The Securities and Exchange Commission proposed an expansion of compensation reporting requirements on July 10, 2009. (SEC Release 34-60280.) The proposed rules are posted on the SEC’s website at http://www.sec.gov/rules/proposed/2009/33-9052.pdf. The proposal contains extensive requests for comment, and may be modified based on the comments received. If adopted, the new rules would be applicable to the 2010 proxy season. The key proposals are

  • The compensation discussion and analysis (CD&A) in companies’ annual proxy statements would need to describe how compensation policies (not just executive compensation policies) may incentivize unnecessary risk, either at the company generally, or at specific business units.
  • Stock and option awards would be reported in the proxy’s Summary Compensation Table at their full grant date fair value under FAS 123R, including for years prior to 2009.
  • The proxy statement would be required to describe each incumbent director’s (and director nominee’s) particular qualifications and disclose his or her involvement in legal proceedings in the prior ten years.
  • If an executive compensation consultant also provides other services to the company, the proxy statement would need to describe the other services, as well as the executive compensation consulting services, and disclose the amount paid for each type of service.
  • The proxy statement would need to include a discussion of the rationale for the company’s leadership structure (including whether there is a separate CEO and Chairman of the Board).
  • Shareholder voting results would need to be reported within four business days on Form 8-K.
  • The proposal would also clarify some rules governing the proxy solicitation process.

The key elements of the release are summarized in greater detail below.

Risk Management Disclosure

Consistent with the current national focus on identifying and eliminating compensation policies that encourage excessive or inappropriate risk taking, the SEC’s proposed rules would require the CD&A to cover how the company rewards and incentivizes its employees (including non-executive employees) if the compensation program creates risks that may have a material effect on the company. This would include, for example, discussion and analysis of

  • compensation policies at a business unit of the company that carries a significant portion of the company’s risk profile,
  • compensation policies at a business unit with a different compensation structure than other units,
  • compensation structure at business units that are more profitable than others,
  • compensation structure where the compensation expense is a significant percentage of the business unit’s revenues, or
  • compensation structure when bonuses are awarded upon the accomplishment of a task, while the income and risk to the company from the task extend over a significantly longer period of time.

Examples of the issues that may need to be addressed include

  • the compensation design philosophy regarding incentives for risk taking and the manner of its implementation
  • how (if at all) the company assesses risk in designing compensation policies or particular awards
  • how compensation policies relate to adverse results of risk taking, such as through claw backs or holding periods
  • the company’s policies regarding adjustments to its compensation policies to address changes in its risk profile
  • the extent to which the company monitors compensation policies to determine whether its risk management objectives are being met with regard to incentive compensation.

In addition, the SEC proposed rules would require a description (outside the CD&A) of the level of the board’s involvement in the risk management process, and the effect this has on the company’s leadership structure. In the proposing release, the SEC stated it expects this description to include how the board implements and manages the risk management function, whether the persons who oversee risk management report directly to the full board or to a committee, and how the board or board committee monitors risk.

Comment. The CD&A risk analysis requirement poses challenges for many reasons. One reason is that many or most compensation committees are not currently engaged in setting incentive compensation for employees below the executive level. While the CD&A is a management statement, the compensation committee must, in effect, condone its inclusion in the annual proxy statement, and therefore will be required to engage in an analysis and review of compensation policies and programs throughout the company where the incentive structure may result in material risk.

Another reason is that there is no description in the SEC release of what “risk” the company should be concerned about. Credit risk? Liquidity risk? Operational risk? Risk of a lower EPS? A policy designed to avoid one kind of risk may, in retrospect, inadvertently encourage an entirely different risk, one that may be unforeseeable. If the CD&A fails to disclose consideration of the other risks, will the directors potentially be liable? It is clear that if the company has a policy against compensation that encourages inappropriate risk taking, but actually encourages risk taking that may have a material effect on the company, disclosure would be required.

In addition, the analysis of whether a given risk may have a “material” effect on the company will be a challenge.

Further, the proposal, if adopted, poses challenges because compensation committees, for the most part, have not engaged in an articulation or quantification of risk-taking behavior inherent in a given incentive structure. Compensation committees have struggled to design incentive structures that are clear, simple, and calibrated to motivate certain behavior toward a specific financial or strategic goal. Good compensation committees will also design structures that are not susceptible of manipulation, and will review the structures periodically to confirm that the motivations continue to be appropriate. Adding an articulated risk analysis will add a new layer of complexity to designing effective incentive tools, no doubt involving new metrics and new layer of consultants. We assume that a best practice will emerge in this area, constraining companies to adopt a uniform approach to risk management at the board level.

Finally, an additional concern is that companies generally have ways of managing risk beyond the design of their compensation programs. A discussion of company risk management through the narrow lens of the CD&A may be incomplete at best, and possibly misleading.  

Stock and Option Award Reporting Under the SEC proposals:

  • Disclosure of option and stock awards in the Summary Compensation Table and Director Compensation Table will reflect the aggregate grant date fair value of awards (as determined under FAS 123(R)), rather than the amount expensed for the year for financial reporting purposes, as currently required.
  • The column showing grant date fair value of individual awards will no longer appear in the Grants of Plan-Based Awards Table (or footnotes to the Director Compensation Table).
  • Salary or bonus foregone at the executive’s election in favor of a different non-cash form of compensation would no longer be included in the salary or bonus column, but only in the appropriate other column, of the Summary Compensation Table.

