You Can’t Shoot Zombie Directors!

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Recently, investor advocacy groups have focused on so-called “zombie directors” – directors of public companies who are elected despite failing to garner a majority of stockholders’ votes in uncontested elections.  CalPERS recently identified 52 directors who failed to win shareholder votes but either stayed in place or subsequently were reinstated. 

Corporate laws across most states, including Delaware, generally adhere to “plurality voting,” which provides that a director receiving the most “for” votes will be elected as a director.  As a result, in an uncontested election, a director receiving just one vote would be elected even though the balance of the votes was withheld.

In recent years, various corporate governance and stockholder advocacy groups have pushed for “majority voting” for directors to make boards accountable to investors.  Majority voting generally provides that, in uncontested elections, a director nominee must receive more “for” votes than “withhold” votes (or if permitted, “against” votes) to be elected. 

The Council of Institutional Investors’ corporate governance policies state that in uncontested elections, directors should be elected by majority vote; directors who fail to receive majority support should step down from the board and not be reappointed.  According to the Council, while more than 70 percent of companies in the Standard & Poor’s 500 Index use the majority vote standard for uncontested board elections, thousands of U.S. companies still use plurality voting.  Further, the Council has noted that some companies that have embraced majority voting for directors give their boards discretion to overrule stockholders and reappoint incumbent directors who fall short of majority support in uncontested elections.

If your company has a majority voting requirement, one way to ensure that you do not have zombie directors is to institute a board policy to the effect that board nominees must submit an irrevocable resignation in advance that will become effective upon the failure of that nominee to receive a majority of votes in an uncontested election.  Such a resignation is now expressly permitted under Delaware corporate law.

But be careful of what you wish for – one unintended consequence of a majority voting requirement coupled with an advance resignation provision is that you may be left with an understaffed board.  For example, a company with a majority voting requirement runs a risk that, in an uncontested election, it may not have a sufficient number of independent directors if either a proxy advisory firm, such as ISS, or a group of dissident stockholders, wages a successful “withhold” vote campaign against some or all of the incumbent board (perhaps due to dissatisfaction with the company’s executive compensation policies).  As a result, a company may be left without a sufficient number of independent directors to satisfy stock exchange listing requirements. 

At the end of the day, in some cases, a zombie director may be better than no director!

Corporate Governance Will Play an Important Role in Swaps

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The Commodity Exchange Act (CEA), as amended by the Dodd-Frank Act, provides that it will be unlawful for any person to engage in a swap unless that person submits such swap for clearing to a derivatives clearing organization, provided the swap is required to be cleared.  The CEA delegates the authority to determine which swaps are required to be cleared to the Commodity Futures Trading Commission (CFTC).  The CFTC has determined that, starting on September 9, 2013, an entity will not be able to engage in certain classes of credit default swaps and interest rate swaps unless the entity submits the swaps for clearing.  However, this clearing requirement does not apply if one of the counterparties to the swap qualifies for and elects to rely on the “end-user exception.”

An entity will be eligible to claim the end-user exception if the entity:

  • is not a financial entity[1];
  • is using swaps to hedge or mitigate commercial risk; and
  • provides certain information to the CFTC or a swap data repository.

In addition, if the party electing this exception is a public company, then to qualify, the company’s board or an appropriate committee[2] of the board needs to review and approve the decision to enter into swaps that are exempt from the clearing requirements under the end-user exception.  This approval can be done either on a general basis or on a swap-by-swap basis.  The board or committee approval should specifically state that the board or committee, as applicable, has approved the decision to enter into swaps that are not being cleared and are not executed on a designated contract market or swap execution facility and that the company will rely on the end-user exception. 

The CFTC also expects public company boards to set appropriate policies governing the company’s use of swaps subject to the end-user exception and to review those policies at least annually and, as appropriate, more often upon a triggering event (e.g., implementing a new hedging strategy that was not contemplated in the original board approval).

Public companies that intend to rely on the end-user exception should, prior to September 9, 2013, adopt (i) appropriate board or committee approvals, and (ii) policies regarding the company’s use of swaps.

