It may be nice to be your own boss, but setting your own compensation – and, at least arguably, giving yourself excessive pay – may get you in trouble.  A number of boards of directors have found that out, as courts have given them judicial whacks upside the head for paying themselves too much.  Not surprisingly, shareholders have gotten on the bandwagon as well.

Executive compensation – at least for public companies – has to be scrutinized and blessed by independent directors and, since the advent of Say on Pay, approved by shareholders (albeit on a non-binding basis).  In contrast, directors have long set their own pay, with little or no scrutiny and no requirement for independent review, much less approval.  (Director plans generally must get shareholder approval if they provide for equity grants, but neither the overall director compensation program nor specific awards have to be approved.)
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No, I’m not referring to my age (I’m old, but not THAT old).

Rather, I’m referring to the supermajority shareholder votes that ISS has required, and that Glass Lewis now requires, for various matters.  Specifically, for the past several years, ISS policy has looked askance at any company whose say-on-pay proposal garnered less than 70% of the votes cast.  More recently, Glass Lewis has adopted a policy stating that boards should respond to any company proposal, including say-on-pay, that fails to receive at least 80% shareholder approval or any shareholder proposal that receives more than 20% approval.

Putting aside the irony that ISS and Glass Lewis have long railed against supermajority voting requirements imposed by companies, one wonders what the rationale is for upping the ante.  One possible reason is frustration that, despite negative voting recommendations from proxy advisory firms, the overwhelming majority of say-on-pay proposals pass – and by relatively large margins.  However, my hunch is that the real frustration is that companies don’t usually respond to shareholder proposals that don’t pass, and most shareholder proposals don’t pass.


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Pay ratio disclosures
Photo by Brian Talbot

After much foot dragging, I have finished reading the adopting release for the new pay ratio disclosure rules.  Yes, the release is long (300 pages or so), but adopting releases are always long.  The real reason why it took so long is that the whole concept of pay ratio disclosure just seems silly to me (and apparently to Bob Lamm as well) so I just hoped it would go away.

I am not against finding ways to strengthen the middle class.  Just like I am not against ending the sale of certain minerals in Central Africa that end up funding deadly conflict.  The problem I have is that public companies should not have to bear the complete burden of fixing social ills.  Less than 1% of the 27 million companies in the United States are publicly traded.  And there are plenty of private companies that are larger than most publicly traded companies.  Thus, while we may not agree whether the social goals are worth achieving, I think we can all agree that there are better ways to achieve them than selective enforcement (particularly since the SEC itself has said that the pay ratio will not be comparable from one company to another).  The Securities Edge  has been criticizing the social disclosure movement for some time, but we haven’t yet seemed to have stopped Congress from continuing to go down that path.

So, unless Congress acts to reverse its mandate for public companies to disclose their pay ratios before 2018 (the first year of required disclosure), I suppose we should all start learning how to comply.  Leading practices for calculating the ratio and providing narrative disclosure will develop over the next couple of years, but I have summarized the important parts of the rules in this post:

What is the required disclosure?

Registrants must disclose:

  • The median of the annual total compensation of all employees of the registrant (excluding the CEO)
  • The annual total compensation of the CEO; and
  • The ratio of the median to the CEO’s compensation.

The ratio needs to be expressed as X:1 or X to 1 where “X” represents the CEO’s total compensation and “1” represents the median employee’s salary.  The ratio can also be expressed in narrative form such as: “The CEO’s annual total compensation is X times the median employee’s annual total compensation.”  You can’t
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Costs of PCAOB proposal greatly outweigh benefitsThe PCAOB’s recently proposed auditing standards aim to “provide investors and other financial statement users with potentially valuable information that investors have expressed interest in receiving but have not had access to in the past” by changing the standard auditor’s report and increasing the auditor’s responsibilities.  Sounds like a lofty goal, except that the information that they are proposing to require auditors to provide is either (i) self-evident; (ii) an infringement on the judgment of the issuer’s audit committee; or (iii) just plain not helpful.  What the proposed auditing standards do accomplish, however, is to add more costs to being a public company just like their last proposal on mandatory auditor rotation.

