SEC Finalizes Revised Executive Compensation Proxy Disclosure Rules

The Securities and Exchange Commission (SEC) voted unanimously to adopt a sweeping overhaul of proxy disclosures for executive compensation. The new disclosures will give shareholders a far more complete picture of compensation paid and payable to the CEO, the CFO and the three highest-compensated named executive officers (NEOs).

The new rules take effect for proxy and information statements filed on or after December 15, 2006, for fiscal years ending on or after the same date. It appears that companies may phase in these disclosures without restating disclosures for earlier years — restatement is optional.

The following paragraphs describe how the final rules affect executive compensation disclosures and the accompanying narrative. We will provide more details after the final rules are published in the Federal Register.

Enhanced Proxy Disclosure Rules

Companies must disclose compensation for the principal executive officer (PEO), principal financial officer (PFO) and the next three highest-compensated executive officers. For purposes of this determination, compensation does not include earnings on nonqualified deferred compensation (NQDC) or increases in the value of pensions or supplemental executive retirement plans. Leaving those compensation elements out should reduce volatility and simplify the determination of the highest-paid executives.

Along with the Summary Compensation Table, companies must submit a narrative disclosure and tables disclosing plan-based awards. The table columns must disclose:

• Total compensation must provide a “tally sheet” total of all compensation disclosed in the other columns.
  
  
• Annual salary and bonus will be similar to existing disclosures.
  
  
• Options, stock appreciation rights and stock grants will be based on FAS 123R disclosures for financial statement purposes. But they will be based on the item’s full value on the grant date rather than on the expense taken over the vesting period. A narrative disclosure must describe any performance-based vesting requirements. In a change from the proposed rules, additional disclosures are not required for dividends or dividend equivalent units (DEUs) in the “All other compensation” column. These values have already been captured in the FAS 123R value.
  
  
• Compensation paid under non-equity incentive plans must show annual earnings from all cash-based long-term incentive plans (LTIPs).
  
  
• NQDC earnings and increase in pension value is a new column, which was part of the “All other compensation” column in the proposal. The SEC scrapped the requirement to disclose all earnings on NQDC. Instead, companies must disclose above-market or preferential earnings (previously defined as earnings that are more than 120 percent of the applicable federal rates (AFR). It is not clear whether the SEC will provide guidance on how to calculate the increase in pension value or companies should continue using reasonable assumptions for calculations.
  
  
• All other compensation must include executive perquisites worth more than $10,000, tax gross-ups and all other compensation not reported elsewhere.
  
  

The narrative following the Summary Compensation Table must describe compensation in the table and footnotes. The SEC modified the “Katie Couric” rule, which required companies to disclose total compensation for up to three non-executive employees who were paid more than the top five executives. Under the reproposed rule, companies with a market capitalization of more than $700 million must disclose compensation information only for up to three higher-paid employees who make policy decisions. This rule is being reproposed, so the SEC will consider comments on its application.

More Disclosures in Equity Value Tables

In response to the backdating controversy, the SEC has added more disclosures to the four equity value tables.

• The Equity Awards at Fiscal-Year End table must show outstanding awards representing potential future payments, including securities underlying exercisable and unexercisable options, and the exercise prices and expiration dates for each outstanding option separately.
  
  
• The Option Exercises and Stock Vested table must disclose amounts realized on equity compensation during the last fiscal year. It no longer needs to show the FAS 123R value at grant date.
  
  
• The Option Grant tables, for both time vested and performance grants, must disclose the key elements of the grants, including vesting schedules or performance periods, expiration dates and potential payouts (for performance grants). It appears that the SEC would require disclosure in these tables, rather than in a separate table, if the market price on grant date exceeds the award’s exercise price. If the exercise price is not the grant date closing market price per share, the company must explain its methodology for determining the exercise price. Additional disclosures are also required in the Compensation Discussion and Analysis (CD&A, discussed below).
  
  

SEC Retains the Retirement, NQDC and Post-Employment Benefit Tables

The SEC made a few key changes to these disclosures:

• The Nonqualified Deferred Compensation table must disclose executive contributions, company contributions, withdrawals, all annual earnings (not just the above-market or preferential portion as in the Summary Compensation Table) and the year-end balance.
  
  
• The final Pension Benefits table is significantly different from the proposed version. Instead of disclosing the annual benefit amount at early or normal retirement age, companies must disclose the total value of each NEO’s accrued pension benefit, separately by plan, assuming payments are deferred to normal retirement age. Apparently, companies must disclose the value even if a lump sum is available. FAS 87 assumptions will be used for the calculation, with one exception: normal retirement age will replace the FAS 87 retirement age (and the benefit will be the accrued rather than the projected benefit). It is not clear whether this requirement creates a disconnect from the yearly buildup in accrued pension value reported in the Summary Compensation Table, since we don’t yet know whether that value is measured by expected retirement age or normal retirement age.
  
  
• The Termination Scenario Narrative requires descriptions of all arrangements that provide payments or benefits to NEOs at termination, change-in-control, etc. It now also requires the disclosure of potential payment/benefit amounts, assuming that the triggering event for payment occurred on the last business day of the last fiscal year, with the closing market price on that date. This approach may not meet the “best practices” standard discussed by the Chancery in the recent Disney decision.
  
  

Director Compensation Table

The Director Compensation table must disclose the same information on director compensation as the Summary Compensation Table, but for the previous fiscal year only. This information was previously disclosed in narrative form.

Compensation Discussion and Analysis

Companies must describe their executive compensation programs in plain English in the CD&A, focusing on the most important factors underlying their compensation objectives, policies and decisions.

Despite considerable criticism of the requirement, the principle executive and principal financial officers must certify and file the CD&A.

The new Compensation Committee Report must state whether the compensation committee reviewed the CD&A with management, and whether — based on the review — the committee recommended its inclusion in the company’s annual report on Form 10-K and the proxy statement.

Rather than being part of the executive compensation disclosures, the performance graph must appear elsewhere in the annual report.

The CD&A also requires enhanced narrative disclosure of option grants to executives. Companies must reveal their reasons for selecting grant dates for awards and their methods of selecting terms of awards, such as the exercise prices of stock options. Companies that coordinate option grants with the release of material nonpublic information — so-called spring loading — must disclose significantly more information.