By Cydney Posner
The SEC has adopted new requirements for enhanced proxy disclosure related to compensation and corporate governance matters. The new rules are designed to respond to the recent focus by investors on corporate accountability and the need for additional information that would enhance investors' ability to make informed voting and investment decisions. Accordingly, the new rules will enhance disclosure related to the impact of compensation policies and practices on risk taking, options and stock awarded to executives and directors, director and nominee qualifications and legal proceedings, diversity policy in connection with board nominations, company leadership structure, the board's role in risk oversight and potential conflicts of interest of compensation consultants. The amendments will be applicable to proxy and information statements, annual reports and registration statements under the 1933 and 1934 Acts. The rule changes will also accelerate disclosure regarding shareholder meeting results by requiring that they be reported on Form 8-K. The new rules will be effective February 28, 2010 and thus will be applicable for the 2010 proxy season.
Enhanced Compensation Disclosure
Compensation Policies and Practices as They Relate to the Company's Risk Management
To help investors identify whether the company has established a system of incentives that can lead to excessive or inappropriate risk-taking by employees, the SEC has adopted in the final rules a requirement to discuss compensation policies and practices for all employees, including non-executive officers, if the compensation policies and practices create risks that are "reasonably likely to have a material adverse effect on the company." The new rule reflects a change from the proposal, which required the discussion if risks were created that "may have a material effect" on the company, largely because the SEC took to heart (speaking metaphorically of course) the comment that the proposed standard could have elicited volumes of speculation. In addition, under the modified new rule, companies that have policies and practices for different groups that mitigate or balance incentives could take these into account in evaluating whether any risks created are reasonably likely to have a material adverse effect on the company as a whole. The addition of "adverse" to the standard is intended to eliminate unnecessary discussion. In another change from the proposal, to avoid the confusion of expanding the CD&A beyond NEOs, the new disclosure requirements will not be a part of the CD&A. However, to the extent that risk considerations are a material aspect of the company's compensation policies or decisions for NEOs, the company is required to discuss them as part of its CD&A under the current rules.
Although the situations that would require disclosure will vary depending on the particular company and its compensation program, the SEC has provided a list of situations that the staff has identified as having the potential to trigger discussion, including the following comp policies and practices:
- At a business unit of the company that carries a significant portion of the company's risk profile
- At a business unit with compensation structured significantly differently than other units within the company
- At a business unit that is significantly more profitable than others within the company
- At a business unit where the compensation expense is a significant percentage of the unit's revenues
- That vary significantly from the overall risk and reward structure of the company, such as when bonuses are awarded upon accomplishment of a task, while the income and risk to the company from the task extend over a significantly longer period of time
However, the disclosure requirement is principles-based, and this list is non-exclusive: there may be other features of a company's compensation policies and practices that have the potential to incentivize its employees to create risks that are reasonably likely to have a material adverse effect on the company (i.e., while the SEC's list may reflect a failure of imagination, the company's better not.) Note that disclosure is required only if the compensation policies and practices create risks that are reasonably likely to have a material adverse effect on the company. Even in the situations identified above, a company may still conclude that its compensation policies and practices are not reasonably likely to have that effect. Smaller reporting companies will not be required to provide the new disclosure.
The following are examples of the issues that companies may need to address once it is determined that disclosure (no boilerplate please) is required:
- "The general design philosophy of the company's compensation policies and practices for employees whose behavior would be most affected by the incentives established by the policies and practices, as such policies and practices relate to or affect risk taking by those employees on behalf of the company, and the manner of their implementation
- The company's risk assessment or incentive considerations, if any, in structuring its compensation policies and practices or in awarding and paying compensation
- How the company's compensation policies and practices relate to the realization of risks resulting from the actions of employees in both the short term and the long term, such as through policies requiring claw backs or imposing holding periods
- The company's policies regarding adjustments to its compensation policies and practices to address changes in its risk profile
- Material adjustments the company has made to its compensation policies and practices as a result of changes in its risk profile
- The extent to which the company monitors its compensation policies and practices to determine whether its risk management objectives are being met with respect to incentivizing its employees."
