SEC posts new FAQs on new executive compensation rules

By: Cydney Posner

The SEC has just posted new guidance on the new executive compensation rules. The new guidance replaces the S-K 402 guidance in the SEC's telephone interp manual and, as a result, some of the FAQs may sound familiar because they are reissued prior responses, updated in some cases as required.

General

• A company with a calendar year end that files a Form S-3 after December 15, 2006 (the effective date of the new rules), but before it files its 2006 Form 10-K can incorporate by reference the 2005 Form 10-K containing disclosure under the old rules. The company would not be required to incorporate by reference the disclosure under the new rules until it is required to include that information in the Form 10-K for the fiscal year ended December 31, 2006. (Presumably that means April 30, but the guidance does not state whether that date is the 10-K due date or April 30. Also, it would appear from the question that, in the context of an S-3, a company is not required to include new compensation information for the prior year just because it has entered a new fiscal year, but instead may continue to incorporate the prior year's compensation information. Compare the response below.)
• If a filing is made on January 2, compensation information for the previous year ended December 31 must be included, when compensation information may not be incorporated by reference into the filing. Compensation disclosure must be included for the prior year because companies should have those numbers available. However, if bonus or other amounts for the prior year have not yet been determined, that information should be footnoted, together with disclosure regarding the date the bonus will be determined, any formula or criteria that will be used and any other pertinent information. When determined, the bonus or other amount must be disclosed in a filing under Item 5.02(f) of Form 8-K. Further, where the compensation disclosure depends upon assumptions used in the financial statements and those financial statements have not yet been audited, it is permissible for the company to note this fact in the compensation disclosure.
• Where a company that is in the process of restating its financial statements has not filed its 2005 Form 10-K, when the company ultimately files the 2005 Form 10-K, it will not be required to comply with the new rules in the 2005 Form 10-K.

• The guidance with respect to CD&A disclosure regarding option grants (e.g., how timing and pricing are determined) is applicable to other forms of equity compensation, such as restricted stock and other non-option equity awards.
• In presenting CD&A disclosure about prior option grant programs, plans or practices, companies may be required, depending upon the particular circumstances, to provide disclosures about programs, plans or practices that occurred outside the scope of the information contained in the tables and otherwise disclosed pursuant to Item 402, such as information about periods before and after the information presented in the tables and otherwise disclosed pursuant to Item 402. See Instruction 2 to Item 402(b). For example, companies are required to include disclosure about programs, plans or practices relating to option grants in the CD&A for fiscal years ending on or after December 15, 2006, as well as any other periods where necessary as contemplated by Instruction 2 to Item 402(b).
• A company should determine if it may omit disclosure of performance target levels or other factors or criteria under Instruction 4 to Item 402(b) using standards established for evaluating whether information may be kept confidential under a CTR (Rule 406 or Rule 24b-2), that is, whether the information constitutes confidential commercial or financial information the disclosure of which would cause competitive harm. However, no CTR is required to be submitted. These standards are addressed in National Parks and Conservation Association v. Morton, 498 F.2d 765 (D.C. Cir. 1974); National Parks and Conservation Association v. Kleppe, 547 F.2d 673 (D.C. Cir. 1976); and Critical Mass Energy Project v. NRC, 931 F.2d 939 (D.C. Cir. 1991), vacated & reh'g en banc granted, 942 F.2d 3 799 (D.C. Cir. 1991), grant of summary judgment to agency aff'd en banc, 975 F.2d 871 (D.C. Cir. 1992). Obviously, to the extent that a performance target level or other factor or criteria has already been publicly disclosed, the Instruction will not be particularly helpful and the information should be included. In reviewing filings, the SEC staff may require companies to demonstrate that the confidential treatment standard has been met. If the staff determine that the standard has not been met, disclosure may be required. If information is withheld under the instruction, the company must discuss how difficult it will be for the executive or how likely it will be for the company to achieve the undisclosed target level, factor or criteria.

