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    Wisconsin Lawyer
    March 05, 2007

    Open Books: Disclosing Executive Compensation

    y opening the books, executive compensation just became more transparent to shareholders and the general public. New SEC rules effective Dec. 15, 2006, require publicly traded companies to disclose executive compensation in tabular form supplemented with explanations in clear English narrative. The breadth of the rules will affect attorneys and clients in many practice areas.

    Sven Skillrud

    Wisconsin LawyerWisconsin Lawyer
    Vol. 80, No. 3, March 2007

     

     

    Aopen bookttracting media attention and generating headlines,1 executive compensation continues to be a hot topic not only among shareholders and members of the general public but also for the federal government. Partly in response to the growing furor and intense interest surrounding executive compensation, the U.S. Securities and Exchange Commission (SEC) substantially rewrote existing executive compensation disclosure requirements and issued new rules that were published in the Federal Register on Sept. 8, 20062 (with the SEC already amending the new rules on Dec. 29, 20063).

    The new disclosure rules are a must read for any attorney who provides counsel to publicly traded companies. Similarly, considering the breadth of the new rules, any attorney or other professional practicing in labor and employment, taxation, securities, or even white-collar criminal defense also should be familiar with the new rules. The rules generally take effect for fiscal years ending on or after Dec. 15, 2006,4 so it is important to understand what to do now (discussed later).

    In 1992, the SEC introduced disclosure rules on executive compensation using a tabular format that required publicly traded companies to make certain compensation disclosures for the company's chief executive officer (CEO) and up to four other executive officers (collectively referred to as named executive officers or NEOs). The 1992 rules also required a publicly traded company to furnish to the SEC a compensation committee report that discussed the company's compensation policies for all its executive officers. The SEC eventually concluded that disclosures under the 1992 rules were inadequate and tended to use boilerplate language. The new rules are designed to address the SEC's concerns by significantly expanding required compensation disclosures and replacing the compensation committee report with the compensation discussion and analysis (CD&A). The CD&A, which is a management report, is intended to elicit material information about the company's compensation objectives and policies for NEOs and provide context for the narrative and tabular disclosures that follow it.

    Sven SkillrudSven Skillrud, Marquette 2005 cum laude, is an associate at Hewitt Associates, Lincolnshire, Ill., within the talent and organizational consulting center of technical expertise. He gratefully acknowledges the assistance of Robbi Fox, Donald Kalfen, Anne-Maureen Maloney, and Michael Powers.

    The new rules apply to the following officers of a publicly traded company:

    • any principal executive officer (PEO) during the reporting period;
    • any principal financial officer (PFO) during the reporting period;
    • three other most highly compensated executive officers as of the end of the fiscal year, if their "total compensation" is at least $100,000 (with "total compensation" being determined by subtracting the change in pension value and nonqualified deferred compensation earnings column from the total column in the summary compensation table); and
    • up to two additional executive officers who are no longer serving as executive officers as of the end of the reporting period but for whom disclosure otherwise would have been required.5

    Compensation and Discussion Analysis (CD&A)

    The purpose of the CD&A is to disclose a company's objectives and policies for compensation of its NEOs and to put into perspective the numbers and narratives that follow it. The CD&A must be written in plain English, use short sentences, avoid legal jargon, avoid boilerplate or overly generic language, and present the information in a clear and concise manner.6 Moreover, the CD&A must be filed with the SEC, which filing then subjects the company (and the PEO and PFO) to the liability provisions of section 18 of the 1934 Securities and Exchange Act.7 It is important to note that the CD&A is a disclosure by a company's management, not a company's compensation committee.

    The compensation committee, however, will play an important role in the final preparation of the CD&A. Specifically, the new rules require compensation committees to furnish an annual report to the SEC that states: 1) whether the compensation committee reviewed and discussed the CD&A with management; and 2) whether, based on this review and discussion, the compensation committee recommended to the board of directors that the CD&A be included in the company's Form 10-K (annual report) and proxy statement.8

    Although the SEC provides guidance about what should be disclosed in the CD&A, the emphasis is on a "principles-based" disclosure. The CD&A should answer the following six principles-based questions regarding NEOs:

    • What are the objectives of the pay programs?
    • What is each program designed to reward?
    • What is each element of compensation?
    • Why does the company choose to pay each element?
    • How does the company determine the amount for each element?
    • How does each element fit into the company's overall compensation objectives and affect decisions regarding other pay elements?9

