United States: Securities Update - March 2013

SEC Approves New NYSE and NASDAQ Compensation Committee Listing Standards

By Kimberly K. Rubel and Peter B. Wolf

The Securities and Exchange Commission (SEC) on January 11, 2013, approved the amended proposals of the NYSE and NASDAQ to amend their respective listing standards relating to independence requirements for compensation committees and compensation advisers of listed companies to comply with Rule 10C-1 adopted by the SEC pursuant to the Securities Exchange Act of 1934, as amended (Exchange Act). The SEC's adoption of Rule 10C-1 had been mandated by Section 952 of the Dodd-Frank Wall Street Reform and Protection Act of 2010.

The full text of the approved amendments can be found for the NYSE at http://www.sec.gov/rules/sro/nyse/2013/34-68639-ex5.pdf and for NASDAQ at http://www.sec.gov/rules/sro/nasdaq/2013/34-68640-ex5.pdf.

Deadlines

The NYSE and NASDAQ amendments become operative on July 1, 2013. By that date, listed companies must comply with the new standards relating to (i) the compensation committee's authority to, in its sole discretion, retain compensation advisers, (ii) the committee's direct responsibility for the appointment, compensation and oversight of compensation advisers, (iii) the company's responsibility to provide appropriate funding to pay the reasonable fees of the compensation advisers, and (iv) the committee's responsibility to consider conflicts of interest before selecting or receiving advice from any compensation advisers. For NYSE listed companies, this includes amending their compensation committee charters to comply with the new standards. For NASDAQ listed companies that do not have a separate compensation committee on July 1, 2013, the new standards described above apply to the independent directors who oversee the compensation of the company's chief executive officer and other executive officers. NYSE listed companies have until the earlier of their first annual shareholders' meeting after January 15, 2014 or October 31, 2014, to comply with the heightened compensation committee member independence standards.

NASDAQ listed companies have until the earlier of their first annual shareholders' meeting after January 15, 2014 or October 31, 2014, to comply with the remaining new standards, including those relating to (i) establishing a compensation committee, if not already in place, (ii) the adoption of a compensation committee charter or amendments thereto that complies with the new standards, and (iii) heightened compensation committee member independence. Each NASDAQ listed company must certify to NASDAQ that it has complied with the new standards no later than 30 days after the final implementation deadline applicable to it. There is no equivalent requirement for NYSE listed companies.

Heightened Compensation Committee Independence Standards

NYSE

In addition to general director independence standards, the amendments to the NYSE listing standards require the board to affirmatively determine the independence of each compensation committee member considering all factors relevant to determining whether he or she has a relationship with the company that is material to his or her ability to be independent from management in connection with his or her duties as a committee member. The board's consideration must include, but need not be limited to:

• Sources of compensation, including any consulting, advisory or other compensatory fees paid by the company to the director. In commentary, the NYSE states that the board should consider whether the committee member receives compensation from any person or entity that would impair his or her ability to make independent judgments about the company's executive compensation.
• Affiliations with the company, a subsidiary of the company or an affiliate of a subsidiary of the company. As explained by the NYSE in commentary, the board should consider whether an affiliate relationship places the committee member under the direct or indirect control of the company or its senior management, or creates a direct relationship between the director and senior management members, in each case of a nature that would impair his or her ability to make independent judgments about the company's executive compensation.

The NYSE retained commentary to director independence standards noting that ownership of even a significant amount of company stock does not, by itself, preclude finding that a director is independent.

While the board must consider these factors, this is not a bright-line test, and the board may find a director independent even though he or she receives a compensatory fee from or has an affiliation with the company, so long as his or her ability to make independent judgments about the company's executive compensation is not impaired.

NASDAQ

The amendments to the NASDAQ listing standards require compensation committee members to meet general independence standards and prohibit them from accepting, directly or indirectly, any consulting, advisory or other compensatory fees from the company or any of its subsidiaries, other than board and committee fees and fixed amounts under retirement plans for prior service (provided that such compensation is not contingent on continued service). Unlike the NYSE, the NASDAQ standard is a bright-line test, such that the receipt of any consulting, advisory or other compensatory fees by a director precludes serving on the compensation committee. This is the same standard NASDAQ applies to audit committee members. NASDAQ company boards must also consider whether compensation committee members are affiliated with the company, a subsidiary of the company or an affiliate of a subsidiary of the company and whether any affiliation impairs his or her judgment as a member of the compensation committee. In commentary, NASDAQ states that it does not view ownership of company stock in and of itself as a bar to compensation committee service, even if that ownership constitutes control.

