31 January 2006

The SEC Proposes Changes to the Executive and Director Compensation Disclosure Rules

In an effort to improve disclosure regarding compensation received by executive officers and directors of public companies, the SEC at an open meeting held on January 17, 2006 voted to propose amendments to the existing compensation disclosure requirements.
United States Corporate/Commercial Law
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Originally published January 27, 2006

I. Overview

In an effort to improve disclosure regarding compensation received by executive officers and directors of public companies, the SEC at an open meeting held on January 17, 2006 voted to propose amendments to the existing compensation disclosure requirements. Proposals to amend the SEC’s disclosure rules pertaining to related party transactions and director independence were also presented at the meeting. These proposals represent the most significant modification to the executive and director compensation disclosure rules since the last comprehensive revision of these rules in 1992.

As noted by each SEC Commissioner during the meeting, the proposed amendments are not intended to and do not establish limits on the compensation paid to executive officers or directors. The proposed amendments would however, require companies to provide more detailed disclosure concerning the total compensation received by executive officers and directors (including information concerning equity awards, perquisites, and retirement benefits) in a new format intended to be more easily understood. The proposed amendments would impact the disclosure provided in proxy statements, annual reports and registration statements.

The text of the proposed amendments is not yet available. The descriptions of the proposed rules contained in this legal alert are based on statements made by the SEC Commissioners and the SEC staff at the open meeting, as well as a press release issued by the SEC regarding the proposed rules. The proposed amendments are expected to be publicly available in the next week or so. We will prepare a more comprehensive legal alert discussing the proposed changes at that time.

II. Compensation Discussion and Analysis

Under the proposed amendments, a new "Compensation Discussion and Analysis" section would replace the compensation committee report and performance graph currently included in proxy statements. This new section, which would precede the summary compensation table, would include a narrative description of a company’s policies and decisions relating to the compensation paid to its named executive officers. Specific items to be discussed in this section would include:

  • The objectives of the company’s compensation program and what it is designed to reward;
  • What elements of compensation are included in the compensation program;
  • What factors the company considered in determining to pay or award its named executive officers each element of compensation;
  • How the company determined the amount of each element; and
  • How each element of compensation fits within the company’s compensation objectives.

The "Compensation Discussion and Analysis" section, unlike the current compensation committee report and performance graph, would be considered "filed" under Section 18 of the Securities Exchange Act of 1934. As a result, a company’s disclosure of such information in proxy statement, Form 10-K or registration statement "filings" would be subject to increased liability under the federal securities laws.

III. Executive Officer Compensation Tables

A. Summary Compensation Table

Under the proposed amendments, compensation information for the past three fiscal years would be provided for the chief executive officer, the chief financial officer and the three other highest paid executive officers (collectively, the named executive officers). This specific inclusion of the chief financial officer generally contrasts with the current inclusion of the CEO plus the four most highly paid executive officers and creates further discontinuity with Internal Revenue Code § 162(m), which refers to the CEO and the remaining most highly compensated four.

Under the proposals, the highest paid executive officers would be determined based on total compensation, rather than simply on the basis of salary and bonus as under the existing rules. In addition, a company would be required to disclose compensation information for up to three additional employees (whether or not they are executive officers) whose total compensation exceeds that of any of the named executive officers.

The position or title, but not the name, of each such employee would also be required to be disclosed.

The SEC proposes to modify the summary compensation table to include six columns to be presented in the following order:

  • First Column – A new total compensation column representing the sum of all of the following columns in the table;
  • Second Column – A salary column similar to the one currently in place;
  • Third Column – A bonus column similar to the one currently in place;
  • Fourth Column – The dollar value of equity-based awards, including restricted stock or options. The value of such awards would be measured as of the grant date and calculated in accordance with the Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 123 (Revised 2004);
  • Fifth Column – A long-term incentive plan column similar to the one currently in place; and
  • Sixth Column – A revised "other compensation" column designed to capture all other compensation received by each named executive officer but not included in the other columns of the table. This column would include items such as aggregate increases in actuarial value of pension plans and all earnings on non-qualified deferred compensation plans, company contributions to such plans, tax gross-ups and perquisites. With regard to perquisites, the SEC is also proposing to reduce the threshold amount for disclosure of perquisites to $10,000 from its previous threshold of $50,000 or 10% of the total annual salary and bonus of the executive officer. Significantly, the SEC intends to include in the proposing release interpretive guidance as to what constitutes a perquisite.

