On July 10, 2009, the SEC proposed revisions to some of its rules governing executive compensation and corporate governance disclosure, as well as rules regulating proxy solicitations. The proposed amendments generally reflect the SEC’s increased focus on issues of risk management, governance and shareholder communication. Comments on the proposals, which were published in Release No. 33- 9052, are due by September 15, 2009.  

Proposed Changes to Compensation Disclosure  

Revised CD&A Disclosure Concerning Risk Incentives. The SEC proposes to require public companies to expand the Compensation Disclosure and Analysis section of their executive compensation disclosures to address, if material, the extent to which the company’s compensation policies and practices create incentives to take risk, and the company’s approach to managing that risk. The CD&A is a principles-based narrative that is intended to provide perspective on the tabular executive compensation information that follows it.  

Recent economic events have provoked strong concern that some companies may have compensation structures that create incentives for insiders to make decisions that significantly and inappropriately increase the company’s risk. Under the SEC’s proposals, companies would have to address in the CD&A their compensation policies and practices for their employees generally (not just for their named executive officers) if the risks arising from those policies or practices may have a material effect on the company. Although the circumstances requiring disclosure will vary from company to company, the SEC identified the following types of compensation programs that might raise material risks:  

  • Compensation policies and practices at business units whose operations entail a significant portion of the company’s overall risk;  
  • Compensation policies and practices at business units that have compensation arrangements structured significantly differently than at other units;  
  • Compensation policies and practices at business units that are significantly more profitable than other units;  
  • Compensation policies and practices at business units in which compensation expense is a significant percentage of the units’ revenues; or
  • Compensation policies and practices that vary significantly from the company’s overall risk and reward structure.  

If a company identifies policies or practices that could present material risks, the company would be required to discuss in its CD&A the risk-related issues associated with those policies and practices. The SEC’s illustrative list of such issues includes:  

  • The general design philosophy of the policies for the employees whose behavior would be most affected by the incentives created by the policies;  
  • The company’s risk assessment or incentive considerations in structuring the policies or in paying compensation;  
  • How the policies relate to the realization of risks resulting from the actions of employees in the short term and long term;  
  • Material adjustments made to policies or practices as a result of changes in the company’s risk profile; and  
  • The extent to which the company monitors its policies in assessing whether risk management objectives are being met.  

Revised Tabular Disclosures of Stock Awards and Option Awards. In the most noteworthy change to the tabular presentation of compensation information, the SEC proposes to require companies to present in the summary compensation table, the grants of plan-based awards table and the director compensation table the grant date fair value of equity awards granted to executive officers and directors in the fiscal years covered by the tables.  

In the 2006 changes to its executive compensation disclosure rules, the SEC initially had proposed requiring tabular disclosure of the aggregate grant date fair value of stock and option awards granted during the fiscal year as computed in accordance with FAS 123R for financial statement reporting purposes. In a controversial move taken before the 2006 proposals became effective, the SEC replaced grant date fair value disclosure with disclosure of the dollar amount recognized by the company for financial reporting purposes for the fiscal year, both for current awards and for awards granted in prior fiscal years.  

The SEC now proposes to restore the grant date fair value treatment, which would require that companies disclose, for all awards granted during the fiscal year, the full grant date fair value of such awards without regard to the vesting period or whether the award is performance-based. The SEC believes that the proposed presentation would be more useful to investors than the current disclosure, and would better reflect the company’s compensation decisions. The current presentation reflects annual adjustments to the value of awards based on stock price volatility and other factors which are not reflective of the compensation committee’s current compensation decisions and which can result in disclosure of negative numbers for equity compensation.

To address these concerns, the SEC proposes to require that the summary compensation table, the grants of plan-based awards table and the director compensation table report stock and option awards based on aggregate grant date fair value. In a corresponding amendment, the SEC proposes to eliminate, as superfluous, the requirement to report the grant date fair value of each individual’s equity awards in the grants of plan-based awards table and corresponding footnote disclosure to the director compensation table. The new treatment would require the company to report the incremental fair value of any options that were repriced during the fiscal year. This is likely to be an important disclosure for some companies in view of the increased use of stock option repricings in recent periods as a result of increased stock market volatility.  

Although the SEC has not yet addressed the transition rules for the new presentation, the SEC indicated that it is considering whether to require companies to present recomputed values for stock and option award disclosure for prior fiscal years covered by the tables. Thus, if the amendments are effective for the next proxy season, companies may need to present, for named executive officers who were executive officers in 2007 or 2008, the grant date fair values of any stock and option awards granted in the prior years, regardless of the amounts that may have been reported in prior proxy statements. For some companies, the new presentation is expected to result in year-over-year changes to the executive officers named in the summary compensation table. The SEC has stated, however, that it does not expect to require companies to re-determine who their named executive officers would have been for prior fiscal years based on recomputed total compensation amounts. In addition, the SEC has indicated that it will not require companies to amend previous filings to change the stock and option award values presented in those filings.  