 

[1] The CFTC exempts from the definition of ‘‘financial entity’’ an entity that: (i) is organized as a bank or a savings association, among others, and the deposits of which are insured by the Federal Deposit Insurance Corporation; and (ii) has total assets of $10 billion or less on the last day of such entity’s most recent fiscal year.

[2] If a company intends to delegate this responsibility to a committee, the committee should be specifically authorized, either by charter amendment or board resolution, to review and approve the company’s decision to enter into swaps, including swaps subject to the end-user exception.

The July 1st Compliance Date for Certain of the New NASDAQ and NYSE Compensation Committee Rules is Around the Corner

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On January 11, 2013, the SEC approved proposed changes to the listing standards of the New York Stock Exchange and NASDAQ Stock Market related to compensation committees. Both exchanges created transition periods to comply with the new rules. We want to remind companies that the following new requirements take effect on July 1, 2013[1]:

Compensation Committee Charter Amendments

NASDAQ and NYSE listed companies will be required to comply with the new rules relating to the authority of a compensation committee to retain compensation consultants, legal counsel, and other compensation advisers; the authority to fund such advisers; and the responsibility of the committee to consider independence factors before selecting, or receiving advice from, such advisers[2].

NASDAQ.  The requirement that such authority and responsibilities of the compensation committee be included in the compensation committee’s written charter does not apply until a later date (see below) for NASDAQ listed companies.  Accordingly, NASDAQ listed companies should consider whether to grant such specific responsibilities and authority by July 1, 2013 through the adoption of a charter, the amendment to an existing charter, or by resolution or other board action. The requirement to adopt a compensation committee charter will not have to be complied with by NASDAQ listed companies until the earlier of their first annual meeting after January 15, 2014, or October 31, 2014.

NYSE.   NYSE listed companies will have to amend their existing charters by July 1, 2013 to address these additional rights and responsibilities of the compensation committee related to compensation consultants, legal counsel, and other compensation advisers.

Assessing the Independence of Compensation Consultants

The new NASDAQ and NYSE rules provide that the compensation committee may only select, or receive advice from, a compensation consultant, legal counsel, or other compensation adviser after considering the following factors[3]:

  • the provision of other services to the company by the person that employs the adviser;
  • the amount of fees received from the company by the person or firm that employs the adviser, as a percentage of the total revenue of the person or firm that employs the adviser;
  • the policies and procedures of the person or firm that employs the adviser that are designed to prevent conflict of interests;
  • any business or personal relationship of the adviser with a member of the compensation committee;
  • any stock of the company owned by the adviser; and
  • any business or personal relationships between the executive officers of the company and the adviser or the person or firm employing the adviser.

Compensation committees must conduct an independence assessment for all of its advisers, with limited exceptions for in-house counsel and compensation advisers that act in a role limited to (i) consulting on broad-based plans that are generally applicable to all salaried employees, or (ii) providing information that is either not customized for the issuer or that is customized based on parameters that are not developed by the adviser, and about which the adviser does not provide advice.

We note that in evaluating compensation committee adviser independence, the NYSE requires consideration of all factors relevant to an adviser’s independence from management, in addition to the six enumerated factors listed above. NASDAQ does not have a similar catch-all requirement.

Both NASDAQ and NYSE listed companies should assess the independence of their current advisers prior to July 1, 2013.  Ordinarily, this assessment will be performed before a potential adviser is selected and will then be re-assessed on an annual basis.  We would suggest utilizing a compensation committee questionnaire to solict information from the compensation consultant in order to complete this assessment. 

 

[1] The new compensation committee independence requirements do not need to be complied with by NASDAQ or NYSE listed companies until the earlier of their first annual meeting after January 15, 2014, or October 31, 2014. Nevertheless,  NASDAQ and NYSE listed companies should begin preparing to comply with such new independence requirements. 

 

[2] To the extent a NASDAQ listed company does not have a compensation committee by July 1, 2013, this requirement will apply to the independent directors who determine, or recommend for the board’s determination, the compensation of the CEO and other executive officers of the company.

 

[3] To the extent a NASDAQ listed company does not have a compensation committee by July 1, 2013, this requirement will apply to the independent directors who determine, or recommend for the board’s determination, the compensation of the CEO and other executive officers of the company.

