Clearing Up Executive Compensation

Part One of Two

The U.S. Securities and Exchange Commission (SEC) published its proposal to revamp the rules governing the disclosure of executive and director compensation on Jan. 27, 2006. The proposed rules stand to significantly alter the compensation disclosure requirements applicable to registration statements, proxy statements, annual reports and Form 8-Ks, and are intended to ensure that investors receive disclosure that is 'clearer and more complete.' The regulations are the first attempt at a major overhaul of compensation disclosure since 1992 and were proposed in response to the widespread criticism that the current disclosure requirements do not engender a complete and accurate description of executive pay packages.

The proposal, to adapt the old saying, combines something old, something new and something borrowed.

• What's old: Retaining the tabular approach as the basis for disclosure to categorize information and promote comparability between years and among companies.
• What's new: A new column has been added to the Summary Compensation Table that would provide one figure disclosing total compensation. There are also several required supplemental tables on equity and non-equity incentive compensation, retirement benefits and other defined compensation arrangements, including a required narrative in which issuers must explain and describe the tabular data. Moreover, the proposed rules require enhanced details with respect to payments to executives upon a separation of employment or a change in control and enhanced tabular disclosure of director compensation arrangements.
• What's borrowed:Portions of Item 303 of Regulation S-K, which calls for Management's Discussion and Analysis of Financial Condition and Results. The staff has created a new Compensation, Discussion and Analysis, or CD&A, requirement that would provide a general overview of compensation and a discussion of the data in the tables. In addition, the plain English rules that apply to prospectuses will also apply to compensation disclosure in proxy statements.

Reform Needed; Does This Do It?

In many ways, the proposed rules are overdue. As compensation techniques have evolved ' and often became more complicated ' it has become increasingly difficult for shareholders to obtain a complete and clear understanding of how issuers are paying their executives. As overall pay levels have mounted, the materiality of these issuer decisions has significantly increased. The SEC's proposal is responsive to these concerns and is laudable in its objective to bring transparency and increased comprehension to this important area. However, as is often the case in most broad ranging rulemaking, certain of the proposals result in confusing, overly complicated or duplicative disclosures.

At the heart of the proposed rules is the SEC's credo that behavior, the regulation of which might not be strictly within the scope of U.S. securities laws, can nevertheless be influenced by requiring companies to shine the bright light of disclosure on their practices. The proposed rules will undoubtedly allow the SEC to affect the decision-making process within the boardroom.

The proposal was subject to public comment until April 10, 2006 and remains subject to amendment and final SEC vote. Accordingly, the revisions are not effective for the 2006 proxy season, but will likely become effective for 2007. Issuers may nevertheless wish to be mindful of the proposed rules when preparing their 2006 proxy disclosure to monitor the impact the proposal would have on future disclosure if enacted.

Overview

Broadly, the proposed rules would group executive compensation disclosure into three major categories, each of which calls for its own tables and accompanying narrative disclosure.

First, the proposed rules would require a general overview of all compensation (including perquisites) to certain executive officers whether paid currently or deferred, as well as current earnings and awards under the issuer's benefit plans.

Second, the proposed rules call for disclosure of equity-related holdings obtained from service that can provide future gains, as well as gains realized through vesting or exercise of equity-related awards in the past fiscal year.

The last category would deal with retirement and other post-employment compensation and benefits, including severance and change in control payments.

Compensation Discussion and Analysis

One of the cornerstones of the SEC's proposal is a new disclosure requirement entitled 'Compensation Discussion and Analysis' or CD&A. This requirement would provide for a discussion and analysis of an issuer's compensation policies and the decisions reflected in the data provided in the tables. The CD&A is meant to provide a discussion of both the compensation program as a whole and each of the particular elements.

The SEC proposes requiring issuers to provide a summary and analysis of the goals and objectives behind what they pay executives and the various factors that directors weigh when making compensation decisions, including:

• The objectives of the issuer's compensation program;
• What an issuer's compensation in-tended to reward and not reward;
• The elements of compensation;
• Why the issuer has selected each element of compensation;
• How the issuer has determined the amount of each compensation element; and
• How each element fits into the issuer's compensation objectives.

