January 17, 2006
Today, the Securities and Exchange Commission (the “SEC”) voted to propose rules that would amend disclosure requirements for:
executive and director compensation;
related party transactions;
director independence and other corporate governance matters;
security ownership of officers and directors; and
Form 8-K reports regarding compensation arrangements.
The final rules are not expected to be enacted in time for the 2006 proxy season, but likely will apply to disclosures of 2006 compensation that are made in companies’ 2007 proxy statements. As discussed below, in addition to filling gaps in required tabular presentations of compensation, the proposals would require additional narrative disclosure to elaborate on the compensation tables. The narrative disclosure must satisfy “plain English” standards.
A summary of the rule proposal is set forth below. This summary is based on information provided at the SEC’s open meeting, and therefore may not reflect nuances that appear in the SEC’s proposing release, which is expected to be issued shortly. We expect to issue additional materials on the rule proposals once the actual rule text has been published and can be fully assessed.
Based on the limited information currently available, the rule proposals appear to reflect a thorough, thoughtful and well-informed effort to provide comprehensive, balanced and informative disclosure on executive compensation and related issues. We expect that many shareholders and companies will welcome greater clarity in the disclosure requirements and a more level playing field for disclosure of differing types of compensation, so that disclosure considerations do not unnecessarily handicap particular types of compensation programs. At the end of this Update, we discuss actions that companies, executives and compensation committees should consider in anticipation of the new rules.
Executive Compensation Disclosure
The proposals would eliminate the Board Compensation Committee Report on Executive Compensation and the five-year stock price performance graph. In their place would appear a Compensation Discussion and Analysis report containing details on the objectives and implementation of executive compensation programs (similar in concept to existing requirements for Management’s Discussion and Analysis covering a company’s financial condition and results of operations). The Compensation Discussion and Analysis would expand disclosure beyond existing standards for Compensation Committee Reports by requiring a discussion of compensation policies and decisions, including details on each element of compensation – its objectives, why it is provided, how amounts are determined and how the compensation fits into the company’s overall compensation program. This report would be styled as a company disclosure; it would not appear “over the names” of a company’s compensation committee.
Existing tabular disclosure of executive compensation would be reformatted and enhanced, and would be accompanied by more narrative disclosure than is currently provided. The tables would be grouped into three broad categories: compensation over the last three years; holdings of outstanding equity-related compensation; and retirement plans and other post-employment payments and benefits.
Compensation would be presented for the Chief Executive Officer, Chief Financial Officer and three other most highly paid executive officers. The additional three executives would be determined based on their total annual compensation, whereas the current rules base that determination on the amount of salary and annual bonus paid to executives. Tabular disclosure over the past three years would be provided through a reorganized Summary Compensation Table, a Performance-Based Award Grant Table and an All Other Equity Award Grant Table.
The Summary Compensation Table:
would have a column reporting “total” annual compensation;
would contain a single column for reporting grant-date fair value of all equity awards for the year (restricted stock/stock unit grants as well as option/stock appreciation right grants), computed under Statement of Financial Accounting Standards No. 123(R); and
would combine the “Other Annual Compensation” and “All Other Compensation” columns, and at the same time expand the disclosure requirements so that the column includes all compensation not elsewhere reported in the table (including, for example, dividends on restricted stock, the aggregate annual increase in the actuarial value of pension benefits and accruals under deferred compensation arrangements that are not tax-qualified plans).
The SEC’s release will contain interpretive guidance on what constitutes a “perquisite” that is subject to disclosure and will request public comment on that guidance. It is unclear whether this guidance will be prospective only, or will apply under the existing disclosure rules, as the Division of Corporation Finance has in the past not provided interpretive guidance in this area. It also is unclear whether the rule proposals will contain new valuation standards for perquisites, but the proposals would lower the disclosure threshold to $10,000 from the current $50,000 threshold.
During the SEC’s open meeting, the Commissioners and Staff discussed a number of aspects of the proposed disclosures for option grants. In particular, it appears that the proposal would require disclosure of the full SFAS No. 123(R) valuation of an option whenever the option is materially modified (such as when the term of an option is extended in connection with termination of employment). This disclosure proposal would differ from the standard applicable for financial statement reporting, where only the incremental value arising from an option modification is expensed.
Holdings of and amounts realized under all forms of equity compensation (including options, restricted stock and stock units) would be reported in two tables, similar to existing disclosure requirements for option holdings and amounts realized from option exercises.
The third category of executive compensation disclosures would entail greatly expanded reporting of retirement, change-in-control and post-employment benefits. The proposed disclosure requirements include:
a table showing the actual annual benefits payable to each named executive officer under defined benefit pension plans;
a table showing annual executive contributions, company contributions, earnings, withdrawals and year-end balance under deferred compensation plans that are not tax-qualified (that is, excluding for example 401(k) plan amounts); and
a description and quantification of payments and benefits payable to each of the five covered executive officers on termination of employment or change in control.
We expect that this last element of disclosure will be a source of extensive public comment. While many compensation committees review calculations of these potential benefits, they involve extensive use of assumptions (which would be disclosed under the rule proposals). Moreover, in our experience these potential benefits often are calculated in a manner that is sufficient to inform compensation committees of the magnitude of change-in-control or severance payments, but that does not obtain the level of precision necessary for an SEC filing.
