Just in time for the upcoming proxy season, the Securities and Exchange Commission (SEC) has adopted final rules designed to enhance company disclosures about the role of risk in compensation policies and other compensation related matters (the Final Rules).1 The Final Rules, to be effective on February 28, 2010, reflect with only minor changes the proposed rules issued by the SEC this past July.2

The Final Rules require a public company to provide expanded disclosure in its annual meeting proxy statement to address its compensation policies and practices for all employees (not merely the top five executive officers) if its compensation policies and practices create risks that are reasonably likely to have a material adverse effect on the company. As compared to the proposed version of the rule, the disclosure threshold has been raised from a “may have a material effect” standard to a “reasonably likely to have a material adverse effect” standard. This may narrow the range of companies that will be required to provide the risk disclosure. The SEC suggests that this standard is one that should be familiar to public companies because it the same one used in the SEC’s Management Discussion and Analysis rules.

The Final Rules also adopt a non-exclusive list of illustrative examples of situations where compensation programs and practices may have the potential to raise material risks to companies. It should be noted that the Final Rules could require a discussion of the compensation practices of an individual business unit of a company, such as where the unit carries a significant portion of the company’s risk profile, is significantly more profitable than others within the company or has practices that vary significantly from those of other business units. If a company determines that it must provide compensation risk disclosure, it will be required to discuss the design philosophy of its risk creating compensation plans, the company’s risk assessment considerations in structuring its compensation policies, how these policies relate to employee risk taking in both the short term and long term, and other mandated disclosures. Unlike the proposed rules, the Final Rules make this risk disclosure a separate section of the proxy statement, rather than placing it in the Compensation Discussion and Analysis section (CDA). This is intended to keep CDA focused on the named executive officers, whereas the risk discussion potentially includes the compensation practices for employees who fall outside of that group.

The Final Rules also adopt changes to the Summary Compensation Table that will now require that the grant date fair value of equity compensation to the named executive officers be shown in the table rather than the amount of equity compensation expense recognized in respect of them during a fiscal year pursuant to FASB ASC Topic 718 (formerly FAS 123R). Correlating changes are made to the Grants of Plan-Based Awards Table and Directors Compensation Table. Where equity grants contain performance conditions, the grant date fair value shown in the table should be calculated on the “most probable outcome” as of the grant date, not the maximum outcome as originally proposed; however, footnote disclosure of the maximum outcome will be required. For companies with fiscal years ended on or after December 20, 2009, prior year data in these tables will have to be recomputed in accordance with the new standard.

The Final Rules will require expanded disclosure regarding the business backgrounds of directors and nominees for directors. This will include disclosure of the particular experiences, attributes or skills that led the board to conclude that a person should serve as director for the company. The SEC did not adopt, as proposed, similar disclosure regarding a director’s qualifications to participate on the board committees upon which the director serves. In addition, disclosure of a director’s service as a director of other public companies is expanded from merely current directorships to all held during the prior five years. The five year look back on director and executive officer involvement in certain legal proceedings has been extended to 10 years, and the list of legal proceedings requiring disclosure has been expanded to cover a wider range of matters, including any proceedings involving mail or wire fraud, or any violations of federal or state securities, banking, commodities or insurance laws and regulations.

The Final Rules also include provisions requiring a description of whether and how a company’s nominating committee considers diversity in identifying nominees, how the policy, if any, is implemented, and an assessment of any such policy’s effectiveness. Under the Final Rules, annual meeting proxies will also have to include an explanation of the company’s board leadership structure, focusing on whether and why the same person serves as both chairman and CEO, and whether there is a lead director. An explanation of why the company believes that its board leadership structure is appropriate to its circumstances will be required as well. The SEC also adopted the proposed enhanced disclosures regarding the role of compensation consultants in the compensation setting process. This disclosure must also include a description of other services provided to the company by the consultant if the fees exceeded $120,000 during the last fiscal year.

The SEC has also issued transitional guidance for the Final Rules.3 All definitive proxy statements filed with the SEC on or after the February 28, 2010 effective date must comply with the Final Rules. Preliminary proxy statements filed before the effective date must also comply with the Final Rules if the definitive proxy statement will be filed on or after the effective date. The SEC has also clarified that the Final Rules do not apply to companies with fiscal years that ended before December 20, 2009, regardless of when their proxy materials are filed. In any event, virtually all proxy statements for the upcoming proxy season will likely need to reflect the new mandated disclosures. In addition, director and officer questionnaires will need to be amended in order to obtain expanded information on director and executive officer legal proceedings and director qualifications.