United States: SEC Adopts Sweeping Changes To Executive And Director Compensation Disclosure Rules - Part 1

On July 26, 2006, the SEC adopted sweeping changes to its rules for disclosing compensation of executive officers and directors of public companies, information about related person transactions, director independence and other corporate governance matters. These changes will generally be effective for the 2007 proxy season. The SEC also adopted changes to Form 8‑K disclosure requirements, limiting "real time" disclosures of management contracts and compensatory plans, contracts and arrangements and consolidating all Form 8-K disclosures regarding management and director issues under a single item. The Form 8-K changes will be effective 60 days after the final rules are published in the Federal Register. The full text (430+ pages) of the final rules, SEC Release No. 33-8732, was made available on August 11, 2006 and can be found at www.sec.gov/rules/ final/2006/33-8732.pdf.

This client alert summarizes the key aspects of these new rules, the compliance dates for which are addressed below. Because the new disclosures require information that is different than what was required in the past, it is important to begin, now, to take action to prepare for the disclosures. Some of the actions that we suggest companies may want to take include:

• Evaluate existing policies, procedures and systems (including disclosure controls and procedures and internal control over financial reporting) to assess what changes need to be made in order to comply with these new disclosure requirements.

• Develop a timeline for making any needed changes, gathering the information necessary to respond to the new rules, drafting the new disclosures and obtaining the input of relevant groups, such as the company’s accounting, finance, legal and human resources departments and the company’s compensation committee.

• Evaluate who within the company must or should be involved in gathering and analyzing the relevant data and drafting and reviewing the required disclosures.

• Begin to collect the relevant information and prepare a "mock up" of required disclosures.

• Compensation Discussion and Analysis – CD&A

• Compensation Committee Report

• Disclosures of Option Grant Practices

• How Named Executive Officers Are Identified

• Re-proposal of "Katie Couric" Provision

• Summary Compensation Table – Focus on Total Compensation, Including Value of Equity Awards

• Guidance For Perquisites Disclosure

• New Tables for Equity and Non-Equity Incentive Awards

• Pension Benefits and Deferred Compensation Tables

• Severance and Change of Control Arrangements

• Director Compensation Table

• Director Independence

• Compensation Committee Disclosures

• Reorganized Corporate Governance Disclosures

• Approval Procedures

• Related Person Transaction Disclosures

• Impact on Rule 16b-3 Non-Employee Directors

The new executive and director compensation disclosure rules are divided into five primary areas:

• Compensation Discussion and Analysis ("CD&A") and a new form of Compensation Committee Report.

• Compensation of named executive officers ("NEOs") for the last fiscal year (and the two preceding fiscal years).

• Grants of equity-related (and incentive plan) interests to NEOs, holdings of outstanding equity-related interests and realization on equity-related interests.

• Retirement plans, deferred compensation and other post-employment payments and benefits for NEOs.

• Director compensation.

The rules continue to rely heavily on tabular disclosure of executive compensation, and now the tables are supplemented with extensive narrative disclosure. New narrative disclosures include, most importantly, CD&A. In addition, supplemental footnotes to the tables and discussions designed to give context to the quantitative tabular disclosures.

With these revisions to its executive compensation disclosure rules, the SEC is seeking to ensure that all elements of compensation are disclosed, and that they are disclosed in a manner that facilitates meaningful comparisons from company to company and from year to year. It is also seeking to make executive compensation information easier to understand in order to provide investors with a clearer and more complete picture of the compensation paid to executives and directors.

Basic Requirements. At the center of executive compensation disclosure will be a new section entitled "Compensation Discussion and Analysis." This section is designed to be a principles-based, narrative report by the company that provides an overview of the material factors underlying the company’s executive compensation policies and decisions. This section should be comprehensive, covering in-service and post-termination compensation arrangements and all types of executive compensation, including enhanced disclosure of executive stock option practices (discussed in more detail below) and employment or change of control arrangements. CD&A should put in perspective for investors the policies and decisions that led to the compensation reflected in the more detailed tables and narrative that follow. CD&A will focus on compensation decisions that were made in the most recent fiscal year, but it may also need to address actions that were taken after fiscal year end and, where necessary to provide context to current compensation disclosures, actions taken in earlier fiscal years. It should clarify material differences in compensation policies and decisions for individual NEOs, but a group discussion of those policies and decisions is acceptable where they are materially similar among the group.