The SEC's proposal seeks insight into the compensation decision-making process ' how the compensation committee reached its decisions, what factors it considered, how surveys, benchmarking and other tools factored into its analysis, as well as information regarding the pay-for-performance relationship, including the performance metrics used in determining compensation. The proposal provides a non-exclusive list of examples of what the CD&A should contain, but does not mandate the contents of the disclosure.

Several of the factors are quite specific, and therefore fairly simple to address, such as the impact of tax and accounting treatments on a particular form of compensation. Others include:

• Whether the issuer has stock ownership guidelines and attendant policies regarding hedging the risks of such ownership;
• How the timing of equity compensation grants is established;
• How gains from prior equity awards are considered in setting other elements of compensation, such as pension benefits;
• Whether the issuer has engaged in benchmarking of total compensation or any elements thereof, and identifying the benchmark and its components (including component companies); and
• The role of the issuer's executive officers in determining compensation.

However, most of the remaining examples are broad policy questions, such as:

• The factors considered in decisions to increase or decrease compensation materially;
• Specific factors taken into account in setting compensation policies and making compensation decisions;
• Policies for allocating between long-term and current compensation between cash and non-cash compensation and among different forms of non-cash compensation;
• The basis for allocating compensation to each different form of award, such as the relationship of the award to the achievement of the issuer's long term goals, management's exposure to downside risk, and the correlation between the expected costs and benefits to the registrant; and
• How specific forms of compensation are structured to reflect a named executive officer's performance and his individual contribution to the issuer's performance.

As is currently the case, issuers would not be required to disclose target levels of specific performance-related factors or any factors or criteria involving confidential commercial or business information. The CD&A disclosure would replace the current compensation committee report and performance graph and would be 'filed' with the SEC, rather than 'furnished.' As a result, the CD&A will be deemed to be 'soliciting materials' subject to liability under Section 18 of the Securities Exchange Act of 1934, as amended, and will be included in the information 'certified' by the CEO and the CFO in accordance with the Sarbanes-Oxley Act of 2002. In addition, the CD&A will be incorporated into the issuer's registration statements. While the previous obligation to 'furnish' the compensation committee report was meant to encourage more fulsome disclosure, it is the Commi-ssion's view that this approach has not necessarily reached its intended goals for many issuers.

Authors' Analysis: Because the CD&A will now be covered by the CEO and CFO certification requirements, issuers will likely need to prepare this disclosure earlier than has historically been the case in order to ensure that it is vetted through the issuer's internal control procedures.

The Proposing Release reiterates at several points that issuers should avoid boilerplate language in the discussion of compensation policies and decisions. While the SEC's aspirations in this regard are laudable, they may be unrealistic. For example, at least some of the objectives of most issuers' compensation programs are quite similar; they include attracting and retaining highly talented executives, linking pay to performance and aligning the interests of executives with those of shareholders. Descriptions of these goals in the proxy statements of different issuers may very well be expressed in language that displays little variation from one proxy statement to another but the standardization of the language is simply a function of the similarity in objectives among issuers.

More significantly, the SEC's proposals seem to be based on a somewhat simplified understanding of how compensation committees operate in some contexts. In our experience, compensation committees do not necessarily arrive at compensation decisions though a process of syllogistic reasoning. Most compensation committees follow a more synthetic, or holistic, approach: Directors are presented with a wide range of both company-specific and comparative data, they listen to the recommendations of management and independent advisors, they confer among themselves, and then they reach their conclusion. Most committee members would be hard-pressed to explain exactly how they arrived at their final decision; consistent with other board decision-making processes, the compensation process is based on judgment and intuition as much as on logical reasoning. Greater transparency concerning compensation decisions is a worthy goal, but the SEC should not employ the proposed CD&A disclosure to require issuers to graft, for purposes of disclosure, an artificial logical structure onto a decision-making process that relies significantly on judgment and discretion.

