Proxies, pay and risk: adventures with the SEC

I was preparing to write this article about the new SEC-enacted proxy access rules when the unexpected happened: The SEC delayed rule finalization until 2010.

What happened to derail the SEC, while driving full-speed ahead on litigating with Bank of America over Merrill Lynch bonuses? And what is the status of new disclosure requirements, relating compensation to risk? And SOX 404 compliance by smaller issuers?

Proxy reform derailed

The SEC proposal requiring companies to circulate shareholder proxy materials for director elections met intense resistance. Over 500 letters, many extensive, were filed during the comment period, not only from lawyers and governance specialists, but also from lobbying groups and from what The Wall Street Journal described as "grass-roots letter-writers."

Some comments focused on watering down the proposal; rather than empowering holders of 1 percent of company shares for one year, the suggestion was made that 3 percent or 5 percent of share holdings for two years should be required. Others commented that the SEC proposal, allowing proxy access for up to 25 percent of the board, should be limited to a single nominee.

Major securities law firms (Cravath, Davis Polk, Latham, Skadden, Wachtell, Simpson Thatcher, and Sullivan and Cromwell) filed a joint letter of 39 pages, flatly opposing amended SEC Rule 14a-11, which would require shareholder nominations to be included in corporate proxy statements.

These firms supported amending Rule 14a-8, permitting shareholders to place on the corporate agenda by-law amendments to permit proxy access for director nominations.

The argument is that a mandatory, one-size-fits-all proposal would not be sensitive to each separate company, and that shareholders should be free to propose customized proxy access (which might be the same as, more liberal than, or more restrictive than the SEC proposal). This position was echoed by the National Association of Corporate Directors.

Shearman & Sterling sought to integrate the mandatory access proposal (if in fact adopted by the SEC) into regular procedures, requiring submission to the nominating committee.

That the SEC's mandatory proposal was an intrusion into the operation of state law, advanced by many, resonated with the two Republican SEC commissioners. It was thought that the independent SEC chair, Mary Schapiro, would side with the two Democratic commissioners supporting the SEC's proposal, but various pressures sent the SEC back to the drawing board.

Compensation developments

Early in 2009, Bank of America acquired a distressed Merrill Lynch; Merrill had lost $25 billion that prior year but nonetheless had authorized over $5 billion of executive bonuses. These bonuses were approved by BofA and over $3 billion were actually paid.

The SEC and BofA proposed that BofA pay a $33 million fine to settle SEC claims that the bonuses were not disclosed to shareholders. In mid-September, U.S. District Court Judge Jed Rakoff disapproved the settlement, indicating it was both too small and fell upon the wrong parties because a fine paid by BofA would further injure BofA shareholders, the very constituency initially harmed by the bonuses.

Judge Rakoff speculated that, since BofA claimed its lawyers controlled disclosure decisions and thus BofA itself had no responsibility, perhaps counsel should be liable. Neither Wachtell (representing BofA) nor Shearman (representing Merrill) responded.

Rakoff's action, contemporaneous with unrelated criticism by the SEC's own investigation of failure to uncover the Madoff frauds, stung the commission; the SEC reversed course and promised vigorous prosecution of the BofA case, demanding a jury for a March 1, 2010, trial.

Lawyers are intrigued by the suggestion that counsel might bear responsibility. No one has yet mounted a public or a private suit against the lawyers. The October 2009 issue of American Lawyer, however, contains a perceptive article that places the legal advice given to BofA in perspective. Secret schedules in M&A agreements, typically (as with BofA) not filed with the SEC, don't trump the obligation to make full shareholder disclosure.

As early as 2005, discussing a secret schedule admitting FCPA violations in connection with the aborted Titan Corporation merger into Lockheed Martin, the SEC issued a report warning that clarification of misleading public statements cannot be made in documents that are themselves not public, seemingly very basic securities law advice. In mid-October, the BofA board voted to waive the attorney-client privilege and turn over to the state of New York the company's communications with its counsel, thus opening the door to a public evaluation of the legal advice.

If the BofA lawyers have so far escaped litigation, the same can't be said for the BofA executives. In late September 2009, a BofA shareholder brought a derivative suit in the Southern District of New York against BofA officers and directors for breach of fiduciary duty.

Although much of the complaint relates to improvident subprime loans, the complaint also alleges dereliction in connection with the bonuses. Claiming that during the "shot gun wedding" with BofA, "Merrill Lynch's management could think of no higher priority than lining its own pockets," the complaint describes the concealment of the bonus agreement from both Merrill and BofA shareholders as a material breach of director and officer duties. Perhaps indicating future direction of the litigation, it is alleged that certain lawyers whose identities "are presently unknown to Plaintiff" facilitated this deception "by eliminating any disclosure of such bonus payments from the proxy statement/prospectus prepared by them in connection with the planned Merger."

Meanwhile, President Obama's "pay czar," Kenneth Feinberg, was busy sorting through compensation packages for 175 executives of the seven companies (including BofA) under his supervision, stressing risk assessment issues.

Emphasis on the relationship between compensation and risk has become thematic in the compensation debate. The government's thinking is reflected in Feinberg's decision for the CEO of American International Group; Feinberg approved a $7 million salary and $3.5 million in long term incentives, but of the base salary of only $3 million will be paid in cash. The remaining $4 million will be AIG stock tied up for five years.

Finally, the Federal Reserve Board is preparing compensation guidelines for financial executives, but the New York Times reports that rather than prohibiting multimillion dollar pay packages, the expected rules will discourage reckless behavior that drives short-term gains.

Although there appears to be no expectation that the Fed will adopt Feinberg's specific strategy, it is hoped by the administration that a combination of Federal Reserve action and a sense that Feinberg's model constitutes a "best practice" will rein in financial institution compensation.

SOX 404

The SEC has granted its last extension for compliance with SOX Section 404(b), requiring auditor attestation of the efficacy of company financial reporting internal controls. Non-accelerated public companies (a public float below $75 million) last year joined larger public companies in being subject to Section 404(a), requiring internal financial controls.

The SEC had delayed the requirement of auditor attestation for these smaller companies, pending release of the SEC's study of 404 costs-benefits, fearing additional accounting costs are not scalable and would thus represent a potentially large hit to the bottom line of smaller companies.

The SEC postponed the requirement of outside attestation for non-accelerated companies until annual reports for fiscal years ending on or after June 15, 2010, so smaller companies will not be required to comply until the 2011 annual report for the prior fiscal year.

The extension was premised on the late delivery of the SEC cost-benefit study in September of this year; non-accelerated companies might not have anticipated that the 404(b) attestations would in fact be required with respect to the year 2009. The SEC study ( ) concludes that, following the SEC's 2007 disclosure reforms, 404 compliance costs have fallen markedly.

While full 404 compliance by 2011 thus will apply to all reporting companies, there are telling observations buried in the report: first, a majority of companies said that although their internal controls were strengthened by 404 compliance (how could they not be?), they saw no effect on an ability to raise capital, or in investor confidence in financial reports, or in overall firm value, or in the liquidity of the company's common stock; and, additionally, a majority found the overall cost-benefit trade-off of 404 compliance to be negative, and the smaller the company the more negative the judgment.


In this period of active rulemaking and litigation, the SEC is buffeted by lawyers, issuers, politicians, press, courts, theorists and the commission's own internal tensions. Whether regulatory reform will allow the SEC to survive, either in its present form or as an even more powerful regulator, remains to be seen, but absent precedent as to how the SEC should ride this regulatory bucking bronco, the commission appears to be holding on for dear life.


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