On January 27, 2006, the Securities and Exchange Commission (SEC) published proposed rules relating to disclosure requirements for executive and director compensation, related party transactions, director independence, security ownership of officers and directors and other corporate governance matters, in public company proxy statements and other SEC filings. While the Proposed Rules are not expected to be effective with respect to companies that file their proxy statements during the spring 2006 "proxy season," recent events that heightened the perceived need for more disclosure related to executive compensation have caused many public companies to review their executive compensation disclosure practices in connection with the 2006 proxy season (please refer to the "Considerations for the 2006 Proxy Season" section below). The text of the Proposed Rules may be found at http://www.sec.gov/rules/proposed.shtml.

The Proposed Rules

The Proposed Rules aim to:

  • provide investors with a clearer and more complete picture of compensation of principal executive officers, principal financial officers, the other highest paid executive officers and directors;
  • refine compensation-related disclosure requirements related to Current Reports on Form-8-K;
  • expand disclosure related to beneficial ownership; and
  • improve disclosure related to participation by executive officers, directors, significant shareholders and other related parties in financial transactions and relationships with the company.

To ensure that the Proposed Rules result in disclosure that is clear, concise and understandable for investors, the SEC would require most of the new disclosure to be presented in plain English.

Executive and Director Compensation Disclosure

The Proposed Rules follow guiding principles designed to expand current disclosure requirements related to compensation that the SEC has called "highly formatted and rigid." The Proposed Rules would:

  • retain the tabular approach to provide clarity and comparability while improving the tabular disclosure requirements;
  • ensure that all elements of compensation be included in the tables;
  • require disclosure in the Summary Compensation Table of a single dollar amount for total compensation; and
  • include narrative disclosure comprising both a general discussion and analysis of compensation and specific material information regarding tabular items necessary to an understanding of the tabular disclosure.

Compensation Discussion and Analysis

The Proposed Rules contemplate a new Compensation Discussion and Analysis (CD&A), which would contain a discussion and analysis of material factors underlying compensation policies and decisions reflected in the data presented in compensation-related tables. This overview, which would precede the compensation tables, would capture material elements of compensation for

  • named executive officers by requiring companies to address the objectives and justifications for their compensation programs;
  • what each element of compensation is and what each is designed to reward;
  • how each element is determined; and
  • how each element fits into the company’s overall compensation objectives.

The CD&A is designed to discourage the use of boilerplate disclosure and would require a comprehensive discussion of post-termination as well as in-service compensation arrangements. The CD&A would replace the Compensation Committee Report and the Performance Graph and would be considered "filed with the SEC." As such, it will be subject to more stringent liability standards under applicable securities laws. To the extent that the CD&A and any of the other disclosure regarding executive officer and director compensation or other matters is included or incorporated by reference into a periodic report, the disclosure would be covered by the certifications that principal executive officers and principal financial officers are required to make under the Sarbanes-Oxley Act of 2002. Forward-looking information in the CD&A would fall within the safe harbor for disclosure of such information.

Compensation Tables

Under the Proposed Rules, the following Summary Compensation Table will require detailed disclosure with respect to compensation received by the named executive officers for the company’s last three completed fiscal years. Unlike under the current rules, all compensation set forth in the Summary Compensation Table would be provided in dollars rather than in numbers of shares or other units.

All tables would require disclosure for the Principal Executive Officer, the Principal Financial Officer and the three other most highly compensated officers. For ease of presentation, we have omitted the lines for names of individuals.

Summary Compensation Table

Name & Principal Position

Year

Total ($)

Salary ($)

Bonus ($)

Stock Awards ($)

Option Awards ($)

Non-Stock Incentive Plan Compensation ($)

All Other Compensation ($)

(a)

(b)

(c)

(d)

(e)

(f)

(g)

(h)

(i)

