WSGR ALERT

Preparing for the 2019 Reporting Season

November 26, 2018

With 2018 quickly drawing to a close, attention now turns to preparing for the 2019 reporting season. As always, there are a number of compliance "musts" to focus on, as well as items that can be addressed in 2018 to make 2019 a little easier.

Determine Your Status as an Issuer

The U.S. Securities and Exchange Commission (SEC) recently adopted final rules to expand the availability of scaled disclosure requirements for a registrant to qualify as a smaller reporting company (SRC). Registrants with a public float of less than $250 million now qualify as an SRC, as compared to the $75 million threshold under the prior definition.1 In addition, registrants that either do not have a public float or have a public float of less than $700 million are now permitted to provide scaled disclosures if annual revenues are less than $100 million, as compared to the prior threshold of less than $50 million in annual revenues. Companies that did not previously qualify as an SRC may wish to avail themselves of the scaled disclosure option. If your company did not previously qualify as an SRC but now does, decisions to scale back disclosure should be made in consultation with legal counsel, the independent auditors and the board of directors. You should also consider more indirect impacts from a scaling back disclosure. For example, Glass, Lewis & Co. (Glass Lewis) has said that if scaled-back disclosure substantially affects shareholders' ability to make an informed assessment of executive pay practices, then this could result in Glass Lewis recommending votes against (or withholding votes from) compensation committee members.

Shareholder Engagement

Review Shareholder Engagement Efforts and Plan for 2019

Conduct an "after-action review" of shareholder engagement efforts so far in 2018. In particular, focus on the feedback from shareholders related to corporate governance and executive compensation practices, as well as any feedback received from shareholder advisory services, such as Institutional Shareholder Services (ISS) and Glass Lewis if those advisors are followed by your shareholders. Changes in voting patterns at your 2018 annual meeting compared with those at the 2017 and 2016 annual meetings (for example, a meaningful increase in votes against the election of one or more directors) also can be informative. Synthesize this information for the board and any relevant committees to provide them an unvarnished view of shareholder perspectives. With shareholder engagement now a year-round priority, inform the board of the shareholder engagement plan—including a timeline—for 2019. Reflect any input from the board in the plan.

Prepare "What We Heard, What We Did" Charts and Summaries

An evolving best practice is to include "what we heard, what we did" charts and summaries in the proxy statement. These describe the nature of shareholder feedback received over the course of the year and detail how the registrant responded to that feedback. Even if this disclosure ultimately is not included in the proxy statement, it can be very helpful for framing discussion with the board and its committees about shareholder concerns.

Consider Any Appropriate Responses to Shareholder Feedback

As appropriate, implement responses to shareholder feedback. As a reminder, ISS generally will recommend votes against (or withhold votes from) directors if the board fails to act on a shareholder proposal that received majority support the prior year.

Thoughtfully considering and implementing responses to shareholder feedback takes time and should be started as early as possible. In order to make informed decisions, plan sufficient time to consider alternatives. In addition, input from key shareholders may be required, as well as approvals from the nominating committee, the compensation committee, and the board.

It is always important to keep in mind that what some consider a "best practice" from a governance perspective may not be the right practice for your company. If this is true, be prepared to explain to the board and shareholders why the practice was not appropriate and was not adopted, particularly if it was recommended by shareholders.

Virtual Shareholder Meetings

As the practice of holding virtual shareholder meetings becomes more popular, companies considering implementing virtual-only meetings should weigh the benefits with the potential downsides.2 These downsides include a perception by some shareholders that virtual-only meetings make it harder for shareholders to express their views to management. As of January 1, 2019, Glass Lewis will increase its scrutiny of a company's disclosure of its virtual meeting procedures and may recommend votes against (or withhold votes from) the members of the nominating committee for failure to provide effective disclosure ensuring that shareholders will have the same opportunities to exercise their rights at a virtual meeting as at in-person meetings.

