Important Disclaimer RiskMetrics Issues 2010 Updates to Corporate Governance Policy December 3, 2009 On November 19, 2009, RiskMetrics Group (RMG) updated its corporate governance policy for the 2010 proxy season.1 This WSGR Alert briefly summarizes the key changes and discusses the implications for U.S. public companies. As our prior alerts on the upcoming proxy season indicated (copies of those alerts may be viewed here and here), we expect that this proxy season will be a challenging one for many companies, especially small- and mid-cap companies with large percentages of retail shareholders. These companies in particular have been impacted by the advent of "e-proxy," which, although intended to reduce barriers for retail shareholders to vote, has actually reduced the number of retail shareholders voting in uncontested elections, according to most studies. In addition, voting of retail shares will be impacted by the recent amendment to NYSE Rule 452 eliminating broker discretionary voting in uncontested director elections. In preparing for their annual meetings, U.S. public companies, as well as individual board members (particularly those serving on such high-profile committees as audit, compensation, and nominating), management, and the companies' outside advisers, should carefully review the updated policies and recognize potential areas of vulnerability sufficiently in advance of the meeting to plan for appropriate response and engagement. Key Changes Director Performance RMG has expanded the circumstances in which it will make a withhold/vote-against recommendation with respect to directors based upon perceived performance concerns. Under the new policy, RMG will recommend a negative vote for an individual director not only for failure to replace management, where RMG deems this appropriate, but also for "material failures of governance, stewardship or fiduciary responsibilities at the company." In addition, RMG will recommend a negative vote if it determines that actions related to the director's service on the board of another company "raise substantial doubt about his or her ability to effectively oversee management and serve the best interests of shareholders." RMG's prior withhold/vote-against policy applied to egregious actions and failures to replace management and did not address service on other corporate boards. Director Qualifications RMG will continue to make case-by-case recommendations on proposals seeking directors with particular subject-matter expertise. RMG has expanded the list of factors on which it will base its recommendation, and now will take into account the following factors: 1) the company's board committee structure, existing subject-matter expertise, and board nomination provisions relative to its peers; 2) the company's existing board and management oversight mechanisms regarding the issue for which board oversight is sought; 3) the company's disclosure and performance relating to the issue for which board oversight is sought and any significant related controversies; and 4) the scope and structure of the proposal. Executive Compensation Not surprisingly, a significant portion of RMG's 2010 policy updates focus on executive compensation. RMG has reorganized its executive compensation evaluation policies to focus on three key considerations: (1) pay for performance (i.e., CEO compensation); (2) pay practices; and (3) board responsiveness and communication on compensation issues. RMG's 2010 policy endorses the use of say-on-pay resolutions as the primary communication avenue initially to address problematic pay practices. In addition, or alternatively, RMG will issue negative recommendations on compensation committee members (or potentially the full board) in what it considers egregious or continuing situations. If, in RMG's view, concerns raised in a say-on-pay vote are not sufficiently addressed in the subsequent year, RMG may make a withhold/vote-against recommendation on compensation committee members. For companies that do not have say-on-pay, RMG will continue to use withhold/vote-against recommendations as a tool to address compensation issues. The 2010 policy updates clarify specific factors that may result in RMG issuing "against" recommendations with respect to say-on-pay proposals, director elections, and equity plan proposals. Based on its 2009/2010 annual policy survey, RMG considers three factors to be most critical in evaluating say-on-pay proposals: pay for performance, performance metrics, and pay practices. Under the new policy, a company that triggers one or more of these factors may elicit an "against" recommendation, regardless of other factors. In addition, RMG has made specific revisions to its policies with regard to the evaluation of pay-for-performance and pay practices to reflect its apparent belief that failures to align CEO compensation sufficiently with long-term performance and policies that incentivized excessive risk-taking contributed significantly to the financial meltdown. Consequently, RMG's pay-for-performance evaluation now will include consideration of the alignment of CEO total direct compensation with total shareholder return over a period of at least five years, and its evaluation of pay practices now will include a review of a variety of factors that RMG believes create potential for excessive risk-taking, such as the use of guaranteed bonuses, "lucrative" severance packages, "disproportionate" supplemental pensions, and "mega" annual