Securities Mosaic® Blogwatch
September 29, 2016
90 Cents of Every "Pay-for-Performance" Dollar are Paid for Luck
by Moshe Levy
Editor's Note:

Moshe Levy is a professor at the Hebrew University of Jerusalem, Jerusalem School of Business Administration. This post is based on a recent paper by Professor Levy. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

It is well-known that CEOs are sometimes rewarded for luck. The classic example is that of oil company CEOs whose compensations increase with the price of oil (Bertrand and Mullainathan 2001). This has been show to hold for other factors that are both outside the control of the manager, and observable to the boards who grant compensation, yet rarely adjust it for these factors. My paper is an attempt to estimate the magnitude of the pay-for-luck component in option-based compensation. How much of the “pay-for-performance” compensation is actually paid for luck?

The answer to this question depends on the ratio between the manager’s talent, T, defined as her ability to increase the firm’s average return, and the inherent “noise” in the stock’s returns, as measured by the standard deviation of returns, σR. We develop an analytical expression for the proportion of option-based compensation that constitutes pay-for-luck as a function of the ratio σ ∕ T. We show that this proportion grows very quickly with σ ∕ T. For the empirically estimated parameters the pay-for-luck component exceeds 90% of the compensation. This result is robust, and stems from the fundamental fact that chance plays a dominant role in determining firm performance.

The large pay-for-luck component implies that, perhaps in contrary to widespread belief, standard option-based compensation does not constitute a strong motivational force for the manager. Indeed, we show that an option’s motivational force is inversely related to its pay-for-luck component. Consider, for example, a manager with talent T=2%, i.e. a manager who can increase the firm’s average annual return by 2% if she exerts effort and manifests her talent. Alternatively, the manager can refrain from exerting effort to manifest her talent, in which case the firm’s average return will be the same as the industry average. By how much does the manager’s expected compensation increase as a result of her effort? We show that for standard non-indexed at-the-money options and realistic parameters the increase is only about 12% relative to the case of exerting no effort. This does not seem to constitute a very strong motivational force. It seems likely that other factors, such as ego, self-fulfillment, and the desire not to be perceived as lazy, are likely much more effective motivating forces. We find that indexing the option to the market (or industry, or both) and setting its strike price 50% higher than the granting-day price almost doubles the option’s motivational force.

Employee stock options may very well be a desirable component of executive compensation. This paper shows that the standard form of option compensation, with non-indexed at-the-money options, is very far from optimal, though, as its pay-for-luck component is in the ballpark of 90%, and its motivational power is rather low. Why are such options the standard practice? A possible answer is provided by the “skimming” view of Bebchuk and Fried (2009). Indexing the option, and setting the strike price much higher than the granting-day price almost doubles the option’s motivational power. It is thus hard to justify the current norm of granting options at-the-money and not indexing them to the industry or market returns.

The full paper is available for download here.

September 29, 2016
Preparing for the 2017 US Proxy and Annual Reporting Season
by Andrew Stanger, David Schuette, Harry Beaudry, Laura Richman, Michael Hermsen, Robert Gray, William Heller, Mayer Brown
Editor's Note:

Laura D. Richman is counsel and Michael L. Hermsen is partner at Mayer Brown LLP. This post is based on a Mayer Brown publication by Ms. Richman, Mr. Hermsen, Harry R. Beaudry, Robert F. Gray, William T. Heller, David A. Schuette, and Andrew J. Stanger.

With autumn just beginning, the proxy and annual reporting season may seem a long way off. However, in light of the amount of work and planning that goes into the proxy statement, annual report and annual meeting of shareholders, this is the ideal time to begin preparations. This post provides an overview of key issues that companies should consider as they get ready for the upcoming 2017 proxy and annual reporting season.

Say-on-Pay and Related Compensation Matters Say-on-Pay

As a result of six years of say-on-pay voting, executive compensation has become a prominent part of the proxy season landscape. Companies have expanded shareholder engagement to encompass executive compensation issues. Many companies are devoting resources to the enhancement of design and style elements in proxy statements—employing color, graphics and plain English—in an effort to more clearly present the link between pay and performance and otherwise make the proxy statement more reader-friendly.

Since the say-on-pay vote became mandatory, shareholders generally have approved executive compensation, often by large margins. Semler Brossy, an executive compensation consultant, reports that, as of July 25, 2016, only 31 Russell 3000 companies (1.7 percent) experienced a failed say-on-pay vote in 2016. The average vote in favor of say-on-pay proposals during that time period was 91 percent. Of the 1,388 Russell 3000 companies that conducted say-on-pay votes in each year between 2011 and 2016, only 10 percent have ever had a failed say-on-pay vote (in some cases more than once); however, 28 percent have received favorable votes at a level below 70 percent at least once.

Although say-on-pay votes are usually favorable, that fact is of little comfort to companies facing the prospect of a negative, or relatively low favorable, say-on-pay vote. While negative recommendations do not always result in failed say-on-pay votes, proxy advisory firms, such as Institutional Shareholder Services (ISS) and Glass Lewis, can be very influential. Many, but not all, companies that receive a negative say-on-pay recommendation from a proxy advisory firm choose to file additional proxy materials with the Securities and Exchange Commission (SEC) that they can present to shareholders to counter the arguments made by the proxy advisory firms. Sometimes a company will make, and publicly disclose, changes to its executive compensation program in an effort to receive a favorable recommendation or obtain a favorable vote. Companies often seek to increase their shareholder engagement in the face of a negative proxy advisory recommendation, although it is more difficult to gain an audience with busy institutional investors during the height of proxy season than it is during the “off season.”

A company’s compensation discussion and analysis must describe whether and, if so, how it has considered the results of the most recent say-on-pay vote in determining compensation policies and decisions and how that consideration affected such policies and decisions. If a company’s say-on-pay vote ultimately fails or is otherwise below 70 percent in favor, it will be especially important for the company to establish that its compensation committee has taken the results of the vote into account when making subsequent decisions. Companies in this situation should consider engaging with shareholders following the meeting to identify what concerns investors have, including the specific elements of its executive compensation program that were viewed as problematic, if any, and ways in which they might address valid concerns.

While the say-on-pay vote is an advisory vote, it can be perilous to ignore a vote against, or a low vote in favor of, executive compensation. Generally, companies whose say-on-pay votes fail make some changes to their executive compensation programs to avoid another failed say-on-pay vote. Failure to do so can result in votes against members of the compensation committee or other directors. Once a company files a Form 8-K following the meeting to report voting results pursuant to Item 5.07, it will be a matter of easily accessible public record if any director’s support has diminished vis-à-vis other directors or prior year votes. Even if such opposition does not result in directors failing to win reelection, the targeted directors may suffer reputational harm.

Compensation Litigation

In recent years executive compensation programs sometimes have given rise to litigation against companies and their directors, with lawsuits alleging breach of fiduciary obligations, alleging insufficient compensation-related proxy disclosures, seeking to enjoin annual meetings and/or challenging specific compensation actions. Accordingly, compensation decisions should be made, and compensation disclosures should be prepared, with care, especially for companies that anticipate resistance to their executive compensation policies. In addition, compensation committee members should be able to demonstrate that they exercised due care in applying their business judgment to executive compensation by reviewing adequate information, asking questions and understanding the pros and cons of various alternatives, any or all of which can involve the assistance of company or outside experts, as appropriate.

Director compensation, which can raise issues of self-dealing requiring a heightened “entire fairness” standard rather than the business judgment rule, has also been the subject of litigation. To minimize this risk, companies and boards should carefully review existing director compensation arrangements (perhaps on a separate cycle from executive compensation) and consider adding shareholder approved annual limits or annual formula-based awards to current (or new) plans. Alternatively, companies and boards may choose to develop a factual record of these arrangements with a view to withstanding an “entire fairness” scrutiny, including by reviewing director compensation paid at a carefully selected group of comparable companies, possibly with the assistance of an outside expert.


