000 to nearly 250 year-to-date in 2014, in addition to numerous undisclosed behind-the-scenes situations.  Activist funds have become an “asset class” in their own right and have amassed an estimated $200 billion of assets under management.  In this environment, boards and management teams have been spending a significant amount of time preparing for and responding to activist attacks, and proactively considering whether adjustments to their companies’ business strategies are warranted in order to avoid becoming a target.

           Three decades of campaigns by public and union pension funds, Institutional Shareholder Services (ISS) and Council of Institutional Investors (CII), and their academic and corporate raider supporters, have served to promote majority voting standards, eliminate rights plans, declassify boards and otherwise shift power to shareholders.  This, in turn, has precipitated important changes to the governance landscape and played a key role in laying the groundwork for today’s activism.  Yesterday’s corporate governance crusades have turned an evolutionary corner in the last few years, to morph into the heavyweight attacks of today where entire boards of directors are ousted in proxy fights and a 3% shareholder can compel a $100+ billion company to accommodate its demands for spin-offs, buybacks and other major changes. 

          The  proliferation of activism has prompted much reflection and revisiting of the basic purpose and role of corporations.  As recently stated by the Financial Times’ chief economics commentator Martin Wolf, “Almost nothing in economics is more important than thinking through how companies should be managed and for what ends.”  Activist attacks vividly illustrate what is truly at stake in corporate governance debates—such as how to balance demands for stock prices that are robust in the short term without sacrificing long-term value creation, and whether maximization of stockholder value should be the exclusive aim of the corporate enterprise.  The special agendas, white papers and “fight letters” of activists are anything but subtle in framing these issues and have direct, real-world implications for the future paths of the corporations they target as well as the futures of employees, local communities and other stakeholders.  In short, the rapid rise in the number of activist attacks, the impact they are having on U.S. companies and the slowing of GDP growth, have added a new spark and sense of urgency to the classic debate about board- versus shareholder-centric models of corporate governance:  who is best positioned to determine what will best serve the interests of the corporation and its stakeholders? 

          In this regard, a key question is whether activists actually create value.  It is clear that many activists have produced alpha returns for themselves and their investors.  Pershing Square, for example, realized an estimated $1 billion gain on its investment in Allergan on the day that Valeant announced its takeover offer for Allergan, and will reap an estimated $2.6 billion profit as a result of Actavis’s pending acquisition of Allergan.  However, it is far from clear that activists have more insight and experience in suggesting value-enhancing strategies than the management teams that actually run the businesses, or are more incentivized than boards and management teams (whose reputations, livelihoods and/or considerable portions of personal wealth tend to be tied to the success of the company) to drive such strategies.  By way of comparison, the management and operational changes that Pershing Square advocated for J.C. Penney had disastrous results for the company and Pershing Square realized steep losses on that investment. 

          Moreover, to the extent that activists do precipitate stock price increases, a further question is whether such gains come at the expense of long-term sustainability and value-creation.  To be sure, some activists tend to engage in a more constructive form of advocacy characterized by a genuine desire to create medium- to long-term value.  However, the far more prevalent form of “scorched-earth” activism features a fairly predictable playbook of advocating a sale of the company, increased debt or asset divestitures to fund extraordinary dividends or share buybacks, employee headcount reductions, reduced capital expenditures and R&D and other drastic cost cuts that go well beyond the scope of prudent cost discipline.

           The experience of the overwhelming majority of corporate managers and their advisors is that attacks by activist hedge funds are followed by declines in long-term future performance, and that such attacks (as well as proactive efforts to avoid becoming the target of an attack) result in increased leverage, decreased investment in capital expenditures and R&D, employee layoffs and poor employee morale.  A number of academic studies confirm this view and rebut the contrary position espoused by shareholder rights activists who believe that activist attacks are beneficial to the targeted companies and should be encouraged.  For example, a recent report by the Institute for Governance of Private and Public Organizations concludes:  “[T]he most generous conclusion one may reach from these empirical studies has to be that ‘activist’ hedge funds create some short-term wealth for some shareholders as a result of investors who believe hedge fund propaganda (and some academic studies), jumping in the stock of targeted companies.  In a minority of cases, activist hedge funds may bring some lasting value for shareholders but largely at the expense of workers and bond holders; thus, the impact of activist hedge funds seems to take the form of wealth transfer rather than wealth creation.” 

          The debate about whether activists create value underscores one of most critical factors in determining the outcome of activist attacks and the future direction of this trend:  credibility.  Starting with the Enron debacle and culminating in the financial crisis, the public confidence level in boards was impaired and shareholders became generally more skeptical of their oversight effectiveness.  Activists, in espousing the virtues of good corporate governance and shareholder rights, gradually rebranded and cleansed themselves of the raider stigma of the 1980s and gained mainstream credibility with shareholder rights proponents, the media, institutional investors and academia.  And some activists clearly have more reputational capital than others.  As hedge funds of varying degrees of firepower and sophistication have sought to claim the activist label, it is clear that not all activists have the same playbook, track record or approach to dealing with companies.  These macro trends boil down to specifics in each proxy fight, with the key questions being whether management and the board can articulate a credible and convincing case for the company’s business plan and demonstrate the results of that plan, and whether institutional investors will support a long-term growth strategy despite the allure of more immediate results.

          Against this backdrop, it is essential that boards not be unduly distracted from their core mission of overseeing the strategic direction and management of the business.  Directors should develop an understanding of shareholder perspectives on the company and foster long-term relationships with shareholders, as well as deal with the requests of shareholders for meetings to discuss governance, the business portfolio and operating strategy.  Directors should also work with management and advisors to review the company’s business and strategy with a view toward minimizing vulnerability to attacks by activist hedge funds.

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Glass Lewis 2015 Proxy Voting Guidelines

GLASS LEWIS (QUIETLY) ISSUES 2015 PROXY VOTING GUIDELINES 
November 10, 2014
Glass Lewis recently posted its guidelines for the 2015 proxy season. Below is a summary of the changes to its policies for the upcoming proxy season. To view Glass Lewis’ 2015 proxy voting guidelines in detail, please click here.
Governance Committee Performance
Glass Lewis adopted a policy regarding instances where a board has amended the company’s governing documents to reduce or remove important shareholder rights, or to otherwise impede the ability of shareholders to exercise such right, and has done so without shareholder approval. Examples of Board actions that may cause such a recommendation include: 

  • The elimination of the ability of shareholders to call a special meeting or to act by written consent;
  • An increase to the ownership threshold required for shareholders to call a special meeting;
  • An increase to vote requirements for charter or bylaw amendments;
  • The adoption of provisions that limit the ability of shareholders to pursue full legal recourse – such as bylaws that require arbitration of shareholder claims or that require shareholder plaintiffs to pay the company’s legal expenses in the absence of a court victory (i.e., “fee-shifting” or “loser pays” bylaws);
  • The adoption of a classified board structure; and
  • The elimination of the ability of shareholders to remove a director without cause. In these instances, depending on the circumstances, we may recommend that shareholders vote against the chairman of the governance committee, or the entire committee.
Board Responsiveness To Majority-Approved Shareholder Proposals
Glass Lewis will generally recommend that shareholders vote against all members of the governance committee during whose tenure a shareholder proposal relating to important shareholder rights received support from a majority of the votes cast (excluding abstentions or broker non-votes) and the board failed to respond adequately. Examples of such shareholder proposals include those seeking to declassified board structure, a majority vote standard for director elections, or a right to call a special meeting. This policy has been expanded to specify that in determining whether a board has sufficiently implemented such a proposal, the quality of the right enacted or proffered by the board for any conditions that may unreasonably interfere with the shareholder’s ability to exercise the right (e.g., overly prescriptive procedural requirements for calling a special meeting) will be examined.
Vote Recommendations Following IPO
Glass Lewis has increased their scrutiny of provisions adopted in a company’s charter or bylaws prior to an initial public offering (“IPO”). While they will generally refrain from issuing voting recommendations on the basis of most corporate governance best practices (e.g., board independence, committee membership and structure, meeting attendance, etc.) during the one-year period following an IPO, they will scrutinize certain provisions adopted in the company’s charter or bylaws prior to the IPO. Specifically, Glass Lewis will consider recommending to vote against all members of the board who served at the time of the adoption of an anti-takeover provision, such as a poison pill or classified board, if the provision is not put up for shareholder vote following the IPO. Additionally, consistent with their approach to boards that adopt exclusive forum provisions or fee-shifting bylaws without shareholder approval, they will recommend that shareholders vote against the governance committee chair in the case of an exclusive forum provision, and against the entire governance committee in the case of a provision limiting the ability of shareholders to pursue full legal recourse (e.g., “fee-shifting” bylaws), if these provisions are not put up to shareholder vote following the IPO.
Glass Lewis Standards For Assessing “Material” Transactions With Directors
With regard to Glass Lewis’ $120,000 threshold for those directors employed by a professionals services firm such as a law firm, investment bank, or consulting firm, where the company pays the firm, not the individual, for services, we have clarified that we may deem such a transaction to be immaterial where the amount represents less than 1% of the firm’s annual revenues and the board provides a compelling rationale as to why the director’s independence is not affected by the relationship.
Advisory Vote On Executive Compensation
Discussion has been added to Glass Lewis’ approach to analyzing one-off awards granted outside of existing incentive programs. Specifically, when such awards have been made, Glass Lewis will examine the following criteria:

  • The description of the award;
  • The disclosed rationale for the award;
  • An explanation of why existing awards do not provide adequate motivation;
  • Whether the award is tied to future service and performance conditions; and
  • If (and how) regular compensation arrangements will be affected by the supplemental awards.
Glass Lewis has also provided clarification regarding their qualitative and quantitative approach to say-on-pay analysis.
Employee Stock Purchase Plans
Glass Lewis enhanced its guidelines for evaluating Employee Stock Purchase Plans (ESPP) by clarifying the key criteria it will examine when making vote recommendations. Glass Lewis generally views such plans favorably because they facilitate employee ownership. The proxy advisor’s underlying approach to reviewing ESPPs is based on the relevant regulatory limits and parameters, such as the expected discount and purchase period. Glass Lewis will also examine the cost of the plan compared to programs at similar companies (using a quantitative model) as well as the number of shares requested and the impact to shareholders from a dilution perspective.
Veritas Executive Compensation Consultants, (“Veritas”) is a truly independent executive compensation consulting firm. 
We are independently owned, and have no entangling relationships that may create potentialconflict of interest scenarios, or may attract the unwanted scrutiny of regulators, shareholders, the media, or create public outcry.  
 
Veritas goes above and beyond to provide unbiased executive compensation counsel. Since we are independently owned, we do our job with utmost objectivity – without any entangling business relationships. 
 
Following stringent best practice guidelines, Veritas works directly with boards and compensation committees, while maintaining outstanding levels of appropriate communication with senior management. 
 
Veritas promises no compromises in presenting the innovative solutions at your command in the complicated arena of executive compensation. 
 
We deliver the advice that you need to hear, with unprecedented levels of responsive client service and attention. 
 

Visit us online at www.veritasecc.com, or contact our CEO Frank Glassner personally via phone at (415) 618-6060, or via email at fglassner@veritasecc.com. He’ll gladly answer any questions you might have. For your convenience, please click here for Mr. Glassner’s contact data, and click here for his bio.

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Proxy Access Proposals for the 2015 Proxy Season

Proxy Access Proposals for the 2015 Proxy Season

          A number of U.S. companies have recently received “proxy access” shareholder proposals submitted under SEC Rule 14a-8.  Many of the recipients have been targeted under the New York City Comptroller’s new “2015 Boardroom Accountability Project,” which is seeking to install proxy access at 75 U.S. publicly traded companies reflecting diverse industries and market capitalizations.  Underlying the Comptroller’s selection of targets is a stated focus on climate change, board diversity and executive compensation.

These proposals are precatory and seek the submission to shareholders of a binding bylaw that would enable shareholders (or groups of shareholders) who meet specified criteria to nominate director candidates for election to the board and to have these nominees and their supporting statements included in the company’s own proxy materials.  If the proposal garners a majority shareholder vote at a company’s 2015 annual meeting, it would not become effective unless and until the shareholders approve an implementing bylaw amendment at the company’s 2016 annual meeting.

Companies that receive such proposals should first assess whether the shareholding, form and content requirements of Rule 14a-8 are satisfied.  The current wave of proxy access proposals has evolved to cure most substantive vulnerabilities and, absent procedural defects, the SEC has generallybeen unsympathetic to proxy access exclusion requests.  For example, the SEC has been unwilling to permit exclusion on the basis of “substantial implementation” where a company adopts its own version of proxy access that requires a higher shareholding amount or longer shareholding duration as compared to the thresholds proposed by the shareholder.  However, the SEC has not yet ruled on whether it will permit exclusion where the company submits its own, more stringent proxy access proposal to a shareholder vote and thus creates a “direct conflict” with the shareholder’s access proposal.  At least one company, Whole Foods, has such an exclusion request currently pending before the SEC.

Assuming that exclusion is not available, the company’s options for responding to the proposal include the following: (1) submit the proposal to a shareholder vote and make a board recommendation as to how shareholders should vote, (2) preemptively adopt a proxy access bylaw or submit a competing proxy access proposal with more stringent requirements, or (3) attempt to negotiate a compromise or alternative outcome with the shareholder proponent.

In weighing these options, a key consideration is whether the proposal is likely to receive majority shareholder support.  If the proposal receives the support of a majority of votes cast, proxy advisory firms such as ISS (as well as members of the investment community) will expect the board to be appropriately responsive to the proposal, such as by adopting a compliant form of proxy access.

In the three years since the SEC first permitted Rule 14a-8 shareholder proposals on proxy access, approval rates have been mixed.  Proposals that require a minimum stock ownership threshold of at least 3% of outstanding shares and a minimum continuous holding period of at least 3 years have had the most success, receiving a majority of votes cast at ten companies (including Verizon Communications (2013), CenturyLink (2013), Darden Restaurants (2013), Abercrombie & Fitch (2014) and Boston Properties (2014)).  However, similar proposals failed to receive such a majority vote at six companies (including The Walt Disney Company (2013), Walgreen’s (2014), Comstock Resources (2014) and Oracle (2014)).  In total, proxy access proposals submitted by shareholders with a 3%/3 year threshold have received an average vote in favor of approximately 50.1% over the period from 2012-2014, although we note that such results are subject to context-specific factors (e.g., large insider positions, activist campaigns, etc.) and companies should consider their own circumstances and shareholder base when considering how to respond.  Upcoming votes on proxy access at Cisco Systems on November 20 and at Microsoft on December 3 will provide further data points.

Many companies will likely conclude that this mixed record of voting results and delayed implementation of proxy access proposals weigh against taking action to proactively adopt proxy access.  However, a few companies—such as Kilroy Realty in 2014, and Western Union and KSW in 2012—have taken the approach of adopting and defending their own, more stringent versions of proxy access in order to defeat a shareholder-sponsored version with lower thresholds.  Alternatively, some companies have engaged in discussions with the shareholder proponent to ascertain whether it would support a different form of proxy access with more stringent requirements, such as a higher ownership threshold or longer holding period, in exchange for the company’s support for a revised proxy access proposal or earlier implementation of proxy access.  For example, Hewlett-Packard (2012) and McKesson (2014) negotiated withdrawals by agreeing to seek shareholder approval for proxy access in a future year, and Walt Disney (2014) settled with a shareholder proponent by agreeing to make other governance changes unrelated to proxy access.

While some proponents of proxy access claim that a “tipping point” of investor support has been reached, the reality is that many institutional investors do not reflexively support access proposals, even those crafted with thresholds mimicking the SEC’s now-withdrawn 3% / 3 years formulation.  Shareholders have many avenues for constructively influencing boards of directors, including with respect to board composition and, as we have longmaintained, proxy access is not an optimal or even necessary element of corporate governance.  In our experience, many major institutional investors are willing to engage in a case-by-case, fact-specific assessment of a company’s circumstances in deciding how to vote on proxy access, even in the face of supportive proxy advisory firm recommendations (ISS and Glass-Lewis can generally be expected to recommend in favor of 3% / 3 year proxy access formulations).

          We hope institutional investors will continue to be willing to take this case-by-case approach, despite the one-size-fits-all pressure being brought to bear by the New York City Comptroller.  We believe companies that have developed good relationships with their shareholders, and that are able to demonstrate that effective governance policies are already in place, should be well-positioned to try to resist these proxy access proposals through further engagement and investor outreach.

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ISS 2015 POLICY SURVEY RESULTS SUMMARY

The following summary was provided by:

Veritas Executive Compensation Consultants, (“Veritas”) is an executive compensation consulting firm. 
ISS 2015 POLICY SURVEY RESULTS SUMMARY
October 6, 2014
As part of its annual policy formulation process, each year ISS seeks feedback from institutional investors, public companies and consulting and legal communities on emerging corporate governance, executive compensation and other issues.
More than 370 total responses were received, including 105 individual institutional investors and 255 members of the corporate issuer community (including consultants/advisors).
The survey, conducted between July 17, 2014 and September 5, 2014, was structured around several high-level themes including:
  • Pay for performance;
  • Board accountability;
  • Boardroom diversity;
  • Equity plan evaluation;
  • Risk oversight and audit;
  • Cross-market listings; and
  • Environmental and social performance goals.
For more information about the survey and to view more detailed survey responses, please click here.
KEY FINDINGS
Pay for Performance
CEO pay limits relative to company performance resonate with investors
In response to whether there is a threshold at which the magnitude of CEO pay warrants concern even if the company’s performance is positive (e.g., outperforming peer group), 60% of investors indicated a concern. Support for alternative solutions varied as 27% favored relative proportional limits based on the degree of outperformance versus the company’s peer group; 19% favored absolute limits on CEO compensation regardless of performance; and 14% advocated for proportional limits on compensation in relation to absolute company performance.
In determining excessive pay magnitude, methods such as comparisons to median CEO pay at peer companies, CEO compensation to pay of other NEOs, and proportion of CEO pay to corporate earnings or revenue have all garnered support.
Positive changes in succeeding year may be a mitigating factor for pay-for-performance concerns for the year in review
When evaluating say-on-pay, 63% of investors (and 34% of issuers) indicate that positive changes to pay programs can somewhat mitigate pay-for-performance concerns. In contrast, 52% of issuers (versus just 14% of investors) indicate that they can substantially mitigate concerns.
Of those investors who indicate that positive changes to pay programs can somewhat or substantially mitigate pay-for-performance concerns, 90% expect disclosure of specific details of such positive changes (e.g., metrics, performance goals, award values, effective dates) in order for the changes to be considered.
European investors and issuers diverge on peer group comparisons in evaluating compensation practices
For European markets, 83% of investors indicate that a European pay for performance quantitative methodology, including the use of peer group comparisons, would be useful as a factor in such evaluations. A significant majority (87%) of investors would also like to see a comparison to cross-market industry sector peer groups. Regarding other factors of comparison, 74%, 83%, and 85% indicate that they would favor local market peer groups, regional peer groups (i.e., Europe-wide), and cross-market peer groups based on company size/capitalization, respectively.
However, 58% of issuers indicate peer group comparisons are not appropriate to gauge each individual company’s compensation practices.
Mixed views on the relationship between goal-setting and target award values
43% of investors (and only 3% of issuers) indicate that if performance goals are significantly reduced from one performance period to the next, target award levels should be commensurately modified to reflect the expected lower level of performance. By contrast, two-thirds of issuers (and 26% of investors) indicate that the compensation committee should have broad discretion to set both goals and target awards at levels deemed to be appropriate under the circumstances. In addition, 25% of issuers (and 19% of investors) indicate that performance goals should be set independently of target awards, which must be maintained at competitive levels in order to attract and retain top quality executives.
Unilateral Adoption of Bylaws
Investors indicate little tolerance for unilateral boardroom adoption of bylaw amendments that diminish shareholder rights
72% of investors indicate that a board should never adopt bylaw/charter amendments that negatively impact investors’ rights without shareholder approval. Other investor respondents say “it depends,” selecting from a list of factors (directors’ track record, level of board independence, other governance concerns, the type of bylaw/charter amendment, and the vote standard for amendments by shareholders) which appear to be relevant in evaluating board accountability. Specifically, more than 85% of investors view each of those factors as relevant.
Conversely, nearly one-half (44%) of issuers indicate that boards should be free to unilaterally adopt any bylaw/charter amendment(s) subject to applicable law, while 34% of issuers say “it depends.”
Investors and issuers diverge on pre-IPO adoption of shareholder unfriendly provisions
63% of investors indicate that directors should be held accountable if shareholder unfriendly provisions are adopted prior to a company’s IPO. When determining whether to hold directors accountable, 21% of investors indicate “it depends,” with common responses including the type of provisions and whether directors are willing to address the issues after the IPO. On the other hand, 62% of issuers do not believe directors should be held accountable for pre-IPO actions.
Boardroom Diversity
Investors and issuers take big picture approach on boardroom diversity
60% of investors and 75% of issuers indicate that they consider overall diversity (including but not limited to gender) on the board when evaluating boards. Meanwhile, 17% of investors and 7% of issuers indicate that they do not consider gender diversity at all when evaluating boards.
Equity Plans
Investors indicate that they would weigh a combination of plan features and grant practices as or more heavily than plan cost alone in a scorecard approach to evaluating U.S. equity-based compensation proposals
ISS plans to implement a “balanced scorecard” approach to evaluating plan proposals for U.S. companies that gives weight to various factors under three broad categories: (1) Cost, (2) Plan Features, and (3) company Grant Practices. With respect to how the plan Cost category should be considered in a scorecard, 70% of investors indicate weights ranging from 30% to 50%. 62% of investors suggest weightings from 25% to 35% for Plan Features; and 64% indicate weights ranging from 20% to 35% for Grant Practices. Weightings suggested by issuers were quite dispersed, but generally skewed somewhat higher with respect to Cost, and somewhat lower for Plan Features and Grant Practices, compared to investors.
Use of performance conditions is a very important factor for investors when voting on equity-based remuneration proposals in markets where levels of disclosure are generally poor
When assessing proposals to implement equity-based remuneration plans benefitting executives in markets where levels of disclosure are generally poor, all factors (pricing conditions, vesting periods, dilution, performance conditions, and plan administration features) are “very” or “somewhat” important to a majority of investors in their voting decision. Use of performance conditions is at the top of the list, deemed by 76% of investors as a factor to be “very important.”
Risk Oversight/Audit
Investors focus on boardroom oversight subsequent to incidents when evaluating the board’s role in risk oversight
Over the past few years, shareholders’ investments have been impacted by a number of well publicized failures of boardroom risk oversight. When evaluating the board’s risk oversight role, a majority of shareholders indicate that the role of the company’s relevant risk oversight committee(s), the board’s risk oversight policies and procedures, boardroom oversight actions prior to incident(s), boardroom oversight actions subsequent to incident(s), and changes in senior management are all either “very” or “somewhat” important to their voting decision on directors. Boardroom oversight action subsequent to an incident garners the highest percentage (85%) as a “very important” factor whereas only 46% indicate that changes in senior management are “very important.”
Investors consider disclosures concerning selection and tenure of audit firms to be very important when voting on auditor ratification and audit committee members
A slim majority of investors identify disclosures of the relevant factors the audit committee considers when selecting or reappointing an audit firm and the tenure of the current audit firm (53% and 51%, respectively) as “very” important factors in making informed voting decisions on auditor ratification and the reelection of audit committee members.
Cross-Market Companies
Investors and issuers provide mixed responses regarding policy selection treatment for cross-market companies
An increasing number of companies incorporate in one market but list in another (or multiple) geographic region. For example, some U.S.-based companies have inverted (reincorporated in non-U.S. markets with more favorable corporate tax regimes) and many non-U. S. companies have listed in the U.S. When asked how ISS should generally evaluate such companies, 47% of investors indicate that ISS should evaluate mainly under its policy guidelines for the main market of coverage, but for individual ballot items that arise from other regimes apply the policy of the market whose stock exchange rules or corporate statutes require the proposal to appear on the ballot. Other investor responses are split between evaluating entirely under ISS policy guidelines for main market of coverage (23%) and evaluating case-by-case depending on the nature of the proposal (24%).
Issuer responses are similar to those of investors with 41% indicating that ISS should evaluate mainly under its policy guidelines for main market of coverage, but for individual ballot items that arise from other regimes apply the policy of the market whose stock exchange rules or corporate statutes require the proposal being on the ballot; 29% indicate that ISS should evaluate entirely under its policy guidelines for the main market of coverage; and 26% indicate case-by-case, depending on the nature of the proposal.
Environmental & Social (E&S) Performance Goals
Investors and issuers differ on the appropriateness of quantitative E&S performance goals
When asked when it is appropriate for a company to utilize quantitative E&S performance goals, a majority of both investors and issuers, 57% and 75%, respectively, indicate a preference for case-by-case analysis (“it depends”). Of those investors, 89% consider if a company’s performance on a given environmental or social issue shows a negative trend or if the company has experienced significant controversies; 92% consider if the company has operations with significant exposure to potential regulatory or financial impacts; and 90% consider if the practice has become an industry norm. A slight majority (51%) indicate that it depends only if/when the quantitative goals are required by government regulations.
In contrast, with respect to issuers who select “it depends,” 65% indicate that only if/when the quantitative goals are required by government regulations and just under one-half (49%) indicate that it depends if a company’s performance on a given environmental or social issue shows a negative trend or if the company has experienced significant controversies.
Notably, 39% of investors indicate that it is appropriate for a company to always utilize quantitative E&S performance goals compared with only 7% of issuers. In the absence of quantitative goals, a significant majority of investors and issuers indicate that both company disclosure of a robust set of E&S policies, oversight mechanisms, and related initiatives, and/or company disclosure of E&S performance data for a multiyear period can be mitigating factors.
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Corporate Governance Update: Important Proxy Advisor Developments

September 25, 2014

Corporate Governance Update: Important Proxy Advisor Developments

By David A. Katz and Laura A. McIntosh*

As 2014 winds down and 2015 approaches, proxy advisory firms—and the investment managers who hire them—are finding themselves under increased scrutiny. Staff guidance issued by the Securities and Exchange Commission at the end of June1
and a working paper published in August by SEC Commissioner Daniel M. Gallagher2 both indicate that oversight of proxy advisory services will be a significant focus for the SEC during next year’s proxy season. Under the rubric of corporate governance, annual proxy solicitations have become referenda on an ever-widening assortment of corporate, social, and political issues, and, as a result, the influence and power of proxy advisors— and their relative lack of accountability—have become increasingly problematic.3 The SEC’s recent actions and statements suggest that the tide may be turning. Proxy advisory firms appear to be entering a new era of increasing accountability and potentially decreasing influence, possibly with further, more significant, SEC action to come.

