This article is reprinted with permission from the
August 30, 1993
edition of

New York Law Journal.

1993 NLP IP Company.


The SEC on Disclosure; Cap on Deductions

By Joseph E. Bachelder.


TWO EVENTS in early August are significant for executive compensation: (a) The Securities and Exchange Commission issued a release on the subject of executive compensation disclosure (including proposed new rules), 1 and (b) Congress passed the Revenue Reconciliation Act of 1993. 2 This column will (i) summarize the SEC executive compensation disclosure, and (ii) comment on one feature of the RRA of particular significance for executive compensation: the $1 million cap on the deduction for certain compensation paid by public companies.

SEC Release on Executive Pay

The release indicates that, as part of the project leading up to the release, the staff reviewed proxy statements of 984 registrants (634 were reviewed in definitive form, and 350 were reviewed in preliminary form). 3

The release indicates that out of 710 proxy statements disclosing option grants, 480 (68 percent) disclosed value on the basis of potential value, assuming 5 percent and 10 percent annualized rates of appreciation, and 230 (32 percent) disclosed value using an option-pricing model. Of those using the Black-Scholes pricing model, only 10 disclosed underlying assumptions and adjustments in it.

There was a fairly high frequency of insider participation on compensation committees. Some 113 registrants reported officers or employees as committee members, and 123 had a former officer on the committee (15 reported having both categories on the committee).

Among interlocking relationships reported, 17 registrants reported an executive officer of the registrant to be a member of the compensation committee of another entity and one of the executive officers of the other entity to be on the compensation committee of the registrant. Thirty-nine registrants reported an executive officer on the board of directors of another entity of which an executive officer served on the registrant's compensation committee.

In the performance graph, 295 registrants (30 percent) used a self-constructed peer group. Forty-eight registrants presented additional performance charts such as a chart with a base measurement point going back more than five years (21 cases), and 15 registrants used a chart ending later than the mandated five-year measurement period. Criteria besides shareholder return that were used in additional charts included return on equity, return on assets and earnings. One registrant made an additional graph showing the total return comparison for the period covered by the tenure of the chief executive officer.

SEC Comments and Responses

The release comments on "common mistakes" and responds to questions of general application. Following are some of the points covered in this part of the release.

1. Consulting agreements and other compensatory arrangements with directors (not simply directors' fees) must be reported in the section covering directors' compensation.

2. The number and value of restricted shares held by each named executive officer (Named Officer) as of year-end must be shown in a footnote to the Summary Compensation Table (SCT). The release indicates that such information is required whether or not a restricted stock grant is reported in the SCT for the reporting year as to which the proxy statement is filed.

3. Individual items of the All Other Compensation column of the SCT should be noted in a footnote to the column in the SCT.

4. End-of-year option and SAR holdings must be reported in the option/SAR exercises/holdings table (technically, the Aggregated Option/SAR Exercises in Last Fiscal Year and FY-End Option/SAR Values Table) even if no Named Officer exercised any options/SARs during the year being reported.

5. If a "related transaction" occurs involving a compensation committee member with an "interlock" or "insider participation," disclosure of the relationship, as well as reportable transactions, is required in the section headed "Compensation Committee Interlocks and Insider Participation."

6. The release comments on reporting as to compensation paid by affiliates of the registrant, reporting of reload and repriced options as new grants, the question of when a particular plan should be treated as a Long-Term Incentive Plan (LTIP) reportable in the LTIP Payouts column of the SCT and in the LTIP awards table (technically, the Long-Term Incentive Plans -- Awards in Last Fiscal Year Table) or as some other type of plan, and performance graph issues such as changes in peer group and uses of different types of indices.

Compensation Committee Report

A substantial portion of the SEC release is devoted to a critique of compensation committee reports. The most frequent criticism is the lack of sufficient specifity. According to the release, committee reports varied in length from one paragraph to five pages. The SEC staff would like to see greater specifity in terms of the CEO compensation in particular and also as to the rationale used in determining the size of pay packages and the criteria on which awards are based.

When a registrant explains that pay levels are based on "competitive rates," the SEC wants indication of the group with which the committee is making the comparison and the level within that group that the company intends to achieve (e.g., at the median, in the 75th percentile, etc.).