Covered Persons

Issuers are currently required to provide compensation disclosure with respect to their named executive officers (NEOs), presently defined as the principal executive officer and the four other most highly compensated executive officers for the relevant fiscal year, and up to two additional individuals for whom disclosure would have been provided but for the fact that the individual was not an executive officer at year end. Under the proposed rules, disclosures will remain limited to five individuals, but the issuer's principal financial officer will be required to be included as an NEO without regard to such individual's compensation level. Additionally, the designation of the most highly compensated officers will be made on the basis of the individual's total compensation rather than just salary and bonus as is presently the case, as the SEC feels that using only salary and bonus could lead to potential manipulation of the persons in the table by moving compensation to another component of pay. Moreover, although currently companies can generally exclude compensation that is 'non-recurring and unlikely to continue' for purposes of determining the identity of the NEOs, the proposed rules significantly limit this ability.

In addition, an issuer will also be required to provide a total compensation figure and job description (but not the names) for up to three other employees who would have been on the table but for the fact that they are not executive officers.

Authors' Analysis: The addition of three non-officer employees to the disclosure regime, coupled with the fact that determinations of covered persons will be made on the basis of total compensation and not just base salary and bonus, will add new burdens on issuers to track a greater number of employees' compensation and a greater amount of data to ensure compliance.

We believe the SEC's proposal, in this regard, is misguided for a number of reasons. The SEC justifies its proposal by citing the interest of shareholders in 'information about the use of corporate assets to compensate extremely highly paid employees.' Shareholders have the same interest, however, in the use of corporate assets of commensurable amount for any purpose, and there is no reason to single out the use of assets for compensatory purposes for special disclosure requirements. The burden of the proposal, moreover, is likely to fall on those industries such as investment banking, entertainment and media where certain star performers are, at least in some years, compensated at very high levels. While there may be an understandable voyeuristic interest in finding out that a bond trader at a major investment bank earned several million dollars more than the CEO in a given year, we question whether this is meaningful disclosure that bears on a shareholder's judgment of whether the bank is well managed. In addition, the potential for conflicts of interest that underlie the disclosure requirements for compensation of executive officers is less present in the compensation of top performers.

Finally, the SEC's proposal will likely result in the requirement that former executives who receive large severance packages be included in the tables. The current rules which only require salary and bonus to be included in determining the NEOs often permitted issuers to exclude executives who left mid-year through the design of the severance packages.

Part I: Current Compensation

The Summary Compensation Table would remain the centerpiece for the disclosure of executive compensation, but with some important revisions. The proposed rules would require issuers to disclose in the first column a single total annual compensation figure for each NEO, which would represent the aggregate of the amounts set forth in the remaining columns of the table.

Authors' Analysis: While the total compensation figure may be useful to shareholders, there is a risk that it will not correspond to the actual value received by the NEOs for the relevant fiscal year, as certain of the building blocks for this figure will only be as good as their underlying assumptions. Additionally, certain of the amounts that will be disclosed are subject to forfeiture or could become less valuable or of no value (for instance, due to failure to meet performance goals) and never actually received by the executive. Finally, certain of the perquisite disclosures will be based on values different from those used for tax purposes, and potentially are not includible in income. Accordingly, it is likely that the total compensation figure will not accurately reflect amounts received by executives, and in many cases, will inflate the amount.

