With the Securities and Exchange Commission poised to approve new proxy disclosures any day now and increased scrutiny by SEC staff looming, companies should prepare to do more than the usual topside tweaking of their Compensation Discussion & Analysis for 2010.
Of course, the SEC would always say corporations should take the CD&A seriously and start afresh every year. For 2010, however, the Commission means it: Bloated executive pay has received extensive criticism for its role in causing the financial crisis, and the SEC is just one of numerous federal agencies that now want companies to disclose the logic behind their compensation policies and the risks that senior executives might be tempted to take excessive gambles with company money.
“There are enough changes and developments in the works that merit taking a holistic approach to revising the CD&A,” says Mark Borges, a principal with compensation consulting firm Compensia. “This isn’t a year you want to just do minimal updates.”
The SEC has already published its proposal for new proxy disclosures and is expected to approve a final rule in time for the 2010 proxy season. While waiting, Borges says, companies should still develop an understanding of how they manage risk in the company generally, since that will help them put their compensation program issues into context. They should also identify which compensation programs or plans generate material risks, and what policies might be in place to manage those risks.
Jim Barrall, head of the executive compensation practice at the law firm Latham & Watkins, says those risk-mitigation policies could be tools such as clawback provisions or stock ownership and stock-holding policies. He recommends companies have those policies in place even for compensation plans they don’t believe are materially risky.
The SEC rule proposal contains a raft of other changes as well, such as requiring new disclosure about director and nominee qualifications, company leadership structure, and the potential for conflicts of interest with compensation consultants. All that adds up to another major challenge with the CD&A: keeping it short. SEC officials have repeatedly said that companies should focus on better, rather than more, disclosure in the upcoming proxy season.
Diamond
For many, the CD&A “has grown and grown and contains a lot of boilerplate language and discussion about processes and procedures,” rather than analysis as to why certain decisions are made, says Colin Diamond, a partner in the law firm White & Case.
Borges says companies could probably start their pruning with disclosures about post-employment compensation, an area where many get hung up on describing the elements of their programs. “Companies often say they provide severance and change-in-control agreements and have a page of narrative explaining how they work, but never answer the question the SEC is looking for: why they provide it in the first place,” he says.
Drafting “good, clear, convincing CD&A disclosure is going to be more important in the new [say-on-pay] world than it has been in the past.”
—Jim Barrall,
Head of Exec Comp Practice,
Latham & Watkins
Companies might also try using more graphs and charts, especially for items such as performance target disclosure, says Joe Sorrentino, a managing director at compensation consulting firm Steven Hall & Partners.
That said, Borges and others note that making the disclosure more concise won’t be easy. “Companies tend to have fairly complex plans, and there’s no way to provide a comprehensive explanation of what you’re doing without describing some of the detail,” he says.
Life Under the Microscope
At the same time, companies should expect more scrutiny by regulators. The SEC’s Division of Corporation Finance, which reviews the CD&A as part of its regular filing reviews, has sent clear signals that errant companies will be expected to amend their filings, not just answer a comment letter from SEC staff and revamp disclosure going forward.
Diamond suggests that even if SEC staff have not reviewed your particular filing, look to comment letters from peer companies. “Follow the tenor and tone of the SEC’s comments and the spirit of what’s required,” he says. Companies “are not going to get a pass if they are reviewed” in 2010.
Companies can divine a few clues from topics that have consistently provoked a large number of SEC staff comments: analysis of compensation decisions, especially why decisions were made; disclosures related to performance targets; and peer groups. Performance targets in particular still garner more comment than any other compensation disclosure item.
Todd
2010 EXPECTATIONS
Below is an excerpt from a speech delivered by Shelley Parratt, deputy director of the SEC Division of Corporation Finance, on how to improve proxy disclosures in 2010.
To begin with, the Division is currently reviewing the comment letters submitted on the Commission’s recent proposal to enhance proxy disclosure, including that related to compensation. In the proposal, the Commission focuses on the current requirement to discuss how compensation relates to risk and proposes to expand CD&A to address how a company’s overall compensation policies for its employees may create incentives that can affect the company’s overall risk. You should start thinking about how you would gather the additional information necessary to make the proposed disclosures because the proposed risk disclosure enhancements may well be in place for the coming proxy season. If this proposal is adopted, you can expect the new disclosure to be of interest to us in our reviews. Of course, the staff and Commission will carefully review the comment letters before the Commission decides on final rules.
