SEC Adopts Sweeping Changes To Executive And Director Compensation Disclosure Rules - Part 2

If the exercise price of an option is not the closing price of the company’s stock on the date of grant (regardless of whether it is higher or lower than the closing price), narrative or footnote disclosure must describe the methodology for determining exercise price. For example, if a company uses an average of several trading day closing prices to arrive at the exercise price (i.e., a "formula" plan), that would be disclosed.

Outstanding Equity Awards at Fiscal-Year End Table. This updated table will now show outstanding stock option or other unvested or unearned equity award held by each NEO, including:

• The number of securities underlying exercisable and unexercisable options (including out-of-the money options) on an option-by-option basis.

• Option exercise prices.

• Option expiration dates.

• The aggregate number of unvested or unearned shares or units under stock awards.

• The aggregate market value of unvested or unearned shares or units under stock awards (based upon the closing market price of the company’s stock at the end of the last completed fiscal year).

Since this disclosure is now required to include a separate line for each option or other equity award that is held by an NEO, this table may be quite lengthy where one or more NEOs have several outstanding option grants.

Option Exercises and Stock Vested Table. This table will show value that NEOs realized on equity awards during the last fiscal year, whether through the exercise of stock options or vesting of restricted stock (disclosure of which was not previously required). The table will include both the number of shares acquired on exercise of an option or vested on lapse of restrictions, and the value realized on those events based upon the market price of the underlying securities at the time of exercise or vesting less any applicable exercise price. Value is measured and disclosed regardless of whether the shares are held or sold.

Practice Tips & Observations: It is unclear how the table will apply to restricted stock units, since restricted stock units may vest in one year and be paid (and therefore taxable) in a following year.

The new rules replace the current table addressing retirement plans with two new tables: the Pension Benefits Table and the Nonqualified Deferred Compensation Table.

Pension Benefits Table. This table will require disclosure of the actuarial present value of each NEO’s accumulated benefit under each company pension plan, computed using the same assumptions (except for the normal retirement age) and measurement period as used for financial reporting purposes under GAAP. The table will also disclose the number of years of service credited to the NEO under the plan. The narrative disclosure following the table must include, among other things, a discussion of the valuation method and all material assumptions applied, or a cross-reference to this information appearing elsewhere in the company’s financial statements, or Management’s Discussion and Analysis.

Nonqualified Deferred Compensation Table. This table will require disclosure with respect to nonqualified deferred compensation plans and executive contributions, company contributions (including contributions reflected in the "All Other Compensation" column of the Summary Compensation Table), withdrawals, all earnings for the year (not just the above-market or preferential portion) and the year-end balance. Footnote disclosure is required to quantify the extent to which amounts in the contributions and earnings columns are reported as compensation in the Summary Compensation Table for the most recent fiscal year, as well as the extent to which other amounts were included in the table for prior years. The narrative disclosure following the table is expected to include additional information about the deferral of, interest on and withdrawals or payments of the compensation reflected in the table.

Practice Tips & Observations: The narrative required as part of the discussion of severance and change of control arrangements (discussed below) will be required to discuss the timing of pension benefit and deferred compensation distributions, including the rationale for the timing of the payments and the form of the distribution.

The new rules require new and detailed narrative disclosure about any contract, plan or arrangement for payments or benefits in connection with NEO termination of employment, NEO change in responsibilities or change in control of the company (no longer limited to payments or benefits exceeding $100,000). In particular, the following must be described and explained:

• The specific circumstances that would trigger payments or benefits.

• The estimated payments and benefits (lump sum, annual or other), including quantification of the amounts, that would be provided in each covered circumstance, the duration of those payments and benefits and the payor or provider.

• How the payment and benefit levels are determined under the various triggers.

• Any material conditions or obligations applicable to the receipt of payments or benefits, including non-compete, non-solicitation, non-disparagement or confidentiality agreements and their duration, and provisions regarding waiver of breach of such agreements.

• Other material factors.

The most significant change in this area is the new requirement that the company quantify the specific dollar amounts of payments that may be made to executives upon such a termination or change in control. To make disclosures meaningful and permit comparisons among issuers, the rules assume that the triggering event took place on the last business day of the company’s last fiscal year and use the closing price per share of the company’s stock on that date to calculate the value of changes in the executives’ equity holdings and other benefits. Special rules apply where triggering events actually occur during the year.

