United States: Proposed Amendments to The Executive Pay Disclosure Rules: Common Sense and What Compensation Committees Should be Thinking About

The recently proposed SEC amendments will require the disclosure of almost all aspects of executive pay and benefits and also require more indepth disclosure of the Compensation Committee’s philosophy and rationale for its decision making. This greater transparency will further accelerate the shift in focus from a Wall Street to Main Street mentality on executive pay with the emphasis on total compensation. Compensation Committees will need to assess how the public perceives the entire executive/director pay package and how and whether the pay practices discussed below fit in the picture.

The proposed amendments are effective for proxy statements filed 90 days after the final amendments are published. The SEC has also solicited comments on numerous aspects of the proposed amendments. It is conceivable that the proposed amendments may change as a result of comments and the final amendments likely will not be published before Summer 2006, at the earliest.

We recommend that Compensation Committees keep abreast of the amendments, but not act precipitously by adopting new compensation policies or changes in executive pay or benefits as a result of the proposed rule changes until the amendments are final. Otherwise, Compensation Committees risk making early and unnecessary changes (which would have to be disclosed on a Form 8-K).

We recommend Compensation Committees take a "wait and see" approach and fully digest the consequences of the final amendments prior to complying with the proposed amendments or changing executive pay or benefits. That said, issuers should enhance their disclosure this proxy season. In addition, we think most Compensation Committees will begin to require the preparation of "tally-sheets" in 2006 in order to be ready to calculate the proposed amendments’ required disclosure of "total compensation."

The proposed amendments require that the total compensation of up to three employees that exceeds that of any named executive officer be disclosed along with the individual’s job description. As a result of this rule, Compensation Committees will take a greater interest in, and will require the approval of, the compensation arrangements for all or most highly compensated non-executive officers.

The proposed amendments require enhanced disclosure of a named executive officer’s annual perquisites that equal or exceed $10,000 in the aggregate. For issuers who offer personal use of cars and planes, club memberships, executive physicals, etc. and have not previously disclosed such perquisites because they have fallen below the current $50,000 threshold, Compensation Committees will begin to think about requiring the executive to pay for the incremental cost of such perquisites. Because investors and the public are fixated on the appropriateness of compensation that benefits only a select group, many Compensation Committees will simply authorize increased salaries and bonuses rather than provide perquisites or, if perquisites are provided, require that perquisites be reimbursed to the corporation rather than be disclosed. For corporations that continue to compensate executives with disclosable perquisites, Compensation Committees must take care to confirm that the methodology and assumptions for calculating the reportable value of perquisites is reasonable and conforms to the SEC’s incremental cost valuation rates.

There is already a trend among Compensation Committees to grant more restricted stock partially or fully in lieu of stock options. The proposed amendments’ requirement to disclose the grant value of options will accelerate this trend. This practice also makes sense to Compensation Committees in terms of shareholder dilution and earnings expense. We also think that grants of restricted stock will be made subject to the achievement of Internal Revenue Code Section 162(m) shareholder approved performance conditions. Where stock options are granted, Compensation Committees will, if they haven’t already, consider shorter option expiration terms which will produce less grant value disclosure and expense.

In terms of how much equity to grant, both as a result of the proposed amendments’ enhanced disclosure of equity holdings and dilution concern, Compensation Committees should evaluate on a case by case basis whether it continues to make sense to grant equity on an annual basis. We think there will be a shift from annual grants to grants on an "as-needed basis" taking into account aggregate equity holdings and prior gains.

The proposed amendments require quantification (not just description) of the expected amounts of severance, change of control and tax-gross-up payments. This comes on top of the trend pushed by Main Street and shareholder proposals to question and require shareholder approval of excessive severance and change of control payments. In addition to the shift from the generally accepted three-times base and bonus severance to no greater than two-times such amount (or lesser amounts), shareholders and the public are beginning to question the circumstances under which severance should be paid.

Compensation Committees should evaluate whether severance should be paid (i) where the corporation terminates an executive who has done a poor job, (ii) where the executive is near retirement and has substantial retirement plan entitlements, and/or (iii) where the executive’s equity stake makes severance less meaningful or necessary. We think that Compensation Committees will evaluate certain definitions like "cause" in these agreements and expand the list of the kinds of conduct that require the forfeiture of severance.

Compensation Committees will continue to require "double trigger" (as opposed to "single trigger") equity vesting in change of control arrangements and excise tax gross ups will be closely scrutinized. Where such arrangements are continued, Compensation Committees should ensure that the excise tax and gross-up calculations and assumptions are correct and reasonable, bearing in mind that these will need to be disclosed accurately (See "Use of Independent Experts" below).

Many companies have nonqualified deferred compensation arrangements ("NDCAs") and Supplemental Executive Retirement Plans ("SERPs") that provide benefits based on levels of compensation over and above the compensation limits for tax-qualified 401(k) and pension plans. The proposed amendments will require disclosure of the interest earned on NDCA accounts (not just the above market component) and accumulated account balances. Compensation Committees should evaluate these plans to determine that the earnings rate for NDCA deferrals are consistent with those offered to all employees in the corporation’s tax-qualified 401(k)/profit sharing plan and if not, be able to explain why. Similarly, with respect to SERPs, Compensation Committees will focus on whether SERPs provide better features than the corporation’s tax-qualified defined benefit plan offered to all employees (e.g., extra years of service, better benefit formulas, etc.) and, if so, Compensation Committees should be prepared to explain why that is the case.

Again, Compensation Committees should take stock of the amounts available under these plans to make sure that they fit in with the entire picture of accumulated equity and severance available.

Finally, care should be taken with respect to the amounts reported and assumptions used to make calculations for these plans to ensure accuracy and reasonableness.

The proposed amendments require tabular quantification of director pay in addition to the existing narrative description.

Compensation Committees and boards of directors will continue the trend, which began with shareholder proposals, to do away with outside director perquisites, deferred compensation and SERPs and will concentrate on levels of total director pay.

Moreover, Compensation Committees and boards of directors will grant restricted stock to a greater extent than stock options to align the interests of directors with shareholders and to encourage directors to require long-term results and not short-term gains. Further, we think that boards of directors will approve a single annual amount of board pay which the director will be able elect to take in cash or restricted stock. Alternatively, where boards begin to eliminate meeting fees but continue to pay annual retainers and special retainers for committee chairs, restricted stock will be a component piece in addition to cash. In this regard, instead of automatic, annual formula director stock option plans, an emerging best corporate governance practice is for boards to reserve the discretion to determine whether, what kind and how much equity will be granted to directors on an annual basis (subject to annual maximums) much the same as Compensation Committees do with executives.

The proposed amendments require the presentation of more quantitative data that often depends on the occurrence of contingent events. This will require more complicated calculations based on uncertain assumptions. We think that in many cases Compensation Committees, in order to satisfy their fiduciary duties, will reach out to their own independent legal, consulting and actuarial experts to ensure that the numbers presented are accurate and based on reasonable assumptions.

While Compensation Committees will continue to use consultants to help develop competitive pay packages, Compensation Committees should not blindly rely on consultants’ reports, but should use common sense in evaluating such reports and the peer groups and assumptions utilized in those reports. At the end of the day, Compensation Committees should be mindful about how the entire pay package will be characterized by the media.

Orrick’s Compensation and Benefits Group, Corporate Group and Securities Litigation Group are all closely monitoring developments under the SEC proposal and the broader area of executive compensation plan design, disclosure and litigation. For further information, please contact any member in these groups.

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.