• If a person becomes an NEO, compensation information is required only for the year in which he or she becomes an NEO, not for either of the prior two years.
• If an executive officer, other than the PEO or PFO, becomes a non-executive employee during the last completed fiscal year but does not leave the company, in determining whether the individual is an NEO, compensation received during the entire fiscal year should be taken into account. If the person would qualify as an NEO, all of the person's compensation for the full fiscal year should be disclosed, including compensation for the period when the person was a non-executive employee.
• Compensation of incoming or departing executives should not be annualized.
• A discretionary cash bonus that was not based on any performance criteria should be reported in the Bonus column, not the Non-equity Incentive Plan Compensation column. The Non-equity Incentive Plan Compensation column should include bonus awards that:
  • Are not within the scope of FAS 123R;
  • Are granted under a plan as incentive compensation for performance occurring over a specified period; and
  • Contain performance targets that are communicated to the executives and the outcome of which were substantially uncertain at the time they were established.

  The length of the performance period is not relevant, and the incentive period could be shorter than a year. Further, a plan that qualifies as a non-equity incentive plan that permits the exercise of negative discretion in determining the amounts of bonuses would generally still be reportable in the Non-equity Incentive Plan Compensation column; however, discretionary amounts over the amounts earned as a result of meeting the performance measures should be reported in the Bonus column. The basis for the use of various targets and negative discretion may be material information to be disclosed in the CD&A.

