SEC Executive Compensation Proposals Merit Prompt Attention: Still Time To Avoid The Glare - Part I

Saturday, April 1, 2006 - 00:00

Editor's Note:Part II of this article will appear in an upcoming issue of The Metropolitan Corporate Counsel.

Earlier this year, the SEC proposed extensive revisions to the rules regarding executive and director compensation. Comments are due by April 10. If the SEC's projected 2007 effective date holds, compensation practices followed in 2006 will form the basis for what is disclosed in 2007 proxies. There is still room to plan, but the implications for current pay practices need to be carefully evaluated now, so that problems can be timely addressed.

This article identifies some areas of concern and compares the principal features of the proposed changes to the current disclosure rules. Once the comment period has closed, we will address in a separate article some of the major concerns with the proposals and discuss the changes affecting Form 8-K filings, director independence and corporate governance matters.

Review Current Disclosure of Perquisites

The proposals offer extensive guidance as to what constitutes a compensatory perquisite. In the SEC's view, unless an item is generally available on a non-discriminatory basis to all employees, it is a perquisite if it confers a direct or indirect benefit that has a personal aspect, regardless of whether it is provided for a business reason or for the convenience of the company ( e.g , use of company-provided aircraft, yachts, commuter transportation services, additional clerical or secretarial services devoted to personal matters or investment management services). In light of the SEC's recent enforcement action against Tyson Foods, Inc., companies need to reconsider whether all perquisites have been identified and accurately disclosed.

Review Current Compensation Policies and Objectives

One of the main features of the proposed rules is the new Compensation Discussion and Analysis (CD&A), which will replace the existing Performance Graph and the Compensation Committee Report on Executive Compensation. The CD&A discussion would address both current and post-termination compensation arrangements. Some of the more important discussion items would include how the determination is made as to when an equity-based award is granted, the impact of accounting and tax treatment, and a detailed explanation of the company's policies regarding equity ownership requirements and hedging the economic risk of such ownership. Other topics would include benchmarking practices, and the role of executive officers in the compensation process. Companies need to evaluate how their current policies and decisions would be disclosed under the proposed rules and consider what structural changes may be needed.

Review Related-Party Transaction And Approval Policies

The proposed rules would significantly revise and reorganize the disclosure of related-party transactions under Item 404 of Regulation S-K and would eliminate certain bright line disclosure requirements in favor of a principles-based materiality analysis. The proposals would also require disclosure of a company's policies and procedures for the review, approval or ratification of related-party transactions, and force identification of any transactions required to be reported that were not subject to review, or where policies were not followed. Companies should examine their current policies and procedures regarding review and approval of related-party transactions, and adopt changes if appropriate or establish policies if none exist currently.

Review Employees Covered Under 162(m)-Compliant Plans

The proposed rules would require disclosure on the basis of "total compensation" for the last fiscal year, rather than just salary and bonus. They would also require disclosure for the chief financial officer, regardless of level of compensation. As a result, the group of named executive officers (NEOs) disclosed for compensation earned in 2006 could be different than the group disclosed in this year's proxy. Because IRC Section 162(m), which can limit the deductibility of executive compensation, uses the SEC's executive compensation disclosure rules to determine "Covered Employees," companies should try to determine now those individuals for whom disclosure would be required for next year's proxy, and may want to take steps now to include those individuals in Section 162(m)-compliant plans.

Principal Changes

Summary Compensation Table (SCT ). Of the many SCT changes, perhaps the most significant is that a new column would be added showing the total dollar value of each form of compensation quantified in all columns in the SCT. Although disclosure would still be required for the last three fiscal years, a transition rule would phase in the new disclosure over three years. For the first year that the rules become effective, SCT disclosure in the new format would only cover the last completed fiscal year.

The Stock Awards column would disclose the dollar value of awards without "option-like" features that derive their value from the company's equity securities or permit settlement by issuance of the company's equity securities, such as restricted stock, restricted stock units, phantom stock, phantom stock units, common stock equivalent units and other similar instruments. The dollar value for these awards would be based on their grant date fair value as determined pursuant to FAS 123R for financial reporting purposes.

The Option Awards column would disclose options, stock appreciation rights, and similar equity-based compensation awards with option-like features. However, instead of reporting the number of securities underlying the awards, as is currently required, the grant date fair value of the award would be reported as determined pursuant to FAS 123R for financial reporting purposes.