The board is not required to apply a "look back" in making these determinations, so the prohibitions on fees and affiliations that must be considered are limited to those fees received or affiliations that existed during a director's committee service. As required by Rule 10C-1 of the Exchange Act, both exchanges' proposed listing standards contain cure periods that allow companies to correct deficiencies under specified limited circumstances by the earlier of its next annual shareholders' meeting or one year from the occurrence of the event that caused the deficiency.

Likewise, under exceptional and limited circumstances, NYSE and NASDAQ companies may appoint a non-independent director to the compensation committee if the company's board determines that such director's membership on the committee is in the best interests of the company and its shareholders, so long as the non-independent director is not currently an executive officer, employee, or a family member of an executive officer, and the committee is comprised of at least three members.

Compensation Committee Authority and Responsibility

NYSE

The NYSE listing standards currently require compensation committees to have charters, but the charters will need to be amended to reflect the authority and responsibilities of committees as required under these new compensation committee and adviser independence standards, including that (i) the committee has the sole discretion to retain compensation advisers, (ii) the committee has direct responsibility for the appointment, compensation and oversight of compensation advisers, (iii) the company must provide appropriate funding, as determined by the committee, for payment of reasonable compensation to the compensation advisers, and (iv) the committee must consider the independence standards discussed below when selecting or receiving advice from a compensation adviser.

NASDAQ

As has been required for NYSE companies, the amendments to the NASDAQ listing standards require NASDAQ companies to have a separate compensation committee with at least two independent members. The new standards also require compensation committees to have a charter that addresses (i) the committee's responsibilities and how it carries out those responsibilities, including structure, processes and membership requirements, (ii) the committee's responsibility for determining, or recommending to the board for determination, the compensation of the chief executive officer and all other executive officers of the company, (iii) the currently applicable prohibition on the chief executive officer being present during voting or deliberations on his or her compensation, (iv) that the committee has the sole discretion to retain compensation advisers, (v) that the committee has direct responsibility for the appointment, compensation and oversight of compensation advisers, (vi) that the company must provide appropriate funding, as determined by the committee, for payment of reasonable compensation to the compensation advisers, and (vii) that the committee must consider the independence standards discussed below when selecting or receiving advice from a compensation adviser. The committee must review and assess the adequacy of the charter annually.

Compensation Committee Adviser Independence

The amendments to the NYSE and NASDAQ standards require compensation committee charters to state that the committee must consider conflicts of interest before selecting consultants, counsel or other advisers (other than (i) in-house legal counsel, and (ii) any adviser whose role is limited to consulting on any broad-based plan or providing information that is either not customized for the company or that is customized based on parameters that are not developed by the adviser and about which the adviser does not provide advice). While compensation committees must consider these factors prior to selecting an adviser, it is important to note that the new standards do not limit the committee to selecting only independent advisers.

The amendments require that compensation committees may select an adviser only after considering the six independence standards specified by the SEC in Rule 10C-1 of the Exchange Act and, in the case of NYSE companies, any other factors relevant to the adviser's independence. The standards specified in Rule 10C-1 include:

• whether the company employing the compensation adviser is providing any other services to the listed company;
• the amount of fees the company employing the compensation adviser has received from the listed company, as a percentage of the compensation adviser's total revenue;
• what policies and procedures have been adopted by the company employing the compensation adviser to prevent conflicts of interest;
• whether the compensation adviser has any business or personal relationship with a member of the compensation committee;
• whether the compensation adviser owns any stock of the company (which the SEC interprets to include stock owned by the adviser and his or her immediate family members); and
• whether the compensation adviser or the company employing the adviser has any business or personal relationship with an executive officer of the listed company.

Since compensation committees are not prohibited from selecting non-independent advisers, a committee could continue to be advised by the company's outside legal counsel.