Base salary and bonus compensation would appear as the next two columns. If an NEO elected to receive all or a portion of his or her salary or bonus in non-cash payments, the aggregate amounts would be reduced and added to the appropriate column or table. Deferred compensation would continue to be disclosed in the current salary or bonus tables. The fourth and fifth columns would set forth the dollar value of all stock awards, other than for options and the dollar value of stock options, SARs or similar instruments, respectively. These two columns would reflect the full grant date fair value computed in accordance with Statement of Financial Accounting Standards 123(R) (SFAS 123(R)), without regard to subsequent vesting criteria and assumptions regarding the expected life of awards, as is the case for purposes of the issuer's financial statements. Thus, the table would include the full value of the awards, not merely the portion recognized as an expense during the year regardless of whether any awards are later cancelled or any value is actually received by the executive. The full value of any options that were re-priced during the year (including options that were materially modified for purposes of the accounting rules) would need to be included in the option column as well, and as a result the SEC is also proposing to eliminate the currently required report on option re-pricings within the prior 10 years. Issuers would be required to cross-reference their financial statements to highlight the assumptions used in the calculation of these amounts.

The sixth column would set forth the dollar value of amounts earned during the relevant fiscal year under non-stock incentive plans and earnings on those amounts. These amounts would be included in the year that the relevant performance criteria have been met and the compensation earned, whether or not payment is made in that year (for example if the award is subject to further service-based vesting or delayed payment). This column would replace the current Long-Term Incentive Plan Payouts column.

The SEC has stated its view that all compensation, to the extent not specifically called for in any of the other columns, should be disclosed under the final column captioned 'All Other Compensation.' This would include increases in the actuarial value of pension benefits during the year; issuer contributions to and earnings on deferred compensation; tax gross-ups, even on perquisites that are exempt from disclosure; interest and dividends on outstanding equity awards; amounts paid or accrued in connection with a termination or a change in control; and perquisites and other personal benefits.

Authors' Analysis: Given the complexity of the required calculations it will become more difficult for many issuers to prepare their proxy statements in-house without the assistance of actuaries or other valuation experts.

The disclosure of perquisites has attracted significant attention over the past few years, as many investors believe that significant portions of compensation to executives can be hidden through perquisites that are not readily ascertainable from public sources. Under the proposal, perquisites must be disclosed in the 'All Other Compensation' column of the Summary Compensation Table, unless the aggregate value to an NEO of all perquisites is less than $10,000 annually. The proposal also requires footnote disclosure identifying all perquisites provided to an NEO, including the value of any individual perquisite that is in excess of $25,000 or 10% of all perquisites paid to the NEO. Currently, disclosure is only required if the aggregate value of all perquisites paid to an NEO exceeds the lesser of $50,000 or 10% of the executive's combined salary and bonus. This will undoubtedly generate a significant increase in the amount of perquisites disclosed and add to the administrative burdens on registrants to track those payments.

The proposed regulations also provide guidance as to how issuers should analyze whether an item must be disclosed as a perquisite. The SEC did not provide a bright-line test for issuers in undertaking their analysis, but noted the following:

• An item will be deemed a perquisite if it confers a 'direct or indirect benefit that has a personal aspect.' This is true even if the benefit is provided for a business reason or for the convenience of the company unless the perquisite is provided on a non-discriminatory basis to all employees. Examples of perquisites include
  personal use of company-owned property or vehicles, personal secretary use, club memberships and home security.
• An item is not a perquisite if it is 'integrally and directly related to the performance of the executive's duties.' This includes security services during business travel, club memberships if only used for business purposes and business-only expense accounts.

For purposes of disclosure, the SEC's proposal notes that the proper measure of value of a perquisite is the aggregate 'incremental cost' to the issuer of providing the benefit ' not the amount attributable for tax purposes. As a result, the use of the Standard Industry Fare Level would not be an appropriate measure for disclosing the cost of personal aircraft use.

The Summary Compensation Table would be supplemented by two tables reporting on the grants of performance-based awards and equity-based compensation awards, respectively. The first table would set forth details of incentive plan awards if they have a performance condition or market condition as defined in SFAS 123(R). The second supplemental table would show details of equity awards under which future value or payment is based on the price of the issuer's stock rather than performance criteria.

In Part Two, coming in next month's issue, the authors examine the proposal's impact on outstanding equity interests, post-employment payments and benefits, deferred and director compensation and corporate governance, among other areas.