There is an evolving list of best practices for virtual-only meetings, including: 1. adopting and publishing in advance procedures for online participation; 2. making arrangements for the presentation of shareholder proposals; 3. establishing reasonable procedures for taking questions; and 4. archiving the meeting so that it is publicly available for a period of time. Additionally, you must confirm that your company's organizational documents and applicable corporate law permits virtual meetings (they are permitted under Delaware law).

Form 10-K Drafting

Changes to Form 10-K Cover Page

Two changes to the Form 10-K cover page are required as a result of SEC rulemaking. The first change applies to the "Non-accelerated filer" box. A smaller reporting company is no longer instructed not to check this box. The second relates to conforming changes to the Inline XBRL rules for operating companies and funds. The Form 10-K cover page has been revised to show that operating companies do not need to file separate XBRL exhibits or publish an interactive data file on their websites. Similar changes will be needed for the cover pages of quarterly reports on Form 10-Q and registration statements filed under the Securities Act. Ensure that you are using the most current cover page.

Disclosure Simplification

The SEC's new rules implementing disclosure simplification mostly address accounting matters in Regulation S-X, but provide some modest relief from disclosure requirements in Form 10-K. Among other things, certain previously-required disclosures have been eliminated from the required description of business section (Item 1 of Form 10-K), and registrants are no longer required to provide a history of stock prices and dividends in their Form 10-K.

Selected Financial Data

The SEC confirmed that registrants that adopt the new revenue recognition standard using the full retrospective method do not need to apply the new standard when reporting selected financial data for periods prior to those presented in its retroactively-adjusted financial statements. However, these registrants must provide the information required by Instruction 2 to Item 301 of Regulation S-K regarding comparability of the data presented. Instruction 2 requires registrants to briefly describe, or cross-reference to, a discussion of factors such as accounting changes, business combinations, or dispositions of business operations that materially affect the comparability of the information reflected in selected financial data.

Critical Audit Matters

The Public Company Accounting Oversight Board adopted a new auditor reporting standard that requires more information about the audit, including critical audit matters. The new standard will be applicable for large accelerated filers for audits of fiscal years ending on or after June 30, 2019. Although it will not be applicable in 2019 for calendar year-end issuers, continued monitoring of the implementation of this new standard and discussion with your independent auditor and the audit committee is appropriate.

Proxy Statement Drafting

Continue to Enhance Board Composition and Diversity Disclosure

Although there are varying views on the utility of including a director skills matrix (with some influential governance-focused shareholders very vocal in their support of such a matrix), they can be useful to highlight board diversity and to illustrate graphically the qualifications of each director. Consider whether one is right for your company.

Board diversity is now viewed by many shareholders as a critical aspect of governance. The proxy statement serves a primary role in communicating the board's approach to diversity. Disclosure should be sufficiently nuanced to allow shareholders to understand how the board thinks about diversity, particularly in the context of board refreshment. As of January 1, 2019, Glass Lewis will generally recommend votes against (or withhold votes from) the chair of the nominating committee, and possibly other nominating committee members, if there are no female board members. Because of the recent California law requiring all California-headquartered companies to have at least one female board member by the end of 2019, Glass Lewis will take a stronger position against California-headquartered companies that do not have at least one female director or have not published a plan to address the issue by the end of 2019. Similarly, State Street Global Advisors announced in October 2018, that it will vote against the entire nominating committee of a company in its portfolio if the company does not have at least one woman on its board and has not engaged in a successful dialogue with State Street on gender diversity for three consecutive years. ISS recently announced that for shareholder meetings held on or after February 1, 2020, it will generally recommend votes against (or withhold votes from) the chair of the nominating committee (and other directors on a case-by-case basis) at companies in the Russell 3000 or S&P 1500 indices where there is no woman on the board.3 For 2019, ISS will not make an adverse recommendation due to a lack of gender diversity.