The proxy advisory industry currently is dominated by two firms, Institutional Shareholder Services (ISS) and Glass Lewis & Co. With nearly 100% market share between them,4 their widespread influence in shareholder activism and proxy voting has resulted in calls from the business community for greater SEC 5 supervision of their business practices, potential conflicts of interest, and transparency.

The SEC will monitor shareholder voting decisions and corporate board elections in 2015 to evaluate the effect of the SEC staff’s recent guidance.6 It is clear that the SEC expects investment advisers to take a more active role in overseeing proxy advisory firms and holding these firms accountable both for the quality of their recommendations and the business practices that produce them. By leveraging the influence of their clients, it appears that the SEC hopes to put pressure on proxy advisors to reform from within. However, as many shareholder activists are also clients of these firms, it may not be easy to promote change.

Need for Reform

Commentators have for years lamented the undue influence of proxy advisory firms in corporate elections. James R. Copland of the Manhattan Institute has observed that an ISS recommendation in favor of a given shareholder proposal increases the approval vote by, on average, fifteen percentage points.7 In other words, as Copland puts it, “At least when it comes to shareholder proposals, a small, thinly funded outfit with 600 employees in Rockville, Maryland, is acting like an owner of fifteen percent of the total stock market.”8 In some instances, ISS’s influence can be even greater. In 2014, for example, shareholder proposals related to social and political issues received9 average support of 29% with ISS’s support, and only 5% if ISS recommended against. That is, ISS directly influenced nearly a quarter of the votes cast on these matters. Because the SEC’s rules for resubmission of a failed proposal by a shareholder in the next year’s proxy statement require that the proposal have received up to 10% of the vote (depending on how many years it has been submitted),10 the significant voting impact of an ISS recommendation can empower a proponent to resubmit a proposal year after year, imposing costs on the company and creating waste and negative publicity to the detriment of the company and its shareholders.

The problem of waste is exacerbated by the fact that ISS’s voting recommendations, on topics from compensation to social issues, have been dramatically out of line with voting results. One example is cumulative voting: ISS has supported 96% of proposals to adopt cumulative voting; however, out of 107 such proposals at Fortune 200 companies between 2006-2012, only one received majority support.11 As Copland notes, “The significant influence of ISS on corporate proxy voting—along with the large, systemic gap between its preferences and those observed in shareholders’ actual votes—raises questions about whether shareholder voting is working effectively to improve share value.”12

Proxy advisors’ influence, elevated to great heights by two 2004 no-action letters noted below, received an additional boost in 2010 from the passage of the Dodd- Frank Act. The legislation’s enshrinement of say-on-pay votes in the annual shareholder meeting raised the stakes for the shareholder vote and provided an annual opportunity for activist shareholders to, with the help of ISS, put public pressure on corporate issuers.13 The Manhattan Institute’s Copland observes that a negative recommendation from ISS on an executive compensation proposal has the effect of reducing shareholder support for it by 17 percentage points.14

In the 2014 proxy season, ISS’s negative recommendations increased and voting results for directors were low, reflecting activist shareholders’ perception that directors were insufficiently responsive to their concerns. One possible cause is a change in ISS’s policies, which now call for withhold recommendations for directors who did not, after the prior annual meeting, implement a shareholder proposal that received a majority of votes cast (as opposed to votes outstanding).15 This policy change likely has had the effect of incentivizing companies to avoid a vote by agreeing to adopt reforms proposed by shareholders, particularly if a proposal is likely to meet ISS’s new, lower standard and thus—if not adopted before the next shareholder meeting—lead to a withhold-the-vote recommendation for directors in the following year. The influence of ISS therefore does not merely affect vote results themselves, but also boards’ decisions as to which proposals actually will come to a vote.16

Recent SEC Guidance

On June 30, 2014, the SEC’s Divisions of Corporate Finance and Investment Management released new guidance regarding investment advisers’ responsibilities relating to proxy voting and their reliance upon proxy advisory firms. Under the “Proxy Voting Rule,” investment advisers have a fiduciary duty to their clients to vote their proxies in the clients’ best interests. Staff Legal Bulletin 20 (SLB 20) prompts investment advisers to take an active role on behalf of their clients, particularly in evaluating and overseeing any proxy advisory firm they may engage to help them fulfill their voting responsibilities. Investment advisers are required to adopt and implement written policies and procedures designed to ensure that they comply with the Proxy Voting Rule. The guidance states that investment advisers should take steps to demonstrate compliance, including reviewing, at least annually, the adequacy of their proxy voting policies and procedures to ensure that they are reasonably designed and being effectively implemented. SLB 20 suggests using proxy vote sampling to ensure that votes have been properly cast.

A key point emphasized in SLB 20 is that the Proxy Voting Rule does not require that investment advisers vote every proxy or take on all of a client’s proxy voting responsibilities.17 Although the SEC had previously conveyed this message in other materials,18 many investment managers interpreted two 2004 no-action letters19 to indicate that they were required to vote on all matters. This interpretation led to heavy reliance on proxy advisory firms, as investment advisers largely outsourced their voting responsibilities.20 The recent guidance refutes this interpretation and suggests a variety of arrangements in which a client and an investment adviser may allocate the proxy voting responsibilities between them as dictated by the best interests of the client. Possible alternatives include focusing resources only on particular types of proposals or establishing default voting parameters for proposals made by management or certain shareholder proponents. At the extremes, the parties may agree that the adviser will vote all of the client’s proxies, or not vote any proxies at all, regardless of whether the client votes them itself. The adviser and client may use a cost-benefit analysis and the preferences of the client to determine the best arrangement for fulfilling proxy voting responsibilities.21

SLB 20 urges investment advisers to be demanding clients themselves when it comes to their proxy advisory firms. The guidance states that, when considering whether to retain or continue utilizing a proxy advisory firm, an investment adviser should make certain that the firm “has the capacity and competency to adequately analyze proxy issues.”22 In addition to the quality of the firm’s personnel, investment advisers are urged to consider the “robustness” of the proxy advisory firm’s policies and procedures designed (a) to ensure that proxy voting recommendations are based on current, accurate information and (b) to identify and address any conflicts of interest and other considerations affecting the nature and quality of the advice and services provided.23 Moreover, the Proxy Voting Rule requires that an investment adviser must oversee a proxy advisory firm on an ongoing basis to ensure that the firm continues to guide proxy voting in the best interests of the investment adviser’s clients. If an investment adviser determines that a proxy advisory firm’s recommendation was based on inaccurate information, the adviser should investigate the error and determine whether such errors are being addressed by the proxy advisory firm. Corporate issuers should take note of this guidance and be proactive in reviewing the information in proxy voting reports and submitting any necessary corrections. The guidance emphasizes the fact that a proxy advisory firm’s business or conflicts policies can change from time to time, requiring an investment adviser to reassess its use of the proxy advisor. Accordingly, investment advisers should monitor changes in a proxy advisory firm’s conflicts or conflicts policies by, for example, requiring updates from the proxy advisory firm as to these matters.

For their part, proxy advisory firms are instructed to be more forthcoming with respect to conflict-of-interest disclosures, which are required when a material conflict exists. SLB 20 states that where a proxy advisory firm provides consulting services to a company on a matter that is also the subject of a voting recommendation (or provides a voting recommendation to clients on a proposal sponsored by another client, or has any other interest in a matter), it must make a fact-specific determination as to whether its relationship with the company or proponent is significant or its interest material. Generally speaking, the SEC considers “significant” and “material” any element that would reasonably affect a client’s assessment of the reliability and objectivity of the proxy advisor’s advice. If necessary, the proxy adviser must then take affirmative steps to disclose the relationship to the client receiving the voting recommendation. The guidance states explicitly that disclosure of a conflict cannot be boilerplate; rather, it should provide the recipient of the disclosure with sufficient information to understand the nature and scope of the conflict, including any steps taken to mitigate it, in order that the client may be able to assess the recommendation. Interestingly, despite the SEC’s push for more robust disclosure, the conflicts disclosure need not be provided publicly so long as it is provided to the client in a timely and relevant manner designed to allow the client to assess both the advice and the conflict at once. Investment advisers, recognizing the increasing significance of conflicts in the proxy advisory industry, may wish to require proxy advisory firms to disclose potential conflicts more broadly than is legally required so that the investment adviser itself can decide what it considers material. In some cases, investment advisers may wish to independently investigate and verify the disclosures provided by proxy advisers to ensure that they do not inadvertently breach their fiduciary duties to their clients by relying on inaccurate information.

The SEC notes that “investment advisers and proxy advisory firms may want or need to make changes to their current systems and processes in light of this guidance” and expects such changes in advance of the 2015 proxy season. Investment advisers should be mindful that they, and not the proxy advisors, are the entity that must fulfill a fiduciary duty to a client. Because of this, investment advisors should promptly evaluate (and create a record of their evaluation of) one or more proxy advisory firms to support a decision to hire one of them or continue to retain such services. From there, investment advisers should, as advised by SLB 20, ensure that their policies and procedures relating to ongoing oversight of a proxy advisory firm are effective and up-to- date.

U.S., Canadian and European Reforms

Commissioner Gallagher, in a working paper published in August, indicated that he supports additional reforms relating to proxy advisors. He observed that “over the past decade, the investment adviser industry has become far too entrenched in its reliance on these firms, and there is therefore a risk that the firms will not take full advantage of the new guidance to reduce that reliance.”24 Promising to closely monitor whether SLB 20 will ameliorate current problems, Commissioner Gallagher noted that public companies may be disregarded by proxy advisory firms and institutional investors when they have concerns about inaccurate information being used to create voting recommendations. His interest and engagement in this issue is such that he has asked that these companies send copies of their shareholder communications directly to his office.

Commissioner Gallagher has suggested that the two 2004 no-action letters should be withdrawn and replaced with Commission-level guidance reminding institutional investors of their responsibility to fulfill their fiduciary duties by taking the lead on voting decisions rather than deferring automatically to proxy advisory firms. He is not alone in this view; former SEC Chairman Harvey Pitt as well as Congressman Patrick McHenry have made similar proposals.25 Though he stops short of calling for comprehensive regulation, Commissioner Gallagher supports the idea of a universal code of conduct for proxy advisory firms to increase transparency and promote accountability and best practices.26

A recent proposal by the European Commission (EC), cited with approval by Commissioner Gallagher, would come close to implementing a universal code of conduct. This spring, the EC released a proposal for legislation designed to improve the accuracy and reliability of advice from proxy advisory firms.27 The EC report calls for action at the European Union level and emphasizes the broad-based need for increased transparency from proxy advisory firms. Under the proposed law, proxy advisors would be required to disclose, on an annual basis, substantial information relating to how their voting recommendations are determined, including their methodologies, their information sources, whether they have taken into account market, legal, and regulatory conditions, and the extent and nature of any dialogues they may have with the companies that are the subject of their recommendations.28 Further, proxy advisory firms would be required to promptly disclose any actual or potential conflicts or business relationships that could influence their recommendations, along with any actions they have taken to reduce or eliminate such conflicts.29

Canada, too, is increasing pressure on proxy advisors to be more transparent and accountable. In April, the Canadian Securities Administration (CSA) published for comment proposed guidance for proxy advisory firms.30 The policy-based approach would provide recommendations for best practices and disclosures on the part of proxy advisors. The proposed guidance highlights conflicts of interest, stating that “[e]ffective identification, management and mitigation of actual or potential conflicts of interest are essential in ensuring the ability of the proxy advisory firm to offer independent and objective services to a client.”31 Additional guidance focuses on transparency, accuracy, tailored governance recommendations, and communications with clients, market participants, the media and the public.32

2015 Proxy Season

At best, proxy advisors play an important role in making investment managers more informed, efficient stewards of their clients’ proxy voting. However, their influence has become so significant that it is crucial that their recommendations be as worthwhile, transparent, and objective as possible. As the focus shifts to the 2015 proxy season, companies should be mindful of the SEC’s increased scrutiny of investment advisers’ voting and use of proxy advisory firms. Corporate issuers can and should be proactive in obtaining and reviewing proxy voting reports relating to the company and promptly requesting any needed corrections of incorrect information. In cases of material misstatements or confusion created by the proxy voting reports, companies may wish to add their own corrections to their proxy materials or other shareholder communications. Companies should, as always, continue to engage directly with their large shareholders and make the case for supporting the recommendations of the board. Healthy communication with issuers will help enable institutional investors to make their own independent, informed decisions about voting matters.

A separate issue that has not been widely discussed is whether the proxy advisory firms should be required to make their reports public, since they influence such a large segment of the voting population. Although the proxy advisory firms currently are not required to publicly file their reports, if the goal is increased transparency, perhaps this should change. As the SEC monitors the proxy advisory firms in the coming months, appropriate consideration should be given to modernizing the antiquated proxy voting system and determining what additional steps, if any, should be taken to regulate these firms and their influence on public companies.

Companies concerned about the undue influence of proxy advisors have an engaged advocate in Commissioner Gallagher, and momentum may be building, both in the United States and abroad, toward further reform in this area. The upcoming proxy season will be a key time for the SEC to observe any ramifications of SLB 20 and to consider next steps. Fundamentally, the SEC has, with SLB 20, reminded investment managers that their fiduciary duties are incompatible with inattentive overreliance on proxy advisors. It remains to be seen what effect the new guidance will have, but if it proves to be effective, it may herald a new era of decreasing relevance for proxy advisory firms.

 

Footnotes

 

∗ David A. Katz is a partner at Wachtell, Lipton, Rosen & Katz. Laura A. McIntosh is a consulting attorney for the firm. The views expressed are the authors’ and do not necessarily represent the views of the partners of Wachtell, Lipton, Rosen & Katz or the firm as a whole.

1 Securities and Exchange Commission Staff Legal Bulletin No. 20, “Proxy Voting: Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms,” June 30, 2014 (“SLB 20”), available at www.sec.gov/interps/legal/cfslb20.htm.

2 Commissioner Daniel M. Gallagher, U.S. Securities and Exchange Commission, “Outsized Power and Influence: The Role of Proxy Advisers,” Washington Legal Foundation Critical Legal Issues Working Paper Series, No. 187, Aug. 2014 (“Gallagher Paper”), available at http://www.wlf.org/upload/legalstudies/workingpaper/GallagherWP8-14.pdf.

3 See, e.g., U.S. Chamber of Commerce, Center for Capital Markets Competitiveness, “Best Practices and Core Principles for the Development, Dispensation, and Receipt of Proxy Advice,” March 2013, at 2, available at www.centerforcapitalmarkets.com/wp-content/uploads/2010/04/Best-Practices-and-Core- Principles-for-Proxy-Advisors.pdf.

4 See U.S. Chamber of Commerce, Center for Capital Markets Competitiveness, supra, at 3 (estimating that the two firms together have 97% market share).

5 See Gallagher Paper, supra, at 12; see also Holly Gregory, “SEC Guidance May Lessen Investment Adviser Demand for Proxy Advisory Services,” Sidley Austin LLP Update, July 29, 2014, available at blogs.law.harvard.edu/corpgov/2014/07/29/sec-guidance-may-lessen-investment-adviser-demand-for- proxy-advisory-services/; Yin Wilczek, “Congress Will Act If SEC Fails To Move on Proxy Advisors,” Bloomberg BNA, June 27, 2014, available at www.bna.com/congress-act-sec-n17179891633/.

6 See Thomson Reuters Tax & Accounting News, “Scrutiny of Proxy Advisers to Continue,” July 28, 2014 (citing statements by Keith Higgins, director of the SEC’s Division of Corporate Finance, on July 24, 2014) available at https://tax.thomsonreuters.com/media-resources/news-media-resources/checkpoint-news/daily- newsstand/scrutiny-proxy-advisers-continue/.

7 See James R. Copland, “SEC Needs To Rethink Its Rules on Proxy Advisory Firms,” Washington Examiner, July 24, 2014, available at washingtonexaminer.com/article/2551268#!.

8 Id.

9 Sullivan & Cromwell LLP, “2014 Proxy Season Review,” June 25, 2014, at 16 (“S&C Proxy Review”), available at http://www.sullcrom.com/siteFiles/Publications/SC_Publication_2014_Proxy_Season_Review.pdf.

10 Securities Exchange Act of 1934, Rule 14a-8(i)(12).

11 See James R. Copland, “Politicized Proxy Advisers vs. Individual Investors,” Wall St. J., Oct. 7, 2012 (“Copland 2012”), available at online.wsj.com/news/articles/SB10000872396390444620104578012252125632908.

12 See id.

13 See David F. Larcker et al., “The Influence of Proxy Advisory Firm Voting Recommendations on Say- on-Pay Votes and Executive Compensation Decisions,” The Conference Board Director Notes, April 2012, available at www.conference-board.org/retrievefile.cfm?filename=TCB-DN-V4N5-12.pdf&type=subsite.

14 See Copland 2012, supra.
15 See S&C Proxy Review at 1.

16 See id. at 6.

17 SLB 20, Answer to Question 2; see also Gallagher Paper, supra, at 3, 13.

18 See, e.g., Investment Advisers Act Rel. No. 2106 (“We do not suggest that an adviser that fails to vote every proxy would necessarily violate its fiduciary obligations. There may even be times when refraining from voting a proxy is in the client’s best interest, such as when the adviser determines that the cost of voting the proxy exceeds the expected benefit to the client.”), available at http://www.sec.gov/rules/final/ia- 2106.htm.

19 Institutional Shareholder Services, Inc., SEC Staff Letter (Sept. 15, 2004), available at http://www.sec.gov/divisions/investment/noaction/iss091504.htm, Egan Jones Proxy Services, SEC Staff Letter (May 27, 2004), available at www.sec.gov/divisions/investment/noaction/egan052704.htm.

20 “Reforming the Proxy Advisory Racket,” WSJ Review & Outlook, July 22, 2014, available at online.wsj.com/articles/reforming-the-proxy-advisory-racket-1405986992.

21 SLB 20 clarifies that a proxy advisory firm engages in a “solicitation” under the federal proxy rules when it furnishes proxy advice. SLB 20, Answer to Question 6; see also Securities and Exchange Act of 1934 Rule 14a-1(l ) and Release No. 34-31326 (Oct. 16, 1992). Proxy advisory firms are therefore subject to the antifraud and other provisions of the proxy rules unless an exemption applies; merely distributing reports containing recommendations would not qualify as a solicitation. SLB 20, Answer to Question 8; see also Securities and Exchange Act of 1934 Rule No. 14a(2(b)(1) and Rule No. 14 a(2(b)(3). However, an exemption would not apply to a proxy advisory firm that allowed a client to establish general guidelines or policies, in advance of receiving proxy materials, that the firm would use to vote on behalf of its client. SLB 20, Answer to Question 7.

22 SLB 20, Answer to Question 3.

23 The U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness has released a set of best practices and core principles for proxy advisory firms that is a useful reference for investment advisers and proxy advisors alike. See U.S. Chamber of Commerce, Center for Capital Markets Competitiveness, supra.

24 Gallagher Paper, supra, at 16.

25 See David Scileppi, “Congress to the Rescue?: Congressman Hints at Legislation To Rein in Proxy Advisory Firms,” The Securities Edge, June 27, 2014, available at www.thesecuritiesedge.com/2014/06/congress-to-the-rescue-congressman-hints-at-legislation-to-reign-in- proxy-advisory-firms/.

26 Gallagher Paper, supra, at 17.

27 European Commission, “Proposal for a Directive of the European Parliament and of the Council amending Directive 2007/36/EC as regards the encouragement of long-term shareholder engagement and Directive 2013/34/EU as regards certain elements of the corporate governance statement (Apr. 9, 2014), available at ec.europa.eu/internal_market/company/docs/modern/cgp/shrd/140409-shrd_en.pdf.

28 Id. at Article 3i, “Transparency of proxy advisors.”

29 Id.

30 Canadian Securities Administration Notice and Request for Comment, Proposed National Policy 25-201, “Guidance for Proxy Advisory Firms,” Apr. 24, 2014 (“CSA Proposal”), available at www.bcsc.bc.ca/Securities_Law/Policies/Policy2/PDF/25-201__NP_Proposed___April_24__2014/. The comment period closed on June 23, 2014.

31 Id. at 2. 32 Id. at 7-8.

 

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Treasury Announces First Steps to Reduce Tax Benefits of Corporate Inversions

http://www.treasury.gov/press-center/press-releases/Pages/jl2647.aspxhttp://www.treasury.gov/press-center/press-releases/Pages/jl2647.aspx

Treasury Announces First Steps to Reduce Tax Benefits of Corporate Inversions

9/22/2014

Unfair Practice Erodes the U.S. Tax Base

WASHINGTON – Today, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) issued a notice that takes targeted action to reduce the tax benefits of — and when possible, stop — corporate tax inversions. Companies are increasingly using the technique of inversion, whereby a U.S. based multinational restructures so that the U.S. parent is replaced by a foreign corporation, in order to avoid U.S. taxes. These transactions erode the U.S. tax base, unfairly placing a larger burden on all other taxpayers, including small businesses and hardworking Americans.

More than two years ago, President Obama laid out his framework for business tax reform. In addition, the Administration’s FY 2015 budget included a legislative plan to reduce the incentives to invert as well as make it more difficult to accomplish an inversion. Secretary Lew has been urging Congress to move forward with anti-inversion legislation, which is the only way to fully rein in these transactions.

“These first, targeted steps make substantial progress in constraining the creative techniques used to avoid U.S. taxes, both in terms of meaningfully reducing the economic benefits of inversions after the fact, and when possible, stopping them altogether,” said Treasury Secretary Jacob J. Lew. “While comprehensive business tax reform that includes specific anti-inversion provisions is the best way to address the recent surge of inversions, we cannot wait to address this problem. Treasury will continue to review a broad range of authorities for further anti-inversion measures as part of our continued work to close loopholes that allow some taxpayers to avoid paying their fair share.”

Genuine cross-border mergers make the U.S. economy stronger by enabling U.S. companies to invest overseas and encouraging foreign investment to flow into the United States. But these transactions should be driven by genuine business strategies and economic efficiencies, not a desire to shift the tax residence of the parent entity to a low-tax jurisdiction simply to avoid U.S. taxes.

Specifically, today’s action eliminates certain techniques inverted companies currently use to gain tax-free access to the deferred earnings of a foreign subsidiary, significantly diminishing the ability of inverted companies to escape U.S. taxation.  It also makes it more difficult for U.S. entities to invert by strengthening the requirement that the former owners of the U.S. company own less than 80 percent of the new combined entity. For some companies considering mergers, today’s action will mean that inversions no longer make economic sense.

Treasury will continue to examine ways to reduce the tax benefits of inversions, including through additional regulatory guidance as well as by reviewing our tax treaties and other international commitments. Today’s Notice requests comments on additional ways that Treasury can make inversion deals less economically appealing.  Today’s actions apply to deals closed today or after today.

Fact Sheet: Treasury Actions to Rein in Corporate Tax Inversions

9/22/2014

 

Actions under sections 304(b)(5)(B), 367, 956(e), 7701(l), and 7874 of the Code 
What is a corporate inversion?
 
A corporate inversion is transaction in which a U.S. based multinational restructures so that the U.S. parent is replaced by a foreign parent, in order to avoid U.S. taxes. Current law subjects inversions that appear to be based primarily on tax considerations to certain potentially adverse tax consequences, but it has become clear by the growing pace of these transactions that for many corporations, these consequences are acceptable in light of the potential benefits.
An inverted company is subject to potential adverse tax consequences if, after the transaction: (1) less than 25 percent of the new multinational entity’s business activity is in the home country of the new foreign parent, and (2) the shareholders of the old U.S. parent end up owning at least 60 percent of the shares of the new foreign parent. If these criteria are met for an inverted company, the tax consequences depend on the continuing ownership stake of the shareholders from the former U.S. parent. If the continuing ownership stake is 80 percent or more, the new foreign parent is treated as a U.S. corporation (despite the new corporate address), thereby nullifying the inversion for tax purposes. If the continuing ownership stake is at least 60 but less than 80 percent, U.S. tax law respects the foreign status of the new foreign parent but other potentially adverse tax consequences may follow. The current wave of inversions involves transactions in this continuing ownership range of 60 to 80 percent.
Genuine cross-border mergers make the U.S. economy stronger by enabling U.S. companies to invest overseas and encouraging foreign investment to flow into the United States. But these transactions should be driven by genuine business strategies and economic efficiencies, not a desire to shift the tax residence of the parent entity to a low-tax jurisdiction simply to avoid U.S. taxes.
Today, Treasury is taking action to reduce the tax benefits of — and when possible, stop — corporate tax inversions. This action will significantly diminish the ability of inverted companies to escape U.S. taxation.  For some companies considering mergers, today’s action will mean that inversions no longer make economic sense.
Specifically, the Notice eliminates certain techniques inverted companies currently use to access the overseas earnings of foreign subsidiaries of the U.S. company that inverts without paying U.S. tax.  Today’s actions apply to deals closed today or after today.
This notice is an important initial step in addressing inversions.  Treasury will continue to examine ways to reduce the tax benefits of inversions, including through additional regulatory guidance as well as by reviewing our tax treaties and other international commitments. Today’s Notice requests comments on additional ways that Treasury can make inversion deals less economically appealing.
Specifically, today’s Notice will:
·         Prevent inverted companies from accessing a foreign subsidiary’s earnings while deferring U.S. tax through the use of creative loans, which are known as “hopscotch” loans(Action under section 956(e) of the code)
o   Under current law, U.S. multinationals owe U.S. tax on the profits of their controlled foreign corporations (CFCs) although they don’t usually have to pay this tax until those profits are repatriated (that is, paid to the U.S. parent firm as a dividend). Profits that have not yet been repatriated are known as deferred earnings.
o   Under current law, if a CFC, tries to avoid this dividend tax by investing in certain U.S. property—such as by making a loan to, or investing in stock of its U.S. parent or one of its domestic affiliates—the U.S. parent is treated as if it received a taxable dividend from the CFC.
o   However, some inverted companies get around this rule by having the CFC make the loan to the new foreign parent, instead of its U.S. parent. This “hopscotch” loan is not currently considered U.S. property and is therefore not taxed as a dividend.
o   Today’s notice removes benefits of these “hopscotch” loans by providing that such loans are considered “U.S. property” for purposes of applying the anti-avoidance rule. The same dividend rules will now apply as if the CFC had made a loan to the U.S. parent prior to the inversion.
·         Prevent inverted companies from restructuring a foreign subsidiary in order to access the subsidiary’s earnings tax-free(Action under section 7701(l) of the tax code)
 
o   After an inversion, some U.S. multinationals avoid ever paying U.S. tax on the deferred earnings of their CFC by having the new foreign parent buy enough stock to take control of the CFC away from the former U.S. parent. This “de-controlling” strategy is used to allow the new foreign parent to access the deferred earnings of the CFC without ever paying U.S. tax on them.
o   Under today’s notice, the new foreign parent would be treated as owning stock in the former U.S. parent, rather than the CFC, to remove the benefits of the “de-controlling” strategy. The CFC would remain a CFC and would continue to be subject to U.S. tax on its profits and deferred earnings.
 