 

Digging Deeper – SEC Issues FAQs Regarding the Conflict Minerals Rule

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Earlier today, the staff of the SEC issued long-awaited FAQs  related to the conflict mineral rules.  The FAQs provide guidance on various aspects of the conflict mineral rules including the following:

  • The conflict mineral rules apply to all issuers that file reports with the SEC under Exchange Act Sections 13(a) or 15(d), whether or not the issuer is required to file such reports.  Accordingly, the rules apply to voluntary filers.  Registered investment companies that are required to file reports pursuant to Rule 30d-1 under the Investment Company Act are not subject to the conflict mineral rules.
  • An issuer that only engages in activities customarily associated with mining is not considered to be manufacturing those minerals.
  • An issuer must determine the origin of conflict minerals, and make any required disclosures regarding conflict minerals, for itself and all of its consolidated subsidiaries.
  • Etching or otherwise marking a generic product that is manufactured by a third party, with a logo, serial number, or other identifier is not considered to be “contracting to manufacture.”
  • An issuer would be required to conduct a reasonable country of origin inquiry with respect to conflict minerals included in generic components included in products it manufactures or contracts to manufacture.  Moreover, the staff stated that there is no distinction between the components of a product that an issuer directly manufactures or contracts to manufacture and the generic ones it purchases to include in a product. 
  • Only a conflict mineral that is contained in a product would be considered “necessary to the functionality or production” of the product.  The packaging or container sold with a product is not considered to be part of the product.  This conclusion is true even if a product’s package or container is necessary to preserve the usability of that product up to and following the product’s purchase.  If, however, an issuer manufactures and sells packaging or containers independent of the product, the packaging or containers, in that circumstance, would be considered a product.
  • Issuers that manufacture or contract for the manufacturing of equipment they use in providing a service they sell are not required to report on the conflict minerals in that equipment. (i.e. cruise ship operators that manufacture or contract to manufacture cruise ships)  The staff would not object if issuers did not file reports on Form SD regarding the conflict minerals in the equipment that they manufacture or contract to have manufactured if that equipment is used for the service provided by the issuer and the equipment is retained by the service provider, is required to be returned to the service provider, or is intended to be abandoned by the customer following the terms of the service. Item 1.01(a) of Form SD requires issuers only to report on conflict minerals that are necessary to the functionality or production of “products” they manufacture or contract to have manufactured, and the staff does not interpret equipment used to provide services to be “products” under the rule.
  • If (i) an issuer manufactures or contracts to have manufactured tools, machines, or other equipment (which contain conflict minerals) which are used by the issuer in the manufacture of products, and (ii) after using such tools, machines, or other equipment the issuer subsequently sells such equipment, the issuer will not be required to file a report on Form SD regarding the conflict minerals in such equipment.  The tools, machines, or other equipment are not products of that issuer, and the staff will not view their later entry into the stream of commerce as transforming them into products of that issuer.
  • Item 1.01(c)(2) of Form SD requires an issuer that manufactures products or contracts for products to be manufactured that have not been found to be “DRC conflict free” or that are “DRC conflict undeterminable” to provide a description of those products.  The rule permits an issuer to describe its products based on its own facts and circumstances because the issuer is in the best position to know its products and to describe them in terms commonly understood within its industry.  An issuer is not required to describe its products using model numbers.  Regardless of the manner by which an issuer describes its products, however, the description in the Conflict Minerals Report filed with Form SD must state clearly that the products “have not been found to be ‘DRC conflict free’” or are “DRC conflict undeterminable,” as applicable.
  • An issuer that determines that the products it manufactures or contracts to manufacture contain conflict minerals from the Democratic Republic of the Congo or an adjoining country, but the products are “DRC conflict free,” is required to file a Form SD with a Conflict Minerals Report and obtain an independent private sector audit of the Conflict Minerals Report.  The issuer, however, is not required to disclose the products containing those conflict minerals in its Conflict Minerals Report or provide certain other disclosures specified in Item 1.01(c)(2) of Form SD because those products are “DRC conflict free.” 
  • The staff will not object if an issuer that conducts an initial public offering starts reporting under the conflict mineral rules for the first reporting calendar year that begins no sooner than eight months after the effective date of its initial public offering registration statement.
  • The failure to timely file a Form SD regarding conflict minerals will not cause an issuer to lose eligibility to use Form S-3. In determining eligibility for use of Form S-3, the requirement that the registrant has filed in a timely manner all reports and materials required to be filed during the prior twelve calendar months refers only to Exchange Act Section 13(a) or 15(d) reports and Exchange Act Section 14(a) and 14(c) materials.  Form SD regarding conflict minerals is required to be filed under Exchange Act Section 13(p).  Therefore, the filing of Form SD regarding conflict minerals does not impact an issuer’s eligibility to use Form S-3.

