SEC Revises Executive Compensation Disclosure

The Securities and Exchange Commission (SEC) has adopted final rules amending the disclosure requirements for executive and director compensation, related person transactions and corporate governance matters. The final rules adopt the amendments substantially as proposed in January 2006. The amendments, which are the first significant revision of the executive compensation disclosure rules in 14 years, affect disclosure in proxy and information statements, periodic reports and registration statements. They also modify the current reporting requirements of Form 8-K regarding compensation arrangements.

The rules are effective for proxy and information statements and registration statements under the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act) that are filed on or after December 15, 2006, and are required to include executive compensation disclosure for fiscal years ending on or after December 15, 2006. Accordingly, companies with December 31 fiscal years will need to comply with the new rules in their next proxy statements. Companies must comply with the amendments applicable to Form 10-Ks for fiscal years ending on or after December 15, 2006. Compliance with the revised Form 8-K disclosure requirements is required for triggering events that occur on or after November 7, 2006.

Background

The goal of the amendments is to elicit clearer, more comprehensive and transparent disclosure of compensation of named executive officers (generally, the principal executive officer, the principal financial officer, and the three other highest paid executives) and the directors. With the last significant revision of the executive disclosure rules in 1992, the SEC moved away from narrative disclosure of executive and director compensation in favor of formatted tables that categorized information and promoted comparability from year to year and company to company. Although the SEC believes that the goal of comparability is worthwhile and has been accomplished by the use of tables, the SEC believes that the formatted nature of the current disclosure has too frequently resulted in disclosure that does not adequately inform investors as to all elements of compensation even where necessary to a full understanding of executive compensation. Too often, information that was not specifically called for in the tables was not provided. With these amendments, the SEC is combining a broader-based tabular presentation with improved narrative disclosure supplementing the tables.

Executive and Director Compensation Disclosure

The final rules divide the discussion of executive compensation under Item 402 of Regulation S-K and S-B into several sections. First, a new Compensation Discussion and Analysis (CD&A) will provide an overview, discussing the material factors underlying compensation policies and decisions and the issuer's practices for the most recent fiscal year. It will largely expand upon and replace the current Compensation Committee Report, although a shorter Compensation Committee Report will be retained. Second, a section will provide information about compensation with respect to the last fiscal year and the two preceding years in a revised Summary Compensation Table. The revised Summary Compensation Table will present all of the elements of compensation that are currently paid and deferred, including the value of compensation in the form of options, restricted stock and similar grants and, most significantly, will require disclosure of total compensation. A supplementary table will provide additional tabular disclosure of grants under equity and non-equity plans. A narrative discussion will also be required to provide additional details. A third section will require disclosure of ownership of equity-based interests related to compensation or that are potential sources of future compensation, including interests awarded in prior years and that are "at risk," as well as recent realization on such interests, including through vesting of restricted stock or the exercise of options or similar instruments. A fourth section will provide disclosure of retirement and other post-employment compensation, such as pensions and deferred compensation, and benefits that are payable in the event of a change in control. Finally, a tabular and narrative section on director compensation will be required. Again, generally, all elements of director compensation must be disclosed.

Notably, the SEC expanded the required disclosure of option compensation. The focus on option disclosure is the SEC's response to the numerous instances of questionable options practices seen over the past few months.

Compensation Discussion and Analysis

The CD&A is intended to be an overview, providing the context for the more detailed disclosures that follow. This overview must explain all material elements of the company's compensation for named executive officers and, in particular, must answer the following questions:

• What are the objectives of the company's compensation programs?
• What is the compensation program designed to reward? (The SEC omitted a proposed requirement that the CD&A describe what the compensation program is not designed to reward.)
• What are the elements of compensation?
• Why does the company choose to pay each element?
• How does the company determine the amount (and, where applicable, the formula for determining the amounts) for each element?
• How does each element and the company's decisions regarding that element fit into the company's overall compensation objectives and affect decisions regarding other elements?

The purpose of the CD&A is to provide material information necessary to an understanding of the company's compensation objectives, policies and decisions, avoiding boilerplate disclosure. The CD&A is intended to put into perspective the numbers and narrative that follow it. Because of the comprehensive and individualized nature of the CD&A, many companies and their compensation committees should focus particularly on this new disclosure requirement in their upcoming proxy statements.

The scope of the CD&A is comprehensive and principles-based. The release identifies general concepts and includes examples of items that may warrant discussion, depending on the company's circumstances, such as:

• policies for allocating between long-term and currently paid out compensation;
• policies for allocating between cash and non-cash compensation and among different forms of non-cash compensation;
• the basis for allocating compensation to each different form of award of long-term compensation;
• how the company determines when to grant awards, 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 elements of compensation are structured and implemented to reflect these items of the company's performance and the executive's individual performance;
• the factors considered in decisions to increase or decrease compensation materially;
• how compensation or amounts realizable from prior compensation are considered in setting other elements of compensation (e.g., how gains from prior option or stock awards are considered in setting retirement benefits);
• the effect of accounting and tax treatments of a particular form of compensation (including the effect of Section 162(m) of the Internal Revenue Code);
• the company's equity or other security ownership requirements or guidelines and any company policies regarding hedging the economic risk of such ownership;
• whether the company engaged in any benchmarking of total compensation or any material element of compensation, identifying the benchmark and, if applicable, its components (including component companies); and
• the role of executive officers in the compensation process.

