The proxy disclosure enhancement rules adopted by the Securities and Exchange Commission on December 16, 2009, became effective on February 28, 2010. Any Form 10-Ks and proxy statements filed on or after February 28, 2010, must comply with the new rules if a company’s last fiscal year ended on or after December 20, 2009. The text of the final rules can be found at http://sec.gov/rules/final/2010/33-9089a.pdf and Drinker Biddle’s original alert on the final rules can be found at http://www.drinkerbiddle. com/publications/.
The final rules require new or modified disclosures for six topics:
1) Board leadership structure and risk oversight;
2) The relationship between compensation policies and risk management;
3) Director and director nominee qualifications;
4) Board diversity;
5) Valuation of stock and option awards in compensation tables; and
6) Fees paid to compensation consultants. This update summarizes the subsequent guidance and real-world application of the final rules, including some observations of actual practices as the 2010 proxy season progresses.
Board Leadership Structure and Risk Oversight
Item 407(h) of Regulation S-K requires a brief description of board leadership, including whether the same person serves as both principal executive officer and chairman of the board and why a company has determined its leadership structure to be appropriate given the company’s specific characteristics and circumstances. Recent disclosures under this rule suggest that a company’s leadership structure may evolve with time. For example, Harley-Davidson, Inc. discloses that its board of directors “retains the authority to modify [its] structure as and when appropriate to best address the company’s unique circumstances and to advance the best interests of all shareholders.” Accordingly, succession planning reviews may necessitate changes to maintain continuity of leadership or to incentivize new or emerging leaders. Thus, it is important that companies not only describe their current board leadership structures, but also periodically evaluate those structures and the corresponding disclosures with an eye to the then-current characteristics and circumstances of a company. Furthermore, companies should craft their disclosure in a way that leaves the door open to changes in their leadership structure.
Item 407(h) also requires disclosure of the board’s role in risk oversight, including how this oversight is administered and the effect on the board’s leadership structure. Much of this disclosure has focused on the process of risk oversight, such as delegation to board committees or the involvement of compensation consultants in helping the board evaluate risk. Proxy observers note that some companies are combining their disclosures about risk oversight and compensation risk management into a single section.
The Relationship between Compensation Policies and Risk Management
Item 402(s) of Regulation S-K requires a narrative disclosure of a company’s compensation policies and practices as they relate to risk management practices and risk-taking incentives. This disclosure is only required to the extent that risks arising from compensation policies and practices are reasonably likely to have a material adverse effect on the company. The final rule raises the threshold for disclosure to those risks that are “reasonably likely” to have a material adverse effect, rather than the disclosure suggested in the proposed rule of risks that “may” have a material adverse effect. Given this higher disclosure threshold, one might have expected to see less disclosure under this rule; however, actual disclosure practices suggest the opposite.
Proxy observers note that a company that includes no disclosure under this rule may have nothing to disclose or may be failing to comply with this rule. There is no obligation to provide negative disclosure; however, many are suggesting that companies at least consider disclosing their process for evaluating the relationship between the company’s compensation policies and practices and risk management. RiskMetrics Group seems to agree with this approach. RiskMetrics does not have an explicit policy on disclosure under this rule, but in its New US Proxy Disclosure Requirements: 2010 FAQ it, “advise[s] issuers to, at a minimum, talk about their process and any mitigating features (such as claw-backs or bonus banks) that they have adopted” and “view[s] this disclosure as an opportunity for communication, not simply compliance.” Moreover, the SEC Staff has indicated that, where a company does not disclose any material adverse risks, the Staff will, during its review, issue a comment asking the company to describe the nature of its analysis in determining that no disclosure is required. Thus, even if a company does not have any risks to disclose that are associated with its compensation policies and practices, and that are reasonably likely to have a material adverse effect on the company, a company may draw scrutiny if it does not at least address its process undertaken in reaching that determination.
The SEC Staff’s Compliance and Disclosure Interpretation (C&DI) 128A.01, regarding placement of the disclosure required by Item 402(s), is also notable in that it does not specify where the information should be disclosed. C&DI 128A.01 clarifies that the SEC Staff recommends locating risk management disclosure with a company’s other Item 402 compensation disclosure. The SEC Staff expresses concern, however, if the Item 402(s) disclosure is “difficult to locate” or “presented in a fashion that obscures it.”
Director and Director Nominee Qualifications
The new director qualification rules added to Item 401(e) of Regulation S-K appear to be fairly straightforward. 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, in light of the company’s business and structure. In C&DI 116.05, the SEC Staff clarified that a company may not provide these disclosures on a group basis if the directors or nominees share similar characteristics; instead, these disclosures must be provided on an individual basis. As expected, the most commonly used approach for providing information on director qualifications has been to incorporate it into the director biographies presentation. The Commission has not, however, issued guidance specifying any particular information that must be provided. The flexibility that companies have in complying with the new director qualification rules presents its own challenge. Companies should be sensitive and even-handed in discussing the qualifications and skills of individual directors to avoid skewing the number of skills per director, which could highlight directors that an investor may perceive as being weak in terms of their qualifications. One issue that has arisen is whether companies should include “soft” skills, such as good judgment, integrity and leadership experience. Again, even-handedness is key because highlighting skills such as leadership skills for one director might suggest that the other directors do not have those skills. Some companies have simply chosen not to cover soft skills. Those that do seem to have coalesced around an approach that begins with an introductory paragraph that presents the board as a whole and states all board members possess certain soft skills, then moves on to note each director’s specific experience and what that director brings to the board.