 

10b5-1 Trading Plans Continue to Draw Attention

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As we previously discussed, executives’ trading under Rule 10b5-1 plans has been the focus of SEC scrutiny.  The Wall Street Journal continues to publish articles casting 10b5-1 trading plans in a harsh light, and the SEC is continuing its aggressive pursuit of those illegal insider trading.  Recently, the Council of Institutional Investors wrote to the SEC to reiterate the requests made in its December 28, 2012 letter asking the SEC to consider various changes to Rule 10b5-1 or the issuance of interpretive guidance “to address the variety and number of abuses that have been identified” with respect to 10b5-1 trading plans. 

The SEC has a lot on its plate at the moment and the SEC may not address the perceived abuses or misuses of 10b5-1 trading plans any time soon.  Nonetheless, public company boards should consider reviewing their policies regarding 10b5-1 trading plans to be sure the policies are up to date and adequately address the needs of the company’s officers and directors as well as investors’ concerns.  For more on what to consider when reviewing your 10b5-1 trading plans, please see our December 2012/January 2013 issue of Up to Date.

NYSE Proposes to Move to Only Website Disclosure of Listing Application Materials and to Otherwise Streamline its Listing Application Process

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It has been a long-standing practice of the NYSE to post on its website the forms of the documents required to be submitted in connection with the NYSE listing applications. On April 30, 2013, the NYSE filed proposed rule changes to its Listed Company Manual (Manual), which, if adopted, will result in the Manual sections containing the listing application materials being deleted, and updated listing application materials will be posted only on the NYSE’s website. 

Although the NYSE amends its Manual from time to time, forms of listing agreements contained in the Manual have not always been amended to reflect changes made to the NYSE listing documents.  Some provisions in the listing agreements contained in the Manual are obsolete. The NYSE proposes to remove from the Manual (i) each of the agreements set forth in Sections 901.01 through 901.05, (ii) the form of original listing application contained in Section 903.01, and (iii) the form of supplemental listing application contained in Section 903.02. 

In the event that in the future the NYSE makes any substantive changes to those documents that are being removed from the Manual, it will submit a rule filing to the SEC to obtain approval of such changes, except for typographical or stylistic changes. The NYSE also plans to maintain all historical versions of those documents on its website after changes have been made, so that it will be possible to review how each document has changed over time. 

In addition, the NYSE proposes to state certain requirements, which it has been imposing as a matter of practice, in the Manual to add transparency to the listing process.  For example, the NYSE proposes to include in the Manual a new Section 107.00, Financial Disclosure and Other Information Requirements, which will contain the following requirements, among others:

  • Section 107.03 (SEC Compliance): No security shall be approved for listing if the issuer has not for the 12 months immediately preceding the date of listing filed on a timely basis all periodic reports required to be filed with the SEC or Other Regulatory Authority or the security is suspended from trading by the SEC pursuant to Section 12(k) of the Exchange Act.
  •  Section 107.04 (Exchange Information Requests): The NYSE may request any information or documentation, public or non-public, deemed necessary to make a determination regarding a security’s initial listing, including, but not limited to, any material provided to or received from the SEC or Other Regulatory Authority. A company’s security may be denied listing if the company fails to provide such information within a reasonable period of time or if any communication to the NYSE contains a material misrepresentation or omits material information necessary to make the communication to the NYSE not misleading. 

