Executive Pay: And Now, The Comments Begin...

The devil is always in the details when it comes to executive compensation, and the Securities and Exchange Commission’s attempt to regulate executive pay is proving no different.

The Commission formally outlined its ideas for overhauling compensation at a meeting Jan. 17. Among the goals of Chairman Christopher Cox: detailed disclosure of total compensation of a company’s principal executive officer, principal financial officer, three other highest-paid executive officers and its directors; and similar disclosures for some non-executive employees if they are more highly paid that the top executive officers (see box at right for details).

Cox

“We want investors to have better information, including one number—a single bottom-line figure—for total annual compensation,” Cox said.

As of early this week, the Commission had yet to publish the full text of its proposed changes. Once they are published on the agency’s Web site and in the Federal Register, the public will have a 60-day comment period to sound off. Then comes the ground war for what is likely to be the biggest battle in corporate governance this year.

“The areas that I’d expect to see a lot of companies comment on are the severance compensation calculations, the possibility of double counting, and the proposed requirement that companies calculate the total compensation of their highest paid non-executives,” says Ronald O. Mueller, a partner at Gibson, Dunn & Crutcher and a former SEC employee.

In particular, Mueller expects companies to be concerned about required compensation calculations for each of the top five highest paid executives. “As described, companies would have to report a number for change-of-control and other terminations scenarios. That could be as many as four different valuations for five executive officers,” he says. “In my experience, companies are doing those types of calculations for the CEO or their top two executives, but not for all five, and they’re not usually a precise dollar calculation since it’s usually a hypothetical number anyway.”

The proposal may raise concerns possible liability if immaterial errors occur in the calculations, Mueller says, or if the explanations do not adequately describe every single assumption involved in making the valuation. He expects the SEC to receive “a lot” of comment on the issue, perhaps suggesting alternatives such as calculations only for the CEO or providing a range instead of an exact dollar amount.

Smith

“It's too premature to tell because the exact rules aren't out and the devil is in the details,” says Edward P. Smith, a partner in the corporate practice at Chadbourne & Parke in New York. However, “it's going to be difficult for companies to attack the proposals conceptually. I think companies may object to some of the details or seek greater clarity on some points.”

Smith expects companies to examine the disclosure requirements related to post-termination compensation. In trying to quantify the cost of future benefits, “companies have to make some assumptions about how much of the benefit the executive is going to use,” he says. “Compensation committees often get a rough estimate of what that is, but not the kind of precise disclosure that a proxy statement would require.” Companies may ask the SEC to allow them to hedge the information they submit with various assumptions, he adds.

Another sore point could be retirement compensation. Under the proposed rules, the year-over-year increase in value of supplemental executive retirement plans will be reported in the summary compensation table, as will the increase in the value from year to year of the deferred compensation accounts.

“People don’t recognize how much value is in executive retirement benefits in mature industries,” says Dave Swinford, senior managing director at compensation consultancy Pearl Meyer & Partners. “That is going to be made very clear under the SEC’s proposed rules. Many companies are going to object to including the full value of investment gains in the deferred compensation accounts because some of that gain is attributable to the executive’s contributions to the account, as opposed to company contributions.”

COMPENSATION DISCLOSURE

Outline Of Proposed Changes

On Jan. 17, 2006, the Securities and Exchange Commission proposed rules that would amend disclosure requirements for executive and director compensation, related party transactions, director independence, and other corporate governance matters. The proposed rules would impact proxy statements, annual reports, registration statements, and even the revised 8-K requirements. Among the changes:

1. Executive and Director Compensation

The proposals would refine the currently required tabular disclosure and combine it with improved narrative disclosure to elicit clearer and more complete disclosure of compensation of the principal executive officer, principal financial officer, the three other highest paid executive officers and the directors.

New company disclosure in the form of a Compensation Discussion and Analysis would address the objectives and implementation of executive compensation programs—focusing on the most important factors underlying each company's compensation policies and decisions.

