This memorandum outlines key considerations from White & Case's Public Company Advisory Practice for US public companies in preparation for the 2020 annual reporting and proxy season.
Section I of this memo describes our key considerations for Annual Reports on Form 10-Ks in two parts:
(1) Housekeeping Items for Form 10-Ks in 2020; and
(2) Top Seven Disclosure Considerations for the Form 10-K in 2020.
Section II of this memo describes our key considerations for Annual Meeting Proxy Statements in two parts:
(1) Housekeeping and Deep Cleaning Items to Prepare for 2020 Annual Meeting Proxy Statements; and
(2) Top Seven Considerations for 2020 Annual Meeting Proxy Statements.
Section I: Considerations for Annual Reports on Form 10-K in 2020
Recent SEC rulemaking and other developments in 2019, including rules adopted in 2019 pursuant to the FAST Act,1 have resulted in a number of changes to SEC filings, including your upcoming 10-K, as described below.
(1) Housekeeping Items for Form 10-Ks in 2020
As a result of the FAST Act rule changes, the following housekeeping items should be addressed for upcoming Form 10-Ks:
Update 10-K Cover Page: First, make sure your Form 10-K cover page is updated to reflect the most recent changes to the form adopted pursuant to the recent FAST Act rule changes, as follows:
- Add the trading symbol (your company's ticker) to the cover page; and
- Remove the statement and checkbox showing delinquent Section 16 filings (this is now left for proxy disclosure, see "Housekeeping Items for Proxy Statement" in Section II below).
Note that two additional changes were made to the Form 10-K cover page in 2018 pursuant to additional rule amendments.2 Given all of these recent changes, it is important to confirm that your Form 10-K cover page reflects all recent updates (see also XBRL changes to the cover page, described in "XBRL Changes" below).3
Update Executive Officer Heading: Second, for companies that include executive officer biographies in the Form 10-K, the heading should be changed to "Information about our Executive Officers," instead of "Executive officers of the registrant."4
(2) Top Seven Disclosure Considerations for the Form 10-K in 2020
Below is our list of the top seven items to consider when preparing your upcoming Form 10-K in 2020.
(1) MD&A: Revised Item 303 of Regulation S-K requires only a two year discussion of financial results. Specifically, companies are permitted to eliminate discussion of the earliest of the three-year period presented in their financial statements if: (i) such discussion is already included in any of its prior SEC filings and (ii) the company identifies the location in the prior filing where the omitted discussion may be found. While we expect most companies to take advantage of this rule change, it is important to first confirm whether any of the discussion of the third earliest year remains material and should therefore still be included in the MD&A.5
(2) Description of Property: Item 102 of Regulation S-K was revised to emphasize materiality and now requires disclosure of physical properties to the extent such properties are material to the company. Accordingly, for this year's Form 10-K, it is important to assess which, if any, of a company's properties warrant discussion based on what is material in light of the company's particular circumstances. In some cases, application of this analysis may result in a description of property on an individual basis or on a collective basis, or may result in no disclosure at all.6
(3) Exhibits: The following items should be considered when preparing your upcoming Form 10-K exhibit list:
- New Exhibit to Form 10-K – Description of Registered Securities: Item 601 of Regulation S-K was revised to now require that companies file a new exhibit with their Form 10-K providing a description of each class of registered securities. Previously, this information was only required to be provided in registration statements filed under the Securities Act of 1933. Descriptions of company securities from prior SEC filings can provide a useful starting point for this new exhibit; however, registrants will need to assess whether updates are needed, for example, to reflect changes to their certificate of incorporation or bylaws.
- Material Contracts No Longer Required If Fully Performed: For companies that are not "newly reporting registrants,"7 Item 601(b)(10) now requires material contracts to be filed only if they are to be performed in whole or in part at or after the filing of the report. The previous rule had also required material contracts that were fully performed before the filing date but that were entered into within two years of the filing to be filed. Accordingly, companies should review their exhibit index to check if any material contracts can be removed from the exhibit index pursuant to this rule change.
- Redaction of Confidential Information: Companies are now permitted to omit confidential information from material contracts without having to submit a formal confidential treatment request ("CTR"), so long as the redacted information: (i) is not material and (ii) would likely cause competitive harm to the company if publicly disclosed. Companies should follow the procedures for redactions described in recent Staff guidance, which also notes that the Staff is selectively reviewing filings for compliance.8 As an alternative, companies can still use the traditional CTR process (see Staff guidance issued in December 2019).9 Furthermore, companies that previously obtained a confidential treatment order that is about to expire must still file an application to continue to protect the confidential information from public release; accordingly, it is important to assess whether existing CTRs are set to expire in the upcoming year.10 In all cases, a company should confirm that the omitted information is not material and that it only omits information that it treats as private or confidential. Information that has previously been made public (either by the company or a third party) would not be eligible for confidential treatment.
- Omission of Schedules; Personally Identifiable Information: New paragraph (a)(5) of Item 601 of Regulation S-K now allows registrants to omit schedules and similar attachments to exhibits, provided: (i) they do not contain material information, and (ii) were not otherwise disclosed in the exhibit or the disclosure document.11 Accordingly, for new exhibits, a company should assess whether it can omit any exhibit schedules or attachments under this rule change. In addition, new paragraph (a)(6) of Item 601 of Regulation S-K now explicitly allows a registrant to omit personally identifiable information from exhibits, such as bank account numbers, social security numbers, home addresses and similar information.
(4) Risk Factors: As a result of the FAST Act rule changes, the SEC relocated the risk factor disclosure rule from Item 503(c) to Item 105 of Regulation S-K. More importantly, the SEC also eliminated the generic risk factor examples from the rule in order to encourage companies to focus on their particular businesses when identifying and disclosing risks.