  • Total Compensation Column (c). This column will show a dollar value of all compensation received by a named executive officer in a given year as determined by adding the total dollar value of each form of compensation quantified in the columns that follow it.
  • Salary and Bonus Columns (d) & (e). These columns will be retained substantially in their current form. However, the Proposed Rules require that any compensation that is currently payable but has been deferred not only will be included in the salary, bonus or other compensation columns as appropriate (as is currently required), but also will be broken out in a footnote to the applicable column.
  • Stock Awards and Option Awards Columns (f) & (g). The Stock Awards column would disclose stock-related awards that derive their value from the company’s equity securities or permit settlement by issuance of the company’s equity securities. Valuation is based on the grant date fair value of the award determined pursuant to Financial Accounting Standards Board Statement of Financial Accounting Standards No. 123 (revised 2004) (FAS 123R). Awards of options, stock appreciation rights grants and similar stock-based compensation instruments that have option-like features will be disclosed in the Option Awards Column based on the grant date fair value of the award as determined pursuant to FAS 123R. In an effort to consolidate related elements of compensation, the Proposed Rules require inclusion in the appropriate columns and footnote identification and quantification of all earnings on outstanding awards, (for instance, dividend equivalent earnings on stock-based awards) in the respective categories. In addition, previously awarded options or freestanding stock appreciation awards that the company repriced or otherwise materially modified during the last fiscal year would be disclosed as a new award based on the total fair value of the award so modified.
  • Non-Stock Incentive Plan Compensation Column (h). This column would disclose the value of all other incentive plan awards where the relevant performance measure is not based on the price of the company’s equity securities (but instead is tied to measures such as return on assets, return on equity, etc.) or which are not settled by the issuance of equity securities. Unlike the immediately preceding columns, these awards would be disclosed in the Summary Compensation Table in the year when the performance criteria are satisfied and the compensation is earned (whether or not paid in that year), not at the time of grant. The grant of the award would be disclosed in the supplemental Grants of Performance-Based Awards Table. As with the immediately preceding columns, earnings on these outstanding awards would also be included in this column.
  • All Other Compensation Column (i). This column would require disclosure of all other current compensation not included in any other column. Each item of compensation included in this column exceeding $10,000 must be separately identified and quantified in a footnote. Examples of compensation required to be disclosed in this column are:
    • company contributions to defined contribution plans, and earnings credited under defined contribution plans that are not tax-qualified, including non-qualified deferred compensation plans;
    • increases in actuarial value of plans that provide for the payment of retirement benefits, including tax-qualified defined benefit plans and supplemental employee retirement plans, but excluding defined contribution plans; and
    • if the aggregate amount of perquisites and other personal benefits equals or exceeds $10,000 (a decrease from the current threshold of $50,000 or 10% of the named executive officer’s annual base salary and bonus, if less), specific identification of each perquisite and other personal benefit and, if the perquisite or other personal benefit is valued at the greater of $25,000 or 10% of total perquisites and other personal benefits, then disclosure of the value as well. The value of perquisites and other personal benefits is the aggregate incremental cost to the Company and its subsidiaries.

In addition, this column would include the following items:

    • amounts paid or accrued pursuant to a plan or arrangement in connection with any termination or constructive termination of employment or a change in control;
    • insurance premiums paid by the company with respect to life insurance for the benefit of a named executive officer;
    • "gross-ups" or other amounts reimbursed during the fiscal year for the payment of taxes; and
    • for any security of the company or its subsidiaries purchased from the company or its subsidiaries at a discount which is not available generally either to all security holders or to all salaried employees of the company, the compensation cost computed in accordance with FAS 123R.

Supplemental Annual Compensation Tables

The Proposed Rules require two Supplemental Tables that provide back-up for information in the Summary Compensation Table.

  • Grants of Performance-Based Awards Table. This table provides disclosure of the material terms of non-stock grants of incentive plan awards, stock-based incentive plan awards and awards of options, restricted stock and similar instruments under plans that are performance-based.

Name

Performance Based Stock and Stockbased Incentive Plans: Number of Shares, Units or Other Rights (#)

Performance -Based Options: Number of Securities Underlying Options (#)

Non- Stock Incentive Plan Awards: Number of Units or Other Rights (#)

Dollar Amount of Consideration Paid for Award, if any ($)

Grant Date for Stock or Option Awards

Performance or Other Period Until Vesting or Payout and Option Expiration Date

Estimated Future Payouts

Threshold ($) or (#)

Target ($) or (#)

Maximum ($) or (#)

(a)

(b)

(c)

(d)

(e)

(f)

(g)

(h)

(i)

(j)

  • Grants of All Other Equity Awards Table. This table would disclose the material terms of equity-based compensation awards that are not performance-based, such as stock, options or similar instruments where the payout or future value is tied to the company’s stock price and not to other performance criteria.