Rule 14a-21(b) first required public companies to conduct an advisory vote on the frequency of the say-on-pay vote at the first annual or other meeting of shareholders on or after January 21, 2011, with subsequent frequency votes no more than every six years thereafter. As a result, many public companies will be required to include an agenda item for their 2017 annual meetings asking shareholders if the say-on-pay vote should occur every one, two or three years. This will need to be done even if the company is already conducting its say-on-pay vote annually and intends to continue this practice. In addition, the Form 8-K reporting voting results will need to disclose not only the results of the say-when-on-pay vote, but also the frequency with which the company intends to conduct the say-on-pay vote in light of the results of the advisory frequency vote. (The intended frequency may be disclosed by amendment to that Form 8-K filed within 150 calendar days after the shareholders’ meeting, as long as the disclosure is made within 60 days prior to the deadline for shareholder proposals.)

Shareholder Proposals General Considerations

Rule 14a-8 under the Securities Exchange Act of 1934 (Exchange Act) permits shareholders who have either owned at least $2,000 in market value or one percent of the voting stock for one year to submit a proposal that a company must include in its proxy statement, unless the proposal has specified procedural deficiencies or can be excluded based on one of the 13 substantive grounds that are set forth in the rule. Shareholder proposals are often one of the first topics that companies address at the start of any proxy season as a result of deadlines specified by Rule 14a-8 for submission of proposals and for notifying the SEC if companies plan to exclude any shareholder proposals. Less frequently, a company may initiate a lawsuit seeking a declaratory judgment that a proposal may be excluded.

To determine whether there is a reasonable basis to exclude a shareholder proposal from a proxy statement, a company should review precedent no-action letters pursuant to Rule 14a-8 as well as the series of Staff Legal Bulletins addressing Rule 14a-8. If a company believes that Rule 14a-8 provides grounds to exclude the shareholder proposal from its proxy statement, it must notify the SEC, generally by submitting a no-action request to the staff of the SEC’s Division of Corporation Finance (Staff), describing each basis upon which the company believes it may omit the shareholder proposal and seeking its concurrence, and the company must provide the proponent with a copy of its submission. Alternatively, or in addition to submitting a no-action request, companies often attempt to negotiate with the proponent to see if an agreement can be reached resulting in the withdrawal of the proposal.

When available, procedural deficiencies (such as failing to provide the requisite proof of ownership) offer clear bases supporting a no-action request to omit a shareholder proposal from the proxy statement but only if the company complies with the Rule 14a-8 requirements and notifies the proponent in writing about the defect within 14 days of its receipt of the proposal. The company does not have to notify the proponent of a defect that cannot be remedied, such as late submission of the proposal. After receiving a notice of a procedural defect, the proponent has 14 days to correct the deficiency. Because these deadlines require prompt action, it is important for companies to have procedures in place to promptly disseminate shareholder proposals internally and to quickly review and analyze shareholder proposals under Rule 14a-8 to identify potential defects in time to preserve an effective basis for exclusion.

If a company must include in its proxy statement a shareholder proposal that the company does not support, the company should carefully draft a persuasive statement of opposition. It must send this statement to the proponent of the proposal at least 30 days before the company files its definitive proxy statement.

Proxy Access

Proxy access initiatives made significant inroads during the last two proxy seasons. Much of the impetus for proxy access came from the Boardroom Accountability Project campaign launched by the Comptroller of New York City and the New York City Pension funds, which submitted proxy access proposals to 75 companies during the 2015 proxy season and to 72 companies for the 2016 proxy season. The proxy solicitation and corporate advisory firm, Alliance Advisors, reports that over 200 proxy access resolutions were submitted by shareholders during the 2016 US proxy season and that, as a result of negotiated withdrawals and voluntary adoptions, over 250 companies had established proxy access rights by the end of June 2016. According to Alliance Advisors, through July 1, 2016, shareholders voted on 79 shareholder-sponsored proxy access proposals, receiving on average 51.1 percent support from shareholders. Of these proxy access proposals, 41(representing 52 percent of the total) received majority votes in favor.

In October 2015, the Staff issued Staff Legal Bulletin No. 14H (SLB 14H) providing, among other matters, that a shareholder proposal would be excludible as directly conflicting with a management proposal only if a reasonable shareholder could not logically vote in favor of both proposals. SLB 14H expressly applied this principle to proxy access, specifying that a shareholder proposal requesting proxy access for a shareholder or group of shareholders holding at least three percent of the company’s outstanding stock for at least three years to nominate up to 20 percent of the directors would not directly conflict with a management proposal that would allow shareholders holding at least five percent of the company’s stock for at least five years to nominate for inclusion in the company’s proxy statement 10 percent of the directors. As a result, no-action requests related to proxy access proposals largely shifted to substantially implemented arguments during the 2016 proxy season. For further information on SLB 14H, see our Legal Update, “US SEC Provides Guidance on Excluding Shareholder Proposals from Proxy Statements,” dated November 3, 2015.

Early in the 2016 proxy season, the Staff granted a series of no-action requests to exclude from their proxy statements shareholder proposals requesting the adoption of proxy access where the companies had adopted proxy access provisions that they claimed “substantially implemented” such proposals before their annual shareholders meetings. The Staff agreed that the companies had substantially implemented the shareholder proposals where they had adopted provisions granting proxy access to shareholders who held three percent of the company’s stock for three years, even though the provisions adopted did not completely mirror the other terms of the shareholder proposals. In these cases, the Staff was satisfied that the proposals that the companies adopted achieved the “essential objective” of the proxy access provision requested by the shareholder proposals.

On the other hand, the Staff denied the no-action requests of companies that argued that they had substantially implemented the requested proxy access proposal when their provisions used a five percent ownership threshold. In those situations the Staff concluded that the policies, practices and procedures adopted by those companies did not compare favorably with the guidelines of the shareholder proposals and that the companies had not, therefore, substantially implemented the proposals.

Most of the US proxy access provisions that have been adopted use a three percent ownership/three-year threshold, comparable to the threshold that the SEC adopted in its original proxy access rule, which was vacated by court action. Other typical terms include requiring shareholders to have full voting and economic ownership in order to use proxy access and allowing aggregation by groups of not more than 20 shareholders to reach the designated threshold. It is also common to limit the number of proxy access nominees to 20 percent of the board, but often with a minimum of two nominees. Although there are quite a few other details on which proxy access provisions vary, to a large degree there have been a sufficient number of US proxy access provisions adopted that there is a growing consensus as to which variations are viewed as “market.”

Companies that do not allow for proxy access may receive shareholder proposals requesting that proxy access be adopted. Such companies may want to consider adopting their own proxy access provisions in order to incorporate the detailed aspects in a manner that they think makes sense, while at the same time satisfying the essential objectives test necessary to persuade the Staff that the shareholder proposals have been substantially implemented. Other companies may choose to submit shareholder proxy access proposals to a vote of shareholders.

Companies that have already adopted proxy access provisions may nevertheless receive proxy access shareholder proposals during the 2017 proxy season that request amendments to specific features of their existing provisions that certain shareholders find objectionable. When a shareholder requests particular amendments to a proxy access provision, a company should expect that it will be more difficult to convince the Staff that a proposal has been substantially implemented by an existing proxy access provision that does not contain the revisions that are being specifically requested.

For example, in H&R Block, Inc. (available July 21, 2016), the Staff did not permit the company to exclude from its proxy statement a proxy access shareholder proposal as being substantially implemented by an existing three percent/three year proxy access bylaw. In that situation, the shareholder proposal requested that the following four substantive revisions be made to the proxy access bylaw:

  • Increasing the number of proxy access nominees to the board of directors to the greater of 25 percent or two nominees
  • Permitting loaned securities to be counted toward the ownership threshold in certain circumstances
  • Eliminating the cap on the number of shareholders that can aggregate their shares to achieve the required three percent ownership threshold for proxy access nominations
  • Eliminating renominations based on the number or percentage of votes received in any election

The Staff responded to H&R Block’s no-action request by stating that it was unable to conclude that the existing proxy access bylaw compared favorably to the guidelines of the proposal. Comparing H&R Block and proxy access no-action relief granted earlier in 2016, it appears that the Staff draws a distinction between proposals requesting the adoption of proxy access provisions and proposals requesting specific amendments to existing proxy access provisions.