The new rules also require discussion of the timing and payment options related to pension payouts and deferred compensation distributions. Where IRC Section 280G gross-up provisions apply, companies will be required to disclose a reasonable estimate (or reasonable range) of the cost of such payments and the assumptions underlying the estimate.

Practice Tips & Observations: Companies that are considering new severance and change in control arrangements in 2006 or later would be well advised to calculate the required hypothetical values of all benefits payable upon the occurrence of a triggering event, including the value of equity awards and any golden parachute payment tax gross-ups. Performing these calculations will enable companies to understand the myriad assumptions associated with such calculations, and to anticipate any issues that might be associated with future disclosures. Companies should also be aware that entering into an agreement that adjusts the treatment of the NEO’s equity awards upon a triggering event may constitute a modification of an equity award, requiring additional disclosures (see the discussion in "Summary Compensation Table – Focus on Total Value of Compensation, Including Value of Equity Awards" above).

Companies should also review currently effective severance and change in control arrangements with any NEOs to understand the new disclosures that will need to be made with respect to these arrangements.

Director compensation (including consulting fees and perquisites) for the most recently completed fiscal year will be required to be disclosed in a new table. This "Director Compensation Table" will be similar in format to the Summary Compensation Table and will be accompanied by supplemental narrative disclosures. Footnotes to the tabular disclosures will include aggregate (rather than award-by-award) numbers of stock awards and option awards outstanding at fiscal year end. The related narrative disclosures will include descriptions of standard director compensation arrangements, and whether any director has a different compensation arrangement.

Of particular note is that director legacy and charitable awards programs must now be disclosed in the table, valued at the annual cost of such arrangements, with footnote disclosure of the total dollar amount and other material terms of each such program.

The new rules add updated and new disclosure requirements about director independence and the operations of the compensation committee, and consolidate existing corporate governance disclosure requirements.

The new director independence disclosures replace disclosure previously required by Item 404(b) of Regulation S-K. The disclosures include the following items:

• Identify each director and nominee who is independent – generally based on the definition of independent director of the exchange on which the company’s securities are listed.

• Describe, by specific category or type, any transactions, relationships or arrangements that were considered by the board of directors when determining if applicable independence standards were satisfied, but are not disclosed as a related person transaction.

• Identify any audit committee, nominating committee or compensation committee members who are not independent.

If the company uses a definition of independence for its directors and committee members that is different than that of the exchange upon which it is listed, the company must state whether the definition is posted on its website, and, if not, to include the definition as an appendix to the company’s proxy statement at least once every three years.

Practice Tips & Observations: Companies should assess their upcoming director independence disclosures, and their procedures for determining director independence. In addition, companies should ensure that they have the procedures in place to capture information about any potential related person transactions (discussed below) that the board should consider in assessing director independence, so that the company will be able to disclose the categories of these matters that were considered for each director – even if the related person transaction is not required to be disclosed specifically.

New disclosure about compensation committee processes and procedures related to executive and director compensation will be required, along the lines of disclosure that is currently required about audit and nominating committees. In particular, the company must disclose:

• Whether the compensation committee has a charter, and if so whether it makes the charter available through its website or proxy materials in one of several permissible manners.

• Compensation committee processes and procedures for considering and determining executive and director compensation, including:

• the committee’s scope of authority;

• the extent to which the committee may delegate any authority, and if so what authority may be delegated and to whom; and

• any role of executive officers in determining or recommending the amount or form of executive and director compensation.

• The role of any compensation consultants in determining or recommending the amount or form of executive or director compensation, identifying the consultants, stating whether the consultants were engaged directly by the compensation committee or by another person, and describing the nature and scope of their assignment and the material elements of instructions given to them with respect to the performance of their duties.

Where a company has no compensation committee, the disclosures would be provided for the persons performing similar functions.

