On December 16, 2009, the SEC issued final rules that are generally effective for the 2010 proxy season and are intended to enhance the disclosure of compensation and corporate governance matters that registered companies are required to provide to their shareholders. Public companies will need to analyze the impact of these rules quickly as they add significant disclosure requirements and information gathering for the 2010 proxy season. The text of the final rules is available at http://www.sec.gov/rules/final/2009/33-9089.pdf. The final rules provide for:
- New disclosure requirements regarding overall compensation policies that create incentives that are reasonably likely to expose the company to a material adverse risk;
- A change in the method of disclosing stock and option awards for named executive officers in the Summary Compensation Table and for directors in the Director Compensation Table;
- Expanded disclosure related to director and nominee qualifications and past legal proceedings;
- New disclosure related to the company’s leadership structure and the board’s role in risk oversight;
- New disclosures regarding potential conflicts of interest of the company’s compensation consultant(s); and
- A change to the requirements regarding the disclosure of shareholder voting results, which will now be required to be reported on a Form 8-K (rather than Form 10-Q or 10-K) within 4 business days after the end of the meeting at which the vote took place.
Enhanced Compensation Disclosure
Compensation Discussion and Analysis
The final rules add a new disclosure obligation that will require a discussion of a company’s compensation policies and practices for employees generally, if the risks arising from those policies and practices are reasonably likely to have a material adverse effect on the registrant. To avoid confusion with the discussion of named executive officer compensation provided in the CD&A, this new disclosure element will appear elsewhere in the proxy statement. The final rules on this issue differ from the proposed rules in two principal respects; by adding a “reasonably likely” threshold to the disclosures (following the applicable standard for the Management Discussion and Analysis section of Form 10-K), and limiting the disclosure to those risks reasonably likely to have a material adverse effect, instead of any material effect. These changes are intended to limit the breadth of the new required disclosures to those that may be most important to investors but will require the significant exercise of judgment, particularly in the early years after adoption, as companies adapt to the requirements of the rules which are based on materiality standards rather than specific dollar thresholds. As the threshold requirement of “reasonably likely to result in a material adverse effect on the company” is a high threshold to meet, most companies will not be required to make disclosures under this new rule.
The SEC has provided a non-exclusive list of situations that may trigger this type of discussion, including policies or practices at any business unit that (i) carries a significant portion of the company’s risk profile; (ii) has a significantly different compensation structure than other business units of the company; (iii) is significantly more profitable than other business units of the company; or (iv) has compensation expense that is a significant percentage of the unit’s revenues. Discussion of this type may also be warranted where a compensation policy varies significantly from the company’s overall risk and reward structure, such as bonuses that are awarded upon accomplishment of a task, but where both the income and risk from that task extend over a significantly longer period of time.
While the SEC recognized that disclosure will vary based on each company’s business and compensation philosophy (and may not be required at all), it has provided examples of issues that may need to be addressed. The examples include:
- The general design and manner of implementation of the policies for employees whose behavior would be most affected by the incentives provided and how such polices relate to or affect risk taking;
- The company’s risk assessment or incentive considerations in structuring such policies or in awarding and paying compensation;
- How policies such as clawbacks or holding period requirements relate to the realization of risks in both the short-term and the long-term;
- Policies regarding adjustment to compensation programs in order to address changes in risk profile and any material adjustments that have actually been made; and
- The extent to which the company monitors its policies to determine whether its risk management objectives are being met in terms of incentivizing employees.
The SEC also noted that if a company has compensation policies in place for different groups of employees that it believes mitigate or balance incentives across business units, these policies can be considered in determining whether risks arising out of the policies are reasonably likely to have a material adverse effect on the company as a whole.
Currently, the value of equity awards shown in a proxy statement’s Summary Compensation Table and Directors Compensation Table reflects the expense attributable to the equity awards in the applicable fiscal year rather than the grant date fair value of awards made during the year. The grant date fair value is shown only in the Grants of Plan-Based Awards Table and in footnote disclosures to the Directors Compensation Table.
