The 2007 Proxy Season

On July 26, 2006, the Securities and Exchange Commission ('SEC') formally adopted new executive compensation disclosure requirements under Item 402 of Regulations S-K ('Item 402'). With the ink barely dry, the SEC on Dec. 22, 2006, modified the reporting requirements related to stock options and stock awards on the Summary Compensation Table, the Director Compensation Table and the Grants of Plan Based Award Table (the 'Item 402 Amendment').

The new rules significantly increase the required disclosure for the 2007 proxy season and ensure that there will be plenty of interesting reading for shareholders, executives and regulators. The new SEC executive and director compensation reporting requirements will likely have a significant effect on executive compensation for many years to come as companies and executives digest the impact of the new disclosure requirements and adjust compensation policies in connection with shareholders reactions. After providing some background, this article discusses two of the most significant changes introduced by the new disclosure rules: the fair value reporting of equity awards and the quantitative disclosure of potential payments to named executive officers (NEOs) upon a change in control (CIC).

Background

Item 402 requires companies, compensation committees and executives to carefully review the process and procedures currently in place for determining compensation and assessing whether they are adequate, appropriately documented and consistent with the new requirements. Because the new rules intend to capture 'total compensation' at a much more granular level, many companies are reexamining all aspects of their compensation philosophy and programs, including equity compensation, fringe benefits, severance benefits and deferred compensation. To meet their proxy requirements without the benefit of examples from prior years, companies are actively coordinating the efforts of their auditors, securities and benefits counsel, and compensation experts to prepare the required Item 402 disclosure in a timely manner.

Equity Compensation Reporting

The Item 402 Amendment requires companies to disclose stock options and stock awards based upon amounts 'earned' during the year as compared with the aggregate grant date fair value. This approach reflects the reporting of equity awards under Financial Accounting Standards No. 123 (revised 2004) Share-Based Payment ('FAS 123R'). Many commentators predicted that reporting the aggregate grant date fair value would result in year-to-year swings in reported equity-based compensation, and inconsistencies in the identification of NEOs. The Item 402 Amendment abandons this aggregate approach, in favor of the annual compensation measurement under FAS 123R.

The Item 402 Amendment modifies the required disclosure for NEOs during the fiscal year under column (e) ' 'Stock Awards' and column (f) ' 'Option Awards' of the Summary Compensation Table (the 'Summary Table') and adds a new column (l) ' 'Grant Date Fair Value of Stock Options and Stock Awards' ' to the Grants of Plan-Based Award Table (the 'Awards Table'). Prior to the Item 402 Amendment, the SEC required companies to disclose in columns (e) and (f) the aggregate grant date fair value of stock awards and stock options granted during the fiscal year. However, as amended, companies will instead report in columns (e) and (f) of the Summary Table the dollar amount recognized for financial statement purpose with respect to the fiscal year in accordance with FAS 123R. The grant date fair value of stock awards and stock options is now required to be disclosed under new column (l) of the Awards Table. Note, grant date fair value is not required for companies covered by Item 402 of Regulation S-B, which does not include an Awards Table equivalent. Finally, the instructions to column (c) ' 'Salary' and column (d) ' 'Bonus' of the Summary Table have been revised to require companies to report in column (c) or column (d) any salary or bonus forgone by the named executive officer in favor of non-cash compensation (i.e., stock options or stock awards) with footnote disclosure of the receipt of non-cash compensation and a reference to the Awards Table.

In general, under FAS 123R, the compensation cost of a stock award or stock option is initially measured based upon the grant date fair value of the award. However, the cost is generally recognized for financial reporting purposes over the period in which the employee is required to provide services to vest in the award. Thus, the Item 402 Amendment limits the required disclosure for stock awards and stock options in the Summary Table to the amount an NEO 'earns' during the fiscal year and shifts the aggregate grant date fair value disclosure to the Awards Table.

The impact of the Item 402 Amendment can be illustrated by the following example based upon Illustration 4 of FAS 123R.