Critical Audit MattersUnder the proposed auditing standards, an auditor will be required to include a discussion in its auditor’s report about the issuer’s “critical audit matters.”  Difficult, subjective, or complex judgments, items that posed the most difficulty in obtaining sufficient evidence, and items that posed the most difficulty in forming the opinion on the financial statements are deemed to be “critical audit matters.”  While this requirement may seem straightforward at first, the reality is that this “new” information should be self-evident by anyone who knows how to read a financial statement.  Revenue recognition, estimates for allowances, pension assumptions, etc. are typically deemed to be “critical audit matters” by an auditor when planning audit procedures.  These critical accounting policies are already discussed in issuers’ MD&A and in their financial statements.  Further, any investor who actually is looking at the fundamentals of an issuer’s business and historical results should already be highly focused on estimates that, if wrong, could materially impact the financial statements.  Auditors will end up being overly inclusive on what is deemed “critical” for fear of having
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Regulations continue to be burden on public companiesAlthough you may have missed the fireworks and the parade, we celebrated the one year anniversary of the JOBS Act on April 5th.  Of course you wouldn’t have been alone if you missed the big celebration because, unfortunately, despite the initial hype surrounding the JOBS Act, not much has happened.  The media has chastised the JOBS Act for not fulfilling its early promise.  Most of the innovative provisions of the JOBS Act remain unimplemented by the SEC such as the relaxation of the ban on general solicitation on private offerings, crowd funding, and the improvement to Regulation A.  But even Title I (generally referred to as the “IPO on Ramp”), which was effective over a year ago, hasn’t had much effect.  In fact, IPOs, according to Jay Ritter at the University of Florida, have actually decreased for the so-called emerging growth companies.

How can this be?  While there can be numerous factors for why IPOs continue to remain elusive (costs of regulation and a poor economy are the top factors), other factors such as a rising stock market and pent up demand for IPOs should be compelling companies to go public.  Or is it possible that the cost of regulation that has been piled on since the fall of Enron trump everything else?

When Congress passed Title I of the JOBS Act, Congress recognized that public companies have been facing increased burdens for being public.  Although the causal relationship was suspect at best, Congress determined that over regulation was responsible for the severe drop off in IPOs from the 1990s through the 2000s.  While I might suggest that the dotcom bubble bursting may have played a part in the decrease in IPOs, I would agree that the unrelenting regulation that has come out of Congress over the past decade (Sarbanes-Oxley, Dodd-Frank) as well as rulemaking from the SEC itself (executive compensation disclosures) must have had some effect.

As a reminder, Title I of the JOBS Act, among other things, reduces executive compensation disclosures.  Specifically, emerging growth companies (companies with less than $1 billion in revenues) are exempt from holding “Say-on-Pay” and “Say-on-Golden Parachutes” votes, disclosing the two controversial executive compensation pay ratios required under Dodd-Frank, and providing a Compensation Discussion and Analysis (CD&A). Other executive compensation disclosure is also shortened by reducing the number of named executive officers, reducing disclosure from three to two years, and eliminating certain compensation tables.  In other words, Title I of the JOBS Act was designed to address over regulation of executive compensation for public companies.

While this was a great start by Congress, companies haven’t taken advantage of Title I because
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Say-on-pay lawsuitsWhy doesn’t the plaintiffs’ bar believe Congress means what it says? The Dodd-Frank Act could not have been more clear that the outcome of the mandatory say-on-pay advisory vote for public companies does not create or imply any change to the fiduciary duties of board members. However, as we have discussed in previous blog posts, this fact hasn’t stopped lawsuits in the wake of failed say-on-pay votes that allege, among other things, breaches of fiduciary duty by the boards of directors and management of public companies related to such failed votes. The vast majority of these cases have been dismissed at the early stages of proceedings, usually for failing to make a proper demand on the board of directors as required by most state corporate law statutes, but this has only lead to a shift in strategies. 

As the old saying goes, if you fail, try and try again. That is exactly what the plaintiffs’ bar is doing. The current tactic du jour seems to involve filing suits to enjoin the annual meeting. Most of these complaints seeking an injunction have typically alleged that directors and/or management breached their respective fiduciary duties by not providing adequate disclosure in the annual proxy statement to enable shareholders to make informed voting decisions, usually as it relates to proposals seeking to approve (i) executive compensation, (ii) a new or amended compensation plan, or (iii) an amendment to the charter to increase the number of authorize shares. Some of the most common allegations include: 

  • “The Proxy fails to disclose the fair summary of any expert’s analysis or any opinion obtain[ed] in connection with the [equity incentive plan]”; 
  • “The Proxy fails to disclose the criteria” used by the compensation committee “to implement the [stock purchase plan] and why the [equity incentive plan] would be in the best interest of shareholders”; 
  • “The Proxy fails to disclose the dilutive impact that issuing additional shares may have on existing shareholders”; and 
  • “The Proxy fails to disclose how the Board determined the number of additional shares requested to be authorized.” 

The timing of these lawsuits is less than ideal for companies as many are only a few weeks away from their scheduled meeting. This, of course, creates increased pressure to
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Finally, we have had some recent bipartisanship in Congress.  The only problem, of course, is that the recent bipartisanship further burdened public companies with additional disclosure requirements.  As Broc Romanek noted in his blog last week, Congress overwhelmingly passed the Iran Threat Reduction and Syria Human Rights Act of 2012 requiring public companies to disclose to the SEC its dealings with Iran. 