Practice Tips & Observations: To prepare for these new disclosures, the compensation committee should review its charter, delegations of authority and other processes in the coming months, and make any changes that are deemed appropriate. Many companies are already reviewing their policies and practices related to stock option grants. In addition, the company should review its relationships with compensation consultants with a view to future disclosure, including who engaged the consultant, the scope of assignments in 2006 and the material elements of the instructions that were or are being given to the consultant.

In addition to the new disclosures discussed above, the new rules consolidate existing corporate governance disclosure requirements.

• Information about board and committee meetings and board member annual meeting attendance (formerly part of Item 7 of Regulation 14A).

• Information about nominating committees and shareholder communications (formerly part of Item 7 of Regulation 14A and Item 401(j) of Regulation S-K).

• Information about audit committees, including audit committee financial experts and the Audit Committee Report (formerly part of Item 7 of Regulation 14A and Items 306, 401(h) and 401(i) of Regulation S-K).

In addition, the reorganized rules regarding audit committee charters reflect revisions permitting companies to post the charters on their websites, rather than delivering them to security holders, if certain conditions are satisfied.

The new rules update, clarify and somewhat expand existing disclosure requirements for related person transactions, while making the requirements more principles-based. Highlights of the new rules include:

• Requires disclosure of the company’s policies and procedures for review, approval or ratification of related person transactions.

• Increased dollar threshold for transactions required to be disclosed, from $60,000 to $120,000.

• Eliminates the separate disclosure requirements for indebtedness and certain business relationships of directors under previous rules, while continuing to require modified disclosure of the substance of both as related person transactions.

• Updates specific exceptions for categories of transactions that do not require related person transaction disclosure.

A new requirement of the rules is that companies describe their policies and procedures regarding related person transactions. Some of the features of such a description might include:

• The types of transactions that are covered by the policies and procedures.

• The standards to be applied under those policies.

• The board member or members (or others) who are responsible for applying those policies and procedures.

• Whether the policies are in writing, and how they are evidenced if they are not in writing.

The new rules also require disclosures of gaps in these policies, or failures to apply them consistently. In particular, companies must now disclose where a related person transaction was required to be reported but under the company’s policies the transaction did not require review, approval or ratification, or where the policies were not followed.

Practice Tips & Observations: Nasdaq listing standards require that companies review all related party transactions for potential conflict of interest situations, and that all such transactions be approved by the audit committee or another independent body of the board of directors, so most companies currently have procedures in place for the review of related person transactions. Companies should revisit these policies and procedures to determine whether any changes are appropriate, such as specification of standards to be applied and commitment of policies to writing. Companies should also review their procedures for early identification of potential related person transactions.

Related person transaction disclosure is now required for any "transaction":

• Since the beginning of the company’s last fiscal year, or that is currently proposed;

• In which the company was or is to be a participant (even if it is not technically a contractual party);

• In an amount exceeding $120,000; and

• In which a "related person" had or will have a direct or indirect material interest.

The rules no longer include the separate category of disclosures for certain relationships between the company and entities with which company directors are affiliated. Formerly, disclosure was required where payments, between the company and businesses with which a director had certain types of relationships (for example, executive officer or 10% shareholder), amounted to more than 5% of either party’s revenue. Now any such relationships will be evaluated on the same standards that apply to related party transactions in general.

Consistent with existing disclosure requirements, the period of time for which disclosures must be provided is expanded to three years for various registration statements filed under the Securities Act or Exchange Act.

Scope of Covered Transactions. The term "transaction" is broadly defined to include, among other things, any financial transaction, arrangement or relationship or series of similar transactions, arrangements or relationships, including indebtedness or guarantees. The new related person transaction rules eliminate the separate disclosure requirements for related person indebtedness and now include indebtedness within the general definition of "transaction."

Related Persons. "Related person" includes any person who:

• At any time during the fiscal year was a director or executive officer of the company, or a member of that person’s immediate family;

• At any time during the fiscal year was a nominee for director, or a member of his or her immediate family, if disclosure is being included in a proxy statement relating to director elections; and

• At the time the transaction in question occurred or existed was a five percent shareholder or, if applicable, a member of his or her immediate family.

For these executives, directors and nominees (and their immediate family members), disclosure is now required if a related person transaction occurred during any part of the last fiscal year, even if the covered party was not a "related person" at the time of the transaction.