• The new new rules provide in Instruction 2 to Item 402(c)(2)(iii) and (iv) (Salary and Bonus columns) that, if an NEO elects to forego amounts of salary or bonus for stock or other non-cash compensation, the amounts foregone should still be included in the Salary or Bonus columns. If the value of the stock or other non-cash compensation is the same as the amount of salary or bonus foregone, the amounts should be reported only in the Salary or Bonus columns and not in any other column of the SCT. However, if the amount of salary or bonus foregone was less than the value of the equity-based compensation received in lieu of salary or bonus, the additional incremental value of the equity award would be reported in the Stock or Option Awards columns. Similarly, if the arrangement under which the NEO could elect settlement in stock or equity-based compensation was within the scope of FAS 123R, the entire award would be reported in the Stock or Option Awards columns. In both of these special cases, the amounts reported in the Stock Awards and Option Awards columns would be the dollar amounts recognized for financial statement reporting purposes with respect to the applicable fiscal year, and footnote disclosure should be provided regarding the circumstances of the awards. Appropriate disclosure about equity-based compensation received instead of salary or bonus must be provided in the Grants of Plan-Based Awards Table, the Outstanding Equity Awards at FYE Table and the Option Exercises and Stock Vested Table.
• The Instruction to Item 402(c)(2)(v) and (vi) (Option Awards and Stock Awards columns) provides that a company must disclose the assumptions made in the valuation for awards reported in the Option Awards and Stock Awards columns by reference to a discussion of those assumptions in the financial statements, footnotes to the financial statements or MD&A. The disclosure is required for any award reported in those columns, not just awards for the subject fiscal year.
• Equity awards made after the end of the fiscal year that relate to services performed in the last completed fiscal year should be reported in the SCT when a dollar amount is recognized for financial statement reporting purposes for the applicable fiscal year. With respect to the Grants of the Plan-Based Awards Table, under Item 402(d)(1), information as to the awards should be reported in the fiscal year in which the award was granted. However, in preparing the CD&A, discussion regarding awards granted after the end of the fiscal year but relating back to service in that completed fiscal year should be considered.
• Where an NEO exercises "reload" options and receives additional options upon exercise, the company should report the additional options as option grants in the Grants of Plan-Based Awards Table. In the SCT, the company would report the dollar amount recognized for the additional options for financial statement purposes with respect to the fiscal year in accordance with FAS 123R.
• Instruction 3 to Item 402(c)(2)(viii) (Change in Pension Value and Nonqualified Deferred Compensation Earnings column) provides that where the amount of the change in the actuarial present value of the accumulated pension benefit is negative, the amount should be disclosed by footnote but should not be reflected in the sum reported in the Change in Pension Value and Nonqualified Deferred Compensation Earnings column. Where an NEO has multiple pension plans, a company may subtract negative values when aggregating the changes in actuarial present values of the accumulated benefits under the plans and apply the "no negative number" position of the instruction for the final number after aggregating all plans. Under this approach, if one plan had a $500 increase and another plan had a $200 decrease, then the net change in the actuarial present value of the accumulated pension benefits would be $300.
• Item 402(c)(2)(viii) (Change in Pension Value and Nonqualified Deferred Compensation Earnings column) and Item 402(h)(2)(iii) and (iv) (Pension Benefits Table) require disclosure of amounts that are computed as of the same pension plan measurement date used for financial reporting purposes in the company's audited financial statements for the last completed fiscal year. This date is used so that the company would not have to use different assumptions when computing the present value for executive compensation disclosure and financial reporting purposes. The pension plan measurement date for most pension plans is September 30 which, in the case of calendar-year companies, does not correspond with the company's fiscal year. As a result, the pension benefit information will be presented for a period that differs from the fiscal year period covered by the disclosure. Under recent changes in pension accounting standards, the pension measurement date will be changed to be the same as the end of the company's fiscal year. In the year in which companies change their pension measurement dates, they may use an annualized approach for the disclosure of the change in the value of the accumulated pension benefits in the SCT (thereby adjusting the 15-month period to a 12-month period) when the transition in pension plan measurement date occurs, so long as the company includes disclosure explaining it has followed this approach. The actuarial present value computed on the new measurement date should be reported in the Pension Benefits Table.
• If the actuarial present value of the accumulated pension benefit for an NEO on the pension measurement date of the prior fiscal year was $1,000,000, and the present value of the accumulated pension benefit on the pension measurement date of the most recently completed fiscal year is $1,000,000, but during the most recently completed fiscal year the NEO earned and received an in-service distribution of $200,000, then $200,000 should be reported as the increase in pension value in the Change in Pension Value and Nonqualified Deferred Compensation Earnings column of the SCT.
• A company need not report earnings on compensation that is deferred on a basis that is not tax qualified as above-market or preferential earnings within the meaning of Item 402(c)(2)(viii)(B) (Change in Pension Value and Nonqualified Deferred Compensation Earnings column) where the return on these earnings is calculated in the same manner and at the same rate as earnings on externally managed investments to employees participating in a tax-qualified plan providing for broad-based employee participation. See n. 43 to Release No. 34-31327 (Oct. 16, 1992); American Society of Corporate Secretaries (January 6, 1993). For example, many issuers provide for deferral of salary or bonus amounts not covered by tax-qualified plans where the return on these amounts is the same as the return paid on amounts invested in an externally managed investment fund, such as an equity mutual fund, available to all employees participating in a non-discriminatory, tax-qualified plan (e.g., 401(k) plan). Although this position generally will be available for so-called "excess benefit plans" (as defined for 16(b)-3(b)(2) purposes), it may not be appropriately applied in the case of a pure "top-hat" plan or SERP (Supplemental Employee Retirement Plan) that bears no relationship to a tax-qualified plan of the issuer. When in doubt, consult the staff. For a deferred compensation plan with a cash-based, interest-only return, earnings would not be reportable as "above-market" unless the rate of interest exceeded 120% of the applicable federal long-term rate, as stated in Instruction 2 to Item 402(c)(2)(viii). Non-qualified deferred compensation plan earnings that are "above-market or preferential" are reportable even if the deferred compensation plan is unfunded and thus subject to risk of loss of principal.
• Item 402(c)(2)(ix)(A) (All Other Compensation column) and Instruction 4 to that item require a company to report as "All Other Compensation" perquisites and personal benefits if the total amount exceeds $10,000 and to identify each such item by type, regardless of the amount. So long as the $10,000 threshold is exceeded, all perquisites and other personal benefits must be separately identified by type, even if they have no aggregate incremental cost. If the NEO has actually fully reimbursed the company for the total cost of an item, it should not be considered a perquisite or other personal benefit and therefore need not be separately identified by type.
• Item 402(c)(2)(ix)(C) (All Other Compensation column) indicates that stock purchased at a discount must be disclosed as "All Other Compensation" unless that discount is available generally to all security holders or to all salaried employees. The compensation cost to be reported, if any, is computed in accordance with FAS 123R. Typically, 423 plans do not need to be disclosed under this column because they are broad based and generally non-discriminatory and are therefore within the exception, even if they require minimum work hours for eligibility or even if the discount is larger than the 5% example in the footnote in the release. (The footnote just explains that, even if there is a discount, there may not be compensation cost under FAS 123R.)
• Item 402(c)(2)(ix)(G) (All Other Compensation column) requires disclosure of the dollar value of any dividends when those amounts were not factored into the grant date fair value required to be reported in the Grants of Plan-Based Awards Table. If disclosure was not previously provided in the Grants of Plan-Based Awards Table for that NEO, the company should analyze whether the dividends, dividend equivalents or other earnings would have been factored into the grant date fair value in accordance with FAS 123R. In this regard, the disclosure would turn on how the rights to the dividends are structured and whether or not the structure brings them within the scope of FAS 123R for the purpose of the grant date fair value calculation.
• A company's reimbursement to an officer of legal expenses with respect to a lawsuit in which the officer was named as a defendant, in his or her capacity as an officer, is not disclosable under Item 402.
• Deferred compensation payouts, lump sum distributions under Section 401(k) plans and earnings on 401(k) plans are not required to be disclosed in the SCT. Rather, non-qualified deferred compensation payouts are disclosed in the Aggregate Withdrawals/ Distributions column of the Nonqualified Deferred Compensation Table. Lump sum distributions from 401(k) plans have already been disclosed in the SCT as compensation that was deferred into the 401(k) plan in prior periods. The requirement to disclose above-market or preferential earnings applies only to non-qualified deferred compensation.

