United States: Summary of SEC Proposed Rules on Executive Compensation and Related Party Disclosure

On January 27, 2006, the Securities and Exchange Commission (SEC) released, for public comment, its proposed rules calling for sweeping changes in the form and substance of the disclosure requirements for executive and director compensation, related party transactions, director independence and other corporate governance matters, and security ownership of officers and directors.

The SEC release is immediately important insofar as it provides interpretive guidance with respect to current reporting obligations, such as the obligation to report all elements of executive compensation, and the treatment of perquisites and personal benefits. For example, the SEC says that the current tabular approach "remains a sound basis for disclosure … [but] results in too many cases in disclosure that does not inform investors adequately as to all elements of compensation. In those cases investors may lack material information that we believe they should receive" (emphasis added). In addition, preparation for the next proxy season, when these proposals will likely be effective, will require considerable current planning. Assuming the rules are adopted as proposed, the following are noteworthy:

• The current requirement to "furnish" a Compensation Committee Report and a Performance Graph would be eliminated and, in their place, a principles-based Compensation Discussion and Analysis discussing the company’s executive compensation program and philosophy would be required to be "filed" with the SEC.

• The Summary Compensation Table for executive officers would contain a "Total" column requiring disclosure of a dollar amount for all elements of compensation for each of the last three completed fiscal years for the principal executive officer (changed from the CEO), the principal financial officer (a new specifically designated executive) as well as the three (changed from four) other highest paid officers with total compensation over $100,000. A new Director Compensation Table, similar in some respects to the executive Summary Compensation table, but only for the last completed fiscal year, would also be required. ¹

• With respect to related person transactions, principles-based disclosures, including for indebtedness, would be required for an expanded group of related persons, including any person (other than an employee or tenant) who shares the household of a director, executive officer or a significant shareholder, and would pertain to any transaction exceeding $120,000 (changed from current $60,000) wherein the company is a participant (changed from "party"). The disclosure would include details about the company’s policies and procedures for reviewing and approving such transactions.

• Disclosures regarding director independence, board policies and board committees, including, most importantly, a new narrative disclosure about the Compensation Committee describing the processes and procedures for considering and determining executive and director compensation, would be required.

• Form 8-K would also be amended to eliminate Item 1.01 and expand the scope of Item 5.02, currently used to disclose appointments and departures of directors and specified officers. The amendment would expand the list of persons covered, the triggering events and the extent of reportable information in the Item 5.02 disclosure, including information regarding employment agreements and new or materially changed compensation plans.

The comment period expires on April 10, 2006. Because the proposals are consistent with the SEC’s historical perspective on the subject of executive compensation and incorporate proposals made by significant investor interest groups, it is likely that these proposals will be adopted substantially as proposed. Nevertheless, the SEC has posed over 200 questions in the form of general and specific requests for comment covering all aspects of these proposals. Additional discussion regarding these matters follows.

In its most extensive proposal, the SEC proposes to amend Item 402 of Regulation S-K to require new and revised tables for quantitative data and new narrative disclosures for qualitative explanatory information. The SEC believes this will provide a clearer and more complete picture of the total compensation earned by a company’s principal executive officer, principal financial officer and highest paid executive officers and members of its board of directors. Among the most significant proposals are:

The proposal would require a new "principles-based" comprehensive (non-boilerplate) narrative overview at the beginning of the compensation disclosure that:

• Explains the material elements of a company’s compensation program and philosophy for named executive officers, including the post-termination (e.g., termination and retirement) components as well as the in-service components.

• Provides investors with a useful perspective about the tabular compensation numbers and the narrative descriptions and explanations that would follow, with details about the objectives of the company’s compensation program:

• What the program rewards and does not reward, including the specific items of corporate performance and how specific elements of compensation are structured to reflect these items, and how the timing of awards is determined;
• Each element (and the rational for each element) of compensation, the manner in which the amount for each element (including the formula if applicable) is calculated and the interrelationships between elements and company decisions about each element, the role of benchmarking and the executives’ role in the compensation process.

