Revisions to the Executive Compensation Disclosure Rules

By: Cydney Posner

On December 22, 2006, without even dropping a hint in advance, the SEC posted, as interim final rules, amendments to Item 402 of Regulation S-K that revise the Summary Compensation Table and Director Compensation Table disclosure with respect to stock awards and option awards, making the rules even more complex than before.

The amendments require, in lieu of the FAS 123R aggregate grant date fair value of awards, disclosure of the compensation cost of awards over the requisite service period, as described in FAS 123R. (FAS 123R defines a requisite service period as the period over which an employee is required to provide service in exchange for a share-based payment.) The amendments revise the Grants of Plan-Based Awards Table to add a column showing, on an grant-by-grant basis, the full grant date fair value of awards computed in accordance with FAS 123R. The amendments also revise the Grants of Plan-Based Awards Table to include information concerning repriced or materially modified options, SARs and similar option-like instruments, disclosing the incremental fair value as of the repricing or modification date computed in accordance with FAS 123R. The amendments to the Director Compensation Table require footnote disclosure corresponding to the new Grants of Plan-Based Awards Table fair value disclosures. The SEC is also making a number of technical corrections. The amendments are effective upon publication in the Federal Register, although there is a 30-day comment period. The compliance dates will be the same as the compliance dates for the recent amendments to Regulation S-K Item 402 that were adopted in the 2006 Executive Compensation Release.

Apparently, there was a fair amount of commentary contending that disclosure of the full grant date fair value would overstate compensation earned related to service rendered for the year, might confuse the discussion and analysis of compensation policies and practices, would not necessarily reflect the cost to the company or the benefit to the NEO or director, would be inconsistent with the financial statements and may not reflect amounts that are ultimately earned.

Summary Compensation Table ("SCT") and Director Compensation Table ("DCT")

Under the revisions, the SCT will now be required to show the FAS 123R compensation cost of awards over the requisite service period. Compensation cost will include both the amounts recorded as compensation expense in the income statement for the fiscal year as well as any amounts earned by an NEO that have been capitalized on the balance sheet for the fiscal year, including compensation cost recognized in the financial statements with respect to awards granted in previous fiscal years and the subject fiscal year. Corresponding changes were made in the DCT. Awards that are forfeited must be disclosed by footnote.

Awards classified under FAS 123R as liability awards (e.g., those with cash-based settlement, certain repurchase features or other features that do not result in an employee's bearing the risks and rewards normally associated with share ownership) are re-measured at each financial statement reporting date through the date the awards are settled. Under the amendments, the re-measurements of liability awards will be reflected in the executive compensation disclosure, providing a more comprehensive measure of liability awards over time.

With respect to employee groups composed to determine expected term assumption used for computing the FAS 123R grant date fair value, where a company uses more than one group for its FAS 123R valuation, the measurement of grant date fair value for purposes of Item 402 will be derived using the expected term assumption for the group that includes the NEOs (or the group that includes directors for purposes of the DCT).

In determining the amount recognized, FAS 123R requires a company to estimate at the grant date the amount of awards that ultimately will be earned and to revise those estimates periodically as awards are vested or forfeited. While the interim final rules are not intended to change a company's FAS 123R methods, the compensation cost disclosed for Item 402 purposes will not include an estimate of forfeitures related to service-based vesting conditions. Rather, compensation cost for awards containing service-based vesting conditions will be disclosed assuming that the NEO will fully vest in the award. If the NEO ultimately forfeits the award, the amount of compensation cost previously disclosed in the SCT will be deducted in the period when the award is forfeited.

With regard to performance-based awards, the new amendments require that compensation cost be disclosed in the SCT only if it is probable that the performance condition will be achieved. If it is not probable at the grant date but later becomes probable, the proportionate amount of compensation cost based on service previously rendered will be disclosed in the SCT during the period when satisfaction of the performance condition becomes probable. If satisfaction of a performance condition was considered probable but becomes improbable in a later period, the amount of compensation cost previously disclosed in the SCT will be reversed during that period. Thus, if a performance or service award ultimately vests, the amount cumulatively recognized in the SCT will, over time, equal 100% of the grant date fair value. If it does not vest, the amount cumulatively reported in the SCT will be zero. If the award has "graded vesting," the amount cumulatively reported will equal 100% of the grant date fair value of that portion of the award that vests.

There may be instances where the timing of recognition leads to disclosure of a negative number, for example, as a result of the accumulation of various forfeitures. In those cases, the negative number will be disclosed in the relevant column and will affect the calculation of "total" for purposes of determining who is an NEO. Similarly, there could be instances when the FAS 123R compensation cost is recognized in the financial statements in the year before the award is granted, for example, when an employee is rendering services in exchange for an award, but a grant has not occurred because the terms of the award have not been finalized. Conversely, a grant may have been made, but no compensation cost is recognized, for example, when an award has a performance condition that is not considered at the date of grant to be probable to vest.

With respect to awards granted to retirement-eligible employees who may retain the award at retirement, the full grant date fair value of the award will be recognized in the company’s financial statements in the year of grant, and the new amendments would not appear to affect that.

The SEC is also revising an instruction to the SCT Salary and Bonus columns regarding salary or bonus forgone at the election of an NEO. Instead of reporting these forgone amounts in the Stock Awards or Option Awards columns, the revisions require the forgone amount to be reported in the Salary or Bonus column, with footnote disclosure of the receipt of non-cash compensation that refers to the Grants of Plan-Based Awards Table where the stock, option or non-equity incentive plan award elected is reported.

Grant of Plan-Based Awards Table

The new amendments move full grant date fair value information from the SCT to a new column in the Grants of Plan-Based Awards Table, on a grant-by-grant basis. The DCT will require conforming footnote disclosure of the FAS 123R grant date fair value of each equity award.

The Grants of Plan-Based Awards Table will also now be required to include information on a grant-by grant basis, regarding repriced or materially modified options, SARs and similar option-like instruments, disclosing the incremental fair value, computed as of the repricing or modification date in accordance with FAS 123R. The DCT will require footnote disclosure of the same information. This disclosure requirement does not apply to changes resulting from antidilution provisions or similar transactions equally affecting all holders of the underlying class of securities, or to repricings that result from a pre-existing formula or mechanism in the terms of the plan or award that results in the periodic adjustment of the exercise or base price (as the adjustment feature would have been reflected in the grant date fair value).

Transition Guidance

The SEC's transition guidance for the SCT and DCT applies to disclosure of awards that were granted before 2006 (because FAS 123R became effective for companies in 2006), including both equity awards that are not yet vested and liability awards that are not yet settled. (The adjustments to update the cumulative compensation costs recognized for certain awards that a company might have in the year that FAS 123R initially is adopted will not be included in the SCT for that year.) In this context, companies will be required to use the FAS 123R modified prospective transition method for Item 402 disclosure purposes, even if they have not adopted that method for financial statement reporting purposes. The modified prospective transition method requires that the accounting for new awards and awards that are modified, repurchased or cancelled after the standard’s effective date must apply the provisions of FAS 123R. In addition, under that method, a proportionate share of the grant date fair value determined under FAS 123 of equity awards that are outstanding at the date FAS 123R was adopted will be recognized in the financial statements over those awards’ remaining vesting periods, if any. Liability awards that are outstanding at the date FAS 123R was adopted will be recognized in the financial statements until those awards are settled, based on the fair values of those awards at each financial statement reporting period under FAS 123R as well as the portion of the awards that have vested. The same approach will apply for presentation of the corresponding information in the SCT and DCT for fiscal 2006 and later fiscal years.