Clearing Up Executive Compensation

[Editor's Note: In Part One, the authors summarized the SEC's proposal to revamp the rules governing the disclosure of executive and director compensation. They focused on the proposal's treatment of current compensation. Part Two picks up with a look at outstanding equity interests, covers post-employment and other types of compensation and benefits, and also discusses other effects of the proposal on corporate counsel.]

Part II: Outstanding Equity Interests

The proposed rules would require enhanced disclosure of executive equity award holdings, including numbers and values of options, restricted stock and restricted stock units held by named executive officers (NEOs). Outstanding equity interests held by NEOs would be presented in two tables. The first table would detail outstanding equity awards held by each NEO at year end (together with market-based values) and the second table would disclose the amount realized by each NEO due to the vesting or exercise of equity compensation during the year. For comparative purposes and to address the risk of double counting, the grant date value previously disclosed in the summary compensation table will be repeated in the second table.

Part III: Post-Employment Payments and Benefits

Severance and Change in Control

The Commission's proposal requires issuers to describe the specific
circumstances that trigger the payment of severance or other benefits and to quantify the payments, benefits and perquisites that would be made to NEOs upon a termination of employment or a change in control, including:

• Severance payments due and payment terms under various termination circumstances;
• Post-termination perquisites;
• Accelerated vesting and payout of equity compensation awards; and
• Tax gross-up payments (eg, with res-pect to Sections 280G and 409A of the Internal Revenue Code).

Authors' Analysis: This is a significant change from the current rules, which only require issuers to provide a brief narrative description of compensation and benefits payable in such events. Given the difficulty in calculating certain amounts (such as the value of equity acceleration and tax gross-ups) and the need for multiple calculations to cover varying termination scenarios, this requirement may create a significant burden for issuers (including significant administrative costs) and could result in overstated and confusing disclosure.

Moreover, the generated amounts will only be as accurate as their underlying assumptions. Some of these ' such as the likelihood of an executive being terminated following a future change in control ' are so speculative that the amounts required to be disclosed seem unlikely to be an accurate predictor of future payment obligations.

Finally, the new deferred compensation rules under Section 409A of the Internal Revenue Code limit an issuer's ability to provide post-termination benefits to executives. As a result, issuers are more likely to curtail post-termination benefits in favor of one-time cash payments and the need for such disclosure will be reduced.

Retirement Benefits

The current pension benefits table would be replaced by a new 'retirement plan potential annual payments and benefits table' that would require issuers to disclose in tabular format the details of all defined benefit retirement benefits to be paid to NEOs, including a plan-by-plan statement of the amount each executive would receive in potential annual payments and benefits and the annual increase in the value of an executive's retirement benefits, determined on an actuarial basis. The calculations must address payments at normal retirement and, if applicable, early retirement. Narrative disclosure of the factors necessary to understand the information in the tables is also required, including the benefit formula and the included elements of compensation, eligibility standards and the policy with respect to granting credit for years of service in excess of actual service.

Currently, issuers are required to provide either of the following:

• If retirement benefits are determined under a defined benefit pension plan under which benefits are primarily determined by final compensation, a pension plan table that sets forth the estimated annual benefits payable upon retirement based on final compensation and years of service; or
• Narrative disclosure with respect to other retirement compensation plans and the estimated benefits paid upon normal retirement.

Authors' Analysis: The information required by the Commission's proposal is extremely technical and detailed. Numerous actuarial assumptions will be required to prepare the retirement benefits table and the information will likely be difficult for the shareholders to digest. The Commission will likely provide further guidance on how to select the assumptions.

Defined Contribution Plans and
Other Deferred Compensation

Under the proposed rules, issuers will be required to prepare a new table setting forth:

• The amount of cash and equity compensation contributed or deferred by an executive during the year;
• The amount of issuer contributions to defined contributions and deferred compensation arrangements on behalf of executives;
• Earnings and withdrawals made during the applicable year; and
• The executive's balance at year-end.