"Immediate family member" is now defined to include a child, stepchild, parent, stepparent, spouse, sibling, mother-in-law, father-in-law, son-in-law, daughter-in-law, brother-in-law, or sister-in-law, and any person (other than a tenant or employee) sharing the household of the indicated person.

Type of Information Required. Descriptions of related person transactions must include:

• The related person’s name and relationship to the company.

• The related person’s interest in the transaction, including his or her relationship to any person or entity that is a party to or has an interest in the transaction.

• The approximate dollar value of the amount involved in the transaction and of the related person’s interest in the transaction.

Exceptions from Disclosure. The new related person disclosure rules contain a number of exceptions from disclosure, including:

• Compensation for an executive officer or director that is reported pursuant to the executive and director compensation disclosure rules.

• Compensation for an executive officer who is not an immediate family member if the compensation would have been reported as compensation for services rendered if the executive was a named executive officer, and the compensation had been approved, or recommended to the company’s board of directors for approval, by the company’s compensation committee.

• Interests in transactions that arise only from the related person’s position as a director of another entity that is a party to the transaction, or from the related person’s ownership, together with all other related persons, , of less than a 10% equity interest in another person (other than a partnership) that is a party to the transaction, or both such position and ownership.

• Interests in transactions that arise only from the related person’s position as a less than 10% limited partner in a partnership (together with all other related persons), and the person is not a general partner of and does not have another position in the partnership.

• Indebtedness transactions of five percent shareholders and their immediate family members (unless they fit within another category of related persons).

• Interests arising solely from the ownership of a class of equity securities where all holders of that class receive the same benefit on a pro rata basis.

Practice Tips & Observations: Since the new rules change the definitions and disclosure standards about related person transactions, companies should reassess the adequacy of their policies in this area, to ensure that any potential transactions will be analyzed for disclosure issues prior to consummation. Existing transactions and relationships with related persons should be evaluated with the new disclosure standards in mind to determine whether new disclosures will be required. Under the new rules, companies will need to monitor transactions involving the company and any entity where a member of the board of directors is an executive officer, major shareholder or in an equivalent position, to assess whether the amount involved may exceed the $120,000 threshold.

In addition, since the new rules permit disclosure of non-NEO officer compensation to be omitted only if the compensation amounts were approved, or recommended to the board for approval, by the compensation committee, companies should ensure that their officer compensation policies include compensation committee approval (or recommendation to the board for approval) of all elements of officer compensation, consistent with existing Nasdaq governance requirements. Disclosure controls and procedures should be reviewed to ensure they would pick up any non-NEO officer compensation that would have to be reported due to failure to obtain compensation committee approval.

Rule 16b-3, which exempts from the Section 16(b) short-swing profit recovery rules certain transactions approved by a Board committee of two or more non-employee directors, refers in part to the related person rules to determine who qualifies as a "non-employee director." As a result, changes made to the related person transaction rules also affect who will qualify as a Rule 16b-3 non-employee director. The SEC has revised the instructions to Rule 16b-3 to specify that, in determining a director’s non-employee director status, a company may rely on its related person transaction disclosures for the most recent fiscal year. However, the company must believe in good faith that any current or contemplated transaction in which the director participates will not be required to be disclosed as a related person transaction, based on information readily available to the company and the director at the time the director proposes to act as a non-employee director.

Practice Tips & Observations: Companies should assess whether their non-employee directors continue to meet the requirements of Rule 16b-3, and whether they have procedures that would require analysis of any potential transactions that could change the status of any current non-employee directors, in advance of any action where the company would rely upon those directors for Rule 16b-3 purposes.

After evaluating the types of agreements filed by public companies following the 2004 amendments to Form 8-K, the SEC observed that some companies filed Forms 8-K to disclose executive compensation arrangements that the SEC believed were not "unquestionably or presumptively material." The SEC has now revised Form 8-K to provide real-time disclosure of employee compensation events that more clearly satisfies this standard. In particular, compensatory arrangements are no longer covered in Form 8-K Item 1.01 (material agreements). Rather, Item 5.02 has been expanded, but only to cover those compensatory arrangements with executive officers and directors that the SEC believes are unquestionably or presumptively material.

