Corporate Governance

What If You Could Choose Your Shareholders?

by Vanessa Schoenthaler on November 3, 2011

Private companies have a fair amount of control over the composition of their shareholder base–at least for the time being, if the market for private shares continues to grow, that may not always be the case.

Public companies, on the other hand, have very little, if any, control. Buying and selling listed or quoted securities is so easy that it’s been compared child’s play:

So, as a public company you have to simply accept that your shareholders choose you, and not the other way around. Correct? Perhaps; but maybe not.

A recent paper by University of Pennsylvania Law School Professor Edward B. Rock, questions the preceding notion by examining the extent to which a public company (or a soon/intended-to-be public company) can influence the composition of its shareholder base using two types of strategies, what he calls: direct or recruitment strategies, and shaping or socializing strategies.

What Does Your Ideal Shareholder Base Look Like?

But before getting into the details of the various strategies, you have to answer the question: what does your ideal shareholder base look like? What are the characteristics of a good shareholder? What about a bad one?

The answer, of course, largely depends on who you are, or as Professor Rock puts it: “one person’s ‘active monitor’ is another person’s ‘intrusive busy-body’ or ‘speculator,’ and shareholders who may be good from a shareholder perspective may be bad from a manager’s perspective.”

Generally, however, from a company’s perspective, a good shareholder is defined as one that provides long-term capital at an attractive price. A good shareholder contributes to the development of a well-functioning secondary market, leading to a reasonably accurate price for your securities, and, in turn, increasing their value as a form of corporate currency. A good shareholder is also defined as one that evaluates management “according to long-term fundamental value rather than short-term earnings” and contributes to an overall increase in company value.

In contrast, a bad shareholder is defined as the opposite of a good one. A bad shareholder is one that seeks personal or short-term gains at the expense of other shareholders or long-term value.

Strategies for Influencing the Composition of Your Shareholder Base

Direct or recruitment strategies are categorized as those that are used to identify good investors and bring them into your shareholder base or, conversely, to identify bad shareholders or investors and oust or discourage them from becoming a part of your shareholder base.

Shaping or socializing strategies are categorized as those that are used to transform your existing shareholders into good shareholders.

The paper goes on at length analyzing the different strategies in each category, but here I’m only going to touch on what I think are the three most operable:

Pursue Relational Investments 

Relationship investing, which gained a degree of popularity in the United States in the early ’90s, comes in many forms, but is typically characterized by a large investor taking a long-term position in a company and playing the role of active monitor.

Pursuing a relationship investment strategy involves identifying virtuous relational investors and recruiting them as shareholders in a negotiated, arm’s-length transaction, such as in a PIPE transaction, with contractual or other incentives put into place to align the relational investors’ interests with those of management and of the remaining shareholders. By way of example, the paper cites Warren Buffet’s $5 billion investment in Goldman Sachs at the height of the financial crisis (Warren Buffet and Berkshire Hathaway are used quite often as examples throughout the paper).

Collaborate with Investor Relations

Investor relations, as defined by the National Investor Relations Institute, is “a strategic management responsibility that integrates finance, communication, marketing and securities law compliance to enable the most effective two-way communication between a company, the financial community, and other constituencies, which ultimately contributes to a company’s securities achieving fair valuation.”

Investor relations should be an integral part of any strategy that looks to influence the composition of your shareholder base, and, at minimum, your investor relations department, team or designee should play a role in:

  • defining your ideal shareholder base;
  • identifying good investors, relational or otherwise, and recruiting them as shareholders;
  • educating shareholders about company policies and practices that will ultimately shape their role as shareholders; and
  • building relationships with key shareholders around issues of strategy and policy in an effort to move those relationships “into a more cooperative and productive” direction.

Cited examples of the potential for shareholder education include Prudential Financial’s “Letter from the Board of Directors to Our Shareholders” and Berkshire Hathaway’s “owner’s manual.” One approach for building relationships with key shareholders is to increase communications by, for example, incorporating a “directors’ discussion and analysis” into your proxy materials or by holding regular meetings with key shareholders around issues of “strategy, risk control, compensation, ethics, CEO succession, [environmental, social and corporate governance]” and so on (similar to the meetings contemplated by the somewhat contentious fifth analyst call).