Option Disclosure. As part of its focus on options disclosure, the SEC included several specific requirements in the CD&A for options. The CD&A should disclose any program, plan or practice to time option grant dates in coordination with the release of material non-public information (e.g., if the company grants options just prior to the release of non-public information likely to increase the stock price, or if the company delays the release of such information until after option grant dates). If a company has a program, plan or practice to time option grants to executives, the SEC also listed several other examples of questions that the CD&A should potentially address, including how such a program, plan or practice comports with the company's program, plan or practice, if any, with regard to option grants to employees more generally; the role of the compensation committee in approving and administering such a program, plan or practice; the role of executive officers in the company's program, plan or practice; and whether such program, plan or practice applies to new executives. The SEC stated that it was not expressing a view as to whether such timing practices are valid or appropriate. Somewhat separately from the issues surrounding timing of grants, the CD&A should also disclose and discuss any program, plan or practice of awarding options and setting the exercise price based on the stock's price on a date other than the actual grant date, including by using formulas based on average prices (or lowest prices) of the company's stock in a period preceding, surrounding or following the grant date. All material information with respect to setting the exercise price based on the stock's price on a date other than the actual grant date must be disclosed.

The SEC clarified that the CD&A must address both compensation for the last fiscal year and actions taken after the end of the last fiscal year. In addition, it may also be necessary to discuss prior years to give the necessary context to the disclosure provided.

In addition, the SEC clarified that the CD&A should discuss compensation programs or policies that apply to any individual named executive, where appropriate. That is, where the policy or decisions relating to any particular named executive officer or officers differ materially from those relating to other executives, an individualized discussion must be included. (Currently, the Compensation Committee Report requires only an individualized discussion of the chief executive officer's compensation.)

As under current rules, companies are not required to disclose specific quantitative or qualitative performance-related targets, or any other factors involving confidential commercial or business information, if such disclosure would result in competitive harm to the company. However, if such information is omitted, the CD&A must disclose how likely it will be for the executives or the company to achieve the relevant targets. Companies must also be prepared to demonstrate to the SEC what competitive harm would result from disclosure of particular targets. The SEC indicated that it would review claims of competitive harm in a manner similar to how requests for confidentiality are treated, which is often quite skeptically. To the extent that a performance target has otherwise been publicly disclosed, disclosure in the CD&A would be required.

Although the SEC, in its proposals of the amendments, described the CD&A as replacing the Compensation Committee Report, the SEC decided to retain a shortened version of the Compensation Committee Report. The revised Compensation Committee Report would simply state, over the signatures of the members of the compensation committee, whether such persons had reviewed and discussed with management the CD&A and whether, based upon that review and discussion, the compensation committee recommends to the board of directors that the CD&A be included in the Form 10-K or proxy or information statement. The Compensation Committee Report, unlike a similar audit committee report, must be included in (or incorporated into) a company's Form 10-K.

The final rules also retain the Performance Graph, which the SEC had initially proposed to eliminate. However, the SEC remains of the view that the Performance Graph should not be included in the executive compensation section, because the CD&A is intended to encourage broader discussion than just that of the relationship of executive compensation to the performance of the company as reflected by stock price. Presenting the Performance Graph as compensation disclosure may weaken this objective. Instead, the Performance Graph will be moved to the disclosure item entitled "Market Price of and Dividends on the Registrant's Common Equity and Related Stockholder Matters" and will be required only in the company's annual report to security holders that accompanies or precedes a proxy or information statement.

The CD&A would be deemed "filed" as part of the proxy statement, rather than "furnished" as is the Compensation Committee Report under current rules. Thus, the CD&A would be incorporated by reference into registration statements and be subject to the liabilities of Section 18 of the Exchange Act, as well as be covered by the certifications provided under the Sarbanes-Oxley Act of 2002. The SEC emphasized that a company's disclosure controls and procedures apply to the preparation of the company's proxy statement and Form 10-K, including the CD&A. The SEC noted that while the CD&A discusses company compensation policies and decisions, the CD&A does not address board or compensation committee deliberations and is not a report of the compensation committee. Accordingly, the certifications that cover the CD&A will not be covering such deliberations. The actual Compensation Committee Report will continue to be furnished, rather than filed, however (as will be the Performance Graph), and thus will not be covered by the certifications.

Summary Compensation Table

The Summary Compensation Table continues to serve as the principal disclosure vehicle regarding executive compensation. This table, as amended, shows the named executive officers' compensation for each of the last three years, whether or not actually paid out. The form of the Summary Compensation Table is included as Exhibit A to this Alert.

Determination of Named Executive Officers. The final rules amend the definition of "Named Executive Officers," for whom the detailed disclosure is required, to consist of the principal executive officer, the principal financial officer and the three other most highly compensated executive officers. This is a change from current practice, under which specified disclosure is not required for the principal financial officer if not among the four most highly compensated executive officers other than the principal executive officer. Consistent with the current practice for principal executive officers, anyone who served as principal financial officer at any time during the fiscal year must be included as a named executive officer. The three additional officers are to be determined on the basis of total compensation for the most recent fiscal year (column (j) of the Summary Compensation Table) less the sum of the increase in pension values and nonqualified deferred compensation above-market or preferential earnings reported in column (h) of the Summary Compensation Table (as compared to total salary and bonus under current rules). Similar to current practice, any such other officers may be excluded as a named executive officer if his or her total compensation is less than $100,000. In addition, for purposes of determining which officers are among the three additional officers, the existing exclusion of payments relating to overseas assignments has been retained, but the exclusion of unusually large, non-recurring cash payments has been eliminated. The SEC also retained the requirement to include up to two additional former executive officers who would have been included as named executive officers but for the fact that they were not serving as executive officers at the end of the fiscal year.

Revisions to Summary Compensation Table. The most significant change to the Summary Compensation Table is the addition of a Total column, aggregating the total dollar values of the compensation quantified in the other columns.

