The SEC’s New Rules on Executive Compensation
Illuminating the Disclosure Requirements

By Kathryn Yeaton

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JULY 2007 - Executive compensation has come under intense scrutiny in recent years, with numerous controversies over compensation, retirement, and severance packages. In response to investors’ criticisms of inadequate and confusing executive compensation information, the SEC has been pushing toward increased transparency and disclosure of crucial elements of executive compensation packages. On July 26, 2006, the SEC adopted new rules addressing “Executive Compensation and Related Person Disclosure.” As of the date of the SEC vote, the SEC had received in excess of 20,000 comments on the proposed changes. According to SEC Press Release 2006-123, this is the greatest interest shown in any SEC revision in the commission’s 72-year history. The amended rules provide for disclosures that incorporate the changing trends in executive compensation, and provide a clearer executive-compensation picture for the investing public. Since the changes were adopted in July 2006, however, the SEC has continued to examine compensation issues and, as a result, adopted interim final rules in December 2006 that amended the July 2006 rules.

While executive and director compensation disclosures have been required since 1933, prior to July 2006 the last substantial revision to the rules was made in 1992. The 436-page document approved in July 2006 made sweeping changes to the existing executive compensation disclosure requirements. Those amendments substantially adopt the rules that the SEC proposed to the public on January 27, 2006, with modifications in certain areas to address concerns raised in the comment process. The July amendments became effective November 7, 2006 (the rule was published in the Federal Register on September 8, 2006, and became effective 60 days after publication), and apply to disclosures required in proxy and information statements, periodic reports, current reports, and other related SEC filings. As finalized, the rules are effective for Forms 10-K and 10-KSB for fiscal years ending on or after December 15, 2006, and for Form 8-Ks filed for triggering events that occurred on or after November 7, 2006.

The most recent amendments adopted in December 2006 became effective on December 29, 2006, with compliance required for proxy statements, information statements, and registration statements filed on or after December 15, 2006, as well as for Forms 10-K and 10-KSB filed for fiscal years ending on or after December 15, 2006.

Overall, the July 2006 amendments require that companies prepare a thorough discussion and analysis on compensation, broaden the scope of required narratives, and provide additional quantitative compensation information. Perhaps most significant, these amended rules require that certifications under the Sarbanes-Oxley Act of 2002 (SOX) apply to the information presented in the disclosures. These certifications place increased responsibility for compensation disclosures on corporate officers.

The disclosures required under the previous rules did not adequately reflect how executive compensation packages have evolved and increased in complexity over time. The amended rules are intended to better disclose these new forms of compensation and provide sufficient flexibility to address additional forms and types of compensation as developed in the future. Exhibit 1 provides an overview and comparison of the most significant rule changes.

Compensation Discussion and Analysis

The amended rules eliminate the Board Compensation Committee Report on Executive Compensation, replacing it with the more comprehensive Compensation Discussion and Analysis (CD&A) and the new Compensation Committee Report. In response to concerns voiced by commenters on the proposed rules, the SEC adopted a Compensation Committee Report similar to the Audit Committee Report already required. The Compensation Committee Report is deemed “furnished” by the compensation committee rather than “filed” by the company and, as such, is not subject to the civil liabilities imposed under section 18 of the Securities Exchange Act of 1934. The Compensation Committee Report is required to state whether the compensation committee has reviewed and discussed the CD&A with management. Furthermore, the Compensation Committee Report is required to state whether or not, after review and discussion with management, the compensation committee recommends the CD&A be included in the annual report, proxy, or information statement.

The new CD&A section consists of a narrative disclosure that provides context to the compensation decisions of the company and a general overview of the material principles and objectives underlying the company’s executive compensation policies and decisions. Specifically, the “Compensation and Analysis” section should address the objectives and implementation of the company’s executive compensation programs and is intended to provide meaningful analysis of the information contained in the tables and disclosed elsewhere. Pursuant to these rules, companies are urged to avoid boilerplate language or information in a “laundry list.” Companies are instead encouraged to be comprehensive and to reflect the individual circumstances of the company.