·         Close a loophole to prevent an inverted companies from transferring cash or property from a CFC to the new parent to completely avoid U.S. tax (Action under section 304(b)(5)(B) of the code)
o   These transactions involve the new foreign parent selling its stock in the former U.S. parent to a CFC with deferred earnings in exchange for cash or property of the CFC, effectively resulting in a tax-free repatriation of cash or property bypassing the U.S. parent. Today’s action would eliminate the ability to use this strategy.
·         Make it more difficult for U.S. entities to invert by strengthening the requirement that the former owners of the U.S. entity own less than 80 percent of the new combined entity:
o   Limit the ability of companies to count passive assets that are not part of the entity’s daily business functions in order to inflate the new foreign parent’s size and therefore evade the 80 percent rule – known as using a “cash box. (Action under section 7874 of the code) Companies can successfully invert when the U.S. entity has, for example, a value of 79 percent, and the foreign “acquirer” has a value of 21 percent of the combined entity.  However in some inversion transactions, the foreign acquirer’s size is inflated by passive assets, also known as “cash boxes,” such as cash or marketable securities. These assets are not used by the entity for daily business functions. Today’s notice would disregard stock of the foreign parent that is attributable to passive assets in the context of this 80 percent requirement. This would apply if at least 50 percent of the foreign corporation’s assets are passive. Banks and other financial services companies would be exempted.
 
o   Prevent U.S. companies from reducing their size pre-inversion by making extraordinary dividends. (Action under section 7874 of the code) In some instances, a U.S. entity may pay out large dividends pre-inversion to reduce its size and meet the 80 percent threshold, also known as “skinny-down” dividends. Today’s notice would disregard these pre-inversion extraordinary dividends for purposes of the ownership requirement, thereby raising the U.S. entity’s ownership, possibly above the 80 percent threshold.
 
o   Prevent a U.S. entity from inverting a portion of its operations by transferring assets to a newly formed foreign corporation that it spins off to its shareholders, thereby avoiding the associated U.S. tax liabilities, a practice known as “spinversion.” (Action under section 7874 of the code)  In some cases a U.S. entity may invert a portion of its operations by transferring a portion of its assets to a newly formed foreign corporation and then spinning-off that corporation to its public shareholders. This transaction takes advantage of a rule that was intended to permit purely internal restructurings by multinationals.  Under today’s action, the spun-off foreign corporation would not benefit from these internal restructuring rules with the result that the spun off company would be treated as a domestic corporation, eliminating the use of this technique for these transactions.

 

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“Activist” hedge funds: creators of lasting wealth?

“Activist” hedge funds: creators of lasting wealth? What do the empirical studies really say?

Yvan Allaire, Ph.D. (MIT), FRSC François Dauphin, MBA, CPA, CMA

Executive Chair, IGOPP Project Director

(Opinions expressed herein are the sole responsibility of the authors)

Executive Summary

Hedge funds have found, in some academic circles, supporters and champions of their enduring contribution to shareholder wealth. Some recent empirical research has triggered an important debate in the American corporate/financial world about the role of board of directors, the rights of shareholders, and the very concept of the business corporation. The terms of the debate run as follows: Are boards of directors responsible for the long-term interest of the company? Or, are there lasting benefits from “activist funds” pushing and prodding reticent boards of directors to take actions these activists consider likely to create significant wealth for shareholders? What are the consequences of this “activism” for other stakeholders and for the very nature of board governance?

A wide range of observers with considerable financial experience and corporate expertise take a dim view of “activist hedge funds”, lambasting them for their greed-fuelled short-term stratagems and their prejudicial influence on the long-term health of companies. Professor Lucian Bebchuk of the Harvard Law School, argue that these wise people, with loads of practical experience, have no “scientific” basis for their collective judgment that activist interventions are detrimental to the long-term interests of shareholders and companies. Having assembled reams of data and statistics, Bebchuk and his colleagues claim they have “scientifically” demonstrated that hedge funds are not “myopic activists”, but on the contrary bring to corporations they target performance improvements which last long after they have exited the target company.

We carefully reviewed Bebchuk et al.’s paper and reached the following conclusions:

First, the authors have not demonstrated that activist hedge funds, per se, create lasting, long- term value and bring a long-term perspective to their “activism”. They have merely shown some statistical relationships to provide (weak) support to their thesis. The weight of experience still trumps the results presented in Bebchuk et al.

Secondly, the most generous conclusion one may reach from these empirical studies has to be that “activist” hedge funds create some short-term wealth for some shareholders as a result of investors who believe hedge fund propaganda (and some academic studies), jumping in the stock of targeted companies. In a minority of cases, activist hedge funds may bring some lasting value for shareholders but largely at the expense of workers and bond holders; thus, the impact of activist hedge funds seems to take the form of wealth transfer rather than wealth creation.

Thirdly, “activist” hedge funds operate in a world without any other stakeholder than shareholders. That is indeed a myopic concept of the corporation bound to create social and economic problems, were that to become the norm for publicly listed corporations.

Finally, the Bebchuk et al. paper illustrates the limits of the econometric tool kit, its weak ability to cope with complex phenomena; and when it does try to cope, it sinks quickly into opaque computations, remote from the observations on which these computations are supposedly based.page2image24960 page2image25120

Introduction

For some time now activist hedge funds have cultivated a revamped reputation as creators of lasting economic value for shareholders. Hedge funds have now found in some academic circles supporters and champions of their enduring contribution to shareholder wealth.

Some recent empirical research has indeed triggered an important debate in the American corporate/financial world, about the role of board of directors, the rights of shareholders, and the very concept of the business corporation.

The terms of the debate run as follows: Are boards of directors responsible for the long-term interest of the company? Or, are there lasting benefits from “activist funds” pushing and prodding reticent boards of directors to take actions these activists consider likely to create significant wealth for shareholders? What are the consequences of this “activism” for other stakeholders and for the very nature of board governance?

Simply stated, would a form of “direct democracy” whereby shareholders have a say in all important decisions of the company lead to better long-term corporate performance? That is the implicit claim of “activist hedge funds”.

But, a wide range of observers with considerable financial experience and expertise take a dim view of “activist hedge funds”, lambasting them for their greed-fuelled short-term stratagems and their prejudicial influence on the long-term health of companies.

Among those sharing this view, one finds top corporate lawyers, public officials, at least one SEC chairman, judges of the Delaware Chancery Court, senior corporate executives, legal academics, influential economists and business school professors, prominent business columnists, business organizations, and so on.

For instance, famed lawyer Martin Lipton, founding partner of Wachtell, Lipton, Rosen & Katz, describes what he sees as the consequence of this new variant of “shareholder activism”:

“U.S. companies, including well-run, high-performing companies, increasingly face:

  • –  pressure to deliver short-term results at the expense of long-term value, whether through excessive risk-taking, avoiding investments that require long-term horizons or taking on substantial leverage to fund special payouts to shareholders;
  • –  challenges in trying to balance competing interests due to excessively empowered special interest and activist shareholders; and significant strain from the misallocation of corporate resources and energy into mandated activist or governance initiatives that provide no meaningful benefit to investors or other critical stakeholders.

These challenges are exacerbated by the ease with which activist hedge funds can, without consequence, advance their own goals and agendas by exploiting the current regulatory and institutional environment and credibly threatening to disrupt corporate functioning if their demands are not met.(Lipton, 2013a)

However, a group of academic researchers, most prominently, Professor Lucian Bebchuk of the Harvard Law School, argue that these wise people, with loads of practical experience, have no “scientific” basis for their collective judgment that activist interventions are detrimental to the long-term interests of shareholders and companies….Having assembled reams of data and statistics, Bebchuk and his colleagues claim they have “scientifically” demonstrated that hedge funds are not “myopic activists”, but on the contrary bring to corporations they target performance improvements which last long after they have exited the target company.

He and his fellow researchers have recently published the results of a large empirical study on the topic. Bebchuk even wrote an op-ed in the Wall Street Journal (August 8th 2013) to herald their findings1. Here’s how he summarizes their study’s findings:

“The Myth of Hedge Funds as ‘Myopic Activists’ ”

Our comprehensive analysis examines a universe of about 2,000 hedge fund interventions during the period of 1994-2007 and tracks companies for five years following an activist’s arrival. We find that:

  • –  During the five-year period following activist interventions, operating performance relative to peers improves consistently through the end of the period;
  • –  The initial stock price spike following the arrival of activists is not reversed in the long term, as opponents assert, and does not fail to reflect the long-term consequences of activism;
  • –  The long-term effects of hedge fund activism are positive even when one focuses on the types of activism that are most resisted and criticized – first, those that lower or constrain long-term investments by enhancing leverage, beefing up shareholder payouts, or reducing capital expenditures; and second, adversarial interventions employing hostile tactics;

    1 Before their paper was reviewed by any professional journal, a rather unusual move. The paper is slated to appear in the December 2014 issue of the Columbia Law Review.

  • –  The “pump-and-dump” claim that activists bail out before negative stock returns arrive is not supported by the data; and
  • –  Contrary to opponents’ beliefs, companies targeted by activists in the years preceding the financial crisis were not made more vulnerable to the subsequent downturn.”

    (Wall Street Journal, August 8th, 2013)

    The authors conclude their paper with the following recommendation:

    “Our findings that the considered claims and concerns are not supported by the data have significant implications for ongoing policy debates. Policymakers and institutional investors should not accept the validity of the frequent assertions that activist interventions are costly to firms and their long-term shareholders in the long term. They should reject the use of such claims as a basis for limiting the rights and involvement of shareholders.” (p.37)

    The paper of Bebchuk, Brav and Jiang (2013) is quoted urbi et orbi as providing compelling evidence in favour of hedge fund activism; but does it really?

    The Bebchuk et al. paper is heavily laden with statistics and econometric jargon. Those “wise” people who disagree with Bebchuk et al. are usually not versed in the arcane of statistical analysis and thus avoid a direct challenge of this “empirical evidence”. Then, as the statistical analysis carried out by Bebchuk, Brav and Jiang abides by the conventional norms and typical methods of econometric studies, no criticism will likely come from specialists of the trade.

    Thus, the paper’s data, analysis, empirical claims and conclusions have not been thoroughly vetted.

EXPERIENCE VERSUS ECONOMETRICS?

Is econometric analysis a better lens through which to understand complex social or economic phenomena than the collective judgment of people expertly engaged with these phenomena?

For instance, anyone with a modicum of experience with the operations of real-life business organizations would list as factors influencing their performance: quality of management and leadership, talented workforce, quality of the products, effective marketing, excellence of the distribution channels, differentiation, lean operations, savvy and timely investments, customer service, etc.

Yet, the common practice in econometrics is to attempt to capture the influence of these complex factors through proxy or dummy variables. The various factors influencing the economic performance of a company are supposedly captured by firm size and its age 2 and a multitude of dummy variables to approximate the dynamics of time, and the subtlety of industrial differences, etc.

At best, these proxy variables assembled together in a generalized linear model can “explain” a small part of the variations in observed performance but in no circumstances should one claim that these variables have “caused” the observed performance.

Econometrics provides a crude tool kit, a weak lens through which the researcher can, at best, view the blurred contours of complex phenomena.

Imagine that a researcher had collected a thousand judicial decisions in criminal cases and wanted to build a regression model to “explain” the decisions of several hundred judges. It would be edifying to have a professor of law, Professor Bebchuk for instance, build such a model; what variables would have to be included to capture the nuances of every situation; would “dummy” variables suffice for that purpose? What conclusions of a policy nature could one draw from such a study?

That is perhaps the reason why the Harvard law school (and its business school) tends to teach law (or business) through cases with their manifold complexity and nuances.

2 Measured by the natural logarithm of the market capitalization and the natural logarithm of the firm’s age.

A CRITIQUE OF THE BEBCHUK ET AL. PAPER

The Bebchuk paper’s fundamental argument and main conclusion are derived from two tables based on 2,040 interventions3 by activist activist hedge funds which were carried out sometime during the period from 1994 to 2007.

To assess the performance of these firms, the authors use two metrics: ROA (return on assets) and Tobin’s Q (a common ratio calculated thus: the sum of the market value of equity and book value of debt, divided by the book value of equity and book value of debt).

Time “t” represents the year of the activist’s “intervention”, and subsequent years are identified as t+1, t+2, etc. up to the fifth year following the intervention.

The first table presents the descriptive data from the sampling of firms analyzed by the authors.

Table 1

Operating Performance Pre- and Post-Intervention

No Industry Adjustment

Average Median Observations

Average Median Observations

PANEL B: TOBIN’S Q

t+1 t+2

t: Event Year

t: Event Year

t+1

PANEL A: ROA

t+2

t+3

t+3

t+4 t+5

0.046 0.089 694

t+4 t+5

2.160 1.412 710

0.022

0.034

0.038

0.048

0.049

0.069

0.075

0.073

0.083

0.091

1,584

1,363

1,187

1,055

926

2.039

1.975

2.003

2.052

2.095

1.373

1.332

1.316

1.363

1.347

1,611

1,384

1,206

1,076

942

Source: Excerpt from Table 2 of Bebchuk, Brav and Jiang, 2013, p.8.

3 “Intervention” sounds almost like some psychological ministration but in fact merely means that a fund has filed a 13D report stating that it has accumulated 5% of a company’s outstanding shares.

So, the average return on assets (ROA) of 1,584 firms calculated at the time of the “intervention” (that is, some in 1994, some in 1995 and so on until 2007) came out at 2.2% and at t+5, the average ROA of 694 firms is now 4.6%.

But they are not quite comparing apples with apples! Where did the 890 missing firms go? What would be their ROA? Did they disappear because of bankruptcy, acquisitions, liquidation or other discomfitures, with the healthier firms from t=event year, presumably with higher ROA, still around five years later? Or, which companies have been acquired, merged or delisted for whatever reason and what is the impact on overall statistical comparisons? The authors mention “normal” attrition rate without supplying any information about the impact of this attrition on their results.

In Panel B, results for Tobin’s Q are reported, again with the sample shrinking from 1,611 observations to 710 by year 5. The median Q results indicate that the companies did not improve at all for four years and then show a small improvement in year 5 (Q=1.412), presumably (?) due to the “intervention” five years earlier of a hedge fund which has long exited the company. Whatever the case may be the authors report that none of the results in Table 1 are statistically significant.

They then proceed to compile the same statistics but in Table 2 adjusted to take into account the industrial sector. This standard procedure in econometrics serves presumably to eliminate the confounding effect of cross-industry variations. The adjusted metrics represent the average (or median) of the difference between the performance measure of a given firm and the average performance of firms in the same industrial sector (defined by 3-digits SIC code).

Table 2

Industry-Adjusted Operating Performance

Pre- and Post-Intervention

PANEL A : INDUSTRY-ADJUSTED ROA (benchmark = industry average)

08

page8image16984 page8image17144 page8image17304

t: Event Year t+1

t+2 t+3 t+4 t+5

-0.009 0.002 694

-0.028

-0.013

-0.010

-0.004

-0.005

-0.005

-0.002

0.001

0.000

0.005

1,584

1,363

1,187

1,055

926

Average Median Observations

PANEL B: : INDUSTRY-ADJUSTED Q (benchmark = industry average)
t: Event Year t+1 t+2 t+3 t+4 t+5

-1.507

-1.369

-1.377

-1.329

-0.984

-0.748

-0.614

-0.540

-0.547

-0.470

1,611

1,384

1,206

1,076

942

Average Median Observations

-0.935 -0.420 710

Source: Excerpt from Table 3 of Bebchuk, Brav and Jiang, 2013, p.9.

Apart from the same observation about the varying sample size over the years, what is most striking about these results is the large number of negative signs. The Tobin’s Q improves but remains decidedly inferior to the mean Q of companies within the same industrial sector.

The median difference in the ROA of 1,584 companies at “intervention” time compared to the mean ROA of companies with the same SIC code came out as (-0.005); that is, these companies in need of the ministrations of hedge funds had a ROA performance minimally under the average performance of the companies in their industry overall. Five years later, the 694 companies remaining from the original sample now show a median ROA difference 0.002. So the positive impact of hedge funds, if that difference were really attributable to their intervention, would amount to going from a performance infinitesimally smaller than industry performance to a performance infinitesimally better than industry performance. These results are reported as “statistically significant” (which merely means that the difference is not zero) but are they significant from a managerial or investment perspective? Yet, that is the basis for the claim of Bebchuck quoted above:

During the five-year period following activist interventions, operating performance relative to peers improves consistently through the end of the period. (Wall Street Journal, August 8th, 2013)

The reduction in sample size between year 1 and year 5 raises significant issues; the authors of the paper should have been more transparent on what happened to the missing cases.

Part of the reason for the discrepancy may be found in another paper by two of the authors writing with Bebchuk. Using the same dataset4, but for the period between 2001 and 2007, Brav, Jiang and Kim (2010) listed the breakdown of various forms of hedge fund exit. Their table reproduced below shows that, on average, close to 13% of the targeted firms disappeared from the sample because they were sold, merged or liquidatedpage9image17384 page9image17544

Table 3

Breakdown of exit

Categories

1. Sold shares on the open market
2. Target company sold
3. Target company merged into another
4. Liquidated
5. Shares sold back to the target company 6. Still holding/no Information

Source: Brav, Jiang & Kim (2010), in Hedge Fund Activism: A Review

Hostile

Non-Hostile

All Events

29.5% 6.8% 5.2% 0.9% 0.4% 57.1%

20.8%

32.9%

11.9%

4.9%

8.2%

4.1%

1.6%

0.7%

0.6%

0.4%

56.9%

57.0%

page9image38352

4 Curiously, the number of events varies between the two papers for the same period. There were, for the same time period, 1,172 events in the Brav, Jiang & Kim (2010) paper, compared to 1,283 in Table 2 of the Bebchuk, Brav & Jiang (2013) paper.

But there have to be other reasons as the sample in Bebchuk et al. shrinks by more than 50%!

Another reason might be linked to the rate of failed attempts at intervention by hedge funds. There is some evidence that failure rate hovers between 17% and 34% (See Brav, Jiang, Partnoy & Thomas, 2008; Klein & Zur, 2009). How these failed interventions were handled in the Bebchuk et al. paper is unclear. Of course, only “successful” interventions should be included in a study purporting to capture the impact of hedge fund intervention on company performance. Is it the case in the Bebchuk et al. paper? Not clear.

A close examination of their results raises additional questions:

A higher Tobin’s Q is not a demonstration of a firm’s improved performance (Dybvig and Warachka, 2012). Write-downs of assets, of goodwill, reductions in capital investments and R&D that have no near-term impact on stock price also boost Tobin’s Q. So will selling assets/divisions with low ROA but perhaps high expected growth in profit. For instance, the following figure (Figure 1) shows how an activist hedge fund could pressure management to sell assets D and E, call on them to pay a special dividend or buy back shares with the proceeds. The result would be a large increase in ROA and given a probable increase in stock price as a result, also a large increase in Tobin’s Q. But even if stock price did not increase, Tobin’s Q would still increase substantially. In the longer run though, having been shorn of its growth assets, the company would stagnate.

Figure 1

A company with five assets/divisions

Average ROA of the Firm
Expected Average Growth Rate in Profit

page10image16416 page10image16576 page10image16736 page10image16896 page10image17056 page10image17216 page10image17376 page10image17536

Asset B

Asset C

Asset A

Asset E
Asset D

Expected Growth in Profit

ROA

  • –  The adjustment for “industry peers”, a common practice in econometric studies, brings up a host of problems rarely, if ever, mentioned in these econometric studies: in many instances, the “peers” are not really comparable companies; companies often operate in several 3-digit SIC classification; newer types of companies are difficult to classify in this old classification (e.g. Google, Facebook, etc.). Indeed, since 1997, a new system, the North American industrial classification system (NAICS), has been developed to replace SIC codes; “NAICS codes provide a greater level of detail about a firm’s activity than SIC codes… There are 358 new industries recognized in NAICS, 250 of which are services producing industries. Additionally, NAICS codes are based on a consistent, economic concept, while SIC codes are not”. Canada has shifted totally to the NAICS while the U.S. is doing so gradually.
  • –  Bebchuck et al.’s research spans the period 1994 to 2012 during which economic conditions fluctuated wildly, the industrial make-up of the American economy shifted dramatically; yet, as is the standard practice in econometric research, all these influences are deemed captured by “dummy variables”. That may be good enough to publish papers in professional journals but not good enough to get at causality and capture complex relationships; that statistical device is a crude, approximate attempt at taking into account subtle, interactive, non-linear phenomena. The introduction of “firm fixed effect” is particularly questionable; the authors write: In regression (2) we include a dummy for each firm, running a firm fixed effect regression, to account for time-invariant factors unique to each firm. Under such a specification, the coefficients on the key variables, t, t+1,…, t+5, should be interpreted as the excess performance of a target firm, during years t to t+5, over its own all-time average and adjusted for market-wide conditions (due to the year fixed effects). Firm fixed effects automatically subsume industry fixed effects. (Emphasis added). In “Hedge Fund Activism, Corporate Governance, and Firm Performance”, Brav, Jiang, Partnoy & Thomas mention that “for the period 2001 to 2006 […], the target companies span 183 three-digit SIC code industries.” That means there are at least 182 dummy variables in the regressions for industry fixed effects. The authors never explain how the original sample of 2,040 interventions observed for 8 years (thus leading to some 16,320 observations) turns into some 120,000 observations (!) for the purpose of regression analysis. The paper utterly lacks transparency about the many unobserved decisions made by the authors in the course of their analysis.
  • –  In their regression analysis, the authors use the natural logarithm of the age of the firm as control variable. In the literature, this variable is frequently used; the well-known relationship is that as firms grow older, the ROA tends to decrease. What is interesting to observe is that the coefficient of Ln(Age) is positive and statistically significant on all the regressions using ROA as dependent variable, a result completely at the opposite of what previous studies have established. The authors give no explanation for this surprising result, which may be an indication of a common, but serious, econometric problem called “multicollinearity”, making the interpretation of all coefficients subject to great caution.

The methodology used by Bebchuk et al. does not provide proof or causal relationships of the benefits of hedge fund “intervention”. [Actually, no econometric study ever does.] For instance, the pattern of changes in ROA and Tobin’s Q reproduced here as Tables 1 and 2 is consistent with typical historical or cyclical patterns of company performance.

The graphs in Figure 2 illustrate this point. By mapping the return on invested capital (ROIC, a close equivalent of ROA) and enterprise value over invested capital (EV/IC, a close equivalent to Tobin’s Q) for 743 firms from 2001 to 2009, McKinsey and Co. found a clear pattern of convergence towards the mean. Firms which showed performances better than average at the beginning of the period tended to do less well eight years later. Firms at the bottom in terms of performance moved closer to the average performance.

The bottom line in these two graphs is virtually identical to the results presented above as Tables 1 and 2 drawn from Bebchuck et al. Yet, there were no generalized hedge fund “intervention” in the data collected by McKinsey; only the dynamic interplay of competition as the advantage of the best-performing firms is eroded by imitation by other firms and best industry practices gradually become the norm and standard for all players (Bradley, Hurt and Smit, 2011).

Figure 2

Market and economic forces drive convergence of performance towards the mean

Markets drive a reversion to mean performance

Performance cohorts based on position in 2001 relative to mean, n = 743*

Return on invested capital (ROIC), %

Ratio of enterprise value to invested capital (EV/IC)

3.5 3.0 2.5 2.0 1.5 1.0 0.5

0 –0.5 –1.0 –1.5

2001 2003 2005 2007 2009

Bottom quintile

20 15 10

5

0 –5 –10 –15

2001

2003

2005

2007

Middle quintile

2009

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Top quintile

page13image18400 page13image18560 page13image18720

*Sample of largest 1,200 nonfinancial US-listed companies in 2009 was narrowed to 743 that were also listed in 2001. Source: Standard & Poor’s Compustat; McKinsey analysis

STOCK PRICE IN THE SHORT AND LONG TERM?

The authors of the paper claim that, not only does the stock price of targeted companies increases in the short term, but that this price increase persists for 36 months or 60 months after the “intervention”.

They never show actual stock prices but proceed by statistical estimations of “alpha” in the well- known capital asset pricing models (CAPM) and the Fama-French four-factor model. This “alpha” is supposed to capture the value added over and above the market risk and other factors that may influence stock price.

Again, the number of treatments5, estimations and assumptions going into producing their results are mind-numbing. Here’s an example:

Specifically, for each event, we compute the buy-and-hold return over a predetermined holding period after the intervention net of a benchmark return that is meant to capture the event firm’s expected return. In particular, for each event firm, we use information on its pre-event market capitalization and book-to-market to match it to one of the Fama and French 25 size and book-to- market value-weight portfolios. [Question: why is a company’s future stock performance supposed to behave in the same way as companies that have similar market capitalization and book-to-market valuation, but may come from different industries?]

Since the target firm’s market capitalization and book to market ratio change over the subsequent holding period we allow the benchmark portfolio to change by using the new firm attributes in every subsequent year. [So, every year the stock market performance of the target firm is compared to that of a new set of companies!] In those cases in which a target firm is missing a book to market ratio in a given year we impute the value from the previous year and if, missing, two years earlier. [What is the impact of this treatment?] Finally, if a target firm delists prior to the chosen investment horizon we reinvest the proceeds in the market portfolio (the Fama and French value weight portfolio, “RM”) and similarly reinvest the benchmark return to that point in the market as well. [How many target firms were delisted? What is the “proceeds”? How many were delisted because of acquisitions? How does the study take into consideration the fact that these acquired companies would have benefited from a control premium? What were the consequences of this treatment on results?] (Bebchuk et al., 2013)

After an examination of these statistical treatments, assumptions and approximations, the “scientific” character of these empirical studies appears dubious. Perhaps, Bebchuk should not be so dismissive of actual real-world experience.