Accordingly, despite many voluntary adoptions of proxy access bylaw provisions during the past year, proxy access is likely to be a continuing subject of shareholder proposals during the 2017 proxy season.

Other Shareholder Proposals

In addition to proxy access, proposals submitted during the 2016 proxy season that companies might anticipate receiving for the 2017 proxy season include corporate governance proposals regarding independent board chairs, action by written consent of shareholders, special shareholder meetings, supermajority voting and board diversity, as well as political contribution and lobbying proposals, environmental and social proposals (such as proposals addressing climate change and greenhouse emissions), and compensation proposals (such as proposals relating to golden parachutes, stock retention, gender pay equality and adjustment of executive pay metrics to exclude the impact of stock buybacks). There are also rumblings of new sorts of proposals for 2017, such as proposals to preclude Internet-only virtual shareholder meetings. For a discussion of virtual shareholder meetings, see “Annual Meeting Mechanics—Virtual Meetings” below.

Dodd-Frank Compensation-Related Rulemaking

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) directed the SEC to adopt rules in several areas involving compensation-related matters, as discussed below.

Pay Ratio Disclosure

Pursuant to the SEC’s final pay ratio disclosure rule, initial pay ratio disclosure will be required with respect to compensation for a company’s first full fiscal year that begins on or after January 1, 2017. Therefore, companies generally will first be required to include pay ratio disclosure in their 2018 proxy statements or later in the case of companies that are new SEC registrants. Pay ratio disclosure will be required in all filings that require executive compensation disclosure pursuant to Item 402 of Regulation S-K, such as proxy statements.

Briefly, pay ratio disclosure will require public companies to disclose:

  • The median of the annual total compensation of all employees other than the chief executive officer;
  • The annual total compensation of the chief executive officer; and
  • The ratio of these amounts.

Although pay ratio is not required for 2017 proxy statements, companies that will be required to provide pay ratio disclosure need to devote time and resources now to prepare for compliance with the rule. Companies should be determining the methodology they will use to calculate and report their pay ratio disclosure and, if necessary, coordinating their reporting systems in various jurisdictions. Companies should evaluate their payroll and other compensation recordkeeping systems for planning purposes, develop strategies for compliance and consider how they will update their disclosure controls and procedures for pay ratio disclosure. Employees responsible for assembling the information needed for the disclosure should be sure they understand what compensation programs the company has, including on a worldwide basis if the company has employees outside of the United States. In addition, it should be determined whether gathered information needs to be adjusted to reflect differences in internal compensation reporting systems in various jurisdictions. Companies should be developing adequate disclosure controls and procedures to ensure compliance. In addition, compensation committees may want to preview what the ratio is likely to be.

The pay ratio calculation must include full-time, part time, temporary and seasonal employees, including employees based outside the United States. The rule permits a company to annualize the compensation for all permanent employees, whether full-time or part-time, who were employed on the calculation date but did not work for the company for the full fiscal year, but the rule does not permit annualization for temporary or seasonal employees. In addition, the pay ratio disclosure rule does not permit the use of full-time-equivalent adjustments.

The pay ratio disclosure rule provides an exemption for employees in a foreign jurisdiction in which data privacy laws or regulations are such that, despite the company’s reasonable efforts to obtain and process the information necessary to comply with the pay ratio disclosure rule, the company is unable to do so without violating those data privacy laws or regulations. It also provides a de minimis exemption for non-US employees representing five percent or less of a company’s total employees.

The pay ratio disclosure rule gives companies flexibility to select a method for identifying the median employee that is appropriate to the size and structure of their businesses and compensation programs. Companies may determine the median employee based on any consistently used compensation measure, such as compensation amounts reported in its tax and/or payroll records. Companies will be permitted to identify the median employee based on total compensation regarding their full employee population. Alternatively, they may do so by using a statistical sample or another reasonable method.

The above description contains just a brief summary of the pay ratio disclosure rule. For more information on the SEC’s pay ratio disclosure rule, see our Legal Update, “Understanding the SEC’s Pay Ratio Disclosure Rule and its Implications,” dated August 20, 2015.


In 2015, the SEC proposed a new rule directing national securities exchanges and associations to establish listing standards that prohibit the listing of any security of a company that does not adopt and implement a written policy requiring the recovery, or “clawback,” of certain incentive-based executive compensation payments. The recovery would be the amount of incentive compensation payments that are later shown to have been paid in error, based on an accounting restatement that is necessary to correct a material error of a financial reporting requirement.

If a current or former executive officer received erroneously awarded incentive-based compensation within the three fiscal years preceding the date of the determination that a restatement is required, the company would have to recover from the executive the excess incentive-based compensation on a “no-fault” basis. The proposal also specifies proxy statement disclosure requirements relating to clawback policies and recovery efforts.

The proposed rule defines incentive-based compensation as any compensation (including stock options and other equity awards) that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure. For this purpose, the term “financial reporting measures” are measures that are determined and presented in accordance with the accounting principles used in preparing the company’s financial statements, any measures derived wholly or in part from such measures, such as non-GAAP financial measures, and stock price and total shareholder return (TSR).

Although the comment period on the SEC’s clawback proposal has closed, the SEC has not issued a final clawback rule, and it is not clear when it will do so. Under the proposal, once the SEC’s final rule is adopted, the stock exchanges would have to file their proposed listing standards within 90 days after the publication of the SEC’s final rule in the Federal Register, and new listing standards would have to become effective no later than one year following such publication date. Thereafter, companies would have 60 days to adopt compliant clawback policies.

For more information on the SEC’s clawback proposal, see our Legal Update, “US Securities and Exchange Commission Proposes Compensation Clawback Listing Standards Requirement,” dated July 16, 2015.

Pay Versus Performance Disclosure

In 2015, the SEC proposed a “pay versus performance” rule to require companies to disclose in a clear manner the relationship between executive compensation actually paid and the financial performance of the company, with performance measured both by company TSR and peer group TSR. If adopted as proposed, companies would need to add a new pay versus performance table to their proxy statements that would separately provide annual compensation information for the chief executive officer for each of the past five fiscal years. In addition, the table would have to provide average annual compensation for the named executive officers (other than the chief executive officer) identified in the summary compensation table for those years.

As proposed, executive compensation actually paid would consist of total compensation as reported in the summary compensation table, modified to adjust the amounts included for pension benefits and equity awards. Equity awards would be considered actually paid on the date of vesting, whether or not exercised. They would be valued at fair value on the vesting date, rather than fair value on the date of grant as reported in the summary compensation table. Accordingly, the stock and option award amounts shown in the summary compensation table would be subtracted from total compensation, and the vesting date fair value amounts for these equity awards would be added back, to calculate compensation actually “paid.” Vesting date valuation assumptions would have to be disclosed if they are materially different from those disclosed in the financial statements as of the grant date. A clear description of the relationship between pay and performance would have to accompany the proposed new table.

The comment period on this proposed rule has expired, but no final rule has been issued. As a result, it is not clear when pay versus performance disclosure will first be required in proxy statements. The proposed phase-in for this rule would require pay versus performance disclosure for three years in the first proxy statement in which such disclosure is required. In each of the two subsequent years, another year of disclosure would be added.

For more information on the SEC’s pay versus performance proposal, see our Legal Update, “US Securities and Exchange Commission Proposes Pay Versus Performance Disclosure Rule,” dated May 13, 2015.

Hedging Disclosure

The SEC also proposed a new disclosure requirement in 2015 addressing hedging by employees, officers and directors. The comment period on this proposed rule has expired, but the SEC has not issued a final rule. Therefore, it is not clear when companies will need to add the new hedging disclosure to their proxy statements.

