United States: The SEC’s Compensation Disclosure Reforms: Principles-Based Disclosure Arrives For Executive Compensation

On July 26, 2006, in response to calls for extensive reform, the Securities and Exchange Commission (SEC) voted to adopt comprehensive changes to the rules last overhauled in 1992 requiring disclosure of compensation for executive officers and directors of public companies. In addition to revising and adding information to the disclosure tables that are required under Item 402 of Regulation S-K, the SEC is now emphasizing that companies must adopt a "principles-based" approach to compensation disclosure. In essence, this means that even if disclosure of a particular element of compensation is not called for by a particular rule, companies are expected to provide disclosure if such disclosure would be relevant or material to an understanding of the compensation of their executive officers or directors. The SEC’s intent is that companies disclose and explain, in plain English, a clearer and more complete picture of the compensation earned by their principal executive officers, principal financial officers, highest paid executive officers and directors. The new rules also address changes to Form 8-K, beneficial ownership disclosure, related party transactions and corporate governance matters.

The changes take effect for all proxy and information statements filed on or after December 15, 2006 that are required to include compensation disclosures for fiscal years ending on or after December 15, 2006, and for all Annual Reports on Form 10-K and Form 10-KSB for fiscal years ending on or after December 15, 2006. The new disclosures must also be included in all registration statements, and all pre-effective and post-effective amendments to registration statements, filed on or after December 15, 2006 that are required to include compensation information for fiscal years ending on or after December 15, 2006. In addition, the SEC adopted certain changes to the Form 8-K reporting requirements with respect to the disclosure of executive compensation arrangements, and those changes took effect on November 7, 2006.¹

Set forth below is a summary of the most significant changes adopted by the SEC.²

The new rules require most companies to provide a Compensation Discussion and Analysis (CD&A) section, discussing a company’s philosophy on executive compensation.³ The SEC views the CD&A as the centerpiece of its new rules. Analogous to the Management’s Discussion and Analysis of financial disclosure, or MD&A, the CD&A is intended to provide a discussion and analysis of the factors considered by a company’s directors when making compensation determinations for the company’s named executive officers (NEOs). John White, Director of the SEC’s Division of Corporation Finance, said in a recent speech that "CD&A is what gives context to the required tables and the numbers in them…. As [SEC] Chairman [Christopher] Cox explained at the Open Meeting at which the Commission adopted the new disclosure rules, CD&A ‘will give companies an opportunity to explain their compensation policies, and to share with investors how they arrived at the particular levels and forms of compensation for their highest paid executives.’"⁴ The CD&A must discuss the six explicit items set forth below, and must also discuss and analyze other information which the directors considered in determining the amounts and types of compensation paid to NEOs during the most recently completed fiscal year.

• What are the objectives of the company’s compensation programs?
• What is the compensation program designed to reward?
• What is each element of compensation?
• Why does the company choose to pay each element?
• How does the company determine the amount (and, where applicable, the formula) for each element?
• How do each element and the company’s decisions regarding that element fit into the company’s overall compensation objectives and affect decisions regarding other elements?

Above all, the CD&A must not consist of boilerplate and it should not be a mere recitation of the process by which the directors determined compensation. The key is to analyze, in plain English, the elements of the company’s executive compensation packages, explaining why decisions were made, by whom, and the interplay between the different elements of compensation and company and individual results. Director White notes that just as with MD&A, the analysis in the CD&A should "tell a compelling story…make that story relevant, qualitative and contextual, and avoid mere quantitative disclosure that just repeats the data" set forth in the compensation tables. The CD&A must also discuss the methods used to select terms of equity awards, including the timing of awards and the policies regarding the determination of the exercise price of options, and how post-employment compensation arrangements, such as termination and change-in-control payments, were determined as they apply to current compensation arrangements.

