NASDAQ Proposes to Align its Independence Standards for Compensation Committee Members with the NYSE’s Approach to Such Standards

On November 26, 2013, The NASDAQ Stock Market LLC proposed to amend its listing rules on compensation committee composition (Rule 5605(d)(2)(A) and IM-5605-6) to replace the prohibition on the receipt of compensatory fees by compensation committee members with a requirement that a board of directors instead consider the receipt of such fees when determining eligibility for compensation committee membership.  NASDAQ cited the feedback that it had received from listed companies as the reason for these changes.  The proposed rules are almost identical to the NYSE’s rules related to compensation committee independence and, if adopted, would remove the anomaly of NASDAQ listing rules being more stringent than NYSE rules.

The proposed Rule 5605(d)(2)(A) states that in affirmatively determining the independence of any compensation committee member, the board must consider all factors specifically relevant to determining whether a director has a relationship to the company which is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member, including, but not limited to:

  • the source of compensation of such director, including any consulting, advisory or other compensatory fee paid by the company to such director; and
  • whether such director is affiliated with the company, a subsidiary of the company or an affiliate of a subsidiary of the company.

In IM-5605-6, NASDAQ proposes to clarify that when considering the sources of a director’s compensation in determining compensation committee member independence, the board should consider whether the director receives compensation from any person or entity that would impair the director’s ability to make independent judgments about the company’s executive compensation, including compensation for board or board committee services. 

The approach to the affiliation prong of the independence analysis is not significantly changed in the proposed rules.  However, NASDAQ proposes to revise IM-5605-6 to explain that the board should consider whether the affiliate relationship places the director under the direct or indirect control of the company or its senior management, or creates a direct relationship between the director and members of senior management, in each case of a nature that would impair the director’s ability to make independent judgments about the company’s executive compensation.

Companies are required to comply with the compensation committee composition aspects of the NASDAQ rules by the earlier of their first annual meeting after January 15, 2014, or October 31, 2014.  NASDAQ intends to implement the proposed changes before companies suggest changes to board and committee composition in connection with their 2014 annual meetings.

Board Oversight of Political Contributions Is Steadily Rising

In September 2013, the Center for Political Accountability and the Zicklin Center for Business Ethics Research published their third annual index of political accountability and disclosure (2013 Index), which focuses on political spending disclosure of the top 200 companies in the S&P 500 Index. The Index reviews companies’ policies disclosed on their websites and describes:

  • the ways that companies manage and oversee political spending;
  • the specific spending restrictions that many companies have adopted; and
  • the policies and practices that need the greatest improvement.

The 2013 Index demonstrates that of the 195 companies reviewed in both 2012 and 2013, 78% of companies improved their overall scores for political disclosure and accountability.  In particular, data from the 2013 Index indicates that a growing number of companies have some level of board oversight of their political contributions and expenditures.  For example,

  •  62% of companies said that their boards of directors regularly oversee corporate political spending in 2013, compared to 56% in 2012;
  • 57% of companies said that a board committee reviews company policy on political spending in 2013, compared to 49% in 2012; and
  • 56% of companies said that a board committee reviews company political expenditures in 2013, compared to 45% in 2012.

Companies Listing on the NYSE Can Appoint an Internal Auditor Within a Year after an IPO

On August 22, 2013, the SEC approved the NYSE’s proposal that permits a company listing in conjunction with an IPO to comply with the internal audit function requirement of Section 303A.07(c) of the NYSE Listed Company Manual within one year of the listing date.  NYSE rules now require such company to have an internal audit function in place no later than the first anniversary of its listing date[1].  Previously, NYSE rules only required each listed company to have an internal audit function but did not provide any transition period for companies listing in connection with an IPO.  

The new one-year transition period for compliance with an internal audit function requirement expanded NYSE corporate governance provisions, to which a transition period applies in connection with an IPO.  Such provisions relate to the composition of the board of directors as well as the composition of the nominating, compensation and audit committees (see Section 303A.00). 

The NYSE believes that a transition period for establishing an internal audit function will make the company’s process of implementation of such function more effective and will reduce the costs it faces in its first year as a public company.  The NYSE also expects that this transition period would enable the company’s audit committee to play a significant role in the design and implementation of the company’s internal audit function. 

In case of a company availing itself of a one-year transition period with respect to its internal audit function, the audit committee must:

  • assist board oversight of the design and implementation of the internal audit function; and
  • meet periodically with the company personnel primarily responsible for the design and implementation of the internal audit function.

Once the company establishes its internal audit function, the audit committee must (i) assist board oversight of the performance of the company’s internal audit function, and (ii) meet periodically with internal auditors or other personnel responsible for the internal audit function.

In addition, if the listed company does not yet have an internal audit function because it is using the internal audit function transition period, the audit committee’s review with the independent auditor of any audit problems should include a discussion of management’s plans with respect to the responsibilities, budget and staffing of the internal audit function and its plans for the implementation of the internal audit function.  Once the transition period is over, the audit committee’s review with the auditors should include a discussion of the responsibilities, budget and staffing of the company’s internal audit function.

The audit committee should also discuss with the board management’s activities with respect to the design and implementation of the internal audit function during the transition period, and after the transition period, the audit committee should review with the full board any issues that arise with respect to the performance of the internal audit function.

 Generally, a listed company must maintain an internal audit function to provide management and the audit committee with ongoing assessments of the company’s risk management processes and system of internal control, and the company can outsource an internal audit function to a third party service provider (other than the company’s independent auditor).   