Also noteworthy, and I’m not going to recap it here, is that the paper touches on, and you should really consider, the implications of Regulation FD on an investor relations strategy.

Consider Clientele Effects

Clientele effects describe the propensity of a group of similarly situated investors to buy and hold the securities of those companies that have policies or practices corresponding to their own investment preferences. Such as the propensity of investors in lower tax brackets (or who are tax-exempt) and in need of current cash flows to hold the securities of companies that pay higher dividends.

Pursuing a strategy based on clientele effects requires that you first consider whether and to what extent clientele effects play a role in the composition of your existing shareholder base, and then whether changes to certain of your policies or practices would encourage shareholders of a good type to acquire, or discourage shareholders of a bad type from holding, your securities.

Beyond your dividend policy, you should consider whether and to what extent your corporate governance policies, polices on stock splits and reverse stock splits as they pertain to share price and liquidity, policies on earnings guidance, and even where you list your securities, will  influence clientele effects.

A Few Honorable Mentions

Finally, some of the other strategies worth mentioning include the influence of: your choice of domicile, such as Delaware as compared to an offshore jurisdiction, the exchange on which you list your securities, such as Nasdaq or NYSE as compared to the LSE, and, if you’re a soon/intended-to-be public company, alternative capital structures, such as the ever polarizing dual-class structure.

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The SEC Adopts Final Whistleblower Incentive and Protection Rules and Forms

by Vanessa Schoenthaler on May 26, 2011

Yesterday, by a vote of 3-2, the Securities and Exchange Commission approved a final set of rules and forms to implement the Whistleblower Incentive and Protection Program added in Section 21F of the Securities Exchange Act by Section 922 of the Dodd-Frank Act.

The purpose of the whistleblower program is to award incentives and afford protections to individuals who provide the Commission with high-quality tips leading to successful enforcement actions. To be eligible for an award, a person must provide original information that leads to a successful administrative or federal enforcement action in which the Commission obtains monetary sanctions in excess of $1 million.

The adopting release, weighing in at 305 pages, is available here, and the rules and forms will be effective 60 days after their publication in the federal register (which is good, because it’s going to take me that long to read them).

In the meantime, as was noted in the Commission’s open meeting yesterday morning, the final rule and forms that were adopted do differ from the proposed rules and forms in some material respects. Comparatively, they seek to strike a more appropriate balance between concerns that the Commission’s whistleblower program will undermine companies’ own internal compliance efforts and the intent of Section 922 in incentivizing would-be whistleblowers to report potential securities law violations. I’ll have more on this after I actually finish reading the rules.

Of course, these final rules and forms really only mark the beginning of the whistleblower program and the Commission’s newly implemented Office of the Whistleblower.  And, even now, there are still efforts underway to amend the Dodd-Frank Act’s whistleblower requirements.

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Proposed Rules Requiring Proposed Listing Standards About Compensation Committees

by Vanessa Schoenthaler on March 31, 2011

Proposed Rules on Compensation Committees and Compensation ConsultantsSection 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act amends the Securities Exchange Act of 1934 by adding new Section 10C, requiring the Securities and Exchange Commission to adopt rules directing the national securities exchanges* to prohibit the listing of the equity securities of a company that does not comply with certain compensation committee and compensation advisor requirements. Yesterday the Commission released a set of proposed rules and amendments that are designed to implement Section 952.

As per usual, the Commission is soliciting public comments on the proposed rules and amendments, which are due on or before April 29, 2011.

Updated April 29, 2011:

On April 29, 2011, in response to a request from the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness, the Commission has extended the comment period through May 19, 2011.

Who do the proposed rules and amendments apply to?

Proposed Rule 10C-1

Proposed Exchange Act Rule 10C-1 requires that the rules of the national securities exchanges prohibit the initial or continued listing of any equity security of a company that does not comply with certain compensation committee and compensation advisor requirements.

As proposed Rule 10C-1 only applies to companies with exchange-listed equity securities, excluding security future products and standardized options. The Commission estimates that there are approximately 76 companies that fall outside of the scope of Rule 10C-1 by virtue of having only exchange-listed debt securities, and is specifically seeking comment on whether these companies should be made to comply with the final rule.

