The SEC's comprehensive proposals for disclosure of executive compensation in the proxy statements of U.S. public companies (Rel. No. 33-8655, January 27, 2006) respond to 14 years of developments in executive compensation since the last major SEC overhaul in 1992. While nothing in the proposed rules mandates specific changes in executive pay, it appears that the SEC's goal is to encourage companies to look at total compensation and actually take action if the compensation appears to be ineffective or inappropriate.
Although the rules did not apply to proxy statements for calendar-year companies in 2006, they have an immediate impact on all U.S. public companies. Companies are well advised to focus on the proposed changes now, because compensation decisions made today will have to be disclosed later under the new rules. Companies also need to begin tracking the data that will likely be required in future years.
The New Disclosures
New Compensation Discussion and Analysis Section. A key feature of the proposed rules is the new Compensation Discussion and Analysis ("CD&A") section, which will require compensation committees to communicate their goals and objectives for executive compensation. This new section is designed as a counterpart to the Management's Discussion and Analysis ("MD&A") required in periodic SEC financial reports. The new CD&A section will replace the Compensation Committee report and the performance graph. The information provided in the new CD&A section will be very similar to the existing Compensation Committee report - but without being over the names of the Compensation Committee members. The most significant change is that now the CD&A section will be soliciting material and will be filed with the SEC, thereby subjecting the company and/or the signing officer to the disclosure liability provisions of securities laws. Furthermore, if the CD&A is included or incorporated by reference in a periodic report, the disclosure would be subject to the certification requirements of Sarbanes-Oxley.
Total Annual Compensation. Another important change under the proposed rules is a requirement that companies report the total annual compensation of their CEOs, CFOs, and three other most highly compensated executive officers (collectively, the "named executive officers"). Identification of the most highly compensated executive officers will be based on total compensation for the fiscal year - not just salary and bonus, which is currently the basis for this determination. Total annual compensation figures would appear in the first column of the Summary Compensation Table in the proxy statement and would aggregate the dollar value of all forms of compensation reported in the other columns of the Summary Compensation Table. Other notable items in the revised Summary Compensation Table that will be part of the total annual compensation figure include the following:
The present value of stock options granted for the year, valued as of the grant date, as discussed below.
An expanded scope for the "All Other Compensation" column, as discussed below.
This "apples plus oranges" approach to total annual compensation is likely to produce some unexpected results. It remains to be seen whether these numbers will be useful for comparing executive pay at one company with the pay at another company. Of greater concern is the amount of work that will be required to calculate the total compensation of executive officers who may never be in the table, simply to determine whether or not their compensation information must be disclosed.
For the first time, companies must also report the total annual compensation for up to three of its most highly compensated employees who were not executive officers and who were paid more than any of the named executive officers. While such employees need not be identified by name, the company must provide a description of those employees' positions.
Changes to the "All Other Compensation" Column in the Summary Compensation Table. Because there is now only one column covering compensation not specifically addressed in the other columns, the proposed rules actually clarify that all benefits not specifically provided for should be included in the "catchall" column-"All Other Compensation." Under the proposed rules, the following items would be included in the "All Other Compensation" column:
Perquisites and other personal benefits.
Amounts paid or accrued under a plan or arrangement in connection with a termination of employment or change in control.
The dollar value of company-paid insurance premiums for life insurance for the benefit of a named executive officer.
Contributions made by the company to defined contribution plans.
The aggregate annual increases in the actuarial value of pension plan and SERP benefits.
Earnings on nonqualified deferred compensation.
Stock Options. The proposed rules provide for disclosure of the monetary value of stock options as of the date granted to top executives in a column of the Summary Compensation Table. Unlike the presentation in financial statements, however, as currently proposed, the full value of the stock options would be presented in the year of grant, rather than being amortized over the vesting period.
Perquisites. The item of executive pay that has received perhaps the most attention is executive perquisites. The proposed rules lower the threshold for disclosure of perquisites to $10,000 from the current requirement of the lesser of an aggregate amount of $50,000 or 10 percent of total annual salary and bonus. Under the proposed rules, if the aggregate value of the perquisites is greater than $10,000, perquisites would have to be included in the "All Other Compensation" column and identified by type in a footnote. Furthermore, each perquisite valued at the greater of $25,000 or 10 percent of a named executive officer's total perquisites would have to be specifically identified by type and amount in a footnote. Under the proposals, perquisites and personal benefits for directors would also have to be disclosed according to the same thresholds used for executive officers. In this area in particular, companies should examine their recordkeeping procedures.