Part One of Two

The U.S. Securities and Exchange Commission (SEC) published its proposal to revamp the rules governing the disclosure of executive and director compensation on Jan. 27, 2006. The proposed rules stand to significantly alter the compensation disclosure requirements applicable to registration statements, proxy statements, annual reports and Form 8-Ks, and are intended to ensure that investors receive disclosure that is 'clearer and more complete.' The regulations are the first attempt at a major overhaul of compensation disclosure since 1992 and were proposed in response to the widespread criticism that the current disclosure requirements do not engender a complete and accurate description of executive pay packages.

The proposal, to adapt the old saying, combines something old, something new and something borrowed.

• What's old: Retaining the tabular approach as the basis for disclosure to categorize information and promote comparability between years and among companies.
• What's new: A new column has been added to the Summary Compensation Table that would provide one figure disclosing total compensation. There are also several required supplemental tables on equity and non-equity incentive compensation, retirement benefits and other defined compensation arrangements, including a required narrative in which issuers must explain and describe the tabular data. Moreover, the proposed rules require enhanced details with respect to payments to executives upon a separation of employment or a change in control and enhanced tabular disclosure of director compensation arrangements.
• What's borrowed:Portions of Item 303 of Regulation S-K, which calls for Management's Discussion and Analysis of Financial Condition and Results. The staff has created a new Compensation, Discussion and Analysis, or CD&A, requirement that would provide a general overview of compensation and a discussion of the data in the tables. In addition, the plain English rules that apply to prospectuses will also apply to compensation disclosure in proxy statements.

Reform Needed; Does This Do It?

In many ways, the proposed rules are overdue. As compensation techniques have evolved ' and often became more complicated ' it has become increasingly difficult for shareholders to obtain a complete and clear understanding of how issuers are paying their executives. As overall pay levels have mounted, the materiality of these issuer decisions has significantly increased. The SEC's proposal is responsive to these concerns and is laudable in its objective to bring transparency and increased comprehension to this important area. However, as is often the case in most broad ranging rulemaking, certain of the proposals result in confusing, overly complicated or duplicative disclosures.

At the heart of the proposed rules is the SEC's credo that behavior, the regulation of which might not be strictly within the scope of U.S. securities laws, can nevertheless be influenced by requiring companies to shine the bright light of disclosure on their practices. The proposed rules will undoubtedly allow the SEC to affect the decision-making process within the boardroom.

The proposal was subject to public comment until April 10, 2006 and remains subject to amendment and final SEC vote. Accordingly, the revisions are not effective for the 2006 proxy season, but will likely become effective for 2007. Issuers may nevertheless wish to be mindful of the proposed rules when preparing their 2006 proxy disclosure to monitor the impact the proposal would have on future disclosure if enacted.

Overview

Broadly, the proposed rules would group executive compensation disclosure into three major categories, each of which calls for its own tables and accompanying narrative disclosure.

First, the proposed rules would require a general overview of all compensation (including perquisites) to certain executive officers whether paid currently or deferred, as well as current earnings and awards under the issuer's benefit plans.

Second, the proposed rules call for disclosure of equity-related holdings obtained from service that can provide future gains, as well as gains realized through vesting or exercise of equity-related awards in the past fiscal year.

The last category would deal with retirement and other post-employment compensation and benefits, including severance and change in control payments.

Compensation Discussion and Analysis

One of the cornerstones of the SEC's proposal is a new disclosure requirement entitled 'Compensation Discussion and Analysis' or CD&A. This requirement would provide for a discussion and analysis of an issuer's compensation policies and the decisions reflected in the data provided in the tables. The CD&A is meant to provide a discussion of both the compensation program as a whole and each of the particular elements.

The SEC proposes requiring issuers to provide a summary and analysis of the goals and objectives behind what they pay executives and the various factors that directors weigh when making compensation decisions, including:

• The objectives of the issuer's compensation program;
• What an issuer's compensation in-tended to reward and not reward;
• The elements of compensation;
• Why the issuer has selected each element of compensation;
• How the issuer has determined the amount of each compensation element; and
• How each element fits into the issuer's compensation objectives.

