ck0001540305-20231031
AAM
S&P 500 HIGH DIVIDEND VALUE ETF (SPDV)
AAM
S&P EMERGING MARKETS HIGH DIVIDEND VALUE ETF (EEMD)
AAM
S&P DEVELOPED MARKETS HIGH DIVIDEND VALUE ETF (DMDV)
AAM
LOW DURATION PREFERRED AND INCOME SECURITIES ETF (PFLD)
AAM
TRANSFORMERS ETF (TRFM)
each
a series of ETF Series Solutions
Listed
on NYSE Arca, Inc.
STATEMENT
OF ADDITIONAL INFORMATION
February 28,
2024
This
Statement of Additional Information (“SAI”) is not a prospectus and should be
read in conjunction with the Prospectus for the AAM S&P 500 High Dividend
Value ETF, AAM S&P Emerging Markets High Dividend Value ETF, AAM S&P
Developed Markets High Dividend Value ETF, AAM Low Duration Preferred and Income
Securities ETF, and AAM Transformers ETF (each, a “Fund” and, together, the
“Funds”), each a series of ETF Series Solutions (the “Trust”), dated
February 28, 2024, as may be supplemented from time to time (the
“Prospectus”). Capitalized terms used in this SAI that are not defined have the
same meaning as in the Prospectus, unless otherwise noted. A copy of the
Prospectus may be obtained, without charge, by calling the Funds at
1‑800‑617-0004, visiting www.aamlive.com/ETF, or writing to the Funds,
c/o U.S. Bank Global Fund Services, P.O. Box 701, Milwaukee, Wisconsin
53201-0701.
The
Funds’ audited financial statements for the fiscal year ended October 31,
2023,
as applicable, are incorporated into this SAI by reference to the Funds’
Annual
Report to Shareholders
(File No. 811-22668). You may obtain a copy of the Funds’ Annual Report at no
charge by contacting the Funds at the address or phone number noted
above.
GENERAL
INFORMATION
ABOUT
THE
TRUST
The
Trust is an open-end management investment company consisting of multiple
investment series. This SAI relates to the Funds. The Trust was organized as a
Delaware statutory trust on February 9, 2012. The Trust is registered with
the U.S. Securities and Exchange Commission (“SEC”) under the Investment Company
Act of 1940, as amended (together with the rules and regulations adopted
thereunder, as amended, the “1940 Act”), as an open-end management investment
company, and the offering of each Fund’s shares (“Shares”) is registered under
the Securities Act of 1933, as amended (the “Securities Act”). The Trust is
governed by its Board of Trustees (the “Board”).
Advisors
Asset Management, Inc. (“AAM” or the “Adviser”) serves as the Funds’ investment
adviser; and Vident Asset Management (“Vident” or the “Sub-Adviser”) serves as
sub-adviser to the Funds. Each Fund’s investment objective is to seek investment
results that, before fees and expenses, track the performance of a rules-based
index, as described in the Prospectus (each, an “Index”).
Each
Fund offers and issues Shares at their net asset value (“NAV”) only in
aggregations of a specified number of Shares (each, a “Creation Unit”). Each
Fund generally offers and issues Shares in exchange for a basket of securities
(“Deposit Securities”) together with the deposit of a specified cash payment
(“Cash Component”). The Trust reserves the right to permit or require the
substitution of a “cash in lieu” amount (“Deposit Cash”) to be added to the Cash
Component to replace any Deposit Security. Shares are listed on the NYSE Arca,
Inc. (the “Exchange”) and trade on the Exchange at market prices that may differ
from the Shares’ NAV. Shares are also redeemable only in Creation Unit
aggregations, primarily for a basket of Deposit Securities together with a Cash
Component. A Creation Unit of the AAM S&P 500 High Dividend Value ETF, AAM
S&P Emerging Markets High Dividend Value ETF, AAM Low Duration Preferred and
Income Securities ETF, and AAM Transformers ETF generally consists of 25,000
Shares. A Creation Unit of the AAM S&P Developed Markets High Dividend Value
ETF generally consists of 10,000 Shares, though this may change from time to
time. As a practical matter, only institutions or large investors purchase or
redeem Creation Units. Except when aggregated in Creation Units, Shares are not
redeemable securities.
Shares
may be issued in advance of receipt of Deposit Securities subject to various
conditions, including a requirement to maintain on deposit with the Trust cash
at least equal to a specified percentage of the value of the missing Deposit
Securities, as set forth in the Participant Agreement (as defined below). The
Trust may impose a transaction fee for each creation or redemption. In all
cases, such fees will be limited in accordance with the requirements of the SEC
applicable to management investment companies offering redeemable securities. As
in the case of other publicly traded securities, brokers’ commissions on
transactions in the secondary market will be based on negotiated commission
rates at customary levels.
ADDITIONAL
INFORMATION
ABOUT
INVESTMENT
OBJECTIVES,
POLICIES,
AND
RELATED
RISKS
Each
Fund’s investment objective and principal investment strategies are described in
the Prospectus. The following information supplements, and should be read in
conjunction with, the Prospectus. For a description of certain permitted
investments, see “Description
of Permitted Investments”
in this SAI.
With
respect to each Fund’s investments, unless otherwise noted, if a percentage
limitation on investment is adhered to at the time of investment or contract, a
subsequent increase or decrease as a result of market movement or redemption
will not result in a violation of such investment limitation.
Diversification
Each
Fund is “diversified” within the meaning of the 1940 Act. Under applicable
federal laws, to qualify as a diversified fund, each Fund, with respect to 75%
of its total assets, may not invest greater than 5% of its total assets in any
one issuer and may not hold greater than 10% of the securities of one issuer,
other than investments in cash and cash items (including receivables), U.S.
government securities, and securities of other investment companies. The
remaining 25% of each Fund’s total assets does not need to be “diversified” and
may be invested in securities of a single issuer, subject to other applicable
laws. The diversification of a fund’s holdings is measured at the time the fund
purchases a security. However, if a fund purchases a security and holds it for a
period of time, the security may become a larger percentage of the fund’s total
assets due to movements in the financial markets. If the market affects several
securities held by a fund, the fund may have a greater percentage of its assets
invested in securities of a single issuer or a small number of issuers. However,
each Fund intends to satisfy the asset diversification requirements for
qualification as a regulated investment company (“RIC”) under Subchapter M
of the Internal Revenue Code of 1986, as amended (the “Code”). See “Federal
Income Taxes”
below for details.
General
Risks
The
value of a Fund’s portfolio securities may fluctuate with changes in the
financial condition of an issuer or counterparty, changes in specific economic
or political conditions that affect a particular security or issuer and changes
in general economic or political conditions. An investor in a Fund could lose
money over short or long periods of time.
There
can be no guarantee that a liquid market for the securities held by a Fund will
be maintained. The existence of a liquid trading market for certain securities
may depend on whether dealers will make a market in such securities. There can
be no assurance that a market will be made or maintained or that any such market
will be or remain liquid. The price at which securities may be sold and the
value of Shares will be adversely affected if trading markets for a Fund’s
portfolio securities are limited or absent, or if bid-ask spreads are wide.
Recent
Events. Beginning
in the first quarter of 2020, financial markets in the United States and around
the world experienced extreme and, in many cases, unprecedented volatility and
severe losses due to the global pandemic caused by COVID-19, a novel
coronavirus. The pandemic resulted in a wide range of social and economic
disruptions, including closed borders, voluntary or compelled quarantines of
large populations, stressed healthcare systems, reduced or prohibited domestic
or international travel, and supply chain disruptions affecting the United
States and many other countries. Some sectors of the economy and individual
issuers experienced particularly large losses as a result of these disruptions.
Although the immediate effects of the COVID-19 pandemic have begun to dissipate,
global markets and economies continue to contend with the ongoing and long-term
impact of the COVID-19 pandemic and the resultant market volatility and economic
disruptions. It is unknown how long circumstances related to the pandemic will
persist, whether they will reoccur in the future, whether efforts to support the
economy and financial markets will be successful, and what additional
implications may follow from the pandemic. The impact of these events and other
epidemics or pandemics in the future could adversely affect Fund
performance.
Russia’s
military invasion of Ukraine in February 2022, the resulting responses by the
United States and other countries, and the potential for wider conflict could
increase volatility and uncertainty in the financial markets and adversely
affect regional and global economies. The United States and other countries have
imposed broad-ranging economic sanctions on Russia, certain Russian individuals,
banking entities and corporations, and Belarus as a response to Russia’s
invasion of Ukraine, and may impose sanctions on other countries that provide
military or economic support to Russia. The sanctions restrict companies from
doing business with Russia and Russian companies, prohibit transactions with the
Russian central bank and other key Russian financial institutions and entities,
ban Russian airlines and ships from using many other countries’ airspace and
ports, respectively, and place a freeze on certain Russian assets. The sanctions
also removed some Russian banks from the Society for Worldwide Interbank
Financial Telecommunications (SWIFT), the electronic network that connects banks
globally to facilitate cross-border payments. In addition, the United States and
the United Kingdom have banned oil and other energy imports from Russia, and the
European Union has banned most Russian crude oil imports and refined petroleum
products, with limited exceptions. The extent and duration of Russia’s military
actions and the repercussions of such actions (including any retaliatory actions
or countermeasures that may be taken by those subject to sanctions, including
cyber attacks) are impossible to predict, but could result in significant market
disruptions, including in certain industries or sectors, such as the oil and
natural gas markets, and may negatively affect global supply chains, inflation
and global growth. These and any related events could significantly impact the
Fund’s performance and the value of an investment in the Fund, even if the Fund
does not have direct exposure to Russian issuers or issuers in other countries
affected by the invasion.
Cyber
Security Risk.
Investment
companies, such as the Funds, and their service providers may be subject to
operational and information security risks resulting from cyber attacks. Cyber
attacks include, among other behaviors, stealing or corrupting data maintained
online or digitally, denial of service attacks on websites, the unauthorized
release of confidential information or various other forms of cyber security
breaches. Cyber attacks affecting a Fund or the Adviser, Sub-Adviser, custodian,
transfer agent, intermediaries and other third-party service providers may
adversely impact a Fund. For instance, cyber attacks may interfere with the
processing of shareholder transactions, impact a Fund’s ability to calculate its
NAV, cause the release of private shareholder information or confidential
company information, impede trading, subject a Fund to regulatory fines or
financial losses, and cause reputational damage. A Fund may also incur
additional costs for cyber security risk management purposes. Similar types of
cyber security risks are also present for issuers of securities in which a Fund
invests, which could result in material adverse consequences for such issuers,
and may cause a Fund’s investments in such portfolio companies to lose
value.
Description
of Permitted Investments
The
following are descriptions of the Funds’ permitted investments and investment
practices and the associated risk factors. A Fund will only invest in any of the
following instruments or engage in any of the following investment practices if
such investment or activity is consistent with a Fund’s investment objective and
permitted by the Fund’s stated investment policies. Each of the permitted
investments described below applies to each Fund unless otherwise
noted.
Borrowing
Although
the Funds do not intend to borrow money, a Fund may do so to the extent
permitted by the 1940 Act. Under the 1940 Act, a Fund may borrow up to one-third
(1/3) of its total assets. A Fund will borrow money only for short-term or
emergency purposes. Such borrowing is not for investment purposes and will be
repaid by the borrowing Fund promptly. Borrowing will tend to exaggerate the
effect on NAV of any increase or decrease in the market value of the borrowing
Fund’s portfolio. Money borrowed will be subject to interest costs that may or
may not be recovered by earnings on the securities purchased. A Fund also may be
required to maintain minimum average balances in connection with a borrowing or
to pay a commitment or other fee to maintain a line of credit; either of these
requirements would increase the cost of borrowing over the stated interest
rate.
Depositary
Receipts
To
the extent a Fund invests in stocks of foreign corporations, a Fund’s investment
in securities of foreign companies may be in the form of depositary receipts or
other securities convertible into securities of foreign issuers. American
Depositary Receipts (“ADRs”) are dollar-denominated receipts representing
interests in the securities of a foreign issuer, which securities may not
necessarily be denominated in the same currency as the securities into which
they may be converted. ADRs are receipts typically issued by U.S. banks and
trust companies which evidence ownership of underlying securities issued by a
foreign corporation. Generally, ADRs in registered form are designed for use in
domestic securities markets and are traded on exchanges or over-the-counter in
the United States. Global Depositary Receipts (“GDRs”), European Depositary
Receipts (“EDRs”), and International Depositary Receipts (“IDRs”) are similar to
ADRs in that they are certificates evidencing ownership of shares of a foreign
issuer; however, GDRs, EDRs, and IDRs may be issued in bearer form and
denominated in other currencies and are generally designed for use in specific
or multiple securities markets outside the U.S. EDRs, for example, are designed
for use in European securities markets, while GDRs are designed for use
throughout the world. Depositary receipts will not necessarily be denominated in
the same currency as their underlying securities.
The
Funds will not invest in any unlisted Depositary Receipts or any Depositary
Receipt that the Sub-Adviser deems to be illiquid or for which pricing
information is not readily available. In addition, all Depositary Receipts
generally must be sponsored. However, a Fund may invest in unsponsored
Depositary Receipts under certain limited circumstances. The issuers of
unsponsored Depositary Receipts are not obligated to disclose material
information in the United States and, therefore, there may be less information
available regarding such issuers and there may not be a correlation between such
information and the value of the Depositary Receipts. For Funds that track an
Index, the use of a Depositary Receipt may increase the Fund’s tracking error
relative to its Index if the Index includes the foreign security instead of the
Depositary Receipt.
Equity
Securities
Equity
securities, such as the common stocks of an issuer, are subject to stock market
fluctuations and therefore may experience volatile changes in value as market
conditions, consumer sentiment or the financial condition of the issuers change.
A decrease in value of the equity securities in a Fund’s portfolio may also
cause the value of the Fund’s Shares to decline.
An
investment in the Funds should be made with an understanding of the risks
inherent in an investment in equity securities, including the risk that the
financial condition of issuers may become impaired or that the general condition
of the stock market may deteriorate (either of which may cause a decrease in the
value of a Fund’s portfolio securities and therefore a decrease in the value of
Shares). Common stocks are susceptible to general stock market fluctuations and
to volatile increases and decreases in value as market confidence and
perceptions change. These investor perceptions are based on various and
unpredictable factors, including expectations regarding government, economic,
monetary and fiscal policies; inflation and interest rates; economic expansion
or contraction; and global or regional political, economic, public health, or
banking crises.
Holders
of common stocks incur more risk than holders of preferred stocks and debt
obligations because common stockholders, as owners of the issuer, generally have
inferior rights to receive payments from the issuer in comparison with the
rights of creditors or holders of debt obligations or preferred stocks. Further,
unlike debt securities, which typically have a stated principal amount payable
at maturity (whose value, however, is subject to market fluctuations prior
thereto), or preferred stocks, which typically have a liquidation preference and
which may have stated optional or mandatory redemption provisions, common stocks
have neither a fixed principal amount nor a maturity. Common stock values are
subject to market fluctuations as long as the common stock remains outstanding.
When-Issued
Securities:
A
when-issued security is one whose terms are available and for which a market
exists, but which has not been issued. When a Fund engages in when-issued
transactions, it relies on the other party to consummate the sale. If the other
party fails to complete the sale, a Fund may miss the opportunity to obtain the
security at a favorable price or yield.
When
purchasing a security on a when-issued basis, a Fund assumes the rights and
risks of ownership of the security, including the risk of price and yield
changes. At the time of settlement, the value of the security may be more or
less than the purchase price. The yield available in the market when the
delivery takes place also may be higher than those obtained in the transaction
itself. Because a Fund does not pay for the security until the delivery date,
these risks are in addition to the risks associated with its other investments.
Decisions
to enter into “when-issued” transactions will be considered on a case-by-case
basis when necessary to maintain continuity in a company’s index membership. A
Fund will segregate cash or liquid securities equal in value to commitments for
the when-issued transactions. A Fund will segregate additional liquid assets
daily so that the value of such assets is equal to the amount of the
commitments.
Types
of Equity Securities:
Common
Stocks
— Common stocks represent units of ownership in a company. Common stocks usually
carry voting rights and earn dividends. Unlike preferred stocks, which are
described below, dividends on common stocks are not fixed but are declared at
the discretion of the company’s board of directors.
Preferred
Stocks
— Preferred stocks are also units of ownership in a company. Preferred stocks
normally have preference over common stock in the payment of dividends and the
liquidation of the company. However, in all other respects, preferred stocks are
subordinated to the liabilities of the issuer. Unlike common stocks, preferred
stocks are generally not entitled to vote on corporate matters. Types of
preferred stocks include adjustable-rate preferred stock, fixed dividend
preferred stock, perpetual preferred stock, and sinking fund preferred stock.
Generally,
the market values of preferred stock with a fixed dividend rate and no
conversion element vary inversely with interest rates and perceived credit risk.
Rights
and Warrants
— A right is a privilege granted to existing shareholders of a corporation to
subscribe to shares of a new issue of common stock before it is issued. Rights
normally have a short life of usually two to four weeks, are freely transferable
and entitle the holder to buy the new common stock at a lower price than the
public offering price. Warrants are securities that are usually issued together
with a debt security or preferred stock and that give the holder the right to
buy proportionate amount of common stock at a specified price. Warrants are
freely transferable and are traded on major exchanges. Unlike rights, warrants
normally have a life that is measured in years and entitles the holder to buy
common stock of a company at a price that is usually higher than the market
price at the time the warrant is issued. Corporations often issue warrants to
make the accompanying debt security more attractive.
An
investment in warrants and rights may entail greater risks than certain other
types of investments. Generally, rights and warrants do not carry the right to
receive dividends or exercise voting rights with respect to the underlying
securities, and they do not represent any rights in the assets of the issuer. In
addition, their value does not necessarily change with the value of the
underlying securities, and they cease to have value if they are not exercised on
or before their expiration date. Investing in rights and warrants increases the
potential profit or loss to be realized from the investment as compared with
investing the same amount in the underlying securities.
Medium-Sized
Companies
— Investors in medium-sized companies typically take on greater risk and price
volatility than they would by investing in larger, more established companies.
This increased risk may be due to the greater business risks of their medium
size, limited markets and financial resources, narrow product lines and frequent
lack of management depth. The securities of medium-sized companies are often
traded in the over-the-counter market and might not be traded in volumes typical
of securities traded on a national securities exchange. Thus, the securities of
medium capitalization companies are likely to be less liquid, and subject to
more abrupt or erratic market movements, than securities of larger, more
established companies.
Smaller-Sized
Companies —
Investors in smaller-sized companies typically take on greater risk and price
volatility than they would by investing in larger, more established companies.
This increased risk may be due to the greater business risks of their smaller
size, limited markets and financial resources, narrow product lines and frequent
lack of management depth. The securities of smaller-sized companies are often
traded in the over-the-counter market and might not be traded in volumes typical
of securities traded on a national securities exchange. Thus, the securities of
smaller capitalization companies are likely to be less liquid, and subject to
more abrupt or erratic market movements, than securities of larger, more
established companies.
Tracking
Stocks —
The
Funds may invest in tracking stocks. A tracking stock is a separate class of
common stock whose value is linked to a specific business unit or operating
division within a larger company and which is designed to “track” the
performance of such business unit or division. The tracking stock may pay
dividends to shareholders independent of the parent company. The parent company,
rather than the business unit or division, generally is the issuer of tracking
stock. However, holders of the tracking stock may not have the same rights as
holders of the company’s common stock.
Exchange-Traded
Funds (“ETFs”)
Each
Fund may invest in shares of other investment companies (including ETFs). As the
shareholder of another ETF, a Fund would bear, along with other shareholders,
its pro rata portion of the other ETF’s expenses, including advisory fees. Such
expenses are in addition to the expenses the Fund pays in connection with its
own operations. A Fund’s investments in other ETFs may be limited by applicable
law.
Disruptions
in the markets for the securities underlying ETFs purchased or sold by a Fund
could result in losses on investments in ETFs. ETFs also carry the risk that the
price a Fund pays or receives may be higher or lower than the ETF’s NAV. ETFs
are also subject to certain additional risks, including the risks of illiquidity
and of possible trading halts due to market conditions or other reasons, based
on the policies of the relevant exchange. ETFs and other investment companies in
which the Fund may invest may be leveraged, which would increase the volatility
of the Fund’s NAV.
Fixed-Income
Securities
Fixed-income
securities include a broad array of short-, medium-, and long-term obligations
issued by the U.S. or foreign governments, government or international agencies
and instrumentalities, and corporate and private issuers of various types. The
maturity date is the date on which a fixed-income security matures. This is the
date on which the borrower must pay back the borrowed amount, which is known as
the principal. Some fixed-income securities represent uncollateralized
obligations of their issuers; in other cases, the securities may be backed by
specific assets (such as mortgages or other receivables) that have been set
aside as collateral for the issuer’s obligation. Fixed-income securities
generally involve an obligation of the issuer to pay interest or dividends on
either a current basis or at the maturity of the security, as well as the
obligation to repay the principal amount of the security at maturity. The rate
of interest on fixed-income securities may be fixed, floating, or variable. Some
securities pay a higher interest rate than the current market rate. An investor
may have to pay more than the security’s principal to compensate the seller for
the value of the higher interest rate. This additional payment is a
premium.
Fixed-income
securities are subject to credit risk, market risk, and interest rate risk.
Except to the extent values are affected by other factors such as developments
relating to a specific issuer, generally the value of a fixed-income security
can be expected to rise when interest rates decline and, conversely, the value
of such a security can be expected to fall when interest rates rise. Some
fixed-income securities also involve prepayment or call risk. This is the risk
that the issuer will repay a Fund the principal on the security before it is
due, thus depriving the Fund of a favorable stream of future interest or
dividend payments. A fund could buy another security, but that other security
might pay a lower interest rate. In addition, many fixed-income securities
contain call or buy-back features that permit their issuers to call or
repurchase the securities from their holders. Such securities may present risks
based on payment expectations. Although a Fund would typically receive a premium
if an issuer were to redeem a security, if an issuer were to exercise a call
option and redeem the security during times of declining interest rates, a Fund
may realize a capital loss on their investment if the security was purchased at
a premium and the Fund may be forced to replace the called security with a lower
yielding security.
Changes
by nationally recognized securities rating organizations (“NRSROs”) in their
ratings of any fixed-income security or the issuer of a fixed-income security
and changes in the ability of an issuer to make payments of interest and
principal may also affect the value of these investments. Changes in the value
of portfolio securities generally will not affect income derived from these
securities, but will affect a Fund’s NAV.
Duration
is an estimate of how much a bond’s price will fluctuate in response to a change
in interest rates. In general, the value of a fixed-income security with
positive duration will generally decline if interest rates increase, whereas the
value of a security with negative duration will generally decline if interest
rates decrease. If interest rates rise by one percentage point, the price of
debt securities with an average duration of five years would be expected to
decline by about 5%. If rates decrease by a percentage point, the price of debt
securities with an average duration of five years would be expected to rise by
about 5%. The greater the duration of a bond (whether positive or negative), the
greater its percentage price volatility. Only a pure discount bond – that is,
one with no coupon or sinking-fund payments – has a duration equal to the
remaining maturity of the bond, because only in this case does the present value
of the final redemption payment represent the entirety of the present value of
the bond. For all other bonds, duration is less than maturity.
A
Fund may invest in variable- or floating-rate securities (including, but not
limited to, floating rate notes issued by the U.S. Treasury), which bear
interest at rates subject to periodic adjustment or provide for periodic
recovery of principal on demand. The value of a Fund’s investment in certain of
these securities may depend on a Fund’s right to demand that a specified bank,
broker-dealer, or other financial institution either purchase such securities
from the Fund at par or make payment on short notice to the Fund of unpaid
principal and/or interest on the securities. These securities are subject to,
among others, interest rate risk and credit risk.
When
investing in fixed income securities, the Funds may purchase securities
regardless of their rating, including fixed income securities rated below
investment grade – securities rated below investment grade are often referred to
as high yield securities or “junk bonds”. High yield securities or “junk bonds,”
involve special risks in addition to the risks associated with investments in
higher rated fixed income securities. While offering a greater potential
opportunity for capital appreciation and higher yields, high yield securities
may be subject to greater levels of interest rate, credit and liquidity risk,
may entail greater potential price volatility, and may be less liquid than
higher rated fixed income securities. High yield securities may be regarded as
predominantly speculative with respect to the issuer’s continuing ability to
meet principal and interest payments. They may also be more susceptible to real
or perceived adverse economic and competitive industry conditions than higher
rated securities. Fixed income securities rated in the lowest investment grade
categories by the rating agencies may also possess speculative characteristics.
If securities are in default with respect to the payment of interest or the
repayment of principal, or present an imminent risk of default with respect to
such payments, the issuer of such securities may fail to resume principal or
interest payments, in which case a Fund may lose its entire investment in the
high yield security. In addition, to the extent that there is no established
retail secondary market, there may be thin trading of high yield securities, and
this may have an impact on a Fund’s ability to accurately value high yield
securities and the Fund’s assets and on the Fund’s ability to dispose of the
securities. Adverse publicity and investor perception, whether or not based on
fundamental analysis, may decrease the values and liquidity of high yield
securities especially in a thinly traded market.
Illiquid
Investments
Each
Fund may invest up to an aggregate amount of 15% of its net assets in illiquid
investments, as such term is defined by Rule 22e-4 under the 1940 Act. A Fund
may not invest in illiquid investments if, as a result of such investment, more
than 15% of the Fund’s net assets would be invested in illiquid investments.
Illiquid investments include securities subject to contractual or other
restrictions on resale and other instruments that lack readily available
markets. The inability of a Fund to dispose of illiquid investments readily or
at a reasonable price could impair a Fund’s ability to raise cash for
redemptions or other purposes. The liquidity of securities purchased by a Fund
that are eligible for resale pursuant to Rule 144A, except for certain 144A
bonds, will be monitored by a Fund on an ongoing basis. In the event that more
than 15% of a Fund’s net assets are invested in illiquid investments, the Fund,
in accordance with Rule 22e-4(b)(1)(iv), will report the occurrence to both the
Board and the SEC and seek to reduce its holdings of illiquid investments within
a reasonable period of time.
Investment
Company Securities
The
Funds may invest in the securities of other investment companies, including ETFs
and money market funds, subject to applicable limitations under
Section 12(d)(1) of the 1940 Act and Rule 12d1-4 under the 1940 Act.
Investing in another pooled vehicle exposes a Fund to all the risks of that
pooled vehicle. Pursuant to Section 12(d)(1), a Fund may invest in the
securities of another investment company (the “acquired company”) provided that
such Fund, immediately after such purchase or acquisition, does not own in the
aggregate: (i) more than 3% of the total outstanding voting stock of the
acquired company; (ii) securities issued by the acquired company having an
aggregate value in excess of 5% of the value of the total assets of such Fund;
or (iii) securities issued by the acquired company and all other investment
companies (other than treasury stock of such Fund) having an aggregate value in
excess of 10% of the value of the total assets of the applicable Fund. To the
extent allowed by law or regulation, the Funds may invest their assets in
securities of investment companies that are money market funds in excess of the
limits discussed above.
The
Funds may rely on Section 12(d)(1)(F) and Rule 12d1-3 under the 1940 Act, which
provide an exemption from Section 12(d)(1) that allow the Funds to invest all of
its assets in other registered funds, including ETFs, if, among other
conditions: (a) a Fund, together with its affiliates, acquires no more than
three percent of the outstanding voting stock of any acquired fund, and (b) the
sales load charged on a Fund’s Shares is no greater than the limits set forth in
Rule 2341 of the Rules of the Financial Industry Regulatory Authority, Inc.
(“FINRA”). In addition, the Funds may invest beyond the limits of Section
12(d)(1) subject to certain terms and conditions set forth in Rule 12d1-4 under
the 1940 Act, including that the Funds enter into an agreement with the acquired
company.
If
a Fund invests in and, thus, is a shareholder of, another investment company,
the Fund’s shareholders will indirectly bear the Fund’s proportionate share of
the fees and expenses paid by such other investment company, including advisory
fees, in addition to both the management fees payable directly by the Fund to
the Fund’s own investment adviser and the other expenses that the Fund bears
directly in connection with the Fund’s own operations.
Section
12(d)(1) of the 1940 Act restricts investments by registered investment
companies (“Investing Funds”) in the securities of other registered investment
companies, including the Funds. The acquisition of Shares by Investing Funds is
subject to the restrictions of Section 12(d)(1) of the 1940 Act, except as may
be permitted by exemptive rules under the 1940 Act such as Rule 12d1-4 under the
1940 Act, subject to certain terms and conditions, including that the Investing
Fund enter into an agreement with the Funds regarding the terms of the
investment.
Non-U.S.
Securities
The
Funds may invest in non-U.S. equity securities. Investments in non-U.S. equity
securities involve certain risks that may not be present in investments in U.S.
securities. For example, non-U.S. securities may be subject to currency risks or
to foreign government taxes. There may be less information publicly available
about a non-U.S. issuer than about a U.S. issuer, and a foreign issuer may or
may not be subject to uniform accounting, auditing and financial reporting
standards and practices comparable to those in the U.S. Other risks of investing
in such securities include political or economic instability in the country
involved, the difficulty of predicting international trade patterns and the
possibility of imposition of exchange controls. The prices of such securities
may be more volatile than those of domestic securities. With respect to certain
foreign countries, there is a possibility of expropriation of assets or
nationalization, imposition of withholding taxes on dividend or interest
payments, difficulty in obtaining and enforcing judgments against foreign
entities or diplomatic developments which could affect investment in these
countries. Losses and other expenses may be incurred in converting between
various currencies in connection with purchases and sales of foreign securities.
Since foreign exchanges may be open on days when the Funds do not price their
Shares, the value of the securities in a Fund’s portfolio may change on days
when shareholders will not be able to purchase or sell the Fund’s Shares.
Conversely, Shares may trade on days when foreign exchanges are closed. Each of
these factors can make investments in the Funds more volatile and potentially
less liquid than other types of investments.
Non-U.S.
stock markets may not be as developed or efficient as, and may be more volatile
than, those in the U.S. While the volume of shares traded on non-U.S. stock
markets generally has been growing, such markets usually have substantially less
volume than U.S. markets. Therefore, a Fund’s investment in non-U.S. equity
securities may be less liquid and subject to more rapid and erratic price
movements than comparable securities listed for trading on U.S. exchanges.
Non-U.S. equity securities may trade at price/earnings multiples higher than
comparable U.S. securities and such levels may not be sustainable. There may be
less government supervision and regulation of foreign stock exchanges, brokers,
banks and listed companies abroad than in the U.S. Moreover, settlement
practices for transactions in foreign markets may differ from those in U.S.
markets. Such differences may include delays beyond periods customary in the
U.S. and practices, such as delivery of securities prior to receipt of payment,
that increase the likelihood of a failed settlement, which can result in losses
to a Fund. The value of non-U.S. investments and the investment income derived
from them may also be affected unfavorably by changes in currency exchange
control regulations. Foreign brokerage commissions, custodial expenses and other
fees are also generally higher than for securities traded in the U.S. This may
cause a Fund to incur higher portfolio transaction costs than domestic equity
funds. Fluctuations in exchange rates may also affect the earning power and
asset value of the foreign entity issuing a security, even one denominated in
U.S. dollars. Dividend and interest payments may be repatriated based on the
exchange rate at the time of disbursement, and restrictions on capital flows may
be imposed.
Set
forth below for certain markets in which a Fund may invest are brief
descriptions of some of the conditions and risks in each such market.
Investments
in Australia.
The economy of Australia is heavily dependent on the price and the demand for
commodities and natural resources as well as its exports from the energy,
agricultural and mining sectors. As a result, the Australian economy is
susceptible to fluctuations in the commodity markets. Conditions that weaken
demand for Australian products worldwide could have a negative impact on the
Australian economy as a whole. Australia is also increasingly dependent on the
economies of its key trading partners, including China, the United States, and
Japan.
Investments
in Brazil. Investments
in securities of Brazilian companies are subject to regulatory and economic
interventions that the Brazilian government has frequently exercised in the
past, including the setting of wage and price controls, blocking access to bank
accounts, imposing exchange controls and limiting imports. Investments are also
subject to certain restrictions on foreign investment as provided by Brazilian
law. The Brazilian economy has historically been subject to high rates of
inflation and a high level of debt, all of which may stifle economic growth.
Despite rapid development in recent years, Brazil still suffers from high levels
of corruption, crime and income disparity. There is the possibility that such
conditions may lead to social unrest and political upheaval in the future, which
may have adverse effects on the Fund's investments.
Investments
in Certain Asian Emerging Market Countries. Many
Asian economies are characterized by over-extension of credit, frequent currency
fluctuation, devaluations and restrictions, rising unemployment, rapid
fluctuations in inflation, reliance on exports and less efficient markets.
Currency devaluation in one Asian country can have a significant effect on the
entire region. The legal systems in many Asian countries are still developing,
making it more difficult to obtain and/or enforce judgments.
Furthermore,
increased political and social unrest in some Asian countries could cause
economic and market uncertainty throughout the region. The auditing and
reporting standards in some Asian emerging market countries may not provide the
same degree of shareholder protection or information to investors as those in
developed countries. In particular, valuation of assets, depreciation, exchange
differences, deferred taxation, contingent liability and consolidation may be
treated differently than under the auditing and reporting standards of developed
countries.
Certain
Asian emerging market countries are undergoing a period of growth and change
which may result in trading volatility and difficulties in the settlement and
recording of securities transactions, and in interpreting and applying the
relevant law and regulations. The securities industries in these countries are
comparatively underdeveloped. Stockbrokers and other intermediaries in Asian
emerging market countries may not perform as well as their counterparts in the
United States and other more developed securities markets. Certain Asian
emerging market countries may require substantial withholding on dividends paid
on portfolio securities and on realized capital gains. There can be no assurance
that repatriation of a fund’s income, gains, or initial capital from these
countries can occur.
Investments
in China and Hong Kong. Investing
in ADRs with underlying shares organized, listed or domiciled in China involves
special considerations not typically associated with investing in countries with
more democratic governments or more established economies or securities markets.
Such risks may include: (i) the risk of nationalization or expropriation of
assets or confiscatory taxation; (ii) greater social, economic and
political uncertainty (including the risk of war); (iii) dependency on
exports and the corresponding importance of international trade;
(iv) increasing competition from Asia’s other low-cost emerging economies;
(v) higher rates of inflation; (vi) controls on foreign investment and
limitations on repatriation of invested capital; (vii) greater governmental
involvement in and control over the economy; (viii) the risk that the
Chinese government may decide not to continue to support the economic reform
programs implemented since 1978 and could return to the prior, completely
centrally planned, economy; (ix) the fact that Chinese companies,
particularly those located in China, may be smaller, less seasoned and newly
organized; (x) the differences in, or lack of, auditing and financial
reporting standards which may result in unavailability of material information
about issuers, particularly in China where, for example, the Public Company
Accounting Oversight Board
(“PCAOB”)
lacks access to inspect PCAOB-registered accounting firms; (xi) the fact
that statistical information regarding the economy of China may be inaccurate or
not comparable to statistical information regarding the U.S. or other economies;
(xii) the less extensive, and still developing, regulation of the
securities markets, business entities and commercial transactions;
(xiii) the fact that the settlement period of securities transactions in
foreign markets may be longer; (xiv) the fact that the willingness and
ability of the Chinese government to support the Chinese and Hong Kong economies
and markets is uncertain; (xv) the risk that it may be more difficult, or
impossible, to obtain and/or enforce a judgment than in other countries;
(xvi) the rapid and erratic nature of growth, particularly in China,
resulting in inefficiencies and dislocations; (xvii) the risk that, because
of the degree of interconnectivity between the economies and financial markets
of China and Hong Kong, any sizable reduction in the demand for goods from
China, or an economic downturn in China, could negatively affect the economy and
financial market of Hong Kong as well; and (xviii) the risk that certain
companies in a Fund’s Index may have dealings with countries subject to
sanctions or embargoes imposed by the U.S. Government or identified as state
sponsors of terrorism.
China
is also vulnerable economically to the impact of a public health crisis, which
could depress consumer demand, reduce economic output, and potentially lead to
market closures, travel restrictions, and quarantines, all of which would
negatively impact China’s economy and could affect the economies of its trading
partners.
After
many years of steady growth, the growth rate of China’s economy has recently
slowed. Although this slowdown was to some degree intentional, the slowdown has
also slowed the once rapidly growing Chinese real estate market and left local
governments with high debts with few viable means to raise revenue, especially
with the fall in demand for housing. Despite its attempts to restructure its
economy towards consumption, China remains heavily dependent on exports.
Accordingly, China is susceptible to economic downturns abroad, including any
weakness in demand from its major trading partners, including the United States,
Japan, and Europe. In addition, China’s aging infrastructure, worsening
environmental conditions, rapid and inequitable urbanization, quickly widening
urban and rural income gap, domestic unrest and provincial separatism all
present major challenges to the country. Further, China’s territorial claims,
including its land reclamation projects and the establishment of an Air Defense
Identification Zone over islands claimed and occupied by Japan, are another
source of tension and present risks to diplomatic and trade relations with
certain of China’s regional trade partners.
Investments
in Hong Kong are also subject to certain political risks not associated with
other investments. Following the establishment of the People’s Republic of China
by the Communist Party in 1949, the Chinese government renounced various debt
obligations incurred by China’s predecessor governments, which obligations
remain in default, and expropriated assets without compensation. There can be no
assurance that the Chinese government will not take similar action in the
future. Investments in China and Hong Kong involve risk of a total loss due to
government action or inaction. China has committed by treaty to preserve Hong
Kong’s autonomy and its economic, political and social freedoms for 50 years
from the July 1, 1997 transfer of sovereignty from Great Britain to China.
However, if China would exert its authority so as to alter the economic,
political or legal structures or the existing social policy of Hong Kong,
investor and business confidence in Hong Kong could be negatively affected,
which in turn could negatively affect markets and business performance. In
addition, the Hong Kong dollar trades at a fixed exchange rate in relation to
(or, is “pegged” to) the U.S. dollar, which has contributed to the growth and
stability of the Hong Kong economy. However, it is uncertain how long the
currency peg will continue or what effect the establishment of an alternative
exchange rate system would have on the Hong Kong economy. Because each Fund’s
NAV is denominated in U.S. dollars, the establishment of an alternative exchange
rate system could result in a decline in a Fund’s NAV. These and other factors
could have a negative impact on each Fund’s performance.
Investments
in Variable Interest Entities (“VIEs”).
In seeking exposure to Chinese companies, a Fund may invest in VIE structures.
VIE structures can vary, but generally consist of a U.S.-listed company with
contractual arrangements, through one or more wholly-owned special purpose
vehicles, with a Chinese company that ultimately provides the U.S.-listed
company with contractual rights to exercise control over and obtain economic
benefits from the Chinese company. Although the U.S.-listed company in a VIE
structure has no equity ownership in the underlying Chinese company, the VIE
contractual arrangements permit the VIE structure to consolidate its financial
statements with those of the underlying Chinese company. The VIE structure
enables foreign investors, such as the Funds, to obtain investment exposure
similar to that of an equity owner in a Chinese company in situations in which
the Chinese government has restricted the non-Chinese ownership of such company.
As a result, an investment in a VIE structure subjects a Fund to the risks
associated with the underlying Chinese company. In its efforts to monitor,
regulate and/or control foreign investment and participation in the ownership
and operation of Chinese companies, including in particular those within the
technology, telecommunications and education industries, the Chinese government
may intervene or seek to control the operations, structure, or ownership of
Chinese companies, including VIEs, to the disadvantage of foreign investors,
such as the Funds. Intervention by the Chinese government with respect to a VIE
could significantly and adversely affect the Chinese company’s performance or
the enforceability of the company’s contractual arrangements with the VIE and
thus, the value of a Fund’s investment in the VIE. In addition to the risk of
government intervention, a Fund’s investment in a VIE structure is subject to
the risk that the underlying Chinese company (or its officers, directors, or
Chinese equity owners) may breach the contractual arrangements with the other
entities in the VIE structure, or that Chinese law changes in a way that
affects
the enforceability of these arrangements, or those contracts are otherwise not
enforceable under Chinese law, in which case a Fund may suffer significant
losses on its VIE investments with little or no recourse available.
Investments
in Emerging Markets.
Investments in securities listed and traded in emerging markets are subject to
additional risks that may not be present for U.S. investments or investments in
more developed non-U.S. markets. Such risks may include: (i) greater market
volatility; (ii) lower trading volume; (iii) greater social, political
and economic uncertainty; (iv) governmental controls on foreign investments
and limitations on repatriation of invested capital; (v) the risk that
companies may be held to lower disclosure, corporate governance, auditing and
financial reporting standards than companies in more developed markets;
(vi) the risk that there may be less protection of property rights than in
other countries; and (vii) fewer investor rights and limited legal or practical
remedies available to investors against emerging market companies. Emerging
markets are generally less liquid and less efficient than developed securities
markets.
Investments
in Europe.
Most
developed countries in Western Europe are members of the European Union (“EU”),
and many are also members of the European Monetary Union (EMU), which requires
compliance with restrictions on inflation rates, deficits, and debt levels.
Unemployment in certain European nations is historically high and several
countries face significant debt problems. These conditions can significantly
affect every country in Europe. The euro is the official currency of the EU.
Each Fund, through its investments in Europe, may have significant exposure to
the euro and events affecting the euro. Recent market events affecting several
of the EU member countries have adversely affected the sovereign debt issued by
those countries, and ultimately may lead to a decline in the value of the euro.
A significant decline in the value of the euro may produce unpredictable effects
on trade and commerce generally and could lead to increased volatility in
financial markets worldwide.
The
UK formally exited from the EU on January 31, 2020 (known as “Brexit”), and
effective December 31, 2020, the UK ended a transition period during which it
continued to abide by the EU’s rules and the UK’s trade relationships with the
EU were generally unchanged. During this transition period and beyond, the
impact on the UK and European economies and the broader global economy could be
significant, resulting in negative impacts, such as increased volatility and
illiquidity, potentially lower economic growth on markets in the UK, Europe, and
globally, and changes in legal and regulatory regimes to which certain Fund
assets are or become subject, any of which may adversely affect the value of
Fund investments.
The
effects of Brexit will depend, in part, on agreements the UK negotiates to
retain access to EU markets, including, but not limited to, current trade and
finance agreements. Brexit could lead to legal and tax uncertainty and
potentially divergent national laws and regulations, as the UK determines which
EU laws to replace or replicate. The extent of the impact of the withdrawal
negotiations in the UK and in global markets, as well as any associated adverse
consequences, remain unclear, and the uncertainty may have a significant
negative effect on the value of Fund investments. If one or more other countries
were to exit the EU or abandon the use of the euro as a currency, the value of
investments tied to those countries or the euro could decline significantly and
unpredictably.
Russia’s
large-scale invasion of Ukraine on February 24, 2022 has led to various
countries imposing economic sanctions on certain Russian individuals and Russian
corporate and banking entities. A number of jurisdictions have also instituted
broader sanctions on Russia, including banning Russia from global payments
systems that facilitate cross-border payments. In response, the government of
Russia has imposed capital controls to restrict movements of capital entering
and exiting the country. As a result, the value and liquidity of Russian
securities and the Russian currency have experienced significant declines.
Further, as of January 1, 2023, the Russian securities markets effectively have
been closed for trading by foreign investors since February 28, 2022.
Russia’s
military incursion and resulting sanctions could have a severe adverse effect on
the region’s economies and more globally, including significant negative impacts
on the financial markets for certain securities and commodities and could affect
the value of the Fund’s investments. Eastern European markets are particularly
sensitive to social, political, economic, and currency events in Russia and may
suffer heavy losses as a result of their trading and investment links to the
Russian economy and currency. Changes in regulations on trade, decreasing
imports or exports, changes in the exchange rate of the euro, a significant
influx of refugees, and recessions among European countries may have a
significant adverse effect on the economies of other European countries
including those of Eastern Europe.
Investments
in India.
India is an emerging market and exhibits significantly greater market volatility
from time to time in comparison to more developed markets. Political and legal
uncertainty, greater government control over the economy, currency fluctuations
or blockage and the risk of nationalization or expropriation of assets may
result in higher potential for losses.
Moreover,
governmental actions can have a significant effect on the economic conditions in
India, which could adversely affect the value and liquidity of a Fund’s
investments. The securities markets in India are comparatively underdeveloped,
and stockbrokers and other intermediaries may not perform as well as their
counterparts in the United States and other more developed securities markets.
The limited liquidity of the Indian securities markets may also affect a Fund’s
ability to acquire or dispose of securities at the price and time that it
desires.
Global
factors and foreign actions may inhibit the flow of foreign capital on which
India is dependent to sustain its growth. In addition, the Reserve Bank of India
(“RBI”) has imposed limits on foreign ownership of Indian securities, which may
decrease the liquidity of a Fund’s portfolio and result in extreme volatility in
the prices of Indian securities. These factors, coupled with the lack of
extensive accounting, auditing and financial reporting standards and practices,
as compared to the United States, may increase a Fund’s risk of loss.
Further,
certain Indian regulatory approvals, including approvals from the Securities and
Exchange Board of India, the RBI, the central government and the tax authorities
(to the extent that tax benefits need to be utilized), may be required before a
Fund can make investments in the securities of Indian companies.
Investments
in Japan.
Economic growth in Japan is heavily dependent on international trade, government
support, and consistent government policy. Slowdowns in the economies of key
trading partners such as the United States, China, and countries in Southeast
Asia could have a negative impact on the Japanese economy as a whole. The
Japanese economy has in the past been negatively affected by, among other
factors, government intervention and protectionism and an unstable financial
services sector. While the Japanese economy has recently emerged from a
prolonged economic downturn, some of these factors, as well as other adverse
political developments, increases in government debt, changes to fiscal,
monetary or trade policies, or other events, such as natural disasters, could
have a negative impact on Japanese securities. Japan also has few natural
resources, and any fluctuation or shortage in the commodity markets could have a
negative impact on Japanese securities.
Investments
in Mexico. Investment
exposure to Mexican issuers involves risks that are specific to Mexico,
including regulatory, political, and economic risks. The Mexican economy, among
other things, is dependent upon external trade with other economies,
specifically with the United States. As a result, Mexico is dependent on, among
other things, the U.S. economy and any change in the price or demand for Mexican
exports may have an adverse impact on the Mexican economy. Recently, Mexico has
experienced an outbreak of violence related to drug trafficking. Incidents
involving Mexico’s security may have an adverse effect on the Mexican economy
and cause uncertainty in its financial markets. In the past, Mexico has
experienced high interest rates, economic volatility and high unemployment
rates.
Mexico
has been destabilized by local insurrections, social upheavals, drug related
violence, and the public health crisis related to the H1N1 influenza outbreak.
Recurrence of these or similar conditions may adversely impact the Mexican
economy. Recently, Mexican elections have been contentious and have been very
closely decided. Changes in political parties or other Mexican political events
may affect the economy and cause instability.
Investments
in Russia and other Eastern European Countries. Many
formerly communist, eastern European countries have experienced significant
political and economic reform over the past decade. However, the democratization
process is still relatively new in a number of the smaller states and political
turmoil and popular uprisings remain threats. Investments in these countries are
particularly subject to political, economic, legal, market and currency risks.
The risks include uncertain political and economic policies and the risk of
nationalization or expropriation of assets, short-term market volatility, poor
accounting standards, corruption and crime, an inadequate regulatory system,
unpredictable taxation, the imposition of capital controls and/or foreign
investment limitations by a country and the imposition of sanctions on an
Eastern European country by other countries, such as the United States. Adverse
currency exchange rates are a risk, and there may be a lack of available
currency hedging instruments.
These
securities markets, as compared to U.S. markets, have significant price
volatility, less liquidity, a smaller market capitalization and a smaller number
of exchange-traded securities. A limited volume of trading may result in
difficulty in obtaining accurate prices and trading. There is little publicly
available information about issuers. Settlement, clearing, and registration of
securities transactions are subject to risks because of insufficient
registration systems that may not be subject to effective government
supervision. This may result in significant delays or problems in registering
the transfer of shares. It is possible that a Fund's ownership rights could be
lost through fraud or negligence. While applicable regulations may impose
liability on registrars for losses resulting from their errors, it may be
difficult for a Fund to enforce any rights it may have against the registrar or
issuer of the securities in the event of loss of share registration.
Political
risk in Russia remains high, and steps that Russia may take to assert its
geopolitical influence may increase the tensions in the region and affect
economic growth. Russia’s economy is heavily dependent on exportation of natural
resources, which may be particularly vulnerable to economic sanctions by other
countries during times of political tension or crisis.
In
response to recent political and military actions undertaken by Russia, the
United States and certain other countries, as well as the European Union, have
instituted economic sanctions against certain Russian individuals and companies.
The political and economic situation in Russia, and the current and any future
sanctions or other government actions against Russia, may result in the decline
in the value and liquidity of Russian securities, devaluation of Russian
currency, a downgrade in Russia’s credit rating, the inability to freely trade
sanctioned companies (either due to the sanctions imposed or related operational
issues) and/or other adverse consequences to the Russian economy, any of which
could negatively impact a Fund’s investments in Russian securities. Sanctions
could result in the immediate freeze of Russian securities, impairing the
ability of a Fund to buy, sell, receive, or deliver
those
securities. Both the current and potential future sanctions or other government
actions against Russia also could result in Russia taking counter measures or
retaliatory actions, which may impair further the value or liquidity of Russian
securities and negatively impact a Fund. Any or all of these potential results
could lead Russia’s economy into a recession. See above, “General Risks – Recent
Events”.
Investments
in South Korea.
Investments in South Korean issuers involve risks that are specific to South
Korea, including legal, regulatory, political, currency, security and economic
risks. Substantial political tensions exist between North Korea and South Korea
and recently these political tensions have escalated. The outbreak of
hostilities between the two nations, or even the threat of an outbreak of
hostilities, will likely adversely impact the South Korean economy. In addition,
South Korea’s economic growth potential has recently been on a decline, mainly
because of a rapidly aging population and structural problems.
Investments
in Taiwan.
Investments in Taiwanese issuers may subject a Fund to legal, regulatory,
political, currency and economic risks that are specific to Taiwan.
Specifically, Taiwan’s geographic proximity and history of political contention
with China have resulted in ongoing tensions between the two countries. These
tensions may materially affect the Taiwanese economy and its securities market.
Taiwan’s economy is export-oriented, so it depends on an open world trade regime
and remains vulnerable to fluctuations in the world economy. The Taiwanese
economy is dependent on the economies of Asia, mainly those of Japan and China,
and the United States. Reduction in spending by any of these countries on
Taiwanese products and services or negative changes in any of these economies
may cause an adverse impact on the Taiwanese economy.
Investments
in Turkey. There
are legal, regulatory, political, currency, security and economic risks specific
to Turkey. Among other things, the Turkish economy is heavily dependent on
relationships with certain key trading partners, including European Union
countries, China and Russia, and changes in the price or demand for Turkish
exports may have an adverse impact on the Turkish economy. The Turkish economy
has certain other significant economic weaknesses, such as its relatively high
current account deficit, which may contribute to prolonged periods of recession
or lower Turkey’s sovereign debt rating. Turkey has historically experienced
acts of terrorism and strained relations related to border disputes and other
geopolitical events with certain neighboring countries. Turkey may be subject to
considerable social and political instability, in part due to the influence
asserted by its military over the national government. Unanticipated or sudden
political or social developments may cause uncertainty in the Turkish stock or
currency market and, as a result, adversely affect a Fund’s investments. In
addition, the earthquakes that struck southeastern Turkey in February 2023 could
adversely affect the economy or the business operations of the companies located
there, causing an adverse impact on a Fund’s investments in, or which are
exposed to, Turkey. These massive earthquakes caused major damage to Turkey’s
infrastructure and energy supply. In the wake of this natural disaster, the
country’s financial markets fluctuated dramatically, resulting in a week-long
closure of Turkey’s national exchange. The full extent of the disaster’s impact
on Turkey’s economy and foreign investment in the country is difficult to
estimate. The risks of natural disasters of varying degrees, such as earthquakes
and tsunamis, and the resulting damage, continue to exist. These and other
factors could have a negative impact on a Fund’s performance.
Investments
in the United Kingdom.