Revisions to the Summary Compensation Table
Hold on if you're already dizzy from the SEC's continuing zigzag on this issue. The SEC now believes that disclosure of the aggregate grant date fair value of stock and option awards better reflects compensation committee decisions and is more informative to investors than previously mandated disclosure of the dollar amount recognized for financial statement reporting purposes for the fiscal year. As a result, he SEC has again reversed its position to return to the original amended rules and require disclosure of the aggregate grant date fair value of awards, computed in accordance with FASB ASC Topic 718, with a special instruction for awards subject to performance conditions. Under the new rules, the value of performance awards reported in the Summary Compensation Table, Grants of Plan-Based Awards Table and Director Compensation Table should be computed based upon the probable outcome of the performance condition as of the grant date, not the maximum potential outcome. This amount will be consistent with the grant date estimate of compensation cost to be recognized over the service period, excluding the effect of forfeitures. The SEC believes that this value better reflects how compensation committees take performance-contingent vesting conditions into account in granting these awards, that is, that the awards are designed to incentivize attainment of target performance and set a higher maximum performance level as a "cap" on attainable compensation. Disclosure of the maximum value, assuming the highest level of performance conditions is probable, will, however, be required in footnotes to the SCT and DCT. Note also that the Release makes clear that disclosure is required for awards granted during the year, not for awards granted at any time for services performed during the year. However, companies are advised to analyze in CD&A their decisions to grant post-fiscal year end equity awards where those decisions could affect a fair understanding of NEO compensation for the last fiscal year and to consider including supplemental tabular disclosure where it facilitates understanding of the CD&A.
The SEC decided not to adopt the proposed revision to Instruction 2 to the salary and bonus column of the SCT which would have allowed companies to report non-cash awards received in lieu of salary or bonus in the column applicable to the form of award elected. The SEC agreed with commenters that disclosing the amounts of salary and bonus that the compensation committee awarded will better enable investors to understand the relative weights the company applied to annual incentives and salary. Accordingly, companies will still be required to report the forgone amounts in the salary or bonus column, with footnote disclosure of the election to receive non-cash compensation and a cross-reference to the Grants of Plan-Based Awards Table where the stock, option or non-equity incentive plan award elected by the NEO is reported. The SEC also decided not rescind, as proposed, the requirement to report the full grant date fair value of each equity award in the Grants of Plan-Based Awards Table and the DCT because commenters continue to consider the information useful.
For transition and comparability purposes, companies providing Item 402 disclosure for fiscal years ending on or after December 20, 2009 will be required to show recomputed disclosure for each preceding fiscal year required to be included in the SCT, so that the stock awards and option awards columns present the applicable full grant date fair values, as described above, and the total compensation column is correspondingly recomputed. If a person who would be an NEO for the most recent fiscal year (2009) also was disclosed as an NEO for 2007, but not for 2008, the NEO's compensation for each of those three fiscal years must be reported. However, there is no requirement to include different NEOs for any preceding fiscal year based upon recomputed total compensation or to amend prior years' Item 402 disclosure in previous filings.