These disclosures will provide useful information to investors only if an effort is made to truly communicate executive compensation policies and incentives. This requires that companies not revert to boilerplate language or merely describe procedural matters. While the CD&A is intended to discuss company compensation policies and decisions, it is not intended to address the deliberations of the compensation committee and is therefore not a report of the committee. The CD&A is considered soliciting material and, consequently, is “filed” with the SEC. As such, these disclosures are deemed part of the proxy statement and any other filings in which they are incorporated by reference. Consequently, the CD&A is subject to the civil liabilities imposed under section 18 of the 1934 Act. If incorporated by reference into a 1934 Act periodic report, the amended rules also require these disclosures be covered by certifications of the company’s principal executive officer (PEO) and principal financial officer (PFO), required under SOX.

Although this requirement is intended to increase accuracy and improve disclosure, it has been controversial. Certifications under SOX require the PEO and PFO of the issuer to substantiate the fairness, accuracy, and completeness of the accompanying information. While the amended rules specifically state that the PEO and the PFO “will not need to certify as [to] the compensation committee deliberations,” according to SEC Release No. 33-8732A, “Executive Compensation and Related Person Disclosure” (pages 41 and 43), the rules direct these officers “to look to the Compensation Committee Report in providing their certifications.” Clearly, the PEO and PFO are not in a position to address the processes and methodologies employed by the committee in setting executive compensation levels, and it remains ambiguous as to what information the executives are certifying. In addition, by placing the responsibility for the CD&A on the PEO and PFO, the resulting disclosures may become overly cautious and lead, once again, to boilerplate language rather than to the vigorous discussion intended by the SEC.

Following the CD&A, the disclosures regarding executive compensation are to be presented in three broad categories:

  • Compensation with respect to the most recent fiscal year (as well as the two preceding fiscal years);
  • Equity compensation; and
  • Retirement and other postemployment compensation.

Compensation with Respect to the Last Three Fiscal Years

The compensation for the named executive officers continues to be presented in the Summary Compensation Table. Although the table continues to serve as the principal disclosure vehicle for executive compensation, the July 2006 amendments reorganized and enhanced the table to provide clearer disclosure of information and to include information excluded in the past. Exhibit 2 summarizes changes in the Summary Compensation Table. In essence, this table is now designed to disclose all compensation of the named executive officers. In fact, all elements of compensation of these officers must be disclosed under these amended rules. The named executive officers are now defined to be the PEO, the PFO, and the three highest-compensated executive officers other than the PEO and the PFO. SEC Release No. 33-8732A (page 120) specifies that the top-earning executive officers are determined based upon their total compensation, “reduced by the sum of the increase in pension values and nonqualified deferred compensation above-market or preferential earnings.”

Of particular significance among the new Summary Compensation Table disclosures is a Total Compensation figure for the named executive officers. One stated goal of the new rules is to clearly disclose all elements of executive compensation and to disclose those amounts in dollars. Total compensation is, therefore, intended to include the total dollar value of all forms of compensation in the table.

As a result, the Summary Compensation Table has been revised and reorganized. In addition to disclosing salary and bonus information for the named executive officers, the table also includes columns for the dollar value for all equity-based awards, nonequity incentive plan compensation, changes in pension value and nonqualified deferred compensation earnings, as well as a column for all other compensation.

Equity-based awards are presented in two separate columns: stock awards and option awards. For purposes of the Summary Compensation Table, the July 2006 amendments initially required that the compensation cost from equity awards be recognized as compensation in the year of grant. The value of the equity-based awards (i.e., stock awards and option awards) was required to be measured as the fair value as of the grant date under SFAS 123(R), Share-Based Payment. Prior to this SEC rule change, only the number of options granted was reported and no attempt was made to report the fair value. While the timing of the option disclosure did not change, the awards were no longer disclosed in numbers of units or shares but in dollars. This was intended to provide a more complete picture of the compensation of named executives and to facilitate the reporting of the dollar value of total compensation.

