The Securities and Exchange Commission this week is taking the first step toward new rules to overhaul the disclosures companies must make about what they pay their top executives and directors.
The SEC will meet to today to propose amendments to the disclosure requirements for executive and director compensation, related party transactions, director independence and other corporate governance matters, and securities ownership of officers and directors. The Commission will also consider whether to propose amendments to require most of the disclosures in proxy and information statements to be provided in plain English.
While the SEC unveiled its plans after Compliance Week went to press, the proposed changes reportedly would require companies to provide in their proxies a total annual compensation figure for their five highest-paid executives, and to be more specific about the value of their various benefits, according to cited SEC officials.
Other expected proposals would force companies put the monetary value of stock option grants to top executives side-by-side with salary and bonus information; lower the threshold at which perks must be disclosed to $10,000; require companies to specify the amount of payments executives would receive upon a change in control or change in responsibilities; and would create a new disclosure table for retirement plans and a new director compensation table that would comprise all payments received in a given year.
During a press conference last week, SEC Chairman Christopher Cox said the changes are designed to eliminate “surprises” in executive pay.
A spokesman for the SEC said he couldn’t confirm published reports about the package “in detail,” but said they were “pretty accurate, though the proposals are subject to change before the meeting.”
Minimal Interpolation
Public companies have been bracing for months for revisions to the existing disclosure rules, which are more than a decade old. Pressure from regulators, legislators and institutional investors to improve the transparency of executive pay has ensured that executive compensation will be a hot-button issue for corporate America in 2006. The proposals will be put out for public comment and are likely to be revised before final rules are adopted. The SEC hopes to have new rules in effect for the 2007 proxy season.
Folladori
“Chairman Cox has indicated from the get-go that executive compensation and the related disclosures are one of the hot buttons that he wants addressed,” says Marc Folladori, a partner at Fulbright & Jaworski in Houston. “The challenge for the SEC is going to be to draft the rules in a form that all companies can use with only minimal internal interpolation of them.”
That will be no easy feat. “What the SEC is trying to do is understandable, but much more difficult than is being painted in some early press reports,” says Michael J. Segal, partner and co-chair of the employee benefits and executive compensation department at Paul, Weiss, Rifkind, Wharton & Garrison. Segal says requiring companies to disclose the aggregate annual value of all types of compensation as a single number “is likely to create significant difficulties for reporting companies, because not all types of compensation are easily capable of being valued.”
Segal
Segal cites stock options as one example. “Everybody is wrestling with how to value them for purposes of the accounting rules,” he says. “There are several different ways to do that which are acceptable under the accounting rules, and not all acceptable methods result in the same value. I don't think the SEC is going to mandate a single acceptable valuation method.”
Segal notes that providing a dollar figure for change-of-control or termination scenarios is “even more difficult to come up with [than one number for total compensation], because it depends on a set of facts which are unknown at the time of the disclosure, such as stock price and salary, bonus and vesting status of stock awards at the time of termination or change of control.” Today, companies are required to describe in words the terms of severance and change of control benefits, but aren’t required to provide numbers.
“There are too many variables to be able to summarize in simple numbers the cost of termination or the cost of a change of control benefit. That's much more problematic than an annual compensation number,” says Segal.
How To React Now
While final rules aren’t expected for this proxy season, Folladori says, “I think a lot of practitioners will advise their clients to give [the proposed rules] more than lip service this proxy season.”
However, Segal says, “I don't typically recommend that clients get out ahead of the rulemaking process. We don't know what rules are going to say.” As a general principle, he says, companies “should make clear, concise, accurate disclosures of their executive compensation, however they decide to do it, as long as they comply with the current rules.”
Dicker
Howard Dicker, a partner at Weil, Gotshal & Manges, advises companies to “carefully review the proposing release, as the SEC will likely use it as a platform to express its views of existing requirements, particularly areas where it believes some companies' disclosure practices have been lacking and where continued non-compliance may prompt enforcement action.”
Says Dicker: “If a company's proxy statement has not yet been prepared when the proposing release becomes available, the company should consider making the disclosures that the proposals call for to the extent practicable and to the extent that doing so would not be inconsistent with existing rules.”