Exemptions

Smaller reporting companies listed on NYSE or NASDAQ do not need to comply with the heightened compensation committee independence standards or the requirement to consider adviser independence; however, listed smaller reporting companies are required to have an independent compensation committee with a written charter. None of the new listing standards apply to controlled companies, limited partnerships, companies in bankruptcy proceedings, open-end management investment companies registered under the Investment Company Act of 1940, and foreign private issuers that disclose in their annual report the reasons that they do not have an independent compensation committee.

What Listed Companies Should Do Now

There are several things that a listed company should do to prepare for the new requirements in advance of the applicable deadlines.

Before July 1, 2013, listed companies should:

• Review the applicable new standards and update the board and compensation committee regarding the new requirements and when they apply to the company.
• Update compensation committee charters or, alternatively for NASDAQ listed companies, adopt board resolutions approving (i) the compensation committee's authority to, in its sole discretion, retain compensation advisers, (ii) the committee's direct responsibility for the appointment, compensation and oversight of compensation advisers, (iii) the company's responsibility to provide appropriate funding to pay the reasonable fees of the compensation advisers, and (iv) the compensation committee's responsibility to consider conflicts of interests before selecting or receiving advice from any compensation advisers. For NASDAQ listed companies that do not have a separate compensation committee on July 1, 2013, the expanded authority and responsibility discussed above must be given to the independent directors who oversee the compensation of the company's chief executive officer and other executive officers.
• Begin to assess compensation adviser independence by collecting conflicts information from advisers, and consider adviser independence under the new standards. Prior to the earlier of the company's first annual shareholders' meeting after January 15, 2014 or October 31, 2014, NYSE listed companies should:
• Affirmatively determine the independence of each compensation committee member under the new standards.
• Update D&O questionnaires, policies, and proxy statement disclosure to comply with the new standards.

Prior to the earlier of the company's first annual shareholders' meeting after January 15, 2014 or October 31, 2014, NASADQ listed companies should:

• Consider the independence of current compensation committee members under the new standards.
• Establish a separate compensation committee that complies with the new standards if they did not previously have one.
• Adopt a compensation committee charter or amend the current charter to comply with the new standards if they did not do so prior to July 1, 2013.
• Update D&O questionnaires, policies, and proxy statement disclosure to comply with the new standards.

NASDAQ listed companies must certify to NASDAQ that they have complied with the new standards within 30 days of the applicable compliance deadline. Finalizing the amendments to the listing standards to comply with Rule 10C-1 of the Exchange Act completes the rule making process required by Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Our prior article discussing Rule 10C-1 in detail can be found at http://www.drinkerbiddle.com/resources/publications/2012/Securities-Update-June-2012.

Recent Trends in Challenges to Compensation: Directors in the Crosshairs

By F. Douglas Raymond and Remy Nshimiyimana

Public company boards and their advisors should be aware of a recent trend of challenges to the sufficiency and adequacy of the proxy statement disclosures. These challenges have been brought as class actions contesting compensation decisions and related disclosures as soon as companies file their proxy statements. These suits often include preliminary injunction motions that seek to enjoin the annual meetings unless the proxy disclosures are expanded. This litigation tactic can create pressure for the targeted company to settle quickly, to avoid potentially having to delay the annual meeting; especially now that, as a recent Delaware case illustrates, directors potentially face a challenging standard of scrutiny in litigation questioning their own compensation. The trend illustrates the particular difficulties directors can face when structuring their own compensation, even on matters that would not have raised eyebrows a few years ago, such as increasing share reserves in stock plans or making stock awards under stockholder-approved incentive plans.

Until recently, there had been a handful of lawsuits challenging compensation decisions of companies that had lost "say-on -pay" advisory votes. However, a recent litigation trend involves efforts to enjoin annual meetings and say-on-pay votes on the grounds that the underlying proxy disclosures are insufficient or misleading. Generally, these lawsuits allege that the company's proxy statement omits material information regarding (i) the analysis provided by compensation consultants to the board of directors on the plan being proposed to the shareholders, (ii) the rationale for the particular mix of salary, cash incentive compensation, and equity incentive compensation chosen by the board, (iii) the financial or compensation metrics of peer companies identified by the company, and (iv) the reasons behind the company's choice of peers for benchmarking purposes. The timing of such lawsuits can leave companies with only a short time to act if they are to hold their annual meetings on schedule, and some of these companies may opt to settle these lawsuits and pay significant sums in attorneys' fees, rather than vigorously defend against the claims. The companies that choose to settle generally agree to supplement the proxy disclosures and to pay the plaintiffs' legal fees.