The SEC's proposal seeks insight into the compensation decision-making process ' how the compensation committee reached its decisions, what factors it considered, how surveys, benchmarking and other tools factored into its analysis, as well as information regarding the pay-for-performance relationship, including the performance metrics used in determining compensation. The proposal provides a non-exclusive list of examples of what the CD&A should contain, but does not mandate the contents of the disclosure.

Several of the factors are quite specific, and therefore fairly simple to address, such as the impact of tax and accounting treatments on a particular form of compensation. Others include:

• Whether the issuer has stock ownership guidelines and attendant policies regarding hedging the risks of such ownership;
• How the timing of equity compensation grants is established;
• How gains from prior equity awards are considered in setting other elements of compensation, such as pension benefits;
• Whether the issuer has engaged in benchmarking of total compensation or any elements thereof, and identifying the benchmark and its components (including component companies); and
• The role of the issuer's executive officers in determining compensation.

However, most of the remaining examples are broad policy questions, such as:

• The factors considered in decisions to increase or decrease compensation materially;
• Specific factors taken into account in setting compensation policies and making compensation decisions;
• Policies for allocating between long-term and current compensation between cash and non-cash compensation and among different forms of non-cash compensation;
• The basis for allocating compensation to each different form of award, such as the relationship of the award to the achievement of the issuer's long term goals, management's exposure to downside risk, and the correlation between the expected costs and benefits to the registrant; and
• How specific forms of compensation are structured to reflect a named executive officer's performance and his individual contribution to the issuer's performance.

As is currently the case, issuers would not be required to disclose target levels of specific performance-related factors or any factors or criteria involving confidential commercial or business information. The CD&A disclosure would replace the current compensation committee report and performance graph and would be 'filed' with the SEC, rather than 'furnished.' As a result, the CD&A will be deemed to be 'soliciting materials' subject to liability under Section 18 of the Securities Exchange Act of 1934, as amended, and will be included in the information 'certified' by the CEO and the CFO in accordance with the Sarbanes-Oxley Act of 2002. In addition, the CD&A will be incorporated into the issuer's registration statements. While the previous obligation to 'furnish' the compensation committee report was meant to encourage more fulsome disclosure, it is the Commi-ssion's view that this approach has not necessarily reached its intended goals for many issuers.

Authors' Analysis: Because the CD&A will now be covered by the CEO and CFO certification requirements, issuers will likely need to prepare this disclosure earlier than has historically been the case in order to ensure that it is vetted through the issuer's internal control procedures.

The Proposing Release reiterates at several points that issuers should avoid boilerplate language in the discussion of compensation policies and decisions. While the SEC's aspirations in this regard are laudable, they may be unrealistic. For example, at least some of the objectives of most issuers' compensation programs are quite similar; they include attracting and retaining highly talented executives, linking pay to performance and aligning the interests of executives with those of shareholders. Descriptions of these goals in the proxy statements of different issuers may very well be expressed in language that displays little variation from one proxy statement to another but the standardization of the language is simply a function of the similarity in objectives among issuers.

More significantly, the SEC's proposals seem to be based on a somewhat simplified understanding of how compensation committees operate in some contexts. In our experience, compensation committees do not necessarily arrive at compensation decisions though a process of syllogistic reasoning. Most compensation committees follow a more synthetic, or holistic, approach: Directors are presented with a wide range of both company-specific and comparative data, they listen to the recommendations of management and independent advisors, they confer among themselves, and then they reach their conclusion. Most committee members would be hard-pressed to explain exactly how they arrived at their final decision; consistent with other board decision-making processes, the compensation process is based on judgment and intuition as much as on logical reasoning. Greater transparency concerning compensation decisions is a worthy goal, but the SEC should not employ the proposed CD&A disclosure to require issuers to graft, for purposes of disclosure, an artificial logical structure onto a decision-making process that relies significantly on judgment and discretion.