Again, in an effort to avoid duplicate reporting of benefits, a footnote would specify amounts previously reported in the Summary Compensation Table in both the applicable year and prior years. Currently, issuers must disclose amounts that are deferred by NEOs in the applicable year and any 'preferential or above market interest or dividends' paid or credited during the applicable year, but are not required to disclose interest or dividends credited or paid at market rates (eg, from third-party investment vehicles such as mutual funds).

Authors' Analysis: The Commission's proposals on deferred compensation are a positive development. Currently, shareholders do not have any reliable way to ascertain the aggregate deferred obligations that an issuer has to its executives. Moreover, until recently, many compensation committees may not have consistently tracked this information. The Commission's proposal will help reinforce evolving 'best practices' of ensuring that compensation committees have an understanding of the full magnitude of the issuer's compensation obligations, and that shareholders have access to the same information.

Director Compensation

The proposal would also require disclosure of non-employee director compensation for the past fiscal year in tabular format similar to the Summary Compensation Table. The table will include a total compensation figure, comprising:

• Cash fees;
• Stock award values;
• Option values;
• Non-stock incentive compensation; and
• All other compensation, including perquisites, tax reimbursements, charitable award programs and consulting fees.

Disclosure would be required on an individual director basis and would require a narrative explanation of benefits. The Commission's proposal will require issuers to pay closer attention to the disclosure of perquisites and other non-cash director compensation (including benefits provided to family members) that have historically varied significantly among issuers and were often ignored.

Modifications to Compensation Disclosure on Form 8-K

The Commission amended its Form 8-K requirements in 2004, resulting in a major increase in the number of current reports filed regarding executive compensation. Under the current rules, issuers must file a Form 8-K within 4 business days of entering into or materially amending an employment or other compensation arrangement with an NEO or, unless immaterial in amount or significance, any other executive officer. The 8-K rules have led to a significant increase in the number and amount of real-time executive compensation disclosure outside of the annual meeting proxy.

The proposed rules attempt to find a better balance between current and annual compensation disclosure by placing limitations on the required Form 8-K disclosure requirements. The modifications are effected by restructuring Form 8-K to provide all current compensation-related disclosure under Item 5.02 of Form 8-K, as opposed to the current split between Items 1.01 and 5.02. Under the proposed rules, disclosure will only be required with respect to the individuals who were NEOs for the prior fiscal year and the issuer's principal executive officer, president, principal financial officer and principal operating officer (the Specified Officers). The events that trigger disclosure include:

• The retirement, termination or resignation of a Specified Officer;
• The appointment of a Specified Officer, including the entering into material plan, contract or arrangement in connection with the appointment;
• The entering into, amending or modifying a material compensation arrangement in which a Specified Employee participates or the grant of an award thereunder to a Specified Employee; and
• The availability of information regarding salary and bonuses for the most recent fiscal year that was not available for disclosure in the proxy statement.

Disclosure upon one of the triggering events must include a brief description of the event and the applicable plan, program or arrangement.

Clarification of Rules for Foreign Private Issuers

The Commission's proposal does not significantly modify the executive compensation rules applicable to foreign private issuers but does clarify that foreign private issuers are not required to file employment agreements as exhibits to their Forms 20-F unless they are obligated to do so under applicable local laws.

Authors' Analysis: The Commission's cautious approach with respect to foreign private issuers will further widen the gap between what the Commission rules require of domestic companies and what they require of foreign private issuers. In the wake of the Sarbanes-Oxley Act and the rule changes initiated in recent years by various stock exchanges, numerous foreign private issuers have already decided to abandon their listings on U.S. exchanges in favor of European or Asian markets. Adding additional disclosure burdens relating to executive compensation could well have the effect of accelerating this trend.

Related Party Transactions

Proposed Item 404(a) would re-vise the disclosure of 'related party transactions' by requiring disclosure of existing or currently proposed transactions in which: 1) the issuer participated; 2) the amount involved was in excess of $120,000; and 3) a 'related person' had or will have a direct or indirect material interest with certain exceptions. The current dollar threshold is $60,000. Moreover, the proposal clarifies the position that the $120,000 threshold is not itself a materiality standard, but actually requires a materiality analysis for transactions above the threshold. In addition, the proposal calls for a description of the registrant's policies for review or approval of reportable transactions and of instances where the policies were not followed.