• Equity incentive plan awards that are denominated in dollars but payable in stock should be disclosed by including the dollar value and a footnote to explain that the awards will be paid in that number of shares equal to the applicable dollar amounts at the time of the payout. Although the equity-based awards (columns (f), (g) and (h)) refer only to numbers and not dollars, in this limited circumstance, and only if all the awards in this column are structured in this manner, the SEC will permit companies to change the captions for columns (f) through (g) to show "($)" instead of "(#)."
• Similarly, if all of the non-equity incentive plan awards were granted under annual plans and, therefore, the awards have already been earned at the end of the year, the company may change the heading over columns (c), (d) and (e) of the Grants of Plan-Based Awards Table from "Estimated future payouts under non-equity incentive plan awards" to "Estimated possible payouts under non-equity incentive plan awards," so long as the earned amounts are also disclosed in the SCT for that year.
• If plans do not include thresholds or maximums (or equivalent items), the company need not include arbitrary sample threshold and maximum amounts. For example, for a non-equity incentive plan that does not specify threshold or maximum payout amounts (e.g., a plan in which each unit entitles the executive to $1.00 of payment for each $.01 increase in EPS during the performance period), threshold and maximum levels need not be shown as "0" and "N/A" because the payouts theoretically may range from nothing to infinity. Rather, an appropriate footnote should state that there are no thresholds or maximums (or equivalent items).

• In-kind earnings on restricted stock awards, such as earned share dividends or share dividend equivalents, should be included in the table. However, in-kind earnings that vested during the fiscal year or in-kind earnings that are already vested when the dividends are declared should instead be reported in the Option Exercises and Stock Vested Table.