Additionally, by definition, companies with securities quoted through inter-dealer quotation systems in an over the counter market, such as the OTC Bulletin Board or the OTC Markets Group (formerly the Pink Sheets), are excluded from Rule 10C-1, unless, of course, they also have a class of equity securities listed on a national securities exchange.

Proposed Amendments to Item 407 of Regulation S-K

The proposed amendments to Item 407 of Regulation S-K broaden the scope of existing disclosure requirements with respect to compensation advisor and conflict of interest disclosures.

As proposed the amendments apply to all Exchange Act reporting companies that are subject to the proxy rules, this includes companies with securities quoted in an over the counter market, such as the OTC Bulletin Board or the OTC Markets Group, and controlled companies, but excludes foreign private issuers, which are not subject to the proxy rules, and registered investment companies, but only because they are not subject to the disclosure requirements of Item 407 of Regulation S-K.

What does proposed Rule 10C-1 require regarding compensation committees?

Proposed Rule 10C-1 requires that if a company has a compensation committee, or a committee performing the function of a compensation committee (i.e., one that oversees executive compensation), each committee member must also be a member of the company’s board of directors and must be independent. The national securities exchanges are themselves tasked with defining independence in the context of compensation committee membership, but must take into consideration factors such as:

  • sources of compensation paid to a board member, including consulting, advisory and other fees paid by the company; and
  • whether a board member is affiliated with the company or a subsidiary of the company.

Notably, as proposed Rule 10C-1 does not direct the national securities exchanges to adopt listing standards that would require a company to have a compensation committee, or to apply the compensation committee independence standards to the independent members of a board of directors that oversee executive compensation when there is no committee. The Commission is also specifically seeking comment on whether the final rule should instead direct the national securities exchanges to adopt listing standards that simply require compensation committees.

What does proposed Rule 10C-1 require regarding compensation advisors?

Proposed Rule 10C-1 requires that a compensation committee have the discretion and reasonable funds available to retain compensation consultants, independent legal counsel and other advisors, and that the committee be responsible for appointing, compensating and overseeing the work of such advisors, but not be required to follow the their advice or recommendations.

When choosing advisors, proposed Rule 10C-1 does not require that they also be independent, only that the compensation committee, in its selection process, consider:

  • whether the advisor provides other services to the company;
  • the amount of fees the advisor receives from the company as a percentage of the advisor’s total revenues;
  • what policies and procedures the advisor has in place to prevent conflicts of interest;
  • whether the advisor has a business or personal relationship with any member of the compensation committee; and
  • whether the advisor owns any company stock.

In addition to the foregoing, the national securities exchanges may adopt other relevant factors for consideration in their respective listing standards.

Are there any exemptions?

Exchange Act Section 10C exempts five categories of companies from the the compensation committee independence requirements:

  • controlled companies;
  • limited partnerships;
  • companies in bankruptcy proceedings;
  • open-ended management companies; and
  • foreign private issuers that disclose in their annual report the reason they do not have an independent compensation committee.

Proposed Rule 10C-1 also authorizes the national securities exchanges to adopt listing standards that exempt:

  • certain relationships from the compensation committee independence requirements; and
  • entire categories of companies from all of the Section 10C requirements, taking into consideration the potential impact that the requirements may have on smaller reporting companies.

When will the new listing standards take effect?

Procedurally, following the public comment period, and once the final rules and amendments are adopted and published in the Federal Register, the national securities exchanges will have 90 days to propose conforming listing standards, which must then be approved by the Commission within one year of the date on which its final rules and amendments were published in the Federal Register.

To the extent that they do not already do so, the listing standards of the national securities exchanges will have to provide companies with a reasonable opportunity to cure any defects that would otherwise cause their securities to be delisted, or ineligible for listing, based on a failure to meet the new standards.

What new disclosures do the proposed amendments to Item 407 of Regulation S-K require?

As proposed, the amendments to Item 407 of Regulation S-K would require a company to make certain expanded disclosures in any proxy or information statement filed in connection with an annual or special meeting at which directors are elected, regarding whether:

  • management or the company’s compensation committee retained or obtained the advice of a compensation advisor during the most recently completed fiscal year; and
  • the work of the compensation advisor raised any conflicts of interest, and, if so, how the conflicts are being addressed.