For upcoming Form 10-Ks, a number of recent trends and events may impact risk factor disclosures, as well as disclosures in other sections of the annual report. Although each company will need to assess its own material risks and tailor risk factors to its unique circumstances, below is a list highlighting certain areas of SEC focus and key trends that a company should also consider when assessing its risk factors.
- Cybersecurity: As cybersecurity incidents and data misuse continue to persist, the SEC staff has been focusing on, and providing comments regarding, cybersecurity and privacy disclosures. As part of this focus, the SEC staff monitors press reports and may raise questions directly with affected companies about the sufficiency of cybersecurity or privacy disclosures in SEC reports on that basis. SEC guidance,12 as well as recent high profile enforcement actions for inadequate or misleading disclosures,13 emphasize that cybersecurity and complying with personal data rights pose economic, operational, and reputational risks that can impact any company. With respect to disclosure issues, recent cases caution against framing risk factor disclosures in hypothetical terms without addressing actual incidents experienced by a company.14 Material cybersecurity and data privacy risks must be disclosed and, to the extent the company already experienced actual cybersecurity or data misuse incidents, such occurrences and their impact on the company should be described if they are material or otherwise are required to be disclosed as a matter of context. Companies are cautioned against the use of "may" happen with respect to something that has already happened in the past or is currently happening. In addition, other specific disclosure with respect to cyber and data risks associated with suppliers and acquisition targets, among others, may be warranted. Meanwhile, the impact on corporate operations of an ever-expanding and complex array of personal data privacy laws throughout the world often requires additional risk disclosures. Most notable in this regard is compliance with the European Union's General Data Protection Regulation (the "GDPR"), which became effective in 2018 and remains a material issue for many companies regardless of whether they have a physical presence in Europe. Compliance with the GDPR could require changes to a company's business practices on whether and how to collect and use certain types of personal data, affect a company's ability to transfer personal data internationally, impact decisions to expand into certain regions or lines of business, and subject companies to sizable financial penalties, all of which could materially adversely affect profitability and outlook. Similarly, the California Consumer Privacy Act (the "CCPA"), effective January 1, 2020, has companies evaluating whether the new law poses material risks to their business model, especially with respect to restrictions on the broadly defined "sale" of personal data. Companies should consider what non-boilerplate disclosures, if any, are necessary with respect to their readiness for compliance, as well as the business impact of compliance, with these and other emerging data privacy laws and regulations.
- IP and Technology Risks: In December 2019, the SEC's Division of Corporation Finance ("Corp Fin") released guidance specifically calling on companies to assess risks related to the potential theft or compromise of their technology, data or intellectual property in connection with their international operations and disclose them where material.15 Beyond direct intrusions, the guidance notes that companies may also face theft or compromise of these assets via indirect routes. For example, a company's products may be reverse engineered by joint venture parties, including those affiliated with state actors. The guidance encourages companies to consider a range of questions when assessing these risks, including whether they are operating in foreign jurisdictions where the ability to enforce rights over intellectual property is limited as a statutory or practical matter, and whether they have controls and procedures in place to adequately protect technology and intellectual property. The Staff also emphasized that disclosure of material risks should be specifically tailored, and that where a company's technology, data or intellectual property is being (or previously was) materially compromised, hypothetical disclosure of potential risks is not sufficient to satisfy a company's reporting obligations. Furthermore, companies should continue to consider this evolving area of risk and evaluate its materiality on an ongoing basis.
- Brexit: Brexit disclosure remains one of the SEC's key areas of focus for the upcoming season. The uncertainty surrounding Brexit-related developments means that companies are preparing for different outcomes, mitigating the risk of whatever outcome they may face, and investors should be informed about the nature and extent of those risks and about the steps companies are taking to prepare for them. Through comment letters, guidance and speeches, the SEC continues to caution companies against boilerplate disclosure in this area. If Brexit-related risks represent material risks to the company, disclosure should be tailored and should describe with sufficient specificity how Brexit is expected to impact the company and its operations. SEC Chairman Jay Clayton and Corp Fin Director Bill Hinman have both emphasized the importance of Brexit disclosure, and SEC Staff may closely review SEC filings to assess whether companies adequately address the impact of Brexit, including indirectly through other businesses and individuals on whom the company relies.16
- LIBOR: In light of the expected discontinuation of LIBOR after 2021,17 the SEC staff issued guidance in July 201918 stating that: (i) companies should consider disclosing their efforts to date to identify and mitigate associated risks and assess their impacts, as well as disclosing any significant matters yet to be addressed; (ii) if a material exposure to LIBOR has been identified but the company cannot yet reasonably estimate the expected impact, companies should consider disclosing that fact; and (iii) disclosures that allow investors to see this issue through the eyes of management are likely to be the most useful for investors (such as information used by management and the board in assessing and monitoring how transitioning from LIBOR may impact the company). The SEC staff expressly indicated that it is actively monitoring the extent to which risks related to the discontinuation of LIBOR are being addressed, and noted that companies should assess whether disclosure may be appropriate in their risk factor section as well as in the MD&A, the business section, the financial statements and/or the discussion of board risk oversight responsibilities.
- Regulatory: Changes and potential changes in law, regulation, policy and/or political leadership may necessitate modifications to risk factor disclosure for certain companies. Some examples include: tariffs (imposed or threatened) on imports, as well as possible retaliatory tariffs imposed on US exports; potential or actual withdrawal or modification of international trade agreements; modifications to sanctions imposed on other countries; changes to immigration policies that may present material risks to companies that rely on foreign employees or contractors; changes in tax or environmental policies; and political developments in the US.