Although Salary and Bonus columns would retain their current form, the SEC made several changes from current rules. First, certain compensation that currently would be reported in the Bonus column may now instead be reported in a new Non-Equity Incentive Plan Compensation column. Performance-related bonuses that were substantially uncertain at the time they were established and that were communicated to the executive will now be reported in the Non-Equity Incentive Plan Compensation column. Accordingly, the only bonuses to be reported in the Bonus column will be non-performance-related bonuses, bonuses based on performance targets that were substantially certain, and bonuses based on performance targets not communicated to the executive. Second, compensation that was earned but deferred (whether at the executive's election or otherwise) must be included in the Salary, Bonus or All Other Compensation column, as appropriate. Such amounts of deferred compensation also will appear in the Nonqualified Deferred Compensation Table (discussed below). Finally, if an executive's salary and bonus cannot be calculated until after the date of the proxy statement or report, the company must disclose that in a footnote, indicating when the amount is expected to be determined, and file a report on Form 8-K when such amounts become calculable.

Additional columns in the Summary Compensation Table cover plan-based awards, including stock awards, option awards and non-equity-based incentive plan compensation. Unlike existing requirements to disclose certain of such elements of compensation (such as stock awards and options) in numbers of shares rather than dollars, all compensation must now be disclosed in the dollar amounts.

The column for stock awards discloses the value of stock-related awards that derive their value from the company's equity securities or permit settlement by issuance of the company's equity securities, and are thus within the scope of FAS 123R for financial reporting, such as restricted stock, phantom stock, common stock equivalent units or other similar instruments that do not have option-like features. The reported value is generally the fair value of the award on the grant date as determined under FAS 123R for financial reporting purposes. The new regulations require a footnote referencing the disclosure of the relevant valuation assumptions in the notes to the company's financial statements or in the Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A). Stock awards subject to performance-based conditions also must be included in the column for stock awards, in contrast to the current rules that permit such awards to be reported as incentive plan awards.

The value of awards of options, stock appreciation rights, and similar equity-based compensation instruments that have option-like features and are within the scope of FAS 123R must be disclosed in the Option Awards column. As with stock awards, the value is generally the fair value of the award on the grant date as determined under FAS 123R for financial reporting purposes. The amendments also eliminate the existing requirement to report the potential realizable value of each option grant at 5% or 10% increases in the market price of the underlying stock; such disclosure is no longer necessary because the grant date fair value of equity-based awards is included in the Summary Compensation Table.

The proposals would have required disclosure of the full fair value of previous awards that were modified or repriced. However, the final rules only require recognition of the incremental cost of the modification, the same expense FAS 123R requires be recognized.

Under the rules as initially proposed, present earnings on outstanding stock awards and option awards (such as dividends) would have been reported in their respective categories when paid. The final rules provide, however, that if the value of such earnings was included in the calculation of the FAS 123R fair value of the award, such earnings are not required to be reported when actually paid, because that would constitute double counting of the value of such earnings. However, if the earnings were not included in the calculation of FAS 123R fair value of the award when the award was granted, then the earnings must be disclosed in the All Other Compensation column when paid.

The new Non-Equity Incentive Plan Compensation column reports the amounts earned under non-equity incentive plans, which are defined as incentive plans other than incentive plans under which awards are granted that fall within the scope of FAS 123R. This reports the value of all other amounts earned under an incentive plan where the performance measure is neither based on the price of the company's equity securities nor settled by the issuance of the company's equity securities, such as pursuant to performance-based bonus programs. Such awards are reported in the year when the relevant performance criteria are satisfied and the compensation is earned, whether or not payment is made during such period.

The final rules add a new column requiring disclosure of increases in the actuarial value of defined benefit plan account balances and earnings on non-tax-qualified deferred compensation. Footnote identification and quantification of the full amount of each element of such earnings is required. In the proposed rules, such amounts were included in the All Other Compensation column; however, because these amounts are to be subtracted from the total compensation amounts for purposes of determining the most highly paid executives qualifying as named executive officers, the final rules present these amounts in a separate column. The amounts of the two types of compensation to be disclosed in this column are determined as follows:

• Earnings on non-tax-qualified deferred compensation need be disclosed only to the extent they are above-market or preferential, as the current rules require. (However, all earnings on nonqualified deferred compensation, not just above-market or preferential earnings, must be disclosed in the separate Nonqualified Deferred Compensation Table, discussed below.) As under the rules prior to these amendments, the above-market or preferential portion is determined for interest by reference to 120% of the applicable federal long-term rate and for dividends by reference to the dividend rate on the company's common stock.
• The increases in pension value to be disclosed refers to the change, from the pension plan measurement date used for the company's audited financial statements for the prior completed fiscal year to the pension plan measurement date used for the company's audited financial statements for the covered fiscal year, in the actuarial present value of the named executive officer's accumulated benefit under all defined benefit and actuarial pension plans (including supplemental plans). This includes the increase in value due to an additional year of service, compensation increases and plan amendments (if any), as well as the increase (or decrease) in value attributable to interest.

The Summary Compensation Table also will contain a column disclosing the value of all other compensation not required to be included in any other column. This would include any item of compensation not properly included in another column, such as:

• the value of all perquisites, unless the aggregate value of the named executive officer's perquisites is less than $10,000;
• payments in connection with termination or change in control of the company;
• company contributions to defined contribution plans (i.e., 401(k) plans);
• the dollar value of life insurance paid by the company for the named executive officer's benefit;
• tax "gross-ups";
• any discount on stock purchased from the company unless the discount is available to all security holders or all salaried employees; and
• the dollar value of any dividends or other earnings paid on stock or option awards when the dividends or earnings were not factored into the grant date fair value.