When do the new disclosure requirements take effect?

The new disclosure requirements will not take effect until the effective date of the final rules and amendments adopted by the Commission.

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* The proposed rules would also apply to a registered national securities association that lists equity securities in an automated inter-dealer quotation system.  At present, the Financial Industry Regulatory Authority (FINRA) is the only registered national securities association, however, FINRA does not list equity securities and, as such, the new rules do not apply to it.

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The SEC Proposes New Rules for Shareholder Advisory Votes on Say-on-Pay and Golden Parachutes

by Vanessa Schoenthaler on October 19, 2010

Yesterday the Securities and Exchange Commission proposed a new set of rule amendments designed to implement the say-on-pay and golden parachutes provisions of Section 951 of the Dodd-Frank Act.

The proposed rules would require companies subject to the Commission’s proxy rules (which includes U.S. issuers, non-U.S. issuers that do not qualify as foreign private issuers and foreign private issuers that voluntarily subject themselves to the Commission’s proxy rules) to provide their shareholders:

  • at the first annual or other shareholder meeting taking place on or after January 21, 2011, and at least once every three years thereafter, with a separate advisory vote on the compensation of those executive officers for whom compensation disclosure is required in the company’s proxy solicitation materials;
  • at the first annual or other shareholder meeting taking place on or after January 21, 2011, and at least once every six years thereafter, with a separate advisory vote on the frequency of the advisory vote on executive compensation, to determine whether it should take place every year, every other year or every three years; and
  • in any proxy or consent solicitation materials to approve a  merger, acquisition or similar transaction, with a separate advisory vote on golden parachute compensation for executive officers, with disclosure in both tabular and narrative formats.

Importantly: the initial shareholder advisory vote on executive compensation and the initial shareholder advisory vote on the frequency of the vote on executive compensation must be included in a company’s proxy statement for the first annual or other shareholder meeting taking place on or after January 21, 2011, regardless of the Commission’s adoption of the proposed implementing rules.

Therefore any proxy solicitation materials, whether preliminary or definitive, for a shareholder meeting taking place on or after January 21, 2011, even if filed prior to that date, must include separate resolutions for shareholders to vote on executive compensation and the frequency of future executive compensation votes.

This is not the case for the advisory vote on golden parachutes; shareholder resolutions for shareholders to vote on golden parachutes are not required to be included in a merger or acquisition proxy statement until after the Commission adopts implementing rules.

The Commission made clear its view that a proxy card for any shareholder advisory vote on the frequency of executive compensation votes should only provide a shareholder with four choices: (1) that the shareholder advisory vote on executive compensation should occur every year; (2) that the shareholder advisory vote on executive compensation should occur every two years; (3) that the shareholder advisory vote on executive compensation should occur every three years; or (4) that the shareholder is abstaining from voting on the matter.

The Commission also pointed out that under the amended exchange rules, for issuers listed on a national securities exchange, broker discretionary voting of uninstructed shares would not be permitted for shareholder advisory votes on executive compensation and shareholder advisory votes on the frequency of votes on executive compensation

On the first read-through, other notable proposals in the Commission’s release include recommendations that:

  • shareholder advisory votes on executive compensation and shareholder advisory votes on the frequency of votes on executive compensation not trigger the required filing of a preliminary proxy statement;
  • smaller reporting companies not be exempt from the proposed shareholder advisory votes or additional disclosure requirements (but without altering existing scaled disclosure requirements related to compensation disclosure) ; and
  • registration statements containing disclosure relating to mergers and similar transactions, going-private transactions and tender-offers include both tabular and narrative disclosure regarding golden parachute compensation for executive officers.

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Reading The SEC’s Tea Leaves: A Preview of Possible Staff Disclosure Comments

by Vanessa Schoenthaler on October 12, 2010

With an onslaught of Dodd-Frank activity looming, the third quarter earnings season officially underway and the year-end fast approaching, wouldn’t it be nice to have some indication of what the Securities and Exchange Commission will focus on when reviewing upcoming year-end filings?  Well there’s certainly no shortage of options, but the Commission’s Chief Accountant, Wayne Carnall, may have just given us a clue, at least with respect to financial disclosures.

