By Cydney Posner

The SEC has now posted the release proposing amendments to the rules regarding compensation and corporate governance disclosures.

The proposal is designed to enhance disclosure related to the impact of compensation policies on risk taking, options and stock awarded to executives and directors, director and nominee qualifications and related legal proceedings, company leadership structure, the board's role in the risk management process and potential conflicts of interest of compensation consultants. The proposal would also accelerate disclosure regarding shareholder meeting results by requiring that they be reported on Form 8-K. In addition, the release includes proposed amendments to the proxy rules to clarify issues that have arisen in connection with the proxy solicitation process. Once again, these proposals were driven by increasing focus by shareholders on corporate accountability and the desire for additional information that would enhance the ability of shareholders to make informed voting and investment decisions. The SEC believes that the recent turmoil in the markets during the past 18 months has reinforced the importance of enhancing transparency, especially with regard to activities that materially contribute to a company's risk profile. The enhanced disclosures would appear, as applicable, in proxy and information statements, annual reports on Form 10-K and registration statements under the Exchange Act and the Securities Act. The SEC anticipates that, if adopted, the amendments would be effective for the 2010 proxy season.

Enhanced Compensation Disclosure

CD&A. CD&A is designed to elicit disclosure about the material elements of the company's compensation for NEOs and is intended to put into perspective for investors the tabular compensation data. However, broader compensation policies applicable to other employees may also be important, especially where compensation policies are not sufficiently aligned with long-term company performance and overall best interests. These policies may instead creating inadvertent perverse incentives for management and employees to make decisions that inappropriately increase the company's risk to a significant degree, often without adequate provision for those risks. The proposal would expand CD&A requirements to discuss and analyze how the company's overall compensation policies and practices for employees, including non-executive officers, create incentives that can affect the company's risk and management of that risk, but only if risks arising from those compensation policies or practices may have a material effect on the company. The SEC expects that, in preparing this disclosure, companies will need to consider the level of risk that employees might be encouraged to take to meet their incentive compensation objectives. (The SEC observes in a footnote that, to the extent that such risk considerations are a material aspect of the company's compensation policies or decisions for NEOs, the company is already required under the current rules to discuss them as part of its CD&A.)

The SEC recognizes that it may be difficult to identify and describe which compensation structures may expose a company to material risks. Whether disclosure will be required will vary depending on the particular company and its compensation programs. The SEC has identified the following as a non-exclusive list of situations where compensation policies and practices could potentially trigger discussion and analysis because they may raise material risks:

  • 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 from other units within the company;
  • At business units that are significantly more profitable than others within the company;
  • At business units where the compensation expense is a significant percentage of the unit's revenues; or
  • 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.

The SEC believes that broader discussion may be merited because policies of these units relevant to all of its employees could be just as essential to the company's overall financial condition and performance as those of its senior executives, and the significance and appropriateness of these policies may be important for investors to assess.

Illustrative examples of the issues that companies may need to address include the following:

  • The general design philosophy of the company's compensation policies for employees whose behavior would be most affected by the incentives established by the policies, as such policies relate to or affect risk taking by those employees on behalf of the company, and the manner of its implementation;
  • The company's risk assessment or incentive considerations, if any, in structuring its compensation policies or in awarding and paying compensation;
  • How the company's compensation policies 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 to address changes in its risk profile;
  • Material adjustments the company has made to its compensation policies or practices as a result of changes in its risk profile; and
  • The extent to which the company monitors its compensation policies to determine whether its risk management objectives are being met with respect to incentivizing its employees.

