The recent actions by the Securities and Exchange Commission (the “SEC”) with regard to proxy rules will have a profound impact on public energy companies. Although energy companies remain focused on whether the SEC will, as has been rumored, mandate climate change disclosure sometime in 2010, the impact of the SEC’s 2009 proxy changes should not be underestimated. These changes provide, in effect, environmental activist groups with significant tools with which to advance their agenda, which often conflict with the best interests of shareholders. The SEC has effectively provided several paths for these groups to impact the governance of energy companies. This Client Alert summarizes the SEC’s 2009 actions and the potential these actions have for impacting public energy companies and offers guidance for companies preparing for the upcoming proxy season.
- Shareholder Proposals… Risk Assessment is No Longer Considered Ordinary Business: On October 27, 2009, the Division of Corporation Finance (the “Staff”) of the SEC issued Staff Legal Bulleting No. 14 E (CF) regarding Rule 14a-8(i)(7) under the Securities Exchange Act of 1934, reversing the Staff’s prior position which permitted companies to exclude shareholder proposals relating to environmental, financial, or health risks on the grounds that these proposals related to evaluations of risk, a matter the Staff traditionally viewed as relating to a company’s ordinary business operations. Going forward, the Staff will evaluate such shareholder resolutions based on whether they raise a major social policy and not whether they inquire as to evaluation of risks associated with such issues. If the underlying subject matter transcends the ordinary day-to-day business matters of the company and raises policy issues so significant that it would be appropriate for a shareholder vote, the proposal probably cannot be excluded under Rule 14a-8(i)(7).
- Proxy Enhancements… More Disclosure about Compensation and Risk: In its meeting on December 16, 2009, the SEC enacted final rules which require additional proxy disclosures related to compensation risks and director qualifications. There is a new requirement that nominating committees disclose whether they consider diversity as a factor in reviewing potential nominees, and to assess the implementation of any diversity policies. Compensation risks must be disclosed only if they are “reasonably likely to have a material adverse effect” on companies. This provision is not limited to the compensation received by named executive officers and encompasses the pay incentives for other employees. The SEC also now will require disclosure of other services performed by compensation consultants to include a $120,000 minimum threshold to trigger disclosure.
The new disclosure rules will require additional disclosure on the qualifications of director nominees and how their skills help them to serve on the board. In addition, companies will have to provide details on outside directorships held during the past five years, instead of only current board memberships. Board nominees also will have to disclose all the legal proceedings they have been a party to over the past 10 years (except for private litigation), instead of the current requirement of five years.
Companies will have to explain why they decided to appoint a non-executive chairman or chose to combine the roles of board chair and CEO, but the new rules do not favor one leadership structure over another. The new rules also include a change on the disclosure of equity compensation. In their summary compensation tables, companies will be required to report the aggregate grant date fair value of equity granted during the previous year, instead of the current accounting value of previous grants.
The rules also include a new requirement for companies to disclose proxy voting results in a Form 8-K filing within four business days after a shareholder meeting, instead of several months later in a 10-Q filing. If final results are not available, companies would have to disclose preliminary results and then disclose final results within four business days once those are ready.
- NYSE Rule 452… Brokers Can No Longer Vote on Election of Directors as Routine Matters: On July 1, 2009, the SEC approved an amendment to New York Stock Exchange Rule 452 which permits brokers to vote on “routine” proposals when the beneficial owner of stock fails to provide specific voting instructions at least ten days before a scheduled meeting. Historically, an uncontested election of members of the board of directors had been considered a routine matter under Rule 452. The amendment, which applies to shareholder meetings held on or after January 1, 2010, makes uncontested director elections (except those at registered investment companies) non-routine. As a result, brokers will no longer be able to vote shares in connection with director elections without instructions from their retail customers. Because Rule 452 applies to all brokers registered with the New York Stock Exchange, it will impact all publicly traded companies regardless of the exchange on which their shares are listed.
- Proxy Access… Shareholder Groups Nominating Directors for Election: On June 9, 2009, the SEC released its proposed new rule 14a-11 and amendments to rule 14a-8, collectively referred to as the proxy access proposal, which would allow shareholder groups to nominate director candidates for placement in a company’s proxy materials, at the company’s expense, effectively eliminating the current practice where the company asks its shareholders to vote for the slate of directors that the company is proposing.