The approach adopted in July 2006, however, differed from the approach required under GAAP for the recognition of compensation expense on the income statement. As a result of the reporting inconsistency, the SEC revisited the disclosures required in the Summary Compensation Table and addressed these issues in the interim final rules adopted in December 2006. The most recent amendments more closely align the mandatory Summary Compensation Table disclosures with financial reporting presentation required under SFAS 123(R). These interim final rules require disclosing the compensation cost of stock and option awards in the Summary Compensation Table over the requisite service period. Exhibit 3 presents a brief numerical example to illustrate the inconsistency that was present in the July 2006 amendments and the consistency resulting from the December 2006 amendments. The grant-date fair value of stock awards and option awards as computed under SFAS 123(R) is now disclosed in the Grants of Plan-Based Awards Table.

The Summary Compensation Table now also includes a column titled Non-Equity Incentive Plan. The amounts disclosed in this column should include all other incentive plan awards not included in the Stock and Option Awards columns. The value of any nonequity incentive plan award is disclosed in the year in which performance criteria under the plan are satisfied and the compensation is earned. This disclosure should occur regardless of whether payment is made to the named executive officer. Some commenters voiced concerns that these awards will be included in the Summary Compensation Table even if the awards remain subject to forfeiture conditions, such as continued service. The SEC postulates, however, that the event that is material to investors for Summary Compensation Table–reporting purposes is the satisfaction of the relevant performance criteria. The nonequity incentive plan awards are also disclosed in the Grants of Plan-Based Awards Table in the year of grant. When performance criteria are satisfied in one year and the grant made in a different year, disclosure in the Summary Compensation Table and the Grants of Plan-Based Awards Table may occur in different years.

Changes in pension value and nonqualified deferred compensation earnings are disclosed in a separate column of the Summary Compensation Table. The information presented in this column includes the aggregate increase in the actuarial value of all defined benefit and actuarial plans accrued during the year, as well as earnings on nonqualified deferred compensation. The earnings on the nonqualified deferred compensation disclosed in the Summary Compensation Table are limited to the above-market or preferential portion.

All other compensation not specifically included in another column should be integrated into the All Other Compensation column. This column may include items as varied as payments for termination or change in control, company contributions to defined contribution plans, the dollar value of life insurance premiums paid by the company for the benefit of the executive officer, or “gross-ups” or other amounts reimbursed for taxes. The column should include amounts for all perquisites unless the aggregate value of the perquisites is less than $10,000.

To support and complement the executive compensation information presented in the Summary Compensation Table, the July 2006 amended rules require a supplemental table titled Grants of Plan-Based Awards. This table discloses the terms of grants made during the current year, including estimated future incentive plan payouts of equity, as well as nonequity plan awards. The table also requires the disclosure of the number of shares of stock underlying the incentive awards.

The December 2006 amendments revise the Grants of Plan-Based Awards Table, adding a column presenting the grant-date fair value as computed under SFAS 123(R) for each equity award. These amendments essentially move the presentation of the total grant-date fair value from the Summary Compensation Table to the Grants of Plan-Based Awards Table. The compensation cost is reported in the Summary Compensation Table over the service period. The total fair value in the year of grant is reported in the Grants of Plan-Based Awards Table. The December 2006 amendments also revise the Grants of Plan-Based Awards Table to require information concerning options or stock appreciation rights repriced or otherwise materially modified during the last completed fiscal year.

While the SEC’s efforts to improve the Summary Compensation Table and the information disclosed are laudable, significant issues remain unresolved. The table combines compensation elements measured at different times and calculated using different valuation methods. As explained in SEC Release No. 33-8732A (page 51), the amended rules concede that, “[g]iven the various forms and complexities of compensation and the different periods they may be designed to relate to, it is unavoidable that the timing of disclosure may vary from element to element in this table.” As a result, the presentation may be misleading to investors. In addition, different companies may use varying assumptions in their computations, resulting in a lack of comparability. Including the SFAS 123(R) grant-date fair value of stock and option awards in the Summary Compensation Table in the year of grant was controversial.

