Companies that had their 2007 proxy disclosures well in hand as they rang in the new year need to think again, thanks to a last-minute change to the Securities and Exchange Commission’s executive compensation disclosure rules that rewrites how companies should value and disclose equity compensation.
Released late on Dec. 22—just before much of Corporate America went on vacation for the holidays—the interim final rules now require companies to state the value of stock and option awards over the entire lifespan of the award, rather than the full, fair value of the award at the time the grant was made. The changes must appear in the new Summary Compensation Table and Director Compensation Table, which will appear for the first time in companies’ proxy statements this spring.
Companies must act quickly, since the 53-page amended rule is in effect for the upcoming proxy season. But the SEC is accepting comment on the new rules, so further changes still might be made.
Kamlet
The SEC’s move is intended to align the reporting of stock and option awards more closely with Financial Accounting Standard No. 123R, Equity-Based Compensation. It means companies need to review—and probably revise—the disclosure surrounding the grants of stock and option awards in the Summary Compensation Table, the Grants of Plan-Based Awards Table, and the Director Compensation Table, says Bradley Kamlet, of the law firm Nixon Peabody.
Some adjustments to those tables will be needed, and those adjustments may change who is designated as a named executive officer for disclosure in the tables, he says. Still, he adds, the amendments resonate with other parts of the compensation disclosure rules. They also should reduce year-to-year fluctuations in executive pay disclosure that otherwise would have cropped up under the prior rules.
Mueller
Ronald Mueller, a partner at the law firm Gibson Dunn & Crutcher, is equally frank: Companies “have to go back to the drawing board,” recalculate the total compensation for their executive officers, and determine whether their named executive officers have changed.
The change won’t have much effect on companies where awards are made annually within a standard guideline, says Lawrence Cagney, chair of the executive-compensation practice at the Debevoise & Plimpton law firm. However, he says, in event-driven industries or where changes in personnel have happened recently, “using the new approach based on what is expensed for the fiscal year could have a significant impact on what, and whose, numbers get reported for the year.”
The SEC says this new approach gives investors a better idea of the compensation earned by an executive or director during a particular reporting period. It also is in accord with the principles of financial-statement disclosure, such as an annual report, where the cost of equity grants is parceled out across all the years the grant is awarded. SEC Chairman Christopher Cox said the new requirements will be “easier for companies to prepare, and for investors to understand.”
Shareholder Supporters Displeased
Critics of the change include the Council of Institutional Investors and U.S. Rep. Barney Frank, newly named chairman of the House Financial Services Committee. Amy Borrus, deputy director of the CII, called the change “a significant step back in terms of clear disclosure.”
RULE
An excerpt follows from the SEC’s interim rules on executive pay disclosures.
A. Summary Compensation Table
Under the amendments we adopt today as interim final rules, the dollar amount of
compensation cost recognized over the requisite service period, as described in FAS
123R, will be the amount reported in the Stock Awards and Option Awards columns in
the Summary Compensation Table. Compensation cost will include both the amounts
recorded as compensation expense in the income statement for the fiscal year as well as
any amounts earned by an executive that have been capitalized on the balance sheet for
the fiscal year. This amount will include compensation cost recognized in the financial
statements with respect to awards granted in previous fiscal years and the subject fiscal
year. The amendments revise the corresponding columns in the Director Compensation
Table in the same way …
Under FAS 123R, the classification of an award as an equity or liability award is
an important aspect of the accounting because the classification will affect the
measurement of compensation cost recognized in each financial statement reporting
period. Awards with cash-based settlement, certain repurchase features, or other features
that do not result in an employee bearing the risks and rewards normally associated with
share ownership for a specified period of time are classified as liability awards under
FAS 123R. For an award classified as an equity award under FAS 123R, the
compensation cost recognized is fixed for a particular award and, absent modification of
the award, is not revised with subsequent changes in market prices or other assumptions
used for purposes of the valuation. In contrast, liability awards are initially measured at
fair value on the grant date, but for purposes of recognition in the financial statements are
then re-measured at each financial statement reporting date through the date the awards
are settled under FAS 123R. Under the amendments to the Summary Compensation
Table and Director Compensation Table, these re-measurements of liability awards will
be reflected in executive compensation disclosure, providing a more comprehensive
measure of liability awards over time.
FAS 123R requires a company to aggregate individuals receiving awards into
relatively homogenous groups, for example, executives and non-executives, with respect
to exercise and post-vesting employment termination behaviors for the purpose of
determining expected term assumption used for computing the grant date fair value. The
rules we adopt today as interim final rules, like the recently adopted amendments, are not
intended to change the method used to value employee stock options for purposes of FAS
123R or to affect the judgments as to reasonable groupings for purposes of determining
the expected term assumption required by FAS 123R. Where a company uses more than
one group, the measurement of grant date fair value for purposes of Item 402 will be
derived using the expected term assumption for the group that includes the named
executive officers (or the group that includes directors for purposes of the Director
Compensation Table).