The SEC received over 520 comment letters recommending various modifications to its proposal. Seemingly because of the complexity of the substantive issues, the SEC has deferred action on proxy access, but has stated that it is committed to bringing the final rules to the full Commission for consideration in early 2010. On December 14, the SEC re-opened for comment the proxy access proposal for another 30-day period to seek views on additional data and related analyses received by the SEC at or after the close of the original public comment period on August 17. Some key issues needing resolution in the final rules are:
- Whether the final rule will be a prescriptive rule which will allow shareholders to adopt a different access regime (or none at all) for their company (also known as “private ordering”);
- How the final rule will ensure against misuse of the rule for change of control purposes;
- How the final rule will be sufficiently flexible for various capital and board structures, and existing state voting requirements; and
- How the final rule will withstand legal challenges to the SEC’s authority and whether or not Congress will intervene with legislation.
While the final rules have not been released, practitioners are in agreement that some form of a shareholder nomination procedure for directors is imminent and will be in place for shareholder meetings held on or after January 1, 2011.
Collectively, the Proxy Rule Changes of 2009 Change the Proxy Landscape for Energy Companies
In 2009, the California Public Employees’ Retirement System petitioned the SEC for a number of corporate governance reforms to improve corporate risk management, including guidance for mandatory corporate disclosure of environmental and governance risks, and specifically climate change-related risks. CalPERS, Ceres (a national coalition of investors, environmental groups and other public interest organizations) and the Environmental Defense Fund are just a sampling of environmental activist groups that have been particularly critical of energy companies and utilities and have called for the SEC to enact stringent disclosure requirements including calling for disclosed mandatory green house gas (“GHG”) reduction policies. While we do not underestimate the impact of potential mandatory climate change disclosure, the SEC’s proxy rule changes during 2009 will have a real and immediate effect on the utility industry. The SEC’s actions with regard to proxy rule changes signal new passageways for environmental activists to successfully advance their agendas with respect to the governance of public energy companies.
First, while the final proxy access rules will not be applicable for the 2010 proxy season, the SEC Staff’s unyielding commitment to bringing proxy access to fruition has led many public companies to consider bylaw amendments and lobby for state law changes with the goal of being able to opt-out of the SEC’s proxy-access regime. Several labor unions and public employee pension plans have suggested that proxy access will only be used in the most egregious situations. Nonetheless, utility company executives should be prepared for vocal environmental groups that are critical of their climate change disclosure and GHG policies to at least threaten to nominate directors, if not to actually do so. These activists will likely advance a number of reasons (most notably, the failure to adopt their agenda) to demonstrate a lack of board accountability, and any directors actually nominated by these activists will undoubtedly share their views on global warming and other social policy initiatives. As a result, utility executives may find themselves engaged in extensive discussions with these activist groups.
Second, the amendment to NYSE rule 452 will effectively afford institutional investors, proxy advisory firms and shareholder activists greater influence with energy companies because retail investors can no longer rely on brokers to vote their shares for management’s director-nominee recommendations as they traditionally have. Utility companies have traditionally had strong retail investor bases because of their attractive dividend practices. In particular, utility companies that have adopted a majority voting standard (requiring a director to receive at least a majority of votes cast in order to be elected to the board of directors, and then requiring the director to resign from the board if this threshold is not met) will find that the inability of brokers to vote uninstructed shares results in fewer shareholder votes cast in an uncontested election of directors. The new rule may force companies to be more active in soliciting shareholder votes to achieve a quorum and to achieve a majority vote, which could materially increase the cost of uncontested elections.
The effect of the rule change will also be keenly felt by utilities using the “notice-only” model for delivery and use of e-proxy materials. Companies who have elected the notice-only delivery method have seen a significant decrease in participation by retail shareholders. Companies who have adopted majority voting for the election of directors should carefully consider whether to use the notice-only method to deliver proxy materials for any such meeting, especially if the participation of retail shareholders is important to the election.