The United Kingdom’s economy relies heavily on the export of both goods and
services to EU member countries, and to a lesser extent the United States and
China. The United Kingdom has one of the largest economies in Europe and is
heavily dependent on trade with EU member countries. Trade between the United
Kingdom and the EU is highly integrated through supply chains and trade in
services, as well as through multinational companies. As a result, the economy
of the United Kingdom may be impacted by changes to the economic health of EU
member countries, the United States and China. In 2016, the United Kingdom voted
via referendum to leave the EU. After years of negotiations between the United
Kingdom and the EU, a withdrawal agreement was reached whereby the United
Kingdom formally left the EU. The precise impact on the United Kingdom’s economy
as a result of its departure from the EU depends to a large degree on its
ability to conclude favorable trade deals with the EU and other countries,
including the United States, China, India and Japan. While new trade deals may
boost economic growth, such growth may not be able to offset the increased costs
of trade with the EU resulting from the United Kingdom’s loss of its membership
in the EU single market. Certain sectors within the United Kingdom’s economy may
be particularly affected by Brexit, including the automotive, chemicals,
financial services and professional services. A particularly contentious element
of the United Kingdom’s negotiated withdrawal from the EU was the treatment of
Northern Ireland (which is part of the United Kingdom) following the United
Kingdom’s departure. Under the terms of the withdrawal agreement, Northern
Ireland would maintain regulatory alignment with the EU (essentially creating a
customs border in the Irish Sea) to maintain an open border with the Republic of
Ireland (an EU member state) while safeguarding the rules of the EU single
market. The ultimate effects of this arrangement on Northern Ireland’s economy
remain to be seen.
Other
Short-Term Instruments
The
Funds may invest in short-term instruments, including money market instruments,
on an ongoing basis to provide liquidity or for other reasons. Money market
instruments are generally short-term investments that may include but are not
limited to: (i) shares of money market funds; (ii) obligations issued
or guaranteed by the U.S. government, its agencies or instrumentalities
(including government-sponsored enterprises); (iii) negotiable certificates
of deposit (“CDs”), bankers’ acceptances, fixed time deposits and other
obligations of U.S. and foreign banks (including foreign branches) and similar
institutions; (iv) commercial paper rated at the date of
purchase
“Prime-1” by Moody’s or “A‑1” by S&P or, if unrated, of comparable quality
as determined by the Sub-Adviser; (v) non-convertible corporate debt
securities (e.g.,
bonds and debentures) with remaining maturities at the date of purchase of not
more than 397 days and that satisfy the rating requirements set forth in Rule
2a-7 under the 1940 Act; and (vi) short-term U.S. dollar-denominated
obligations of foreign banks (including U.S. branches) that, in the opinion of
the Sub-Adviser, are of comparable quality to obligations of U.S. banks which
may be purchased by a Fund. Any of these instruments may be purchased on a
current or a forward-settled basis. Money market instruments also include shares
of money market funds. Time deposits are non-negotiable deposits maintained in
banking institutions for specified periods of time at stated interest rates.
Bankers’ acceptances are time drafts drawn on commercial banks by borrowers,
usually in connection with international transactions.
Real
Estate Investment Trusts (“REITs”)
A
REIT is a corporation or business trust (that would otherwise be taxed as a
corporation) which meets the definitional requirements of the Code. The Code
permits a qualifying REIT to deduct from taxable income the dividends paid,
thereby effectively eliminating corporate level federal income tax. To meet the
definitional requirements of the Code, a REIT must, among other things: invest
substantially all of its assets in interests in real estate (including mortgages
and other REITs), cash and government securities; derive most of its income from
rents from real property or interest on loans secured by mortgages on real
property; and, in general, distribute annually 90% or more of its taxable income
(other than net capital gains) to shareholders.
REITs
are sometimes informally characterized as Equity REITs and Mortgage REITs. An
Equity REIT invests primarily in the fee ownership or leasehold ownership of
land and buildings (e.g.,
commercial equity REITs and residential equity REITs); a Mortgage REIT invests
primarily in mortgages on real property, which may secure construction,
development or long-term loans.
REITs
may be affected by changes in underlying real estate values, which may have an
exaggerated effect to the extent that REITs in which a Fund invests may
concentrate investments in particular geographic regions or property types.
Additionally, rising interest rates may cause investors in REITs to demand a
higher annual yield from future distributions, which may in turn decrease market
prices for equity securities issued by REITs. Rising interest rates also
generally increase the costs of obtaining financing, which could cause the value
of a Fund’s investments to decline. During periods of declining interest rates,
certain Mortgage REITs may hold mortgages that the mortgagors elect to prepay,
which prepayment may diminish the yield on securities issued by such Mortgage
REITs. In addition, Mortgage REITs may be affected by the ability of borrowers
to repay when due the debt extended by the REIT and Equity REITs may be affected
by the ability of tenants to pay rent.
Certain
REITs have relatively small market capitalization, which may tend to increase
the volatility of the market price of securities issued by such REITs.
Furthermore, REITs are dependent upon specialized management skills, have
limited diversification and are, therefore, subject to risks inherent in
operating and financing a limited number of projects. By investing in REITs
indirectly through a Fund, a shareholder will bear not only his or her
proportionate share of the expenses of a Fund, but also, indirectly, similar
expenses of the REITs. REITs depend generally on their ability to generate cash
flow to make distributions to shareholders.
In
addition to these risks, Equity REITs may be affected by changes in the value of
the underlying property owned by the trusts, while Mortgage REITs may be
affected by the quality of any credit extended. Further, Equity and Mortgage
REITs are dependent upon management skills and generally may not be diversified.
Equity and Mortgage REITs are also subject to heavy cash flow dependency
defaults by borrowers and self-liquidation. In addition, Equity and Mortgage
REITs could possibly fail to qualify for the favorable U.S. federal income tax
treatment generally available to REITs under the Code or fail to maintain their
exemptions from registration under the 1940 Act. The above factors may also
adversely affect a borrower’s or a lessee’s ability to meet its obligations to
the REIT. In the event of default by a borrower or lessee, the REIT may
experience delays in enforcing its rights as a mortgagee or lessor and may incur
substantial costs associated with protecting its investments.
Repurchase
Agreements
Each
Fund may invest in repurchase agreements to generate income from its excess cash
balances and to invest securities lending cash collateral. A repurchase
agreement is an agreement under which a Fund acquires a financial instrument
(e.g.,
a security issued by the U.S. government or an agency thereof, a banker’s
acceptance or a certificate of deposit) from a seller, subject to resale to the
seller at an agreed upon price and date (normally, the next Business Day). A
repurchase agreement may be considered a loan collateralized by securities. The
resale price reflects an agreed upon interest rate effective for the period the
instrument is held by the applicable Fund and is unrelated to the interest rate
on the underlying instrument.
In
these repurchase agreement transactions, the securities acquired by a Fund
(including accrued interest earned thereon) must have a total value in excess of
the value of the repurchase agreement and are held by the Custodian until
repurchased. No more than an aggregate of 15% of a Fund’s net assets will be
invested in illiquid investments, including repurchase agreements having
maturities longer than seven days and securities subject to legal or contractual
restrictions on resale, or for which there are no readily available market
quotations.
The
use of repurchase agreements involves certain risks. For example, if the other
party to the agreement defaults on its obligation to repurchase the underlying
security at a time when the value of the security has declined, a Fund may incur
a loss upon disposition of
the
security. If the other party to the agreement becomes insolvent and subject to
liquidation or reorganization under the U.S. Bankruptcy Code or other laws, a
court may determine that the underlying security is collateral for a loan by a
Fund not within the control of the Fund and, therefore, the Fund may not be able
to substantiate its interest in the underlying security and may be deemed an
unsecured creditor of the other party to the agreement.
Securities
Lending
Each
Fund may lend portfolio securities in an amount up to one-third of its total
assets to brokers, dealers and other financial institutions. In a portfolio
securities lending transaction, a Fund receives from the borrower an amount
equal to the interest paid or the dividends declared on the loaned securities
during the term of the loan as well as the interest on the collateral
securities, less any fees (such as finders or administrative fees) the Fund pays
in arranging the loan. A Fund may share the interest it receives on the
collateral securities with the borrower. The terms of each Fund’s loans permit
each Fund to reacquire loaned securities on five business days’ notice or in
time to vote on any important matter. Loans are subject to termination at the
option of the applicable Fund or borrower at any time, and the borrowed
securities must be returned when the loan is terminated. The Funds may pay fees
to arrange for securities loans.
The
SEC currently requires that the following conditions must be met whenever a
Fund’s portfolio securities are loaned: (1) the Fund must receive at least 100%
cash collateral from the borrower; (2) the borrower must increase such
collateral whenever the market value of the securities rises above the level of
such collateral; (3) the Fund must be able to terminate the loan at any time;
(4) the Fund must receive reasonable interest on the loan, as well as any
dividends, interest or other distributions on the loaned securities, and any
increase in market value; (5) the Fund may pay only reasonable custodian fees
approved by the Board in connection with the loan; (6) while voting rights
on the loaned securities may pass to the borrower, the Board must terminate the
loan and regain the right to vote the securities if a material event adversely
affecting the investment occurs; and (7) the Fund may not loan its portfolio
securities so that the value of the loaned securities is more than one-third of
its total asset value, including collateral received from such loans. These
conditions may be subject to future modification. Such loans will be terminable
at any time upon specified notice. A Fund might experience the risk of loss if
the institution with which it has engaged in a portfolio loan transaction
breaches its agreement with the Fund. In addition, the Funds will not enter into
any portfolio security lending arrangement having a duration of longer than one
year. The principal risk of portfolio lending is potential default or insolvency
of the borrower. In either of these cases, a Fund could experience delays in
recovering securities or collateral or could lose all or part of the value of
the loaned securities. As part of participating in a lending program, the
applicable Fund may be required to invest in collateralized debt or other
securities that bear the risk of loss of principal. In addition, all investments
made with the collateral received are subject to the risks associated with such
investments. If such investments lose value, a Fund will have to cover the loss
when repaying the collateral.
Any
loans of portfolio securities are fully collateralized based on values that are
marked-to-market daily. Any securities that a Fund may receive as collateral
will not become part of the Fund’s investment portfolio at the time of the loan
and, in the event of a default by the borrower, the Fund will, if permitted by
law, dispose of such collateral except for such part thereof that is a security
in which the Fund is permitted to invest. During the time securities are on
loan, the borrower will pay a Fund any accrued income on those securities, and
the Fund may invest the cash collateral and earn income or receive an
agreed-upon fee from a borrower that has delivered cash-equivalent collateral.
Undertakings
for Collective Investment in Transferable Securities Funds (All
Funds other than the AAM Transformers ETF)
The
Funds may invest in funds that are Undertakings for Collective Investment in
Transferable Securities (“UCITS funds”). UCITS funds are open-ended pooled or
collective investment undertakings established in accordance with the UCITS
Directive adopted by EU member states. Similar to open-end investment companies,
the underlying investments of a UCITS fund must be liquid enough to fulfill
redemptions at the request of holders, either directly or indirectly out of the
underlying investments. The assets themselves are entrusted to an independent
custodian or depositary for safekeeping and must be held on a segregated basis.
To the extent the Fund holds interests in a UCITS fund, it is expected that the
Fund will bear two layers of asset-based management fees and expenses (directly
at the Fund level and indirectly at the UCITS fund level), and the Fund may bear
a single layer of incentive fees (at the UCITS fund level). UCITS funds that are
listed on a securities exchange are also subject to the risks associated with
ETFs described above and in the Prospectus.
U.S.
Government Securities
Each
Fund may invest in U.S. government securities. Securities issued or guaranteed
by the U.S. government or its agencies or instrumentalities include U.S.
Treasury securities, which are backed by the full faith and credit of the U.S.
Treasury and which differ only in their interest rates, maturities, and times of
issuance. U.S. Treasury bills have initial maturities of one-year or less; U.S.
Treasury notes have initial maturities of one to ten years; and U.S. Treasury
bonds generally have initial maturities of greater than ten years. Certain U.S.
government securities are issued or guaranteed by agencies or instrumentalities
of the U.S. government including, but not limited to, obligations of U.S.
government agencies or instrumentalities such as the Federal National Mortgage
Association (“Fannie Mae”), the Government National Mortgage Association
(“Ginnie Mae”), the Small Business Administration, the Federal Farm Credit
Administration, the Federal Home Loan Banks, Banks for Cooperatives (including
the Central Bank for Cooperatives),
the
Federal Land Banks, the Federal Intermediate Credit Banks, the Tennessee Valley
Authority, the Export-Import Bank of the United States, the Commodity Credit
Corporation, the Federal Financing Bank, the Student Loan Marketing Association,
the National Credit Union Administration and the Federal Agricultural Mortgage
Corporation (“Farmer Mac”).
Some
obligations issued or guaranteed by U.S. government agencies and
instrumentalities, including, for example, Ginnie Mae pass-through certificates,
are supported by the full faith and credit of the U.S. Treasury. Other
obligations issued by or guaranteed by federal agencies, such as those
securities issued by Fannie Mae, are supported by the discretionary authority of
the U.S. government to purchase certain obligations of the federal agency, while
other obligations issued by or guaranteed by federal agencies, such as those of
the Federal Home Loan Banks, are supported by the right of the issuer to borrow
from the U.S. Treasury, while the U.S. government provides financial support to
such U.S. government-sponsored federal agencies, no assurance can be given that
the U.S. government will always do so, since the U.S. government is not so
obligated by law. U.S. Treasury notes and bonds typically pay coupon interest
semi-annually and repay the principal at maturity.
On
September 7, 2008, the U.S. Treasury announced a federal takeover of Fannie Mae
and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), placing the two
federal instrumentalities in conservatorship. Under the takeover, the U.S.
Treasury agreed to acquire $1 billion of senior preferred stock of each
instrumentality and obtained warrants for the purchase of common stock of each
instrumentality (the “Senior Preferred Stock Purchase Agreement” or
“Agreement”). Under the Agreement, the U.S. Treasury pledged to provide up to
$200 billion per instrumentality as needed, including the contribution of cash
capital to the instrumentalities in the event their liabilities exceed their
assets. This was intended to ensure that the instrumentalities maintain a
positive net worth and meet their financial obligations, preventing mandatory
triggering of receivership. On December 24, 2009, the U.S. Treasury
announced that it was amending the Agreement to allow the $200 billion cap on
the U.S. Treasury’s funding commitment to increase as necessary to accommodate
any cumulative reduction in net worth over the next three years. As a result of
this Agreement, the investments of holders, including the Funds, of
mortgage-backed securities and other obligations issued by Fannie Mae and
Freddie Mac are protected.
The
total public debt of the United States as a percentage of gross domestic product
has grown rapidly since the beginning of the 2008–2009 financial downturn.
Although high debt levels do not necessarily indicate or cause economic
problems, they may create certain systemic risks if sound debt management
practices are not implemented. A high national debt can raise concerns that the
U.S. government will not be able to make principal or interest payments when
they are due. This increase has also necessitated the need for the U.S. Congress
to negotiate adjustments to the statutory debt limit to increase the cap on the
amount the U.S. government is permitted to borrow to meet its existing
obligations and finance current budget deficits. In August 2023, Fitch lowered
its long-term sovereign credit rating on the U.S. In explaining the downgrade,
Fitch cited, among other reasons, expected fiscal deterioration of the U.S.
government and extended and contentious negotiations related to raising the
government's debt ceiling. An increase in national debt levels may also
necessitate the need for the U.S. Congress to negotiate adjustments to the
statutory debt ceiling to increase the cap on the amount the U.S. Government is
permitted to borrow to meet its existing obligations and finance current budget
deficits. Future downgrades could increase volatility in domestic and foreign
financial markets, result in higher interest rates, lower prices of U.S.
Treasury securities and increase the costs of different kinds of debt. Any
controversy or ongoing uncertainty regarding the statutory debt ceiling
negotiations may impact the U.S. long-term sovereign credit rating and may cause
market uncertainty. As a result, market prices and yields of securities
supported by the full faith and credit of the U.S. government may be adversely
affected.
INVESTMENT
RESTRICTIONS
The
Trust has adopted the following investment restrictions as fundamental policies
with respect to the Funds. These restrictions cannot be changed with respect to
a Fund without the approval of the holders of a majority of the Fund’s
outstanding voting securities. For the purposes of the 1940 Act, a “majority of
outstanding shares” means the vote of the lesser of: (1) 67% or more of the
voting securities of a Fund present at the meeting if the holders of more than
50% of the Fund’s outstanding voting securities are present or represented by
proxy; or (2) more than 50% of the outstanding voting securities of a
Fund.
Except
with the approval of a majority of the outstanding voting securities, each of
the AAM S&P 500 High Dividend Value ETF, the AAM S&P Emerging Markets
High Dividend Value ETF, and AAM S&P 500 Developed Markets High Dividend
Value ETF may not:
1.Concentrate
its investments (i.e.,
hold more than 25% of its total assets) in any industry or group of related
industries, except that each Fund will concentrate to approximately the same
extent that the Index concentrates in the securities of such particular industry
or group of related industries. For purposes of this limitation, securities of
the U.S. government (including its agencies and instrumentalities), repurchase
agreements collateralized by U.S. government securities, and tax-exempt
securities of state or municipal governments and their political subdivisions
are not considered to be issued by members of any industry.
2.Borrow
money or issue senior securities (as defined under the 1940 Act), except to the
extent permitted under the 1940 Act.
3.Make
loans, except to the extent permitted under the 1940 Act.
4.Purchase
or sell real estate unless acquired as a result of ownership of securities or
other instruments, except to the extent permitted under the 1940 Act. This shall
not prevent a Fund from investing in securities or other instruments backed by
real estate, real estate investment trusts or securities of companies engaged in
the real estate business.
5.Purchase
or sell physical commodities unless acquired as a result of ownership of
securities or other instruments, except to the extent permitted under the 1940
Act. This shall not prevent a Fund from purchasing or selling options and
futures contracts or from investing in securities or other instruments backed by
physical commodities.
6.Underwrite
securities issued by other persons, except to the extent permitted under the
1940 Act.
7.With
respect to 75% of its total assets, purchase the securities of any one issuer
if, immediately after and as a result of such purchase, (a) the value of the
Fund’s holdings in the securities of such issuer exceeds 5% of the value of the
Fund’s total assets, or (b) the Fund owns more than 10% of the outstanding
voting securities of the issuer (with the exception that this restriction does
not apply to the Fund’s investments in the securities of the U.S. government, or
its agencies or instrumentalities, or other investment companies).
Except
with the approval of a majority of the outstanding voting securities, the AAM
Low Duration Preferred and Income Securities ETF may not:
1.Concentrate
its investments in an industry or group of industries (i.e., hold 25% or more of
its total assets in the stocks of a particular industry or group of industries),
except that the Fund will concentrate to approximately the same extent that its
underlying Index concentrates in the stocks of such particular industry or group
of industries. For purposes of this limitation, securities of the U.S.
government (including its agencies and instrumentalities), repurchase agreements
collateralized by U.S. government securities, and tax-exempt securities of state
or municipal governments and their political subdivisions are not considered to
be issued by members of any industry.
2.Borrow
money or issue senior securities (as defined under the 1940 Act), except to the
extent permitted under the 1940 Act, the rules and regulations thereunder or any
exemption therefrom, as such statute, rules or regulations may be amended or
interpreted from time to time.
3.Make
loans, except to the extent permitted under the 1940 Act, the rules and
regulations thereunder or any exemption therefrom, as such statute, rules or
regulations may be amended or interpreted from time to time.
4.Purchase
or sell commodities or real estate, except to the extent permitted under the
1940 Act, the rules and regulations thereunder or any exemption therefrom, as
such statute, rules or regulations may be amended or interpreted from time to
time.
5.Underwrite
securities issued by other persons, except to the extent permitted under the
1940 Act, the rules and regulations thereunder or any exemption therefrom, as
such statute, rules or regulations may be amended or interpreted from time to
time.
6.Purchase
securities of an issuer if such purchase is inconsistent with the maintenance of
its status as an open-end diversified company under the 1940 Act, the rules or
regulations thereunder or any exemption therefrom, as such statute, rules or
regulations may be amended or interpreted from time to time.
7.With
respect to 75% of its total assets, purchase the securities of any one issuer
if, immediately after and as a result of such purchase, (a) the value of the
Fund’s holdings in the securities of such issuer exceeds 5% of the value of the
Fund’s total assets, or (b) the Fund owns more than 10% of the outstanding
voting securities of the issuer (with the exception that this restriction does
not apply to the Fund’s investments in the securities of the U.S. government, or
its agencies or instrumentalities, or other investment companies).
Except
with the approval of a majority of the outstanding voting securities, the AAM
Transformers ETF may not:
1.Concentrate
its investments (i.e.,
hold more than 25% of its total assets) in any industry or group of related
industries, except that the Fund will concentrate to approximately the same
extent that its underlying Index concentrates in the securities of such
particular industry or group of related industries. For purposes of this
limitation, securities of the U.S. government (including its agencies and
instrumentalities), repurchase agreements collateralized by U.S. government
securities, registered investment companies, and tax-exempt securities of state
or municipal governments and their political subdivisions are not considered to
be issued by members of any industry.
2.Borrow
money or issue senior securities (as defined under the 1940 Act), except to the
extent permitted under the 1940 Act, the rules and regulations thereunder or any
exemption therefrom, as such statute, rules or regulations may be amended or
interpreted from time to time.
3.Make
loans, except to the extent permitted under the 1940 Act, the rules and
regulations thereunder or any exemption therefrom, as such statute, rules or
regulations may be amended or interpreted from time to time.
4.Purchase
or sell real estate unless acquired as a result of ownership of securities or
other instruments, except to the extent permitted under the 1940 Act. This shall
not prevent the Fund from investing in securities or other instruments backed by
real estate, real estate investment trusts or securities of companies engaged in
the real estate business.
5.Purchase
or sell physical commodities unless acquired as a result of ownership of
securities or other instruments, except to the extent permitted under the 1940
Act. This shall not prevent the Fund from purchasing or selling options and
futures contracts or from investing in securities or other instruments backed by
physical commodities.
6.Underwrite
securities issued by other persons, except to the extent permitted under the
1940 Act, the rules and regulations thereunder or any exemption therefrom, as
such statute, rules or regulations may be amended or interpreted from time to
time.
7.With
respect to 75% of its total assets, purchase the securities of any one issuer
if, immediately after and as a result of such purchase, (a) the value of the
Fund’s holdings in the securities of such issuer exceeds 5% of the value of the
Fund’s total assets, or (b) the Fund owns more than 10% of the outstanding
voting securities of the issuer (with the exception that this restriction does
not apply to the Fund’s investments in the securities of the U.S. government, or
its agencies or instrumentalities, or other investment companies).
In
addition to the investment restrictions adopted as fundamental policies as set
forth above, each Fund (unless otherwise indicated) observes the following
non-fundamental restrictions, which may be changed without a shareholder
vote.
1.Under
normal circumstances, at least 80% of the net assets, plus borrowings for
investment purposes, of the AAM S&P 500 High Dividend Value ETF will be
invested in equity securities that (i) are included in the S&P 500 Index and
(ii) have had a positive indicated annual dividend yield within the past
year.
2.Under
normal circumstances, at least 80% of the net assets, plus borrowings for
investment purposes, of the AAM S&P Emerging Markets High Dividend Value ETF
will be invested in equity securities that (i) are tied economically to the
Emerging Markets (as defined in the Prospectus) and (ii) have had a positive
realized annual dividend yield within the past year.
3.Under
normal circumstances, at least 80% of the net assets, plus borrowings for
investment purposes, of the AAM S&P Developed Markets High Dividend Value
ETF will be invested in equity securities that (i) are traded principally on an
exchange in a Developed ex-U.S. & Korea Markets country (as defined in the
Prospectus) and (ii) have had a positive realized annual dividend yield within
the past year.
4.Under
normal circumstances, at least 80% of the net assets, plus borrowings for
investment purposes, of the AAM Low Duration Preferred and Income Securities ETF
will be invested in preferred and income securities (as defined in the
Prospectus).
In
determining its compliance with the fundamental investment restriction on
concentration, a Fund will consider the investments of other investment
companies in which such Fund invests to the extent it has sufficient information
about such investment companies. With respect to a Fund’s investments in
affiliated investment companies, the Fund will consider its entire investment in
any investment company with a policy to concentrate, or having otherwise
disclosed that it is concentrated, in a particular industry or group of related
industries as being invested in such industry or group of related
industries.
If
a percentage limitation is adhered to at the time of investment or contract, a
later increase or decrease in percentage resulting from any change in value or
total or net assets will not result in a violation of such restriction, except
that the percentage limitation with respect to the borrowing of money will be
observed continuously.
The
following descriptions of certain provisions of the 1940 Act may assist
investors in understanding the above policies and restrictions:
Concentration.
The
SEC has defined concentration as investing more than 25% of a Fund’s total
assets in an industry or group of industries, with certain
exceptions.
Borrowing.
The 1940 Act presently allows a Fund to borrow from a bank (including pledging,
mortgaging or hypothecating assets) in an amount up to 33 1/3% of its total
assets (not including temporary borrowings up to 5% of its total
assets).
Senior
Securities.
Senior securities may include any obligation or instrument issued by a Fund
evidencing indebtedness. The 1940 Act generally prohibits a fund from issuing
senior securities.
An
exemptive rule under the 1940 Act, however, permits a fund to enter into
transactions that might otherwise be deemed to be senior securities, such as
derivative transactions, reverse repurchase agreements and similar financing
transactions, and short sales, subject to certain conditions.
Lending.
Under the 1940 Act, a Fund may only make loans if expressly permitted by its
investment policies. The Funds’ current investment policy on lending is that a
Fund may not make loans if, as a result, more than 33 1/3% of its total assets
would be lent to other parties, except that a Fund may: (i) purchase or hold
debt instruments in accordance with its investment objective and policies; (ii)
enter into repurchase agreements; and (iii) engage in securities lending as
described in this SAI.
Real
Estate and Commodities.
The 1940 Act does not directly restrict a Fund’s ability to invest in real
estate or commodities, but the 1940 Act requires every investment company to
have a fundamental investment policy governing such investments.
Underwriting.
Under the 1940 Act, underwriting securities involves the Funds purchasing
securities directly from an issuer for the purpose of selling (distributing)
them or participating in any such activity either directly or
indirectly.
EXCHANGE
LISTING
AND
TRADING
Shares
are listed for trading and trade throughout the day on the Exchange.
There
can be no assurance that a Fund will continue to meet the requirements of the
Exchange necessary to maintain the listing of Shares. The Exchange will consider
the suspension of trading in, and will initiate delisting proceedings of, the
Shares if any of the requirements set forth in the Exchange rules, including
compliance with Rule 6c-11(c) under the 1940 Act, are not continuously
maintained or such other event shall occur or condition shall exist that,
in the opinion of the Exchange, makes further dealings on the Exchange
inadvisable. The Exchange will remove the Shares of a Fund from listing and
trading upon termination of such Fund.
The
Trust reserves the right to adjust the price levels of Shares in the future to
help maintain convenient trading ranges for investors. Any adjustments would be
accomplished through stock splits or reverse stock splits, which would have no
effect on the net assets of the applicable Fund.
MANAGEMENT
OF THE
TRUST
Board
Responsibilities.
The management and affairs of the Trust and its series are overseen by the
Board, which elects the officers of the Trust who are responsible for
administering the day-to-day operations of the Trust and the Funds. The Board
has approved contracts, as described below, under which certain companies
provide essential services to the Trust.
The
day-to-day business of the Trust, including the management of risk, is performed
by third-party service providers, such as the Adviser, the Sub-Adviser, the
Distributor, and the Administrator. The Board is responsible for overseeing the
Trust’s service providers and, thus, has oversight responsibility with respect
to risk management performed by those service providers. Risk management seeks
to identify and address risks, i.e.,
events or circumstances that could have material adverse effects on the
business, operations, shareholder services, investment performance or reputation
of a Fund. The Funds and their service providers employ a variety of processes,
procedures and controls to identify such events or circumstances, to lessen the
probability of their occurrence and/or to mitigate the effects of such events or
circumstances if they do occur. Each service provider is responsible for one or
more discrete aspects of the Trust’s business (e.g.,
the Sub-Adviser is responsible for the day-to-day management of each Fund’s
portfolio investments) and, consequently, for managing the risks associated with
that business. The Board has emphasized to the Funds’ service providers the
importance of maintaining vigorous risk management.
The
Board’s role in risk oversight begins before the inception of the Funds, at
which time certain of the Funds’ service providers present the Board with
information concerning the investment objectives, strategies, and risks of the
Funds as well as proposed investment limitations for the Funds. Additionally,
the Adviser and Sub-Adviser provide the Board with an overview of, among other
things, its investment philosophy, brokerage practices, and compliance
infrastructure. Thereafter, the Board continues its oversight function as
various personnel, including the Trust’s Chief Compliance Officer, as well as
personnel of the Sub-Adviser, and other service providers such as the Funds’
independent registered public accounting firm, make periodic reports to the
Audit Committee or to the Board with respect to various aspects of risk
management. The Board and the Audit Committee oversee efforts by management and
service providers to manage risks to which the Funds may be exposed.
The
Board is responsible for overseeing the nature, extent, and quality of the
services provided to the Funds by the Adviser and the Sub-Adviser and receives
information about those services at its regular meetings. In addition, on an
annual basis (following the initial two-year period), in connection with its
consideration of whether to renew the Investment Advisory Agreement with the
Adviser, and Sub-Advisory Agreement with the Sub-Adviser, the Board or its
designee may meet with the Adviser and/or Sub-Adviser to review such services.
Among other things, the Board regularly considers the Adviser’s and
Sub-Adviser’s adherence to each Fund’s investment restrictions and compliance
with various Fund policies and procedures and with applicable securities
regulations. The Board also reviews information about each Fund’s performance
and each Fund’s investments, including, for example, portfolio holdings
schedules.
The
Trust’s Chief Compliance Officer reports regularly to the Board to review and
discuss compliance issues and Fund and Adviser or Sub-Adviser risk assessments.
At least annually, the Trust’s Chief Compliance Officer, as well as personnel of
the Adviser, provides the Board with a report reviewing the adequacy and
effectiveness of the Trust’s policies and procedures and those of its service
providers, including the Adviser and the Sub-Adviser. The report addresses the
operation of the policies and procedures of the Trust and each service provider
since the date of the last report; any material changes to the policies and
procedures since the date of the last report; any recommendations for material
changes to the policies and procedures; and any material compliance matters
since the date of the last report.
The
Board receives reports from the Funds’ service providers regarding operational
risks and risks related to the valuation and liquidity of portfolio securities.
Annually, the Funds’ independent registered public accounting firm reviews with
the Audit Committee its audit of the Funds’ financial statements, focusing on
major areas of risk encountered by the Funds and noting any significant
deficiencies or material weaknesses in the Funds’ internal controls.
Additionally, in connection with its oversight function, the Board oversees Fund
management’s implementation of disclosure controls and procedures, which are
designed to ensure that information required to be disclosed by the Trust in its
periodic reports with the SEC are recorded, processed, summarized, and reported
within the required time periods. The Board also oversees the Trust’s internal
controls over financial reporting, which comprise policies and procedures
designed to provide reasonable assurance regarding the reliability of the
Trust’s financial reporting and the preparation of the Trust’s financial
statements.
From
their review of these reports and discussions with the Adviser and Sub-Adviser,
the Chief Compliance Officer, independent registered public accounting firm and
other service providers, the Board and the Audit Committee learn in detail about
the material risks of each Fund, thereby facilitating a dialogue about how
management and service providers identify and mitigate those risks.
The
Board recognizes that not all risks that may affect a Fund can be identified
and/or quantified, that it may not be practical or cost-effective to eliminate
or mitigate certain risks, that it may be necessary to bear certain risks (such
as investment-related risks) to achieve a Fund’s goals, and that the processes,
procedures and controls employed to address certain risks may be limited in
their effectiveness. Moreover, reports received by the Board as to risk
management matters are typically summaries of the relevant information. Most of
the Funds’ investment management and business affairs are carried out by or
through the Adviser, Sub-Adviser, and other service providers, each of which has
an independent interest in risk management but whose policies and the methods by
which one or more risk management functions are carried out may differ from the
Funds’ and each other’s in the setting of priorities, the resources available or
the effectiveness of relevant controls. As a result of the foregoing and other
factors, the Board’s ability to monitor and manage risk, as a practical matter,
is subject to limitations.
Members
of the Board. There
are four members of the Board, three of whom are not interested persons of the
Trust, as that term is defined in the 1940 Act (the “Independent Trustees”).
Mr. Michael A. Castino serves as Chairman of the Board, and Mr. Leonard M.
Rush serves as the Trust’s Lead Independent Trustee. As Lead Independent
Trustee, Mr. Rush acts as a spokesperson for the Independent Trustees in between
meetings of the Board, serves as a liaison for the Independent Trustees with the
Trust’s service providers, officers, and legal counsel to discuss ideas
informally, and participates in setting the agenda for meetings of the Board and
separate meetings or executive sessions of the Independent Trustees.
The
Board is comprised of a super-majority (75 percent) of Independent Trustees.
There is an Audit Committee of the Board that is chaired by an Independent
Trustee and comprised solely of Independent Trustees. The Audit Committee chair
presides at the Audit Committee meetings, participates in formulating agendas
for Audit Committee meetings, and coordinates with management to serve as a
liaison between the Independent Trustees and management on matters within the
scope of responsibilities of the Audit Committee as set forth in its
Board-approved charter. There is a Nominating and Governance Committee of the
Board that is chaired by an Independent Trustee and comprised solely of
Independent Trustees. The Nominating and Governance Committee chair presides at
the Nominating and Governance Committee meetings, participates in formulating
agendas for Nominating and Governance Committee meetings, and coordinates with
management to serve as a liaison between the Independent Trustees and management
on matters within the scope of responsibilities of the Nominating and Governance
Committee as set forth in its Board-approved charter. The Trust has determined
its leadership structure is appropriate given the specific characteristics and
circumstances of the Trust. The Trust made this determination in consideration
of, among other things, the fact that the Independent Trustees of the Trust
constitute a super-majority of the Board, the number of Independent Trustees
that constitute the Board, the amount of assets under management in the Trust,
and the number of funds overseen by the Board. The Board also believes that its
leadership structure facilitates the orderly and efficient flow of information
to the Independent Trustees from Fund management.
Additional
information about each Trustee of the Trust is set forth below. The address of
each Trustee of the Trust is c/o U.S. Bank Global Fund Services, 615 E.
Michigan Street, Milwaukee, WI 53202.
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Name
and Year of Birth |
Position
Held with the Trust |
Term
of Office and Length of Time Served |
Principal
Occupation(s) During Past 5 Years |
Number
of Portfolios in Fund Complex Overseen by Trustee |
Other
Directorships Held by Trustee
During
Past 5 Years |
Independent
Trustees |
Leonard
M. Rush, CPA Born: 1946 |
Lead
Independent Trustee and Audit Committee Chairman |
Indefinite
term; since 2012 |
Retired;
formerly Chief Financial Officer, Robert W. Baird & Co. Incorporated
(wealth management firm) (2000–2011). |
60 |
Independent
Trustee, Managed Portfolio Series (34 portfolios) (since
2011). |
David
A. Massart Born: 1967 |
Trustee
and Nominating and Governance Committee Chairman |
Indefinite
term; Trustee
since
2012;
Committee
Chairman
since
2023 |
Partner
and Managing Director, Beacon Pointe Advisors, LLC (since 2022);
Co-Founder, President, and Chief Investment Strategist, Next Generation
Wealth Management, Inc. (2005–2021). |
60 |
Independent
Trustee, Managed Portfolio Series (34 portfolios) (since
2011). |
Janet
D. Olsen Born: 1956 |
Trustee |
Indefinite
term; since 2018 |
Retired;
formerly Managing Director and General Counsel, Artisan Partners Limited
Partnership (investment adviser) (2000–2013); Executive Vice President and
General Counsel, Artisan Partners Asset Management Inc. (2012–2013); Vice
President and General Counsel, Artisan Funds, Inc. (investment company)
(2001–2012). |
60 |
Independent
Trustee, PPM Funds (2 portfolios) (since 2018). |
Interested
Trustee |
Michael
A. Castino Born: 1967 |
Trustee
and Chairman |
Indefinite
term; Trustee since 2014; Chairman since 2013 |
Managing
Director, Investment Manager Solutions, Sound Capital Solutions LLC (since
2023); Senior Vice President, U.S. Bancorp Fund Services, LLC (2013–2023);
Managing Director of Index Services, Zacks Investment Management
(2011–2013). |
60 |
None. |
Individual
Trustee Qualifications. The
Trust has concluded that each of the Trustees should serve on the Board because
of their ability to review and understand information about the Funds provided
to them by management, to identify and request other information they may deem
relevant to the performance of their duties, to question management and other
service providers regarding material factors bearing on the management and
administration of the Funds, and to exercise their business judgment in a manner
that serves the best interests of each Fund’s shareholders. The Trust has
concluded that each of the Trustees should serve as a Trustee based on his or
her own experience, qualifications, attributes and skills as described below.
The
Trust has concluded that Mr. Rush should serve as a Trustee because of his
substantial industry experience, including serving in several different senior
executive roles at various global financial services firms, and the experience
he has gained as serving as trustee of another investment company trust since
2011. He most recently served as Managing Director and Chief Financial Officer
of Robert W. Baird & Co. Incorporated and several other affiliated entities
and served as the Treasurer for Baird Funds. He also served as the Chief
Financial Officer for Fidelity Investments’ four broker-dealers and has
substantial experience with mutual fund and investment advisory organizations
and related businesses, including Vice President and Head of Compliance for
Fidelity Investments, a Vice President at Credit Suisse First Boston, a Manager
with Goldman Sachs, & Co. and a Senior Manager with Deloitte & Touche.
Mr. Rush has been determined to qualify as an Audit Committee Financial
Expert for the Trust.
The
Trust has concluded that Mr. Massart should serve as a Trustee because of his
substantial industry experience, including over two decades working with high
net worth individuals, families, trusts, and retirement accounts to make
strategic and tactical asset allocation decisions, evaluate and select
investment managers, and manage complex client relationships, and the experience
he has gained as serving as trustee of another investment company trust since
2011. He is currently a Partner and Managing Director at Beacon Pointe Advisors,
LLC. Previously, he served as President and Chief Investment Strategist of an
SEC-registered investment advisory firm he co-founded, as a Managing Director of
Strong Private Client, and as a Manager of Wells Fargo Investments, LLC.
The
Trust has concluded that Ms. Olsen should serve as a Trustee because of her
substantial industry experience, including nearly 20 years as a practicing
attorney representing primarily registered investment companies and investment
advisers, over a decade serving as a senior executive of an investment
management firm and a related public company, and the experience she has gained
by serving as an executive officer of another investment company from 2001 to
2012. Ms. Olsen most recently served as Managing Director and General Counsel of
Artisan Partners Limited Partnership, a registered investment adviser serving
primarily investment companies and institutional investors, and several
affiliated entities, including its general partner, Artisan Partners Asset
Management Inc. (NYSE: APAM), and as an executive officer of Artisan Funds Inc.
The
Trust has concluded that Mr. Castino should serve as Trustee because of the
experience he gained as Chairman of the Trust since 2013, as a senior officer of
U.S. Bancorp Fund Services, LLC, doing business as U.S. Bank Global Fund
Services (“Fund Services” or the “Transfer Agent”), from 2012 to 2023, and in
his past roles with investment management firms and indexing firms involved with
ETFs, as well as his experience in and knowledge of the financial services
industry. Mr. Castino currently serves as Managing Director, Investment Manager
Solutions, of Sound Capital Solutions, LLC, a state-registered investment
adviser.
In
its periodic assessment of the effectiveness of the Board, the Board considers
the complementary individual skills and experience of the individual Trustees
primarily in the broader context of the Board’s overall composition so that the
Board, as a body, possesses the appropriate (and appropriately diverse) skills
and experience to oversee the business of the funds.
Board
Committees.
The Board has established the following standing committees of the Board:
Audit
Committee.
The Board has a standing Audit Committee that is composed of each of the
Independent Trustees of the Trust. The Audit Committee operates under a written
charter approved by the Board. The principal responsibilities of the Audit
Committee include: recommending which firm to engage as the Funds’ independent
registered public accounting firm and whether to terminate this relationship;
reviewing the independent registered public accounting firm’s compensation, the
proposed scope and terms of its engagement, and the firm’s independence;
pre-approving audit and non-audit services provided by the Funds’ independent
registered public accounting firm to the Trust and certain other affiliated
entities; serving as a channel of communication between the independent
registered public accounting firm and the Trustees; reviewing the results of
each external audit, including any qualifications in the independent registered
public accounting firm’s opinion, any related management letter, management’s
responses to recommendations made by the independent registered public
accounting firm in connection with the audit, reports submitted to the Committee
by the internal auditing department of the Trust’s Administrator that are
material to the Trust as a whole, if any, and management’s responses to any such
reports; reviewing the Funds’ audited financial statements and considering any
significant disputes between the Trust’s management and the independent
registered public accounting firm that arose in connection with the preparation
of those financial statements; considering, in consultation with the independent
registered public accounting firm and the Trust’s senior internal accounting
executive, if any, the independent registered public accounting firms’ report on
the adequacy of the Trust’s internal financial controls; reviewing, in
consultation with the Funds’ independent registered public accounting firm,
major changes regarding auditing and accounting principles and practices to be
followed when preparing the Funds’ financial statements; and other audit related
matters. During the fiscal year ended October 31,
2023,
the Audit Committee met four times.
The
Audit Committee also serves as the Qualified Legal Compliance Committee (“QLCC”)
for the Trust for the purpose of compliance with Rules 205.2(k) and 205.3(c) of
the Code of Federal Regulations, regarding alternative reporting procedures for
attorneys retained or employed by an issuer who appear and practice before the
SEC on behalf of the issuer (the “issuer attorneys”). An issuer attorney who
becomes aware of evidence of a material violation by the Trust, or by any
officer, director, employee, or agent of the Trust, may report evidence of such
material violation to the QLCC as an alternative to the reporting requirements
of Rule 205.3(b) (which requires reporting to the chief legal officer and
potentially “up the ladder” to other entities).
Nominating
and Governance Committee.
The Board has a standing Nominating and Governance Committee that is composed of
each of the Independent Trustees of the Trust. The Nominating and Governance
Committee operates under a written charter approved by the Board. The principal
responsibility of the Nominating and Governance Committee is to consider,
recommend and nominate candidates to fill vacancies on the Trust’s Board, if
any. The Nominating and Governance Committee generally will not consider
nominees recommended by shareholders. The Nominating and Governance Committee is
also responsible for, among other things, reviewing and making recommendations
regarding Independent Trustee compensation and the Trustees’ annual
“self-assessment.” The Nominating and Governance Committee meets periodically,
as necessary. During the fiscal year ended October 31,
2023,
the Nominating and Governance Committee met two times.
Principal
Officers of the Trust
The
officers of the Trust conduct and supervise its daily business. The address of
each officer of the Trust is c/o U.S. Bank Global Fund Services,
615 E. Michigan Street, Milwaukee, WI 53202. Additional information about
the Trust’s officers is as follows:
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Name
and
Year
of Birth |
Position(s)
Held with the Trust |
Term
of Office and Length of Time Served |
Principal
Occupation(s)
During
Past 5 Years |
Kristina
R. Nelson Born: 1982 |
President |
Indefinite
term;
since
2019 |
Senior
Vice President, U.S. Bancorp Fund Services, LLC (since 2020); Vice
President, U.S. Bancorp Fund Services, LLC (2014–2020). |
Cynthia
L. Andrae Born: 1971 |
Chief
Compliance Officer and Anti-Money Laundering Officer |
Indefinite
term;
since
2022
(other
roles since 2021) |
Vice
President, U.S. Bancorp Fund Services, LLC (since 2019); Deputy Chief
Compliance Officer, U.S. Bancorp Fund Services, LLC (2021–2022);
Compliance Officer, U.S. Bancorp Fund Services, LLC
(2015-2019). |
Kristen
M. Weitzel Born: 1977 |
Treasurer |
Indefinite
term;
since
2014
(other
roles since 2013) |
Vice
President, U.S. Bancorp Fund Services, LLC (since 2015). |
Joshua
J. Hinderliter Born: 1983 |
Vice
President and Secretary |
Indefinite
term;
since
2023 |
Assistant
Vice President, U.S. Bancorp Fund Services, LLC (since 2022); Managing
Associate, Thompson Hine LLP (2016–2022). |
Jason
E. Shlensky Born: 1987 |
Assistant
Treasurer |
Indefinite
term;
since
2019 |
Assistant
Vice President, U.S. Bancorp Fund Services, LLC (since 2019); Officer,
U.S. Bancorp Fund Services, LLC (2014–2019). |
Jessica
L. Vorbeck Born: 1984 |
Assistant
Treasurer |
Indefinite
term; since 2020 |
Assistant
Vice President, U.S. Bancorp Fund Services, LLC (since 2022); Officer,
U.S. Bancorp Fund Services, LLC (2014–2017,
2018–2022). |
Trustee
Ownership of Shares. The
Funds are required to show the dollar amount ranges of each Trustee’s
“beneficial ownership” of Shares and each other series of the Trust as of the
end of the most recently completed calendar year. Dollar amount ranges disclosed
are established by the SEC. “Beneficial ownership” is determined in accordance
with Rule 16a-1(a)(2) under the 1934 Act.
As
of December 31, 2023, Mr. Rush owned, in the aggregate, between $1 and $10,000
of shares in other series of the Trust. No other Trustee owned Shares or shares
of any other series of the Trust.
Board
Compensation. The
Trustees each receive an annual trustee fee of $228,000 for attendance at the
four regularly scheduled quarterly meetings and one annual meeting, if
necessary, and receive additional compensation for each additional meeting
attended of $2,000, as well as reimbursement for travel and other out-of-pocket
expenses incurred in connection with attendance at Board meetings. The Lead
Independent Trustee receives an additional annual fee of $18,000. The Chairman
of the Audit Committee receives an additional annual fee of $18,000. The
Chairman of the Nominating and Governance Committee receives an additional
annual fee of $8,000. The Trust has no pension or retirement plan.
The
following table shows the compensation earned by each Trustee for the Funds’
fiscal year ended October 31,
2023.
Trustee fees are paid by the Adviser to each series of the Trust and not by the
Funds. Trustee compensation does not include reimbursed out-of-pocket expenses
in connection with attendance at meetings.
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Name |
Aggregate
Compensation From the Funds |
Total
Compensation from Fund Complex Paid to Trustees |
Interested
Trustee |
Michael
A. Castino |
$0 |
$105,311 |
Independent
Trustees |
Leonard
M. Rush, CPA |
$0 |
$250,375 |
Janet
D. Olsen |
$0 |
$220,375 |
David
A. Massart |
$0 |
$225,042 |
PRINCIPAL
SHAREHOLDERS,
CONTROL
PERSONS,
AND
MANAGEMENT
OWNERSHIP
A
principal shareholder is any person who owns of record or beneficially 5% or
more of the outstanding Shares of a Fund. A control person is a shareholder that
owns beneficially or through controlled companies more than 25% of the voting
securities of a company or acknowledges the existence of control. Shareholders
owning voting securities in excess of 25% may determine the outcome of any
matter affecting and voted on by shareholders of a Fund. In addition, Scott
Colyer, the Adviser’s Chief Executive Officer, and Lisa Colyer, are deemed
control persons of the Adviser, each by virtue of their roles with entities that
own directly and indirectly over 25% of the outstanding capital stock of AAM
Holdings, Inc.
As
of January 31, 2024, the Trustees and officers of the Trust as a group owned
less than 1% of the Shares of the Funds, and the following shareholders were
considered to be a principal shareholder of each Fund:
AAM
S&P 500 High Dividend Value ETF
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Name
and Address |
%
Ownership |
Type
of Ownership |
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| |
National
Financial Services LLC 200 Liberty Street New York, NY
10281 |
22.33% |
Record |
LPL
Financial 75 State Street, 22nd Floor Boston, MA 02109 |
21.13% |
Record |
Charles
Schwab & Co., Inc. 101 Montgomery St. San Francisco, CA
94104 |
20.04% |
Record |
Pershing,
LLC For the Benefit of Its Customers PO Box 2052 Jersey City, NJ
07303-2052 |
8.74% |
Record |
Stifel
Nicolaus & Co Inc 501 North Broadway St Louis, MO
63102-2188 |
5.17% |
Record |
Vanguard
Brokerage Services P.O. Box 1170 Valley Forge, PA
19482-1170 |
5.12% |
Record |
AAM
S&P Emerging Markets High Dividend Value ETF
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| |
Name
and Address |
%
Ownership |
Type
of Ownership |
|
| |
National
Financial Services LLC 200 Liberty Street New York, NY
10281 |
24.55% |
Record |
Charles
Schwab & Co., Inc. 101 Montgomery St. San Francisco, CA
94104 |
20.44% |
Record |
Pershing,
LLC For the Benefit of Its Customers PO Box 2052 Jersey City, NJ
07303-2052 |
19.69% |
Record |
Goldman
Sachs & Co., LLC 200 West Street New York, NY 10282 |
9.30% |
Record |
LPL
Financial 75 State Street, 22nd Floor Boston, MA 02109 |
8.53% |
Record |
Morgan
Stanley Smith Barney, LLC Harborside Financial Center Plaza, 23rd
Floor Jersey City NJ 07311 |
7.29% |
Record |
AAM
S&P Developed Markets High Dividend Value ETF
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| |
Name
and Address |
%
Ownership |
Type
of Ownership |
|
| |
Charles
Schwab & Co., Inc. 101 Montgomery St. San Francisco, CA
94104 |
36.70% |
Record |
Pershing,
LLC For the Benefit of Its Customers PO Box 2052 Jersey City, NJ
07303-2052 |
17.43% |
Record |
J.P.
Morgan Securities LLC
383
Madison Avenue
New
York, NY 10179 |
10.63% |
Record |
National
Financial Services LLC 200 Liberty Street New York, NY
10281 |
10.42% |
Record |
Goldman
Sachs & Co., LLC 200 West Street New York, NY 10282 |
8.21% |
Record |
AAM
Low Duration Preferred and Income Securities ETF
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| |
Name
and Address |
%
Ownership |
Type
of Ownership |
|
| |
Morgan
Stanley Smith Barney, LLC Harborside Financial Center Plaza, 23rd
Floor Jersey City NJ 07311 |
33.13% |
Record |
Charles
Schwab & Co., Inc. 101 Montgomery St. San Francisco, CA
94104 |
14.92% |
Record |
National
Financial Services LLC 200 Liberty Street New York, NY
10281 |
13.25% |
Record |
Pershing,
LLC For the Benefit of Its Customers PO Box 2052 Jersey City, NJ
07303-2052 |
11.39% |
Record |
LPL
Financial 75 State Street, 22nd Floor Boston, MA 02109 |
7.40% |
Record |
Stifel
Nicolaus & Co Inc 501 North Broadway St Louis, MO
63102-2188 |
6.57% |
Record |
AAM
Transformers ETF
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| |
Name
and Address |
%
Ownership |
Type
of Ownership |
|
| |
LPL
Financial 75 State Street, 22nd Floor Boston, MA 02109 |
89.76% |
Record |
CODES
OF
ETHICS
The
Trust, the Adviser, and the Sub-Adviser have each adopted codes of ethics
pursuant to Rule 17j-1 of the 1940 Act. These codes of ethics are designed
to prevent affiliated persons of the Trust, the Adviser, and the Sub-Adviser
from engaging in deceptive, manipulative or fraudulent activities in connection
with securities held or to be acquired by a Fund (which may also be held by
persons subject to the codes of ethics). Each Code of Ethics permits personnel
subject to that Code of Ethics to invest in securities for their personal
investment accounts, subject to certain limitations, including limitations
related to securities that may be purchased or held by a Fund. The Distributor
(as defined below) relies on the principal underwriters exception under Rule
17j-1(c)(3), specifically where the Distributor is not affiliated with the
Trust, the Adviser, the Sub-Adviser, and no officer, director, or general
partner of the Distributor serves as an officer, director, or general partner of
the Trust, the Adviser, or the Sub-Adviser.