Authors' Analysis: There is an exception under the Commission's proposal that allows for the exclusion of related party transactions if certain requirements are met. As the proposal does not include a bright-line test, it could increase the administrative burdens on issuers to determine and monitor related party transactions.

Disclosure of Pledged Securities

New footnote disclosure would be required to the management beneficial ownership table setting forth the number of shares pledged as security by the NEOs, directors, nominees and directors and officers as a group. The Commission's proposal provides that information regarding pledges, which are often akin to an actual sale of shares, could be material to shareholders because of their potential to influence management decisions.

Corporate Governance

The Commission has proposed a new Item 407 to Regulation S-K that would require disclosure regarding whether each director or nominee is independent under applicable stock exchange listing standards, a description of any relationships not otherwise disclosed that were considered when determining whether each director or nominee is independent, and disclosure of any audit, nominating and compensation committee member who is not independent. Item 407 would also require a narrative description of the compensation committee's procedures for determining executive and director compensation, including the scope of the committee's authority and its ability to delegate.

Conclusion

On the whole, the Commission should be applauded for the proposed revisions to the executive compensation disclosure requirements for promoting transparency and attempting to address perceived past abuses. However, the question of whether disclosure quality and comparability among issuers resulting from certain of the proposed changes will be worth the increased expenses and administrative burdens remains to be seen. The encroachment of the Commission into areas that arguably have long been reserved to the states may result in a substantive shift in the development of executive compensation.

The impact of the Commission's proposal is already being felt inside boardrooms. In making decisions for compensating executives in 2006, boards of directors are well advised to consider the way such decisions will be reflected in their 2007 proxy statements. It is safe to assume that many, if not most, of the Commission's proposals will be adopted and effective in the near term.

[Editor's Note: In Part One, the authors summarized the SEC's proposal to revamp the rules governing the disclosure of executive and director compensation. They focused on the proposal's treatment of current compensation. Part Two picks up with a look at outstanding equity interests, covers post-employment and other types of compensation and benefits, and also discusses other effects of the proposal on corporate counsel.]

Part II: Outstanding Equity Interests

The proposed rules would require enhanced disclosure of executive equity award holdings, including numbers and values of options, restricted stock and restricted stock units held by named executive officers (NEOs). Outstanding equity interests held by NEOs would be presented in two tables. The first table would detail outstanding equity awards held by each NEO at year end (together with market-based values) and the second table would disclose the amount realized by each NEO due to the vesting or exercise of equity compensation during the year. For comparative purposes and to address the risk of double counting, the grant date value previously disclosed in the summary compensation table will be repeated in the second table.

Part III: Post-Employment Payments and Benefits

Severance and Change in Control

The Commission's proposal requires issuers to describe the specific
circumstances that trigger the payment of severance or other benefits and to quantify the payments, benefits and perquisites that would be made to NEOs upon a termination of employment or a change in control, including:

• Severance payments due and payment terms under various termination circumstances;
• Post-termination perquisites;
• Accelerated vesting and payout of equity compensation awards; and
• Tax gross-up payments (eg, with res-pect to Sections 280G and 409A of the Internal Revenue Code).

Authors' Analysis: This is a significant change from the current rules, which only require issuers to provide a brief narrative description of compensation and benefits payable in such events. Given the difficulty in calculating certain amounts (such as the value of equity acceleration and tax gross-ups) and the need for multiple calculations to cover varying termination scenarios, this requirement may create a significant burden for issuers (including significant administrative costs) and could result in overstated and confusing disclosure.

Moreover, the generated amounts will only be as accurate as their underlying assumptions. Some of these ' such as the likelihood of an executive being terminated following a future change in control ' are so speculative that the amounts required to be disclosed seem unlikely to be an accurate predictor of future payment obligations.

