Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

As many know, the SEC adopted the proxy access rules on August 25, 2010.  The new rules will be effective 60 days from publication in the Federal Register, excepting smaller reporting companies, for which the rules are deferred for three years.  Federal Register publication is expected fairly quickly barring some bureaucratic snafu.

 We recommend that public companies gain an understanding of the proxy access rules as soon as possible, even if your annual meeting is months away.  The reason—the rules permit activist shareholders to begin taking public steps toward submitting nominations, or in some cases actually submitting nominations, once the 60 day waiting period has passed.  By SEC standards, the rules are taking effect with a lightning speed not seen since the days following Sarbanes-Oxley.

 In addition, proxy statements filed after the 60 days have passed will be required to include new disclosures.  There are new Form 8-K triggering items as well.

 What public steps can an activist take after the 60 days have passed?  The activists will begin filing new Schedule 14N.  It’s likely some activists will use the 60 day period to select targets (if they have not already) and begin laying the groundwork for filing a Schedule 14N.

 A Schedule 14N filed by an activist will contain the following information that will be important for public company targets to immediately understand and digest.  That information includes:

  • A shareholder’s intent to use written soliciting materials to form a shareholder group to submit a nominee for inclusion in a company’s proxy statement under rule 14a-2(b)(7).  Under the rules shareholders can form a group to meet the 3% ownership threshold necessary to submit a nominee.  Basically, the filing of the Schedule 14N is a written advertisement of interest to form a shareholders group, a tactic that would not have been allowed before the proxy access rules.
  • A shareholder’s intent to orally solicit other shareholders to form a nominating committee.  Again, another written advertisement.

 Public companies should monitor EDGAR for Schedule 14N filings with respect to their company.  If one should come to their attention, a core team should be formed, including legal counsel, to consider an appropriate action plan.

 New Rule 14a-11(b)(10) requires a shareholder or shareholder group that wishes to include a nominee in a company’s proxy statement to file a Schedule 14N during a specified “window period.”  The window period is not more than 150 calendar days and not less than 120 calendar days before the anniversary of the date the company mailed its proxy statement for the prior year’s annual meeting.  At this point, the public company will engage in a complex dance with the nominating shareholder and the SEC to determine whether the nominee must be included or may be excluded from the company’s proxy statement.

 There are other disclosure and Form 8-K filing requirements that will become effective 60 days after publication in the Federal Register.  Under amended Rule 14a-5, every proxy statement filed after the new rules become effective will have to disclose the deadline for submitting nominees for inclusion in the company’s proxy materials for the next annual meeting of shareholders.

 A Form 8-K will be required if the company did not hold an annual meeting in the prior year, or if the date of the meeting has changed by more than 30 calendar days from the prior year.  The Form 8-K must advise shareholders of the date by when a Schedule 14N must be filed to be considered timely to include a nominee in the company’s proxy statement.

Check frequently for updates on the new proxy access rules.

Section 407 of the Dodd-Frank Act provides an exemption from registration as an investment adviser if the investment adviser provides advice solely to one or more venture capital funds.  The Dodd-Frank Act goes on to require the SEC to define the term “venture capital fund.” 

The SEC previously attempted to regulate hedge funds, but not private equity groups or venture capital funds, when it adopted Rule 203(b)(3)-2 under the Investment Advisers Act.  Rule 203(b)(3)-2 was ultimately invalidated in the case of Goldstein v. SEC (D.C. Cir. June 23, 2006). However, the Rule’s history demonstrates the difficulty the SEC will have in distinguishing venture capital funds from private equity and hedge funds.

Rule 203(b)(3)-2 was adopted in SEC Release No. IA-2333.  In that release, the SEC noted that one of the distinguishing characteristics of a venture capital fund was that venture capital funds are generally organized to invest in the start-up or early stages of a company.  That does not seem to be a precise enough line on which to exclude venture capital funds from regulatory jurisdiction.  In that same release, the SEC also said distinguishing a venture capital fund from a hedge fund based on investment strategy or portfolio composition was not appropriate because the SEC was concerned that it could serve to chill advisers’ use of certain investment strategies solely in order to avoid registration under the Investment Advisers Act, which might negatively affect the markets.

The task is further complicated because of the similarities between venture capital funds and private equity funds.  The SEC noted that venture capital funds have the same features that distinguish private equity funds generally from hedge funds, such as capital contributions over the life of the fund and the long-term nature of the investment.   Finally, the SEC noted that a venture capital fund typically seeks to liquidate its investment once the value of the company increases above the value of the investment.