Covered Persons

Issuers are currently required to provide compensation disclosure with respect to their named executive officers (NEOs), presently defined as the principal executive officer and the four other most highly compensated executive officers for the relevant fiscal year, and up to two additional individuals for whom disclosure would have been provided but for the fact that the individual was not an executive officer at year end. Under the proposed rules, disclosures will remain limited to five individuals, but the issuer's principal financial officer will be required to be included as an NEO without regard to such individual's compensation level. Additionally, the designation of the most highly compensated officers will be made on the basis of the individual's total compensation rather than just salary and bonus as is presently the case, as the SEC feels that using only salary and bonus could lead to potential manipulation of the persons in the table by moving compensation to another component of pay. Moreover, although currently companies can generally exclude compensation that is 'non-recurring and unlikely to continue' for purposes of determining the identity of the NEOs, the proposed rules significantly limit this ability.

In addition, an issuer will also be required to provide a total compensation figure and job description (but not the names) for up to three other employees who would have been on the table but for the fact that they are not executive officers.

Authors' Analysis: The addition of three non-officer employees to the disclosure regime, coupled with the fact that determinations of covered persons will be made on the basis of total compensation and not just base salary and bonus, will add new burdens on issuers to track a greater number of employees' compensation and a greater amount of data to ensure compliance.

We believe the SEC's proposal, in this regard, is misguided for a number of reasons. The SEC justifies its proposal by citing the interest of shareholders in 'information about the use of corporate assets to compensate extremely highly paid employees.' Shareholders have the same interest, however, in the use of corporate assets of commensurable amount for any purpose, and there is no reason to single out the use of assets for compensatory purposes for special disclosure requirements. The burden of the proposal, moreover, is likely to fall on those industries such as investment banking, entertainment and media where certain star performers are, at least in some years, compensated at very high levels. While there may be an understandable voyeuristic interest in finding out that a bond trader at a major investment bank earned several million dollars more than the CEO in a given year, we question whether this is meaningful disclosure that bears on a shareholder's judgment of whether the bank is well managed. In addition, the potential for conflicts of interest that underlie the disclosure requirements for compensation of executive officers is less present in the compensation of top performers.

Finally, the SEC's proposal will likely result in the requirement that former executives who receive large severance packages be included in the tables. The current rules which only require salary and bonus to be included in determining the NEOs often permitted issuers to exclude executives who left mid-year through the design of the severance packages.

Part I: Current Compensation

The Summary Compensation Table would remain the centerpiece for the disclosure of executive compensation, but with some important revisions. The proposed rules would require issuers to disclose in the first column a single total annual compensation figure for each NEO, which would represent the aggregate of the amounts set forth in the remaining columns of the table.

Authors' Analysis: While the total compensation figure may be useful to shareholders, there is a risk that it will not correspond to the actual value received by the NEOs for the relevant fiscal year, as certain of the building blocks for this figure will only be as good as their underlying assumptions. Additionally, certain of the amounts that will be disclosed are subject to forfeiture or could become less valuable or of no value (for instance, due to failure to meet performance goals) and never actually received by the executive. Finally, certain of the perquisite disclosures will be based on values different from those used for tax purposes, and potentially are not includible in income. Accordingly, it is likely that the total compensation figure will not accurately reflect amounts received by executives, and in many cases, will inflate the amount.

