Corporate Governance Perspective: Current Bearings, Future Directions

Due to last summer’s enactment of the Dodd-Frank Act, we are now in a watershed period of corporate governance reform. Processes now underway have transformed the relations between corporate boards and corporate shareholders. Even further changes lie ahead. These developments could have significant implications for the liability exposures of corporate officials.

Governance Changes Already Underway

1. Say on Pay: Under Section 951 of the Dodd Frank Act, all but the smallest public companies must put their executive compensation practices to an advisory shareholder vote during the current proxy season. Although the vote is advisory, the implementation of this requirement is having a significant impact on executive compensation practices. Many companies, scrambling to win shareholder approval in the say on pay vote, have been pressured to alter pay practices. As a recent Wall Street Journal article stated, “despite some early skepticism, the prospect of such votes has sparked boardroom debate over executive-pay practices that were long-rubber stamped.”

   At a few companies, shareholders have voted against their companies’ pay practices. In at least some instances, litigation has followed the negative vote. These lawsuits are being filed in the form of shareholders derivative suits against the board of directors, the members of the board compensation committee and in some instances, even the company’s compensation consultants.

   What seems clear is that activist investors have targeted executive compensation, and the advisory say on pay vote is helping to fuel the fire and even contributing to shareholder litigation.

2. Proxy Access: The U.S. Securities and Exchange Commission (SEC) has adopted rules effective later this year requiring all but the smallest public companies to include that board candidates be nominated by shareholders on their board election ballots (contained in companies’ proxy materials). To nominate a candidate, a shareholder or shareholder group must individually or collectively own at least 3 percent of the voting power of company’s shares and must have held those shares for at least three years.

   However, in September 2010, business groups filed a lawsuit challenging the proxy access rules. In response, the SEC stayed the rules while the legal challenge is pending. A ruling in the legal challenge is expected later this year.

   The current governance changes are here to stay and will require corporate officials to adapt to the new environment.

   While the outcome of the legal challenge is uncertain, the likelihood is that in the future, shareholders will enjoy greater shareholder access to the board election process. As one law firm memo noted, “whether under the rules now being considered by the court or some revision thereof, the Dodd-Frank Act, and its focus on shareholder protection and access, ensures shareholder activism is here to stay.”

3. Board Declassification: One of the long-standing objectives of corporate governance reformers has been the elimination of classified or staggered board structures, whereby directors were elected for three-year terms ensuring that in any given year only one-third of the directors are up for vote. Reformers have succeeded in obtaining the voluntary agreement of a number of companies to the declassification of their boards, pursuant to which the companies will put their entire board to an annual vote. As one commentator noted, “the overwhelming trend in corporate governance is toward the declassification of boards.”
4. Majority Voting: In many U.S. public companies, director election requires only a plurality vote, so that a director candidate in an uncontested election who receives only one vote will be elected. In a majority vote model, a director in an uncontested election who fails to receive a majority of votes must offer their resignation. As one commentator noted, the 2011 proxy season is the “culmination of a major drive to install majority voting standards,” and shareholders at several companies have voted in favor of shareholder proposals calling for majority voting standards.

Changes Just Ahead

1. Compensation Ratios: Section 953(b) of the Dodd Frank Act directs the SEC to require public companies to disclose the ratio between total annual compensation of their CEO and the median annual compensation of their employees. Rules implanting these provisions are required to be adopted before the end of 2011. The provision suggests a concern that there is a disparity between the compensation paid to executives and the compensation paid to other company employees.

   These disclosures seem likely to trigger a discussion of compensation fairness and compensation equity, as popular notions about the appropriate ratios develop over time. Companies whose ratios suggest greater compensation disparity are likely to face pressure on executive compensation issues.

2. Compensation Clawbacks: In Section 954 of the Dodd-Frank Act, the SEC requires public companies to implement compensation clawback provisions. Under Section 954, companies making accounting restatements of prior financials must recover from any current or former officer all incentive-based compensation paid during the preceding three-year period above what would have been paid without the misstated financials. The SEC plans to propose and adopt rules implanting these requirements between Aug. 2011 and year-end.

   As one commentator has noted, these provisions have a “potentially far-reaching impact” that may “result in serious reconsideration of how incentive compensation plans are designed.” It is also possible, companies who in the future find that they must restate prior financials, may face litigation (or rather their officers and directors may face litigation) on questions whether a compensation clawback is required, against whom it should be enforced, and for what types or amounts of incentive compensation.

What It All Means

1. Heightened Scrutiny: Not all companies are going to give in on executive compensation issues or on board process issues like board declassification and majority voting. While companies may respond to these developments in different ways, companies that resist these governance developments may face heightened levels of scrutiny, both from shareholders and from the media.
2. Increased Litigation Risk: Companies (and their directors and officers) that resist shareholder-driven reform initiatives may face scrutiny, as well as an increased likelihood of litigation. Directors at companies that experience a negative “say on pay” vote may find themselves facing shareholder litigation relating to the companies’ compensation practices. Other current reforms – for example, the clawback provisions – could also encourage shareholder litigation.
3. Changing Judicial Attitudes: A very strong principle traditionally informing judicial scrutiny of board processes and decision-making has been a broad judicial deference to the boards themselves. With the shift toward greater shareholder empowerment, courts may also be less inclined than perhaps they were in the past to defer to boards.

There is room for debate about whether these changes will advance or impede corporate performance, and what impact all of this will have on the relatively competitiveness of U.S companies in a global marketplace. But whatever may be said, it seems clear that the current governance changes are here to stay and will require corporate officials to adapt to the new environment. The changes may mean new areas of litigation exposure for corporate officials, as well.

Topics Lawsuits Trends