United States: U.S. Public Companies Advised to Prepare Now for Revamped SEC Executive Compensation Disclosure Requirements

On January 27, 2006, the U.S. Securities and Exchange Commission (SEC) proposed significant changes to the rules governing public company disclosure of executive and director compensation arrangements and related party transactions.¹ While technical refinements to the proposed rules are anticipated, it is expected that final rules substantially similar to those proposed will be adopted, most likely by late summer or early fall, to be effective commencing with the 2007 proxy season.

We strongly recommend that U.S. public companies begin planning for the new rules now without waiting for final rules to be adopted despite what would appear to be substantial lead time. Preparing for next year’s proxy statement disclosure now could help, in the words of John W. White, the new Director of the SEC’s Division of Corporation Finance, "avoid unpleasant surprises."²

Mr. White began his new job with the SEC on March 20, 2006, and just two weeks later embraced the SEC’s proposed overhaul of executive compensation disclosure by making a speech in which he urged public companies to immediately:

• Make sure they actually know the relevant information related to their executives’ compensation—recognizing that some of the information they should know may be brought into sharper focus by the disclosures that the new rules will require, and

• Make sure that the right disclosure in their public documents will follow when revised rules are adopted.

Mr. White also urged public companies to commence reviewing and preparing to revise their disclosure controls and procedures so they will be able to fully comply with the anticipated new requirements.

We believe that public companies should give strong consideration to the following matters immediately or soon after completing this year’s annual proxy statement in order to be prepared for revised proxy disclosure rules next year:

A total compensation figure (in dollars) will appear in the Summary Compensation Table. The following items will be included in the table for the first time:

• The assumed fair value of options (based on FAS 123(R) disclosure) at the grant date along with the value of other equity awards,

• The increase in the present value of pension and retirement benefits over the previous year, and

• Any increased value of deferred compensation.

This total amount will very likely be significantly larger than the sum of the dollar values disclosed in 2006 proxy statements because the dollar value of the items noted above are not currently included in the summary compensation table. The rules as proposed will require detailed tabular disclosure of all these elements of compensation, as well as a projection of future severance and pension costs. Complying with these requirements will also require companies to compile and calculate compensation differently than in the past.

A comprehensive description of all executive compensation arrangements will be required as part of a new Compensation Discussion & Analysis in lieu of the current compensation committee report and performance graph. The CD&A can be viewed as the equivalent of the "Management’s Discussion & Analysis" for executive compensation. The proposed rules call for the CD&A disclosure to be a "filed document" subject to potential liability under Section 18 of the Securities Exchange Act (unlike the current Compensation Committee report which is "furnished" and not subject to Section 18 liability) and covered disclosure for purposes of the chief executive officer (CEO) and chief financial officer (CFO) certifications mandated by the Sarbanes-Oxley Act. Preparing the CD&A will require public companies to focus on creating detailed meaningful disclosures about the process and rationale for compensation decisions. As proposed, CD&A will require companies to disclose the attention that the Compensation Committee gave to various factors, such as the following:

• For what are the executive officers to be compensated,

• How much compensation should the executive officers receive,

• What form should the compensation take, and

• What is the methodology and frequency by which the company will measure whether compensation objectives have been achieved.

Records created by the Compensation Committee should support the CD&A disclosure, including detail in minutes that reflect the factors outlined in the proposed rules. We suggest that counsel play a significant role in preparing the CD&A early in the process.

The proposed rules would require new detailed disclosure regarding the process by which the compensation committee makes decisions. This disclosure would include:

• The role that executive officers play in determining or recommending the amount or form of executive or director compensation,

• The identity and role of the compensation consultant,

• Who engaged the compensation consultant,

• The nature and extent of any consulting arrangements, and

• The extent to which the compensation committee delegates authority to make pay decisions.

The proposed rules would require public companies to disclose the details of their executive officer compensation as a related party transaction if it is not approved by the compensation committee. The proposed rules would also require additional disclosure with respect to the independence of directors. We recommend that public companies evaluate their compensation committee charters and current compensation processes in light of these new disclosure and approval requirements. Contracts with consultants should contemplate disclosure of material terms of the arrangement.

It will be difficult to determine in advance who is a "named executive officer" (NEO) under the rules as proposed. It is important to identify who is an NEO for both SEC disclosure and tax purposes. Only NEOs are included in the Summary Compensation Table, and current 8-K rules require disclosure of any compensatory arrangement with NEOs. Payments to NEOs that do not qualify as "performance based compensation" are subject to deduction limits under Section 162(m) of the Internal Revenue Code of 1986, as amended (the Code).