After many years of silence, the SEC has taken this opportunity to set forth guidance on the items that constitute perquisites. While declining to stipulate a black-letter definition, the proposals provide some guidance and examples. An item of executive pay that confers a direct or indirect benefit that has a "personal aspect" will be a perquisite or other personal benefit unless the item is "integrally and directly related to the performance of the executive's duties" or unless the item is generally available on a nondiscriminatory basis to all employees. An item satisfying those guidelines will be considered a perquisite or other personal benefit whether or not a company provides the item for a business reason or for the company's convenience. In the proposals, the SEC cautions against interpreting the concepts of perquisites and other personal benefits "artificially narrowly." To that end, the SEC explains that the "integrally and directly related" exception should not be broadly construed.
The proposed rules also reiterate that the proper measure of the value of perquisites and other personal benefits is the aggregate incremental cost to the company. The Standard Industry Fare Level ("SIFL") rules, used to value the cost of aircraft travel for federal tax purposes, may not be used to value such travel for purposes of proxy disclosures. Much to the disappointment of many, the proposals provide no further guidance related to valuation of the personal use of aircraft by company personnel and their families.
Retirement Plans. Besides providing for the inclusion of the aggregate increase in the actuarial value of pension plans during the year in the "All Other Compensation" column of the Summary Compensation Table, the proposed rules also provide for a new table and related narrative description in which companies disclose estimates of individual annual retirement benefits payable at normal retirement age and at early retirement, if available, under qualified and nonqualified plans. The new table would replace the current Pension Plan Table, which does not require figures to be broken down by executive. The details of this table will likely evolve during the comment period.
Deferred Compensation. Information about a named executive officer's nonqualified defined contribution and deferred compensation plans would be disclosed in a separate table. This table would report contributions made by the company and the executives to deferral accounts during the year, as well as the earnings and balances of such accounts. Currently, only above-market earnings on nonqualified deferred compensation must be disclosed. Given the publicity over deferred compensation, this new table comes as no surprise.
Severance Arrangements. Another new disclosure would require companies to specify the dollar amount of severance payments each named executive officer is entitled to receive and whether such payments are triggered by a change in control or a termination of the executive's employment. Although these arrangements generally have been described in narrative, few companies have elected to present their projected financial costs. One obvious problem with determining such projected financial costs is that the SEC failed to provide guidance as to permissible assumptions ( e.g. , payout date and stock price) for use in calculating these costs. This guidance is especially significant for change-in-control agreements that provide for excise tax gross-ups. In calculating costs under this type of arrangement, assumptions as to the date of the change in control, the deal price, and the executive's compensation at that time would have to be made, which could produce a wide range of results.
Director Compensation. Companies will have to disclose all payments received by directors during the year in a new table similar to the Summary Compensation Table, together with a related narrative.
Stock Pledges. For the first time, companies will be required to disclose the number of shares of company stock pledged as collateral for loans taken by the companies' directors and five highest-paid executive officers. This new disclosure would be made in a footnote. The proposals indicate that the SEC is concerned about the potential for stock pledges to affect the decisions made by directors and executive officers.
Other Proposed Changes
The proposed rules cover issues relating to disclosure not only of executive and director compensation but also of related-party transactions and corporate governance, as well as certain disclosures required by Form 8-K.
Effect Of The Proposed Rules On Executive Pay
The SEC's desire for greater transparency seems to have pleased some of those calling for reforms. The proposed rules arguably will allow investors and analysts to gauge more easily and precisely which named executive officers are receiving certain types of compensation and how much those executives are receiving in the aggregate. It remains to be seen, however, whether transparency in executive pay will curb its upward trend.
Lisa K. Kunkle, a corporate and securities law practitioner, advises corporations on all aspects of their executive compensation programs with an emphasis on securities matters. Louis Rorimer, trained as a transactional lawyer, deals with all legal issues concerning design, implementation, and operation of stock incentive plans for executives and other employees. Both are Partners in the Cleveland office of Jones Day.