The SEC distinguished private equity and venture capital funds from hedge funds in Release No. IA-2333 by basing the determination on whether the fund permits investors to redeem their interests in the fund within two years of purchasing them.  Since both private equity and venture capital funds share that characteristic, it does not provide a useful tool to isolate venture capital funds.

The SEC has a difficult task in defining the term “venture capital fund.”  It appears the only avenue is to base the determination on investment strategy or portfolio composition, but the SEC has previously rejected that mechanic.

With respect to the borrowing of securities from customers, Section 929X of the Dodd-Frank Act imposes the following two additional requirements on broker-dealers:  (i) every registered broker or dealer must provide notice to its customers that they may elect not to allow their fully paid securities to be used in connection with short sales and (ii) if a broker or dealer uses a customer’s securities in connection with short sales, the broker or dealer must provide notice to its customer that the broker or dealer may receive compensation in connection with lending the customer’s securities.

SIFMA has outlined the following best practices for compliance with the notice requirements of Section 929X, which are based on discussions with various SIFMA members, as well as discussions with the staff in the SEC Division of Trading and Markets. Pursuant to Rule 15c3-3 under the Securities Exchange Act of 1934, broker-dealers are generally prohibited from borrowing a customer’s fully-paid securities unless the broker-dealer enters into a separate written agreement with the customer that contains the provisions set forth under Rule 15c3-3(b)(3).  Accordingly, broker-dealers should review their disclosures to existing customers with brokerage accounts with whom the broker-dealer has entered into a fully-paid lending agreement pursuant to Rule 15c3-3(b)(3) for compliance with the notice requirements of the Dodd-Frank Act, and make any necessary adjustments to such disclosures before engaging in any new borrows with such customers.  Specifically, broker-dealers should consider whether their disclosures provide notice to such customers that fully-paid securities they lend to the broker-dealer may be used in connection with short sales, and that the broker-dealer may receive compensation in connection with the use of the customer’s fully-paid securities.

Broker-dealers should also consider that the second requirement above does not specifically state that the disclosure only applies to fully-paid securities.  Therefore, Broker-dealers should consider whether such disclosure should also be sent to margin customers whose securities may be rehypothecated.  For existing margin customers, firms could include such notice in the course of standard information provided to existing margin customers in the next available cycle as part of information provided in a customer statement or otherwise.  This notice should be incorporated into the customer agreements for future margin customers.  The SEC may by rule, prescribe the form, content, time and manner of delivery of any such notice, but this provision of the Dodd-Frank Act otherwise appears to be self-operative.

As we noted, the SEC and CFTC held a joint roundtable on August 20, 2010 addressing governance and conflicts of interest on clearing and listing of swap transactions.  Gary Gensler, Chairman of the CFTC issued a statement which stated “Today’s public roundtable will help us as we move forward to write rules on the important matters of governance of clearinghouses and trading facilities and how to best protect their decision making from conflicts of interest. I thank the CFTC and SEC staffs who worked cooperatively and constructively to plan and execute today’s roundtable. We will continue to collaborate closely with the SEC and other Federal regulators as we draft rules to implement the Dodd-Frank Wall Street Reform and Consumer Protection Act. We look forward to hosting several more roundtables along with the SEC on other important matters related to the Act.”

 Beyond that statement, there appears to have been little agreement in this highly contentious rule making effort resulting from the Dodd-Frank Act.  The Wall Street Journal (subscription required) noted that it was standing room only at the meeting.

 Parts of the debate appeared to center on ownership of any clearing and trading facilities required by the Dodd-Frank Act.  According to press reports,  Swaps and Derivatives Market Association Vice Chairman Jason Kastner told regulators at a public meeting  “If we put stuff into a clearinghouse and the clearinghouse has the same five guys in the room and the biggest three of them start to wobble, it’s going to be back to Congress with a one-pager asking for $750 billion.”

Others suggested diversified ownership of clearing and trading facilities would not serve the goals of the Dodd-Frank Act.  A representative of a large financial institution stated “They have to be able to trade very large amount of highly complex illiquid OTC derivatives, and if they can’t do that, by introducing them as a member into the clearinghouse you actually increase risk in the clearinghouse.”

