October 2006
THE NEW EXECUTIVE COMPENSATION DISCLOSURE RULES
FOR PUBLIC COMPANIES –
WHAT SHOULD “SMALL BUSINESS ISSUERS” DO NOW?
As we reported in our Legal Alert in July 2006, the Securities and Exchange Commission has adopted new rules for disclosure of compensation paid to executive officers and directors of public companies. The new rules require public companies to articulate their compensation policies and priorities in much greater detail than has been required previously. Also, under the final rules, more detailed compensation tables and other new compensation disclosures will be required. The final rules significantly impact public companies’ disclosure procedures and will cause many public companies to revisit their objectives and methodologies for officer and director compensation.
For public companies categorized as “small business issuers” – companies that file their periodic reports on Forms 10-KSB and 10-QSB and are governed by Regulation S-B – the rules have somewhat less impact than for other public companies. However, there are still many new requirements, and small business issuers need to plan accordingly.
This letter describes some of the significant requirements of the final compensation disclosure rules for small business issuers. We also list a number of action items such a company should consider addressing as soon as possible. If you would like more detailed information on the final rules or how your company should address them, please contact one of our attorneys listed below.
Effective Dates
The new compensation disclosure rules are effective for a small business issuer’s proxy statement and Form 10-KSB for a fiscal year ending on or after December 15, 2006. Registration statements or post-effective amendments will also be subject to the new rules if they are filed on or after December 15, 2006 and are required to include financial statements for a fiscal year ending on or after December 15, 2006.
Differences From Disclosure Requirements for Larger Companies
The SEC declined to apply some of the most rigorous new disclosure requirements to small business issuers, recognizing that such companies generally have much less complex compensation programs than larger companies. The SEC also intended to relieve small business issuers of the regulatory burdens of these disclosures, which would be disproportionate for smaller companies.
Therefore, unlike larger public companies, small business issuers will not be required to prepare the extensive new “Compensation Discussion and Analysis” (CD&A) section, in which larger companies must provide detailed disclosures about the objectives of each of the company’s compensation programs. Also, a number of the newly required compensation tables will not apply to small business issuers.
However, the new compensation disclosure rules do impose some significant new requirements on small business issuers.
Named Executive Officers
The new rules include a number of changes in the determination of the “named executive officers” – the individuals who are included in the Summary Compensation Table and other tables. As in the existing rules, anyone who served as the principal executive officer at any time during the year must be included, regardless of compensation. In addition, the named executive officers include the two other most highly compensated executive officers who were serving at the end of the fiscal year, provided their total compensation exceeded $100,000. Therefore, generally small business issuers will have only three named executive officers under the new rules, compared with five in most cases under the existing rules.
The determination of the most highly compensated officers is now based on total compensation as reported in the Summary Compensation Table (with one adjustment), rather than on the sum of salary and bonus as provided under the current rules. Therefore, the calculation will include the fair value of stock option grants and other equity awards, severance and retirement payments and a variety of other factors. This will make it more difficult to predict who will be included in the tables, and there will likely be more variations in the named executive officers from year to year than under the existing rules.
In addition, the new rules require the inclusion of 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. Because severance and retirement payments will now be included in total compensation, officers who retired or terminated their employment during the year are more likely than ever to be included in the tables.
Summary Compensation Table
The Summary Compensation Table continues as the principal disclosure vehicle regarding executive compensation and now includes a column for the disclosure of “total compensation” for each named executive officer. The revised Summary Compensation Table shows the named executive officers’ compensation, whether or not actually paid, for the last two fiscal years (compared to three fiscal years under the existing rules). However, the rules provide some transition relief – the information need only be provided for the most recent fiscal year in the first year for which the new table is required.
We can provide you with copies of the Summary Compensation Table and the other new tables, in Word format. Please contact one of the attorneys listed at the end of this letter to request copies.
Some new features of the Summary Compensation Table include the following:
- The Option Awards column will disclose the fair value, as determined under FAS 123R, of stock options and similar instruments granted in the fiscal year, even if the award is subject to vesting and only a portion of the cost of the award will be expensed in the company’s financial statements for the given fiscal year.
- The Stock Awards column will disclose the FAS 123R fair value of equity awards other than stock options, such as restricted stock and performance shares, again without regard to the portion of the cost that will be expensed currently.
- The new Non-Equity Incentive Plan Compensation column will report the dollar value of all amounts earned under incentive plans that are not considered equity awards under FAS 123R.
- The All Other Compensation column replaces and expands the coverage of the Other Annual Compensation and All Other Compensation columns in the current Summary Compensation Table. Any item of compensation included in the All Other Compensation column, including any perquisite, that exceeds the greater of $25,000 or 10% of the total amount included in that category, must be separately identified in a narrative disclosure.
Perquisites and Other Personal Benefits
The SEC continues to take the position that it is not appropriate to provide a definition of “perquisites” or “personal benefits,” but the SEC release that adopted the rules includes interpretive guidance about factors to be considered in determining whether an item is a perquisite or other personal benefit:
- An item is not a perquisite or personal benefit if it is “integrally and directly related” to the performance of the executive’s duties (i.e., “the executive needs it to do the job”).
- If an item confers a direct or indirect benefit that has a personal aspect, then it is a perquisite or personal benefit unless the item is generally available on a non-discriminatory basis to all employees.
The SEC release includes the following examples of items that will be considered perquisites or personal benefits: club memberships not used exclusively for business entertainment purposes; personal financial or tax advice; personal travel using vehicles owned or leased by the company; personal use of other property owned or leased by the company; security provided at a personal residence or during personal travel; commuting expenses; and discounts on company products not generally available to employees on a non-discriminatory basis. Perquisites and personal benefits continue to be valued on the basis of aggregate incremental cost to the company. However, standards and methods for such valuation are likely to evolve, because larger public companies will be required to disclose their valuation methods in footnotes to their tables.
