The SEC has released its final rules enhancing required proxy statement and Form 10-K information on executive compensation, director background and qualifications, potential compensation consultant conflicts of interest, risk assessment. The rules also require faster reporting of the results of shareholder votes. [SEC Release 33-9089]

The final rules will generally apply to 2010 proxy statements and Forms 10-K for companies with fiscal years ending on or after December 20, 2009. They also apply to IPO registration statements filed on or after December 20, 2009. The new rules require, in overview:

  • Disclosure of the company’s compensation policies and practices as they relate to risk management.
  • Disclosure of the full grant date fair value of equity grants (in the Summary Compensation Table and Director Compensation Table).
  • Enhanced disclosure about directors and director nominees.
  • Discussion of the rationale for the board’s leadership structure, and an explanation of the board’s role in risk oversight.
  • Disclosures of compensation consultants’ fees under certain conditions.
  • Faster reporting of the results of shareholder votes.

These items are discussed in more detail below.

Risk Management Compensation Policies and Practices

The SEC's final rules require narrative disclosure of the company’s compensation policies and practices as they relate to the company’s risk management. A company must address its compensation policies and practices for all employees, including non-executive officers, if the compensation policies and practices create risks that are “reasonably likely to have a material adverse effect on the company.” If a company has compensation policies and practices for different groups that mitigate or balance incentives, these could be considered in deciding whether risks arising from the company’s compensation policies and practices for employees are reasonably likely to have a material adverse effect on the company as a whole.

The release accompanying the new rules provides a non-exhaustive list of examples of the types of situations that could trigger a discussion of risk, to assist in the determination of whether a given compensation program may have the potential to raise material risks to a company:

  • Compensation policies and practices at a business unit of the company that carries a significant portion of the company’s risk profile;
    • with compensation structured significantly differently than other units within the company; or
    • that is significantly more profitable than others within the company;
  • Compensation policies and practices that vary significantly from the overall risk and reward structure of the company, such as when bonuses are awarded upon accomplishment of a task, while the income and risk to the company from the task extend over a significantly longer period of time.

If a company determines that risk disclosure is required, the final rule provides illustrative examples of issues that would be appropriate for a company to address:

  • The general design philosophy of the company’s compensation policies and practices for employees whose behavior would be most affected by the incentives established by the policies and practices, such as policies and practices that relate to or affect risk-taking by those employees on behalf of the company, and the manner of their implementation;
  • The company’s risk assessment or incentive considerations, if any, in structuring its compensation policies and practices or in awarding and paying compensation;
  • How the company’s compensation policies and practices relate to the realization of risks resulting from the actions of employees in both the short-term and the long-term, such as through policies requiring claw backs or imposing holding periods;
  • The company’s policies regarding adjustments to its compensation policies and practices to address changes in its risk profile;
  • Material adjustments the company has made to its compensation policies and practices as a result of changes in its risk profile; and
  • The extent to which the company monitors its compensation policies and practices to determine whether its risk management objectives are being met with respect to incentivizing employees.

It will not be necessary to discuss the compensation and policies if the company concludes that the incentives are not reasonably likely to have a material adverse effect on the company. In other words, discussion of risks and the mitigating effects of compensation policies or structures need not be discussed unless the disclosure threshold has been met.

Risk disclosure would be separate from the Compensation Discussion and Analysis (“CD&A”) because it is not limited to information about named executive officers. It remains to be seen what practice will develop regarding placement of this discussion. We expect many companies will place it following the discussion of Potential Payments upon Termination or Change in Control. Smaller reporting companies are not subject to this risk management disclosure.

Full Grant Date Fair Value Disclosure of Equity Grants in the Summary Compensation Table

Disclosure will be required in the Summary Compensation Table (“SCT”) and the Director Compensation Table of the full grant date fair value of equity grants made in a year to named executive officers (in lieu of disclosure of the amount expensed for financial statement reporting purposes). Similar disclosure will continue to be required in the Grants of Plan-Based Awards Table. Consistent with the accounting literature, if there is a range of possible values for the award (such as if there are threshold, target, and maximum amounts payable, depending on performance), the value should be computed based on the probable outcome of the performance conditions as of the grant date. Footnote disclosure of the maximum potential award is required.

This, of course, may change the identity of the named executive officers. For fiscal years ending on or after December 20, 2009, companies are required to present recomputed disclosure for each preceding fiscal year required to be included in the SCT, so that the stock awards and option awards columns present the applicable full grant date fair values, and the total compensation column is correspondingly recomputed.

