The Corporation Secretary's Blog

On September 1, 2009, the New York Stock Exchange announced that it would form a Commission on Corporate Governance to address U.S. corporate governance and the proxy process.  In creating the Commission the NYSE sought to include a diverse group of governance experts, including representatives of issuers, investors and others with significant backgrounds and experience in corporate governance and related issues. The Commission has issued a report, dated September 23, 2010, entitled “Report of the New York Stock Exchange Commission on Corporate Governance”.   The Report includes ten principles of good corporate governance, summarized below.  Some of these principles apply to privately held companies, not just NYSE listed companies.  The full report can be found at http://www.nyse.com/pdfs/CCGReport.pdf:

Principle 1: The board’s fundamental objective should be to build long­term sustainable growth in shareholder value for the corporation, and the board is accountable to shareholders for its performance in achieving this objective.

Principle 2: While the board’s responsibility for corporate governance has long been established, the critical role of management in establishing proper corporate governance has not been sufficiently recognized. The Commission believes that a key aspect of successful governance depends upon successful management of the company, as management has primary responsibility for creating an environment in which a culture of performance with integrity can flourish.

Principle 3: Shareholders have the right, a responsibility and a long­term economic interest to vote their shares in a thoughtful manner, in recognition of the fact that voting decisions influence director behavior, corporate governance and conduct, and that voting decisions are one of the primary means of communicating with companies on issues of concern.

Principle 4: Good corporate governance should be integrated with the company’s business strategy and objectives and should not be viewed simply as a compliance obligation separate from the company’s long­term business prospects.

Principle 5: Legislation and agency rule­making are important to establish the basic tenets of corporate governance and ensure the efficiency of our markets. Beyond these fundamental principles, however, the Commission has a preference for market­based governance solutions whenever possible.

Principle 6: Good corporate governance includes transparency for corporations and investors, sound disclosure policies and communication beyond disclosure through dialogue and engagement as necessary and appropriate.

Principle 7: While independence and objectivity are necessary attributes of board members, companies must also strike the right balance between the appointment of independent and non­independent directors to ensure that there is an appropriate range and mix of expertise, diversity and knowledge on the board.

Principle 8: The Commission recognizes the influence that proxy advisory firms have on the market, and believes that such firms should be held to appropriate standards of transparency and accountability. The Commission commends the SEC for its issuance of the Concept Release on the U.S. Proxy System, which includes inviting comments on how such firms should be regulated.

Principle 9: The SEC should work with the NYSE and other exchanges to ease the burden of proxy voting and communication while encouraging greater participation by individual investors in the proxy voting process.

Principle 10: The SEC and/or the NYSE should consider a wide range of views to determine the impact of major corporate governance reforms on corporate performance over the last decade. The SEC and/or the NYSE should also periodically assess the impact of major corporate governance reforms on the promotion of sustainable, long­term corporate growth and sustained profitability.

Many companies with defined benefit pension plans are using unrealistic projections for the future income from portfolio investments, which in turn conceals the extent of underfunding.  Last month David Zion of Credit Suisse issued a report on the defined benefit pensions of S&P 500 companies.   Zion described the impact of today’s low interest rate environment:

“Even with all of the changes to pension asset allocations over the past few years, it appears as if many plans continue to make big bets on interest rates (hoping they go up) and on the stock market (around 50% of plan assets are still in equities). Therefore, unless we see a spike in yields on high-grade bonds or a stock market rally in the fourth quarter (the last few weeks have helped) it looks like the health of most pension plans will deteriorate in 2010. We estimate the funded status of the S&P 500 companies’ pension plans may have dropped by $134 billion this year and are now $402 billion underfunded (75% funded). To put that into perspective, we are estimating the pension plans are in worse shape now then they were at the end of 2008, when the underfunding reached $326 billion (78% funded).”

Many companies are still using long-term earnings assumptions of around 8% per year for pension investment portfolios.  It is hard to imagine where the 8% returns will come from, given that the 10-year Treasury rate is currently around 2.5% and the annualized return on the S&P 500 for the past ten year is -1.38% (www2.standardandpoors.com/spf/pdf/index/SP_500_130-30_Strategy_Index_Factsheet.pdf).  Year after year directors have accepted the optimistic earnings projections provided to them by HR consultants and investment managers.  Sooner or later—probably sooner—there is going to be an awakening (or more challenges from Boards) and those advisers and managers will be presenting much lower projections.  This will necessitate a recognition of much greater underfunding in defined benefit pensions and cause a big hit to earnings at some companies as they try to close the funding gap.  When companies play ‘catch up’ it will be fertile ground for the lawyers who bring class action lawsuits alleging misleading financial information in past SEC filings.  Why misleading?  The lawyers will allege that directors should have known that they were using unrealistic projections when they approved pension funding levels.