As we have been blogging about for nearly a year, Congress has picked up a bad habit of burdening public companies in advancing an agenda that has nothing to do with the protection of investors.  These so called “social disclosures” (many of which are really “political” – or politically motivated – disclosures) while arguably related to important issues, burden public companies with specific tasks to compile and disclose certain information.  These same burdens, however, are not placed on private companies.  Yet, Congressman Darrell Issa, the Chairman of the House Committee on Oversight and Government Reform, has been demanding to know why there are fewer public companies today as compared to a decade ago. 

To be fair, I note that the House has recently passed (in bipartisan fashion) HR 4078, Red Tape Reduction and Small Business Job Creation Act, which would limit the ability of the SEC to add more regulatory burden on public companies, but given recent Congressional acts, HR 4078 appears more “Do as I say and not as I do.”  For example, Congress passed the American Jobs Creation Act of 2004, which requires public companies to disclose in its Form 10-K if the company incurs a specific type of tax penalty from the IRS involving abusive or tax avoidance (shelter) transactions.  More recently, as everyone is keenly aware, laws have passed pertaining to conflict minerals, mine safety, and executive compensation pay ratios.  Laws that have been proposed, but have not passed (yet), include
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Following the recent financial crisis and government bailouts of major U.S. financial institutions, the federal government has gradually facilitated a power shift from companies and their officers and boards of directors to their shareholders. A prime example of this is the recently enacted “say-on-pay voting” requirements. Through provisions of the Dodd-Frank Act which was passed in July 2011, Congress directed the SEC to adopt rules requiring public companies to give their shareholders a vote, on an advisory basis, on the approval of executive compensation (“say-on-pay”). The implemented rules also require public companies to hold an advisory vote on the frequency (“say-on-when”) with which the say-on-pay vote would occur. Taking into account the results of the say-on-when vote, companies determined whether to hold say-on-pay votes on an annual, biennial, or triennial basis, with most electing to hold annual say-on-pay votes. Despite these shareholder votes being advisory, and as we explained in a previous blog, these votes may actually be more impactful than originally anticipated due to the effect of poor or failed say-on-pay votes on the recommendations from proxy advisory firms, such as ISS. For example, a “poor” (i.e., less than 70% shareholder approval) or “failed” say-on-pay vote result (i.e., less than 50% shareholder approval) could lower one or more of a company’s ISS “GRId” scores (or other proprietary proxy advisory firm corporate governance rating scores) which would negatively impact the recommendations published by the proxy advisory firms with respect to the election of directors and other corporate governance matters being put to a vote of the shareholders at the annual meeting. By way of example, if a public company receives less than 70% shareholder approval for executive compensation, the company must show that it took steps to address its perceived executive pay shortcomings, otherwise ISS will recommend a “withhold” vote for the directors up for re-election at the next annual meeting.

Going one-step further, however, the United Kingdom announced on June 20, 2012 that it will be implementing a binding say-on-pay vote requirement for public companies. According to the Department for Business Innovation and Skills, the U.K. government will “introduce a new binding vote on companies’ pay policies in order to empower shareholders and
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Section 951 of the Dodd-Frank Act states that the results of a shareholder say-on-pay advisory vote will not trigger or imply a breach of fiduciary duty. Because Congress went out of its way to be explicitly clear on this point, most legal commentators felt that shareholder derivative suits based on failed say-on-pay votes, without more, would likely never be successful. To further support this position, a number of derivative lawsuits were in fact filed on this very basis in 2011 but none have been successful to date. However, a recent decision by the Federal District Court for the Southern District of Ohio may have breathed new life back into the debate.

In NECA-IBEW Pension Fund v. Cox, the plaintiff shareholders (suing derivatively on behalf of Cincinnati Bell) alleged the company’s board of directors breached its duty by approving and recommending approval of an executive compensation package to the shareholders in its annual proxy statement. The compensation package included significant bonuses and pay increases for executives despite a $61 million decrease in the company’s net income and a drop in earnings per share from $0.39 to $0.07. The plaintiffs alleged that the board-approved executive compensation, which was subsequently rejected by 66% of the shareholders in the say-on-pay vote at the annual meeting, was contrary to the company’s written compensation policy which stated “a significant portion of the total compensation for each of our executives is directly related to the Company’s earnings and revenues and other performance factors” and that at-risk compensation should be “tied to the achievement of specific short-term and long-term performance objectives, principally the Company’s earnings, cash flow, and the performance of the Company’s common shares, thereby linking executive compensation with the returns realized by shareholders.”

The director defendants filed a motion to dismiss the complaint for failure to state a claim for which relief could be granted arguing, among other things, that executive compensation determinations are board decisions protected by the business judgment rule. The business judgment rule generally protects directors that make informed business decisions absent a deliberate
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When Congress passed the Say-on-Pay provision in Dodd-Frank, there was some concern whether the required vote, even though advisory, would increase the risk for Boards.  As it turns out, the risk is real.  Approximately 35 companies have received a vote of less than 50% in support of their executive compensation programs.  Of these 35 failed