The NYSE also proposes to no longer require the following supporting documents in connection with an original listing application (see Section 702.04):

  •  Stock Distribution Schedule (the stock distribution schedule requirement is obsolete because the NYSE obtains the distribution information it needs from the applicant’s public filings and from its transfer agent). 
  • Certificate of Transfer Agent/Certificate of Registrar (the information that the NYSE needs about the applicant’s outstanding shares is available in its prospectus or periodic SEC reports, as well as the report of the applicant’s outstanding shares that will be required to be delivered to the Exchange once a quarter after listing). 
  • Notice of Availability of Stock Certificates (all transactions in listed securities in the national market system are conducted electronically through DTCC). 
  • Prospectus (final prospectuses are publicly available on the SEC’s website). 
  • Financial Statements (financial statements are included in the applicant’s SEC filings which are publicly available on the SEC’s website).

 

Update to Nasdaq Proposed Rule Relating to Internal Audit Function

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As we discussed previously in our recent Up to Date  issue, the Nasdaq Stock Market recently proposed a rule that would require Nasdaq listed companies to establish and maintain an internal audit function. The proposal provides that each company listed on Nasdaq on or before June 30, 2013 establish an internal audit function by no later than December 31, 2013. Companies listed after June 30, 2013 would be required to estab­lish an internal audit function prior to listing. The SEC was scheduled to approve or disapprove such proposed rule on or before April 22, 2013. However, on April 18, 2013, the SEC designated June 6, 2013, as the date by which the SEC should either approve or disapprove or institute proceedings to determine whether to disapprove the proposed rule change.

SEC Adopts New Rules Addressing Identity Theft

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Not long after being sworn in as the new Chairman of the Securities and Exchange Commission, Mary Jo White presided over her first open SEC meeting on April 10, 2013.  At that meeting, the SEC adopted rules requiring certain businesses regulated by the SEC to adopt and implement programs to detect and respond to indicators of possible identity theft.  The rules were adopted jointly by the SEC and the Commodity Futures Trading Commission (CFTC), but they aren’t exactly new.

In 2003, Congress amended the Fair Credit Reporting Act (FCRA) to require certain federal agencies to issue joint rules and guidelines on detecting, preventing and mitigating identity theft.  At that time, the FCRA did not require the SEC or the CFTC  to adopt such rules.  However, the FCRA gave the Federal Trade Commission (FTC) the authority to adopt and enforce identity theft rules related to entities regulated by the SEC and CFTC.  The Dodd-Frank Act amended the FCRA and effectively transferred rulemaking responsibility and enforcement authority with respect to identify theft rules to the SEC and CFTC with respect to those entities that are subject to each agency’s enforcement authority.  

The SEC indicates in its press release that the proposed SEC/CFTC rules relating to identify theft were largely identical to the rules that the FTC and the other federal agencies adopted under the FCRA (see our Up to Date article regarding proposed rules).  The SEC’s rules apply only to SEC-regulated entities that meet the definition of “financial institution” or “creditor” in the FCRA, such as broker-dealers, mutual funds and investment advisers.  The rules generally require these entities to adopt an identity theft prevention program designed to (i) identify relevant types of identity theft red flags, (ii) detect the occurrence of those red flags, (iii) respond appropriately to those red flags, and periodically update the identity theft program.  The rules go into effect 30 days after publication in the Federal Register and compliance is required six months after the effective date.

The Green Light to Social Media Use for Regulation FD Purposes Looks More Like Yellow

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I was excited to see the SEC’s press release about its report of investigation related to Netflix and social media issues yesterday.  The report (i) brings closure to the Division of Enforcement investigation of whether Netflix, Inc. and its CEO, Reed Hastings, violated Regulation FD and Section 13(a) of the Securities Exchange Act of 1934 (see previous blog posts and coverage in Up to Date newsletter about Netflix and Mr. Hastings each receiving a “Wells Notice” from the SEC Staff in connection with Mr. Hastings’ July 2012 announcement on his Facebook page that Netflix’s monthly viewing exceeded 1 billion hours) and (ii) provides guidance on the use of social media for Regulation FD purposes. 

The report brings good news that the SEC determined not to pursue an enforcement action against Netflix and Mr. Hastings (a different determination was likely to have a chilling effect on corporate communications via social media channels).  And even more significantly, the SEC uses this report as a forum to extend the principles set forth in its 2008 Guidance on the Use of Company Web Sites (2008 Guidance) to announcements made through social media channels (e.g., Facebook and Twitter) for Regulation FD compliance purposes. 