The release discusses questions involving the omission of "specific target levels and any factor of criteria involving confidential commercial or business information disclosure of which would adversely affect the registrant."

The SEC continues to allow non-disclosure of information if disclosure of such information might harm the registrant. However, the release indicates that such non-disclosure must be noted in the committee report and a statement must be made by the committee that it believes identifying applicable factors or criteria would adversely affect the registrant.

The release also notes that if performance comparisons are made in addition to the requisite performance graph, the committee must explain the link between the performance measure so displayed and the executive compensation for the year being reported.

Finally, the release notes that the compensation committee must include in its discussion any former CEO required to be included in the SCT under the new proposed rules and also should include severance compensation arrangements for any former executive officers who, in addition to a former CEO, must be included in the SCT under the proposed new rule. The proposed new rule is discussed in the following section.

Proposed Rule Changes

Persons covered. The Named Officers are expanded to include the following:

* any person who served as a chief executive officer during the fiscal year being reported (whether or not employed as chief executive officer at the end of the year) and

* any other individual who would have been included as a Named Officer but for the fact that he was not serving as an executive officer at the end of the fiscal year being reported (the number of additional individuals that can be required to be included in this category is limited to two). 4

Accordingly, the proposed new rule may increase the number of executives reported in the SCT for a particular year to more than five (in a particular case, to seven or eight or conceivably even more). Assume, for example, that the CEO of a registrant resigned during the fiscal year being reported and a new chief executive officer filled the position at year-end. Assume also that two of the executive officers of the same registrant, whose compensation actually paid to them during the year would have put them into the SCT had they been there at year-end, also resigned during the same year. This registrant would be required to include eight individuals as Named Officers in the SCT for that fiscal year.

A result of the new rule will be the required inclusion of severance arrangements entered into during the fiscal year being reported for retiring senior level executives in the "Named Officer" category. For example, if a CEO retires during the year and a severance arrangement is entered into with him during that year, the proposed new rule, in contrast to the original rule, makes clear that disclosure of the severance arrangement will be required.

Restricted stock information. Under the original rule, at least as interpreted by some registrants, restricted stock owned at the end of the year was not required to be reported in footnote form to the SCT if there was no restricted stock award during the year. The proposed new rule states that footnote disclosure of end-of-year stock holdings is required whether or not a restricted stock grant is made during the three-year period covered by the SCT. (The release also notes that in the case of stock options a report of options/SARs held at fiscal year-end is required in the option/SAR exercises/holdings table, notwithstanding the fact that no Named Officer exercised any options/SARs during the year.)

Use of Black-Scholes to value stock options. Under the original rule, if a registrant chose to use grant date valuation as determined under the Black-Scholes model for purposes of reporting option/SAR grants in the Option/SAR Grants in Last Fiscal Year Table, the registrant was not required to discuss underlying assumptions or modifications in the basic Black-Scholes model. The proposed rule provides that if a registrant uses the Black-Scholes model, it should "describe the assumptions used relating to the expected volatility, risk-free rate of return, dividend yield and time of exercise. Any adjustments for non-transferability or risk of forfeiture also should be disclosed."

Performance graph: Market capitalizations of peer group. Under the original rule, market capitalization for a self-constructed peer group index was required to be weighted according to the respective stock market capitalization as of the end of each fiscal period for which a return is indicated. The proposed rule changes the date for determining market capitalization to the beginning of the period. According to the SEC release, such change more accurately reflects the performance over the applicable period because it eliminates appreciation from the calculation of market weight.

In addition to the foregoing proposed rule changes, there are other changes of a more technical nature that are proposed. These include clarification that restricted stock holdings for purposes of the SCT are to be valued at year-end and that references to the ratios of certain defined benefit pension plans to a Named Officer's compensation are to be made only in respect of annual compensation.

Limit on Deductibility

Section 162(m)(1) of the Internal Revenue Code of 1986, as added by 13211(a) of the RRA, provides as follows:

In the case of any publicly held corporation, no deduction shall be allowed under this chapter for applicable employee renumeration with respect to any covered employee to the extent that the amount of such remuneration for the taxable year with respect to such employee exceeds $1,000,000.