- Environmental: Environmental issues such as climate change have been receiving increased attention, and companies should consider whether they present material risks for their businesses. Risk factor disclosure related to environmental issues should be tailored to the specific circumstances of a company and can address a number of topics, including applicable environmental regulations and the impact of climate change on a company's business, such as risks of increased costs or reduced demand for products, carbon asset risk, risks due to severe weather events, and management of greenhouse gas emissions, among other environmental issues. In 2019, Corp Fin director Bill Hinman specifically encouraged companies "to consider their disclosure on all emerging issues, including risks that may affect their long-term sustainability" and "whether their disclosure is sufficiently detailed to provide insight as to how management plans to mitigate material risks."19
- Human Capital Management: Companies should assess whether they have material risks associated with human capital management. The SEC recently proposed rules that would require the business section of a company's Form 10-K to include, to the extent material, a description of the company's human capital resources, including any human capital measures or objectives that management focuses on in managing the business.20 Although these are only proposed rules at this stage, there is heightened focus on this issue from the SEC and investors, and accordingly, a company should be assessing what—if any—material issues their company faces with respect to human capital management and consider any appropriate updates to risk factor disclosure.
- Industry Specific Risks: Each company needs to identify its specific material risks, and many risk factor trends are industry specific. For example, certain companies in the health or pharmaceutical industry have included disclosure regarding risks related to the health crisis involving opioid abuse, while several companies, mainly in the retail industry, have added risk factors related to the potential impact of gun violence on their businesses.
(5) Critical Audit Matters ("CAMs")21: Under the Public Company Accounting Oversight Board's ("PCAOB") new auditing standard, AS 3101, subject to transition periods, an auditor's report in a Form 10-K must disclose any CAMs arising from the current period's audit, or state that the auditor determined there were no CAMs for that period.22 Large accelerated filers are now subject to the CAM requirements (large accelerated filers with June 30, 2019 fiscal year ends were the first companies required to disclose CAMs). Accelerated filers and non-accelerated filers will be subject to the CAM requirements for audits of fiscal years ending on or after December 15, 2020.
For any CAM, the auditor must disclose the principal considerations that led the auditor to determine that the matter is a CAM and how the CAM was addressed in the audit, among other items. A CAM is any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (i) relates to accounts or disclosures that are material to the financial statements and (ii) involved especially challenging, subjective or complex auditor judgment. The PCAOB's standard also provides a non-exclusive list of factors to be considered by an auditor to determine whether a matter is a CAM, including risks of material misstatement, the extent of audit effort and subjectivity required, and the degree of judgment involving estimates with significant measurement uncertainty.
It is important for a company to engage with its auditor early and on a regular basis regarding potential CAM disclosure. The PCAOB recently noted that some audit teams began the process to determine CAMs as early as the second or third quarter of the fiscal year and that starting early provided ample time to identify CAMs and draft disclosure.23 The most frequently communicated CAMs have so far related to goodwill and other intangible assets; revenue recognition; taxes; and business combinations.24 For companies reporting CAMs in their upcoming Form 10-Ks, it will be important to ensure that disclosure is consistent throughout an annual report with respect to any matter disclosed as a CAM.
(6) Non-GAAP Financial Measures: The SEC continues to focus on non-GAAP measures, so it is important to pay careful attention to the use and disclosure of such measures each fiscal quarter, including:
- Ensuring that when a non-GAAP measure is used, the comparable GAAP measure is disclosed with equal or greater prominence, and a reconciliation of the two measures provided; and
- Maintaining consistent treatment of items between periods.
Moreover, the Staff's Compliance & Disclosure Interpretation ("C&DI") 100.01 reminds companies that some adjustments may be prohibited because they result in a non-GAAP presentation that is misleading. The example provided in the C&DI—that a performance measure excluding normal, recurring, cash operating expenses necessary to operate a registrants business could be misleading—is the basis for a number of recent Staff comments. Accordingly, a company should not only assess its compliance with non-GAAP disclosure requirements, but should also assess whether a non-GAAP measure itself may be misleading.
(7) XBRL Changes and Hyperlinking
- Tagging of Cover Page in Inline XBRL: As a result of the FAST Act rule changes, subject to the transition periods described below, all of the information on the cover page of the Form 10-K (as well as the Form 10-Q and Form 8-K) must be tagged in Inline XBRL, which embeds XBRL data directly into an HTML document.25 Large Accelerated Filers were the first filers required to begin tagging cover pages in Inline XBRL (starting with Form 10-Qs filed for fiscal periods ending on or after June 15, 2019). Accelerated Filers will be required to tag cover pages in Inline XBRL starting with Form 10-Qs for fiscal periods ending on or after June 15, 2020, and all other filers will be required to do so starting with Form 10-Qs for fiscal periods ending on or after June 15, 2021. These dates are identical to the mandatory compliance dates for the tagging of financial statement information in Inline XBRL elsewhere in periodic reports.26
- New Exhibit for Cover Page Inline XBRL Data: The FAST Act rule amendments also now require companies tagging cover page data in Inline XBRL (as described above) to list new Exhibit 104 in the exhibit index of their periodic reports (as well as in Form 8-Ks when other exhibits are also listed).27 New exhibit 104 should include the word "Inline" within the title description and should cross-reference the Interactive Data Files submitted under Exhibit 101.28 In addition, companies subject to Inline XBRL requirements should also update Exhibit 101, including by adding the word "Inline" to their title descriptions.29
- Hyperlinking: As a result of the FAST Act rule changes, the SEC now requires an active hyperlink to information incorporated by reference from another SEC filing. Accordingly, to the extent a company's Form 10-K incorporates by reference information from a prior SEC filing, it will need to include an active hyperlink to the prior filing. With respect to a company's financial statements, however, the SEC now explicitly prohibits incorporating by reference to (or cross-referencing to) information outside of the financial statements, unless otherwise specifically permitted or required by SEC rules, US GAAP or IFRS, as applicable.