• The CD&A would eliminate the currently required Performance Graph and the Compensation Committee report.

• Unlike the Compensation Committee Report, which was "furnished" to the SEC, the CD&A will be "filed" with the Commission and will be considered soliciting material, part of the proxy statement and part of any other filing in which it is included, subject to Regulations 14A or 14C and the liabilities of Section 18 of the Exchange Act.

As modified, the Summary Compensation Table would continue as the principal disclosure vehicle for executive compensation showing the named executive officers’ compensation for each of the last three completed fiscal years, whether or not actually paid out. Key changes are:

• Named Executive Officers: The named executive officers would be the principal executive officer (changed from CEO), the principal financial officer (a new designated executive) and the three (changed from four) most highly compensated executive officers other than the principal executive officer and the principal financial officer. In addition, disclosure would continue to be required for up to two additional individuals for whom disclosure would have been required, but for the fact that they were no longer serving as executive officers at the end of the last completed fiscal year.²

• Total Compensation: A new column would require a disclosure of total compensation in a dollar amount for each named officer, which would aggregate the total dollar value of each form of compensation (from the other columns on this table), providing an accurate computation of aggregate compensation.³

• Plan-Based Awards: Stock Awards, Option Awards and Non-Stock Incentive Plan Compensation, and the dollar value of Non-Stock Incentive Plan Compensation when earned during the fiscal year, whether or not paid in the fiscal year, would continue to be reported on the proposed summary compensation table. However, the distinction between "annual" and "long term" compensation in the table columns would be eliminated.

• In a new requirement, stock and option awards (including repriced and modified prior awards) would require disclosure of the entire grant date fair value (in dollars) of the award, as determined pursuant to FAS 123R as compensation in the year in which the grant is made, even though for financial reporting purposes FAS 123R recognizes the fair value compensation cost over the grant’s required period of service. ⁴

• All Other Compensation. In keeping with the emphasis on "disclosure of all compensation," the All Other Compensation column would capture anything not reported in the prior columns, including all items currently reported in the "Other Annual Compensation" column, which would be eliminated. This would include:

• All earnings on non-tax qualified deferred compensation (including non-tax qualified defined contribution retirement plans);
• The aggregate increase in actuarial value accrued during the fiscal year in defined benefit and actuarial plans, including SERPs;
• Perquisites and other personal benefits, as discussed below;
• Additional items, such as amounts paid or accrued in connection with termination of employment or change in control, company contributions to defined contribution plans, insurance premiums paid by the company, tax gross-ups or other tax reimbursements; and
• Each item of compensation in this column that exceeds $10,000 must be separately identified and quantified in a footnote.

Perquisites and Personal Benefits: While not defined, a perquisite or personal benefit would be an item that confers "a direct or indirect benefit that has a personal aspect, without regard to whether it may be provided for some business reason or for the convenience of the company, unless it is generally available on a non-discriminatory basis to all employees."

• The aggregate value threshold has been reduced to $10,000 from the current threshold of the lesser of either $50,000 or 10 percent of the total of annual salary and bonus.
• Footnote disclosure would be required to identify each perquisite and personal benefit by type. Any benefit exceeding the greater of $25,000 or 10 percent of the total of all the perquisites and personal benefits, as measured by the aggregate incremental cost to the company and not the amount attributable for federal income tax purposes, must be specifically identified and quantified.

Two new supplemental tables related to annual compensation (derived from two currently required tables), together with narratives, would be required to help better explain the information in the Summary Compensation Table:

• Performance-Based Award Table—Proposed Item 402(d).

• Grants of All Other Equity Awards Table—Proposed Item 402(e).

Two tables for outstanding, previously awarded equity compensation that is unexercised or unvested, and the amounts realized in the current year due to exercises of options or vesting of stock awards, would be required:

• Outstanding Equity Awards Table—Proposed Item 402(g).

• Option Exercises and Stock Vested Table—Proposed Item 402(h).

