This article is reprinted with permission from the
March 31, 2006
edition of
New York Law Journal.
2006 NLP IP Company.


SEC Proposes New Rules on Executive Pay Disclosure

By Joseph E. Bachelder

On Jan. 27, 2006, the Securities and Exchange Commission (the SEC) published its proposed new rules on the disclosure of executive compensation. These proposals contain substantial changes from current rules including:

(1) Eight new or modified tables (including a new total compensation column added to the Summary Compensation Table) requiring significantly more disclosure of quantitative aspects of executive and director pay (two of the tables are discussed in this column and other tables will be discussed in a later column);

(2) Expanded narrative disclosure and footnote requirements accompanying the Summary Compensation Table and other tables;

(3) A new Compensation Discussion and Analysis that would replace the current Compensation Committee Report;

(4) Elimination of the stock performance graph; and

(5) New disclosure requirements regarding director independence and corporate governance.

This column will discuss the modified Summary Compensation Table (See page 26 of the Proposed Rule), the new Director Compensation Table (See page 307 of the Proposed Rule) and the new Compensation Discussion and Analysis (CD&A). A later column, as noted, will discuss other aspects of the proposed rules. (A controversial proposal requiring identification and quantification of potential severance and change in control payments and other benefits, noted briefly here, will be discussed in the later column.)

I. Summary Compensation Table and Accompanying Narrative and Footnotes.

Chart 1

A. Who is covered.

1. Named Executive Officers. As in the current tables, named executive officers will generally total five. Under the proposal, like the Chief Executive Officer (renamed the "Principal Executive Officer") under current rules, the Chief Financial Officer (renamed the "Principal Financial Officer") will be a named executive officer regardless of his or her pay level. The remaining three will be the other three executive officers who are highest paid.

2. Up to three other highly paid employees. The three highest-paid employees not included in the named executive officers category "whose total compensation for the last completed fiscal year was greater than that of any named executive officers" must be included in the narrative accompanying the Summary Compensation Table to the extent of showing their total compensation and positions. (They are not required to be identified by name.)

B. What is covered: Key changes in the Summary Compensation Table (SCT) columns.

1. New compensation "Total" column. This column includes the total for all elements of compensation for the fiscal year. It includes salary, bonus, stock awards, option awards, non-stock incentive plan compensation and compensation included in the "All Other Compensation" column. Compensation must be included even if called for by another Item, such as a related transaction disclosure.

2. "Other Annual Compensation" column. This column, and the information it contains, will be merged into the "All Other Compensation" column.

3. Stock options. Stock option grants will be shown at grant date value, not as the number of shares granted under the option. Valuation of option grants will be based on FAS 123R using the same assumptions that the company uses for financial reporting purposes.

4. "Non-Stock Incentive Plan Compensation" column. A new column entitled Non-Stock Incentive Plan Compensation replaces, in part, the LTIP Payouts column. This column will report compensation at the time earned rather than at the time of award, which continues the distinction between it, and the LTIP Payouts column, and the Stock Awards and Option Awards columns which continue to report awards at time of grant. (Non-Stock Incentive Plan Compensation is also reported at the time of grant in a separate table entitled Grants of Performance-Based Awards Table.)

5. "All Other Compensation" column. As noted above, this column will be expanded to include data currently included in the "Other Annual Compensation" column. The expanded column will provide the aggregate value of compensation of named executive officers not covered in columns (d) through (h) (see chart setting out SCT below) including the following:

• Perquisites and other personal benefits if, in the aggregate, they total $10,000 or more

• Earnings on deferred compensation (with certain exceptions such as earnings on tax-qualified defined contribution retirement plans) and earnings on stock, stock option and non-stock incentive awards

• "Gross-ups" and other reimbursements of taxes

• Discounts on purchases of employer securities not generally available to security holders or employees

• Amounts paid or accrued pursuant to a plan or arrangement in connection with a termination of employment or a change in control of the company[1]

• Company contributions and allocations to defined contribution plans

• Increase in actuarial value of defined benefit plans

• Dollar value of life insurance premiums

C. Narrative accompanying SCT and Related Tables.

The proposed rules will consolidate certain narrative disclosure requirements (currently required in other parts of the proxy statement) into the narrative to the SCT and related tables. For example, current rules require description of terms and conditions of employment contracts between a named executive officer and the company in another section of the proxy statement. This description will now appear in the narrative accompanying the SCT.[2] In addition, new narrative disclosures will be required.