5 It is curious that for their estimation of stock price performance, the authors manage to retain some 1397 firms after five years but for the ROA/Q computations reported in Tables 1 and 2, the number of cases dropped to 694 and 710 after five years. Can it be that more than 600 companies were “delisted” and the authors “reinvest the proceeds in the market portfolio and similarly reinvest the benchmark return to that point in the market as well”? The net effect of these treatments cannot be assessed without more information. Some explanation and detailed divulgation would have been welcome here.

ACTIVIST HEDGE FUND: LONG-TERM OR SHORT-TERM INVESTOR?

The Bebchuk et al. paper is discreet about the length of time that hedge funds remain engaged with target companies. But, in another study based on the same data set, the authors, Brav, Jiang and Kim (2010) provide this useful information: the duration (in days) of hedge fund activists’ investment in target companies.

The results reproduced in the Table 4 below show that half of the interventions, from the first Schedule 13D filing to divestment, had duration of 266 days or less (not even 9 months). Claiming that these are long-term “investors” seems a bit of a stretch. It is even more of a stretch to credit these activist funds for a favourable, enduring effect on the performance of a firm 3 to 4 years after their departure.

page15image8296 page15image8456

Table 4

Length of Holding Period (Days) for Completed Spells

Percentile

5% 25% 50% 75% 95%

Hostile (Initial)

Non-hostile (Initial)

All Events

22 126 266 487 1,235

11

23

96

141

229

285

439

504

840

1,273

Source: Brav, Jiang & Kim (2010), in Hedge Fund Activism: A Review

VALUE CREATION OR VALUE TRANSFER?

Assuming for a moment that “interventions” by activist hedge funds produce positive (or “abnormal”) returns at least in the short term6 and possibly in the longer term, the question becomes: where did this added value come from? Certainly the data reported above on the ROA improvement do not explain stock price improvement.

Several studies actually show that there is no “creation” of value, but rather a “transfer” of value in favour of the shareholders from employees (Brav, Jiang and Kim, 2010, 2013) and bondholders (Klein and Zur, 2009).

Brav, Jiang and Kim (2013), two of them co-authors of the Bebchuk paper and thus strong supporters of the benefits of activist hedge funds, must nevertheless acknowledge that:

Overall, results in this section suggest that target firm workers do not share in the improvements associated with hedge fund activism. They experience a decrease in work hours and stagnation in wages, while their productivity improves significantly. Moreover, the relative decrease in productivity-adjusted wages from above-par levels suggests that hedge fund activism facilitates a transfer of “labor rents” to shareholders which may account for part of the positive abnormal return at the announcement of hedge fund interventions. (Brav et al, 2013, p.22, emphasis added)

This “admission” provides a counterpoint to the fawning description of the whole undertaking:

create value for shareholders by taking it from workers!

Other studies show that the value created for shareholders comes in part at the expense of bond holders.

“For our sample, on average, bondholders lose an average excess return of -3.9% around the initial 13D filing, and an additional -4.5% over the remaining year after the filing date…We also find evidence suggesting an expropriation of wealth from the bondholder to the shareholder”. (Klein and Zur, 2009)

Aslan and Maraachlian (2009) also claim that existing bonds of companies that were targeted by the activist investors performed more poorly than a portfolio of comparable bonds by a difference of 5% per year on average for the two years following the announcement of the intervention, in addition to being more likely to undergo a ratings downgrade.

“Collectively, our results indicate that activism is viewed negatively by bondholders in the long-run and that part of the overall gain to stockholders is the result of a wealth transfer from bondholders”. (Aslan and Maraachlian, 2009)

These empirical results reveal a more sombre reality than that painted by the new admirers of these activist “benefactors”.

6 The more academic researchers claim to have proven the benefits to shareholders from “activist interventions”, the more likely and the stronger will markets react to the news that a hedge fund has taken a position in a target company!

CONCLUSIONS

What conclusions can one draw from these various considerations?

First, Bebchuk et al. have not demonstrated that activist hedge funds, per se, create lasting, long- term value and bring a long-term perspective to their “activism”. They have merely shown some contorted statistical relationships to provide some (weak) support to their thesis.

Their paper provides little “scientific” support for their categorical final recommendation:

“Policymakers and institutional investors should not accept the validity of the frequent assertions that activist interventions are costly to firms and their long-term shareholders in the long term. They should reject the use of such claims as a basis for limiting the rights and involvement of shareholders.”

Policy makers should weigh the experience and expertise of knowledgeable people rather more than tortured statistics.

Secondly, the most generous conclusion one may reach from these empirical studies has to be that “activist” hedge funds create some short-term wealth for some shareholders (and immense riches for themselves) as a result of investors, who believe hedge fund propaganda (and some academic studies), jumping in the stock of targeted companies. In a minority of cases, activist hedge funds may bring some lasting value for shareholders but largely at the expense of workers and bond holders; thus, the impact of activist hedge funds seems to take the form of wealth transfer rather than wealth creation.

Thirdly, “activist” hedge funds operate in a world without any other stakeholder than shareholders. That is indeed a myopic concept of the corporation bound to create social and economic problems, were that to become the norm for publicly listed corporations.

Finally, the Bebchuk et al. paper illustrates the limits of the econometric tool kit, its weak ability to cope with complex phenomena; and when it does try to cope, it sinks quickly into opaque computations, remote from the observations on which these computations are supposedly based.

REFERENCES

  • –  Aslan, H. & H. Maraachlian. (2009) “Wealth Effects of Hedge Fund Activism”. SSRN Working Paper Series.
  • –  Bebchuk, L. A., A. Brav & W. Jiang. (2013) “The long-term effects of hedge fund activismColumbia Business School, July, 40p.
  • –  Becht, M., J. Franks, J. Grant & H. Wagner. “The Returns to Hedge Fund Activism:
    An International Study
    ”. European Corporate Governance Institute Working Paper Series in Finance, No 402/2014.
  • –  Borstadt, L. & T. Zwirlein. (1992) “The Efficient Monitoring Role of Proxy Contests: An Empirical Analysis of Post-Contest Control Changes and Firm Performance”. Financial Management, Vol. 21, No. 3.
  • –  Bradley, C, M. Hirt & S. Smit. (2011) “Have you tested your strategy lately?”. McKinsey Quarterly, January.
  • –  Bratton, William W. “Hedge Funds and Governance Targets”. Georgetown Law Journal, Vol. 95, p. 1375; SSRN No 928689, August 11, 2010
  • –  Brav, A. W. Jiang & H. Kim. (2013) “The Real Effects of Hedge Fund Activism: Productivity, Asset Allocation, and Industry Concentration”.
    SSRN Working Paper Series.
  • –  Brav, A., W. Jiang, F. Partnoy & R. Thomas (2008) “Hedge Fund Activism, Corporate Governance and Firm Performance”. The Journal of Finance, Vol. 63, no. 4, 1729-1775.
  • –  Brav, A., W. Jiang & H. Kim. (2010). “Hedge Fund Activism: A Review”. SSRN Working Paper Series.
  • –  Brav, Alon, Michael Bradley, Itay Goldstein and Wei Jiang, “Shareholder Activism and Price Dynamics: Evidence from Closed-End Funds”, Duke University, University of Pennsylvania, and Columbia University, Working paper 2007
  • –  Dos Santos, J. & C. Song. (2009). Analysis of the Wealth Effects of Shareholder Proposals – Volume II. U.S. Chamber of Commerce, May, 25p.
  • –  Dybvig, P. H. & M. Warachka (2012). “Tobin’s q Does Not Measure Firm Performance: Theory, Empirics, and Alternative Measures”. SSRN Working Paper Series.
  • –  Fleming, M. J. (1995) “New Evidence on the Effectiveness of the Proxy MechanismFederal Reserve Bank of New York, Research Paper No. 9503.

18

page18image18704 page18image18864 page18image19024 page18image19184 page18image19344 page18image19504 page18image19664 page18image19824 page18image19984 page18image20144 page18image20304 –  Greenwood, R. & M. Schor. (2007) “Hedge fund investor activism and takeoversHarvard Business School, July, 08-004.

  • –  Ikenberry, D. & J. Lakonishok. (1993) “Corporate Governance through the Proxy Contest. Evidence and Implications.” Journal of Business, vol 66, no 3, 405-435.
  • –  Ingraham, A. T. & A. Koyfman. (2013) Analysis of the Wealth Effects of Shareholder Proposals – Volume III. U.S. Chamber of Commerce, May, 25p.
  • –  Karpoff, J. M., P. H. Malatesta & R. A. Walkling. (1996) “Corporate Governance and Shareholder Initiatives: Empirical Evidence”. Journal of Financial Economics,
    Vol. 42, 365-395.
  • –  Klein, A. & E. Zur (2009). The Impact of Hedge Fund Activism on the Target Firm’s Existing Bondholders. SSRN Working Paper Series.
  • –  Lipton, M. (2007) “Shareholder Activism And The ‘Eclipse of The Public Corporation’The Corporate Board, May/June.
  • –  Lipton, M. (2013a). “Empiricism and Experience; Activism and Short-Termism; the Real World of Business”. The Harvard Law School Forum on Corporate Governance and Financial Regulation, October 28.
  • –  Lipton, M. (2013b). “The Bebchuk Syllogism”. The Harvard Law School Forum on Corporate Governance and Financial Regulation, August 26.
  • –  Macey, J. & E. Buckberg (2009). Report on Effects of Proposed SEC Rule 14a-11 on Efficiency, Competitiveness and Capital Formation. NERA Economic Consulting, August 17, 29p.
  • –  Prevost, A. K. & R. P Rao. (2000). “Of What Value Are Shareholder Proposals Sponsored by Public Pension Funds”. The Journal of Business, Vol. 73, No. 2.
  • –  Romano, R. (2001). “Less is More: Making Institutional Shareholder Activism a Valuable Mechanism of Corporate Governance”. Yale Law School, Faculty Scholarship Series. Paper 1916.
  • –  Strine, Jr., L. E. (2010). “One Fundamental Corporate Governance Question We Face: Can Corporations Be Managed for the Long Term Unless Their Powerful Electorates Also Act and Think Long Term?” 66 Business Lawyer 1, November, 32p.
  • –  Strine, Jr., L. E. (2014). “Can we do better by ordinary investors? A pragmatic reaction to the dueling ideological mythologists of corporate law”. Columbia Law Review, Vol. 114, 449-502.
  • –  Wahal, S. (1996). “Pension Fund Activism and Firm Performance”. Journal of Financial Quantitative Analysis, Vol. 31, No. 1, 1-23.

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SEC Issues Regulatory Guidance On Proxy Advisory Firms And Voting

SOURCE:  VERITAS EXECUTIVE COMPENSATION CONSULTANTS 255 California Street, Suite 1300 | San Francisco, CA 94111, USA | 415-429-8080 | www.veritasecc.com
On June 30, 2014, the Staff of the Securities and Exchange Commission’s Divisions of Investment Management and Corporation Finance issued regulatory guidance (in the form of 13 Q&As) concerning the proxy voting responsibilities of investment advisers, the use of proxy advisory firms and the applicability of the proxy rules to such firms.  
Although this guidance does not eliminate the fundamental structural concerns of the proxy advisory industry, it is certainly a step in the right direction towards addressing the outsized role of proxy advisory firms in corporate governance and economic matters. It will hopefully lead to more thoughtful and responsible use of proxy voting advice and propel further action to ensure greater disclosure regarding conflicts of interest, lack of transparency and other concerns that have been expressed.
The regulatory guidance issued by the SEC on proxy advisory firms and proxy voting responsibilities is in the format of 13 Q&As outlined below:
QUESTION 1.  As a fiduciary, an investment adviser owes each of its clients a duty of care and loyalty with respect to services undertaken on the client’s behalf, including proxy voting. Further, the Commission’s rules provide that it is a fraudulent, deceptive, or manipulative act, practice, or course of business for an investment adviser registered or required to be registered with the Commission to exercise voting authority with respect to client securities unless the adviser, among other things, adopts and implements written policies and procedures that are reasonably designed to ensure that the investment adviser votes proxies in the best interest of its clients (“Proxy Voting Rule”). What steps could an investment adviser take to seek to demonstrate that proxy votes are cast in accordance with clients’ best interests and the adviser’s proxy voting procedures?
ANSWER.  Compliance could be demonstrated by, for example, periodically sampling proxy votes to review whether they complied with the investment adviser’s proxy voting policy and procedures. The investment adviser also could specifically review a sample of proxy votes that relate to certain proposals that may require more analysis. In addition, as part of an investment adviser’s ongoing compliance program, it should review, no less frequently than annually, the adequacy of its proxy voting policies and procedures to make sure they have been implemented effectively, including whether these policies and procedures continue to be reasonably designed to ensure that proxies are voted in the best interests of its clients.
QUESTION 2.  Is an investment adviser required to vote every proxy?
ANSWER.  The Proxy Voting Rule does not require that investment advisers and clients agree that the investment adviser will undertake all of the proxy voting responsibilities. We understand that in most cases, clients delegate to their investment advisers the authority to vote proxies relating to equity securities. We further understand that, in general, clients usually delegate this authority completely, without retaining authority to vote any of the proxies. The staff notes that investment advisers and their clients also may agree to this type of delegation, as well as other proxy voting arrangements in which the adviser would not assume all of the proxy voting authority. Some agreements between investment advisers and their clients may include the following arrangements:
  • An investment adviser and its client may agree that the time and costs associated with the mechanics of voting proxies with respect to certain types of proposals or issuers may not be in the client’s best interest.  
  • An investment adviser and its client may agree that the investment adviser should exercise voting authority as recommended by management of the company or in favor of all proposals made by a particular shareholder proponent, as applicable, absent a contrary instruction from the client or a determination by the investment adviser that a particular proposal should be voted in a different way if, for example, it would further the investment strategy being pursued by the investment adviser on behalf of the client.  
  • An investment adviser and its client may agree that the investment adviser will abstain from voting any proxies at all, regardless of whether the client undertakes to vote the proxies itself.   
  • An investment adviser and its client may agree that the investment adviser will focus resources on only particular types of proposals based on the client’s preferences. 
As these non-exclusive examples demonstrate, an investment adviser and its client have flexibility in determining the scope of the investment adviser’s obligation to exercise proxy voting authority. We reiterate, however, that an investment adviser that assumes proxy voting authority must do so in compliance with the Proxy Voting Rule.
QUESTION 3.  What are some of the considerations that an investment adviser may wish to take into account if it retains a proxy advisory firm to assist it in its proxy voting duties?
ANSWER.  When considering whether to retain or continue retaining any particular proxy advisory firm to provide proxy voting recommendations, the staff believes that an investment adviser should ascertain, among other things, whether the proxy advisory firm has the capacity and competency to adequately analyze proxy issues. In this regard, investment advisers could consider, among other things: the adequacy and quality of the proxy advisory firm’s staffing and personnel; the robustness of its policies and procedures regarding its ability to (i) ensure that its proxy voting recommendations are based on current and accurate information and (ii) identify and address any conflicts of interest and any other considerations that the investment adviser believes would be appropriate in considering the nature and quality of the services provided by the proxy advisory firm.
QUESTION 4.  Does an investment adviser have an ongoing duty to oversee a proxy advisory firm that it retains?
ANSWER.  The staff believes that an investment adviser that has retained a third party (such as a proxy advisory firm) to assist with its proxy voting responsibilities should, in order to comply with the Proxy Voting Rule, adopt and implement policies and procedures that are reasonably designed to provide sufficient ongoing oversight of the third party in order to ensure that the investment adviser, acting through the third party, continues to vote proxies in the best interests of its clients. In addition, the staff notes that a proxy advisory firm’s business and/or policies and procedures regarding conflicts of interest could change after an investment adviser’s initial assessment, and some changes could alter the effectiveness of the policies and procedures and require the investment adviser to make a subsequent assessment. Consequently, the staff has stated that investment advisers should establish and implement measures reasonably designed to identify and address the proxy advisory firm’s conflicts that can arise on an ongoing basis, such as by requiring the proxy advisory firm to update the investment adviser of business changes the investment adviser considers relevant (i.e., with respect to the proxy advisory firm’s capacity and competency to provide proxy voting advice) or conflict policies and procedures.
QUESTION 5.  What are an investment adviser’s duties when it retains a proxy advisory firm with respect to the material accuracy of the facts upon which the proxy advisory firm’s voting recommendations are based?
ANSWER.  As stated above, it is the staff’s position that an investment adviser that receives voting recommendations from a proxy advisory firm should ascertain that the proxy advisory firm has the capacity and competency to adequately analyze proxy issues, which includes the ability to make voting recommendations based on materially accurate information. For example, an investment adviser may determine that a proxy advisory firm’s recommendation was based on a material factual error that causes the adviser to question the process by which the proxy advisory firm develops its recommendations. In such a case, the staff believes that the investment adviser should take reasonable steps to investigate the error, taking into account, among other things, the nature of the error and the related recommendation, and seek to determine whether the proxy advisory firm is taking reasonable steps to seek to reduce similar errors in the future.
QUESTION 6.  When is a proxy advisory firm subject to the federal proxy rules?
ANSWER.  A proxy advisory firm would be subject to the federal proxy rules when it engages in a “solicitation,” which is defined under Exchange Act Rule 14a-1(I) to include “the furnishing of a form of proxy or other communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy.” As a general matter, the Commission has stated that the furnishing of proxy voting advice constitutes a “solicitation” subject to the information and filing requirements of the federal proxy rules. Providing recommendations that are reasonably calculated to result in the procurement, withholding, or revocation of a proxy would subject a proxy advisory firm to the proxy rules. Exchange Act Rule 14a-2(b) provides exemptions from the information and filing requirements of the federal proxy rules that a proxy advisory firm may rely upon if it meets the requirements of the exemptions. 
QUESTION 7.  Where a shareholder (such as an institutional investor) retains a proxy advisory firm to assist in the establishment of general proxy voting guidelines and policies and authorizes the proxy advisory firm to execute a proxy or submit voting instructions on its behalf, and permits the proxy advisory firm to use its discretion to apply the guidelines to determine how to vote on particular proposals, may the proxy advisory firm providing such services rely on the exemption from the proxy rules in Exchange Act Rule 14a-2(b)(1)?
ANSWER.  No. Rule 14a-2(b)(1) provides an exemption from most provisions of the federal proxy rules for “any solicitation by or on behalf of any person who does not, at any time during such solicitation, seek directly or indirectly, either on its own or another’s behalf, the power to act as a proxy for a security holder and does not furnish or otherwise request, or act on behalf of a person who furnishes or requests, a form of revocation, abstention, consent or authorization.” The exemption would not be available for a proxy advisory firm offering a service that allows the client to establish, in advance of receiving proxy materials for a particular shareholder meeting, general guidelines or policies that the proxy advisory firm will apply to vote on behalf of the client.
In this instance, the proxy advisory firm would be viewed as having solicited the “power to act as a proxy” for its client. This would be the case even if the authority was revocable by the client. 
QUESTION 8.  If a proxy advisory firm only distributes reports containing recommendations, would it be able to rely on the exemption in Rule 14a-2(b)(1)?
ANSWER.  Yes. To the extent that a proxy advisory firm limits its activities to distributing reports containing recommendations and does not solicit the power to act as proxy for the client(s) receiving the recommendations, the proxy advisory firm would be able to rely on the exemption, so long as the other requirements of the exemption are met.
QUESTION 9.  To the extent that Rule 14a-2(b)(1) is not available to a proxy advisory firm, either for the reason specified in the answer to Question 7 or otherwise, is there any other exemption from the proxy rules that might apply? 
ANSWER.  Yes. Exchange Act Rule 14a-2(b)(3) exempts the furnishing of proxy voting advice by any person to another person with whom a business relationship exists, subject to certain conditions. The exemption is available if the person gives financial advice in the ordinary course of business; discloses to the recipient of the advice any significant relationship with the company or any of its affiliates, or a security holder proponent of the matter on which advice is given, as well as any material interests of the person in such matter; receives no special commission or remuneration for furnishing the advice from any person other than the recipient of the advice and others who receive similar advice; and does not furnish the advice on behalf of any person soliciting proxies or on behalf of a participant in a contested election.
QUESTION 10.  If a proxy advisory firm provides consulting services to a company on a matter that is the subject of a voting recommendation or provides a voting recommendation to its clients on a proposal sponsored by another client, would the proxy advisory firm be precluded from relying on Rule 14a-2(b)(3)?
ANSWER.  In order to rely on Rule 14a-2(b)(3), a proxy advisory firm would need to first assess whether its relationship with the company or security holder proponent is significant or whether it otherwise has any material interest in the matter that is the subject of the voting recommendation and disclose to the recipient of the voting recommendation any such relationship or material interest. Whether a relationship would be “significant” or what constitutes a “material interest” will depend on the facts and circumstances. In making such a determination, a proxy advisory firm would likely consider the type of service being offered to the company or security holder proponent, the amount of compensation that the proxy advisory firm receives for such service, and the extent to which the advice given to its advisory client relates to the same subject matter as the transaction giving rise to the relationship with the company or security holder proponent. A similar inquiry would be made for any interest that might be material. A relationship generally would be considered “significant” or a “material interest” would exist if knowledge of the relationship or interest would reasonably be expected to affect the recipient’s assessment of the reliability and objectivity of the advisor and the advice. 
QUESTION 11.  If a proxy advisory firm determines that it has a significant relationship or a material interest that requires disclosure for purposes of relying on Rule 14a-2(b)(3), what must it disclose?
ANSWER.  The proxy advisory firm must provide the recipient of the advice with disclosure that provides notice of the presence of a significant relationship or a material interest. We do not believe that boilerplate language that such a relationship or interest may or may not exist provides such notice. In addition, we believe the disclosure should enable the recipient to understand the nature and scope of the relationship or interest, including the steps taken, if any, to mitigate the conflict, and provide sufficient information to allow the recipient to make an assessment about the reliability or objectivity of the recommendation.   
QUESTION 12.  Does the disclosure requirement in Rule 14a-2(b)(3) permit a proxy advisory firm to state only that information about significant relationships or material interests will be provided upon request?
ANSWER.  No. Rule 14a-2(b)(3) imposes an affirmative duty to disclose significant relationships or material interests to the recipient of the advice. We do not believe that providing the information upon request would satisfy the requirement in the rule.
QUESTION 13.  Does disclosure of a significant relationship or material interest have to be provided in a document that conveys a voting recommendation or advice, such as the proxy advisory firm’s report about a company, and must it be publicly available?
ANSWER.  Rule 14a-2(b)(3) does not specify where the required disclosure should be provided. A proxy advisory firm should provide the disclosure in such a way as to allow the client to assess both the advice provided and the nature and scope of the disclosed relationship or interest at or about the same time that the client receives the advice. This disclosure may be made publicly or between only the proxy advisory firm and the client.
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SEC Issues Proxy Voting Responsibilities of Investment Advisers

Division of Investment Management
Division of Corporation Finance
Securities and Exchange Commission

Proxy Voting:  Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms

Staff Legal Bulletin No. 20 (IM/CF)

Action: Publication of IM/CF Staff Legal Bulletin

Date: June 30, 2014

Summary: The Division of Investment Management is providing guidance about investment advisers’ responsibilities in voting client proxies and retaining proxy advisory firms.  The Division of Corporation Finance is providing guidance on the availability and requirements of two exemptions to the federal proxy rules that are often relied upon by proxy advisory firms.

Supplementary Information: The statements in this bulletin represent the views of the Division of Investment Management and the Division of Corporation Finance.  This bulletin is not a rule, regulation or statement of the Commission.  Further, the Commission has neither approved nor disapproved its content.

Contacts: For further information relating to investment advisers, please contact the Division of Investment Management’s Office of Chief Counsel by calling (202) 551-6825 or by e-mailing IMOCC@sec.gov.  For further information relating to the proxy rules, please contact the Division of Corporation Finance’s Office of Chief Counsel by calling (202) 551-3500 or by submitting a web-based request form at https://tts.sec.gov/cgi-bin/corp_fin_interpretive.

Question 1.  As a fiduciary, an investment adviser owes each of its clients a duty of care and loyalty with respect to services undertaken on the client’s behalf, including proxy voting.1  Further, the Commission’s rules provide that it is a fraudulent, deceptive, or manipulative act, practice, or course of business for an investment adviser registered or required to be registered with the Commission to exercise voting authority with respect to client securities unless the adviser, among other things, adopts and implements written policies and procedures that are reasonably designed to ensure that the investment adviser votes proxies in the best interest of its clients (“Proxy Voting Rule”).2  What steps could an investment adviser take to seek to demonstrate that proxy votes are cast in accordance with clients’ best interests and the adviser’s proxy voting procedures?

Answer.  Compliance could be demonstrated by, for example, periodically sampling proxy votes to review whether they complied with the investment adviser’s proxy voting policy and procedures.  The investment adviser also could specifically review a sample of proxy votes that relate to certain proposals that may require more analysis.  In addition, as part of an investment adviser’s ongoing compliance program, it should review, no less frequently than annually, the adequacy of its proxy voting policies and procedures to make sure they have been implemented effectively, including whether these policies and procedures continue to be reasonably designed to ensure that proxies are voted in the best interests of its clients.3

Question 2.  Is an investment adviser required to vote every proxy?

Answer.  The Proxy Voting Rule does not require that investment advisers and clients agree that the investment adviser will undertake all of the proxy voting responsibilities.  We understand that in most cases, clients delegate to their investment advisers the authority to vote proxies relating to equity securities.4  We further understand that, in general, clients usually delegate this authority completely, without retaining authority to vote any of the proxies.  The staff notes that investment advisers and their clients also may agree to this type of delegation, as well as other proxy voting arrangements in which the adviser would not assume all of the proxy voting authority.    Some agreements between investment advisers and their clients may include the following arrangements:

  • An investment adviser and its client may agree that the time and costs associated with the mechanics of voting proxies with respect to certain types of proposals or issuers may not be in the client’s best interest.
  • An investment adviser and its client may agree that the investment adviser should exercise voting authority as recommended by management of the company or in favor of all proposals made by a particular shareholder proponent, as applicable, absent a contrary instruction from the client or a determination by the investment adviser that a particular proposal should be voted in a different way if, for example, it would further the investment strategy being pursued by the investment adviser on behalf of the client.
  • An investment adviser and its client may agree that the investment adviser will abstain from voting any proxies at all, regardless of whether the client undertakes to vote the proxies itself.
  • An investment adviser and its client may agree that the investment adviser will focus resources on only particular types of proposals based on the client’s preferences.