The new director qualification rules discussed above work together with the existing requirements of Item 407 of Regulation S-K dealing with criteria the board has for selecting and evaluating potential director nominees. In turn, Item 407(c) has been amended so that 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 has specifically declined to define “diversity,” recognizing that companies may define diversity in various ways. The trend among filers is to define diversity in terms of the diversity of background and viewpoints of director nominees. What the disclosure requirement means by “policy” is also unclear. Because most companies have a statement on diversity considerations either in their corporate governance principles or in their nominating committee charter, the trend among early filers has been to state that diversity is one of the factors that the board evaluates, but that the board does not have a formal policy about diversity. Practitioners in this area, however, have debated whether including a statement in the corporate governance principles or nominating committee charter that diversity (among other things) will be considered in determining the proper nominees could be considered a “policy” for which the company would then have to address effectiveness in implementation. Opinion is split, and the Commission has not provided any formal guidance on this question, but the SEC Staff observations or comment letters may provide some guidance for future proxy seasons.
Valuation of Stock and Option Awards in 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 SEC Staff has issued a number of new C&DIs regarding the reporting of equity compensation awards.
For example, the reporting of an equity award when the award is granted and subsequently forfeited in the same fiscal year because the executive officer leaves the company is addressed in C&DI 117.04. C&DI 119.20 clarifies that the grant date fair value reported for awards subject to time-based vesting excludes the effect of estimated forfeitures. In addition, C&DI 119.21 addresses the reporting of an equity award when the award is granted and subsequently has its vesting accelerated in the same fiscal year. The position taken by C&DI 119.21 could effectively double the amount of compensation reported with respect to a grant that is accelerated. Taken together, C&DIs 119.22 and 119.23 illustrate that the reporting of an annual incentive award to a named executive officer where the named executive officer elects to settle the award in company stock is dependent on whether the award has an embedded stock settlement feature. The SEC Staff also clarified, through C&DI 119.24, when and how to report the grant of a equity incentive plan award with a multi-year performance period where the equity incentive plan allows the compensation committee to exercise its discretion to reduce the amount earned pursuant to the award, consistent with Internal Revenue Code Section 162(m). Finally, C&DIs 119.25 and 119.26, which involve executives declining non-equity incentive plan awards and discretionary bonuses, respectively, are consistent with the SEC Staff’s position that the amount reported should reflect the underlying compensation decision, not subsequent events. The fact that the SEC Staff has issued guidance on a number of discrete topics, including those outlined above, serves to illustrate some of the complexities that arise by changing the valuation and reporting of equity awards.
Fees Paid to Compensation Consultants
Item 407(e)(3) of Regulation S-K, which already requires disclosure about the role of compensation consultants in recommending or establishing the amount or form of executive officer and director compensation, has been expanded to address a conflict of interest that exists where a compensation consultant, in addition to providing advice or services relating to the amount or form of executive officer and director compensation, also performs additional services for the company or for affiliates of the company during the fiscal year that have an aggregate value that exceeds $120,000. Under the new rule, if a consultant who is performing compensation-related services for the company also performs non-compensation-related services or additional services for the company exceeding $120,000, then the fees paid to the consultant must be disclosed, subject to one exception. If the compensation committee and management have retained different compensation consultants, even if management’s consultant is providing additional services to the company exceeding $120,000, there is no requirement for fee disclosure.
The SEC Staff has indicated that there is no limitation on the types of services that are included in “additional services.” For example, revenues received by the consultant as a result of products sold to the company must be included in the amount of fees disclosed. Observers have noted that the new requirements are fairly straightforward and that the biggest challenge will be gathering information to determine whether a company has triggered the disclosure requirement, rather than the disclosure itself. And for the time being, RiskMetrics Group has stated that it will not apply formulas or any specific policy with regard to compensation consultant fees. Nevertheless, some believe that there will be an uptick in the number of compensation committees or boards of directors adopting independence standards for their compensation consultants, or for compensation consultants retained by management. Because fee disclosure can be avoided in settings in which the compensation committee retains its own independent compensation consultant, the new rules could cause a significant movement toward a two-consultant model, with an independent firm advising the compensation committee while a multi-service firm represents management.
Disclosure Going Forward
In conclusion, the new proxy disclosure enhancement rules provide for new or modified disclosure in a number of areas. Actual practices of companies complying with the new rules should take into account not only the plain language of the rules but also subsequent guidance from the securities bar and the SEC Staff. We expect to see further developments in the evolution of these disclosures as the 2010 proxy season progresses.