The December 2006 amendments were designed to address concerns about the timing of compensation recognition but are not flawless. Some commenters felt that including the total fair value in the Summary Compensation Table in the year of grant provided a more comprehensive portrayal of compensation and, consequently, would be more consistent with the purpose of executive compensation disclosure. [See, for example, CFA Centre for Financial Market Integrity, April 13, 2006; State of Connecticut, Office of the State Treasury, April 10, 2006; and State Board of Administration (SBA) of Florida, April 10, 2006.]

Although the amended rules substantially change the compensation information required to be disclosed in the Summary Compensation Table, the SEC is not requiring companies to recalculate and restate compensation information presented for prior years. The amended rules provide instead for a phased-in implementation. Consequently, in 2007, the first year of implementation, companies are required to present compensation information in the Summary Compensation Table for only the most recent fiscal year, and information for prior years need not be presented. In 2008, the second year of implementation, companies need present only the two most recent fiscal years.

The reorganized Summary Compensation Table and the Grants of Plan-Based Awards Table are accompanied by narrative disclosure intended to provide context to the quantitative disclosures and to delineate material factors necessary for understanding the information presented in the tables. The material factors described will vary based upon the facts and circumstances of each company, but requiring these disclosures in the proximity of the Summary Compensation Table is intended to make the tabular information more meaningful.

Equity Compensation

The equity disclosures required in the Grants of Plan-Based Awards Table pertain only to current-year compensation awards. The July 2006 amendments require two additional tabular disclosures concerning previous year activity:

  • The Outstanding Equity Awards at Fiscal Year-End Table and
  • The Option Exercises and Stock Vested Table.

Exhibit 4 provides an overview of tables in which equity compensation information is disclosed. The Outstanding Equity Awards at Fiscal Year-End Table discloses equity compensation that was awarded in previous years but remains outstanding at fiscal year-end and is unexercised or unvested. The Option Exercises and Stock Vested Table presents the amounts realized during the most recent fiscal year when a named executive officer either exercises an option or a stock award vests.

Retirement and Other Postemployment Compensation

The amended rules have made significant changes to the required disclosures concerning postemployment compensation. These required disclosures include tabular disclosure of the actuarial present value of each executive officer’s accumulated pension plan, as well as the contributions, earnings, and balances of each executive officer’s nonqualified deferred compensation account. This supplemental information is disclosed in two additional tables (the Pension Benefits Table and the Non-Qualified Deferred Compensation Table) and some additional required narrative disclosures that describe other potential postemployment payments. These disclosures present specific aspects of payments following or in connection with the termination of a named executive officer. Exhibit 5 provides an overview of the Retirement and Other Postemployment Compensation Disclosures required under the amended rules.

Other Provisions

Compensation paid to directors. Due to the increasing complexity of director compensation packages, the July 2006 amendments require that director compensation be disclosed in a table similar to the Summary Compensation Table for executive officers. The Director Compensation Table, however, requires disclosure for only the last complete fiscal year (not the last three years, as required for executive officers). The Director Compensation Table is accompanied by narrative disclosure of additional material information similar to the narrative disclosure required for the Summary Compensation Table.

The December 2006 amendments make further changes to the disclosure of director compensation. The compensation cost of stock and option awards must be disclosed in the Director Compensation Table over the requisite service period, in accordance with SFAS 123(R). This approach parallels the compensation cost presented in the Summary Compensation Table for executives. The December 2006 amendments also add two footnote disclosures concerning director compensation. The grant-date fair value of each equity award, as well as information concerning repricing or stock materially modifying stock options or stock appreciation rights during the last completed fiscal year, is now required to be disclosed in the footnotes to the Director Compensation Table.

Certain relationships and related transactions disclosure. To present a materially complete picture of the financial relationships within the reporting company, the July 2006 amended rules make significant revisions to the disclosure requirements for related-party transactions. Like many of the new requirements, these rules are more principles-based and intended to streamline and modernize previous rules. That is, while the previous rules required disclosure of related-party transactions, the superseded rules delineated what transactions were reportable and what transactions were excludable. The July 2006 amended rules are more subjective and require a general statement of disclosure principles.