 

 

 


[1] It is interesting to note that The NASDAQ Stock Market LLC (NASDAQ) does not have an internal audit function requirement.  Earlier this year, NASDAQ proposed, and later withdrew, an amendment to its listing requirements that each listed company establish and maintain an internal audit function to provide management and the audit committee with ongoing assessments of the company’s risk management processes and system of internal control.  The SEC received 42 comment letters on the proposal, and NASDAQ stated in its withdrawal that it was withdrawing the proposal to fully consider such comments and that it intends to file a revised proposal (see SEC Release No. 34-69792).

You Can’t Shoot Zombie Directors!

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

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

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.

 

10b5-1 Trading Plans Continue to Draw Attention

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.

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

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.

Netflix’s CEO Facebook Post Triggers a Debate

We have previously blogged about and covered in our Up to Date newsletter the fact that Netflix and its CEO, Reed Hastings, each received a “Wells Notice” from the SEC Staff over Hastings’ Facebook post in July 2012, in which Mr. Hastings wrote that Netflix’s members had enjoyed over one billion hours in June 2012.  The SEC Staff indicated in the Wells Notice its intent to recommend to the SEC that it institute a cease and desist proceeding and/or bring a civil injunctive action against the company and Mr. Hastings for violations of Regulation FD, Section 13(a) of the Securities Exchange Act and Rules 13a-11 and 13a-15.

Mr. Hastings continues to post on Facebook and said in an interview last week referring to his July post, “I’m not going to back down and say it’s inappropriate. I think it’s perfectly fine. Sometimes you’re just the example that triggers the debate.”  Mr. Hastings post has indeed triggered the debate of what constitutes “public disclosure” of material information under Regulation FD. 

Regulation FD requires a public company to publicly disclose material, non-public information (oral or written) that is selectively disclosed to market professionals and securityholders.  Under the regulation, the required public disclosure may be made by filing or furnishing a Form 8-K, or by another method or combination of methods that is reasonably designed to effect broad, non-exclusionary distribution of the information to the public.  

Despite this broad approach, from the time of the adoption of Regulation FD in 2000 until August 2008, a press release or a Form 8-K was practically the only form of distribution of information under Regulation FD.  In August 2008, when the SEC issued its Guidance on the Use of Company Web Sites (2008 Guidance) it officially acknowledged that a company website could serve as a broad, non-exclusionary method of distribution of the information to the public under Regulation FD, provided (i) such website is a recognized channel of distribution, (ii) posting of information on a company website disseminates the information in a manner making it available to the securities marketplace in general, and (iii) there has been a reasonable waiting period for investors and the market to react to the posted information.

The debate started by Mr. Hastings has revealed that there are two unofficial “camps” on this issue: one camp believes that CEOs and other public company executive officers should refrain from posting company information on social media to ensure that Regulation FD and other securities rules and regulations are not violated, and the other camp encourages the SEC to take a clear position on which social media postings would be considered Regulation FD compliant given the role that social media is playing in our society today.

It seems that Joseph A. Grundfest, Stanford Law School professor and former SEC commissioner, is in the second camp.  On January 30, 2013, Stanford Law School and The Rock Center for Corporate Governance published his article, Regulation FD in the Age of Facebook and Twitter:  Should the SEC Sue Netflix? This article is in the form of an amicus Wells Submission and suggests that the SEC should proceed by rulemaking to address issues raised by the evolution of social media instead of initiating enforcement proceedings against Netflix and Mr. Hastings.  Professor Grundfest’s article stated that any prosecution on these facts would constitute a “dramatic divergence from precedent” and would violate the SEC’s commitments not to “second guess” good faith attempts to comply with Regulation FD. Professor Grundfest also believes that while the posting was not “inconsistent with the Commission’s 2008 Guidance regarding the implementation of Regulation FD and the use of company websites, that guidance is, in any event, outdated because it fails to account for the evolution of social media.”  

Other interesting arguments outlined in Professor Grundfest’s article include the following:

  • Regulation FD is vulnerable as an unconstitutional restraint on truthful speech, particularly as applied on the facts of this case.
  • The Staff’s Wells Notice has already had a chilling effect on the use of social media without a contemporaneous Form 8-K filing. The Staff has thus obtained much of the remedy it seeks without subjecting its action to SEC review.
  • The proposed enforcement action is a questionable allocation of limited agency resources.
  • The SEC’s regulatory solution should emulate many practices that are now common in the social media rather than challenge information dissemination through the social media.

Generally, I give conservative advice to executives to stay away from the social media posts until the SEC comes out with additional rulemaking on this issue.  But I have to confess that now I am one of Reed Hastings’ 200,000 + followers on Facebook to be able to follow firsthand posts that may lead the SEC to extend permissible broad non-exclusionary forms of distribution of information under Regulation FD to social media.

SEC Announces Small and Emerging Companies Advisory Committee Agenda

The SEC has announced the agenda for a meeting of its Advisory Committee on Small and Emerging Companies being held this Friday, February 1st.
The Committee will consider recommendations about:
• trading spreads for smaller exchange-listed companies,
• creation of a separate U.S. equity market limited to sophisticated investors for small and emerging companies, and
• disclosure rules for smaller reporting companies.
The meeting will begin at 9:30 a.m. in the multi-purpose room at the SEC’s Washington D.C. headquarters. Public seating will be on a first-come, first-served basis. The event will be webcast live on the SEC website and will be archived for later viewing.
For information about providing written comments, see the SEC’s press release available at http://www.sec.gov/news/press/2013/2013-11.htm.