No Boilerplate. The SEC intends that CD&A disclosure will go well beyond disclosure that was formerly included in compensation committee reports, in particular because CD&A will provide material information about the compensation objectives and policies for NEOs. The SEC specifically and repeatedly cautions that "boilerplate" disclosure will not be acceptable. Unlike the current compensation committee reports, which are "furnished" as opposed to "filed" with the SEC, the CD&A will be filed and subject to the same liability standards that apply to other annual report or proxy statement disclosures. It will also be covered by CEO and CFO certifications and disclosure controls and procedures requirements.

Address All Material Elements of Compensation. CD&A must explain all material elements of compensation for the company’s NEOs, by answering these questions:

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

• What is the compensation program designed to reward?

• What is each element of compensation?

• Why does the company choose to pay each element?

• How does the company determine the amount (and, where applicable, the formula) for each element?

• How does each compensation element fit into the company’s overall compensation objectives, and how do the company’s decisions regarding that element affect decisions regarding other elements?

In preparing to draft CD&A for the 2007 proxy season, companies need to evaluate all of their particular compensation programs, plans and arrangements. Companies will also be required to disclose significant information about their option and other equity grant programs and practices, as discussed separately below. Among the questions that should be considered when drafting CD&A are the following:

• What are the company’s policies for allocating between long-term and current compensation, and between cash and equity compensation?

• What is the basis for allocating compensation to each type of long-term compensation award (e.g., related to the company’s long-term goals, management’s exposure to downside equity performance risk, correlation between cost and expected benefits for the company)?

• How is timing of awards determined – including the timing of options and other equity awards?

• What specific items of corporate performance are taken into account in making compensation decisions, and can discretion be exercised in awarding the targeted compensation?

• How does each element of compensation reflect corporate performance or the specific performance of the individual executive?

• Why are different compensation elements weighted as they are?

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

• What factors were considered in materially increasing or decreasing compensation?

• How were amounts realized from prior compensation (such as gains from prior option grants or stock awards) considered in setting other elements of compensation?

• What was the basis for selecting particular events as triggering payment under termination and change of control arrangements?

• What is the impact of accounting and tax treatments of different forms of compensation?

• What are the company’s guidelines for ownership of company securities and hedging?

• Does the company engage in benchmarking of total compensation or any element of compensation, and if so which companies were used as benchmark companies?

• What is the role of executive officers in the compensation process?

No Disclosure of Confidential Performance Targets. Performance targets that involve confidential trade secrets or confidential commercial or financial information, the disclosure of which would result in competitive harm under existing SEC confidential treatment rules, are not required to be disclosed in CD&A (or the tables or related narrative discussions that follow CD&A). However, if they are not disclosed, the company will be required to address how difficult it will be for the executive, or how likely it will be for the company, to achieve the targets.

Practice Tips & Observations: In order to be able to prepare the new CD&A disclosure, companies will want to understand the manner in which information will be displayed in the executive compensation tables and narrative disclosures that are required by the new rules and for which CD&A is designed to serve as an overview. Where applicable, these tables and narrative disclosures may need to be cross-referenced in CD&A. As a result, companies likely will find it useful to get a head start in collecting required information so that it is available to support the preparation of the CD&A and related disclosure.

Analysis of specific policies behind executive compensation is a new exercise for companies that goes beyond the scope of existing compensation committee reports and may require substantial lead time to develop.

Because CD&A requires discussion of tax and accounting treatments of different forms of compensation, the company may need to obtain guidance from its professional tax and accounting advisors in preparing CD&A.