Name

Number of Securities Underlying Options Granted (#)

Exercise or Base Price ($/Sh)

Expiration Date

Number of Shares of Stock or Units Granted (#)

Vesting Date

Grant Date

(a)

(b)

(c)

(d)

(e)

(f)

(g)

Narrative Disclosure to Summary Compensation Table and Supplemental Tables

The Proposed Rules require a narrative description of any additional material factors necessary to an understanding of the quantitative disclosure in the tables immediately following the Summary Compensation Table and Supplemental Tables, such as:

  • material terms of employment agreements;
  • repricings or other material modifications of outstanding options or other stock-based awards during the last fiscal year;
  • material terms of awards such as the vesting schedule, a description of the performance-based conditions and whether dividends will be paid;
  • any material waiver or modification of any specified performance target, goal or condition to payout under any reported incentive plan payout; and
  • information regarding defined benefit and deferred compensation plans, such as material assumptions underlying the determination of increases in actuarial value or earnings on deferred compensation plans.

The Proposed Rules also require disclosure of total compensation for the most recent fiscal year and a job description (rather than the name) for up to three employees who were not executive officers during the last completed fiscal year but whose total compensation for that year was greater than that of any of the named executive officers.

Exercises and Holdings of Previously Awarded Equity

The section following the Summary Compensation Table and Supplemental Tables will consist of two tables:

  • Outstanding Equity Awards at Fiscal Year-End Table. This table would contain information regarding outstanding equity-based awards, including the potential dollar amounts realizable with respect to each award.

Name

Number of Securities Underlying Unexercised Options (#) Exercisable/ Unexercisable

In-the-money Amount of Unexercised Options ($) Exercisable/ Unexercisable

Number of Shares or Units of Stock Held That Have not Vested

Market Value of Shares or Units of Stock Held That Have not Vested ($)

Incentive Plans: Number of Nonvested Shares, Units or Other Rights Held (#)

Incentive Plans: Market or Payout Value of Nonvested Shares, Units or Other Rights Held ($)

(a)

(b)

(c)

(d)

(e)

(f)

(g)

  • Option Exercises and Stock Vesting Table. This table would show the dollar amounts realized pursuant to the vesting or exercise of equity-based awards during the latest fiscal year.

Name of Executive Officer

Number of Shares Acquired on Exercise or Vesting (#)

Value Realized Upon Exercise or Vesting ($)

Grant Date Fair Value Previously Reported in Summary Compensation Table

(a)

(b)

(c)

(d)

Name –Options

Stock

Post-Employment Compensation

The third section, replacing the current Pension Plan Table, would consist of the following two tables and specific narrative disclosure of payments made in connection with the severance or other termination of a named executive officer, a change in his or her responsibilities, or a change in control of the company:

  • Retirement Plan Potential Annual Payments and Benefits Table. This table requires disclosure of the estimated annual retirement payments under defined benefit plans and will be followed by narrative disclosure of material factors necessary to an understanding of each plan disclosed in the table. Where the named executive officer is not yet eligible to retire, the dollar amount of annual benefits to which he or she would be entitled upon becoming eligible is computed assuming the officer continued to earn the same amount of compensation as reported for the company’s last fiscal year. The Proposed Rules suggest material factors to be discussed in the narrative disclosure may include:
    • the plan’s retirement benefit formula, eligibility standards and early retirement arrangements;
    • if the executive or company may elect a lump sum distribution, the amount of distribution that would be available upon election as of the end of the last fiscal year, including disclosure of the valuation method and material assumptions applied in quantifying such amount;
    • the specific elements of compensation included in applying the benefit formula; and
    • regarding participation in multiple plans, the reasons for each plan; and company policies with regard to such matters as granting extra years of credited service.

Name

Plan Name

Number of Years Credited Service (#)

Normal Retirement Age (#)

Estimated Normal Retirement Annual Benefit ($)

Early Retirement Age (#)

Estimated Early Retirement Annual Benefit ($)

(a)

(b)

(c)

(d)

(e)

(f)

(g)

  • Nonqualified Defined Contribution and Other Deferred Compensation Plans Table. This table would require disclosure of information regarding non-qualified defined contribution and other deferred compensation plans, followed by a narrative description of material factors necessary to an understanding of the disclosure in the table, such as:
    • the types of compensation permitted to be deferred, and any limitations on the extent to which deferral is permitted;
    • the measures of calculating interest or other plan earnings; and
    • material terms with respect to payouts, withdrawals and other distributions.

