Originally published in A Director's Guide to Executive Compensation, September 2006.
- Telling It Right Disclosure of Executive Compensation
- To Report or Not to Report
- Executive Compensation Disclosure Under Securities Regulations
- TSX Requirements for Disclosure of Compensation Plans
- Market Practice in Compensation Disclosure
Disclosure Of Executive Compensation
Current Canadian Rules
The current Canadian rules for disclosure of executive compensation, which were introduced in 1993, were very closely modelled on the U.S. rules introduced two years earlier. The rules heralded a radical change in Canadian disclosure of executive compensation.
The Canadian rules require disclosure of compensation details for the company’s five most highly compensated officers for the previous three years. The details include disclosure of salary, bonus, perks, options and stock appreciation rights, restricted stock and long-term incentive entitlements. The disclosure is generally made in the circular prepared for the annual general meeting of shareholders.
Proposed U.S. Rules
The U.S. Securities and Exchange Commission (SEC) has proposed new disclosure rules for executive and director compensation because it believes that the current rules are out of date and can be manipulated. The SEC has stated that the primary objective of the new rules is to ensure that companies provide clearer and more thorough disclosure.
These are the major changes proposed in the new U.S. rules:
- A column for total compensation would be added to the summary compensation table and would include the dollar value of stock, option and similar incentive awards, based on their fair market value on the date of the grant.
- The determination of the named executive officers would be based on total compensation, rather than salary and bonus.
- Total compensation would have to be disclosed for up to an additional three employees whose compensation exceeds that of any named executive officer.
- A new "compensation discussion and analysis" section would answer—in plain English—specific questions regarding the company’s policies and decisions about executive compensation.
- Post-employment compensation and benefits would have to be disclosed in substantially more detail than under the current requirements and would include items to be received upon retirement, termination or change of control of the company.
Where Is Canadian Disclosure Heading?
The Canadian Securities Administrators (CSA) is currently reviewing the area of executive compensation disclosure. We expect that a CSA committee will be engaged in a review and research process in the near term. According to the chair of the Ontario Securities Commission, David Wilson, a new Canadian compensation rule is expected to be published in 2006. Any proposed rule would be circulated for comment, so it is unlikely that Canada will have its new rules in place before the effective date of the new U.S. rules. Mr. Wilson said, in a lunch-time address May 29, 2006, that executive compensation is getting harder to understand and that the CSA is looking at ways to ensure greater clarity in the way executive compensation is disclosed. He expressed the hope that Canada will adopt a rule based on broad principles, rather than adopting the detailed U.S. rules. However, given past practice, we expect the Canadian rules to closely follow the new U.S. rules. Moreover, simple disclosure of executive compensation may be increasingly difficult to achieve as incentive plans themselves become more complex in response to shareholder demand for performance-based compensation.
Backdating And Springloading Of Options
Recently, the U.S. press and securities regulators have become concerned about "backdating" and "springloading" of option grants. Backdating refers to backdating the grant of an option to a time when the market price of the underlying share was lower than the current market price. Springloading is the granting of an option when the board has material undisclosed information that it believes will increase the market price of the underlying shares. Both backdating and springloading options are designed to achieve the same result—namely, granting an option that is already "in-the-money" (the exercise price exceeds the grant price) on the grant date.
This practice is coming under fire in the United States because companies have not been properly disclosing the grants. Neither backdating nor springloading options are illegal per se in the United States, although both may reflect poor governance. The SEC is proposing to require specific disclosure of backdated options and may also issue guidance regarding when it is appropriate for companies to springload option grants. In addition, a number of large pension funds are commencing class action lawsuits against companies that have backdated options. These lawsuits are targeting directors on the basis of breaching their fiduciary duty to shareholders.
The situation in Canada is quite different. Both backdating options (to take advantage of a lower market value of shares) and granting options when the board has material undisclosed information are prohibited. The TSX Company Manual (section 613(h)(i)) expressly requires that the exercise price of an option not be lower than the fair market value on the grant date of the option. This rule applies notwithstanding shareholder approval. The Manual (section 613(i)) also prohibits setting option exercise prices on the basis of market prices that do not reflect material undisclosed information. Further, to attract the equivalent of capital gains rates tax on the exercise of an option, the option must have an exercise price of not less than fair market value on the date of the grant.