CD&A may require discussion of employment agreements and change of control agreements that are in place during the fiscal year and that are the basis for executive compensation during the fiscal year. This will require companies to review existing agreements in the context of preparing CD&A.

The new rules require companies to provide a new Compensation Committee Report that at a minimum addresses two specific points. First, whether the compensation committee has reviewed and discussed the company’s CD&A with management. Second, whether, based on that review and discussion, the committee has recommended to the board that the CD&A be included in the company’s annual report on Form 10-K and, as applicable, its proxy statement.

Like the Audit Committee Report, the new Compensation Committee Report will be "furnished," not filed. It will be required only once during any fiscal year, and the names of each member of the compensation committee (or persons performing the functions of that committee) will appear below the report.

In order to address concerns about CEO and CFO certifications of CD&A disclosure, which is likely to describe actions taken by the compensation committee without the involvement of the these officers, the CEO and CFO may rely on the new Compensation Committee Report in providing their certifications of CD&A.

Practice Tips & Observations: Since compensation committee reports must state whether the committee has reviewed and discussed CD&A with management, companies will want to ensure that they allocate sufficient time to gather CD&A information, prepare and review the required disclosures, and provide them to the compensation committee for review and discussion. Time should also be allowed to educate the compensation committee about the new standards for disclosure.

Disclosures of Option Grant Practices Option and Other Equity Plan Disclosures. The final rules include expanded disclosures about stock options and other equity plans. These rules respond, in part, to the flood of recent reports of company, SEC and Department of Justice reviews of questionable stock option practices, including allegations of "backdating" of option grants and timing of option grants to take advantage of the release, or withholding, of material non-public information. Expanded stock option disclosures will be found in CD&A and in a new "Grants of Plan-Based Awards" table, discussed separately below.

• CD&A requires enhanced narrative discussion of option grants to executives and directors (including reasons why a company selects options or other equity awards, timing of grants and how exercise price is determined).

• A new "Grants of Plan-Based Awards" table will include detailed information about grants to NEOs under the company’s equity incentive plans as well as its and nonequity incentive plans.

Disclosure About Stock Option Timing and Exercise Prices. Enhanced disclosure will be required, in CD&A and in certain parts of the tables and accompanying narrative disclosures, about the timing of stock option grants in relation to the company’s release of material non-public information, and any program, plan or practice of setting exercise prices based on the company’s stock price on a date other than the actual grant date (including grants under so-called "formula" plans).

In particular, the SEC believes that companies should address the following questions when preparing their CD&A disclosures:

• Does the company have any program, plan or practice to time option grants to executives in connection with the release (or withholding) of material non-public information?

• How does any program, plan or practice to time option grants to executives fit in the context of the company’s program, plan or practice (if any) with respect to option grants to employees more generally?

• What role did the compensation committee play in administering the program, plan or practice regarding option grants?

• How did the board or compensation committee take into account the information to be released, when determining whether and in what amounts to make option grants?

• Did the compensation committee delegate any aspect of the actual administration of a program, plan or practice to any other person?

• What role did the company’s executive officers play in the program, plan or practice of option timing?

• Does the company set the grant date of its stock option grants to new executives in coordination with the release of material non-public information?

• Does the company plan to time, or has it timed, its release of material non-public information for the purpose of affecting the value of executive compensation?

Companies will also be required to provide enhanced tabular disclosure reflecting any difference between the exercise price of an option and the closing market price on the date that the award was made by the compensation committee or board, as well as the reason for any difference.

Practice Tips & Observations: We understand that even though this SEC guidance is specifically addressed to options, the same principles will apply to other equity grants, such as stock appreciation rights, restricted stock and restricted stock units. The SEC has indicated that disclosure of similar information related to director grants should also appear in the narrative accompanying the new Director Compensation table. Accordingly, until additional guidance is provided, we recommend that companies consider providing disclosure of this sort for all forms of equity grants, and for all executives and directors to the extent applicable.

