SEC adopts amendments to executive pay disclosure rules

By: Cydney Posner

Today, the SEC adopted, substantially as proposed, amendments to the disclosure requirements for executive and director compensation, related-party (now related-person) transactions, security ownership of officers and directors, independence of directors and other corporate governance matters. The release will also provide guidance with regard to disclosure of timing of option grants and practices regarding establishment of exercise prices (although Corp Fin Director John White stressed that the terms "backdating" and "springloading" appear nowhere in the release, given their misuse and ambiguity in general parlance). The SEC also adopted final rules requiring that disclosure under the amended items generally be provided in plain English. One surprise coming out of the meeting is that the provision regarding disclosure of compensation paid to up to three employees who were paid more than any of the named executives (the so-call "Katie Couric provision") has been modified and is being reproposed for large accelerated filers only.

The original proposal received more comments (over 20,000) than any other proposal in the history of the SEC, although rumor has it that thousands of the comment letters were identical and part of structured campaigns by various organizations. The release is apparently over 400 pages, and it appeared that some sections are still in process, so it may not be available for awhile.

Chairman Christopher Cox emphasized that the SEC does not seek to judge or limit the amounts of compensation paid; rather, he views that determination as the duty of the compensation committee members, who represent the shareholders. The new rules are instead designed to help committees and shareholders make better decisions about compensation with clearer, more understandable disclosure. In addition, since the rules were originally adopted in 1992, there have been many changes to the types of compensation paid to executives (such as the extensive use of perquisites and retirement and termination benefits), and these modernized rules are designed to capture the new or expanded use of these types of compensation. Commissioner Campos raised the issue of providing for advisory shareholder votes regarding executive compensation, similar to practices in the UK. (Hmm, a little late for that.)

Key elements of the new rules include:

• Disclosure of "total compensation" in the Summary Compensation Table;
• A plain English, narrative Compensation Discussion and Analysis section, that is "filed," not "furnished," and will be covered by CEO and CFO certifications;
• Detailed narrative discussion of termination/change-of-control benefits and expanded tabular disclosure regarding post-retirement benefits;
• Principles-based disclosure of related-person transactions, including substantial elimination of differences between disclosure regarding indebtedness and other transactions;
• Restructuring of the equity tables to include supplementary tables and related explanatory narrative;
• Retention of the performance graph, in a change from the proposal, required now, under S-K item 201, to be located in annual reports;
• Aggregation of expanded corporate governance disclosure requirements under new S-K item 407, including expanded disclosure regarding compensation committees and description of the types of transactions considered by the board of directors in determining independence;
• Tabular disclosure of director compensation;
• Changes, as proposed, to beneficial ownership disclosure and to Form 8-K regarding executive compensation agreements; and
• Significant expansion of option disclosure, particularly with respect to timing and exercise price selection practices.

As proposed, the new SCT will require disclosure for five NEOs: the CEO, CFO and three other highest paid executives, based on total compensation. To address concerns that some components previously proposed to be included in the total could severely skew the totals, the new rules exclude from the calculation earnings on non-qualified deferred compensation and changes in pension value. One column of the SCT will instead now report annual changes in the actuarial value of accumulated pension benefits and above-market or preferential earnings on nonqualified deferred compensation. Consistent with the original proposal, valuation of options in the SCT will be based on FAS 123R; however, as opposed to the requirement under FAS 123R, the value will not be recognized over the vesting period, but would rather included in its entirety for the year of grant. In response to comments, the option column in the SCT will include only the incremental value of repriced options, not the entire option value as originally proposed. A column for all other compensation will include perquisites with an aggregate value over the threshold of $10,000. The total column will now be moved to the right (a point that seemed to have particular importance for White). The staff stated that some effort was made to reduce double counting of compensation, but there was no real discussion at the meeting of the success of the effort.