Finally, the new deferred compensation rules under Section 409A of the Internal Revenue Code limit an issuer's ability to provide post-termination benefits to executives. As a result, issuers are more likely to curtail post-termination benefits in favor of one-time cash payments and the need for such disclosure will be reduced.

Retirement Benefits

The current pension benefits table would be replaced by a new 'retirement plan potential annual payments and benefits table' that would require issuers to disclose in tabular format the details of all defined benefit retirement benefits to be paid to NEOs, including a plan-by-plan statement of the amount each executive would receive in potential annual payments and benefits and the annual increase in the value of an executive's retirement benefits, determined on an actuarial basis. The calculations must address payments at normal retirement and, if applicable, early retirement. Narrative disclosure of the factors necessary to understand the information in the tables is also required, including the benefit formula and the included elements of compensation, eligibility standards and the policy with respect to granting credit for years of service in excess of actual service.

Currently, issuers are required to provide either of the following:

• If retirement benefits are determined under a defined benefit pension plan under which benefits are primarily determined by final compensation, a pension plan table that sets forth the estimated annual benefits payable upon retirement based on final compensation and years of service; or
• Narrative disclosure with respect to other retirement compensation plans and the estimated benefits paid upon normal retirement.

Authors' Analysis: The information required by the Commission's proposal is extremely technical and detailed. Numerous actuarial assumptions will be required to prepare the retirement benefits table and the information will likely be difficult for the shareholders to digest. The Commission will likely provide further guidance on how to select the assumptions.

Defined Contribution Plans and
Other Deferred Compensation

Under the proposed rules, issuers will be required to prepare a new table setting forth:

• The amount of cash and equity compensation contributed or deferred by an executive during the year;
• The amount of issuer contributions to defined contributions and deferred compensation arrangements on behalf of executives;
• Earnings and withdrawals made during the applicable year; and
• The executive's balance at year-end.

Again, in an effort to avoid duplicate reporting of benefits, a footnote would specify amounts previously reported in the Summary Compensation Table in both the applicable year and prior years. Currently, issuers must disclose amounts that are deferred by NEOs in the applicable year and any 'preferential or above market interest or dividends' paid or credited during the applicable year, but are not required to disclose interest or dividends credited or paid at market rates (eg, from third-party investment vehicles such as mutual funds).

Authors' Analysis: The Commission's proposals on deferred compensation are a positive development. Currently, shareholders do not have any reliable way to ascertain the aggregate deferred obligations that an issuer has to its executives. Moreover, until recently, many compensation committees may not have consistently tracked this information. The Commission's proposal will help reinforce evolving 'best practices' of ensuring that compensation committees have an understanding of the full magnitude of the issuer's compensation obligations, and that shareholders have access to the same information.

Director Compensation

The proposal would also require disclosure of non-employee director compensation for the past fiscal year in tabular format similar to the Summary Compensation Table. The table will include a total compensation figure, comprising:

• Cash fees;
• Stock award values;
• Option values;
• Non-stock incentive compensation; and
• All other compensation, including perquisites, tax reimbursements, charitable award programs and consulting fees.

Disclosure would be required on an individual director basis and would require a narrative explanation of benefits. The Commission's proposal will require issuers to pay closer attention to the disclosure of perquisites and other non-cash director compensation (including benefits provided to family members) that have historically varied significantly among issuers and were often ignored.

Modifications to Compensation Disclosure on Form 8-K

The Commission amended its Form 8-K requirements in 2004, resulting in a major increase in the number of current reports filed regarding executive compensation. Under the current rules, issuers must file a Form 8-K within 4 business days of entering into or materially amending an employment or other compensation arrangement with an NEO or, unless immaterial in amount or significance, any other executive officer. The 8-K rules have led to a significant increase in the number and amount of real-time executive compensation disclosure outside of the annual meeting proxy.