Given the existing prohibitions, we would not expect the backdating or springloading of options to become significant issues for Canadian companies. On this topic, Canada appears to be well ahead of the United States.
To Report Or Not To Report
Insider Reporting Of Share-Based Compensation
Insiders of a reporting issuer must file insider reports when their ownership of a security of the reporting issuer changes. A "security" is broadly defined to include a variety of instruments. A "reporting issuer" includes an issuer whose securities are listed and traded on a stock exchange. An "insider" generally includes the following: (i) every director or officer of a reporting issuer; (ii) every director or officer of a company that is an insider or a subsidiary of the reporting issuer; (iii) a person or company that directly or indirectly owns at least 10% of the voting securities of the reporting issuer; and (iv) a reporting issuer that has purchased or redeemed any of its own securities.
National Instrument 55-101, Insider Reporting Exemptions, provides guidance on situations requiring insider reporting. Generally, the grant or disposition of shares or stock options to or by an insider requires an insider report. Insider reporting of other types of compensation, such as restricted share units (RSUs) and deferred share units (DSUs), is not as clearly dealt with under securities laws.
There are two bases on which the grant of RSUs or DSUs requires insider reporting:
- If the unit is a security; or
- If the unit is subject to Multilateral Instrument 55-103, Insider Reporting for Certain Derivative Transactions (MI55-103).
The lengthy period for which a DSU is required to be held and other characteristics of DSUs indicate that a DSU is not a security. An RSU is similar to a DSU except that the period until redemption is shorter. This difference is driven solely by the different tax deferral periods provided for RSUs by the Income Tax Act. The relatively short period of tax deferral available for an RSU may be significant in determining whether it is a security. In some respects, an RSU is similar to a share purchased under an employee share purchase plan with a three-year vesting period, for which insider reporting would be required. However, when the grant of RSUs involves no investment decision by the employee because the grant is not subject to an election, and when the organization has the discretion to make the award in cash, shares or both, there is good support for the argument that an RSU is not a security.
MI55-103 contains both a very broad obligation to file insider reports and a number of exemptions from this rule. MI55-103, section 2.1(a), requires an insider to file a report if the insider enters into an arrangement whose effect is to alter the insider’s economic exposure to the reporting issuer. "Economic exposure" is broadly defined as the extent to which the economic interests of an entity are aligned with the trading price of the reporting issuer’s securities or with the issuer’s economic or financial interests.
The grant of a DSU or an RSU is within section 2.1(a), but an exemption from the insider reporting requirements is available if the requirements in section 2.2 of MI55-103 are met. The exemption is thus available if the existence and material terms of the compensation arrangements are, or are required to be, described in
- the annual audited financial statements;
- an annual filing relating to executive compensation, or any other filing required to be made under any provision of Canadian securities legislation; or
- any public filing required to be made under the rules or policies of a stock exchange.
A compensation arrangement is a plan under which securities, phantom stock or similar instruments may be received.
The proper insider reporting of RSUs and DSUs is influenced by market practice. In an informal market practice survey of 20 major Canadian companies, insider reporting practice was evenly divided between those companies that do and those that do not file insider reports of DSU grants. No predominant market practice in this regard has therefore yet emerged. Given the uncertainties regarding insider reporting of RSUs and DSUs, if a predominant market practice develops, that practice should be followed.
Executive Compensation Disclosure Under Securities Regulations
Securities regulators require reporting issuers to disclose various aspects of their executive compensation. National Instrument 51-102 applies to all reporting issuers (other than investment funds) and sets out a standardized form for the continuous disclosure of executive compensation. The Ontario Securities Commission Rule 41-501 requires executive compensation disclosure in any prospectus filed in Ontario. Further, an issuer that solicits proxies from its securityholders to elect directors is required to disclose certain executive compensation components as set out in Form 58-101F1.
