SEC Adopts Proxy Disclosure Amendments on Risk, Compensation and Corporate Governance Matters
The Securities and Exchange Commission at its open meeting on December 16, 2009, approved by a 4-1 vote rule amendments expanding disclosure requirements related to risk, compensation and corporate governance. The final rules, which are effective February 28, 2010, address disclosure regarding:
- compensation policies and practices;
- compensation tables;
- director and nominee qualifications;
- director and executive officer backgrounds;
- board diversity;
- board leadership structure and risk oversight;
- compensation consultants; and
- results of shareholder votes.
To facilitate companies’ preparation for the upcoming 2010 proxy season, the Commission published the adopting release, including the text of the final rules, the same day it approved the rules. The Commission’s adopting release, Proxy Disclosure Enhancements, Release No. 33 9089, can be found at http://www.sec.gov/rules/final/2009/33-9089.pdf.
PHASE-IN OF THE FINAL RULES: The February 28, 2010, effective date of the final rules raised questions relating to timing for companies in the process of preparing annual reports on Form 10-K for the 2009 fiscal year and proxy statements containing fiscal 2009 compensation disclosure. In an effort to address these questions, the SEC, on December 22, 2009, issued Compliance and Disclosure Interpretations (CDIs) consisting of five questions and answers regarding the phase-in of the final rules. The phase-in CDIs can be found at http://www.sec.gov/divisions/corpfin/guidance/pdetinterp.htm.
Companies with fiscal years ending on or after December 20, 2009, must comply with the new disclosure requirements for their annual reports on Form 10-K and related proxy statements filed on or after February 28, 2010. If a company is required to file a preliminary proxy statement and expects to file its definitive proxy statement on or after February 28, 2010, then the preliminary proxy statement must comply with the new proxy disclosure requirements, even if filed before February 28, 2010. If a company files its 2009 Form 10-K before February 28, 2010, and its proxy statement on or after February 28, 2010, the proxy statement must comply with the new proxy disclosure requirements. If a company’s fiscal year ends before December 20, 2009, its 2009 Form 10-K and related proxy statement are not required to comply, even if filed on or after February 28, 2010. With respect to the reporting of results of shareholder votes on Form 8-K, the new requirement applies to any shareholder meeting that takes place on or after February 28, 2010.
COMPENSATION POLICIES AND PRACTICES: In its July 2009 release, the SEC proposed a new rule that would have required a public company to include in its Compensation Discussion and Analysis (CD&A) a discussion of how the company’s compensation policies and practices for non-executive employees affected the company’s risk exposure and ability to manage that risk. This proposal generated a spate of critical comments from public companies and members of the securities bar. Many commenters suggested that, seemingly motivated by concerns about recent events in the financial services industry, the SEC was attempting to mandate disclosure that would be irrelevant for many public companies and their investors. Furthermore, a number of commenters argued that the CD&A was supposed to focus on executive compensation and adding a discussion regarding non-executive compensation policies would be inappropriate. Finally, commenters were concerned that the Commission’s proposal was less than clear in terms of what risks the disclosure was intended to address.
In the final rules, the Commission attempted to address many of the comments. First, the final rules only require a narrative description of how a company’s overall compensation policies and practices for employees create incentives that can affect the company’s risk and management of that risk, if and to the extent that risks arising from these policies and practices are reasonably likely to have a material adverse effect on the company. If a company concludes that risks arising from these policies and practices are not reasonably likely to have a material adverse effect on it, the company can omit the disclosure and need not make an affirmative statement regarding its conclusion. Second, to the extent that a company concludes that disclosure is required, the disclosure will not be required as part of CD&A, but instead will be included as an additional executive compensation item. Finally, in a footnote in the adopting release, the SEC reiterated its view that under existing rules, to the extent that risk considerations are a material aspect of a company’s compensation policies or decisions for named executive officers, the company must discuss those risk considerations in CD&A. Smaller reporting companies, already exempt from the requirement to provide a CD&A, will also be exempt from the new disclosure requirement regarding risk and compensation.
In the adopting release, the Commission added some discussion of the types of situations that could trigger the new risk disclosure, addressing in particular those features of a company’s compensation policies and practices that have the potential to incentivize its employees to create risks. For example, the Commission observed that disclosure of compensation policies and practices of a business unit within a company that carries a significant portion of the company’s risk profile may be required. The release also noted that companies may want to discuss their risk assessment or incentive considerations, if any, in structuring their compensation policies and practices, or in awarding compensation. Finally, new Item 402(s) of Regulation S-K includes several illustrative examples of the issues that a company likely would need to address if the disclosure is required.
COMPENSATION TABLES: Under the revised rules, stock and option awards granted during the fiscal year to company executives and directors must be reported in the Summary Compensation Table and Director Compensation Table at their aggregate grant date fair values, computed in accordance with Financial Accounting Standards Board Accounting Standards Codification Topic 718, Compensation – Stock Compensation. The revised disclosure requirement replaces the currently mandated disclosure of the dollar amount recognized each year for financial statement reporting purposes for all grants regardless of the year in which the grants were made. This shift in approach is likely to affect the calculation of total compensation for purposes of determining who is a named executive officer. Furthermore, the change will have the effect of creating large annual swings in reported compensation for companies that make multi-year grants rather than annual grants.