Section 926 of the Dodd-Frank Act directs the SEC to issue rules which would prevent the use of Regulation D Rule 506 offerings by certain “bad actors.”  The Dodd-Frank Act directs the SEC to adopt rules similar to the current disqualifiers in Regulation A.  The SEC rules must also prohibit Rule 506 offerings by persons subject to final orders which bar them from association with entities regulated by certain authorities, such as state securities commissions, or that have been convicted of any felony or misdemeanor in connection with the purchase or sale of any security. 

 The “bad actor” disqualifications of Regulation A can be found in Rule 262 of the Securities Act rules.  The disqualifications apply to all officers, directors and beneficial owners of 10% or more of any class of securities.  Assuming the SEC uses similar concepts to implement the Dodd-Frank Act, this has a number of implications for private companies raising capital.  Companies will need to be careful when selecting board members and officers to make sure they are not disqualified.  Likewise, care must be taken as to whom securities are sold to prevent a 10% beneficial owner from disqualifying the company.  In addition, modifications may be necessary to subscription documents.

 We recommend that public companies revise their annual officer and director questionnaires to solicit appropriate inquiries to determine eligibility for Rule 506 offerings if that is a likely method of corporate fund raising.  For example, it’s not unusual for a public company to rely on Regulation D when privately placing securities in an acquisition.

The SEC has announced that it will “consider” the adoption of proxy access rules on August 25, 2010.  It is probably a safe bet that when they are done “considering” the issue they will adopt final rules.  Sometimes the final rules are not available for immediate publication and availability is delayed for a couple of weeks, so it may  be difficult to tell for a period of time what actually has been adopted.  In the meantime, refresh your recollection on the SEC’s prior proposal which Jill posted here, and my analysis of some of the problems with the proposed rule here.  This will change the corporate governance landscape, and the only thing I can predict is the rules will be difficult to understand.

The Dodd-Frank Wall Street Reform and Consumer Protection Act will require listed public companies to hold periodic say-on-pay shareholder votes.  Say-on-pay votes are non-binding votes on the compensation of an issuer’s executive officers.  Ethan has posted an example of a say-on-pay vote here.

  A  June 2010 Towers Watson survey found that only 12% of respondents said they are very well prepared for the say-on-pay legislation, while 46% said they were somewhat prepared. Just under one-fourth of respondents (22%) did not know if their companies were ready. 

 So the question becomes, what can be done to prepare for your first say-on-pay vote?  It is a little difficult to come up with an exhaustive list because the SEC has not yet published any proposed rules.  However, it should be noted that this provision of the Dodd-Frank Act becomes effective for shareholder meetings on or after January 21, 2011 even if the SEC does not issue any rules.  Since the SEC now has a heavy rule-making agenda, and they might not illuminate the issuer universe for some time, it is probably best to start preparation now.  As Mark points here, preparation is important because brokers will not be able to vote uninstructed shares on say-on-pay matters.

 The first step is to assemble your team.  Members should include human resources, investor relations, internal and external counsel, compensation consultants and possibly a proxy solicitor.

 The team should then review current executive pay practices.  Are there any practices that could be criticized as excess, resulting in a pay-for-performance disconnect or the like?  If there are undesirable practices, can steps be taken to eliminate them?  The following are some of the items included on Riskmetric’s list of problematic pay practices:

 Multi-year guarantees for salary increases, non-performance based bonuses, and equity compensation;

  • Including additional years of unworked service that result in significant additional benefits, without sufficient justification, or including long-term equity awards in the pension calculation;
  • Perquisites for former and/or retired executives, and extraordinary relocation benefits (including home buyouts) for current executives;
  • Change-in-control payments exceeding 3 times base salary and target bonus; change-in-control payments without job loss or substantial diminution of duties; or
  • New or materially amended agreements that provide for an excise tax gross-up.

 One of the key steps in preparing for say-on-pay will then be to concisely explain to your shareholders your compensation policies and practices.  This of course places a premium on making sure the compensation discussion and analysis included in your proxy statement is clear and concise.  That should be reviewed and revisited and cleaned-up if necessary.

 Where do your key investors stand on compensation issues?  It is time to find out.  Discuss your pay practices with them or review their voting policies or both.