An Example

In 2006, Company X grants to Executive A, an NEO, a stock option to purchase 100,000 shares of Company X stock with an exercise price of $30 per share (the fair market value of Company X stock on the date of grant equals $30 per share). The option has a ten-year term and cliff vests at the end of three years. Based upon a lattice model of valuation under FAS 123R, Executive A's stock option has a 'fair value' of $14.69 per share. The total aggregate grant date fair value of Executive A's stock option under FAS 123R equals $1,469,000 (100,000 x $14.69), while Company X's annual compensation cost related to Executive A's stock option under FAS 123R equals $489,666 ($1,469,000/3 years).

Prior to the Item 402 Amendment, the entire $1,469,000 total aggregate grant date fair value would have been reported in the Summary Table in Company X's 2007 proxy statement. As amended, the disclosure in the Summary Table for 2007 will be $489,666. The entire $1,469,000 of the aggregate grant date fair value will now appear in column (l) of the Awards Table. The cumulative amount reported over time in the Summary Table for Executive A's fully vested stock option award should equal the grant date fair of the option.

Because FAS 123R became effective for companies in 2006, it did not apply to stock options and stock awards granted prior to 2006. However, disclosure will be required in the 2007 proxy for pre-2006 stock options and stock awards awarded that vest in 2006. The SEC mandates that companies utilize the elective FAS 123R 'modified prospective transaction method' for Item 402 disclosure. Under the mandated transition methodology, companies will include in the Summary Table a proportionate share of the grant date fair value of a stock option or stock award that was outstanding at the date that FAS 123R was adopted over the award's remaining vesting periods, if any.

The Item 402 Amendment also modified the related instructions to the Summary Table to reflect the change in the disclosure. These changes include, among other conforming changes, the requirement for a footnote disclosure of all assumptions made in the valuation by reference to a discussion of the assumptions in a company's financial statements, footnotes to the financial statements, or discussion in the Management's Discussion and Analysis (and providing that the referenced sections are deemed part of the Item 402 disclosure). In addition, while forfeited equity awards will be reflected as negative compensation in the Summary Table, the instructions to the Item 402 Amendment also add a requirement for footnote disclosure of any forfeited awards.

For the Award Table, in addition to providing instructions to disclose the aggregate grant date fair value of awards, the Item 402 Amendment requires that modifications and repricing of stock options and stock appreciation rights, including the increase in incremental fair value resulting from the modification, be disclosed in the Awards Table footnotes. Finally, the Item 402 Amendments makes corresponding changes to the Director Compensation Table.

Because 2007 is the first year companies are required to comply with the new executive compensation disclosure rules, the Item 402 Amendments did not change any long-standing practices. However, the Item 402 Amendment required companies to take extra care to ensure that the right information is being gathered and will be properly disclosed for the upcoming proxy report.

Potential Payments upon a Change in Control

One of the most intriguing issues to arise under revised Item 402 is the SEC's requirement that companies provide quantitative disclosure of potential payments to its NEOs upon a CIC. Prior to the new requirements for the 2007 proxy season, the calculation of: 1) CIC payments under Section 280G of the Internal Revenue Code of 1986, as amended (the 'Code'); 2) the 20% potential excise tax on 'excess' parachute payments under Section 4999 of the Code; and 3) executive tax gross-up payment related to the CIC payment were relatively obscure issues that were of interest mainly to executives and the buyer after most of the major business points were settled. Companies and NEOs now realize that the position taken in the 2007 proxy filing for potential CIC payments will create a benchmark that may later be scrutinized by executives, shareholders and other governmental agencies upon an actual CIC. One issue causing frustration to companies and its NEOs is what value to attribute to non-compete provisions for purposes of calculating and disclosing potential CIC payments in the 2007 proxy.

Typically, an NEO who receives a significant payment upon a termination of employment in connection with a CIC will be subject to some form of non-competition provision. Section 280G(b)(4)(a) of the Code provides that the amount of a parachute payment does not include the reasonable compensation for services rendered after a CIC. Treasury Regulation ' 1.280G-1, Q-40 makes it clear that reasonable compensation includes the value of a non-compete.