Cybersecurity Disclosure and Controls

Earlier this year, the SEC published interpretive guidance for preparing disclosures about cybersecurity risks and incidents. In light of this new guidance, take a fresh look at related disclosure and disclosure controls around potential incidents. In addition, consider how you would treat a cybersecurity incident (or knowledge of the possibility of one) for purposes of your insider trading policy, and consider updating the policy to clarify that cyber-related incidents may be material, non-public information for purposes of insider trading.

In October 2018, the SEC also issued an investigative report regarding certain cyber-related fraud and internal accounting controls requirements. The investigation and report considered whether companies that had suffered certain cyber-related incidents had sufficient internal controls under the securities laws. Although no enforcement actions were pursued and the SEC was clear that not every company that suffered a cyber-related fraud incident was in violation of the internal controls requirements, the report emphasized that internal controls around cyber-related fraud are important for enterprise risk management and should be included in the design and evaluation of a registrant's system of internal controls.

Environmental, Social, and Governance Disclosure

For several years, shareholders have engaged with companies regarding environmental, social, and governance (ESG) issues and sustainability. Many companies already do some form of corporate social responsibility/sustainability reporting as part of or outside of their normal reporting process. However, shareholders have been increasingly vocal about their expectations for transparency and reporting on these issues. In 2017, 331 asset owners, investment managers, and service providers in the U.S. and 1,753 worldwide signed the Principles for Responsible Investment, a set of investment principles that offer a menu of possible actions for incorporating ESG issues into investment practice. Further, Vanguard recently announced its intention to take more public positions on select governance topics, including climate risk and gender diversity. Similarly, BlackRock indicated that it may support shareholder proposals on environmental or social issues if a company fails to demonstrate that it is handling these issues appropriately.

ISS has implemented an ESG QualityScore to go side by side with the existing Governance QualityScore. Glass Lewis announced a partnership with Sustainalytics to provide ESG information. The ESG scores are based on publicly available disclosure. To date, both ISS and Glass Lewis have said that the scores will not affect their voting policies or recommendations, but the scores are publicly available on Yahoo! Finance and other platforms.

Several prominent shareholder groups and governance advocates have also turned their focus to ESG issues, and an uptick in shareholder proposals or other informal engagement on these issues should be expected as a result. The "Chevedden Group" (James McRitchie/Myra Young, John Chevedden, and Kenneth Steiner) has announced that it will broaden its focus to ESG issues, notably environmental matters and campaign finance disclosures. The New York State Comptroller and the New York City Comptroller have also increased focus on ESG matters, such as investment in Saudi Arabian companies, board diversity and environmental matters. Importantly, although there were fewer ESG shareholder proposals in 2018 as compared to 2017, the support for such proposals increased.

The Sustainability Accounting Standards Board continues to develop sustainability accounting standards to help companies disclose sustainability information to investors in mandatory filings. It also provides education and resources that may provide helpful guidance with respect to disclosures.

A coalition of shareholders, primarily on behalf of state pension funds, has petitioned the SEC for rulemaking on ESG disclosure. The SEC has not mandated such disclosure and, as with governance generally, a one-size-fits-all approach to ESG disclosure is likely not the preferred outcome. Registrants should engage with shareholders to understand their priorities. In addition, consider proxy or other publicly available disclosure enhancements regarding the actions already being taken.

Responding to Shareholder Proposals

In order to secure no-action relief to exclude certain shareholder proposals, some registrants in recent years have asked shareholders to ratify a contrary governance provision. For example, a registrant that receives a shareholder proposal asking for the shareholder special meeting threshold to be set at 10 percent of the outstanding stock might instead ask shareholders to ratify an existing threshold set at 25 percent of the outstanding stock. In so doing, the registrant is typically able to exclude the shareholder proposal from the proxy statement because it directly conflicts with a management proposal.