Section II: Considerations for 2020 Annual Meeting Proxy Statements
Recent SEC rulemaking and developments in corporate governance have resulted in a number of changes to consider for 2020 proxy statements. Due to heightened focus by investors and litigants on proxy statement disclosure, it is crucial for companies to carefully draft and review their proxy disclosure in light of all applicable rules and policies, including SEC rules and proxy advisory firm and investor policies, among others. The following are key considerations from White & Case's Public Company Advisory Practice for your upcoming annual meeting proxy statement.
(1) Housekeeping and Deep Cleaning Items to Prepare for 2020 Proxy Statements
When preparing for proxy season and the drafting of your proxy statement, the following initial items should be addressed:
- Finalize Your Proxy Calendar: First, make sure you have a proxy calendar that is reviewed and vetted by the company's advisers and service providers (outside counsel, transfer agent, printer, proxy solicitor, etc.). Key dates to confirm include the annual meeting date, the record date and the proxy statement filing date, among others, and there are a number of applicable rules (SEC, state law, company governance documents) as well as practical considerations to consider in order to finalize your calendar.
- Confirm if a Preliminary Proxy Statement is Required: In order to finalize a proxy calendar, companies need to confirm at an early stage that no preliminary proxy statement is required (a preliminary proxy is required if there is an item on the agenda that is not listed in Rule 14a-6, such as a proposal to amend a certificate of incorporation). When a preliminary proxy statement is required, changes must be made to a proxy calendar to allow for the earlier filing and ten calendar-day SEC review period.30
- Review, Update and Distribute D&O Questionnaires: Make sure your D&O Questionnaires are reviewed and updated as appropriate and distributed to (and received from) directors and executive officers on a timely basis. In light of the Staff's 2019 C&DI on board diversity,31 questions for a D&O Questionnaire that inquire about diversity characteristics remain a topic of debate, but to the extent a company plans to include disclosure related to directors' diversity characteristics, a company should obtain the consent of directors for such disclosure, and a D&O Questionnaire can be one way to obtain such consent.
- Confirm Updates for 162(m) Changes: In light of the 2017 Tax Cuts and Jobs Act changes to Section 162(m) of the Internal Revenue Code, a company should assess if it still has any outstanding incentive awards that are grandfathered for purposes of Section 162(m) and thus require final certification of payout by an outside director committee.32 As long as a company still has outstanding grandfathered awards , Section 162(m) performance-based items such as "outside director" status should remain in a company's compensation committee charter, and questions on "outside director" status should remain in a company's D&O Questionnaire. However, once a company no longer has outstanding grandfathered awards, these references to "outside director" status and to any other Section 162(m) performance-based requirements may be removed from a compensation committee charter and D&O Questionnaire. When it comes to a company's CD&A in its proxy statement, each company should consider any appropriate updates to its tax-related disclosure, including any appropriate clarifications on the impact of the Section 162(m) related regulatory developments.33
- Confirm Sufficient Shares Available for Grants under Equity Compensation Plans: Confirm as early as possible that no additional shares are required for future grants under an equity compensation plan. A company should confirm both the number of existing shares still available for grant, as well as its plans for future equity grants. Adding shares to a plan can be a straightforward exercise when planned well in advance, but it also involves many to-do items (including, for example, updating the equity compensation plan itself; carefully form-checking the equity plan proposal, which has been a hot-bed target for litigants; considering ISS and Glass Lewis policies to determine whether they will support the proposal and drafting disclosure to obtain their support; and finally, drafting a Form S-8 and supplemental listing application to list the additional shares).
- Draft and Review Voting Standards Disclosure: Once an annual meeting agenda is finalized, confirm proxy statement disclosure on the voting standards that will apply to each agenda item, as well as how broker non-votes and abstentions will be treated. Getting this correct means considering the applicability of state law, your certificate of incorporation, bylaws and stock exchange requirements to each proposal.
- New Heading for Delinquent Section 16(a) Reports: Under the FAST Act rule changes, the proxy statement heading that discloses any late Section 16 reports must be changed from "Section 16(a) Beneficial Ownership Reporting Compliance" to "Delinquent Section 16(a) Reports." Companies are encouraged to exclude this heading when they have no Section 16(a) delinquencies to report. Given the focus by certain litigants on proxy statement disclosure, including this section, it is crucial that companies vet this information carefully, making sure that their proxy statement disclosure aligns with the timing of Section 16 reports filed publicly with the SEC during the year.
- Audit Committee Report Rule Updated (Finally): For companies' audit committee reports, the FAST Act rule changes finally removed an outdated PCAOB rule reference in Item 407(d)(3)(i)(B) so that it now simply refers to "the matters required to be discussed by the applicable requirements of the PCAOB" when referencing the matters that the audit committee discussed with the auditors.34 Over the years, many companies updated their audit committee reports with a generic reference similar to the one adopted by the SEC, but to the extent a company has not updated its audit committee report (or had instead opted to update the specific auditing standard reference), we recommend simply making the change this year to align with the amended rule.
(2) Top Seven Considerations for 2020 Annual Meeting Proxy Statements
Below are our top seven items to consider when drafting your annual meeting proxy statements.