Unlike the former Compensation Committee Report, the CD&A is considered a company disclosure, rather than a report of a committee of the board of directors. It will be considered "filed" and not "furnished" under the securities laws. This means both that a company will be liable for any material misstatements contained in the CD&A and that a company’s principal executive and principal financial officers are required to certify the information contained in the CD&A as part of their Sarbanes-Oxley Act certifications filed as exhibits to the Form 10-K. For companies planning to incorporate into the Form 10-K their compensation disclosures from their proxy statements, as is common, the CD&A disclosure should be completed or near completion prior to the filing of the Form 10-K.

In addition to the CD&A, the compensation committee or other board committee performing equivalent functions will have to furnish a report, similar to the Audit Committee Report that is currently required in proxy statements, as to whether it has reviewed and discussed the CD&A with management, and based on this review and discussion whether the compensation committee recommended to the Board of Directors that the CD&A be included in the company’s Form 10-K and proxy statement. Unlike the Audit Committee Report, however, this Compensation Committee Report will be furnished in the proxy statement and not filed or incorporated by reference into any filing other than the Form 10-K and will not be covered by the company’s officer certifications. This Compensation Committee Report may, however, be relied upon by the company’s officers when providing their certifications.

The rules add a new column to the Summary Compensation Table for the amount of "total compensation" paid to each NEO during the last completed fiscal year. This new concept is intended to capture a total dollar value of salary, bonus, equity grants, cash incentive awards, increases in actuarial value of defined benefit plans, above market earnings on non-qualified defined contribution plans, and all perquisites exceeding $10,000 in the aggregate. Grants of equity issued during the year will now be reflected in the Summary Compensation Table at the grant date fair value computed in accordance with Statement of Financial Accounting Standards 123R ("Share-Based Payment"), rather than as a number of shares or options.

The SEC has emphasized repeatedly, in the adopting release for the new rules and in speeches and conferences discussing the rules, that it wants companies to be guided by the principle of full, complete and comprehensible disclosure when describing executive compensation and responding to the new requirements. The SEC’s expectation and requirement is that all material elements of the compensation that is paid to executive officers and directors must be disclosed, unless specifically excluded from disclosure by the rules. It is insufficient to say, when analyzing whether a particular element of compensation must be disclosed, that "the rules don’t require it"—if it is material to investors, it must be disclosed, regardless of whether a specific rule exists that requires its disclosure.

In addition, clarity and completeness of compensation-related disclosure is critically important to the SEC. When the SEC initially began the process of re-evaluating its required executive compensation disclosures, Alan Beller, former Director of the SEC’s Division of Corporation Finance, stated the SEC’s concern that "…too many issuers and their advisers have followed a pattern of opaque or unhelpful disclosure that confirms the worst suspicions of concerned investors, whether or not they are in fact true—there’s something to hide and it’s being hidden. Too much executive compensation disclosure has become an example of the kind of disclosure companies should disavow—disclosure that says as little as possible while seeking to avoid liability, rather than disclosure that seeks to inform."⁵

As a result, a theme that runs throughout the new rules and the SEC’s commentary on the rules is that of "telling the compensation story"—not merely presenting numbers and charts, but explaining rationales, presenting contexts, and exploring the relationships between one element of compensation and another, and the achievement of results as compared to the compensation paid for those results.

The new rules change the group of NEOs for whom all compensation information must be disclosed in the tables, as well as how those persons are determined.

Previously, the rules required disclosure for the principal executive officer (PEO) and anyone who served as the PEO during the last completed fiscal year (regardless of salary), the four other most highly compensated executive officers who were serving at the end of the last completed fiscal year and who made more than $100,000, determined by reference to only their salary and bonus payments, and up to two additional individuals who would have been in the prior category but who were not serving as executive officers at the end of the year.

Under the new rules, compensation information must be provided for the PEO and anyone who served as the PEO during the last completed fiscal year (regardless of salary), the principal financial officer (PFO) and anyone who served as the PFO during the last completed fiscal year (regardless of salary), the three other most highly compensated executive officers who were serving at the end of the last completed fiscal year and who made more than $100,000, and up to two additional individuals who would have been in the prior category but who were not serving as executive officers at the end of the year. In addition, the $100,000 amount will now be determined by reference to total compensation earned by an officer, reduced by any increases in the actuarial value of defined benefit plans and above market earnings on non-qualified defined contribution plans.