The ability to exclude the value of a non-compete from the calculation of a parachute payment is important because the value of the parachute payment determines the amount of any excise tax and/or the gross-up payment. In general, each dollar attributable to the value of a non-compete that reduces a potential parachute payment lowers the amount subject to excise tax and lowers any required gross-up payment. This will have a direct impact on the required disclosure for each NEO under the proxy for potential CIC payments.

Companies need to verify that their benefit consultants attribute some value to a non-compete agreement for purposes of potential CIC payments. Two common approaches to value non-competes include: 1) the 'salary' approach, which considers compensation, including base, bonus, and other benefits that a company would otherwise pay to the NEO if the NEO continued employment for the non-compete period; or 2) the 'market' approach, which considers the financial impact the NEO's competition would have on the company. One reasonable way to view the 'salary' approach would be to look to the amount listed for the NEO on the Summary Compensation Table. The value under the market approach would need to be established by the company and likely supported by independent analysis. Without further guidance from the SEC, both the salary or market approach should be acceptable for Item 402 purposes so long as the reasonable valuation assumptions are selected and disclosed in the required narrative.

Most importantly, a company needs to be mindful that, upon an actual sales transaction, a buyer may be reluctant to allocate value to a non-compete if no value was attributable to the non-compete for proxy purposes. The inability to reduce excise tax and gross-up payments upon an actual CIC may result in a lower purchase price and/or the need for other concessions by NEOs with regard to CIC benefits.

Conclusion

The new Item 402 executive compensation disclosure requirements will undoubtedly have a significant impact on executive compensation for many years to come. When the dust settles following the close of the 2007 proxy season, companies and executives will have the opportunity to adjust compensation policies in connection with shareholders' reactions.

David N. Pardys, a partner in the Philadelphia office of Reed Smith LLP, is a member of the firm's Benefits and Executive Compensation Practice Groups and focuses his practice on all aspects of employee benefits, executive compensation and employment arrangements. He can be reached at [email protected]. Benjamin A. Bigler is an associate in the Tax, Benefits and Wealth Planning Practice Group. He can be reached at [email protected].

On July 26, 2006, the Securities and Exchange Commission ('SEC') formally adopted new executive compensation disclosure requirements under Item 402 of Regulations S-K ('Item 402'). With the ink barely dry, the SEC on Dec. 22, 2006, modified the reporting requirements related to stock options and stock awards on the Summary Compensation Table, the Director Compensation Table and the Grants of Plan Based Award Table (the 'Item 402 Amendment').

The new rules significantly increase the required disclosure for the 2007 proxy season and ensure that there will be plenty of interesting reading for shareholders, executives and regulators. The new SEC executive and director compensation reporting requirements will likely have a significant effect on executive compensation for many years to come as companies and executives digest the impact of the new disclosure requirements and adjust compensation policies in connection with shareholders reactions. After providing some background, this article discusses two of the most significant changes introduced by the new disclosure rules: the fair value reporting of equity awards and the quantitative disclosure of potential payments to named executive officers (NEOs) upon a change in control (CIC).

Background

Item 402 requires companies, compensation committees and executives to carefully review the process and procedures currently in place for determining compensation and assessing whether they are adequate, appropriately documented and consistent with the new requirements. Because the new rules intend to capture 'total compensation' at a much more granular level, many companies are reexamining all aspects of their compensation philosophy and programs, including equity compensation, fringe benefits, severance benefits and deferred compensation. To meet their proxy requirements without the benefit of examples from prior years, companies are actively coordinating the efforts of their auditors, securities and benefits counsel, and compensation experts to prepare the required Item 402 disclosure in a timely manner.

Equity Compensation Reporting

The Item 402 Amendment requires companies to disclose stock options and stock awards based upon amounts 'earned' during the year as compared with the aggregate grant date fair value. This approach reflects the reporting of equity awards under Financial Accounting Standards No. 123 (revised 2004) Share-Based Payment ('FAS 123R'). Many commentators predicted that reporting the aggregate grant date fair value would result in year-to-year swings in reported equity-based compensation, and inconsistencies in the identification of NEOs. The Item 402 Amendment abandons this aggregate approach, in favor of the annual compensation measurement under FAS 123R.

