Some of the key developments in 2011 showed movement toward reconciliation between stockholders and incumbent boards on governance matters. Shareholder governance proposals were at their lowest level in a decade and support declined for several types of proposals. Institutional Shareholder Services (ISS) concluded that its recommendations about written consent proposals should reflect the company's governance as a whole. In the first year of say-on-pay votes (other than for many financial institutions), there were only a small number of failed say-on-pay votes and the existence of the say-on-pay process gave shareholders the means to express more targeted dissatisfaction. This appears to have driven a decline in opposition to director incumbents, and prompted better dialogue between many companies and their major shareholders and better disclosure about the business rationale for pay decisions.
Other trends from the past year dictate against complacency by boards in 2012. Regulators and shareholders remain energized. The SEC brought a record number of enforcement proceedings in 2011, a trend likely to continue. For their part, shareholders remain acutely focused on stock performance as the yardstick to evaluate a company's execution, despite volatility largely resulting from fragile economic and political conditions worldwide. In this context, it is critical for boards to frame their deliberative processes in a way that assures the protection of the business judgment rule, while positioning themselves and management to meet expectations of regulators and investors alike.
Summarized below are some of the issues boards should keep in mind in 2012.
M&A Opportunities and Risks
While the first half of 2011 continued 2010's M&A growth trends, growth stalled in the second half leading to only a very modest uptick for the full year. Spin-offs were the one type of transaction that attracted substantial interest, as companies decided (sometimes on their own, but sometimes after prompting from activists or other investors) that their businesses would generate better returns and have better prospects if split into two or more companies.
Despite current market and economic challenges, there could be increased deal activity in 2012. Prospective acquirers have substantial cash resources and reasonable or even strong stock prices, banks are willing to lend for at least some acquisitions, interest rates are low, private equity firms have significant unused investor commitments, and hedge funds are actively seeking positive results. In this environment, directors should be mindful of whether the company's current condition presents opportunities for it and its stakeholders.
The above factors suggest that advantageous pricing may be achievable for companies considering a sale of control or selected divestitures. Firms considering strategic sell-side transactions should review the current financial state of the firm, markets, likely bidders, and antitrust or other regulatory uncertainties. Careful planning for any transaction process in light of legal requirements is also important. Among other things, boards pursuing these transactions should be sensitive to, and take steps to prevent or limit, potential conflicts of interest on the part of their financial advisors, and should make sure they get a careful analysis of antitrust and regulatory risks.
Directors of prospective acquirors should do their homework to understand the business being acquired; integration challenges and plans, including anticipated positive and negative synergies; antitrust or other regulatory risks in the United States and overseas; and financing, litigation, and other consummation and post-closing risks. For example, acquiring a company that turns out not to be compliant with the Foreign Corrupt Practices Act (whether or not it was subject to those provisions prior to being acquired), can result in expenses to investigate and fix the problem, loss in income from possible changes in the target's business model and the payment of fines.
If a board believes its CEO may be approached by a financial sponsor regarding a potential LBO, the CEO should be instructed to advise the lead independent director immediately of any such approach. And if an approach is made and the board decides to explore it, the board should put appropriate protocols in place to assure that the process is actively supervised by the independent directors.
The past two years have witnessed a modest but meaningful amount of hostile deal activity and shareholder insurgency, as well as negotiated deals disrupted by interlopers. Given this activity, directors of potential targets should consider a review of their defenses to understand vulnerabilities and be prepared to move quickly to fulfill their fiduciary obligations. One difficult decision to be faced by some boards this year relates to the renewal or non-renewal of a shareholder rights plan scheduled to expire. In reviewing these plans, boards should take into account potential threats to shareholder interests that may justify such defenses, as well as the policy of ISS to recommend "no" or "withhold" on director nominees who have voted to extend a right plan and the policies of relevant institutional shareholders.
Some companies have rights plans "on the shelf" that a board can consider adopting quickly if appropriate when faced with actual hostile activity. But the "on the shelf" approach is not entirely satisfactory for many smaller companies or even for some larger companies, given the expanded use of derivatives by some investors to establish a large economic position that can effectively be converted (after regulatory clearance) into a large ownership position. Nevertheless, given the policies of proxy advisory firms and some institutional shareholders, it is not surprising that almost 80 percent of companies with rights plans scheduled to expire in 2011 allowed them to expire, and a majority of the extensions were for periods of two to five years rather than the once-standard 10 years.