Companies now must include a separate table disclosing all compensation paid to their directors during the past fiscal year. The table, which is similar to the revised Summary Compensation Table required for NEOs, will include all compensation paid for services as a director, including retainer fees, committee and/or chairmanship fees, meeting fees, the aggregate fair value as of the grant date of all equity and equity-based awards, all perquisites and other personal benefits, unless the aggregate amount of such benefits does not exceed $10,000, changes in pension values, above market earnings on nonqualified deferred compensation and all other types of compensation. A narrative description of any material factors necessary to an understanding of the table must follow the table, including a description of the standard compensation arrangements for the directors, and whether any director has a compensation arrangement that differs from the standard arrangement.

In addition to the narrative disclosure that is required in the CD&A regarding the existence and impact of change in control, severance and termination provisions, companies are also required to include extensive disclosure on the payments that could be made to each of their NEOs in the event of various termination or change in control scenarios. This disclosure should be presented in a table to enhance readability, followed by a narrative explanation of any material facets of the arrangements. The table will present a range of possible payment and compensation scenarios for each of the NEOs in the event that their employment is terminated as a result of a change in control, retirement, a voluntary termination of employment, a termination for cause, a termination without cause, death or disability and all other permutations of severance set forth in the applicable officer’s employment package. The information must be set forth assuming that the triggering event resulting in the payment occurred at the end of the last completed fiscal year, using the company’s stock price as of the same date.

Companies should start now to review the change in control, severance and termination provisions in the employment agreements and other arrangements that they have with their NEOs and other executives who may be NEOs, in order to be prepared to include these disclosures in next year’s proxy statement.

The new rules update, clarify and somewhat expand existing disclosure requirements for related party transactions. The SEC views related party disclosure—now called "related person" disclosure—as critical to investors in evaluating executive compensation and director independence. As with executive compensation, the SEC has emphasized that the new rules for related person disclosure focus on principles, rather than bright-line rules, and the SEC has accordingly eliminated some of the instructions and specific exceptions that previously permitted issuers to exclude disclosure. Generally, revised Item 404 of Regulation S-K:

• focuses on a materiality analysis, based on principles rather than explicit rules and exceptions;
• increases the de minimis dollar threshold for disclosure, from $60,000 to $120,000, such that transactions below that amount need not be evaluated for materiality;
• eliminates separate disclosure under Item 404(b) and (c) for certain director relationships and indebtedness, bringing this disclosure under the materiality analysis of Item 404(a);
• expands the definitions of "transaction," "related person," and "immediate family member;" and
• requires disclosure of companies’ policies and procedures for the review, approval or ratification of related person transactions.

New Item 404(a) requires the disclosure of:

• any "transaction" (including indebtedness, which was previously covered under Item 404(c)), since the beginning of the company’s last fiscal year, or any currently proposed transaction;
• in which the company was or is to be a "participant";
• if the amount involved exceeds $120,000; and
• any "related person" has or will have a direct or indirect material interest.

Materiality determinations are to continue to be made on the basis of the significance of the information to investors in light of all the circumstances, even though the SEC has eliminated its former instruction to this effect. Also, once it is determined that disclosure is required, the content of the disclosure remains largely unchanged, except that the new rule adds a "catch all" provision requiring disclosure of any other information that is material to investors in light of the circumstances.

Although the new rule doubles the disclosure threshold from $60,000 to $120,000, the new principles-based approach of the rule and broader defined terms will in many cases result in greater disclosure. The rule now applies where the company is a "participant," not just formally a "party," and the term "transaction" now includes any transaction, relationship or arrangement (including indebtedness) or any series of similar transactions, relationships or arrangements. Similarly, "related person" now includes any person who was a related person at any time during the company’s last fiscal year, even if not a related person at year end or at the time of the transaction (except that transactions involving 5% beneficial owners will continue to be evaluated at the time of the transaction, or if the transaction continues after a person becomes a 5% shareholder). Finally, the SEC has expanded the definition of "immediate family member" to include stepchildren, stepparents and any other person (other than a tenant or employee) sharing the household of the related person.

