In the April issue, we summarized some of the principal changes that would result from the SEC's proposals regarding disclosure of executive compensation practices. The SEC comment period has now closed, with most comments broadly supporting the SEC's initiatives.
While it will take time to evaluate the many constructive suggestions that were provided, there is nothing to suggest that the SEC's projected 2007 effective date will change. Thus it still seems likely that compensation practices followed in 2006 will form the basis for what must be disclosed in 2007 proxies, when the new rules take effect.
At the same time as the SEC is trying to decide how to strike the right balance between making compensation practices transparent, without making compliance obligations too unwieldy, there has been a steady stream of front page disclosures of compensation practices that, if they don't necessarily mark the apex of greed, plainly underscore the need for change.
On March 14, the Wall Street Journal reported that the CEO of North Fork Bancorp would receive a $111 million tax gross up relating to change in control payments. The gross up made the CEO whole, not only for golden parachute excise taxes, but also for basic income taxes as well. A few days later, the WSJ reported that the SEC is examining a number of companies whose annual option grant practices displayed a striking pattern of hitting the exact bottom of the market for many years in succession, suggesting the possibility that grants were backdated.
In April, the WSJ reported that the CEO of one of these companies, United Health Group, had accumulated $1.6 billion in unrealized option gains. A day later, in an interesting role reversal, the CEO sought to close the barn door by recommending to his compensation committee that the company suspend many forms of senior executive pay, including stock options. Vitesse Semiconductor announced that it had suspended its CEO and two other top executives because of questions related to the "integrity of documents" involving its stock option programs. And the New York Times ran its own front page story questioning how a compensation consultant can objectively advise a compensation committee about executive compensation if it derives millions in revenues by providing other services to the same company.
It remains to be seen whether stockholder outrage over these latest disclosures will translate into effective reforms. No one is yet suggesting that absolute limits be imposed on executive pay (other than for companies undergoing a Chapter 11 restructuring). But it does seem likely that the rules of the game are changing in a direction that will make it much harder to hide practices that previously went unquestioned.
On a broader level, just as out of control compensation practices provided the telltale sign of bigger problems at Enron and Tyco, executive compensation disclosures are becoming an investor's report card on whether there is effective management of the compensation process, and the grade is becoming an increasingly important gauge of effective corporate governance. The new SEC rules can only accelerate this process.
The balance of this article provides a summary of how the SEC proposals would affect the disclosure of director compensation, Form 8-K filings, and several corporate governance matters, and then closes with a review of recurring concerns from some of the comments filed with the SEC.
Other Proposed Changes
Director Compensation Disclosure. The proposed rules would require, for every director, compensation to be disclosed in a Director Compensation Table (DCT) similar to the Summary Compensation Table (SCT), including perquisites. Disclosure would only be required for the last completed fiscal year. Narrative disclosure would follow the table and would describe any material factors necessary to an understanding of the DCT, including a description of all consulting fees, director legacy awards and charitable award programs.
Form 8-K Disclosure. The SEC acknowledged in the proposed rules that the 2004 amendments to Form 8-K, which significantly expanded the number of events subject to Form 8-K reporting, resulted in disclosures that had not always been "unquestionably or presumptively material" as was the intent for the accelerated Form 8-K disclosure. The proposed rules would revise Items 1.01 and 5.02 of Form 8-K to limit the information required and consolidate the Form 8-K reporting of executive compensation matters into one Item. As such, a company's annual proxy statement would continue to be the primary vehicle for disclosure of executive and director compensation information, unless such information was "unquestionably or presumptively material."
Currently, all management contracts and compensatory arrangements with a company's named executive officers (NEOs) and directors are deemed to be material, and Form 8-K disclosure is required of the appointment or departure of a company's principal officers and directors, and of the material terms of any employment agreement between the company and any principal officer upon his or her appointment.
Form 8-K disclosure would be revised as follows:
The concept that all compensatory arrangements with NEOs are deemed material would be eliminated. This disclosure would now cover only compensation arrangements with a company's current principal executive officer, principal financial officer and NEOs for the previous fiscal year, and would be limited to a brief description of any material compensatory arrangement or material amendment thereto. As is currently the case, grants or awards (or modifications thereto) under a compensatory arrangement that are materially consistent with the previously disclosed terms of such compensatory arrangement need not be disclosed under Item 5.02(e), provided the grants or awards (or modifications) are properly disclosed in the proxy statement (or other filing as required).
