United States: SEC Guidance Affects Form 8-K Disclosure of Executive and Director Compensation

Originally published February 14, 2005

New Form 8-K rules issued by the Securities and Exchange Commission (the SEC) became effective on August 23, 2004. The new rules greatly expanded the disclosure requirements under the Securities Exchange Act of 1934 and shortened the filing deadline for most 8-K items to four business days after the occurrence of any reportable event. These rules represent a shift toward more "real time" disclosure, as contemplated by Section 409 of the Sarbanes-Oxley Act of 2002.

On November 23, 2004, the staff of the SEC's Division of Corporate Finance (the Staff) issued 30 frequently answered questions (FAQs) regarding the new rules. Nearly half the FAQs relate to issues concerning compensation paid by reporting companies to directors and executive officers pursuant to "material definitive agreements." Since the release of the FAQs, the Staff has given informal indications at conferences and in conversations with lawyers in our firm that they are reading the rules much more broadly than practitioners have in the past. We believe these Staff positions merit special attention in this eAlert.

Which compensation arrangements should be considered "material definitive agreements" and thus disclosable under Item 1.01 of the new rules? The determination is based on the exhibit requirements of Item 601(b)(10)(iii)(A) of Regulation S-K. In practice, the new 8-K rules require the disclosure of (i) any management contract or compensatory plan, contract, or arrangement in which any director or named executive officer (NEO) participates; and (ii) any other management contract or compensatory plan in which any non-NEO executive officer participates, unless immaterial in amount or significance.

The biggest shift in interpretation under the Item 610(b)(10) rules covers the compensatory arrangements that should be filed, and thus that must be described in an 8-K filing. The SEC has long held that oral contracts should be summarized and filed as an exhibit, if the contract would have been required to be filed had it been in writing. Notwithstanding this position, most companies typically have not considered "at will" employment arrangements or the details of compensation (such as base salaries and bonuses) to be "material definitive agreements" that should be filed as exhibits. Similarly, companies whose filings were subject to Staff review rarely, if ever, received comments concerning the absence of any exhibits summarizing such unwritten or ad hoc arrangements.

The new Staff interpretative position on compensation arrangements would require an 8-K filing in cases where, historically, companies and their legal counsel had not considered a filing to be required.

Question 5 of the FAQs provides that, whenever directors' meeting fees and other compensation are set, a "summary sheet" setting forth the terms of the arrangement must be disclosed as a material definitive agreement. The Staff considers such an ad hoc arrangement with a director to be within the scope of Item 610(b)(10) defining material contracts and, thus, disclosable.

The Staff has informally stated that the analysis of director compensation applies equally to written and oral determinations of NEO salaries and other compensation. Consequently, "at will" compensation arrangements with NEOs typically will be considered material definitive agreements that are subject to the 8-K reporting requirement.

The criteria for whether an agreement or arrangement is subject to reporting under the 8-K rules are identical to the criteria for whether a copy of the agreement or written summary of any arrangement must be filed as a material contract under Item 601(b)(10) of Regulation S-K. Accordingly, in the Staff's view, companies should not only be reporting oral "at will" compensation arrangements on Form 8-K, but should also be filing summaries of such arrangements as exhibits to the Form 10-Q and 10-K (if not the Form 8-K itself).

Given the interpretation described above, it seems that the Staff will consider the determination of director fees or retainers and of NEOs salaries (as well as a change in any of them) to be an 8-K disclosure item, even if immaterial in amount. Consequently, under this new interpretive position, at least until clarifying guidance is provided by the Staff, companies should carefully consider whether they have an obligation to file an 8-K to report such changes in director and NEO compensation. We are increasingly seeing 8-K filings describing even routine annual changes to such compensation arrangements.

Question 6 of the FAQs states that an 8-K filing obligation will also be triggered if the company enters into, or materially amends, an employment agreement with any non-NEO executive officer, unless the agreement or amendment is "immaterial in amount or significance." How does one determine whether an employment agreement with an executive officer is immaterial in amount or significance? This decision must be based on a facts-and-circumstances basis from the perspective of a reasonable investor "in light of established standards of materiality." The Staff again appears to consider an ad hoc compensation arrangement to be potentially disclosable.

Under the new interpretive position, the setting of compensation for a new "at will" non-NEO executive officer would trigger a Form 8-K filing, unless the company determines that the arrangement is immaterial in amount or significance. Thereafter, a change in the compensation for such non-NEO executive officers would be treated as an amendment of the initial agreement, thus triggering a filing unless the amendment itself is deemed immaterial from an investor perspective.

Based on filings to date, companies appear to be taking the position that most ad hoc non-NEO compensation arrangements are not material. It seems likely that, if an annual salary increase is authorized for non-NEO executive officers in accordance with the company's normal practices and annual review process, or to reflect the increased seniority or cost of living, then such changes should generally not be considered material amendments requiring disclosure. However, a significant salary increase to such a non-NEO executive officer or an increase in duties, titles, and/or responsibility may be considered a material amendment which would require such a change to be disclosed in a filing. Note that the naming of a principal executive officer will still require an 8-K filing.

The FAQs also provide specific examples of when cash bonus arrangements require an 8-K filing.

(1) Establishment of New Cash Bonus Plan. Question 12 provides that an 8-K is required when a cash bonus plan is adopted under which NEOs are eligible to participate even though no specific performance criteria are established and no goals or bonus opportunities are communicated to plan participants. Question 12 also provides that a Form 8-K is required when a cash bonus plan is adopted in which non-NEO executive officers are eligible to participate, unless the plan is immaterial in amount or significance.

(2) Establishment of Performance Criteria Under Plan. Question 13 provides that a separate 8-K is required when, under such a previously adopted cash bonus plan, specific performance goals and business criteria are established.

(3) Actual Payment of Bonuses Under Plan. Question 14 provides that, when the "form" of the plan has already been filed pursuant to Questions 12 and 13, a Form 8-K is not required when a cash bonus is actually paid under such a plan.

Under the FAQs, companies that have adopted a shareholder-approved performance bonus plan under Section 162(m) of the Internal Revenue Code would most likely not have to file an 8-K for the actual payment of performance bonuses under the plan.

Although we believe that these evolving Staff interpretations of the 8-K rules would be more appropriately handled by a formal revision of Regulation S-K, we also believe companies should carefully consider these Staff positions in deciding whether to file an 8-K for a particular compensation arrangement.

Many companies may be parties to existing compensation arrangements that, based on the new Staff interpretations described above, are subject to these filing requirements. We recommend that companies carefully consider whether any actions taken (or about to be taken) to set or change director and executive officer compensation should be disclosed in a Form 8-K filing and filed or summarized as exhibits to their next Form 10-Q or Form 10-K.

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