equity grants. Director Independence The 2010 updates codify and extend RMG's definitions and policies with regard to director independence. The updates specify that the materiality test for transactional relationships will be bifurcated such that companies following NYSE/Amex listing standards will be subject to the NYSE-based test of the greater of $1 million or 2 percent of the recipient's gross annual revenue, while all others will be subject to the NASDAQ-based test of the greater of $200,000 or 5 percent of the recipient's gross annual revenue. The updates also expand the characterization of professional services from services that are "advisory in nature" to those that are "advisory in nature, generally involving access to sensitive company information or to strategic decision-making, and typically having a commission or fee-based payment structure." Consistent with the updated definition, insurance services, information technology services (other than tech support), certain marketing services, lobbying services, executive search services, property management and realtor services, and most "of counsel" relationships now will be considered professional services. Educational services, tech support, and certain marketing services will not be considered professional services, but transactional. The $10,000 de minimis threshold will continue to apply, but will be considered not only with regard to the director (or immediate family member), but also to any organization in which the director (or immediate family member) is a partner, controlling shareholder, or employee. The updates also remove the officer requirement from the definition of "Insider Director." Previously, an "Insider Director" was defined as a "non-employee officer of the company if among the five most highly paid"; now an Insider Director is simply one who is "among the five most highly paid individuals." (However, non-employee directors who serve as officers to satisfy statutory requirements (e.g., corporate secretary) only will be classified as Insider Directors if they receive in excess of $10,000 of additional compensation for serving in such capacity.) Poison Pills RMG continues to refine and expand its policies relating to poison pills. Previously, RMG made withhold/vote-against recommendations for all directors if the board adopted or renewed a poison pill without committing to a shareholder vote on the pill within 12 months. While this policy encouraged boards to seek shareholder approval of poison pills, it did not fully reflect that short-term pills can be a valuable tool to maximize shareholder value in the event of an opportunistic offer. Thus, under the new policy, RMG will make recommendations based on the term of the pill. RMG will make withhold/vote-against recommendations for all directors if the board adopts a long-term pill (greater than 12 months) without shareholder approval. However, boards that adopt short-term pills (12 months or less) also will be subject to scrutiny by RMG. RMG will make case-by-case recommendations for boards that adopt short-term pills after considering 1) the date of the pill's adoption relative to the next shareholder meeting; 2) the rationale for the adoption; 3) the issuer's governance structure and practices; and 4) the issuer's track record of accountability to shareholders. Further, RMG now will review companies that adopt or renew poison pills without shareholder approval every year for companies with classified boards and every three years for companies with annually elected boards. In addition, for 2010 RMG is adding a new policy under which it will issue withhold/vote-against recommendations for directors who make a "material, adverse change" to an existing poison pill without shareholder approval. NOL Poison Pills RMG also has adopted a new policy pursuant to which it will make case-by-case determinations on whether a board's decision to adopt or amend a poison pill to protect net operating losses (NOLs) is reasonable based upon a variety of factors, including but not limited to 1) the ownership threshold (typically 5 percent); 2) the value of the NOLs; 3) shareholder-protection mechanisms such as whether the defensive measure has an expiration provision that ends the protective amendment when the NOLs expire; and 4) the company's existing governance structure, including: board independence, existing takeover defenses, track record of responsiveness to shareholders, and any other problematic governance concerns, as well as any other factor that RMG considers significant. Supermajority Vote Requirements, Special Meetings, and Action by Written Consent Consistent with past practices, RMG will continue to generally recommend against proposals that require (and in favor of proposals that reduce) supermajority shareholder votes. However, RMG has recognized that a reduction in supermajority voting requirements may, in some cases, be detrimental to minority shareholders, e.g., where highly dilutive stock and warrant issuances by distressed companies have increased the potential for large investors to effectively take control of the company. Accordingly, RMG will examine future proposals on a case-by-case basis, taking into account the ownership structure, quorum requirements, and the specific supermajority vote requirements. RMG also reiterated its policy of recommending in favor of proposals that increase (and against proposals that restrict) shareholders' ability to call special