Following this new section, executive compensation disclosure would be organized into three broad categories: compensation over the last three years; holdings of outstanding equity-related interests received as compensation that are the source of future gains; and Retirement plans and other post-employment payments and benefits.

A reorganized Summary Compensation Table would be the principal vehicle for showing three-year compensation and would include additional information.

A new column would report total compensation.

A dollar value will be shown for all stock-based awards, including stock and stock options, measured at grant date fair value, computed pursuant to Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, to provide a more complete picture of compensation and facilitate reporting total compensation.

The "All Other Compensation" column would include the aggregate increase in actuarial value of pension plans accrued during the year and all earnings on deferred compensation that is not tax-qualified.

The threshold for disclosing perquisites would be reduced to $10,000 and interpretive guidance is provided for determining what is a perquisite.

Two supplemental tables would report Grants of Performance-Based Awards and Grants of All Other Equity Awards.

Disclosure regarding outstanding equity interests would include

the Outstanding Equity Awards at Fiscal Year-End Table, which would show outstanding awards representing potential amounts that may be received in the future; and

the Option Exercises and Stock Vested Table, which would show amounts realized on equity compensation during the last year.

Retirement plan and post-employment disclosure would include

the Retirement Plan Potential Annual Payments and Benefits Table, which would disclose annual benefits payable to each named executive officer;

the Nonqualified Defined Contribution and Other Deferred Compensation Plans Table, which would disclose year-end balance, and executive contributions, company contributions, earnings and withdrawals for the year; and

disclosure of payments and benefits (including perquisites) payable on termination or change in control, including quantification of these potential payments and benefits.

A Director Compensation Table, similar to the Summary Compensation Table, and related narrative would disclose director compensation for the last year.

2. Related Person Transactions, Director Independence, Other Corp. Gov. Matters

The proposals would update, clarify, and slightly expand the disclosure provisions regarding related person transactions. Principal changes would include a disclosure requirement regarding policies and procedures for approving related party transactions, a slight expansion of the categories of related persons and a change in the threshold for disclosure from $60,000 to $120,000. The requirement to disclose these transactions would also be made more principles-based, and would require disclosure if the company is a participant in a transaction in which a related person has a direct or indirect material interest.

A proposed new item (Item 407 of Regulations S-K and S-B) would require

disclosure of whether each director and director nominee is independent;

a description of any relationships not otherwise disclosed that were considered when determining whether each director and director nominee is independent; and

disclosure of any audit, nominating and compensation committee members who are not independent.

Proposed Item 407 also would consolidate corporate governance related disclosure requirements currently set forth in a number of places in the proxy rules and Regulations S-K or S-B. This would include disclosure regarding board meetings and committees, and specific disclosure about nominating and audit committees. Proposed Item 407 would also require similar disclosure regarding compensation committees and a narrative description of their procedures for determining executive and director compensation.

3. Security Ownership of Officers and Directors

The proposals would require disclosure of the number of shares pledged by management.

4. Form 8-K

The proposals would modify the disclosure requirements in Form 8-K to capture some employment arrangements and material amendments thereto only for named executive officers. The proposals would also consolidate all Form 8-K disclosure regarding employment arrangements under a single item.

5. Plain English Disclosure

The proposals would require companies to prepare most of this information using plain English principles in organization, language and design.

Source

SEC Votes To Propose Changes To Disclosure Requirements Concerning Executive Compensation (Released Jan. 17)

With the value of retirement benefits brought into such sharp relief, Swinford expects compensation committees to take much closer looks at the packages they grant to executives. Says he: “There’s going to be a real debate around the issue of long-term, secure pay, versus highly risk-oriented pay.”

“Double counting,” or parts of executive pay that could end up counted twice, is also expected to be a concern raised by companies. Mueller gives the example of deferred compensation and pension plan payouts will show up in the severance calculations, when separate disclosure of those items will already be required elsewhere. The value of stock options will also have to be reported when they’re granted and then again in the year when they’re vested.