Specifically, Form 8-K Item 5.02 covers the following primary additional events and disclosures:

• Retirement, resignation or termination of employment for any person that was an NEO for the company’s previous fiscal year, as well as for any principal executive officer, president, principal financial officer, principal accounting officer, principal operating officer or any person performing similar functions, as is currently required.

• Entering into or materially amending any material plan, contract or arrangement in connection with the appointment of a new principal executive officer, president, principal financial officer, principal operating officer or person performing similar functions, where such officer is a party to or participates in the arrangement, or receives any grant or award, or modification of a grant or award, under any such arrangement, in connection with the appointment.

• Entering into or materially amending any material plan, contract or arrangement in connection with the election of a new director, where the director is a party to or participates in the arrangement, or receives any grant or award, or modification, under any such arrangement, in connection with such election.

• Entering into, adopting or commencing, or materially amending or modifying, a material compensatory plan, contract or arrangement in which the company’s principal executive officer, principal financial officer or other named executive officer participates or is a party, or a material grant or award to one of those officers (or material modification thereof) under any such plan, contract or arrangement. Grants or awards are not required to be disclosed if they are consistent with previously disclosed terms of the plan and the grant is disclosed the next time the company is required to provide new executive compensation disclosure (e.g., the next proxy statement).

In connection with its executive compensation and related person transaction rulemaking, the SEC modified other disclosure rules, including the following:

• Pledges of Stock Shown in Security Ownership Table. The beneficial ownership table will require disclosure of the number of shares that have been pledged by named executive officers, directors and director nominees, and inclusion of any directors’ qualifying shares in the total amount of securities owned.

Practice Tips & Observations: In light of these changes, companies should amend their director and officer questionnaires and other information gathering procedures to ensure that they obtain current information about any possible pledges of company stock by named executive officers, directors and nominees. Companies may also wish to revisit any existing policies related to executive officer and director pledges of securities.

• Performance Graph. The stock price performance graph has been retained but moved to the portion of the annual report to stockholders that deals with stock price information (Item 201 of Regulation S-K), rather than having it associated with executive compensation. The stock price performance graph will continue to be considered "furnished," not filed.

• Plain English. The new rules require companies to prepare most disclosures using plain English principles in organization, language and design. These principles are the same as those that the SEC has applied to some prospectus disclosures in the past.

• Special Rules for Small Business Issuers and Foreign Private Issuers. Small business issuers (as defined in Regulation S-B) will be subject to a subset of the new rules. The new rules also contain exceptions for foreign private issuers.

The SEC adopted the new executive and director compensation rules and the related person transaction and corporate governance rule revisions so that they would be in effect for the 2007 proxy season for calendar year-end companies. Generally speaking, compliance is required for fiscal years ending on or after December 15, 2006.

Specific compliance dates for particular types of filings are as follows:

• For Forms 10-K and 10-KSB, compliance is required for fiscal years ending on or after December 15, 2006;

• For proxy and information statements covering registrants that are not registered investment companies, compliance is required for any proxy or information statements filed on or after December 15, 2006 that are required to include executive compensation or related person transactions disclosures (Items 402 and 404 of Regulation S-K) for fiscal years ending on or after December 15, 2006;

• For registration statements covering registrants that are not registered investment companies, compliance is required for registration statements that are filed with the SEC on or after December 15, 2006 that are required to include executive compensation or related person transactions disclosures (Items 402 and 404 of Regulation S-K) for fiscal years ending on or after December 15, 2006; and

• For proxy and information statements covering registered investment companies, compliance is required for any new proxy or information statement filed on or after December 15, 2006.

Companies will not be required to "restate" compensation disclosure, or related person transaction disclosure, for prior fiscal years where disclosure under the existing rules was already provided. As a result, only the most recent fiscal year will be required to be reflected in the revised Summary Compensation Table when the new rules and amendments become effective. The information for 2004 and 2005 will not have to be presented at all. The additional two years of summary compensation information will phase in over the ensuing two years.

Form 8-K compliance is required for triggering events that occur 60 days or more after publication of the final rules in the Federal Register, which is likely to result in a compliance date in late October of this year.

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