There
can be no assurance that the codes of ethics will be effective in preventing
such activities. Each code of ethics may be examined at the office of the SEC in
Washington, D.C. or on the Internet at the SEC’s website at
http://www.sec.gov.
PROXY
VOTING
POLICIES
The
Funds have delegated proxy voting responsibilities to the Adviser, subject to
the Board’s oversight. A copy of the Adviser’s proxy voting policies (the “Proxy
Voting Policies”) is set forth in Appendix
A
to this SAI. In delegating proxy responsibilities, the Board has directed that
proxies be voted consistent with each Fund’s and its shareholders’ best
interests and in compliance with all applicable proxy voting rules and
regulations. The Adviser has engaged Glass, Lewis & Co. (“Glass Lewis”) to
make recommendations on the voting of proxies relating to securities held by the
Funds and has adopted the Glass Lewis Guidelines as part of each of its proxy
voting policies. A copy of the Glass Lewis Guidelines is set forth in
Appendix
B
to this SAI. The Trust’s Chief Compliance Officer is responsible for monitoring
the effectiveness of the Proxy Voting Policies. The Proxy Voting Policies have
been adopted by the Trust as the policies and procedures that the Adviser will
use when voting proxies on behalf of the Funds.
When
available, information on how the Funds voted proxies relating to portfolio
securities during the most recent 12-month period ended June 30 will be
available (1) without charge, upon request, by calling 1–800–617–0004 and (2) on
the SEC’s website at www.sec.gov.
INVESTMENT
ADVISER
AND
SUB-ADVISER
Investment
Adviser
Advisors
Asset Management, Inc., a Delaware corporation, serves as the investment adviser
to the Funds. AAM is located at 18925 Base Camp Road, Suite 203, Monument,
Colorado 80132. AAM is a wholly-owned subsidiary of AAM Holdings, Inc., which is
majority-owned by Sun Life Financial, Inc., through its subsidiaries. Sun Life
Financial, Inc. is a publicly-traded company. In addition, Scott Colyer, the
Adviser’s Chief Executive Officer, and Lisa Colyer, are deemed control persons
of the Adviser, each by virtue of their ownership of at least 25% of AAM
Holdings, Inc., directly or through one or more trusts or other entities. AAM is
a registered broker dealer, member FINRA and SIPC, and SEC registered investment
adviser.
Pursuant
to an investment advisory agreement (the “Advisory Agreement”), AAM provides
investment advice to the Funds subject to the direction and control of the Board
and the officers of the Trust. Under the Advisory Agreement, AAM arranges for
sub-advisory, transfer agency, custody, fund administration, distribution, and
all other services necessary for such Funds to operate. AAM provides oversight
of the Sub-Adviser, defined below, monitoring of the Sub-Adviser’s buying and
selling of securities for such Funds, and review of the Sub-Adviser’s
performance. For the services it provides to the Funds, each Fund pays AAM a
unified management fee, which is calculated daily and paid monthly, at an annual
rate of each Fund’s average daily net assets as follows:
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Name
of Fund |
Management
Fee |
AAM
S&P 500 High Dividend Value ETF |
0.29 |
% |
AAM
S&P Emerging Markets High Dividend Value ETF |
0.49 |
% |
AAM
S&P Developed Markets High Dividend Value ETF |
0.39 |
% |
AAM
Low Duration Preferred and Income Securities ETF |
0.45 |
% |
AAM
Transformers ETF |
0.49 |
% |
Under
the Advisory Agreement, AAM has agreed to pay all expenses of the Funds, except
for: the fee paid to AAM pursuant to the Advisory Agreement, interest charges on
any borrowings, dividends and other expenses on securities sold short, taxes,
brokerage commissions and other expenses incurred in placing orders for the
purchase and sale of securities and other investment instruments, acquired fund
fees and expenses, accrued deferred tax liability, extraordinary expenses, and
distribution (12b-1) fees and expenses.
Additionally,
under the Advisory Agreement, AAM, in turn, compensates the Sub-Adviser from the
management fee it receives from the applicable Fund. AAM shall not be liable to
the Trust or any shareholder for anything done or omitted by it, except acts or
omissions involving willful misfeasance, bad faith, gross negligence or reckless
disregard of the duties imposed upon it by its agreement with the
Trust.
The
table below shows management fees paid by the Funds to the Adviser for the
fiscal year ended October 31.
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|
|
| |
Name
of Fund |
2023 |
2022 |
2021 |
AAM
S&P 500 High Dividend Value ETF |
$208,509 |
$175,436 |
$103,293 |
AAM
S&P Emerging Markets High Dividend Value ETF |
$47,746 |
$33,654 |
$31,494 |
AAM
S&P Developed Markets High Dividend Value ETF |
$8,212 |
$8,548 |
$9,307 |
AAM
Low Duration Preferred and Income Securities ETF |
$866,167 |
$652,554 |
$147,387 |
AAM
Transformers ETF |
$67,423 |
$6,984(1) |
N/A |
(1)
For the fiscal period July 11, 2022 (commencement of operations) through October
31, 2022.
The
Advisory Agreement will continue in force for an initial period of two years.
The Advisory Agreement will be renewable from year to year with respect to such
Funds, so long as its continuance is approved at least annually (1) by the vote,
cast in person at a meeting called for that purpose, of a majority of those
Trustees who are not “interested persons” of the Adviser or the Trust; and (2)
by the majority vote of either the full Board or the vote of a majority of the
outstanding Shares. The Advisory Agreement automatically terminates on
assignment and is terminable on a 60-day written notice either by AAM or the
Trust.
Sub-Adviser
Vident
Asset Management
The
Trust, on behalf of the AAM S&P 500 High Dividend Value ETF, AAM S&P
Emerging Markets High Dividend Value ETF, AAM S&P Developed Markets High
Dividend Value ETF, AAM Low Duration Preferred and Income Securities ETF, and
AAM Transformers ETF (collectively, the “Funds”), and the Adviser have retained
Vident Asset Management, 1125 Sanctuary Parkway, Suite 515, Alpharetta, Georgia
30009, to serve as sub-adviser for the Funds. The Sub-Adviser was established in
2016 and is owned by Vident Capital Holdings, LLC. Vident Capital Holdings, LLC
is controlled by MM VAM, LLC which is owned by Casey Crawford.
Pursuant
to an Investment Sub-Advisory Agreement (the “Sub-Advisory Agreement”) among the
Adviser, the Sub-Adviser, and the Trust, on behalf of each of the Funds, the
Sub-Adviser is responsible for trading portfolio securities on behalf of such
Funds, including selecting broker-dealers to execute purchase and sale
transactions as instructed by the Adviser or in connection with any rebalancing
or reconstitution of a Fund’s respective Index, subject to the supervision of
the Adviser and the Board. For the services it provides to the Funds, the
Sub-Adviser is compensated by the Adviser from the management fees paid by the
Funds to the Adviser.
The
Sub-Advisory Agreement will continue in force for an initial period of two
years. Thereafter, the Sub-Advisory Agreement will be renewable from year to
year with respect to a Fund, so long as its continuance is approved at least
annually (1) by the vote, cast in person at a meeting called for that purpose,
of a majority of those Trustees who are not “interested persons” of the Trust;
and (2) by the majority vote of either the full Board or the vote of a majority
of the outstanding Shares. The Sub-Advisory Agreement will terminate
automatically in the event of its assignment, and is terminable at any time
without penalty by the Board or, with respect to a Fund, by a majority of the
outstanding Shares or by the Adviser on not less than 60 days’ written notice to
the Sub-Adviser, or by the Sub-Adviser on 90 days’ written notice to the Adviser
and the Trust. The Sub-Advisory Agreement provides that the Sub-Adviser shall
not be protected against any liability to the Trust or its shareholders by
reason of willful misfeasance, bad faith, or gross negligence on its part in the
performance of its duties or from reckless disregard of its obligations or
duties thereunder.
The
table below shows fees earned by the Sub-Adviser for services provided to each
Fund for the fiscal year ended October 31.
|
|
|
|
|
|
|
|
|
|
| |
Name
of Fund |
2023 |
2022 |
2021 |
AAM
S&P 500 High Dividend Value ETF |
$28,740 |
$24,201 |
$13,932 |
AAM
S&P Emerging Markets High Dividend Value ETF |
$25,000 |
$25,000 |
$25,000 |
AAM
S&P Developed Markets High Dividend Value ETF |
$18,000 |
$18,000 |
$18,000 |
AAM
Low Duration Preferred and Income Securities ETF |
$77,026 |
$57,993 |
$22,660 |
AAM
Transformers ETF |
$30,000 |
$9,205(1) |
N/A |
(1)
For the fiscal period July 11, 2022 (commencement of operations) through October
31, 2022.
PORTFOLIO
MANAGERS
The
AAM S&P 500 High Dividend Value ETF, AAM S&P Emerging Markets High
Dividend Value ETF, AAM S&P Developed Markets High Dividend Value ETF, and
AAM Transformers ETF are co-managed by Austin Wen, CFA, and Rafael Zayas, CFA,
each of Vident. The AAM Low Duration Preferred and Income Securities ETF is
co-managed by Jeff Kernagis, CFA, Jim Iredale, CFA, and Rafael Zayas, CFA, each
of Vident.
Share
Ownership
The
Funds are required to show the dollar ranges of the portfolio managers’
“beneficial ownership” of Shares of each Fund as of the end of the most recently
completed fiscal year or a more recent date for a new portfolio manager. Dollar
amount ranges disclosed are established by the SEC. “Beneficial ownership” is
determined in accordance with Rule 16a-1(a)(2) under the 1934 Act. As of
October 31,
2023,
the portfolio managers for Vident did not beneficially own Shares of the AAM
S&P 500 High Dividend Value ETF, AAM S&P Emerging Markets High Dividend
Value ETF, AAM S&P Developed Markets High Dividend Value ETF, AAM Low
Duration Preferred and Income Securities ETF, or AAM Transformers ETF.
Other
Accounts
In
addition to the Funds, the portfolio managers for Vident managed the following
other accounts as of October 31, 2023, none of which were subject to a
performance based management fee:
|
|
|
|
|
|
|
|
|
|
|
|
| |
Portfolio
Manager |
Type
of Accounts |
Total
Number of Accounts |
Total
Assets of Accounts |
| |
Austin
Wen, CFA |
Registered
Investment Companies |
27 |
$3.78
billion |
| |
Other
Pooled Investment Vehicles |
7 |
$654
million |
| |
Other
Accounts |
1 |
$21
million |
| |
Rafael
Zayas, CFA |
Registered
Investment Companies |
17 |
$2.5
billion |
| |
Other
Pooled Investment Vehicles |
22 |
$1.17
billion |
| |
Other
Accounts |
0 |
$0 |
| |
Jeff
Kernagis, CFA |
Registered
Investment Companies |
4 |
$577
million |
| |
Other
Pooled Investment Vehicles |
0 |
$0 |
| |
Other
Accounts |
0 |
$0 |
| |
Jim
Iredale, CFA |
Registered
Investment Companies |
2 |
$553
million |
| |
Other
Pooled Investment Vehicles |
0 |
$0 |
| |
Other
Accounts |
281 |
$350
million |
| |
Compensation
The
portfolio managers for Vident receive a fixed base salary and discretionary
bonus that are not tied to the performance of the AAM S&P 500 High Dividend
Value ETF, AAM S&P Emerging Markets High Dividend Value ETF, AAM S&P
Developed Markets High Dividend Value ETF, AAM Low Duration Preferred and Income
Securities ETF, and AAM Transformers ETF.
Conflicts
of Interest
A
Portfolio Manager’s management of “other accounts” may give rise to potential
conflicts of interest in connection with their management of the Funds’
investments, on the one hand, and the investments of the other accounts, on the
other. The other accounts may have the same investment objectives as a Fund.
Therefore, a potential conflict of interest may arise as a result of the
identical investment objectives, whereby a Portfolio Manager could favor one
account over another. Another potential conflict could include a Portfolio
Manager’s knowledge about the size, timing and possible market impact of Fund
trades, whereby a Portfolio Manager could use this information to the advantage
of other accounts and to the disadvantage of the Funds they manage. However, the
Sub-Adviser has established policies and procedures to ensure that the purchase
and sale of securities among all accounts the Sub-Adviser manages are fairly and
equitably allocated.
THE
DISTRIBUTOR
The
Trust, the Adviser, and
Quasar
Distributors, LLC (the “Distributor”), a wholly-owned subsidiary of Foreside
Financial Group, LLC (d/b/a ACA Group), are parties to a distribution agreement
(the “Distribution Agreement”), whereby the Distributor acts as principal
underwriter for the Funds and distributes Shares. Shares are continuously
offered for sale by the Distributor only in Creation Units. The Distributor will
not distribute Shares in amounts less than a Creation Unit and does not maintain
a secondary market in Shares. The principal business address of the Distributor
is Three Canal Plaza, Suite 100, Portland, Maine 04101.
Under
the Distribution Agreement, the Distributor, as agent for the Trust, will review
orders for the purchase and redemption of Creation Units, provided that any
subscriptions and orders will not be binding on the Trust until accepted by the
Trust. The Distributor is a broker-dealer registered under the 1934 Act and a
member of FINRA.
The
Distributor may also enter into agreements with securities dealers (“Soliciting
Dealers”) who will solicit purchases of Creation Units of Shares. Such
Soliciting Dealers may also be Authorized Participants (as discussed in
“Procedures
for Purchase of Creation Units”
below) or DTC participants (as defined below).
The
Distribution Agreement will continue for two years from its effective date and
is renewable annually thereafter. The continuance of the Distribution Agreement
must be specifically approved at least annually (i) by the vote of the Trustees
or by a vote of the shareholders of the Fund and (ii) by the vote of a majority
of the Independent Trustees who have no direct or indirect financial interest in
the operations of the Distribution Agreement or any related agreement, cast in
person at a meeting called for the purpose of voting on such approval. The
Distribution Agreement is terminable without penalty by the Trust on 60 days’
written notice when authorized either by majority vote of its outstanding voting
Shares or by a vote of a majority of its Board (including a majority of the
Independent Trustees), or by the Distributor on 60 days’ written notice, and
will automatically terminate in the event of its assignment. The Distribution
Agreement provides that in the absence of willful misfeasance, bad faith or
gross negligence on the part of the Distributor, or reckless disregard by it of
its obligations thereunder, the Distributor shall not be liable for any action
or failure to act in accordance with its duties thereunder.
Intermediary
Compensation.
The
Adviser, the Sub-Adviser, or their affiliates, out of their own resources and
not out of Fund assets (i.e.,
without additional cost to the Fund or its shareholders), may pay certain broker
dealers, banks and other financial intermediaries (“Intermediaries”) for certain
activities related to the Funds, including participation in activities that are
designed to make Intermediaries more knowledgeable about exchange traded
products, including the Funds, or for other activities, such as marketing and
educational training or support. These arrangements are not financed by the
Funds and, thus, do not result in increased Fund expenses. They are not
reflected in the fees and expenses listed in the fees and expenses sections of
the Funds’ Prospectus and they do not change the price paid by investors for the
purchase of Shares or the amount received by a shareholder as proceeds from the
redemption of Shares. Such compensation may be paid to Intermediaries that
provide services to the Funds, including marketing and education support (such
as through conferences, webinars and printed communications).
The
Adviser has a separate arrangement to make payments, other than for the
marketing and educational activities described above, to LPL Financial LLC (the
“Firm”). Pursuant to the arrangement with the Firm, the Firm has agreed to offer
certain AAM Funds to its customers and not to charge certain customers any
commissions when those customers purchase or sell shares of an AAM Fund. These
payments, which may be significant, are paid by the Adviser from its own
resources and not from the assets of a Fund.
The
Adviser and Sub-Adviser periodically assess the advisability of continuing to
make these payments. Payments to an Intermediary may be significant to the
Intermediary, and amounts that Intermediaries pay to your adviser, broker or
other investment professional, if any, may also be significant to such adviser,
broker or investment professional. Because an Intermediary may make decisions
about what investment options it will make available or recommend, and what
services to provide in connection with various products, based on payments it
receives or is eligible to receive, such payments create conflicts of interest
between the Intermediary and its clients. For example, these financial
incentives may cause the Intermediary to recommend a Fund over other
investments. The same conflict of interest exists with respect to your financial
adviser, broker or investment professional if he or she receives similar
payments from his or her Intermediary firm.
Intermediary
information is current only as of the date of this SAI. Please contact your
adviser, broker, or other investment professional for more information regarding
any payments his or her Intermediary firm may receive. Any payments made by the
Adviser, Sub-Adviser or their affiliates to an Intermediary may create the
incentive for an Intermediary to encourage customers to buy Shares.
If
you have any additional questions, please call 1-800-617-0004.
Distribution
and Service Plan.
The Trust has adopted a Distribution and Service Plan (the “Plan”) in accordance
with the provisions of Rule 12b-1 under the 1940 Act, which regulates
circumstances under which an investment company may directly or indirectly bear
expenses relating to the distribution of its shares. No payments pursuant to the
Plan are expected to be made during the twelve (12) month period from the date
of this SAI. Rule 12b-1 fees to be paid by a Fund under the Plan may only be
imposed after approval by the Board.
Continuance
of the Plan must be approved annually by a majority of the Trustees of the Trust
and by a majority of the Trustees who are not interested persons (as defined in
the 1940 Act) of the Trust and have no direct or indirect financial interest in
the Plan or in any agreements related to the Plan (“Qualified Trustees”). The
Plan requires that quarterly written reports of amounts spent under the Plan and
the purposes of such expenditures be furnished to and reviewed by the Trustees.
The Plan may not be amended to increase materially the amount that may be spent
thereunder without approval by a majority of the outstanding Shares of a Fund.
All material amendments of the Plan will require approval by a majority of the
Trustees of the Trust and of the Qualified Trustees.
The
Plan provides that each Fund pays the Distributor an annual fee of up to a
maximum of 0.25% of the average daily net assets of the Shares. Under the Plan,
the Distributor may make payments pursuant to written agreements to financial
institutions and intermediaries such as banks, savings and loan associations and
insurance companies including, without limit, investment counselors,
broker-dealers and the Distributor’s affiliates and subsidiaries (collectively,
“Agents”) as compensation for services and reimbursement of expenses incurred in
connection with distribution assistance. The Plan is characterized as a
compensation plan since the distribution fee will be paid to the Distributor
without regard to the distribution expenses incurred by the Distributor or the
amount
of
payments made to other financial institutions and intermediaries. The Trust
intends to operate the Plan in accordance with its terms and with the FINRA
rules concerning sales charges.
Under
the Plan, subject to the limitations of applicable law and regulations, each
Fund is authorized to compensate the Distributor up to the maximum amount to
finance any activity primarily intended to result in the sale of Creation Units
of the Fund or for providing or arranging for others to provide shareholder
services and for the maintenance of shareholder accounts. Such activities may
include, but are not limited to: (i) delivering copies of a Fund’s then
current reports, prospectuses, notices, and similar materials, to prospective
purchasers of Creation Units; (ii) marketing and promotional services,
including advertising; (iii) paying the costs of and compensating others,
including Authorized Participants (as discussed in “Procedures for Purchase of
Creation Units” below) with whom the Distributor has entered into written
Participant Agreements (as defined below), for performing shareholder servicing
on behalf of a Fund; (iv) compensating certain Authorized Participants for
providing assistance in distributing the Creation Units of a Fund, including the
travel and communication expenses and salaries and/or commissions of sales
personnel in connection with the distribution of the Creation Units of a Fund;
(v) payments to financial institutions and intermediaries such as banks,
savings and loan associations, insurance companies and investment counselors,
broker-dealers, mutual fund supermarkets and the affiliates and subsidiaries of
the Trust’s service providers as compensation for services or reimbursement of
expenses incurred in connection with distribution assistance;
(vi) facilitating communications with beneficial owners of Shares,
including the cost of providing (or paying others to provide) services to
beneficial owners of Shares, including, but not limited to, assistance in
answering inquiries related to shareholder accounts; and (vii) such other
services and obligations as are set forth in the Distribution Agreement. The
Distributor does not retain Fund monies for profit. Instead, it keeps them in
retention for future distribution related expenses. The Adviser compensates the
Distributor for certain distribution related services.
THE
TRANSFER
AGENT,
INDEX
RECEIPT
AGENT,
AND
ADMINISTRATOR
U.S.
Bancorp Fund Services, LLC, doing business as U.S. Bank Global Fund Services,
located at 615 East Michigan Street, Milwaukee, Wisconsin 53202, serves as the
Funds’ transfer agent, administrator, and index receipt agent.
Pursuant
to a Fund Administration Servicing Agreement and a Fund Accounting Servicing
Agreement between the Trust and Fund Services, Fund Services provides the Trust
with administrative and management services (other than investment advisory
services) and accounting services, including portfolio accounting services, tax
accounting services and furnishing financial reports. In this capacity, Fund
Services does not have any responsibility or authority for the management of the
Funds, the determination of investment policy, or for any matter pertaining to
the distribution of Shares. As compensation for the administration, accounting
and management services, the Adviser pays Fund Services a fee based on each
Fund’s average daily net assets, subject to a minimum annual fee. Fund Services
also is entitled to certain out-of-pocket expenses for the services mentioned
above, including pricing expenses.
The
table below shows fees earned by Fund Services for services provided to each
Fund for the fiscal years or periods ended October 31.
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|
|
|
|
|
|
|
|
|
| |
Name
of Fund |
2023 |
2022 |
2021 |
AAM
S&P 500 High Dividend Value ETF |
$85,931 |
$85,784 |
$84,812 |
AAM
S&P Emerging Markets High Dividend Value ETF |
$81,863 |
$82,178 |
$83,419 |
AAM
S&P Developed Markets High Dividend Value ETF |
$109,754 |
$95,282 |
$80,101 |
AAM
Low Duration Preferred and Income Securities ETF |
$131,707 |
$120,976 |
$46,380 |
AAM
Transformers ETF |
$54,863 |
$14,036(1) |
N/A |
(1)
For the fiscal period July 11, 2022 (commencement of operations) through October
31, 2022.
CUSTODIAN
AND
SECURITIES
LENDING
AGENT
Pursuant
to a Custody Agreement, U.S. Bank National Association (the “Custodian” or “U.S.
Bank”), 1555 North Rivercenter Drive, Suite 302, Milwaukee, Wisconsin 53212,
serves as the Custodian of the Funds’ assets. The Custodian holds and
administers the assets in each Fund’s portfolio. Pursuant to the Custody
Agreement, the Custodian receives an annual fee from the Adviser based on the
Trust’s total average daily net assets, subject to a minimum annual fee, and
certain settlement charges. The Custodian also is entitled to certain
out-of-pocket expenses.
The
Funds may participate in securities lending arrangements whereby a Fund lends
certain of its portfolio securities to brokers, dealers, and financial
institutions (not with individuals) to receive additional income and increase
the rate of return of its portfolio. U.S. Bank serves as the Funds’ securities
lending agent and is responsible for (i) negotiating the fees (rebates) of
securities loans within parameters approved by the Board; (ii) delivering loaned
securities to the applicable borrower(s), a list of which has been approved by
the Board; (iii) investing any cash collateral received for a securities loan in
investments pre-approved by the Board; (iv) receiving the returned securities at
the expiration of a loan’s term; (v) daily monitoring of the value of the loaned
securities and the collateral received; (vi) notifying borrowers to make
additions to the collateral, when required; (vii) accounting and recordkeeping
services
as necessary for the operation of the securities lending program, and (viii)
establishing and operating a system of controls and procedures to ensure
compliance with its obligations under the Funds’ securities lending
program.
LEGAL
COUNSEL
Morgan,
Lewis & Bockius LLP, located at 1111 Pennsylvania Avenue NW, Washington, DC
20004-2541, serves as legal counsel for the Trust.
INDEPENDENT
REGISTERED
PUBLIC
ACCOUNTING
FIRM
Cohen
& Company, Ltd., located at 342 North Water Street, Suite 830, Milwaukee,
Wisconsin 53202, serves as the independent registered public accounting firm for
the Funds.
PORTFOLIO
HOLDINGS
DISCLOSURE
POLICIES
AND
PROCEDURES
The
Board has adopted a policy regarding the disclosure of information about each
Fund’s security holdings. Each Fund’s entire portfolio holdings are publicly
disseminated each day a Fund is open for business and may be available through
financial reporting and news services, including publicly available internet web
sites. In addition, the composition of the Deposit Securities (as defined below)
is publicly disseminated daily prior to the opening of the Exchange via the
National Securities Clearing Corporation (“NSCC”).
DESCRIPTION
OF
SHARES
The
Declaration of Trust authorizes the issuance of an unlimited number of funds and
Shares. Each Share represents an equal proportionate interest in the applicable
Fund with each other Share. Shares are entitled upon liquidation to a pro rata
share in the net assets of the applicable Fund. Shareholders have no preemptive
rights. The Declaration of Trust provides that the Trustees may create
additional series or classes of Shares. All consideration received by the Trust
for shares of any additional funds and all assets in which such consideration is
invested would belong to that fund and would be subject to the liabilities
related thereto. Share certificates representing Shares will not be issued.
Shares, when issued, are fully paid and non-assessable.
Each
Share has one vote with respect to matters upon which a shareholder vote is
required, consistent with the requirements of the 1940 Act and the rules
promulgated thereunder. Shares of all funds of the Trust vote together as a
single class, except that if the matter being voted on affects only a particular
fund it will be voted on only by that fund and if a matter affects a particular
fund differently from other funds, that fund will vote separately on such
matter. As a Delaware statutory trust, the Trust is not required, and does not
intend, to hold annual meetings of shareholders. Approval of shareholders will
be sought, however, for certain changes in the operation of the Trust and for
the election of Trustees under certain circumstances. Upon the written request
of shareholders owning at least 10% of the Trust’s Shares, the Trust will call
for a meeting of shareholders to consider the removal of one or more Trustees
and other certain matters. In the event that such a meeting is requested, the
Trust will provide appropriate assistance and information to the shareholders
requesting the meeting.
Under
the Declaration of Trust, the Trustees have the power to liquidate a Fund
without shareholder approval. While the Trustees have no present intention of
exercising this power, they may do so if a Fund fails to reach a viable size
within a reasonable amount of time or for such other reasons as may be
determined by the Board.
LIMITATION
OF
TRUSTEES’
LIABILITY
The
Declaration of Trust provides that a Trustee shall be liable only for his or her
own willful misfeasance, bad faith, gross negligence or reckless disregard of
the duties involved in the conduct of the office of Trustee, and shall not be
liable for errors of judgment or mistakes of fact or law. The Trustees shall not
be responsible or liable in any event for any neglect or wrong-doing of any
officer, agent, employee, adviser or principal underwriter of the Trust, nor
shall any Trustee be responsible for the act or omission of any other Trustee.
The Declaration of Trust also provides that the Trust shall indemnify each
person who is, or has been, a Trustee, officer, employee or agent of the Trust,
any person who is serving or has served at the Trust’s request as a Trustee,
officer, trustee, employee or agent of another organization in which the Trust
has any interest as a shareholder, creditor or otherwise to the extent and in
the manner provided in the Amended and Restated By-laws. However, nothing in the
Declaration of Trust shall protect or indemnify a Trustee against any liability
for his or her willful misfeasance, bad faith, gross negligence, or reckless
disregard of the duties involved in the conduct of the office of Trustee.
Nothing contained in this section attempts to disclaim a Trustee’s individual
liability in any manner inconsistent with the federal securities
laws.
BROKERAGE
TRANSACTIONS
The
policy of the Trust regarding purchases and sales of securities for a Fund is
that primary consideration will be given to obtaining the most favorable prices
and efficient executions of transactions. Consistent with this policy, when
securities transactions are effected on a stock exchange, the Trust’s policy is
to pay commissions which are considered fair and reasonable without necessarily
determining that the lowest possible commissions are paid in all circumstances.
The Trust believes that a requirement always to seek the lowest possible
commission cost could impede effective portfolio management and preclude the
Funds and the Sub-Adviser from obtaining a high quality of brokerage and
research services. In seeking to determine the reasonableness of brokerage
commissions paid
in
any transaction, the Sub-Adviser will rely upon its experience and knowledge
regarding commissions generally charged by various brokers and on its judgment
in evaluating the brokerage services received from the broker effecting the
transaction. Such determinations are necessarily subjective and imprecise, as in
most cases, an exact dollar value for those services is not ascertainable. The
Trust has adopted policies and procedures that prohibit the consideration of
sales of Shares as a factor in the selection of a broker or dealer to execute
its portfolio transactions.
The
Sub-Adviser owes a fiduciary duty to their clients to seek to provide best
execution on trades effected. In selecting a broker/dealer for each specific
transaction, the Sub-Adviser chooses the broker/dealer deemed most capable of
providing the services necessary to obtain the most favorable execution. “Best
execution” is generally understood to mean the most favorable cost or net
proceeds reasonably obtainable under the circumstances. The full range of
brokerage services applicable to a particular transaction may be considered when
making this judgment, which may include, but is not limited to: liquidity,
price, commission, timing, aggregated trades, capable floor brokers or traders,
competent block trading coverage, ability to position, capital strength and
stability, reliable and accurate communications and settlement processing, use
of automation, knowledge of other buyers or sellers, arbitrage skills,
administrative ability, underwriting and provision of information on a
particular security or market in which the transaction is to occur. The specific
criteria will vary depending upon the nature of the transaction, the market in
which it is executed, and the extent to which it is possible to select from
among multiple broker/dealers. The Sub-Adviser will also use electronic crossing
networks (“ECNs”) when appropriate.
Subject
to the foregoing policies, brokers or dealers selected to execute a Fund’s
portfolio transactions may include such Fund’s Authorized Participants (as
discussed in “Procedures
for Purchase of Creation Units”
below) or their affiliates. An Authorized Participant or its affiliates may be
selected to execute a Fund’s portfolio transactions in conjunction with an
all-cash creation unit order or an order including “cash-in-lieu” (as described
below under “Purchase
and Redemption of Shares in Creation Units”),
so long as such selection is in keeping with the foregoing policies. As
described below under “Purchase
and Redemption of Shares in Creation Units—Creation Transaction Fee”
and “—Redemption
Transaction Fee”,
each Fund may determine to not charge a variable fee on certain orders when the
Adviser has determined that doing so is in the best interests of Fund
shareholders, e.g.,
for creation orders that facilitate the rebalance of the applicable Fund’s
portfolio in a more tax efficient manner than could be achieved without such
order, even if the decision to not charge a variable fee could be viewed as
benefiting the Authorized Participant or its affiliate selected to execute the
Fund’s portfolio transactions in connection with such orders.
The
Sub-Adviser may use a Fund’s assets for, or participate in, third-party soft
dollar arrangements, in addition to receiving proprietary research from various
full-service brokers, the cost of which is bundled with the cost of the broker’s
execution services. The Sub-Adviser does not “pay up” for the value of any such
proprietary research. Section 28(e) of the 1934 Act permits the Sub-Adviser,
under certain circumstances, to cause a Fund to pay a broker or dealer a
commission for effecting a transaction in excess of the amount of commission
another broker or dealer would have charged for effecting the transaction in
recognition of the value of brokerage and research services provided by the
broker or dealer. The Sub-Adviser may receive a variety of research services and
information on many topics, which it can use in connection with its management
responsibilities with respect to the various accounts over which it exercises
investment discretion or otherwise provides investment advice. The research
services may include qualifying order management systems, portfolio attribution
and monitoring services and computer software and access charges which are
directly related to investment research. Accordingly, a Fund may pay a broker
commission higher than the lowest available in recognition of the broker’s
provision of such services to the Sub-Adviser, but only if the Sub-Adviser
determines the total commission (including the soft dollar benefit) is
comparable to the best commission rate that could be expected to be received
from other brokers. The amount of soft dollar benefits received depends on the
amount of brokerage transactions effected with the brokers. A conflict of
interest exists because there is an incentive to: 1) cause clients to pay a
higher commission than the firm might otherwise be able to negotiate; 2) cause
clients to engage in more securities transactions than would otherwise be
optimal; and 3) only recommend brokers that provide soft dollar benefits.
The
Sub-Adviser faces a potential conflict of interest when it uses client trades to
obtain brokerage or research services. This conflict exists because the
Sub-Adviser is able to use the brokerage or research services to manage client
accounts without paying cash for such services, which reduces the Sub-Adviser’s
expenses to the extent that the Sub-Adviser would have purchased such products
had they not been provided by brokers. Section 28(e) permits the Sub-Adviser to
use brokerage or research services for the benefit of any account it manages.
Certain accounts managed by the Sub-Adviser may generate soft dollars used to
purchase brokerage or research services that ultimately benefit other accounts
managed by the Sub-Adviser, effectively cross subsidizing the other accounts
managed by the Sub-Adviser that benefit directly from the product. The
Sub-Adviser may not necessarily use all of the brokerage or research services in
connection with managing a Fund whose trades generated the soft dollars used to
purchase such products.
The
Sub-Adviser is responsible, subject to oversight by the Adviser and the Board,
for placing orders on behalf of each Fund for the purchase or sale of portfolio
securities. If purchases or sales of portfolio securities of a Fund and one or
more other investment companies or clients supervised by the Sub-Adviser is
considered at or about the same time, transactions in such securities are
allocated among the several investment companies and clients in a manner deemed
equitable and consistent with its fiduciary obligations to all by the
Sub-Adviser. In some cases, this procedure could have a detrimental effect on
the price or volume of the security so far as a Fund is concerned. However, in
other cases, it is possible that the ability to participate in volume
transactions and
to
negotiate lower brokerage commissions will be beneficial to a Fund. The primary
consideration is prompt execution of orders at the most favorable net price.
A
Fund may deal with affiliates in principal transactions to the extent permitted
by exemptive order or applicable rule or regulation.
The
table below shows brokerage commissions paid in the aggregate amount by each
Fund for the fiscal years or periods ended October 31.
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Name
of Fund |
2023 |
2022 |
2021 |
AAM
S&P 500 High Dividend Value ETF |
$40,083 |
$36,147 |
$12,494 |
AAM
S&P Emerging Markets High Dividend Value ETF |
$31,672 |
$12,488 |
$16,764 |
AAM
S&P Developed Markets High Dividend Value ETF |
$2,282 |
$2,600 |
$2,299 |
AAM
Low Duration Preferred and Income Securities ETF |
$172,576 |
$173,768 |
$48,812 |
AAM
Transformers ETF |
$9,240 |
$596(1) |
N/A |
(1)
For the fiscal period July 11, 2022 (commencement of operations) through October
31, 2022.
Directed
Brokerage.
During the fiscal year ended October 31,
2023,
the Funds did not direct brokerage transactions to a broker because of research
services provided.
Brokerage
with Fund Affiliates.
A Fund may execute brokerage or other agency transactions through registered
broker-dealer affiliates of the Funds, the Adviser, the Sub-Adviser or the
Distributor for a commission in conformity with the 1940 Act, the 1934 Act and
rules promulgated by the SEC. These rules require that commissions paid to the
affiliate by the Funds for exchange transactions not exceed “usual and
customary” brokerage commissions. The rules define “usual and customary”
commissions to include amounts which are “reasonable and fair compared to the
commission, fee or other remuneration received or to be received by other
brokers in connection with comparable transactions involving similar securities
being purchased or sold on a securities exchange during a comparable period of
time.” The Trustees, including those who are not “interested persons” of the
Funds, have adopted procedures for evaluating the reasonableness of commissions
paid to affiliates and review these procedures periodically.
During
the fiscal year ended October 31,
2023,
the Funds did not pay brokerage commissions to any registered broker-dealer
affiliates of the Funds, the Adviser, the Sub-Adviser, or the Distributor.
Securities
of “Regular Broker-Dealers.”
Each Fund is required to identify any securities of its “regular brokers and
dealers” (as such term is defined in the 1940 Act) that it may hold at the close
of its most recent fiscal year. “Regular brokers or dealers” of a Fund are the
ten brokers or dealers that, during the most recent fiscal year: (i) received
the greatest dollar amounts of brokerage commissions from the Fund’s portfolio
transactions; (ii) engaged as principal in the largest dollar amounts of
portfolio transactions of the Fund; or (iii) sold the largest dollar amounts of
Shares. As of October 31,
2023,
the Funds, except those listed in the table below, did not own securities of
their “regular brokers or dealers”.
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Name
of Fund |
Broker-Dealer |
Amount |
AAM
Low Duration Preferred and Income Securities ETF |
Bank
of America/Merrill Lynch |
$8,750,833 |
AAM
Low Duration Preferred and Income Securities ETF |
JP
Morgan Chase |
$7,569,427 |
PORTFOLIO
TURNOVER
RATE
Portfolio
turnover may vary from year to year, as well as within a year. High turnover
rates are likely to result in comparatively greater brokerage expenses. The
overall reasonableness of brokerage commissions is evaluated by the Sub-Adviser
based upon its knowledge of available information as to the general level of
commissions paid by other institutional investors for comparable
services.
The
table below lists the portfolio turnover rate for each Fund for the fiscal years
or period ended October 31.
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Name
of Fund |
2023 |
2022 |
|
AAM
S&P 500 High Dividend Value ETF |
63% |
68% |
|
AAM
S&P Emerging Markets High Dividend Value ETF |
183% |
123% |
|
AAM
S&P Developed Markets High Dividend Value ETF |
93% |
100% |
|
AAM
Low Duration Preferred and Income Securities ETF |
100% |
154% |
|
AAM
Transformers ETF |
82% |
27%(1) |
|
(1)
For the fiscal period July 11, 2022 (commencement of operations) through October
31, 2022.
BOOK
ENTRY
ONLY
SYSTEM
The
Depository Trust Company (“DTC”) acts as securities depositary for Shares.
Shares are represented by securities registered in the name of DTC or its
nominee, Cede & Co., and deposited with, or on behalf of, DTC. Except in
limited circumstances set forth below, certificates will not be issued for
Shares.
DTC
is a limited-purpose trust company that was created to hold securities of its
participants (the “DTC Participants”) and to facilitate the clearance and
settlement of securities transactions among the DTC Participants in such
securities through electronic book-entry changes in accounts of the DTC
Participants, thereby eliminating the need for physical movement of securities
certificates. DTC Participants include securities brokers and dealers, banks,
trust companies, clearing corporations and certain other organizations, some of
whom (and/or their representatives) own DTC. More specifically, DTC is owned by
a number of its DTC Participants and by the New York Stock Exchange (“NYSE”) and
FINRA. Access to the DTC system is also available to others such as banks,
brokers, dealers, and trust companies that clear through or maintain a custodial
relationship with a DTC Participant, either directly or indirectly (the
“Indirect Participants”).
Beneficial
ownership of Shares is limited to DTC Participants, Indirect Participants, and
persons holding interests through DTC Participants and Indirect Participants.
Ownership of beneficial interests in Shares (owners of such beneficial interests
are referred to in this SAI as “Beneficial Owners”) is shown on, and the
transfer of ownership is effected only through, records maintained by DTC (with
respect to DTC Participants) and on the records of DTC Participants (with
respect to Indirect Participants and Beneficial Owners that are not DTC
Participants). Beneficial Owners will receive from or through the DTC
Participant a written confirmation relating to their purchase of Shares. The
Trust recognizes DTC or its nominee as the record owner of all Shares for all
purposes. Beneficial Owners of Shares are not entitled to have Shares registered
in their names and will not receive or be entitled to physical delivery of Share
certificates. Each Beneficial Owner must rely on the procedures of DTC and any
DTC Participant and/or Indirect Participant through which such Beneficial Owner
holds its interests, to exercise any rights of a holder of Shares.
Conveyance
of all notices, statements, and other communications to Beneficial Owners is
effected as follows. DTC will make available to the Trust upon request and for a
fee a listing of Shares held by each DTC Participant. The Trust shall obtain
from each such DTC Participant the number of Beneficial Owners holding Shares,
directly or indirectly, through such DTC Participant. The Trust shall provide
each such DTC Participant with copies of such notice, statement, or other
communication, in such form, number and at such place as such DTC Participant
may reasonably request, in order that such notice, statement or communication
may be transmitted by such DTC Participant, directly or indirectly, to such
Beneficial Owners. In addition, the Trust shall pay to each such DTC Participant
a fair and reasonable amount as reimbursement for the expenses attendant to such
transmittal, all subject to applicable statutory and regulatory requirements.
Share
distributions shall be made to DTC or its nominee, Cede & Co., as the
registered holder of all Shares. DTC or its nominee, upon receipt of any such
distributions, shall credit immediately DTC Participants’ accounts with payments
in amounts proportionate to their respective beneficial interests in a Fund as
shown on the records of DTC or its nominee. Payments by DTC Participants to
Indirect Participants and Beneficial Owners of Shares held through such DTC
Participants will be governed by standing instructions and customary practices,
as is now the case with securities held for the accounts of customers in bearer
form or registered in a “street name,” and will be the responsibility of such
DTC Participants.
The
Trust has no responsibility or liability for any aspect of the records relating
to or notices to Beneficial Owners, or payments made on account of beneficial
ownership interests in Shares, or for maintaining, supervising, or reviewing any
records relating to such beneficial ownership interests, or for any other aspect
of the relationship between DTC and the DTC Participants or the relationship
between such DTC Participants and the Indirect Participants and Beneficial
Owners owning through such DTC Participants.
DTC
may determine to discontinue providing its service with respect to a Fund at any
time by giving reasonable notice to the Fund and discharging its
responsibilities with respect thereto under applicable law. Under such
circumstances, the applicable Fund shall take action either to find a
replacement for DTC to perform its functions at a comparable cost or, if such
replacement is unavailable, to issue and deliver printed certificates
representing ownership of Shares, unless the Trust makes other arrangements with
respect thereto satisfactory to the Exchange.
PURCHASE
AND
REDEMPTION
OF
SHARES
IN
CREATION
UNITS
The
Trust issues and redeems Shares only in Creation Units on a continuous basis
through the Transfer Agent, without a sales load (but subject to transaction
fees, if applicable), at their NAV per share next determined after receipt of an
order, on any Business Day, in proper form pursuant to the terms of the
Authorized Participant Agreement (“Participant Agreement”). The NAV of Shares is
calculated each business day as of the scheduled close of regular trading on the
NYSE, generally 4:00 p.m., Eastern time. The Funds will not issue fractional
Creation Units. A “Business Day” is any day on which the NYSE is open for
business.
Fund
Deposit.
The consideration for purchase of a Creation Unit of a Fund generally consists
of the in-kind deposit of a designated portfolio of securities (the “Deposit
Securities”) per each Creation Unit and the Cash Component (defined below),
computed as described below. Notwithstanding the foregoing, the Trust reserves
the right to permit or require the substitution of a “cash in lieu”
amount
(“Deposit Cash”) to be added to the Cash Component to replace any Deposit
Security. When accepting purchases of Creation Units for all or a portion of
Deposit Cash, a Fund may incur additional costs associated with the acquisition
of Deposit Securities that would otherwise be provided by an in-kind purchaser.
Together,
the Deposit Securities or Deposit Cash, as applicable, and the Cash Component
constitute the “Fund Deposit,” which represents the minimum initial and
subsequent investment amount for a Creation Unit of the applicable Fund. The
“Cash Component” is an amount equal to the difference between the NAV of Shares
(per Creation Unit) and the value of the Deposit Securities or Deposit Cash, as
applicable. If the Cash Component is a positive number (i.e.,
the NAV per Creation Unit exceeds the value of the Deposit Securities or Deposit
Cash, as applicable), the Cash Component shall be such positive amount. If the
Cash Component is a negative number (i.e.,
the NAV per Creation Unit is less than the value of the Deposit Securities or
Deposit Cash, as applicable), the Cash Component shall be such negative amount
and the creator will be entitled to receive cash in an amount equal to the Cash
Component. The Cash Component serves the function of compensating for any
differences between the NAV per Creation Unit and the value of the Deposit
Securities or Deposit Cash, as applicable. Computation of the Cash Component
excludes any stamp duty or other similar fees and expenses payable upon transfer
of beneficial ownership of the Deposit Securities, if applicable, which shall be
the sole responsibility of the Authorized Participant (as defined below).
Each
Fund, through NSCC, makes available on each Business Day, prior to the opening
of business on the Exchange (currently 9:30 a.m., Eastern time), the list of the
names and the required number of Shares of each Deposit Security or the required
amount of Deposit Cash, as applicable, to be included in the current Fund
Deposit (based on information at the end of the previous Business Day) for the
applicable Fund. Such Fund Deposit is subject to any applicable adjustments as
described below, to effect purchases of Creation Units of the applicable Fund
until such time as the next-announced composition of the Deposit Securities or
the required amount of Deposit Cash, as applicable, is made available.
The
identity and number of Shares of the Deposit Securities or the amount of Deposit
Cash, as applicable, required for a Fund Deposit for the Fund changes as
rebalancing adjustments and corporate action events are reflected from time to
time by the Sub-Adviser with a view to the investment objective of the Fund. The
composition of the Deposit Securities may also change in response to adjustments
to the weighting or composition of the component securities of an Index.
The
Trust reserves the right to permit or require the substitution of Deposit Cash
to replace any Deposit Security, which shall be added to the Cash Component,
including, without limitation, in situations where the Deposit Security: (i) may
not be available in sufficient quantity for delivery; (ii) may not be eligible
for transfer through the systems of DTC for corporate securities and municipal
securities; (iii) may not be eligible for trading by an Authorized Participant
(as defined below) or the investor for which it is acting; (iv) would be
restricted under the securities laws or where the delivery of the Deposit
Security to the Authorized Participant would result in the disposition of the
Deposit Security by the Authorized Participant becoming restricted under the
securities laws; or (v) in certain other situations (collectively, “custom
orders”). The Trust also reserves the right to include or remove Deposit
Securities from the basket in anticipation of Index rebalancing changes. The
adjustments described above will reflect changes, known to the Sub-Adviser on
the date of announcement to be in effect by the time of delivery of the Fund
Deposit, in the composition of the subject Index being tracked by the Fund or
resulting from certain corporate actions.
Procedures
for Purchase of Creation Units.
To be eligible to place orders with the Transfer Agent to purchase a Creation
Unit of a Fund, an entity must be (i) a “Participating Party” (i.e.,
a broker-dealer or other participant in the clearing process through the
Continuous Net Settlement System of the NSCC (the “Clearing Process”)), a
clearing agency that is registered with the SEC; or (ii) a DTC Participant (see
“Book
Entry Only System”).
In addition, each Participating Party or DTC Participant (each, an “Authorized
Participant”) must execute a Participant Agreement that has been agreed to by
the Distributor, and that has been accepted by the Transfer Agent, with respect
to purchases and redemptions of Creation Units. Each Authorized Participant will
agree, pursuant to the terms of a Participant Agreement, on behalf of itself or
any investor on whose behalf it will act, to certain conditions, including that
it will pay to the Trust, an amount of cash sufficient to pay the Cash Component
together with the creation transaction fee (described below), if applicable, and
any other applicable fees and taxes.
AAM
S&P Emerging Markets High Dividend Value ETF.
All orders to purchase Shares directly from the Fund on the next Business Day
must be submitted as a “Future Dated Trade” for one or more Creation Units
between 4:30 p.m. Eastern time and 5:30 p.m. Eastern time on the prior Business
Day and in the manner set forth in the Participant Agreement and/or applicable
order form. With respect to the Fund, the Business Day following the day on
which such an order is submitted to purchase Creation Units (or an order to
redeem Creation Units, as set forth below) is referred to as the “Order
Placement Date.”
All
Funds other than the AAM S&P Emerging Markets High Dividend Value
ETF.
All orders to purchase Shares directly from the AAM S&P 500 High Dividend
Value ETF, AAM S&P Developed Markets High Dividend Value ETF, AAM Low
Duration Preferred and Income Securities ETF, and the AAM Transformers ETF must
be placed for one or more Creation Units and in the manner and by the time set
forth in the Participant Agreement and/or applicable order form. With respect to
each of these Funds, the order cut-off time for orders to purchase Creation
Units is 4:00 p.m. Eastern time, which time may be modified by each Fund from
time-to-time by amendment to the Participant Agreement and/or applicable order
form. The date on which an order to purchase Creation Units (or an order to
redeem Creation Units, as set forth below) is received and accepted is referred
to as the “Order Placement Date.”
All
Funds.
An Authorized Participant may require an investor to make certain
representations or enter into agreements with respect to the order (e.g.,
to provide for payments of cash, when required). Investors should be aware that
their particular broker may not have executed a Participant Agreement and that,
therefore, orders to purchase Shares directly from a Fund in Creation Units have
to be placed by the investor’s broker through an Authorized Participant that has
executed a Participant Agreement. In such cases there may be additional charges
to such investor. At any given time, there may be only a limited number of
broker-dealers that have executed a Participant Agreement and only a small
number of such Authorized Participants may have international capabilities.
On
days when the Exchange closes earlier than normal, a Fund may require orders to
create Creation Units to be placed earlier in the day. In addition, if a market
or markets on which a Fund’s investments are primarily traded is closed, the
applicable Fund will also generally not accept orders on such day(s). Orders
must be transmitted by an Authorized Participant by telephone or other
transmission method acceptable to the Transfer Agent pursuant to procedures set
forth in the Participant Agreement and in accordance with the applicable order
form. On behalf of the Funds, the Transfer Agent will notify the Custodian of
such order. The Custodian will then provide such information to the appropriate
local sub-custodian(s). Those placing orders through an Authorized Participant
should allow sufficient time to permit proper submission of the purchase order
to the Transfer Agent by the cut-off time on such Business Day. Economic or
market disruptions or changes, or telephone or other communication failure may
impede the ability to reach the Transfer Agent or an Authorized Participant.
Fund
Deposits must be delivered by an Authorized Participant through the Federal
Reserve System (for cash) or through DTC (for corporate securities), through a
subcustody agent (for foreign securities) and/or through such other arrangements
allowed by the Trust or its agents. With respect to foreign Deposit Securities,
the Custodian shall cause the subcustodian of the Funds to maintain an account
into which the Authorized Participant shall deliver, on behalf of itself or the
party on whose behalf it is acting, such Deposit Securities (or Deposit Cash for
all or a part of such securities, as permitted or required), with any
appropriate adjustments as advised by the Trust. Foreign Deposit Securities must
be delivered to an account maintained at the applicable local subcustodian. A
Fund Deposit transfer must be ordered by the Authorized Participant in a timely
fashion so as to ensure the delivery of the requisite number of Deposit
Securities or Deposit Cash, as applicable, to the account of the applicable Fund
or its agents by no later than 12:00 p.m. Eastern time (or such other time as
specified by the Trust) on the Settlement Date. If a Fund or its agents do not
receive all of the Deposit Securities, or the required Deposit Cash in lieu
thereof, by such time, then the order may be deemed rejected and the Authorized
Participant shall be liable to the applicable Fund for losses, if any, resulting
therefrom. The “Settlement Date” for a Fund is generally the second Business Day
after the Order Placement Date. All questions as to the number of Deposit
Securities or Deposit Cash to be delivered, as applicable, and the validity,
form and eligibility (including time of receipt) for the deposit of any tendered
securities or cash, as applicable, will be determined by the Trust, whose
determination shall be final and binding. The amount of cash represented by the
Cash Component must be transferred directly to the Custodian through the Federal
Reserve Bank wire transfer system in a timely manner so as to be received by the
Custodian no later than the Settlement Date. If the Cash Component and the
Deposit Securities or Deposit Cash, as applicable, are not received by the
Custodian in a timely manner by the Settlement Date, the creation order may be
cancelled. Upon written notice to the Transfer Agent, such canceled order may be
resubmitted the following Business Day using a Fund Deposit as newly constituted
to reflect the then current NAV of the applicable Fund.
The
order shall be deemed to be received on the Business Day on which the order is
placed provided that the order is placed in proper form prior to the applicable
cut-off time and the federal funds in the appropriate amount are deposited with
the Custodian on the Settlement Date. If the order is not placed in proper form
as required, or federal funds in the appropriate amount are not received on the
Settlement Date, then the order may be deemed to be rejected and the Authorized
Participant shall be liable to the applicable Fund for losses, if any, resulting
therefrom. A creation request is considered to be in “proper form” if all
procedures set forth in the Participant Agreement, order form and this SAI are
properly followed.