Name

Executive Contributions in Last FY ($)

Registrant Contributions in Last FY ($)

Aggregate Earnings in Last FY ($)

Aggregate Withdrawals/ Distributions ($)

Aggregate Balance at Last FYE ($)

(a)

(b)

(c)

(d)

(e)

(f)

  • Other Potential Post-Employment Payments. The Proposed Rules require narrative disclosure of specific aspects of any written or unwritten arrangement that provides for payments related to the resignation, severance, retirement or other termination (including constructive termination) of a named executive officer, a change in his or her responsibilities, or a change in control of the company, including:
    • a description of the triggering events;
    • the estimated payments and benefits that would be provided in each termination circumstance;
    • the factors used to determine the appropriate payment and benefit levels under each termination circumstance; and
    • any material conditions or obligations applicable to the receipt of payments or benefits.

The discussion would require disclosure of the duration of non-compete and similar agreements, provisions regarding waiver of breach of these agreements and any tax gross-up payments. Where uncertainties exist as to the provision of payments or benefits or the amounts involved, the company would make reasonable estimates and disclose material assumptions underlying the estimates.

Officers Covered

Named Executive Officers

The named executive officers under the Proposed Rules consist of the principal executive officer, the principal financial officer and the three most highly compensated executive officers other than the principal executive officer and principal financial officer. This is a departure from the current rules which require compensation disclosure for the chief executive officer and the next four most highly paid executive officers, which may or may not include the principal financial officer. In addition, disclosure will continue to be required for up to two additional individuals for whom disclosure would have been required but for the fact that they were no longer serving as executive officers at the end of the last completed fiscal year.

Identification of Most Highly Compensated Officers;

Dollar Threshold for Disclosure

The Proposed Rules require identification of the most highly compensated executive officers on the basis of total compensation for the most recent fiscal year and revise the dollar threshold for disclosure of named executive officers other than the principal executive officer and the principal financial officer to $100,000 of total compensation for the last fiscal year. This is in contrast to the current rules which look only to total annual salary and bonus. In addition, under the current rules, companies are permitted to exclude an executive officer other than the chief executive officer due to either an unusually large amount of cash compensation that is not part of a recurring arrangement and is unlikely to continue, or cash compensation relating to overseas assignments attributed predominantly to such assignments; the Proposed Rules eliminate the first exclusion.

Compensation of Directors

Under the Proposed Rules, director compensation will be presented in a Director Compensation Table accompanied by narrative disclosure of additional material information. The Director Compensation Table resembles the proposed Summary Compensation Table but would require disclosure of information only with respect to the last completed fiscal year.

Proposed Revisions to Form 8-K

The SEC proposes to revise Form 8-K by eliminating the need to disclose employment compensation arrangements under Item 1.01 and to cover compensation arrangements involving named executive officers under a modified Item 5.02. The SEC proposes to do this by:

  • expanding the information regarding retirement, resignation or termination of directors and officers to include all named executive officers for the company’s previous fiscal year;
  • expanding the items requiring disclosure to include a description of any material plan, contract or arrangement to which a covered officer or director is a party or in which he or she participates that is entered into or materially amended in connection with any of the triggering events specified in Item 5.02, or any grant or award to a covered person, or modification thereto, in connection with any specified event;
  • with respect to the principal executive officer, the principal financial officer, or named executive officers for the company’s previous fiscal year, expanding the disclosure to include a description of any material new compensatory plan, contract or arrangement, or new grant or award thereunder (whether oral or written), and any material amendment to any compensatory plan, contract or arrangement (or any modification to a grant or award thereunder), whether or not the occurrence is in connection with a triggering event specified in Item 5.02. Disclosure would not be required if the grants, awards or modifications are consistent with the terms of previously disclosed plans or arrangements and they are disclosed the next time the company is required to provide new disclosure under Item 402 of Regulation S-K; and
  • adding a requirement for disclosure of salary and bonus for the most recent fiscal year that was not available at the latest practicable date in connection with disclosure under Item 402 of Regulation S-K.

The Proposed Rules extend the safe harbors regarding Section 10(b) and Rule 10b-5 and Form S-3 eligibility if a company fails to timely file reports required by Item 5.02(e) of Form 8- K.

Beneficial Ownership Disclosure

The Proposed Rules amend Item 403(b) of Regulation S-K to require disclosure of the number of shares pledged as security by named executive officers, directors and director nominees as the SEC believes that the existence of these securities pledges could be material to shareholders. The Proposed Rules also specifically require disclosure of beneficial ownership of directors’ qualifying shares, which is currently not required.