The SEC also proposes to amend the summary compensation table to eliminate required disclosure of the amount of salary or bonus foregone at a named executive officer’s election, and to require that any non-cash awards received in lieu of foregone salary or bonus be shown in the appropriate column to reflect accurately the form of compensation ultimately received by the officer. For example, if an executive officer elects to receive stock options in lieu of salary or bonus, the value of the options would be reported in the option awards column.  

Proposed Changes to Corporate Governance Disclosure

The SEC’s proposal would amend Items 401 and 407 of Regulation S-K to require additional disclosures about directors and director nominees, the company’s leadership structure, the board’s role in risk management, and the engagement of compensation consultants.  

Qualifications of Directors and Board Nominees. The SEC proposes to amend Item 401 to require companies to disclose, in light of the company’s business or structure, the specific experience, qualifications or skills that qualify each incumbent director and nominee to serve on the board and its committees. The SEC noted that this disclosure could include information about the individual’s risk assessment skills, as well as other specific experience and expertise that would be useful to the company. The SEC also proposes to require companies to disclose public company directorships held by their directors and nominees at any time during the past five years, rather than current directorships only, as required under the existing item. The SEC believes the additional disclosure would afford investors a sounder basis for evaluating both the relevance of the individual’s past board memberships and the professional or financial relationships that might pose potential conflicts of interest with service on the reporting company’s board. The Item 401 amendments also would expand from five to ten years the prior period for which companies would have to disclose the involvement of their directors, nominees and executive officers in specified types of legal proceedings.  

In its proposals, the SEC has solicited comment on whether to expand the current requirement that companies disclose specific minimum qualifications for board nominees to include disclosure concerning the extent to which board diversity or other factors play a role in considering director candidates.  

Leadership Structure and the Board’s Role in Risk Management. The SEC proposes to amend Item 407 of Regulation S-K and Item 7 of Schedule 14A of its proxy rules to require disclosure of the company’s leadership structure and the board’s role in risk management, which are areas of corporate governance disclosure the SEC’s current rules do not specifically address. NYSE-listed companies currently are subject to a limited form of this disclosure under the exchange’s rules requiring them to describe in their proxy statement or Form 10-K the manner in which they choose directors to preside over executive board sessions.  

Amended Item 407 would require companies to disclose why they believes that the leadership structure they have chosen is the most suitable structure for the company. The company would be required to discuss whether and why it has chosen to combine or separate the roles of principal executive officer and board chair. Companies that have combined these roles and designated a lead independent director to chair meetings of the independent directors would be required to discuss whether and why the company has a lead independent director and the role of that individual in the leadership of the company.  

The SEC also proposes to add disclosure requirements on the board’s role in the risk management process. The new disclosure would address such matters as whether the persons who oversee risk management for the company report directly to the board or to a board committee (such as the audit committee) to which the board has delegated the risk management responsibility, and whether or how the board or a committee monitors risk.  

The SEC would extend a tailored version of the new requirements to investment companies registered under the Investment Company Act. Recognizing the special governance structure of these companies, the SEC would require them to disclose whether the board chair is an “interested person” of the investment company, and if so, to discuss whether the company has a lead independent director and the role this director assumes in the leadership of the company.  

Compensation Consultants and Potential Conflicts of Interest. The SEC further proposes to amend Item 407 to require disclosure about the fees paid to a compensation consultant and the consultant’s affiliates if the consultant plays any role in determining or recommending the amount or form of executive and director compensation and also provides other services to the company.  

Item 407 currently requires a company to identify any compensation consultant who plays a role in determining or recommending executive and director compensation. Some investors have expressed concern that the executive compensation services provided by compensation consultants may be influenced by the consultants’ provision of other services to the company, such as benefits administration and human resources consulting, thereby creating the risk of a conflict of interest.  

The SEC’s proposal would require the company to disclose the additional services provided to it by the consultant or the consultant’s affiliates, including:  

  • The nature and extent of the additional services provided during the last fiscal year by the consultant or its affiliates;  
  • The aggregate amount of fees paid to the consultant or its affiliates for both compensation-related services and additional services;  
  • Whether the decision to engage the consultant or its affiliates for additional services was made, recommended or reviewed by management; and  
  • Whether the company’s board or compensation committee approved all of the additional services.  

The company would not have to provide this disclosure if the compensation consultant’s services in determining or recommending the amount or form of compensation are limited to broad-based plans, such as 401(k) or health insurance plans, that do not discriminate in favor of executive officers or directors.  

Proposed Accelerated Reporting of Shareholder Voting Results on Form 8-K  

The SEC proposes to add a new Item 5.07 to Form 8-K to require that a company disclose the results of a shareholder vote taken at a shareholder meeting within four business days after the meeting date. In the case of a contested election of directors, the company would be required to disclose the preliminary voting results within four business days after the meeting date and to disclose the final voting results in an amended Form 8-K within four business days after certification of the final results. The proposed change to Form 8-K would replace the current requirement that a company disclose shareholder voting results in the first Form 10-Q or Form 10-K report filed after the fiscal quarter in which a matter was submitted for a shareholder vote.  

