As calendar-year companies begin preparing their Compensation Discussion & Analysis for their 2008 proxies, they are caught in the middle of the Securities and Exchange Commission’s desire for a “plain English” description of the “how and why” of executive compensation and the SEC staff’s demand for more detailed information. Those two imperatives come from the SEC’s targeted review of the new executive compensation disclosures filed earlier this year.
Shelly Parratt, deputy director of the SEC Division of Corporation Finance, is conducting the targeted review project, where some 300 of the Fortune 500 companies have received comment letters related specifically to their 2007 CD&As. The second phase is a more comprehensive report, released earlier this month, to provide guidance for preparing the 2008 compensation disclosures—intended for the vast majority of companies whose proxies were not part of the first review process.
The second-phase report is now available on the SEC Web site for anyone curious to read it. But based on the comment letters circulating among general counsels, CFOs and other executives so far, this appears to be what the SEC is looking for:
More detailed analysis of the different components of compensation and of change-of-control and termination payments.
More specificity in describing performance targets. John White, director of the SEC Division of Corporation Finance, said in a recent speech: “We’re seeing a lot of really vague disclosure in this area about ‘individual performance goals and targets’ without further discussion.” If performance targets were withheld based on the confidential treatment standards, the staff wants to know the reasons why.
If the performance targets were properly withheld based on competitive harm, did the company provide adequate disclosure concerning the difficulty of attaining alternative performance goals?
If benchmarking is used, the staff wants to know what specific companies were used to create the industry benchmarks.
Additional information about the role the chief executive played in setting his or her own compensation and that of other key executives.
One reason why performance targets were vague in many of the 2007 CD&As is that companies had to explain their executive compensation based on factors determined before boards knew this information would have to be disclosed. Many companies had been caught up in the escalating compensation game instigated by compensation consultants telling boards what they should pay to retain their top executives (usually an amount well above the industry median regardless of the company’s performance; this is one reason why the say-on-pay movement gained so much momentum this year). Hopefully, boards got the message and developed well-defined performance goals going forward, so this should not be the problem next year that it was this year.
Keep It Simple?
SEC Chairman Christopher Cox, in announcing the new disclosure rules early this year, called on companies to draft their CD&As in plain English so investors could clearly understand why and how the top executives are being paid. Yet, the comment letters to many companies reviewed as part of the first phase posed highly technical questions. This is not likely to result in a simplified, plain English discussion of executive compensation.
A similar situation occurred when the SEC issued its December 2003 guidance release calling on companies to communicate their Management’s Discussion and Analysis in plain English and to avoid duplicating information. Yet, when companies received comment letters about subsequent MD&As, the comments often extensively called for more detailed information and duplication of information. Consequently, the plain English objective was not achieved and companies continued to use boilerplate language in their filings. Indeed, when the SEC Office of Economic Analysis studied the MD&A disclosures of Fortune 500 companies in 2004 and 2005, it found the language was 90 percent consistent from year to year.
Before talking about how companies should communicate their executive compensation goals and strategies to investors, let’s make a distinction between complying with disclosure rules and communicating meaningful information to investors. Communication is voluntary discussion of what the company is doing to enhance shareholder value above and beyond compliance with the rules; this is what I believe the SEC was trying to accomplish in the new rules. But most companies are still struggling to achieve that level of communication so investors can understand how compensation relates to increasing share value.
There has been much discussion recently in several high-level forums about Corporate America’s short-term focus to the detriment of managing the company to create longer-term value. Among the causes that lead to short-term focus is the perceived need to meet quarterly earnings guidance and analysts’ quarterly earnings expectations. One way boards can get management to focus on the longer term is through the executive compensation program. This can be communicated to investors in the introduction of the CD&A, where the executive compensation program objectives, philosophy, and design principles are explained in plain English.
Here’s an example of how a company can explain its executive compensation program:
The compensation objectives are:
To attract and retain talented executives who have the experience and skills to lead the company in achieving both short-term (annual) and long-term (multiple-year) objectives.
To tie their compensation to the achievement of both short-term and long-term objectives.
The compensation philosophy and design principles are:
Compensation should be performance-based, where annual salary and incentive-based pay are provided in cash, and long-term compensation objectives are stock-based.
Annual and long-term compensation are tied to the attainment of annual and long-term objectives based on the achievement of specific financial and strategic goals. It is important that strategic objectives not be sacrificed to achieve short-term quarterly earnings expectations.
The discussion and analysis of the compensation components:
The compensation committee reviews the total compensation of the named executives that include the compensation reports or tally sheets that state the dollar value of base salary, annual and long-term compensation, deferred compensation, outstanding equity awards, benefits, perquisites, and the potential termination scenarios.
Specific criteria should be provided to demonstrate how base salary and annual incentive pay are determined. If the base salary is based on a peer company median, the peer companies should be disclosed.
The annual incentive pay or bonus is determined based on the maximum percentage each executive may receive and the criteria for determining that percentage. The compensation committee then establishes performance goals for each executive and measures each against those goals.
The long-term incentive compensation is stock-based to ensure the executives’ interests are aligned with those of the shareholders. The compensation goals should be expressed as the achievement of multiyear strategic and financial objectives. The target award percentage for each executive is described in how much is in stock grants and stock options along with the holding period for the latter.
The specific benefits that the named executives receive are explained along with the perquisites to which each is entitled.
The rationale is explained for change-of-control and separation pay.
All of the above must then be described in a summary compensation table containing the dollar amounts each executive receives for each category. Separate tables may be provided to more fully explain each category of compensation.
Even though the SEC is calling for more detailed discussion and analysis of the various components of executive compensation, companies still have the opportunity to make the CD&A both transparent and a document that communicates to investors how the board is attempting to achieve both short-term goals and longer-term strategic objectives leading to enhanced shareholder value. To use obfuscation and opaque disclosure to avoid providing competitive information can result in a great disservice to investors. After all, companies should recognize that today’s technologies provide their competitors with a lot more information than they may realize.
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