Each item of compensation included in this column, other than perquisites, which is in excess of $10,000 must be separately specifically identified and quantified in a footnote. The value of each perquisite that is valued at the greater of $25,000, or which constitutes 10% of the total value of all perquisites, must be separately identified, unless the total value of all perquisites is less than $10,000. The SEC retained the current practice of valuing perquisites at their aggregate incremental cost to the company. The methodology of such valuation must be disclosed in a footnote.

Guidance Regarding Perquisites. In the proposal, the SEC provided interpretive guidance about factors to be considered in determining whether an item is a perquisite or other personal benefit. In adopting the final rules, the SEC provided additional interpretive guidance for identifying and disclosing perquisites. While the SEC continues to avoid providing a definition of what items constitute perquisites, the SEC suggested that companies engage in a two-pronged analysis. First, companies should determine whether an item is "integrally and directly related to the performance of the executive's duties." If so, it is not a perquisite. (The SEC mentioned BlackBerries and laptops as items that are integrally and directly related to the performance of the executive's duties and thus are not perquisites.) If not, then an item is a perquisite if it confers a direct or indirect benefit that has a personal aspect, without regard to whether it may be provided for some business reason or for the convenience of the company, unless it is generally available on a non-discriminatory basis to all employees.

Also of note is that the SEC eliminated relocation plans from the list of broad-based plans for which disclosure is not required (such as group life, health, hospitalization, and medical reimbursement plans), even if generally available to all salaried employees and not discriminatory in favor of executive officers or directors. Accordingly, amounts paid under relocation plans must be disclosed in the All Other Compensation column.

Supplemental Table of Grants of Plan-Based Awards. The final rules combine two proposed supplemental tables into one supplemental table: Grants of Plan-Based Awards, eliminating the distinction between performance-based awards and non-performance-based awards. The form of Grants of Plan-Based Awards Table is attached as Exhibit B to this Alert.

The Grants of Plan-Based Awards Table is intended to complement the information in the Summary Compensation Table regarding awards granted during the year that are based on an incentive plan or are otherwise contingent on the achievement of performance goals (including performance-based bonuses, even though such information is included in the Summary Compensation Table). While the Summary Compensation Table contains the grant date fair value of such awards, the Grants of Plan-Based Awards Table contains certain terms of the awards, the number of shares underlying such awards and the estimated future payouts of the awards (including, if appropriate, what the estimated payouts would be if the executive met threshold, target and maximum performance levels). The final rules eliminate certain of the proposed columns, including the vesting of the awards column and the column describing whether consideration was paid (both of which will be described in the narrative disclosure discussed below) as well as the expiration date column (which will be included in the Outstanding Equity Awards Table discussed below). Additional columns must be included if a non-equity incentive plan award is denominated in units or other rights, if the exercise or base price is less than the closing market price on the date of grant, and if the date on which the compensation committee (or a committee of the board of directors performing a similar function or the full board of directors) takes action or is deemed to take action is different from the date of grant.

The SEC eliminated the proposed rule that would have allowed aggregation of all option grants with the same exercise or base price in favor of grant-by-grant disclosure in the Grants of Plan-Based Awards Table.

Narrative Disclosure. The rules also require narrative disclosure to describe any material factors necessary to understand the Summary Compensation Table and Grants of Plan-Based Awards Table. While the CD&A focuses on broader topics regarding the objectives and implementation of executive compensation policies, the narrative disclosures following the Summary Compensation Table and Grants of Plan-Based Awards Table focus on and provide specific context to the quantitative disclosure. This might include such topics as terms of named executive officers' employment agreements, terms of option repricings or significant changes to outstanding awards (replacing the former 10-year option repricing table), and award terms relating to disclosure in the Grants of Plan-Based Awards Table (e.g., vesting schedules or a general description of formula determining amounts payable).

Three-Year Phase In. Companies are not required to restate compensation or related-party transaction disclosure for fiscal years in which current rules were applied. This means, for example, that only the most recent fiscal year will be required to be reflected in the revised Summary Compensation Table in the first year after the amendments applicable to the Summary Compensation Table become effective, and therefore the information for years prior to the most recent fiscal year will not have to be presented at all. For the subsequent year's Summary Compensation Table, companies will be required to present only the most recent two fiscal years in the Summary Compensation Table, and for the next and all subsequent years will be required to present all three fiscal years in the Summary Compensation Table.

Non-Executive Employees. The proposed rules would have required disclosure for up to three persons who were not executive officers but whose compensation exceeded the least-highly paid of the three additional officers (the so-called "Katie Couric Rule" - an example of the type of person for whom disclosure would have been required). In response to extensive comments on this proposal, the SEC did not include the proposal in the final rules. Instead, the SEC is requesting comment on a proposal that large accelerated filers include narrative (not tabular) disclosure as to three such persons if such persons have responsibility for significant policy decisions within the company. The SEC stated that this might consist of the exercise of strategic, technical, editorial, creative, managerial or similar responsibilities, for example, by the news director of a major network, the principal creative leader of the entertainment function of a media conglomerate, or the head of a principal business unit developing a significant technological innovation. However, this would not include employees such as salespersons, entertainment personalities, or, as a general matter, investment professionals (although investment professionals who have broader responsibilities in a firm may be deemed to have responsibility for significant policy decisions). As with the prior proposal, such non-executive employees would not be required to be identified by name.