Revisions to the Summary Compensation Table. The proposal would also amend Reg S-K Item 402 to revise in the Summary Comp Table and Director Comp Table the disclosure of stock and option awards to focus more on the amount awarded, rather than the amount earned. That is, the proposed amendment would require disclosure of the aggregate grant date fair value of awards computed in accordance with FAS 123R instead of the currently mandated disclosure of the dollar amount recognized for financial statement reporting purposes for the fiscal year in accordance with FAS 123R. This change would mark a return to the original 2006 revised proxy rules that were never actually implemented because of a sharp turn to the current formulation in the 2006 December surprise. Apparently, investors are puzzled by the information currently provided (especially when application of the rules results in reporting a negative number in one of the SCT columns) and would prefer to have information about grant date fair value because it reflects compensation decisions made during the fiscal year and is indicative of which executives the company intends to compensate most highly. The SEC also contends that the current rules may cause the list of NEOs to change more frequently from year to year due to factors unrelated to the company's compensation decisions, effectively excluding executives whom the company considers the most highly compensated based on its compensation decisions. If a company does not believe that full grant date fair value reflects an NEO's compensation, it can provide appropriate explanatory narrative disclosure. (Note that presentation of aggregate grant date fair value would include the incremental fair value of options repriced during the fiscal year.) With regard to transition, the SEC is considering whether to require recomputed disclosure for each preceding fiscal year required to be included in the SCT. In that regard, the SEC expects that, 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 would be reported pursuant to the proposed amendments, but the company would not be required to include different NEOs for any preceding fiscal year based on recomputing total compensation for those years to amend prior filings.

In addition, the proposed amendments would:

  • Rescind the requirement to report the full grant date fair value of each individual equity award in the Grants of Plan-Based Awards Table and corresponding footnote disclosure to the DCT; and
  • Amend Instruction 2 to the salary and bonus columns of the SCT to provide that registrants will not be required to report in those columns the amount of salary or bonus forgone at an NEO's election, and that non-cash awards received instead are reportable in the column applicable to the form of award elected, with the result that the SCT disclosure would reflect the form of compensation ultimately received by the NEO.

Enhanced Director and Nominee Disclosure

The SEC is also proposing amendments to Item 401 of Reg S-K to expand the disclosure requirements regarding the qualifications of directors and nominees, past directorships held by directors and nominees and the time frame for disclosure of legal proceedings involving directors, nominees and executive officers.

Under the proposal, for each director or nominee (including nominees put forward by other proponents), disclosure would be included detailing the particular experience, qualifications, attributes or skills that qualify that person to serve as a director of the company as of the time of the filing, and as a member of any committee that the person serves on or is chosen to serve on (if known), in light of the company's business and structure. Currently, the rules require only brief biographical information about directors and nominees for the past five years, along with general disclosure about the company's qualification requirements for directors. The types of information that may be disclosed include, for example, information about the individual's risk assessment skills and any specific past experience that would be useful to the company, as well as information about his or her particular area of expertise and why his or her service as a director would benefit the company. The proposal is designed to help investors in their voting decisions, especially in light of today's increasing financial and operational challenges and the need to effectively assess risk.

The SEC is also proposing to require disclosure of any directorships held by each director and nominee at any time during the past five years at public companies (now, only current directorships must be disclosed) and to extend from five years to 10 years the time during which disclosure of "bad boy" legal proceedings is required. This new disclosure is intended to allow investors to better evaluate the relevance of a director's or nominee's past board memberships or professional or financial relationships that might pose potential conflicts of interest (such as membership on boards of major suppliers, customers or competitors) and to give investors more extensive information regarding an individual's competence and character. The release also requests comment on whether investors and other market participants believe that diversity in the boardroom is a significant issue and whether the types of "bad boy" disclosure should be expanded.

New Disclosure about Company Leadership Structure and the Board's Role in the Risk Management Process

The SEC is also proposing to amend Item 407 of Reg S-K to add a requirement to disclose the company's leadership structure and the reasons why the company believes it is the best structure for the company, including whether and why they have chosen to combine or separate the principal executive officer and board chair positions and 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 acknowledges that different leadership structures may be suitable for different companies and cautions that the proposed amendments are not intended to influence a company's decision regarding its board leadership structure. The disclosure is intended to increase transparency regarding the company's corporate governance practices and leadership structures.

In addition, the proposal would require enhanced disclosure about the board's role in the company's risk management process, including credit risk, liquidity risk and operational risk. The disclosure should provide 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. Information regarding the adequacy of risk oversight has become particularly important in light of the recent market crisis. The disclosure could address, for example, how the risk management function is implemented, whether through the board as a whole or through a committee, the relevant reporting relationships and how the board, or board committee, monitors risk. The disclosure is intended to provide insights into "how a company's board perceives and manages a company's risks."