The proposed rules attempt to find a better balance between current and annual compensation disclosure by placing limitations on the required Form 8-K disclosure requirements. The modifications are effected by restructuring Form 8-K to provide all current compensation-related disclosure under Item 5.02 of Form 8-K, as opposed to the current split between Items 1.01 and 5.02. Under the proposed rules, disclosure will only be required with respect to the individuals who were NEOs for the prior fiscal year and the issuer's principal executive officer, president, principal financial officer and principal operating officer (the Specified Officers). The events that trigger disclosure include:

• The retirement, termination or resignation of a Specified Officer;
• The appointment of a Specified Officer, including the entering into material plan, contract or arrangement in connection with the appointment;
• The entering into, amending or modifying a material compensation arrangement in which a Specified Employee participates or the grant of an award thereunder to a Specified Employee; and
• The availability of information regarding salary and bonuses for the most recent fiscal year that was not available for disclosure in the proxy statement.

Disclosure upon one of the triggering events must include a brief description of the event and the applicable plan, program or arrangement.

Clarification of Rules for Foreign Private Issuers

The Commission's proposal does not significantly modify the executive compensation rules applicable to foreign private issuers but does clarify that foreign private issuers are not required to file employment agreements as exhibits to their Forms 20-F unless they are obligated to do so under applicable local laws.

Authors' Analysis: The Commission's cautious approach with respect to foreign private issuers will further widen the gap between what the Commission rules require of domestic companies and what they require of foreign private issuers. In the wake of the Sarbanes-Oxley Act and the rule changes initiated in recent years by various stock exchanges, numerous foreign private issuers have already decided to abandon their listings on U.S. exchanges in favor of European or Asian markets. Adding additional disclosure burdens relating to executive compensation could well have the effect of accelerating this trend.

Related Party Transactions

Proposed Item 404(a) would re-vise the disclosure of 'related party transactions' by requiring disclosure of existing or currently proposed transactions in which: 1) the issuer participated; 2) the amount involved was in excess of $120,000; and 3) a 'related person' had or will have a direct or indirect material interest with certain exceptions. The current dollar threshold is $60,000. Moreover, the proposal clarifies the position that the $120,000 threshold is not itself a materiality standard, but actually requires a materiality analysis for transactions above the threshold. In addition, the proposal calls for a description of the registrant's policies for review or approval of reportable transactions and of instances where the policies were not followed.

Authors' Analysis: There is an exception under the Commission's proposal that allows for the exclusion of related party transactions if certain requirements are met. As the proposal does not include a bright-line test, it could increase the administrative burdens on issuers to determine and monitor related party transactions.

Disclosure of Pledged Securities

New footnote disclosure would be required to the management beneficial ownership table setting forth the number of shares pledged as security by the NEOs, directors, nominees and directors and officers as a group. The Commission's proposal provides that information regarding pledges, which are often akin to an actual sale of shares, could be material to shareholders because of their potential to influence management decisions.

Corporate Governance

The Commission has proposed a new Item 407 to Regulation S-K that would require disclosure regarding whether each director or nominee is independent under applicable stock exchange listing standards, a description of any relationships not otherwise disclosed that were considered when determining whether each director or nominee is independent, and disclosure of any audit, nominating and compensation committee member who is not independent. Item 407 would also require a narrative description of the compensation committee's procedures for determining executive and director compensation, including the scope of the committee's authority and its ability to delegate.

Conclusion

On the whole, the Commission should be applauded for the proposed revisions to the executive compensation disclosure requirements for promoting transparency and attempting to address perceived past abuses. However, the question of whether disclosure quality and comparability among issuers resulting from certain of the proposed changes will be worth the increased expenses and administrative burdens remains to be seen. The encroachment of the Commission into areas that arguably have long been reserved to the states may result in a substantive shift in the development of executive compensation.

The impact of the Commission's proposal is already being felt inside boardrooms. In making decisions for compensating executives in 2006, boards of directors are well advised to consider the way such decisions will be reflected in their 2007 proxy statements. It is safe to assume that many, if not most, of the Commission's proposals will be adopted and effective in the near term.