Comment. Adoption of the changes as proposed will carry some immediate effects of which reporting companies should be aware:

  • Companies and their advisors preparing the CD&A tables must ensure they have the data to determine grant date fair values. Merely updating last year’s spreadsheets will not work.
  • The identity of named executive officers (which is determined by total compensation reported in the Summary Compensation Table) may change or fluctuate more frequently, particularly if some executives receive multi-year grants.
  • The proposed changes contemplate requiring issuers to restate prior year compensation reported in the Summary Compensation Table to reflect grant date fair value of (rather than the financial statement expense) of equity awards in those years (i.e., the 2007 and 2008 disclosures, as well as 2009, assuming the change becomes effective as scheduled for the 2010 proxy season.) They do not, however, propose changing the identity of the individuals reported as named executive officers for prior years. Large reporting companies should have these figures from the data developed for the Grants of Plan-Based Awards Tables in prior years. Small reporting companies, who were not required to include a Grants of Plan-Based Awards Table, but were required to include figures for one (rather than two) prior years in the Summary Compensation Table, may face a special task in developing this data retroactively, if this transition feature is included in the final regulations.

This proposed change was motivated in part by concerns that the amount ultimately paid out would differ from the amounts reported in the tables. But trying to define any appropriate current value for the amount ultimately to be paid out under an equity award is the pursuit of a phantom. The amount ultimately paid out cannot accurately be determined until the option is exercised (or lapses or terminates without payout), or the stock award vests and stock is issued. Indeed, the amount actually received by the executive from the award may not fairly be determinable until the executive sells that stock.

Showing the grant date fair value is surely more meaningful in disclosing the compensation the compensation committee intends to grant in any given year. Many if not most compensation committees use some variant of grant date fair value (not invariably the FAS 123(R) definition) in determining the size of option grants and other stock awards. Indeed, some companies in their CD&A have supplemented the required Summary Compensation Table with an alternative table showing stock awards at grant date fair value, in the belief that it more fairly reflects the compensation decisions actually made in the year.  

Enhanced Director and Nominee Disclosure

In addition to the biographical information (covering the past 5 years), and the general disclosure about director qualification requirements at a company, the proposed SEC rules would require disclosure of the specific experience, qualifications, attributes or skills that qualify an incumbent director or director nominee to serve as a director as of the time of the disclosure, and to serve on any committee the person serves on or (if known) will serve on. The stated purpose of this new requirement is to enable shareholders to better determine if the incumbent director (or director nominee) has risk assessment skills, specific past experience, or a particular area of expertise that would benefit the company, and to determine, generally, if the director (or director nominee) is a good fit for the company.

In addition, the proposal would require disclosure of any directorships held at a public company by each incumbent director and each director nominee in the past five years, and would lengthen the look-back period for disclosing various legal matters (e.g., personal or business bankruptcy, criminal convictions or proceedings, enforcement orders, judgments and decrees) from five to ten years. The stated purpose of this expanded disclosure is to give investors more extensive information about the person’s competence and character. These disclosures would appear in the company’s proxy and information statements, annual report on Form 10-K, and any registration statements.

New Disclosure Regarding Compensation Consultant Services and Fees

In addition to the current requirements for disclosure regarding compensation consultants (role of compensation consultants regarding executive or director compensation, who engages them, nature and scope of assignment, material elements of their instructions), the proposed SEC rules would further require a description of the additional services a compensation consultant (or any affiliate) provides to the company. In addition, the company would be required to disclose the amount paid to the consultant both in connection with executive (and director) compensation consulting and in connection with the other services the consultant (or any affiliate) provides to the company. The company would also be required to disclose whether the decision to engage the consultant for non-executive compensation services was made, recommended, subject to screening or reviewed by management, and whether the board (or compensation committee) approved all the services in addition to the executive compensation services. If the only role played by the consultant in executive compensation is based on the executives’ participation in broad-based plans for which the consultant provides services, and such participation is on the same term as other employees, the additional disclosure requirements do not apply.

Comment. Although the rules do not prohibit consultants from providing services other than executive compensation services to the company, these disclosures are clearly designed to shed light on any appearance of a conflict of interest and may be a precursor to the imposition of auditor-style independence requirements on compensation consultants.  

Reporting Voting Results on Form 8-K

The results of shareholder votes would be required to be reported within four business days after the shareholder meeting on Form 8-K, rather than later, on Form 10-Q or 10-K, as currently required. The SEC’s stated view is that if a matter is important enough to submit to shareholder vote, it is likely important enough to be reported currently on Form 8-K. In the case of a contested election, where the voting results are not definitively determined at the end of the meeting, the preliminary voting results would be disclosed on Form 8-K, and the final results would be reported on an amended form 8-K within four business days after the final results are certified.

Both the companies that must make the disclosures and investors who are the intended beneficiaries of the disclosures should review the proposed changes and the many specific questions on which the SEC has specifically requested comment. Comments within the 60-day period following publication may assist the SEC in ultimately issuing an improved version of the requirements to take effect for the 2010 proxy season.