Issuance
of a Creation Unit.
Except as provided in this SAI, Creation Units will not be issued until the
transfer of good title to the Trust of the Deposit Securities or payment of
Deposit Cash, as applicable, and the payment of the Cash Component have been
completed. When the subcustodian has confirmed to the Custodian that the
required Deposit Securities (or the cash value thereof) have been delivered to
the account of the relevant subcustodian or subcustodians, the Transfer Agent
and the Adviser shall be notified of such delivery, and the Trust will issue and
cause the delivery of the Creation Units. The delivery of Creation Units so
created generally will occur no later than the second Business Day following the
day on which the purchase order is deemed received by the Transfer Agent.
However, the AAM S&P Emerging Markets High Dividend Value ETF and AAM
S&P Developed Markets High Dividend Value ETF reserve the right to settle
Creation Unit transactions on a basis other than the second Business Day
following the day on which the purchase order is deemed received by the
Distributor to accommodate foreign market holiday schedules, to account for
different treatment among foreign and U.S. markets of dividend record dates and
ex-dividend dates (that is the last day the holder of a security can sell the
security and still receive dividends payable on the security), and in certain
other circumstances.
Creation
Units may be purchased in advance of receipt by the Trust of all or a portion of
the applicable Deposit Securities as described below. In these circumstances,
the initial deposit will have a value greater than the NAV of Shares on the date
the order is placed in proper form since, in addition to available Deposit
Securities, cash must be deposited in an amount equal to the sum of (i) the Cash
Component, plus (ii) an additional amount of cash equal to a percentage of the
value as set forth in the Participant Agreement, of the undelivered Deposit
Securities (the “Additional Cash Deposit”), which shall be maintained in a
separate non-interest bearing collateral
account.
The Authorized Participant must deposit with the Custodian the Additional Cash
Deposit, as applicable, by 12:00 p.m. Eastern time (or such other time as
specified by the Trust) on the Settlement Date. If a Fund or its agents do not
receive the Additional Cash Deposit in the appropriate amount, by such time,
then the order may be deemed rejected and the Authorized Participant shall be
liable to the applicable Fund for losses, if any, resulting therefrom. An
additional amount of cash shall be required to be deposited with the Trust,
pending delivery of the missing Deposit Securities to the extent necessary to
maintain the Additional Cash Deposit with the Trust in an amount at least equal
to the applicable percentage, as set forth in the Participant Agreement, of the
daily market value of the missing Deposit Securities. The Participant Agreement
will permit the Trust to buy the missing Deposit Securities at any time.
Authorized Participants will be liable to the Trust for the costs incurred by
the Trust in connection with any such purchases. These costs will be deemed to
include the amount by which the actual purchase price of the Deposit Securities
exceeds the value of such Deposit Securities on the day the purchase order was
deemed received by the Transfer Agent plus the brokerage and related transaction
costs associated with such purchases. The Trust will return any unused portion
of the Additional Cash Deposit once all of the missing Deposit Securities have
been properly received by the Custodian or purchased by the Trust and deposited
into the Trust. In addition, a transaction fee, as described below under
“Creation
Transaction Fee,”
may be charged. The delivery of Creation Units so created generally will occur
no later than the Settlement Date.
Acceptance
of Orders of Creation Units.
The Trust reserves the right to reject an order for Creation Units transmitted
to it by the Transfer Agent with respect to a Fund including, without
limitation, if (a) the order is not in proper form; (b) the Deposit Securities
or Deposit Cash, as applicable, delivered by the Participant are not as
disseminated through the facilities of the NSCC for that date by the Custodian;
(c) the investor(s), upon obtaining Shares ordered, would own 80% or more of the
currently outstanding Shares of the applicable Fund; (d) the acceptance of the
Fund Deposit would, in the opinion of counsel, be unlawful; (e) the acceptance
or receipt of the order for a Creation Unit would, in the opinion of counsel to
the Trust, be unlawful; or (f) in the event that circumstances outside the
control of the Trust, the Custodian, the Transfer Agent and/or the Adviser make
it for all practical purposes not feasible to process orders for Creation Units.
Examples
of such circumstances include acts of God or public service or utility problems
such as fires, floods, extreme weather conditions and power outages resulting in
telephone, telecopy and computer failures; market conditions or activities
causing trading halts; systems failures involving computer or other information
systems affecting the Trust, the Distributor, the Custodian, a sub-custodian,
the Transfer Agent, DTC, NSCC, Federal Reserve System, or any other participant
in the creation process, and other extraordinary events. The Transfer Agent
shall notify a prospective creator of a Creation Unit and/or the Authorized
Participant acting on behalf of the creator of a Creation Unit of its rejection
of the order of such person. The Trust, the Transfer Agent, the Custodian, any
sub-custodian and the Distributor are under no duty, however, to give
notification of any defects or irregularities in the delivery of Fund Deposits
nor shall either of them incur any liability for the failure to give any such
notification. The Trust, the Transfer Agent, the Custodian and the Distributor
shall not be liable for the rejection of any purchase order for Creation Units.
All
questions as to the number of Shares of each security in the Deposit Securities
and the validity, form, eligibility and acceptance for deposit of any securities
to be delivered shall be determined by the Trust, and the Trust’s determination
shall be final and binding.
Creation
Transaction Fee.
A fixed purchase (i.e.,
creation) transaction fee, payable to the Fund’s custodian, may be imposed for
the transfer and other transaction costs associated with the purchase of
Creation Units (“Creation Order Costs”). The standard fixed creation transaction
fee for each Fund, regardless of the number of Creation Units created in the
transaction, can be found in the table below. Each Fund may adjust the standard
fixed creation transaction fee from time to time. The fixed creation fee may be
waived on certain orders if the applicable Fund’s custodian has determined to
waive some or all of the Creation Order Costs associated with the order or
another party, such as the Adviser, has agreed to pay such fee.
In
addition, a variable fee, payable to the applicable Fund, of up to the maximum
percentage listed in the table below of the value of the Creation Units subject
to the transaction may be imposed for cash purchases, non-standard orders, or
partial cash purchases of Creation Units. The variable charge is primarily
designed to cover additional costs (e.g.,
brokerage, taxes) involved with buying the securities with cash. Each Fund may
determine to not charge a variable fee on certain orders when the Adviser has
determined that doing so is in the best interests of Fund shareholders,
e.g.,
for creation orders that facilitate the rebalance of the Fund’s portfolio in a
more tax efficient manner than could be achieved without such order.
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Name
of Fund |
Fixed
Creation Transaction Fee |
Maximum
Variable Transaction Fee |
AAM
S&P 500 High Dividend Value ETF |
$300 |
2% |
AAM
S&P Emerging Markets High Dividend Value ETF |
$1,000 |
2% |
AAM
S&P Developed Markets High Dividend Value ETF |
$500 |
2% |
AAM
Low Duration Preferred and Income Securities ETF |
$500 |
2% |
AAM
Transformers ETF |
$300 |
2% |
Investors
who use the services of a broker or other such intermediary may be charged a fee
for such services. Investors are responsible for the fixed costs of transferring
the Fund Securities from the Trust to their account or on their order.
Risks
of Purchasing Creation Units.
There are certain legal risks unique to investors purchasing Creation Units
directly from a Fund. Because Shares may be issued on an ongoing basis, a
“distribution” of Shares could be occurring at any time. Certain activities that
a shareholder performs as a dealer could, depending on the circumstances, result
in the shareholder being deemed a participant in the distribution in a manner
that could render the shareholder a statutory underwriter and subject to the
prospectus delivery and liability provisions of the Securities Act. For example,
a shareholder could be deemed a statutory underwriter if it purchases Creation
Units from a Fund, breaks them down into the constituent Shares, and sells those
Shares directly to customers, or if a shareholder chooses to couple the creation
of a supply of new Shares with an active selling effort involving solicitation
of secondary-market demand for Shares. Whether a person is an underwriter
depends upon all of the facts and circumstances pertaining to that person’s
activities, and the examples mentioned here should not be considered a complete
description of all the activities that could cause you to be deemed an
underwriter.
Dealers
who are not “underwriters” but are participating in a distribution (as opposed
to engaging in ordinary secondary-market transactions), and thus dealing with
Shares as part of an “unsold allotment” within the meaning of Section 4(a)(3)(C)
of the Securities Act, will be unable to take advantage of the prospectus
delivery exemption provided by Section 4(a)(3) of the Securities Act.
Redemption.
Shares may be redeemed only in Creation Units at their NAV next determined after
receipt of a redemption request in proper form by a Fund through the Transfer
Agent and only on a Business Day. EXCEPT UPON LIQUIDATION OF A FUND, THE TRUST
WILL NOT REDEEM SHARES IN AMOUNTS LESS THAN CREATION UNITS. Investors must
accumulate enough Shares in the secondary market to constitute a Creation Unit
to have such Shares redeemed by the Trust. There can be no assurance, however,
that there will be sufficient liquidity in the public trading market at any time
to permit assembly of a Creation Unit. Investors should expect to incur
brokerage and other costs in connection with assembling a sufficient number of
Shares to constitute a redeemable Creation Unit.
With
respect to the Funds, the Custodian, through the NSCC, makes available prior to
the opening of business on the Exchange (currently 9:30 a.m., Eastern time) on
each Business Day, the list of the names and Share quantities of each Fund’s
portfolio securities that will be applicable (subject to possible amendment or
correction) to redemption requests received in proper form (as defined below) on
that day (“Fund Securities”). Fund Securities received on redemption may not be
identical to Deposit Securities.
Redemption
proceeds for a Creation Unit are paid either in-kind or in cash, or combination
thereof, as determined by the Trust. With respect to in-kind redemptions of a
Fund, redemption proceeds for a Creation Unit will consist of Fund Securities—as
announced by the Custodian on the Business Day of the request for redemption
received in proper form plus cash in an amount equal to the difference between
the NAV of Shares being redeemed, as next determined after a receipt of a
request in proper form, and the value of the Fund Securities (the “Cash
Redemption Amount”), less a fixed redemption transaction fee, as applicable, as
set forth below. In the event that the Fund Securities have a value greater than
the NAV of Shares, a compensating cash payment equal to the differential is
required to be made by or through an Authorized Participant by the redeeming
shareholder. Notwithstanding the foregoing, at the Trust’s discretion, an
Authorized Participant may receive the corresponding cash value of the
securities in lieu of the in-kind securities value representing one or more Fund
Securities.
Redemption
Transaction Fee.
A fixed redemption transaction fee, payable to the Fund’s custodian, may be
imposed for the transfer and other transaction costs associated with the
redemption of Creation Units (“Redemption Order Costs”). The standard fixed
redemption transaction fee for each Fund, regardless of the number of Creation
Units redeemed in the transaction, can be found in the table below. Each Fund
may adjust the redemption transaction fee from time to time. The fixed
redemption fee may be waived on certain orders if the applicable Fund’s
custodian has determined to waive some or all of the Redemption Order Costs
associated with the order or another party, such as the Adviser, has agreed to
pay such fee.
In
addition, a variable fee, payable to the applicable Fund, of up to the maximum
percentage listed in the table below of the value of the Creation Units subject
to the transaction may be imposed for cash redemptions, non-standard orders, or
partial cash redemptions (when cash redemptions are available) of Creation
Units. The variable charge is primarily designed to cover additional costs
(e.g.,
brokerage, taxes) involved with selling portfolio securities to satisfy a cash
redemption. Each Fund may determine to not charge a variable fee on certain
orders when the Adviser has determined that doing so is in the best interests of
Fund shareholders, e.g.,
for redemption orders that facilitate the rebalance of the Fund’s portfolio in a
more tax efficient manner than could be achieved without such order.
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Name
of Fund |
Fixed
Redemption Transaction Fee |
Maximum
Variable Transaction Fee |
AAM
S&P 500 High Dividend Value ETF |
$300 |
2% |
AAM
S&P Emerging Markets High Dividend Value ETF |
$1,000 |
2% |
AAM
S&P Developed Markets High Dividend Value ETF |
$500 |
2% |
AAM
Low Duration Preferred and Income Securities ETF |
$500 |
2% |
AAM
Transformers ETF |
$300 |
2% |
Investors
who use the services of a broker or other such intermediary may be charged a fee
for such services. Investors are responsible for the fixed costs of transferring
the Fund Securities from the Trust to their account or on their order.
Procedures
for Redemption of Creation Units.
AAM
S&P Emerging Markets High Dividend Value ETF.
Orders to redeem Creation Units of the Fund on the next Business Day must be
submitted in proper form to the Transfer Agent as a “Future Dated Trade” for one
or more Creation Units between 4:30 p.m. Eastern time and 5:30 p.m. Eastern time
on the prior Business Day and in the manner set forth in the Participant
Agreement and/or applicable order form.
All
Funds other than the AAM S&P Emerging Markets High Dividend Value
ETF.
Orders to redeem Creation Units of the Funds must be submitted in proper form to
the Transfer Agent prior to 4:00 p.m. Eastern time.
All
Funds.
A redemption request is considered to be in “proper form” if (i) an Authorized
Participant has transferred or caused to be transferred to the Trust’s Transfer
Agent the Creation Unit(s) being redeemed through the book-entry system of DTC
so as to be effective by the time as set forth in the Participant Agreement and
(ii) a request in form satisfactory to the Trust is received by the Transfer
Agent from the Authorized Participant on behalf of itself or another redeeming
investor within the time periods specified in the Participant Agreement. If the
Transfer Agent does not receive the investor’s Shares through DTC’s facilities
by the times and pursuant to the other terms and conditions set forth in the
Participant Agreement, the redemption request shall be rejected.
The
Authorized Participant must transmit the request for redemption, in the form
required by the Trust, to the Transfer Agent in accordance with procedures set
forth in the Participant Agreement. Investors should be aware that their
particular broker may not have executed a Participant Agreement, and that,
therefore, requests to redeem Creation Units may have to be placed by the
investor’s broker through an Authorized Participant who has executed a
Participant Agreement. Investors making a redemption request should be aware
that such request must be in the form specified by such Authorized Participant.
Investors making a request to redeem Creation Units should allow sufficient time
to permit proper submission of the request by an Authorized Participant and
transfer of the Shares to the Trust’s Transfer Agent; such investors should
allow for the additional time that may be required to effect redemptions through
their banks, brokers or other financial intermediaries if such intermediaries
are not Authorized Participants.
Additional
Redemption Procedures.
In connection with taking delivery of Shares of Fund Securities upon redemption
of Creation Units, a redeeming shareholder or Authorized Participant acting on
behalf of such shareholder must maintain appropriate custody arrangements with a
qualified broker-dealer, bank, or other custody providers in each jurisdiction
in which any of the Fund Securities are customarily traded, to which account
such Fund Securities will be delivered. Deliveries of redemption proceeds
generally will be made within two business days of the trade date.
However,
due to the schedule of holidays in certain countries, the different treatment
among foreign and U.S. markets of dividend record dates and dividend ex-dates
(that is the last date the holder of a security can sell the security and still
receive dividends payable on the security sold), and in certain other
circumstances, the delivery of in-kind redemption proceeds with respect to the
AAM S&P Emerging Markets High Dividend Value ETF and AAM S&P Developed
Markets High Dividend Value ETF may take longer than two Business Days after the
day on which the redemption request is received in proper form. If neither the
redeeming Shareholder nor the Authorized Participant acting on behalf of such
redeeming Shareholder has appropriate arrangements to take delivery of the Fund
Securities in the applicable foreign jurisdiction and it is not possible to make
other such arrangements, or if it is not possible to effect deliveries of the
Fund Securities in such jurisdiction, the Trust may, in its discretion, exercise
its option to redeem such Shares in cash, and the redeeming Shareholders will be
required to receive its redemption proceeds in cash.
In
addition, an investor may request a redemption in cash that a Fund may, in its
sole discretion, permit. In either case, the investor will receive a cash
payment equal to the NAV of its Shares based on the NAV of Shares of the
applicable Fund next determined after the redemption request is received in
proper form (minus a redemption transaction fee, if applicable, and additional
charge for requested cash redemptions specified above, to offset the Trust’s
brokerage and other transaction costs associated with the disposition of Fund
Securities). A Fund may also, in its sole discretion, upon request of a
shareholder, provide such redeemer a portfolio of securities that differs from
the exact composition of the Fund Securities but does not differ in NAV.
Redemptions
of Shares for Fund Securities will be subject to compliance with applicable
federal and state securities laws and the Funds (whether or not it otherwise
permits cash redemptions) reserve the right to redeem Creation Units for cash to
the extent that the
Trust
could not lawfully deliver specific Fund Securities upon redemptions or could
not do so without first registering the Fund Securities under such laws. An
Authorized Participant or an investor for which it is acting subject to a legal
restriction with respect to a particular security included in the Fund
Securities applicable to the redemption of Creation Units may be paid an
equivalent amount of cash. The Authorized Participant may request the redeeming
investor of the Shares to complete an order form or to enter into agreements
with respect to such matters as compensating cash payment. Further, an
Authorized Participant that is not a “qualified institutional buyer,” (“QIB”) as
such term is defined under Rule 144A of the Securities Act, will not be able to
receive Fund Securities that are restricted securities eligible for resale under
Rule 144A. An Authorized Participant may be required by the Trust to provide a
written confirmation with respect to QIB status to receive Fund Securities.
Because
the portfolio securities of the Funds may trade on other exchanges on days that
the Exchange is closed or are otherwise not Business Days for such Fund,
shareholders may not be able to redeem their Shares of the applicable Fund, or
to purchase or sell Shares of the applicable Fund on the Exchange, on days when
the NAV of the applicable Fund could be significantly affected by events in the
relevant foreign markets.
The
right of redemption may be suspended or the date of payment postponed with
respect to a Fund (1) for any period during which the Exchange is closed (other
than customary weekend and holiday closings); (2) for any period during which
trading on the Exchange is suspended or restricted; (3) for any period during
which an emergency exists as a result of which disposal of the Shares of the
applicable Fund or determination of the NAV of the Shares is not reasonably
practicable; or (4) in such other circumstance as is permitted by the SEC.
DETERMINATION
OF
NET
ASSET
VALUE
NAV
per Share for a Fund is computed by dividing the value of the net assets of the
applicable Fund (i.e.,
the value of its total assets less total liabilities) by the total number of
Shares outstanding, rounded to the nearest cent. Expenses and fees, including
the management fees, are accrued daily and taken into account for purposes of
determining NAV. The NAV of each Fund is calculated by Fund Services and
determined at the scheduled close of the regular trading session on the NYSE
(ordinarily 4:00 p.m., Eastern time) on each day that the NYSE is open, provided
that fixed-income assets may be valued as of the announced closing time for
trading in fixed-income instruments on any day that the Securities Industry and
Financial Markets Association (“SIFMA”) announces an early closing time.
Pursuant
to Rule 2a-5 under the 1940 Act, the Board has appointed the Adviser as the
Funds’ valuation designee (the “Valuation Designee”) to perform all fair
valuations of each Fund’s portfolio investments, subject to the Board’s
oversight. As the Valuation Designee, the Adviser has established procedures for
its fair valuation of each Fund’s portfolio investments. These procedures
address, among other things, determining when market quotations are not readily
available or reliable and the methodologies to be used for determining the fair
value of investments, as well as the use and oversight of third-party pricing
services for fair valuation. The Adviser’s fair value determinations will be
carried out in compliance with Rule 2a-5 and based on fair value methodologies
established and applied by the Adviser and periodically tested to ensure such
methodologies are appropriate and accurate with respect to each Fund’s portfolio
investments. The Adviser’s fair value methodologies may involve obtaining inputs
and prices from third-party pricing services.
In
calculating each Fund’s NAV per Share, each Fund’s investments are generally
valued using market quotations to the extent such market quotations are readily
available. If market quotations are not readily available or are deemed to be
unreliable by the Adviser, the Adviser will fair value such investments and use
the fair value to calculate each Fund’s NAV. When fair value pricing is
employed, the prices of securities used by the Adviser to calculate each Fund’s
NAV may differ from quoted or published prices for the same securities. Due to
the subjective and variable nature of fair value pricing, it is possible that
the fair value determined for a particular security may be materially different
(higher or lower) from the price of the security quoted or published by others,
or the value when trading resumes or is realized upon its sale. There may be
multiple methods that can be used to value a portfolio investment when market
quotations are not readily available. The value established for any portfolio
investment at a point in time might differ from what would be produced using a
different methodology or if it had been priced using market quotations.
DIVIDENDS
AND
DISTRIBUTIONS
The
following information supplements and should be read in conjunction with the
section in the Prospectus entitled “Dividends, Distributions and Taxes.”
General
Policies.
Dividends from net investment income, if any, are declared and paid at least
annually by each Fund. Distributions of net realized securities gains, if any,
generally are declared and paid once a year, but a Fund may make distributions
on a more frequent basis to improve index tracking for the Fund or for the Fund
to comply with the distribution requirements of the Code to preserve a Fund’s
eligibility for treatment as a RIC, in all events in a manner consistent with
the provisions of the 1940 Act.
Dividends
and other distributions on Shares are distributed, as described below, on a pro
rata basis to Beneficial Owners of such Shares. Dividend payments are made
through DTC Participants and Indirect Participants to Beneficial Owners then of
record with proceeds received from the Trust.
Each
Fund makes additional distributions to the extent necessary (i) to distribute
the entire annual taxable income of the applicable Fund, plus any net capital
gains and (ii) to avoid imposition of the excise tax imposed by Section 4982 of
the Code. Management of the Trust reserves the right to declare special
dividends if, in its reasonable discretion, such action is necessary or
advisable to preserve a Fund’s eligibility for treatment as a RIC or to avoid
imposition of income or excise taxes on undistributed income.
Dividend
Reinvestment Service.
The Trust will not make the DTC book-entry dividend reinvestment service
available for use by Beneficial Owners for reinvestment of their cash proceeds,
but certain individual broker-dealers may make available the DTC book-entry
Dividend Reinvestment Service for use by Beneficial Owners of the Funds through
DTC Participants for reinvestment of their dividend distributions. Investors
should contact their brokers to ascertain the availability and description of
these services. Beneficial Owners should be aware that each broker may require
investors to adhere to specific procedures and timetables to participate in the
dividend reinvestment service and investors should ascertain from their brokers
such necessary details. If this service is available and used, dividend
distributions of both income and realized gains will be automatically reinvested
in additional whole Shares issued by the Trust of the applicable Fund at NAV per
Share. Distributions reinvested in additional Shares will nevertheless be
taxable to Beneficial Owners acquiring such additional Shares to the same extent
as if such distributions had been received in cash.
FEDERAL
INCOME
TAXES
The
following is only a summary of certain U.S. federal income tax considerations
generally affecting a Fund and its shareholders that supplements the discussion
in the Prospectus. No attempt is made to present a comprehensive explanation of
the federal, state, local or foreign tax treatment of a Fund or its
shareholders, and the discussion here and in the Prospectus is not intended to
be a substitute for careful tax planning.
The
following general discussion of certain U.S. federal income tax consequences is
based on provisions of the Code and the regulations issued thereunder as in
effect on the date of this SAI. New legislation, as well as administrative
changes or court decisions, may significantly change the conclusions expressed
herein, and may have a retroactive effect with respect to the transactions
contemplated herein.
Shareholders
are urged to consult their own tax advisers regarding the application of the
provisions of tax law described in this SAI in light of the particular tax
situations of the shareholders and regarding specific questions as to federal,
state, foreign or local taxes.
Taxation
of the Funds.
Each Fund intends to elect and intends to continue to qualify each year to be
treated as a separate RIC under the Code. As such, the Funds should not be
subject to federal income taxes on their net investment income and capital
gains, if any, to the extent that they timely distribute such income and capital
gains to their shareholders. To qualify for treatment as a RIC, a Fund must
distribute annually to its shareholders at least the sum of 90% of its net
investment income (generally including the excess of net short-term capital
gains over net long-term capital losses) and 90% of its net tax-exempt interest
income, if any (the “Distribution Requirement”) and also must meet several
additional requirements. Among these requirements are the following: (i) at
least 90% of the applicable Fund’s gross income each taxable year must be
derived from dividends, interest, payments with respect to certain securities
loans, gains from the sale or other disposition of stock, securities or foreign
currencies, or other income derived with respect to its business of investing in
such stock, securities or foreign currencies and net income derived from
interests in qualified publicly traded partnerships (the “Qualifying Income
Requirement”); and (ii) at the end of each quarter of the Fund’s taxable year,
the Fund’s assets must be diversified so that (a) at least 50% of the value of
the Fund’s total assets is represented by cash and cash items, U.S. government
securities, securities of other RICs, and other securities, with such other
securities limited, in respect to any one issuer, to an amount not greater in
value than 5% of the value of the Fund’s total assets and to not more than 10%
of the outstanding voting securities of such issuer, including the equity
securities of a qualified publicly traded partnership, and (b) not more than 25%
of the value of its total assets is invested, including through corporations in
which the Fund owns a 20% or more voting stock interest, in the securities
(other than U.S. government securities or securities of other RICs) of any one
issuer, the securities (other than securities of other RICs) of two or more
issuers which the applicable Fund controls and which are engaged in the same,
similar, or related trades or businesses, or the securities of one or more
qualified publicly traded partnerships (the “Diversification Requirement”). The
determination of the value and the identity of the issuer of derivative
investments that the Fund may invest in are often unclear for purposes of the
Diversification Requirement described above. Although each Fund intends to
carefully monitor its investments to ensure that it is adequately diversified
under the Diversification Requirement, there are no assurances that the IRS will
agree with a Fund’s determination of the issuer under the Diversification
Requirement with respect to such derivatives.
It
may not be possible for a Fund to fully implement a replication strategy or a
representative sampling strategy while satisfying the Diversification
Requirement. A Fund’s efforts to satisfy the Diversification Requirement may
affect the Fund’s execution of its investment strategy and may cause the Fund’s
return to deviate from that of the Index, and the Fund’s efforts to represent
the Index using a sampling strategy, if such a strategy is used at any point,
may cause it inadvertently to fail to satisfy the Diversification
Requirement.
To
the extent a Fund makes investments that may generate income that is not
qualifying income, the Fund will seek to restrict the resulting income from such
investments so that the Fund’s non-qualifying income does not exceed 10% of its
gross income.
Although
the Funds intend to distribute substantially all of their net investment income
and may distribute their capital gains for any taxable year, the Funds will be
subject to federal income taxation to the extent any such income or gains are
not distributed. Each Fund is treated as a separate corporation for federal
income tax purposes. A Fund therefore is considered to be a separate entity in
determining its treatment under the rules for RICs described herein. The
requirements (other than certain organizational requirements) for qualifying RIC
status are determined at the fund level rather than at the Trust level.
If
a Fund fails to satisfy the Qualifying Income Requirement or the Diversification
Requirement in any taxable year, the applicable Fund may be eligible for relief
provisions if the failures are due to reasonable cause and not willful neglect
and if a penalty tax is paid with respect to each failure to satisfy the
applicable requirements. Additionally, relief is provided for certain
de
minimis
failures of the Diversification Requirement where a Fund corrects the failure
within a specified period of time. To be eligible for the relief provisions with
respect to a failure to meet the Diversification Requirement, a Fund may be
required to dispose of certain assets. If these relief provisions were not
available to a Fund and it were to fail to qualify for treatment as a RIC for a
taxable year, all of its taxable income would be subject to tax at the regular
21% corporate rate without any deduction for distributions to shareholders, and
its distributions (including capital gains distributions) generally would be
taxable to the shareholders of the applicable Fund as ordinary income dividends,
subject to the dividends received deduction for corporate shareholders and the
lower tax rates on qualified dividend income received by non-corporate
shareholders, subject to certain limitations. To requalify for treatment as a
RIC in a subsequent taxable year, a Fund would be required to satisfy the RIC
qualification requirements for that year and to distribute any earnings and
profits from any year in which the applicable Fund failed to qualify for tax
treatment as a RIC. If a Fund failed to qualify as a RIC for a period greater
than two taxable years, it would generally be required to pay a Fund-level tax
on certain net built in gains recognized with respect to certain of its assets
upon a disposition of such assets within five years of qualifying as a RIC in a
subsequent year. The Board reserves the right not to maintain the qualification
of a Fund for treatment as a RIC if it determines such course of action to be
beneficial to shareholders. If a Fund determines that it will not qualify as a
RIC, the applicable Fund will establish procedures to reflect the anticipated
tax liability in the Fund’s NAV.
A
Fund may elect to treat part or all of any “qualified late year loss” as if it
had been incurred in the succeeding taxable year in determining the Fund’s
taxable income, net capital gain, net short-term capital gain, and earnings and
profits. The effect of this election is to treat any such “qualified late year
loss” as if it had been incurred in the succeeding taxable year in
characterizing Fund distributions for any calendar year. A “qualified late year
loss” generally includes net capital loss, net long-term capital loss, or net
short-term capital loss incurred after October 31 of the current taxable year
(commonly referred to as “post-October losses”) and certain other late-year
losses.
Capital
losses in excess of capital gains (“net capital losses”) are not permitted to be
deducted against a RIC’s net investment income. Instead, for U.S. federal income
tax purposes, potentially subject to certain limitations, a Fund may carry a net
capital loss from any taxable year forward indefinitely to offset its capital
gains, if any, in years following the year of the loss. To the extent subsequent
capital gains are offset by such losses, they will not result in U.S. federal
income tax liability to the applicable Fund and may not be distributed as
capital gains to its shareholders. Generally, a Fund may not carry forward any
losses other than net capital losses. The carryover of capital losses may be
limited under the general loss limitation rules if the Fund experiences an
ownership change as defined in the Code.
The
table below shows the capital loss carryforward amounts for each Fund as of the
fiscal year ended October 31,
2023.
These amounts do not expire.
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Name
of Fund |
Short-Term
Capital Loss Carry Forward |
Long-Term
Capital Loss Carry Forward |
AAM
S&P 500 High Dividend Value ETF |
$1,939,888 |
$2,836,894 |
AAM
S&P Emerging Markets High Dividend Value ETF |
$285,069 |
$1,609,484 |
AAM
S&P Developed Markets High Dividend Value ETF |
$298,045 |
$114,913 |
AAM
Low Duration Preferred and Income Securities ETF |
$19,215,977 |
$4,260,369 |
AAM
Transformers ETF |
$795,366 |
$44,375 |
A
Fund will be subject to a nondeductible 4% federal excise tax on certain
undistributed income if it does not distribute to its shareholders in each
calendar year an amount at least equal to 98% of its ordinary income for the
calendar year plus 98.2% of its capital gain net income for the one-year period
ending on October 31 of that year, subject to an increase for any shortfall in
the prior year’s distribution. For this purpose, any ordinary income or capital
gain net income retained by a Fund and subject to corporate income tax will be
considered to have been distributed. The Funds intend to declare and distribute
dividends and distributions in the amounts and at the times necessary to avoid
the application of the excise tax, but can make no assurances that all such tax
liability will be completely eliminated. A Fund may in certain circumstances be
required to liquidate Fund investments in order to make sufficient distributions
to avoid federal excise tax liability at a time when the investment adviser
might not otherwise have chosen to do so, and liquidation of investments in such
circumstances may affect the ability of the Fund to satisfy the requirement for
qualification as a RIC.
If
a Fund meets the Distribution Requirement but retains some or all of its income
or gains, it will be subject to federal income tax to the extent any such income
or gains are not distributed. A Fund may designate certain amounts retained as
undistributed net capital gain in a notice to its shareholders, who (i) will be
required to include in income for U.S. federal income tax purposes, as long-term
capital gain, their proportionate shares of the undistributed amount so
designated, (ii) will be entitled to credit their proportionate shares of the
income tax paid by the Fund on that undistributed amount against their federal
income tax liabilities and to claim refunds to the extent such credits exceed
their tax liabilities, and (iii) will be entitled to increase their tax basis,
for federal income tax purposes, in their Shares by an amount equal to the
excess of the amount of undistributed net capital gain included in their
respective income over their respective income tax credits.
Taxation
of Shareholders – Distributions.
Each Fund intends to distribute annually to its shareholders substantially all
of its investment company taxable income (computed without regard to the
deduction for dividends paid), its net tax-exempt income, if any, and any net
capital gain (net recognized long-term capital gains in excess of net recognized
short-term capital losses, taking into account any capital loss carryforwards).
The distribution of investment company taxable income (as so computed) and net
realized capital gain will be taxable to Fund shareholders regardless of whether
the shareholder receives these distributions in cash or reinvests them in
additional Shares.
Each
Fund (or your broker) will report to shareholders annually the amounts of
dividends paid from ordinary income, the amount of distributions of net capital
gain, the portion of dividends which may qualify for the dividends received
deduction for corporations, and the portion of dividends which may qualify for
treatment as qualified dividend income, which, subject to certain limitations
and requirements, is taxable to non-corporate shareholders at rates of up to
20%. Distributions from a Fund’s net capital gain will be taxable to
shareholders at long-term capital gains rates, regardless of how long
shareholders have held their Shares.
Qualified
dividend income includes, in general, subject to certain holding period and
other requirements, dividend income from taxable domestic corporations and
certain foreign corporations. Subject to certain limitations, eligible foreign
corporations include those incorporated in possessions of the United States,
those incorporated in certain countries with comprehensive tax treaties with the
United States, and other foreign corporations if the stock with respect to which
the dividends are paid is readily tradable on an established securities market
in the United States. Dividends received by a Fund from an underlying fund
taxable as a RIC or from a REIT may be treated as qualified dividend income
generally only to the extent so reported by such underlying fund or REIT,
however, dividends received by a Fund from a REIT are generally not treated as
qualified dividend income. If 95% or more of a Fund’s gross income (calculated
without taking into account net capital gain derived from sales or other
dispositions of stock or securities) consists of qualified dividend income, the
Fund may report all distributions of such income as qualified dividend income.
Fund
dividends will not be treated as qualified dividend income if a Fund does not
meet holding period and other requirements with respect to dividend paying
stocks in its portfolio, and the shareholder does not meet holding period and
other requirements with respect to the Shares on which the dividends were paid.
Distributions by a Fund of its net short-term capital gains will be taxable as
ordinary income. Distributions from a Fund’s net capital gain will be taxable to
shareholders at long-term capital gains rates, regardless of how long
shareholders have held their Shares. Distributions may be subject to state and
local taxes.
In
the case of corporate shareholders, certain dividends received by a Fund from
U.S. corporations (generally, dividends received by the Fund in respect of any
share of stock (1) with a tax holding period of at least 46 days during the
91-day period beginning on the date that is 45 days before the date on which the
stock becomes ex-dividend as to that dividend and (2) that is held in an
unleveraged position) and distributed and appropriately so reported by the Fund
may be eligible for the 50% dividends received deduction. Certain preferred
stock must have a holding period of at least 91 days during the 181-day period
beginning on the date that is 90 days before the date on which the stock becomes
ex-dividend as to that dividend to be eligible. Capital gain dividends
distributed to a Fund from other RICs are not eligible, and dividends
distributed to a Fund from REITs are generally not eligible for the dividends
received deduction. To qualify for the deduction, corporate shareholders must
meet the minimum holding period requirement stated above with respect to their
Shares, taking into account any holding period reductions from certain hedging
or other transactions or positions that diminish their risk of loss with respect
to their Shares, and, if they borrow to acquire or otherwise incur debt
attributable to Shares, they may be denied a portion of the dividends received
deduction with respect to those Shares. Since the AAM S&P Emerging Markets
High Dividend Value ETF and AAM S&P Developed Markets High Dividend Value
ETF invest primarily in securities of non-U.S. issuers, it is not expected that
a significant portion of the dividends received from these Funds will qualify
for the dividends-received deduction for corporations.
Although
dividends generally will be treated as distributed when paid, any dividend
declared by a Fund in October, November or December and payable to shareholders
of record in such a month that is paid during the following January will be
treated for U.S. federal income tax purposes as received by shareholders on
December 31 of the calendar year in which it was declared.
U.S.
individuals with adjusted gross income (subject to certain adjustments)
exceeding certain threshold amounts ($250,000 if married filing jointly or if
considered a “surviving spouse” for federal income tax purposes, $125,000 if
married filing separately, and $200,000 in other cases) are subject to a 3.8%
tax on all or a portion of their “net investment income,” which includes taxable
interest, dividends, and certain capital gains (generally including capital gain
distributions and capital gains realized on the sale of Shares).
This
3.8% tax also applies to all or a portion of the undistributed net investment
income of certain shareholders that are estates and trusts.
Shareholders
who have not held Shares for a full year should be aware that a Fund may report
and distribute, as ordinary dividends or capital gain dividends, a percentage of
income that is not equal to the percentage of the Fund’s ordinary income or net
capital gain, respectively, actually earned during the applicable shareholder’s
period of investment in the Fund. A taxable shareholder may wish to avoid
investing in a Fund shortly before a dividend or other distribution, because the
distribution will generally be taxable even though it may economically represent
a return of a portion of the shareholder’s investment.
To
the extent that a Fund makes a distribution of income received by the Fund in
lieu of dividends (a “substitute payment”) with respect to securities on loan
pursuant to a securities lending transaction, such income will not constitute
qualified dividend income to individual shareholders and will not be eligible
for the dividends received deduction for corporate shareholders.
If
a Fund’s distributions exceed its earnings and profits, all or a portion of the
distributions made for a taxable year may be recharacterized as a return of
capital to shareholders. A return of capital distribution will generally not be
taxable, but will reduce each shareholder’s cost basis in a Fund and result in a
higher capital gain or lower capital loss when the Shares on which the
distribution was received are sold. After a shareholder’s basis in the Shares
has been reduced to zero, distributions in excess of earnings and profits will
be treated as gain from the sale of the shareholder’s Shares.
Taxation
of Shareholders – Sale or Exchange of Shares.
A sale or exchange of Shares may give rise to a gain or loss. For tax purposes,
an exchange of your Fund shares of a different fund is the same as a sale. In
general, provided that a shareholder holds Shares as capital assets, any gain or
loss realized upon a taxable disposition of Shares will be treated as long-term
capital gain or loss if Shares have been held for more than 12 months.
Otherwise, such gain or loss on the taxable disposition of Shares will generally
be treated as short-term capital gain or loss. Any loss realized upon a taxable
disposition of Shares held for six months or less will be treated as long-term
capital loss, rather than short-term capital loss, to the extent of any amounts
treated as distributions to the shareholder of long-term capital gain (including
any amounts credited to the shareholder as undistributed capital gains). All or
a portion of any loss realized upon a taxable disposition of Shares may be
disallowed if substantially identical Shares are acquired (through the
reinvestment of dividends or otherwise) within a 61-day period beginning 30 days
before and ending 30 days after the disposition. In such a case, the basis of
the newly acquired Shares will be adjusted to reflect the disallowed loss.
The
cost basis of Shares acquired by purchase will generally be based on the amount
paid for Shares and then may be subsequently adjusted for other applicable
transactions as required by the Code. The difference between the selling price
and the cost basis of Shares generally determines the amount of the capital gain
or loss realized on the sale or exchange of Shares. Contact the broker through
whom you purchased your Shares to obtain information with respect to the
available cost basis reporting methods and elections for your account.
An
Authorized Participant who exchanges securities for Creation Units generally
will recognize a gain or a loss. The gain or loss will be equal to the
difference between the market value of the Creation Units at the time and the
sum of the exchanger’s aggregate basis in the securities surrendered plus the
amount of cash paid for such Creation Units. The ability of Authorized
Participants to receive a full or partial cash redemption of Creation Units of a
Fund may limit the tax efficiency of such Fund. An Authorized Participant who
redeems Creation Units will generally recognize a gain or loss equal to the
difference between the exchanger’s basis in the Creation Units and the sum of
the aggregate market value of any securities received plus the amount of any
cash received for such Creation Units. The Internal Revenue Service (“IRS”),
however, may assert that a loss realized upon an exchange of securities for
Creation Units cannot currently be deducted under the rules governing “wash
sales” (for a person who does not mark-to-market its portfolio) or on the basis
that there has been no significant change in economic position.
The
Trust, on behalf of the Funds, has the right to reject an order for Creation
Units if the purchaser (or a group of purchasers) would, upon obtaining the
Creation Units so ordered, own 80% or more of the outstanding Shares and if,
pursuant to Section 351 of the Code, a Fund would have a basis in the deposit
securities different from the market value of such securities on the date of
deposit. The Trust also has the right to require the provision of information
necessary to determine beneficial Share ownership for purposes of the 80%
determination. If a Fund does issue Creation Units to a purchaser (or a group of
purchasers) that would, upon obtaining the Creation Units so ordered, own 80% or
more of the outstanding Shares, the purchaser (or a group of purchasers) will
not recognize gain or loss upon the exchange of securities for Creation Units.
Authorized
Participants purchasing or redeeming Creation Units should consult their own tax
advisers with respect to the tax treatment of any creation or redemption
transaction and whether the wash sales rule applies and when a loss may be
deductible.
Taxation
of Fund Investments.
Certain of a Fund’s investments may be subject to complex provisions of the Code
(including provisions relating to hedging transactions, straddles, integrated
transactions, foreign currency contracts, forward foreign currency contracts,
and notional principal contracts) that, among other things, may affect a Fund’s
ability to qualify as a RIC, affect the character of gains and losses realized
by the Fund (e.g.,
may affect whether gains or losses are ordinary or capital), accelerate
recognition of income to the Fund and defer losses. These rules could therefore
affect the character, amount and timing of distributions to shareholders. These
provisions also may require a Fund to mark to market certain types of positions
in its portfolio (i.e.,
treat them
as
if they were closed out) which may cause the Fund to recognize income without
the Fund receiving cash with which to make distributions in amounts sufficient
to enable the Fund to satisfy the RIC distribution requirements for avoiding
income and excise taxes. A Fund intends to monitor its transactions, intends to
make appropriate tax elections, and intends to make appropriate entries in its
books and records to mitigate the effect of these rules and preserve the Fund’s
qualification for treatment as a RIC. To the extent a Fund invests in an
underlying fund that is taxable as a RIC, the rules applicable to the tax
treatment of complex securities will also apply to the underlying funds that
also invest in such complex securities and investments.
Foreign
Investments.
Dividends and interest received by a Fund from sources within foreign countries
may be subject to withholding and other taxes imposed by such countries. Tax
treaties between certain countries and the U.S. may reduce or eliminate such
taxes.
If
more than 50% of the value of a Fund’s assets at the close of any taxable year
consists of stock or securities of foreign corporations, which for this purpose
may include obligations of foreign governmental issuers, the Fund may elect, for
U.S. federal income tax purposes, to treat any foreign income or withholding
taxes paid by the Fund as paid by its shareholders. For any year that a Fund is
eligible for and makes such an election, each shareholder of the Fund will be
required to include in income an amount equal to his or her allocable share of
qualified foreign income taxes paid by the Fund, and shareholders will be
entitled, subject to certain holding period requirements and other limitations,
to credit their portions of these amounts against their U.S. federal income tax
due, if any, or to deduct their portions from their U.S. taxable income, if any.
No deductions for foreign taxes paid by a Fund may be claimed, however, by
non-corporate shareholders who do not itemize deductions. No deduction for such
taxes will be permitted to individuals in computing their alternative minimum
tax liability. Shareholders that are not subject to U.S. federal income tax, and
those who invest in a Fund through tax-advantaged accounts (including those who
invest through individual retirement accounts or other tax-advantaged retirement
plans), generally will receive no benefit from any tax credit or deduction
passed through by such Fund. Each Fund does not expect to satisfy the
requirements for passing through to its shareholders any share of foreign taxes
paid by the Fund, with the result that shareholders will not include such taxes
in their gross incomes and will not be entitled to a tax deduction or credit for
such taxes on their own tax returns. Foreign taxes paid by a Fund will reduce
the return from the Fund’s investments.
If
a Fund holds shares in a “passive foreign investment company” (“PFIC”), it may
be subject to U.S. federal income tax on a portion of any “excess distribution”
or gain from the disposition of such shares even if such income is distributed
as a taxable dividend by the Fund to its shareholders. Additional charges in the
nature of interest may be imposed on a Fund in respect of deferred taxes arising
from such distributions or gains.
Each
Fund may be eligible to treat a PFIC as a “qualified electing fund” (“QEF”)
under the Code in which case, in lieu of the foregoing requirements, the Fund
will be required to include in income each year a portion of the ordinary
earnings and net capital gains of the qualified electing fund, even if not
distributed to the Fund, and such amounts will be subject to the 90% and excise
tax distribution requirements described above. To make this election, a Fund
would be required to obtain certain annual information from the PFICs in which
it invests, which may be difficult or impossible to obtain. Alternatively, a
Fund may make a mark-to-market election that will result in such Fund being
treated as if it had sold and repurchased its PFIC stock at the end of each
year. In such case, a Fund would report any gains resulting from such deemed
sales as ordinary income and would deduct any losses resulting from such deemed
sales as ordinary losses to the extent of previously recognized gains. The
election must be made separately for each PFIC owned by a Fund and, once made,
is effective for all subsequent taxable years, unless revoked with the consent
of the IRS. By making the election, a Fund could potentially ameliorate the
adverse tax consequences with respect to its ownership of shares in a PFIC, but
in any particular year may be required to recognize income in excess of the
distributions it receives from PFICs and its proceeds from dispositions of PFIC
stock. A Fund may have to distribute this excess income to satisfy the 90%
distribution requirement and to avoid imposition of the 4% excise tax. To
distribute this income and avoid a tax at the fund level, a Fund might be
required to liquidate portfolio securities that it might otherwise have
continued to hold, potentially resulting in additional taxable gain or loss.
Each Fund intends to make the appropriate tax elections, if possible, and take
any additional steps that are necessary to mitigate the effect of these rules.
Amounts included in income each year by a Fund arising from a QEF election, will
be “qualifying income” under the Qualifying Income Requirement (as described
above) even if not distributed to the Fund, if the Fund derives such income from
its business of investing in stock, securities or currencies.
Additional
Tax Information Concerning REITs.
The Funds may invest in entities treated as REITs for U.S. federal income tax
purposes.
Investments
in REIT equity securities may require a Fund to accrue and distribute income not
yet received. To generate sufficient cash to make the requisite distributions, a
Fund may be required to sell securities in its portfolio (including when it is
not advantageous to do so) that it otherwise would have continued to hold. A
Fund’s investments in REIT equity securities may at other times result in a
Fund’s receipt of cash in excess of the REIT’s earnings; if a Fund distributes
these amounts, these distributions could constitute a return of capital to such
Fund’s shareholders for federal income tax purposes. Dividends paid by a REIT,
other than capital gain distributions, will be taxable as ordinary income up to
the amount of the REIT’s current and accumulated earnings and profits. Capital
gain dividends paid by a REIT to a Fund will be treated as long-term capital
gains by a Fund and, in turn, may be distributed by a Fund to its shareholders
as a capital gain distribution. Dividends received by a Fund from a REIT
generally will not constitute qualified dividend income or qualify for the
dividends received deduction. If a REIT is operated in a manner such that it
fails to
qualify
as a REIT, an investment in the REIT would become subject to double taxation,
meaning the taxable income of the REIT would be subject to federal income tax at
the regular corporate rate without any deduction for dividends paid to
shareholders and the dividends would be taxable to shareholders as ordinary
income (or possibly as qualified dividend income) to the extent of the REIT’s
current and accumulated earnings and profits.
REITs
in which a Fund invests often do not provide complete and final tax information
to a Fund until after the time that such Fund issues a tax reporting statement.
As a result, a Fund may at times find it necessary to reclassify the amount and
character of its distributions to you after it issues your tax reporting
statement. When such reclassification is necessary, you will be sent a
corrected, final Form 1099-DIV to reflect the reclassified information. If you
receive a corrected Form 1099-DIV, use the information on this corrected form,
and not the information on the previously issued tax reporting statement, in
completing your tax returns.
“Qualified
REIT dividends” (i.e.,
ordinary REIT dividends other than capital gain dividends and portions of REIT
dividends designated as qualified dividend income eligible for capital gain tax
rates) are eligible for a 20% deduction by non-corporate taxpayers. This
deduction, if allowed in full, equates to a maximum effective tax rate of 29.6%
(37% top rate applied to income after 20% deduction). Distributions by a Fund to
its shareholders that are attributable to qualified REIT dividends received by
such Fund and which the Fund properly reports as “section 199A dividends,” are
treated as “qualified REIT dividends” in the hands of non-corporate
shareholders. A section 199A dividend is treated as a qualified REIT dividend
only if the shareholder receiving such dividend holds the dividend-paying RIC
shares for at least 46 days of the 91-day period beginning 45 days before the
shares become ex-dividend, and is not under an obligation to make related
payments with respect to a position in substantially similar or related
property. A Fund is permitted to report such part of its dividends as section
199A dividends as are eligible, but is not required to do so.
Backup
Withholding.
Each Fund will be required in certain cases to withhold (as “backup
withholding”) on amounts payable to any shareholder who (1) fails to provide a
correct taxpayer identification number certified under penalty of perjury; (2)
is subject to backup withholding by the IRS for failure to properly report all
payments of interest or dividends; (3) fails to provide a certified statement
that he or she is not subject to “backup withholding”; or (4) fails to provide a
certified statement that he or she is a U.S. person (including a U.S. resident
alien). The backup withholding rate is currently 24%. Backup withholding is not
an additional tax and any amounts withheld may be credited against the
shareholder’s ultimate U.S. tax liability. Backup withholding will not be
applied to payments that have been subject to the 30% withholding tax on
shareholders who are neither citizens nor permanent residents of the U.S.
Non-U.S.
Shareholders.
Any non-U.S. investors in a Fund may be subject to U.S. withholding and estate
tax and are encouraged to consult their tax advisers prior to investing in the
Fund. Foreign shareholders (i.e.,
nonresident alien individuals and foreign corporations, partnerships, trusts and
estates) are generally subject to U.S. withholding tax at the rate of 30% (or a
lower tax treaty rate) on distributions derived from taxable ordinary income.
Each Fund may, under certain circumstances, report all or a portion of a
dividend as an “interest-related dividend” or a “short-term capital gain
dividend,” which would generally be exempt from this 30% U.S. withholding tax,
provided certain other requirements are met. Short-term capital gain dividends
received by a nonresident alien individual who is present in the U.S. for a
period or periods aggregating 183 days or more during the taxable year are not
exempt from this 30% withholding tax. Gains realized by foreign shareholders
from the sale or other disposition of Shares generally are not subject to U.S.
taxation, unless the recipient is an individual who is physically present in the
U.S. for 183 days or more per year. Foreign shareholders who fail to provide an
applicable IRS form may be subject to backup withholding on certain payments
from a Fund. Backup withholding will not be applied to payments that are subject
to the 30% (or lower applicable treaty rate) withholding tax described in this
paragraph. Different tax consequences may result if the foreign shareholder is
engaged in a trade or business within the United States. In addition, the tax
consequences to a foreign shareholder entitled to claim the benefits of a tax
treaty may be different than those described above.
Unless
certain non-U.S. entities that hold Shares comply with IRS requirements that
will generally require them to report information regarding U.S. persons
investing in, or holding accounts with, such entities, a 30% withholding tax may
apply to Fund distributions payable to such entities. A non-U.S. shareholder may
be exempt from the withholding described in this paragraph under an applicable
intergovernmental agreement between the U.S. and a foreign government, provided
that the shareholder and the applicable foreign government comply with the terms
of the agreement.
For
foreign shareholders to qualify for an exemption from backup withholding,
described above, the foreign shareholder must comply with special certification
and filing requirements. Foreign shareholders in a Fund should consult their tax
advisers in this regard.
Tax-Exempt
Shareholders.
Certain tax-exempt shareholders, including qualified pension plans, IRAs, salary
deferral arrangements, 401(k) plans, and other tax-exempt entities, generally
are exempt from federal income taxation except with respect to their unrelated
business taxable income (“UBTI”). Tax-exempt entities are not permitted to
offset losses from one unrelated trade or business against the income or gain of
another unrelated trade or business. Certain net losses incurred prior to
January 1, 2018 are permitted to offset gain and income created by an
unrelated trade or business, if otherwise available. Under current law, each
Fund generally serves to block UBTI from being realized by its tax-exempt
shareholders with respect to their shares of Fund income. However,
notwithstanding the foregoing, tax-exempt shareholders could realize UBTI by
virtue of their investment in a Fund if, for example, (i) the Fund invests in
residual interests of Real Estate Mortgage Investment Conduits (“REMICs”), (ii)
the Fund invests in a REIT that is a taxable mortgage pool (“TMP”) or that has a
subsidiary that is a TMP or that invests in the residual interest of a REMIC, or
(iii) Shares
constitute
debt-financed property in the hands of the tax-exempt shareholders within the
meaning of section 514(b) of the Code. Charitable remainder trusts are subject
to special rules and should consult their tax advisers. The IRS has issued
guidance with respect to these issues and prospective shareholders, especially
charitable remainder trusts, are strongly encouraged to consult with their tax
advisers regarding these issues.