Exercise and Holdings of Previously Awarded Equity

The next section of executive compensation disclosure requires disclosure of holdings of previously awarded equity compensation that is unexercised or unvested and disclosure of amounts realized on previously awarded equity during the past fiscal year. Some of this information had been required under current rules in the Aggregated Option/SAR Exercises in Last Fiscal Year Table and Fiscal Year-End Option/SAR Value Table.

Outstanding Equity Awards at Fiscal Year-End Table. The SEC expanded the proposed disclosure in the Outstanding Equity Awards at Fiscal Year-End Table. The final rules provide that the table will include a complete inventory of all awards held by named executive employees, rather than disclosure on an aggregate basis. Multiple awards may be aggregated only where the expiration date and the exercise or base price of the instruments are identical. While the proposed rules contemplated disclosure of the value of in-the-money options, the revised disclosure under the final rules will allow investors to determine both the value of in-the-money options and the amount the stock price must rise for out-of-the-money options to have value. Information as to performance awards will be disclosed assuming threshold performance goals have been met, unless the prior year's performance would have met target or maximum levels. Footnotes add disclosure of vesting schedules, whether options that expired after year-end but before disclosure had been exercised, and awards that were transferred other than for value. The form of Outstanding Equity Awards at Fiscal Year-End Table is attached as Exhibit C to this Alert.

Option Exercises and Stock Vested Table. The second table in the section, the Option Exercises and Stock Vested Table, reports amounts the named executive officers realized in the past fiscal year upon the exercise of any previously awarded options or similar instruments, or the vesting of any equity right. It was adopted substantially as proposed, except that the proposed grant date fair value column is not required. Amounts realized on transfers of awards for value must also be disclosed. The form of Option Exercises and Stock Vested Table is attached as Exhibit D to this Alert.

Post-Employment Compensation

The SEC significantly revised the existing disclosure requirements concerning post-employment compensation, replacing the existing pension plan table and other disclosures with a table regarding defined benefit pension plans, a second table relating to nonqualified defined contribution plans and other deferred compensation, and narrative discussion related to each table and of compensation arrangements triggered by termination of employment or a change of control.

Pension Benefits Table. This table will require disclosure of the value of pension benefits for each named executive officer under all qualified and nonqualified defined benefit plans and supplemental employee retirement plans (excluding defined contribution plans, which are covered in the Nonqualified Deferred Compensation Table discussed below). The value under each plan is to be set out separately for each executive. Calculations of such values are to be made on the same basis as the pension disclosure in the company's financial statements. The table is to be followed by a narrative discussion of the material factors necessary to an understanding of each plan disclosed in the table. Examples of such factors may include, among other things:

• the material terms and conditions of benefits available under the plan, including the plan's retirement benefit formula and eligibility standards;
• early retirement arrangements;
• the specific elements of compensation included in applying the benefit formula;
• the different purposes for various plans for those participating in multiple plans; and
• company policies with regard to such matters as granting extra years of credited service.

The form of Option Exercises and Stock Vested Table is attached as Exhibit E to this Alert.

Nonqualified Deferred Compensation Table. The second table in this section is a new table that discloses contributions, earnings and balances under each defined contribution or other plan that provides for the deferral of compensation on a basis that is not tax-qualified. So that investors can avoid "double counting" of deferred amounts that were previously reported as currently earned compensation, the final rules require footnotes quantifying the extent to which amounts reported in the table were previously reported in the Summary Compensation Table for prior years. The table is to be followed by a narrative description of material factors necessary to an understanding of the disclosure in the table. Examples of such factors may include, among other things:

• type(s) of compensation permitted to be deferred, and any limitations on the amounts for which deferral is permitted;
• the measures of calculating interest or other plan earnings; and
• material terms with respect to payouts, withdrawals and other distributions.

The form of Nonqualified Deferred Compensation Table is attached as Exhibit F to this Alert.

Other Potential Post-Employment Payments. The final rules also significantly revise existing requirements to describe termination and change of control payments to named executive officers. The rules require narrative disclosure of any arrangement that provides for payments at, following or in connection with the resignation, severance, retirement or other termination of a named executive officer, a change in such person's responsibilities or a change in control of the company. The disclosure must specify:

• the circumstance triggering such payments or benefits;
• a quantification of the estimated payments upon such circumstance (the prior $100,000 disclosure threshold has been eliminated) and, if not lump sum, the duration of such payments;
• factors used to determine the appropriate payment and benefit level;
• any material condition or obligation applicable to receipt of the payment or benefit; and
• any other material feature necessary to understand the provisions, such as any tax gross-up payments.

A company will be required to provide quantitative disclosure under these requirements even where uncertainties exist as to amounts payable under these plans and arrangements. Where uncertainties exist, companies will be required to make reasonable estimates and disclose the assumptions underlying the estimates. For purposes of quantifying the amounts of such benefits, companies may assume that the triggering event took place on the last business day of the company's last completed fiscal year and the company's stock price is the closing price as of that date. The SEC recognizes that forward-looking information may be required for such quantifications.

Disclosure of Director Compensation

The final rules also require tabular disclosure for director compensation, as proposed. The table is to be similar to the Summary Compensation Table (including that disclosure of perquisites is subject to the same thresholds and disclosure as in the Summary Compensation Table), but presenting information only with respect to the company's last fiscal year. Director fees paid in cash would be reported separately from fees paid in stock or options, and items such as consulting fees and awards under director legacy or charitable awards programs would be reported in the All Other Compensation column. Footnote disclosure of aggregate option and stock awards outstanding at year-end is also required. In addition, narrative disclosure of any other material information is required. For example, disclosure of option timing or option dating practices may be necessary if directors receive stock options. The form of Director Compensation Table is attached as Exhibit G to this Alert.