The recent litigation trend is a reminder of just how challenging corporate directorship has become. Indeed, a recent Delaware case highlights the difficulty that directors may face in defending against challenges to their own compensation. In Seinfeld v. Slager, the Delaware Court of Chancery recently denied business judgment deference to a decision by the board of Republic Services, Inc., a public company that provides waste management services, to grant equity incentive awards to board members under a stockholder-approved equity incentive plan. As a consequence, the defendant directors would have to establish at trial that the awards they granted themselves were entirely fair to the company—a level of judicial scrutiny more challenging, and surely more expensive to defend in litigation, than the traditional business judgment rule.

For many years, the business judgment rule has protected directors against challenges to their actions. Under this doctrine, in general, courts will not second-guess the decisions of corporate boards unless a decision is potentially influenced by a conflict of interest or the gross negligence of the board. This well-established corporate principle has been central to court rejections of notable challenges to extremely generous executive compensation packages. However, the Seinfeld Court let stand a claim that the directors of Republic Services had breached their fiduciary duties by giving themselves awards under the company's equity incentive plan. The case illustrates the pitfalls of today's governance environment, particularly in the area of board compensation, where boards historically had significant latitude in structuring their own compensation packages.

The result in Seinfeld came as a surprise to many. In 1999, the Chancery Court had dismissed a similar claim in In re 3Com Corp. Shareholders Litigation, holding that corporate directors who administer a stockholder-approved director stock option plan are entitled to the protection of the business judgment rule, provided there has been "no waste, a total failure of consideration." The Court distinguished the two cases on the basis that the Republic Services equity incentive plan gave the directors virtually unbounded discretion over how to compensate themselves, subject to certain quantitative restrictions, while the 3Com stock plan had better defined terms, with parameters that confined the 3Com board's discretion to issue awards. The plan relied upon by the Republic Services board had two quantitative restrictions: the awards could not exceed an aggregate maximum of 10.5 million shares or an individual limit of 1.25 million shares. The court noted that:

• even if the directors stayed within plan's limits, the plan gave the Republic Services directors "the theoretical ability to award themselves as much as tens of millions of dollars per year, with few limitations;"
• where a plan gave a board the freedom "to use its absolute discretion, with little guidance as to the total pay that can be awarded" the board's decision could not be "labeled disinterested and qualify for protection under the business judgment rule;" and
• the board that exercised such discretion would "ultimately have to show that the transaction is entirely fair" to the company and do so in a courtroom.

While not discussed in the opinion, it is not clear how this differs from the practice of boards setting their own cash compensation for board service, which, like the plan in Seinfeld, is done entirely at the discretion of the board, absent corporate waste or a total failure of consideration.

A great benefit of the business judgment rule is the freedom it gives boards to operate without being second-guessed in a courtroom, and putting the burden on the board to demonstrate that its actions are "entirely fair" inevitably creates an incentive for some to litigate these issues. Combined with the recent litigation trend involving say-on-pay votes, it is becoming increasingly difficult for directors to navigate potential conflicts of interest, particularly in the current environment, where many are sceptical of the loyalty of directors to the best interests of stockholders.

Boards should develop a comprehensive record to support compensation decisions with an eye towards ensuring that it is detailed and clear in order to protect against breach of fiduciary duty claims. In particular, directors should be cautious in making decisions regarding their own compensation, and should consider whether to submit specific limitations on their own compensation programs, both cash and equity, to the stockholders for approval. With respect to proxy statements, boards should consider directing that the compensation discussion and analysis is as extensive and detailed as reasonably feasible so as to limit their exposure to litigation that may delay annual meetings and could result in significant legal fees.

Fair Disclosure and Facebook Posts

By Troy M. Calkins and J. Joseph Connaughton

Social media sites have proved to be invaluable platforms on which public companies may communicate with their customers and investors, but those added benefits have come with some potential pitfalls for company management. On December 5, 2012, Netflix and its CEO Reed Hastings received a Wells Notice from the Securities and Exchange Commission. This type of notice is meant to inform a party that the SEC intends to bring an enforcement action against it and provides the party with an opportunity to explain why the enforcement action is inappropriate.

