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May 2006 Public Companies Should Prepare for Proposed Amendments to the SEC's Compensation Disclosure Rules To: Our Clients and Friends In January 2006, the SEC issued a 370-page release that proposed extensive amendments to its executive compensation disclosure rules that apply to public companies’ proxy statements and other reports. The SEC is currently reviewing more than 1,000 substantive comment letters received on the proposed rules and evaluating what changes to make in the release. However, it is safe to assume that the new rules, when adopted, will contain the principal features of the proposal described in the release; and that the new rules will be in effect for the 2007 proxy season. The new rules will require compensation committees of public companies to articulate their compensation policies and priorities in much greater detail than is required under the current rules. Also, under the new rules, more detailed compensation tables and other new compensation information will be required. Public companies and their compensation committees should take action now to prepare for the new rules. As John W. White, the SEC’s new Director of the Division of Corporation Finance, stated in a speech in April 2006: “I would encourage you to treat the proposals as a wakeup call.” The Proposed New Disclosure Rules Under the SEC’s proposed amendments, the new rules will contain significant new narrative disclosures, as well as enhancements to the compensation tables. Compensation Discussion and Analysis A major feature of the proposed new rules is a narrative section, to be called “Compensation Discussion and Analysis” (CD&A), that will provide a general overview of the company’s compensation policies – similar to the financial overview currently required in the management’s discussion and analysis disclosure. The CD&A section will require analysis of the compensation policies and decisions reflected in the data presented in the compensation tables in the proxy statement. The CD&A will replace the compensation committee report currently required to be included in proxy statements of larger companies, which the SEC believes often contains only boilerplate language. (How many companies’ compensation committee reports state, year after year, that the compensation programs are designed to “tie compensation to performance”?) The new CD&A will require disclosure of specific types of information on the compensation committee’s decision-making process for the compensation of executive officers, including the answers to the following questions:
Clearly, in order to answer the above questions, the compensation committee must consider and articulate its compensation objectives, and how they fit into overall executive compensation practices, in much greater detail than has been necessary in the past. In addition to the questions listed above, the proposing release includes a number of other additional factors that might be considered appropriate to discuss in the CD&A, including the manner in which specific elements of compensation are structured to reflect company and individual performance; stock ownership guidelines; how profits from prior compensation (for example, unrealized gains in stock options that are in-the-money) are considered in setting other compensation elements (including retirement benefits); the role of executive officers in the compensation process; and other factors. Unlike the current compensation committee report, the CD&A will be considered “filed” rather than “furnished” under the securities laws. Therefore, the CD&A will be incorporated by reference in registration statements for the offering of securities, with the attendant heightened liability standards involved in this incorporation. In addition, the CD&A will be covered by the CEO and CFO certifications filed with Form 10-K. These factors will raise the stakes involved in providing clear and accurate disclosure and avoiding misstatements. Under the SEC proposal, small business issuers would be exempt from the requirement to include CD&A in their proxy statements, although the SEC solicited comments on whether this exemption should be adopted. Compensation Tables The SEC proposes to reorganize and streamline the compensation tables contained in the proxy statement to provide disclosures in three broad categories:
The Summary Compensation Table will continue as the principal disclosure vehicle regarding executive compensation, with a number of changes from the current table. First, there will be a column for the disclosure of “total compensation” for each named executive. Also, the threshold for disclosure of perquisites will be lowered to $10,000 in the aggregate. The current threshold for perquisites is the lesser of $50,000 or 10% of total of annual salary and bonus. The proposals also require the addition of two supplementary tables with information about grants of performance-based awards and all other equity awards, respectively. The rules would require narrative disclosure following these three tables, disclosing material information necessary to an understanding of the information in the tables. The new requirements would also make a number of changes in the determination of the individuals named in the Summary Compensation Table. Anyone who served as the principal financial officer at any time during the year must be included, regardless of compensation – similar to the existing treatment of the CEO. In addition to all persons who served as principal executive and financial officers during the fiscal year, the table would include the three other most highly compensated executive officers who were serving at the end of the fiscal year, as well as up to two other individuals who would have been included in the table but for the fact that they were not serving as executive officers at the end of the last completed fiscal year. The determination of the most highly compensated executive officers will be based on the aggregate figure in the total compensation column, rather than on the sum of salary and bonus as provided under the current rules. Further, the proposal also requires the job description and total compensation (but not the name) of up to three additional employees who were not executive officers during the prior fiscal year but whose total compensation during the year was greater than that of any named executive officer. This latter proposal (often referred to as the “Katie Couric clause”) has been the subject of much controversy, especially regarding companies in the entertainment industry, and may be modified or dropped by the Commission. Other Proposed Changes The new proposed rules would make a number of other changes to compensation disclosure requirements and other disclosure requirements in related areas, including the following:
What Should Public Companies Do Now? The new executive compensation disclosure rules will shine an increasingly harsh light on public companies’ compensation practices, decisions and priorities, regardless of any changes in the proposed amendments before they are adopted. This comes at the same time as a number of other changes in the “compensation landscape”: an increasing number of shareholder lawsuits against compensation committees and directors, creating increased concerns for director liability; increased institutional investor activism in campaigning against directors whose compensation practices are criticized; media criticism of boards of directors and compensation committees for excessive compensation and other compensation practices; and a major shift in compensation policies and priorities, due to recent accounting changes that create a charge against income for stock option grants. This latter factor “levels the playing field” to a significant degree and is causing compensation committees to consider other sorts of compensation, such as restricted stock and performance shares. Therefore, at a minimum, any public company should consider the following practices and activities in the months leading up to adoption of the new rules:
* * * * * If you have any questions, feel free to contact any of the members of the Maslon Business and Securities Group listed below. Neil I. Sell Jerome B. Simon William M. Mower Martin R. Rosenbaum Douglas T. Holod Christopher J. Melsha Alan M. Gilbert Paul D. Chestovich David Polgreen
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