In any contest for control, a company's strategic plan will take center stage and may very well prove to be the determinative factor. In order to mount an adequate defense against any unsolicited offer or proxy contest--and for more basic reasons of oversight--the board should ensure that the company's strategic plan is current, has adequate support in company and market data, and reflects the best judgment of management.
Balance Sheet Management and Vulnerability to Insurgency
The ratio of liquid assets to total assets of non-financial institutions in the United States is the highest in over 50 years. Feeding this fattening of the balance sheets are a historically low level of business investment relative to pre-tax corporate profits and, in some cases, issuances of debt at low cost without any near-term plans for use of proceeds. While the financial crisis and subsequent economic uncertainties may have led to this situation, directors should now be considering how much longer their companies should retain significant excess capital and asking themselves and management how much longer investors will tolerate this trend. A common misconception is that hedge fund insurgents target only underperforming or distressed companies. In fact, one recent study concluded that the boards and managements that are most frequently attacked in activist filings on Schedule 13D are those overseeing companies characterized by steady cash flows and healthy balance sheets. Accordingly, directors should be carefully considering:
- Whether to invest more in the business;
- Whether to engage in more strategic acquisitions or similar transactions;
- Whether to return more value to shareholders through share buybacks and dividends; and
- Whether to incur more leverage to have additional flexibility to do any or all of the above.
Studies have shown hedge fund activists to be highly effective at inducing increases in leverage, share buybacks, and dividends. The same studies have shown that, despite the frequent adoption by hedge fund insurgents of the moniker "operational activist," they have been less successful at causing improvements to the operating performance of companies. But when a board is perceived to be "standing still" on top of a healthy and growing balance sheet, activists will not hesitate to enter the scene to advocate changes to the board, management, and strategic plan. Boards should explore, and push outside advisors and management to help them understand, whether more aggressive uses of excess capital may be appropriate and communicate their conclusions and reasoning to investors. This effort may do more than traditional anti-takeover mechanics to protect a company from a campaign by an operational activist who, in the face of a seemingly passive board, may generate enough momentum to steer the company in directions that conflict with what the board believes to be in the company's best interests. Despite the challenges of macroeconomic and industry uncertainties, by focusing appropriately on these issues in advance, boards may be able to reduce the likelihood of activist campaigns or have more credibility with investors if a campaign is launched.
Preparing for the Annual Meeting
One-size-fits-all Approaches to Governance Practices
The past several years have seen the homogenization of governance practices due both to the press of shareholder concerns and the threat of "no" or "withhold" recommendations by the principal proxy advisory firms in director elections. Even as boards have refreshed their practices, the pressure to conform continues, whether or not justified.
Boards should recall that the exercise of their fiduciary duties in the interests of the company and its shareholders may not always be coincident with the voting policies of proxy advisory firms. Those policies may reflect a generic viewpoint, and one that may or may not reflect the majority view of the particular company's shareholders. Boards should not hesitate to deviate from them when the company's circumstances warrant, while recognizing that doing so will place pressure on effective shareholder relations. In 2011, there was a marked increase in companies that challenged recommendations of proxy advisory firms often reflected in additional soliciting materials, utilized and filed after distribution of the proxy statement. We expect this practice to grow, since the proxy statement has become a cumbersome legal document. Of course, in preparing their proxy statements companies should seek to anticipate the positions of proxy advisory firms and investors.
Private Ordering Proposals for Proxy Access
A fairly modest number of companies have received shareholder proposals advocating proxy access bylaws. The proponents are a mix of institutional and retail investors (including public funds). True to predictions, the proponents emphasize that their proposals have been targeted at companies that have either had well-publicized issues or where performance is perceived as poorly correlated with executive pay.
- Almost all proposals require the nominating shareholder or group to own 1%, 2%, or 3% for a period of one, two or three years, except for one proposal requiring 15% ownership for only one month.
- Proposals following the model published by U.S. Proxy Exchange would also permit nominations made by 100 investors each owning $2,000 of stock for one year.
- A slim majority of the proposals are precatory, with the remainder purporting to be binding bylaw amendments.
- About half of the proposals have a cap on the number of access board seats (generally 25%); the rest have no cap.