Among the new narrative disclosures required by the proposed rules are (i) as noted above, for up to three employees "whose total compensation for the last complete fiscal year was greater than that of any named executive officers," disclosure of total compensation for the last fiscal year and job positions (identification of names not required), (ii) assumptions used in disclosures of value of defined benefit plans[3] and (iii) waivers or modifications, if any, of performance targets and conditions with respect to any amount included in non-stock incentive plan compensation.

D. Footnote Disclosure.

Significant footnote disclosure is required in the proposed regulations — much of it new. Certain of these disclosures are as follows:

1. Footnote disclosure is required as to salary and bonus if the amount is not calculable for purposes of the filing by indicating the date it is expected to be determinable. (Such amount must be disclosed by filing a Form 8-K when it is determined.)

2. For stock and stock option awards, there must be footnote discussion of the assumptions used in determining values by reference to the company's financial statements or Management Discussion and Analysis.

3. Earnings on outstanding stock, stock option and non-stock incentive awards must be disclosed in a footnote to the respective column (column (f), (g) or (h)).

4. Earnings on non-tax-qualified deferred compensation arrangements must be identified and quantified if all such earnings exceed $10,000.

5. If perquisites and other personal benefits equal or exceed $10,000 in the aggregate (thus requiring reporting of the amount of such perquisites and benefits in the All Other Compensation column), identification must be made of each perquisite or other personal benefit and each item so identified must also be quantified "if it is valued at the greater of $25,000 or 10 percent of total perquisites and other personal benefits."

6. If a named executive officer also receives compensation as a director, that compensation must be reflected in the SCT and a footnote provided identifying and itemizing such compensation and amount (in such event the compensation of the named executive officer as a director is not required to be reported in the Director Compensation Table).

7. Any amounts deferred, whether or not at the election of the named executive officer, are to be included in the appropriate column of the SCT and "the amounts so deferred must be disclosed in a footnote to the applicable column."

II. Director Compensation Table.

(See page 307 of the Proposed Rule setting out the columns of the proposed Director Compensation Table.)

Chart 2

For the first time, compensation of directors will be required to be reported in tabular form.[4] The table resembles the Summary Compensation Table for named executive officers discussed above. However, the Director Compensation Table, unlike the Summary Compensation Table, covers only the prior fiscal year. Directors as to whom all elements of their compensation are identical may be grouped together into a single row. Instructions to the proposed rules, however, state that "[t]he names of the directors for whom disclosure is presented on a group basis should be clear from the Table." (Instruction to Item 402(l)(2))

The proposal raises a question whether director compensation will undergo a "ratcheting effect" similar to that experienced in connection with named executive officers over the past decade and a half following the adoption in 1992 of the current SEC executive compensation disclosure rules which substantially expanded the information disclosed. This allowed executives to see what their peers were making at other companies in greater detail and led to what has been broadly criticized as a ratcheting effect in executive pay. No doubt directors also will be interested in seeing in tabular form, including the new "Total Compensation" column, what their peers are paid at other companies.

III. CD&A.

The CD&A, which replaces the Compensation Committee Report, will be treated as "soliciting material and would be filed with the Commission." Thus it will be subject to applicable filing rules under Regulations 14A and 14C and to liabilities under §18 of the Securities Exchange Act. The SEC considers that Chief Executive Officer and Chief Financial Officer certifications to 10-Ks and 10-Qs cover proxy statement material deemed to be filed. The Compensation Committee Report was deemed "furnished" but not part of the material "filed" whereas the proposed rules, as noted, would treat the CD&A in the "filed" material category. It is interesting to note that the proposed rules do not require the CD&A to be over the signatures of the compensation committee members.