(1) New Hedging Disclosure Requirement in Effect: New Item 407(i) of Regulation S-K requires that a company describe any practices or policies it has adopted (whether written or not) regarding the ability of its employees, officers or directors (or any of their designees) to purchase financial instruments or to engage in transactions that hedge or offset, or are designed to hedge or offset, any decrease in the market value of equity securities granted as compensation to, or held directly or indirectly by, the employee or director.35
For the upcoming proxy season, it is important to review existing hedging policies and practices, and confirm that proxy disclosure is drafted to align with these. Although there is no requirement under the SEC rule to revise existing hedging policies (which companies commonly include in insider trading policies), there are several to-do items as a result of the new disclosure rule, including the following:
First, Describe Your Existing Hedging Policy. The new hedging disclosure must accurately describe a company's existing hedging policy (such as its coverage of directors and executive officers, and categories of transactions that are specifically permitted or disallowed by the policy). A company is not required to describe what its hedging policy does not include (such as that its policy does not cover employees other than executive officers), but if a company does not have any hedging policy or practice, it must disclose that fact (or state that hedging is generally permitted).36
Second, Consider Placement in Proxy Statement. Placement of the Item 407(i) hedging disclosure can be in the CD&A or outside of the CD&A. To the extent existing CD&A disclosure already describes a company's hedging policy, the new SEC rule does not require companies to move or duplicate this disclosure elsewhere. The SEC's adopting release notes that including the disclosure outside of the CD&A would avoid subjecting it to say-on-pay votes.37 However, due to the nature of this disclosure and the fact that it is already commonly disclosed in the CD&A pursuant to Item 402(b)(2)(xiii), we do not typically expect there to be benefits to moving it outside the CD&A.
Third, Consider ISS, Glass Lewis and Your Investor Policies. Although the new SEC rule does not require a company to adopt a hedging policy, there will likely be increasing pressure on companies without any hedging policy to adopt one. Proxy advisory firms and institutional investors generally favor robust hedging policies. For example, ISS notes in its reports whether a company has a "robust" hedging policy, which it defines as one that prohibits all types of hedging transactions by a broad group of participants.38 To the extent pressure from proxy advisory firms and investors increases on this issue, it may be prudent to reassess and consider expanding existing hedging policies (for example, to cover employees, rather than only executive officers).
(2) Director Elections—Focus on Key Disclosure Items for Director Support: A crucial aspect of annual proxy statement preparation is ensuring that disclosure is drafted in order to obtain shareholder support for your directors. Understanding where your disclosure can raise red flags and reduce shareholder support for your directors is key. Below is a sample list of some items to consider:
Director Elections: Director Independence Disclosure. Proxy advisory firms each have their own director independence criteria, and these criteria generally should be assessed alongside NYSE or Nasdaq requirements, as applicable, to ensure shareholder support for a company's directors.
For a proxy statement's director independence section, under Item 407(a), a company must identify each director who is independent under NYSE or Nasdaq standards (as applicable). In addition, under Item 407(a)(3), a company's proxy statement must describe, by specific category or type, any transaction, relationship or arrangement that was considered by the board of directors under the applicable independence standard in determining that a director is independent.39 For this disclosure, there is a range of practices, but in any event, companies should consult with counsel to, among other things: (i) determine which transactions, relationships and arrangements warrant consideration by a board in an independence determination and therefore require proxy disclosure, and (ii) draft disclosure clearly so as not to raise issues under the proxy advisory firm independence criteria.
Director Elections: Director Attendance Disclosure. A director's poor attendance at board and/or committee meetings, which typically means attendance at less than 75 percent of such meetings, can result in reduced shareholder support for that director. During the 2019 proxy season, more than 60 directors at Russell 3000 companies received negative ISS recommendations for this reason, with four such directors receiving less than 50 percent of the votes cast as a result. In the proxy statement, companies should make sure that their disclosure under Item 407(b) clearly notes whether their directors attended at least 75 percent of the meetings of the board and committees on which they served. If a director did not attend this threshold percentage of meetings, the SEC rule requires a company to name such director, and in this situation, a company should carefully consider the best approach to drafting this disclosure.40
Director Elections: Overboarding/Outside Directorship Disclosure. Given the increasingly strict overboarding policies of institutional investors, it is crucial to monitor the number of outside directorships your company's directors hold. During the 2019 proxy season, opposition to directors of Russell 3000 companies increased to its highest level since 2011, due in part to new or stricter overboarding policies of some institutional investors. Public company executives who sat on more than two outside public company boards were particularly hard hit, and a number of directors saw their support drop 25 percent or more on a year-over-year basis. Two key tips on this:
First, Know Your Key Investors' Policies. A company should be aware of what its investors' policies are with respect to overboarding and educate its board of directors on these policies. If a director serves on more than the number of public company boards permitted by a particular policy, consider and weigh the range of options before filing your proxy statement (for example, by considering the percentage of votes which could potentially be lost if a director is overboarded, and if necessary, by requesting that the director step down from an outside board). In any event, controls should be in place to avert overboarding issues in the future. An overview of the overboarding policies of ISS and Glass Lewis, as well as key institutional investors, is provided below for your reference.41
Second, Carefully Draft Your Director Biographies in the Proxy Statement. In proxy statements, information on outside directorships is provided in the directors' biographical section pursuant to Item 401(e)(2) of Regulation S-K. Based on this disclosure, investors can find information on the number of outside directorships which a company's directors hold.
One key point on this outside directorship disclosure is that, to the extent a director at your company is serving on an outside private company's board of directors, there should be no need to disclose this information under the SEC rule.42 Moreover, if a private company directorship is voluntarily disclosed, your proxy statement should clarify that the outside directorship is at a private company in order to avoid having that directorship inadvertently counted against the director under an overboarding policy.