“In any event, companies should recognize that the bar for best practices—or at least, better processes and disclosure—has already been raised,” Dicker says. “During the 2005 proxy season, a number of companies provided disclosures similar to those expected to be part of the SEC's proposals,” including items such as reporting “total compensation” and payment amounts upon termination and change-in-control scenarios.
EXPECTED CHANGES
Though the SEC proposal was unveiled after Compliance Week went to press, the proposed changes were expected to include provisions such as:
Total Comp.—Would require companies to provide in their proxies a total annual compensation figure for their five highest-paid executives;
Benefits—Would require greater specificity about the value of top executives' various benefits;
Equity Totals—Would require disclosure of the monetary value of stock option grants to top executives, side-by-side with salary and bonus information;
Perks—Would lower to $10,000 the threshold at which perks must be disclosed (the current disclosure threshold is $50,000);
Change-In-Control—Would require companies to specify the amount of payments executives would receive upon a change in control or change in responsibilities;
Retirement Plans—Would create a new disclosure table for retirement plans; and
Directors—Would create a new director compensation table that would comprise all payments received in a given year.
Source: SEC, published reports.
Almost as soon as he stepped into the top spot at the SEC, Cox warned Corporate America that improving compensation disclosure would be a high priority for the Commission. In an August interview just days into his tenure at the Commission, Cox said the SEC would put out “improved rules on disclosure to make sure that, for example, shareholders can have one number, that the different kinds of executive compensation add up to a number that’s comparable executive to executive and company to company, and at the same time that this information is provided in a timely way before rather than after the fact.”
Revising the current compensation disclosure rules—which date back to 1992—was on the SEC’s radar screen prior to Cox’s arrival. In October 2004, Alan Beller, SEC director of the Division of Corporation Finance, noted in a speech that the agency was examining a number of compensation-related issues, such as how companies value perks and how they might be avoiding categorizing some items as perks; the disclosure requirements related to supplemental executive retirement plans and non-qualified deferred compensation plans; the need for enhanced disclosure of total compensation and how it might be achieved; the criteria for determining the named executive officers; and the disclosure of overall director compensation.
Companies Get In Gear
Segal says companies got the message. “I do believe there's been significant effort by most companies to clean up and clarify their disclosures in reaction to Alan Beller's October 2004 speech,” he says. “Even companies which were trying to play the rules loosely before, I think that game largely ended with Beller's speech.”
Still, experts say the disclosure rules haven’t kept pace with the changes in compensation practices.
“The current rules are very outmoded by today’s compensation practices,” says Folladori. “In the late ‘90s, when the themes and variations involving option compensation were changing quickly, it became plain that the rules… were outmoded.”
One area ripe for reform, he says, is related-party transaction disclosures—a topic Beller cited in his 2004 speech. “The current standard, Item 404 of Reg S-K, is hard to follow,” Folladori says. “The concepts of director independence have changed considerably since Item 404 was adopted.”
Regarding the expected proposal on perks, Folladori says, “Lowering the dollar threshold will require much more thought in terms of disclosing them, and hopefully guidance will be given in the SEC release with regards to what is really a ‘perk’ and what is a reimbursable expense.”
Despite pressure to rein in executive compensation, an October study by governance watchdog The Corporate Library concluded that many CEOs unjustifiably pocketed outsized salaries in 2004. As Compliance Week reported, the TCL study showed a median increase in total CEO compensation of 30.2 percent from 2003 to 2004, double the prior year’s increase. According to the watchdog group, only five of the 10 CEOs in the study who received the highest pay increases received them “with any kind of justification.”
Legislators have also been pushing for transparency in executive pay. In November, House lawmakers introduced a bill aimed at improving the transparency of executive pay that would, among other things, require public companies to include in annual reports and proxies a comprehensive executive compensation plan, which would have to be approved by shareholders and include full disclosure of top executives’ compensation.
In addition, proxy advisory firm Institutional Shareholder Services updated its voting policies to recommend tally sheets for CEO pay. ISS wants companies to provide a table for CEO pay that lists base salary, annual incentives, stock options, restricted stock, performance shares, deferred compensation, retirement plans and other perks. For companies that don’t meet a minimum standard of disclosure, ISS will note the deficiency and include cautionary language in its analysis.
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