As these non-exclusive examples demonstrate, an investment adviser and its client have flexibility in determining the scope of the investment adviser’s obligation to exercise proxy voting authority. 5  We reiterate, however, that an investment adviser that assumes proxy voting authority must do so in compliance with the Proxy Voting Rule.

Question 3.  What are some of the considerations that an investment adviser may wish to take into account if it retains a proxy advisory firm to assist it in its proxy voting duties?

Answer.  When considering whether to retain or continue retaining any particular proxy advisory firm to provide proxy voting recommendations, the staff believes that an investment adviser should ascertain, among other things, whether the proxy advisory firm has the capacity and competency to adequately analyze proxy issues.6  In this regard, investment advisers could consider, among other things: the adequacy and quality of the proxy advisory firm’s staffing and personnel; the robustness of its policies and procedures regarding its ability to (i) ensure that its proxy voting recommendations are based on current and accurate information and (ii) identify and address any conflicts of interest and any other considerations that the investment adviser believes would be appropriate in considering the nature and quality of the services provided by the proxy advisory firm.

Question 4.  Does an investment adviser have an ongoing duty to oversee a proxy advisory firm that it retains?

Answer.  The staff believes that an investment adviser that has retained a third party (such as a proxy advisory firm) to assist with its proxy voting responsibilities should, in order to comply with the Proxy Voting Rule, adopt and implement policies and procedures that are reasonably designed to provide sufficient ongoing oversight of the third party in order to ensure that the investment adviser, acting through the third party, continues to vote proxies in the best interests of its clients. 7  In addition, the staff notes that a proxy advisory firm’s business and/or policies and procedures regarding conflicts of interest could change after an investment adviser’s initial assessment, and some changes could alter the effectiveness of the policies and procedures and require the investment adviser to make a subsequent assessment.  Consequently, the staff has stated that investment advisers should establish and implement measures reasonably designed to identify and address the proxy advisory firm’s conflicts that can arise on an ongoing basis,8 such as by requiring the proxy advisory firm to update the investment adviser of business changes the investment adviser considers relevant  (i.e., with respect to the proxy advisory firm’s capacity and competency to provide proxy voting advice) or conflict policies and procedures.

Question 5.  What are an investment adviser’s duties when it retains a proxy advisory firm with respect to the material accuracy of the facts upon which the proxy advisory firm’s voting recommendations are based?

Answer.  As stated above, it is the staff’s position that an investment adviser that receives voting recommendations from a proxy advisory firm should ascertain that the proxy advisory firm has the capacity and competency to adequately analyze proxy issues, which includes the ability to make voting recommendations based on materially accurate information.9  For example, an investment adviser may determine that a proxy advisory firm’s recommendation was based on a material factual error that causes the adviser to question the process by which the proxy advisory firm develops its recommendations.   In such a case, the staff believes that the investment adviser should take reasonable steps to investigate the error, taking into account, among other things, the nature of the error and the related recommendation, and seek to determine whether the proxy advisory firm is taking reasonable steps to seek to reduce similar errors in the future.

Question 6.  When is a proxy advisory firm subject to the federal proxy rules?

Answer.  A proxy advisory firm would be subject to the federal proxy rules when it engages in a “solicitation,” which is defined under Exchange Act Rule 14a-1(l) to include “the furnishing of a form of proxy or other communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy.”  As a general matter, the Commission has stated that the furnishing of proxy voting advice constitutes a “solicitation” subject to the information and filing requirements of the federal proxy rules.10  Providing recommendations that are reasonably calculated to result in the procurement, withholding, or revocation of a proxy would subject a proxy advisory firm to the proxy rules.  Exchange Act Rule 14a-2(b) provides exemptions from the information and filing requirements of the federal proxy rules that a proxy advisory firm may rely upon if it meets the requirements of the exemptions.

Question 7.  Where a shareholder (such as an institutional investor) retains a proxy advisory firm to assist in the establishment of general proxy voting guidelines and policies and authorizes the proxy advisory firm to execute a proxy or submit voting instructions on its behalf, and permits the proxy advisory firm to use its discretion to apply the guidelines to determine how to vote on particular proposals, may the proxy advisory firm providing such services rely on the exemption from the proxy rules in Exchange Act Rule 14a-2(b)(1)?

Answer.  No.  Rule 14a-2(b)(1) provides an exemption from most provisions of the federal proxy rules for “any solicitation by or on behalf of any person who does not, at any time during such solicitation, seek directly or indirectly, either on its own or another’s behalf, the power to act as a proxy for a security holder and does not furnish or otherwise request, or act on behalf of a person who furnishes or requests, a form of revocation, abstention, consent or authorization.”  The exemption would not be available for a proxy advisory firm offering a service that allows the client to establish, in advance of receiving proxy materials for a particular shareholder meeting, general guidelines or policies that the proxy advisory firm will apply to vote on behalf of the client.

In this instance, the proxy advisory firm would be viewed as having solicited the “power to act as a proxy” for its client.  This would be the case even if the authority was revocable by the client.

Question 8.  If a proxy advisory firm only distributes reports containing recommendations, would it be able to rely on the exemption in Rule 14a-2(b)(1)?

Answer.  Yes.  To the extent that a proxy advisory firm limits its activities to distributing reports containing recommendations and does not solicit the power to act as proxy for the client(s) receiving the recommendations, the proxy advisory firm would be able to rely on the exemption, so long as the other requirements of the exemption are met.

Question 9.  To the extent that Rule 14a-2(b)(1) is not available to a proxy advisory firm, either for the reason specified in the answer to Question 7 or otherwise, is there any other exemption from the proxy rules that might apply?

Answer.  Yes.  Exchange Act Rule 14a-2(b)(3) exempts the furnishing of proxy voting advice by any person to another person with whom a business relationship exists, subject to certain conditions. 11  The exemption is available if the person gives financial advice in the ordinary course of business; discloses to the recipient of the advice any significant relationship with the company or any of its affiliates, or a security holder proponent of the matter on which advice is given, as well as any material interests of the person in such matter; receives no special commission or remuneration for furnishing the advice from any person other than the recipient of the advice and others who receive similar advice; and does not furnish the advice on behalf of any person soliciting proxies or on behalf of a participant in a contested election.

Question 10.  If a proxy advisory firm provides consulting services to a company on a matter that is the subject of a voting recommendation or provides a voting recommendation to its clients on a proposal sponsored by another client, would the proxy advisory firm be precluded from relying on Rule 14a-2(b)(3)?

Answer.  In order to rely on Rule 14a-2(b)(3), a proxy advisory firm would need to first assess whether its relationship with the company or security holder proponent12 is significant or whether it otherwise has any material interest in the matter that is the subject of the voting recommendation and disclose to the recipient of the voting recommendation any such relationship or material interest.  Whether a relationship would be “significant” or what constitutes a “material interest” will depend on the facts and circumstances.  In making such a determination, a proxy advisory firm would likely consider the type of service being offered to the company or security holder proponent, the amount of compensation that the proxy advisory firm receives for such service, and the extent to which the advice given to its advisory client relates to the same subject matter as the transaction giving rise to the relationship with the company or security holder proponent.  A similar inquiry would be made for any interest that might be material.  A relationship generally would be considered “significant” or a “material interest” would exist if knowledge of the relationship or interest would reasonably be expected to affect the recipient’s assessment of the reliability and objectivity of the advisor and the advice.

Question 11.  If a proxy advisory firm determines that it has a significant relationship or a material interest that requires disclosure for purposes of relying on Rule 14a-2(b)(3), what must it disclose?

Answer.  The proxy advisory firm must provide the recipient of the advice with disclosure that provides notice of the presence of a significant relationship or a material interest.  We do not believe that boilerplate language that such a relationship or interest may or may not exist provides such notice.  In addition, we believe the disclosure should enable the recipient to understand the nature and scope of the relationship or interest, including the steps taken, if any, to mitigate the conflict, and provide sufficient information to allow the recipient to make an assessment about the reliability or objectivity of the recommendation.

Question 12.  Does the disclosure requirement in Rule 14a-2(b)(3) permit a proxy advisory firm to state only that information about significant relationships or material interests will be provided upon request?

Answer.  No.  Rule 14a-2(b)(3) imposes an affirmative duty to disclose significant relationships or material interests to the recipient of the advice.  We do not believe that providing the information upon request would satisfy the requirement in the rule.

Question 13.  Does disclosure of a significant relationship or material interest have to be provided in a document that conveys a voting recommendation or advice, such as the proxy advisory firm’s report about a company, and must it be publicly available?

Answer.  Rule 14a-2(b)(3) does not specify where the required disclosure should be provided.  A proxy advisory firm should provide the disclosure in such a way as to allow the client to assess both the advice provided and the nature and scope of the disclosed relationship or interest at or about the same time that the client receives the advice.  This disclosure may be made publicly or between only the proxy advisory firm and the client.

*    *    *    *    *

The staff recognizes that investment advisers and proxy advisory firms may want or need to make changes to their current systems and processes in light of this guidance.  The staff expects any necessary changes will be made promptly, but in any event in advance of next year’s proxy season.

1 Proxy Voting by Investment Advisers, Release No. IA-2106, at n. 2 and accompanying text (Jan. 31, 2003) (“Proxy Voting Release”), citing SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963) (interpreting Section 206 of the Investment Advisers Act of 1940 (“Advisers Act”)).

2 Rule 206(4)-6 under the Advisers Act.

3 See Rule 206(4)-7 under the Advisers Act (e.g., requiring investment advisers to adopt and implement written policies and procedures reasonably designed to prevent violation, by the adviser and its supervised person, of the Advisers Act).  See also Rule 38a-1 under the Investment Company Act of 1940 (“1940 Act”) (e.g., requiring each registered investment company to adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws by the fund, including policies and procedures that provide for the oversight of compliance by the registered investment company’s investment adviser, among others).

4 See Proxy Voting Release.

5 See id. at n. 19 (“The scope of an adviser’s responsibilities with respect to voting proxies would ordinarily be determined by the adviser’s contracts with its clients, the disclosures it has made to its clients, and the investment policies and objectives of its clients.”)

6 See Egan-Jones Proxy Services, SEC Staff Letter (May 27, 2004) (“Egan-Jones”) and Institutional Shareholder Services, Inc., SEC Staff Letter (Sept. 15, 2004) (“ISS”).

7 See Rule 206(4)-7 under the Advisers Act and Rule 38a-1 under the 1940 Act.

8 See Egan-Jones and ISS.

9 Id.

10 See Shareholder Communications, Shareholder Participation in the Corporate Electoral Process and Corporate Governance Generally, Release No. 34-16104 (Aug. 13, 1979).

11 In 1992, the Commission noted that “advice given with respect to matters subject to a shareholder vote by . . . proxy advisory services in the ordinary course of business is covered by the exemption provided by [Rule 14a-2(b)(3)], so long as the other requirements of that exemption are met.”  SeeRegulation of Communications Among Shareholders, Release No. 34-31326 (Oct. 16, 1992).

12 Rule 14a-8 does not require that the identity of the shareholder proponent be disclosed in the proxy statement.  Therefore, there may be instances in which the proxy advisory firm has no knowledge that the proponent is a client.  In such a case, we do not believe that there would be a duty to investigate who the proponent is.  To the extent that the identity of the proponent is unknown, there is little concern that the relationship would affect the proxy advisory firm’s recommendation regarding that proposal.

http://www.sec.gov/interps/legal/cfslb20.htm


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2014 SAY-ON-PAY VOTING RESULTS

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Veritas Executive Compensation Consultants
COMPENSATION IN CONTEXT
2014 SAY-ON-PAY VOTING RESULTS
June 23, 2014
So far this proxy season, 2,602 companies have held Say on Pay votes. Of the 2,602 companies, 49 companies failed their Say on Pay with an average 60% “Against” vote, 73% of companies received greater than 90% “For” vote, and the average “For”, “Against” and “Abstain” votes among all companies was 90.5%, 8.0% and 1.5% respectively. The results, broken down by Revenue, Market Cap and Industry are summarized below. 
Of the 49 companies that failed their Say on Pay vote this year, 14 failed votes in previous years, 35 had 1 year total shareholder returns of over 10%, and 15 companies received 90% “For” votes in 2013. A full list of companies that failed Say on Pay in 2014 thus far can be viewed below. 
Since 2011 (when Say on Pay became mandatory), the reasons for companies failing Say on Pay have remained much the same, with Problematic Pay Practices, Pay and Performance, and Rigor of Performance Goals being the most problematic issues.
Veritas Executive Compensation Consultants, (“Veritas”) is a truly independent executive compensation consulting firm. 
We are independently owned, and have no entangling relationships that may create potentialconflict of interest scenarios, or may attract the unwanted scrutiny of regulators, shareholders, the media, or create public outcry.  
 
Veritas goes above and beyond to provide unbiased executive compensation counsel. Since we are independently owned, we do our job with utmost objectivity – without any entangling business relationships. 
 
Following stringent best practice guidelines, Veritas works directly with boards and compensation committees, while maintaining outstanding levels of appropriate communication with senior management. 
 
Veritas promises no compromises in presenting the innovative solutions at your command in the complicated arena of executive compensation. 
 
We deliver the advice that you need to hear, with unprecedented levels of responsive client service and attention. 
 

Visit us online at www.veritasecc.com, or contact our CEO Frank Glassner personally via phone at (415) 618-6060, or via email at fglassner@veritasecc.com. He’ll gladly answer any questions you might have. For your convenience, please click here for Mr. Glassner’s contact data, and click here for his bio.

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Renewed Focus on Corporate Director Tenure

By David A. Katz and Laura A. McIntosh

United States and abroad. U.S. public companies generally do not have spe-cific term limits on director service, though some indicate in their bylaws a “mandatory” retirement age for directors—typically between 72 and 75—which can generally be waived by the board of directors. Importantly, there are no regulations or laws in the United States under which a long tenure would, by itself, prevent a director from qualify-ing as independent.

Institutional Shareholder Services (ISS) and other shareholder activist groups are beginning to include director tenure in their checklists as an element of direc-tor independence and board composition. Yet even these groups acknowledge that there is no ideal term limit applicable to all directors, given the highly fact-specific context in which an individual director’s tenure must be evaluated. In our view, director tenure is an issue that is best left to boards to address individually, both as to board policy, if any, and as to specific directors, should the need arise. Boards should and do engage in annu-al director evaluations and self-assessment, and shareholders are best served when they do not attempt to artificially constrain the board’s ability to exercise its judgment and dis-cretion in the best interests of the company. In addition, much the same way boards con-sider CEO succession issues, boards are beginning to address director succession issues as well.

Director Tenure in the United States

According to executive recruiting firm SpencerStuart, the average tenure of directors at S&P 500 companies in 2013 and 2012 was 8.6 years.1 The average tenure of CEOs was close, at 7.2 years, in both 2013 and 2012.2 ISS reports that the average tenure of S&P 1500 directors was 10.8 years in 2013, an increase from 10.3 years in 2012.3

Very few U.S. companies—only 3 percent of the S&P 500—have term limits for directors, none of which is less than 10 years.4

There appears to be a recent trend toward raising retirement ages and ex-tending board service as valuable directors grow older. In the S&P 500, over the last 10 years, the percentage of boards with a mandatory retirement age of 70 has decreased from 51 percent to 11 percent, while the percentage of boards with a mandatory retirement age of 75 or greater has increased from 3 percent to 24 percent.5 Meanwhile, the average age of independent directors in this group has increased from 60 to 63.6 Board turnover was reported last year to be at a 10-year low; one source reports that 291 board seats turned over at S&P 500 companies in 2012, as compared to 401 in 2002.7

Despite these trends, boards are steadily becoming more diverse.8 Long tenure is often cited as an obstacle to achieving board diversity,9 yet current patterns of tenure and retirement have not prevented increases in gender and racial diversity on U.S. boards. The number of women directors continues to rise; at S&P 500 companies, the percentage with at least one woman director has grown in the last decade from 85 percent to 93 percent, and the total percentage of women directors has increased from 13 percent to 18 percent.10 Minority representation has also increased in this timeframe, as has the percentage of independent directors of non-U.S. origin.11

In the United States and Canada, regulators have wisely refrained from adopting guidelines regarding director tenure. Long tenure on a corporate board histori-cally has been understood—and demonstrated—to be an asset to board effectiveness and a feature that goes hand-in-hand with solid corporate performance and good management. Having a core group of long-term directors has been seen as beneficial to board dynamics as well as to the relationship between the board and management.

12 According to some estimates, new directors require between three and five years to acquire sufficient com-pany-specific knowledge,13 with more time required for directors of companies with complex operations and more intangible assets.14 Long-serving outside directors thus are highly valued for their experience and organizational memory. Often, they have made important and useful industry connections over the course of their careers. Such directors frequently have gained a deep understanding of the relevant industry, and in board dis-cussions they can offer historical context for consideration in corporate strategic deci-sionmaking. These resources are particularly valuable to a company whose business is highly complex or whose significant projects have unusually long-term horizons for completion.15

In recent years activists’ attempts to micromanage the boardroom have begun to complicate the traditional view. Boards with many long-serving directors are now described as “entrenched” and deaf to shareholder concerns.16 Critics posit that old-er directors—who are typically the longer-tenured directors—can no longer keep current with respect to industrial or technological developments and are unable to offer new in-sights into corporate issues; they fear that these directors may hold fossilized positions that are no longer relevant in the changing economic and business environment.17 Some argue that extended board service can create a culture of undue deference to management, particularly in cases where the chief executive also has held the position for many years. While these may be valid concerns in isolated situations, it is often the case that older directors are among the savviest and most skilled board members, and that long-tenured directors may be in the best position to manage a powerful chief executive by virtue of their shared history and many years of building trust and collegiality together. Whether the advantages outweigh the disadvantages of long tenure for any given director on any particular board ultimately can only be evaluated by considering the specific circum-stances. As with many other important elements of corporate governance, in matters of director tenure, one size does not fit all.

Director Tenure Abroad

A growing number of countries have adopted tenure-related guidelines or restrictions for independent directors.18 With very few exceptions, the “comply and ex-plain” model prevails, and the recommended maximum tenure for a corporate director is between nine and 12 years. The European Commission recommends that independent directors serve a maximum of three terms or twelve years.19 In the United Kingdom, the UK Corporate Governance Code (formerly known as the Combined Code) provides that a board should explain, in its annual disclosures, its reasons for determining that a director who has served more than nine years qualifies as independent.20 The average tenure of a UK director is less than five years.21 In Hong Kong, an independent director is limited to a three-term, nine-year maximum tenure unless shareholders separately vote on a resolu-tion permitting re-appointment, which should include the board’s justification for deter-mining his or her independence.22 Singapore recommends “rigorous review” of the in-dependence of a director who has served more than nine years, and the board is expected to explain any determination of independence in such case.23 In France, the only country with a mandatory regime, directors may not be deemed independent after the end of a

term in which they reach 12 years of service on the board.

24 The French rule creates an effective term limit, as longer-serving directors are not eligible for audit committee membership or other board roles left to independent directors.

In Australia, a recent move toward a recommended term limit was quashed by significant opposition. The Australia Stock Exchange Governance Council, an advisory committee that includes business, shareholder, and industry groups, last year proposed a “comply or explain” guideline that ASX-listed companies’ independent direc-tors be limited to nine years of service. Reportedly, pressure from several of the coun-try’s largest companies resulted in the Council’s dropping the tenure restriction in its fi-nal guidelines.25 The final report incorporates references to tenure limits, recommending that one factor to be considered in assessing director independence is whether the indi-vidual “has been a director of the entity for such a period that his or her independence may have been compromised.”26 The commentary expands on this point: “The mere fact that a director has served on a board for a substantial period does not mean that he or she has become too close to management to be considered independent. However, the board should regularly assess whether that might be the case for any director who has served in that position for more than ten years.”27 According to one source, 21 percent of nonex-ecutive directors at the top 50 listed companies in Australia have directors who had served at least nine years.28 The Australian episode demonstrates that strong opposition to director tenure limits still exists abroad despite the increasing international popularity of such policies.

Academic Studies

Academic researchers have examined the question of whether there is an optimal length of tenure for outside directors, with varying results. Studies from the 1980s through the 2000s have shown, for example, that longer tenure tends to increase director independence because it fosters camaraderie and improves the ability of directors to evaluate management without risking social isolation.29 A 2010 study confirmed that companies with high average board tenure (roughly eight or more years) performed better

than those companies with lower average board tenure, and that companies with diverse board tenure performed better than those with homogeneity in tenure.

30 A 2011 study, by contrast, examined a sample of S&P 1500 boards and found that long-serving directors (roughly six or more years)—as well as directors who served on many boards, older di-rectors, and outside directors—were more likely to be associated with corporate govern-ance problems at the companies they served.31 One 2012 study found that boards with a higher proportion of long-serving outside directors were more effective in fulfilling their monitoring and advising responsibilities,32 while another 2012 study found that having inside directors increased a board’s effectiveness in monitoring real earnings manage-ment and financial reporting behavior, presumably due to their superior firm-specific knowledge and operational sophistication.33 On the related topic of board turnover, a recent study of S&P 500 companies from 2003 to 2013 found that companies that re-placed three or four directors over the three-year period outperformed their peers.34 The study found further that two-thirds of companies did not experience this optimal turnover and that the worst-performing companies had either no director changes at all or five or more changes during the three-year period.35

A 2013 study on director tenure by a professor from the INSEAD Busi-ness School has received significant attention. The study hypothesizes that there is a tradeoff between independence and expertise for outside directors—a prejudgment that is widely disputed36—and examines the effect of tenure on the monitoring and advising ca-pacities of the board.37 After review of over 2,000 companies, the author finds that the optimal average tenure for an outside director is between seven and 11 years, though in-dustry- and company-specific factors create substantial variability.38 He concludes that nine years is generally the optimal point at which a director has accumulated the benefits

of firm-specific knowledge but has not yet accumulated the costs of entrenchment.

39 As a policy matter, however, he suggests that in light of the significant variations across in-dustries and company characteristics, regulating director tenure with a single mandatory term limit would not be appropriate.40

Taken together, the academic studies show that conclusions about optimal director tenure are elusive. Common sense indicates that a board should use tenure benchmarks not as limits but as opportunities to evaluate the current mix of board com-position, diversity, and experience.

Activists and Term Limits

Shareholder groups have begun to highlight the issue of director tenure. The Council of Institutional Investors (CII) last year announced a new policy calling for boards to evaluate director tenure when assessing director independence.41 The statement accompanying the policy change suggested that long tenure can affect a director’s “unbi-ased judgment” and asserted that “[e]xtended tenure can lead an outside director to start to think more like an insider.”42 Nonetheless, CII stopped short of endorsing a tenure limit, noting that “[r]equiring all directors to step down after a certain number of years could rob the board of critical expertise.”43

Beginning in the 2014 proxy season, ISS offered a new product called Governance QuickScore 2.0, which uses specific governance factors and technical speci-fications to rate public company governance.44 Company ratings (based on data that companies may review and correct) were released in February, and the scores are includ-ed in proxy research reports issued to institutional shareholders. ISS has stated that it will use corporate public disclosures to update ratings on a continuous basis throughout the year. Director tenure will now factor into a company’s rating: ISS views tenure of more than nine years as “excessive” by virtue of “potentially compromis[ing] a director’s inde-pendence.”45 Having long-tenured directors thus may negatively affect a company’s score.

While the factors ISS uses to produce a company’s rating are public, the specific calculation methodology is not. There is no reason to believe that a rating gener-ated by this new product will bear any relation to the actual quality of governance or fi-nancial performance of a particular company. The very name of the QuickScore metric alludes to the superficiality of its mechanically derived results, generated without regard to the fact-specific circumstances of a board of directors and the real-world needs of the company it supervises.

Governance QuickScore 2.0 is an outlier with respect to director tenure—not in terms of the nine-year limit, which may well have been determined by reference to the policies of some foreign countries and perhaps even to the 2013 study mentioned above—but in considering any longer service to be automatically detrimental. We are not aware of any country whose governance guidelines create a mandatory maximum of nine years for a corporate director. While various countries use the three-term, nine-year time frame as a benchmark, they recognize that boards may indeed have excellent reasons to extend a director’s term well beyond that limit. Hence the flexibility of the “comply-or-explain” model, which requires a board to consider director tenure and communicate with its shareholders, yet still preserves the board’s ability to make informed decisions for the company using its business judgment.

Outside of the QuickScore product, ISS itself recognizes the wisdom of a more reasonable approach. The ISS 2014 Proxy Voting Manual discusses the pros and cons of limiting director tenure and contains the following, eminently reasonable, lan-guage on director retirement age and term limits:

Rather than impose a narrow rule on director tenure, shareholders gain much more by retaining the ability to evaluate and cast their vote on all di-rector nominees once a year and by encouraging companies to perform pe-riodic director evaluations.46

Accordingly, ISS offers the following proxy voting policy for U.S. companies in 2014: “Vote against management and shareholder proposals to limit the tenure of outside direc-tors through mandatory retirement ages. Vote against management proposals to limit the tenure of outside directors through term limits. However, scrutinize boards where the average tenure of all directors exceeds fifteen years for independence from management and for sufficient turnover to ensure that new perspectives are being added to the board.”47 ISS endorses—rightly, in our view—a robust director evaluation process, con-ducted annually by the corporate governance or nominating committee of the board.