A second key point is to consider disclosing any extenuating or additional circumstances. For some investors, this additional explanation may be helpful if a director is overboarded. For example, Vanguard's policy states that a fund might vote for an overboarded director if the director has publicly committed to stepping down from a directorship in order to fall within the thresholds.43
Director Elections: Disclosure to Prepare for Special Cases. A number of other situations necessitate additional and often significant proxy disclosure to address investor concerns and maintain support for a company's directors, such as: (i) support below 70 percent for a say-on-pay proposal and (ii) significant support for a shareholder proposal. Even if your company is not facing these issues, it is important to plan in advance and strategize on your proxy statement disclosure to maintain investor support and help avert these types of situations.44
(3) Perquisites—Prioritize Your Company's Perquisite Processes: Perquisites continue to be a hot-button disclosure issue and a focus for the SEC in its reviews of proxy statement disclosure.45 In 2018, two SEC enforcement actions put the spotlight on perquisite disclosure. The key take-away for companies is to be organized and have processes in place to ensure that all benefits provided to executive officers are tracked, evaluated under the appropriate disclosure standard and properly disclosed if required.
SEC Perquisite Disclosure Standard. As a reminder, under the SEC's perquisite disclosure standard, an item is not a perquisite if it is integrally and directly related to the performance of the executive's duties. However, an item is a perquisite if it confers a direct or indirect benefit that has a personal aspect, even if it may be provided for some business reason or for the company's convenience, unless it is generally available on a non-discriminatory basis to all employees. As the SEC reiterated in a recent enforcement action, the concept of a benefit that meets the first exception and is therefore integrally and directly related to job performance is "a narrow one" and only applies to items that an executive "needs [to] do the job."46
(4) Pay Ratio—Year Three: The 2020 proxy season will be the third year for mandatory pay ratio disclosure.47 The pay ratio rule, which requires disclosure of the ratio of the annual total compensation of a company's median employee to that of its chief executive officer, permits a company to identify its median employee once every three years, as long as the company reasonably believes there has not been a change in its employee population or compensation arrangements that would significantly alter the pay ratio disclosure. Whether or not a company used the same median employee for the first two years, it should confirm based on its own facts and circumstances if it is appropriate to do so for this year's proxy disclosure.48
(5) Clawback Policies on the SEC Agenda Again: The SEC's proposed clawback rules from 2015 pursuant to Section 954 of the Dodd-Frank Act, which would have required a company to recover compensation from current and former Section 16 officers if a company were required to prepare an accounting restatement due to material noncompliance with any financial reporting requirement,49 have not been adopted, but the SEC recently put clawbacks back on the agenda by listing a new clawback rule proposal as an item that the SEC intends to complete within the next year.50
Increased Investor Scrutiny of Clawback Policies. A large number of companies have adopted clawback policies,51 which often meet ISS "best practice" and, for example, trigger a clawback of compensation from an executive officer when there is a financial restatement and misconduct by the executive. Moreover, high-profile scandals have led to scrutiny of clawback policies by investors as well as a push to expand clawback policies,52 while shareholder proposals on clawback policies appear to be gaining some traction. During the 2019 proxy season, two shareholder proposals on clawback policies passed, and there was significant average support of 45 percent for the three clawback proposals that went to a vote.53
Expanding Clawback Policies. Meanwhile, some companies have been expanding their clawback policies to trigger a clawback of compensation not only in the case of a financial restatement, but also if there is a significant violation of a code of conduct or reputational harm to a company. With clawback policy drafting, the devil, of course, is in the details, and when drafting a clawback policy, it is crucial to, among other things, weigh state law considerations, determine appropriate triggering events, and provide the board with sufficient discretion to act appropriately in times of crisis to address investor concerns.
Next Steps on Clawbacks. Given the recent SEC agenda, it may be appropriate to take a wait-and-see approach before modifying an existing policy, but knowing what your clawback policy says, and making sure it is accurately described in your proxy statement, is a crucial first step. In addition, some companies may consider assessing the feasibility of a more expanded clawback policy and weigh the benefits of adopting such a policy.
(6) Don't Forget Non-GAAP: Given the SEC scrutiny of non-GAAP disclosures (see Section I of this memo), a company should also make sure it is appropriately disclosing any non-GAAP financial measures in its proxy statement. When compensation target levels disclosed in a CD&A are non-GAAP financial measures, the disclosure is not subject to the SEC's non-GAAP requirements in Regulation G and Item 10(e), but a company must still provide disclosure as to how the numbers are calculated from the company's financial statements.54 For other pay-related circumstances, non-GAAP financial measures disclosed in a proxy statement are subject to the SEC's non-GAAP rules, but a company may be able to provide the required GAAP reconciliation in an annex to the proxy statement, provided that there is a prominent cross-reference to such annex.55
(7) Last (but not least)—Board Role in Risk Oversight: One of the evolving sections of the proxy statement in recent years has been the board risk oversight section. Item 407(h) of Regulation S-K requires companies to disclose the board's role in the risk oversight of a company, such as how the board administers its oversight function. In recent guidance, the SEC has emphasized that companies should also discuss how their boards oversee the management of material risks. For example, with respect to cybersecurity, SEC guidance notes that, "[t]o the extent cybersecurity risks are material to a company's business, we believe this discussion [under Item 407(h)] should include the nature of the board's role in overseeing the management of that risk."56 Similarly, Corp Fin Director Bill Hinman noted in a 2019 speech that companies may find the SEC's cybersecurity guidance useful when preparing disclosures about sustainability matters and other risks.57 Accordingly, companies should assess their disclosure for this section and consider providing additional information on the key risks that their boards oversee, as well as which committees oversee such risks.58
1 Referred to herein as the FAST Act rule changes. For more information, see our prior alert, "SEC Adopts Amendments to Modernize and Simplify Disclosure Requirements."
2 These changes included the removal of language on "posting" the company's Interactive Data Files on its corporate website and the removal of language next to the non-accelerated filer checkbox that companies "not check" the box if they are a smaller reporting company.
3 The SEC website generally provides a current version of the SEC's forms, available here. Regulation S-K is available here.