• When reporting on the exercise or settlement of an SAR or a cashless exercise of options in the Number of Shares Acquired on Exercise column, companies should report the gross number of shares underlying the exercised SAR or option, not the net number of shares received upon exercise. Consider adding a footnote or narrative to explain and quantify the net number of shares received.

• Instruction 2 to Item 402(h)(2) indicates that, when computing the actuarial present value of an NEO's accumulated benefit under each pension plan, the company must use the same assumptions as those used for financial reporting purposes under GAAP, except for the retirement age assumption. The company may not deviate from the assumptions used for accounting purposes regardless of the individual circumstances of the NEO or the plan.
• Instruction 2 to Item 402(h)(2) specifies that, in calculating the actuarial present value of accumulated pension benefits, the assumed retirement age is to be the normal retirement age as defined in the plan or, if not defined, the earliest time at which the NEO may retire without any benefit reduction. If the plan has a specifically defined retirement age, but also allows participants to retire at an earlier age without any benefit reduction, the younger age should be used for determining pension benefits. The older age may be included as an additional column.
• If a pension plan provides that a particular benefit is earned at a specified age (e.g., an award granted to an NEO is earned only if he or she stays with the company until age 60, and retirement age is 65), the company should compute the actuarial present value of the accumulated benefit before the NEO has achieved the target age based on the accumulated benefit as of the pension measurement date, assuming that the NEO continues to live and will work at the company until retirement and thus will reach age 60 and receive the award.
• Assumptions regarding pre-retirement "decrements" (i.e., decreases--I looked it up for you) should not be factored into the calculation of the actuarial present value accumulated benefit. For purposes of calculating the actuarial present value, companies should assume that each NEO will live to and retire at the plan's normal retirement age (or the earlier retirement age if the NEO may retire early with unreduced benefits) and should ignore pre-retirement decrements. Accordingly, the assumptions that should be used for calculating the actuarial present value are the discount rate, the lump sum interest rate (if applicable), post-retirement mortality and payment distribution assumptions. Any contingent benefits arising upon death, early retirement or other termination of employment events should be disclosed in the post-employment narrative.

• The instruction to Item 402(i)(2) requires footnote disclosure quantifying the extent to which amounts reported in the table were reported in the SCT in the last completed fiscal year and in previous fiscal years. If amounts were not "previously reported" (e.g., because of transition guidance or because the NEO appears in the table for the first time), amounts do not need to be disclosed in the footnote; amounts need to be disclosed in the footnote only if they were actually previously reported in the SCT.

• Disclosure of director compensation is still required for a person who served as a director for only part of the last completed fiscal year, even if the person was no longer a director at the end of the last completed fiscal year or if the director will not stand for re-election the next year.
• Consulting arrangements between the company and a director are disclosable as director compensation under Item 402(k)(2)(vii), even where the arrangements cover services provided by the director to the company other than as director (e.g., as an economist).
• Where an executive officer is also a director but is not an NEO and does not receive any additional compensation for services as a director, the compensation that the director receives for services as an executive officer does not need to be reported in the DCT. The director may be omitted from the table, provided that footnote or narrative disclosure explains that the director is an executive officer, but not an NEO, and does not receive any additional compensation for services provided as a director.