Board Judgment

It is unfortunate that the tenure of outside directors may become yet an-other point of controversy in shareholder activists’ ongoing efforts to dictate ever more elaborate standards for director independence and board composition. There is no reason to believe that extended director service does, in and of itself, compromise director inde-pendence. Indeed, as the studies mentioned above suggest, factors ranging from indus-try-wide characteristics all the way to company-, board- and candidate-specific elements can be meaningful in assessing appropriate director tenure. Term limits, like any bright-line rule, may offer superficial appeal, but the potential downside is that valuable direc-tors may be forced off the board in circumstances that would be detrimental to the board, the company, and the shareholders.48 Moreover, term limits can interfere with the devel-opment of effective collaboration among board members, a crucial element of a success-ful board and one than can be built only over a period of time. “In the end, creating a stellar Board of Directors is part science, part art.”49

48

Many arguments both for and against long tenure are valid. The debate can best be resolved in individual cases by reference to the facts on the ground, and no arbiter is better positioned to determine the appropriate length of service of a director than the board as a whole. Companies and their shareholders should resist any pressure to establish term limits, a mandatory retirement age, or another mechanism that would constrain board discretion in evaluating the effectiveness and performance of individual directors. With annual evaluations and self-assessments, most boards monitor and man-age their own performance quite effectively, and they should continue to have the latitude to determine the tenure of their directors in light of their conclusions regarding the needs of the company. As a general matter, this country is well served by directors’ using their business judgment to act in an informed manner in furtherance of the best interests of the company and its shareholders, and the area of director tenure is no exception.

 

Footnotes:

1 SpencerStuart Board Index 2013 at 17.

2 See id.

3 ISS 2014 U.S. Proxy Voting Manual at 37. See also Vipal Monga, “Board Directors Are Extending Their Tenures,” CFO Journal, WSJonline, April 1, 2014. An investigation by the Wall Street Journal found that 28 outside directors in the Russell 3000 had served on a single board for at least 40 years. See Joanne S. Lublin, “The 40-Year Club: America’s Longest-Serving Directors,” Wall St. J., July 16, 2013.

4 See SpencerStuart Board Index 2013 at 15. One oft-cited example of a U.S. company with term limits is Target Corporation, which recently raised its directors’ term limit from 15 to 20 years. See Target Corpo-rate Governance Guidelines, § 24, November 2013, available at www.target.com.

5 See SpencerStuart Board Index 2013 at 6.

6 See id. 

7 See Carol Hymowitz and Jeff Green, “Corporate Directors Get Older, Hold Their Seats Longer,” Bloom-berg Businessweek, May 23, 2013.

8 As we have previously discussed, while diversity on U.S. boards of directors has improved in recent years, significant additional improvement is both desirable and necessary. See David A. Katz and Laura A. McIntosh, “Developments Regarding Gender Diversity on Public Boards,” N.Y.L.J., Oct. 31, 2013, availa-ble at http://www.wlrk.com/webdocs/wlrknew/WLRKMemos/WLRK/WLRK.22908.13.pdf.

9 See, e.g., Kimberly Gladman & Michelle Lamb, “Director Tenure and Gender Diversity in the United States: A Scenario Analysis,” GMI Ratings, June 2013, available at www.gmiratings.com.

10 See SpencerStuart Board Index 2013 at 6.

11 See id. at 19-20.

12 See, e.g., Judy Canavan et al., “Board tenure: How long is too long?” Directors & Boards, Board Guide-lines 2004, at 39 available at www.highbeam.com/doc/1G1-114244181.html.

13 See Raymond K. Van Ness et al., “Board of Director Composition and Financial Performance in a Sar-banes-Oxley World,” Academy of Business & Economics Journal10 (5), 56-74 (2010), at 8 available at www.albany.edu/faculty/vanness/AA/ARTICLES/DirectorSOX.pdf.

14 See Sterling Huang, “Zombie Boards: Board Tenure and Firm Performance,” July 2013 Draft, at 30, available at papers.ssrn.com/sol3/papers.cfm?abstract_id=2302917

15 See, e.g., BHP Billiton, Submission to the ASX Corporate Governance Council, Nov. 15, 2013 (“[W]e believe that particularly in a long-cycle business such as ours, governance is enhanced by having a balance of longer serving Directors…. Formulaic considerations of tenure should not override the other considera-tions of independence and the proven ability of Directors to be able to exercise independent judgement and act in the best interests of the Group and shareholders.”), available at www.asx.com.au/documents/public-consultations/bhp_submission.pdf.

16 See, e.g., Hymowitz & Green, supra note 7

17 See, e.g., Canavan et al., supra note 12.

18 See, e.g., Janet McFarland, “Countries Set out Rules on Directors’ Tenure,” theglobeandmail.com, Nov. 24, 2013 available at www.theglobeandmail.com/report-on-business/careers/management/board-games-2013/countries-set-out-rules-on-directors-tenure/article15574442/.

19 See Official Journal of the European Union, Commission Recommendation of 15 February 2005, Annex II, “Profile of Independent Non-Executive or Supervisory Directors,” Section 1(h), available at eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2005:052:0051:0063:EN:PDF.

20 The UK Corporate Governance Code B.1.1 (September 2012), available at www.frc.org.uk/Our-Work/Codes-Standards/Corporate-governance/UK-Corporate-Governance-Code.aspx. .

21 “Investors Focus More Attention on Director Tenure,” Society of Corp. Secretaries & Governance Pro-fessionals, July 30, 2013 (citing a Grant Thornton survey of 2012 data).

22 HKEx Corporate Governance Code and Corporate Governance Report A.4.3, available at www.hkex.com.hk/eng/rulesreg/listrules/mbrules/documents/appendix_14.pdf (updated per HKEx Consul-tation Conclusions on Review of the Corporate Governance Code and Associated Listing Rules, Oct. 28, 2011).

23 Singapore Code of Corporate Governance 2.4 (May 2, 2012), available at www.ecgi.org/codes/documents/cg_code_singapore_2may2012_en.pdf.

24 Afep-Medef Code, Corporate Governance Code of Listed Corporations Section 9.4 (June 2013), availa-ble at www.ecgi.org/codes/documents/afep_medef_code_revision_jun2013_en.pdf.

25 See Ross Kelly, “Australia Backs Away from Proposed Director-Tenure Cap,” Asian Business News, March 25, 2014.

26 ASX Governance Council, Corporate Governance Principles and Recommendations (Third Edition), March 27, 2014, at 16, available at www.asx.com.au/documents/asx-compliance/cgc-principles-and-recommendations-3rd-edn.pdf.

27 Id. at 17.

28 See Kelly, supra note 25

29 See Van Ness, supra note 13, at 8-9 (citing various studies) .

30 See id. at 18.

31 See Greg Berberich and Flora Niu, “Director Busyness, Director Tenure and the Likelihood of Encoun-tering Corporate Governance Problems,” January 2011, at 5, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1742483.

32 See ISS Benchmark Policy Consultation, “Director Tenure (US and Canada),” 2014, available at www.issgovernance.com/file/files/Directortenure-USandCanada.pdf.

33 See Jeff Zeyun Chen et al., “Can Inside Directors Be Effective Monitors?—Evidence from Real Activi-ties Manipulation,” Aug. 24, 2012 Draft, available at busi-ness.gwu.edu/accountancy/workshops/files/katherine percent20gunny.pdf.

34 See George M. Anderson & David Chun, “How Much Board Turnover Is Best?” Harvard Business Re-view, April 2014, available at hbr.org/2014/04/how-much-board-turnover-is-best/ar/pr.

35 See id. 

36 See, e.g., Van Ness et al., supra note 13.

37 See Huang, supra note 14. The study examined 2009 data.

38 See id. at 30-32.

39 See id. at 4-5.

40 See id. at 7.

41 See Amy Borus, “More on CII’s New Policies on Universal Proxy and Board Tenure,” Council of Insti-tutional Investors, Oct. 1, 2013, available at www.cii.org/article_content.asp?article=208.

42 Id. 

43 Id. 

44 For more information on Governance QuickScore 2.0, see David A. Katz et al., “ISS QuickScore 2.0,” Wachtell, Lipton, & Katz Client Memorandum, Jan. 28, 2014, available at www.wlrk.com; see also ISS’s website: www.issgovernance.com/governance-solutions/investment-tools-data/quickscore.

45 See ISS’s website: www.issgovernance.com/governance-solutions/investment-tools-data/quickscore.

46 ISS 2014 U.S. Proxy Voting Manual at 39.

47 Id. at 37.

48 See, e.g., Carnavan et al., supra, at 41.

49 Amy Errett, “The Dream Team: What it Takes to Build an Effective Board of Directors,” Maveron Fea-tures (2011), available at www.maveron.com/blog/2011/10/the-dream-team-what-it-takes-to-build-an-effective-board-of-directors/.

 

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Are CEO’s Paid Too Much?

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Steve Odland discusses the state of CEO pay on Fox Business Opening Bell program with Maria Bartiromo on May 16, 2014.

 

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Odland: The Consumer Is Not Back

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Steve Odland discusses the state of the consumer on Fox Business Opening Bell program with Maria Bartiromo on May 16, 2014.

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Fink: Deliver Sustainable, Long-term Results

Text of letter sent by Larry Fink, BlackRock’s Chairman and CEO, encouraging a focus on long-term growth strategies.

March 21, 2014

Dear Chairman or CEO,

As a fiduciary investor, one of BlackRock’s primary objectives is to secure better financial futures for our clients and the people they serve. This responsibility requires that we be good stewards of their capital, addressing short-term challenges but always with a focus on the longer term.

To meet our clients’ needs, we believe the companies we invest in should similarly be focused on achieving sustainable returns over the longer term. Good corporate governance is critical to that goal. That is why, two years ago, I wrote to the CEOs of the companies in which BlackRock held significant investments on behalf of our clients urging them to engage with us on issues of corporate governance. While important work remains to be done, good progress has been made on company-shareholder engagement. I write today re-iterating our call for engagement with a particular focus on companies’ strategies to drive longer term growth.

Many commentators lament the short-term demands of the capital markets. We share those concerns, and believe it is part of our collective role as actors in the global capital markets to challenge that trend. Corporate leaders can play their part by persuasively communicating their company’s long-term strategy for growth. They must set the stage to attract the patient capital they seek: explaining to investors what drives real value, how and when far-sighted investments will deliver returns, and, perhaps most importantly, what metrics shareholders should use to assess their management team’s success over time.

It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies. Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks. We certainly believe that returning cash to shareholders should be part of a balanced capital strategy; however, when done for the wrong reasons and at the expense of capital investment, it can jeopardize a company’s ability to generate sustainable long-term returns.

We do recognize the balance that must be achieved to drive near-term performance while simultaneously making those investments – in innovation and product enhancements, capital and plant equipment, employee development, and internal controls and technology – that will sustain growth.

BlackRock’s mission is to earn the trust of our clients by helping them meet their long-term investment goals. We see this mission as indistinguishable from also aiming to be a trusted, responsible shareholder with a longer term horizon. Much progress has been made on company-shareholder engagement and we will continue to play our part as a provider of patient capital in ensuring robust dialogue. We ask that you help us, and other shareholders, to understand the investments you are making to deliver the sustainable, long-term returns on which our clients depend and in which we seek to support you.

Yours sincerely,

Laurence D. Fink

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Remarks at the 26th Annual Corporate Law Institute, Tulane University Law School: Federal Preemption of State Corporate Governance

http://www.sec.gov/News/Speech/Detail/Speech/1370541315952#_edn10

Commissioner Daniel M. Gallagher

New Orleans, LA

March 27, 2014

In April 2010, when my friend and former colleague Troy Paredes spoke at this conference, he expressed his misgivings about the draft legislation moving through Congress that ultimately became the Dodd-Frank Act.[i]  Today, nearly four years after its enactment, the fundamentally flawed nature of the Act has become clear—or, to those of us who recognized its many faults from the start, clearer.

Title I of Dodd-Frank, for example, created the apparently unaccountable and inherently politicized Financial Stability Oversight Council, or FSOC.  The FSOC is dominated by bank regulators, and Title I authorizes it to designate non-bank financial services companies as systemically important financial institutions, thereby making them subject to prudential regulation.  This can happen without regard for whether that regulatory paradigm is appropriate for non-bank entities operating in the capital markets—or, as I like to call them, the “non-centrally controlled” markets.

I believe it is important for the SEC and other capital markets regulators to openly debate and resist where necessary the encroachment of the bank regulatory paradigm into the capital markets.  I hope that market participants and lawmakers will join the debate about the proper regulatory framework for non-bank markets.  To be clear, this is not a partisan issue.  The structure of FSOC vests tremendous authority to appointees from the President’s party.  Those who enthusiastically support FSOC today may well be singing a different tune upon a change in administration.

I should also make clear that I’m not motivated by turf wars or empire building.  In fact, I believe the SEC should be willing to recognize areas where we should be the ones to stand down in favor of an alternative legal regime that is a better fit.

And so today I’d like to focus on an area where the SEC should be taking less of a role:  the regulation of corporate governance.

I.          Federalization of Corporate Governance

Unfortunately, the trend towards increased federalization of corporate governance law seems well-entrenched.[ii]  The Sarbanes-Oxley Act included significant incursions into state corporate governance regulation, but Title IX of Dodd-Frank may cause some of you to long for the simpler days of SOX § 404.

Title IX mandates an array of new federal regulations relating to matters traditionally left to state corporate governance law, the most infamous being a requirement to hold a shareholder vote on executive compensation, or “say on pay.”  Concerns that a negative vote may harm a company’s reputation or encourage litigation can lead companies to expend significant resources to guarantee passage of the vote.  Even more concerning, boards of directors could substitute proxy advisors’ views on pay for their own judgment as a means of minimizing potential conflict.

And that’s just one of the new Dodd-Frank requirements encroaching on corporate governance.  Others include the politically-motivated pay ratio disclosure requirement, proposed by a majority of the Commission in September 2013,[iii] as well as mandated rules micromanaging certain incentive-based compensation structures, which were proposed jointly with other regulators, again by a majority of the Commission, in March 2011.[iv]  In addition, Dodd-Frank calls for rules regarding compensation clawbacks in the event of an accounting restatement, pay for performance, and employee and director hedging of company stock.

Some of these requirements unashamedly interfere in corporate governance matters traditionally and appropriately left to the states.  Others masquerade as disclosure, but are in reality attempts to affect substantive behavior through disclosure regulation.  This mandated intrusion into corporate governance will impose substantial compliance costs on companies, along with a one-size-fits-all approach that will likely result in a one-size-fits-none model instead.  This stands in stark contrast with the flexibility traditionally achieved through private ordering under more open-ended state legal regimes.

II.        Shareholder Proposals

One area where the SEC’s incursions into corporate governance have had a particularly negative effect is shareholder proposals.

1.         The Problem

While the conduct of the annual shareholder meeting is generally governed by state law, the process of communicating with shareholders to solicit proxies for voting at that meeting is regulated by the Commission.  The Commission’s rules have for decades permitted qualifying shareholders to require the company to publish certain proposals in the company’s proxy statement, which are then voted upon at the annual meeting.

Unfortunately, the Commission has never adequately assessed the costs and benefits of this process.  Currently, a proponent can bring a shareholder proposal if he or she has owned $2,000 or 1% of the company’s stock for one year, so long as the proposal complies with a handful of substantive—but in some cases discretionary—requirements.  Activist investors and corporate gadflies have used these loose rules to hijack the shareholder proposal system.

The data and statistics are striking.  In 2013, the number of shareholder proposals rose,[v] with an amazing 41% of those proposals addressing social and environmental issues.[vi]  And while proposals calling for disclosure of political contributions or lobbying activities continued to predominate,[vii] these proposals received particularly poor support from shareholders.[viii] Overall, only 7% of shareholder proposals received majority support in 2013.[ix]

These proposals are not coming from ordinary shareholders concerned with promoting shareholder value for all investors.  Rather, they are predominantly from organized labor, including union pension funds, which brought approximately 34% of last year’s shareholder proposals, as well as social or policy investors and religious institutions, which accounted for about 25% of 2013’s proposals.  Approximately 40% were brought by an array of corporate gadflies, with a staggering 24% of those proposals brought by just two individuals.[x]

In other words, the vast majority of proposals are brought by individuals or institutions with idiosyncratic and often political agendas that are often unrelated to, or in conflict with, the interests of other shareholders.  I find it particularly notable that corporations that donated more funds to Republicans than to Democrats were more than twice as likely to be targeted with political spending disclosure proposals sponsored by labor-affiliated funds.[xi]

Astonishingly, only 1% of proposals are brought by ordinary institutional investors—including hedge funds.  As you all know, hedge funds are not shy about elbowing their way into the boardroom when they believe a shake-up is overdue.  The low level of hedge fund activism here implies that their concerns with corporate management are being addressed using avenues other than shareholder proposals—as most legitimate concerns can be.[xii]

Given all of this, it’s time we asked whether the shareholder proposal system as currently designed is a net negative for the average investor.[xiii]

2.         Needed Reforms

a.         Who should be able to bring a proposal?

All of this isn’t to condemn shareholder activism per se.  I’ll leave that debate to Marty Lipton and Lucian Bebchuk.  But existing shareholders who are unhappy with management have a range of well-accepted responses other than proposals.  Given the depth and liquidity of today’s markets, passive investors can simply sell their position—taking the s0-called “Wall Street Walk.”  Activist investors can threaten to take this Walk as a means of influencing management.  Investors can also vote against directors who are not sufficiently overseeing management—this strategy doesn’t have a clever name, but perhaps “vote the bums out” will do.

And, of course, where management is breaching its fiduciary duties, investors can have recourse to the courts.  This “see you in court” strategy is particularly viable given the outstanding job the Delaware courts do, day in and day out, in refereeing disputes between shareholders and management.  Given these and other strategies, I’m not sure we need shareholder proposals at all.

But if we must have shareholder proposals, the SEC’s rules can and should do a better job ensuring that activist investors don’t crowd out everyday and long-term investors—and that their causes aren’t inconsistent with the promotion of shareholder value.

One thing is clear:  we can’t continue to take the approach of our current regulatory program, especially the all too liberal program of the last five years, and simply err on the side of over-inclusion.  It is enormously expensive for companies to manage shareholder proposals.  They must negotiate with proponents, seek SEC no-action to exclude improper ones, form and articulate views in support or opposition in the proxy, include the proposal and the statement in the proxy itself, then take the vote on it at the annual meeting.  Conversely, companies can simply fold and acquiesce to the activists’ demands.  Both approaches are costly, and these costs are borne by all shareholders.  Taking money out of the pocket of someone investing for retirement or their child’s education and using it instead to subsidize activist agendas is simply inexcusable.  It is incumbent on the Commission to create a regulatory environment that promotes shareholder value over special interest agendas.  I have a few suggestions.

First, the holding requirement to submit proxies should be updated.  $2,000 is absurdly low, and was not subject to meaningful economic analysis when adopted.[xiv]  The threshold should be substantially more, by orders of magnitude:  perhaps $200,000 or even better, $2 million.  But I don’t believe that this is actually the right fix:  a flat number is inherently over- or under-inclusive, depending on the company’s size.  A percentage threshold by contrast is scalable, varies less over time, better aligns with the way that many companies manage their shareholder relations, and is more consistent with the Commission’s existing requirements.  Therefore, I believe the flat dollar test should be dropped, leaving only a percentage test.

Of course, we’d have to make sure we get the percentage holding requirement right.  Requiring a sufficient economic stake in the company could lead to proposals that focus on promoting shareholder value rather than those championed by gadflies with only a nominal stake in the company.  We would need to apply rigorous economic analysis to determine what percentage would be an appropriate default, as well as what factors should be taken into account when deviating from that default.  This could be an opportunity to address the practice of “proposal by proxy,” where the proponent of a resolution—typically one of the corporate gadflies—has no skin in the game, but rather receives permission to act “on behalf” of a shareholder that meets the threshold.  While I would support banning proposal by proxy, we could also consider alternatives such as requiring a proponent acting on behalf of one or more shareholders to meet a higher percentage threshold of outstanding shares than would be the case for a proponent who owns the shares directly.

I also think we need to take another look at the length of the holding requirement.  A one-year holding period is hardly a serious impediment to some activists, who can easily buy into a company solely for the purpose of bringing a proposal.  All that’s needed is a bit of patience, and perhaps a hedge.  A longer investment period could help curtail some of this gamesmanship.

Making adjustments along these lines will go a long way towards ensuring that the proposals that make it onto the proxy are brought by shareholders concerned first and foremost about the company—and the value of their investments in that company—not their pet projects.

b.         What issues should proponents be able to raise?

I also believe that we need to do a better job setting requirements as to the substance of proposals.  While I don’t think a complete reevaluation of the existing categories for exclusion is necessary, we do need to re-think their application.

For example, the “ordinary business” criterion for exclusion in our rules has been perennially problematic.[xv]  This provision permits exclusion of a proposal that deals with the company’s “ordinary business operations,” unless it raises “significant policy issues.”  However, these terms are not defined and the Commission has given no guidance, leaving the Staff to fend for itself in determining whether to issue no-action relief pursuant to the provision.

As a result, we have seen a number of dubious “significant policy issue” proposals.  For example, in 2013 the Staff denied no-action relief to PNC Bank with respect to a proposal requesting a report on greenhouse gas emissions resulting from its lending portfolio, on the grounds that climate change is a significant policy issue—arguably a reversal of a prior Staff position.[xvi]  And, in 2012, Staff denials of no-action relief forced AT&T, Verizon, and Sprint to include a net neutrality proposal, even though proposals on that same topic were excludable in prior years as ordinary business.  That year, 94% of AT&T shareholders voted “no” on the net neutrality proposal despite the best efforts of Michael Diamond, who some of you will know as Mike D. of the Beastie Boys—who, by helping to bring the proposal to a vote, at least succeeded in his fight for the right to proxy.[xvii]

It is a disservice to the Staff—and, more importantly to investors—when the Commission promulgates a discretion-based rule for the Staff to administer without providing guidance as to how to exercise that discretion.  In addition to providing better guidance, the Commission needs to become more involved in the administration of this rule.  In particular, I believe that the Commission should be the final arbiter on the types of proposals for which the Staff proposes to deny no-action relief on “significant policy issue” grounds.  The Presidential appointees should vote on these often-thorny policy issues and not hide behind the Staff.

We also need to take another look at the rule which permits the exclusion of proposals that are contrary to the Commission’s proxy rules—including proposals that are materially false and misleading or that are overly vague.[xviii]  In Staff Legal Bulletin 14B, issued in 2004,[xix] the Staff curtailed the use of this ground for exclusion in light of the extensive Staff resources that were being consumed in their line-by-line review of shareholder proposals, instead forcing issuers to use their statement in opposition to take issue with factual inaccuracies or vagueness.[xx]  I believe issuers have raised some legitimate concerns with this approach.  For example, while issuers are not legally responsible for the proposals or statements in support, they are still being forced to publish, in their proxy, statements they believe are false or misleading.  Moreover, use of the statement in opposition is sometimes an incomplete remedy.  Taking valuable space to correct misstatements distracts from a substantive discussion about the proposal itself, and proposals that are overly vague make it difficult to draft a sensible rebuttal.

In light of these competing concerns, I believe the pendulum has swung too far in the direction of non-intervention.  And I’m not alone in this belief.  Recently, a district court in Missouri granted summary judgment to Express Scripts, permitting it to exclude a proposal that contained four separate misstatements.[xxi]  While I support companies exercising their right to take matters to the court system,[xxii] which can serve as a useful external check on the SEC’s no-action process, companies shouldn’t have to go through the time and expense of litigation to vindicate their substantive rights under our rules.  The burden to ensure that a submission is clear and factually accurate should be placed on the proponent, not the company.  I believe that the Staff should take a more aggressive posture toward proponents that fail to meet that burden.  And I hope issuers would refrain from using our rule to quibble over minutiae.  If this happy medium is not achievable, I believe the SEC needs to revisit our rules:  we as a Commission either need to give the Staff the capacity to enforce the rule as it is currently written, or craft a rule that is enforceable.

c.         How many times may a proposal be repeated?

The final issue I want to raise today with respect to the shareholder proposal process is the frequency of reproposals.  Currently, once a proposal is required to be included in the proxy, it can be resubmitted for years to come, even if it never comes close to commanding majority support.  Proposals need only 3, 6, or 10% of votes in support to stay alive, depending on whether the proposal has been brought once, twice, or three times or more in the past five years.[xxiii]  So a proposal that gets a bare 10% of the votes, year after year, is not excludable on that basis under our current rules.  Such proposals are an enormous waste of time and shareholder money.

We need to substantially strengthen the resubmission thresholds, perhaps by taking a “three strikes and you’re out” policy.  That is, if a proposal fails in its third year to garner majority support, the proposal should be excludable for the following 5 years.  The thresholds for the prior 2 years should be high enough to demonstrate that the proposal is realistically on the path toward 50%, for example, 5% and 20%.

3.         Conclusion

Implementing these kinds of reforms can, I believe, help provide some much-needed improvement to the shareholder proposal system.  I hope the Commission can consider such common-sense issues in the near future.  These are real and substantial issues, and the Commission has the authority to effectuate needed change.  We should not dare Congress to intervene due to our inaction, as it had to with the JOBS Act.

III.       Remaining the Right Regulator

Finally, I want to return to my original theme:  good government requires that, when we must regulate, we should do so in the most efficient manner possible.  This means assigning the right regulator to the issue and minimizing unnecessary regulatory overlap.  And of course, the Commission must continue to ensure that its regulatory approach advances its core goals of investor protection and the promotion of efficiency, competition, and capital formation.

That means, for example, pressing ahead with much-needed reforms to our corporate disclosure requirements to ensure that our filings provide investors with the information they need to make informed investment decisions and are not overwhelmed by extraneous information—like conflict minerals reports.

We must also take exception to efforts by third parties that attempt to prescribe what should be in corporate filings.  It is the Commission’s responsibility to set the parameters of required disclosure.

The somewhat confusingly-named Sustainability Accounting Standards Board provides a good example of an outside party attempting to prescribe disclosure standards.  I say “confusingly-named” because the SASB does not actually promulgate accounting standards, nor does it limit itself to sustainability topics, although I suppose it is in fact a Board.  The SASB argues that its disclosure standards elicit material information that management should assess for inclusion in companies’ periodic filings with the Commission.[xxiv]

I don’t mean to single out the SASB, but it’s important to stress that, with the sole exception of financial accounting—where the Commission, as authorized by Congress, has recognized the standards of the Financial Accounting Standards Board as generally accepted, and therefore required under Regulation S‑X—the Commission does not and should not delegate to outside, non-governmental bodies the responsibility for setting disclosure requirements.  So while companies are free to make whatever disclosures they choose on their own time, so to speak, it is important to remember that groups like SASB have no role in the establishment of mandated disclosure requirements.

