News

October 2006

The New  Executive Compensation Disclosure Rules –
What Should Public Companies Do Now?

To: Our Clients and Friends

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.

  This letter describes some of the significant requirements of the final compensation disclosure rules. We also list a number of action items a public 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.

  The new rules impose somewhat less rigorous requirements on public companies that are categorized as “small business issuers.”  However, small business issuers will still be required to prepare many new compensation-related disclosures and will be subject to some of the same considerations as larger companies. We have prepared a separate letter regarding the requirements for small business issuers, which is available upon request from one of the attorneys listed below.

Effective Dates

The new compensation disclosure rules are effective for a public company’s proxy statement and Form 10-K 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. 

Compensation Discussion and Analysis and the New Compensation Committee Report

A major feature of the new rules is a narrative section, called “Compensation Discussion and Analysis” (CD&A) that will provide a general narrative overview of the company’s compensation policies – similar to the overview of financial matters required in the existing management’s discussion and analysis disclosure. Like all of the narrative compensation disclosures under the new rules, CD&A is required to be written in plain English.

The CD&A section requires analysis of the compensation policies and decisions reflected in the data presented in the proxy statement’s compensation tables.  CD&A will require disclosure of specific types of information related to the compensation committee’s decision-making process for compensation of executive officers, including answers to the following questions:

• What are the objectives of the company’s compensation programs?

• What is the compensation program designed to reward and not reward?

• What is each element of compensation (e.g., stock options, incentive bonus, etc.)?

• Why does the company choose to pay each element?

• How does the company determine the amount (and, where applicable, the formula) for each element?

• How does each element and the company’s decisions regarding that element fit in to the company’s overall compensation objectives and affect decisions regarding other elements?

In addition to the six questions above that must be discussed, the final rules include a list of fifteen example topics that may be considered appropriate to discuss in the CD&A.  These topics include discussion of the following general subjects, among others: (1) policies for allocating between long-term and current compensation; (2) the manner in which specific elements of compensation are structured to reflect company and individual performance; (3) what specific items of corporate performance are taken into account in making compensation decisions; (4) whether discretion can be exercised to adjust the levels of compensation under various awards; (5) guidelines related to stock ownership; (6) how profits from prior compensation (for example, unrealized gains in stock options that are in-the-money) are considered in setting current and future compensation elements (including retirement benefits); (7) the basis for selecting particular events as triggering events for change-in-control or termination payments; and (8) the role of executive officers in the compensation process.

The rules impose new standards for whether target levels for performance awards and other performance-related compensation factors must be disclosed. The instructions provide that these levels and factors need not be disclosed if disclosure would cause competitive harm. However, any company that relies on this test is required to discuss how difficult it will be for the executive or how likely it will be for the registrant to achieve the undisclosed target levels or other factors. This disclosure is likely to be present difficult drafting issues, and any disclosure of the likelihood of reaching target levels must be considered in light of the company’s earnings guidance and other factors.

Unlike the Compensation Committee Report currently required in proxy statements, the CD&A is considered “filed” rather than “furnished” under the securities laws. This has several consequences. First, the disclosure will be incorporated by reference in registration statements for the offering of securities, with the attendant heightened liability standards involved in this incorporation. Second, CD&A disclosures will be covered by the certifications of the CEO and CFO filed as exhibits to the Form 10-K, and the company must have adequate disclosure controls and procedures in place to ensure that the officers can verify the accuracy of the information. Third, the disclosures will be subject to SEC comments, and the SEC has stated its intention to issue comments on the CD&A disclosures. All of these factors raise the stakes involved in providing clear and accurate disclosure and avoiding misstatements. 

The final rules also require the inclusion in the proxy statement of a shorter, revamped Compensation Committee Report, which will be similar to the current Audit Committee Report. In this report, the compensation committee confirms that it has reviewed the CD&A disclosure and authorized its inclusion in the proxy statement. The Compensation Committee Report also must contain narrative disclosure about the compensation committee’s role and authority and the role of compensation consultants, including the identification of any executive officer whom the consultant contacted in completing its assignment. Unlike the CD&A, the Compensation Committee Report will be considered “furnished” rather than “filed” with the SEC.

