article is reprinted with permission from the
March 30, 1992
New York Law Journal.
© 1992 NLP IP Company.
Recent SEC Initiatives
By Joseph E. Bachelder.
DURING THE 1980s corporate governance issues swirled around poison pills, corporate raiders and Wall Street's financing of takeovers. In the 1990s corporate governance issues swirl more broadly around management responsiveness to shareholder concerns and a greater openness in the corporate governance process. At the center of the current corporate governance colloquy is executive compensation.
In the midst of a serious recession and extraordinary publicity, most of it adverse, on executive pay, a number of bills were introduced in Congress in 1991 and early 1992 directed at executive pay. In addition, one new law was enacted in December, imposing regulation on executive pay in the banking industry. 1
The Federal Deposit Insurance Corp. Improvement Act of 1991, Pub. L. No. 102-242, §132, 105 Stat. 2236 (1991), adds a new §39 to the Federal Deposit Insurance Act prohibiting excessive compensation in the banking industry. A provision under the Family Tax Fairness, Economic Growth, and Health Care Access Act of 1992, which was passed by Congress and immediately vetoed by the President on March 20, would have eliminated a corporate tax deduction on executive compensation in excess of $1 million per year.
Prompted at least in part by the foregoing proposed and enacted legislation, the Securities and Exchange Commission very recently has taken several initiatives involving executive compensation. This column will focus on these recent actions.
* On Feb. 13, the SEC announced that it had sent letters to 10 corporations advising them that they could not exclude from proxy statements advisory proposals by shareholders relating to executive pay.
* On the same date, SEC Chairman Richard C. Breeden announced that the SEC will be proposing new rules relating to proxy statement disclosure of executive pay.
* On the same date, Chairman Breeden announced that the Chief Accountant of the SEC, Walter P. Schuetze, has been directed to report by June to the SEC his conclusions as to the appropriate accounting treatment for stock options.
* On March 19 and 20, the SEC held a public forum in Washington entitled "Corporate Governance and American Economic Competitiveness: The Role of Shareholders, Directors and Management" in which discussions on the subject of executive compensation played a prominent role.
The SEC Proposals
As a consequence of these recent initiatives by the SEC, it is very likely that the pressure to enact legislation of the sort represented by the bills noted above will be reduced. In fact, in remarks at the SEC conference on March 19, Senator Carl Levine, D-Mich., reviewed the key points of his bill, the Corporate Pay Responsibility Act, compared them with the SEC proposals and indicated that he viewed the SEC proposals favorably.
Following is a more detailed discussion of the SEC actions.
1. Inclusion in the proxy statement of shareholder proposals on executive compensation. Chairman Breeden has emphasized that the types of shareholder proposals that, under the SEC's new policy, must be included in the proxy statement are limited to those that are advisory, not mandatory. Citing widespread public debate on the policies and practices relating to senior executives and directors and the recognition that these matters raise significant policy issues, the SEC has concluded that these proposals can no longer be excluded pursuant to the "ordinary business operations" exception under Rule 14a-8(c)(7). 2
Before its February change of position, the SEC had taken the position that shareholder proposals on executive pay generally constituted interference with the ordinary conduct of the business by the board of directors and, therefore, could be excluded under Rule 14a-8(c)(7). Additionally, many such proposals were found to be excludable under Rule 14a-8(c)(1) because they were not a proper subject of action by shareholders under applicable state laws. 3 Over the past three years, the SEC has allowed advisory proposals on certain aspects of executive pay, including proposals relating to parachute payments, disclosure as to executive pay and shareholders' advisory committees. 4
As earlier noted, in connection with its announcement of a change in policy regarding disclosure of shareholder proposals on executive compensation, the SEC released letters to 10 issuers requiring inclusion in their proxy statements of shareholder proposals on this subject. 5 Further evidence that the SEC is actively implementing this new policy was a report in The New York Times on March 20 that the SEC sent Reebok International Ltd. a letter requiring it to include a proposal by the New York City Employees Retirement System, a substantial shareholder, to restrict membership of the compensation committee to directors who have no business dealings with the company.
A consequence of this SEC change probably will be a dramatic increase in the number of shareholder proposals for inclusion in proxy statements. Chairman Breeden noted in his Feb. 13 statement that the number of shareholder proposals on compensation and benefits had risen from 35 in 1986 to 110 in 1990. 6
Additionally, the proposals, in large degree, are emanating from major institutional shareholders such as pension funds. These major shareholders, in a significant number of cases, have made clear that they intend to become more closely involved with the management of corporations in which they have investments that are underperforming. This is a far different situation from that of the historic "corporate gadfly," in the form of an individual investor with limited shareholdings, who causes disruption at shareholder meetings. Large institutional investor proposals represent a force to be reckoned with, not simply a nuisance.