The requirements for disclosure of perquisites are less rigorous for small business issuers than for larger companies. However, under the new rules, the nature of any large perquisites will be disclosed in the narrative disclosures. Because of the attention focused on perquisites by investors, regulators and media, small business issuers that provide extensive perquisites should carefully consider their disclosures in this area.
Other Required Compensation Tables
The new rules have changed the compensation tables to be included in the proxy statement, in addition to the Summary Compensation Table. The following new tables are required:
- The Outstanding Equity Awards at Fiscal Year-End Table will disclose information on outstanding equity awards, such as the number of shares underlying vested and unvested stock options and restricted stock grants. This table requires a separate line for each stock option and other equity award held by each named executive officer. Therefore, the table will be quite lengthy and time-consuming to prepare.
- The Director Compensation Table will disclose information on director compensation similar to the information provided in the Summary Compensation Table for the named executive officers, except that the information will be required only for the company’s most recent fiscal year. This table will, for the first time, require companies to break out specific compensation levels for each director and will require disclosure of a total compensation figure for each director.
Interestingly, several of the tables required for small business issuers under the existing rules, such as the tables of option grants and option exercises in the preceding fiscal year, have been eliminated under the new rules.
Narrative Disclosures
The new rules require that the Summary Compensation Table be accompanied by a narrative description of “any additional material factors necessary to an understanding of the information disclosed in the Table . . . .” These narrative disclosures must be in plain English. Types of disclosure that may be required include descriptions of the material terms of the named executive officers’ employment agreements, material modifications to options, and option vesting schedules. Another example given is the disclosure of the waiver or modification of any specified performance target or goal for incentive plan payouts listed in the Summary Compensation Table.
Also, the narrative disclosure must include a “general description” of the formula or criteria applied under a non-equity incentive plan award in the past year. It is not clear whether the SEC will take the position that the formula must be disclosed unless disclosure would cause competitive harm – this is the test applied to larger companies under the new rules.
The new rules also require narrative disclosures about the material terms of retirement programs, including supplemental executive retirement programs, or SERPs, and pension plans. Narrative disclosures are also required regarding written and unwritten arrangements for payments in connection with the resignation, severance, retirement or other termination of a named executive officer, or a change in the responsibilities of such an officer or a change in control of the company. These disclosures are no longer subject to a $100,000 threshold, as under the existing rules.
Stock Option Practices
In response to the recent stock option backdating scandals and related controversies relating to stock options, the SEC indicated that it expects public companies to focus on their practices for granting equity compensation. Unlike the rules for larger companies, no specific new disclosures are provided for option granting practices. However, option granting practices are in the spotlight for all companies, and small business issuers should take care to examine their option granting practices to ensure that stock options are priced and reported properly. Further, if a small business issuer has any practice or program to time stock option grants or other equity awards in connection with the release of material non-public information, the company should disclose that practice in the narrative disclosure as a material feature of the program and should strongly consider discontinuing the practice.
Suggested Action Items for Small Business Issuers
The new executive compensation disclosure rules will shine an increasingly harsh light on the compensation practices, decisions and priorities of all public companies, including small business issuers. Many of the new narrative and tabular disclosures will take a great deal of time to compile and refine. Therefore, it is important that public companies act quickly to get ready. Public companies should consider taking the following steps as soon as possible:
- Designate an appropriate point person or persons within the organization to gather the necessary information for the new tables and narrative disclosures. Recognize the multi-disciplinary nature of the project, which will involve financial, human resources and legal aspects.
- Prepare mock-ups of the required tables to start to get an idea of (1) which officers may be named executive officers in the next proxy statement, (2) what new data items will be difficult to calculate, and (3) what areas must be explained adequately in footnotes or the narrative disclosures.
- In addition, consider preparing tally sheets and wealth accumulation tables for internal use of the compensation committee. Tally sheets are spreadsheets that list many possible aspects of a given executive’s compensation and allow the compensation committee, and the full board, to see all of those elements in one place and tally them up quickly and easily. Wealth accumulation tables quantify the value of each named executive officer’s vested and unvested equity holdings and the wealth the executive has already realized from equity awards. At a minimum, these tools should be examined every time there is any change in an executive officer’s compensation.
- Carefully review the amounts and types of perquisites paid for by the company, keeping in mind the need to provide specific information on the nature of perks with a large incremental cost to the company.
- Review and evaluate option granting procedures in light of the attention currently being paid to stock options. Consider simplifying option granting practices (e.g., one or two grant dates per year, set in advance) and adopting a formal stock option granting policy.
- Evaluate the company’s “disclosure controls and procedures” to ensure that the top officers have adequate information to verify the accuracy of the company’s compensation disclosures. At the very least, make sure it is clear who is responsible for providing and verifying each item of information required by the rules.
- Review and revise, if necessary, the company’s compensation committee charter.
- Consider the specific role of the compensation committee and the role of any executive officers in communicating with the committee. Keep in mind that any such communications will need to be disclosed in the proxy statement.
- Make sure that the timetables for preparation of the company’s disclosure documents provide adequate time to deal with all of the above tasks.
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If you have any questions, feel free to contact any of the following Maslon attorneys:
Martin R. Rosenbaum
Martin.Rosenbaum@maslon.com
(612) 672-8326
Christopher J. Melsha
Chris.Melsha@maslon.com
(612) 672-8343
William M. Mower
Bill.Mower@maslon.com
(612) 672-8358
Douglas T. Holod
Doug.Holod@maslon.com
(612) 672-8313
Alan M. Gilbert
Alan.Gilbert@maslon.com
(612) 672-8381