This new provision is effective as to compensation otherwise deductible by a corporation in a taxable year beginning on or after Jan. 1, 1994.

Section 162(m)(3) defines a "covered employee" to include the person serving as CEO at the close of the taxable year in question plus any other employee of such employer who was required by the SEC to be reported in the proxy statement as a Named Officer by reason of being "among the 4 highest compensated officers for the taxable year (other than the chief executive officer)." 5

Section 162(m)(4) defines "applicable employee remuneration." In general, it means "the aggregate amount allowable as a deduction under this chapter for such taxable year (determined without regard to this subsection) for remuneration for services performed by such employee (whether or not during the taxable year)."

Among the exceptions to the definition are contributions by the employer to a qualified retirement plan (including salary-reduction contributions) and benefits available under other tax-qualified employee benefit plans, such as a tax-qualified medical plan. Also excluded are commissions paid in respect of an individual's own services (such as a salesman's commissions on his own sales).

The most important exception for executive compensation purposes is the exception for certain "performance-based compensation." This exception as described in 162(m)(4)(C), is applicable if

(i) the performance goals are determined by a compensation committee of the board of directors of the taxpayer which is comprised solely of two or more outside directors.

(ii) the material terms under which the remuneration is to be paid, including the performance goals, are disclosed to shareholders and approved by a majority of the vote in a separate shareholder vote before the payment of such remuneration, and

(iii) before any payment of such remuneration, the compensation committee referred to in clause (i) certifies that the performance goals and any other material terms were in fact satisfied.

The language of the statute leaves open the definition of certain terms and the interpretation of some of its provisions. Following are some of the comments on "performance based compensation" contained in the Conference Committee Report as released on Aug. 4. 6

Performance Goals

According to the Conference Committee Report, the "performance goals" requirement will be satisfied only if the award is paid "pursuant to a preestablished objective performance formula or standard that precludes discretion." 7 (Separate discussion on this point as to stock options and stock appreciation rights is made below.)

The Conference Committee Report limits an "outside director" for purposes of 162(m)(4)(C)(i) to a director who

is not a current employee of the corporation (or related entities), is not a former employee of the corporation (or related entities) who is receiving compensation for prior services (other than benefits under a tax-qualified pension plan), was not an officer of the corporation (or related entities) at any time, and is not currently receiving compensation for personal services in any capacity (e.g., for services as a consultant) other than as a director. 8

The Conference Committee Report goes on to provide that the shareholder approval requirement is satisfied as to a plan (other than a stock option plan as noted below) in which shareholders approve the "specific terms of the plan, including the class of executives to which it applies." 9

The Conference Committee Report, after noting that not all details of the plan need to be disclosed to shareholders, states as follows:

It is expected that shareholders will, at a minimum, be made aware of the general performance goals on which the executive's compensation is based and the maximum amount that could be paid to the executive if such performance goals were met. For example, it would not be adequate if the shareholders merely informed that an executive would be awarded $x "if the executive meets certain performance goals established by the compensation committee." 10

It is unclear why the Conference Committee chose to refer to a specific executive in the portion of the report just noted. In other respects the report appears to contemplate description of the plan in terms of covered executives generally, not as to any individual executive.

Stock option and SAR plans. The legislative history explains that stock options and SARs by definition meet the requirement that a plan be "performance based" because the award is dependent upon increase in stock price. (At the same time, the Conference Committee concludes that restricted stock will not be deemed performance based because the executive will be rewarded even if the stock declines in value. 11 Thus, a stock award, like a cash award, will qualify only if it is subject to some independent, performance-based standard such as growth in earnings, sales, etc.)

In contrast to other performance-based plans, a stock option plan, as approved by shareholders, must include "the option price (or formula under which the price is determined) and the maximum number of shares subject to option that can be awarded under the plan to any executive." 12 Thus, an important difference between a stock option plan and other performance-based plans, according to the Conference Committee Report, is that the stock option plan must identify the maximum award (in terms of shares) that can be made to any one executive.