\”Legal Outsourcing: Time to Take things Outside?\”

On October 4, 2010, the Securities and Exchange Commission announced a delay in the effectiveness of its recently adopted proxy access rules, scheduled to take effect on November 15, 2010.   The new proxy rules, which apply to all U.S. companies filing SEC reports under the Exchange Act, were designed to give large shareholders (i.e., 3% of the outstanding stock held for at least three years) the right to include their own board nominees in a company’s proxy materials.  This would give the shareholders a broader choice of candidates for the Board of Directors, not just those nominated by the incumbent directors (who typically nominate themselves).   To quote from the SEC release of August 25, 2010 announcing the new rules (SEC Release Nos. 33-9136; 34-62764; IC-29384; File No. S7-10-09): “Without the ability to effectively utilize the proxy process, shareholder nominees do not have a realistic prospect of being elected because most, if not all, shareholders return their proxy cards in advance of the shareholder meeting and thus, in essence, cast their votes before the meeting at which they may nominate directors. Recognizing that this failure of the proxy process to facilitate shareholder nomination rights has a practical effect on the right to elect directors, the new rules will enable the proxy process to more closely approximate the conditions of the shareholder meeting.”  A related amendment to the proxy rules would require companies to include in their proxy statements shareholder proposals to amend the company’s governing documents to provide even more liberal procedures for proxy access.

The SEC’s announcement of a delay in the effectiveness of the new rules was a response to a lawsuit filed by the Business Roundtable and the Chamber of Commerce of the United States of America (Business Roundtable, et al. v. SEC, No. 10-1305 (D.C. Cir., filed Sept. 29, 2010)).  These business groups seek to overturn the new proxy rules on the grounds that they are “arbitrary and capricious” and, in addition, that the SEC failed to properly assess the costs of proxy access or the effects on “efficiency, competition and capital formation,” as required by law.

As a result of the SEC announcement delaying effectiveness, the new proxy rules are not likely to affect the 2011 proxy season.  The lawsuit will probably not be resolved for at least six months.  Prior to the suspension of effectiveness, the new rules had applied to any companies that had mailed proxy materials for their previous annual meeting after March 13, 2010.

We predict that the SEC will prevail in the lawsuit and the new rules will become effective again sometime in late Spring 2011.   The court will undoubtedly take notice of the fact that in the recently enacted Dodd-Frank Act, the Congress confirmed the SEC’s authority to require inclusion of shareholder nominees for director in company proxy materials. (Dodd-Frank Act §§ 971(a) and (b)).  In addition, the SEC followed an elaborate rule making-process that began in June 2009.   Many comments were submitted in response to the proposed rules and those comments are discussed in the adopting SEC Release of August 25th, which is 451 pages long.

We also predict that after the new proxy rules again become effective, they will have a profound effect on corporate governance at many SEC reporting companies.

There are many situations where approval by the directors of a corporation is important.  For example, complete and accurate minutes of Board meetings can be vital as a defense against unfavorable tax consequences.   The minutes may serve as proof of a business’ intentions should its tax return positions ever be challenged by the IRS.  Minutes should also be used to indicate that executive compensation increases and bonuses have been approved and ratified by the board of directors, along with detailing reasons for the decisions. With this information, the IRS is less likely to rule that the corporation is using a wage increase to disguise a dividend and avoid double taxation or to argue that an executive’s salary is not “reasonable.” Corporate minutes can also confirm that loans made to executives are not taxable dividends or compensation.   Excess accumulated earnings are subject to tax but can be limited or eliminated with evidence included in corporate minutes that indicate business reasons to not distribute the earnings. Some of the things a corporation can include in its minutes are plans to expand, plans to buy new inventory or equipment, meeting pension and profit-sharing obligations, providing for potential losses from lawsuits, maintaining sufficient working capital, and projecting investment in business-related properties.  To achieve maximum tax savings for a business and employees, the corporation retirement and stock option plans have to satisfy IRS rules. If they do, employees can defer income taxes on contributions to and earnings from the plans until the funds are distributed to them, while the corporation may take a current deduction for the contributions.  Resolutions adopted by the directors should include the approval of the annual company contribution and other actions taken with regard to the plan.