Directors’ Compensation Disclosure
Compensation provided to each director in the last fiscal year would be itemized in a compensation table similar to the Summary Compensation Table provided for executives, with a narrative discussion of the elements of directors’ compensation.
Disclosure of Other Employees’ Compensation
An unanticipated aspect of the proposed rules would require disclosure of the compensation paid to up to three employees who are not executive officers, if that compensation exceeds the compensation paid to executive officers covered in the Summary Compensation Table. Although the proposals would not require the employees to be named, their job responsibilities would be disclosed. We expect that this proposal will raise concerns regarding the competitive impact on the market for non-managerial sales staff and creative or technical talent, and that comments will address whether the proposed disclosures provide meaningful information for investors.
Related Party Transactions
Item 404(a) of Regulation S-K currently requires disclosure of transactions in which executives, directors and large shareholders, or their family members, have a direct or indirect material interest, if the value of the transaction exceeds $60,000. While details were vague, it appears that the proposals will raise the transaction threshold to $120,000, but otherwise would expand the scope of transactions required to be disclosed. During and after the SEC’s open meeting, the Commissioners and Staff described the proposed changes as leading to a more “principles-based” disclosure requirement, and involving the repeal of existing rules that allow certain types of relationships to not be disclosed. Companies will be required to disclose their policies for approving related party transactions.
Director Independence and Other Corporate Governance Matters
The proposals would expand the disclosure requirements for a company’s business relationships with other businesses where a director is employed or is a significant owner, so that the disclosure thresholds more closely conform to the stricter standards applied under New York Stock Exchange and NASDAQ Stock Market independence standards. While details were not clear, the proposals also would require disclosure of other material relationships that were considered when evaluating a director’s independence. Other proposed rule changes would consolidate existing corporate governance disclosure requirements into a single set of rules, while easing disclosure burdens by allowing enhanced reliance upon internet availability of committee charters and other information.
Security Ownership of Officers and Directors
The proposals would require that the table reporting the number of shares of company stock that executives and directors beneficially own disclose the number of shares, if any, that are subject to pledges.
The proposals would revise the scope of executive compensation disclosure requirements on Form 8-K, so that only executive officers’ employment arrangements and material amendments to such arrangements are covered. It appears that this rule amendment may eliminate the need for Form 8-K reports on directors compensation. It is unclear whether the proposals also will provide greater clarity on when a Form 8-K may be required to report compensation decisions under bonus and employee benefit plans, although we expect this to be an area that companies will wish to cover in comments submitted to the SEC.
Planning for the New Rules
Over the last several years, many companies have provided enhanced compensation disclosures that address many of the areas covered by the proposed rules, and we expect the rule proposals to expand that practice. Because the scope of required disclosures will clearly expand for the 2007 proxy season, companies and compensation committees should consider now whether to provide those additional disclosures in 2006. While it will be appropriate to provide additional disclosures on elements of compensation that are not clearly required under the existing rules, it is unclear whether 2006 proxy disclosures will be permitted to deviate from the current required tabular presentations in favor of the reformatted compensation tables set forth in the rule proposals, as consistency in presentation remains an SEC priority for compensation disclosures.
Compensation committees should not view elimination of the Board Compensation Committee Report as easing their disclosure responsibilities. The proposed new Compensation Discussion and Analysis will require more detail on the operation of compensation programs and on the basis for compensation decisions, and that disclosure will flow from the decisions made by compensation committees. It is clear that the SEC is not only seeking additional numerical information; the narrative disclosures will cover both the “big picture” and the details of compensation programs. There will continue to be an opportunity to discuss compensation “best practices,” such as evaluations of internal pay equity and accumulated wealth.
Compensation committees that are not already using tally sheets to evaluate “total” compensation should do so in 2006, since current compensation decisions will be reflected under the new rules in 2007. Likewise, because of the expense and effort that will be required to precisely quantify the value of change-in-control and severance benefits, compensation committees should plan on undertaking that effort in 2006. Any renegotiations or adjustments to severance programs should be in place by fiscal year-end, since that could be the point in time when those benefits are valued for disclosure purposes. Some compensation committees likely will evaluate whether to cap the value of post-employment benefits, so as to avoid disclosing, for example, that airplane use benefits are potentially of unlimited value.
Companies should assess how the proposed “total” compensation standard may alter which executives are covered by the compensation disclosure rules. Companies that do not have restrictions on their executives’ pledging or hedging company stock should evaluate whether to implement policies addressing those practices, as the final disclosure standards may cover arrangements that are in place during 2006, and executives may wish to close-out existing arrangements over the coming year.
Finally, investors, companies and directors, particularly compensation committee members, should carefully review the proposed rules once they are made available, and should consider submitting pragmatic comments to the SEC. If aspects of the proposals could unduly bias or burden compensation decisions, those elements should be pointed out and alternative means to enhance disclosure suggested. The comment period for the rule proposals is scheduled to end 60 days after the proposals are published in the Federal Register.
Gibson, Dunn & Crutcher lawyers are available to assist clients in addressing any questions they may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or John F. Olson (202-955-8522, [email protected]), Ronald O. Mueller (202-955-8671, [email protected]), Brian J. Lane (202-887-3646, [email protected]) or Amy L. Goodman (202-955-8653, [email protected]) in the firm’s Washington, D.C. office.
© 2006 Gibson, Dunn & Crutcher LLP