The Non-Stock Incentive Compensation Column would report the dollar value of all non-equity-based amounts earned during the fiscal year ( i.e. in the year when the performance criteria are satisfied, whether or not payment is actually made) pursuant to performance-based incentive plans. This column would be limited to performance-based awards where the relevant performance measure is not based on the price of the company's equity securities and the award may not be settled by issuance of a company's equity securities.

The All Other Compensation column would disclose all compensation not required to be included in any other column. Examples would include all earnings on deferred compensation, the annual increase in value of pension plan benefits, tax gross-ups and other tax reimbursements, and amounts paid or accrued in connection with any termination of employment or change in control. Any item of compensation that exceeds $10,000 would be separately identified and quantified in a footnote. Items less than $10,000 (other than perquisites) would be included, but footnote disclosure would not be required.

Footnote disclosure would be required for each perquisite to the extent it is valued at the greater of $25,000 or 10% of total perquisites. A perquisite's value would continue to be determined based on the company's incremental cost of providing the benefit and not on the cost attributed for Federal income tax purposes.

Grants of Performance-Based Awards Table. Because a performance-based award is not disclosed in the SCT until earned, the Grants of Performance-Based Awards table would supplement the SCT by including information regarding the grant of all performance-based awards to each NEO during the last fiscal year. This table would include grants of both non-equity-based awards and equity-based awards with performance features, and show the estimated future payout values for these awards. Awards would be considered performance-based if they are subject to either a performance condition or a market condition, as those terms are defined in FAS 123R.

Grants of All Other Equity Awards Table. The Grants of All Other Equity Awards table would supplement the SCT by disclosing, for each NEO, certain material terms of equity-based awards granted in the last fiscal year that are not performance-based ( i.e. where the payout or future value is tied to the company's stock price, and not to other performance criteria).

Narrative Disclosure to SCT and Supplemental Tables. The proposed rules would require additional narrative disclosure following the SCT and the related supplemental tables, where necessary to give context to the tabular disclosure. This could include disclosure of the material terms in NEO employment agreements, repricings or other material modifications of options or other stock-based awards during the last fiscal year, and changes or elimination of applicable performance criteria.

In a new twist, disclosure would also be required for up to three employees who were not executive officers during the last fiscal year, whose total compensation for the last fiscal year was greater than that of any of the NEOs. Required disclosure would include the amount of each such employee's total compensation for the last fiscal year and a description of his or her job position. The individuals would not need to be named.

Outstanding Equity Awards at Fiscal Year-End Table. This table would require disclosure of all equity awards outstanding as of the end of the last fiscal year for each NEO where the ultimate outcome has not yet been realized, including the number and value of awards such as stock options, stock appreciation rights, restricted stock, restricted stock units and other equity awards, including those subject to performance benchmarks. Disclosure of the market value of unvested restricted stock awards would replace the current footnote disclosure of the market value of restricted stock. Footnote disclosure would be required indicating the expiration dates for stock options, stock appreciation rights, and similar instruments held at fiscal year-end and the vesting dates for stock awards.

Option Exercises and Stock Vesting. This table would require disclosure for each NEO of the amounts realized upon exercise of stock options and similar equity-based compensation with option-like features and the vesting of stock and similar equity-based compensation during the last fiscal year. The table would also require disclosure of the grant date fair value for these awards, as previously reported in the SCT. This table expands upon the current disclosure requirements in the Aggregated Option/SAR Exercises in Last Fiscal Year table by adding the value of vested stock awards.

Post-Employment Compensation. The proposed rules would significantly revise the current rules regarding the disclosure of post-employment compensation. Companies would be required to disclose an estimate of the tax-qualified and non-qualified retirement benefits payable to each NEO at normal and early retirement age under each defined benefit plan. The tabular disclosure would be followed by narrative disclosure of the material factors necessary to an understanding of each plan or arrangement disclosed, including the amount of any lump sum distribution that could be elected, and related actuarial assumptions.

A new table would require, for each NEO, disclosure of contributions, earnings and distributions during the last fiscal year and balances as of the end of the last fiscal year under other nonqualified deferred compensation plans.

In addition, a new narrative disclosure would be required for each aspect of any arrangement that provides for payments in connection with the resignation, severance, retirement or other termination (including constructive termination) of an NEO, or upon a change in control. The disclosure would need to be quantitative and companies would be required to make reasonable estimates and disclose material assumptions.

All in all, the proposed changes would turn up the spotlight on executive compensation, although there is still time to avoid the glare.

Stephen T. Lindo and Frank A. Daniele are Partners in the Executive Compensation and Employee Benefits Department in the New York office of Willkie Farr & Gallagher LLP.

Please email the authors at slindo@willkie.com or fdaniele@willkie.com with questions about this article.