Revisions to Form 8-K and the Periodic Report Exhibit Requirements

Since the recent changes to Form 8-K became effective, the SEC has observed (and many issuers have complained) that Item 1.01 of Form 8-K has elicited disclosure regarding executive compensation matters that does not appear always to be unquestionably or presumptively "material" (the standard that the SEC set for Form 8-K disclosure events). The amendments limit the triggers for disclosure of executive compensation information that must be made on Form 8-K.

The final rules revise Items 1.01 and 5.02 of Form 8-K to move all disclosures of executive compensation into Item 5.02. Specifically, the final rules amend Item 1.01 to provide that an agreement relating to executive compensation information (the subject matter identified in Items 601(b)(10)(iii)(A) and (B) of Regulation S-K) need not be reported under Item 1.01. This change also applies to terminations of material agreements in Item 1.02, because Item 1.02 references the definition of material definitive agreement in Item 1.01. Item 5.02 is amended to:

• cover the departure of any named executive officer for the last fiscal year, instead of just certain specified officers and directors;
• expand the disclosure relating to the appointment of a principal executive officer, president, principal financial officer, principal accounting officer, or principal operating officer to require a brief description of any material plan, contract or arrangement to which the new officer is a party or in which he or she participates that is entered into or materially amended in connection with the appointment, or any grant or award to such new officer (or any modification of a grant or award);
• add new Item 5.02(e) to require, with respect to the principal executive officer and the principal financial officer (as of the time of the event) or any named executive officer (as of the end of the prior fiscal year), a brief description of any material new compensatory plan, contract or arrangement, or material new grant or award thereunder, and any material amendment, whether or not such occurrence is in connection with another triggering event specified in Item 5.02 (grants or awards or modifications will not be required to be disclosed if they are consistent with the terms of previously disclosed plans or arrangements and they are disclosed the next time the company is required to provide new executive compensation disclosure); and
• if the company did not, in its last proxy statement, disclose a named executive officer's salary and bonus for the most recent fiscal year because it was not then determinable, disclose such information when it becomes determinable.

The SEC emphasized that Item 5.02 would only require a brief description of the specified matters, rather than a full update of all disclosure required in the proxy statement.

The SEC also extended the limited safe harbor provision, and preservation of eligibility for Form S-3, to late filings under the amended Item 5.02.

Beneficial Ownership Disclosure

As proposed, the final rules amend Item 403(b) of Regulation S-K and Regulation S-B to require that the table of ownership of the company's equity securities by officers and directors include footnote disclosure of the numbers of shares pledged as security by each named executive officer, each director or director nominee, and the directors and executive officers as a group. The SEC believes that such pledges of the company's securities could influence management's performance and decisions. This requirement does not apply to shares owned by significant shareholders who are not members of management, other than pledges that may result in a change of control. The final rules also require disclosure of beneficial ownership of directors' qualifying shares.

Related Person Transaction Disclosure

The final rules contain significant revisions to Item 404 of Regulation S-K and S-B (previously entitled "Certain Relationships and Related Transactions," now entitled "Transactions with Related Persons, Promoters and Certain Control Persons") to make this disclosure requirement more principles-based.

Transactions with Related Persons

The final rules retain the principles for disclosure of related person transactions that are specified in current Item 404(a), but no longer include all of the instructions that served to delineate what transactions are reportable or excludable from disclosure based on bright lines that can depart from a more appropriate materiality analysis. Instead, Item 404(a) consists of a general statement of the principle for disclosure, followed by specific disclosure requirements and instructions. Item 404(a) requires that a company provide disclosure regarding:

• any transaction since the beginning of the company's last fiscal year, or any currently proposed transaction;
• in which the company was or is to be a participant;
• in which the amount involved exceeds $120,000; and
• in which any related person had or will have a direct or indirect material interest.

The "materiality" standard for disclosure currently embodied in Item 404(a) would be retained, although the final rules delete the duplicative instructions that repeat that standard and state that the dollar threshold for disclosure is not a bright line test for materiality. The materiality of any interest continues to be determined on the basis of the significance of the information to investors in light of all the circumstances and the significance of the interest to the person having the interest. In that regard, the relationship of the related persons to the transaction, and with each other, and the amount involved in the transaction are among the factors to be considered.

Unlike the current Item 404(a) requirements, the amendments call for disclosure if a company is a "participant" in a transaction, rather than if it is "a party" to the transaction, because "participant" more accurately connotes the company's involvement. In addition, the amendments increase the $60,000 threshold for disclosure to $120,000 to adjust for inflation.

The final rules also eliminate the current distinction between indebtedness and other types of related person transactions. Disclosure of indebtedness transactions is required with regard to all related persons covered by the related person transaction disclosure requirement except for significant shareholders (or their immediate family members). The exemption for significant shareholders mirrors the exemption under current rules; the proposals would have eliminated it.

Definitions. The final rules define the terms "transaction," "related person" and "amount involved" and clarify the broad scope of financial transactions and relationships covered by the rule.

"Transaction" broadly includes any financial transaction, arrangement or relationship, or any series of similar transactions, arrangements or relationships, and specifically includes indebtedness and guarantees of indebtedness. The SEC states that the term "transaction" should be interpreted broadly, not narrowly.

The definition of "related person" is expanded to include, beyond those persons covered under the current rules, stepchildren, stepparents, and any person (other than a tenant or employee) sharing the household of a related person. The amendments also revise the related person definition to change the timeframe applicable to determining whether a person is a related person. As revised, disclosure of related person transactions during the last fiscal year is required if the person was a related person at any time during the fiscal year, rather than only if the person was a related person at the time of the transaction. However, significant shareholders (and their immediate families) are related persons for purposes of disclosure of a transaction only if they own of record or beneficially more than 5% of a class of the company's voting securities when the transaction occurred.