 Finally, as the process unfolds, known and unknown wrinkles will develop so it will be important to stay tuned for new issues.  For instance, the Dodd-Frank Act requires issuers to vote on whether the say-on-pay referendum should take place every one, two or three years.  Other than beginning to think about what interval you would recommend to your shareholders to adopt for a say-on-pay vote, there are by-law and state law questions that will crop up.  How do you know which of the three timing options has been approved if none receive a majority of the votes cast?  Hopefully the SEC will issue rules that clarify these matters.

Under the Dodd-Frank Act, listed issuers will be required to include a say-on-pay vote for any shareholder meeting occurring on or after January 21, 2011.  A say-on-pay-vote is a nonbinding shareholder vote on an issuer’s executive compensation.  Financial institutions that were recipients of funds under the Troubled Asset Relief Program, also known as TARP, have been required to include say-on-pay votes in their proxy statements.  So there are a number of examples to look at.

 U.S. Bancorp’s 2010 proxy disclosure for its say-on-pay resolution is set forth below.  As you can see, it is well written and advances strong and succinct arguments as to why its compensation package is reasonable.

 The U.S. Bancorp disclosure is as follows:


 The Board of Directors is committed to excellence in governance and is aware of the significant interest in executive compensation matters by investors and the general public, and in the idea of U.S. public corporations proposing advisory votes on compensation practices for executive officers (commonly referred to as a “say-on-pay” proposal). Our Board has determined that providing shareholders with an advisory vote on executive compensation may produce useful information on investor sentiment with regard to the Compensation and Human Resources Committee’s executive compensation philosophy, policies, and procedures.

 The Company has designed its executive compensation program to attract, motivate, reward and retain the senior management talent required to achieve our corporate objectives and increase shareholder value. We believe that our compensation policies and procedures are centered on a pay-for-performance philosophy and are strongly aligned with the long-term interests of our shareholders. See “Executive Compensation–Compensation Discussion and Analysis.”

 As a result, the Company is presenting this proposal, which gives you as a shareholder the opportunity to endorse or not endorse our executive pay program by voting for or against the following resolution:

 “RESOLVED, that the shareholders approve the compensation of U.S. Bancorp executives, as disclosed in the Compensation Discussion and Analysis, the compensation tables, and the related disclosure contained in the proxy statement.”

 The Board of Directors urges shareholders to endorse the compensation program for our executive officers by voting FOR the above resolution. As discussed in the Compensation Discussion and Analysis contained in this proxy statement, the Compensation and Human Resources Committee of the Board of Directors believes that the executive compensation for 2009 is reasonable and appropriate, is justified by the performance of the Company in an extremely difficult environment and is the result of a carefully considered approach.

 In deciding how to vote on this proposal, the Board urges you to consider the following factors, many of which are more fully discussed in the Compensation Discussion and Analysis:

  •  Our company has been a top performer among its peers by numerous industry measures for many years, and our Compensation and Human Resources Committee has designed the compensation packages for our senior executives to be competitive with the compensation offered by those peers with whom we compete for management talent.
  • Unlike many of our peers, our company was profitable in every quarter of 2009 and 2008.
  • There is no history at this company of the compensation practices evidenced at some large financial institutions that have received so much recent negative publicity.
  •  We recognize the need to fairly compensate and retain a senior management team that has produced some of the best operating results in the financial services industry over the past several years.

 Because your vote is advisory, it will not be binding upon the Board of Directors. However, the Board values shareholders’ opinions and the Compensation and Human Resources Committee will take into account the outcome of the vote when considering future executive compensation arrangements.

 The Board of Directors recommends that you vote FOR approval of U.S. Bancorp’s executive compensation program as described in the Compensation Discussion and Analysis and the compensation tables and otherwise in this proxy statement. Proxies will be voted FOR approval of the proposal unless otherwise specified.

The Federal Reserve Sytsem has issued a proposed rule under Regulation Z issued pursuant to the Truth in Lending Act.  The proposed rule would implement Section 1461 of the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act.  Section 1461 amends TILA to provide a separate, higher threshold for determining coverage of the Board’s escrow requirement applicable to higher-priced mortgage loans, for loans that exceed the maximum principal balance eligible for sale to Freddie Mac.


On August 20, 2010, commencing at 9:00 a.m. and ending at 12:00 p.m., staff of the SEC and CFTC (the “Agencies”) will hold a public roundtable discussion at which invited participants will discuss governance and conflicts of interest in the context of certain authority that Sections 726 and 765 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) granted to the Agencies respectively.  Find more information here.