Compliance In 2007: Implementing 2006

Three governance issues loomed large over executives and boards at public companies in 2006: compliance with Sarbanes-Oxley and Section 404, disclosure of executive compensation, and stock option backdating.

We may be in a new year now, but corporations should expect those same three to dog them in 2007.

Still, while that trio of compliance issues dominated much of the landscape in 2006, looking ahead to this year, those issues should gain some closure, says David Mittelman, an attorney at the law firm Reed Smith, who previously worked at the Securities and Exchange Commission’s Division of Corporation Finance.

Mittelman

He cites backdating as one example. What seemed like an isolated issue at a few Silicon Valley companies last year, Mittelman says, quickly “ballooned into a widespread national problem.” Once the annual audit cycle is completed this spring, however, “companies … will be in a position to know if they have an option backdating problem.” Mittelman also expects guidance from the SEC to help companies sort out how they should report option backdating issues.

Others warn that the end of the audit cycle won’t herald backdating’s departure from the governance spotlight. Many companies have reviewed their practices and determined what remediation (up to and including a restatement, the worst-case scenario) may be necessary, but some will continue their investigations in 2007, says Jeffrey Zuckerman a former SEC lawyer now with the law firm Pillsbury Winthrop Shaw Pittman. In addition, he says, backdating investigations are likely to remain a priority for the SEC’s enforcement division well into this year.

Hoenig

Lawrence Hoenig, also at Pillsbury Winthrop, agrees that backdating woes are likely to continue even for companies that have completed their investigations. Section 409A of the federal tax code might spring surprise tax bills on recipients of backdated options; companies could face delisting (particularly from Nasdaq) for late filings while they sift through their options paperwork. Most far-reaching, he says, are the lawsuits destined to follow, which “could take much longer to resolve.”

Focus On Executive Compensation Continues

Last year, many companies tried to deduce what the SEC might include in its new rules for disclosure of executive compensation, and then attempted to digest those rules once they were finally published in August. This spring’s annual reporting season will put companies’ disclosure systems to the test, and, according to Mittelman, test the theory that better disclosure might restrain soaring executive pay. “[T]he 10-K reporting season will really flesh things out,” he says.

Jeffrey Capwell, a partner at the law firm McGuireWoods, agrees. One sure area of focus will be “what will executive compensation disclosures look like under the new SEC disclosure rules,” and whether that new picture will prod companies to change how they design compensation packages. Post-termination pay arrangements and nonqualified deferred-compensation arrangements are likely to attract considerable attention, he says, because of the limited level of disclosure required under prior rules.

“Disclosure of such amounts may lead to increased pressure to impose limits payments on executive severance pay, which has already been the case with a number of recent shareholder proposals to impose specified caps,” Capwell says. “This may cause companies to restructure existing agreements and re-examine the group of managers who have such arrangements.”

Amounts accumulated under nonqualified deferred-compensation plans also will attract attention. While Capwell doesn’t expect the idea of deferred compensation itself to disappear, “overly generous benefit formulas or earning assumptions may be targets for criticism and candidates for adjustment or elimination.”

As Always, Section 404 Issues Linger

Mittelman calls Section 404 the last remaining “sticking point” of Sarbanes-Oxley; it just happens to be the biggest point of them all. But the SEC’s newly proposed guidance to help companies through the establishment and testing of internal controls over financial reporting, along with new guidance for external auditors from the Public Company Accounting Oversight Board, should help resolve those lingering issues.

Zuckerman

Zuckerman says companies are likely to see additional relief and guidance related to Section 404, as pressure remains on Congress and the SEC to grant relief to small issuers and new public companies—especially since non-accelerated filers now will need to start complying with Section 404 in their first fiscal year that ends after Dec. 15, 2007. “The concern remains that the cost of compliance is potentially prohibitive ... making U.S. markets less attractive,” says Zuckerman.

Mittelman predicts that the SEC will consider overhauling the small business reporting regime over the next year. Currently, the SEC defines a small-business issuer as one with less than $25 million in assets and revenues. His speculation: the SEC could raise that threshold to as high as $75 million to allow more issuers to comply with the less burdensome reporting requirements. “Especially now that more and more companies are looking to foreign markets, re-examining the small business issuer standards may be worthwhile,” he says.

“The concern remains that the cost of compliance is potentially prohibitive ... making U.S. markets less attractive.”

— Jeffrey Zuckerman, Pillsbury Winthrop Shaw Pittman

Mittelman also expects shareholder activism to be a big theme in 2007, driven by the growing power of private equity firms to influence management and to take companies private; new rules allowing for Internet distribution of proxy materials, which will reduce the costs of launching proxy contests; and the possibility that the SEC will issue new rules on shareholder access to the proxy statement.

SEC staffing levels—and the low numbers thereof—also might affect companies in the new year. Yes, Mittelman says, some companies might find the idea of fewer SEC staff a cause for celebration, “but in the short term, it renders it difficult to effectively implement new rules and oversee ongoing administrative aspects that companies depend on,” he says. “If they don’t start hiring, it will be a problem.”

Meanwhile, John Iino, head of the corporate securities group at Reed Smith, says the migration of initial public offerings to overseas exchanges may continue, as companies looking to go public continue to eye the valuations accorded by foreign markets, such as AIM on the London Stock Exchange, and the ease of going public there rather than here.

Iino

Iino, who says his firm has done multiple IPOs involving U.S. companies on the AIM exchange, says SOX has been a big driver for U.S. companies listing overseas. “One of the reasons our clients decided to go abroad is that the cost of ongoing annual compliance is significantly lower,” he says.

Still, Iino says to the extent that Nasdaq rebounds, the U.S. IPO market may come back strong, since the market is home to many small companies that go public. When Nasdaq improves and stock valuations rise, executives will weigh the balance of higher stock prices versus the costs of Sarbanes-Oxley compliance. “The prospect of higher valuations will make the expense of compliance seem less significant,” he says.

And even if companies go public overseas, he says, that doesn’t mean they’ll stay there. “We expect that a lot of U.S. clients that decided to go public on AIM over the last three to five years will come back and look for NYSE and Nasdaq listings when they’re bigger and further along in their development cycle and more able to absorb some of the ongoing compliance costs,” Iino says.