4 See Instruction to Item 401 of Regulation S-K.
5 The SEC's adopting release on the FAST rule changes, available here, states: "We continue to encourage registrants to take the opportunity to reevaluate their disclosure in light of these amendments and determine whether a discussion of the earliest year's information remains material."
6 Note that the SEC did not revise the Item 102 instructions for the mining, oil and gas, and real estate industries under the FAST Act rule changes. Companies with material mining operations should also note that the SEC recently adopted rules to modernize the mining property disclosure requirements (see "SEC Adopts Rules to Modernize Property Disclosures for Mining Registrants" (October 31, 2018), available here).
7 The term is defined in Instruction 1 to paragraph (b)(10) of Item 601 and includes companies that are not subject to Exchange Act reporting obligations and certain shell companies.
8 For more information on the procedures for exhibit redactions, as well as information on Staff reviews of redacted exhibits, see Staff guidance, available here.
9 See Staff guidance, available here. Also see prior Staff guidance on extensions available here.
10 The short-form application provides a streamlined process to file an application to extend the time for which confidential treatment has been granted, but may only be used if the confidential material is the subject of an unexpired order granting confidential treatment. See Staff guidance, available here.
11 Note that new Item 601(a)(5) requires companies that omit schedules to provide a list in the filed exhibit that briefly identifies the contents of all omitted schedules; however, the new rule also states that companies "need not prepare a separate list of omitted information if such information is already included within the exhibit in a manner that conveys the subject matter of the omitted schedules and attachments."
12 In February 2018, the SEC published interpretive guidance to assist public companies in preparing disclosures about cybersecurity risks and incidents, available here.
13 With respect to cybersecurity, the SEC found that Yahoo's risk factor disclosures in its annual and quarterly reports were materially misleading in that they claimed the company only faced the "risk of potential future data breaches" that might expose the company to loss and liability "without disclosing that a massive data breach had in fact already occurred." The SEC's action is available here. For more information, see our prior alert, "SEC Fines Yahoo $35 Million for Failure to Timely Disclose a Cyber Breach." With respect to data privacy, Facebook agreed to pay $100 million to resolve SEC allegations regarding the sufficiency of the social network's public disclosures that, according to the SEC, "presented the risk of misuse of user data as merely hypothetical" despite knowing that a third party developer had actually misused the data. The SEC complaint is available here.
14 For example, the Yahoo case focused on disclosure of "possible" data breaches when the company had already experienced such a breach.
15 The guidance is available here.
16 See "SEC Rulemaking Over the Past Year, the Road Ahead and Challenges Posed by Brexit, LIBOR Transition and Cybersecurity Risks" (December 6, 2018), available here; see also "Applying a Principles-Based Approach to Disclosing Complex, Uncertain and Evolving Risks" (March 15, 2019), available here.
17 LIBOR is an indicative measure of the average interest rate at which major global banks could borrow from one another and is quoted for multiple currencies and time frames. It is used extensively in the US and globally as a "benchmark" or "reference rate" for various commercial and financial contracts. See SEC guidance available here.
18 Available here.
19 See "Applying a Principles-Based Approach to Disclosing Complex, Uncertain and Evolving Risks" (March 15, 2019), available here.
20 See "SEC Proposes Amendments to Modernize Disclosures; Considers Requiring Human Capital Resources Disclosure" (August 12, 2019), available here.
21 For more information, see our prior alert, "SEC Approves PCAOB's New Audit Report Standard to Enhance the Relevance of the Auditor's Report to Investors and Other Market Participants." Also see AS 3101, available here.
22 Does not apply to audit reports of emerging growth companies ("EGCs"), certain brokers and dealers, investment companies other than business development companies and benefit plans.
23 See Critical Audit Matters Spotlight, available on the PCAOB website here.
24 As of November 30, 2019. See Critical Audit Matters Spotlight, available on the PCAOB website here.
25 See the FAST Act rule changes adopting release, available here. Also see newly adopted Rule 406 of Regulation S-T.
26 Under SEC rules adopted in 2018, public companies are required, subject to transition periods, to submit financial statement information using the Inline XBRL format. The adopted rules also eliminated the requirements for filers to post Interactive Data Files on their websites. See Inline XBRL Filing of Tagged Data, Release No. 33-10514 (June 28, 2018), available here.
27 See Item 601(b)(104) to Regulation S-K, Rule 406 of Regulation S-T, and Question 101.04 of the Interactive Data C&DIs, available here.
28 See Question 101.01 of the Interactive Data C&DIs, available here. Also see Section 6.3.2 of the Edgar Filer Manual.
29 See Question 101.01 of the Interactive Data C&DIs, available here. Also see Section 5.2.5 of the Edgar Filer Manual.
30 See Rule 14a-6(a) of the Exchange Act. Also see Question 126.03 of the Proxy Rules and Schedules 14A/14C C&DIs, available here.
31 See Question 116.11 available here.
32 The Tax Cuts and Jobs Act eliminated the performance-based exception to the $1 million per executive annual deduction limit under §162(m), but provided for a transition rule to protect grandfathered contracts which were in effect as of November 2, 2017. Under the prior rule, outside directors were those directors who met the definition of "outside director" status and who could certify the performance of achievement goals under Section 162(m). For more information, see "Initial Guidance on Recent Changes to Section 162(m): Covered Employees and Grandfather Rule" (September 4, 2018), available here.
33 The IRS recently proposed rules to provide additional clarifications on the grandfather rule.
34 Previously, the language in Item 407(d) had stated: "the matters required to be discussed by the statement on Auditing Standards No. 61, as amended (AICPA, Professional Standards, Vol. 1. AU section 380), as adopted by the Public Company Accounting Oversight Board in Rule 3200T." In recent years, Auditing Standards No. 61 was updated to Auditing Standards No. 16, and subsequently, to the current standard in Auditing Standards No. 1301, which is available here.