The "amount involved" in a transaction means the dollar value of the transaction, even if the amount was set or expensed in a different currency. For indebtedness, this means the largest aggregate amount outstanding at any time during the last fiscal year and all amounts of interest payable on it during the fiscal year.

Disclosure Requirements. If the transaction with a related person falls under the purview of the regulations, the company is required to describe the related person transaction, including:

• the person's relationship to the company;
• the person's interest in the transaction with the company, including the related person's position or relationship with, or ownership in, a firm, corporation, or other entity that is a party to or has an interest in the transaction; and
• the approximate dollar value of the amount involved in the transaction and of the related person's interest in the transaction.

Exceptions. The rules also provide certain exceptions to the disclosure requirements for related person transactions that the SEC believes are consistent with its principles-based approach. Most importantly, disclosure of compensation to an executive officer is not required under the related person transaction rules if the compensation is reported pursuant to Item 402 or if the executive officer is not an immediate family member of a related person and such compensation would have been reported under Item 402 as compensation earned for services to the company if the executive officer was a named executive officer and such compensation had been approved as such by the compensation committee (or group of independent directors performing a similar function) of the company. The SEC provided other exceptions to the disclosure requirements, including exceptions for ordinary course loans by banks; as a result of indirect interests that arise only from the related person's position as director or less than 10% equity holder or partner of another party to the transaction; for transactions involving competitive bids or at prescribed rates; for transactions involving services as a bank depositary of funds, transfer agent, registrar, trustee, or similar services; and as a result solely of ownership of a class of equity securities where all holders received the same benefit on a pro rata basis. The SEC declined to create a new exception for ordinary course of business transactions, although it noted that whether a transaction is in the ordinary course of business may affect the required materiality analysis.

Effect on "Non-Employee Directors." Because the amendments to Item 404(a) may require disclosure of transactions that are not disclosable under current rules (and, conversely, may permit non-disclosure of certain transactions that must be disclosed under current rules), whether a director qualifies as a "non-employee director" under Rule 16b-3 under the Exchange Act may differ from under the prior rules. Companies will need to assess whether the new rules will cause any previously ineligible directors to become "non-employee directors" or any previously eligible directors to become ineligible.

Policies and Procedures for the Review, Approval or Ratification of Related Person Transactions

The final rules adopt new Item 404(b), which requires the disclosure of the policies and procedures established by the company and its board of directors regarding related person transactions. The Item requires a description of the material features of the company's policies and procedures for the review, approval or ratification of transactions with related persons that would be reportable under Item 404(a). Examples of such features may include, among other things:

• the types of transactions that are covered by such policies and procedures, and the standards to be applied pursuant to such policies and procedures;
• the persons or groups of persons on the board of directors or otherwise who are responsible for applying such policies and procedures; and
• whether such policies and procedures are in writing and, if not, how such policies and procedures are evidenced.

Companies are also required to disclose transactions that are required to be reported under Item 404(a) but where the company's policies and procedures did not require review, approval or ratification, or where such policies and procedures were not followed.

Promoters

The final rules amend the required disclosure of promoters in Securities Act registration statements on Form S-1 or SB-2, and in Exchange Act registration statements on Form 10 or 10-SB. The rules will require disclosure regarding promoters if the company had a promoter at any time in the last five years. The exemption for companies organized more than five years ago has been eliminated.

Interplay of Items 402 and 404 of Regulation S-K and Regulation S-B

As noted above, related person transactions need not be disclosed under Item 404 if the transactions relate to compensation and the compensation is reported pursuant to Item 402. The final rules also amend Item 402 to eliminate the current exclusion from the disclosure requirements information about compensatory transactions that had been disclosed under Item 404. All compensatory information will be disclosed under Item 402, including transactions between the company and a third party where the primary purpose of the transaction is to furnish compensation to a named executive officer. Accordingly, in some cases, disclosure may be required under both Item 402 and Item 404.

Corporate Governance Disclosure

The final rules consolidate and expand existing requirements regarding director independence and corporate governance issues under a single item, new Item 407 of Regulation S-K and Regulation S-B (Corporate Governance). The disclosure previously required in other Items and now required by Item 407 includes information relating to the audit committee (such as the identification of audit committee independence and the audit committee financial expert, and the audit committee report), changes to procedures for director nominations by shareholders, and compensation committee interlocks.

Director Independence

Item 407 requires expanded disclosure with respect to director independence. Companies must identify all independent directors (and, in the case of disclosure in proxy or information statements relating to elections for director, all independent nominees for director). In addition, disclosure of any members of the compensation, nominating and audit committees that the company has not identified as independent is also required; if the company does not have such committees, then it must provide independence disclosure as to all members of the board of directors. Independence is determined under the exchange listing standards applicable to the company or, if the company is not listed, the listing standards of a national securities exchange or inter-dealer quotation system specified by the company (which must be applied consistently to all directors). Accordingly, the SEC has, in effect, imported the exchange listing standards into its corporate governance rules. The final rules clarify that, if a company is exempt from independence requirements under the listing standards applicable to it (for example under the "controlled company" exemption under the NYSE and Nasdaq listing standards), the company must disclose the exemption relied upon and the basis for its conclusion that the exemption is applicable.

A company that uses its own definition of "independence" for purposes of determining whether directors and committee members are independent must disclose such definition by posting it on the company's Web site or including the definition as an attachment to its proxy statement or information statement at least once every three years (or in the next proxy or information statement if the policy has been materially amended).