The proposal would require companies to disclose in their proxy statements whether their employees (including officers) or directors are permitted to engage in transactions to hedge or offset any decrease in the market value of their companies’ equity securities granted to them as compensation or held directly or indirectly by employees or directors.

The proposal covers all transactions that establish downside price protection in a company’s equity securities, whether by purchasing or selling a security or derivative security or otherwise. The resulting disclosure would need to make clear which categories of price protection transactions a company permits and which it prohibits.

The proposed hedging disclosure requirement would extend beyond the existing requirement in the compensation discussion and analysis with respect to hedging. Currently, the compensation discussion and analysis only requires a discussion of hedging policies affecting the named executive officers, while the proposed rule would mandate disclosure of hedging policies with respect to all employees, officers and directors. In addition, the proposed hedging disclosure rule would apply to all companies that are required to comply with the SEC’s proxy rules, even companies that are not required to include compensation discussion and analysis, such as smaller reporting companies, emerging growth companies, business development companies and registered closed-end investment companies.

For more information on the SEC’s hedging disclosure proposal, see our Legal Update, “US Securities and Exchange Commission Proposes Hedging Disclosure Rules,” dated February 20, 2015.

Other Key Disclosure Topics for the 2017 Proxy and Annual Reporting Season Non-GAAP Financial Measures

Companies sometimes use non-GAAP financial measures in their annual reports on Form 10-K, as well as other SEC filings. In addition, it has become common for companies to highlight performance measures, including non-GAAP financial measures, in their proxy statements to demonstrate the connection between pay and performance. To the extent that non-GAAP performance measures are disclosed in documents filed with the SEC, companies must pay attention to the requirements of Regulation G and Item 10(e) of Regulation S-K.

There are special rules for non-GAAP financial measures in the proxy statement context. The disclosure of target levels for incentive compensation arrangements that are non-GAAP financial measures is not subject to Regulation G, although a company must disclose how the numbers are calculated from its audited financial statements. In compliance and disclosure interpretation (C&DI) number 118.09 relating to Regulation S-K, the Staff extended this principle to the disclosure of the actual result of the non-GAAP financial measure that is used as a target, provided that this disclosure is made in the context of a discussion about target levels.

When non-GAAP financial measures are included in a proxy statement for any purpose other than with respect to target levels, a company must comply with Regulation G and Item 10(e) of Regulation S-K. For pay-related circumstances only, the Staff stated in C&DI 118.08 that it will not object if a registrant includes the required GAAP reconciliation and other information in an annex to the proxy statement, provided that the registrant includes a prominent cross-reference to this annex. If the non-GAAP financial measures are the same as those included in the Form 10-K that is incorporating by reference the proxy statement’s executive compensation disclosures, the Staff stated that it will not object if the company complies with these rules by providing a prominent cross-reference to the pages in the Form 10-K containing the required GAAP reconciliation and other information. When providing a non-GAAP performance measure in a proxy statement, including in a proxy statement summary, a company wishing to rely on these Staff interpretations should be careful to tie such disclosure to compensation.

In the past year the SEC has increased its focus on compliance with the requirements for use of non-GAAP financial measures, and the Staff issued new and updated C&DIs on the subject in May 2016. These C&DIs provide insight into what the Staff considers to be misleading use of non-GAAP financial measures and what is considered unacceptable prominence of a non-GAAP financial measure presentation in an SEC filing. Even before these C&DIs were issued, the Staff had been issuing comment letters with respect to filings in order to improve the level of company compliance with SEC rules on non-GAAP disclosures, and the Staff has already issued, and made public, comment letters in which it specifically references the new guidance.

By the time the 2017 proxy and annual reporting season gets into full swing, SEC reporting companies already will have had experience applying the new guidance to their presentations of non-GAAP financial measures. However, compliance with these interpretations is an ongoing process. As companies transition from disclosures that investors or analysts may have come to expect or are accustomed to seeing but that are now identified as potentially misleading or otherwise unacceptable, they may find it useful to further update their approaches to reflect refinements that their peers have developed in response to the SEC’s guidance. Companies may also gain insights from comments given to other companies, especially as SEC comment letters become public. Companies should expect the SEC to focus on non-GAAP financial measures when reviewing proxy statements and annual reports for the 2017 proxy and annual reporting season. Therefore, companies should pay particular attention to such presentations as they draft such documents.

For more information on the SEC’s new and updated guidance on non-GAAP financial measures, see our Legal Update, “SEC Provides Guidance on Non-GAAP Financial Measures,” dated May 24, 2016.

Audit Committee Disclosure

On July 1, 2015, the SEC issued a concept release requesting comments on possible revisions to audit committee disclosures. The concept release focused on three main areas of disclosure:

  • The audit committee’s oversight of the auditor
  • The audit committee’s process for appointing or retaining the auditor
  • The audit committee’s consideration of the qualifications of the audit firm and certain members of the engagement team

The concept release also requested comments on the location of audit committee disclosures in SEC filings and comments relating to audit committee disclosure by smaller reporting companies and emerging growth companies, as well as other miscellaneous questions related to audit committee disclosures.

The comment period for the audit committee disclosure concept release has expired, but the SEC has not issued any specific proposals in response to the issues raised by the concept release. However, the conversation about whether there should be more audit committee disclosure already has begun. Some institutional investors have been advocating for additional audit committee disclosures even before the SEC issued its concept release. Some companies, in the interest of transparency, are already expanding audit committee disclosures beyond the mandatory requirements, for example, by providing greater detail about the audit committee’s oversight of the independent auditor. As the 2017 proxy season approaches, those responsible for preparing the proxy statement may want to discuss with audit committees and auditors whether they consider it appropriate to voluntarily expand any audit committee disclosures at this time.

Form 10-K Summaries

In accordance with the Fixing America’s Surface Transportation Act, the SEC issued an interim final rule amending the Form 10-K to expressly allow, but not require, companies to include a summary of information required by that form. New Item 16 of Form 10-K authorizes optional summary information that is presented fairly and accurately if there is a hyperlink to the material contained in the Form 10-K, including exhibits, to which the summary relates. The summary may only refer to information that is included in the Form 10-K at the time it is filed. Companies do not need to update the summary for information required by Part III of Form 10-K that is incorporated by reference to a proxy or information statement filed after the Form 10-K, but in that case, the summary must state that it does not include Part III information because that information will be incorporated from a later-filed proxy or information statement involving the election of the board of directors.

Risk Factors

Companies should review their risk factors in full as part of the process for preparing the annual report on Form 10-K to ensure that current risks are not only identified but described in relation to their businesses. For some companies, the potential impact of Brexit and related developments present a risk factor topic that may be particularly relevant. (To the extent that Brexit is, or could, materially affect a company’s financial results, it may also be appropriate for that company to discuss it as part of management’s discussion and analysis of financial condition and results of operation.) Issues regarding sustainability and climate change disclosure have been gaining increasing attention, so it may be useful to consider whether any additional risk factor disclosure is warranted in that area. Recognition has been growing that cybersecurity poses both economic and security threats. Therefore, companies should carefully analyze whether they need new, revised or expanded cybersecurity disclosure. These subjects represent just a few recent areas of concern. Each company should consider its own risk profile to be sure that the risk factor section of its Form 10-K adequately reflects the specific risks currently facing that company. In this regard, it can be helpful to review precedents of similarly situated companies, as long as the end result is tailored to be relevant to the particular company and does not reflect a boilerplate description of a general risk.

Other Disclosure Initiatives

The SEC has commenced a number of initiatives during 2016 as part of a program to review and enhance disclosure effectiveness. These efforts are in the beginning stages and, therefore, are not likely to directly impact the 2017 proxy and annual reporting season. However, it is useful to keep these issues in mind as annual disclosures are being prepared.