35 Equity securities include securities of the company, any parent of the company, any subsidiary of the company, or any subsidiary of any parent of the company. The SEC did not define the term "hedge" in the new; rather, all transactions that establish downside price protection are covered.
36 As an alternative to a summary, a company may also disclose the practices or policies in full. See Item 407(i)(2). Also see page 21 of the adopting release on hedging, available here, for a discussion of the type of disclosure required by Item 407(i).
37 See footnote 119 of the SEC adopting release for Item 407(i), available here.
38 ISS definition available in Q244 here. Also see Glass Lewis policy available under "Hedging of Stock" on page 37 here, and Blackrock's policy available here.
39 Disclosure under Item 407(a)(3) is not required if the transaction, relationship or arrangement is already disclosed under Item 404(a) in the related person disclosure section of the proxy statement.
40 For example, consideration should be given to the "acceptable reasons" for absences under ISS and other policies.
41 Chart information is as of December 30, 2019. We note that some policies are drafted in terms of the total number of boards a director may serve on (including the subject company), while other policies are drafted in terms of the total number of outside boards a director may serve on (excluding the subject company). Our chart interprets each policy and presents them both ways for clarity.
42 See Item 401(e)(2) of Regulation S-K, which only requires a company to disclose current outside directorships (and those held in the past five years) of a company's directors at public companies (i.e., those with securities registered under section 12 or subject to the requirements of section 15(d) of the Exchange Act) and registered investment companies.
43 See Vanguard policy on "Overboarded Directors" available on page four here.
44 One-third of S&P 500 companies have received say-on-pay support below 70% at least once since 2011.
45 In one of these actions, the SEC imposed a cease-and-desist order against The Dow Chemical Company for omitting disclosure of approximately $3 million in perquisites received by its CEO, including the following items: use of company aircraft for personal purposes, including travel to outside board meetings and sporting events; club memberships; and membership fees to sit on the board of a charitable organization. Also in July 2018, the SEC charged the CEO of Energy XXI, Ltd., for failing to disclose as perquisites, among other items, first class airline tickets for the CEO's family members to attend a board meeting to which board member spouses were invited; the CEO's share of a bottle of wine purchased with other industry executives at a charity auction; use of a company aircraft to attend a football game featuring his college alma mater with other industry executives; and a private bar in the CEO's company office suite used for entertaining employees and guests.
46 See paragraph four of the SEC's order, available here.
47 Pay ratio disclosure is not required for EGCs or SRCs.
48 The analysis of whether a new determination of the median employee is required is a company-specific matter. For example, in some situations, a significant acquisition or divestiture may affect workforce composition or compensation arrangements. In other situations, changes in a company's employee population that have cumulated over two years may require a company to identify a new median employee for the third year of pay ratio disclosure. For more information, see our prior alerts, "SEC Adopts Final Rules on CEO Pay Ratio Disclosure" and "The SEC's New Guidance Provides Additional Flexibility for Compliance With CEO Pay Ratio Disclosure."
49 See proposed rules here. The proposed rules were broader than the existing clawback provisions under the Sarbanes-Oxley Act of 2002, which are limited to the CEO and CFO and require an accounting restatement due to material noncompliance as a result of misconduct.
50 See the SEC's active agenda under the Regulatory Flexibility Act (commonly known as the "Reg Flex Agenda"), which includes "Listing Standards for Recovery of Erroneously Awarded Compensation," available here.
51 In fact, according to one publicly available survey of 100 S&P 500 companies, more than 90 percent of the surveyed companies disclosed having a clawback policy in 2018.
52 See, e.g., "Investment Group Calls for Executive Clawback, Two New Board Directors at Wells Fargo" (September 23, 2016), The Wall Street Journal. With respect to investor policies, see, e.g., Blackrock's January 2019 Proxy Voting Guidelines available here, which state: "We generally favor recoupment from any senior executive whose compensation was based on faulty financial reporting or deceptive business practices. In addition to fraudulent acts, we also favor recoupment from any senior executive whose behavior caused direct financial harm to shareholders, reputational risk to the company or resulted in a criminal investigation, even if such actions did not ultimately result in a material restatement of past results. This includes, but is not limited to, settlement agreements arising from such behavior and paid for directly by the company. We typically support shareholder proposals on these matters unless the company already has a robust clawback policy that sufficiently addresses our concerns." Also see page 5 of CalPERS Proxy Voting Guidelines, available here.
53 In total, according to ISS data, there were approximately nine clawback proposals submitted to Russell 3000 companies during the 2019 proxy season, including:
Two shareholder proposals seeking the adoption of a clawback policy;
Three proposals seeking to expand a company's existing clawback policy to cover additional situations, such as "misconduct resulting in a material violation of law or the company's policy that causes significant financial or reputational harm to the company"; and
Three proposals requesting disclosure of recoupment activity from senior officers.
54 See Instruction 5 to Item 402(b).
55 See Question 108.01 in the Staff's C&DIs on Non-GAAP Financial Measures, available here.
56 Available here. Also see our prior alert, "SEC Issues Interpretive Guidance on Public Company Cybersecurity Disclosures: Greater Engagement Required of Officers and Directors."
57 See "Applying a Principles-Based Approach to Disclosing Complex, Uncertain and Evolving Risks" (March 15, 2019), available here.
58 Also see Glass Lewis’s policy which states: "Glass Lewis believes that companies should ensure appropriate board-level oversight of material risks to their operations, including those that are environmental and social in nature. Accordingly, for large cap companies and in instances where we identify material oversight issues, Glass Lewis will review a company’s overall governance practices and identify which directors or board-level committees have been charged with oversight of environmental and/or social issues," available here.
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