In order to prepare for these new disclosures, companies should assess their practices regarding the timing of option grants during the current fiscal year, and whether any changes to, or formalization of, those practices should be made. Companies should also assess their practices regarding option exercise prices for the fiscal year, and whether any changes to those practices are needed. To respond to the more general option disclosure requirements of CD&A, companies should review their standard practices and the terms of their option plans and agreements, and any deviations from those terms for executive officers, to assess the types of disclosures they will need to include, and to assess whether they should make any changes to their standard option grant terms and procedures. Companies should review their formal SOX 404 description of option grant policies and procedures and update as necessary.

The focus of the final executive compensation rules, highlighted by the revised Summary Compensation Table, is on compensation information for NEOs, the definition of which has changed. Going forward, the NEOs will be:

• any person who served during the last fiscal year as the principal executive officer (usually the CEO),

• any person who served as the principal financial officer (usually the CFO), and

• the three most highly compensated executive officers who were serving as such at the end of the company’s fiscal year and who earned compensation in that year of at least $100,000.

In addition, consistent with existing rules, up to two additional executives who were no longer serving as such at the end of the company’s fiscal year must also be included as NEOs if their total compensation exceeded that of any one of the other three executives named in the table.

Identification of the most highly compensated executive officers will be based upon total compensation for the last fiscal year (excluding the earnings on deferred compensation and the actuarial increase in pension benefit accruals that are included in the Summary Compensation Table), compared to just salary and bonus under the existing rules. As a result, an option grant, such as a large refresh grant to a current executive officer or an initial grant to a new executive, could cause that person to become an NEO. The SEC no longer permits exclusion of unusually large amounts of cash compensation, not part of a recurring arrangement and unlikely to continue, in identifying the NEOs.

Practice Tips & Observations: With the change from salary and bonus to total compensation as the relevant metric for determining NEO status, companies should assess their systems for valuing, gathering and analyzing the information that goes into total compensation. Companies should assure themselves that they are able to produce a "total compensation" amount for current executives and for those who served as an executive during the year. In addition, the switch to total compensation means that large equity or other incentive plan awards may raise the compensation of an individual executive sufficiently for him or her to be one of the three most highly compensated executives other than the CEO and CFO, so companies may want to assess in advance who are likely to be the NEOs included in the Summary Compensation Table for fiscal 2007.

The final rules did not adopt one of the more controversial provisions of the original rule proposals, which had targeted compensation disclosure about a new group of non-executive employees – the so-called "Katie Couric" provision. As proposed, total compensation for the year would have been provided for up to three employees who were not executives but whose compensation exceeded that of any of the NEOs. As re-proposed, disclosure would be required only for employees with significant policy-making authority within the company, a significant subsidiary or a principal business unit, division or function, and it would only apply to large accelerated filers (those with greater than $700 million in market capitalization). Further, the disclosure would be provided in narrative, rather than tabular, format and would not require the disclosure of the individual’s name but only his job position.

Overview. The revised Summary Compensation Table and accompanying supplemental narrative disclosures remain the principal vehicle for executive compensation disclosure. The table requires compensation for each NEO over the last three years, but the rules provide a phase-in for the new disclosures over three years, avoiding the need to recalculate previously-disclosed compensation information. For the 2007 proxy season, companies will be required to provide information about 2006 compensation only.

All Elements of Compensation Covered. Revisions to the Summary Compensation Table are designed to elicit disclosure of all elements of NEO compensation and to include an aggregate number for NEO total compensation. The Summary Compensation Table will require the following information, in separate columns:

• Salary.

• Bonus (now defined to include only bonus payments that are discretionary or guaranteed; performance-based incentive payments are disclosed separately).

• Dollar value of stock awards, based on FAS 123R value on grant date, including the incremental value of any awards that were modified during the year.

• Dollar value for all option awards, based on FAS 123R value on grant date, including the incremental value of any awards that were modified during the year (current rules require disclosure of the number, not value, of option awards).