In their recent policy updates, both ISS and Glass Lewis have sought ways to police this behavior, which they view as a gaming of the shareholder proposal process. Starting in 2019, ISS will 1. generally vote against management proposals to ratify provisions of a registrant's existing charter or bylaws, unless these governance provisions align with best practice; and 2. recommend votes against (or withhold votes from) individual directors, members of the governance committee, or the full board, where boards ask shareholders to ratify existing charter or bylaw provisions (subject to consideration of various factors). Glass Lewis will consider situations where the SEC has permitted a registrant to exclude a shareholder proposal but may recommend votes against (or withhold votes from) members of the governance committee if Glass Lewis believes that the exclusion is detrimental to shareholders. In cases where the registrant excludes a shareholder proposal seeking a reduced special meeting right by means of ratifying a management proposal that is materially different from the shareholder proposal, Glass Lewis will generally recommend voting against the chair or members of the governance committee.

Consider Proxy Statement Enhancements

Review your proxy statement to see if there are areas for readability improvements. In particular, focus on areas where pictures, charts, and graphs could tell the story more easily or more convincingly than text. Also take a fresh look at how you are describing your voting standards to be sure that it aligns with your organizational documents and other applicable voting requirements (such as relevant tax law or stock exchange requirements), as this is an area of renewed focus for the SEC.

Many registrants are including an "executive summary" at the start of their proxy statements and in the beginning of their compensation discussion and analysis section (CD&A). Institutional investors often say that a tailored summary—that appropriately focuses on the key metrics, particularly around executive compensation—greatly enhances their ability to review a proxy statement.

Emerging Growth Company Considerations

Transition from Emerging Growth Company Status4

If a registrant's status as an emerging growth company will terminate as of the end of its current fiscal year, the next year's proxy statement will require several enhancements, including compensation disclosure that is not limited to the principal executive officer and the two highest paid other executive officers and a full CD&A section. Further, a registrant is required to hold a say-when-on-pay vote the first year in which it is no longer an emerging growth company. It is recommended that the first say-on-pay vote be held at the same time, even if the registrant can take advantage of a longer transition period (due to being an emerging growth company for less than two years). In addition, pay ratio disclosure will apply for the first full fiscal year that a registrant ceases to be an emerging growth company. For example, if a calendar year registrant ceases to be an emerging growth company at the end of 2018, pay ratio disclosure will be required in 2020 with respect to fiscal year 2019.

Compensation Matters

Perquisite Disclosures

Ensure compensation-related disclosures are being properly prepared. In a recent settled enforcement action, the SEC targeted an issuer for using the wrong standard for disclosures of perquisites in the summary compensation table. In addition, the SEC alleged that the issuer did not adequately train employees in key roles, including those tasked with drafting the CD&A section and compiling the executive compensation tables, to ensure that the proper standard was applied for perquisites disclosure. The SEC also alleged that the issuer had inadequate processes and procedures to ensure proper reporting of perquisites. In particular, the issuer's personnel compiled the executive compensation table from a variety of sources without ensuring that the amounts reported were consistent with the SEC's perquisite disclosure rules. The issuer, who did not admit or deny the SEC's findings, agreed to pay a civil money penalty in the amount of $1,750,000. Additionally, the issuer also agreed to retain at its own expense an independent consultant, not unacceptable to the staff of the SEC, for a period of one year, to conduct a review of the issuer's policies, procedures, controls, and training relating to the evaluation of whether payments and other expense reimbursements should be disclosed as perquisites under the securities laws, including the SEC's rules and standards.

Review Pay Ratio Disclosure

The first year of pay ratio disclosure was largely uneventful and it remains to be seen how, if at all, investors will use this disclosure in the future. As you turn to 2019, review the process used and assumptions made for preparing the pay ratio disclosure to see if any updates are necessary or improvements could be made. In addition, review the disclosure of peers and governance leaders to see if any improvements could be made in your disclosure, including enhancements that may explain why your ratios may differ materially from your peers. As a reminder, it is recommended that the pay ratio disclosure appear outside of the CD&A, as it was not part of the executive compensation program.

Begin Preparing the 2019 CD&A Section

Prepare key business milestones to support executive compensation decisions and payouts and for possible inclusion in an executive summary for the CD&A. As compensation decisions are made in the next few months, consider how they will be described and explained in the 2019 CD&A section and begin preparing draft disclosure.