Corporate governance disclosure. While not making many substantive changes, the July 2006 amended rules consolidate existing corporate governance requirements with respect to director independence and other related corporate governance matters. Specifically, these rules include disclosures regarding the independence of each director or director nominee, as well as disclosure of any audit, nominating committee, or compensating committee members who are not independent.

Disclosures in “plain English.” The amended rules are intended to make compensation disclosures easier to understand by requiring, among other things, the use of “plain English.” On April 3, 2006, SEC Chairman Christopher Cox stated in his opening remarks before the Executive Compensation Disclosure Conference that the narratives required under the new rules should be written in “plain English—the new official language of the SEC.” He further stated that he hopes to “see less legalese and Dilbert-ese, and more plain speaking.” Plain English requires that the compensation disclosures be presented in “clear, concise sections, paragraphs and sentences” using the active voice. These disclosures are also now required to use “concrete, everyday words.”

Highly Paid Nonexecutive Compensation Disclosures

The rules proposed in January 2006 included a provision requiring disclosure of the total compensation and job description of up to three additional highly compensated employees (also known as the “Katie Couric Clause”). This provision focused on employees who are not executive officers or directors but who earn more than any named executive officers. This element of the proposed rules proved highly controversial and, as a result, the SEC did not adopt the provision. The SEC instead modified the proposal and requested additional comments concerning the issue.

In determining the three most highly compensated employees, the revised proposal excludes employees who have no responsibility for significant policy decisions. Although the revision precludes disclosure for highly compensated salespeople, entertainers, and professional athletes, opposition to the provision remains vigorous. Comment letters, including those from Jeffrey C. McGuiness, president of the Human Resources Policy Association; James B. Lootens, secretary and deputy general counsel of Eli Lilly and Company; and David G. Tittsworth, executive director of the Investment Advisor Association, expressed concern that the proposal would not facilitate understanding of the compensation structure of the named executive officers because it fails to define responsibility for significant policy decisions and, consequently, lacks the clarity necessary for consistent application. An additional concern is that the rule, as proposed, will invade employee privacy and undermine employers’ ability to attract, retain, and motivate key employees.

Complying with the rule even as it currently stands will require companies to develop total compensation information for a significant number of additional employees, which could be quite costly. Comments on the proposed rule were due to the SEC by October 23, 2006.

Preparing for Proxy Season

Companies can implement a number of measures now in preparation for their proxy season:

  • Communicate the new informational requirements to the appropriate parties and begin a dialogue about any needed systems or recordkeeping changes. This may involve specifying the individuals responsible for the information gathering and preparation. Simultaneously, the appropriate parties can establish the company’s disclosure and presentation strategy, which may involve writing drafts or mock-ups of the CD&A disclosures.
  • Attempt to assess the relative strengths and weaknesses of current board and compensation committee oversight. This may involve examining the company’s current executive compensation incentive structure as well as the relationship between pay and performance. As companies begin filing, information will become available that may be useful for benchmarking executive compensation.
  • Identify individuals who may need to be included in the Summary Compensation Table (i.e., PEO, PFO, and the other three most highly compensated executive officers). This will require computing the total compensation as defined by the new rules, less the increase in pension values and the increase in nonqualified deferred compensation above-market or preferential earnings. This potentially involves gathering information from a number of sources for several individuals. Unfortunately, this will not be the same information already used in preparing W-2s, and the process may be quite time consuming.

The Goal: Better Information for the Investing Public

The SEC has made it clear that these amended rules are designed to clarify and provide transparency to executive earnings. The amended rules are not intended to control or dictate the compensation decisions or philosophies of companies. As the result of these amended rules, the SEC hopes to provide the investing public clearer and more complete information regarding the compensation of executive officers.


Kathryn Yeaton, PhD, CPA, is an assistant professor of accounting at Ramapo College, Mahwah, N.J. 


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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