To address concerns that reporting the aggregate grant date fair value of awards may exaggerate total compensation for executives and directors who receive performance awards, thereby discouraging companies from granting these awards, the Commission clarified that the value of performance awards should be computed based upon the probable outcome of the performance conditions as of the grant date. Instructions to the Summary Compensation Table and Director Compensation Table require the disclosure of the grant date estimate of the value of performance awards in the table, along with footnote disclosure of the potential maximum value assuming the highest level of performance conditions is achieved.
The rule amendments require companies providing disclosure for a fiscal year ending on or after December 20, 2009, to present recomputed disclosure for each preceding fiscal year required to be included in the table, so that the stock awards and option awards can be compared year to year. In addition, if a person who is a named executive officer for the 2009 fiscal year also was disclosed as a named executive officer for the 2007 fiscal year, the named executive officer’s compensation for each of the 2007, 2008 and 2009 fiscal years must be reported. The final rules, however, do not require companies to determine or disclose who would have been named executive officers in prior years based on recomputed total compensation or to amend prior disclosure in previously filed annual reports or proxy statements.
DIRECTOR & NOMINEE QUALIFICATIONS: The final rules significantly expand disclosure relating to qualifications of directors and nominees for director. First, companies must disclose for each director and director nominee the particular experience, qualifications, attributes or skills that led the board to conclude that the person should serve as a director of the company as of the time at which the relevant filing is made with the Commission. The final rules require this disclosure annually for all nominees, as well as for all continuing directors. A third-party proponent nominating a director must include in the proponent’s proxy solicitation materials the same information with respect to the proponent’s nominee.
Persuaded by comments that in many instances companies will rotate directors among several committee positions during their tenure on the board, the Commission decided not to adopt the proposed requirement to disclose the specific experience, qualifications or skills that qualify an individual to serve on a particular board committee. If, however, a person is chosen to be a director or a nominee because of a particular attribute or experience related to service on a specific committee, then this qualification should be disclosed. In addition, the Commission dropped the proposed requirement to discuss “risk assessment skills” of directors and nominees to allow companies the flexibility in determining what qualifications, attributes or experience should be disclosed to investors. Nevertheless, if a particular experience, qualification, attribute or skill of an individual, including risk assessment expertise, led the board to conclude that person should serve on the board, this should be disclosed.
DIRECTOR & EXECUTIVE OFFICER BACKGROUNDS: The final rules require disclosure of any directorships held at any public company or registered investment company by each director and nominee at any time during the past five years, as opposed to only currently held directorships as required under the previous rules.
In addition, the final rules extend from five to 10 years the period during which legal proceedings involving directors, director nominees and executive officers will require disclosure to the extent they are material to an evaluation of the ability or integrity of the director, nominee or executive officer. The rules also expand the list of disclosable legal proceedings to include:
- any judicial or administrative proceeding resulting from involvement in mail or wire fraud or fraud in connection with any business entity;
- any judicial or administrative proceeding based on violations of federal or state securities, commodities, banking or insurance laws and regulations, or any settlement to such actions (excluding settlement of civil proceedings); and
- any disciplinary sanctions or orders imposed by a stock, commodities or derivatives exchange or other self-regulatory organization.
BOARD DIVERSITY: The final rules require new disclosure regarding whether board diversity is a factor considered in identifying candidates for board membership. While this new requirement was not included in the July 2009 proposing release, that release did solicit input regarding the importance to investors of disclosure about board diversity. In response, the Commission received a significant number of comments suggesting that information about board diversity would enable investors to make more informed voting decisions. Under the final rules, a company must disclose whether, and if so how, its nominating committee or its full board considers diversity in identifying director nominees. Specifically, if the nominating committee or the board has a policy with respect to the consideration of diversity in the evaluation of candidates for director, the company must provide information on how this policy is implemented and how the nominating committee or the board assesses its effectiveness. The Commission recognized that companies may define diversity in various ways. For example, some companies may focus on diversity concepts such as race, gender and national origin, while others may view diversity more expansively to include differences of viewpoint, professional experience, education, skill and other individual qualities and attributes. Accordingly, the final rules do not define diversity, leaving each company to define the term as it is understood by the nominating committee or the board.
BOARD LEADERSHIP STRUCTURE AND RISK OVERSIGHT: Further reflecting the Commission’s focus on corporate governance matters, the final rules expand disclosure relating to the board’s leadership structure and its role in risk oversight. Under the final rules, a company is required to disclose whether and why it has chosen to combine or separate the positions of principal executive officer and chairman of the board, as well as why the company believes that its board leadership structure is the most appropriate for it at the time of the filing. In circumstances where the role of principal executive officer and chairman of the board are combined, and a lead independent director is designated to chair meetings of the independent directors, the company must disclose that fact, explain why it has a lead independent director and describe the specific role the lead independent director plays in company leadership.