Review 2019 Peer Group Selection

With the compensation committee, review your compensation peer group for appropriateness and any changes (including as the result of mergers and bankruptcies). Consider using any views expressed by proxy advisory firms as to the appropriateness of your current peer group as one input in setting the 2019 peer group. Once the compensation committee has picked a peer group, take note of the deadlines for submitting your selected peer group to each of ISS and Glass Lewis so that they can use it in their analysis. The window for submission to ISS is currently open until December 7, 2018 and the window for submission to Glass Lewis is open until December 31, 2018.

Review 162(m) Disclosure

The Tax Cuts and Jobs Act essentially eliminated the performance-based exception under Section 162(m), and CD&A disclosure likely will need to be updated to reflect this change. In August 2018, the Internal Revenue Service issued initial guidance on that change and the other amendments to Section 162(m). Although the guidance is limited in some respects, it is important to examine your company's practices in this new light. For example, the guidance on what compensation will not be grandfathered under amended Section 162(m) may be very restrictive with respect to performance-based compensation that is subject to negative discretion.

Equity Plan Checkup

Ensure that:

  • There are sufficient shares in your equity plans for planned grants in 2019.
  • All necessary equity plan shares have been registered on a Form S-8 registration statement and appropriate filings have been made with the applicable stock exchange.
  • All forms of award agreements have been filed.

Additional Compensation-Related Items to Consider

Given the litigation environment surrounding director pay, consider whether to have shareholders approve director pay. Previously, companies typically did this by including meaningful limits in a compensation plan that shareholders were asked to approve. Based on recent litigation in Delaware, that approach is less protective than having shareholders approve actual director compensation or a hard-wired formula by which director compensation will be paid. However, to date, only a small number of companies have followed these more protective approaches.

For several years, many companies have received demand letters from plaintiffs claiming that share withholding or net settlement is not exempt from being matched as a disposition under the Section 16 short swing profit rules. The theory on which the demand is based is weak, but there are prophylactic measures that you can take to ensure that you are in the clear if you receive one of these demands.

For more information about the 2019 proxy season or any related matter, please contact any member of the public company or employee benefits and compensation practices at Wilson Sonsini Goodrich & Rosati.


1 A registrant determines whether it qualifies as a SRC annually as of the last business day of its second fiscal quarter. If it qualifies as an SRC on that date, it may elect to reflect that determination and use the scaled disclosure accommodations in its subsequent filings, beginning with its second quarter Form 10-Q. A registrant must reflect its SRC status in its Form 10-Q for the first fiscal quarter of the next year.
2 Virtual-only meetings are online only meetings with no corresponding in-person meetings. Another model used by some companies is a hybrid meeting, which is an in-person meeting which permits virtual attendance by shareholders, including the ability to vote online while the polls are officially open. Hybrid meetings (that is, meetings that include both a physical and virtual component) are less scrutinized, but have different benefits.
3 ISS has stated that it will consider mitigating factors such as a firm commitment in the proxy statement to add at least one female director in the near term and the presence of a woman on the board at the preceding meeting.
4 Emerging growth company status terminates on the earliest of: 1. the last day of the first fiscal year in which the registrant's annual gross revenues exceed $1 billion; 2. the date on which the registrant is deemed to be a large accelerated filer; 3. the date on which the registrant has, during the previous three-year period, issued more than $1 billion in non-convertible debt; and 4. the last day of the fiscal year in which the fifth anniversary of the registrant's first sale of equity securities pursuant to an effective registration statement occurs.

A registrant becomes a large accelerated filer as of the end of the first fiscal year when it 1. has an aggregate market value of voting and non-voting common equity held by non-affiliates of $700 million or more as of the last business day of the registrant's most recently completed second fiscal quarter; 2. has been a public reporting company for a period of at least 12 calendar months; 3. has filed at least one annual report on Form 10-K; and 4. is not a smaller reporting company.