Currently, the determination of who is an NEO, other than the CEO, is based on annual salary and bonus, which is relatively easy to calculate or project. The proposed rules instead would use total compensation to determine who is an NEO (besides the CEO and CFO, who will automatically be NEOs). The likely result is that the NEOs will change from year to year more often depending on several factors, such as substantial equity and non-equity awards, pension accruals, equity grants upon hiring and negotiated severance agreements.

The SEC has proposed to substantially revise the circumstances under which transactions are required to be disclosed as related party transactions and has proposed to eliminate many of the current exceptions. One of the more significant changes is that the threshold for disclosure of transactions in which a related party has a material interest would be increased from $60,000 to $120,000, but the threshold would be applicable to all transactions (eliminating the current percentage of revenues test and ordinary course exception for corporate transactions). The rules would also require a description of company policies and procedures for approval of related party transactions. Failure of the related party approval policy to require approval of a transaction subject to disclosure (or failure to follow the policy) must be reported in the proxy. Careful records should be kept to ensure that all related party transactions are approved as contemplated by applicable policies. The company should also re-evaluate its corporate governance regime and recurring or potential related party transactions in light of the expanded disclosure requirements.

In his speech on April 3, 2006, Mr. White stated that clients should know now what additional disclosures might be required next year about events occurring this year. He noted that as companies, their directors and their management "become more well-versed in these areas, they may not like the answers they find" and that it may be advisable to make changes now.

Leaving little doubt that major changes will not be made to the framework for the proposed rules, Mr. White made the following comments on key compliance aspects of the proposed rules:

Total Compensation: "The key to my mind is that companies and their compensation committees need to have a firm command of what total compensation is for each of their executives. If your company in the past has not been able to quickly and easily get its hands around this information, it seems to me that it's probably time to start."

Processes for Setting Compensation: "[C]ompanies may be well-served by preparing to tell their compensation stories tomorrow, and thus really learning the processes and procedures behind their compensation programs today. And by thinking about the story they’d like to tell, some companies may, perhaps, even decide to reshape their processes now. A determination like that is, again, up to the individual company. But it seems to me that all companies should make sure they know the facts today, if they do not already."

The Role of Executive Officers in Setting Compensation: "Under the proposals, companies will need to know, and be prepared to disclose, any role played by their executive officers in their compensation decisions, including disclosing any recommendation an executive has made about the amount or form of compensation the company pays. Recognizing that disclosure of an executive officer’s role could be required in the future, again, perhaps companies will want to reshape that role today. Future required disclosure may also include the interaction between executives and any compensation consultants engaged by the company’s board . . . ."

The Role and Identity of Compensation Consultants: "What are the nature and scope of their assignments? What instructions have they received? If the compensation committee engaged a consultant, did that same consultant do any work for the company or for any executives? If companies do not know the answers to these questions, they might want to find out. If they do not like the idea of disclosing the answers, again, perhaps they should reconsider their arrangements."

Perquisites: "Are you in a position to identify each perk that a named executive received and to specify the value of those perks meeting a particular threshold?"

Named Executive Officers: "Are you tracking the total compensation of a sufficiently inclusive group of your executives? [I]f adopted, the proposals could compel companies to monitor the compensation of a greater number of executives than just the five for whom disclosure is ultimately required."

Deferred and Retirement Compensation: "What amounts of compensation have been deferred by the executives during the year? What is the total amount of deferred compensation each executive has accumulated? What compensation is potentially payable upon an executive’s retirement or severance? Upon a change in control of the company? Have you done what you need to do in order to provide that disclosure quantitatively?"

Disclosure Controls and Procedures: "[P]ublic companies will have to ensure that their disclosure controls and procedures [DCP] cover any new executive compensation disclosure requirements that the Commission adopts. I do believe, though, that companies would be well-advised to start thinking now about how their disclosure controls and procedures will need to be revised and updated to handle any new executive compensation disclosure requirements that may be adopted. Who will collect and aggregate these different types of information, which may not fit neatly with information collected to meet existing disclosure requirements? Who will be responsible for maintaining the information? For analyzing it? For ensuring that the company’s compensation story (that’s the new CD&A) is told correctly (this may be more than having the technical executive compensation group, who puts the compensation packages together, generate accurate numbers)? Are existing disclosure committees properly positioned for the task? Do they include the right people? . . . Finally, don't forget that disclosure controls and procedures are, of course, intricately connected to the certifications that chief executive and chief financial officers must provide for periodic reports pursuant to Section 302 of the Sarbanes-Oxley Act. Companies need to make sure their CEO’s and CFO’s are prepared for their certifications to cover all disclosure that is required for their periodic filings."

Conclusion: "I highly recommend looking at these questions and starting to get ready now."