New Disclosure Regarding Compensation Consultants

In addition to recommending executive compensation plans or policies, compensation consultants, or their affiliates, often provide a broad range of other services, such as benefits administration, human resources consulting and actuarial services, many of which generate higher fees than those earned for executive compensation services. Some investors have expressed concerns that the provision of these additional services may create the risk of a conflict of interest that may call into question the objectivity of the consultants' executive pay recommendations. The SEC's proposal would amend Item 407 of Reg S-K to require disclosure about the fees paid to compensation consultants and their affiliates when they play any role in determining or recommending the amount or form of executive and director compensation, if they also provide other services to the company. The disclosure would include the following:

  • The nature and extent of all additional services provided to the company or its affiliates during the last fiscal year by the compensation consultant and any affiliates of the consultant;
  • The aggregate fees paid for all additional services and the aggregate fees paid for work related to determining or recommending the amount or form of executive and director compensation;
  • Whether the decision to engage the compensation consultant or its affiliates for non-executive compensation services was made, recommended, subject to screening or reviewed by management; and
  • Whether the board of directors or the compensation committee has approved all of these services in addition to executive compensation services.

The proposed amendments would not apply where the compensation consultant's only role in recommending executive or director compensation is in connection with consulting on broad-based plans that do not discriminate in favor of executive officers or directors of the company, such as 401(k) plans or health insurance plans, even though executives or directors may be eligible to participate in them, since the SEC does not view these types of services as giving rise to the type of potential conflict of interest intended to be addressed by the proposal. On the other hand, if a consultant provides other services involving executive or director compensation and also provides services regarding broad-based, non-discriminatory plans, the new disclosure requirements would be applicable to all services provided by the consultant or its affiliates.

Reporting of Voting Results on Form 8-K

To ensure more timely reporting of voting results, the SEC is proposing to transfer the requirement to disclose voting results from Forms 10-Q and 10-K to Form 8-K, due within four business days after the end of the meeting at which the vote was held. The SEC is concerned that the delay between the end of an annual or special meeting and the time when the voting result of the meeting is disclosed in a Form 10-Q or 10-K may make the information, which may directly affect shareholder interests, less useful to investors and the markets. The SEC believes that "if a matter is important enough to submit to a vote at a meeting of shareholders, it likely is important enough to warrant current reporting of the results on Form 8-K." Although technological advances in shareholder communications and the growing use of third-party proxy services have increased the ability of companies to tabulate vote results and disseminate this information on a more expedited basis, if final results of a contested election are not available within the required timeframe, companies would need to disclose on Form 8-K the preliminary voting results within four business days after the preliminary voting results are determined and file an amended report on Form 8-K within four business days after the final voting results are certified. The release requests comment on whether failure to timely provide the proposed new 8-K item should affect S-3 eligibility or 10b-5 liability.

Proxy Solicitation Process

The SEC is also proposing revisions to the proxy solicitation rules to provide clarity and address issues that have arisen.

Exchange Act Rule 14a-2(b)(1) Introductory Text. Exchange Act Rule 14a-2(b)(1) exempts from most of the requirements of the proxy rules those solicitations by shareholders or other non-management parties who are not seeking proxy authority (for example, in a "just vote no" campaign) and do not have a substantial interest in the subject matter of the solicitation. The exemption is not available to a person who furnishes or otherwise requests a "form of revocation." The SEC believes that a person would not be seeking authority for itself if the person provides a solicited shareholder with an unmarked copy of management's proxy card that is requested to be returned directly to management. Accordingly, the SEC proposes to amend the rule to clarify that a "form of revocation" does not include an unmarked copy of management's proxy card that the soliciting shareholder requests be returned directly to management, even if a solicited shareholder's use of that proxy card resulted in a revocation of the shareholder's prior vote. The amendment would allow persons not seeking proxy authority to provide shareholders a convenient opportunity to vote without having to request another proxy card from management.