Certain
Potential Tax Reporting Requirements.
Under U.S. Treasury regulations, if a shareholder recognizes a loss on
disposition of Shares of $2 million or more for an individual shareholder or $10
million or more for a corporate shareholder (or certain greater amounts over a
combination of years), the shareholder must file with the IRS a disclosure
statement on IRS Form 8886. Direct shareholders of portfolio securities are in
many cases excepted from this reporting requirement, but under current guidance,
shareholders of a RIC are not excepted. Significant penalties may be imposed for
the failure to comply with the reporting requirements. The fact that a loss is
reportable under these regulations does not affect the legal determination of
whether the taxpayer’s treatment of the loss is proper. Shareholders should
consult their tax advisers to determine the applicability of these regulations
in light of their individual circumstances.
Other
Issues.
In those states which have income tax laws, the tax treatment of a Fund and of
Fund shareholders with respect to distributions by the Fund may differ from
federal tax treatment.
FINANCIAL
STATEMENTS
The
annual
report
for the Funds for the fiscal year ended October 31,
2023
is a separate document and the financial statements and accompanying notes
appearing therein are incorporated by reference into this SAI. You may request a
copy of the Funds’ Annual Report at no charge by calling 1-800-617-0004 or
through the Funds’ website at www.aamlive.com/ETF.
ADDITIONAL
NOTICES
The
S&P 500 Dividend and Free Cash Flow Yield Index, S&P Emerging Markets
Dividend and Free Cash Flow Yield Index, and S&P Developed Ex-U.S. Dividend
and Free Cash Flow Yield Index (each, an “S&P Index”) are each a product of
S&P Dow Jones Indices LLC, a division of S&P Global, or its affiliates
(“SPDJI”), and has been licensed for use by the Adviser. Standard & Poor’s®,
S&P®, and S&P 500® are registered trademarks of Standard & Poor’s
Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow
Jones Trademark Holdings LLC (“Dow Jones”); and these trademarks have been
licensed for use by SPDJI and sublicensed for certain purposes by the Adviser.
It is not possible to invest directly in an index. The Funds are not sponsored,
endorsed, sold or promoted by SPDJI, Dow Jones, S&P, any of their respective
affiliates (collectively, “S&P Dow Jones Indices”). S&P Dow Jones
Indices makes no representation or warranty, express or implied, to the owners
of the Funds or any member of the public regarding the advisability of investing
in securities generally or in the Funds particularly. Past performance of an
index is not an indication or guarantee of future results. S&P Dow Jones
Indices’ only relationship to the Adviser with respect to each S&P Index is
the licensing of each S&P Index and certain trademarks, service marks and/or
trade names of S&P Dow Jones Indices and/or its licensors. Each S&P
Index is determined, composed and calculated by S&P Dow Jones Indices
without regard to the Adviser or the Funds. S&P Dow Jones Indices has no
obligation to take the needs of the Adviser or the owners of the Funds into
consideration in determining, composing or calculating each S&P Index.
S&P Dow Jones Indices is not responsible for and has not participated in the
determination of the prices, and number of shares of the Funds or the timing of
the issuance or sale of shares of the Funds or in the determination or
calculation of the equation by which shares of the Funds are to be converted
into cash, surrendered or redeemed, as the case may be. S&P Dow Jones
Indices has no obligation or liability in connection with the administration,
marketing or trading of the Funds. There is no assurance that investment
products based on each S&P Index will accurately track index performance or
provide positive investment returns. S&P Dow Jones Indices LLC is not an
investment or tax advisor. A tax advisor should be consulted to evaluate the
impact of any tax-exempt securities on portfolios and the tax consequences of
making any particular investment decision. Inclusion of a security within an
index is not a recommendation by S&P Dow Jones Indices to buy, sell, or hold
such security, nor is it considered to be investment advice.
S&P
DOW JONES INDICES DOES NOT GUARANTEE THE ADEQUACY, ACCURACY, TIMELINESS AND/OR
THE COMPLETENESS OF EACH S&P INDEX OR ANY DATA RELATED THERETO OR ANY
COMMUNICATION, INCLUDING BUT NOT LIMITED TO, ORAL OR WRITTEN COMMUNICATION
(INCLUDING ELECTRONIC COMMUNICATIONS) WITH RESPECT THERETO. S&P DOW JONES
INDICES SHALL NOT BE SUBJECT TO ANY DAMAGES OR LIABILITY FOR ANY ERRORS,
OMISSIONS, OR DELAYS THEREIN. S&P DOW JONES INDICES MAKES NO EXPRESS OR
IMPLIED WARRANTIES, AND EXPRESSLY DISCLAIMS ALL WARRANTIES, OF MERCHANTABILITY
OR FITNESS FOR A PARTICULAR PURPOSE OR USE OR AS TO RESULTS TO BE OBTAINED BY
THE ADVISER, OWNERS OF THE FUNDS, OR ANY OTHER PERSON OR ENTITY FROM THE USE OF
EACH S&P INDEX OR WITH RESPECT TO ANY DATA RELATED THERETO. WITHOUT LIMITING
ANY OF THE FOREGOING, IN NO EVENT WHATSOEVER SHALL S&P DOW JONES INDICES BE
LIABLE FOR ANY INDIRECT, SPECIAL, INCIDENTAL, PUNITIVE, OR CONSEQUENTIAL DAMAGES
INCLUDING BUT NOT LIMITED TO, LOSS OF PROFITS, TRADING LOSSES, LOST TIME OR
GOODWILL, EVEN IF THEY HAVE BEEN ADVISED OF THE POSSIBILITY OF SUCH DAMAGES,
WHETHER IN CONTRACT, TORT, STRICT LIABILITY, OR OTHERWISE. THERE ARE NO
THIRD-PARTY BENEFICIARIES OF ANY AGREEMENTS OR
ARRANGEMENTS
BETWEEN S&P DOW JONES INDICES AND THE ADVISER, OTHER THAN THE LICENSORS OF
S&P DOW JONES INDICES.
Source
ICE Data Indices, LLC (“ICE Data”), is used with permission. “ICESM/®”
is a service/trade mark of ICE Data Indices, LLC or its affiliates and has been
licensed, along with the ICE 0-5 Year Duration Exchange-Listed Preferred &
Hybrid Securities Index (“Index”) for use by the Adviser in connection with the
Fund. Neither the Adviser, ETF Series Solutions (the “Trust”), nor the Fund, as
applicable, is sponsored, endorsed, sold or promoted by ICE Data Indices, LLC,
its affiliates or its Third Party Suppliers (“ICE Data and its Suppliers”). ICE
Data and its Suppliers make no representations or warranties regarding the
advisability of investing in securities generally, in the Fund particularly, the
Trust or the ability of the Index to track general stock market performance. ICE
Data’s only relationship to the Adviser is the licensing of certain trademarks
and trade names and the Index or components thereof. The Index is determined,
composed and calculated by ICE Data without regard to the Adviser or the Fund or
its holders. ICE Data has no obligation to take the needs of the Adviser or the
holders of the Fund into consideration in determining, composing or calculating
the Index. ICE Data is not responsible for and has not participated in the
determination of the timing of, prices of, or quantities of the Fund to be
issued or in the determination or calculation of the equation by which the Fund
is to be priced, sold, purchased, or redeemed. Except for certain custom index
calculation services, all information provided by ICE Data is general in nature
and not tailored to the needs of the Adviser or any other person, entity or
group of persons. ICE Data has no obligation or liability in connection with the
administration, marketing, or trading of the Fund. ICE Data is not an investment
advisor. Inclusion of a security within an index is not a recommendation by ICE
Data to buy, sell, or hold such security, nor is it considered to be investment
advice.
ICE
DATA AND ITS SUPPLIERS DISCLAIM ANY AND ALL WARRANTIES AND REPRESENTATIONS,
EXPRESS AND/OR IMPLIED, INCLUDING ANY WARRANTIES OF MERCHANTABILITY OR FITNESS
FOR A PARTICULAR PURPOSE OR USE, INCLUDING THE INDICES, INDEX DATA AND ANY
INFORMATION INCLUDED IN, RELATED TO, OR DERIVED THEREFROM (“INDEX DATA”). ICE
DATA AND ITS SUPPLIERS SHALL NOT BE SUBJECT TO ANY DAMAGES OR LIABILITY WITH
RESPECT TO THE ADEQUACY, ACCURACY, TIMELINESS OR COMPLETENESS OF THE INDICES AND
THE INDEX DATA, WHICH ARE PROVIDED ON AN “AS IS” BASIS AND YOUR USE IS AT YOUR
OWN RISK.
APPENDIX
A
Proxy
Voting Policies and Procedures
Where
AAM acts as Advisor to ESS, the duty to vote proxies for securities held in the
Fund’s portfolio is the responsibility of AAM as Adviser to the ESS funds or
delegated to the Sub- Advisor. For those funds where AAM is responsible for
proxy voting, AAM has retained the services of Broadridge to vote proxies for
securities held in the Fund’s portfolio. The voting for these funds will be in
line with Glass Lewis recommendations.
Unlike
other funds, proxy voting responsibilities for the AAM Bahl & Gaynor
Small/Mid Cap Income Growth ETF (SMIG) are handled by the fund’s sub-advisor,
Bahl & Gaynor, as detailed in the Sub-Advisory Agreement. The Sub-Advisor is
instructed to vote proxies in accordance with the Sub-Advisor’s Proxy Voting
Policy and at all times in a manner consistent with Rule 206(4)-6, under the
Advisers Act. AAM reviews the Sub-Advisors’ Proxy Voting Policy and Procedures,
including proxy voting vendor oversight, during the initial due diligence
request and periodically on an ongoing basis. On a quarterly basis, the
Sub-Advisor is asked to confirm that their firm has been in compliance with
their proxy voting policies. If the Sub-Advisor was out of compliance with their
proxy voting policies at any time during the quarter, they must provide a
written explanation.
The
Trust shall file an annual report of each proxy voted with respect to portfolio
securities held by the Funds during the 12-month period on Form N-PX. AAM’s CCO
(or designee) will review the voting record for accuracy before it is
filed.
APPENDIX
B
United
States
2024
Benchmark Policy Guidelines
www.glasslewis.com
Table
of Contents
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About
Glass Lewis
Glass
Lewis is the world’s choice for governance solutions. We enable
institutional investors and publicly listed companies to make informed decisions
based on research and data. We cover 30,000+ meetings each year, across
approximately 100 global markets. Our team has been providing in-depth
analysis of companies since 2003, relying solely on publicly available
information to inform its policies, research, and voting
recommendations.
Our
customers include the majority of the world’s largest pension plans, mutual
funds, and asset
managers, collectively managing over $40 trillion in
assets. We have teams located across the United States, Europe, and
Asia-Pacific giving us global reach with a local perspective on the important
governance issues.
Investors
around the world depend on Glass Lewis’ Viewpoint
platform to manage their proxy voting, policy implementation, recordkeeping, and
reporting. Our industry leading Proxy
Paper
product provides comprehensive environmental, social, and governance research
and voting recommendations weeks ahead of voting deadlines. Public companies can
also use our innovative Report
Feedback Statement
to deliver their opinion on our proxy research directly to the voting decision
makers at every investor client in time for voting decisions to be made or
changed.
The
research team engages extensively with public companies, investors, regulators,
and other industry stakeholders to gain relevant context into the realities
surrounding companies, sectors, and the market in general. This enables us to
provide the most comprehensive and pragmatic insights to our customers.
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Guidelines
Introduction
Summary
of Changes for 2024
Glass
Lewis evaluates these guidelines on an ongoing basis and formally updates them
on an annual basis. This year we’ve made noteworthy revisions in the following
areas, which are summarized below but discussed in greater detail in the
relevant section of this document:
Material
Weaknesses
We
have included a new discussion on our approach to material weaknesses. Effective
internal controls over financial reporting should ensure the integrity of
companies’ accounting and financial reporting. A material weakness occurs when a
company identifies a deficiency, or a combination of deficiencies, in internal
controls over financial reporting, such that there is a reasonable possibility
that a material misstatement of the company's annual or interim financial
statements will not be prevented or detected on a timely basis.
We
believe it is the responsibility of audit committees to ensure that material
weaknesses are remediated in a timely manner and that companies disclose
remediation plans that include detailed steps to resolve a given material
weakness.
When
a material weakness is reported and the company has not disclosed a remediation
plan, or when a material weakness has been ongoing for more than one year and
the company has not disclosed an updated remediation plan that clearly outlines
the company’s progress toward remediating the material weakness, we will
consider recommending that shareholders vote against all members of a company’s
audit committee who served on the committee during the time when the material
weakness was identified.
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Cyber
Risk Oversight
We
have updated our discussion on our approach to cyber risk oversight. On July 26,
2023, the U.S. Securities and Exchange Commission (SEC) announced rules
requiring public companies to report cybersecurity incidents deemed material
within four days of identifying them; furthermore, in annual reports, they must
disclose their processes for assessing, identifying, and managing material
cybersecurity risks, along with their material effects and past incidents'
impacts. Similar rules were also adopted for foreign private issuers. The final
rules became effective on September 5, 2023. Given the continued regulatory
focus on and the potential adverse outcomes from cyber-related issues, it is our
view that cyber risk is material for all companies.
In
the absence of material cybersecurity incidents, we will generally not make
voting recommendations on the basis of a company’s oversight or disclosure
concerning cyber-related issues. However, in instances where cyber-attacks have
caused significant harm to shareholders, we will closely evaluate the board’s
oversight of cybersecurity as well as the company’s response and
disclosures.
Moreover,
in instances where a company has been materially impacted by a cyber-attack, we
believe shareholders can reasonably expect periodic updates from the company
communicating its ongoing progress towards resolving and remediating the impact
of the cyber-attack. These disclosures should focus on the company’s response to
address the impacts to affected stakeholders and should not reveal specific
and/or technical details that could impede the company’s response or remediation
of the incident or that could assist threat actors.
In
instances where a company has been materially impacted by a cyber-attack, we may
recommend against appropriate directors should we find the board’s oversight,
response or disclosures concerning cybersecurity-related issues to be
insufficient or are not provided to shareholders.
Board
Oversight of Environmental and Social Issues
We
have updated our discussion of board oversight of environmental and social
issues. Given the importance of the board’s role in overseeing environmental and
social risks, we believe that this responsibility should be formally designated
and codified in the appropriate committee charters or other governing
documents.
When
evaluating the board’s role in overseeing environmental and/or social issues, we
will examine a company’s committee charters and governing documents to determine
if the company has codified a meaningful level of oversight of and
accountability for a company’s material environmental and social
impacts.
Board
Accountability for Climate-Related Issues
We
have updated our discussion of board accountability for climate-related issues,
and how our policy is applied. In 2023, our policy on this topic was applied to
the largest, most significant emitters; however beginning in 2024, Glass Lewis
will apply this policy to companies in the S&P 500 index operating in
industries where the Sustainability Accounting Standards Board (SASB) has
determined that the companies’ GHG emissions represent a financially material
risk, as well as companies where we believe emissions or climate impacts, or
stakeholder scrutiny thereof, represent an outsized, financially material risk.
We
will assess whether such companies have produced disclosures in line with the
recommendations of the Task Force on Climate-related Financial Disclosures
(TCFD). We have further clarified that we will also assess whether
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these
companies have disclosed explicit and clearly defined board-level oversight
responsibilities for climate-related issues. In instances where we find either
of these disclosures to be absent of significantly lacking, we may recommend
voting against responsible directors.
Clawback
Provisions
In
light of new NYSE and Nasdaq listing requirements to comply with SEC Rule 10D-1
under the Securities Exchange Act of 1934, Glass Lewis has updated our views on
the utility of clawback provisions. Although the negative impacts of excessive
risk-taking do not always result in financial restatements, they may nonetheless
prove harmful to shareholder value. In addition to meeting listing requirements,
effective clawback policies should provide companies with the power to recoup
incentive compensation from an executive when there is evidence of
problematic decisions or actions, such as material misconduct, a material
reputational failure, material risk management failure, or a material
operational failure, the consequences of which have not already been reflected
in incentive payments and where recovery is warranted. Such power to recoup
should be provided regardless of whether the employment of the executive
officer was terminated
with or without cause.
In these circumstances, rationale should be provided if the company determines
ultimately to refrain from recouping compensation as well as disclosure of
alternative measures that are instead pursued, such as the exercise of negative
discretion on future payments.
Executive
Ownership Guidelines
We
have added a discussion to formally outline our approach to executive ownership
guidelines. We believe that companies should facilitate an alignment between the
interests of the executive leadership with those of long-term shareholders by
adopting and enforcing minimum share ownership rules for their named executive
officers. Companies should provide clear disclosure in the Compensation
Discussion and Analysis section of the proxy statement of their executive share
ownership requirements and how various outstanding equity awards are treated
when determining an executive’s level of ownership.
In
the process of determining an executive’s level of share ownership, counting
unearned performance-based full value awards and/or unexercised stock options is
inappropriate. Companies should provide a cogent rationale should they count
these awards towards shares held by an executive.
Proposals
for Equity Awards for Shareholders
Regarding
proposals seeking approval for individual equity awards, we have included new
discussion of provisions that require a non-vote, or vote of abstention, from a
shareholder if the shareholder is also the recipient of the proposed grant. Such
provisions help to address potential conflict of interest issues and provide
disinterested shareholders with more meaningful say over the proposal. The
inclusion of such provisions will be viewed positively during our holistic
analysis, especially when a vote from the recipient of the proposed grant would
materially influence the passage of the proposal.
Net
Operating Loss (NOL) Pills
We
have updated our discussion of NOL pills to include our concerns with acting in
concert provisions. Over the past several years, the terms and structures of NOL
pills have evolved to include features such as acting in
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concert
provisions, among other concerning terms, that may disempower shareholders and
insulate the board and management. When acting in concert provisions are present
within the terms of a NOL pill, we believe this may raise concerns as to the
true objective of the pill.
Acting
in concert provisions broaden the definition of beneficial ownership to prohibit
parallel conduct, or multiple shareholders party to a formal or informal
agreement collaborating to influence the board and management of a company, and
aggregate the ownership of such shareholders towards the triggering threshold.
As
such, we have added the inclusion of an acting in concert provision and whether
the pill is implemented following the filing of a Schedule 13D by a shareholder
or there is evidence of hostile activity or shareholder activism as part of our
considerations to recommend shareholders vote against a management proposed NOL
pill.
Control
Share Statutes
We
have added a new discussion outlining our approach to control share statutes.
Certain states, including Delaware, have adopted control share acquisition
statutes as an anti-takeover defense for certain closed-end investment companies
and business development companies. Control share statutes may prevent changes
in control by limiting voting rights of a person that acquires the ownership of
“control shares.” Control shares are shares of stock equal to or exceeding
specified percentages of company voting power, and a control share statute
prevents shares in excess of the specified percentage from being voted, unless:
(i) the board approves them to be voted; or (ii) the holder of the “control
shares” receives approval from a supermajority of “non-interested”
shareholders.
Depending
on the state of incorporation, companies may automatically rely on control share
statutes unless the fund’s board of trustees eliminates the application of the
control share statute to any or all fund share acquisitions, through adoption of
a provision in the fund's governing instrument or by fund board action alone. In
certain other states, companies must adopt control share
statutes.
In
our view, control share statues disenfranchise shareholders by reducing their
voting power to a level less than their economic interest and effectively
function as an anti-takeover device. We believe all shareholders should have an
opportunity to vote all of their shares. Moreover, we generally believe
anti-takeover measures prevent shareholders from receiving a buy-out premium for
their stock.
As
such, we will generally recommend voting for proposals to opt out of control
share acquisition statutes, unless doing so would allow the completion of a
takeover that is not in the best interests of shareholders; and recommend voting
against proposals to amend the charter to include control share acquisition
provisions.
Further,
in cases where a closed-end fund or business development company has received a
public buyout offer and has relied on a control share statute as a defense
mechanism in the prior year, we will generally recommend shareholders vote
against the chair of the nominating and governance committee, absent a
compelling rationale as to why a rejected acquisition was not in the best
interests of shareholders.
Clarifying
Amendments
The
following clarifications of our existing policies are included this year:
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Board
Responsiveness
We
have clarified our discussion of board responsiveness to remove a reference to
shareholder proposals from our discussion of when 20% or more of shareholders
vote contrary to management. In addition, we have clarified that our calculation
of opposition includes votes cast as either AGAINST and/or ABSTAIN.
Interlocking
Directorships
We
have clarified our policy on interlocking directorships to reference that, on a
case-by-case basis, we evaluate other types of interlocking relationships, such
as interlocks with close family members of executives or within group
companies.
Board
Gender Diversity
We
have clarified our policy on board gender diversity to emphasize that when
making these voting recommendations, we will carefully review a company’s
disclosure of its diversity considerations and may refrain from recommending
that shareholders vote against directors when boards have provided a sufficient
rationale or plan to address the lack of diversity on the board, including a
timeline of when the board intends to appoint additional gender diverse
directors (generally by the next annual meeting or as soon as is reasonably
practicable).
Underrepresented
Community Diversity
We
have clarified our policy on underrepresented community diversity to emphasize
that when making these voting recommendations, we will carefully review a
company’s disclosure of its diversity considerations and may refrain from
recommending that shareholders vote against directors when boards have provided
a sufficient rationale or plan to address the lack of diversity on the board,
including a timeline of when the board intends to appoint additional directors
from an underrepresented community (generally by the next annual meeting or as
soon as is reasonably practicable).
Furthermore,
we have revised our definition of “underrepresented community director” to
replace our reference to an individual who self-identifies as gay, lesbian,
bisexual, or transgender with an individual who self-identifies as a member of
the LGBTQIA+ community.
Non-GAAP
to GAAP Reconciliation Disclosure
We
have expanded the discussion of our approach to the use of non-GAAP measures in
incentive programs in order to emphasize the need for thorough and transparent
disclosure in the proxy statement that will assist shareholders in reconciling
the difference between non-GAAP results used for incentive payout determinations
and reported GAAP results. Particularly in situations where significant
adjustments were applied and materially impacts incentive pay outcomes, the lack
of such disclosure will impact Glass Lewis’ assessment of the quality of
executive pay disclosure and may be a factor in our recommendation for the
say-on-pay.
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Pay-Versus-Performance
Disclosure
We
have revised our discussion of the pay-for-performance analysis to note that the
pay-versus-performance disclosure mandated by the SEC may be used as part of our
supplemental quantitative assessments supporting our primary pay-for-performance
grade.
Company
Responsiveness for Say-on-Pay Opposition
For
increased clarity, we amended our discussion of company responsiveness to
significant levels of say-on-pay opposition to note that our calculation of
opposition includes votes cast as either AGAINST and/or ABSTAIN, with opposition
of 20% or higher treated as significant.
A
Board of Directors that Serves Shareholder Interest
Election
of Directors
The
purpose of Glass Lewis’ proxy research and advice is to facilitate shareholder
voting in favor of governance structures that will drive performance, create
shareholder value and maintain a proper tone at the top. Glass Lewis looks for
talented boards with a record of protecting shareholders and delivering value
over the medium- and long-term. We believe that a board can best protect and
enhance the interests of shareholders if it is sufficiently independent, has a
record of positive performance, and consists of individuals with diverse
backgrounds and a breadth and depth of relevant experience.
Independence
The
independence of directors, or lack thereof, is ultimately demonstrated through
the decisions they make. In assessing the independence of directors, we will
take into consideration, when appropriate, whether a director has a track record
indicative of making objective decisions. Likewise, when assessing the
independence of directors we will also examine when a director’s track record on
multiple boards indicates a lack of objective decision-making. Ultimately, we
believe the determination of whether a director is independent or not must take
into consideration both compliance with the applicable independence listing
requirements as well as judgments made by the director.
We
look at each director nominee to examine the director’s relationships with the
company, the company’s executives, and other directors. We do this to evaluate
whether personal, familial, or financial relationships (not including director
compensation) may impact the director’s decisions. We believe that such
relationships make it difficult for a director to put shareholders’ interests
above the director’s or the related party’s interests. We also believe that a
director who owns more than 20% of a company can exert disproportionate
influence on the board, and therefore believe such a director’s independence may
be hampered, in particular when serving on the audit committee.
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Thus,
we put directors into three categories based on an examination of the type of
relationship they have with the company:
Independent
Director
— An independent director has no material financial, familial or other current
relationships with the company, its executives, or other board members, except
for board service and standard fees paid for that service. Relationships that
existed within three to five years1
before the inquiry are usually considered “current” for purposes of this test.
For material financial relationships with the company, we apply a three-year
look back, and for former employment relationships with the company, we apply a
five-year look back.
Affiliated
Director
— An affiliated director has, (or within the past three years, had) a material
financial, familial or other relationship with the company or its executives,
but is not an employee of the company.2
This includes directors whose employers have a material financial relationship
with the company.3
In addition, we view a director who either owns or controls 20% or more of the
company’s voting stock, or is an employee or affiliate of an entity that
controls such amount, as an affiliate.4
We
view 20% shareholders as affiliates because they typically have access to and
involvement with the management of a company that is fundamentally different
from that of ordinary shareholders. More importantly, 20% holders may have
interests that diverge from those of ordinary holders, for reasons such as the
liquidity (or lack thereof) of their holdings, personal tax issues, etc.
Glass
Lewis applies a three-year look back period to all directors who have an
affiliation with the company other than former employment, for which we apply a
five-year look back.
Definition
of “Material”:
A material relationship is one in which the dollar value exceeds:
•$50,000
(or where no amount is disclosed) for directors who are paid for a service they
have agreed
to perform for the company, outside of their service as a
director, including professional or other services. This threshold also applies
to directors who are the majority or principal owner of a firm that receives
such payments; or
•$120,000
(or where no amount is disclosed) for those directors employed by a professional
services firm such as a law firm, investment bank, or consulting firm and the
company pays the firm, not the
1
NASDAQ originally proposed a five-year look-back period but both it and the NYSE
ultimately settled on a three-year look-back prior to finalizing their rules. A
five-year standard for former employment relationships is more appropriate, in
our view, because we believe that the unwinding of conflicting relationships
between former management and board members is more likely to be complete and
final after five years. However, Glass Lewis does not apply the five-year
look-back period to directors who have previously served as executives of the
company on an interim basis for less than one year.
2
If a company does not consider a non-employee director to be independent, Glass
Lewis will classify that director as an affiliate.
3
We allow a five-year grace period for former executives of the company or merged
companies who have consulting agreements with the surviving company. (We do not
automatically recommend voting against directors in such cases for the first
five years.) If the consulting agreement persists after
this five-year grace
period, we apply the materiality thresholds outlined in the definition of
“material.”
4
This includes a director who serves on a board as a representative (as part of
his or her basic responsibilities) of an investment firm with greater than 20%
ownership. However, while we will generally consider him/her to be affiliated,
we will not recommend voting against unless (i) the investment firm has
disproportionate board representation or (ii) the director serves on the audit
committee.
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individual,
for services.5
This dollar limit would also apply to charitable contributions to schools where
a board member is a professor; or charities where a director serves on the board
or is an executive;6
and any aircraft and real estate dealings between the company and the director’s
firm; or
•1%
of either company’s consolidated gross revenue for other business relationships
(e.g., where the director is an executive officer of a company that provides
services or products to or receives services or products from the
company).7
Definition
of “Familial”
— Familial relationships include a person’s spouse, parents, children, siblings,
grandparents, uncles, aunts, cousins, nieces, nephews, in-laws, and anyone
(other than domestic employees) who shares such person’s home. A director is an
affiliate if: i) he or she has a family member who is employed by the company
and receives more than $120,0008
in annual compensation; or, ii) he or she has a family member who is employed by
the company and the company does not disclose this individual’s
compensation.
Definition
of “Company”
— A company includes any parent or subsidiary in a group with the company or any
entity that merged with, was acquired by, or acquired the company.
Inside
Director —
An inside director simultaneously serves as a director and as an employee of the
company. This category may include a board chair who acts as an employee of the
company or is paid as an employee of the company. In our view, an inside
director who derives a greater amount of income as a result of affiliated
transactions with the company rather than through compensation paid by the
company (i.e., salary, bonus, etc. as a company employee) faces a conflict
between making decisions that are in the best interests of the company versus
those in the director’s own best interests. Therefore, we will recommend voting
against such a director.
Additionally,
we believe a director who is currently serving in an interim management position
should be considered an insider, while a director who previously served in an
interim management position for less than one year and is no longer serving in
such capacity is considered independent. Moreover, a director who previously
served in an interim management position for over one year and is no longer
serving in such capacity is considered an affiliate for five years following the
date of the director’s resignation or departure from the interim management
position.
Voting
Recommendations on the Basis of Board Independence
Glass
Lewis believes a board will be most effective in protecting shareholders’
interests if it is at least two-thirds independent. We note that each of the
Business Roundtable, the Conference Board, and the Council of
5
We may deem such a transaction to be immaterial where the amount represents less
than 1% of the firm’s annual revenues and the board provides a compelling
rationale as to why the director’s independence is not affected by the
relationship.
6
We will generally take into consideration the size and nature of such charitable
entities in relation to the company’s size and industry along with any other
relevant factors such as the director’s role at the charity. However, unlike for
other types of related party transactions, Glass Lewis generally does not apply
a look-back period to affiliated relationships involving charitable
contributions; if the relationship between the director and the school or
charity ceases, or if the company discontinues its donations to the entity, we
will consider the director to be independent.
7
This includes cases where a director is employed by, or closely affiliated with,
a private equity firm that profits from an acquisition made by the company.
Unless disclosure suggests otherwise, we presume the director is
affiliated.
8
Pursuant
to SEC rule Item 404 of Regulation S-K under the Securities Exchange Act,
compensation exceeding $120,000 is the minimum threshold deemed material for
disclosure of transactions involving family members of directors.
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Institutional
Investors advocates that two-thirds of the board be independent. Where more than
one-third of the members are affiliated or inside directors, we
typically8
recommend voting against some of the inside and/or affiliated directors in order
to satisfy the two-thirds threshold.
In
the case of a less than two-thirds independent board, Glass Lewis strongly
supports the existence of a
presiding or lead director with authority to set
the meeting agendas and to lead sessions outside the insider chair’s presence.
In
addition, we scrutinize avowedly “independent” chairs and lead directors. We
believe that they should be unquestionably independent, or the company should
not tout them as such.
Committee
Independence
We
believe that only independent directors should serve on a company’s audit,
compensation, nominating, and governance committees.9
We typically recommend that shareholders vote against any affiliated or inside
director seeking appointment to an audit, compensation, nominating, or
governance committee, or who has served in that capacity in the past year.
Pursuant
to Section 952 of the Dodd-Frank Act, as of January 11, 2013, the U.S.
Securities and Exchange Commission (SEC) approved new listing requirements for
both the NYSE and NASDAQ which require that boards apply enhanced standards of
independence when making an affirmative determination of the independence of
compensation committee members. Specifically, when making this determination, in
addition to the factors considered when assessing general director independence,
the board’s considerations must include: (i) the source of compensation of the
director, including any consulting, advisory or other compensatory fee paid by
the listed company to the director (the “Fees Factor”); and (ii) whether the
director is affiliated with the listing company, its subsidiaries, or affiliates
of its subsidiaries (the “Affiliation Factor”).
Glass
Lewis believes it is important for boards to consider these enhanced
independence factors when assessing compensation committee members. However, as
discussed above in the section titled Independence, we apply our own standards
when assessing the independence of directors, and these standards also take into
account consulting and advisory fees paid to the director, as well as the
director’s affiliations with the company and its subsidiaries and affiliates. We
may recommend voting against compensation committee members who are not
independent based on our standards.
Independent
Chair
Glass
Lewis believes that separating the roles of CEO (or, more rarely, another
executive position) and chair creates a better governance structure than a
combined CEO/chair position. An executive manages the business according to a
course the board charts. Executives should report to the board regarding their
performance in
8
With a staggered board, if the affiliates or insiders that we believe should not
be on the board are not up for election, we will express our concern regarding
those directors, but we will not recommend voting against the other affiliates
or insiders who are up for election just to achieve two-thirds independence.
However, we will consider recommending voting against the directors subject to
our concern at their next election if the issue giving rise to the concern is
not resolved.
9
We will recommend voting against an audit committee member who owns 20% or more
of the company’s stock, and we believe that there should be a maximum of one
director (or no directors if the committee is composed of less than three
directors) who owns 20% or more of the company’s stock on the compensation,
nominating, and governance committees.
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achieving
goals set by the board. This is needlessly complicated when a CEO chairs the
board, since a CEO/chair presumably will have a significant influence over the
board.
While
many companies have an independent lead or presiding director who performs many
of the same functions of an independent chair (e.g., setting the board meeting
agenda), we do not believe this alternate form of independent board leadership
provides as robust protection for shareholders as an independent
chair.
It
can become difficult for a board to fulfill its role of overseer and policy
setter when a CEO/chair controls the agenda and the boardroom discussion. Such
control can allow a CEO to have an entrenched position, leading to
longer-than-optimal terms, fewer checks on management, less scrutiny of the
business operation, and limitations on independent, shareholder-focused
goal-setting by the board.
A
CEO should set the strategic course for the company, with the board’s approval,
and the board should enable the CEO to carry out the CEO’s vision for
accomplishing the board’s objectives. Failure to achieve the board’s objectives
should lead the board to replace that CEO with someone in whom the board has
confidence.
Likewise,
an independent chair can better oversee executives and set a pro-shareholder
agenda without the management conflicts that a CEO and other executive insiders
often face. Such oversight and concern for shareholders allows for a more
proactive and effective board of directors that is better able to look out for
the interests of shareholders.
Further,
it is the board’s responsibility to select a chief executive who can best serve
a company and its shareholders and to replace this person when his or her duties
have not been appropriately fulfilled. Such a replacement becomes more difficult
and happens less frequently when the chief executive is also in the position of
overseeing the board.
Glass
Lewis believes that the installation of an independent chair is almost always a
positive step from a corporate governance perspective and promotes the best
interests of shareholders. Further, the presence of an independent chair fosters
the creation of a thoughtful and dynamic board, not dominated by the views of
senior management. Encouragingly, many companies appear to be moving in this
direction — one study indicates that only 10 percent of incoming CEOs in 2014
were awarded the chair title, versus 48 percent in 2002.10
Another study finds that 53 percent of S&P 500 boards now separate the CEO
and chair roles, up from 37 percent in 2009, although the same study found that
only 34 percent of S&P 500 boards have truly independent chairs.11
We
do not recommend that shareholders vote against CEOs who chair the board.
However, we typically recommend that our clients support separating the roles of
chair and CEO whenever that question is posed in a proxy (typically in the form
of a shareholder proposal), as we believe that it is in the long-term best
interests of the company and its shareholders.
Further,
where the company has neither an independent chair nor independent lead
director, we will recommend voting against the chair of the governance
committee.
10
Ken Favaro, Per-Ola Karlsson and Gary L. Nelson. “The $112 Billion CEO
Succession Problem.” (Strategy+Business,
Issue 79, Summer 2015).
11
Spencer Stuart Board Index, 2019, p. 6.
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Performance
The
most crucial test of a board’s commitment to the company and its shareholders
lies in the actions of the board and its members. We look at the performance of
these individuals as directors and executives of the company and of other
companies where they have served.
We
find that a director’s past conduct is often indicative of future conduct and
performance. We often find directors with a history of overpaying executives or
of serving on boards where avoidable disasters have occurred serving on the
boards of companies with similar problems. Glass Lewis has a proprietary
database of directors serving at over 8,000 of the most widely held U.S.
companies. We use this database to track the performance of directors across
companies.
Voting
Recommendations on the Basis of Performance
We
typically recommend that shareholders vote against directors who have served on
boards or as executives of companies with records of poor performance,
inadequate risk oversight, excessive compensation, audit- or accounting-related
issues, and/or other indicators of mismanagement or actions against the
interests of
shareholders. We will reevaluate such directors based on, among
other factors, the length of time passed since the incident giving rise to the
concern, shareholder support for the director, the severity of the issue, the
director’s role (e.g., committee membership), director tenure at the subject
company, whether ethical lapses accompanied the oversight lapse, and evidence of
strong oversight at other companies.
Likewise,
we examine the backgrounds of those who serve on key board committees to ensure
that they have the required skills and diverse backgrounds to make informed
judgments about the subject matter for which the committee is
responsible.
We
believe shareholders should avoid electing directors who have a record of not
fulfilling their responsibilities to shareholders at any company where they have
held a board or executive position. We typically recommend voting
against:
1.A
director who fails to attend a minimum of 75% of board and applicable committee
meetings, calculated in the aggregate.12
2.A
director who belatedly filed a significant form(s) 4 or 5, or who has a pattern
of late filings if the late filing was the director’s fault (we look at these
late filing situations on a case-by-case basis).
3.A
director who is also the CEO of a company where a serious and material
restatement has occurred after the CEO had previously certified the
pre-restatement financial statements.
4.A
director who has received two against recommendations from Glass Lewis for
identical reasons within the prior year at different companies (the same
situation must also apply at the company being analyzed).
Furthermore,
with consideration given to the company’s overall corporate governance,
pay-for-performance alignment and board responsiveness to shareholders, we may
recommend voting against directors who served throughout a period in which the
company performed significantly worse than peers and the directors have not
taken reasonable steps to address the poor performance.
12
However, where a director has served for less than one full year, we will
typically not recommend voting against for failure to attend 75% of meetings.
Rather, we will note the poor attendance with a recommendation to track this
issue going forward. We will also refrain from recommending to vote against
directors when the proxy discloses that the director missed the meetings due to
serious illness or other extenuating circumstances.
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Board
Responsiveness
Glass
Lewis believes that boards should be responsive to shareholders when a
significant percentage of shareholders vote contrary to the recommendation of
management, depending on the issue.
When
20% of more of shareholders vote contrary to management (which occurs when more
than 20% of votes on the proposal are cast as AGAINST and/or ABSTAIN), we
believe that boards should engage with shareholders on the issue and demonstrate
some initial level of responsiveness. These include instances when 20% or more
of shareholders:
(i)withhold
votes from (or vote against) a director nominee; or
(ii)vote
against a management-sponsored proposal.
In
our view, a 20% threshold is significant enough to warrant a close examination
of the underlying issues and an evaluation of whether the board responded
appropriately following the vote, particularly in the case of a compensation or
director election proposal. While the 20% threshold alone will not automatically
generate a negative vote recommendation from Glass Lewis on a future proposal
(e.g., to recommend against a director nominee, against a say-on-pay proposal,
etc.), it may be a contributing factor to our recommendation to vote against
management’s recommendation in the event we determine that the board did not
respond appropriately.
When
a majority of shareholders vote contrary to management, we believe that boards
should engage with shareholders on the issue and provide a more robust response
to fully address shareholder concerns. These include instances when a majority
or more of shareholders:
(i)withhold
votes from (or vote against) a director nominee;
(ii)vote
against a management-sponsored proposal; or
(iii)vote
for a shareholder proposal.
In
the case of shareholder proposals, we believe clear action is warranted when
such proposals receive support from a majority of votes cast (excluding
abstentions and broker non-votes). In our view, this may include fully
implementing the request of the shareholder proposal and/or engaging with
shareholders on the issue and providing sufficient disclosures to address
shareholder concerns.
At
controlled companies and companies that have multi-class share structures with
unequal voting rights, we will carefully examine the level of approval or
disapproval attributed to unaffiliated shareholders when determining whether
board responsiveness is warranted. In the case of companies that have
multi-class share structures with unequal voting rights, we will generally
examine the level of approval or disapproval attributed to unaffiliated
shareholders on a “one share, one vote” basis. At controlled and multi-class
companies, when at least 20% or more of unaffiliated shareholders vote contrary
to management, we believe that boards should engage with shareholders and
demonstrate some initial level of responsiveness, and when a majority or more of
unaffiliated shareholders vote contrary to management, we believe that boards
should engage with shareholders and provide a more robust response to address
shareholder concerns.
As
a general framework, our evaluation of board responsiveness involves a review of
publicly available disclosures (e.g., the proxy statement, annual report, 8-Ks,
company website, etc.) released following the date of the company’s last annual
meeting up through the publication date of our most current Proxy Paper.
Depending on the specific issue, our focus typically includes, but is not
limited to, the following:
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•At
the board level, any changes in directorships, committee memberships, disclosure
of related party transactions, meeting attendance, or other
responsibilities;
•Any
revisions made to the company’s articles of incorporation, bylaws or other
governance documents;
•Any
press or news releases indicating changes in, or the adoption of, new company
policies, business practices or special reports; and
•Any
modifications made to the design and structure of the company’s compensation
program, as well as an assessment of the company’s engagement with shareholders
on compensation issues as discussed in the Compensation Discussion &
Analysis (CD&A), particularly following a material vote against a company’s
say-on-pay.
•Proxy
statement disclosure discussing the board’s efforts to engage with shareholders
and the actions taken to address shareholder concerns.
Our
Proxy Paper analysis will include a case-by-case assessment of the specific
elements of board responsiveness that we examined along with an explanation of
how that assessment impacts our current voting recommendations.
The
Role of a Committee Chair
Glass
Lewis believes that a designated committee chair maintains primary
responsibility for the actions of his or her respective committee. As such, many
of our committee-specific voting recommendations are against the applicable
committee chair rather than the entire committee (depending on the seriousness
of the issue). In cases where the committee chair is not up for election due to
a staggered board, and where we have identified multiple concerns, we will
generally recommend voting against other members of the committee who are up for
election, on a case-by-case basis.
In
cases where we would ordinarily recommend voting against a committee chair but
the chair is not specified, we apply the following general rules, which apply
throughout our guidelines:
•If
there is no committee chair, we recommend voting against the longest-serving
committee member or, if the longest-serving committee member cannot be
determined, the longest-serving board member serving on the committee (i.e., in
either case, the “senior director”); and
•If
there is no committee chair, but multiple senior directors serving on the
committee, we recommend voting against both (or all) such senior
directors.
In
our view, companies should provide clear disclosure of which director is charged
with overseeing each committee. In cases where that simple framework is ignored
and a reasonable analysis cannot determine which committee member is the
designated leader, we believe shareholder action against the longest serving
committee member(s) is warranted. Again, this only applies if we would
ordinarily recommend voting against the committee chair but there is either no
such position or no designated director in such role.
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Audit
Committees and Performance
Audit
committees play an integral role in overseeing the financial reporting process
because stable capital markets depend on reliable, transparent, and objective
financial information to support an efficient and effective capital market
process. Audit committees play a vital role in providing this disclosure to
shareholders.
When
assessing an audit committee’s performance, we are aware that an audit committee
does not prepare financial statements, is not responsible for making the key
judgments and assumptions that affect the financial statements, and does not
audit the numbers or the disclosures provided to investors. Rather, an audit
committee member monitors and oversees the process and procedures that
management and auditors perform. The 1999 Report and Recommendations of the Blue
Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees
stated it best:
A
proper and well-functioning system exists, therefore, when the three main groups
responsible for financial reporting — the full board including the audit
committee, financial management including the internal auditors, and the outside
auditors — form a ‘three legged stool’ that supports responsible financial
disclosure and active participatory oversight. However, in the view of the
Committee, the audit committee must be ‘first among equals’ in this process,
since the audit committee is an extension of the full board and hence the
ultimate monitor of the process.
Standards
for Assessing the Audit Committee
For
an audit committee to function effectively on investors’ behalf, it must include
members with sufficient knowledge to diligently carry out their
responsibilities. In its audit and accounting recommendations, the Conference
Board Commission on Public Trust and Private Enterprise said “members of the
audit committee must be independent and have both knowledge and experience in
auditing financial matters.”13
We
are skeptical of audit committees where there are members that lack expertise as
a Certified Public Accountant (CPA), Chief Financial Officer (CFO) or corporate
controller, or similar experience. While we will not necessarily recommend
voting against members of an audit committee when such expertise is lacking, we
are more likely to recommend voting against committee members when a problem
such as a restatement occurs and such expertise is lacking.
Glass
Lewis generally assesses audit committees against the decisions they make with
respect to their oversight and monitoring role. The quality and integrity of the
financial statements and earnings reports, the completeness of disclosures
necessary for investors to make informed decisions, and the effectiveness of the
internal controls should provide reasonable assurance that the financial
statements are materially free from errors. The independence of the external
auditors and the results of their work all provide useful information by which
to assess the audit committee.
When
assessing the decisions and actions of the audit committee, we typically defer
to its judgment and generally recommend voting in favor of its members. However,
we will consider recommending that shareholders vote against the
following:
13
Commission on Public Trust and Private Enterprise. The Conference Board.
2003.
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1.All
members of the audit committee when options were backdated, there is a lack of
adequate controls in place, there was a resulting restatement, and disclosures
indicate there was a lack of documentation with respect to the option
grants.
2.The
audit committee chair, if the audit committee does not have a financial expert
or the committee’s financial expert does not have a demonstrable financial
background sufficient to understand the financial issues unique to public
companies.
3.The
audit committee chair, if the audit committee did not meet at least four times
during the year.
4.The
audit committee chair, if the committee has less than three
members.
5.Any
audit committee member who sits on more than three public company audit
committees, unless the audit committee member is a retired CPA, CFO, controller
or has similar experience, in which case the limit shall be four committees,
taking time and availability into consideration including a review of the audit
committee member’s attendance at all board and committee meetings.14
6.All
members of an audit committee who are up for election and who served on the
committee at the time of the audit, if audit and audit-related fees total
one-third or less of the total fees billed by the auditor.
7.The
audit committee chair when tax and/or other fees are greater than audit and
audit-related fees paid to the auditor for more than one year in a row (in which
case we also recommend against ratification of the auditor).
8.The
audit committee chair when fees paid to the auditor are not
disclosed.
9.All
members of an audit committee where non-audit fees include fees for tax services
(including, but not limited to, such things as tax avoidance or shelter schemes)
for senior executives of the company. Such services are prohibited by the Public
Company Accounting Oversight Board (PCAOB).
10.All
members of an audit committee that reappointed an auditor that we no longer
consider to be independent for reasons unrelated to fee
proportions.
11.All
members of an audit committee when audit fees are excessively low, especially
when compared with other companies in the same industry.
12.The
audit committee chair if the committee failed to put auditor ratification on the
ballot for shareholder approval. However, if the non-audit fees or tax fees
exceed audit plus audit-related fees in either the current or the prior year,
then Glass Lewis will recommend voting against the entire audit
committee.
13.All
members of an audit committee where the auditor has resigned and reported that a
section 10A15
letter has been issued.
14
Glass Lewis may exempt certain audit committee members from the above threshold
if, upon further analysis of relevant factors such as the director’s experience,
the size, industry-mix and location of the companies involved and the director’s
attendance at all the companies, we can reasonably determine that the audit
committee member is likely not hindered by multiple audit committee
commitments.
15
Auditors are required to report all potential illegal acts to management and the
audit committee unless they are clearly inconsequential in nature. If the audit
committee or the board fails to take appropriate action on an act that has been
determined to be a violation of the law, the independent auditor is required to
send a section 10A letter to the SEC. Such letters are rare and therefore we
believe should be taken seriously.
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14.All
members of an audit committee at a time when material accounting fraud occurred
at the company.16
15.All
members of an audit committee at a time when annual and/or multiple quarterly
financial statements had to be restated, and any of the following factors
apply:17
a.The
restatement involves fraud or manipulation by insiders;
b.The
restatement is accompanied by an SEC inquiry or investigation;
c.The
restatement involves revenue recognition;
d.The
restatement results in a greater than 5% adjustment to costs of goods sold,
operating expense, or operating cash flows; or
e.The
restatement results in a greater than 5% adjustment to net income, 10%
adjustment to assets or shareholders equity, or cash flows from financing or
investing activities.
16.All
members of an audit committee if the company repeatedly fails to file its
financial reports in a timely fashion. For example, the company has filed two or
more quarterly or annual financial statements late within the last five
quarters.
17.All
members of an audit committee when it has been disclosed that a law enforcement
agency
has charged the company and/or its employees with a violation of the
Foreign Corrupt Practices
Act (FCPA).
18.All
members of an audit committee when the company has aggressive accounting
policies and/or poor disclosure or lack of sufficient transparency in its
financial statements.
19.All
members of the audit committee when there is a disagreement with the auditor and
the auditor resigns or is dismissed (e.g., the company receives an adverse
opinion on its financial statements from the auditor).
20.All
members of the audit committee if the contract with the auditor specifically
limits the auditor’s liability to the company for damages.18
21.All
members of the audit committee who served since the date of the company’s last
annual meeting if, since the last annual meeting, the company has reported a
material weakness that has not yet been corrected and the company has not
disclosed a remediation plan; or when a material weakness has been ongoing for
more than one year and the company has not disclosed an updated remediation plan
that clearly outlines the company’s progress toward remediating the material
weakness.
16
Research indicates that revenue fraud now accounts for over 60% of SEC fraud
cases, and that companies that engage in fraud experience significant negative
abnormal stock price declines—facing bankruptcy, delisting, and material asset
sales at much higher rates than do non-fraud firms (Committee of Sponsoring
Organizations of the Treadway Commission. “Fraudulent Financial Reporting:
1998-2007.” May 2010).
17
The SEC issued guidance in March 2021 related to classification of warrants as
liabilities at special purpose acquisition companies (SPACs). We will generally
refrain from recommending against audit committee members when the restatement
in question is solely as a result of the aforementioned SEC
guidance.
18
The Council of Institutional Investors. “Corporate Governance Policies,” p. 4,
April 5, 2006; and “Letter from Council of Institutional Investors to the
AICPA,” November 8, 2006.
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Material
Weaknesses
Effective
internal controls over financial reporting should ensure the integrity of
companies’ accounting and financial reporting.
The
SEC guidance regarding Management's Report on Internal Control Over Financial
Reporting requires that reports on internal control should include: (i) a
statement of management's responsibility for establishing and maintaining
adequate internal control over financial reporting for the company; (ii)
management's assessment of the effectiveness of the company's internal control
over financial reporting as of the end of the company's most recent fiscal year;
(iii) a statement identifying the framework used by management to evaluate the
effectiveness of the company's internal control over financial reporting; and
(iv) a statement that the registered public accounting firm that audited the
company's financial statements included in the annual report has issued an
attestation report on management's assessment of the company's internal control
over financial reporting.
A
material weakness occurs when a company identifies a deficiency, or a
combination of deficiencies, in internal controls over financial reporting, such
that there is a reasonable possibility that a material misstatement of the
company's annual or interim financial statements will not be prevented or
detected on a timely basis. Failure to maintain effective internal controls can
create doubts regarding the reliability of financial reporting and the
preparation of financial statements in accordance with U.S. GAAP and may lead to
companies publishing financial statements that are not free of errors or
misstatements.
We
believe it is the responsibility of audit committees to ensure that material
weaknesses are remediated in a timely manner and that companies disclose
remediation plans that include detailed steps to resolve a given material
weakness. In cases where a material weakness has been ongoing for more than one
fiscal year, we expect the company to disclose an updated remediation plan at
least annually thereafter. Updates to existing remediation plans should state
the progress the company has made toward remediating the material weakness and
the remaining actions the company plans to take until the material weakness is
fully remediated. As such, we are critical of audit committees when companies
disclose remediation plans that remain unchanged from a prior
period.
When
a material weakness is reported and the company has not disclosed a remediation
plan, or when a material weakness has been ongoing for more than one year and
the company has not disclosed an updated remediation plan that clearly outlines
the company’s progress toward remediating the material weakness, we will
consider recommending that shareholders vote against all members of a company’s
audit committee who served on the committee during the time when the material
weakness was identified.