    Whereas the above questions are principles-based, the CD&A also must include certain fact-specific disclosures. The CD&A must disclose policies and practices relating to the timing of option grants and the determination of exercise price. Specifically, the CD&A must disclose any policy or practice to grant options in coordination with the release of material nonpublic information and any policy or practice to set the option exercise price at a price that differs from the closing price on the grant date.10

    The new rules also suggest that certain fact-specific disclosures be made in the CD&A. The new rules list 15 nonexclusive examples of issues that may be appropriate for discussion in the CD&A, depending on a company's specific situation. A few key examples include:

    • What factors were considered in decisions to materially increase or decrease compensation?
    • What are the accounting and tax treatments of certain forms of compensation?
    • What role do executive officers play in the compensation process?
    • Did the company engage in the benchmarking of any material or total compensation? If so, what were the benchmarks and the methodology used to obtain those benchmarks?11

    Note: Companies may refuse to include certain types of confidential information in the CD&A if disclosure would result in competitive harm to the company, which the SEC might require the company to demonstrate. If a company does not disclose performance goals applicable to incentive compensation arrangements, the company will be required to disclose the likelihood of the company or executive achieving the nondisclosed target performance goals.12

    Compensation Tables and Related Narrative Disclosures

    Following the CD&A are tabular and related narrative disclosures.13 Six tables are used to disclose the NEOs' compensation, including: the primary disclosure table (known as the summary compensation table); the grants of plan-based awards table, the outstanding equity awards table, and the option exercises and stock vested table, which collectively disclose the life cycle of equity compensation from grant date to eventual realization; and the pension benefits table, the nonqualified deferred compensation table, and narrative disclosure regarding other potential postemployment compensation, which taken together disclose most postemployment compensation.

    The summary compensation table (SCT) (see Figure 1) is the principal table for disclosing NEO compensation. A related narrative disclosure is required to discuss any material factors necessary to understand the table. Each NEO's total compensation (and each applicable compensation component) for the reporting year and for each of the two prior reporting years must be disclosed; prior year disclosure will be phased in over a three-year period. The SCT must show the following for each NEO:

    • Salary. Any salary that is earned during the reporting year (including salary earned during the reporting year that is deferred to a later reporting year);
    • Bonus. Any nonperformance based bonus (that is, sign-on, guaranteed, or discretionary bonuses) earned during the reporting year (including bonuses earned during the reporting year that are deferred to a later reporting year);14
    • Stock Awards. Any stock award or other equity vehicle that does not contain option-like features (that is, restricted stock or restricted stock units) and that is granted during the reporting year; such award must be disclosed at its compensation cost over the requisite service period as determined under FAS 123R;15
    • Options Award. Any option award or other similar vehicle that contains option-like features (that is, stock appreciation rights) and that is granted during the reporting year; such award must be disclosed at its compensation cost over the requisite service period as determined under FAS 123R;16
    • Nonequity Incentive Plan Compensation. Any nonequity incentive plan compensation earned during the reporting year. A nonequity incentive plan is any compensation arrangement (that is, annual or long-term incentive plan) that meets the following two conditions: 1) the payment of compensation is conditioned on the satisfaction of predetermined performance goals; and 2) the arrangement is not subject to accounting treatment under FAS 123(R). Compensation under such an incentive arrangement is disclosed in the reporting year when all required performance conditions are satisfied, even if the award is still subject to forfeiture;
    • Change in Pension Value and Nonqualified Deferred Compensation Earnings. Any annual increase in the actuarial value of retirement benefits under defined benefit plans (both qualified and nonqualified plans) and above-the-market earnings on nonqualified deferred compensation (earnings are considered above the market to the extent the earnings are greater than 120 percent of the applicable federal long-term rate) with the required amounts disclosed in an aggregate total. Footnote disclosure is required to individually identify and quantify the increase in the above-market earnings on deferred compensation and the increase or decrease in the value of retirement benefits under defined benefit plans for each separate pension plan;
    • All Other Compensation. Any other forms of compensation that are not disclosed elsewhere, including perquisites. Footnote disclosure is required to identify and quantify each compensation item that exceeds $10,000 (additional disclosure may be required for perquisites); and
    • Total. The aggregate total of all the other columns.17

    Supplemental to the SCT is the grants of plan-based awards table (see Figure 2), which discloses estimated future payments for nonequity and equity incentive plan awards and the grant date fair value, the number of shares, and exercise price, if applicable, for all other stock and option awards. Two additional columns must be added to this table if an option exercise price is less than the closing price on the date of grant and if the date on which the board of directors or compensation committee authorizes the grant differs from the actual grant date. Related narrative disclosure must come after this table and discuss any material factors necessary to understand the table and the SCT.18 The outstanding equity awards at fiscal year-end table (see Figure 3) generally requires disclosure of any outstanding equity awards (that is, awards initially reported in the stock awards and options award columns of the SCT), such as stock options, stock appreciation rights, or restricted stock.19 The option exercises and stock vested table (see Figure 4) discloses amounts realized during the reporting year when options and similar instruments are exercised and when restricted stock and similar instruments are vested.20