The disclosure required under Item 5.02(b), regarding retirement, resignation or termination of employment would be expanded to include all NEOs for the prior fiscal year.
The disclosure required under Items 5.02(c) and (d) upon the appointment of a new principal officer or director would be expanded beyond just employment agreements to include a brief description of any other material plan, contract or arrangement with such principal officer or director that is entered into or materially amended, and any grant or award under any such arrangement in connection with such appointment.
Where the salary or bonus of any NEO cannot be calculated in time to be included in the SCT, disclosure of such information will be required on Form 8-K when the amounts become calculable.
Beneficial Ownership Disclosure. The proposed rules would require disclosure in a footnote to the beneficial ownership table of the number of shares pledged by each NEO, director and director nominee as collateral for a loan from the company.
Corporate Governance. The proposed rules would consolidate and expand existing disclosure requirements regarding director independence and corporate governance. Among the significant new disclosure requirements are the following:
Director Independence. The proposed rules would require identification of each director, or director nominee who is independent and each non-independent director who is a member of the compensation, nominating or audit committee.
Compensation Committee. The proposed rules would require a narrative description of the processes and procedures for determining executive and director compensation, including (i) the scope of authority of the committee, (ii) the committee's ability to delegate that authority, (iii) the name and role of any compensation consultant who advised the committee with respect to executive and director compensation decisions, including whether such consultant was engaged by the committee or another person, (iv) any contact between the consultant and any executive officer and (v) the role any executive officer played in determining or recommending the amount or form of executive or director compensation.
Selected SEC Comments
Make Compensation Committee Responsible for Compensation Discussion and Analysis ("CD&A"). While supportive of the need for an expanded CD&A discussion, many commentators said that responsibility for the explanation and justification should remain with the Compensation Committee. Companies complained that their senior executive officers are not in a position to certify to the processes and methodologies used by the compensation committee in setting their own compensation. Others felt that the compensation committee should be required to take ownership of the CD&A to reinforce the independence-in-fact of directors.
Evaluate Independence of Compensation Committee Advisors. Several comments suggested that the compensation committee disclosures be amplified to require a broader discussion of factors bearing upon the independence of any advisor used by the committee, and an assessment of the nature and extent of the advisor's other fee generating relationships with the company.
Rationalize Basis for Presenting Items in Summary Compensation Table ("SCT"). Many comments focused on the confusion that would result from including in the SCT, for the same reporting year, both items of actual compensation and awards representing potential compensation for the current and future years. For example, the entire grant date value of an option award is required to be included at date of grant. For comparisons between NEOs at different companies to be useful, the items reported in all columns of the SCT need to be fairly allocable to the year for which the aggregate is being calculated.
Drop Requirement to Disclose up to Three Non-Executive Officers. Commentators thought this would be difficult to track, not useful and not under the control of the compensation committee in the first place.
Simplify Presentation of Actuarial Value of NEO Pensions. Further consideration will be needed so that extraneous information can be eliminated and actuarial calculations can be standardized to facilitate more meaningful comparisons between companies.
Standardize Assumptions for Calculating Value of Change in Control Payments . Again, this is needed to make inter-company comparisons useful.
Additional Suggested Disclosures . Other comments suggested that the rules require disclosure of practices regarding:
the ability of NEOs to receive simultaneous payments of severance and retirement benefits;
the remedies used in connection with violation of non-competes; and
a company's trading policies and stock ownership and retention policies for executive officers and directors, along with the level of compliance.
Clearly, recent revelations of new compensation abuses will sharpen the SEC's focus on the task at hand. Companies will still need to pay market rates of compensation in order to attract and retain key executives, especially as the talent pool shrinks over the next decade. It will be interesting to see how the SEC strikes the final balance.
When pay is backed up by performance and performance measures are set with credible governance procedures, companies should retain substantial flexibility to structure incentive compensation. But it seems likely that a company's compensation processes, and determinants of performance, are both in line for closer scrutiny.
Stephen T. Lindo is a Partner in the Executive Compensation and Employee Benefits Department in the New York office of Willkie Farr & Gallagher LLP.