Proposed Changes to Proxy Solicitation Rules  

The SEC also has proposed amendments to its proxy rules under the Exchange Act that are intended to codify a number of SEC interpretations relating to rules governing shareholder communication and solicitation of proxy authority by shareholders and other non-management parties. If adopted, the rule changes may encourage additional shareholder action through the proxy process.  

Exception from Proxy Solicitation Rules. The SEC proposes two amendments to clarify the scope of Rule 14a-2(b)(1), which exempts from compliance with most proxy rules solicitations by shareholders or other non-management parties who are not seeking “proxy authority” and who do not have a “substantial interest” in the subject matter of the solicitation. Rule 14a-2(b)(1) would be amended to clarify that a person that provides a solicited shareholder with an unmarked copy of management’s proxy card and asks that it be returned to management would not be deemed to have furnished a “form of revocation” of the solicited shareholder’s prior vote that would constitute the solicitation of proxy authority and thereby preclude the soliciting person from relying on the exemption. The SEC believes that its proposed clarification will enable persons not seeking proxy authority to facilitate voting by other shareholders sharing the same views (such as in a “vote no” campaign) without incurring the costs and efforts of a full proxy solicitation. Rule 14a- 2(b)(1) also would be amended to clarify that a soliciting person could be deemed ineligible to rely on the rule, even if the person is not a holder of the class of security being solicited, if the person would receive a benefit from a successful solicitation that would not be related to or derived from holdings of that class of security.  

Rounding Out a “Short Slate” of Nominees. The SEC proposes to amend Rule 14a-4(d)(4) to permit a nonmanagement group seeking to place candidates on the company’s board to round out its nominee slate by seeking authority to vote for nominees named in any other person’s proxy statement as well as the company’s proxy statement. The rule provides an exception to the requirement that, to solicit authority to vote for the election of a person to office, the person must be a bona fide nominee who consents to being named in the soliciting person’s proxy statement and to serving if elected. Rule 14a-4(d)(4) permits a person soliciting support for nominees who, if elected, would constitute a minority of the board of directors, or a “short slate,” to round out the short slate (up to the total number of director positions then subject to election) by seeking authority to vote for nominees named in the company’s proxy statement. The rule does not currently address whether a person instead can round out the short slate by seeking authority to vote for nominees named in the proxy statements of other soliciting persons. The SEC’s proposed amendment permitting rounding out in these circumstances would be available only when non-management parties are not acting together in a manner that would be deemed to cause the formation of a “group” as determined under Section 13(d)(3) of the Exchange Act and in Regulation 13D-G under the Exchange Act. A nonmanagement soliciting person seeking to rely on the proposed exception would be required to represent in such person’s proxy statement that the person is not a participant in the other non-management person’s solicitation.  

Limitation of “Reasonable Specified Conditions” Under Which Proxy Shares May Not be Voted. Rule 14a- 14(e) requires that a proxy statement or form of proxy provide that the shares represented by the proxy be voted “subject to reasonable specified conditions.” The SEC proposes to amend the rule to clarify that the reasonable specified conditions must be “objectively determinable.” The SEC believes that for a shareholder to make an informed decision regarding whether or not to grant a proxy, the shareholder must know whether the recipient of the proxy will vote the shareholder’s shares only subject to some condition. The proposed amendment would prevent the recipient of the proxy from seeking to exercise a degree of discretion that would be inconsistent with the limitations under the proxy rules regarding when a proxy can confer discretionary authority.  

Timing of Filing Participant Information. Rule 14a-12 permits a solicitation to be made before furnishing shareholders with a proper proxy statement if, among other requirements, each written communication that is part of the solicitation contains specified participant information, including the identity of the participants in the solicitation and a description of their direct or indirect interests, or a legend advising shareholders where they can obtain that information. The SEC has proposed to amend Rule 14a-12 to clarify that the required participant information must be filed under cover of Schedule 14A as part of a proxy statement or other soliciting materials no later than the time at which the first soliciting communication is made.  

Conclusion  

The SEC’s compensation and corporate governance disclosure proposals would require companies to report on practices that have attracted increasing scrutiny from the SEC and investors. The process of preparing the CD&A would have to include a consideration of the relationship between a company’s executive compensation programs and the risks assumed by the company in managing its business. The new requirements are likely to produce disclosure of some questionable compensation policies and practices and ensure that the swelling volume of criticism from investors and other interested parties concerning executive compensation will continue unabated. The expanded corporate governance disclosures would have to address some sensitive matters of board structure and operation, including the much-debated issue of the advisability of combining or separating the rules of board chair and CEO. Although the SEC disclaimed any intention in issuing the proposals to “influence a company’s decision regarding its board leadership structure,” it is likely that the new disclosure requirements will cause many companies to re-examine, and some companies to revise, their current practices. If, as expected, the SEC will seek to adopt the proposals in time for them to be effective for the next proxy season, companies would be well-served by beginning the reassessment process without delay.