United States: Executive Compensation Disclosure Memo Series (Part 2 of 6)

To read Part 1 of 6 please click here

Part 2 of 6 summarizes the principal aspects of the new Compensation Discussion and Analysis ("CD&A") section that will be required in proxy statements (or 10-K’s for companies not subject to the proxy rules) filed in the upcoming proxy season.

The SEC’s director of the Division of Corporate Finance, John White, has characterized CD&A as the "heart" of the new compensation disclosure regime. The CD&A is intended to serve a similar purpose for compensation disclosure as that served for financial disclosure by Management’s Discussion and Analysis ("MD&A"). The CD&A will explain all material elements of a company’s compensation program and provide a discussion and analysis of the material factors underlying compensation policies and decisions. The implementation of those decisions should be reflected in the data presented in the Summary Compensation Table (see Part 3 of 6) and other tables accompanying such narrative discussion.

In general, the CD&A will explain the material elements of compensation of all named executive officers, including information relating to the following specific items:

• The objectives of the company’s compensation program;

• What the compensation program is designed to reward;

• Each element of compensation (salary, bonus, equity, perks, retirement benefits, etc.);

• Why the company chooses to pay each element;

• How the company determines the amount (and where applicable, the formula) for each element; and

• How each compensation element and the company’s decisions regarding that element fit into the company’s overall compensation objectives and affect decisions regarding other elements.

The CD&A rules are "principles-based," and as such the CD&A should focus on material elements underlying the company’s executive compensation policies and decisions. Because the discussion will be based on the individual company’s circumstances and the numbers reflected in its compensation tables, each company will have to decide for itself the material elements of its compensation and decision-making that should be discussed in the CD&A. The discussion should avoid "boilerplate" language, year-to-year comparisons similar to MD&A, and language that merely repeats the more detailed dollar amounts that follow in the required tables, although cross references to such tables are encouraged where useful.

The discussion should not begin, as many Compensation Committee Reports currently do, with a description of each element of the company’s compensation program or the general objectives of the program. Instead, the discussion should provide analysis of the compensation program as a whole, explaining why the individual elements of the program were selected and how they operate together to meet the program’s objectives. The SEC has included in the CD&A rules illustrative examples of information that might be covered in the CD&A. Issues that are appropriate for discussion in the CD&A include the following:

• The policies for allocating between long-term and currently paid out compensation;

• The policies for allocating between cash and non-cash compensation, and among different forms of non-cash compensation;

• For long-term compensation, the basis for allocating compensation to each different form of award (such as the relationship of the award to the achievement of the company’s long-term goals, management’s exposure to downside equity performance risk, correlation between cost and expected benefits to the company);

• How determinations are made as to when awards are granted, including awards of equity-based compensation, such as options;

• What specific items of corporate performance are taken into account in setting compensation policies and making compensation decisions;

• How specific forms of compensation are structured and implemented to reflect such items of corporate performance, including whether discretion can be or has been exercised either to award compensation absent attainment of the goal or to reduce or increase the size of award, and if such discretion has been exercised, stating whether it affected any of the named executive officers or all compensation subject to the relevant goal;

• How specific forms of compensation are structured and implemented to reflect the named executive officer’s individual performance and/or individual contribution to such items of corporate performance, describing the elements of individual performance and/or contributions that are taken into account;

• The company’s policies and decisions regarding the adjustment or recovery of awards or payments if the relevant items of corporate performance are restated or otherwise adjusted in a manner that would reduce the size of an award or payment;

• The factors considered in decisions to increase or decrease compensation materially;

• How amounts realizable from prior compensation are considered in setting other elements of compensation;

• With respect to any contract that provides for payment in connection with termination or changein- control, the basis for selecting particular events as triggering payment;

• The impact of accounting and tax treatments on particular compensation;

• Whether the company engaged in any benchmarking of total compensation, or any material element of compensation, identifying the benchmark and, if applicable, its components;

• Stock ownership guidelines and polices regarding hedging the economic risk of such ownership; and

• The role of executive officers in determining executive compensation.