If a person who was a named executive officer for 2009 was also a named executive officer in 2007 but not 2008, disclosure of the person’s compensation for each of the three years is required. Companies are not required to include different named executive officers for any prior year based on the recomputation of total compensation as required by this rule change.

Enhanced Disclosure of Director Qualifications, Directorships and Legal Proceedings

Companies are required to disclose, for each director and any nominee for director the particular experience, qualifications, attributes or skills that led the board to conclude that the person should serve as a director for the company as of the time of the disclosure. If an individual has specific experience, qualifications or skills that qualify the person to serve as a committee member, it should be disclosed as part of the individual’s qualifications to serve on the board. This disclosure will be required for all nominees and all directors, including those not up for reelection. The same disclosure is required with respect to any nominee for director put forward by another proponent.

The required corporate governance disclosures in item 407(c) of Regulation S-K will be expanded to include, as part of the discussion of the nominating committee’s process for identifying and evaluating nominees for director, whether (and if so, how) the nominating committee (or the board) considers diversity in identifying director nominees. If the nominating committee (or board) has a policy regarding diversity in identifying director nominees, a description of how the policy is implemented is required, as well as a self-assessment of the effectiveness of the nominating committee’s (or board’s) policy. The minimum specific qualification requirements for service as a director will continue to be required.

In addition, companies will be required to disclose all directorships at public companies and registered investment companies held by each director and nominee at any time during the past five years (in lieu of the current requirement to disclose current directorships).

Also, legal proceedings involving directors, nominees and executive officers in the past ten years (up from five) must be disclosed. The list of legal proceedings to be disclosed has also been expanded. The company will need to solicit information about the following additional items in the director and officer questionnaires being prepared for the 2010 Form 10-K and proxy statement:

  • Judicial or administrative proceedings resulting from involvement in mail or wire fraud or fraud in connection with any business entity;
  • Judicial or administrative proceedings based on violations of federal or state securities, commodities, banking or insurance laws and regulations, or any settlement thereof (other than settlement of a civil proceeding among private parties); and
  • Any disciplinary sanctions or orders imposed by a stock, commodities or derivatives exchange or other self-regulatory organization.

Rationale for the Company’s Board Leadership Structure

The corporate governance portion of the proxy statement must also disclose the board leadership structure, including whether and why the company has chosen to combine or separate the principal executive officer and board chairman positions, and the reasons why the company believes that this board leadership structure is the most appropriate structure for the company at the time of filing. If the roles of principal executive officer and board chairman are combined, disclosure of whether and why there is a lead independent director is required, as well as the specific role the lead independent director plays in the leadership of the company.

In addition, the final rules require a description of the board’s role in the oversight of risk. “Risk” is not specifically defined, but the release accompanying the final rules notes that companies face a variety of risks, including credit risk, liquidity risk, and operational risk. This requirement is intended to provide information to investors about how a company perceives the role of its board and the relationship between the board and senior management in managing the material risks facing the company.

Disclosure Regarding Compensation Consultants

If the compensation committee (or board) has its own compensation consultant for executive compensation advice, and the same compensation consultant (or an affiliate) provides advice on non-executive compensation matters (or both executive compensation and non-executive compensation) to the company management, fee disclosure is required if the non-executive compensation consulting fees exceed $120,000 for the company’s fiscal year. Both the executive compensation and non-executive compensation consulting fees must be disclosed if the threshold is attained. In addition, the proxy statement must disclose whether the decision to hire the consultant (or an affiliate) for non-executive compensation matters was made by the board or by management, and if the latter, whether the board approved it.

If the compensation committee (or board) does not have its own compensation consultant, and a compensation consultant (or an affiliate) provides both executive compensation advice and non-executive compensation advice to company management, fee disclosure for both types of service is required if the non-executive compensation consulting fees exceed $120,000 for the company’s fiscal year.

As before, disclosure is required as to the nature and scope of executive compensation services provided by a compensation consultant. Under the new rules, no disclosure is required as to the nature and extent of the non-executive compensation advice.

Consulting services related solely to broad-based non-discriminatory plans or limited to non-customized survey information are not treated as executive compensation consulting services.

Results of Shareholder Votes

The results of shareholder votes will be required to be disclosed on Form 8-K (in lieu of Forms 10-Q and 10-K) within four business days after the end of the meeting at which the vote was held. If the vote is too close to call, preliminary voting results must be disclosed, with the final voting results shown on an amended Form 8-K filed within four business days after the final voting results are known. Any shareholder meeting that takes place on or after February 28, 2010 is subject to this new rule.