The rules regarding certain business relationships between companies and entities with which directors or nominees are affiliated, formerly in Item 404(b), has been consolidated (together with former Item 404(c) on indebtedness) into new Item 404(a). Previously, disclosure was not required under Item 404 unless the director or nominee was an executive officer or greater than 10% owner of an entity which made payments to the registrant (or from which the registrant received payments) in excess of 5% of either party’s gross revenues. Now, such arrangements must be reviewed using the same materiality and other standards that apply to related person transactions in general in Item 404(a).

Revised Item 404 does continue some exceptions to disclosure, notably:

• director and NEO compensation reported pursuant to Item 402 need not be duplicated under Item 404;
• compensation for other executive officers, (i) if they are not an immediate family member of another related person, (ii) if the compensation is of the type that would have been reported if such executive officer had been named in the Summary Compensation Table, and (iii) if such compensation had been approved, or recommended for approval, by the compensation committee or group of independent directors performing a similar function;
• interests that arise only from the related person’s position as a director of the entity that is a participant in the transaction, or from the ownership (together with the ownership of all other related persons) of less than a 10% interest in the other entity (provided that for partnerships, the person cannot be a general partner); and
• transactions, such as the receipt of dividends, in which the interest arises solely from the ownership of the company’s equity securities and the related person receives the same benefits on a pro rata basis.

Revised Item 404(b) now requires disclosure of a company’s policies and procedures for the review, approval or ratification of related person transactions. Companies are required to disclose the material features of such policies and procedures, including, among other things, the types of transactions covered, the standards applied, the persons or committees of the board of directors responsible for applying such policies, and a statement of whether such policies and procedures are in writing, and if not, how such policies and procedures are evidenced.

The SEC also made a corresponding change to the definition of a non-employee director for purposes of the exemption from liability for transactions between an issuer and its officers and directors under Section 16 of the Securities Exchange Act of 1934, as amended. Because the definition of "non-employee director" under Section 16 is determined based on the director not having any disclosure under Item 404 of Regulation S-K, companies should review the makeup of their compensation committees to determine whether all of their compensation committee members continue to meet the Section 16 definition of non-employee director in light of these changes to Item 404.

The new rules also consolidate the disclosure requirements concerning various corporate governance matters, including director independence and disclosures concerning committees of the board, into one location, new Item 407.

Companies must identify each of their directors who qualify as independent under the definition for determining independence that applies to that company. For example, if a company has a class of securities that is listed on the NASDAQ Global Market, the applicable independence definition is the one set forth in the NASDAQ Marketplace rules. A company will also have to identify any members of its audit, compensation or nominating committee who are not independent under the independence rules applicable to such committees. If a company relies on an exception to such requirements that is available to it, such as the "controlled company" exception for companies that are more than 50% owned by another entity, the company must specify that reliance in its disclosures.

The definitions for independence that are relied upon by each company must either be posted on the Company’s website or added as an appendix to the company’s proxy or information statement at least once every three years, or earlier if the definition used by the company has changed since the start of the last fiscal year.

With respect to all directors or director nominees who are identified as independent, the company must describe, by category or type, any transactions, relationships or arrangements not separately disclosed under the related person transaction section that were considered by the board of directors in determining that the person qualified as independent.

Companies are now required to include a comparable level of detail for compensation committees and their members as they have in prior years for audit and nominating committees. For example, companies must state whether or not the compensation committee has a written charter, and if it does, the charter must be posted on the company’s website or filed with its proxy materials. In addition, companies must also describe their processes for determining executive and director compensation, including:

• the scope of authority of the compensation committee;
• the extent to which the compensation committee may delegate any authority to other persons (such as the delegation of authority to the principal executive officer to grant stock options), specifying what authority may be so delegated and to whom; and
• the role, if any, of executive officers in determining or recommending the amount or form of executive and director compensation.