As reported in CFO.com, Carnall, in a recent accounting-industry speech, named several areas that are of particular interest to the Commission and likely to be the focus of future staff comment letters.* Among them, Carnall pointed to disclosure regarding short-term liquidity.  No surprises there; just last month the Commission proposed a new set of rule amendments that would require companies to provide greater quantitative and qualitative disclosure of short-term borrowing during a reporting period.

Carnall also indicated that the Commission will increase its focus on the credentials and experience of those preparing and auditing the financial statements of companies with operations in developing countries.  For example the Commission has recently issued comments such as:

We note that your operations are in [a developing county] but your audit report was signed by an audit firm based in [the United States]. In this regard, please describe for us how the U.S. auditor performed the audit of [your foreign] operations.  In your response, please tell us whether another foreign audit firm assisted in the audit. If so, please tell us the name of the other firm, whether the other firm is registered with the PCAOB, and the extent to which audit work was performed by the other firm.

Other named areas of Commission focus included disclosure regarding the calculation of contingent liabilities, non-cash charges involving impairment to goodwill and deferred tax assets, and the consistency and accuracy of non-GAAP disclosure.

What about non-financial disclosures?  Carnall didn’t touch on any, but Director Meredith Cross, in recent testimony before the House Committee on Financial Services, indicated:

Executive compensation disclosure review remains a focal point of the Division’s review program and the staff continues to comment on ways that companies can enhance their disclosure.

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*Of course the Commission disclaims responsibility for the public statements of its employees, so Carnall’s predictions may not actually reflect future Commission policy.

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The New Proxy Access Rules Are On Hold … For Now

by Vanessa Schoenthaler on October 4, 2010

Last week the U.S. Chamber of Commerce and the Business Roundtable announced the filing of a joint lawsuit challenging the Securities and Exchange Commission’s adoption of proxy access Rule 14a-11. The groups also filed a motion requesting that the Commission stay the effect of the Rule pending resolution of the suit.

Today the Commission did just that; staying not only the effect of Rule 14a-11, but also of the amendments to Rule 14a-8. The groups’ motion didn’t actually request a stay of the effect of the amendments to Rule 14a-8, but the Commission reasoned that the amendments, “designed to complement” Rule 14a-11, were so “intertwined” that allowing them to become effective while staying Rule 14a-11 could potentially be confusing.

At this point the Commission and the groups will file a joint motion with the U.S. Court of Appeals for the District of Columbia Circuit requesting an expedited review of the suit.  However, as reported by Bloomberg, the Commission doesn’t expect the suit to be resolved until “late spring”.  So, even if the Commission prevails, it now looks like the new proxy access rules will not affect most issuers before the 2012 proxy season.

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The Battle for Proxy Access Isn’t Over Yet

by Vanessa Schoenthaler on September 30, 2010

Yesterday the U.S. Chamber of Commerce and the Business Roundtable announced the filing of a joint lawsuit challenging the Securities and Exchange Commission’s adoption of proxy access Rule 14a-11 as, among other things, arbitrary and capricious and in excess of the Commission’s authority.  In a joint press release, members of the Chamber of Commerce assert that:

The SEC’s proxy access rule empowers unions and other special interests at the expense of the vast majority of retail shareholders … [and] will give small groups of special interest activist investors significant leverage over a business’ activities. …  The SEC failed to engage in evidence-based rulemaking, and we intend to hold the SEC to its statutory obligation to conduct a thorough cost-benefit analysis.

The groups also filed a motion requesting that the Commission stay Rule 14a-11, including its November 15, 2010 effective date, pending resolution of the suit.  The Commission has until October 5, 2010 to respond, but in a preliminary statement, as reported by Bloomberg News, a spokesman for the Commission stated that:

We believe that the commission’s proxy-access rules are both lawful and in the best interests of the public and shareholders. The commission will, of course, carefully consider and timely respond to the motion for a stay.

So, unless and until the Commission or the Court of Appeals stays the effective date, if you mailed your proxy materials out on or after March 15, 2010 you should continue to anticipate Rule 14a-11 affecting your 2011 proxy season.  Also of note, the motion is not seeking a stay of the amendments to Rule 14a-8 so, regardless of its outcome, those amendments will be effective on November 15, 2010.