With respect to information that the Commission requires to be included in filings, we need to be sure that our requirements are eliciting decision-useful and up-to-date information.  We should be willing to reexamine all of our disclosure requirements.  Indeed, the Commission should be engaged in a comprehensive program of periodic re-assessment of its disclosure rules to ensure that the benefits of disclosure continue to justify its often-substantial costs.

This is of course a tall order, but I know the fine men and women who serve the public at the Commission are up for the challenge.

* * *

Thank you all for your time and attention today, and I hope you enjoy the rest of the conference.



  [i]       See Troy A. Paredes, Speech by SEC Commissioner:  Remarks at the 22nd Annual Tulane Corporate Law Institute (Apr. 15, 2010), available athttp://www.sec.gov/news/speech/2010/spch041510tap.htm.

  [ii]       See Daniel M. Gallagher, Speech, Remarks before the Corporate Directors Forum(Jan. 29, 2013), available at www.sec.gov/News/Speech/Detail/Speech/1365171492142; see also, e.g., J. Robert Brown, Jr., The Politicization of Corporate Governance:  Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors, 2 Harv. Bus. L. Rev. 61, 62 (2012).

  [iii]      Rel. 33-9452, Pay Ratio Disclosure (Sept. 18, 2013).

  [iv]      Rel. 34-64140, Incentive-based Compensation Arrangements (Mar. 29, 2011).

  [v]       James R. Copeland & Margaret M. O’Keefe, Proxy Monitor 2013:  A Report on Corporate Governance and Shareholder Activism (Manhattan Institute, Fall 2013) at 2 (average Fortune 250 company faced 1.26 proposals in 2013 versus 1.22 in 2012); Gibson, Dunn & Crutcher LLP, Shareholder Proposal Developments During the 2013 Proxy Season(July 9, 2013) at 1 (noting more proposals in 2013 (~820) than 2012 (~739)).

  [vi]      Proxy Monitor 2013 at 7.

  [vii]     Proxy Monitor 2013 at 12 (“[P]roposals related to corporate political spending or lobbying have been more numerous than any other class of proposal in each of the last two years.”).

  [viii]     ISS reports political contribution/lobbying activity approval percentage at 29%, an increase of 7.3% over 2012.  See Gibson Dunn at 6.  However, Proxy Monitor finds the opposite trend, at least with respect to the Fortune 250 companies.  See Proxy Monitor 2013 at 2.  Specifically, disaggregating lobbying and political spending proposals shows adecline in y-o-y support for both proposal classes:  22% in 2012 to 20% in 2013 for lobbying, and 17% to 16% for political spending.  Id.  But a change in the mix of proposals—there were more lobbying-related proposals, which typically garner higher support, given that 2013 is a non-election year—creates the impression of an increasing overall rate.

  [ix]      Proxy Monitor 2013 at 2 (contrasting with 9% in 2012).

  [x]       Proxy Monitor 2013 at 6–7.

  [xi]      Proxy Monitor 2013 at 8 (“Those companies [giving at least $1.5 million to candidates or PACs], as a group, were much more likely to be targeted by shareholder proposals introduced by labor-affiliated pension funds in 2013: 44 percent of these politically most active companies faced a labor-sponsored proposal, as opposed to only 18 percent of all other companies.  What’s more, those corporations that gave at least half of their donations to support Republicans were more than twice as likely to be targeted by shareholder proposals sponsored by labor-affiliated funds as those companies that gave a majority of their politics-related contributions on behalf of Democrats.”).

  [xii]     James R. Copeland, Proxy Monitor 2011: A Report on Corporate Governance and Shareholder Activism (Manhattan Institute, Sept. 2011) at 4.

  [xiii]     Allan T. Ingraham & Anna Koyfman, Analysis of the Wealth Effects of Shareholder Proposals–Vol. III (U.S. Chamber of Commerce, May 2, 2013).

  [xiv]     See Rel. 34-40018, Amendments to Rules on Shareholder Proposals (May 21, 1998) (describing the change from $1,000 to $2,000 as an adjustment for inflation).

  [xv]     Exchange Act Rule 14a‑8(i)(7).

  [xvi]     See, e.g., Hunton & Williams, Client Alert, SEC Refused to Allow Bank to Omit Climate Change Proposal from Proxy Materials (Mar. 2013).  It has been argued, however, that PNC was not a reversal, but rather was driven by some substantive differences with PNC’s lending portfolio.  See Gibson Dunn at 9–10 (citing a “SEC spokesman” commenting to that effect).  This may indicate a need for the Staff to provide fuller statements of their reasoning in no-action letters, so as to avoid confusion among practitioners and the public.

  [xvii]    See Larry Downes, AT&T, Verizon, and Sprint Net Neutrality Proposals: Simply Awful, Forbes.com (Apr. 12, 2012, updated Apr. 27, 2012), athttp://www.forbes.com/sites/larrydownes/2012/04/12/att-verizon-and-sprint-net-neutrality-proposals-simply-awful/.

  [xviii]   Exchange Act Rule 14a‑8(i)(3).

  [xix]     See SLB 14B (2004).

  [xx]     Of 90 denials of exclusion during the 2013 proxy season, 63% of them had raised (i)(3) arguments.  Gibson Dunn at 2.  While there could be several reasons for this trend, it calls for further examination.

  [xxi]     Express Scripts Holding Co. v. Chevedden, No. 4:13-CV-2520-JAR (E.D. Mo., Feb. 18, 2014).

  [xxii]    See Waste Connections v. Chevedden, No. 13-20336, slip op. (5th Cir., Feb. 13, 2014) (affirming court’s subject matter jurisdiction over company’s declaratory judgment action despite Chevedden’s promise not to sue if company excluded the proposal).

  [xxiii]   See Exchange Act Rule 14a‑8(i)(12).

  [xxiv]   See, e.g., SASB, Commercial Banks Sustainability Accounting Standard, Provisional Version (Feb. 2014) (“SASB Standards are comprised of (1) disclosure guidance and (2) accounting standards on sustainability topics for use by U.S. and foreign public companies in their annual filings (Form 10-K or 20-F) with the U.S. Securities and Exchange Commission (SEC).  To the extent relevant, SASB Standards may also be applicable to other periodic mandatory fillings with the SEC, such as the Form 10-Q, Form S-1, and Form 8-K.  SASB’s disclosure guidance identifies sustainability topics at an industry level, which may be material—depending on a company’s specific operating context—to a company within that industry.  Each company is ultimately responsible for determining which information is material and is therefore required to be included in its Form 10-K or 20-F and other periodic SEC filings.”).

 

 

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SEC CLOSE TO WEIGHING POSSIBLE ACTION ON PROXY ADVISORY FIRMS

March 24, 2014
On March 19, 2014, SEC Chair Mary Jo White stated that the Securities and Exchange Commission will soon review recommendations for possible regulatory action targeting proxy advisory firms. 
White did not offer any details regarding new rules or changes that could be in store for proxy advisory firms like Glass Lewis and Institutional Shareholder Services, which help large institutional investors weigh how to vote on critical company issues such as board elections and compensation.
The SEC previously held a roundtable about the sector, where stakeholders discussed a variety of concerns such as whether the firms properly disclose potential conflicts of interest and whether investment advisers rely too heavily on their advice when they vote on behalf of clients.
Without signaling what the SEC might do, White, speaking to an audience at the U.S. Chamber of Commerce, said that she was “particularly” interested during the roundtable in hearing the discussions about improving disclosure of possible conflicts and about how much investment advisers rely upon proxy advisory firms and what this means for their fiduciary obligations.
The U.S. Chamber of Commerce has been among the most vocal in pressing the SEC to reform the proxy advisory sector.
“The staff now will be making recommendations to me in the very near term about what additional action might be taken on these issues,” White told the audience.
Some of White’s colleagues on the commission, including Dan Gallagher, a Republican, have said the SEC has enabled investment advisers to rely too heavily on proxy advisory firms for advice after the SEC staff issued letters that permit advisers to rely on the advice without the fear of possible enforcement action.
This is problematic because investment advisers have a fiduciary obligation to put their customers’ interests first, Gallagher has said.
Most recently, in a March 18 letter, 10 members of Congress, including New Jersey Republican Scott Garrett and North Carolina Republican Patrick McHenry, called on the SEC to require more disclosures of conflicts.
In the letter, lawmakers expressed concern that the SEC does not require proxy advisory firms to disclose whether a proponent of a shareholder proposal or a competing director slate is a client.
“In our view, this lack of disclosure calls into question the legitimacy and veracity of the advice dispensed by proxy advisory firms and undercuts the ability of their clients to meet their fiduciary duty to individual investors,” they wrote.
Published by Veritas Executive Compensation Consultants, (“Veritas”), an  independent executive compensation consulting firm. 
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Court of Chancery Stresses Need for Board Monitoring of Advisors and Potential Conflicts

By Paul K. RoweDavid A. KatzWilliam SavittRyan A. McLeod

Last week, the Delaware Court of Chancery reached the rare conclusion that an independent, disinterested board breached its fiduciary duties in connection with an arm’s-length, third-party, premium merger transaction.  In re Rural Metro Corp. Stockholders Litig., C.A. No. 6350-VCL (Del. Ch. Mar. 7, 2014).  The decision, which relies heavily on findings that the board’s financial advisor had undisclosed conflicts of interest, holds the advisor liable for aiding and abetting the breaches, but does not reach the question of whether the directors themselves could have been liable, as they settled before trial.  The decision sends a strong message that boards should actively oversee their financial advisors in any sale process.

The opinion arose out of the 2011 sale of Rural Metro to a private equity buyer.  In late 2010, Rural’s board formed a special committee to evaluate the potential acquisition of a competitor then being auctioned.  The Court found that the committee’s financial advisor believed that if Rural were involved in a sale process at the same time as its competitor, the possibility of combining all or part of the two companies would present financing opportunities to the advisor that would dwarf the advisory fees it stood to receive from the special committee assignment alone.  Without disclosing its desire to provide such buy-side financing, the advisor counseled the special committee to commence a limited auction for Rural, and the committee proceeded to do so.  The Court found that this decision was a breach of duty, because the committee did not give appropriate weight to the fact that there were restrictive confidentiality agreements that many potential bidders for Rural had entered into in connection with the process being run by its competitor, thus making it an inopportune time to sell Rural.  The Court also found fault in the fact that the board never authorized the special committee to explore the sale of the company.  In its ruling, the Court was influenced by evidence that the members of the special committee had personal reasons to favor a near-term sale of the company unrelated to shareholder interests generally.

Even after it became clear that Rural would not be a buyer for its competitor, the special committee continued with the sale process and the financial advisor continued to desire a role in buy-side financing for any potential sale of Rural itself.  Although the special committee negotiated for a sale price representing a 37% premium to market, the Court found that the committee’s process was insufficient and ill-informed, as the committee held “only two formal meetings” and “had not received any valuation information until three hours before the meeting to approve the deal.”  And that valuation information, the Court found, was revised downward by the financial advisor at the same time the advisor was “secret[ly] lobbying” the buyer to supply buy-side financing.

On this record, the Court ruled that the Rural directors failed to discharge their responsibility to provide “active and direct oversight” of both the process and the activities of their financial advisor.  The Court explained that this required the directors to be “reasonably informed about the alternatives available to the company” and to “act reasonably to identify and consider the implications of the investment banker’s compensation structure, relationships, and potential conflicts.”  The Court noted that the actions taken here may have been reasonable had they been made by a “well-informed board.”  But because here the financial advisor “misled the Board,” and because the board failed to provide appropriate oversight, it was “not a case where a Board’s independent sense of the value of the company is sufficient to carry the day.”  Because the directors settled before trial, the Court did not address the question of whether the kinds of breaches found on this record could result in personal liability.

          Rural Metro does not disturb the well-established principle that Delaware courts will respect the decisions of well-informed boards that engage in a careful sale strategy.  It does emphasize the importance of the board’s role in identifying and addressing potential conflicts—be they of management, other directors, or financial advisors.  To ensure that directors are protected in a sale process, boards should be sensitive to conflicts and should satisfy themselves that any sale process is thoughtfully structured, supported by an appropriate contemporaneous record, and at all times executed under the supervision of the board itself.

Paul K. Rowe
David A. Katz
William Savitt
Ryan A. McLeod

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Governance QuickScore 2.0

By David A. Katz , Sabastian V. Niles, Francis J. Stapleton

ISS QuickScore 2.0 

Institutional Shareholder Services Inc. (ISS) has announced the governance factors and other technical specifications underlying its new Governance QuickScore 2.0 product, which ISS will apply to publicly traded companies for the 2014 proxy season. Companies have until 8pm ET on Friday, February 7th to verify the underlying raw data and can submit updates and corrections through ISS’s data review and verification site. ISS will release company ratings on Tuesday, February 18th, and the scores will be included in proxy research reports issued to institutional shareholders. While previous QuickScore ratings remained static between annual meeting periods, ISS has now committed to update ratings on an on-going basis based on a company’s public disclosures throughout the calendar year.

We have listed the individual factors used by QuickScore 2.0 in Annex A. However, the specific weightings and balancing between quantitative and qualitative factors remain undisclosed, and companies will not be able to calculate scores on their own. As we have previously noted, the relationship between ISS’s governance metrics and company financial performance has been dubious at best, and we continue to urge companies and boards to see QuickScore for what it is—a data point generated by an artfully marketed product, rather than a target or an ideal—and to consider their individual circumstances in establishing and evaluating appropriate corporate governance practices and compensation policies for their companies. No single metric or bundle of metrics can substitute for the informed business judgment of a well-advised board as to what is necessary to promote corporate and shareholder interests in dynamic, real-world circumstances.

Scoring under QuickScore 2.0 will continue to use the familiar “four pillar” approach that analyzes governance across Audit, Board Structure, Compensation/Remuneration and Shareholder Rights categories, and company-level and underlying pillar scores will continue to be presented on a 1 to 10 scale, relying upon “decile” comparisons of a company’s raw scores against the scores of other companies within the applicable index and region. Accordingly, ISS’s QuickScore 2.0 unfortunately continues to deploy an unproven and opaque methodology that reduces the complex realities of corporate governance into an easily digestible, but inherently misleading, decile system. Given the success to date of governance activists in driving companies towards one-size-fits-all governance structures, it is likely that only minor differences will separate the deciles, resulting in companies with no serious governance concerns receiving an unjustified “taint” by virtue of a lower score.

Although the new specification builds mostly upon the methodology used in previous years (which began as the CGQ Corporate Governance Quotient and then evolved into the GRId Governance Risk Indicators in 2010, which was then supplanted by QuickScore 1.0 in 2013), several new factors will be incorporated into the overall scoring model and a few additional “zero-impact” factors will be disclosed in the QuickScore report for informational purposes but will not, at this point, impact ratings.

New Factors that Impact Scoring 

“Excessive” Director Tenure. Tenure of more than nine years will be considered “excessive” by QuickScore 2.0 on account of “potentially compromis[ing] a director’s independence” and negatively factor into weightings depending on the proportion of directors with such tenure. Given that ISS had recently announced a longer-term review of this issue for possible application to the 2015 proxy season and beyond, its inclusion in QuickScore for the 2014 proxy season may signal that ISS has already prejudged the issue. As we have previously stated, we do not believe that there is a sufficient basis to consider an extended tenure of board service in and of itself as indicative of a lack of director 2

independence. Given the significant differences in companies’ needs and directors’ attributes and experiences, this is a clear instance where a company-specific approach is superior to a rigid rule.

Director Approval Rates. In addition to continuing to consider whether one or more directors received 50% or greater “against” or “withhold” votes, QuickScore 2.0 will now consider the percentage of directors who receive “less than average” levels (as measured against the company’s industry index) of shareholder support for their election.

Compensation of Outside Directors. How a company’s outside director compensation compares to median levels of the ISS-determined peer group will now be considered. Specifically, QuickScore 2.0 will measure the prior year’s average outside director’s pay (based on total compensation reported for each director in the company’s proxy statement) as a multiple of the median pay of its ISS-determined comparison group for the same period.

Alignment between Pay and TSR. Consistent with ISS’s 2014 voting policy updates, QuickScore 2.0 will now incorporate the relative degree of alignment (RDA) between compensation and TSR based on a single, annualized RDA measure for a three-year measurement period, instead of the previous 40/60 weighted average of one- and three-year RDA. The previous QuickScore factors of three- and one-year RDA will still be included for informational purposes only and will be zero-weight factors on the scoring model.

Say-on-Pay Support. The level of shareholder support on the company’s most recent say-on-pay proposal and how such support compares to industry-index levels will also affect ratings.

New Informational Factors with No Impact on Scoring 

Three new board composition-related factors will be included in the QuickScore report for informational purposes. According to ISS, these factors, however, will not currently impact overall scoring for the issuer.

Board-Level Gender Diversity. According to ISS, some academic and other studies have shown that increasing the number of women on the board correlates with better financial performance. As a result, QuickScore will now begin analyzing the number of female directors as well as the relative proportion of male to female directors on the board.

Number of Financial Experts on Audit Committee. QuickScore will provide information on the number of financial experts that serve on the board’s audit committee. This is a zero-weight issue for U.S. companies, most of which are required to have at least one financial expert serving on the audit committee due to stock exchange listing requirements.

Board Size. QuickScore will begin providing information on the number of directors on the board. According to ISS, boards should generally have no fewer than six directors and no more than 15. A board composed of nine to 12 directors is considered by ISS to be optimal.

 

ANNEX A

ISS QuickScore 2.0 Factors for U.S. Companies

1. Non-Audit fees represent what percentage of total fees?

2. Did the auditor issue an adverse opinion in the past year?

3. Has the company restated financials for any period within the past two years?

4. Has the company made non-timely financial disclosure filings in the past two years?

5. Has a securities regulator taken enforcement action against the company in the past two years?

6. Has a securities regulator taken enforcement action against a director or officer of the company in the past two years?

7. Is the company, or any of its directors and officers, currently under investigation by a regulatory body?

8. Has the company disclosed any material weaknesses in its internal controls in the past two years?

9. How many financial experts serve on the audit committee?

10. How many directors serve on the board?

11. What is the number / proportion of women on the board?

12. What is the independent director composition of the board?

13. What proportion of directors sit on the board for an excessive length of time?

14. What is the classification of the chairman of the board?

15. Has the company an identified senior independent director?

16. What percentage of the board consists of immediate family members of majority shareholders, executives, and former executives (within the past five years)?

17. What percentage of the board are former or current employees of the company?

18. What percentage of nominating committee members are independent based on ISS standards?

19. What is the independent status of the compensation committee members?

20. What is the independent status of the audit committee members?

21. Does the CEO serve on an excessive number of outside boards? / How many boards does the CEO sit on? (U.S. only)?

22. How many non-executives serve on an excessive number of outside boards?

23. Did any directors attend less than 75% of aggregate board & committee meetings without a valid excuse?

24. How many directors received withhold/ against votes of 50% or greater at the last annual meeting?

25. What percentage of directors received shareholder approval rates below the industry-index level?

26. Has the board failed to implement a shareholder resolution supported by a majority vote?

27. What is the average size of outside directors’ compensation as a multiple of the median of company peers?

28. What is the aggregate level of stock ownership of the officers and directors, as a percentage of shares outstanding?

29. Are directors subject to stock ownership guidelines?

30. Do all directors with more than one year of service own stock?

31. Did any executive or director pledge company shares?

32. Does the company have a robust policy prohibiting hedging of company shares by employees?

33. Does the company disclose board/governance guidelines?

34. What percent of the directors were involved in material RPTs [related party transactions]?

35. Do the directors with RPTs sit on key board committees?

36. Are there material related-party transactions involving the CEO?

37. Does the company have classes of stock with different voting rights?

38. Are there any directors on the board who are not up for election by all classes of common shareholders?

39. Are all directors elected annually?

40. Is the board authorized to issue blank check preferred stock?

41. Does the company have a poison pill (shareholder rights plan) in effect?

42. What is the trigger threshold for the poison pill?

43. Does the poison pill have a sunset provision?

44. Does the poison pill have a TIDE provision?

45. Does the poison pill have a qualified offer clause?

46. What is the expiration date of the poison pill?

47. Is the poison pill designed to preserve tax assets (NOL pill)?

48. When was the poison pill implemented or renewed?

49. Does the company’s poison pill include a modified slow-hand or dead-hand provision?

50. If the company has a majority voting standard, is there a plurality carve-out in contested elections?

51. Does the company require a super-majority vote to approve amendments to the charter and bylaws?

52. Does the company require a super-majority vote to approve mergers/business combinations?

53. What is the percentage of share capital needed to convene a special meeting?

54. Can shareholders act by written consent?

55. Does the company have a majority vote standard in uncontested elections?

56. Are there material restrictions as to timing or topics to be discussed, or ownership levels required to call the meeting?

57. What is the degree of alignment between the company’s cumulative 3-year pay percentile rank, relative to peers, and its 3-year cumulative TSR rank, relative to peers?

58. What is the degree of alignment between the company’s cumulative 1-year pay percentile rank, relative to peers, and its 1-year cumulative TSR rank, relative to peers?

59. What is the size of the CEO’s 1-year cumulative pay, as a multiple of the median pay for company peers?

60. What is the degree of alignment between the company’s TSR and change in CEO pay over the past five years?

61. What is the ratio of the CEO’s total compensation to the next highest paid executive?

62. What is the degree of alignment between the company’s annualized 3-year pay percentile rank, relative to peers, and its 3-year annualized TSR rank, relative to peers?

63. Are any of the NEOs eligible for multiyear guaranteed bonuses?

64. What is the ratio of the CEO’s non-performance-based compensation (All Other Compensation) to Base Salary?

65. Do the company’s active equity plans prohibit share recycling for options/SARS?

66. Do the company’s active equity plans prohibit option/ SAR repricing?

67. Does the company’s active equity plans prohibit option/ SAR cash buyouts?

68. Do the company’s active equity plans have an evergreen provision?

69. Do the company’s active equity plans have a liberal CIC definition?

70. Has the company repriced options or exchanged them for shares, options or cash without shareholder approval in the last three years?

71. Does the company grant equity awards at an excessive rate, according to ISS policy?

72. Did the company disclose a claw back or malus provision?

73. What are the minimum vesting periods mandated in the plan documents for executives’ stock options or SARS in the equity plans adopted/amended in the last 3 years?

74. What are the minimum vesting periods mandated in the plan documents, adopted/amended in the last three years, for executives’ restricted stock / stock awards?

75. What is the holding/retention period for stock options (for executives)?

76. What is the holding/retention period for restricted shares / stock awards (for executives)?

77. What proportion of the salary is subject to stock ownership requirements/guidelines for the CEO?

78. Does the company disclose a performance measure for the short-term incentive plan (for executives)?

79. What is the level of disclosure on performance measures for the latest active or proposed long-term incentive plan?

80. Did the most recent say-on-pay proposal receive shareholders’ support below the industry-index level?

81. What’s the trigger under the change-in-control agreements?

82. Do equity based plans or other long-term plans vest completely upon a change-in-control?

83. What is the multiple of the change-in-control/severance payment for the CEO (upon a change-in-control)?

84. What is the basis for the change-in-control or severance payment for the CEO?

85. Does the company provide excise tax gross-ups for change-in-control payments?

86. What is the length of employment agreement with the CEO?

87. Has ISS’ qualitative review identified a pay-for-performance misalignment?

88. Has ISS identified a problematic pay practice or policy that raises concerns?

 

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Corporate Governance Update: Boardroom Confidentiality Under Focus

January 23, 2014

David A. Katz and Laura A. McIntosh

In our Age of Communication,1 confidential information is more easily exposed than ever before. Real-time communication tools and social media give everyone with Internet access the ability to publicize information widely, and confidential information is always at risk of inadvertent or intentional exposure. The current cultural emphasis on transparency and disclosure—punctuated by headline news of high-profile leakers and whistleblowers, and exacerbated in the corporate context by aggressive activist shareholders and their director nominees—has contributed to an atmosphere in which sensitive corporate information is increasingly difficult to protect. There is limited statutory or case law to guide boards and directors in this area, and there exists a range of opinions among market participants and media commentators as to whether leaking information (other than illegal insider tipping) is problematic at all.2

3 Directors’ legal obligations with respect to confidentiality are not well articulated, and confidential board information is unique in the corporate context. It includes material, non-public information, the disclosure of which is regulated by federal securities laws and by company-wide policies and procedures, but it also includes sensitive boardroom discussions that have both personal and business elements and implications. In order for boards

to function effectively, directors must feel comfortable expressing their views in the boardroom on corporate matters honestly and freely, without concern that their conversations will be made public.

Concerns about leaks often increase with the election of “constituent” directors. These directors, placed on public company boards through proxy access or a proxy fight, are typically perceived—rightly or wrongly—as representatives of those shareholders that nominated them and are considered likely to share details of board deliberations with their sponsors. When sensitive board information is deliberately exposed by a director, boards may struggle to respond effectively, as the remedies available to the board and the company are limited, particularly since directors cannot require another director to resign. In order to protect confidential and sensitive information, boards should, at a minimum, have robust director confidentiality policies and, in appropriate circumstances, should consider adopting bylaws regarding preserving confidentiality. Companies may also want to review their crisis management plans to ensure that they cover breaches of confidentiality by directors in addition to employees.

Confidential Board Information

Confidential, non-public corporate information falls generally into three categories: proprietary information that is of competitive, commercial value to the company; inside information about the company’s finances, operations, and strategy; and sensitive information regarding board proceedings and deliberations. Unauthorized disclosures of proprietary information could imperil a company’s competitive advantage or commercial success while unauthorized disclosures of inside information can lead to illegal insider trading and manipulation of the company’s stock price. Information in any category that is material and non- public may be disclosed by company insiders only in specific ways prescribed by the federal securities laws, including Regulation FD. For these reasons, all companies should have comprehensive corporate confidentiality policies that apply to employees as well as directors. The authorized processes and channels for disclosure of confidential corporate information should be well defined and understood within the company, as improper disclosures can lead to criminal and civil liability in certain circumstances.

The third category, sensitive board information, includes information to which a director is privy by virtue of his or her membership on the board of directors. In the course of fulfilling their fiduciary duties and director responsibilities, directors are entrusted with significant amounts of material, non-public information of all types; however, they also become aware of the inside story: how this confidential corporate information is discussed, used, and understood within the board itself. Directors generally know how their fellow board members view corporate executives, strategic initiatives, potential acquisitions, competitive and legal threats, and even each other. They also understand how board deliberations have developed over time. Any element of this “meta-information” may be of particular importance, may be potentially disruptive or embarrassing if disclosed, or may simply have been shared within the boardroom with the expectation of privacy. Leaks of sensitive board information—as opposed to proprietary or valuable corporate information—also can be highly damaging to a company. Such

leaks can be made publicly, to the media and the investor community at large, or privately, to a director’s sponsor or other influential shareholders.