Enhanced Director and Nominee Disclosure
Many commenters expressed concern that disclosure of the qualifications of individual directors and nominees on a person-by-person basis would not be meaningful since boards are assembled from a diverse group so that the board, as a body, possesses the appropriate skills and experience. Nevertheless, the SEC decided to adopt the rules requiring enhanced disclosure regarding directors because it would enable investors to determine whether any director or nominee is an appropriate choice for a particular company. The final rules require companies to disclose annually, for each director and nominee, "the particular experience, qualifications, attributes or skills that led the board to conclude that the person should serve as a director for the company" as of the time of the filing. However, the final rules do not include the proposed requirement for similar disclosure of qualifications to serve as a committee member because the SEC was persuaded by commenters that many companies rotate directors among different committee positions. If an individual were chosen to be a director or a nominee because of a particular qualification, attribute or experience related to service on a specific committee, such as the audit committee, then disclosure would be required under the new rules as part of the individual's qualifications to serve on the board. Notwithstanding the adoption of these new rules, companies will still need to comply with the requirement, currently in Item 407(c)(2)(v) of Reg S-K, to disclose the specific minimum qualifications or skills applied by the nominating committee in making nominations. The new rules do not specify the particular information that should be disclosed, but seek to retain flexibility. As a result, the reference to "risk assessment skills" in the proposed amendments was not adopted. (However, if particular skills, such as risk assessment or financial reporting expertise, were part of the specific experience, qualifications, attributes or skills that led the board or proponent to conclude that the person should serve as a director, that should be disclosed.)
The final rules also expand Item 401 of Reg S-K to require disclosure of any directorships at public companies and registered investment companies held by each director and nominee at any time during the past five years. The current rules require disclosure of only current directorships. Disclosure will now be required even if the director or nominee no longer serves on that board.
The final rules will also extend the time period for required disclosure of legal proceedings involving directors, director nominees and executive officers from five to ten years. The amendments also expand the list of legal proceedings in Item 401(f) to include the following:
(7) Being subject of, or a party to, any Federal or State judicial or administrative order, judgment, decree, or finding, not subsequently reversed, suspended or vacated, relating to an alleged violation of:
- Any Federal or State securities or commodities law or regulation
- Any law or regulation respecting financial institutions or insurance companies including, but not limited to, a temporary or permanent injunction, order of disgorgement or restitution, civil money penalty or temporary or permanent cease-and-desist order, or removal or prohibition order
- Any law or regulation prohibiting mail or wire fraud or fraud in connection with any business entity
(8) Being subject of, or a party to, any sanction or order, not subsequently reversed, suspended or vacated, of any securities or commodities exchange or other self-regulatory organization or organization that has disciplinary authority over its members.
Paragraph (7) above would apparently apply to settlements, except that it would not apply to any settlement of a civil proceeding among private litigants. As is currently the case, no disclosure would be required if the legal proceedings were not material to an evaluation of the ability or integrity of the director or nominee.
The final rules also amend Item 407(c) of Reg S-K to require disclosure of whether, and if so, how, a nominating committee considers diversity in identifying nominees for director. If the nominating committee (or the board) has a diversity policy for identifying director nominees, companies will need to describe how this policy is implemented, as well as how the nominating committee (or the board) assesses the effectiveness of its policy. There is no definition in the new rules of "diversity." As a result, it may be defined by each company as broadly or narrowly as appropriate and could include differences of viewpoint, professional experience, education, skill and other individual qualities and attributes that contribute to board heterogeneity, as well as race, gender and national origin.
New Disclosure about Board Leadership Structure and the Board's Role in Risk Oversight
Under the new amendments to Item 407 of Reg S-K, companies will be required to disclose their board leadership structures and the reasons why they believe those structures are appropriate at the time of filing, including whether and why they have chosen to combine or separate the principal executive officer and board chair positions. In companies that have combined those roles and have designated a lead independent director to chair meetings of the independent directors, the amendments will require disclosure of whether and why the company has a lead independent director, as well as the specific role the lead independent director plays in the leadership of the company. The SEC believes that disclosure of a company's board leadership structure and the reasons the company believes that structure is appropriate will increase the transparency for investors about board functions. However, the amendments are not intended to influence a company's decision regarding its board leadership structure.
The new rules will also require disclosure about the board's role in oversight of the company's risk management process, including risks such as credit risk, liquidity risk and operational risk. The SEC believes that "disclosure about the board's involvement in the oversight of the risk management process should provide important information to investors about how a company perceives the role of its board and the relationship between the board and senior management in managing the material risks facing the company." Disclosure about the board's approach to risk oversight might address how the board administers its risk oversight function -- such as through the whole board, or through a separate risk committee or the audit committee -- whether the individuals who supervise the day-to-day risk management responsibilities report directly to the board as whole or to a committee (or how the board or committee otherwise receives information from these individuals), and whether and how the board, or board committee, monitors risk.
