SEC Proposes New Rules on Executive Compensation Disclosure

The U.S. Securities and Exchange Commission has proposed new disclosure rules for executive and director compensation and related party transactions in response to investors’ calls for more transparent disclosure.¹The SEC believes that the current rules are out of date and manipulable, and its overriding objective is to ensure that companies provide clearer and more thorough disclosure.

The SEC’s proposals apply only to U.S. domestic companies, not to Canadian or other foreign private issuers that file annual reports with the SEC on Form 20-F or Form 40-F.

This memo is based on a recent SEC webcast. The actual text of the SEC’s proposals will be posted to the SEC’s website at www.sec.gov, under "Proposed Rules". There will be a public comment period of at least 60 days before the rules are finalized, and the new regime will be effective in 2007 at the earliest. However, the SEC staff has stated that the proposals will include interpretive guidance on the existing rules that are applicable for the 2006 proxy season and will also encourage early adoption of some of the new rules.

• The summary compensation table would contain a column for total compensation (including the dollar value of stock, option and similar incentive awards, based on their fair value on the date of grant (calculated the same way as now required under U.S. GAAP for expensing stock options).

• A "named executive officer" (NEO) would be determined by total compensation, rather than just salary and bonus.

• In addition to the disclosure of total compensation for the CEO, the CFO and three other NEOs, total compensation would now also have to be disclosed for up to three other employees, identified by job description only, whose compensation exceeds that of any NEO. These could include any highly paid employees, such as traders, salespeople, entertainers and athletes.

• A new "compensation discussion and analysis" would have to answer specific questions that explain the company’s policies and decisions about executive compensation—in non-boilerplate language, and in plain English (that is, expect close scrutiny by the SEC).

The new disclosure would start with a "compensation discussion and analysis" (CD&A) that explains the company’s policies and decisions on executive compensation, replacing the current compensation committee report and performance graph. The CD&A would disclose material information specific to the company rather than boilerplate. It would also have to be written, along with the rest of the compensation disclosure, in accordance with the plain English rules that apply to U.S. prospectuses. Companies would have to answer the following questions in their CD&A:

• What are the objectives of the company’s compensation program?

• What is the program designed to reward and not reward?

• What are the elements of compensation?

• Why does the company choose to pay each element?

• How does the company determine the amount of each element? and

• How does each element fit into the overall objectives of the compensation program?

Companies’ disclosure following the CD&A would be divided into three categories: (a) compensation during the last three fiscal years; (b) outstanding equity-related interests and gains during the last fiscal year; and (c) post-employment or change of control compensation and benefits. Each of the three categories would require tables, supplemented by narrative disclosure of the material factors necessary to understand the information in the tables.

The summary compensation table is and would remain the key disclosure item under this category. The first column would be the sum of the other columns and would show the total compensation of the CEO, the CFO and the next three highest paid executive officers (for a total of five NEOs, as is the case now, except that under current rules, the CFO only needs to be included if he or she ranks in the top five). Total compensation would also be disclosed for up to three other employees, identified by job description rather than by name, whose compensation exceeds that of an NEO. These could include any highly paid employees, such as traders, salespeople, entertainers and athletes. The individual elements of the summary compensation table would be as follows:

• annual salary and bonus;

• the dollar value of stock, option and similar incentive awards, based on their fair value on the date of grant (calculated the same way as now required under U.S. GAAP for expensing stock options);

• cash incentive awards not tied to performance of the company’s stock; and

• all other compensation, which would include anything not fitting into another column—for example, increases in pension plan actuarial values during the year, company contributions and earnings on deferred compensation, tax gross-ups and similar payments, and perquisites and other personal benefits (which would have to be itemized unless they total less than $10,000).

The SEC has designed the new summary compensation table to address perceived shortcomings in companies’ disclosures under current requirements. For example, whether or not someone is an NEO would depend on total compensation, rather than just salary and bonus. This is intended to reduce the incentive under the current requirements to keep an executive officer from being an NEO by shifting his or her compensation into categories other than salary or bonus. Further, the total compensation figure in the first column of the table is not always calculable under current requirements because the number of stock options does not need to be converted into a dollar amount.

The SEC is not proposing to require disclosure of a company’s total compensation cost as a percentage of its profit. A cost-of-management ratio (COMR) would be readily calculable on the basis of the totals in the first column of the summary compensation table, but only for the five NEOs.

In addition to the summary compensation table, the proposals call for two other tables, accompanied by narrative explanations: a table for grants of performance-based awards during the year (whether stock-based or not); and a table for all other equity awards, such as time-based awards.

Disclosure relating to equity holdings would consist of two tables plus narrative explanations: a table of outstanding equity awards showing the value of year-end holdings of equity interests received as compensation; and a table of options exercised and stock vested showing amounts realized during the year.

Disclosure of post-employment compensation and benefits would include items receivable upon retirement, termination or a change of control of the company. The amount of detail would substantially exceed current requirements. The first table would disclose potential annual payments and benefits under retirement and deferred benefit plans, showing specific amounts for each NEO. The second table would disclose non-qualified defined contribution and deferred compensation plans, showing company and executive contributions, aggregate earnings and withdrawals during the last fiscal year and the total balance at the end of the fiscal year. Companies would have to describe any arrangement providing for payments or benefits, including perquisites, in connection with any termination or change in responsibility of an NEO or a change of control of the company. The estimated payments and benefits would have to be quantified, with assumptions disclosed where necessary.

Directors’ compensation would be disclosed in tabular format similar to the summary compensation table, but for one year rather than three years.

Companies would have to disclose their policies and procedures for reviewing and approving related party transactions. The current $60,000 threshold for disclosure would be raised to $120,000 and the disclosure requirements for insider indebtedness would be revised to reflect the general prohibition under the Sarbanes-Oxley Act of 2002.

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