For example, in April 2016, the SEC issued a concept release examining many aspects of the business and financial disclosures required by Regulation S-K that companies provide in their periodic reports. This concept release not only focuses on what information should be disclosed, but also on whether information can be presented in a way that is more effective. It explores the extent to which technology may be able to improve disclosure, such as through hyperlinks and navigability tools, and whether such features can be harnessed to streamline disclosure. The concept release also considers whether there are new topics that should be added to disclosure requirements, such as in the sustainability and climate change area. For a further discussion of this concept release, see our Legal Update, “Modernization of US Business and Financial Disclosures: A ‘Taste’ of the SEC’s Concept Release,” dated April 26, 2016.

Another initiative was introduced in July 2016, when the SEC proposed amendments to eliminate redundant, overlapping, outdated or superseded regulations in light of subsequent changes to SEC disclosure requirements, US GAAP, International Financial Reporting Standards and technology. The proposing release for those amendments also solicited comments on certain disclosure requirements that overlap with US GAAP to determine whether to retain, modify, eliminate or refer them to the Financial Accounting Standards Board for potential incorporation into US GAAP.

In August 2016, the SEC requested comments on subpart 400 of Regulation S-K, which contains disclosure requirements with respect to directors, executive officers, promoters and control persons, including compensation, security ownership and related person transaction information, as well as corporate governance matters, code of ethics information and late filings of insider trading reports. The request for comments does not propose any amendments or raise specific questions for comments. Rather, the release states that comments can be directed at existing requirements or potential disclosure issues that commenters believe the rules should address. (With respect to executive compensation, the SEC is requesting comments on the disclosure requirements of Item 402 generally, as opposed to comments on the outstanding clawback, pay versus performance disclosure and hedging disclosure proposals discussed in “Dodd-Frank Compensation-Related Rulemaking” above.) Comments on this proposal are due by October 31, 2016. It is unlikely that amendments to subpart 400 of Regulation S-K will be made in time to affect the 2017 proxy and annual reporting season.

Also in August 2016, the SEC proposed amendments to require companies that file registration statements and periodic and current reports that are subject to the exhibit requirements of Item 601 of Regulation S-K, or that file on Forms F-10 or 20-F, to include a hyperlink to each electronically filed exhibit (other than the XBRL exhibit) listed in the exhibit index to these filings. Companies would be required to file the forms affected by the proposal in HTML format (as opposed to ASCII format). Comments on this proposal are due later this fall. It is not clear whether a final amendment implementing this hyperlinked exhibit requirement will be in place prior to the filing deadlines for 2016 annual reports on Form 10-K or 20-F. However, if the SEC adopts these amendments, the hyperlink requirement would apply to nearly all of the forms that are required to include exhibits under Item 601, including periodic and current reports, so companies should monitor this rulemaking throughout the year.

Finally, companies involved in mining should be aware that in June 2016, the SEC proposed revisions to property disclosure requirements for mining registrants and related guidance that are currently contained in Item 102 of Regulation S-K and Industry Guide 7. This proposal is intended to modernize disclosure requirements for mining properties in order to align the SEC’s rules with current industry and global regulatory practices and standards. The proposal would rescind Guide 7 and create new Regulation S-K subpart 1300, which would govern disclosure for registrants with mining operations.

Specialized Disclosure

Form SD, although not part of the annual report on Form 10-K, represents an annual filing requirement for issuers that are subject to reporting under both the conflict minerals and resource extraction issuer disclosure rules.

Conflict Minerals

The SEC adopted conflict minerals disclosure rules in accordance with the directive of Dodd-Frank. These rules require SEC reporting companies to file a Form SD with respect to conflict minerals for any year in which they used conflict minerals that were necessary to the functionality or production of a product they manufactured or contracted to be manufactured. The first such reports were required in 2014, so there are now three years of precedent.

Litigation over required conflict minerals disclosure has resulted in a judicial opinion holding that the conflict minerals statute and rule violated the First Amendment to the extent that it required companies to report to the SEC and to state on their web sites that any of their products have “not been found to be ‘DRC conflict free.’” However, the other portions of the conflict minerals disclosure requirements have been upheld. Affected companies must file their reports on Form SD, complying with the portions of the conflicts mineral rules that the court upheld. Keith Higgins, Director of the SEC’s Division of Corporation Finance, issued a statement in April 2014 specifying that as a result of the court opinion, companies are not required to describe their products as “DRC conflict free,” as having “not been found to be ‘DRC conflict free’” or as “DRC conflict undeterminable.” The statement also provided that no independent private sector audit (IPSA) would be required unless a company voluntarily elects to describe any of its products as “DRC conflict free” in its conflict minerals report. Therefore, unless the SEC provides guidance to the contrary, there is still no IPSA requirement for any Form SD being filed in spring 2017 with respect to usage of conflict minerals in 2016 unless a company chooses to affirmatively describe any product as “DRC conflict free.”

Resource Extraction Issuer Payment Disclosure

On June 27, 2016, the SEC adopted final resource extraction issuer payment disclosure rules pursuant to a Dodd-Frank mandate, replacing an earlier version that had been vacated by the US District Court for the District of Columbia in 2013. The final rules require resource extraction issuers to disclose payments made to US federal or foreign governments for the commercial development of oil, natural gas or minerals. New Rule 13q-1 under the Exchange Act requires resource extraction issuers to file their payment information reports on Form SD.

A resource extraction issuer will have to file a Form SD containing payment disclosure annually, not later than 150 days after the end of the issuer’s fiscal year, but the SEC has provided a transition period for compliance. Resource extraction issuers will first need to comply with the final rules for fiscal years ending on or after September 30, 2018. This means that calendar-year companies impacted by the new rules will first need to comply by May 30, 2019.

Although there is a transition period before reporting is required, and no resource extraction issuer payment disclosure will be required during the 2017 proxy and annual reporting season, companies affected by the rules should realize that there may be considerable start-up time and expense required in order to be ready to comply by the required deadline. These could require IT consulting, establishing new reporting systems, training local personnel on tracking and reporting, and developing guidance to ensure consistency across reporting units. In addition, some companies may need their accounting groups to develop new information systems, processes and controls.

Companies that fall within the definition of resource extraction issuer should also begin reviewing their systems and controls for financial accounting and financial reporting to determine what additional procedures and processes they may need in order to report the payments required to be disclosed. Additional disclosure controls and procedures may also need to be implemented in order to track payments by subsidiaries and controlled joint ventures to governments and government-controlled entities, as well as to comply with the XBRL (interactive data) reporting requirements.

For more information on the resource extraction issuer payment disclosure rules, see our Legal Update, “US SEC Adopts Final Rules for Payments by Resource Extraction Issuers,” dated July 13, 2016.

Annual Meeting Mechanics Proxy Cards

In March 2016, the Staff issued an interpretation of the requirement in Rule 14a-4(a)(3) that the form of proxy “identify clearly and impartially each separate matter intended to be acted upon.” C&DI 301.01 emphasized that a proxy card must describe the specific action on which shareholders will be asked to vote, whether the proposal is one submitted by management or one submitted by a shareholder. The proxy card must contain sufficient detail to explain the proposal. For example, if management proposes an amendment to the company’s articles of incorporation to increase the number of authorized shares of common stock, it is not appropriate for the proxy card to describe the proposal as “a proposal to amend our articles of incorporation.” Similarly, it would be insufficient for a proxy card to describe a shareholder proposal calling for a bylaw amendment to allow shareholders holding 10 percent of the company’s common stock to call a special meeting as “a shareholder proposal on special meetings.”

C&DI 301.01 also provided the following examples of proxy card descriptions of shareholder proposals that are too general to satisfy Rule 14a-4(a)(3):

  • A shareholder proposal on executive compensation
  • A shareholder proposal on the environment
  • A shareholder proposal, if properly presented
  • Shareholder proposal #3

Because C&DI 301.01 was issued fairly late in the 2016 proxy and annual reporting season, some companies may have already released the proxy cards for their 2016 annual meetings before this guidance became available. In preparing for their 2017 annual meetings, companies should make sure that the descriptions of proposals on their proxy cards contain sufficient detail to comply with the Staff’s guidance.