Although these items do not represent an exhaustive list, it is likely that most companies will at a minimum want to address each of the aforementioned fifteen items in their first CD&A. However, material items that do not fit under such items must also be disclosed.

Although the new executive compensation rules do not require small business issuers to provide the CD&A in their year-end materials, the requirements of thorough analysis and unambiguous compensation policies are best practices that compensation committees should incorporate into their compensation decision making process.

Following current practice, companies will generally not be required to disclose in their CD&A the specific quantitative or qualitative performance-related factors considered in determining executive compensation, if such disclosure would result in competitive harm for the company. Further, the company will not be required to disclose any factors or criteria involving confidential commercial or business information. However, where targets or other performance-related factors are not disclosed, the company should disclose how difficult or easy it is expected to be for the individual or the company to achieve such benchmarks. It is important to note, however, that the SEC’s "default standard" is disclosure of specific performance targets, and that the SEC is likely to require strong support for nondisclosure under the standards listed above. Formulating that rationale in advance will simplify the process of responding to an SEC request for substantiation of a decision made as a result of non-disclosed performance-related factors.

The CD&A instructions take note that some performance measures that may be disclosed (either in terms of specific targets or by description) involve the use of non-GAAP financial measures. The instructions provide relief from the general rules regarding the disclosure and reconciliation of non-GAAP information. However, the company must provide some explanation of how the measures may be calculated from the audited financial statements.

In keeping with the focus on the totality of the compensation package, the CD&A should address the committee’s use of a tally sheet or other compensation tools to determine each named executive officer’s total compensation. The discussion should describe the elements of compensation included in the tally sheet, and explain how the tally sheet totals were relevant to the decisions made by the committee. In addition, the discussion must provide the committee’s analysis of the findings and an explanation of the resulting actions taken. Finally, if the committee relied on a compensation consultant for any advice, the company will need to disclose the identity of the consultant and the nature of the work assigned to such consultant. Where the policies or decisions for the named executive officers are materially similar, the CD&A is not required to discuss each named executive officer’s compensation on an individual basis. However, each element of compensation will still need to be analyzed in relation to the whole. For example, if a company provides perks that have a significant value to the executive, it will not be sufficient to set forth "to be competitive" justifications. For each compensation element, and where different for each executive, the CD&A will need to address uncomfortable questions and issues, including, for example, how gains from prior option or stock awards were considered and affected compensation decisions, why there is a need for a severance provision after an executive has become established in his position, and whether there is a need to provide for post-employment financial security once a CEO has already accumulated a significant nest egg from previous equity and long-term incentive grants.

Drafting the CD&A will require looking back over the last year (and possibly longer) and explaining what decisions the compensation committee made and what factors were taken into account when making the decisions. To direct and facilitate this compensation discussion on an ongoing basis, the committee should have in front of it, at each meeting at which a compensation decision will be made, a checklist of factors to consider, which as a starting point could consist of the 15 CD&A factors identified above. The committee should also delegate someone to lead the discussion and document the committee’s analysis as well as its decisions.

The nature of the CD&A requires that the first draft be prepared by someone who is familiar with the company’s compensation programs and the decisions made by the compensation committee during the year. The person(s) responsible for drafting the CD&A should review the background materials relevant to the required disclosures, including minutes of the committee’s meetings and compensation consultants’ reports or presentations. Once the initial draft is prepared, the CD&A should be circulated for review to the appropriate persons in human resources, accounting, and legal as well as outside counsel and, if appropriate, compensation consultants. This process will be difficult and time consuming, so it is best to start now. Even if past decisions as to compensation were analyzed in the depth covered by the CD&A rules, future decisions and analysis regarding 2007 compensation – if made deliberately and with the new rules in mind – can demonstrate the company’s commitment to full and fair disclosure of its executive compensation policies.

• Assign responsibility for preparing the initial draft of the CD&A

• Review background materials relevant to the required disclosures, including minutes to committee meetings and materials circulated at or in advance of committee meetings

• Draft a mock-up based on last year’s compensation

As you begin to implement many of these items in preparation for the 2007 proxy season, and need additional advice or assistance, please feel free to contact your regular Powell Goldstein contact.

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.