We
also take a dim view of audit committee reports that are boilerplate, and which
provide little or no information or transparency to investors. When a problem
such as a material weakness, restatement or late filings occurs, in forming our
judgment with respect to the audit committee we take into consideration the
transparency of the audit committee report.
Compensation
Committee Performance
Compensation
committees have a critical role in determining the compensation of executives.
This includes deciding the basis on which compensation is determined, as well as
the amounts and types of compensation
to be paid. This process begins with
the hiring and initial establishment of employment agreements, including the
terms for such items as pay, pensions and severance arrangements. It is
important in establishing
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compensation
arrangements that compensation be consistent with, and based on the long-term
economic performance of, the business’s long-term shareholders returns.
Compensation
committees are also responsible for the oversight of the transparency of
compensation. This oversight includes disclosure of compensation arrangements,
the matrix used in assessing pay for performance, and the use of compensation
consultants. In order to ensure the independence of the board’s compensation
consultant, we believe the compensation committee should only engage a
compensation consultant that is not
also providing any services to the
company or management apart from their contract with the compensation committee.
It is important to investors that they have clear and complete disclosure of all
the significant terms of compensation arrangements in order to make informed
decisions with respect to the oversight and decisions of the compensation
committee.
Finally,
compensation committees are responsible for oversight of internal controls over
the executive compensation process. This includes controls over gathering
information used to determine compensation, establishment of equity award plans,
and granting of equity awards. For example, the use of a compensation consultant
who maintains a business relationship with company management may cause the
committee to make decisions based on information that is compromised by the
consultant’s conflict of interests. Lax controls can also contribute to improper
awards of compensation such as through granting of backdated or spring-loaded
options, or granting of bonuses when triggers for bonus payments have not been
met.
Central
to understanding the actions of compensation committee is a careful review of
the CD&A report included in each company’s proxy. We review the CD&A in
our evaluation of the overall compensation practices of a company, as overseen
by the compensation committee. The CD&A is also integral to the evaluation
of compensation proposals at companies, such as advisory votes on executive
compensation, which allow shareholders to vote on the compensation paid to a
company’s top executives.
When
assessing the performance of compensation committees, we will consider
recommending that shareholders vote against the following:
1.All
members of a compensation committee during whose tenure the committee failed to
address shareholder concerns following majority shareholder rejection of the
say-on-pay proposal in the previous year. Where the proposal was approved but
there was a significant shareholder vote (i.e., greater than 20% of votes cast)
against the say-on-pay proposal in the prior year, if the board did not respond
sufficiently to the vote including actively engaging shareholders on this issue,
we will also consider recommending voting against the chair of the compensation
committee or all members of the compensation committee, depending on the
severity and history of the compensation problems and the level of shareholder
opposition.
2.All
members of the compensation committee who are up for election and served when
the company failed to align pay with performance if shareholders are not
provided with an advisory vote on executive compensation at the annual
meeting.19
19
If a company provides shareholders with a say-on-pay proposal, we will initially
only recommend voting against the company's say-on-pay proposal and will not
recommend voting against the members of the compensation committee unless there
is a pattern of failing to align pay and performance and/or the company exhibits
egregious compensation practices. For cases in which the disconnect between pay
and performance is marginal and the company has outperformed its peers, we will
consider not recommending against compensation committee members.
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3.Any
member of the compensation committee who has served on the compensation
committee of at least two other public companies that have consistently failed
to align pay with performance and whose oversight of compensation at the company
in question is suspect.
4.All
members of the compensation committee (during the relevant time period) if the
company entered into excessive employment agreements and/or severance
agreements.
5.All
members of the compensation committee when performance goals were changed (i.e.,
lowered) when employees failed or were unlikely to meet original goals, or
performance-based compensation was paid despite goals not being
attained.
6.All
members of the compensation committee if excessive employee perquisites and
benefits
were allowed.
7.The
compensation committee chair if the compensation committee did not meet during
the year.
8.All
members of the compensation committee when the company repriced options or
completed a “self tender offer” without shareholder approval within the past two
years.
9.All
members of the compensation committee when vesting of in-the-money options is
accelerated.
10.All
members of the compensation committee when option exercise prices were
backdated. Glass Lewis will recommend voting against an executive director who
played a role in and participated in
option backdating.
11.All
members of the compensation committee when option exercise prices were
spring-loaded or otherwise timed around the release of material
information.
12.All
members of the compensation committee when a new employment contract is given to
an executive that does not include a clawback provision and the company had a
material restatement, especially if the restatement was due to
fraud.
13.The
chair of the compensation committee where the CD&A provides insufficient or
unclear information about performance metrics and goals, where the CD&A
indicates that pay is not tied to performance, or where the compensation
committee or management has excessive discretion to alter performance terms or
increase amounts of awards in contravention of previously defined targets.
14.All
members of the compensation committee during whose tenure the committee failed
to implement a shareholder proposal regarding a compensation-related issue,
where the proposal received the affirmative vote of a majority of the voting
shares at a shareholder meeting, and when a reasonable
analysis suggests
that the compensation committee (rather than the governance committee) should
have taken steps to implement the request.20
15.All
members of the compensation committee when the board has materially decreased
proxy statement disclosure regarding executive compensation policies and
procedures in a manner which substantially impacts shareholders’ ability to make
an informed assessment of the company’s executive pay practices.
16.All
members of the compensation committee when new excise tax gross-up provisions
are adopted in employment agreements with executives, particularly in cases
where the company previously committed not to provide any such entitlements in
the future.
17.All
members of the compensation committee when the board adopts a frequency for
future advisory votes on executive compensation that differs from the frequency
approved by shareholders.
18.The
chair of the compensation committee when” mega-grants” have been granted and the
awards present concerns such as excessive quantum, lack of sufficient
performance conditions, and/or are excessively dilutive, among others.
20
In all other instances (i.e., a non-compensation-related shareholder proposal
should have been implemented) we recommend that shareholders vote against the
members of the governance committee.
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Nominating
and Governance Committee Performance
The
nominating and governance committee is responsible for the governance by the
board of the company and its executives. In performing this role, the committee
is responsible and accountable for selection of objective and competent board
members. It is also responsible for providing leadership on governance policies
adopted by the company, such as decisions to implement shareholder proposals
that have received a majority vote. At most companies, a single committee is
charged with these oversight functions; at others, the governance and nominating
responsibilities are apportioned among two separate committees.
Consistent
with Glass Lewis’ philosophy that boards should have diverse backgrounds and
members with a
breadth and depth of relevant experience, we believe that
nominating and governance committees should
consider diversity when making
director nominations within the context of each specific company and its
industry. In our view, shareholders are best served when boards make an
effort to ensure a constituency that is
not only reasonably diverse on the
basis of age, race, gender and ethnicity, but also on the basis of geographic
knowledge, industry experience, board tenure and culture.
Regarding
the committee responsible for governance, we will consider recommending that
shareholders vote against the following:
1.All
members of the governance committee21
during whose tenure a shareholder proposal relating to important shareholder
rights received support from a majority of the votes cast (excluding abstentions
and broker non-votes) and the board has not begun to implement or enact the
proposal’s subject matter.22
Examples of such shareholder proposals include those seeking a declassified
board structure, a majority vote standard for director elections, or a right to
call a special meeting. In determining whether a board has sufficiently
implemented such a proposal, we will examine the quality of the right enacted or
proffered by the board for any conditions that may unreasonably interfere with
the shareholders’ ability to exercise the right (e.g., overly restrictive
procedural requirements for calling a special meeting).
2.All
members of the governance committee when a shareholder resolution is excluded
from the meeting agenda but the SEC has declined to state a view on whether such
resolution should be excluded, or when the SEC has verbally permitted a company
to exclude a shareholder proposal but there is no written record provided by the
SEC about such determination and the company has not provided any disclosure
concerning this no-action relief.
3.The
governance committee chair when the chair is not independent and an independent
lead or presiding director has not been appointed.23
21
If the board does not have a committee responsible for governance oversight and
the board did not implement a shareholder proposal that received the requisite
support, we will recommend voting against the entire board. If the shareholder
proposal at issue requested that the board adopt a declassified structure, we
will recommend voting against all director nominees up for
election.
22
Where a compensation-related shareholder proposal should have been implemented,
and when a reasonable analysis suggests that the members of the compensation
committee (rather than the governance committee) bear the responsibility for
failing to implement the request, we recommend that shareholders only vote
against members of the compensation committee.
23
We believe that one independent individual should be appointed to serve as the
lead or presiding director. When such a position is rotated among directors from
meeting to meeting, we will recommend voting against the governance committee
chair as we believe the lack of fixed lead or presiding director means that,
effectively, the board does not have an independent board leader.
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4.The
governance committee chair at companies with a multi-class share structure and
unequal voting rights when the company does not provide for a reasonable sunset
of the multi-class share structure (generally seven years or less).
5.In
the absence of a nominating committee, the governance committee chair when there
are fewer than five, or the whole governance committee when there are more than
20 members on the board.
6.The
governance committee chair when the committee fails to meet at all during the
year.
7.The
governance committee chair, when for two consecutive years the company provides
what we consider to be “inadequate” related party transaction disclosure (i.e.,
the nature of such transactions and/or the monetary amounts involved are unclear
or excessively vague, thereby preventing a share-
holder from being able to
reasonably interpret the independence status of multiple directors above and
beyond what the company maintains is compliant with SEC or applicable stock
exchange listing requirements).
8.The
governance committee chair, when during the past year the board adopted a forum
selection clause (i.e., an exclusive forum provision)24
designating either a state's courts for intra-corporate disputes, and/or federal
courts for matters arising under the Securities Act of 1933 without shareholder
approval,25
or if the board is currently seeking shareholder approval of a forum selection
clause pursuant to a bundled bylaw amendment rather than as a separate proposal.
9.All
members of the governance committee during whose tenure the board adopted,
without shareholder approval, provisions in its charter or bylaws that, through
rules on director compensation, may inhibit the ability of shareholders to
nominate directors.
10.The
governance committee chair when the board takes actions to limit shareholders’
ability to vote on matters material to shareholder rights (e.g., through the
practice of excluding a shareholder proposal by means of ratifying a management
proposal that is materially different from the shareholder
proposal).
11.The
governance committee chair when directors’ records for board and committee
meeting attendance are not disclosed, or when it is indicated that a director
attended less than 75% of board and committee meetings but disclosure is
sufficiently vague that it is not possible to determine which specific
director’s attendance was lacking.
12.The
governance committee chair when a detailed record of proxy voting results from
the prior annual meeting has not been disclosed.
13.The
governance committee chair when a company does not clearly disclose the identity
of a shareholder proponent (or lead proponent when there are multiple filers) in
their proxy statement. For a detailed explanation of this policy, please refer
to our comprehensive Proxy
Paper Guidelines for Shareholder Proposals & ESG-Related Issues,
available at www.glasslewis.com/voting-policies-current/.
In
addition, we may recommend that shareholders vote against the chair of the
governance committee, or the entire committee, where the board has amended the
company’s governing documents to reduce or remove important shareholder rights,
or to otherwise impede the ability of shareholders to exercise such right, and
has done so without seeking shareholder approval. Examples of board actions that
may cause such a recommendation include: the elimination of the ability of
shareholders to call a special meeting or to act by
24
A forum selection clause is a bylaw provision stipulating that a certain state
or federal jurisdiction is the exclusive forum for specified legal matters. Such
a clause effectively limits a shareholder's legal remedy regarding appropriate
choice of venue and related relief.
25
Glass Lewis will evaluate the circumstances surrounding the adoption of any
forum selection clause as well as the general provisions contained therein.
Where it can be reasonably determined that a forum selection clause is narrowly
crafted to suit the particular circumstances facing the company and/or a
reasonable sunset provision is included, we may make an exception to this
policy.
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written
consent; an increase to the ownership threshold required for shareholders to
call a special meeting; an increase to vote requirements for charter or bylaw
amendments; the adoption of provisions that limit the ability of shareholders to
pursue full legal recourse — such as bylaws that require arbitration of
shareholder claims
or that require shareholder plaintiffs to pay the
company’s legal expenses in the absence of a court victory
(i.e.,
“fee-shifting” or “loser pays” bylaws); the adoption of a classified board
structure; and the elimination of the ability of shareholders to remove a
director without cause.
Regarding
the nominating committee, we will consider recommending that shareholders vote
against the following:
1.All
members of the nominating committee, when the committee nominated or renominated
an individual who had a significant conflict of interest or whose past
actions demonstrated a lack of integrity or inability to represent shareholder
interests.
2.The
nominating committee chair, if the nominating committee did not meet during the
year.
3.In
the absence of a governance committee, the nominating committee chair when the
chair is not independent, and an independent lead or presiding director has not
been appointed.
4.The
nominating committee chair, when there are fewer than five, or the whole
nominating committee when there are more than 20 members on the
board.
5.The
nominating committee chair, when a director received a greater than 50% against
vote the prior year and not only was the director not removed, but the issues
that raised shareholder concern were not corrected.26
6.The
chair of the nominating committee of a board that is not at least 30 percent
gender diverse,27
or all members of the nominating committee of a board with no gender diverse
directors, at companies within the Russell 3000 index. For companies outside of
the Russell 3000 index, we will recommend voting against the chair of the
nominating committee if there are no gender diverse directors.
7.The
chair of the nominating committee of a board with fewer than one director from
an underrepresented community on the board, at companies within the Russell 1000
index.
8.The
nominating committee chair when, alongside other governance or board performance
concerns, the average tenure of non-executive directors is 10 years or more and
no new independent directors have joined the board in the past five years. We
will not be making voting recommendations solely on this basis; rather,
insufficient board refreshment may be a contributing factor in our
recommendations when additional board-related concerns have been
identified.
In
addition, we may consider recommending shareholders vote against the chair of
the nominating committee where the board’s failure to ensure the board has
directors with relevant experience, either through periodic director assessment
or board refreshment, has contributed to a company’s poor performance. Where
these issues warrant an against vote in the absence of both a governance and a
nominating committee, we will recommend voting against the board chair, unless
the chair also serves as the CEO, in which case we will recommend voting against
the longest-serving director.
26
Considering that shareholder disapproval clearly relates to the director who
received a greater than 50% against vote rather than the nominating chair, we
review the severity of the issue(s) that initially raised shareholder concern as
well as company responsiveness to such matters, and will only recommend voting
against the nominating chair if a reasonable analysis suggests that it would be
most appropriate. In rare cases, we will consider recommending against the
nominating chair when a director receives a substantial (i.e., 20% or more) vote
against based on the same analysis.
27
Women and directors that identify with a gender other than male or
female.
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Board-Level
Risk Management Oversight
Glass
Lewis evaluates the risk management function of a public company board on a
strictly case-by-case basis. Sound risk management, while necessary at all
companies, is particularly important at financial firms which inherently
maintain significant exposure to financial risk. We believe such financial firms
should have a chief risk officer reporting directly to the board and a dedicated
risk committee or a committee of the board charged with risk oversight.
Moreover, many non-financial firms maintain strategies which involve a high
level of exposure to financial risk. Similarly, since many non-financial firms
have complex hedging or trading strategies, those firms should also have a chief
risk officer and a risk committee.
Our
views on risk oversight are consistent with those expressed by various
regulatory bodies. In its December 2009 Final Rule release on Proxy Disclosure
Enhancements, the SEC noted that risk oversight is a key competence of the board
and that additional disclosures would improve investor and shareholder
understanding of the role of the board in the organization’s risk management
practices. The final rules, which became effective on February 28, 2010, now
explicitly require companies and mutual funds to describe (while allowing for
some degree of flexibility) the board’s role in the oversight of
risk.
When
analyzing the risk management practices of public companies, we take note of any
significant losses or writedowns on financial assets and/or structured
transactions. In cases where a company has disclosed a sizable loss or
writedown, and where we find that the company’s board-level risk committee’s
poor oversight contributed to the loss, we will recommend that shareholders vote
against such committee members on that basis. In addition, in cases where a
company maintains a significant level of financial risk exposure but fails to
disclose any explicit form of board-level risk oversight (committee or
otherwise),28
we will consider recommending to vote against the board chair on that basis.
However, we generally would not recommend voting against a combined chair/CEO,
except in egregious cases.
28
A committee responsible for risk management could be a dedicated risk committee,
the audit committee, or the finance committee, depending on a given company’s
board structure and method of disclosure. At some companies, the entire board is
charged with risk management.
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Board
Oversight of Environmental and Social Issues
Glass
Lewis recognizes the importance of ensuring the sustainability of companies’
operations. We believe that insufficient oversight of material environmental and
social issues can present direct legal, financial, regulatory and reputational
risks that could serve to harm shareholder interests. Therefore, we believe that
these issues should be carefully monitored and managed by companies, and that
all companies should have an appropriate oversight structure in place to ensure
that they are mitigating attendant risks and capitalizing on related
opportunities to the best extent possible.
To
that end, Glass Lewis believes that companies should ensure that boards maintain
clear oversight of material risks to their operations, including those that are
environmental and social in nature. These risks could include, but are not
limited to, matters related to climate change, human capital management,
diversity, stakeholder relations, and health, safety & environment. Given
the importance of the board’s role in overseeing environmental and social risks,
we believe this responsibility should be formally designated and codified in the
appropriate committee charters or other governing documents.
While
we believe that it is important that these issues are overseen at the board
level and that shareholders are afforded meaningful disclosure of these
oversight responsibilities, we believe that companies should determine the best
structure for this oversight. In our view, this oversight can be effectively
conducted by specific directors, the entire board, a separate committee, or
combined with the responsibilities of a key committee.
For
companies in the Russell 3000 index and in instances where we identify material
oversight concerns, Glass Lewis will review a company’s overall governance
practices and identify which directors or board-level committees have been
charged with oversight of environmental and/or social issues. Furthermore, given
the importance of the board’s role in overseeing environmental and social risks,
Glass Lewis will generally recommend voting against the governance committee
chair of a company in the Russell 1000 index that fails to provide explicit
disclosure concerning the board’s role in overseeing these issues.
When
evaluating the board’s role in overseeing environmental and/or social issues, we
will examine a company’s committee charters and governing documents to determine
if the company has codified and maintained a meaningful level of oversight of
and accountability for a company’s material environmental and social
impacts.
Cyber
Risk Oversight
Companies
and consumers are exposed to a growing risk of cyber-attacks. These attacks can
result in customer or employee data breaches, harm to a company’s reputation,
significant fines or penalties, and interruption to a company’s operations.
Further, in some instances, cyber breaches can result in national security
concerns, such as those impacting companies operating as utilities, defense
contractors, and energy companies.
In
response to these issues, regulators have increasingly been focused on ensuring
companies are providing appropriate and timely disclosures and protections to
stakeholders that could have been adversely impacted by a breach in a company’s
cyber infrastructure.
On
July 26, 2023, the SEC approved final rules requiring public companies to report
cybersecurity incidents deemed material within four days of identifying them,
detailing their nature, scope, timing, and material impact under Item 1.05 on
Form 8-K.
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Furthermore,
in annual reports, companies must disclose their processes for assessing,
identifying, and managing material cybersecurity risks, along with their
material effects; and describe whether any risks from prior incidents have
materially affected its business strategy, results of operations, or financial
condition (or are reasonably likely to), pursuant to Regulation S-K Item 106.
Item 106 will also require registrants to describe the board of directors’
oversight of risks from cybersecurity threats and management’s role and
expertise in assessing and managing material risks from cybersecurity threats.
Similar rules were also adopted for foreign private issuers. The final rules
became effective on September 5, 2023.
Given
the regulatory focus on, and the potential adverse outcomes from, cyber-related
issues, it is our view that cyber risk is material for all companies. We
therefore believe that it is critical that companies evaluate and mitigate these
risks to the greatest extent possible. With that view, we encourage all issuers
to provide clear disclosure concerning the role of the board in overseeing
issues related to cybersecurity, including how companies are ensuring directors
are fully versed on this rapidly evolving and dynamic issue. We believe such
disclosure can help shareholders understand the seriousness with which companies
take this issue.
In
the absence of material cyber incidents, we will generally not make voting
recommendations on the basis of a company’s oversight or disclosure concerning
cyber-related issues. However, in instances where cyber-attacks have caused
significant harm to shareholders we will closely evaluate the board’s oversight
of cybersecurity as well as the company’s response and disclosures.
Moreover,
in instances where a company has been materially impacted by a cyber-attack, we
believe shareholders can reasonably expect periodic updates communicating the
company’s ongoing progress towards resolving and remediating the impact of the
cyber-attack. We generally believe shareholders are best served when such
updates include (but are not necessarily limited to) details such as when the
company has fully restored its information systems, when the company has
returned to normal operations, what resources the company is providing for
affected stakeholders, and any other potentially relevant information, until the
company considers the impact of the cyber-attack to be fully remediated. These
disclosures should focus on the company’s response to address the impacts to
affected stakeholders and should not reveal specific and/or technical details
that could impede the company’s response or remediation of the incident or that
could assist threat actors.
In
such instances, we may recommend against appropriate directors should we find
the board’s oversight, response or disclosure concerning cybersecurity-related
issues to be insufficient, or are not provided to shareholders.
Board
Accountability for Environmental and Social Performance
Glass
Lewis carefully monitors companies’ performance with respect to environmental
and social issues, including those related to climate and human capital
management. In situations where we believe that a company has not properly
managed or mitigated material environmental or social risks to the detriment of
shareholder value, or when such mismanagement has threatened shareholder value,
Glass Lewis may recommend that shareholders vote against the members of the
board who are responsible for oversight of environmental and social risks. In
the absence of explicit board oversight of environmental and social issues,
Glass Lewis may recommend that shareholders vote against members of the audit
committee. In making these determinations, Glass Lewis will carefully review the
situation, its effect on shareholder value, as well as any corrective action or
other response made by the company.
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For
more information on how Glass Lewis evaluates environmental and social issues,
please see Glass Lewis’ Overall Approach to ESG as well as our comprehensive
Proxy
Paper Guidelines for Shareholder Proposals & ESG-Related Issues,
available at www.glasslewis.com/voting-policies-current/.
Board
Accountability for Climate-related Issues
Given
the exceptionally broad impacts of a changing climate on companies, the economy,
and society in general, we view climate risk as a material risk for all
companies. We therefore believe that boards should be considering and evaluating
their operational resilience under lower-carbon scenarios. While all companies
maintain exposure to climate-related risks, we believe that additional
consideration should be given to, and that disclosure should be provided by
those companies whose GHG emissions represent a financially material risk.
We
believe that companies with this increased risk exposure should provide clear
and comprehensive disclosure regarding these risks, including how they are being
mitigated and overseen. We believe such information is crucial to allow
investors to understand the company’s management of this issue, as well as the
impact of a lower carbon future on the company’s operations.
In
line with this view, Glass Lewis will carefully examine the climate-related
disclosures provided by companies in the S&P 500 index with material
exposure to climate risk stemming from their own operations29,
as well as companies where we believe emissions or climate impacts, or
stakeholder scrutiny thereof, represent an outsized, financially material risk,
in order to assess whether they have produced disclosures in line with the
recommendations of the Task Force on Climate-related Financial Disclosures
(TCFD). We will also assess whether these companies have disclosed explicit and
clearly defined board-level oversight responsibilities for climate-related
issues. In instances where we find either (or both) of these disclosures to be
absent or significantly lacking, we may recommend voting against the chair of
the committee (or board) charged with oversight of climate-related issues, or if
no committee has been charged with such oversight, the chair of the governance
committee. Further, we may extend our recommendation on this basis to additional
members of the responsible committee in cases where the committee chair is not
standing for election due to a classified board, or based on other factors,
including the company’s size, industry and its overall governance profile.
Director
Commitments
We
believe that directors should have the necessary time to fulfill their duties to
shareholders. In our view, an overcommitted director can pose a material risk to
a company’s shareholders, particularly during periods of crisis. In addition,
recent research indicates that the time commitment associated with being a
director has been on a significant upward trend in the past decade.30
As a result, we generally recommend that shareholders vote against
a
29
This policy will generally apply to companies in the following SASB-defined
industries: agricultural products, air freight & logistics, airlines,
chemicals, construction materials, containers & packaging, cruise lines,
electric utilities & power generators, food retailers & distributors,
health care distributors, iron & steel producers, marine transportation,
meat, poultry & dairy, metals & mining, non-alcoholic beverages, oil
& gas, pulp & paper products, rail transportation, road transportation,
semiconductors, waste management.
30
For example, the 2015-2016 NACD Public Company Governance Survey states that, on
average, directors spent a total of 248.2 hours annual on board-related matters
during the past year, which it describes as a “historically high level” that is
significantly above the average hours recorded in 2006. Additionally, the 2020
Spencer Stuart Board Index indicates that, while 39% of S&P 500 CEOs serve
on one additional public board, just 2% of S&P 500 CEOs serve on two
additional public boards and only one CEO serves on three.
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director
who serves as an executive officer (other than executive chair) of any public
company31
while serving on more than one external public company board, a director who
serves as an executive chair of any public company while serving on more than
two external public company boards, and any other director who serves on more
than five public company boards.
Because
we believe that executives will primarily devote their attention to executive
duties, we generally will not recommend that shareholders vote against
overcommitted directors at the companies where they serve as an
executive.
When
determining whether a director’s service on an excessive number of boards may
limit the ability of the director to devote sufficient time to board duties, we
may consider relevant factors such as the size and location of the other
companies where the director serves on the board, the director’s board roles at
the companies in question, whether the director serves on the board of any large
privately-held companies, the director’s tenure on the boards in question, and
the director’s attendance record at all companies. In the case of directors who
serve in executive roles other than CEO (e.g., executive chair), we will
evaluate the specific duties and responsibilities of that role in determining
whether an exception is warranted.
We
may also refrain from recommending against certain directors if the company
provides sufficient rationale for their continued board service. The rationale
should allow shareholders to evaluate the scope of the directors’ other
commitments, as well as their contributions to the board including specialized
knowledge of the company’s industry, strategy or key markets, the diversity of
skills, perspective and background they provide, and other relevant factors. We
will also generally refrain from recommending to vote against a director who
serves on an excessive number of boards within a consolidated group of companies
in related industries, or a director that represents a firm whose sole purpose
is to manage a portfolio of investments which include the company.
Other
Considerations
In
addition to the three key characteristics — independence, performance,
experience — that we use to evaluate board members, we consider
conflict-of-interest issues as well as the size of the board of directors when
making voting recommendations.
Conflicts
of Interest
We
believe board members should be wholly free of identifiable and substantial
conflicts of interest, regardless of the overall level of independent directors
on the board. Accordingly, we recommend that shareholders vote against the
following types of directors:
1.A
CFO who is on the board: In our view, the CFO holds a unique position relative
to financial reporting and disclosure to shareholders. Due to the critical
importance of financial disclosure and reporting, we believe the CFO should
report to the board and not be a member of it.
2.A
director who provides — or a director who has an immediate family member who
provides — material consulting or other material professional services to the
company. These services may include legal,
31
When the executive officer in question serves only as an executive at a special
purpose acquisition company (SPAC) we will generally apply the higher threshold
of five public company directorships.
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consulting,32
or financial services. We question the need for the company to have consulting
relationships with its directors. We view such relationships as creating
conflicts for directors, since they may be forced to weigh their own interests
against shareholder interests when making board decisions. In addition, a
company’s decisions regarding where to turn for the best professional
services may be compromised when doing business with the professional
services firm of one of the company’s directors.
3.A
director, or a director who has an immediate family member, engaging in
airplane, real estate, or similar deals, including perquisite-type grants from
the company, amounting to more than $50,000. Directors who receive these sorts
of payments from the company will have to make unnecessarily complicated
decisions that may pit their interests against shareholder interests.
4.Interlocking
directorships: CEOs or other top executives who serve on each other’s boards
create an interlock that poses conflicts that should be avoided to ensure the
promotion of shareholder interests above all else.33
5.All
board members who served at a time when a poison pill with a term of longer than
one year was adopted without shareholder approval within the prior twelve
months.34
In the event a board is classified and shareholders are therefore unable to vote
against all directors, we will recommend voting against the remaining directors
the next year they are up for a shareholder vote. If a poison pill with a term
of one year or less was adopted without shareholder approval, and without
adequate justification, we will consider recommending that shareholders vote
against all members of the governance committee. If the board has, without
seeking shareholder approval, and without adequate justification, extended the
term of a poison pill by one year or less in two consecutive years, we will
consider recommending that shareholders vote against the entire
board.
Size
of the Board of Directors
While
we do not believe there is a universally applicable optimal board size, we do
believe boards should have at least five directors to ensure sufficient
diversity in decision-making and to enable the formation of key board committees
with independent directors. Conversely, we believe that boards with more than 20
members will typically suffer under the weight of “too many cooks in the
kitchen” and have difficulty reaching consensus and
making timely decisions.
Sometimes the presence of too many voices can make it difficult to draw on the
wisdom and experience in the room by virtue of the need to limit the discussion
so that each voice may be heard.
To
that end, we typically recommend voting against the chair of the nominating
committee (or the governance committee, in the absence of a nominating
committee) at a board with fewer than five directors or more than 20
directors.
32
We will generally refrain from recommending against a director who provides
consulting services for the company if the director is excluded from membership
on the board’s key committees and we have not identified significant governance
concerns with the board.
33
We do not apply a look-back period for this situation. The interlock policy
applies to both public and private companies. On a case-by-case basis, we
evaluate other types of interlocking relationships, such as interlocks with
close family members of executives or within group companies. Further, we will
also evaluate multiple board interlocks among non-insiders (i.e., multiple
directors serving on the same boards at other companies), for evidence of a
pattern of poor oversight.
34
Refer to the “Governance Structure and the Shareholder Franchise” section for
further discussion of our policies regarding anti-takeover measures, including
poison pills.
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Controlled
Companies
We
believe controlled companies warrant certain exceptions to our independence
standards. The board’s function is to protect shareholder interests; however,
when an individual, entity (or group of shareholders party to a formal
agreement) owns more than 50% of the voting shares, the interests of the
majority of shareholders are the interests of that entity or individual.
Consequently, Glass Lewis does not apply our usual two-thirds board independence
rule and therefore we will not recommend voting against boards whose composition
reflects the makeup of the shareholder population.
Independence
Exceptions
The
independence exceptions that we make for controlled companies are as follows:
1.We
do not require that controlled companies have boards that are at least
two-thirds independent. So long as the insiders and/or affiliates are connected
with the controlling entity, we accept the presence of non-independent board
members.
2.The
compensation committee and nominating and governance committees do not need to
consist solely of independent directors.
a.We
believe that standing nominating and corporate governance committees at
controlled companies are unnecessary. Although having a committee charged with
the duties of searching for, selecting, and nominating independent directors can
be beneficial, the unique composition of a controlled company’s shareholder base
makes such committees weak and irrelevant.
b.Likewise,
we believe that independent compensation committees at controlled companies are
unnecessary. Although independent directors are the best choice for approving
and monitoring
senior executives’ pay, controlled companies serve a unique
shareholder population whose voting power ensures the protection of its
interests. As such, we believe that having affiliated directors on a controlled
company’s compensation committee is acceptable. However, given that a controlled
company has certain obligations to minority shareholders we feel that an insider
should not serve on the compensation committee. Therefore, Glass Lewis will
recommend voting against any insider (the CEO or otherwise) serving on the
compensation committee.
3.Controlled
companies do not need an independent chair or an independent lead or presiding
director. Although an independent director in a position of authority on the
board — such as chair or presiding director — can best carry out the board’s
duties, controlled companies serve a unique shareholder population whose voting
power ensures the protection of its interests.
Size
of the Board of Directors
We
have no board size requirements for controlled companies.
Audit
Committee Independence
Despite
a controlled company’s status, unlike for the other key committees, we
nevertheless believe that audit committees should consist solely of independent
directors. Regardless of a company’s controlled status, the interests of all
shareholders must be protected by ensuring the integrity and accuracy of the
company’s financial statements. Allowing affiliated directors to oversee the
preparation of financial reports could create an insurmountable conflict of
interest.
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Board
Responsiveness at Multi-Class Companies
At
controlled companies and companies that have multi-class share structures with
unequal voting rights, we will carefully examine the level of approval or
disapproval attributed to unaffiliated shareholders when determining whether
board responsiveness is warranted. In the case of companies that have
multi-class share structures with unequal voting rights, we will generally
examine the level of approval or disapproval attributed to unaffiliated
shareholders on a “one share, one vote” basis. At controlled and multi-class
companies, when at least 20% or more of unaffiliated shareholders vote contrary
to management, we believe that boards should engage with shareholders and
demonstrate some initial level of responsiveness, and when a majority or more of
unaffiliated shareholders vote contrary to management we believe that boards
should engage with shareholders and provide a more robust response to fully
address shareholder concerns.
Significant
Shareholders
Where
an individual or entity holds between 20-50% of a company’s voting power, we
believe it is reasonable to allow proportional representation on the board and
committees (excluding the audit committee) based on the individual or entity’s
percentage of ownership.
Governance
Following an IPO, Spin-Off, or Direct Listing
We
believe companies that have recently completed an initial public offering (IPO),
spin-off, or direct listing should be allowed adequate time to fully comply with
marketplace listing requirements and meet basic corporate governance standards.
Generally speaking, we refrain from making recommendations on the basis of
governance standards (e.g., board independence, committee membership and
structure, meeting attendance, etc.) during the one-year period following an
IPO.
However,
some cases warrant shareholder action against the board of a company that have
completed an IPO, spin-off, or direct listing within the past year. When
evaluating companies that have recently gone public, Glass Lewis will review the
terms of the applicable governing documents in order to determine whether
shareholder rights are being severely restricted indefinitely. We believe boards
that approve highly restrictive governing documents have demonstrated that they
may subvert shareholder interests following the IPO. In conducting this
evaluation, Glass Lewis will consider:
1.The
adoption of anti-takeover provisions such as a poison pill or classified
board
2.Supermajority
vote requirements to amend governing documents
3.The
presence of exclusive forum or fee-shifting provisions
4.Whether
shareholders can call special meetings or act by written consent
5.The
voting standard provided for the election of directors
6.The
ability of shareholders to remove directors without cause
7.The
presence of evergreen provisions in the company’s equity compensation
arrangements
8.The
presence of a multi-class share structure which does not afford common
shareholders voting power that is aligned with their economic
interest
In
cases where Glass Lewis determines that the board has approved overly
restrictive governing documents, we will generally recommend voting against
members of the governance committee. If there is no governance committee, or if
a portion of such committee members are not standing for election due to a
classified board
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structure,
we will expand our recommendations to additional director nominees, based on who
is standing for election.
In
cases where, preceding an IPO, the board adopts a multi-class share structure
where voting rights are not aligned with economic interest, or an anti-takeover
provision, such as a poison pill or classified board, we will generally
recommend voting against all members of the board who served at the time of the
IPO if the board: (i) did not also commit to submitting these provisions to a
shareholder vote at the company’s first shareholder meeting following the IPO;
or (ii) did not provide for a reasonable sunset of these provisions (generally
three to five years in the case of a classified board or poison pill; or seven
years or less in the case of a multi-class share structure). In the case of a
multi-class share structure, if these provisions are put to a shareholder vote,
we will examine the level of approval or disapproval attributed to unaffiliated
shareholders when determining the vote outcome.
In
our view, adopting an anti-takeover device unfairly penalizes future
shareholders who (except for electing to buy or sell the stock) are unable to
weigh in on a matter that could potentially negatively impact their ownership
interest. This notion is strengthened when a board adopts a classified board
with an infinite duration or a poison pill with a five- to ten-year term
immediately prior to going public, thereby insulating management for a
substantial amount of time.
In
addition, shareholders should also be wary of companies that adopt supermajority
voting requirements before their IPO. Absent explicit provisions in the articles
or bylaws stipulating that certain policies will be phased out over a certain
period of time, long-term shareholders could find themselves in the predicament
of having to attain a supermajority vote to approve future proposals seeking to
eliminate such policies.
Governance
Following a Business Combination with a Special Purpose Acquisition
Company
The
business combination of a private company with a publicly traded special purpose
acquisition company (SPAC) facilitates the private entity becoming a publicly
traded corporation. Thus, the business combination represents the private
company’s de-facto IPO. We believe that some cases warrant shareholder action
against the board of a company that have completed a business combination with a
SPAC within the past year.
At
meetings where shareholders vote on the business combination of a SPAC with a
private company, shareholders are generally voting on a new corporate charter
for the post-combination company as a condition to approval of the business
combination. In many cases, shareholders are faced with the dilemma of having to
approve corporate charters that severely restrict shareholder rights to
facilitate the business combination. Therefore, when shareholders are required
to approve binding charters as a condition to approval of a business combination
with a SPAC, we believe shareholders should also be provided with advisory votes
on material charter amendments as a means to voice their opinions on such
restrictive governance provisions.
When
evaluating companies that have recently gone public via business combination
with a SPAC, Glass Lewis will review the terms of the applicable governing
documents to determine whether shareholder rights are being severely restricted
indefinitely and whether these restrictive provisions were put forth for a
shareholder vote on an advisory basis at the prior meeting where shareholders
voted on the business combination.
In
cases where, prior to the combined company becoming publicly traded, the board
adopts a multi-class share structure where voting rights are not aligned with
economic interest, or an anti-takeover provision, such as a
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poison
pill or classified board, we will generally recommend voting against all members
of the board who served at the time of the combined company becoming publicly
traded if the board: (i) did not also submit these provisions to a shareholder
vote on an advisory basis at the prior meeting where shareholders voted on the
business combination; (ii) did not also commit to submitting these provisions to
a shareholder vote at the company’s first shareholder meeting following the
company becoming publicly traded; or (iii) did not provide for a reasonable
sunset of these provisions (generally three to five years in the case of a
classified board or poison pill; or seven years or less in the case of a
multi-class share structure).
Consistent
with our view on IPOs, adopting an anti-takeover device unfairly penalizes
future shareholders who (except for electing to buy or sell the stock) are
unable to weigh in on a matter that could potentially negatively impact their
ownership interest.
Dual-Listed
or Foreign-Incorporated Companies
For
companies that trade on multiple exchanges or are incorporated in foreign
jurisdictions but trade only in the U.S., we will apply the governance standard
most relevant in each situation. We will consider a number of factors in
determining which Glass Lewis country-specific policy to apply, including but
not limited to: (i) the corporate governance structure and features of the
company including whether the board structure is unique to a particular market;
(ii) the nature of the proposals; (iii) the location of the company’s primary
listing, if one can be determined; (iv) the regulatory/governance regime that
the board is reporting against; and (v) the availability and completeness of the
company’s SEC filings.
OTC-listed
Companies
Companies
trading on the OTC Bulletin Board are not considered “listed companies” under
SEC rules and therefore not subject to the same governance standards as listed
companies. However, we believe that more stringent corporate governance
standards should be applied to these companies given that their shares are still
publicly traded.
When
reviewing OTC companies, Glass Lewis will review the available disclosure
relating to the shareholder meeting to determine whether shareholders are able
to evaluate several key pieces of information, including: (i) the composition of
the board’s key committees, if any; (ii) the level of share ownership of company
insiders or directors; (iii) the board meeting attendance record of directors;
(iv) executive and non-employee director compensation; (v) related-party
transactions conducted during the past year; and (vi) the board’s leadership
structure and determinations regarding director independence.
We
are particularly concerned when company disclosure lacks any information
regarding the board’s key committees. We believe that committees of the board
are an essential tool for clarifying how the responsibilities of the board are
being delegated, and specifically for indicating which directors are accountable
for ensuring: (i) the independence and quality of directors, and the
transparency and integrity of the nominating process; (ii) compensation programs
that are fair and appropriate; (iii) proper oversight of the company’s
accounting, financial reporting, and internal and external audits; and (iv)
general adherence to principles of good corporate governance.
In
cases where shareholders are unable to identify which board members are
responsible for ensuring oversight of the above-mentioned responsibilities, we
may consider recommending against certain members of the board. Ordinarily, we
believe it is the responsibility of the corporate governance committee to
provide thorough
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disclosure
of the board’s governance practices. In the absence of such a committee, we
believe it is appropriate to hold the board’s chair or, if such individual is an
executive of the company, the longest-serving non-executive board member
accountable.
Mutual
Fund Boards
Mutual
funds, or investment companies, are structured differently from regular public
companies (i.e., operating companies). Typically, members of a fund’s advisor
are on the board and management takes on a different role from that of regular
public companies. Thus, we focus on a short list of requirements, although many
of our guidelines remain the same.
The
following mutual fund policies are similar to the policies for regular public
companies:
1.Size
of the board of directors
— The board should be made up of between five and twenty directors.
2.The
CFO on the board
— Neither the CFO of the fund nor the CFO of the fund’s registered investment
advisor should serve on the board.
3.Independence
of the audit committee
— The audit committee should consist solely of independent
directors.
4.Audit
committee financial expert
— At least one member of the audit committee should be designated as the audit
committee financial expert.
The
following differences from regular public companies apply at mutual funds:
1.Independence
of the board
— We believe that three-fourths of an investment company’s board should be made
up of independent directors. This is consistent with a proposed SEC rule on
investment company boards. The Investment Company Act requires 40% of the board
to be independent, but in 2001, the SEC amended the Exemptive Rules to require
that a majority of a mutual fund board be independent. In 2005, the SEC proposed
increasing the independence threshold to 75%. In 2006, a federal appeals court
ordered that this rule amendment be put back out for public comment, putting it
back into “proposed rule” status. Since mutual fund boards play a vital role in
overseeing the relationship between the fund and its investment manager, there
is greater need for independent oversight than there is for an operating company
board.
2.When
the auditor is not up for ratification
— We do not recommend voting against the audit committee if the auditor is not
up for ratification. Due to the different legal structure of an investment
company compared to an operating company, the auditor for the investment company
(i.e., mutual fund)
does not conduct the same level of financial review for
each investment company as for an
operating company.
3.Non-independent
chair
— The SEC has proposed that the chair of the fund board be independent. We agree
that the roles of a mutual fund’s chair and CEO should be separate. Although we
believe this would be best at all companies, we recommend voting against the
chair of an investment company’s nominating committee as well as the board chair
if the chair and CEO of a mutual fund are the same person and the fund does not
have an independent lead or presiding director. Seven former SEC commissioners
support the appointment of an independent chair and we agree with them that “an
independent board chair would be better able to create conditions favoring the
long-term interests of fund shareholders than would a chair who is an executive
of the advisor.” (See the comment letter sent to the SEC in support of the
proposed rule at http://www.sec.gov/news/studies/indchair.pdf.)
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4.Multiple
funds overseen by the same director
— Unlike service on a public company board, mutual fund boards require much less
of a time commitment. Mutual fund directors typically serve on dozens of other
mutual fund boards, often within the same fund complex. The Investment Company
Institute’s (ICI) Overview of Fund Governance Practices, 1994-2012, indicates
that the average number of funds served by an independent director in 2012 was
53. Absent evidence that a specific director is hindered from being an effective
board member at a fund due to service on other funds’ boards, we refrain from
maintaining a cap on the number of outside mutual fund boards that we believe a
director can serve on.
Declassified
Boards
Glass
Lewis favors the repeal of staggered boards and the annual election of
directors. We believe staggered boards are less accountable to shareholders than
boards that are elected annually. Furthermore, we feel the annual election of
directors encourages board members to focus on shareholder
interests.
Empirical
studies have shown: (i) staggered boards are associated with a reduction in a
firm’s valuation; and (ii) in the context of hostile takeovers, staggered boards
operate as a takeover defense, which entrenches management, discourages
potential acquirers, and delivers a lower return to target
shareholders.
In
our view, there is no evidence to demonstrate that staggered boards improve
shareholder returns in a takeover context. Some research has indicated that
shareholders are worse off when a staggered board blocks a transaction; further,
when a staggered board negotiates a friendly transaction, no statistically
significant difference in premium occurs.35
Additional research found that charter-based staggered boards “reduce the market
value of a firm by 4% to 6% of its market capitalization” and that “staggered
boards bring about and not merely reflect this reduction in market
value.”36
A subsequent study reaffirmed that classified boards reduce shareholder value,
finding “that the ongoing process of dismantling staggered boards, encouraged by
institutional investors, could well contribute to increasing shareholder
wealth.”37
Shareholders
have increasingly come to agree with this view. In 2019, 90% of S&P 500
companies had declassified boards, up from 68% in 2009.38
Management proposals to declassify boards are approved with near unanimity and
shareholder proposals on the topic also receive strong shareholder support; in
2014, shareholder proposals requesting that companies declassify their boards
received average support of 84% (excluding abstentions and broker non-votes),
whereas in 1987, only 16.4% of votes cast favored board
declassification.39
Further, a growing number of companies, nearly half of all those targeted by
shareholder proposals requesting that all directors stand for election annually,
either recommended shareholders support the proposal or made no recommendation,
a departure from the more traditional management recommendation to vote against
shareholder proposals.
35
Lucian Bebchuk, John Coates IV, Guhan Subramanian, “The Powerful Antitakeover
Force of Staggered Boards: Further Findings and a Reply to Symposium
Participants,” 55 Stanford Law Review 885-917 (2002).
36
Lucian Bebchuk, Alma Cohen, “The Costs of Entrenched Boards”
(2004).
37
Lucian Bebchuk, Alma Cohen and Charles C.Y. Wang, “Staggered Boards and the
Wealth of Shareholders: Evidence from a Natural Experiment,”
SSRN:
http://ssrn.com/abstract=1706806
(2010), p. 26.
38
Spencer Stuart Board Index, 2019, p. 15.
39
Lucian Bebchuk, John Coates IV and Guhan Subramanian, “The Powerful Antitakeover
Force of Staggered Boards: Theory, Evidence, and Policy”.
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Given
our belief that declassified boards promote director accountability, the
empirical evidence suggesting staggered boards reduce a company’s value and the
established shareholder opposition to such a structure, Glass Lewis supports the
declassification of boards and the annual election of directors.
Board
Composition and Refreshment
Glass
Lewis strongly supports routine director evaluation, including independent
external reviews, and periodic board refreshment to foster the sharing of
diverse perspectives in the boardroom and the generation of new ideas and
business strategies. Further, we believe the board should evaluate the need for
changes to board composition based on an analysis of skills and experience
necessary for the company, as well as the results of
the director
evaluations, as opposed to relying solely on age or tenure limits. When
necessary, shareholders can address concerns regarding proper board composition
through director elections.
In
our view, a director’s experience can be a valuable asset to shareholders
because of the complex, critical issues that boards face. This said, we
recognize that in rare circumstances, a lack of refreshment can contribute to a
lack of board responsiveness to poor company performance.
We
will note as a potential concern instances where the average tenure of
non-executive directors is 10 years or more and no new directors have joined the
board in the past five years. While we will be highlighting this as a potential
area of concern, we will not be making voting recommendations strictly on this
basis, unless we have identified other governance or board performance
concerns.
On
occasion, age or term limits can be used as a means to remove a director for
boards that are unwilling to police their membership and enforce turnover. Some
shareholders support term limits as a way to force change in such circumstances.
While
we understand that age limits can aid board succession planning, the long-term
impact of age limits restricts experienced and potentially valuable board
members from service through an arbitrary means. We believe that shareholders
are better off monitoring the board’s overall composition, including the
diversity of its members, the alignment of the board’s areas of expertise with a
company’s strategy, the board’s approach to corporate governance, and its
stewardship of company performance, rather than imposing inflexible rules that
don’t necessarily correlate with returns or benefits for
shareholders.
However,
if a board adopts term/age limits, it should follow through and not waive such
limits. In cases where the board waives its term/age limits for two or more
consecutive years, Glass Lewis will generally recommend that shareholders vote
against the nominating and/or governance committee chair, unless a compelling
rationale is provided for why the board is proposing to waive this rule, such as
consummation of a corporate transaction.
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Board
Diversity
Glass
Lewis recognizes the importance of ensuring that the board is composed of
directors who have a diversity of skills, thought and experience, as such
diversity benefits companies by providing a broad range of perspectives and
insights. Glass Lewis closely reviews the composition of the board for
representation of diverse director candidates.
Board
Gender Diversity
We
consider the nominating and governance committee to be responsible for ensuring
sufficient board diversity, or for publicly communicating its rationale or a
plan for increasing diversity. As such, we will generally recommend voting
against the chair of the nominating committee of a board that is not at least 30
percent gender diverse, or all members of the nominating committee of a board
with no gender diverse directors, at companies within the Russell 3000 index.
For companies outside the Russell 3000 index, our policy requires a minimum of
one gender diverse director.
When
making these voting recommendations, we will carefully review a company’s
disclosure of its diversity considerations and may refrain from recommending
that shareholders vote against directors when boards have provided sufficient
rationale for the lack of diversity or a plan to address the lack of diversity,
including a timeline of when the board intends to appoint additional gender
diverse directors (generally by the next annual meeting or as soon as reasonably
practicable).
We
may extend our gender diversity recommendations to additional members of the
nominating committee in cases where the committee chair is not standing for
election due to a classified board, or based on other factors, including the
company’s size and industry, applicable laws in its state of headquarters, and
its overall governance profile.
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Board
Underrepresented Community Diversity
We
will generally recommend against the chair of the nominating committee of a
board with fewer than one director from an underrepresented community on the
board at companies within the Russell 1000 index.
We
define “underrepresented community director” as an individual who
self-identifies as Black, African American, North African, Middle Eastern,
Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or
Alaskan Native, or who self-identifies as a member of the LGBTQIA+ community.
For the purposes of this evaluation, we will rely solely on self-identified
demographic information as disclosed in company proxy statements.
When
making these voting recommendations, we will carefully review a company’s
disclosure of its diversity considerations and may refrain from recommending
that shareholders vote against directors when boards have provided a sufficient
rationale or plan to address the lack of diversity on the board, including a
timeline to appoint additional directors from an underrepresented community
(generally by the next annual meeting or as soon as reasonably
practicable).
We
may extend our underrepresented community diversity recommendations to
additional members of the nominating committee in cases where the committee
chair is not standing for election due to a classified board, or based on other
factors, including the company’s size and industry, applicable laws in its state
of headquarters, and its overall governance profile.
State
Laws on Diversity
Several
states have begun to encourage board diversity through legislation. Some state
laws imposed mandatory board composition requirements, while other states have
enacted or are considering legislation that encourages companies to diversify
their boards but does not mandate board composition requirements. Furthermore,
several states have enacted or are considering enacting certain disclosure or
reporting requirements in filings made with each respective state
annually.
Glass
Lewis will recommend in accordance with mandatory board composition requirements
set forth in applicable state laws when they come into effect. We will generally
refrain from recommending against directors when applicable state laws do not
mandate board composition requirements, are non-binding, or solely impose
disclosure or reporting requirements.
We
note that during 2022, California’s Senate Bill 826 and Assembly Bill 979
regarding board gender and “underrepresented community” diversity, respectively,
were both deemed to violate the equal protection clause of the California state
constitution. These laws are currently in the appeals process.
Accordingly,
where we previously recommended in accordance with mandatory board composition
requirements set forth in California’s SB 826 and AB 979, we will refrain from
providing recommendations pursuant to these state board composition requirements
until further notice while we continue to monitor the appeals process. However,
we will continue to monitor compliance with these requirements.
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Disclosure
of Director Diversity and Skills
Because
company disclosure is critical when measuring the mix of diverse attributes and
skills of directors, Glass Lewis assesses the quality of such disclosure in
companies’ proxy statements. Accordingly, we reflect how a company’s proxy
statement presents: (i) the board’s current percentage of racial/ethnic
diversity; (ii) whether the board’s definition of diversity explicitly includes
gender and/or race/ethnicity; (iii) whether the board has adopted a policy
requiring women and minorities to be included in the initial pool of candidates
when selecting new director nominees (aka “Rooney Rule”); and (iv) board skills
disclosure. Such ratings will help inform our assessment of a company’s overall
governance and may be a contributing factor in our recommendations when
additional board-related concerns have been identified.
At
companies in the Russell 1000 index that have not provided any disclosure in any
of the above categories, we will generally recommend voting against the chair of
the nominating and/or governance committee. Further, when companies in the
Russell 1000 index have not provided any disclosure of individual or aggregate
racial/ethnic minority board demographic information, we will generally
recommend voting against the chair of the nominating and/or governance
committee.