• Non-equity incentive plan compensation earned during the year, whether or not paid during the year (including bonuses earned under cash incentive plans, such as under a single-year IRC Section 162(m) bonus plan).

• Annual change in actuarial present value of accumulated pension benefits and above-market or preferential earnings on nonqualified deferred compensation.

• Aggregate amount of all other compensation not reported in other columns of the table, including perquisites (discussed in more detail below) that in the aggregate are equal to or greater than $10,000 (compared to $50,000 under current rules) and contributions to defined contribution plans. Any item reported in this column (other than perquisites, which are discussed below) that exceeds $10,000 must be separately identified and quantified in a footnote for the last fiscal year.

• Total compensation, reflecting the sum of all of the other columns in the table for each NEO.

Additional New Requirements. The new rules include many detailed provisions on specific topics, including the following:

• How to account for deferrals of compensation.

• How to handle salary and bonus amounts that cannot be calculated at the most recent practicable date.

• How to distinguish between bonuses and non-equity incentive compensation.

• Required footnote or narrative disclosures with respect to the calculation of the FAS 123R values of equity awards.

• Timing of the disclosure of non-equity incentive plan compensation.

• Treatment of amounts received upon satisfaction of performance measures.

• Calculation of annual change in actuarial present value of accumulated pension benefits and above-market or preferential earnings on deferred compensation.

• Examples of "All Other Compensation" and the very limited types of compensation that are not required to be included.

• Guidance about determining, valuing and disclosing information about perquisites.

• Footnote disclosures required with respect to certain amounts included in the "All Other Compensation" column.

• Guidance about what should be included in the required narrative discussion that is to follow the Summary Compensation Table, including in some cases material terms of employment agreements and an explanation of the amount of salary and bonus in proportion to total compensation.

Practice Tips & Observations: Even where a company does nothing new in 2006 compared to prior years, executive compensation information will be presented very differently than in the past. For example, the dollar value of equity compensation grants (rather than share amounts as required under current rules) and above-market earnings on deferred compensation (even deferred compensation invested in mutual funds) will be included in the table and in total compensation. Moreover, each option grant will be valued at its full FAS 123R value on date of grant, regardless of vesting – so the Summary Compensation Table will reflect in the year of grant the entire amount of compensation expense that is expected to be included in the company’s financial statements over the vesting period of the grant. As a result, executive compensation totals will often appear higher than in the past.

Companies will need to evaluate their systems and processes for valuing, gathering and analyzing compensation information for NEOs (part of their disclosure controls and procedures) to ensure that they will be able to produce accurate figures for each of the required columns of the Summary Compensation Table, including the catchall "All Other Compensation," and to provide any related narrative explanations. This review should include an immediate assessment of which departments and personnel within the company should be responsible for gathering and reviewing the various executive compensation disclosures, as well as updating the company’s form of director and officer questionnaire. Companies may also want to begin immediately to prepare tally sheets or a "mock up" of the Summary Compensation Table, as well as the other required tables, since they will want to have plenty of time to finalize the table and circulate it for review and comment by necessary parties, including the compensation committee.

Principles Used to Determine Perquisites. The final rules contain useful interpretive guidance from the SEC about perquisites disclosure. While the SEC eschewed any bright-line definition of the term "perquisite or other personal benefit," it did discuss the principles to be used in determining whether an item is a perquisite, and in valuing those items. Under the SEC’s principles:

• An item is not a perquisite or personal benefit if it is integrally and directly related to the performance of the executive’s duties.

• An item is a perquisite or personal benefit if it confers a direct or indirect benefit that has a personal aspect, even if it is provided for a business reason, unless it is generally available to all employees on a nondiscriminatory basis.

• The appropriate way to measure the value of a perquisite is to determine the actual incremental cost to the company of providing the benefit (which generally is different than how perquisites are valued for tax purposes).