5. Post-Retirement Compensation Tables and Narrative

Disclosure of post-employment (retirement and termination-related) compensation, to provide a clearer picture of this potential future compensation, would be required using the following tables (together with footnotes and detailed narrative) and a separate termination-related descriptive narrative:

• Retirement Plan Potential Annual Payments and Benefits Table—Proposed Item 402(i).

• Nonqualified Defined Contribution and Other Deferred Compensation Plans Table—Proposed Item 402(j).

• Potential Payments Upon Termination or Change-in-Control Narrative⁵—Proposed Item 402(k).

Director compensation would be disclosed in a tabular presentation similar to the Summary Compensation Table for executive compensation (but without the supplemental and additional tables), together with a narrative disclosure of additional material information necessary to an understanding of the table. The table would set forth the dollar amount of total director compensation, including the dollar values of all of the component elements of that total for the last completed fiscal year.

Item 404 would be amended to become more principles-based, disclosing transactions where the company is a participant, including indebtedness, involving the company and related persons, exceeding $120,000 (an increase from the current $60,000), and in which any related person had a direct or indirect material interest.

• Related Person: Would include any person (other than an employee or tenant) who shares the household of a director, executive officer or a significant shareholder.

• Procedures for Approval of Related-Person Transactions: A new disclosure would be required regarding the policies and procedures established by the company and its board of directors regarding related-person transactions.

The SEC proposes to consolidate and update disclosure requirements regarding director independence, and related corporate governance information under a proposed new Item 407 to Regulation S-K, which, among other things, would eliminate certain duplicative disclosures and would require:

• Compensation Committee Disclosure: This would require a new disclosure for the compensation committee similar to that currently required for the audit and nominating committees of the board. This narrative disclosure would require a description of the processes and procedures for the consideration and determination of executive and director compensation, including:

• The scope of authority of the compensation committee and the extent to which the compensation committee may delegate any authority to other persons, specifying what authority may be so delegated and to whom.
• The identification of the committee’s charter or other documentation of its authority and the company’s Web site address at which a current copy is available, if it is so posted, and if not so posted, attaching the charter to the proxy statement once every three years.
• The identification of any role of executive officers or compensation consultants in determining or recommending the amount or form of executive and director compensation, and identifying such consultants, whether such consultants are engaged directly by the compensation committee or any other person, the nature and scope of their assignment, the material elements of the instructions or directions given to the consultants with respect to the performance of their duties under the engagement, and any executive officer within the company that the consultants contacted in carrying out their assignment.
• The identification of compensation committee interlocks and insider participation in compensation decisions.

Other Item 407 disclosures would include:

• Identifying the independent directors of the company (and the nominees for director in the case of proxy or information statements) as measured by the company’s definition of independence. ⁶

• Identifying the members of the compensation, nominating and audit committees that the company had not identified as independent under such definition.

• Describing any transactions, relationships or arrangements not disclosed in Item 404 that were part of the board of directors’ consideration in determining that the independence standard has been met as to each independent director or director nominee.

• Disclosing the number of board meetings during the fiscal year and certain attendance information, including the board’s policy on attendance at annual shareholder meetings and attendance information with respect to the last annual meeting.

• Identifying any standing audit, nominating and compensation committees, the membership composition and the number of meetings, together with certain descriptive information regarding such committees and their charters (see compensation committee disclosure discussion above).

• Information about the audit committee’s independence and expertise, and material changes in procedures for shareholders submitting nominee recommendations.

Item 403(b) would be amended to require footnote disclosure of the number of shares pledged as security by named executive officers, directors and director nominees, and of all executive officers and directors as a group, and the amount of shares with respect to which such persons have the right to acquire beneficial ownership. This would require specific disclosure of the beneficial ownership of directors’ qualifying shares.