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.  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 named executive officers include the three other most highly compensated executive officers who were serving at the end of the fiscal year.

The determination of the most highly compensated officers is now based on total compensation as reported in the Summary Compensation Table (with some adjustments), 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 three fiscal years. 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, and for the two most recent fiscal years in the second year for which the new table is required.

We can provide you with copies of the Summary Compensation Table and all of 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.

• A 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 that exceeds $10,000, including perquisites, must be separately identified and quantified in a footnote. 

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, but under the new rules disclosure of the methodology for computing the aggregate incremental cost must be included in a footnote to the Summary Compensation Table.

Other Required Compensation Tables and Narrative Disclosure

The new rules have significantly changed and expanded the compensation tables to be included in the proxy statement, in addition to the Summary Compensation Table. The following tables are required:

• The Grants of Plan-Based Awards Table will disclose back-up information for the equity award information in the Summary Compensation Table, such as the number of shares underlying option grants and the exercise price of options granted.

• 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 Option Exercises and Stock Vested Table will disclose information on the amounts a named executive officer realized during the fiscal year upon the exercise of option awards and the vesting of stock awards.

• The Pension Benefits Table will disclose information about the named executive officers’ accumulated benefits under all defined benefit plans, including qualified plans and supplemental executive retirement plans. The table includes the actuarial present value of such accumulated benefits, the number of years of credited service under the plan and the amount of payments made during the last fiscal year. The calculation of the actuarial present value of the accumulated benefits, in particular, will present challenges to companies, including the selection of assumptions underlying the calculation.

• The Nonqualified Deferred Compensation Table will disclose the contributions, earnings and balances under each plan that provides for the deferral of compensation on a basis that is not tax qualified.

• 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.

The new rules require that the Summary Compensation Table and Grants of Plan-Based Awards Table be accompanied by “a narrative description of any additional material factors necessary to an understanding of the information disclosed in the tables.”  Types of disclosure that may be required include descriptions of the material terms of the named executive officers’ employment agreements, material modifications to options, option vesting schedules and descriptions of performance-based conditions applicable to awards. Narrative disclosures also are required to accompany the other tables. All of these narrative disclosures must be in plain English.

Post-Employment Benefits, Including Change-In-Control Benefits

The new rules require narrative disclosures about written and unwritten arrangements that provide 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.  The disclosures must include descriptions of the specific circumstances that would trigger payment or other provision of benefits and, for the first time, the rules require estimates of the amounts of the benefits in these circumstances.  Many companies will choose to disclose these estimated payments and triggering events in one or more tables.

Stock Option Disclosures

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. For example, if the company has any program for timing stock option grants in connection with the release of material information, this needs to be disclosed in the CD&A section, and the reasons for the program need to be described. Further, in the compensation tables, companies will be required to make additional disclosures if the exercise price of any option is different from the closing price of stock on the date of grant, or if the grant date is different from the date the compensation committee or the board took action to grant the award.

Suggested Action Items for Public Companies

The new executive compensation disclosure rules will shine an increasingly harsh light on public companies’ compensation practices, decisions and priorities. 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, both for CD&A and for the new tables. 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 by CD&A, 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.

• At a compensation committee or board meeting, consider and discuss the laundry list of questions that need to be answered in the CD&A, along with a discussion of the other topics that the company may want to address in the CD&A. For purposes of this discussion, the directors should review the mock-ups of the required tables and, if available, tally sheets and wealth accumulation tables.

• Carefully review the amounts and types of perquisites paid for by the company, keeping in mind the lowered threshold under the final rules ($10,000) and the need to provide specific information on the nature of all perks if the threshold is exceeded.

• Review and evaluate option granting procedures in light of the new disclosures with regards 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.

* * * * *

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