The comments prompting this Wells Notice were made by Hastings on July 3, 2012. Posting to his personal Facebook page, Hastings stated that "Netflix monthly viewing exceeded 1 billion hours for the first time ever in June." The SEC believes this comment violated Regulation FD, a rule adopted to address the selective disclosure of information by public companies. The SEC summarizes Regulation FD as follows: when an issuer discloses material nonpublic information to certain individuals or entities—generally, securities market professionals, such as stock analysts, or holders of the issuer's securities who may well trade on the basis of the information—the issuer must make public disclosure of that information.

The SEC's concerns with Hastings' statement were twofold. First, because Netflix's business is based largely on selling access to video streaming, statistics relating to viewership are closely-tied to sales figures. The SEC believes this type of information is material because a reasonable investor would consider it important in making an investment decision. In fact, on the day of Hastings' post, Netflix shares rose 6.2%.

Next, Hastings made the comment via Facebook, but did not make a concurrent disclosure in a press release or Form 8-K filed with the SEC, the methods normally used to disclose such information. Though Facebook and other social media sites may one day become recognized channels through which a company may disclose its financial information, the SEC does not believe that they currently hold such a distinction. When he made the comment, Hastings had over 200,000 followers on his Facebook page, but the SEC is not just concerned about the number of people that information reaches; it is also concerned with the method of dissemination and whether the investment community is on notice of a company's disclosure practices. The question then becomes whether a CEO's personal Facebook page has made the list of sources that the investment community is expected to monitor. The SEC seems to think it has not, at least in the case of Netflix.

It remains unclear how the Netflix case will be resolved. The SEC decided to use its enforcement power to dictate policy in this instance, rather than simply issuing an interpretive release aimed specifically at the use of social media. While the SEC may ultimately choose to bring an action against Netflix, it is unlikely that such an action would provide clarity for other public companies in their use of social media. If anything, an enforcement action may produce more questions than answers. For that reason, commentators have expressed both frustration with the SEC's actions to this point and skepticism regarding the Commission's ability to adapt to technological developments.

The SEC has not expressly addressed the use of social media sites in the context of Regulation FD, but it has provided guidance on the use of company websites in such situations. In August 2008, the SEC issued an interpretive release (Exchange Act Release No. 34-58288) detailing how companies can use their web sites to provide information to investors in compliance with the federal securities laws. A company wishing to use its website to satisfy the "public disclosure" element of Regulation FD must evaluate whether and when:

• a company web site is a recognized channel of distribution;
• posting of information on a company web site disseminates the information in a manner making it available to the securities marketplace in general; and
• there has been a reasonable waiting period for investors and the market to react to the posted information.

It will be interesting to see whether the SEC provides official guidance on whether a company may establish a social media site as a source of its financial information in a similar fashion to how a company would do the same with its website. Tom Kim, Chief Counsel of the SEC's Division of Corporation Finance, spoke to this issue during a panel discussion for TheCorporateCounsel.net in May of 2011. Kim's personal view, rather than that of the SEC as a whole, was that the SEC's 2008 guidance pertaining to company websites may also be applied to communications made via social media sites. If the SEC adopts this view, it is possible that companies like Netflix, which has a strong following on social media sites, would eventually be able to satisfy the three prongs outlined in the SEC's 2008 release.

Until the SEC provides a definitive answer, companies would be wise to closely monitor communications they make via social media sites. The informal nature of these sites often creates a false sense of security, but Netflix's situation has shown that even casual comments can lead to SEC sanctions. As always, the most certain way to disclose information in compliance with Regulation FD is to first issue a press release or file the information via the SEC's EDGAR website. In fact, it seems that Hastings may have already learned this lesson and may be moving toward establishing Facebook as a recognized channel for the distribution of Netflix's financial information. On December 6, 2012, Hastings responded to the SEC's claims, once again using his Facebook page. But this time, prior to posting the statement on Facebook, Netflix filed a Form 8-K with the SEC, noting that "a copy of a statement that will be made by Mr. Hastings to subscribers on his publicly available Facebook page is attached as Exhibit 99.1."

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