Under the proposed rules, the SEC would amend Item 1.01 of Form 8-K to eliminate the reporting of employment compensation arrangements under that item. The amendment would broaden the scope of Item 5.02,⁷ which would be modified to capture generally the currently required information under that item, as well as additional information regarding material employment compensation arrangements involving named executive officers that currently fall under Item 1.01. In addition to the current requirements of Item 5.02, the amendment would:

• Expand the current list of persons for whom information regarding retirement, resignation or termination is required to include all persons falling within the definition of named executive officers for the previous fiscal year;

• Require a brief description of any material new compensatory plan, contract or arrangement, or new grant or award thereunder, and any material amendment to any compensatory plan, contract or arrangement, whether or not such occurrence is in connection with a current Item 5.02 triggering event;

• Require, in addition to employment agreements, a brief description of any material plan, contract or arrangement to which a covered officer or director is a party or participates, that is entered into or materially amended or under which any grant or award, or modification is made in connection with any of the Item 5.02 triggering events; and

• Require disclosure of salary and bonus for the most recent fiscal year that was not available at the latest practicable date in connection with disclosure under Item 402.

As proposed, the goal of a Form 8-K compensation arrangement disclosure under Item 5.02, would be to inform investors of specified material events and developments, but without the level of information necessary to comply with Item 402.

When finally adopted, the proposed new rules and amendments would become effective following publication of the adopting release in the Federal Register as follows:

• Forms 10-K and 10-KSB for fiscal years ending 60 days or more after publication;

• Forms 8-K for triggering events that occur 60 days or more after publication;

• Securities Act and Investment Company Act registration statements (including post-effective amendments) and Exchange Act registration statements that become effective 120 days or more after publication; and

• Proxy statements that are filed 90 days or more after publication.

Footnotes

^{1. Both summary tables would require disclosure of the dollar value of “total” compensation comprised of salary and bonus for executives or fees for directors, stock awards, option awards, non-stock incentives and all other compensation. Stock and option awards would be disclosed at the dollar amount of their entire FAS 123R grant date fair value in the year granted. Perquisites and Personal Benefits would be disclosed and identified by type unless under $10,000 (changed from the current lesser of $50,000 or 10 percent of current annual salary and bonus), and would require itemized quantification if the value exceeds the greater of $25,000 or 10 percent of the total perquisites. Both tables would require explanatory narrative disclosures. The Executive Summary Compensation Table (but not the Director’s Compensation Table) would also be supplemented by additional tables for annual compensation details and narrative disclosures, as well as new and modified existing tables for outstanding previously awarded equity and post-employment (including termination and change in control) compensation.}

2. A narrative disclosure to the Summary Compensation Table would also be required to provide information for up to three employees who were not executive officers during the last completed fiscal year, and whose total compensation for such year was greater than that of any of the named executive officers but whose total compensation was greater than any of the named executive officers. Disclosure would be required of each such employee’s total compensation for that year, together with a description of their job position (but not names).

3. The dollar threshold for disclosure of named executive officers, other than the principal executive officer and the principal financial officer, would be total compensation of $100,000 for the last fiscal year. While payments attributed to overseas assignments may be excluded from this threshold calculation, compensation that is considered “not recurring and unlikely to continue” would not be excluded from the calculation.

4. An instruction to Item 402 would require footnotes to (i) reference “the relevant assumptions in the notes to the company’s financial statements or to the discussion of relevant assumptions in the MD&A,” which would be deemed to be part of the Item 402 disclosure, and (ii) identify and quantify all earnings on outstanding stock and option awards whether or not paid during the fiscal year.

5. Quantitative disclosure would be required even where uncertainties exist as the amounts to be paid under given circumstances, requiring the company to make reasonable estimates and disclose the material assumptions of such estimates, such that the disclosure would be considered forward-looking information and subject to the safe harbor for such disclosure.

6. If a listed company, the definition or standard of independence is the one the company has adopted in order, at a minimum, to comply with the listing standards for such company. If not a listed company, the definition would be one from a national securities exchange or association specified by the company. Similar requirements that currently apply regarding the nominating committee under Item 7 of Schedule 14A would also apply to the audit committee and would be consolidated in proposed new Item 407.

7. Item 5.02 currently requires disclosure within four business days of the appointment or departure of directors and specified officers, a brief description of the material terms of any applicable employment agreement, and a description of any disagreements between the company and the executive.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.