In our first several years of reviewing disclosures under the existing rules, we wanted to encourage compliance generally by issuing futures comments to give companies and their advisors time to understand and apply the new requirements to their circumstances and compensation practices. As companies have been digesting and applying the rules, we too have been enhancing our understanding of how they apply to various facts and circumstances. As we enter our fourth year of disclosure, our expectations for quality disclosure are heightened and we will reflect this in our comments.
What does that mean for you? It means that after three years of futures comments, we expect companies and their advisors to understand our rules and apply them thoroughly. So, any company that waits until it receives staff comments to comply with the disclosure requirements should be prepared to amend its filings if it does not materially comply with the rules.
What should you focus on this year? Well, it’s no secret where we think companies can improve disclosure—I think we’ve been pretty clear about it in our comments, reports and speeches—but let me remind you one more time. First, please focus on making your disclosure more meaningful and understandable. When a company explains its compensation decision-making processes but does not explain why it made the compensation decisions it made, we will ask for enhanced disclosure of the analysis. When a company states that it determined a material element of compensation based on the achievement of performance targets, we will ask for specific disclosure of the targets and the actual achievement level against the targets, or for the company to provide us with an explanation of how such disclosure would cause it competitive harm. And if disclosure of material performance targets is not required, we will insist on meaningful degree of difficulty disclosure. When a company refers to a peer group used for benchmarking purposes, we’ll ask for the names of the peer group companies and how you selected them, and where actual awards fell relative to the benchmark. Companies and their advisors should take care to address these themes as they draft next year’s executive compensation disclosure. Now is the time to undertake an earnest attempt to prepare the best possible executive compensation disclosure consistent with the principles set forth in the rules.
As a principles-based disclosure requirement, the CD&A provides companies with wide discretion on how to address those principles. As such, companies should think broadly and not limit their disclosure to the non-exclusive examples the Commission provided in Item 402(b) of Regulation S-K. Where additional disclosure would be material to an understanding of a company’s compensation policies or decisions, a company should provide that disclosure. While our principles-based disclosure requirement doesn’t specifically require companies to disclose all aspects of their compensation programs, in these economic times with the attention shareholders are paying to executive compensation, a company should evaluate evolving materiality concerns with a view towards complete and transparent executive compensation disclosure.
Source
Shelley Parratt Speech on Executive Compensation (Nov. 9, 2009).
“Be prepared to disclose your performance targets or to defend why they’re eligible for confidential treatment,” says Paula Todd, a partner at compensation consultancy Towers Perrin.
Barrall notes that the staff have recently been issuing comments about the disclosure of individual performance targets, which he says are trickier to handle because they’re often confidential, qualitative, and subjective.
“If they’re targets and are material to the compensation, they’re subject to the same disclosure requirements as company-wide financial targets, and the SEC will ask for more information about them,” he says.
Some companies, however, are taking adjustment factors that compensation committees consider and labeling them as targets for individual performance. If it’s a target, Barrall says, companies should disclose it or prepare to argue that doing so will cause competitive harm. If it isn’t, companies should clarify that it was simply a subjective factor taken into account by the compensation committee while exercising its usual discretion.
Compensation experts also recommend that companies draft the 2010 CD&A with shareholder say-on-pay votes in mind, since those votes will almost certainly be the law of the land by 2011. Most companies receiving government bailout money must already provide say-on-pay votes anyway, and a stack of legislative or regulatory proposals want to impose the same on all other public companies.
Borges
“It’s coming, and companies should start to re-orient their CD&A toward using it as the device by which they solicit shareholder approval of their compensation program,” Borges says. That means disclosure should be easy to understand and key messages should be upfront.
“Draw out two or three messages to communicate to shareholders that you want them to think about as they vote,” he says.
Barrall
Likewise, Barrall says drafting “good, clear, convincing CD&A disclosure is going to be more important in the new [say-on-pay] world than it has been in the past.”
Sorrentino says companies should revisit their basic compensation philosophy—that is, why they paid what they paid—to see if that disclosure is still relevant. “They should look at how it all fits together, how they derived that total number, and how it helps the company achieve its strategy,” he says.
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