The SEC stated that the intent of the reconfigured compensation table is to capture all compensation received by the named executive officers. Moreover, the new "first column" attempts to reduce to a single number the value of that compensation. Given that determinations for certain items, such as the option pricing model values assigned to options and the increases in the actuarial values assigned to pension accruals, will be based on assumptions that will vary from company to company, inter-company comparisons of total compensation will remain imperfect at best.

B. Equity Holdings Table

To better convey information concerning the equity holdings of each named executive officer, the SEC is proposing two new tables:

  • A table listing the outstanding equity awards at fiscal year end. This table would show the amount of outstanding awards that each named executive officer held at the end of the fiscal year; and
  • A table reflecting options exercised and restricted stock vested during the year for each named executive officer to show the amounts realized on equity compensation during the last fiscal year.

To the extent any performance conditions, other than the stock price or passage of time, must be satisfied for the exercise of an option or for a restricted stock to vest, such conditions would be required to be disclosed.

C. Retirement Plan and Post-Employment Table

In addition to including increases in the actuarial value of pensions and all earnings credited under deferred compensation plans in the summary compensation table numbers, the SEC also proposes disclosure of substantial additional information concerning any compensation to be paid to a named executive officer under the company’s retirement plans. The tables proposed by the SEC include:

  • A new "Retirement Plan Potential Annual Payments and Benefits Table," disclosing annual benefits payable to each named executive officer; and
  • A new "Nonqualified Defined Contribution and Other Deferred Compensation Plans Table," disclosing the year-end balance and any activities during the year, including the executive’s contributions, company’s contributions, earnings and withdrawals. Unlike the current rules, disclosure of earnings credited would be required even if the earnings were at a market rate or lower.

In a further change, a company would be required to provide both a narrative description and a quantified amount for any payments and benefits payable to each named executive officer upon termination of employment or a change of control.

IV. Director Compensation Table

The SEC is also proposing the disclosure of compensation information for directors comparable to the summary compensation table and narrative disclosure that is proposed for the company’s named executive officers. This information, however, would only need to be provided for the most recently completed fiscal year.

V. Miscellaneous Matters

Finally, the SEC has proposed a number of other changes to its disclosure rules that pertain to related party transactions and director independence matters.

A. Related Party Transactions

As part of the proposed amendments, the SEC is proposing the following changes to the related party transaction disclosure:

  • A discussion of the company’s policies and procedures for reviewing and approving related party transaction; and
  • Increasing the threshold for disclosure of related party transaction from $60,000 to $120,000.

B. Director Independence

In addition, the SEC is proposing a new Item 407 of Regulation S-K, which would require disclosure of the following items concerning director independence:

  • Whether each director and director nominee is independent based on the applicable listing standard;
  • A description of any factors considered by the board of directors when assessing a director’s independence; and
  • The identification of any directors serving on the compensation, audit or nominating committee who are not independent.

C. Form 8-K

The SEC is proposing to narrow the circumstances that would trigger the requirement to file a Form 8-K when a company enters into employment arrangements

and material amendments to those arrangements with its executive officers. Currently, such a filing is required when a company enters into such arrangements or amendments with its named executive officers and, in certain situations, its other executive officers. The proposed rules would limit the Form 8-K disclosure requirement to named executive officers only. The proposed rules would also create a new item within Form 8-K under which all disclosure concerning employment arrangements would be consolidated.

D. Plain English

The SEC’s proposal includes a requirement that all the above information be presented in plain English to facilitate investor understanding of compensation information.

VI. Application of Proposed Rules to Business Development Companies

The SEC intends to require business development companies to comply with the proposed rules. Currently, business development companies are required comply with executive and director compensation rules applicable to registered open-end and closed-end investment companies (which differ from the current and proposed executive and director compensation rules applicable to operating companies).

VII. Anticipated Timing

The proposed rules, which we expect will be publicly available in the next week or so, will be subject to a 60-day comment process. After the SEC staff has reviewed and considered the comments regarding the proposed rules, the final rules will be presented to the SEC for a vote at another meeting. It is difficult to estimate when the SEC staff will present final rules to the SEC for adoption. The last time the SEC undertook such a significant overhaul of its executive compensation rules, the SEC staff issued a second proposal as a result of, and in response to, the comments received on the initial proposal. While it is hard to predict if that will occur this time, the perceived significance of the subject matter makes it likely that final rules will be adopted in time for the 2007 proxy season. Moreover, we expect the proposed rules will influence compensation disclosure "best practices" in the 2006 proxy season. We will send out a detailed analysis of the proposed rules when they are issued.

This article is for informational purposes and is not intended to constitute legal advice.

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