Compensation Issues, Financial Reporting, Director and Officer Questionnaires: Preparing for 2017 Proxy Season
With 2017 proxy season kicking off, we would like to remind clients and friends of some developments that could impact public company annual reporting for 2017.
Say on Frequency Votes
Companies that held their most recent “Say on Frequency” vote in 2011 (the first year that SEC Rule 14a-21(b) applied) must conduct another Say on Frequency vote in 2017 by submitting a resolution to their shareholders asking them to vote, on a non-binding, advisory basis, on whether “Say on Pay” votes should occur every one, two, or three years. Say on Frequency votes are required at least every six years. Companies that held a Say on Frequency vote more recently than 2011 (smaller reporting companies or companies that had an IPO subsequent to 2011) are not required to hold another vote this year but should be mindful of the upcoming sixth anniversary of such vote.
A company must report both the results of its Say on Frequency vote and the company’s decision with respect to the frequency of future Say on Pay votes on Form 8-K under Item 5.07. The company’s decision with respect to the frequency of future Say on Pay votes can be reported on the same Form 8-K on which voting results are reported (due four business days after the annual meeting) or in an amendment to that Form 8-K that is filed within 150 calendar days after the Say on Frequency vote and no more than 60 days prior to the deadline for shareholder proposals for the company’s next annual meeting.
A board of directors needs to consider what frequency (i.e., every one, two, or three years) it will recommend to its shareholders for their vote. We expect most boards will recommend an annual Say on Pay vote, given guidance from the proxy advisory firms and institutional investors, the relative ease of presenting the proposal annually, and that shareholders voted overwhelmingly in 2011 and subsequently for an annual vote.
Shareholder Approval of Compensation Plans
Although not a new development, public companies should remember to check whether any of their annual or long term incentive compensation plans need to be resubmitted for shareholder approval for continued exemption under Section 162(m) of the Internal Revenue Code. Section 162(m) provides a mechanism for exempting performance-based compensation paid to covered executives from the $1 million deduction limitation. One of the requirements for 162(m) exemption is that shareholders approve the material terms of the compensation plan. If a plan gives the compensation committee the authority to change the targets under a performance goal, shareholders must reapprove the material terms no later than the annual meeting that occurs in the fifth year following the year in which shareholders previously approved the plan.
Please note that shareholder re-approval is not required for an “overlay” type of plan, which is often used by companies in connection with their annual bonus plans. An overlay plan has pre-established goals and targets and gives the compensation committee authority to use negative discretion to reduce the maximum amount otherwise payable to the executives. This type of arrangement does not need further approval once initial shareholder approval is obtained.
Pay Ratio Disclosures
The SEC’s Pay Ratio Disclosure Rule (Regulation S-K Item 402(u)), which requires a public company to disclose the ratio of the median compensation of all of its employees to the compensation of its principal executive officer, was adopted in August 2015 to take effect January 1, 2017, with the first pay ratio disclosures to be included in annual reports or proxy or information statements for fiscal years beginning on or after that date (for calendar year filers, this will be the proxy or information statement filed in 2018). However, there is a significant amount of speculation and uncertainty concerning whether the Pay Ratio Disclosure Rule will be repealed or amended before the first pay ratio disclosures are required. An executive order issued on February 3, 2017, entitled Core Principles for Regulating the United States Financial System, is expected to lead to substantial revision to, and potential repeal of, the Dodd-Frank Act and financial regulations enacted pursuant to the Act. Additionally, on February 6, 2017, the acting chair of the SEC issued a public statement directing the agency’s staff to reconsider implementation of the Pay Ratio Disclosure Rule. Legislative action to amend or repeal the Dodd-Frank Act could remove the statutory basis for the Pay Ratio Disclosure Rule, leaving the door open for a repeal of the rule by SEC action. Additionally, the Pay Ratio Disclosure Rule could be repealed directly by statute. It is unclear how urgent a priority compensation disclosure reform is for the new administration or Congress, or whether the necessary support can be obtained to muster 60 votes for Senate action. Until we have further clarity on the likelihood and timing of any such action, issuers should continue to prepare for the possibility that pay ratio disclosures (disclosing pay ratios for fiscal years beginning in 2017) will be required in the following proxy season.
The February 6 SEC public statement solicited comments concerning challenges that issuers have experienced in preparing to comply with the Pay Ratio Disclosure Rule. Comments may be submitted through the SEC’s online form available at https://www.sec.gov/news/statement/reconsideration-of-pay-ratio-rule-implementation.html (click on the “submission of detailed comments” link in the third paragraph), by mail addressed to SEC Complaint Center, 100 F Street NE, Washington, D.C. 20549-0213, or by fax sent to 703-813-6965. All comments will be made publicly available and issuers should submit only information that they wish to make available publicly. Comments must be submitted no later than March 23, 2017.
Financial Reporting Issues
Non-GAAP Financial Measures
The SEC issued new Compliance and Disclosure Interpretations in May 2016 in order to address perceived abuses in the use of non-GAAP financial measures and failures to comply with Regulation G and Item 10(e) of Regulation S-K. These CD&Is, and recent SEC staff comment letters, highlight a renewed emphasis on (1) the requirement to give equal or greater prominence to GAAP measures, (2) statements of reasons why an issuer believes non-GAAP measures are useful to investors, (3) reconciliations of non-GAAP measures to the comparable GAAP measures, including the reconciliation of non-GAAP projections to GAAP projections, (4) proper labeling, and (5) use of impermissible non-GAAP measures. Companies presenting non-GAAP measures in their 2017 proxy statements or annual reports should consult the CD&Is and comment letters for further guidance.
When drafting discussions of compensatory plans, keep in mind that disclosure of performance targets that use non-GAAP financial measures, while not subject to the non-GAAP measures rules, still requires a discussion of how such measures are calculated.
Audit Committee Report
The reference to PCAOB Auditing Standard No. 16 in audit committee reports should be changed to Auditing Standard No. 1301 as a result of a reorganization of PCOAB standards that became effective on December 31, 2016.
Director and Officer Questionnaires
Nasdaq “Golden Leash” Rule. Effective August 1, 2016, companies listed on the Nasdaq stock market are required to disclose, on their websites or in their annual proxy statements, any compensation paid to their directors or director nominees by third parties in connection with their service or candidacy for service on such company’s board and the material terms of such arrangements. Companies listed on the Nasdaq stock market should review their D&O Questionnaires to confirm that they contain questions aimed at eliciting the required information. Questions prompted by existing SEC rules (such as Items 401(a), 402(k) and 404(a) of Regulation S-K) should already elicit much, if not all, of the disclosure the Nasdaq rule requires, so changes should be minimal.
Form 10-K Summary Sections
In 2016, the SEC amended Form 10-K by adding a new Item 16 to allow issuers to include an optional summary section in their annual reports on Form 10-K, so long as each summary item is presented fairly and accurately and includes a hyperlink to the complete discussion located elsewhere in the Form 10-K. An issuer may not include in its summary any disclosure that is not included in the Form 10-K at the time of filing. If Part III information will be included in the Form 10-K through incorporation by reference to a proxy or information statement filed after the Form 10-K, the issuer should state in the summary that it does not include Part III information because it will be incorporated by reference from a later filed proxy or information statement. An issuer who elects to include a summary in its Form 10-K (including any issuer who has previously included a summary page in its Form 10-K), should take care to ensure that the summary included in its Form 10-K for fiscal year 2016, and forward, adheres to the requirements of new Item 16.