- Several companies are utilizing the SEC process in seeking to omit proposals on a variety of procedural and substantive grounds. One no-action request was initially based on a claimed conflict of the proponent's 1% one-year proposal with the board's subsequently proposed 5%, three-year bylaw proposal, but the company later decided not to make that competing proposal and withdrew that basis for seeking no-action, but has proposed
- An H-P shareholder has agreed to withdraw its 3-year, 3% precatory proposal in exchange for H-P committing to submit a binding board-recommended proxy access proposal with those thresholds at its 2013 annual meeting.
As in the case of other practices (e.g., majority voting), we expect a limited number of approaches to the principal elements of an access bylaw will gain traction over time, but there are more "moving parts" to an access bylaw than the thresholds noted above. These include how "beneficial ownership" is calculated (e.g., how derivative positions are treated) and various disclosures or undertakings that could be requested of the nominating shareholder or group. Although most companies will not face these proposals in 2012, boards should be familiar with the main elements of an access bylaw as well as 2012 vote outcomes and responses by affected companies.
Re-slating and Succession Practices
Shareholder involvement in the director nominating process is likely to increase, particularly when a company has performance issues. A board can mitigate the risk of activism by focusing on the quality of its own composition and being able to demonstrate how well director skills and experience align with company needs. Steps to improve nominating and succession processes include:
Re-slating process. Implement a meaningful re-slating process for incumbents based on evaluations of their individual contributions. Many boards have shied away from individual evaluations, probably because they would be viewed as potentially divisive, but in today's environment of smaller boards, even one director who lacks engagement can be a handicap. A board should evaluate whether its composition is optimal not just in terms of the existing business, but also in terms of the direction the business must go to thrive in an uncertain environment. The board should also consider the dynamics of the group. Each year, there are several prominent examples of board dysfunction. It is better to face the issue head-on than to deal with the challenges of fixing the problem after a visible collective failure.
Policies on director nomination and succession. Review the board's policies on director nomination and board succession matters. Thoughtful attention to these documents can help the board build consensus about what is needed, facilitate sensible re-slating and prioritize recruiting.
Director turnover. Many boards keep a list of potential candidates, detailing their qualifications and other attributes for ready reference. This practice can reduce recruitment time and board disruption when vacancies occur. Boards should also consider whether they have enough of what they need--whether, for example, a key skill set or experience profile is embodied in a single director who may be hard to replace.
Audit, Compliance, and Control Matters
Relationship with Auditor
The Public Company Accounting Oversight Board (PCAOB) has expressed renewed concern about audit quality and auditor skepticism. PCAOB officials say that audit inspections have shown a surprising number of cases in which auditors have accepted management representations without verification. The PCAOB's request for comment about whether it should require audit firm rotation to address the problem has elicited mostly negative reactions. But some audit committees now periodically consider auditor rotation, and many others have undertaken contingency planning, including maintaining the independence of at least one other potential audit firm, in case a change becomes necessary or desirable. While we view these as appropriate steps, there are other steps the audit committee can take to improve the auditor relationship and add value to its oversight of management, such as those described below.
Auditor/Audit Committee Communications
Even before the PCAOB finalizes its proposed role with respect to audit committee/auditor interactions, the audit committee should review the proposed standard and consider asking the auditor to provide the information called for under the proposed standard (to the extent appropriate, given the company's circumstances). Likewise, the committee should be prepared to respond to the auditor inquiries the new standard would prompt. These include questions about the committee's knowledge of "violations or possible violations of laws or regulations," which are not limited to accounting or auditing matters.
The audit committee should also consider whether other board and committee activities complement auditor communications. These include the committee's executive session practices with the auditor and management personnel (e.g., internal audit and compliance) and management presentations about significant accounting policies. These activities, taken together, should be designed to ensure the committee receives both candid appraisals of material financial reporting matters and sufficient contextual information to facilitate its oversight.
Evaluation of Auditor Performance
In view of regulatory skepticism, the audit committee should review its process for evaluating the auditor. In addition to reading the auditor's standard quality control report and independence communication, the committee should make separate inquiries of both management (including senior financial management) and the auditor about the quality of the working relationship and the auditor's expertise and qualifications. It should understand the significant areas where the auditor relies on representations of management or work of internal audit personnel, and the appropriateness of the reliance.