    The pension benefits table (see Figure 5) includes the disclosure of the present value of the accumulated benefits under qualified and nonqualified defined benefit plans that cover each NEO, but excludes defined contribution plans. Following this table is a narrative description of the material factors necessary to understand each plan disclosed in the table.21 The nonqualified deferred compensation table (see Figure 6) includes disclosure of contributions made on behalf of or by each NEO to nonqualified deferred compensation plans and the NEO's account balance under the plan. Following this table is a narrative disclosure explaining any material factors necessary to understand the plans disclosed in the table.22

    After the nonqualified deferred compensation table, narrative disclosure (no required table) is required for each NEO for other potential postemployment payments, including arrangements that provide for payments at, following, or in connection with change in control, retirement or resignation, other termination of employment, or change in job responsibilities. This narrative disclosure also must describe the circumstances that trigger the payments, provide a reasonable estimate of the payments and benefits that would be provided in each covered circumstance, and list any other material factors regarding each applicable contract, agreement, plan, or arrangement.23

    What to Do Now

    In preparation for complying with the new executive compensation disclosure rules, counsel should do the following:

    Inform clients about potential liability. Because the CD&A is filed with the SEC, it is subject to the liability provisions of section 18 of the 1934 Securities and Exchange Act and creates a private right of action for anyone who relies on a false or misleading statement or omission within the CD&A.

    Understand the nature of disclosures and compensation. The new rules specify how the compensation needs to be disclosed. For example, in the SCT, disclosure for stock and option awards is based on the FAS 123(R) compensation cost and not the initial grant date fair value, while for cash awards the amount earned is the basis of disclosure in the SCT.

    Ask about recordkeeping measures. Given the heightened disclosure requirements, accurate recordkeeping is a must. Companies need to have procedures in place to confirm the accuracy of the required data and information, and companies may want to review these procedures with an outside auditor.

    Be aware of subsequent guidance. The SEC already has released questions and answers, interpretive guidance, and an amendment to the new rules.

    Plan for extra time. Given the additional disclosure requirements, do not underestimate the time and resources necessary for compliance with the new rules.

    Use the new rules as a bridge. Counsel not only should review relevant employment, change in control, and severance agreements for the applicable executives and officers but also should use this as an opportunity to discuss employee compensation and benefits in general.

    Conclusion

    The new executive compensation disclosure rules significantly affect disclosure requirements for publicly traded companies. This impact will be felt not only by the company, but also by counsel and other professionals. A full reading of the new rules and an understanding of what you can do now to prepare to meet the new disclosure requirements will help eliminate uncertainty and create a much smoother transition.

    Endnotes

    1Rich Rovito, Options Rule the Day for Executive Pay, Business J. Milwaukee, June 2, 2006; Alan Murray, CEOs Get Off the Ropes on Executive Pay, Wall St. J., July 5, 2006, at A2.

    2Executive Compensation and Related Person Disclosure, 71 Fed. Reg. 53,158 (Sept. 8, 2006).

    3Executive Compensation Disclosure, 71 Fed. Reg. 78,338 (Dec. 29, 2006).

    471 Fed. Reg. at 53,158.

    5Id. at 53,189-91.

    6Id. at 53,208-09.

    7Id. at 53,167.

    8Id.at 53,168.

    9Id.at 53,164.

    10Id. at 53,163-64.

    11Id.at 53,165.

    12Id. at 53,166-67.

    13Although not specifically discussed in this article, the new rules require a director compensation table that is similar to the SCT and illustrates the total compensation for each director; however, if compensation for each director is the same, then all director compensation can be grouped into a single row.

    1471 Fed. Reg. at 53,169-71.

    15Financial Accounting Standards Board Statement of Financial Accounting Standards No. 123 (revised 2004) Share-Based Payment (FAS 123R).

    16Id. at 78,338.

    17Id. at 53,171-79.

    18Id. at 53,179-83.

    19Id. at 53,183-85.

    20Id. at 53,185.

    21Id. at 53,185-87.

    22Id. at 53,187-88.

    23Id. at 53,188-89.

    24Id. at 53,170.

    25Id. at 78,350.

    26Id. at 53,183-84.

    27Id. at 53,185.

    28Id. at 53,186-87.

    29Id. at 53,187-88.


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