Atkins

Commissioner Paul Atkins said he expected that issue to be addressed during the rulemaking process. “Our proposed rules attempt to provide a common base for discussion and to avoid double counting. I am sure that we will get much commentary on this aspect,” said Atkins.

The Perk: Endangered Species?

The SEC also proposed lowering the reporting threshold for perquisites to $10,000. Currently, companies must report a lump sum if an executive's perks exceed $50,000 or 10 percent of his salary and bonus. Individual perks have to be reported only if they represent more than 25 percent of all the perks an executive receives. If the rule is adopted as proposed, Swinford says, “We’ll see a wholesale destruction of executive perquisite programs.”

“How do you defend to the average employee why the company is buying a computer for an executive to use at home?,” Swinford says. “I think it’s going to be much easier for companies to say they’ll give an executive a $50,000 raise and wipe out the perquisites. I think three years from now, if we survey companies about their perks and what they’re worth, it will be a much skinnier perk world then,” he says.

Observers say expected interpretive guidance on perks, while welcome, may also be of concern. Noting that there hasn’t been interpretive guidance from the SEC on what’s considered a perk for the past 14 years, Mueller says such guidance “will be helpful.” But, he adds, “it is surprising that in the context of a rule proposal the SEC would issue interpretations instead of acting through rulemaking that would be prospective only.”

Mueller

“Given the complex nature of this issue—which is part of the reason the SEC got out of the business of providing interpretive guidance previously—there will likely be concern about whether the interpretations will be overly expansive or suitable for all the different types of issues that can arise,” he says.

Other areas of the proposal where observers expect see much discussion during the comment period are stock-option valuations, the compensation discussion and analysis, and related-party and director independence disclosures.

The SEC proposed raising the dollar threshold for related party transactions to $120,000 from $60,000,which Mueller says is “still fairly low.” But agency also says it’s moving toward more principles-based rules on this front, and on director independence as well, he adds. “When they talk about principles-based rules, it raises concern over what that’s going to mean. Is it going to result in clearer, more consistent disclosure, or is it moving in the opposite direction of the compensation rules, where more specificity is being proposed?”

Swinford expects the new compensation discussion and analysis (which will replace the Compensation Committee Report and performance graph) to have the most impact on compensation practices.

“Long term, what’s going to have more impact on the way investors understand and think about compensation than any of the material in the tables themselves is going to be the new [proposed] compensation disclosure and analysis report,” he says. “The SEC is going to require much stronger descriptions of the pay decisions being made, of why companies are granting a number.”

“Under the current rules, the compensation committee report isn’t considered to be a filing in the same sense as the proposed compensation discussion and analysis report is going to be,” he continues. “Directors will be liable for any intentional misstatements or significant omissions. I think we’ll see directors insist that the explanations for their decisions be more thorough and less pure boilerplate than in the past.”

Other changes expected to be welcomed by companies are additional guidance on Form 8-K requirements and consolidated information related to directors.

McCoy

“Providing additional guidance on the Form 8-K requirement as it relates to employment agreements will be of benefit to companies,” notes Michael R. McCoy, an associate at Bryan Cave and a former SEC staffer. “There was a flood of 8-Ks because most companies took a ‘better safe than sorry’ approach to disclosure.”

In addition, McCoy says, “consolidating all of the information related to directors will be beneficial for companies in determining what the appropriate disclosures will be.”

Mueller agrees. “The clarifications of when a Form 8-K has to be filed disclosing a compensation matter will be welcome by companies and helpful for shareholders because it will help eliminate a lot of trivial 8-Ks that are being filed currently,” he says. “There’s lot of uncertainty and disparate practice in that area now.”

“It appears to be a very well-thought and comprehensive approach to the rules,” Mueller says. “I think companies and shareholders will welcome greater clarity and consistency on what needs to be disclosed.”

Related coverage and resources can be found in the box above, right.