• Whether a spin-off is treated like the IPO of a new "spun-off" registrant for purposes of Item 402 disclosure depends upon the particular facts and circumstances. When determining whether disclosure of compensation before the spin-off is necessary, the "spun-off" registrant should consider whether it was a reporting company or a separate division before the spin-off, as well as its continuity of management. For example, if a parent company spun off a subsidiary that conducted one line of the parent company's business, and before and after the spin-off the executive officers of the subsidiary: (1) were the same; (2) provided the same type of services to the subsidiary; and (3) provided no services to the parent, historical compensation disclosure likely would be required. In contrast, if a parent company spun off a newly formed subsidiary consisting of portions of several different parts of the parent's business and having new management, it is more likely that the spin-off could be treated as the IPO of a new "spun-off" registrant.
• In the context of a merger, there is no concept of "successor" compensation. Therefore, the surviving company in the merger need not report compensation paid by predecessor corporations that disappeared in the merger. Similarly, a parent corporation would not pick up compensation paid to an employee of its subsidiary prior to the time the subsidiary became a subsidiary (i.e., when it was still a target). Moreover, amounts paid by these predecessor companies need not be counted in computing whether an individual is an NEO of the surviving corporation. A different result may apply, however, in situations involving an amalgamation or combination of companies.
• A subsidiary of a public company is going public. The officers of the subsidiary previously were officers of the parent and, in some cases. all of the work that they did for the parent related to the subsidiary. The registration statement of the subsidiary would not be required to include compensation previously awarded by the parent corporation. The subsidiary would start reporting as of the IPO date.
• Options or other rights to purchase securities of the parent or a subsidiary of the registrant should be reported in the same manner as compensatory options to purchase registrant securities.
• A parent and its subsidiary are both Exchange Act reporting companies. Some of the executive officers of the parent may receive a portion of their compensation from the subsidiary corporation. If an executive spends 100% (or near 100%) of his or her time working for the subsidiary but is paid by the parent, then the compensation paid by the parent must be reported in the SCT of the subsidiary. However, if the executive officer splits time between the parent and the subsidiary requiring an allocation of the amounts paid by the parent, the payments made by the parent need not be included in the subsidiary's SCT. In addition, in the event that the subsidiary pays a management fee to the parent for use of the executives, disclosure of the structure of the management agreement and fees would have to be reported under Item 404, Related-Person Transactions. Compensation paid by the subsidiary to executives of the parent company must be included in the parent's SCT if the payments are paid directly by the subsidiary. If the payments are part of a management contract, disclosure of the structure of the management agreement and fees would have to be reported under Item 404.

• Instruction 1 to Item 402(a)(3) states that compensation disclosure for highly compensated executive officers is not required for an executive officer (other than the PEO or PFO) whose total compensation for the last fiscal year, reduced by the amount required to be disclosed in the Changes in Pension Value and Non-Qualified Deferred Compensation Earnings column (Item 402(c)(2)(viii)), did not exceed $100,000. A reporting company that recently changed its fiscal year end from December 31 to June 30 is preparing its transition report for the six-month period ended June 30, having filed its Form 10-K for the fiscal year ended six months earlier on December 31. The reporting company generally has a group of executive officers who earn in excess of $100,000 each year. In addition, during the six-month period, the company made an acquisition that resulted in new executive officers who, on an annual basis, will earn more than $100,000. During the six-month period, however, none of these existing or new officers earned more than $100,000 in total compensation. In the report for the six-month period, no disclosure need be provided with respect to executive officers that started employment with the company during the six-month period and did not, during that period of employment, earn more than $100,000. With respect to executive officers who were employed by the company both during and before the six-month period, however, Item 402 disclosure must be provided for those who earned in excess of $100,000 during the one-year period ending June 30 (the same ending date as the six-month period, but extending back six months into the preceding fiscal year).
• If a company changes its fiscal year, compensation must be reported for the "stub period," without annualizing or restating compensation. In addition, compensation must be reported for the last three full fiscal years, in accordance with Item 402. For example, in late 1997, a company changed its fiscal year end from June 30 to December 31. In the SCT, disclosure should be provided for each of the following four periods: July 1, 1997 to December 31, 1997; July 1, 1996 to June 30, 1997; July 1, 1995 to June 30, 1996 and July 1, 1994 to June 30, 1995. Disclosure for four periods (three full fiscal years and the stub period) should continue to be provided until there is disclosure for three full fiscal years after the stub period (December 31, 2000 in the example). If the company were to go public in February 1998, it would furnish disclosure for both of the following periods in the SCT: July 1, 1997 to December 31, 1997; and July 1, 1996 to June 30, 1997.

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