Preparing for the 2013 Proxy Season

As issuers look ahead to the 2013 proxy season, a few new issues loom on the horizon, including the new Securities and Exchange Commission (SEC) disclosure requirements for compensation consultant conflicts of interest, the continued focus on governance and compensation issues by proxy advisors and institutional investors and new standards for communication between the audit committee and auditors.

Compensation Consultant Conflict of Interest Disclosure

The SEC adopted new rules in 2012 broadening disclosure requirements related to compensation consultants. Existing regulations require issuers to disclose the role of compensation consultants in determining or recommending the amount or form of executive and director compensation. Issuers must identify the consultants, state who retained the consultants, describe the nature and scope of the assignment and, in certain circumstances, disclose the aggregate fees paid to the consultants.

Proxy statements for 2013 annual meetings must now also provide disclosure about any conflict of interest with the compensation consultant, including the nature of the conflict and how it is being addressed. The SEC did not define conflict of interest, but indicated that the following six factors are relevant to the analysis:

1. Other services provided by the compensation consulting firm to the issuer;
2. Fees paid by the issuer as a percentage of the compensation consulting firm’s total revenue;
3. Policies or procedures maintained by the compensation consulting firm to prevent a conflict of interest;
4. Any business or personal relationship between the compensation consultant and a compensation committee member;
5. Any issuer stock owned by the compensation consultant; and
6. Any business or personal relationships between the compensation consultant or the compensation consulting firm and the executive officers of the issuer.

Issuers are not required to disclose potential conflicts of interest or the appearance of a conflict of interest. Disclosure is only required if a compensation consultant has an actual conflict of interest. While a specific disclosure in the absence of an identified conflict of interest is not required, it may be good practice to provide "negative assurances" that the compensation committee undertook the assessment and concluded that there was no conflict of interest. This is similar to the approach taken with respect to the disclosure of whether the issuer’s compensation policies and practices create risks.

ISS and Glass Lewis Voting Policy Updates for 2013

ISS and Glass Lewis & Co., the two leading proxy advisory firms, revised their proxy voting policies for the 2013 proxy season. Both firms addressed board responsiveness to shareholder votes in their updated guidelines. For meetings in 2013, ISS adopted a transition rule that it will recommend a vote against directors if the board failed to act on a shareholder proposal that received the support of a majority of the shares outstanding the previous year, or if the board failed to act on a shareholder proposal that received a majority of shares cast in the last year and one of the two previous years. For meetings in 2014 and later, ISS will recommend a vote against directors if the board failed to act on a shareholder proposal that received a majority of shares cast in the previous year. ISS generally considers a board to be responsive if it fully implements the proposal or management puts the proposal on the ballot for the next annual meeting if a shareholder vote is required to implement the proposal. If the board’s response is less than full implementation, ISS will consider its recommendation on a case-by-case basis based on the steps the company has taken to be responsive. Glass Lewis formalized a policy that it will review the board’s responsiveness on any issue where 25 percent or more of the shareholders vote against the board’s recommendation on any proposal.

ISS also updated its policies for pay-for-performance evaluations, hedging and pledging stock and say-on-golden parachute votes. ISS made two changes to its pay-for-performance polices. ISS will incorporate a company’s self-selected pay benchmarking peer group when selecting the peer group ISS uses to evaluate pay-for-performance. For large capitalization companies, ISS will include a comparison of "realizable" pay to grant date pay in its pay-for-performance evaluations. Realizable pay will measure pay based on the actual pay earned during a specific performance period as a result of final payouts of performance-based awards or changes in value due to gains or losses in stock price. ISS will recommend a negative vote on directors if directors or executives hedge their company stock and, on a case-by-case basis, will recommend a negative vote for pledging significant amounts of company stock. In addition, ISS will no longer grandfather existing change-in-control severance arrangements in its evaluation of say-on-golden parachute votes. Glass Lewis adopted revisions to policies for overboarding of public company CEOs, equity-based compensation plan proposals and exclusive forum provisions.

PCAOB Adopts New Standard for Communications Between Auditor and Audit Committee

The Public Company Accounting Oversight Board (PCAOB) adopted a new set of procedures in 2012 to govern the communications between auditors and audit committees: Auditing Standard No. 16 - Communications with Audit Committees. According to the PCAOB, this new auditing standard is geared towards enhancing the relevance and quality of the communications between external auditors and audit committees, thereby assisting audit committees in fulfilling their statutory oversight responsibilities to investors in the preparation of financial statements and audits.

A key distinction between Auditing Standard No. 16 and the existing standard is the requirement that the auditor establish an understanding of the terms of the audit engagement with the audit committee, rather than with management. This is intended to underscore the imperative that the audit committee is responsible for the appointment of the auditor. The standard provides that if the engagement letter is not signed by either the audit committee or its chair, the auditor is required to determine that the audit committee has nevertheless acknowledged and agreed to the terms of the engagement.

Auditing Standard No. 16 and its related amendments became effective for public company audits of fiscal years beginning on or after December 15, 2012. In addition, the SEC determined that the standard and its related amendments will apply to audits of "emerging growth companies" under the Jumpstart Our Business Startups Act of 2012.

Audit committees should begin to examine the possibility of expanding their meeting agendas with the auditors in order to accommodate the increased communication requirements under Auditing Standard No. 16. Moreover, audit committees may wish to evaluate the existing processes for receiving and reviewing information on compliance matters, given the heightened communication requirement between external auditors and audit committees under the new standard. With respect to a new requirement for auditors to obtain information from the audit committee about possible violations of laws or regulations, the audit committee may wish to consider what procedures, if any, should be implemented in order to respond to such inquiries and whether the company’s compliance program is robust enough to identify most violations before the auditors’ review. Finally, audit committees and boards of directors should consider if updates to the audit committee charter and other organizational documents are warranted to reflect the new communication requirements.