For each director identified as independent, disclosure is required as to the categories or types of transactions, relationships or arrangements that the board of directors considered when determining the independence of a director or director nominee, regardless of materiality, unless the transactions were disclosed as related person transactions under Item 404. Although the rule requires disclosure only of categories and types of transactions, this disclosure must be provided in enough detail as is necessary to fully describe the nature of the transactions, relationships or arrangements.

Independence disclosure is required for any person who served as a director of the company during any part of the year for which disclosure must be provided.

Audit Committee Disclosure

As noted above, the SEC moved the audit committee disclosure requirement to Item 407. In doing so, it did not make any substantive change to the disclosure requirement other than to conform the audit committee charter disclosure requirement to the more recently adopted nominating committee charter disclosure requirement. As revised, the audit committee charter is no longer required to be delivered to security holders (as an attachment to the proxy or information statement) if it is posted on the company's Web site.

Compensation Committee Disclosure

The amendments require new disclosures regarding the compensation committee that are similar to the disclosures required regarding audit and nominating committees. Companies must state whether their compensation committees have charters and, if so, must disclose such charters on their Web sites or as attachments to their proxy or information statements. The final rules also require the company to describe its processes and procedures for the consideration and determination of executive and director compensation, including:

• the scope of the committee's authority;
• the extent to which the committee may delegate any authority to other persons;
• any role of executive officers in determining or recommending the amount or form of executive and director compensation; and
• any role of compensation consultants in determining or recommending the amount or form of executive and director compensation.

The SEC did not adopt the proposal to require disclosure of the identity of any executive officer within the company whom any compensation consultant contacted in carrying out its assignment.

The final rules continue to differentiate between small business issuers and other issuers. With respect to executive compensation, the SEC declined to require small business issuers to provide a CD&A. Small business issuers are only required to provide:

• the Summary Compensation Table (for only the last two fiscal years);
• the Outstanding Awards at Fiscal Year-End Table;
• the Director Compensation Table; and
• related narrative disclosure.

Named executive officers will include only the principal executive officer and the two other most highly paid executives.

With respect to related person transaction disclosure, small business issuers are not required to provide disclosure regarding policies and procedures for reviewing related person transactions, and the disclosure threshold for such transactions is the smaller of $120,000 or 1% of the average total assets of the company for the last three fiscal years.

Foreign Private Issuers

The final rules do not change the current rules regarding disclosure of executive compensation information by foreign private issuers, which provide that a foreign private issuer is deemed to comply with Item 402 of Regulation S-K if it provides the information required by Items 6.B. and 6.E.2. of Form 20-F, with more detailed information provided if otherwise made publicly available. However, the SEC is amending the exhibit instructions to Form 20-F so that foreign private issuers will be required to file an employment or compensatory plan (or portion of such plan) with management or directors only if the foreign private issuer either is required to publicly file the plan (or a portion of it) in its home country or has otherwise publicly disclosed the plan.

Similarly, the final rules do not change the current rules providing that a foreign private issuer is deemed to comply with Item 404 of Regulation S-K if it provides the information required by Item 7.B. of Form 20-F. However, the final rules require that, if more detailed information is otherwise made publicly available or required to be disclosed by the issuer's home jurisdiction or a market in which its securities are listed or traded, that same information must also be disclosed pursuant to Item 404.

Plain English

The executive compensation, beneficial ownership, related persons and corporate governance disclosure must be in plain English.

Timing and Transition Rules

The amendments are effective:

• for proxy and information statements and registration statements under the Securities Act and the Exchange Act that are filed on or after December 15, 2006 and are required to include executive compensation disclosure for fiscal years ending on or after December 15, 2006;
• for Forms 10-K and 10-KSB, for fiscal years ending on or after December 15, 2006; and
• for Form 8-K, for triggering events that occur on or after November 7, 2006.

As noted above, compensation and related person transaction disclosure is phased in over a three-year period. Companies are not required to restate disclosure for fiscal years in which current rules were applied.

Comments on the proposal to require disclosure regarding up to three non-executive employees are due October 23, 2006.

Finally, the interpretive guidance regarding perquisites is effective immediately.

Contact Us

These new rules broadly change the compensation disclosure landscape. We urge all executives, boards and compensation committee members to begin analyzing the new rules' effect now to prepare for decisions this fall, which will be disclosed in proxy statements filed in 2007.

If you have any questions regarding the rules, including how they may affect your company, please contact Alex Sudnik of the Securities Law Practice Group or the lawyer in the firm with whom you are regularly in contact.

Links to Alert Tables

Exhibit A -- Summary Compensation Table

Exhibit B -- Grants of Plan-Based Awards

Exhibit C -- Outstanding Equity Awards at Fiscal Year-End

Exhibit D -- Option Exercises and Stock Vested

Exhibit E -- Pension Benefits

Exhibit F -- Nonqualified Deferred Compensation

Exhibit G -- Director Compensation Table

This article is for general information and does not include full legal analysis of the matters presented. It should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances. The description of the results of any specific case or transaction contained herein does not mean or suggest that similar results can or could be obtained in any other matter. Each legal matter should be considered to be unique and subject to varying results. The invitation to contact the authors or attorneys in our firm is not a solicitation to provide professional services and should not be construed as a statement as to any availability to perform legal services in any jurisdiction in which such attorney is not permitted to practice.

Duane Morris LLP, among the 100 largest law firms in the United States, is a full-service firm of more than 600 lawyers. In addition to legal services, Duane Morris has independent affiliates employing approximately 100 professionals engaged in other disciplines. With offices in major markets, and as part of an international network of independent law firms, Duane Morris represents clients across the nation and around the world.