Director and Officer Questionnaires

The Nasdaq Stock Market adopted a “golden leash” rule, effective August 1, 2016, that requires its listed companies to disclose on their web sites and/or in their proxy or information statements compensation paid by third parties to directors or nominees for directors. Therefore, Nasdaq companies should either add questions to their director and officer questionnaires to elicit the information necessary to determine if any such disclosure is needed or to confirm that their existing questionnaire template already covers this topic. For more information on this Nasdaq requirement, see our Legal Update, “US SEC Approves Nasdaq Rule Amendments Requiring Disclosure of ‘Golden Leash’ Arrangements,” dated July 18, 2016.

In addition, Auditing Standard 18 regarding related parties became effective for audits for fiscal years beginning on or after December 15, 2014, thereby impacting 2015 and later audits for calendar year companies. Among other things, this new standard requires auditors to perform procedures to obtain an understanding of a company’s relationships and transactions with its related parties and to evaluate whether the company has properly identified its related parties and relationships and transactions with its related parties. In preparing questionnaires with respect to the 2017 proxy and annual reporting season, companies should either confirm that their questionnaires contain questions that will elicit the identification of parties related to their directors and executive officers so that they can appropriately monitor related person transactions or otherwise satisfy themselves that alternative information gathering procedures are in place for this purpose. Some companies already added such questions to their 2016 questionnaires. Companies should confirm that their auditors are satisfied with their procedures to identify reportable relationships, including the wording of questions in director and officer questionnaires involving related party matters if they are the vehicles used to elicit such information.

There are no recent rule changes under the federal securities laws that would require changes to existing director and officer questionnaires for the 2017 proxy and annual reporting season. However, public companies should review their existing forms of questionnaires to determine whether developments from the past few years are adequately addressed. Companies should also consider whether there are regulatory developments outside of the federal securities laws, or any new or amended state or foreign laws, requiring additions or modifications to director and officer questionnaires for the 2017 proxy and annual reporting season.

Virtual Meetings

The number of companies conducting virtual annual meetings has increased over the past few years. Online shareholder meetings can take a variety of forms. Some are hybrids, with in-person meetings supplemented by audio and/or video options. Other companies conduct fully virtual meetings. For example, HP Inc. (formerly Hewlett-Packard Company) conducted completely virtual annual meetings in both 2015 and 2016, providing shareholders with the opportunity to submit questions online but not the opportunity to be physically present with management or directors of the company. Similarly, Intel held a completely virtual annual meeting in 2016.

Companies hosting virtual meetings often emphasize shareholder engagement as well as cost savings. Intel explained in its proxy statement that virtual meeting technology saves time and money, both for the company and its investors, while also observing that web participation has grown significantly and has proven to be substantially more popular than physical attendance. HP noted that the virtual meeting format allows shareholders to participate from any location around the world.

* * *

The complete publication, including footnotes, is available here.

September 29, 2016
Cleary Gottlieb Discusses the High Bar to Post-Closing Damages in M&A Cases
by Meredith E. Kotler and Anderson P. Heston

As discussed in prior posts on the Cleary M&A and Corporate Governance Watch blog, recent applications of the Delaware Supreme Court’s decision in Corwin v. KKR Financial Holdings, 125 A.3d 304 (Del. 2015) have emphasized the high bar for surviving a motion to dismiss in damages actions by stockholder plaintiffs after completion of a merger transaction, as "dismissal is typically the result" where informed, disinterested stockholder approval requires application of the business judgment rule to extinguish all claims except for waste. See Singh v. Attenborough, 137 A.3d 151, 152 (Del. 2016). Two recent Chancery Court decisions have further underscored the claim-extinguishing effect of informed, disinterested stockholder approval.

In the first, City of Miami Gen. Employees v. Comstock, No. CV 9980-CB, 2016 WL 4464156 (Del. Ch. Aug. 24, 2016), Chancellor Bouchard dismissed plaintiff’s post-closing damages claim after over 97% of the target’s stockholders voted to approve the transaction. Despite "the preference under Delaware law" that disclosure allegations be litigated pre-closing, Comstock, 2016 WL 4464156 at *9, the Court considered the merits of plaintiff's various post-closing disclosure claims, as Corwin requires an informed stockholder electorate for the vote to be given cleansing effect. The Court concluded that plaintiff’s disclosure claims were meritless, necessitating dismissal of all non-waste claims under "a straightforward application of Corwin and Attenborough" unless the transaction were subject to entire fairness review. Id. at *17. Attempting to invoke entire fairness, plaintiff pointed to (a) the target’s board members’ purported desire for board seats in the surviving entity, and (b) the alleged tainting effect of the target’s CEO’s pursuit of a post-closing position, id. at *17, but neither argument persuaded the Court, which noted the board’s majority of outside directors and the absence of any self-interested "duplicitous conduct" by the CEO. Id. at *18-21. As such, plaintiff’s breach of fiduciary duty claims were dismissed, as were its aiding and abetting claims against the target’s financial advisor, the buyer, and others.

While neither argument for entire fairness review prevailed in Comstock, the Court’s decision necessarily assumed that several different triggers for entire fairness review, including allegedly conflicted target board members, could preclude claim extinguishment. The day after Comstock was decided, however, Vice Chancellor Slights outlined a much narrower scope for entire fairness review in post-closing actions, which would require that "a controlling stockholder [have] extracted personal benefits" from the merger for entire fairness to apply following informed, disinterested stockholder approval and thus to avoid claim extinguishment. Larkin v. Shah, C.A. No. 10918-VCS, 2016 WL 4485447, at *1 (Del. Ch. Aug. 25, 2016). Larkin concerned a post-closing challenge to a two-step merger pursuant to Section 251(h) of the Delaware General Corporation Law, in which 78% of stockholders tendered their shares. Labeling the cleansing effect of informed, disinterested stockholder approval as the "irrebuttable" business judgment rule, the Court contrasted scenarios involving a conflicted board and a controlling stockholder involved in a conflicted transaction, both of which trigger entire fairness outside the merger context. Id. at *8. The Court concluded that only the latter case should require entire fairness review in post-closing actions following fully-informed stockholder approval, as only controlling stockholder cases involve "[c]oercion[,] [which] is deemed inherently present in controlling stockholder transactions . . ., but not in transactions where the concerns justifying some form of heightened scrutiny derive solely from board-level conflicts or lapses of due care." Id. at *12 (emphasis added). Thus, in the absence of a "looming conflicted controller," id. at *13, the business judgment rule, "irrebuttable in this context," id. at *8, would cleanse the transaction of all claims save waste. With no "looming conflicted controller" or pled claim for waste, plaintiffs’ complaint was easily dismissed, with prejudice, as plaintiffs had no hope of alleging waste.

Key Takeaways
In the year since Corwin was decided, Delaware courts have only strengthened the deference afforded to informed, disinterested, uncoerced stockholder approval of merger transactions. As such, robust pre-closing disclosures should in most cases be sufficient to extinguish nearly all post-closing damages claims, although transactions involving (or alleged to involve) controlling stockholders will continue to receive additional scrutiny. Finally, with at least one pending appeal concerning the cleansing effect of Corwin, the Delaware Supreme Court will no doubt be providing further guidance concerning the post-closing application of the irrebuttable business judgment rule.

This post comes to us from Cleary Gottlieb Steen & Hamilton LLP. It is based on the firm’s client update, "Recent Applications of Corwin v. KKR Financial Holdings LLC Confirm High Bar to Pleading Post-Closing Damages Actions," dated September 12, 2016, and available here.

September 29, 2016
The Upside of Delaware Limits on Fee-Shifting and Forum Selection Provisions
by Jonathan Rohr

Until very recently, it was not controversial to claim that shareholder litigation had entered a period of crisis. A significant majority of deals involving publicly-traded corporations (most of which are organized in Delaware) were challenged in litigation, and to make matters worse, much of that litigation was multi-jurisdictional. In large part, this resulted from the ability of plaintiffs’ firms to secure fee awards in connection with settlements that included no monetary relief. In a typical "disclosure only settlement," defendants agreed to provide additional, deal-related disclosures in exchange for a very broad release. With the cooperation of released defendants, plaintiffs’ counsel could secure a fee award by characterizing the disclosures as a corporate benefit.