The cornerstone of Regulation FD is the concept that material non-public information should be disseminated in a manner “reasonably designed to provide broad, non-exclusionary distribution of the information to the public.” When the SEC issued its 2008 Guidance, it officially acknowledged that a company’s website could serve as a broad, non-exclusionary method of distribution of the information to the public under Regulation FD, provided such website was a recognized channel of distribution.  The SEC now expects issuers “to examine rigorously the factors indicating whether a particular [social media] channel is a ‘recognized channel of distribution’ for communicating with their investors.”  

The SEC’s report emphasizes the importance of providing notice to “the market about which forms of communication a company intends to use for the dissemination of material, non-public information, including the social media channels that may be used and the types of information that may be disclosed through these channels.”  The SEC suggests that “disclosures on corporate websites identifying the specific social media channels a company intends to use … would give investors and the markets the opportunity to take the steps necessary to be in a position to receive important disclosures — e.g., subscribing, joining, registering, or reviewing that particular channel.”  Netflix chose to file a Form 8-K on April 10, 2013 encouraging investors and the media to review the information posted on the social media channels listed in its Form 8-K, including Mr. Hastings’ Facebook page.

However, in addition to the notice to investors, applying the 2008 Guidance, there are other factors that are important in the determination of whether the company’s website, and now social media channels, can be viewed as “recognized” channels of distribution of information.  For example, companies should evaluate “the extent to which information posted … is regularly picked up by the market and readily available media, and reported in, such media … and the size and market following of the company involved.” 

Having read the report, my initial excitement has faded.  The SEC guidance leaves a company to perform a difficult facts-and-circumstances analysis of whether the company’s website or Facebook page is a recognized channel of distribution of information to the investing public even if the company provides the required notice to investors.  In the absence of a clear definition of what constitutes such “recognized channel,” companies may not be utilizing the full potential of the SEC’s 2008 Guidance and its 2013 extension to social media channels.

The SEC Is Taking a Hard Look at Fixed Income Markets

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On March 28, 2013, the SEC announced the agenda and potential topics for discussion at its April 16 Fixed Income Markets Roundtable. The roundtable will focus on the transparency and efficiency of fixed income markets and will be divided into four panels. The first two panels will examine the current market structure for municipal securities and corporate bonds, and the last two panels will discuss potential improvements to the market structure for municipal securities, corporate bonds and asset-backed securities. The SEC’s list of possible agenda items for the panels makes it clear that the SEC is taking a hard look at the structure of the fixed income markets. Please see below a few discussion points related to corporate bonds that the SEC is interested in:

• How large is the corporate bond market? How diverse is the universe of corporate bond issuers and products? How large is the institutional investor presence? If a retail customer wishes to buy or sell a corporate bond, how would the transaction typically be handled by the customer’s broker? Does the process for buying and selling a corporate bond differ for an institutional investor?

• Does trading in corporate bonds differ depending on whether the bonds were sold in offerings registered under the Securities Act or in private offerings, including Rule 144A eligible offerings? Do different types of corporate bonds (e.g., plain vanilla, convertible bonds, structured debt) trade differently? Do investment grade bonds trade differently from non-investment grade bonds?

• What are the liquidity characteristics of the corporate bond market? Do some types of corporate bonds tend to be more liquid than others? If so, which ones and why?

• Are transaction costs for certain types of convertible bonds (e.g., convertible bonds, high-yield bonds) materially different from other corporate bonds?

• Does the primary offering process differ depending on whether it is registered under the Securities Act or made in reliance on an exemption from registration, including Rule 144A eligible offerings? Does it differ based on the type of debt being offered? What are the significant trends in the primary market for corporate bonds? What are the trends in private debt and how do they affect the public debt markets? Are there concerns about the availability of corporate bonds in primary offerings?

• Does the pricing of primary offerings or do prices in the secondary market differ depending on whether the bonds were sold in registered offerings or in exempt offerings, including Rule 144A eligible offerings? Does pricing differ depending on the type of purchaser for the corporate bonds?

• Are there ways to improve the availability or timing of information on the corporate bond issuer that is made available to investors? Are there ways to improve the pricing of corporate bonds in primary offerings?

The SEC expects that the information provided in connection with this roundtable may influence the SEC’s decision to engage, or not engage, in rulemaking in this area.