Public and Private Disclosures

The most sensational type of leak happens when a disgruntled or dissatisfied director provides confidential information to the media in order to put pressure on the rest of the board. One recent headline-making situation involved J.C. Penney director, and activist investor, William Ackman. Ackman was a major stockholder of J.C. Penney, owning nearly 18 percent of the company’s shares through his hedge fund Pershing Square Capital Management. In August 2013, Ackman provided to a major news outlet two letters from himself to the J.C. Penney Board.4 The letters detailed boardroom discussions and expressed frustration with the leadership of the company and the J.C. Penney board, particularly with respect to the ongoing chief executive search process. The public firestorm that ensued benefited no one; the outcome included high-profile criticism of Ackman’s behavior from prominent members of the corporate community, Ackman’s resigning from the J.C. Penney board, Pershing Square’s sale of its holdings in the company, and a dramatic (and ongoing) decline in the value of J.C. Penney stock.

A less dramatic but likely more prevalent type of boardroom leak is the private communication of confidential information by constituent directors to their sponsoring shareholders. Activist shareholders and the investment community are increasingly pushing for shareholder-sponsored directors on public company boards, and indeed their numbers are growing.5 Dissident success in proxy fights put more constituent directors on boards in 2013 than in any year since 2009. In 2013, there were 90 proxy fights, 30 of which went to a shareholder vote. Of those 30, 17—over half—were won by the dissident. By contrast, 2012 6 saw only 77 proxy fights, of which 28 went to a vote, and nine of those were won by dissidents.

The possibility of mandatory proxy access still lingers, though fortunately it is no longer on the near-term horizon. Proxy access had been a top Securities and Exchange Commission (SEC) priority but suffered a setback in 2011 when the U.S. Court of Appeals for the D.C. Circuit overturned the rule on the basis that the SEC had not conducted an adequate analysis of the rule’s economic impact.7 In 2012, SEC Chairman Mary Schapiro told a

Congressional panel that the SEC had no immediate plans to revisit its proxy access rule.8 Nonetheless, shareholder proposals on proxy access slightly increased in number and shareholder support in 2013, and two did receive shareholder approval.9

Constituent directors may be chosen for board seats by their sponsoring entities on the explicit understanding that they will share inside information for investment evaluation purposes. Indeed, the Delaware Chancery Court recently expressed the view that “[w]hen a director serves as the designee of a stockholder on the board, and when it is understood that the director acts as the stockholder’s representative, then the stockholder is generally entitled to the same information as the director.”10 Absent contractual or bylaw provisions to the contrary, Delaware law permits constituent directors to disclose information to their sponsors so long as they do so in a manner that is consistent with their fiduciary duties. If the corporation were harmed by the disclosures, or if the director knew that the sponsor would use the information disclosed to usurp corporate opportunities belonging to the company, the director likely would be found to have breached his or her duty of loyalty.11 Regardless of the director’s intention, however, once information has been passed outside of the board, as a practical matter it is impossible to control the flow of information from the sponsoring shareholder’s employees to others in the investment community, absent specific confidentiality obligations being in place. Other directors may not be aware of the extent or type of information that a constituent director is providing to the sponsoring shareholder, nor how widely the information is being disseminated. Certain activists routinely enter into confidentiality agreements with companies on whose boards they participate, and these agreements, when properly drafted, protect both the company and the activist.

Some activist hedge funds have begun the unfortunate practice of providing their constituent directors with special compensation arrangements, some of which are contingent on certain events or on the implementation of the shareholding entity’s plans for the company. These arrangements are deeply problematic, as directors—regardless of who nominates them— owe fiduciary duties to all shareholders of the company and should not be prioritizing any particular agenda for personal benefit. As one commentator has observed, “If this nonsense is not illegal, it ought to be.”12 Boards should give consideration to adopting a bylaw that would

disqualify candidates from serving as directors if they are party to such arrangements,13 although a position recently taken by ISS makes this decision more difficult.14

Confidentiality Policies

There is a risk of harm to the company itself when any confidential information is leaked, but there is certain harm to the functioning of the board of directors when its sensitive deliberations are publicly disclosed. An effective group of directors trusts and relies on each other, encourages discussion and debate, and can tolerate even strongly-held dissenting views. When trust has been undermined, board effectiveness will be seriously compromised. A major breach of confidentiality, or an ongoing flow of sensitive information outside the board, can have a chilling effect on board deliberations, thereby depriving shareholders of the full benefit of the directors’ expertise and judgment. Meetings are likely to become contentious, and the board may become incapable of consensus or timely decision-making. All of this is particularly true when a leak exacerbates existing board dysfunction. Showing a lack of understanding of board dynamics, activist director William Ackman opined—in one of his letters to the J.C. Penney board that he provided to the media—that “[e]xtreme candor among directors is critical.”15

Public company boards should consider implementing a confidentiality policy specific to directors. The policy should define “confidential information” broadly, listing examples of the types of information covered, and emphasize that the category includes all non- public information entrusted to or obtained by directors due to their position on the board. The policy should remind directors of their fiduciary duties and state that directors may only use confidential information for the benefit of the company, and not for personal benefit or the benefit of any other entities. The policy should specifically address the issue of disclosure by constituent directors to their sponsors and should note that directors are bound by their confidentiality obligations even after their tenure on the board concludes. The policy should

expressly state that, while directors may disclose confidential information when required by law, in such cases a director should provide advance notice of the upcoming disclosure to the board, its chairman, and the chief executive officer. The policy could also require the director is to attempt, in cooperation with the company and at the company’s expense, to avoid or minimize any required disclosures through legally available steps.

Having a detailed and robust board confidentiality policy will serve both to advise directors (and their sponsors, if any) as to their obligations with respect to sensitive board information and to create a board culture that views leaking as unacceptable and dishonorable behavior. The chairman of the board should provide the policy to director candidates before they are nominated (or, in the case of constituent directors, directors-elect before they begin service) and may wish to obtain written or oral assurances that they understand and can abide by the terms of the policy. Another available mechanism is a board-approved bylaw requiring director nominees to confirm their acceptance of the board’s confidentiality policy and to agree that they will not act as representatives of particular constituencies while on the board. Advance notice bylaws for director nominations may also contain confidentiality requirements. To the extent information will be shared with sponsors by their directors, the board should require the execution of a confidentiality agreement with the sponsor.

The board should review its confidentiality policy during its annual review of the company’s corporate governance policies. The board chairman or board counsel may wish to specifically remind directors of their confidentiality obligations when contentious or sensitive situations are at the forefront of board affairs. As a general matter, the board chairman should ensure to the best of his or her ability that directors never lose sight of their shared obligation to fulfill the fiduciary duties they owe to all shareholders.

If legal disputes do arise, a well-drafted confidentiality policy can be a factor in a court’s determination of whether information should be deemed confidential. In a 2005 Delaware Chancery Court case involving the Walt Disney Company, the court determined that certain documents relating to “‘private communications among or deliberations of the Company’s board of directors’” should remain confidential. Vice Chancellor Lamb based his decision on the company’s written confidentiality policy, which covered documents of this type, as well as on the expectation of privacy of the individuals who participated in the communications described therein.16 The court observed that “By adopting this [confidentiality] policy, the board has recognized the necessity of keeping the thoughts, opinions, and 17 deliberations of its members confidential. This board policy deserves significant weight.”

Breaching Confidentiality

There are legal ramifications for some breaches of confidentiality. Disclosure of material, non-public information can result in civil or criminal charges. A damaging leak of

confidential material could in certain circumstances amount to a breach of the duty of loyalty, which could result in personal liability for damages and limit the director’s legal and contractual protections against such liability. At the board level, however, breaches of confidentiality by directors are notoriously difficult to handle. The first principle should be for the board not to exacerbate the situation by taking actions that would create negative publicity for the company. Removing a director, for example, can only be done by the shareholders and is a very difficult and time-consuming process, and attempting to do so likely would result in protracted public controversy.

Typically, when a serious breach of confidentiality occurs, the board asks for the offending director’s resignation. A board cannot demand it, however, unless the director has signed an advance resignation letter, which commits a director to resign under certain specified circumstances. The effectiveness of advance resignation letters is likely to depend largely on the fairness of the process to determine whether the triggering event has in fact occurred. If the director or sponsoring shareholder resists, enforcement could result in a damaging public controversy regardless of the validity of the process used. Moreover, if the trigger is a finding by a court that the director breached his obligations, the issue is unlikely to be resolved in a timely fashion. Thus, boards commonly wait until the director’s term has expired and decline to renominate him or her when faced with trust issues of this type. A board may wish to adopt a bylaw stating that no director who is determined by the board to have violated the board confidentiality policy may be eligible to serve on the board.

When a request for a director’s resignation fails, a board usually creates special committees for sensitive topics. A director cannot be completely isolated, however, as all directors must have the information needed to fulfill their fiduciary duties. In the 2013 case Kalisman v. Friedman, which involved a constituent director who sought access to board information that had been kept from him, Vice Chancellor J. Travis Laster of the Delaware Chancery Court reiterated a director’s broad right to information, stating, “A director’s right to information is ‘essentially unfettered in nature.’”18 The letter opinion observed that a special committee is entitled to have protected communications with its separate legal counsel to the extent necessary for its work but cautioned that “[t]he degree to which such a committee would need to provide some form of update periodically or upon request to other directors or the board has not been fully determined and is likely fact-dependent….”19 One exception in extreme cases is that “a board or a committee can withhold [attorney-client] privileged information once sufficient adversity exists between the director and the corporation such that the director could no longer have a reasonable expectation that he was a client of the board’s counsel.”20

Finally, the board’s crisis management plan should include provisions regarding director leaks of sensitive board information, whether private or public and whether intentional or inadvertent. Advance preparation can help to ensure procedural fairness and to prevent emotional responses to what can be perceived as a personal betrayal from clouding the board’s judgment.

Culture of Trust

The obligation of confidentiality fundamentally derives from the fiduciary duties of loyalty and care, and questions of disclosure are, when not covered by existing agreements or company policy, matters of business judgment. Ultimately, there is no substitute for genuine trust, collegiality, and a proper amount of respect among board members. The creation of a culture of confidence is probably a board’s best protection against damaging leaks, and the chairman or lead director should proactively build trust and cohesiveness among directors whenever possible. As a matter of best practices, boards also should establish and maintain clear policies about the handling of confidential board information and the process to be followed in the event of a leak and should require confidentiality agreements in situations where directors may be sharing confidential information with their sponsors.

 

Footnotes:

1 See, e.g., Zion Lights, “Is This the Age of Communication,” HuffPost Tech (United Kingdom), Dec. 29, 2012 (“One person can send a short message via a tweet that might be read by a million people within a minute. Or spam three million people with the click of a button.”), available at www.huffingtonpost.co.uk/zion-lights/is-this-the-age- of-communication_b_2372785.html.

2 See, e.g., Nell Minow, “Coverage of H-P ‘Pretexting’ Scandal Misses Point,” WSJ.online MarketWatch, Sept. 11, 2006 (lamenting “journalists’ automatic bias in favor of leaks”), available at http://www.marketwatch.com/story/commentary-coverage-of-h-p-pretexting-scandal-misses-point; Justin Fox, “When Leaking Is the Right Thing To Do,” Time.com, Sept. 21, 2006 (“From the perspective of a shareholder in a public corporation, there are times when you want the board members to be blabbermouths, and times when you don’t.”), available at business.time.com/2006/09/21/when_leaking_is_the_right_thin/.

3 See, e.g., Cyril Moscow, “Director Confidentiality,” 74 Law and Contemporary Problems 197, 198, 200 (Winter 2011) (“A [board] confidentiality requirement does not arise directly from statutory formulations…. There is little case authority dealing directly with a director’s duty to maintain the confidentiality of corporate information.”), available at scholarship.law.duke.edu/cgi/viewcontent.cgi?article=1620&context=lcp.

4 “JC Penney Board Erupts into Fight over next CEO,” Aug. 8, 2013, CNBC.com, available at http://www.cnbc.com/id/100948492; “Bill Ackman’s Aug. 9 Letter to J.C. Penney’s Board,” Aug. 9, 2013, CNBC.com, available at http://www.cnbc.com/id/100952339.

5 See, e.g., “Rethinking Director Nomination Requirements and Conduct in an Era of Shareholder Activism,” Skadden, Arps, Slate, Meagher & Flom LLP Memorandum, available at www.skadden.com/insights/rethinking- director-nomination-requirements-and-conduct-era-shareholder-activism.

6 SharkRepellent.net, Proxy Fight Trend Analysis, available at www.sharkrepellent.net.

7 Business Roundtable v. SEC, 647 F.3d 1144 (D.C. Cir. 2011) available at www.casetext.com/case/bus-roundtable- v-sec/.

8 Securities and Exchange Commission Chairman Mary L. Schapiro, “Testimony on SEC Oversight,” Testimony Before the Capital Markets and Government Sponsored Enterprises Subcommittee and Financial Institutions and Consumer Credit Subcommittee of the U.S. House of Representatives Committee on Financial Services, April 25, 2012, available at http://www.sec.gov/News/Testimony/Detail/Testimony/1365171489436#.UttQXs9Ombg.

9 Sullivan & Cromwell LLP, 2013 Proxy Season Review, July 2, 2013, available at www.sullcrom.com. 10 Kalisman v. Friedman, C.A. No. 8447-VCL, letter op. (Del. Ch. April 17, 2013), at 6, available at

courts.delaware.gov/opinions/download.aspx?ID=188280. 11 See, e.g., Agranoff v. Miller, No. Civ. A 16795 (Del. Ch. April 12, 1999), 1999 WL 219650.

12 Stephen Bainbridge, “Can Corporate Directors Take Third Party Pay from Hedge Funds?” April 8, 2013, available at http://www.professorbainbridge.com/professorbainbridgecom/2013/04/can-corporate-directors-take-third-party- pay-from-hedge-funds.html.

13 See “Bylaw Protection Against Dissident Director Conflict/Enrichment Schemes,” Wachtell, Lipton, Rosen & Katz Memorandum, May 9, 2013, available at www.wlrk.com.

14 See “Director Qualification/Compensation Bylaws FAQs,” ISS (Jan. 13, 2014) (“The adoption of restrictive director qualification bylaws without shareholder approval may be considered a material failure of governance because the ability to elect directors is a fundamental shareholder right. Bylaws that preclude shareholders from voting on otherwise qualified candidates unnecessarily infringe on this core franchise right. Consistent with ISS’ “Governance Failures” policy, we may, in such circumstances, recommend a vote against or withhold from director nominees for material failures of governance, stewardship, risk oversight, or fiduciary responsibilities.”), available at www.issgovernance.com/files/directorqualificationcompensationbylaws.pdf; see also “ISS Publishes Guidance on Director Compensation (and Other Qualification) Bylaws,” Wachtell, Lipton, Rosen & Katz Memorandum, Jan. 16, 2014 (“In light of ISS’ threat that it may issue withhold vote recommendations against boards that adopt director compensation bylaws, it can be expected that many companies will decide that discretion is the better part of valor and avoid a confrontation with ISS, despite the risks posed by “golden leash” schemes. This would be a rational response given the hopefully low probability for any company of actually having to deal with this issue, the fact that “golden leash” arrangements taint dissident candidates and can be used against them in proxy contests, and the prospect that the courts may step in to address the conflicts of interest and duty of loyalty problems created by such schemes.”), available at www.wlrk.com.

15 Ackman Aug. 9 Letter, supra.

16 Disney v. The Walt Disney Co., 2005 Del. Ch. LEXIS 94 (Del. Ch. June 20, 2005), at *10-*11. 17 Disney, at *11.

18 Kalisman, at 5 (citations omitted). 19 Kalisman, at 6.

20 Kalisman, at 7 (citing SBC Interactive, Inc. v. Corporate Media P’rs, 1997 WL 770715, at *6 (Del. Ch. Dec. 9, 1997)).

 

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Increased Shareholder Governance Reduces Firm Value

A Corporate Culture Channel: How Increased Shareholder Governance Reduces Firm Value


Jillian A. Popadak


University of Pennsylvania – The Wharton School

October 25, 2013

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2345384
Abstract: 

I show corporate culture is an important channel through which shareholder governance affects firm value. I develop a novel data set to measure aspects of corporate culture and use a regression discontinuity strategy to demonstrate stronger shareholder governance significantly increases results-orientation but decreases customer-orientation, integrity, and collaboration. Consistent with a positive link between governance and value, shareholders initially realize financial gains from the results-oriented corporate culture: increases in sales, profitability, and payout occur. However, by concentrating on tangible benchmarks, managers hurt the intangibles, which is not in the best long-term interest of the firm. Over time, the value of the firm’s intangible assets significantly deteriorates. This longer-term negative link between governance and value appears to act via the governance-induced changes in corporate culture. Estimates suggest firm value declines 1.4% via the corporate culture channel. I use an instrumental variable design and interventions by activist hedge funds to test the external validity of these inferences. Across these complementary research designs, I consistently find strong support for the importance of a corporate culture channel.

 

Number of Pages in PDF File: 82

Keywords: Corporate Governance, Intangible Assets, Corporate Culture, Hedge Fund Activism, Managerial Myopia, Multitasking

JEL Classification: D23, G23, G30, K22, M14, O16

working papers series 

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Firms That Adopt A Staggered Board Increase In Firm Value

Staggered Boards and Firm Value, Revisited


Martijn Cremers


University of Notre Dame

Lubomir P. Litov


University of Arizona – Department of Finance; University of Pennsylvania – Wharton Financial Institutions Center

Simone M. Sepe


University of Arizona – James E. Rogers College of Law

December 5, 2013

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2364165
Abstract: 

This paper revisits the association between firm value (as proxied by Tobin’s Q) and whether the firm has a staggered board. As is well known, in the cross-section firms with a staggered board tend to have a lower value. Using a comprehensive sample for 1978-2011, we show an opposite result in the time series: firms that adopt a staggered board increase in firm value, while de-staggering is associated with a decrease in firm value. We further show that the decision to adopt a staggered board seems endogenous, and related to an ex ante lower firm value, which helps reconciling the existing cross-sectional results to our novel time series results. To explain our new results, we explore potential incentive problems in the shareholder-manager relationship. Short-term oriented shareholders may generate myopic incentives for the firm to underinvest in risky long-term projects. In this case, a staggered board may helpfully insulate the board from opportunistic shareholder pressure. Consistent with this, we find that the adoption of a staggered board has a stronger positive association with firm value for firms where such incentive problems are likely more severe: firms with more R&D, more intangible assets, more innovative and larger and thus likely more complex firms.

 

Number of Pages in PDF File: 81

Keywords: Staggered Boards, Classified Boards, Firm Value, Incentive Problems, Entrenchment

JEL Classification: G34, K22

working papers series 

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ISS Releases 2014 Voting Policies and Announces New Longer-Term Consultations

ISS Releases 2014 Voting Policies and
Announces New Longer-Term Consultations

By David A.  Katz
Trevor S.  Norwitz
David E.  Kahan
Sabastian V.  Niles
S.  Iliana Ongun

          Institutional Shareholder Services Inc.  (ISS) recently published its 2014 Corporate Governance Policy Updates, which would apply to annual meetings beginning in February 2014.  ISS updated relatively few of its policies this year, but the changes largely represent a more measured, company-specific approach to corporate governance practices, which reflects a move by ISS to avoid “one-size-fits-all” policies and recommendations.  ISS also announced a new consultation and comment period concerning potential policy changes applicable to the 2015 proxy season or beyond with respect to director tenure, director independence, independent chair shareholder proposals, equity-based compensation plans and auditor ratification.

2014 Policy Updates

          Board Response to Majority Supported Shareholder Proposals.  As announced last year, ISS evaluates a company’s response to shareholder proposals that receive a majority of shares cast in considering “withhold” recommendations against the full board, committee members or individual directors.  With respect to such majority supported shareholder proposals, ISS will now make vote recommendations on director elections on a case-by-case basis and will no longer require boards to fully implement majority supported shareholder proposals in all cases.  Instead, ISS will consider mitigating factors in cases involving less than full implementation, including the board’s articulated rationale for its response and level of implementation (with consideration of such rationales being a new factor not previously considered by ISS), disclosed shareholder outreach efforts by the board in the wake of the vote, the level of support and opposition for the proposal, actions taken,  and the continuation of the underlying issue as a voting item on the ballot (as either shareholder or management proposals).

Beginning in 2014, ISS will also address case-by-case whether “withhold” recommendations are warranted in the following circumstances: where the board failed to act on a takeover offer into which a majority of shares tendered and where a director received more than 50% withhold/against votes of the shares cast at the last election and the company has not addressed the issue that caused the high withhold/against vote.  Implementing an advisory vote on executive compensation on a less frequent basis than the frequency that received a plurality, but not a majority, of the votes cast at the most recent shareholder meeting at which shareholders voted on say-on-pay frequency will also result in a case-by-case review.

Pay-for-Performance Quantitative Screen.  ISS has modified the methodology for calculating its Relative Degree of Alignment (RDA) pay-for-performance screen, a core component of its say-on-pay recommendation analysis.  Currently, RDA is calculated by reference to the difference between a company’s TSR rank and the CEO’s total pay rank within an ISS-selected peer group, as measured over one-year and three-year periods (weighted 40% and 60%, respectively).  Beginning with the 2014 proxy season, ISS will eliminate the one-year measurement period and calculate RDA solely by reference to relative TSR rank and CEO total pay rank over the three-year period.

Lobbying.  ISS has revised the factors it considers in evaluating shareholder proposals requesting details on a company’s lobbying activities (direct, indirect and grassroots).  Beginning in 2014, ISS will consider the company’s current disclosure of relevant lobbying policies and oversight by the board as well as management, the company’s disclosure regarding trade associations (a new ISS focus) or other groups that it supports (or is a member of) that engage in lobbying activities, and recent significant controversies, fines or litigation regarding the company’s lobbying activities.  ISS will no longer consider the impact that the public policy issues may have on the company’s business operations, if specific issues are addressed in the proposal.

Human Rights Risk Assessment.  Beginning in 2014, ISS will consider on a case-by-case basis proposals requesting that a company conduct an assessment of the human rights risks in its supply chain or operations or publish a report on its risk assessment process.  In evaluating such proposals, ISS will consider the degree to which existing relevant policies and practices are disclosed (including as to actual implementation and oversight), the company’s industry and whether the company or its suppliers operate in areas where there is a history of human rights concerns, the presence of recent, significant controversies, fines or litigation regarding human rights involving the company or its suppliers, and whether the proposal is unduly burdensome or overly prescriptive.

Consultation on Possible Longer-Term Voting Policy Changes for 2015 and Beyond

          Director Tenure.  ISS is considering whether director tenure should be a factor in classifying directors as independent or determining vote recommendations on director elections, such as potential “withhold” votes against members of the nominating and governance committee.  As ISS notes in its explanation for the new consultation, academic studies on this topic offer conflicting conclusions.  We do not believe that there is a sufficient basis to consider an extended tenure of board service to be in and of itself indicative of a lack of director independence.  Indeed, given the significant differences in companies’ needs and directors’ attributes and experiences, this is a clear instance where a company-specific approach is superior to a rigid rule.

Director Independence.  ISS is considering whether to replace its bright-line distinctions for classifying a director as an inside director, an affiliated outside director or an independent outsider with a case-by-case analysis.  Certain of the standards that ISS currently uses to classify directors are more stringent than those used by the Securities and Exchange Commission and national stock exchanges.  In particular, ISS is considering taking into account facts and circumstances in assessing whether former CEO status, familial relationships, and professional services provided to the company should impact independence.  We encourage ISS to adopt a case-by-case approach to classifying individual directors, rather than relying on inflexible standards.

Independent Chair Shareholder Proposals.  Currently, ISS recommends a vote “for” independent chair shareholder proposals unless the company has a robust lead director position and has no other material governance or performance concerns.  ISS is considering moving away from accommodating a strong lead director structure and instead always recommending a vote “for” independent chair proposals or, alternatively, generally recommending a vote “for” independent chair proposals but considering certain company-specific circumstances, such as company size, the company’s length of time as a public entity, and CEO transition, that may warrant a combined CEO/chair position.  We believe that the current ISS policy, which permits a thorough review of a company’s governance practices and recognizes that a robust lead director structure can provide effective leadership at boards with an executive chairperson, is superior to the proposed alternatives.

Equity-Based Compensation Plans.  ISS’s current policy can result in a recommendation against an equity compensation plan based on a failure of the plan to satisfy one of six tests enumerated by ISS.  ISS is considering replacing this policy, which it describes as not taking into account mitigating factors, with a “balanced scorecard approach that allows the weighting of multiple factors in a holistic evaluation of the equity plan.”  We agree that all plan evaluations should be holistic, although any “scorecard” approach should avoid recommendations based solely on mechanical generic formulae and allow for appropriate exercise of judgment and flexibility to consider the situation of the particular company.

Auditor Ratification.  ISS is considering whether to take into account the length of auditor tenure in determining the vote recommendation to ratify independent auditors.  Currently, ISS recommends that shareholders vote to ratify auditors unless certain rare circumstances exist, such as if the auditor has a financial interest in the company or if fees for non-audit services are excessive.  The interaction between an independent auditor and a company is an area of focus for regulators, national stock exchanges and industry participants, which are well-suited to evaluate appropriate requirements for sufficient auditor independence, and that audit committees can exercise appropriate discretion as to whether to require rotation based on company-specific circumstances.  We believe that current regulations, in particular the legally mandated rotation of the lead audit partner every five years, and audit committee practices are appropriate.

*          *          *

          In contrast to policy changes in recent years, ISS’ 2014 policy updates generally avoid a “one-size-fits-all” approach to corporate governance.  However, the alternatives presented for consultation present a potential shift away from this more nuanced approach in certain important areas.  We encourage companies to express their views of these potential changes to ISS.  As always, we recommend that companies facing anticipated negative recommendations consider engaging with their shareholders and, if appropriate, with ISS in advance of the 2014 proxy season to ensure that all parties understand each company’s unique business and governance situation.

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Developments Regarding Gender Diversity on Public Boards