In addition, commentators have suggested that the amendment to NYSE rule 452 sets the stage for increased effectiveness of “just vote no” campaigns in uncontested director elections, a tactic of institutional investors or hedge funds seeking governance reform. In a “just vote no” campaign, there are no opposition nominees and attention is focused on the shareholder concerns motivating the campaign. Even if such a campaign is ultimately not waged in the end, energy companies threatened with such campaigns will by necessity find themselves in discussions with the activist institutional investors and hedge funds involved in making these threats.
Third, and most significantly, the Staff’s shift in its interpretation of Rule 14a-8(i)(7), effectively mandating the inclusion of shareholder proposals focusing on risk management and matters of climate change, GHG emissions, and other environmental-related risks because these are matters of social policy, will have a profound impact on public utility companies. As a result, utility company executives will spend increasing amounts of time negotiating with shareholders concerning these proposals, or eventually responding to them within the proxy framework. While proxy access rules will give environmental groups the opportunity to nominate a director, this route may not be entirely attractive for them. It is possible that the publicity resulting from such a nomination will be focused on the director’s qualifications, and not necessarily the agenda of the proposing shareholder. Moreover, this proposed director, if actually elected, will have a fiduciary duty to all of the company’s shareholders regardless of the agenda of the entity which nominated him or her. The change in Rule 14a-8(i)(7), however, will very likely result in numerous and lengthy activist shareholder proposals being included in companies’s proxy statements, at company expense. There will be significantly fewer limitations with respect to submitting these shareholder proposals of the nature that are expected to be in the proxy access nomination procedures. In short, the shareholder proposal route will likely be considered an easier method for shareholder activists to quickly publicize and promote their agendas.
Importantly, on November 3, 2009, the risk-analysis firm RiskMetrics Group announced its acquisition of KLD Research, which specializes in environmental, social, and governance issues for investors. Such an acquisition signals that RiskMetrics’ traditional approach to analyzing risks affecting companies like exchange rate and commodity pricing risk will also include an analysis of environmental issues, including climate change. The change in Rule 452 will likely raise the profile of proxy advisory firms, such as RiskMetrics and Glass, Lewis and the change in Rule 14a-8(i)(7) will increase the number of shareholder proposals that RiskMetrics will analyze and recommend voting for or against. As such, RiskMetrics November 20, 2009, publication of its 2010 Corporate Governance Policy Updates is particularly important to consider. Previously, RiskMetrics had recommended to generally vote against proposals targeting GHG emissions which ask a target company to adopt GHG reduction goals for its operational emissions as well as for its products unless a company lagged behind industry standards and was subject of recent, significant violations, fines, litigation or controversy related to GHG emissions. While acknowledging that adopting GHG goals in certain industries could be problematic, however, the updated RiskMetrics policy analyzes these proposals on a case-by-case basis, taking into account factors including whether the proposal is overly prescriptive in defining specific amounts and/or timeframes for GHG reduction, the quality of company disclosure relative to industry norms, and the feasibility of GHG reduction given the company’s product line and technology. So, in the past two months, we have seen the SEC open the door to more proposals by environmental activists, a popular proxy advisory firm add a new group to analyze these same proposals and that same firm alter its general recommendation to vote against these proposals.
Fourth, the new rules on proxy enhancement will increase the level of disclosure related to the risk management practices of energy companies. And the new requirement for companies to disclose proxy voting results in a Form 8-K filing within four business days after a shareholder meeting will continue to highlight voting results related to shareholder proposals included in the proxy statement.
While the impact of mandatory climate change disclosure from the SEC should not be underestimated when and if it happens, utility companies should already be prepared for a changed dynamic with shareholder activists as it prepares for the 2010 proxy season. Those shareholders now have the SEC’s acquiescence to put forth shareholder proposals addressing their environmental concerns. Recommendations from firms like RiskMetrics are even more meaningful following the revisions to Rule 452, and RiskMetrics own policy on these environmentalist proposals has shifted. The result may very well be actual majority votes on these proposals, and if they are not acted on by boards, this may lead to director withhold votes in subsequent periods. Indeed, director withhold votes subsequent to the SEC’s adoption of some form of proxy access will only enhance the ability of shareholder activists groups, acting singly or in concert with other groups, to garner support for their nominees who are loyal to their agendas.