The CD&A must describe (i) the objectives of the company's compensation programs, (ii) what each compensation program is designed to reward and not reward, (iii) each element of compensation, (iv) why the company chooses to pay each element, (v) how the company determines the amount to pay (and, where applicable, the formula) for each element and (vi) how each compensation element and the company's decisions regarding that element fit into the registrant's overall compensation objectives and affect decisions regarding other elements. Depending upon the facts and circumstances, the company is expected to disclose specific information which the proposal suggests may include, in a given case, the following:

A. Allocation between different types of compensation including (i) allocation between cash and non-cash compensation, (ii) allocation between long-term and currently paid out compensation and (iii) as to long-term compensation, the basis for allocating compensation between different forms of award.

B. Explanation as to how and when different forms of compensation are determined and the policies for implementation including (i) how the determination is made as to when equity-based awards are granted, (ii) what specific items of corporate performance are taken into account in setting pay policies and making pay decisions, (iii) what specific aspects of individual performance of named executive officers are taken into account in determining their compensation and (iv) what criteria are considered on decisions to increase or decrease compensation materially.

C. Other factors suggested by the SEC for disclosure in the CD&A include (i) how prior awards, such as previously awarded stock options, are taken into account in setting the current levels of compensation, (ii) the impact of tax and accounting treatments of a particular form of compensation, (iii) the company's equity ownership requirements or guidelines for executive officers and company policies regarding hedging the economic risk of such ownership, (iv) if compensation is determined by reference to a peer group, the identification of that peer group, including the component companies and (v) the role of executive officers in determining execution compensation.[5]

Undoubtedly, a great deal of effort will be required of companies to acquaint themselves with the proposed new rules. Certainly, for a while, a new "cottage industry" will be created for consultants and other advisers to compensation committees. In this connection, the proposed rules require identification of any consultant engaged directly by the compensation committee.

The proposed regulations contain numerous requests for comments, set forth throughout the text of the discussion preceding the proposed regulations. In the announcement accompanying the proposed rules, the SEC invites comments to be received on or before April 10, 2006.


FOOTNOTES:

[1] This item in the "All Other Compensation" column does not refer to "aggregate amounts potentially payable in the future" that may be associated with a future severance or a change in control (which may never occur). (See §II.B.1.d.iv, footnote 118 of the discussion accompanying the proposed rules.) Presumably, what the SEC intends to require in the All Other Compensation column in this regard are amounts being paid out or that are fixed by the end of the year being reported. Payments or benefits that may be received pursuant to an event in the future, such as parachute payments, are to be reported in another section of the proxy statement, not in the All Other Compensation column (See Item 402(k) of the proposed rules for discussion of such potential payments).

[2] Distinction should be made between an employment agreement, on the one hand, and a severance or change in control agreement or arrangement, on the other hand. As noted in footnote 1, under the proposed rules, agreements providing for possible future payments, such as pursuant to a possible termination of employment or change in control, will appear in another part of the proxy statement, presumably after the tables dealing with pensions and other forms of deferred compensation.

[3] Current rules require that the company make a "statement as to the basis upon which benefits are computed." The proposed rules would require more complete disclosure of the assumptions, actuarial and financial, used in the determination of the pension values.

[4] In 1995 the SEC proposed a separate table reporting director compensation. This proposal was not adopted.

[5] The CD&A goes into much greater detail than the current Compensation Committee Report. As provided in Item 402(k) of the current rules, the Compensation Committee Report requires (i) the disclosure of the compensation committee's compensation policies applicable to executive officers including the specific relationship of corporate performance to compensation reported for the last fiscal year and (ii) the committee's bases for the CEO's compensation for the last fiscal year, including a specific discussion of the relationship of the CEO's compensation to the company's performance. Item 402(k) also requires that the Compensation Committee Report be made over the name of each member of the Compensation Committee.