Base salary and bonus compensation would appear as the next two columns. If an NEO elected to receive all or a portion of his or her salary or bonus in non-cash payments, the aggregate amounts would be reduced and added to the appropriate column or table. Deferred compensation would continue to be disclosed in the current salary or bonus tables. The fourth and fifth columns would set forth the dollar value of all stock awards, other than for options and the dollar value of stock options, SARs or similar instruments, respectively. These two columns would reflect the full grant date fair value computed in accordance with Statement of Financial Accounting Standards 123(R) (SFAS 123(R)), without regard to subsequent vesting criteria and assumptions regarding the expected life of awards, as is the case for purposes of the issuer's financial statements. Thus, the table would include the full value of the awards, not merely the portion recognized as an expense during the year regardless of whether any awards are later cancelled or any value is actually received by the executive. The full value of any options that were re-priced during the year (including options that were materially modified for purposes of the accounting rules) would need to be included in the option column as well, and as a result the SEC is also proposing to eliminate the currently required report on option re-pricings within the prior 10 years. Issuers would be required to cross-reference their financial statements to highlight the assumptions used in the calculation of these amounts.

The sixth column would set forth the dollar value of amounts earned during the relevant fiscal year under non-stock incentive plans and earnings on those amounts. These amounts would be included in the year that the relevant performance criteria have been met and the compensation earned, whether or not payment is made in that year (for example if the award is subject to further service-based vesting or delayed payment). This column would replace the current Long-Term Incentive Plan Payouts column.

The SEC has stated its view that all compensation, to the extent not specifically called for in any of the other columns, should be disclosed under the final column captioned 'All Other Compensation.' This would include increases in the actuarial value of pension benefits during the year; issuer contributions to and earnings on deferred compensation; tax gross-ups, even on perquisites that are exempt from disclosure; interest and dividends on outstanding equity awards; amounts paid or accrued in connection with a termination or a change in control; and perquisites and other personal benefits.

Authors' Analysis: Given the complexity of the required calculations it will become more difficult for many issuers to prepare their proxy statements in-house without the assistance of actuaries or other valuation experts.

The disclosure of perquisites has attracted significant attention over the past few years, as many investors believe that significant portions of compensation to executives can be hidden through perquisites that are not readily ascertainable from public sources. Under the proposal, perquisites must be disclosed in the 'All Other Compensation' column of the Summary Compensation Table, unless the aggregate value to an NEO of all perquisites is less than $10,000 annually. The proposal also requires footnote disclosure identifying all perquisites provided to an NEO, including the value of any individual perquisite that is in excess of $25,000 or 10% of all perquisites paid to the NEO. Currently, disclosure is only required if the aggregate value of all perquisites paid to an NEO exceeds the lesser of $50,000 or 10% of the executive's combined salary and bonus. This will undoubtedly generate a significant increase in the amount of perquisites disclosed and add to the administrative burdens on registrants to track those payments.

The proposed regulations also provide guidance as to how issuers should analyze whether an item must be disclosed as a perquisite. The SEC did not provide a bright-line test for issuers in undertaking their analysis, but noted the following:

• An item will be deemed a perquisite if it confers a 'direct or indirect benefit that has a personal aspect.' This is true even if the benefit is provided for a business reason or for the convenience of the company unless the perquisite is provided on a non-discriminatory basis to all employees. Examples of perquisites include
  personal use of company-owned property or vehicles, personal secretary use, club memberships and home security.
• An item is not a perquisite if it is 'integrally and directly related to the performance of the executive's duties.' This includes security services during business travel, club memberships if only used for business purposes and business-only expense accounts.

For purposes of disclosure, the SEC's proposal notes that the proper measure of value of a perquisite is the aggregate 'incremental cost' to the issuer of providing the benefit ' not the amount attributable for tax purposes. As a result, the use of the Standard Industry Fare Level would not be an appropriate measure for disclosing the cost of personal aircraft use.

The Summary Compensation Table would be supplemented by two tables reporting on the grants of performance-based awards and equity-based compensation awards, respectively. The first table would set forth details of incentive plan awards if they have a performance condition or market condition as defined in SFAS 123(R). The second supplemental table would show details of equity awards under which future value or payment is based on the price of the issuer's stock rather than performance criteria.

In Part Two, coming in next month's issue, the authors examine the proposal's impact on outstanding equity interests, post-employment payments and benefits, deferred and director compensation and corporate governance, among other areas.