In addition, if the company uses a compensation consultant to advise on aspects of the company’s executive compensation practices, the proxy statement must identify the consultant, state whether the consultant was hired by the compensation committee or another group within the company, and include a description of the scope of the work performed by the consultant.

The SEC has emphasized that this information is separate from the disclosure required by the CD&A, and should focus on the structure of the governance requirements that are in place with respect to executive compensation, as opposed to the philosophies and analysis behind the compensation-setting process.

The SEC has both revised existing disclosure tables on executive compensation matters and has added new tables covering various elements of compensation. The following are some highlights of the new and revised tables.

The SEC has added a new "Grants of Plan-Based Awards" table requiring companies to disclose on an award-by-award basis all equity and non-equity estimated future payouts under performance-based awards and amounts payable under other equity awards.

Following the Summary Compensation Table and the Grants of Plan-Based Awards table, narrative disclosure will be required to describe any material factors necessary to an understanding of the information disclosed in those tables, providing context, under a principles-based approach, for the quantitative information.

As part of the revised "Outstanding Equity Awards at Fiscal Year End" table, each outstanding stock option held by each NEO as of the end of the fiscal year must be disclosed on a grant-by-grant basis, as opposed to on an aggregate basis as has been required in the past. This will require companies to collect and disclose the number of shares underlying the options, in a vested or unvested column, the exercise price and the expiration date for each option held by the NEOs. In addition, the number of shares and market value or payout value of other equity awards must be disclosed in the aggregate on a vested or unvested basis.

The new "Option Exercises and Stock Vested" table requires information for the prior fiscal year regarding the number of options exercised and value realized upon exercise. With respect to restricted stock, restricted stock units and similar instruments, the table must include information as to the number of shares of stock vested or received and the dollar amount of the value realized upon vesting or receipt of freely transferable shares.

The Pension Benefits table has been completely revised. Information must also be provided under a new "Nonqualified Deferred Compensation" table regarding any nonqualified deferred compensation plans in which an NEO participates. The table must set forth for the last fiscal year contributions made by either the company or the NEO, as well as aggregate earnings under, aggregate distributions or withdrawals from and the aggregate balance of the plan as of the last day of a company’s fiscal year.

For the first year following adoption of these rules, companies will only need to provide disclosure for the most recently completed fiscal year, and will not need to go back and "restate" compensation information provided for the 2005 and 2004 fiscal years. In the second year following adoption, two years of information will be required, and in the third and future years following adoption, three years of information will be required (as is currently the case).

The SEC has also revised the disclosure rules concerning beneficial ownership of an issuer’s securities to require that any shares pledged as security by the NEOs, directors and director nominees be disclosed in a footnote to the beneficial ownership table. This requirement does not apply to greater than 5% shareholders. The SEC believes that the pledge of securities by NEOs, directors and director nominees could impact their decisionmaking with respect to the company, and may therefore be material to shareholders. Accordingly, any pledge arrangements will need to be described in the footnotes to this table.

Recognizing that small business issuers may be disproportionately affected by the changes imposed by these expanded disclosure requirements, the SEC has provided for some modifications to the new rules for small business issuers.

Small business issuers:

• are not required to provide a CD&A or a Compensation Committee Report;
• need only treat their principal executive officer and the two other most highly compensated executive officers as NEOs, not their principal financial officer;
• need only provide information in the Summary Compensation Table for the last two completed fiscal years; and
• need only provide information in the following tables: Summary Compensation Table, Outstanding Equity Awards at Fiscal Year-End table and Director Compensation table.

In addition, for related person transaction disclosure, small business issuers are required to include disclosure if transactions exceed a threshold of the lesser of (1) $120,000 or (2) one percent of the average of the issuer’s total assets at fiscal year-end for the last three completed fiscal years. In addition, small business issuers are not required to have policies and procedures in place with respect to the review and approval of related person transactions, although we would still recommend that such policies be adopted by all companies.

Consistent with prior requirements, the SEC will continue to treat foreign private issuers as having complied with the SEC’s executive compensation requirements if the issuers have complied with the applicable disclosure requirements of their home country jurisdictions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.