For a short period, however, fee-shifting and forum selection provisions offered hope to Delaware corporations. With a one-way fee-shifting provision in either its charter or bylaws, a Delaware corporation could make filing litigation prohibitively risky. With a forum selection provision, it could corral litigation into a single forum – either in Delaware or in another jurisdiction where the corporate decision-makers perceived some sort of advantage. The promise of these measures was not hypothetical: In a series of three decisions, Delaware courts upheld the addition of one-way fee-shifting provisions, exclusive Delaware forum selection provisions, and exclusive non-Delaware forum selection provisions to the bylaws of Delaware corporations, even when added unilaterally by the board of directors.[1]

With the 2015 amendments to the Delaware General Corporation Law, however, the Delaware legislature significantly limited the ability of its corporations to adopt these measures. Both fee-shifting and exclusive non-Delaware forum selection provisions are now completely forbidden. Of the three measures previously approved by Delaware courts, only forum selection provisions that allow litigation in Delaware remain fair game.

On the surface, Delaware’s adoption of two new mandatory corporate law rules appears inconsistent with the state’s flexible, pro-private ordering approach to corporate law. For this reason, the decision to repudiate a series of pro-private ordering decisions authored by some of the state’s most well-respected jurists was a curious development, to say the least.

In Corporate Governance, Collective Action and Contractual Freedom: Justifying Delaware’s New Restrictions on Private Ordering, I argue that there are strong justifications for Delaware’s new limitations on private ordering and that they are consistent with the state’s policies favoring flexibility and private ordering in corporate law. This is not to say that problematic litigation practices should have gone unaddressed. Instead, the legislative restrictions should be understood alongside the Chancery Court’s new, more skeptical approach to disclosure only settlements and the fee applications that accompany them. With an exclusive Delaware forum selection provision, Delaware corporations are able to corral litigation into a jurisdiction that now disfavors disclosure only settlements. They cannot, however, destroy many of the important benefits that result from shareholder litigation by over-deterring it (with fee-shifting provisions) or dispersing it into non-Delaware fora (with exclusive non-Delaware forum selection provisions).

Delaware corporations derive significant benefits from the ability of their shareholders to challenge management conduct in Delaware’s courts. Delaware corporate law generally eschews bright-line rules in favor of generally-stated principles that are applied by the state’s specialized judiciary. The resulting opinions are factually saturated (and for this reason some have argued that they are excessively narrow in scope), but it is through these decisions that Delaware corporations, their counsel, and others who provide them with corporate services are able to understand the applicable legal principles, design transactions, and assess risk. Importantly, the benefits that result from the availability of this legal information are both backward- and forward-looking. When a decision to incorporate or reincorporate in Delaware is made, the firm will have immediate access to the already existing body of Delaware case law. It will also be able to count on a future flow of case law that addresses new issues when they arise.

Widespread adoption of fee-shifting and exclusive non-Delaware forum selection provisions (the two measures now prohibited by the DGCL) would significantly diminish many of these benefits. The fee shifting provisions previously approved by the Chancery Court would over-deter shareholder litigation by putting plaintiffs in a fundamentally unbalanced situation with regard to litigation risk and reward. Because any monetary recovery will be shared among affected shareholders, a plaintiff holding less than all of the affected shares will enjoy only a fraction of any benefit recovered. But, if there is a one-way fee shifting provision in place, that plaintiff bears all of the risk of having to reimburse defendants for their fees. Defendants, of course, are not exposed to any additional risk on account of the provision. There is little doubt that frivolous filings would be deterred by this realignment in the risk profile of shareholder litigation. But it would also deter much litigation that is not frivolous, and that is where the problem lies.

Exclusive non-Delaware forum selection provisions would similarly destroy these benefits by dispersing litigation into non-Delaware fora. Over time, the number of conflicting decisions would likely increase, and the lack of a common appellate court to harmonize conflicting precedent would create uncertainty as to the applicable rule or principle.

With regard to the informational benefits that result from case law, fee-shifting and exclusive non-Delaware forum selection provisions present a collective action problem. The generation of these benefits requires a steady stream of disputes to enter and be decided by the Delaware courts. While individual corporations have an incentive to opt-out of the costs of Delaware shareholder litigation by adopting one or both of the prohibited measures, widespread adoption would cut-off the flow of cases into Delaware’s courts and, with it, the benefits that result when those cases are decided. Firms who opt-out while continuing to benefit from the generation of case law would be free-riding on the contributions of those that continue to have their shareholder disputes adjudicated by the Delaware courts.

Widespread adoption of fee-shifting provisions would also lead to a decrease in the flexibility available to Delaware corporations and their managers. When investors can challenge management’s conduct after the fact (e.g., through fiduciary duty litigation), they have less need for ex ante rules intended to discipline and constrain management. This, of course, benefits management who are able to operate with increased freedom and discretion. But, if investors do not have a mechanism for challenging management’s conduct, they will be more likely to require rules and limitations up front. Delaware’s success as a corporate home is likely due to the balance it has struck in this regard: The freedom and discretion that management enjoys under Delaware law depends, to some extent, on the ability of shareholders to challenge management’s decisions after the fact. Over-deterrence of shareholder litigation will put Delaware’s enabling approach to corporate law at risk by giving shareholders a reason to seek more extensive ex ante rules.

Shareholder litigation also indirectly facilitates flexibility and freedom by generating much of the factual information that fuels non-legal accountability mechanisms (e.g., the labor market for management and the risk of reputational sanctions). These disciplinary forces are commonly cited reasons for the discretion and deference corporate management enjoys under applicable legal regimes. When managers face reputational and professional consequences for behaving badly, there is less work for corporate law to do. If over-deterrence of shareholder litigation restricts the flow of information about the conduct of management, however, non-legal accountability mechanisms will be less effective. Investors will have reason to look to corporate law to fill the gaps.

Of course, the presence of strong justifications for Delaware’s new restrictions on private ordering does not do anything about the abusive litigation practices that made fee-shifting and forum selection provisions desirable to begin with. This is where the Chancery Court comes in. As a result of new case law announcing the Court’s unwillingness to allow the disclosure only settlement status quo to persist,[2] shareholder litigation has declined significantly in a short period of time. The key is the ability of Delaware corporations to prevent migration of litigation into jurisdictions that are more permissive when it comes to fee awards by adopting exclusive Delaware forum selection provisions. Together with this case law, the Delaware legislature’s approach to fee-shifting and forum selection provisions makes sense. Yes, the state has adopted new mandatory rules that limit the scope of possible private ordering. But, in the long-run, these restrictions will help to preserve Delaware’s flexible, pro-private ordering approach to corporate law and the benefits that result from it.


[1] ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (2014) (upholding addition of fee-shifting bylaw); City of Providence v. First Citizens Bancshares, Inc., 99 A.3d 229 (Del. Ch. 2014) (upholding addition of non-Delaware forum selection bylaw); Boilermakers Local 154 Retirement Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013) (upholding addition of Delaware forum selection bylaw).

[2] See, e.g., In re Riverbed Tech., Inc. Stockholders Litig, 2015 WL 5458041 (Del Ch. Sept. 17, 2015) and In re Trulia, Inc. Stockholders Litig., 2016 WL 325008 (Del. Ch. Jan. 22, 2016).

This post comes to us from Jonathan Rohr, a visiting assistant professor at Cardozo Law School. It is based on his paper, "Corporate Governance, Collective Action, and Contractual Freedom: Justifying Delaware’s New Restrictions on Private Ordering," available here.

September 29, 2016
SEC, Bank Settle Action Tied to Loan Loss Reserves
by Tom Gorman

Since the market crisis the Commission has brought a series of enforcement actions centered on the failure of financial institutions to properly evaluate their loan loss reserves. Those issues are not solely the result of that time period however. To the contrary, they continue as a recent case illustrates. In the Matter of Orrstown Financial Services, Inc., Adm. Proc. File No. 3-17583 (Sept. 27, 2016).