In determining the amount recognized, FAS 123R requires a company to estimate
at the grant date the number of awards that ultimately will be earned. Those estimates are
revised each period as awards vest or are forfeited. The interim final rules that we adopt
today are not intended to change the method a company uses to estimate forfeitures under
FAS 123R. However, under the amendments, the compensation cost disclosed for Item
402 purposes will not include an estimate of forfeitures related to service-based vesting
conditions. Compensation cost for awards containing service-based vesting conditions33
will be disclosed assuming that a named executive officer will perform the requisite
service to vest in the award. If the named executive officer fails to perform the requisite
service and forfeits the award, the amount of compensation cost previously disclosed in
the Summary Compensation Table will be deducted in the period during which the award
is forfeited.
Under the interim final rules, compensation cost for awards containing a
performance-based vesting condition will be disclosed in the Summary Compensation
Table only if it is probable that the performance condition will be achieved. If the
achievement of the performance condition is not probable at the grant date but becomes
probable in a subsequent period, the proportionate amount of compensation cost based on
service previously rendered will be disclosed in the Summary Compensation Table
during the period in which achievement of the performance condition becomes probable.
Likewise, if the achievement of a performance condition was previously considered
probable but in a later period is no longer considered probable, the amount of
compensation cost previously disclosed in the Summary Compensation Table will be
reversed during the period in which it is determined that achievement of the performance
condition is no longer probable.
In summary, if an award with service or performance-based conditions ultimately
vests, the amount cumulatively recognized in the Summary Compensation Table over a
period of years should equal 100% of the grant date fair value of the equity award or the
total fair value at the date of settlement for a liability award. The amount cumulatively
reported in the Summary Compensation Table for awards with service or performance-
based conditions that do not vest will be zero. On this basis, the amount cumulatively
reported for equity awards with graded vesting will equal 100% of the grant date fair
value of the portion of the award that vests. For example, if 20% of an award to the
principal executive officer vests in each of the five years following the grant and the
principal executive officer leaves the company after the fourth year of service, 80% of the
award’s grant date fair value will be reported cumulatively in the Summary
Compensation Table over those four years of service.
Source
RIN 3235-AI80: Interim Final Rule On Executive Compensation Disclosure (Securities and Exchange Commission; Dec. 22, 2006)
Borrus’ chief complaint is that while investors would be able to see the full value of equity-compensation grants over time, they would not get a single, entire picture of the compensation that a company’s board of directors decided to award to an executive. The change “will certainly make compensation numbers look smaller in 2007 than they otherwise would,” she says.
The whole purpose of a proxy statement is to give shareowners a “better view of board decision making,” Borrus says. “They won’t have a full picture of what the board decided to do for top executives if they can’t see the full magnitude in value of the compensation granted.”
In a public response to the news, Frank said he was “disappointed” in the SEC’s decision. He called the move “backtracking,” and said it reinforces his determination that Congress “must act to deal with the problem of executive compensation.”
Mueller, however, says that “other than the change of course right now, in the long-term, this isn’t really momentous.” He calls it “a technical adjustment in how and when things are being reported.” Mueller also notes that the full grant-date value still appears in the proxy, but in the Grants of Plan-Based Awards Table on the page after the Summary Compensation Table. He also praises the use of accounting standards to report the compensation figures, since it creates “a more rigorous, more consistent standard of how companies report equity awards.”
The change more accurately reflects the compensation’s accounting cost to the company by spreading it over the life of the grant and eliminates some uncertainty under the prior rules, he adds. For example, if a company planned to grant options in February 2007 but those options were part of an executive’s 2006 bonus, companies might not know whether they could report the options as 2006 compensation. Under the earlier rule, the answer was unclear. But under the revised rule, the answer is a clear “no,” Mueller says, since none of the accounting charge is allocated to 2006.
For The Better, Or Worse?
Still, Cagney says the changes will cause more difficulty for issuers assembling the required information. Because of certain transition rules, under the earlier regulations, companies would only have reported 2006 equity awards in the Summary Compensation Table for their 2007 proxies. Under the interim final rules, he says, “Virtually every company will have to factor in the FAS 123R fair value of awards made in 2004 and 2005, and perhaps earlier.”
Cagney
In addition, the numbers to be reported for awards that vest based on a completion of a service condition must be recalculated. While the FAS 123R fair value takes into account some level of discount for the possibility of forfeiture, Cagney says the new rules don’t permit the effect of a possible forfeiture of a service-related award to be factored into the numbers required in the Summary Compensation Table.
“So, despite the latest change to the rules, the amounts disclosed in the proxy are quite likely to differ—although to a lesser extent—from the corresponding amounts reported for the same fiscal year in the company’s financial statements,” he says. “My personal guess is that the disclosure will be somewhat clearer for the professional analyst who is looking to reconcile the proxy with the financial statements, but it will be more confusing for the average shareholder.”
Cagney notes that if a company made a stock award or granted a stock option to an executive in 2006, each award will factor into what gets reported in the 2007 proxy in at least three different tables, on at least four different bases.
“There will be two different accounting-based values, at least two different presentations of the number of shares subject to the award, and a valuation based on the market price of the stock on a date different from the date used to determine the accounting valuations,” says Cagney. “Sherlock Holmes might find it all elementary, but the Dr. Watsons of the world will need someone with Holmes’ skills to explain the explanation.”
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