New Disclosure Regarding Compensation Consultants
Many compensation consultants, or their affiliates, provide a range of services, such as benefits administration, human resources consulting and actuarial services, in addition to services regarding executive and director compensation. Moreover, providing these additional services may be more lucrative for the consultant than providing executive and director compensation services. As a result, analogous to the provision of non-audit services by auditors, there may be significant conflicts of interest that may call into question the objectivity of the consultant's advice and recommendations on executive compensation. In that light, to provide some transparency, the SEC believes that disclosure regarding a consultant's additional fees and services is necessary.
The final rules amend Item 407 of Reg S-K to provide as follows:
- If the board (including throughout, the compensation committee or other persons performing the equivalent functions) has engaged its own consultant to advise on executive and director compensation and if that consultant or its affiliates provides other non-executive compensation consulting services to the company in an amount in excess of $120,000 during the company's fiscal year, the company must disclose the following:
- the aggregate fees paid for services provided to either the board or the company with regard to determining or recommending the amount or form of executive and director compensation
- the aggregate fees paid for any non-executive compensation consulting services provided by the compensation consultant or its affiliates
- whether the decision to engage the compensation consultant for the non-executive compensation consulting services was made or recommended by management
- whether the board approved these additional services.
- If the board has not engaged its own consultant, fee disclosures are required if there is a consultant (including its affiliates) providing executive compensation consulting services and non-executive compensation consulting services to the company, provided the fees for the non-executive compensation consulting services exceed $120,000 during the company's fiscal year. The SEC believes that, while the board may not be relying on the consultant used by management, the absence of a board compensation consultant to help filter any advice provided by management's consultant raises conflict concerns
- If the board has its own consultant (which does not provide any additional non-executive compensation consulting services), and management engages a different consultant to provide executive compensation consulting services and one or more additional non-executive compensation consulting services, no fee or related disclosure is required because there is less potential for conflict. This exception would be available without regard to whether management's consultant participates in board meetings
- Services involving only broad-based non-discriminatory plans (like 401(k) plans) or the provision of information, such as surveys that are not customized for the company or are customized based on parameters that are not developed by the consultant, are not treated as executive compensation consulting services for purposes of these disclosure rules. However, the exception would not be available if the consultant provided advice or recommendations in connection with the information provided in the survey
In a change from the proposal, to avoid competitive harm to consultants, the final rule does not require disclosure of the nature and extent of additional services provided by the compensation consultant. Of course, companies may provide this information in their discretion.
Reporting of Voting Results on Form 8-K
Currently, disclosure of the results of matters submitted to a vote of shareholders is required to be disclosed in either Form 10-Q or Form 10-K, depending on when the vote occurred, with the result that it may be months before voting results are made public. However, the matters submitted to votes often involve issues that directly impact shareholder interests. The new amendments eliminate the 10-Q/10-K requirement and instead add new Item 5.07 to Form 8-K, requiring companies to disclose the results of a shareholder vote within four business days after the end of the meeting at which the vote was held. An instruction provides that companies are required to file the preliminary voting results within four business days after the end of the shareholders' meeting and then file an amended report on Form 8-K within four business days after the final voting results are known. Of course, if definitive results were reported instead, there would be no requirement to file preliminary results. To avoid confusion or misleading shareholders, companies may include additional disclosure that helps to put preliminary voting disclosure in a proper context. Corresponding information would be required with respect to matters submitted for shareholder consent.
Proposals Not Adopted
The SEC had proposed several amendments regarding the proxy solicitation process, but decided to defer consideration of those proposed amendments until consideration of the proxy access proposal.