Orrstown is the holding company of Orrstown Bank, a Pennsylvania chartered bank. Respondents Thomas Quinn, Bradley Everly, Jeffrey Embly and Douglas Barton were, respectively, the CEO, CFO, Chief Credit/Risk Officer and CAO of the bank.

In 2010 the firm had a loan policy which governed its review process. Loan reviews were to be performed by a Loan Review Officer, supervised by Mr. Embly and the firm’s Credit Administration Committee. The policy required a risk review of 45% to 60% of the bank’s total outstanding loan portfolio annually. A risk rating was to be assigned to each loan. As a practical matter all commercial loans with a balance of $750,000 or more were reviewed each year. The policy also required that quarterly the Loan Review Officer review the bank’s allowance for loan and lease losses to ensure the reserve was adequate. Here the bank did not properly follow those policies.

The key issue centers on three significant commercial lending relationships which involved the bank’s largest customers. Meetings were held with each customer. Messrs. Quinn, Everly and Embly attended the meetings. One customer had a total outstanding balance of about $28.8 million; a second had a balance of $12.2 million; the third had a balance of about $7.7 million. Each of the loans was impaired. The bank did not, however, disclose any of the loans as impaired.

In addition, Orrstown did not disclose the value of other impaired loans in its quarterly filings for the periods ended June 30, 2010 and September 30, 2010. During that period, the firm conducted an impairment analysis under its policy. GAAP requires that loans with an impairment loss be disclosed. The bank’s policy required that where the loan’s carrying value exceeded the estimate of the collateral’s net realizable value, an impairment loss be recorded in the amount of the difference. Although the analysis was conducted, in certain instances the bank failed to include the impairment on the schedule of impaired loans. This caused the quarterly filings to be incorrect. The bank also failed conduct its loan loss calculation in accord with GAAP and to maintain the proper books and records. In this regard its internal controls were not adequate. As a result there were violations of Securities Act Sections 17(a)(2) and (3) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B).

To resolve the action each Respondent consented to the entry of a cease and desist order based on the Sections cited in the Order except, the order as to Mr. Barton was only based on the cited Exchange Act Sections. In addition, the bank will pay a penalty of $1 million; Messrs. Quin, Everly and Embly, will each pay $100,000 and Mr. Barton $25,000.

September 29, 2016
The Wells Fargo Clawback: Innovative - & Wave of the Future?
by Broc Romanek

As noted in this NY Times article and Reuters article, CEO John Stumpf and (now former) head of community banking for Wells Fargo have agreed to forfeit unvested equity awards to the tune of $41 million and $19 million, respectively (the CEO also agreed to forego bonuses for this year, nor draw any salary while an internal investigation is ongoing). These actions by the board more than effectuate what the company’s clawback policy would have otherwise required. The look of clawbacks going forward, perhaps? Here’s the related Form 8-K that Wells Fargo filed yesterday.

Here’s four notable items:

– The board was able to impose an "unvested equity" clawback that was much easier than clawing back dollars/stock that had already been delivered into the executive’s hands.
– Avoids possible need for the executive to amend past tax returns & file for a credit under Code Section 1341 (which Mike Melbinger has discussed in a few blogs).
– Necessary PR move, as the board was under a lot of pressure to show responsiveness. This came at little immediate cost to the company or the CEO (merely cancelling unvested equity awards for Stumpf). In theory, these forfeited awards could be made up in the future.
– We’ll see whether this situation leads to a restatement for the company. So far, news reports suggest it’s immaterial to the company’s financials. Maybe a good lesson for drafting future clawback policies: don’t provide for a clawback triggered only upon a restatement...

Members of might want to check out this blog that I posted yesterday: "Does Wells Fargo Prove That All This Governance Stuff Is Just a Charade?"...

Our Executive Pay Conferences: Only 3 Weeks Left! Clawbacks will be tackled during our upcoming "Tackling Your 2017 Compensation Disclosures: Proxy Disclosure Conference" & "Say-on-Pay Workshop: 13th Annual Executive Compensation Conference" to be held October 24-25th in Houston and via Live Nationwide Video Webcast. Here are the agendas – 20 panels over two days.

Register Now: Huge changes are afoot for executive compensation practices with pay ratio disclosures on the horizon. We are doing our part to help you address all these changes – and avoid costly pitfalls – by offering a reasonable rate to help you attend these critical conferences (both of the Conferences are bundled together with a single price). So register now.

SEC’s ALJs: SCOTUS Denies Cert

Speaking of Enforcement, the US Supreme Court denied cert a few days ago in the Tilton case that challenged the SEC’s ALJ system...

SEC’s Simplification Proposal: Extended Comment Deadline

The SEC has extended the deadline for comments for its disclosure simplification proposal to November 2nd. Here’s the comments received so far...

Broc Romanek

September 28, 2016
No Longer a Mirage: FCPA Compliance and Cooperation Has Its Benefits
by Blake Osborn, M. Todd Scott and William Alderman

On September 12, 2016, the SEC announced that it had reached a settlement with Jun Ping Zhang ("Ping"), a former executive of a Chinese subsidiary of Harris Corporation ("Harris"), regarding alleged violations of the Foreign Corrupt Practices Act ("FCPA"). The settlement was unusual, in that the SEC declined to also bring charges against Harris, an international communications and information technology company.

The SEC’s investigation against Ping found that, as chairman and CEO of a Chinese subsidiary of Harris, he had authorized and facilitated a practice of giving gifts (between $200,000 and $1 million) to officials at state-owned hospitals in China that resulted in awarding $9.6 million in contracts to the subsidiary. In particular, with Ping’s knowledge and under his management and supervision, the subsidiary’s sales staff fabricated false expense claims to generate cash for the gifts. These false expense reports were then improperly recorded in the subsidiary’s books and records as legitimate expenses or fees. Harris was implicated in the FCPA allegations because the subsidiary’s financials were consolidated into Harris’s books and records, such that Ping caused Harris to keep inaccurate books, records, and accounts as required under the FCPA. These allegations created clear potential FCPA liability for Harris.

However, the SEC declined to prosecute Harris due to the company’s due diligence and cooperation with the investigation. Harris took immediate and significant steps after its acquisition of the subsidiary to train staff in China and integrated the subsidiary into Harris’s system of internal accounting controls. It also created an anonymous complaint hotline and discovered the misconduct within five months of the acquisition. Upon that discovery, Harris self-reported this misconduct, remediated the problems, and cooperated with the SEC’s investigation.

This is the first time that an SEC investigation involving only FCPA misconduct fully declined to prosecute a large public multinational corporation where one of its former employees was sanctioned for FCPA violations. Both the SEC and DOJ have seen a skeptical reaction to their claims that they will reward companies that greatly cooperate with their investigations. But the SEC’s decision not to prosecute Harris shows this plan in action and holds promise for companies that have strong and robust procedures on due diligence, anti-corruption controls and self-reporting.

View today's posts

9/29/2016 posts

The Harvard Law School Forum on Corporate Governance and Financial Regulation: 90 Cents of Every "Pay-for-Performance" Dollar are Paid for Luck
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Preparing for the 2017 US Proxy and Annual Reporting Season
CLS Blue Sky Blog: Cleary Gottlieb Discusses the High Bar to Post-Closing Damages in M&A Cases
CLS Blue Sky Blog: The Upside of Delaware Limits on Fee-Shifting and Forum Selection Provisions
SEC Actions Blog: SEC, Bank Settle Action Tied to Loan Loss Reserves Blog: The Wells Fargo Clawback: Innovative - & Wave of the Future?
Securities Litigation, Investigations and Enforcement: No Longer a Mirage: FCPA Compliance and Cooperation Has Its Benefits

Blog posts are subject to copyrights held by the authors and are republished here with permission. Views expressed are those of the authors alone. Infringement Notification.