The Item 402 Amendment modifies the required disclosure for NEOs during the fiscal year under column (e) ' 'Stock Awards' and column (f) ' 'Option Awards' of the Summary Compensation Table (the 'Summary Table') and adds a new column (l) ' 'Grant Date Fair Value of Stock Options and Stock Awards' ' to the Grants of Plan-Based Award Table (the 'Awards Table'). Prior to the Item 402 Amendment, the SEC required companies to disclose in columns (e) and (f) the aggregate grant date fair value of stock awards and stock options granted during the fiscal year. However, as amended, companies will instead report in columns (e) and (f) of the Summary Table the dollar amount recognized for financial statement purpose with respect to the fiscal year in accordance with FAS 123R. The grant date fair value of stock awards and stock options is now required to be disclosed under new column (l) of the Awards Table. Note, grant date fair value is not required for companies covered by Item 402 of Regulation S-B, which does not include an Awards Table equivalent. Finally, the instructions to column (c) ' 'Salary' and column (d) ' 'Bonus' of the Summary Table have been revised to require companies to report in column (c) or column (d) any salary or bonus forgone by the named executive officer in favor of non-cash compensation (i.e., stock options or stock awards) with footnote disclosure of the receipt of non-cash compensation and a reference to the Awards Table.

In general, under FAS 123R, the compensation cost of a stock award or stock option is initially measured based upon the grant date fair value of the award. However, the cost is generally recognized for financial reporting purposes over the period in which the employee is required to provide services to vest in the award. Thus, the Item 402 Amendment limits the required disclosure for stock awards and stock options in the Summary Table to the amount an NEO 'earns' during the fiscal year and shifts the aggregate grant date fair value disclosure to the Awards Table.

The impact of the Item 402 Amendment can be illustrated by the following example based upon Illustration 4 of FAS 123R.

An Example

In 2006, Company X grants to Executive A, an NEO, a stock option to purchase 100,000 shares of Company X stock with an exercise price of $30 per share (the fair market value of Company X stock on the date of grant equals $30 per share). The option has a ten-year term and cliff vests at the end of three years. Based upon a lattice model of valuation under FAS 123R, Executive A's stock option has a 'fair value' of $14.69 per share. The total aggregate grant date fair value of Executive A's stock option under FAS 123R equals $1,469,000 (100,000 x $14.69), while Company X's annual compensation cost related to Executive A's stock option under FAS 123R equals $489,666 ($1,469,000/3 years).

Prior to the Item 402 Amendment, the entire $1,469,000 total aggregate grant date fair value would have been reported in the Summary Table in Company X's 2007 proxy statement. As amended, the disclosure in the Summary Table for 2007 will be $489,666. The entire $1,469,000 of the aggregate grant date fair value will now appear in column (l) of the Awards Table. The cumulative amount reported over time in the Summary Table for Executive A's fully vested stock option award should equal the grant date fair of the option.

Because FAS 123R became effective for companies in 2006, it did not apply to stock options and stock awards granted prior to 2006. However, disclosure will be required in the 2007 proxy for pre-2006 stock options and stock awards awarded that vest in 2006. The SEC mandates that companies utilize the elective FAS 123R 'modified prospective transaction method' for Item 402 disclosure. Under the mandated transition methodology, companies will include in the Summary Table a proportionate share of the grant date fair value of a stock option or stock award that was outstanding at the date that FAS 123R was adopted over the award's remaining vesting periods, if any.

The Item 402 Amendment also modified the related instructions to the Summary Table to reflect the change in the disclosure. These changes include, among other conforming changes, the requirement for a footnote disclosure of all assumptions made in the valuation by reference to a discussion of the assumptions in a company's financial statements, footnotes to the financial statements, or discussion in the Management's Discussion and Analysis (and providing that the referenced sections are deemed part of the Item 402 disclosure). In addition, while forfeited equity awards will be reflected as negative compensation in the Summary Table, the instructions to the Item 402 Amendment also add a requirement for footnote disclosure of any forfeited awards.