Finally, such proposals may play a role in future litigation. For example, assume a majority of the shareholders vote in favor of a shareholder advisory proposal to limit executive pay, which management ignores. It later turns out that executive payouts far exceed the norm. Such a shareholder resolution possibly might be taken into account by a court in determining whether the board of directors had shown proper care for purposes of determining the applicability of the business judgment rule.
2. New rules relating to executive compensation disclosure. The proposed revisions to the proxy rules were summarized by Chairman Breeden in February in three parts:
* Current cash compensation (salary and bonus) will appear, under the SEC proposal, in the same table with information showing stock and stock option values. The company will be required to show the present value of grants of stock or stock options in the year of grant.
* To enable shareholders to evaluate the correlation between pay and performance, corporate performance over a period of years will be shown together with changes in CEO compensation over the same period.
* Boards of directors will be required to make a statement of the criteria used in rewarding incentive compensation and to explain their reasons for making specific compensation awards.
Disclosure in Proxies
The SEC appears ready to jump into the fray on the issue of valuation of stock options at the time of grant. Not only is the SEC proposing that stock options be valued at time of award for disclosure purposes but, as noted in the next section, it is studying change in accounting rules as well.
3. Change in accounting for stock options. Under current accounting rules, there is generally no charge against earnings for stock option awards, whether at time of grant or time of exercise (this assumes, among other things, the exercise price is at least equal to the market price as date of grant). Chairman Breeden, as noted, will receive a report by June from the Chief Accountant of the SEC on the subject of possible change in the accounting for stock options. Already the Chief Accountant has indicated he will be working with the Financial Accounting Standards Board on this subject.
The vice chairman of the FASB, James J. Leisenring, has indicated that the FASB expects to take up the subject of accounting for stock options during 1992. However, it may be two years before the FASB completes its review of the issue. It would seem doubtful that the SEC would adopt an accounting rule for stock options while the FASB is actively reviewing the issue. Accordingly, it is unlikely that an accounting challenge for stock options would occur before 1993, and it could be 1994 before such a new rule takes effect.
At hearings on Jan. 31 on the Corporate Pay Responsibility Act, Senator Levin indicated great impatience with the pace at which the issue of accounting for stock options was being addressed. He indicated to the vice chairman of the FASB that the legislation he was proposing would take away from the FASB the responsibility for adopting a rule change. On the other hand, his comment at the March 19 SEC conference, as noted above, indicated agreement with the approach being proposed by the SEC.
If the SEC sticks by the position that it will not adopt a new accounting rule for stock options without coordinating with the FASB, Senator Levin may have to be patient (unless his proposed legislation is enacted). For nearly a decade, from the late 1970s until the late 1980s, the FASB and its predecessor, the Accounting Principles Board (working with a special task force of the American Institute of Certified Public Accountants), thoroughly addressed the issue of accounting for stock options and decided not to change the accounting treatment established by APB No. 25 (1972). In any event, for at least another year it would appear unlikely that any change in the stock option accounting rules will occur.
4. Washington Conference of March 19-20. The very fact that Chairman Breeden called the conference on March 19 and 20, with an imposing panel of speakers, including compensation specialists, indicates the seriousness with which the SEC is addressing matters of corporate governance, including those involving executive pay. One entire afternoon of the two-day session was devoted to the role of management, with particular attention paid to issues involving executive compensation. Among the topics covered at that session were:
* Corporate Pay Responsibility Act (Senator Levin);
* executive pay and issues of corporate governance (Linda C. Quinn, director of corporate finance, SEC);
* problems associated with design of appropriate incentives for management (Professor Myron S. Scholes, Stanford Business School);
* the importance of focusing on pay for performance rather than level of pay (Associate Professor Kevin J. Murphy, Harvard Business School); and
* the quality of the executive as a more fundamental issue than executive pay itself (Professor Joseph Gundfest, Stanford Law School, former SEC commissioner).
In addition, problems associated with executive compensation surfaced repeatedly in the panel discussions concerning the role of directors and the role of shareholders.
1. Boards of directors, and compensation committees in particular, should expect closer scrutiny of their compensation decisions. It is clear, from comments by Chairman Breeden and others, that the SEC advocates a more open flow of information as well as dialogue, between shareholders and boards of directors. Compensation committees should review how their executive pay decisions relate to the objectives, strategies and polices of the corporation. Important pay decisions should be the subject of written reports indicating review of the compensation issue being described in light of such objectives, strategies and polices. If any shareholder resolutions on the subject have been included in the proxy statement during a particular year, any decision that could be considered within the reach of such a shareholder resolution should be accompanied by a written statement reflecting consideration by the committee of the shareholder's proposal and providing explanation as to why the committee, if such is the case, chooses not to follow the proposal.