Exception for certain contracts. According to 162(m)(4)(D), the new rule shall not be applicable to "any remuneration payable under a written binding contract which was in effect on Feb. 17, 1993, and which was not modified thereafter in any material respect before such remuneration is paid." According to the Committee Report, it is not the existence of a plan that determines the exception. There must be a written binding contract covering the employee that was in effect on Feb. 17, 1993. The contract may not be renewed after that date without loss of the grandfather exception. If the contract is terminable at will by either part, it also will not enjoy the benefit of this exception. Termination due to termination of employment, however, is not deemed a right to terminate the contract for this purpose.


1 Securities and Exchange Commission Release No. 33-7009; 34-32723, "Executive Compensation Disclosure; Securityholder List and Mailing Requests," 58 Fed. Reg. 42,882 (August 12, 1993) (hereinafter SEC Release).

2 The RRA is Title XIII of the Omnibus Budget Reconciliation Act, Pub. L. No. 103-66 (Aug. 10, 1993).

3 The SEC reports that through May 1993 more than 5,000 registrants had filed their annual meeting proxy statements containing the new compensation disclosure. SEC Release, supra note 1, at 42,883.

4 A member of the SEC staff has indicated that only actual salary and bonus compensation paid -- not annualized salary and bonus compensation -- is to be used in determining whether such an individual is a Named Officer.

5 The proposed amendments to Item 402 of Regulation S-K under the Securities Exchange Act of 1934, as amended, would include as Named Officers all individuals serving as the CEO during the last fiscal year. SEC Release, supra note 1, at 42,893. IRC 162(m)(3) applies only to the CEO as of the close of the taxable year. The SEC release expands Named Officers to include individuals, not to exceed two, who would have been among the four highest compensated executive officers (other than the CEO) at the end of the year if they had been employed as executive officers on that date. SEC Release, supra note 1, at 42,893. See also discussion in text under "Proposed Rule Changes -- Persons Covered." Accordingly, IRC 162(m)(3) may be applied to put a cap on the deduction for compensation paid to one or two higher-paid executive officers leaving during the year.

6 Thus far, the legislative history of the RRA includes: Joint Committee on Taxation, Summary of the Revenue Provisions of the Omnibus Budget Reconciliation Act of 1993 (H.R. 2264), (JCX-12-93) (released Aug. 10, 1993); Statement of Managers, Conference Reports, Omnibus Budget of Revenue Provisions of H.R. 2264 (Omnibus Budget Reconciliation Act of 1993) as Passed by the House and Senate, (JCS-9-93) (released July 14, 1993); Senate Finance Committee Revenue Committee), Omnibus Budget Reconciliation Act of 1993 (released July 23, 1993); House Ways and Means Committee Revenue Provisions (as submitted to the House Budget Committee), Revenue Reconciliation Bill of 1993 (released May 19, 1993).

7 Conference Committee Report, supra note 6, at 95. Performance standards include increases in stock price, market share, sales or earnings per share. Id.

8 Id. at 96.

9 Id. at 97.

10 Id. The subject of confidential corporate information and disclosure to shareholders is addressed in the SEC proxy statement disclosure rules. Instruction 2 to Item 402(k) of Regulation S-K permits a compensation committee (or board) to not disclose "target levels with respect to specific quantitative or qualitative performance-related factors considered by the committee (or board), or any factors or criteria involving confidential commercial or business information, the disclosure of which would have an adverse effect on the registrant." 17 CFR 229.402(k) (1992). The SEC release does not change this instruction. See SEC Release, supra note 1, at 42,889. However, in its interpretation of the instruction, the release indicates that a statement by the committee of the fact of non-disclosure would adversely affect the registrant should be given. Id. The Conference Committee Report with respect to IRC 162(m) states that "[it] is intended that not all the details of a plan (or agreement) need be disclosed in all cases. In developing standards as to whether disclosure of the terms of a plan or agreement is adequate, the Secretary should take into account the SEC rules regarding disclosure." Conference Committee Report, supra not 6, at 97.

11 Similarly, stock options that are granted with an exercise price below fair market balue at the time of grant will not constitute performance-based compensation because the executive would have the right to receive compensation on the exercise of the option even if the stock price decreases or remains the same. Conference Committee Report, supra note 6, at 96.

12 Id. at 97.