Under the final rules, companies are also required to discuss the board’s role in the oversight of the risk management process. Specifically, a company must describe how the board administers its risk oversight function, for example, whether through the whole board or through a committee. The Commission also suggests that the disclosure include a discussion of how the board or committee receives information from individuals within the company who supervise day-to-day risk management responsibilities.
COMPENSATION CONSULTANTS: Reflecting concern about potential conflicts of interest compensation consultants may face in recommending the amount or form of director and executive compensation, the final rules include a requirement that a company disclose, in certain circumstances, fees paid to compensation consultants and their affiliates for executive compensation services, as well as fees paid for other services they provide that are unrelated to executive and director compensation.
Subject to the $120,000 threshold and other limitations discussed below, the final rules require the following disclosure with respect to compensation consultants:
- If the board engages a compensation consultant to advise it on executive and board compensation and the board’s compensation consultant (or one of its affiliates) provides other non-executive consulting services to the company, then the company must disclose (i) the aggregate fees paid to the consultant for determining or recommending the amount or form of executive and director compensation, (ii) the aggregate fees paid to the consultant (or its affiliates) for all other non-executive consulting services to the company, (iii) whether management made, or recommended, the decision to engage the consultant (or its affiliates) for the other services, and (iv) whether the compensation committee or board approved the other services performed by the consultant (or its affiliates).
- If the board does not engage a compensation consultant, but management receives executive compensation advice from a consultant and also obtains other non-executive consulting services from the same consultant (or one of its affiliates), then the company must disclose (i) the aggregate fees paid to the consultant for determining or recommending the amount or form of executive and director compensation, and (ii) the aggregate fees paid to the consultant (or its affiliates) for all other non-executive consulting services to the company.
- If the board and management each engage separate compensation consultants to advise on executive and board compensation and no other non-executive consulting services are provided to the company by the board’s consultant, then no disclosure is required, even where management’s consultant provides other non-executive consulting services to the company.
No disclosure is required where the fees paid for other non-executive consulting services provided to the company do not exceed $120,000 for the company’s fiscal year. The final rules do not require disclosure of the nature and extent of any non-executive consulting services provided by a consultant. For purposes of the final rule, the following services will not be considered to be the provision of either advice as to executive and board compensation or other non-executive consulting services: (i) consulting on broad-based plans; and (ii) providing survey or other information that is not customized or is customized based on parameters not developed by the consultant. Accordingly, the fees for these specified services do not need to be disclosed or included for purposes of determining whether the $120,000 threshold has been exceeded.
RESULTS OF SHAREHOLDER VOTES: The final rules include new Item 5.07 of Form 8-K, requiring reporting of shareholder voting results within four business days following the meeting at which the vote was held. This eliminates the previous requirement to report voting results on Forms 10-Q or 10-K. To accommodate certain situations, such as contested elections, where it may take longer than four business days to determine definitive voting results, the rules allow companies to file the preliminary voting results within four business days after the end of the shareholders’ meeting and then file an amended report on Form 8-K within four business days after the final voting results are known.
WHAT YOU SHOULD DO NOW: To prepare for disclosure under the final rules, we suggest that companies and boards consider the following actions:
- Compensation committees and senior management should review compensation policies and practices for employees generally and consider whether those policies and practices create an incentive for risk taking that can have a material adverse effect on the company.
- Identify 2009 named executive officers using the aggregate grant date fair value amount for equity awards. For awards subject to performance conditions, determine the grant date fair value using the probable outcome of the performance conditions as of the grant date. Recalculate 2007 and 2008 grant date fair values for the identified group of named executive officers.
- Nominating committees should consider the new rules in evaluating nominees. Discuss the particular experience, qualifications, attributes and skills that support the board membership of each director and nominee. Consider adding an item to director and officer questionnaires to inform this discussion.
- Nominating committees should be prepared to discuss whether and how they consider diversity – and what diversity means to them – in evaluating nominees. If there is no policy for the consideration of diversity in making nominating decisions, consider whether to adopt one.
- Update director and officer questionnaires to cover five years of public company and registered investment company board memberships for directors and nominees, as well as 10 years of legal proceedings (including the three new categories) for directors, nominees and executive officers.
- Nominating committees should be prepared to justify the current leadership structure, particularly if the CEO is also the chairman of the board. A board with a non-independent chairman should consider whether to appoint a lead independent director if it has not already done so.
- Evaluate the risk management process and the board’s oversight role. Consider the effectiveness of information flow between day-to-day risk management supervisors and the board or relevant board committee.
- Examine relationships with compensation consultants and their affiliates, and the executive and non-executive compensation services they provide to the board and management. Consider whether these relationships and services create, or may give the appearance of creating, a conflict of interest. If they do not exist, develop procedures to track fees paid to and services provided by compensation consultants. Determine whether additional disclosure is required under the new rules.
- Notify responsible persons that results of shareholder votes taking place on or after February 28, 2010, must be reported on a Form 8-K within four business days.