Form 51-102F6 requires the issuer to set out a summary of its executive compensation in table form. Disclosure is required of the compensation provided to the CEO, the CFO and the three other most highly compensated executive officers, each of whose salaries and bonuses totalled more than $150,000 in the most recently completed financial year (the "named executive officers").
The table requires disclosure of compensation provided in the last three completed financial years, including the following:
- Annual compensation, such as salary and bonuses.
- Other compensation, such as a car allowance, club memberships, financial assistance for a child’s education and for provision of accounting, tax and other financial services.
- Amounts paid or benefits gained with respect to securities, when the amount paid was more than the market would have paid; long-term incentive payments; tax reimbursements; purchases of securities at less than fair market value; and loans provided by the organization to the executive.
- Securities issued to the executives under option, as well as any share appreciation rights (SARs) granted in the most recently completed financial year; this disclosure must be further detailed under a separate table that requires the disclosure of each exercise of options or SARs.
- Repricing of any options or SARs, which is required to be specifically disclosed and explained.
- Payouts under long-term incentive plans.
- Defined benefit pension plans with the estimated annual benefits payable upon retirement.
- Employment agreements if the executive is entitled to a payment of $100,000 or more on termination of employment, a change of control or a change in the executive’s responsibilities.
The OSC’s Rule 41-501 sets out the general requirements for information to be included in a prospectus and requires that indebtedness of directors and officers to the issuer or any of its subsidiaries be disclosed.
Toronto Stock Exchange Requirements For Disclosure Of Compensation Plans
Section 613 of the TSX Company Manual contains certain disclosure requirements for any compensation plan that involves the issuance of shares, such as stock options, stock purchase plans or share appreciation rights. Below are some highlights.
- The plan must be approved by a majority vote of directors and shareholders
- when the plan is put in place;
- every three years after the plan is put in place; and
- whenever there is an amendment to the plan that would extend its term or reduce the exercise or purchase price of securities.
- Insiders entitled to receive a benefit under the arrangement can vote to approve the arrangement only if the total issued and outstanding securities of the issuer that are issuable to insiders under that arrangement and all other arrangements do not exceed 10% of the issuer’s securities.
- Those who are entitled to vote on the approval must be provided with disclosure materials, which must contain information such as
- eligible participants under the plan;
- total number of securities issued and issuable under the plan;
- maximum percentage, if any, of securities available to insiders;
- method for determining the exercise price;
- vesting and term of any stock option; and
- procedure for amending the plan.
- Once approval has been obtained, it must be filed with the TSX along with a copy of the plan itself.
- Each year, the issuer must disclose the terms of the plan in its shareholder disclosure documentation, such as information circulars.
- Keep the following in mind when designing the plan:
- at the time of grant, the option’s exercise price must be at least the current market price;
- the plan must include a maximum number of issuable securities. That maximum number may be expressed as a fixed number or as a fixed percentage of outstanding capital represented by the stock.
- A report in standardized form, listing all granted, exercised or cancelled options under the plan, must be submitted monthly.
Market Practice In Compensation Disclosure
RSU, DSU And PSU Disclosure Alternatives
The main summary compensation table set out in Form 51-102F6 provides issuers with some flexibility in characterizing various types of compensation. For example, RSUs (restricted share units), DSUs (deferred share units) and performance share units can all be characterized as "shares or units subject to resale restrictions," in which case they would be reported in the main summary compensation table under that heading. Alternatively, they could also be described as "a long term incentive plan payout," in which case they would be reported in the main summary compensation table under that heading. If no payment has been made under the grant, they could be characterized as long-term incentive plan (LTIP) awards and included in the specialized LTIP table prescribed by Form 51-102F6.
A survey of the reporting of 80 large Canadian corporations reveals that most (83%) report these awards in the main summary compensation table as "units subject to resale restrictions." Characterizing them in this fashion means that the award must be reported in the year it is granted, but not at the time of payout.
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.