Certain Relationships and Related Transactions Disclosure

The SEC proposes to make significant changes to Item 404 of Regulation S-K in order to provide a complete picture of financial relationships with a company and related persons. First, the threshold for disclosure of related-party transactions would increase from $60,000 to $120,000. Additional changes would be achieved by amending:

  • Item 404(a) to contain general principles for disclosure of related-person transactions, including those involving indebtedness and transactions with 5% or greater shareholders; and
  • Item 404(b) to include disclosure regarding the company’s policies and procedures for the review, approval or ratification of related-person transactions.

In addition, a new Item 407 would require disclosing whether each director or nominee for director is independent (according to applicable stock exchange listing standards), and whether any members of the company’s compensation, nominating and audit committees are not independent.

Considerations for the 2006 Proxy Season

While the Proposed Rules are not expected to be effective with respect to companies that file their proxy statements during spring 2006, and the existing rules governing compensation disclosure must continue to complied with, companies may consider taking proactive steps to enhance the compensation disclosure in their proxy statements filed in spring 2006.

Executive Compensation

Compensation Committee Report. Companies should consider what efforts they can take to improve the disclosures in their Compensation Committee Report. For example, Compensation Committee Reports can be enhanced to include much of the discussion and analysis that is proposed to be required under the new CD&A, including material factors underlying compensation policies, the overall objectives of a company’s compensation program and discussion of how each component of a company’s executive compensation addresses specific items of performance. Other examples include discussion of a company’s policies for allocating long-term and current compensation, compensation recovery policies and the use of tally sheets. The report should be written in plain English and companies should review existing disclosure to improve readability. In addition, in making compensation decisions in 2006, compensation committees should carefully consider the factors that will have to be discussed regarding those decisions in the new CD&A to be filed in 2007.

Summary Compensation Table. While companies must comply with present compensation disclosure requirements, companies may consider the use of supplemental disclosure in the Summary Compensation Table. For example, a company may add an additional column setting forth the value of stock option awards as determined pursuant to FAS 123R in addition to the number of securities underlying the stock option awards. Companies should also consider treating stock-related awards awarded in early 2006 based on 2005 performance as grants in 2005, providing an explanatory footnote. Other supplemental disclosures companies may consider in the Summary Compensation Table include footnote disclosure of the amount of compensation voluntarily deferred under a non-qualified deferred compensation program, narrative explanations of the components of All Other Compensation and adding a Total Compensation column.

Supplemental Tables. Companies may consider supplementing the Summary Compensation Table with additional tables. For example, in addition to being included in the Summary Compensation Table, companies can provide a supplemental listing of perquisites, consider separate tabular disclosure of restricted stock units setting forth the dollar value of restricted stock units vesting in a given year, and tabular disclosure quantifying amounts payable under severance arrangements as a result of a change in control of the company or termination of the executive’s employment.

Perquisites. The SEC release on the Proposed Rules contains guidance on the disclosure of perquisites that is effective for 2006 proxies which basically restated and encapsulated previous guidance. The guidance defines an item as a perquisite if it confers a direct or indirect benefit that has a personal aspect, without regard to whether it may be provided for a business reason or for the convenience of the company. The only two exceptions are if the item is generally available on a non-discriminatory basis to all employees and if the item is "integrally and directly related" to the performance of the executive’s duties. The guidance clarifies that a company’s decision to provide an item of personal benefit for security purposes (for instance, private jet travel) does not affect its characterization as a perquisite, and that the cost of aircraft travel attributed to an executive for federal income tax purposes is not the cost to be disclosed under the proxy rules. Incremental cost must be used instead, as for all prerequisites.

Director Compensation. Companies should consider providing a separate table summarizing the components of director compensation for the last fiscal year.

Certain Relationship and Related Transaction Disclosure

In anticipation of the adoption of the Proposed Rules, companies should begin identifying relationships with related persons that might require enhanced disclosure. Upon the identification of any such relationship, companies should evaluate the impact the relationship may have on director independence and the related impact on director committee service, similar to the exercise currently done by New York Stock Exchange and Nasdaq companies. Finally, companies should begin reviewing their existing policies and, to the extent necessary, adopt new policies regarding approval of related party transactions.

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.