2. The compensation committee should have prepared for it a proxy statement presentation of the information and statements required under the proposed rules, including board statements as to compensation decisions and specific awards. Although new rules may not be proposed for some months, a pro forma proxy statement presentation should be reviewed by the compensation committee well in advance of the 1993 proxy season, so that committee members can see what it will look like. Questions may surface that need to be addressed before the proxy statement is filed.
3. A review by the compensation committee of its practices involving executive compensation (internal procedures, written records, communications with management, shareholders, etc.) should be undertaken well before the end of the current fiscal year. Such a review may take time and will require discussion within the committee and perhaps with the entire board. In view of the implications of the SEC proposals in terms of directors' responsibilities, and even liabilities, the importance of such a review is obvious.
4. A key topic discussed at the SEC conference was the importance of having independent directors reach corporate governance decisions, including decisions on executive compensation. Panelists at the conference repeatedly commented that, in addition to independent directors, the "corporate governance system," if it is to work, must increase the accountability of directors for their decisions. As decisions of compensation committees become more closely scrutinized by shareholders and others, the independence of the members of those committees will undoubtedly be given greater attention. In this connection, it should be anticipated that director compensation itself will be the subject of closer scrutiny.
1 Pending legislation involving executive compensation
* the Corporate Pay Responsibility Act, S. 1198 (Senator Carl Levin, D-Mich.) and H.R. 2522 (Representative John Bryant, D-Texas), 102d Cong., 1st Sess. (1991) (requiring inclusion in proxy statement of shareholder proposals regarding executive compensation, greater disclosure of executive compensation and alternate slates of directors proposed by shareholders, as well as changes to long-term compensation accounting, access to shareholder lists and confidentiality of proxy votes);
* S. 2030 (Senator William S. Cohen, R-Me.), 102d Cong., 1st Sess. (1991) (requiring confidential proxy voting and inclusion in proxy statements of shareholder proposals regarding compensation of directors proposed by shareholders);
* S. 2329 (Senator Tom Harkin, D-Iowa), 102d Cong., 2d Sess. (1992) (requiring limitation of corporate tax deduction for executive compensation to $500,000);
* S. 2330 (Senator Harkin), 102d Cong., 2d Sess. (1992) (requiring broader inclusion of shareholder proposals in proxy statements, greater disclosure of executive compensation and accounting changes for long-term compensation); and
* the Income Disparities Act of 1991, H.R. 3056 (Representative Martin O. Sabo, D-Minn.), 102d Cong., 1st Sess. (1991) (requiring limitation of tax deductibility for salary, wages and bonuses to any employee for any one year to 25 times the compensation of the lowest paid worker of the employer).
2 Rule 14a-8(c)(7) permits a company to omit a shareholder's proposal from its proxy materials "[if] the proposal deals with a matter relating to the conduct of the ordinary business operations of the registrant."
3 Rule 14a-8(c)(1) permits a company to omit a shareholder's proposal from its proxy materials "[if] the proposal is, under the laws of the registrant's domicile, not a proper subject for action by security holders."
4 See SEC No-Action Letters of Transamerica Corp., available Jan. 10, 1990 (proposal relating to executive compensation pursuant to change in control); UAL Corp., available Oct. 13, 1989 (proposal relating to disclosure of executive compensation); McDonald & Co. Investments Inc., available May 6, 1991 (proposal relating to establishment of shareholders' advisory committee).
5 Among the corporations receiving letters were the
following. (All letters are dated Feb. 13, 1992. Subject matter
of each shareholder proposal is summarized in parentheses.)
* Chrysler Corp. (proposal of permanent strike price for future stock option grants);
* Aetna Life and Casualty Co. (proposal to amend the schedule of compensation for outside directors);
* Grumman Corp. (proposal recommending management incentive plan prohibit bonuses until dividends reach a specified limit);
* International Business Machines Corp. (proposal recommending future proxy statements include more detailed and clearer disclosure regarding officer compensation along with justification of officers' salaries and incentives);
* Eastman Kodak Co. (proposal recommending company disclose severance compensation made to executive officers); and
* Bell Atlantic Corp. (proposal to abolish company's short-term incentive plan for senior managers).
6 Figures given are for 12-month periods ending June 30, 1986, and June 30, 1990. See Report on Shareholder Proposals, American Society of Corporate Secretaries.