The final rules will require that the Summary Compensation Table and the Directors Compensation Table include the grant date fair value of equity awards granted during the applicable fiscal year. For performance-based equity awards, the amount shown is to be determined on the basis of the “probable outcome” under the applicable performance conditions. This is to be determined in a manner consistent with the estimate of compensation cost to be recognized over the service period under FASB ASC Topic 718. Footnote disclosure will be required to show the grant date fair value of performance-based awards assuming the highest level of performance. The grant date fair value of individual equity awards will continue to be required to be shown in the Grants of Plan-Based Awards Table, but will need to be shown on the revised basis in the case of performance-based grants.
For all disclosures required to be made after December 20, 2009, the revised manner of presentation of equity awards will be required and will also apply to awards made in prior years. Thus, amounts shown in the Summary Compensation Table for prior years for equity awards and in the total compensation column will have to be recomputed. However, these new computations would be for informational purposes and will not require a company to change the individuals that were reported as its named executive officers for any preceding year or amend an earlier filing.
The proposal that any salary or bonus foregone at the election of the named executive officer in exchange for equity or other non-cash based awards would no longer be reported in the respective salary or bonus column was eliminated in the final rules. Thus, companies will continue to report such amounts in the Summary Compensation Table with appropriate footnote disclosure of the equity or other awards made in lieu of the salary or bonus.
Enhanced Director and Nominee Disclosure
For purposes of supplementing the general information about directors and nominees currently included in proxy statement disclosures, the final rules require more specific discussion of the backgounds of these individuals. Presently, disclosure only of the individuals’ biographies, including business experience over the past five years, current directorships and certain legal proceedings dating back five years, is required.
Under the final rules, the discussion concerning the background of directors has been expanded to include a discussion of the director’s or nominee’s specific experience, qualifications, attributes or skills that led to the conclusion that the person should serve as a director. This disclosure would be required for all nominees and for all continuing directors, even if a particular director is not up for reelection. If material, this discussion should include information about the person’s particular areas of expertise or other relevant qualifications and may include information that covers more than the five years that is currently required. While the requirement in the proposed rules that information should be provided about the person’s risk assessment skills has been eliminated in the final rules, the SEC did note that such information should be disclosed if it was part of what led the board to reach its conclusion that the person should serve as a director.
The final rules also require the disclosure of all other directorships at a public company or registered investment company that a director or nominee has held during the past five years (not just the individual’s current directorships). Similarly, the final rules expand the period for disclosure of past legal proceedings from five to ten years and include additional proceedings that will be required to be disclosed. These include proceedings involving mail or wire fraud, fraud in connection with any business entity, violations of any securities, commodities, insurance or banking laws and disciplinary sanctions imposed by any exchange or other self-regulatory organization.
Finally, the new rules require disclosure of whether, and if so how, a company’s nominating committee considers diversity in identifying director nominees. If the committee has a policy regarding diversity, disclosure will be required as to how the policy is implemented and how the committee assesses the policy’s effectiveness. Of particular note, the SEC does not define diversity for this purpose, recognizing that different companies may have different perspectives on diversity and should be allowed to define diversity in the way they deem appropriate.
Company Leadership Structure and the Board’s Role in Risk Oversight
The final rules require disclosure regarding a company’s leadership structure and the board’s role in risk oversight. All companies will have to briefly describe their board’s leadership structure, including whether and why the same person serves as both principal executive officer and chairman of the board or if it has separated those roles. The disclosure should discuss why the company believes its leadership structure is appropriate given the specific characteristics and circumstances of the company at the time of filing.
As part of this new requirement, the company must describe the board’s role in risk oversight, how the board administers its oversight function and the effect this has on the company’s leadership structure. The SEC notes that it is seeking information about how a company perceives the role of its board, including its relationship to senior management, in managing the material risks facing the company. Examples of types of risk that may be relevant include credit risk, liquidity risk and operational risk, and the SEC has suggested that disclosure may include whether the board implements its risk oversight function through the board or through a committee and whether the employees who oversee risk management report to the board or such committee.
Disclosure Regarding Compensation Consultants
The final rules expand the disclosure requirements relating to a company’s compensation consultants where the compensation consultant provides services to the company in addition to its work related to executive and director compensation and the fees for such other services exceeds $120,000 in the fiscal year. The expanded disclosure would be required in cases where either the board (including the compensation committee) or management has engaged the compensation consultant. However, no additional disclosure will be required where the board has engaged a compensation consultant exclusively to provide consulting services to the board and management has engaged its own compensation consultant, even if management’s consultant also provides other services to the company. Services involving only broad-based non-discriminatory plans or the provision of certain non-customized information (e.g. compensation surveys) are not treated as executive compensation services for these purposes.
