United States: Corporate Law Bulletin - July 2006

SEC Announces Approval of Final Rules on Executive Compensation Disclosure — New Requirements Designed to Address Options Back-Dating Controversy

On July 26, 2006, the SEC approved final rules on executive and director compensation disclosure and issued a press release announcing the final rules. (http://www.sec.gov/news/press/2006/2006-123.htm) The SEC has not yet released the full text of the final rules themselves, but a detailed release containing the final rules is expected to be issued shortly. The final rules will mandate significant changes in the format and scope of disclosure of executive and director compensation.

It is particularly noteworthy that the final rules require unprecedented disclosure related to stock option grants intended to address the recent options back-dating controversy embroiling many public companies. We believe it is important for management and compensation committees to evaluate now and to anticipate going forward how a company’s proposed, current and past compensation policies, plans and practices would be presented to the public under the final rules for several reasons:

• Many compensation committees may wish to develop and adopt new policies and procedures or more formally memorialize existing policies and procedures in order to provide a clearer executive compensation disclosure.

• Substantial amounts of new data will need to be captured, analyzed and discussed under the final rules, which may be difficult to complete if companies wait to start until next year’s proxy season.

• Compensation committees and management should quickly assess the impact of the new disclosure requirements with regard to option grants in the current year.

The final rules will be generally effective for Forms 10-K and proxy statements filed for fiscal years ending on or after December 15, 2006. It is unclear why the SEC elected not to seek public comment on the new provisions in the final rules covering disclosure on options practices. This bulletin is based upon information contained in the SEC press release announcing the final rules and statements by the SEC Staff at the open meeting approving the final rules. See our Corporate Law Bulletin at http://www.mofo.com/news/updates/bulletins/bulletin02144.html for a discussion of the rules as originally proposed in January 2006.

Below is a discussion of the SEC’s newly mandated disclosure regarding options grant practices followed by a summary of some of the key provisions of the final rules with a focus on the changes from the previously proposed rules.

The final rules require detailed disclosures regarding the process, timing, pricing and rationale for stock option grants. These disclosures fall into two major categories: disclosures relating to the selection of stock option exercise prices that differ from the stock price at the time of grant (e.g., granting options with discounted prices, including "back-dating") and disclosures related to any process of coordinating the timing of grants with disclosures of non-public information (e.g., so-called "spring-loading" and "bullet-dodging"). Among the required disclosures are:

• Detailed tabular disclosure specifying (i) the grant date of options used by the company for expensing the options under the new stock-based accounting regulations (FAS 123R), (ii) the total fair value of the option on the grant date under FAS 123R, (iii) any variance between the closing market price and the exercise price of an option on the grant date, (iv) the date the compensation committee or board of directors took action to grant the option if this date is different from the grant date of the option, and (v) a description of the methodology for determining the option exercise price if it varies from the closing market price per share on the grant date.

• A plain English narrative in the new "Compensation Discussion and Analysis" ("CD&A") section (described below) discussing:

Full and accurate compliance with these new options disclosure requirements will require careful fact-finding and analysis of processes that were not previously the focus of attention at many companies. Moreover, since the final rules will generally be effective for proxies filed on or after December 15, 2006, they appear to require companies to disclose information about any timing of option grants made during this current fiscal year (e.g., a fiscal year ending December 31, 2006), notwithstanding the fact that some companies no doubt already made such grants weeks or months prior to this announcement of the final rules.¹ The final rules, when published, may provide additional clarification on how and whether these past grants need to be addressed, but it is important that management and compensation committees start thinking now about how best to properly comply with these new disclosure requirements and the potential shareholder reaction to the description of these matters in next year’s proxy.

It should also be noted that the SEC has indicated it will target for enforcement action those companies it determines have deliberately mischaracterized their options grant practices.

Finally, it should be noted that, on July 28, 2006, the PCAOB issued its Staff Audit Practice Alert No. 1 "Matters Related to Timing and Accounting for Option Grants," which provides that auditors should assess the nature and potential magnitude of the risks associated with the granting of stock options and perform procedures to appropriately address those risks.

As anticipated, the final rules require a new "Compensation Discussion and Analysis" intended, in the spirit of the "Management’s Discussion and Analysis" ("MD&A") section currently found in 10-K filings, to give shareholders greater insight into executive compensation policies, plans and programs as seen through the eyes of management as affirmed by the compensation committee.

The final rules require that the CD&A address the objectives and implementation of executive compensation programs and focus on the most important factors underlying each company’s compensation policies and decisions. The CD&A is required to be "filed" (not just "furnished") with the SEC and, as a result, is subject to the liability provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934. Moreover, this section will be subject to the Sarbanes-Oxley certification requirements for the CEO and the CFO.

Since the final rules will be generally effective for proxies filed on or after December 15, 2006 (and thus impact companies’ 2007 proxies), it is important that management and compensation committees think now about how the executive compensation analysis they undertake this year will be described in next year’s proxy as well as how best to keep a record of the process of analysis.

The final rules, unlike the proposed rules, require that the CD&A be filed in addition to (rather than in place of) a separate compensation committee report that companies are already required to furnish. The final rules, however, modify the content of the compensation committee report and require that it state whether the compensation committee has reviewed the CD&A with management and, based on this review, whether it has recommended that it be included in the 10-K and proxy. This revised approach is designed to foster discussion among the compensation committee and management about a company’s executive compensation practices and disclosure. In addition, the final rules undo the proposed elimination of the traditional stock performance graph set forth in the proposed rules.

Under the proposed rules, companies would have been required to disclose the compensation of up to three non-executive officers whose total compensation exceeded that of any "named executive officer." In response to public comments that this rule (the so-called "Katie Couric Rule") would require disclosing competitive information about salaries of key non-management employees, the SEC has now "re-proposed" this rule such that it would only apply to companies that are "large accelerated filers," and then only to employees with responsibility for significant policy decisions within the company, a significant subsidiary or division. The re-proposal of this rule by the SEC means that it remains subject to additional public comment.

The revised rule proposal, consistent with the previously proposed rules, would not require disclosure of the names of these non-executive officers, but would still require identification by job position. This will enable people familiar with the company to easily deduce these employees’ identities, and thus we remind compensation committees to take into account now the impact of this disclosure on their overall compensation program.

The final rules will provide for a separate column in the Summary Compensation Table to report the annual change in the actuarial present value of accumulated pension benefits and above-market or preferential earnings on nonqualified deferred compensation. As a result, these amounts can be excluded from the compensation amount used to determine which officers need to be identified as named executive officers based on total compensation. Many commentators had complained that including these amounts for the purposes of determining the named executive officers would lead to inconsistency from year to year as a result of differing returns on individual investment portfolios, and the SEC appears to have addressed this problem.

The proposed rules included a detailed description of termination and change-in-control benefits for Named Executive Officers, including a quantification of these benefits. The final rules require that, in quantifying these benefits, companies must assume that the event triggering the benefit occurred on the last business day of the last fiscal year and that the stock price to be used for calculating the value of applicable benefits would be the price on such date.

The final rules will modify the requirements in Form 8-K to limit the disclosure of some employment arrangements and material amendments to only those with "named executive officers." These modifications to Form 8-K will take effect earlier than the other changes and will be effective for triggering events that occur 60 days or more after publication of the final rules in the Federal Register.

Footnote

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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