March 6, 2012 Practice Group(s): Corporate Employee Benefits Focus on Your CD&A in 2012: Being Responsive to Stockholders and Avoiding Say-On-Pay Lawsuits By Phillip J. Kardis II, James E. Earle, and Robert K. Smith During 2011, stockholders voted on an advisory basis on the executive compensation of most all public companies (generally known as “say-on-pay”). Stockholders also voted on the frequency of future say-on-pay votes (generally, annually or every two or three years). In 2012, companies should focus on the disclosure requirements of the Compensation Discussion and Analysis (CD&A) contained in their proxy statements, particularly with a view toward being responsive to stockholders and minimizing the risk of say-on-pay lawsuits. Background Stockholders overwhelmingly approved their company’s say-on-pay proposals in 2011.1 Companies should now focus on the level of that approval and the appropriate responsive actions to take. SEC rules require that a company disclose in its proxy statement whether and how the company took into account the say-on-pay vote in making future executive compensation decisions. Additionally, Institutional Shareholder Services (ISS) has stated that if the company’s say-on-pay vote received less than 70% of stockholder support, ISS will closely scrutinize the company’s responsiveness to stockholder concerns, and depending on that review potentially recommend voting against compensation committee members and the company’s next say-on-pay vote. Finally, some companies with failed say-on-pay votes have been sued by plaintiffs that have generally alleged that the company’s proxy was misleading because, notwithstanding the company’s assertion that it pays for performance, there was evidence to the contrary (including the fact of a failed say-on-pay vote). CD&A Disclosure in Response to Say-On-Pay Vote Item 402(b)(vii) of Regulation S-K requires that public companies disclose whether and, if so, how, the company has considered the results of the most recent say-on-pay vote (i.e., 2011 vote) in determining compensation policies and decisions. Question: Our say-on-pay proposal received over 70% of the vote last year – Is there anything we need to do? Answer: While it may be tempting to just “roll forward” the CD&A under these circumstances, particularly for companies that were well over 70%, the SEC rules require that the CD&A include discussion about how the prior say-on-pay vote was considered. This discussion could include a statement that the compensation committee viewed the favorable vote as further validation of the company’s approach and as a result no changes were made. Clearly identifying that the last vote received greater than 70% support may help in the current year’s say-on-pay vote, and will mark the company as being outside of ISS’s policy on heightened scrutiny. But even companies with very high 1 Some reports on the 2011 proxy season have noted that over 98% of Russell 3000 companies had say-on-pay votes that were approved by shareholders. Focus on Your CD&A in 2012: Being Responsive to Stockholders and Avoiding Say-On-Pay Lawsuits levels of stockholder support should not rest on their laurels. They should continue to remain cognizant of the perspectives of their key institutional stockholders. In addition, executive compensation disclosure practices are continuing to evolve, and stockholder expectations regarding the transparency and quality of such disclosures, especially the CD&A, continue to rise. Maintaining an effective stockholder outreach program and always looking for ways to improve the quality of executive compensation disclosures may help preserve high levels of stockholder support for future say-on-pay votes. Question: Our say-on-pay proposal received under 70% of the vote last year – What should we be doing? Answer: For companies in this category, the focus should be to get above 70% and, in any case, certainly not fall below 50%. As noted above, companies that are below the 70% threshold are subject to increased ISS scrutiny. These companies have been, or should strongly be considering, engaging in a proactive outreach effort with key institutional stockholders to get a sense of the principal concerns that these stockholders have with the executive compensation program. ISS will likely closely review the company’s CD&A for a description of the concerns raised by institutional stockholders and the steps the company took to address those concerns. For companies with stockholders that tend to follow ISS recommendations, making changes that are likely to address ISS’s concerns may be important. For companies in this category, members of the compensation committee are at increased risk of receiving “against” or “withhold” votes, adding additional incentive to take appropriate actions and presenting a descriptive and persuasive CD&A. Question: Our say-on-pay proposal failed last year – What should we be doing? Answer: Companies in this category have surely been engaged in an aggressive outreach program with institutional stockholders (and perhaps retail stockholders, as well). All of the same considerations for companies in the 50% to 70% approval range described above apply to companies with failed say-on-pay votes. However, the outreach program, changes in executive compensation and the corresponding CD&A disclosure take on even more importance because of the issues related to failed say-on-pay votes, including the potential for say-on-pay lawsuits. The Impact of Say-On-Pay Lawsuits A number of companies with failed say-on-pay votes during 2011 have been sued. In general, these derivative actions allege that the company’s proxy statement was false and misleading because, notwithstanding the company’s assertion that it pays for performance, the company paid excessive compensation as evidenced by the failed say-on-pay vote. While an in-depth analysis of these lawsuits is beyond the scope of this Alert, suffice to say it is not yet clear how the majority of courts will deal with these lawsuits. We believe that these lawsuits generally should be meritless because the Dodd-Frank Wall Street Reform and Consumer Protection Act, which added the say-on-pay vote requirement, expressly states that the existence of the say-on-pay vote requirement does not “create or imply any additional fiduciary duties” for the board of directors of a company. As long as compensation committees act in good faith following a reasonable review process, courts should not be able to second-guess their compensation decisions. Nevertheless, companies with failed say-onpay votes continue to be in the firing line for these lawsuits, possibly having implications not only for the company itself but also its officers and directors. The impact of say-on-pay lawsuits should provide more incentive for companies to successfully address any stockholder concerns and make adequate disclosures in the proxy statement. 2 Focus on Your CD&A in 2012: Being Responsive to Stockholders and Avoiding Say-On-Pay Lawsuits Next Steps and How We Can Help Companies concerned about their say-on-pay vote should be engaging major institutional investors by this time. This outreach effort should be designed to elicit the principal concerns that these investors have with the company’s executive compensation program. Companies should be careful not to inadvertently violate the securities laws in connection with these efforts – for example, companies should consider any Regulation FD issues that might arise. Companies should be working closely with their compensation committees, outside advisors and management to craft a CD&A that will withstand stockholder scrutiny and clearly communicate the company’s pay-for-performance approach. While there is no “boilerplate” approach to drafting the CD&A, there are evolving best practices, such as the use of an “executive summary” and other forms of “layered disclosures” to provide easy-to-read summary information within the CD&A. Many companies are beginning to consider ways to visually display the pay-for-performance link. The CD&A usually presents the most difficult drafting task in the proxy statement, as the company attempts to balance compliance with both the letter and spirit of the SEC rules on the one hand and creation of a compelling, easy to read stockholder communication on the other hand. While these goals need not be mutually exclusive, they often create tension and drafting challenges. Companies should be aware of the latest developments regarding say-on-pay lawsuits. While companies were previously concerned with SEC comments and/or investor scrutiny over CD&A disclosures, these lawsuits add a layer of concern for companies and their officers and directors. We continue to monitor closely these lawsuits and can advise on how companies should consider the risks regarding these lawsuits as part of the executive compensation decision-making and disclosure process. Proxy season is now in full swing. We have extensive experience in representing companies and directors and officers in addressing executive compensation matters, including crafting an appropriate process and complying with SEC rules and regulations. If you have any questions about executive compensation in 2012, or any other disclosure matters, please call Phil Kardis, Jim Earle, or Rob Smith at the phone numbers or email addresses listed below. Authors: Phillip J. Kardis II phillip.kardis@klgates.com +1.202.778.9401 James E. Earle jim.earle@klgates.com +1.704.331.7530 Robert K. Smith robert.smith@klgates.com +1.202.778.9376 3 Focus on Your CD&A in 2012: Being Responsive to Stockholders and Avoiding Say-On-Pay Lawsuits 4