For the Award Table, in addition to providing instructions to disclose the aggregate grant date fair value of awards, the Item 402 Amendment requires that modifications and repricing of stock options and stock appreciation rights, including the increase in incremental fair value resulting from the modification, be disclosed in the Awards Table footnotes. Finally, the Item 402 Amendments makes corresponding changes to the Director Compensation Table.

Because 2007 is the first year companies are required to comply with the new executive compensation disclosure rules, the Item 402 Amendments did not change any long-standing practices. However, the Item 402 Amendment required companies to take extra care to ensure that the right information is being gathered and will be properly disclosed for the upcoming proxy report.

Potential Payments upon a Change in Control

One of the most intriguing issues to arise under revised Item 402 is the SEC's requirement that companies provide quantitative disclosure of potential payments to its NEOs upon a CIC. Prior to the new requirements for the 2007 proxy season, the calculation of: 1) CIC payments under Section 280G of the Internal Revenue Code of 1986, as amended (the 'Code'); 2) the 20% potential excise tax on 'excess' parachute payments under Section 4999 of the Code; and 3) executive tax gross-up payment related to the CIC payment were relatively obscure issues that were of interest mainly to executives and the buyer after most of the major business points were settled. Companies and NEOs now realize that the position taken in the 2007 proxy filing for potential CIC payments will create a benchmark that may later be scrutinized by executives, shareholders and other governmental agencies upon an actual CIC. One issue causing frustration to companies and its NEOs is what value to attribute to non-compete provisions for purposes of calculating and disclosing potential CIC payments in the 2007 proxy.

Typically, an NEO who receives a significant payment upon a termination of employment in connection with a CIC will be subject to some form of non-competition provision. Section 280G(b)(4)(a) of the Code provides that the amount of a parachute payment does not include the reasonable compensation for services rendered after a CIC. Treasury Regulation ' 1.280G-1, Q-40 makes it clear that reasonable compensation includes the value of a non-compete.

The ability to exclude the value of a non-compete from the calculation of a parachute payment is important because the value of the parachute payment determines the amount of any excise tax and/or the gross-up payment. In general, each dollar attributable to the value of a non-compete that reduces a potential parachute payment lowers the amount subject to excise tax and lowers any required gross-up payment. This will have a direct impact on the required disclosure for each NEO under the proxy for potential CIC payments.

Companies need to verify that their benefit consultants attribute some value to a non-compete agreement for purposes of potential CIC payments. Two common approaches to value non-competes include: 1) the 'salary' approach, which considers compensation, including base, bonus, and other benefits that a company would otherwise pay to the NEO if the NEO continued employment for the non-compete period; or 2) the 'market' approach, which considers the financial impact the NEO's competition would have on the company. One reasonable way to view the 'salary' approach would be to look to the amount listed for the NEO on the Summary Compensation Table. The value under the market approach would need to be established by the company and likely supported by independent analysis. Without further guidance from the SEC, both the salary or market approach should be acceptable for Item 402 purposes so long as the reasonable valuation assumptions are selected and disclosed in the required narrative.

Most importantly, a company needs to be mindful that, upon an actual sales transaction, a buyer may be reluctant to allocate value to a non-compete if no value was attributable to the non-compete for proxy purposes. The inability to reduce excise tax and gross-up payments upon an actual CIC may result in a lower purchase price and/or the need for other concessions by NEOs with regard to CIC benefits.

Conclusion

The new Item 402 executive compensation disclosure requirements will undoubtedly have a significant impact on executive compensation for many years to come. When the dust settles following the close of the 2007 proxy season, companies and executives will have the opportunity to adjust compensation policies in connection with shareholders' reactions.

David N. Pardys, a partner in the Philadelphia office of Reed Smith LLP, is a member of the firm's Benefits and Executive Compensation Practice Groups and focuses his practice on all aspects of employee benefits, executive compensation and employment arrangements. He can be reached at [email protected]. Benjamin A. Bigler is an associate in the Tax, Benefits and Wealth Planning Practice Group. He can be reached at [email protected].