Stock
Exchange Diversity Disclosure Requirements
On
August 6, 2021, the SEC approved new listing rules regarding board diversity and
disclosure for Nasdaq-listed companies. Beginning in 2022, companies listed on
the Nasdaq stock exchange are required to disclose certain board diversity
statistics annually in a standardized format in the proxy statement or on the
company's website. Nasdaq-listed companies are required to provide this
disclosure by the later of (i) August 8, 2022, or (ii) the date the company
files its proxy statement for its 2022 annual meeting. Accordingly, for annual
meetings held after August 8, 2022, of applicable Nasdaq-listed companies, we
will recommend voting against the chair of the governance committee when the
required disclosure has not been provided.
Proxy
Access
In
lieu of running their own contested election, proxy access would not only allow
certain shareholders to nominate directors to company boards but the shareholder
nominees would be included on the company’s ballot, significantly enhancing the
ability of shareholders to play a meaningful role in selecting their
representatives. Glass Lewis generally supports affording shareholders the right
to nominate director candidates to management’s proxy as a means to ensure that
significant, long-term shareholders have an ability to nominate candidates to
the board.
Companies
generally seek shareholder approval to amend company bylaws to adopt proxy
access in response to shareholder engagement or pressure, usually in the form of
a shareholder proposal requesting proxy access, although some companies may
adopt some elements of proxy access without prompting. Glass Lewis considers
several factors when evaluating whether to support proposals for companies to
adopt proxy access including the specified minimum ownership and holding
requirement for shareholders to nominate one or more directors, as well as
company size, performance and responsiveness to shareholders.
For
a discussion of recent regulatory events in this area, along with a detailed
overview of the Glass Lewis approach to shareholder proposals regarding Proxy
Access, refer to Glass Lewis’ Proxy
Paper Guidelines for Shareholder Proposals & ESG-Related Issues,
available at www.glasslewis.com.
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Majority
Vote for Election of Directors
Majority
voting for the election of directors is fast becoming the de facto standard in
corporate board elections. In our view, the majority voting proposals are an
effort to make the case for shareholder impact on director elections on a
company-specific basis.
While
this proposal would not give shareholders the opportunity to nominate directors
or lead to elections where shareholders have a choice among director candidates,
if implemented, the proposal would allow shareholders to have a voice in
determining whether the nominees proposed by the board should actually serve as
the overseer-representatives of shareholders in the boardroom. We believe this
would be a favorable outcome for shareholders.
The
number of shareholder proposals requesting that companies adopt a majority
voting standard has declined significantly during the past decade, largely as a
result of widespread adoption of majority voting or director
resignation
policies at U.S. companies. In 2019, 89% of the S&P 500 Index had
implemented a resignation policy for directors failing to receive majority
shareholder support, compared to 65% in 2009.40
The
Plurality Vote Standard
Today,
most U.S. companies still elect directors by a plurality vote standard. Under
that standard, if one shareholder holding only one share votes in favor of a
nominee (including that director, if the director is a shareholder), that
nominee “wins” the election and assumes a seat on the board. The common concern
among companies with a plurality voting standard is the possibility that one or
more directors would not receive a majority of votes, resulting in “failed
elections.”
Advantages
of a Majority Vote Standard
If
a majority vote standard were implemented, a nominee would have to receive the
support of a majority of the shares voted in order to be elected. Thus,
shareholders could collectively vote to reject a director they believe will not
pursue their best interests. Given that so few directors (less than 100 a year)
do not receive majority support from shareholders, we think that a majority vote
standard is reasonable since it will neither result in many failed director
elections nor reduce the willingness of qualified, shareholder-focused directors
to serve in the future. Further, most directors who fail to receive a majority
shareholder vote in favor of their election do not step down, underscoring the
need for true majority voting.
We
believe that a majority vote standard will likely lead to more attentive
directors. Although shareholders only rarely fail to support directors, the
occasional majority vote against a director’s election will likely deter the
election of directors with a record of ignoring shareholder interests. Glass
Lewis will therefore generally support proposals calling for the election of
directors by a majority vote, excepting contested director elections.
In
response to the high level of support majority voting has garnered, many
companies have voluntarily taken steps to implement majority voting or modified
approaches to majority voting. These steps range from a modified approach
requiring directors that receive a majority of withheld votes to resign (i.e., a
resignation policy) to actually requiring a majority vote of outstanding shares
to elect directors.
40
Spencer Stuart Board Index, 2019, p. 15.
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We
feel that the modified approach does not go far enough because requiring a
director to resign is not the same as requiring a majority vote to elect a
director and does not allow shareholders a definitive voice in the election
process. Further, under the modified approach, the corporate governance
committee could reject a resignation and, even if it accepts the resignation,
the corporate governance committee decides on the director’s replacement. And
since the modified approach is usually adopted as a policy by the board or a
board committee, it could be altered by the same board or committee at any
time.
Conflicting
and Excluded Proposals
SEC
Rule 14a-8(i)(9) allows companies to exclude shareholder proposals “if the
proposal directly conflicts with one of the company’s own proposals to be
submitted to shareholders at the same meeting.” On October 22, 2015, the SEC
issued Staff Legal Bulletin No. 14H (SLB 14H) clarifying its rule concerning the
exclusion of certain shareholder proposals when similar items are also on the
ballot. SLB 14H increased the burden on companies to prove to SEC staff that a
conflict exists; therefore, many companies still chose to place management
proposals alongside similar shareholder proposals in many cases.
During
the 2018 proxy season, a new trend in the SEC’s interpretation of this rule
emerged. Upon submission of shareholder proposals requesting that companies
adopt a lower special meeting threshold, several companies petitioned the SEC
for no-action relief under the premise that the shareholder proposals conflicted
with management’s own special meeting proposals, even though the management
proposals set a higher threshold than those requested by the proponent.
No-action relief was granted to these companies; however, the SEC stipulated
that the companies must state in the rationale for the management proposals that
a vote in favor of management’s proposal was tantamount to a vote against the
adoption of a lower special meeting threshold. In certain instances, shareholder
proposals to lower an existing special meeting right threshold were excluded on
the basis that they conflicted with management proposals seeking to ratify the
existing special meeting rights. We find the exclusion of these shareholder
proposals to be especially problematic as, in these instances, shareholders are
not offered any enhanced shareholder right, nor would the approval (or
rejection) of the ratification proposal initiate any type of meaningful change
to shareholders’ rights.
In
instances where companies have excluded shareholder proposals, such as those
instances where special meeting shareholder proposals are excluded as a result
of “conflicting” management proposals, Glass Lewis will take a case-by-case
approach, taking into account the following issues:
•The
threshold proposed by the shareholder resolution;
•The
threshold proposed or established by management and the attendant rationale for
the threshold;
•Whether
management’s proposal is seeking to ratify an existing special meeting right or
adopt a bylaw that would establish a special meeting right; and
•The
company’s overall governance profile, including its overall responsiveness to
and engagement with shareholders.
Glass
Lewis generally favors a 10-15% special meeting right. Accordingly, Glass Lewis
will generally recommend voting for management or shareholder proposals that
fall within this range. When faced with conflicting proposals, Glass Lewis will
generally recommend in favor of the lower special meeting right and will
recommend voting against the proposal with the higher threshold. However, in
instances where there are conflicting management and shareholder proposals and a
company has not established a special meeting right, Glass Lewis may recommend
that shareholders vote in favor of the shareholder proposal and that they
abstain from a
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management-proposed
bylaw amendment seeking to establish a special meeting right. We believe that an
abstention is appropriate in this instance in order to ensure that shareholders
are sending a clear signal regarding their preference for the appropriate
threshold for a special meeting right, while not directly opposing the
establishment of such a right.
In
cases where the company 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, we will generally recommend
voting against the chair or members of the governance committee.
In
other instances of conflicting management and shareholder proposals, Glass Lewis
will consider the following:
•The
nature of the underlying issue;
•The
benefit to shareholders of implementing the proposal;
•The
materiality of the differences between the terms of the shareholder proposal and
management proposal;
•The
context of a company’s shareholder base, corporate structure and other relevant
circumstances; and
•A
company’s overall governance profile and, specifically, its responsiveness to
shareholders as evidenced by a company’s response to previous shareholder
proposals and its adoption of progressive shareholder rights
provisions.
In
recent years, we have seen the dynamic nature of the considerations given by the
SEC when determining whether companies may exclude certain shareholder
proposals. We understand that not all shareholder proposals serve the long-term
interests of shareholders, and value and respect the limitations placed on
shareholder proponents, as certain shareholder proposals can unduly burden
companies. However, Glass Lewis believes that shareholders should be able to
vote on issues of material importance.
We
view the shareholder proposal process as an important part of advancing
shareholder rights and encouraging responsible and financially sustainable
business practices. While recognizing that certain proposals cross the line
between the purview of shareholders and that of the board, we generally believe
that companies should not limit investors’ ability to vote on shareholder
proposals that advance certain rights or promote beneficial disclosure.
Accordingly, Glass Lewis will make note of instances where a company has
successfully petitioned the SEC to exclude shareholder proposals. If after
review we believe that the exclusion of a shareholder proposal is detrimental to
shareholders, we may, in certain very limited circumstances, recommend against
members of the governance committee.
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Transparency
and Integrity in Financial Reporting
Auditor
Ratification
The
auditor’s role as gatekeeper is crucial in ensuring the integrity and
transparency of the financial information necessary for protecting shareholder
value. Shareholders rely on the auditor to ask tough questions and to do a
thorough analysis of a company’s books to ensure that the information provided
to shareholders is complete, accurate, fair, and that it is a reasonable
representation of a company’s financial position. The only way shareholders can
make rational investment decisions is if the market is equipped with accurate
information about a company’s fiscal health. As stated in the October 6, 2008
Final Report of the Advisory Committee on the Auditing Profession to the U.S.
Department of the Treasury:
“The
auditor is expected to offer critical and objective judgment on the financial
matters under consideration, and actual and perceived absence of conflicts is
critical to that expectation. The Committee believes that auditors, investors,
public companies, and other market participants must understand the independence
requirements and their objectives, and that auditors must adopt a mindset of
skepticism when facing situations that may compromise their independence.”
As
such, shareholders should demand an objective, competent and diligent auditor
who performs at or above professional standards at every company in which the
investors hold an interest. Like directors, auditors should be free from
conflicts of interest and should avoid situations requiring a choice between the
auditor’s interests and the public’s interests. Almost without exception,
shareholders should be able to annually review an auditor’s performance and to
annually ratify a board’s auditor selection. Moreover, in October 2008, the
Advisory Committee on the Auditing Profession went even further, and recommended
that “to further enhance audit committee oversight and auditor accountability
... disclosure in the company proxy statement regarding shareholder ratification
[should] include the name(s) of the senior auditing partner(s) staffed on the
engagement.”41
On
August 16, 2011, the PCAOB issued a Concept Release seeking public comment on
ways that auditor independence, objectivity and professional skepticism could be
enhanced, with a specific emphasis on mandatory audit firm rotation. The PCAOB
convened several public roundtable meetings during 2012 to further discuss such
matters. Glass Lewis believes auditor rotation can ensure both the independence
of the auditor and the integrity of the audit; we will typically recommend
supporting proposals to require auditor rotation when the proposal uses a
reasonable period of time (usually not less than 5-7 years), particularly at
companies with a history of accounting problems.
On
June 1, 2017, the PCAOB adopted new standards to enhance auditor reports by
providing additional important information to investors. For companies with
fiscal year end dates on or after December 15, 2017, reports were required to
include the year in which the auditor began serving consecutively as the
company’s auditor. For large accelerated filers with fiscal year ends of June
30, 2019 or later, and for all other companies
41
“Final Report of the Advisory Committee on the Auditing Profession to the U.S.
Department of the Treasury.” p. VIII:20, October 6, 2008.
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with
fiscal year ends of December 15, 2020 or later, communication of critical audit
matters (CAMs) will also be required. CAMs are matters that have been
communicated to the audit committee, are related to accounts or disclosures that
are material to the financial statements, and involve especially challenging,
subjective, or complex auditor judgment.
Glass
Lewis believes the additional reporting requirements are beneficial for
investors. The additional disclosures can provide investors with information
that is critical to making an informed judgment about an auditor’s independence
and performance. Furthermore, we believe the additional requirements are an
important step toward enhancing the relevance and usefulness of auditor reports,
which too often are seen as boilerplate compliance documents that lack the
relevant details to provide meaningful insight into a particular
audit.
Voting
Recommendations on Auditor Ratification
We
generally support management’s choice of auditor except when we believe the
auditor’s independence or audit integrity has been compromised. Where a board
has not allowed shareholders to review and ratify an auditor, we typically
recommend voting against the audit committee chair. When there have been
material restatements of annual financial statements or material weaknesses in
internal controls, we usually recommend voting against the entire audit
committee.
Reasons
why we may not recommend ratification of an auditor include:
1.When
audit fees plus audit-related fees total less than the tax fees and/or other
non-audit fees.
2.Recent
material restatements of annual financial statements, including those resulting
in the reporting of material weaknesses in internal controls and including late
filings by the company where the auditor bears some responsibility for the
restatement or late filing.42
3.When
the auditor performs prohibited services such as tax-shelter work, tax services
for the CEO or CFO, or contingent-fee work, such as a fee based on a percentage
of economic benefit to the company.
4.When
audit fees are excessively low, especially when compared with other companies in
the same industry.
5.When
the company has aggressive accounting policies.
6.When
the company has poor disclosure or lack of transparency in its financial
statements.
7.Where
the auditor limited its liability through its contract with the company or the
audit contract requires the corporation to use alternative dispute resolution
procedures without adequate justification.
8.We
also look for other relationships or concerns with the auditor that might
suggest a conflict between the auditor’s interests and shareholder
interests.
9.In
determining whether shareholders would benefit from rotating the company’s
auditor, where relevant we will consider factors that may call into question an
auditor’s effectiveness, including auditor tenure, a pattern of inaccurate
audits, and any ongoing litigation or significant controversies. When Glass
Lewis considers ongoing litigation and significant controversies, it is mindful
that such matters may involve unadjudicated allegations. Glass Lewis does not
assume the truth of such allegations or that the law has been violated. Instead,
Glass Lewis focuses more broadly on whether, under the particular facts and
circumstances presented, the nature and number of such lawsuits or other
significant controversies
42
An auditor does not audit interim financial statements. Thus, we generally do
not believe that an auditor should be opposed due to a restatement of interim
financial statements unless the nature of the misstatement is clear from a
reading of the incorrect financial statements.
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reflects
on the risk profile of the company or suggests that appropriate risk mitigation
measures may be warranted.”
Pension
Accounting Issues
A
pension accounting question occasionally raised in proxy proposals is what
effect, if any, projected returns on employee pension assets should have on a
company’s net income. This issue often arises in the executive-compensation
context in a discussion of the extent to which pension accounting should be
reflected in business performance for purposes of calculating payments to
executives.
Glass
Lewis believes that pension credits should not be included in measuring income
that is used to award performance-based compensation. Because many of the
assumptions used in accounting for retirement plans are subject to the company’s
discretion, management would have an obvious conflict of interest if pay were
tied to pension income. In our view, projected income from pensions does not
truly reflect a company’s performance.
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The
Link Between Compensation and Performance
Glass
Lewis carefully reviews the compensation awarded to senior executives, as we
believe that this is an important area in which the board’s priorities are
revealed. Glass Lewis strongly believes executive compensation should be linked
directly with the performance of the business the executive is charged with
managing. We believe the most effective compensation arrangements provide for an
appropriate mix of performance-based short- and long-term incentives in addition
to fixed pay elements while promoting a prudent and sustainable level of
risk-taking.
Glass
Lewis believes that comprehensive, timely and transparent disclosure of
executive pay is critical to allowing shareholders to evaluate the extent to
which pay is aligned with company performance. When reviewing proxy materials,
Glass Lewis examines whether the company discloses the performance metrics used
to determine executive compensation. We recognize performance metrics must
necessarily vary depending on the company and industry, among other factors, and
may include a wide variety of financial measures as well as industry-specific
performance indicators. However, we believe companies should disclose why the
specific performance metrics were selected and how the actions they are designed
to incentivize will lead to better corporate performance.
Moreover,
it is rarely in shareholders’ interests to disclose competitive data about
individual salaries below the senior executive level. Such disclosure could
create internal personnel discord that would be counterproductive for the
company and its shareholders. While we favor full disclosure for senior
executives and we view pay disclosure at the aggregate level (e.g., the number
of employees being paid over a certain amount or in certain categories) as
potentially useful, we do not believe shareholders need or will benefit from
detailed reports about individual management employees other than the most
senior executives.
Advisory
Vote on Executive Compensation
(Say-on-Pay)
The
Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”)
required companies to hold an advisory vote on executive compensation at the
first shareholder meeting that occurs six months after enactment of the bill
(January 21, 2011).
This
practice of allowing shareholders a non-binding vote on a company’s compensation
report is standard practice in many non-U.S. countries, and has been a
requirement for most companies in the United Kingdom since 2003 and in Australia
since 2005. Although say-on-pay proposals are non-binding, a high level of
“against” or “abstain” votes indicates substantial shareholder concern about
a company’s compensation policies
and procedures.
Given
the complexity of most companies’ compensation programs, Glass Lewis applies a
highly nuanced approach when analyzing advisory votes on executive compensation.
We review each company’s compensation on a case-by-case basis, recognizing that
each company must be examined in the context of industry, size, maturity,
performance, financial condition, its historic pay for performance practices,
and any other relevant internal or external factors.
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We
believe that each company should design and apply specific compensation policies
and practices that are appropriate to the circumstances of the company and, in
particular, will attract and retain competent executives and other staff, while
motivating them to grow the company’s long-term shareholder value.
Where
we find those specific policies and practices serve to reasonably align
compensation with performance, and such practices are adequately disclosed,
Glass Lewis will recommend supporting the company’s approach. If, however, those
specific policies and practices fail to demonstrably link compensation with
performance, Glass Lewis will generally recommend voting against the say-on-pay
proposal.
Glass
Lewis reviews say-on-pay proposals on both a qualitative basis and a
quantitative basis, with a focus on several main areas:
•The
overall design and structure of the company’s executive compensation programs
including selection and challenging nature of performance metrics;
•The
implementation and effectiveness of the company’s executive compensation
programs including pay mix and use of performance metrics in determining pay
levels;
•The
quality and content of the company’s disclosure;
•The
quantum paid to executives; and
•The
link between compensation and performance as indicated by the company’s current
and past pay-for-performance grades.
We
also review any significant changes or modifications, including post fiscal
year-end changes and one-time awards, particularly where the changes touch upon
issues that are material to Glass Lewis recommendations. Additionally, while we
recognize their rarity in the U.S. market, beneficial features such as but not
limited to post-vesting and/or post-termination holding requirements may be
viewed positively in our holistic analysis.
Say-on-Pay
Voting Recommendations
In
cases where we find deficiencies in a company’s compensation program’s design,
implementation or management, we will recommend that shareholders vote against
the say-on-pay proposal. Generally, such instances include:
•Evidence
of a pattern of poor pay-for-performance practices (i.e., deficient or failing
pay-for-performance grades),
•Unclear
or questionable disclosure regarding the overall compensation structure (e.g.,
limited information regarding benchmarking processes, limited rationale for
bonus performance metrics and targets, etc.),
•Questionable
adjustments to certain aspects of the overall compensation structure (e.g.,
limited rationale for significant changes to performance targets or metrics, the
payout of guaranteed bonuses or sizable retention grants, etc.), and/or
•Other
egregious compensation practices.
Although
not an exhaustive list, the following issues when weighed together may cause
Glass Lewis to recommend voting against a say-on-pay vote:
•Inappropriate
or outsized self-selected peer groups and/or benchmarking issues such as
compensation targets set well above the median without adequate
justification;
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•Egregious
or excessive bonuses, equity awards or severance payments, including golden
handshakes and golden parachutes;
•Insufficient
response to low shareholder support;
•Problematic
contractual payments, such as guaranteed bonuses;
•Insufficiently
challenging performance targets and/or high potential payout
opportunities;
•Performance
targets lowered without justification;
•Discretionary
bonuses paid when short- or long-term incentive plan targets were not
met;
•High
executive pay relative to peers that is not justified by outstanding company
performance; and
•The
terms of the long-term incentive plans are inappropriate (please see “Long-Term
Incentives”).
The
aforementioned issues may also influence Glass Lewis’ assessment of the
structure of a company’s compensation program. We evaluate structure on a “Good,
Fair, Poor” rating scale whereby a “Good” rating represents a compensation
program with little to no concerns, a “Fair” rating represents a compensation
program with some concerns and a “Poor” rating represents a compensation program
that deviates significantly from best practice or contains one or more egregious
compensation practices.
We
believe that it is important for companies to provide investors with clear and
complete disclosure of all the significant terms of compensation arrangements.
Similar to structure, we evaluate disclosure on a “Good, Fair, Poor” rating
scale whereby a “Good” rating represents a thorough discussion of all elements
of compensation, a “Fair” rating represents an adequate discussion of all or
most elements of compensation and a “Poor” rating represents an incomplete or
absent discussion of compensation. In instances where a company has simply
failed to provide sufficient disclosure of its policies, we may recommend
shareholders vote against this proposal solely on this basis, regardless of the
appropriateness of compensation levels.
In
general, most companies will fall within the “Fair” range for both structure and
disclosure, and Glass Lewis largely uses the “Good” and “Poor” ratings to
highlight outliers.
Where
we identify egregious compensation practices, we may also recommend voting
against the compensation committee based on the practices or actions of its
members during the year. Such practices may include approving large one-off
payments, the inappropriate, unjustified use of discretion, or sustained poor
pay for performance practices. (Refer to the section on "Compensation Committee
Performance" for more information.)
Company
Responsiveness
When
companies receive a significant level of shareholder opposition to a say-on-pay
proposal, which occurs when more than 20% of votes on the proposal are cast as
AGAINST and/or ABSTAIN. we believe the board should demonstrate a commensurate
level of engagement and responsiveness to the concerns behind the disapproval,
with a particular focus on responding to shareholder feedback. When assessing
the level of opposition to say-on-pay proposals, we may further examine the
level of opposition among disinterested shareholders as an independent group.
While we recognize that sweeping changes cannot be made to a compensation
program without due consideration, and that often a majority of shareholders may
have voted in favor of the proposal, given that the average approval rate for
say-on-pay proposals is about 90%, we believe the compensation committee should
provide some level of response to a significant vote against. In general, our
expectations regarding the minimum appropriate levels of responsiveness will
correspond with the level of shareholder opposition, as expressed both through
the magnitude of opposition in a single year, and through the persistence of
shareholder disapproval over time.
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Responses
we consider appropriate include engaging with large shareholders, especially
dissenting shareholders, to identify their concerns, and, where reasonable,
implementing changes and/or making commitments that directly address those
concerns within the company’s compensation program. In cases where particularly
egregious pay decisions caused the say on pay proposal to fail, Glass Lewis will
closely consider whether any changes were made directly relating to the pay
decision that may address structural concerns that shareholders have. In the
absence of any evidence in the disclosure that the board is actively engaging
shareholders on these issues and responding accordingly, we may recommend
holding compensation committee members accountable for failing to adequately
respond to shareholder opposition. Regarding such recommendations, careful
consideration will be given to the level of shareholder protest and the severity
and history of compensation practices.
Pay
for Performance
Glass
Lewis believes an integral part of a well-structured compensation package is a
successful link between pay and performance. Our proprietary pay-for-performance
model was developed to better evaluate the link between pay and performance.
Generally, compensation and performance are measured against a peer group of
appropriate companies that may overlap, to a certain extent, with a company’s
self-disclosed peers. This quantitative analysis provides a consistent framework
and historical context for our clients to determine how well companies link
executive compensation to relative performance. Companies that demonstrate a
weaker link are more likely to receive a negative recommendation; however, other
qualitative factors such as overall incentive structure, significant forthcoming
changes to the compensation program or reasonable long-term payout levels may
mitigate our concerns to a certain extent.
While
we assign companies a letter grade of A, B, C, D or F based on the alignment
between pay and performance, the grades derived from the Glass Lewis
pay-for-performance analysis do not follow the traditional U.S. school letter
grade system. Rather, the grades are generally interpreted as
follows:
Grade
of A:
The company’s percentile rank for pay is significantly less than its percentile
rank for performance
Grade
of B:
The company’s percentile rank for pay is moderately less than its percentile
rank for performance
Grade
of C:
The company’s percentile rank for pay is approximately aligned with its
percentile rank for
performance
Grade
of D:
The company’s percentile rank for pay is higher than its percentile rank for
performance
Grade
of F:
The company’s percentile rank for pay is significantly higher than its
percentile rank for performance
Separately,
a specific comparison between the company’s executive pay and its peers’
executive pay levels may be discussed in the analysis for additional insight
into the grade. Likewise, a specific comparison between the company’s
performance and its peers’ performance is reflected in the analysis for further
context.
We
also use this analysis to inform our voting decisions on say-on-pay proposals.
As such, if a company receives a “D” or “F” from our proprietary model, we are
more likely to recommend that shareholders vote against the say-on-pay proposal.
However, supplemental quantitative factors like analyses of realized pay levels
and the “compensation actually paid” data mandated by the SEC’s 2022 final rule
regarding pay versus performance may be considered, and other qualitative
factors such as an effective overall incentive structure, the relevance of
selected performance metrics, significant forthcoming enhancements or reasonable
long-term payout levels may give us cause to recommend in favor of a proposal
even when we have identified a disconnect between pay and
performance.
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In
determining the peer groups used in our A-F pay-for-performance letter grades,
Glass Lewis utilizes a proprietary methodology that considers both market and
industry peers, along with each company’s network of self-disclosed peers. Each
component is considered on a weighted basis and is subject to size-based ranking
and screening. The peer groups used are provided to Glass Lewis by Diligent
Intel based on Glass Lewis’ methodology and using Diligent Intel’s data.
Selecting
an appropriate peer group to analyze a company’s compensation program is a
subjective determination, requiring significant judgment and on which there is
not a “correct” answer. Since the peer group used is based on an independent,
proprietary technique, it will often differ from the one used by the company
which, in turn, will affect the resulting analyses. While Glass Lewis believes
that the independent, rigorous methodology it uses provides a valuable
perspective on the company’s compensation program, the company’s self-selected
peer group may also presented in the Proxy Paper for comparative
purposes.
Short-Term
Incentives
A
short-term bonus or incentive (STI) should be demonstrably tied to performance.
Whenever possible, we believe a mix of corporate and individual performance
measures is appropriate. We would normally expect performance measures for STI
plans to be based on company-wide or divisional financial measures as well as
non-financial, qualitative or non-formulaic factors such as those related to
safety, environmental issues, and customer satisfaction. While we recognize that
companies operating in different sectors or markets may seek to utilize a wide
range of metrics, we expect such measures to be appropriately tied to a
company’s business drivers.
Further,
the threshold, target and maximum performance goals and corresponding payout
levels that can be achieved under STI plans should be disclosed. Shareholders
should expect stretching performance targets for the maximum award to be
achieved. Any increase in the potential target and maximum award should be
clearly justified to shareholders, as should any decrease in target and maximum
performance levels from the previous year.
Glass
Lewis recognizes that disclosure of some measures or performance targets may
include commercially confidential information. Therefore, we believe it may be
reasonable to exclude such information in some cases as long as the company
provides sufficient justification for non-disclosure. However, where a
short-term bonus has been paid, companies should disclose the extent to which
performance has been achieved against relevant targets, including disclosure of
the actual target achieved.
Where
management has received significant short-term incentive payments but overall
performance and/or the shareholder experience over the measurement year prima
facie appears to be poor or negative, we believe the company should provide a
clear explanation of why these significant short-term payments were made. We
also believe any significant changes to the program structure should be
accompanied by rationalizing disclosure. Further, where a company has applied
upward discretion, which includes lowering goals mid-year, increasing calculated
payouts or retroactively pro-rating performance periods, we expect a robust
discussion of why the decision was necessary.
In
addition, we believe that where companies use non-GAAP or bespoke metrics, clear
reconciliations between these figures and GAAP figures in audited financial
statements should be provided. Adjustments to GAAP figures may be considered in
Glass Lewis’ assessment of the effectiveness of the incentive at tying executive
pay with performance. Moreover, Glass Lewis believes that in circumstances where
significant adjustments were applied
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to
performance results, thorough, detailed discussion of adjustments akin to a
GAAP-to-non-GAAP reconciliation and their impact on payouts within the proxy
statement is warranted. The absence of such enhanced disclosure for significant
adjustments will impact Glass Lewis' assessment of the quality of disclosure
and, in turn, may play a role in the overall recommendation for the advisory
vote on executive compensation.
Glass
Lewis recognizes the importance of the compensation committee’s judicious and
responsible exercise of discretion over incentive pay outcomes to account for
significant, material events that would otherwise be excluded from performance
results of selected metrics of incentive programs. For instance, major
litigation settlement charges may be removed from non-GAAP results before the
determination of formulaic incentive payouts, or health and safety failures may
not be reflected in performance results where companies do not expressly include
health and safety metrics in incentive plans; such events may nevertheless be
consequential to corporate performance results, impact the shareholder
experience, and, in some cases, may present material risks. Conversely, certain
events may adversely impact formulaic payout results despite being outside
executives' control. We believe that companies should provide thorough
discussion of how such events were considered in the committee’s decisions to
exercise discretion or refrain from applying discretion over incentive pay
outcomes. The inclusion of this disclosure may be helpful when we consider
concerns around the exercise or absence of committee discretion.
We
do not generally recommend against a pay program due to the use of a
non-formulaic plan. If a company has chosen to rely primarily on a subjective
assessment or the board’s discretion in determining short-term bonuses, we
believe that the proxy statement should provide a meaningful discussion of the
board’s rationale in determining the bonuses paid as well as a rationale for the
use of a non-formulaic mechanism. Particularly where the aforementioned
disclosures are substantial and satisfactory, such a structure will not provoke
serious concern in our analysis on its own. However, in conjunction with other
significant issues in a program’s design or operation, such as a disconnect
between pay and performance, the absence of a cap on payouts, or a lack of
performance-based long-term awards, the use of a non-formulaic bonus may help
drive a negative recommendation.
Long-Term
Incentives
Glass
Lewis recognizes the value of equity-based incentive programs, which are often
the primary long-term incentive for executives. When used appropriately, they
can provide a vehicle for linking an executive’s pay to company performance,
thereby aligning their interests with those of shareholders. In addition,
equity-based compensation can be an effective way to attract, retain and
motivate key employees.
There
are certain elements that Glass Lewis believes are common to most
well-structured long-term incentive (LTI) plans. These include:
•No
re-testing or lowering of performance conditions;
•Performance
metrics that cannot be easily manipulated by management;
•Two
or more performance metrics;
•At
least one relative performance metric that compares the company’s performance to
a relevant peer group or index;
•Performance
periods of at least three years;
•Stretching
metrics that incentivize executives to strive for outstanding performance while
not encouraging excessive risk-taking;
•Reasonable
individual award limits; and
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•Equity
granting practices that are clearly disclosed.
In
evaluating long-term incentive grants, Glass Lewis generally believes that at
least half of the grant should consist of performance-based awards, putting a
material portion of executive compensation at-risk and demonstrably linked to
the performance of the company. While we will consistently raise concern with
programs that do not meet this criterion, we may refrain from a negative
recommendation in the absence of other significant issues with the program’s
design or operation. However, in cases where performance-based awards are
significantly rolled back or eliminated from a company’s long-term incentive
plan, such decisions will generally be viewed negatively outside of exceptional
circumstances and may lead to a recommendation against the proposal.
As
with the short-term incentive, Glass Lewis recognizes the importance of the
compensation committee’s judicious and responsible exercise of discretion over
incentive pay outcomes to account for significant events that would otherwise be
excluded from performance results of selected metrics of incentive programs. We
believe that companies should provide thorough discussion of how such events
were considered in the committee’s decisions to exercise discretion or refrain
from applying discretion over incentive pay outcomes. Furthermore,
considerations related to the use of non-GAAP metrics under the STI plan
similarly apply to the long-term incentive program.
Performance
measures should be carefully selected and should relate to the specific
business/industry in which the company operates and, especially, to the key
value drivers of the company’s business. As with short-term incentive plans, the
basis for any adjustments to metrics or results should be clearly explained, as
should the company’s judgment on the use of discretion and any significant
changes to the performance program structure.
While
cognizant of the inherent complexity of certain performance metrics, Glass Lewis
generally believes that measuring a company’s performance with multiple metrics
serves to provide a more complete picture of the company’s performance than a
single metric. Further, reliance on just one metric may focus too much
management attention on a single target and is therefore more susceptible to
manipulation. When utilized for relative measurements, external benchmarks such
as a sector index or peer group should be disclosed and transparent. The
rationale behind the selection of a specific index or peer group should also be
disclosed. Internal performance benchmarks should also be disclosed and
transparent, unless a cogent case for confidentiality is made and fully
explained. Similarly, actual performance and vesting levels for previous grants
earned during the fiscal year should be disclosed.
We
also believe shareholders should evaluate the relative success of a company’s
compensation programs, particularly with regard to existing equity-based
incentive plans, in linking pay and performance when evaluating potential
changes to LTI plans and determining the impact of additional stock awards. We
will therefore review the company’s pay-for-performance grade (see above for
more information) and specifically the proportion of total compensation that is
stock-based.
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Grants
of Front-Loaded Awards
Many
U.S. companies have chosen to provide large grants, usually in the form of
equity awards, that are intended to serve as compensation for multiple years.
This practice, often called front-loading, is taken up either in the regular
course of business or as a response to specific business conditions and with a
predetermined objective. The so-called “mega-grant”, an outsized award to one
individual sometimes valued at over $100 million is sometimes but not always
provided as a front-loaded award. We believe shareholders should generally be
wary of this approach, and we accordingly weigh these grants with particular
scrutiny.
While
the use of front-loaded awards is intended to lock-in executive service and
incentives, the same rigidity also raises the risk of effectively tying the
hands of the compensation committee. As compared with a more responsive annual
granting schedule program, front-loaded awards may preclude improvements or
changes to reflect evolving business strategies or to respond to other
unforeseen factors. Additionally, if structured poorly, early vesting of such
awards may reduce or eliminate the retentive power at great cost to
shareholders. The considerable emphasis on a single grant can place intense
pressures on every facet of its design, amplifying any potential perverse
incentives and creating greater room for unintended consequences. In particular,
provisions around changes of control or separations of service must ensure that
executives do not receive excessive payouts that do not reflect shareholder
experience or company performance.
We
consider a company’s rationale for granting awards under this structure and also
expect any front-loaded awards to include a firm commitment not to grant
additional awards for a defined period, as is commonly associated with this
practice. Even when such a commitment is provided, unexpected circumstances may
lead the board to make additional payments or awards for retention purposes, or
to incentivize management towards more realistic goals or a revised strategy. If
a company breaks its commitment not to grant further awards, we may recommend
against the pay program unless a convincing rationale is provided. In situations
where the front-loaded award was meant to cover a certain portion of the regular
long-term incentive grant for each year during the covered period, our analysis
of the value of the remaining portion of the regular long-term incentives
granted during the period covered by the award will account for the annualized
value of the front-loaded portion, and we expect no supplemental grant be
awarded during the vesting period of the front-loaded portion.
The
multiyear nature of these awards generally lends itself to significantly higher
compensation figures in the year of grant than might otherwise be expected. In
our qualitative analysis of the grants of front-loaded awards to executives,
Glass Lewis considers the quantum of the award on an annualized basis and may
compare this result to the prior practice and peer data, among other benchmarks.
Additionally, for awards that are granted in the form of equity, Glass Lewis may
consider the total potential dilutive effect of such award on
shareholders.
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Linking
Executive Pay to Environmental and Social Criteria
Glass
Lewis believes that explicit environmental and/or social (E&S) criteria in
executive incentive plans, when used appropriately, can serve to provide both
executives and shareholders a clear line of sight into a company’s ESG strategy,
ambitions, and targets. Although we are strongly supportive of companies’
incorporation of material E&S risks and opportunities in their long-term
strategic planning, we believe that the inclusion of E&S metrics in
compensation programs should be predicated on each company’s unique
circumstances. In order to establish a meaningful link between pay and
performance, companies must consider factors including their industry, size,
risk profile, maturity, performance, financial condition, and any other relevant
internal or external factors.
When
a company is introducing E&S criteria into executive incentive plans, we
believe it is important that companies provide shareholders with sufficient
disclosure to allow them to understand how these criteria align with its
strategy. Additionally, Glass Lewis recognizes that there may be situations
where certain E&S performance criteria are reasonably viewed as
prerequisites for executive performance, as opposed to behaviors and conditions
that need to be incentivized. For example, we believe that shareholders should
interrogate the use of metrics that award executives for ethical behavior or
compliance with policies and regulations. It is our view that companies should
provide shareholders with disclosures that clearly lay out the rationale for
selecting specific E&S metrics, the target-setting process, and
corresponding payout opportunities. Further, particularly in the case of
qualitative metrics, we believe that shareholders should be provided with a
clear understanding of the basis on which the criteria will be assessed. Where
quantitative targets have been set, we believe that shareholders are best served
when these are disclosed on an ex-ante basis, or the board should outline why it
believes it is unable to do so.
While
we believe that companies should generally set long-term targets for their
environmental and social ambitions, we are mindful that not all compensation
schemes lend themselves to the inclusion of E&S metrics. We also are of the
view that companies should retain flexibility in not only choosing to
incorporate E&S metrics in their compensation plans, but also in the
placement of these metrics. For example, some companies may resolve that
including E&S criteria in the annual bonus may help to incentivize the
achievement of short-term milestones and allow for more maneuverability in
strategic adjustments to long-term goals. Other companies may determine that
their long-term sustainability targets are best achieved by incentivizing
executives through metrics included in their long-term incentive
plans.
One-Time
Awards
Glass
Lewis believes shareholders should generally be wary of awards granted outside
of the standard incentive schemes, as such awards have the potential to
undermine the integrity of a company’s regular incentive plans or the link
between pay and performance, or both. We generally believe that if the existing
incentive programs fail to provide adequate incentives to executives, companies
should redesign their compensation programs rather than make additional
grants.
However,
we recognize that in certain circumstances, additional incentives may be
appropriate. In these cases, companies should provide a thorough description of
the awards, including a cogent and convincing explanation of their necessity and
why existing awards do not provide sufficient motivation and a discussion of how
the quantum of the award and its structure were determined. Further, such awards
should be tied to future service and performance whenever possible.
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Additionally,
we believe companies making supplemental or one-time awards should also describe
if and how the regular compensation arrangements will be affected by these
additional grants. In reviewing a company’s use of supplemental awards, Glass
Lewis will evaluate the terms and size of the grants in the context of the
company’s overall incentive strategy and granting practices, as well as the
current operating environment.
Contractual
Payments and Arrangements
Beyond
the quantum of contractual payments, Glass Lewis will also consider the design
of any entitlements. Certain executive employment terms may help to drive a
negative recommendation, including, but not limited to:
•Excessively
broad change in control triggers;
•Inappropriate
severance entitlements;
•Inadequately
explained or excessive sign-on arrangements;
•Guaranteed
bonuses (especially as a multiyear occurrence); and
•Failure
to address any concerning practices in amended employment agreements.
In
general, we are wary of terms that are excessively restrictive in favor of the
executive, or that could potentially incentivize behaviors that are not in a
company’s best interest.
Sign-on
Awards and Severance Benefits
We
acknowledge that there may be certain costs associated with transitions at the
executive level. In evaluating the size of severance and sign-on arrangements,
we may consider the executive’s regular target compensation level, or the sums
paid to other executives (including the recipient’s predecessor, where
applicable) in evaluating the appropriateness of such an arrangement.
We
believe sign-on arrangements should be clearly disclosed and accompanied by a
meaningful explanation of the payments and the process by which the amounts were
reached. Further, the details of and basis for any “make-whole” payments (paid
as compensation for awards forfeited from a previous employer) should be
provided.
With
respect to severance, we believe companies should abide by predetermined payouts
in most circumstances. While in limited circumstances some deviations may not be
inappropriate, we believe shareholders should be provided with a meaningful
explanation of any additional or increased benefits agreed upon outside of
regular arrangements. However, where Glass Lewis determines that such
predetermined payouts are particularly problematic or unfavorable to
shareholders, we may consider the execution of such payments in a negative
recommendation for the advisory vote on executive compensation.
In
the U.S. market, most companies maintain severance entitlements based on a
multiple of salary and, in many cases, bonus. In almost all instances we see,
the relevant multiple is three or less, even in the case of a change in control.
We believe the basis and total value of severance should be reasonable and
should not exceed the upper limit of general market practice. We consider the
inclusion of long-term incentives in cash severance calculations to be
inappropriate, particularly given the commonality of accelerated vesting and the
proportional weight of long-term incentives as a component of total pay.
Additional considerations, however, will be accounted for when reviewing
atypically structured compensation approaches.
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Change
in Control
Glass
Lewis considers double-trigger change in control arrangements, which require
both a change in control and termination or constructive termination, to be best
practice. Any arrangement that is not explicitly double-trigger may be
considered a single-trigger or modified single-trigger arrangement.
Further,
we believe that excessively broad definitions of change in control are
potentially problematic as they may lead to situations where executives receive
additional compensation where no meaningful change in status or duties has
occurred.
Excise
Tax Gross-ups
Among
other entitlements, Glass Lewis is strongly opposed to excise tax gross-ups
related to IRC § 4999 and their expansion, especially where no consideration is
given to the safe harbor limit. We believe that under no normal circumstance is
the inclusion of excise tax gross-up provisions in new agreements or the
addition of such provisions to amended agreements acceptable. In consideration
of the fact that minor increases in change-in-control payments can lead to
disproportionately large excise taxes, the potential negative impact of tax
gross-ups far outweighs any retentive benefit.
Depending
on the circumstances, the addition of new gross-ups around this excise tax may
lead to negative recommendations for a company’s say-on-pay proposal, the chair
of the compensation committee, or the entire committee, particularly in cases
where a company had committed not to provide any such entitlements in the
future. For situations in which the addition of new excise tax gross ups will be
provided in connection with a specific change-in-control transaction, this
policy may be applied to the say-on-pay proposal, the golden parachute proposal
and recommendations related to the compensation committee for all involved
corporate parties, as appropriate.
Amended
Employment Agreements
Any
contractual arrangements providing for problematic pay practices which are not
addressed in materially amended employment agreements will potentially be viewed
by Glass Lewis as a missed opportunity on the part of the company to align its
policies with current best practices. Such problematic pay practices include,
but are not limited to, excessive change in control entitlements, modified
single-trigger change in control entitlements, excise tax gross-ups, and
multi-year guaranteed awards.
Recoupment
Provisions (Clawbacks)
On
October 26, 2022, the SEC adopted Rule 10D-1 under the Securities Exchange Act
of 1934. The rule mandates national securities exchanges and associations to
promulgate new listing standards requiring companies to maintain recoupment
policies (“clawback provisions”). The final clawback listing standards were
approved by the SEC, effective October 2, 2023 and required listed companies to
adopt a compliant policy by December 1, 2023. Glass Lewis believes that clawback
provisions play an important role in mitigating excessive risk-taking that may
be encouraged by poorly structured variable incentive programs. Current listing
standards require recoupment of erroneously awarded payouts to current and
former executive officers in the event of an accounting restatement or
correction to previous financial statements that is material to the current
period, regardless of fault or misconduct.
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Glass
Lewis recognizes that excessive risk-taking that can materially and adversely
impact shareholders may not necessarily result in such restatements. We
believe that clawback policies should allow recovery from current and former
executive officers in the event of a restatement of financial results or similar
revision of performance indicators upon which the awards were based.
Additionally, recoupment policies should provide companies with the ability
to claw back variable incentive payments (whether time-based or
performance-based) when there is evidence of problematic decisions or
actions, such as material misconduct, a material reputational failure, material
risk management failure, or a material operational failure, the consequences of
which have not already been reflected in incentive payments and where recovery
is warranted.
In
situations where the company ultimately determines not to follow through with
recovery, Glass Lewis will assess the appropriateness of such determination for
each case. A thorough, detailed discussion of the company's decision to not
pursue recoupment and, if applicable, how the company has otherwise rectified
the disconnect between executive pay outcomes and negative impacts of their
actions on the company and the shareholder experience will be considered. The
absence of such enhanced disclosure may impact Glass Lewis' assessment of the
quality of disclosure and, in turn, may play a role in Glass Lewis' overall
recommendation for the advisory vote on executive compensation. The clawback
policy should provide recoupment authority regardless of whether the
employment of the executive officer was terminated with or without
cause.
Hedging
of Stock
Glass
Lewis believes that the hedging of shares by executives in the shares of the
companies where they are employed severs the alignment of interests of the
executive with shareholders. We believe companies should adopt strict policies
to prohibit executives from hedging the economic risk associated with their
share ownership in the company.
Pledging
of Stock
Glass
Lewis believes that shareholders should examine the facts and circumstances of
each company rather than apply a one-size-fits-all policy regarding employee
stock pledging. Glass Lewis believes that shareholders benefit when employees,
particularly senior executives, have meaningful financial interest in the
success of the company under their management, and therefore we recognize the
benefits of measures designed to encourage employees to both buy shares out of
their own pocket and to retain shares they have been granted; blanket policies
prohibiting stock pledging may discourage executives and employees from doing
either.
However,
we also recognize that the pledging of shares can present a risk that, depending
on a host of factors, an executive with significant pledged shares and limited
other assets may have an incentive to take steps to avoid a forced sale of
shares in the face of a rapid stock price decline. Therefore, to avoid
substantial losses from a forced sale to meet the terms of the loan, the
executive may have an incentive to boost the stock price in the short term in a
manner that is unsustainable, thus hurting shareholders in the long-term. We
also recognize concerns regarding pledging may not apply to less senior
employees, given the latter group’s significantly more limited influence over a
company’s stock price. Therefore, we believe that the issue of pledging shares
should be reviewed in that context, as should policies that distinguish between
the two groups.
Glass
Lewis believes that the benefits of stock ownership by executives and employees
may outweigh the risks of stock pledging, depending on many factors. As such,
Glass Lewis reviews all relevant factors in evaluating proposed policies,
limitations and prohibitions on pledging stock, including:
•The
number of shares pledged;
•The
percentage executives’ pledged shares are of outstanding shares;
•The
percentage executives’ pledged shares are of each executive’s shares and total
assets;
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•Whether
the pledged shares were purchased by the employee or granted by the company;
•Whether
there are different policies for purchased and granted shares;
•Whether
the granted shares were time-based or performance-based;
•The
overall governance profile of the company;
•The
volatility of the company’s stock (in order to determine the likelihood of a
sudden stock price drop);
•The
nature and cyclicality, if applicable, of the company’s industry;
•The
participation and eligibility of executives and employees in pledging;
•The
company’s current policies regarding pledging and any waiver from these policies
for employees and executives; and
•Disclosure
of the extent of any pledging, particularly among senior executives.
Executive
Ownership Guidelines
The
alignment between shareholder interests and those of executives represents an
important assurance to disinterested shareholders that executives are acting in
their best long-term interests. Companies should facilitate this relationship
through the adoption and enforcement of minimum executive share ownership
requirements. Companies should clearly disclose their executive ownership
requirements in their Compensation Discussion and Analysis section and how the
various types of outstanding equity awards are counted or excluded from the
ownership level calculation.
In
determining whether executives have met the requirements or not, the inclusion
of unearned performance-based full value awards and/or unexercised stock options
without cogent rationale may be viewed as problematic. While Glass Lewis views
the inclusion of unearned performance-based equity in the ownership
determination as problematic, we continue to believe that performance-based
equity compensation plays an important role in aligning executive pay with
performance.
Compensation
Consultant Independence
As
mandated by Section 952 of the Dodd-Frank Act, as of January 11, 2013, the SEC
approved listing requirements for both the NYSE and NASDAQ which require
compensation committees to consider six factors
(https://www.sec.gov/rules/final/2012/33-9330.pdf, p.31-32) in assessing
compensation advisor independence. According to the SEC, “no one factor should
be viewed as a determinative factor.” Glass Lewis believes this six-factor
assessment is an important process for every compensation committee to undertake
but believes companies employing a consultant for board compensation, consulting
and other corporate services should provide clear disclosure beyond just a
reference to examining the six points, in order to allow shareholders to review
the specific aspects of the various consultant relationships.
We
believe compensation consultants are engaged to provide objective,
disinterested, expert advice to the compensation committee. When the consultant
or its affiliates receive substantial income from providing other services to
the company, we believe the potential for a conflict of interest arises and the
independence of the consultant may be jeopardized. Therefore, Glass Lewis will,
when relevant, note the potential for a conflict of interest when the fees paid
to the advisor or its affiliates for other services exceed those paid for
compensation consulting.
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CEO
Pay Ratio
As
mandated by Section 953(b) of the Dodd-Frank Wall Street Consumer and Protection
Act, beginning in 2018, issuers will be required to disclose the median annual
total compensation of all employees except the CEO, the total annual
compensation of the CEO or equivalent position, and the ratio between the two
amounts. Glass Lewis will display the pay ratio as a data point in our Proxy
Papers, as available. While we recognize that the pay ratio has the potential to
provide additional insight when assessing a company’s pay practices, at this
time it will not be a determinative factor in our voting
recommendations.
Frequency
of Say-on-Pay
The
Dodd-Frank Act also requires companies to allow shareholders a non-binding vote
on the frequency of say-on-pay votes (i.e., every one, two or three years).
Additionally, Dodd-Frank requires companies to hold such votes on the frequency
of say-on-pay votes at least once every six years.
We
believe companies should submit say-on-pay votes to shareholders every year. We
believe that the time and financial burdens to a company with regard to an
annual vote are relatively small and incremental and are outweighed by the
benefits to shareholders through more frequent accountability. Implementing
biannual or triennial votes on executive compensation limits shareholders’
ability to hold the board accountable for its compensation practices through
means other than voting against the compensation committee. Unless a company
provides a compelling rationale or unique circumstances for say-on-pay votes
less frequent than annually, we will generally recommend that shareholders
support annual votes on compensation.
Vote
on Golden Parachute Arrangements
The
Dodd-Frank Act also requires companies to provide shareholders with a separate
non-binding vote on approval of golden parachute compensation arrangements in
connection with certain change-in-control transactions. However, if the golden
parachute arrangements have previously been subject to a say-on-pay vote which
shareholders approved, then this required vote is waived.
Glass
Lewis believes the narrative and tabular disclosure of golden parachute
arrangements benefits all shareholders. Glass Lewis analyzes each golden
parachute arrangement on a case-by-case basis, taking into account, among other
items: the nature of the change-in-control transaction, the ultimate value of
the payments particularly compared to the value of the transaction, any excise
tax gross-up obligations, the tenure and position of the executives in question
before and after the transaction, any new or amended employment agreements
entered into in connection with the transaction, and the type of triggers
involved (i.e., single vs. double). In cases where new problematic features,
such as excise tax gross-up obligations, are introduced in a golden parachute
proposal, such features may contribute to a negative recommendation not only for
the golden parachute proposal under review, but for the next say-on-pay proposal
of any involved corporate parties, as well as recommendations against their
compensation committee as appropriate.
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Equity-Based
Compensation Proposals
We
believe that equity compensation awards, when not abused, are useful for
retaining employees and providing an incentive for them to act in a way that
will improve company performance. Glass Lewis recognizes that equity-based
compensation plans are critical components of a company’s overall compensation
program, and we analyze such plans accordingly based on both quantitative and
qualitative factors.
Our
quantitative analysis assesses the plan’s cost and the company’s pace of
granting utilizing a number of different analyses, comparing the program with
absolute limits we believe are key to equity value creation and with a carefully
chosen peer group. In general, our model seeks to determine whether the proposed
plan is either absolutely excessive or is more than one standard deviation away
from the average plan for the peer group on a range of criteria, including
dilution to shareholders and the projected annual cost relative to the company’s
financial performance. Each of the analyses (and their constituent parts) is
weighted and the plan is scored in accordance with that weight.