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The SEC Proposes Enhanced Disclosure Requirements for Short-term Borrowing

by Vanessa Schoenthaler on September 17, 2010

Earlier today, in an open meeting, the Securities and Exchange Commission proposed a new set of rule amendments designed to expand and enhance company disclosure of short-term borrowings.  If adopted the amendments would require reporting companies to include detailed quantitative and qualitative information about short-term borrowings in their filings with the Commission.

In her opening statement at the meeting Chairman Shapiro commented that:

The proposed rules we are considering today, if adopted, would shed greater light on a company’s short-term borrowings, including a practice some refer to as balance sheet ‘window-dressing.’ Under these proposals, investors would have better information about a company’s financing activities during the course of a reporting period — not just a period-end snapshot. With this information, investors would be better able to evaluate the company’s ongoing liquidity and leverage risks.

The Commission also approved additional interpretive guidance relating to discussions of liquidity and capital resources in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Comments on the proposed short-term borrowing rule amendments can be made here and are due 60 days after amendments’ publication in the Federal Registrar.  The MD&A guidance is effective as soon as it’s published in the Federal Registrar.

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The SEC’s New Proxy Access Rule is Set to Take Effect

by Vanessa Schoenthaler on September 16, 2010

The Securities and Exchange Commission’s new proxy access rule was published in the Federal Register today.  The rule is effective on November 15, 2010 for all companies except smaller reporting companies, which have a three-year deferral.  That means if you mailed your proxy materials out on or before March 14, 2010, the 2011 window for shareholder submissions will have already lapsed by the November 15, 2010 effective date (with November 14, 2010 being the 120th calendar day before the one year anniversary of a March 14, 2010 mailing date) and the rule will not effect you until the 2012 proxy season.  If you mailed your proxy materials out on or after March 15, 2010 the rule will affect your 2011 proxy season (although for companies that mailed their proxy materials out between March 15, 2010 and April 12, 2010, the 2011 window for shareholder submissions will vary in length between 1 and 29 days, rather than the full 30 days prescribed in the new rule).

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SEC Adopts New Proxy Access Rule

by Vanessa Schoenthaler on August 26, 2010

Yesterday the Securities and Exchange Commission adopted Exchange Act Rule 14a-11, a new proxy access rule requiring public companies to include the director nominees of certain shareholders in their proxy materials.

The new rule is effective for all companies except smaller reporting companies 60 days after its publication in the federal register.  The rule is effective for smaller reporting companies after a three year deferral period.  The rule does not effect foreign private issuers, which are exempt from the Exchange Act proxy rules altogether.

Under the new rule a company is required to include a shareholder’s director nominee in its proxy materials if the nominating shareholder:

  • owns a minimum of 3% of the total voting power of the company’s securities (groups of shareholders can aggregate their shares to meet this minimum threshold);
  • has held the minimum number of shares for at least three years;
  • certifies that they will continue to hold the minimum number of shares through the date of the shareholder meeting; and
  • certifies that they are not holding the shares for purposes of effecting a change in control or to gain a number of board seats in excess of the maximum permitted under the rule.

A nominating shareholder must provide notice to the Commission and the company of their director nominees between 150 and 120 days before the date on which the company’s proxy materials were mailed the year before.  To be eligible, a shareholder nominee must meet the requirements of applicable federal, state and foreign laws and the national securities exchange or association rules.

The new rule also limits the number of shareholder nominees to the greater of one nominee or up to 25% of the total number of board seats.  If more shareholder nominees are put forth than seats are available, only the nominees of the shareholder or shareholder group with the largest percentage of qualifying voting power must be included in the company’s proxy materials.

The Commission also amended Exchange Act Rule 14a-8(i)(8) to allow shareholders to propose amendments to a company’s governing documents that would establish procedures for the inclusion of shareholder director nominees in the company’s proxy materials.

The Commission’s full adopting release (all 451 pages) is available here.

of their intent to have a director nominee included in a company’s annual proxy materials between 150 and 120 days before the date on which the prior year’s proxy materials were mailed

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