meetings or act by written consent. Historically, RMG has strongly supported these rights (as well as the right to vote on all directors on an annual basis). This year's updates specify the factors that RMG considers when assessing specific proposals; they include: 1) shareholders' current rights to call special meetings or act by written consent; 2) minimum ownership or consent thresholds; 3) exclusionary or prohibitive language; 4) investor ownership structure; and 5) shareholder support of and management's response to previous shareholder proposals. Stock Authorization As in previous years, RMG continues to broaden its inquiry into proposals for increasing the number of shares of common stock authorized for issuance. Beginning this year, RMG also will consider the company's use of authorized shares during the last three years, and one- and three-year total shareholder return. These factors, combined with the factors specified last year—specific reasons for the proposed increase, dilutive impact of the increase based on RMG's quantitative model, the board's governance structure and practices, and the risk to shareholders of not approving the request—will inform RMG's case-by-case determination about whether to recommend for or against share-increase proposals. RMG also will consider these same factors when making case-by-case determinations with regard to proposals to increase the number of shares of preferred stock. If the proposal relates to "blank check" preferred stock, RMG will further consider whether the proposal will create or strengthen anti-takeover devices. Board Diversity RMG will continue to evaluate on a case-by-case basis proposals to increase board diversity. However, RMG has clarified that "diversity" refers to the racial and gender composition of the board, rather than the mix of professional skills represented. Environmental and Social Issues Regarding proposals related to greenhouse gas emissions, RMG generally will recommend proposals that seek additional disclosure or reporting of greenhouse gas emissions, but make case-by-case recommendations on proposals calling for specific reduction targets. Factors relevant to RMG's recommendation include current disclosures and plans; the company's policies relative to its peers; the existence (or lack) of significant controversies, fines, penalties, or litigation associated with the company's greenhouse gas emissions; and the feasibility of such reductions given the company's product line and current technology. Conclusion As a result of RMG's 2010 policy changes, there are now more than 40 categories of practices that could lead to a withhold/vote-against recommendation for directors, including such factors as the director's service on other boards, the board's adoption of a "non-RMG-approved" shareholder rights plan, lack of a formal nominating committee (even if the board attests that independent directors fulfill the functions of such a committee), or "problematic pay practices." Indeed, one of the frustrations most frequently expressed by directors is that the criteria used by RMG to evaluate "good governance" change every year, raising the question of whether these new standards are reactions to topical issues rather than the result of a rigorous analytical process. RMG's new policies will continue the trend of making more directors vulnerable to "withhold" votes in uncontested elections, a trend that has grown dramatically over the last several years. In fact, according to one study, directors receiving withhold/against votes of 15 percent or more increased by over 68 percent from 2008 to 2009, with more than 1,000 directors at more than 375 companies receiving such votes.2 Many of these directors sat on particular committees, such as compensation or audit committees, that acted in a manner inconsistent with RMG's guidelines, or were part of a board that adopted measures such as "poison pills" that were not compliant with the types of plans recommended by RMG. At the same time, it appears that shareholder activists will continue to be emboldened to initiate proxy contests by their potential ability to win the endorsement of RMG. Although many thought activism would diminish in 2009 as a result of the decline in the financial markets in 2008 and early 2009, Georgeson reported a total of 57 formal proxy contests as of the end of September 2009, one more than the record set in 2008.3 Further, in those contests that actually went to a full vote, dissidents were successful in gaining at least one seat in essentially half of all the contests and, if settlements are included, then dissidents obtained seats in nearly two-thirds of all announced contests through this period, a much higher figure than in the prior year. These trends are likely to continue into 2010, and also will be particularly felt by small- and mid-cap companies, as these companies in general remain the most susceptible to shareholder activism. For all these reasons, we believe it is prudent for directors and management to consider a more proactive approach to both shareholder communications and the upcoming proxy season, so that companies are prepared for the multiplicity of issues that may be facing them. For more information on the implications of RMG's 2010 updates for your company, please contact David J. Berger, Lawrence M. Chu, Warren de Wied, Robert T. Ishii, or any member of your Wilson Sonsini Goodrich & Rosati team.
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