United States: SEC Adopts Further Executive Compensation Disclosure Changes

On December 22, 2006, the SEC amended its executive and director compensation disclosure rules, which had become effective in November. The new amendments are in the form of "interim final rules" that became immediately effective upon their publication in the Federal Register on December 29, 2006.¹

The interim final rules, contained in SEC Release No. 33-8765 (the "SEC Release"), amend the disclosure contemplated by Item 402 of Regulations S-K and S-B with respect to executive compensation in the form of equity and options awards. The amendments require disclosure of the compensation cost of equity and option awards over the requisite service period consistent with FAS 123R,² an accounting standard that requires recognition of the costs of equity awards over the period in which an employee is required to provide service in exchange for the award.

The SEC Release also contains important transition guidance, which will immediately affect the preparation of fiscal year 2006 disclosures that will now require FAS 123R calculations for equity and option awards made prior to 2006 that were not vested on December 31, 2005, and may influence the determination of which officers are named executive officers for 2006. This transition guidance requires careful consideration since it is likely to cause confusion.³

The interim final rules provide two principal modifications to the recently adopted rules.⁴ First, they modify the timing of reporting option and stock awards as compensation in the Summary Compensation Table and Director Compensation Table so that it is more comparable to FAS 123R financial accounting recognition. Second, they amend Item 402 of Regulation S-K by moving the reporting of the full grant date fair value of stock and option awards to a new column in the Grants of Plan-Based Awards Table and by requiring footnote disclosure of the same information in the Director Compensation Table. The details of these modifications are described below.

• The dollar amount of the compensation cost for stock and option awards as calculated under FAS 123R will be the amount reported in the Stock Awards and Option Awards columns of the Summary Compensation Table and the Director Compensation Table.

• Time-based Awards. FAS 123R accounts for equity and liability awards differently, and this treatment is reflected in the interim final rules.

• Liability awards are given for a specified period of time with cash-based settlement or other features that do not require the employee to bear the risk normally associated with share ownership. Under FAS 123R, these awards are measured at fair value on the grant date and re-measured at each financial statement reporting date over the vesting period. The interim final rules require the disclosure of the compensation costs of these liability awards over the requisite service period using the FAS 123R measured and re-measured values.
• For equity awards that vest based on the passage of time, the compensation costs of such awards must be recognized over the course of the vesting period.

• Performance-based Awards. The interim final rules also incorporate the FAS 123R treatment of awards that require the achievement of a performance condition in order to vest.

• Like the time-based awards, the proportional compensation costs of performance-based awards must be disclosed in the Summary Compensation Table over the course of the performance period, but only if it is probable that the performance condition will be achieved.
• This may result in the disclosure of proportionate amounts for such awards in some years and not in others, or in the deduction of prior year amounts in a subsequent year because the achievement of the performance condition is no longer probable. This may result in negative numbers in the Summary Compensation Table and can affect the determination as to who is a named executive officer.⁵

• Because the disclosure of each award will likely be spread over several years, the total amount disclosed each year for equity compensation on the Summary Compensation Table will likely reflect awards made in both the current and prior years.

• The compensation cost disclosed for Item 402 purposes will not include an estimate of forfeitures related to service-based vesting conditions, but will include the deduction of the compensation costs for awards actually forfeited during the reporting period, together with a footnote disclosure regarding such awards. The deduction of forfeited awards can also result in negative numbers in the Summary Compensation Table and can affect the determination as to who is a named executive officer.

• Salary or bonus forgone at the election of a named executive officer in favor of receiving a non-cash form of compensation will now be reported in the Salary or Bonus column of the Summary Compensation Table, together with footnote disclosure regarding such election and a cross-reference to the Grants of Plan-Based Awards Table where the stock, option or non-equity incentive plan award that the executive elected in lieu of cash is reported.

Changes to the Grant of Plan-Based Awards Table⁶

• The entire grant date fair value information, computed in accordance with FAS 123R, with respect to stock and option awards to named executive officers is moved to a new Grant Date Fair Value of Stock and Option Awards column in the Grants of Plan-Based Awards Table and expanded to include grant-by-grant information. This information may result in less, rather than more, correlation with information reported in the Summary Compensation Table, because the grant date fair value information may not be the same as that now required in the Stock Awards and Option Awards columns of the Summary Compensation Table.

• The Grant Date Fair Value of Stock and Option Awards column will also include disclosure of information concerning re-priced or materially-modified options, stock appreciation rights, and similar option-like instruments, disclosing the incremental fair value, computed as of the re-pricing or modification date in accordance with FAS 123R on a grant-by-grant basis. The same disclosure by footnote is also required in the Director Compensation Table pursuant to Item 402 of Regulation S-K.

• The SEC is requiring the use of the FAS 123R "modified prospective transition method" for Item 402 disclosure purposes even if a company has not adopted that methodology for financial statement reporting purposes.⁷ For 2006 reporting purposes, this transition approach will require companies to disclose:

• an amortized share of the grant date fair value of equity awards that are outstanding (i.e., granted, but not fully vested, before 2006) based on the remaining vesting period for such awards; and
• the fair value of liability awards (i.e., awards settled in cash or awards that do not require the executive to bear the risk of share ownership) at each financial statement reporting period until the awards are settled as well as the portion that has vested.

• This approach is likely to be a source of confusion and additional work for companies with respect to their disclosures, calculations, and decisions (e.g., regarding named executive officers) for fiscal year 2006 that are already in process. It is also likely to give rise to additional comments to the SEC.

• Although the SEC issued the amendments as interim final rules, it also solicited comments on the amendments by January 29, 2007 and stated that it will consider any timely comments and will revise the amendments to Item 402 of Regulations S-K and S-B if necessary.

Companies subject to Regulations S-K and S-B are required to comply with the interim final rules with respect to proxy statements, information statements, and registration statements filed on or after December 15, 2006 that are required to include Item 402 disclosure for fiscal years ending on or after December 15, 2006, and with respect to Forms 10-K and 10-KSB for fiscal years ending on or after December 15, 2006.

While the SEC’s interim final rules address certain concerns about the recently-adopted executive compensation disclosure rules, they also provide new sources of complexity for boards of directors and management in their disclosure drafting and calculation efforts.

The timing of the SEC’s release will require additional internal information collection efforts or the reworking of internal processes that companies have already adopted and implemented for purposes of their 2006 reporting. For instance, the new requirements may also cause confusion for investors where the changes arguably result in less, rather than more, correlation between the Summary Compensation Table and the Grants of Plan-Based Awards Table, or if identical grants to executives result in different compensation being reported for each because of FAS 123R calculations taking into account individual factors such as retirement eligibility. Given the SEC’s short, 30-day post-effectiveness comment period and its reservation of the right to make further changes, companies subject to Regulations S-K and S-B may find it useful to maintain information regarding the differences between what would have been disclosed prior to and after the interim final rules, including any differences in the identification of named executive officers.

Thelen Reid Brown Raysman & Steiner LLP attorneys can assist you in meeting the compliance and other challenges presented by the new regulations, including assisting you in addressing comments to the SEC about the interim final rules.

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