A Guide to the SEC s Revised Executive Compensation and Related Disclosure Rules
| Author | Penny Somer-Greif |
| Pages | 02 |
By Penny Somer-Greif 1
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On July 26, 2006, the Securities and Exchange Commission ("Commission") adopted new and amended rules (which were amended in December 2006) governing executive compensation and related disclosures including related party transactions, director independence, and other corporate governance matters. This article summarizes the new rules and provides guidance on what companies should do in order to prepare for and meet these heightened disclosure requirements. Understanding these new rules is important for public companies; however, these rules are also relevant to private companies who are considering going public.2
Perhaps the most challenging portion of the new disclosure3 requirements is the Compensation Discussion and Analysis ("CD&A"). This section requires companies to address their objectives and implementation plans for executive compensation programs and explain the factors influencing their underlying compensation policies and decisions. Small business issuers are not required to provide a CD&A.4
After completing the CD&A, companies are required to make a number of specific disclosures intended to add transparency to executive compensation. A description of some of these disclosures and their corresponding tables follow: First, executive compensation over the last three years must be disclosed in the Summary Compensation Table, Supplemental Grants of Plan- Based Awards Table, and Narrative Disclosure to Summary Compensation and Supplemental Grants Tables. Second, outstanding equity interests and amounts realized on equity compensation during the last fiscal year must be disclosed in the Outstanding Equity Awards at Fiscal Year-End Table, Option Exercises and Stock Vested Table, and Narrative Disclosure to Outstanding Equity Awards and Option Exercises and Stock Vested Tables. Third, retirement and other post-employment compensation disclosures must be disclosed in the Pension Benefits Table, Nonqualified Deferred Compensation Table, and other potential postemployment benefits. Finally, director compensation is disclosed in the Director Compensation Table. Small business issuers do not have to include the Option Exercises and Stock Vested Table or the post-employment compensation tables.5
Other than small business issuers, compensation disclosure must begin with a narrative discussion providing an overview of the company's compensation program- the CD&A.6 The CD&A must provide a discussion and analysis of the material elements of the company's compensation for the named executive officers, and should focus on the material principles underlying the company's executive compensation policies and decisions, and the most important factors relevant to an analysis of those polices and decisions.7 Materiality is what investors would consider important information in making an investment decision.8 Therefore, if a company knows that investors care about a certain component of compensation, it should discuss that issue even if it is not material from a quantitative standpoint. The CD&A is principles-based disclosure, requiring companies to discuss the material elements of their own compensation programs even if such disclosure is not specifically called for in the new rules.9 The CD&A should analyze the objectives of the company's compensation programs and discuss how these programs promote, or otherwise relate to, those objectives. For example, if the compensation program is designed to "attract, retain and motivate the executive officers," the CD&A should discuss how the various elements of the company's compensation Page 11 programs accomplish those goals. A discussion of how this relates to the company's overall business objectives may also be appropriate. Therefore, what is included will vary from company to company. However, the new rules require companies to address six points in their CD&A: (1) the objectives of the company's compensation programs, (2) what the compensation programs are designed to reward, (3) each element of compensation, (4) why the company chooses to pay each element, (5) how the company determines the amount for each element, and (6) how each compensation element fits into the company's overall compensation objectives and affects decisions regarding other elements.10 While the CD&A should focus on the information required by the executive compensation disclosure rules (Item 402 of Regulation S-K), the CD&A must also cover actions taken after the end of the last fiscal year.Disclosable actions include adoption or implementation of new or modified programs and policies, as well as steps taken that could affect a fair understanding of the named executive officers' compensation for the last fiscal year.11 For example, if the compensation committee takes action in early 2007 to revise its compensation program based on its review and analysis of 2006 compensation, this action should be included in the CD&A discussing 2006 compensation. For context, discussion of prior years should also be provided, and information about post-termination compensation and ongoing compensation arrangements that will apply in the future may also be required to the extent material.12
The new rules provide a list of fifteen nonexclusive examples of the kind of information that may be considered material and should be addressed in the CD&A. However, the Adopting Release and the instructions to Item 402 of Regulation S-K stress thatthe CD&A should reflect each company's individual circumstances. Companies should avoid boilerplate disclosures or disclosures repeating the information that follows the CD&A.13 Each company must discuss the material elements of its compensation policies that it applies regardless of whether it is included in the list of examples.14 Conversely, some of the examples may not be material to a particular company, in which case no disclosure about such element would be required.15 The new rules may require the disclosure of other elements, including policies regarding compensation allocation and structure, the effect of corporate performance on compensation decisions, and other factors that influence compensation decisions, such as stock options, taxes, and other agreements.16
Generally, companies should discuss any performance measures on which incentive compensation is or will be based, including how and why those measures were chosen, why such measures were chosen instead of other measures, and what those performance targets are.17 However, companies are not required to disclose specific target levels with respect to quantitative and qualitative performance-related factors if such disclosure involves confidential trade secrets or confidential commercial or financial information and would result in competitive harm to the company. 18 The Commission may require companies to demonstrate that any undisclosed performance- related factors satisfy such standard. If the Commission determines that the standard has not been satisfied it may require public disclosure of such information.19 Companies that choose not to disclose specific performance-related factors must discuss how difficult it will be for the executive, or how likely it will be for the company, to achieve such undisclosed target levels.20
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Unlike the Compensation Committee Report, the CD&A is considered "soliciting material," and must be filed, not furnished. 21 The CD&A falls under Regulation 14A or 14C, and is subject to the liabilities of Section 18 of the Securities Exchange Act of 1934 ("Exchange Act"), and covered by the certifications provided by the company's CEO and CFO with its annual report filed with the Commission.22
The CD&A must discuss the company's practices regarding option grants, and in particular, the timing and pricing of stock options.23 This requirement is a response to recent revelations that some companies granted, and did not properly disclose or account for, stock options with an exercise price lower than the closing price of the underlying security on the date of the grant, or that these companies otherwise timed option grants to ensure a low exercise or base price. Even absent timing issues such as these, the CD&A should address all equity-based compensation (including restricted stock and other forms of non-option equity awards)24 practices to the extent material, including practices that might develop in the future.
The new rules have substantially modified the Compensation Committee Report. Companies must report whether its compensation committee has reviewed the CD&A with management and, based on such review and discussions, has recommended to the board that the CD&A be included in the company's annual report on Form 10-K and, as applicable, the company's proxy or information statement.25 The Compensacomtion Committee Report is furnished, not filed, and appears over the names of the members of the compensation committee.26 Since small business issuers do not need to include the CD&A, they also do not need to include a compensation committee report.27
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