We
compare the program’s expected annual expense with the business’s operating
metrics to help determine whether the plan is excessive in light of company
performance. We also compare the plan’s expected annual cost to the enterprise
value of the firm rather than to market capitalization because the employees,
managers and directors of the firm contribute to the creation of enterprise
value but not necessarily market capitalization (the biggest difference is seen
where cash represents the vast majority of market capitalization). Finally, we
do not rely exclusively on relative comparisons with averages because, in
addition to creeping averages serving to inflate compensation, we believe that
some absolute limits are warranted.
We
then consider qualitative aspects of the plan such as plan administration, the
method and terms of exercise, repricing history, express or implied rights to
reprice, and the presence of evergreen provisions. We also closely review the
choice and use of, and difficulty in meeting, the awards’ performance metrics
and targets, if any. We believe significant changes to the terms of a plan
should be explained for shareholders and clearly indicated. Other factors such
as a company’s size and operating environment may also be relevant in assessing
the severity of concerns or the benefits of certain changes. Finally, we may
consider a company’s executive compensation practices in certain situations, as
applicable.
We
evaluate equity plans based on certain overarching principles:
•Companies
should seek more shares only when needed;
•Requested
share amounts or share reserves should be conservative in size so that companies
must seek shareholder approval every three to four years (or more
frequently);
•If
a plan is relatively expensive, it should not grant options solely to senior
executives and board members;
•Dilution
of annual net share count or voting power, along with the “overhang” of
incentive plans, should be limited;
•Annual
cost of the plan (especially if not shown on the income statement) should be
reasonable as a percentage of financial results and should be in line with the
peer group;
•The
expected annual cost of the plan should be proportional to the business’s
value;
•The
intrinsic value that option grantees received in the past should be reasonable
compared with the business’s financial results;
•Plans
should not permit repricing of stock options without shareholder
approval;
•Plans
should not contain excessively liberal administrative or payment
terms;
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•Plans
should not count shares in ways that understate the potential dilution, or cost,
to common shareholders. This refers to “inverse” full-value award multipliers;
•Selected
performance metrics should be challenging and appropriate, and should be subject
to relative performance measurements; and
•Stock
grants should be subject to minimum vesting and/or holding periods sufficient to
ensure sustainable performance and promote retention.
Meanwhile,
for individual equity award proposals where the recipient of the proposed grant
is also a large shareholder of the company whose vote can materially affect the
passage of the proposal, we believe that the company should strongly consider
the level of approval from disinterested shareholders before proceeding with the
proposed grant. Glass Lewis recognizes potential conflicts of interests when
vote outcomes can be heavily influenced by the recipient of the grant. A
required abstention vote or non-vote from the recipient for an equity award
proposal in these situations can help to avoid such conflicts. This favorable
feature will be weighed alongside the structure, disclosure, dilution, provided
rationale, and other provisions related to the individual award to assess the
award’s alignment with long-term shareholder interests.
Option
Exchanges and Repricing
Glass
Lewis is generally opposed to the repricing of employee and director options
regardless of how it is accomplished. Employees should have some downside risk
in their equity-based compensation program and repricing eliminates any such
risk. As shareholders have substantial risk in owning stock, we believe that the
equity compensation of employees and directors should be similarly situated to
align their interests with those of shareholders. We believe this will
facilitate appropriate risk- and opportunity-taking for the company by
employees.
We
are concerned that option grantees who believe they will be “rescued” from
underwater options will be more inclined to take unjustifiable risks. Moreover,
a predictable pattern of repricing or exchanges substantially alters a stock
option’s value because options that will practically never expire deeply out of
the money are worth far more than options that carry a risk of
expiration.
In
short, repricings and option exchange programs change the bargain between
shareholders and employees after the bargain has been struck.
There
is one circumstance in which a repricing or option exchange program may be
acceptable: if macroeconomic or industry trends, rather than specific company
issues, cause a stock’s value to decline dramatically and the repricing is
necessary to motivate and retain employees. In viewing the company’s stock
decline as part of a larger trend, we would expect the impact to approximately
reflect the market or industry price decline in terms of timing and magnitude.
In this circumstance, we think it fair to conclude that option grantees may be
suffering from a risk that was not foreseeable when the original “bargain” was
struck. In such a scenario, we may opt to support a repricing or option exchange
program only if sufficient conditions are met. We are largely concerned with the
inclusion of the following features:
•Officers
and board members cannot participate in the program; and
•The
exchange is value-neutral or value-creative to shareholders using very
conservative assumptions.
•In
our evaluation of the appropriateness of the program design, we also consider
the inclusion of the following features:
•The
vesting requirements on exchanged or repriced options are extended beyond one
year;
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•Shares
reserved for options that are reacquired in an option exchange will permanently
retire (i.e., will not be available for future grants) so as to prevent
additional shareholder dilution in the future; and
•Management
and the board make a cogent case for needing to motivate and retain existing
employees, such as being in a competitive employment market.
Option
Backdating, Spring-Loading and Bullet-Dodging
Glass
Lewis views option backdating, and the related practices of spring-loading and
bullet-dodging, as egregious actions that warrant holding the appropriate
management and board members responsible. These practices are similar to
repricing options and eliminate much of the downside risk inherent in an option
grant that is designed to induce recipients to maximize shareholder return.
Backdating
an option is the act of changing an option’s grant date from the actual grant
date to an earlier date when the market price of the underlying stock was lower,
resulting in a lower exercise price for the option. In past studies, Glass Lewis
identified over 270 companies that have disclosed internal or government
investigations into their past stock-option grants.
Spring-loading
is granting stock options while in possession of material, positive information
that has not been disclosed publicly. Bullet-dodging is delaying the grants of
stock options until after the release of material, negative information. This
can allow option grants to be made at a lower price either before the release of
positive news or following the release of negative news, assuming the stock’s
price will move up or down in response to the information. This raises a concern
similar to that of insider trading, or the trading on material non-public
information.
The
exercise price for an option is determined on the day of grant, providing the
recipient with the same market risk as an investor who bought shares on that
date. However, where options were backdated, the executive or the board (or the
compensation committee) changed the grant date retroactively. The new date may
be at or near the lowest price for the year or period. This would be like
allowing an investor to look back and select the lowest price of the year at
which to buy shares.
A
2006 study of option grants made between 1996 and 2005 at 8,000 companies found
that option backdating can be an indication of poor internal controls. The study
found that option backdating was more likely to occur at companies without a
majority independent board and with a long-serving CEO; both factors, the study
concluded, were associated with greater CEO influence on the company’s
compensation and governance practices.43
Where
a company granted backdated options to an executive who is also a director,
Glass Lewis will recommend voting against that executive/director, regardless of
who decided to make the award. In addition, Glass Lewis will recommend voting
against those directors who either approved or allowed the backdating. Glass
Lewis feels that executives and directors who either benefited from backdated
options or authorized the practice have failed to act in the best interests of
shareholders.
Given
the severe tax and legal liabilities to the company from backdating, Glass Lewis
will consider recommending voting against members of the audit committee who
served when options were backdated, a restatement occurs, material weaknesses in
internal controls exist and disclosures indicate there was a lack of
43
Lucian Bebchuk, Yaniv Grinstein and Urs Peyer. “LUCKY CEOs.” November,
2006.
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documentation.
These committee members failed in their responsibility to ensure the integrity
of the company’s financial reports.
When
a company has engaged in spring-loading or bullet-dodging, Glass Lewis will
consider recommending voting against the compensation committee members where
there has been a pattern of granting options at or near historic lows. Glass
Lewis will also recommend voting against executives serving on the board who
benefited from the spring-loading or bullet-dodging.
Director
Compensation Plans
Glass
Lewis believes that non-employee directors should receive reasonable and
appropriate compensation for the time and effort they spend serving on the board
and its committees. However, a balance is required. Fees should be competitive
in order to retain and attract qualified individuals, but excessive fees
represent a financial cost to the company and potentially compromise the
objectivity and independence of non-employee directors. We will consider
recommending support for compensation plans that include option grants or other
equity-based awards that help to align the interests of outside directors with
those of shareholders. However, to ensure directors are not incentivized in the
same manner as executives but rather serve as a check on imprudent risk-taking
in executive compensation plan design, equity grants to directors should not be
performance-based. Where an equity plan exclusively or primarily covers
non-employee directors as participants, we do not believe that the plan should
provide for performance-based awards in any capacity.
When
non-employee director equity grants are covered by the same equity plan that
applies to a company’s broader employee base, we will use our proprietary model
and analyst review of this model to guide our voting recommendations. If such a
plan broadly allows for performance-based awards to directors or explicitly
provides for such grants, we may recommend against the overall plan on this
basis, particularly if the company has granted performance-based awards to
directors in past.
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Employee
Stock Purchase Plans
Glass
Lewis believes that employee stock purchase plans (ESPPs) can provide employees
with a sense of ownership in their company and help strengthen the alignment
between the interests of employees and shareholders. We evaluate ESPPs by
assessing the expected discount, purchase period, expected purchase activity (if
previous activity has been disclosed) and whether the plan has a “lookback”
feature. Except for the most extreme cases, Glass Lewis will generally support
these plans given the regulatory purchase limit of $25,000 per employee per
year, which we believe is reasonable. We also look at the number of shares
requested to see if a ESPP will significantly contribute to overall shareholder
dilution or if shareholders will not have a chance to approve the program for an
excessive period of time. As such, we will generally recommend against ESPPs
that contain “evergreen” provisions that automatically increase the number of
shares available under the ESPP each year.
Executive
Compensation Tax Deductibility — Amendment to IRC 162(M)
The
“Tax Cut and Jobs Act” had significant implications on Section 162(m) of the
Internal Revenue Code, a provision that allowed companies to deduct compensation
in excess of $1 million for the CEO and the next three most highly compensated
executive officers, excluding the CFO, if the compensation is performance-based
and is paid under shareholder-approved plans. Glass Lewis does not generally
view amendments to equity plans and changes to compensation programs in response
to the elimination of tax deductions under 162(m) as problematic. This
specifically holds true if such modifications contribute to the maintenance of a
sound performance-based compensation program.
As
grandfathered contracts may continue to be eligible for tax deductions under the
transition rule for Section 162(m), companies may therefore submit incentive
plans for shareholder approval to take of advantage of the tax deductibility
afforded under 162(m) for certain types of compensation.
We
believe the best practice for companies is to provide robust disclosure to
shareholders so that they can make fully informed judgments about the
reasonableness of the proposed compensation plan. To allow for meaningful
shareholder review, we prefer that disclosure should include specific
performance metrics, a maximum award pool, and a maximum award amount per
employee. We also believe it is important to analyze the estimated grants to see
if they are reasonable and in line with the company’s peers.
We
typically recommend voting against a 162(m) proposal where: (i) a company fails
to provide at least a list of performance targets; (ii) a company fails to
provide one of either a total maximum or an individual maximum; or (iii) the
proposed plan or individual maximum award limit is excessive when compared with
the plans of the company’s peers.
The
company’s record of aligning pay with performance (as evaluated using our
proprietary pay-for-performance model) also plays a role in our recommendation.
Where a company has a record of setting reasonable pay relative to business
performance, we generally recommend voting in favor of a plan even if the plan
caps seem large relative to peers because we recognize the value in special pay
arrangements for continued
exceptional performance.
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As
with all other issues we review, our goal is to provide consistent but
contextual advice given the specifics of the company and ongoing performance.
Overall, we recognize that it is generally not in shareholders’ best interests
to vote against such a plan and forgo the potential tax benefit since
shareholder rejection of such plans will not curtail the awards; it will only
prevent the tax deduction associated with them.
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Governance
Structure and the Shareholder Franchise
Anti-Takeover
Measures
Poison
Pills (Shareholder Rights Plans)
Glass
Lewis believes that poison pill plans are not generally in shareholders’ best
interests. They can reduce management accountability by substantially limiting
opportunities for corporate takeovers. Rights plans can thus prevent
shareholders from receiving a buy-out premium for their stock. Typically we
recommend that shareholders vote against these plans to protect their financial
interests and ensure that they have an opportunity to consider any offer for
their shares, especially those at a premium.
We
believe boards should be given wide latitude in directing company activities and
in charting the company’s course. However, on an issue such as this, where the
link between the shareholders’ financial interests and their right to consider
and accept buyout offers is substantial, we believe that shareholders should be
allowed to vote on whether they support such a plan’s implementation. This issue
is different from other matters that are typically left to board discretion. Its
potential impact on and relation to shareholders is direct and substantial. It
is also an issue in which management interests may be different from those of
shareholders; thus, ensuring that shareholders have a voice is the only way to
safeguard their interests.
In
certain circumstances, we will support a poison pill that is limited in scope to
accomplish a particular objective, such as the closing of an important merger,
or a pill that contains what we believe to be a reasonable qualifying offer
clause. We will consider supporting a poison pill plan if the qualifying offer
clause includes each of the following attributes:
•The
form of offer is not required to be an all-cash transaction;
•The
offer is not required to remain open for more than 90 business days;
•The
offeror is permitted to amend the offer, reduce the offer, or otherwise change
the terms;
•There
is no fairness opinion requirement; and
•There
is a low to no premium requirement.
Where
these requirements are met, we typically feel comfortable that shareholders will
have the opportunity to voice their opinion on any legitimate offer.
NOL
Poison Pills
Similarly,
Glass Lewis may consider supporting a limited poison pill in the event that a
company seeks shareholder approval of a rights plan for the express purpose of
preserving Net Operating Losses (NOLs). While companies with NOLs can generally
carry these losses forward to offset future taxable income, Section 382
of
the Internal Revenue Code limits companies’ ability to use NOLs in the event of
a “change of ownership.”44
In this case
44
Section 382 of the Internal Revenue Code refers to a “change of ownership” of
more than 50 percentage points by one or more 5% shareholders within a
three-year period. The statute is intended to deter the “trafficking” of net
operating losses.
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,
a company may adopt or amend a poison pill (NOL pill) in order to prevent an
inadvertent change of ownership by multiple investors purchasing small chunks of
stock at the same time, and thereby preserve the ability to carry the NOLs
forward. Often such NOL pills have trigger thresholds much lower than the common
15% or 20% thresholds, with some NOL pill triggers as low as 5%.
In
many cases, companies will propose the adoption of bylaw amendments specifically
restricting certain share transfers, in addition to proposing the adoption of a
NOL pill. In general, if we support the terms of a particular NOL pill, we will
generally support the additional protective amendment in the absence of
significant concerns with the specific terms of that proposal.
As
with traditional poison pills, NOL pills may deter shareholders and potentially
serve as entrenchment mechanisms. Certain features such as low thresholds
combined with acting in concert provisions, among other concerning terms, may
disempower shareholders and insulate the board and management. When acting in
concert provisions are present within the terms of a NOL pill, we believe this
may raise concerns as to the true objective of the pill.
Acting
in concert provisions broaden the definition of beneficial ownership to prohibit
parallel conduct, or multiple shareholders party to a formal or informal
agreement collaborating to influence the board and management of a company, and
aggregate the ownership of such shareholders towards the triggering threshold.
In our view, acting in concert provisions broadly limit the voice of
shareholders and may diminish their ability to engage in a productive dialogue
with the company and with other shareholders. When a board adopts defensive
measures without engaging with shareholders, we take a dim view of the board and
the overall governance of the company.
As
such, Glass Lewis evaluates NOL pills on a strictly case-by-case basis, taking
into consideration, among other factors: (i) the value of the NOLs to the
company; (ii) the likelihood of a change of ownership based on the size of the
holdings and the nature of the larger shareholders; (iii) the trigger threshold;
(iv) the duration of the plan (i.e., whether it contains a reasonable “sunset”
provision, generally one year or less); (v) the inclusion of an acting in
concert provision; (vi) whether the pill is implemented following the filing of
a Schedule 13D by a shareholder or there is evidence of hostile activity or
shareholder activism; and (vii) if the pill is subject to periodic board review
and/or shareholder ratification.
We
believe that shareholders should be offered the opportunity to vote on any
adoption or renewal of a NOL pill regardless of any potential tax benefit that
it offers a company. As such, we will consider recommending voting against those
members of the board who served at the time when an NOL pill was adopted without
shareholder approval within the prior twelve months and where the NOL pill is
not subject to shareholder ratification.
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Fair
Price Provisions
Fair
price provisions, which are rare, require that certain minimum price and
procedural requirements be observed by any party that acquires more than a
specified percentage of a corporation’s common stock. The provision is intended
to protect minority shareholder value when an acquirer seeks to accomplish a
merger or other transaction which would eliminate or change the interests of the
minority shareholders. The provision is generally applied against the acquirer
unless the takeover is approved by a majority of “continuing directors” and
holders of a majority, in some cases a supermajority as high as 80%, of the
combined voting power of all stock entitled to vote to alter, amend, or repeal
the above provisions.
The
effect of a fair price provision is to require approval of any merger or
business combination with an “interested shareholder” by 51% of the voting stock
of the company, excluding the shares held by the interested shareholder. An
interested shareholder is generally considered to be a holder of 10% or more of
the company’s outstanding stock, but the trigger can vary.
Generally,
provisions are put in place for the ostensible purpose of preventing a back-end
merger where the interested shareholder would be able to pay a lower price for
the remaining shares of the company than he or she paid to gain control. The
effect of a fair price provision on shareholders, however, is to limit their
ability to gain a premium for their shares through a partial tender offer or
open market acquisition which typically raise the share price, often
significantly. A fair price provision discourages such transactions because of
the potential costs of seeking shareholder approval and because of the
restrictions on purchase price for completing a merger or other transaction at a
later time.
Glass
Lewis believes that fair price provisions, while sometimes protecting
shareholders from abuse in a takeover situation, more often act as an impediment
to takeovers, potentially limiting gains to shareholders from a variety of
transactions that could significantly increase share price. In some cases, even
the independent directors of the board cannot make exceptions when such
exceptions may be in the best interests of shareholders. Given the existence of
state law protections for minority shareholders such as Section 203 of the
Delaware Corporations Code, we believe it is in the best interests of
shareholders to remove fair price provisions.
Control
Share Statutes
Certain
states, including Delaware, have adopted control share acquisition statutes as
an anti-takeover defense for certain closed-end investment companies and
business development companies. Control share statutes may prevent changes in
control by limiting voting rights of a person that acquires the ownership of
“control shares.” Control shares are shares of stock equal to or exceeding
specified percentages of company voting power, and a control share statute
prevents shares in excess of the specified percentage from being voted, unless:
(i) the board approves them to be voted; or (ii) the holder of the “control
shares” receives approval from a supermajority of “non-interested”
shareholders.
Depending
on the state of incorporation, companies may automatically rely on control share
statutes unless the fund’s board of trustees eliminates the application of the
control share statute to any or all fund share acquisitions, through adoption of
a provision in the fund's governing instrument or by fund board action alone. In
certain other states, companies must adopt control share
statutes.
In
our view, control share statues disenfranchise shareholders by reducing their
voting power to a level less than their economic interest and effectively
function as an anti-takeover device. We believe all shareholders should have an
opportunity to vote all of their shares. Moreover, anti-takeover measures may
prevent shareholders from receiving a buy-out premium for their
stock.
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As
such, we will generally recommend voting for proposals to opt out of control
share acquisition statutes, unless doing so would allow the completion of a
takeover that is not in the best interests of shareholders; and against
proposals to amend the charter to include control share acquisition
provisions.
Further,
in cases where a closed-end fund or business development company has received a
public buyout offer and has relied on a control share statute as a defense
mechanism in the prior year, we will generally recommend shareholders vote
against the chair of the nominating and governance committee, absent a
compelling rationale as to why a rejected acquisition was not in the best
interests of shareholders.
Quorum
Requirements
Glass
Lewis believes that a company’s quorum requirement should be set at a level high
enough to ensure that a broad range of shareholders are represented in person or
by proxy, but low enough that the company can transact necessary business.
Companies in the U.S. are generally subject to quorum requirements under the
laws of their specific state of incorporation. Additionally, those companies
listed on the NASDAQ Stock Market are required to specify a quorum in their
bylaws, provided however that such quorum may not be less than one-third of
outstanding shares. Prior to 2013, the New York Stock Exchange required a quorum
of 50% for listed companies, although this requirement was dropped in
recognition of individual state requirements and potential confusion for
issuers. Delaware, for example, required companies to provide for a quorum of no
less than one-third of outstanding shares; otherwise such quorum shall default
to a majority.
We
generally believe a majority of outstanding shares entitled to vote is an
appropriate quorum for the transaction of business at shareholder meetings.
However, should a company seek shareholder approval of a lower quorum
requirement we will generally support a reduced quorum of at least one-third of
shares entitled to vote, either in person or by proxy. When evaluating such
proposals, we also consider the specific facts and circumstances of the company,
such as size and shareholder base.
Director
and Officer Indemnification
While
Glass Lewis strongly believes that directors and officers should be held to the
highest standard when carrying out their duties to shareholders, some protection
from liability is reasonable to protect them against certain suits so that these
officers feel comfortable taking measured risks that may benefit shareholders.
As such, we find it appropriate for a company to provide indemnification and/or
enroll in liability insurance to cover its directors and officers so long as the
terms of such agreements are reasonable.
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Officer
Exculpation
In
August 2022, the Delaware General Assembly amended Section 102(b)(7) of the
Delaware General Corporation Law (“DGCL”) to authorize corporations to adopt a
provision in their certificate of incorporation to eliminate or limit monetary
liability of certain corporate officers for breach of fiduciary duty of care.
Previously, the DGCL allowed only exculpation of corporate directors from breach
of fiduciary duty of care claims if the corporation’s certificate of
incorporation includes an exculpation provision.
The
amendment authorizes corporations to provide for exculpation of the following
officers: (i) the corporation’s president, chief executive officer, chief
operating officer, chief financial officer, chief legal officer, controller,
treasurer or chief accounting officer, (ii) “named executive officers”
identified in the corporation’s SEC filings, and (iii) individuals who have
agreed to be identified as officers of the corporation.
Corporate
exculpation provisions under the DGCL only apply to claims for breach of the
duty of care, and not to breaches of the duty of loyalty. Exculpation provisions
also do not apply to acts or omissions not in good faith or that involve
intentional misconduct, knowing violations of the law, or transactions involving
the receipt of any improper personal benefits. Furthermore, officers may not be
exculpated from claims brought against them by, or in the right of, the
corporation (i.e., derivative actions).
Under
Section 102(b)(7), a corporation must affirmatively elect to include an
exculpation provision in its certificate of incorporation. We will closely
evaluate proposals to adopt officer exculpation provisions on a case-by-case
basis. We will generally recommend voting against such proposals eliminating
monetary liability for breaches of the duty of care for certain corporate
officers, unless compelling rationale for the adoption is provided by the board,
and the provisions are reasonable.
Reincorporation
In
general, Glass Lewis believes that the board is in the best position to
determine the appropriate jurisdiction of incorporation for the company. When
examining a management proposal to reincorporate to a different state or
country, we review the relevant financial benefits, generally related to
improved corporate tax treatment, as well as changes in corporate governance
provisions, especially those relating to shareholder rights, resulting from the
change in domicile. Where the financial benefits are de minimis and there is a
decrease in shareholder rights, we will recommend voting against the
transaction.
However,
costly, shareholder-initiated reincorporations are typically not the best route
to achieve the furtherance of shareholder rights. We believe shareholders are
generally better served by proposing specific shareholder resolutions addressing
pertinent issues which may be implemented at a lower cost, and perhaps even with
board approval. However, when shareholders propose a shift into a jurisdiction
with enhanced shareholder rights, Glass Lewis examines the significant ways
would the company benefit from shifting jurisdictions including the
following:
•Is
the board sufficiently independent?
•Does
the company have anti-takeover protections such as a poison pill or classified
board in place?
•Has
the board been previously unresponsive to shareholders (such as failing to
implement a shareholder proposal that received majority shareholder
support)?
•Do
shareholders have the right to call special meetings of
shareholders?
•Are
there other material governance issues of concern at the company?
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•Has
the company’s performance matched or exceeded its peers in the past one and
three years?
•How
has the company ranked in Glass Lewis’ pay-for-performance analysis during the
last three years?
•Does
the company have an independent chair?
We
note, however, that we will only support shareholder proposals to change a
company’s place of incorporation in exceptional circumstances.
Exclusive
Forum and Fee-Shifting Bylaw Provisions
Glass
Lewis recognizes that companies may be subject to frivolous and opportunistic
lawsuits, particularly in conjunction with a merger or acquisition, that are
expensive and distracting. In response, companies have sought ways to prevent or
limit the risk of such suits by adopting bylaws regarding where the suits must
be brought or shifting the burden of the legal expenses to the plaintiff, if
unsuccessful at trial.
Glass
Lewis believes that charter or bylaw provisions limiting a shareholder’s choice
of legal venue are not in the best interests of shareholders. Such clauses may
effectively discourage the use of shareholder claims by increasing their
associated costs and making them more difficult to pursue. As such, shareholders
should be wary about approving any limitation on their legal recourse including
limiting themselves to a single jurisdiction (e.g., Delaware or federal courts
for matters arising under the Securities Act of 1933) without compelling
evidence that it will benefit shareholders.
For
this reason, we recommend that shareholders vote against any bylaw or charter
amendment seeking to adopt an exclusive forum provision unless the company: (i)
provides a compelling argument on why the provision would directly benefit
shareholders; (ii) provides evidence of abuse of legal process in other,
non-favored jurisdictions; (iii) narrowly tailors such provision to the risks
involved; and (iv) maintains a strong record of good corporate governance
practices.
Moreover,
in the event a board seeks shareholder approval of a forum selection clause
pursuant to a bundled bylaw amendment rather than as a separate proposal, we
will weigh the importance of the other bundled provisions when determining the
vote recommendation on the proposal. We will nonetheless recommend voting
against the chair of the governance committee for bundling disparate proposals
into a single proposal (refer to our discussion of nominating and governance
committee performance in Section I of the guidelines).
Similarly,
some companies have adopted bylaws requiring plaintiffs who sue the company and
fail to receive a judgment in their favor pay the legal expenses of the company.
These bylaws, also known as “fee-shifting” or “loser pays” bylaws, will likely
have a chilling effect on even meritorious shareholder lawsuits as shareholders
would face an strong financial disincentive not to sue a company. Glass Lewis
therefore strongly opposes the adoption of such fee-shifting bylaws and, if
adopted without shareholder approval, will recommend voting against the
governance committee. While we note that in June of 2015 the State of Delaware
banned the adoption of fee-shifting bylaws, such provisions could still be
adopted by companies incorporated in other states.
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Authorized
Shares
Glass
Lewis believes that adequate capital stock is important to a company’s
operation. When analyzing a
request for additional shares, we typically
review four common reasons why a company might need additional capital
stock:
1.Stock
Split
— We typically consider three metrics when evaluating whether we think a stock
split is likely or necessary: The historical stock pre-split price, if any; the
current price relative to the company’s most common trading price over the past
52 weeks; and some absolute limits on stock price that, in our view, either
always make a stock split appropriate if desired by management or would almost
never be a reasonable price at which to split a stock.
2.Shareholder
Defenses
— Additional authorized shares could be used to bolster takeover defenses such
as a poison pill. Proxy filings often discuss the usefulness of additional
shares in defending against or discouraging a hostile takeover as a reason for a
requested increase. Glass Lewis is typically against such defenses and will
oppose actions intended to bolster such defenses.
3.Financing
for Acquisitions
— We look at whether the company has a history of using stock for acquisitions
and attempt to determine what levels of stock have typically been required to
accomplish such transactions. Likewise, we look to see whether this is discussed
as a reason for additional shares in the proxy.
4.Financing
for Operations
— We review the company’s cash position and its ability to secure financing
through borrowing or other means. We look at the company’s history of
capitalization and whether the company has had to use stock in the recent past
as a means of raising capital.
Issuing
additional shares generally dilutes existing holders in most circumstances.
Further, the availability of additional shares, where the board has discretion
to implement a poison pill, can often serve as a deterrent to interested
suitors. Accordingly, where we find that the company has not detailed a plan for
use of the proposed shares, or where the number of shares far exceeds those
needed to accomplish a detailed plan, we typically recommend against the
authorization of additional shares. Similar concerns may also lead us to
recommend against a proposal to conduct a reverse stock split if the board does
not state that it will reduce the number of authorized common shares in a ratio
proportionate to the split.
With
regard to authorizations and/or increases in preferred shares, Glass Lewis is
generally against such authorizations, which allow the board to determine the
preferences, limitations and rights of the preferred shares (known as
“blank-check preferred stock”). We believe that granting such broad discretion
should be of concern to common shareholders, since blank-check preferred stock
could be used as an anti-takeover device or in some other fashion that adversely
affects the voting power or financial interests of common shareholders.
Therefore, we will generally recommend voting against such requests, unless the
company discloses a commitment to not use such shares as an anti-takeover
defense or in a shareholder rights plan, or discloses a commitment to submit any
shareholder rights plan to a shareholder vote prior to its
adoption.
While
we think that having adequate shares to allow management to make quick decisions
and effectively operate the business is critical, we prefer that, for
significant transactions, management come to shareholders to justify their use
of additional shares rather than providing a blank check in the form of a large
pool of unallocated shares available for any purpose.
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Advance
Notice Requirements
We
typically recommend that shareholders vote against proposals that would require
advance notice of shareholder proposals or of director nominees.
These
proposals typically attempt to require a certain amount of notice before
shareholders are allowed to place proposals on the ballot. Notice requirements
typically range between three to six months prior to the annual meeting. Advance
notice requirements typically make it impossible for a shareholder who misses
the deadline to present a shareholder proposal or a director nominee that might
be in the best interests of the company and its shareholders.
We
believe shareholders should be able to review and vote on all proposals and
director nominees. Shareholders can always vote against proposals that appear
with little prior notice. Shareholders, as owners of a business, are capable of
identifying issues on which they have sufficient information and ignoring issues
on which they have insufficient information. Setting arbitrary notice
restrictions limits the opportunity for shareholders to raise issues that may
come up after the window closes.
Virtual
Shareholder Meetings
A
growing contingent of companies have elected to hold shareholder meetings by
virtual means only. Glass Lewis believes that virtual meeting technology can be
a useful complement to a traditional, in-person shareholder meeting by expanding
participation of shareholders who are unable to attend a shareholder meeting in
person (i.e., a “hybrid meeting”). However, we also believe that virtual-only
meetings have the potential to curb the ability of a company’s shareholders to
meaningfully communicate with the company’s management.
Prominent
shareholder rights advocates, including the Council of Institutional Investors,
have expressed concerns that such virtual-only meetings do not approximate an
in-person experience and may serve to reduce the board’s accountability to
shareholders. When analyzing the governance profile of companies that choose to
hold virtual-only meetings, we look for robust disclosure in a company’s proxy
statement which assures shareholders that they will be afforded the same rights
and opportunities to participate as they would at an in-person
meeting.
Examples
of effective disclosure include: (i) addressing the ability of shareholders to
ask questions during the meeting, including time guidelines for shareholder
questions, rules around what types of questions are allowed, and rules for how
questions and comments will be recognized and disclosed to meeting participants;
(ii) procedures, if any, for posting appropriate questions received during the
meeting and the company’s answers, on the investor page of their website as soon
as is practical after the meeting; (iii) addressing technical and logistical
issues related to accessing the virtual meeting platform; and (iv) procedures
for accessing technical support to assist in the event of any difficulties
accessing the virtual meeting.
We
will generally recommend voting against members of the governance committee
where the board is planning to hold a virtual-only shareholder meeting and the
company does not provide such disclosure.
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Voting
Structure
Multi-Class
Share Structures
Glass
Lewis believes multi-class voting structures are typically not in the best
interests of common shareholders. Allowing one vote per share generally operates
as a safeguard for common shareholders by ensuring that those who hold a
significant minority of shares are able to weigh in on issues set forth by the
board.
Furthermore,
we believe that the economic stake of each shareholder should match their voting
power and that no small group of shareholders, family or otherwise, should have
voting rights different from those of other shareholders. On matters of
governance and shareholder rights, we believe shareholders should have the power
to speak and the opportunity to effect change. That power should not be
concentrated in the hands of a few for reasons other than economic
stake.
We
generally consider a multi-class share structure to reflect negatively on a
company’s overall corporate governance. Because we believe that companies should
have share capital structures that protect the interests of non-controlling
shareholders as well as any controlling entity, we typically recommend that
shareholders vote in favor of recapitalization proposals to eliminate dual-class
share structures. Similarly, we will generally recommend against proposals to
adopt a new class of common stock. We will generally recommend voting against
the chair of the governance committee at companies with a multi-class share
structure and unequal voting rights when the company does not provide for a
reasonable sunset of the multi-class share structure (generally seven years or
less).
In
the case of a board that adopts a multi-class share structure in connection with
an IPO, spin-off, or direct listing within the past year, we will generally
recommend voting against all members of the board who served at the time of the
IPO if the board: (i) did not also commit to submitting the multi-class
structure to a shareholder vote at the company’s first shareholder meeting
following the IPO; or (ii) did not provide for a reasonable sunset of the
multi-class structure (generally seven years or less). If the multi-class share
structure is put to a shareholder vote, we will examine the level of approval or
disapproval attributed to unaffiliated shareholders when determining the vote
outcome.
At
companies that have multi-class share structures with unequal voting rights, we
will carefully examine the level of approval or disapproval attributed to
unaffiliated shareholders when determining whether board responsiveness is
warranted. In the case of companies that have multi-class share structures with
unequal voting rights, we will generally examine the level of approval or
disapproval attributed to unaffiliated shareholders on a “one share, one vote”
basis. At controlled and multi-class companies, when at least 20% or more of
unaffiliated shareholders vote contrary to management, we believe that boards
should engage with shareholders and demonstrate some initial level of
responsiveness, and when a majority or more of unaffiliated shareholders vote
contrary to management we believe that boards should engage with shareholders
and provide a more robust response to fully address shareholder concerns.
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Cumulative
Voting
Cumulative
voting increases the ability of minority shareholders to elect a director by
allowing shareholders to cast as many shares of the stock they own multiplied by
the number of directors to be elected. As companies generally have multiple
nominees up for election, cumulative voting allows shareholders to cast all of
their votes for a single nominee, or a smaller number of nominees than up for
election, thereby raising the likelihood of electing one or more of their
preferred nominees to the board. It can be important when a board is controlled
by insiders or affiliates and where the company’s ownership structure includes
one or more shareholders who control a majority-voting block of company
stock.
Glass
Lewis believes that cumulative voting generally acts as a safeguard for
shareholders by ensuring that those who hold a significant minority of shares
can elect a candidate of their choosing to the board. This allows the creation
of boards that are responsive to the interests of all shareholders rather than
just a small group of
large holders.
We
review cumulative voting proposals on a case-by-case basis, factoring in the
independence of the board and the status of the company’s governance structure.
But we typically find these proposals on ballots at companies where independence
is lacking and where the appropriate checks and balances favoring shareholders
are not in place. In those instances we typically recommend in favor of
cumulative voting.
Where
a company has adopted a true majority vote standard (i.e., where a director must
receive a majority of votes cast to be elected, as opposed to a modified policy
indicated by a resignation policy only), Glass Lewis will recommend voting
against cumulative voting proposals due to the incompatibility of the two
election methods. For companies that have not adopted a true majority voting
standard but have adopted some form of majority voting, Glass Lewis will also
generally recommend voting against cumulative voting proposals if the company
has not adopted anti-takeover protections and has been responsive to
shareholders.
Where
a company has not adopted a majority voting standard and is facing both a
shareholder proposal to adopt majority voting and a shareholder proposal to
adopt cumulative voting, Glass Lewis will support only the majority voting
proposal. When a company has both majority voting and cumulative voting in
place, there is a higher likelihood of one or more directors not being elected
as a result of not receiving a majority vote. This is because shareholders
exercising the right to cumulate their votes could unintentionally cause the
failed election of one or more directors for whom shareholders do not cumulate
votes.
Supermajority
Vote Requirements
Glass
Lewis believes that supermajority vote requirements impede shareholder action on
ballot items critical to shareholder interests. An example is in the takeover
context, where supermajority vote requirements can strongly limit the voice of
shareholders in making decisions on such crucial matters as selling the
business. This in turn degrades share value and can limit the possibility of
buyout premiums to shareholders. Moreover,
we believe that a supermajority
vote requirement can enable a small group of shareholders to overrule the will
of the majority shareholders. We believe that a simple majority is appropriate
to approve all matters presented to shareholders.
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Transaction
of Other Business
We
typically recommend that shareholders not give their proxy to management to vote
on any other business items that may properly come before an annual or special
meeting. In our opinion, granting unfettered discretion is unwise.
Anti-Greenmail
Proposals
Glass
Lewis will support proposals to adopt a provision preventing the payment of
greenmail, which would serve to prevent companies from buying back company stock
at significant premiums from a certain shareholder. Since a large or majority
shareholder could attempt to compel a board into purchasing its shares at a
large premium, the anti-greenmail provision would generally require that a
majority of shareholders other than the majority shareholder approve the
buyback.
Mutual
Funds: Investment Policies and Advisory Agreements
Glass
Lewis believes that decisions about a fund’s structure and/or a fund’s
relationship with its investment advisor or sub-advisors are generally best left
to management and the members of the board, absent a showing of egregious or
illegal conduct that might threaten shareholder value. As such, we focus our
analyses of such proposals on the following main areas:
•The
terms of any amended advisory or sub-advisory agreement;
•Any
changes in the fee structure paid to the investment advisor; and
•Any
material changes to the fund’s investment objective or strategy.
We
generally support amendments to a fund’s investment advisory agreement absent a
material change that is not in the best interests of shareholders. A significant
increase in the fees paid to an investment advisor would be reason for us to
consider recommending voting against a proposed amendment to an investment
advisory agreement or fund reorganization. However, in certain cases, we are
more inclined to support an increase in advisory fees if such increases result
from being performance-based rather than asset-based. Furthermore, we generally
support sub-advisory agreements between a fund’s advisor and sub-advisor,
primarily because the fees received by the sub-advisor are paid by the advisor,
and not by the fund.
In
matters pertaining to a fund’s investment objective or strategy, we believe
shareholders are best served when a fund’s objective or strategy closely
resembles the investment discipline shareholders understood and selected when
they initially bought into the fund. As such, we generally recommend voting
against amendments to a fund’s investment objective or strategy when the
proposed changes would leave shareholders with stakes in a fund that is
noticeably different than when originally purchased, and which could therefore
potentially negatively impact some investors’ diversification strategies.
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Real
Estate Investment Trusts
The
complex organizational, operational, tax and compliance requirements of Real
Estate Investment Trusts (REITs) provide for a unique shareholder evaluation. In
simple terms, a REIT must have a minimum of 100 shareholders (the 100
Shareholder Test) and no more than 50% of the value of its shares can be held by
five or fewer individuals (the “5/50 Test”). At least 75% of a REITs’ assets
must be in real estate, it must derive 75% of its gross income from rents or
mortgage interest, and it must pay out 90% of its taxable earnings as dividends.
In addition, as a publicly traded security listed on a stock exchange, a REIT
must comply with the same general listing requirements as a publicly traded
equity.
In
order to comply with such requirements, REITs typically include percentage
ownership limitations in their organizational documents, usually in the range of
5% to 10% of the REITs outstanding shares. Given the complexities of REITs as an
asset class, Glass Lewis applies a highly nuanced approach in our evaluation of
REIT proposals, especially regarding changes in authorized share capital,
including preferred stock.
Preferred
Stock Issuances at REITs
Glass
Lewis is generally against the authorization of "blank-check preferred stock."
However, given the requirement that a REIT must distribute 90% of its net income
annually, it is inhibited from retaining capital to make investments in its
business. As such, we recognize that equity financing likely plays a key role in
a REIT’s growth and creation of shareholder value. Moreover, shareholder concern
regarding the use of preferred stock as an anti-takeover mechanism may be
allayed by the fact that most REITs maintain ownership limitations in their
certificates of incorporation. For these reasons, along with the fact that REITs
typically do not engage in private placements of preferred stock (which result
in the rights of common shareholders being adversely impacted), we may support
requests to authorize shares of blank-check preferred stock at
REITs.
Business
Development Companies
Business
Development Companies (BDCs) were created by the U.S. Congress in 1980; they are
regulated under the Investment Company Act of 1940 and are taxed as regulated
investment companies (RICs) under the Internal Revenue Code. BDCs typically
operate as publicly traded private equity firms that invest in early stage to
mature private companies as well as small public companies. BDCs realize
operating income when their investments are sold off, and therefore maintain
complex organizational, operational, tax and compliance requirements that are
similar to those of REITs—the most evident of which is that BDCs must distribute
at least 90% of their taxable earnings as dividends.
Authorization
to Sell Shares at a Price Below Net Asset Value
Considering
that BDCs are required to distribute nearly all their earnings to shareholders,
they sometimes need to offer additional shares of common stock in the public
markets to finance operations and acquisitions. However, shareholder approval is
required in order for a BDC to sell shares of common stock at a price below Net
Asset Value (NAV). Glass Lewis evaluates these proposals using a case-by-case
approach, but will recommend supporting such requests if the following
conditions are met:
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•The
authorization to allow share issuances below NAV has an expiration date of one
year or less from the date that shareholders approve the underlying proposal
(i.e., the meeting date);
•The
proposed discount below NAV is minimal (ideally no greater than
20%);
•The
board specifies that the issuance will have a minimal or modest dilutive effect
(ideally no greater than 25% of the company’s then-outstanding common stock
prior to the issuance); and
•A
majority of the company’s independent directors who do not have a financial
interest in the issuance approve the sale.
In
short, we believe BDCs should demonstrate a responsible approach to issuing
shares below NAV, by proactively addressing shareholder concerns regarding the
potential dilution of the requested share issuance, and explaining if and how
the company’s past below-NAV share issuances have benefitted the company.
Auditor
Ratification and Below-NAV Issuances
When
a BDC submits a below-NAV issuance for shareholder approval, we will refrain
from recommending against the audit committee chair for not including auditor
ratification on the same ballot. Because of the unique way these proposals
interact, votes may be tabulated in a manner that is not in shareholders’
interests. In cases where these proposals appear on the same ballot, auditor
ratification is generally the only “routine proposal,” the presence of which
triggers a scenario where broker non-votes may be counted toward shareholder
quorum, with unintended consequences.
Under
the 1940 Act, below-NAV issuance proposals require relatively high shareholder
approval. Specifically, these proposals must be approved by the lesser of: (i)
67% of votes cast if a majority of shares are represented at the meeting; or
(ii) a majority of outstanding shares. Meanwhile, any broker non-votes counted
toward quorum will automatically be registered as “against” votes for purposes
of this proposal. The unintended result can be a case where the issuance
proposal is not approved, despite sufficient voting shares being cast in favor.
Because broker non-votes result from a lack of voting instruction by the
shareholder, we do not believe shareholders’ ability to weigh in on the
selection of auditor outweighs the consequences of failing to approve an
issuance proposal due to such technicality.
Special
Purpose Acquisition Companies
Special
Purpose Acquisition Companies (SPACs), also known as “blank check companies,”
are publicly traded entities with no commercial operations and are formed
specifically to pool funds in order to complete a merger or acquisition within a
set time frame. In general, the acquisition target of a SPAC is either not yet
identified or otherwise not explicitly disclosed to the public even when the
founders of the SPAC may have at least one target in mind. Consequently, IPO
investors often do not know what company they will ultimately be investing
in.
SPACs
are therefore very different from typical operating companies. Shareholders do
not have the same expectations associated with an ordinary publicly traded
company and executive officers of a SPAC typically do not continue in employment
roles with an acquired company.
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Extension
of Business Combination Deadline
Governing
documents of SPACs typically provide for the return of IPO proceeds to common
shareholders if no qualifying business combination is consummated before a
certain date. Because the time frames for the consummation of such transactions
are relatively short, SPACs will sometimes hold special shareholder meetings at
which shareholders are asked to extend the business combination deadline. In
such cases, an acquisition target will typically have been identified, but
additional time is required to allow management of the SPAC to finalize the
terms of the deal.
Glass
Lewis believes management and the board are generally in the best position to
determine when the extension of a business combination deadline is needed. We
therefore generally defer to the recommendation of management and support
reasonable extension requests.
SPAC
Board Independence
The
board of directors of a SPAC’s acquisition target is in many cases already
established prior to the business combination. In some cases, however, the
board’s composition may change in connection with the business combination,
including the potential addition of individuals who served in management roles
with the SPAC. The role of a SPAC executive is unlike that of a typical
operating company executive. Because the SPAC’s only business is identifying and
executing an acquisition deal, the interests of a former SPAC executive are also
different. Glass Lewis does not automatically consider a former SPAC executive
to be affiliated with the acquired operating entity when their only position on
the board of the combined entity is that of an otherwise independent director.
Absent any evidence of an employment relationship or continuing material
financial interest in the combined entity, we will therefore consider such
directors to be independent.
Director
Commitments of SPAC Executives
We
believe the primary role of executive officers at SPACs is identifying
acquisition targets for the SPAC and consummating a business combination. Given
the nature of these executive roles and the limited business operations of
SPACs, when a directors’ only executive role is at a SPAC, we will generally
apply our higher limit for company directorships. As a result, we generally
recommend that shareholders vote against a director who serves in an executive
role only at a SPAC while serving on more than five public company
boards.
Shareholder
Proposals
Glass
Lewis believes that shareholders should seek to promote governance structures
that protect shareholders, support effective ESG oversight and reporting, and
encourage director accountability. Accordingly, Glass Lewis places a significant
emphasis on promoting transparency, robust governance structures and companies’
responsiveness to and engagement with shareholders. We also believe that
companies should be transparent on how they are mitigating material ESG risks,
including those related to climate change, human capital management, and
stakeholder relations.
To
that end, we evaluate all shareholder proposals on a case-by-case basis with a
view to promoting long-term shareholder value. While we are generally supportive
of those that promote board accountability, shareholder rights, and
transparency, we consider all proposals in the context of a company’s unique
operations and risk profile.
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For
a detailed review of our policies concerning compensation, environmental,
social, and governance shareholder proposals, please refer to our comprehensive
Proxy
Paper Guidelines for Shareholder Proposals & ESG-Related Issues,
available at www.glasslewis.com/voting-policies-current/.
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Overall
Approach to Environmental, Social & Governance Issues
Glass
Lewis evaluates all environmental and social issues through the lens of
long-term shareholder value. We believe that companies should be considering
material environmental and social factors in all aspects of their operations and
that companies should provide shareholders with disclosures that allow them to
understand how these factors are being considered and how attendant risks are
being mitigated. We also are of the view that governance is a critical factor in
how companies manage environmental and social risks and opportunities and that a
well-governed company will be generally managing these issues better than one
without a governance structure that promotes board independence and
accountability.
We
believe part of the board’s role is to ensure that management conducts a
complete risk analysis of company operations, including those that have material
environmental and social implications. We believe that directors should monitor
management’s performance in both capitalizing on environmental and social
opportunities and mitigating environmental and social risks related to
operations in order to best serve the interests of shareholders. Companies face
significant financial, legal and reputational risks resulting from poor
environmental and social practices, or negligent oversight thereof. Therefore,
in cases where the board or management has neglected to take action on a
pressing issue that could negatively impact shareholder value, we believe that
shareholders should take necessary action in order to effect changes that will
safeguard their financial interests.
Given
the importance of the role of the board in executing a sustainable business
strategy that allows for the realization of environmental and social
opportunities and the mitigation of related risks, relating to environmental
risks and opportunities, we believe shareholders should seek to promote
governance structures that protect shareholders and promote director
accountability. When management and the board have displayed disregard for
environmental or social risks, have engaged in egregious or illegal conduct, or
have failed to adequately respond to current or imminent environmental and
social risks that threaten shareholder value, we believe shareholders should
consider holding directors accountable. In such instances, we will generally
recommend against responsible members of the board that are specifically charged
with oversight of the issue in question.
When
evaluating environmental and social factors that may be relevant to a given
company, Glass Lewis does so in the context of the financial materiality of the
issue to the company’s operations. We believe that all companies face risks
associated with environmental and social issues. However, we recognize that
these risks manifest themselves differently at each company as a result of a
company’s operations, workforce, structure, and geography, among other factors.
Accordingly, we place a significant emphasis on the financial implications of a
company’s actions with regard to impacts on its stakeholders and the
environment.
When
evaluating environmental and social issues, Glass Lewis examines
companies’:
Direct
environmental and social risk
— Companies should evaluate financial exposure to direct environmental risks
associated with their operations. Examples of direct environmental risks include
those associated with oil or gas spills, contamination, hazardous leakages,
explosions, or reduced water or air quality, among others. Social risks may
include non-inclusive employment policies, inadequate human rights policies, or
issues that adversely affect the company’s stakeholders. Further, we believe
that firms should consider their exposure to risks
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emanating
from a broad range of issues, over which they may have no or only limited
control, such as insurance companies being affected by increased storm severity
and frequency resulting from climate change.
Risk
due to legislation and regulation —
Companies should evaluate their exposure to changes or potential changes in
regulation that affect current and planned operations. Regulation should be
carefully monitored in all jurisdictions in which the company operates. We look
closely at relevant and proposed legislation and evaluate whether the company
has responded proactively.
Legal
and reputational risk
— Failure to take action on important environmental or social issues may carry
the risk of inciting negative publicity and potentially costly litigation. While
the effect of high-profile campaigns on shareholder value may not be directly
measurable, we believe it is prudent for companies to carefully evaluate the
potential impacts of the public perception of their impacts on stakeholders and
the environment. When considering investigations and lawsuits, Glass Lewis is
mindful that such matters may involve unadjudicated allegations or other charges
that have not been resolved. Glass Lewis does not assume the truth of such
allegations or charges or that the law has been violated. Instead, Glass Lewis
focuses more broadly on whether, under the particular facts and circumstances
presented, the nature and number of such concerns, lawsuits or investigations
reflects on the risk profile of the company or suggests that appropriate risk
mitigation measures may be warranted.
Governance
risk
— Inadequate oversight of environmental and social issues carries significant
risks to companies. When leadership is ineffective or fails to thoroughly
consider potential risks, such risks are likely unmitigated and could thus
present substantial risks to the company, ultimately leading to loss of
shareholder value.
Glass
Lewis believes that one of the most crucial factors in analyzing the risks
presented to companies in the form of environmental and social issues is the
level and quality of oversight over such issues. When management and the board
have displayed disregard for environmental risks, have engaged in egregious or
illegal conduct, or have failed to adequately respond to current or imminent
environmental risks that threaten shareholder value, we believe shareholders
should consider holding directors accountable. When companies have not provided
for explicit, board-level oversight of environmental and social matters and/or
when a substantial environmental or social risk has been ignored or inadequately
addressed, we may recommend voting against members of the board. In addition, or
alternatively, depending on the proposals presented, we may also consider
recommending voting in favor of relevant shareholder proposals or against other
relevant management-proposed items, such as the ratification of auditor, a
company’s accounts and reports, or ratification of management and board
acts.
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DISCLAIMER
©
2023 Glass, Lewis & Co., and/or its affiliates. All Rights
Reserved.
This
document is intended to provide an overview of Glass Lewis’ proxy voting
guidelines. It is not intended to be exhaustive and does not address all
potential voting issues. Glass Lewis’ proxy voting guidelines, as they apply to
certain issues or types of proposals, are further explained in supplemental
guidelines and reports that are made available on Glass Lewis’ website –
http://www.glasslewis.com. These guidelines have not been set or approved by the
U.S. Securities and Exchange Commission or any other regulatory body.
Additionally, none of the information contained herein is or should be relied
upon as investment advice. The content of this document has been developed based
on Glass Lewis’ experience with proxy voting and corporate governance issues,
engagement with clients and issuers, and review of relevant studies and surveys,
and has not been tailored to any specific person or entity.
Glass
Lewis’ proxy voting guidelines are grounded in corporate governance best
practices, which often exceed minimum legal requirements. Accordingly, unless
specifically noted otherwise, a failure to meet these guidelines should not be
understood to mean that the company or individual involved has failed to meet
applicable legal requirements.
No
representations or warranties express or implied, are made as to the accuracy or
completeness of any information included herein. In addition, Glass Lewis shall
not be liable for any losses or damages arising from or in connection with the
information contained herein or the use, reliance on, or inability to use any
such information. Glass Lewis expects its subscribers to possess sufficient
experience and knowledge to make their own decisions entirely independent of any
information contained in this document.
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information contained in this report is protected by law, including, but not
limited to, copyright law, and none of such information may be copied or
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