The committee should also request information from the auditor about its most recent PCAOB inspection. Most deficiencies are included in a non-public portion of the inspection report pending a remediation period, but the committee can request that auditors summarize those non-public matters which can provide insights (despite the small number of audits reviewed), so as to avoid surprises. Of course the auditor engagement should require the auditor to notify the committee if the company's audit is selected for PCAOB review. Similarly, the committee should make inquires of the auditor any time press reports indicate that the auditor has been involved in a material independence violation or other proceeding.
Preparation and Red Flags
In its review of the audit plan, the audit committee should be attentive to the changing risk profile of the company. Although the new PCAOB Staff Audit Practice Alert No. 9, Assessing and Responding to Risk in the Current Economic Environment (Dec. 6, 2011), is applicable to auditors, audit committees should be encouraged to review it. Highlighting the current challenging economic conditions, the alert calls attention to several red flags that should be taken into account in planning the audit, both in connection with the close of the 2011 audit and the planning of the 2012 audit. Among them are:
- Performance measures that may have become too aggressive, which may increase the pressure on management to manipulate results.
- Additional fraud risk factors that can exist when financial stability or profitability is threatened.
- Financing or liquidity requirements that may raise challenges in funding or the risk of covenant violations.
- Bias in accounting estimates, which could be signaled by inconsistencies in assumptions; and overly optimistic assumptions or assumptions that are inconsistent with industry economic forecasts or the company's budgets or future business plans.
Status of International Financial Reporting Standards (IFRS) Adoption
Audit committees should ensure that financial management and auditors are paying attention. In particular, the items of the company's accounting and financial reporting that would change most significantly under IFRS should be identified. In addition, systems development and implementation should even now take into account the potential impact of IFRS.
SEC Bounty Program
Much has been written about the SEC's bounty program for whistleblowers and the potentially adverse incentives it creates. Less attention has been devoted to what boards and audit committees should do.
Hot spots. Boards should ensure that management considers areas of compliance risk that may come to the attention of whistleblowers. Key areas of concern could include violations of the Foreign Corrupt Practices Act (and, if applicable, the United Kingdom's new Bribery Act), material errors in financial statements or other disclosure, misconduct in respect of customers or suppliers, and anti-money laundering rules.
Compliance programs. The SEC's rules have provisions to encourage whistleblowers to first report internally, and the audit committee should focus on maximizing the likelihood that this will be the case. Steps should include management review of whistleblower anonymity and retaliation protections, use of surveys to obtain employee feedback about whistleblower programs, and a review by the committee of management actions taken to strengthen compliance programs. Ensuring that supervisors at all levels receive training about avoiding retaliation is also critical, as is linking supervisor pay and performance evaluations to compliance. The importance of these steps should not be underestimated: there is substantial evidence that employees do not use formal complaint procedures, but simply approach their supervisors if they believe complaints will be taken seriously and there will be no retaliation.
Investigations and self-reporting. Because whistleblowers who first approach a company must go to the SEC within 120 days to get maximum credit under the bounty program, the company and the audit committee need to have a process in place to be able to make prompt and informed decisions. The committee also needs a process for determining whether a complaint can be handled internally or whether it should involve outside advisors. Board oversight should also include ensuring that management has "pre-cleared" (including for conflicts) potential advisors, including counsel, forensic accountants, and crisis management consultants.
Changed dynamics. The bounty program could change the dynamics of investigations and enforcement matters. Whistleblowers and their lawyers may seek to influence the SEC, through the political process and the media and will urge the SEC to find wrongdoing and impose substantial penalties. The SEC will also be more likely to conduct investigations and to increase the thoroughness, time, and expense of such investigations.
Executive Compensation Matters
Finally, executive compensation must continue to receive substantial attention from boards, as the challenges in that area have not subsided. Early 2012 experience suggests that proxy advisory firms are increasing efforts to dictate specific compensation decisions to boards. Furthermore, executive pay in this political year seems certain to become a highly public issue. Directors should thus particularly focus on performance metrics in incentive plans, ensuring that they permit a simple and clear explanation of the correlation between pay and performance and result in a defensible peer group analysis. Also, especially in light of expected regulatory action that will highlight the issue of clawbacks, directors should consider the interplay between compensation design and business risks in order to minimize the chance that they will have to make difficult judgments regarding clawback claims against their executives.