Where the additional disclosure is required, the company will be required to disclose (i) the aggregate fees paid for all additional, non-executive compensation services provided by the compensation consultant or its affiliates; (ii) the aggregate fees paid for determining executive officer and director compensation; (iii) in the case of a compensation consultant engaged by the compensation committee, whether the decision to engage the compensation consultant for non-executive compensation work was made or recommended by management and (iv) whether the compensation committee or the board approved these other services.
Accelerated Disclosure of Annual Meeting Election Results
Currently, public companies are required to disclose the results of any matter that was submitted to a vote of its shareholders at an annual or special meeting in the Form 10-Q for the fiscal quarter in which the shareholder meeting occurred or, if the meeting occurred during the fourth fiscal quarter, in the Form 10-K. Under the final rules, disclosure of voting results will now be accelerated by requiring that the results of a shareholder vote be disclosed on a Form 8-K within four business days after the meeting at which the vote took place. An amended report on Form 8-K must also be filed to disclose the final voting results within four business days after the final voting results are known. If a company discloses final voting results within four business days of its shareholder’s meeting then a second Form 8-K filing is not required.
What Should Companies Be Doing Now
One of the more difficult short-term challenges faced by reporting companies will be to timely assess whether the risks arising from their compensation policies and practices are reasonably likely to have a material adverse effect on the company. This evaluation process will likely vary significantly based on the size of the company, the scope and variety of its operations, the number of business units, and the number and complexity of its compensation arrangements. Moreover, this process will likely require input from a variety of disciplines (e.g., human resources, risk management, business unit management, legal, etc.). Thus, companies should act quickly to assemble the appropriate teams to gather and assess the company’s compensation programs and policies (not only those that cover named executives) to determine what effect, if any, these programs may have on risk taking. As part of this process, companies should be identifying the risks within each of its business units and establishing parameters defining acceptable levels of risk-taking going forward. In addition, it may be appropriate to establish procedures and responsibilities for measuring and monitoring the risk presented by a company’s compensation policies and practices.
Board’s Role in Oversight of the Company’s Risk Management.
The board’s current role in the company’s risk management process should be reviewed and the board should determine whether additional measures should be taken to better assess and monitor risk. The board’s role is fundamentally one of oversight. Day-to-day risk management should be the responsibility of the company’s management team. Some companies establish a “risk committee” or employ a chief risk officer to monitor risks. This is not necessary, but may be appropriate in businesses which have unusual or significant risks. Alternatively, the board could delegate to the audit or nominating committee responsibility for evaluating and overseeing the risk management process.
Companies should begin collecting the additional information required with respect to all of its directors’ and nominees’ board services and background. This will require updating the company’s D&O Questionnaire to elicit the information that will now be required to be included in the proxy statement as well as a review of each board member’s qualifications to identify those skills or characteristics that should be highlighted in the new disclosures. In addition, companies may want to consider having an appropriate committee of the board discuss and evaluate the company’s current leadership structure and the rationale for it, and make any recommendations that it deems appropriate. Companies should consider and discuss with their boards what their disclosures will be regarding leadership structure and their policies and practices, if any, regarding the consideration of diversity in the selection of director nominees.
Evaluation of Relationship with Compensation Consultant
Companies should consider whether additional disclosure will be required based on the company’s (and / or the board’s) current relationship with its compensation consultant(s) and their affiliates. This will require an assessment of what services are being provided to the company and / or the board by the compensation consultant, whether the consultant was engaged by the compensation committee or by management and the aggregate fees that were paid to the consultant for both compensation consulting services and other covered services. In addition, companies will need to review all arrangements with their compensation consultants and potentially makes changes to those arrangements.
Summary Compensation Table
Companies should begin to gather the information and perform the necessary calculations that will be required to be included in the Summary Compensation Table and the Grants of Plan-Based Awards Table, including for prior years. While much of the information may already be available from previous proxy statements, revised calculations may be required in the case of performance-based awards. In addition, the revised equity award calculations may have the effect of changing the composition of the named executive officer group, which could necessitate gathering information that had not previously been disclosed.