Generally, the SEC expects "perquisite or other personal benefits" to be interpreted broadly, and "integrally and directly related to the performance of duties" to be interpreted narrowly. The SEC suggests that companies approach a perquisite analysis by first evaluating whether the item is integrally and directly related to the performance of the executive’s duties. If so, that is the end of the analysis and no perquisite disclosure about the item is required. If not, then companies must assess whether the item confers a personal benefit, and if so, determine the incremental cost of that item.

Examples of Perquisites. Examples of items that would require disclosure as perquisites include:

"...club memberships not used exclusively for business entertainment purposes, personal financial or tax advice, personal travel using vehicles owned or leased by the company, personal travel otherwise financed by the company, personal use of other property owned or leased by the company, housing and other living expenses (including but not limited to relocation assistance and payments for the executive or director to stay at his or her personal residence), security provided at a personal residence or during personal travel, commuting expenses (whether or not for the company’s convenience or benefit), and discounts on the company’s products or services not generally available to employees on a non-discriminatory basis."

By contrast, the following are examples of items that would not be perquisites (no required disclosure):

"...travel to and from business meetings, other business travel, business entertainment, security during business travel, and itemized expense accounts the use of which is limited to business purposes."

The SEC generally believes that companies and their advisors are best suited to determine from the facts of particular situations whether perquisite disclosure is required. The interpretive guidance provided in the release is the SEC’s attempt to help companies identify and value perquisites, for disclosure that is required even under current rules. To underscore how seriously it takes perquisite disclosure, the release reminds companies that in the past the SEC has taken enforcement action against companies that did not properly report perquisites.

Specific Disclosures May Be Required. The new rules require that the aggregate amount of perquisites received by NEOs must be included in "All Other Compensation" if that amount is at least $10,000. Footnote disclosures must identify each perquisite included for the last fiscal year, and quantification in the footnote is required for each perquisite paid in the last fiscal year that exceeds the greater of $25,000 or 10% of the total amount of perquisites for that NEO. Where perquisite quantification is required, it must be accompanied by a description of the methodology used to compute aggregate incremental cost to the company.

Practice Tips & Observations: To prepare for the 2007 proxy season, we suggest that companies identify any items that are provided to their NEOs and directors to determine whether they are integrally and directly related to the performance of their duties – and, if not, whether they convey benefits to the NEOs and directors that have a personal aspect. For any items determined to be perquisites, companies should determine how to calculate the "aggregate incremental cost," establish systems to gather the relevant data, and be prepared to disclose this information.

Three separate tables address various aspects of equity and non-equity incentive awards under the new compensation disclosure rules.

Grants of Plan-Based Awards. This new table requires the following information about each equity-based award and non-equity incentive award to an NEO during the last fiscal year:

• The estimated dollar value of future payouts upon achievement of performance conditions under nonequity incentive plan awards, or the range of payouts where applicable (note that time-based additional vesting for non-equity incentive awards should be footnoted).

• The grant date for equity awards and, if different than the date the compensation committee or board took action to grant the award, the date of that action;

• The number of shares of stock, or shares underlying stock options, that are to be paid or vested upon satisfaction of performance conditions under equity incentive plan awards (or the range of shares to be paid or vested where applicable);

• The number of shares of stock, or stock options, granted during the year that are not reflected in the table as performance-vested; and

• The per share exercise price of options granted and, if the exercise price is lower than the closing market price on the grant date, an adjoining column with the closing market price on the grant date.

This table will include information about all non-equity incentive awards, regardless of whether they are one-year or multi-year awards. Thus, a cash incentive award payable under an IRC Section 162(m) plan covering only one year will be reported in this table for the year in which the plan is established, and the actual payment will also be reflected in the Summary Compensation Table for that fiscal year if the NEO earns the award.

The table must be supplemented with a narrative discussion of the material factors necessary to an understanding of the information included in the table, including and most importantly, the material terms of the awards reported in the table, such as vesting information and performance criteria. For example, the supplemental narrative could also be used to explain that an award that was earned in the same year appears in both the Summary Compensation Table and the Grants of Plan-Based Awards table.

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