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New Executive Compensation Disclosure Rules Require Significant Changes

Final rules adopted by the Securities and Exchange Commission on July 26, 2006, will require companies with publicly-traded securities to significantly alter the way that they disclose their executive compensation practices in proxy and registration statements. These rules are generally designed to require the disclosure of all of the compensation that executives receive. They expand the list of executives for whom disclosures must be made, substantially modify the format and content of the required disclosures, and place heightened scrutiny on options-granting practices. The rules will affect disclosures in proxy statements, annual reports, registration statements, and current reporting of compensation, beginning generally for fiscal years ending on or after December 15, 2006.

The SEC first announced its proposed revisions in late January, as an effort to address investor complaints about a lack of clarity in compensation disclosures. This effort did not go unnoticed. The Commission received more than 20,000 comments about the proposed rules. The recently-announced final rules take many of these comments into account, while also addressing the growing concern about the potential misuse of stock option awards to executives. Affected Executives

The SEC’s new disclosure requirements expand the group of named executive officers (“NEOs”) whose compensation must be described. This group now will include a company’s chief financial officer, regardless of his or her compensation level. Thus, disclosures typically will be required for the CEO, CFO, and the other three most highly paid executives.

As originally proposed, the rules also would have required disclosures for up to three non-executive officers who receive total compensation exceeding that of any NEO. (This was the so-called “Couric Rule,” named after Katie Couric, a television personality whose compensation would have been disclosed under this provision.) In response to public criticism, the SEC dropped this requirement in the final rules, although it intends to re-propose a modified version of the rule for additional public comment. Compensation Discussion and Analysis

The central component of the revised disclosures is a new Compensation Discussion and Analysis (“CD&A”) section, which will require companies to explain the principles underlying their compensation policies and decisions. This section replaces the current Board Compensation Committee Report and company performance graph. The CD&A is intended to provide an overview of the company’s compensation objectives, identify what they are designed to reward, and explain how various compensation practices are intended to meet those objectives. Among other things, this section will require compensation committees that approve bonuses when performance objectives are not satisfied to justify their decisions.

The CD&A must be presented in narrative form, and must be written in “plain English” to allow ordinary investors to understand it. The SEC has specifically discouraged standard “boilerplate” language. The compensation committee of the board must be actively involved in preparing the CD&A, and must submit a report (the “Compensation Committee Report”) certifying its approval of the CD&A.

Because the CD&A will be considered a document that is “filed” with the SEC, it will be subject to certification by the company’s principal executive and financial officers. Thus, it will be subject to the liability provisions of the proxy rules. Moreover, to the extent that it is incorporated into a registration statement, the company and its officers and directors could be subject to liability for material misstatements or omissions in the CD&A. Other Disclosures

Following the Compensation Discussion and Analysis, disclosures will be arranged into three broad categories: compensation over the past three years; holdings of equity-based interests that relate to compensation or are the source of future gains; and retirement plans, deferred compensation, and other post-employment benefits.

Executive compensation will be displayed in tabular form through a Summary Compensation Table (“SCT”), which will be accompanied by a narrative disclosure and a Grants of Plan-Based Awards Table. The SCT will include columns for salary and bonuses, as well as the value of all equity-based awards, compensation under non-equity incentive plans, the annual change in the actuarial value of accumulated pension benefits and above-market earnings on nonqualified deferred compensation, other perquisites (if the aggregate amount of such perquisites is $10,000 or more), and total compensation.

The new disclosures will include two post-employment benefits tables that will provide detailed information about benefits that may be paid to NEOs. A Pension Benefits Table replaces the current Retirement Plan Potential Annual Payments and Benefits Table. It will require disclosure of the actuarial present value of each NEO’s accrued benefit under each of the defined benefit plans sponsored by the company. A Nonqualified Deferred Compensation Table will list employee and employer contributions to, withdrawals from, annual earnings on, and end-of-year balances of nonqualified deferred compensation amounts. Special Emphasis on Options

Largely as a result of the ongoing investigations into option granting practices, the final SEC disclosure rules add extensive new requirements concerning option grants and other equity awards. Companies now must describe their methodology for setting award terms – such as exercise prices – and disclose how they decide when options will be granted. These new disclosure requirements may cause companies to completely overhaul their stock option programs.

Investigations by the SEC and, more recently, the Justice Department, into the timing of stock option awards appear to be expanding at an exponential rate. Currently there are at least 80 investigations under way, focused largely on practices known as “springloading” and “backdating.” Option springloading generally involves timing the grant of option awards to immediately precede the release of positive corporate news that increases the value of the underlying stock. This practice causes the option to have immediate value to the award recipient. Option backdating occurs when the grant date for an award – and thus the exercise price for the option – differs from the date that the option was actually authorized or approved by the board or compensation committee.

The new pay disclosure rules require companies to divulge whether they use a methodology other than the closing market price on the date of grant to establish an option’s price. Thus, for example, companies that set option prices on the basis of the average trading price on the date of grant, or the closing market price on the day before the grant, must either amend their practices to comply with the SEC’s approach (which may require shareholder approval), or provide the additional disclosure required by the new rules. Severance Arrangements and Director Compensation

Amounts payable under severance and similar arrangements must be described in a narrative format. Arrangements that must be disclosed include those covering separation due to resignation, retirement, involuntary termination, constructive discharge, and changes in job responsibilities or corporate control. The new rules simplify the manner in which such payments must be estimated. In addition, compensation paid to directors will have to be disclosed in a table similar to the Summary Compensation Table for NEOs. Compliance Dates

Although initial disclosures under the new guidelines will be required as early as December 15, 2006, the rules will be phased in over the next three years for most public companies. This transition period will relieve companies from having to restate prior years’ executive compensation disclosures in order to comply with the new requirements. Generally, the new rules will apply to:

  • Proxy and registration statements filed on or after December 15, 2006, for fiscal years ending on or after December 15, 2006;
  • Annual reports on Form 10-K for fiscal years ending on or after December 15, 2006; and
  • Forms 8-K filed for triggering events occurring 60 days or more after publication of the final rules in the Federal Register.

As a result of the transition rules, the initial Summary Compensation Table prepared under the new standards (for 2007) will cover only the last fiscal year (2006).

The second SCT (for 2008) will cover the last two fiscal years (2006 and 2007), and the 2009 SCT will be the first to present three years of information under the new format. Practical Implications

Because companies must begin to disclose executive compensation pursuant to the new rules with respect to compensation earned and paid in the current fiscal year, it is imperative that they act now to evaluate how to comply. The initial Compensation Discussion and Analysis will be substantially different from any prior disclosures. In light of the wide range of issues to address in that disclosure, the necessary involvement of senior management and the compensation committee, and the SEC’s directive to avoid boilerplate, getting an early start on the first draft may be warranted. This is especially true if the new option granting disclosures may cause the company (or its directors) to rethink current practices.