Exchange Act Rule 14a-2(b)(1)(ix). Exchange Act Rule 14a-2(b)(1)(ix) provides that the Rule 14a-2(b)(1) exemption is not available to any person with a "substantial interest" in the subject matter of the solicitation who is likely to receive a non-pro rata benefit from a successful solicitation. A question has arisen as to whether a "substantial interest" exists only where a person is a security holder. The SEC's position is that the "substantial interest" contemplated by the rule is broader, and that shareholders should have the benefit of required disclosure when deciding how to vote, whether or not the soliciting party is a shareholder. To clarify that the exemption is limited to disinterested persons, the SEC proposes to amend the rule to clarify that, for a person to be disqualified from relying on the exemption, a person need not be a security holder and that a benefit need not be related to or derived from any security holdings in the class being solicited.

Exchange Act Rule 14a-4(d)(4). Exchange Act Rule 14a-4(d)(4) is an exception to the requirement that authority to vote for the election of a person can be solicited only if the person is a bona fide nominee who consents to being named in the soliciting person's proxy statement and to serving if elected. The exception permits a person soliciting for a "short," or minority, slate, to round out its short slate of nominees up to the total number of director positions open for election by seeking authority to vote for nominees named in the company's proxy statement. To eliminate unnecessary impediments to short slate elections, the SEC is proposing to revise the rule to allow the short slate rounding exception to apply, not just the company's nominees, but also to nominees named in any other persons' proxy statements. The proposed exception would not be available when non-management parties act together so as to incur reporting obligations under Sections 13(d) and 13(g) of the Exchange Act. If a non-management person "actively recommends" another set of nominees or does not act independently of another non-management person, the person could be deemed to be soliciting in support of more than a minority of the board. As a result, the soliciting person that seeks to round out its short slate with any nominee named in another non-management person's proxy statement would be required to represent that it has not formed a "group" under Section 13(d)(3).

Exchange Act Rule 14a-4(e). Exchange Act Rule 14a-4(e) requires that a proxy statement or form of proxy provide that the shares represented by the proxy be voted "subject to reasonable specified conditions." The SEC believes that, to enable the shareholder to make an informed decision with respect to granting proxy authority and to confirm that any later withholding of shares from voting is consistent with the authority granted, "reasonable specified conditions" should be limited to conditions that are objectively determinable. A condition would be objectively determinable, for example, if voting the shares were subject to a third party's filing, within a specified time before the scheduled date for the meeting, a Schedule TO for a tender offer for over half of the issuer's shares. If the conditions were not objectively determinable, the proxyholder could exercise a degree of discretion that would be inconsistent with Rule 14a-4(c)'s limits on when a proxy can confer discretionary authority. Accordingly, the proposal would amend Rule 14a-4(e) to clarify that the reasonable specified conditions must be objectively determinable.

Exchange Act Rule 14a-12(a)(1)(i). Exchange Act Rule 14a-12 permits a solicitation to be made before furnishing a proxy statement if, among other requirements, each written communication that is part of the solicitation contains specified participant information, including the identity of the participants in the solicitation and a description of their direct or indirect interests or a legend advising security holders where they can obtain that information. For the legend to be useful, the information referenced in the legend must be available when the soliciting person uses the soliciting material with the legend. Accordingly, the SEC proposes to amend the rule to clarify that the required participant information must be filed no later than the time the first soliciting communication is made.

Other Improvements?

The SEC is also brimming with all kinds of other ideas to improve proxy disclosures and requests comment on a number of other concepts not proposed, including whether to:

  • Expand compensation disclosure to all executives, not just the NEOs;
  • Eliminate the instruction that allows performance targets to be excluded based on the potential anti-competitive effect or, alternatively, require disclosure of performance targets after the fact;
  • Treat the CD&A as part of the Comp Committee Report and whether to then treat the Report as furnished or filed;
  • Require disclosure regarding whether a member of the compensation committee has expertise in compensation matters and whether the committee has the resources to hire its own independent legal counsel;
  • Require additional disclosure about whether or not a company has "hold to retirement" or claw back provisions;
  • Require disclosure of whether the amounts of executive compensation reflect any considerations of internal pay equity, such as the ratio of the total compensation of the NEOs, or total compensation of each NEO, to the total compensation of the average non-executive employee of the company;
  • Require disclosure regarding the total number of compensation plans a company has and the total number of variables in all of its compensation plans (a complexity issue); and
  • Supplement the required disclosure of tax gross-up arrangements for the NEOs to include a requirement to disclose and quantify the savings to each executive.

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