CD&A

The new CD&A will be, as proposed, a plain English, principles-based narrative discussion of the company's compensation policies and practices, primarily with respect to executives (as Cox phrased it, a description of how the company arrived at these levels of compensation). The analysis would address various topics as outlined in the proposal, although, as discussed below, the option discussion has been significantly beefed up to address option timing and pricing issues. As noted above, the CD&A will be "filed" and subject to officer certification and disclosure controls. This provision of the proposal had come under significant attack because it required the CEO and CFO to certify as to matters from which they are, under good governance principles, expressly excluded. White noted that the CD&A is not a report regarding compensation committee deliberation or activities, but rather about company policies and decisions. Nevertheless, he commented that the staff had really wrestled with this requirement, because, as proposed, it required the signing officers to interject themselves into processes from which they are necessarily removed. The staff's resolution, which White characterized as "elegant," is to retain, in addition to the CD&A, a brief and significantly modified Compensation Committee Report, which will be signed by the committee members, furnished, not filed and, much like the current Audit Committee Report, will require only a statement as to whether the committee reviewed and discussed the CD&A with management and whether, based on that review and discussion, the committee recommends that the CD&A be included in the Form 10-K. The release will specifically note that, in making their certifications, the CEO and CFO may "look to" this report. In his comments, Commissioner Paul Atkins noted that he viewed the certification in this context as inappropriate.

With regard to disclosure of specific quantitative or qualitative performance targets considered in the determination of compensation, the rules will not require disclosure of trade secrets or confidential commercial or business information that would result in competitive harm to the company, using the standard commonly applied to CTRs. Campos stressed that targets that do not meet that threshold must be disclosed. Campos also noted that he expected Corp Fin to be alert to discouraging boilerplate in the CD&A.

Option Grant Disclosure Guidance

The release will contain guidance with respect to disclosure of programs and practices regarding two general categories of option grant practices: timing (i.e., when companies grant options in coordination with the release of material information, whether positive or negative, whether involving the delay or acceleration of the grant or the release of the information) and establishment of exercise prices (i.e., setting of the exercise price at other than the market price on the grant date). Both Cox and White emphasized that companies may have valid reasons for engaging in either of these practices and that the SEC does not address their advisability nor does it suggest that there is anything inherently wrong with these practices so long as the options granted are properly accounted for and the practices appropriately disclosed. Atkins emphasized that some commentators had failed to distinguish between ministerial problems with dating and nefarious practices designed to disguise compensation. He noted that the option disclosure guidance remained a work in progress and that he "looked forward" to assisting in the process to ensure that the discussion was "balanced." (Atkins has, in the past, made his views on this topic quite clear. See my emails of 7/10/06 and 7/11/06.) The expanded option disclosure requirements affect both the tabular presentation and the CD&A narrative.

As noted above, the SCT will contain the full FAS 123R value of options granted for the year of grant. There will now be a table for grants of plan-based awards, showing the grant date of option grants, determined under FAS 123R. If the actual date of the corporate action is different from the grant date used, an additional column would be required to show the other date. If the exercise price is less than the closing market price on the grant date, a separate column would be added to show the grant date price. (It was unclear whether options granted with a price based on the close on the preceding day, a common practice, would be included here.) The methodology used to determine the exercise price, if not based on the grant date, must be explained.

The CD&A must include, as applicable, a separate analysis of the two option grant practices described above. Where there is any program or plan to time grants in coordination with the release of information, the CD&A must address, among other topics, the role of the compensation committee, how the plan or practice fit in the context of grants to all employees, whether the timing was chosen to affect value and whether grants to new executives were similarly timed. The same general rules apply to practices with regard to establishment of exercise prices where a prior date or formula is used. The discussion of option grant practices will also apply to grants to directors, and the SEC is seeking input on whether practices related to general employee grants, if different, should also be discussed.

Compensation to Three Highly Paid Employees

Although it was widely reported that the proposal to require disclosure of compensation to the three most highly paid non-executives, if higher than that paid to any NEO, would be eliminated, the SEC decided to modify and repropose it. Public comments were almost uniformly opposed to the requirement, with concerns raised regarding competition, privacy and cost. The staff believes that the revised version of the provision will address these concerns. As reproposed, the provision would apply only to large accelerated filers (public float of $700 million or more), and would not apply to the entire employee pool, but rather only to those employees responsible for significant policy decisions (including strategic or technical policies) or principal business functions or units at the parent or significant-subsidiary level. White expects the provision to now capture primarily executives at subsidiaries (for e.g., acquired companies) and not athletes, traders (or Katie Couric), unless they are also involved in policy making. Atkins objected that almost all highly paid employees would likely be involved in some type of policy-making, given the breadth of the definition.

Compliance Dates

The changes to Form 8-K will apply to events occurring 60 days after publication of the final rules in the Federal Register. The changes to Form 10-K will apply to reports for fiscal years ending on or after 12/15/06. The changes to proxies will apply to proxies filed on or after 12/15/06 for fiscal years ending on or after 12/15/06. There is no requirement to restate previously reported compensation information or related-person transactions for prior periods.