In August, the Securities and Exchange Commission (“SEC”) issued final rules relating to disclosure requirements for executive compensation. The rules apply to disclosure in proxy statements and other filings required by the Securities Exchange Act of 1934. In addition to extensive disclosure, the new rules require that a single total compensation figure be provided for each named executive officer each year.
The new rules take effect for new proxy and information statements filed on or after December 15, 2006. Below is a summary of these new rules.
Five Primary Areas of the Rule.
The new rules can be broken down into five major areas:
- the compensation discussion and analysis;
- disclosure of compensation in a “summary compensation table”;
- disclosure of grants of equity interests;
- disclosure of retirement benefits and other posttermination compensation; and
- disclosure of director compensation.
Who Are the Named Executive Officers?
The new rules require extensive disclosure about the compensation of the Named Executive Officers (“NEOs”), who are the following individuals:
- the principal executive officer (usually the CEO);
- the principal financial officer (usually the CFO); and
- the three other highest paid executive officers who were serving as such at the end of the company’s fiscal year ranked on their compensation, excluding earnings on deferred compensation and increases in pension benefits.
In addition, disclosure is required for up to two additional individuals for whom disclosure would have been required except that such individuals were not serving as executive officers at the end of the fiscal year. Because income from equity compensation is included in the compensation calculation for determining the NEOs, it is possible that companies will not be able to identify the NEOs until after the end of the fiscal year.
Compensation Discussion and Analysis (“CD&A”)
This new section is a narrative report that provides an overview of the company’s executive compensation policies and decisions. According to the SEC, this is at the heart of the new rules. The CD&A must contain an in-depth, non-boilerplate discussion of executive compensation that puts the compensation of the NEOs into context. The CD&A must respond to the following questions regarding executive compensation:
- What are the objectives of the company’s compensation program?
- What is the compensation program designed to award?
- Why does the company choose to pay each element of the compensation package?
- How does the company determine the amount for each element?
- How does each element and the company’s decision about that element fit into the company’s overall compensation objectives?
The CD&A must discuss the last fiscal year, and actions taken after the fiscal year end. The rules must identify the policies for and decisions made on the compensation of each of the NEOs, except where the policies or decisions are materially similar.
In the final rules, the SEC provides 15 examples of issues that would potentially be appropriate to address in the CD&A. Included, for example, are:
- the policy for allocating between long-term and currently paid-out compensation;
- how specific forms of compensation are structured and implemented to reflect the company’s performance;
- how compensation is structured to reflect the NEO’s individual performance;
- the impact of accounting and tax treatments of a particular form of compensation;
- the role of an executive in determining compensation; and
- the factors used to determine an increase in the NEO’s compensation.
One of the new items that has been added to the final rules is a discussion of stock option grant practices, including how a company determines when options will be granted and how options will be priced. Clearly, this expansion of the disclosure of stock option grants was added due to the stock-option backdating issue that has been the focus of the SEC for the last several months. (See our July 2006 issue.)
Under the final rules, the CD&A is “filed” with the SEC. This means that the CEO and CFO must certify that the CD&A is accurate and complete, increasing their liability under Federal securities laws for any material misstatement or omission.
Lastly, the CD&A requires a new Compensation Committee Report that is similar in style to the current audit committee report. The Compensation Committee Report will continue to be “furnished” rather than “filed” with the SEC. The report must include a statement that the committee has reviewed and discussed the CD&A with management and has recommended to the Board of Directors that it be included in the proxy statement.
Due to the expansive nature of the CD&A and the fact that it must be filed with the SEC, it will require input from the compensation committee, corporate counsel, benefits counsel and the accountants. Companies should start drafting the CD&A now in order to provide enough time for the committee to review the CD&A and for the company to incorporate the committee’s comments.
Summary Compensation Table
The SEC states that the summary compensation table is the principal disclosure vehicle regarding executive compensation. The table shows the NEOs’ compensation for each of the last three fiscal years, whether or not actually paid. The summary compensation table includes a disclosure of a figure that represents each of the NEOs’ total compensation. All compensation must be provided in dollars rather than in numbers of shares or units.
The summary compensation table includes the following columns:
(a) the name and principal position
(e) stock awards
(f) option awards
(g) non-equity incentive plan compensation
(h) change in pension value and non-qualified deferred compensation earnings
(i) all other compensation
For the salary and bonus columns (columns (c) and (d)), all compensation that is earned, even if it is deferred, must be included. Amounts deferred must be disclosed in a footnote to the applicable column. Where salary and bonus cannot be calculated as of the date of the disclosure, a footnote disclosure is required noting when the calculation can be made; once determined, the amount will be reported on the Form 8-K.
The stock award column (column (e)), discloses stock-related awards that derive their value from the company’s equity securities or permit settlement by the issuance of the company’s equity securities, and are within the scope of FAS 123R (such as restricted stock, restricted stock units, phantom stock, phantom stock units, common stock equivalent units or other similar instruments that do not have option-like features). Valuation is based on the grant date fair value of the award calculated in accordance with FAS 123R.
For option awards (column (f)), awards of options, stock appreciation rights, and similar equity-based compensation instruments that have option-like features that are within the scope of FAS 123R, must be disclosed. This column requires disclosure of the grant date fair value of the award calculated in accordance with FAS 123R. For previously awarded options or free-standing stock appreciation rights that the company repriced or otherwise materially modified during the last fiscal year, the incremental increase in value resulting from the repricing or material modification must be disclosed.
The non-equity incentive plan compensation column (column (g)) reports the dollar value of all amounts earned during the fiscal year pursuant to nonequity incentive plans. This column includes incentive plan awards that were not disclosed in columns (e) and (f). Compensation awarded under an incentive plan that is not within the scope of FAS 123R is to be disclosed in the year when the relevant specified performance criteria under the plan are satisfied and the compensation is earned, whether or not payment is actually made to the NEO.
The change in pension value and nonqualified deferred compensation earnings column (column (h)) includes the aggregate increase in actuarial value to the NEO of all defined benefit and actuarial plans accrued during the year and earnings on nonqualified deferred compensation. Any amount attributable to defined benefit and actuarial plans that is a negative number should be disclosed by footnote and not reflected in the amount reported in the column. Earnings on nonqualified deferred compensation are included only to the extent that they are above-market or preferential. The abovemarket or preferential portion is determined for interest by reference to 120% of the applicable federal long-term rate, and for dividends by reference to the dividend rate on the company’s common stock.
The all other compensation column (column (i)) discloses all other compensation not required to be included in any other column. Each item of compensation exceeding $10,000 must be separately identified and quantified in a footnote. Each item of compensation less than that amount should be included in the column but is not required to be identified by type.
Examples of compensation required to be disclosed include but are not limited to:
- perquisites and other personal benefits unless the aggregate amount of such compensation is less than $10,000;
- amounts paid or accrued pursuant to a plan or arrangement in connection with any termination (or constructive termination) of employment or a change in control;
- annual company contributions or other allocations to vested and unvested defined contribution plans;
- the dollar value of any insurance premiums paid by the company with respect to life insurance for the benefit of the NEO;
- gross-ups or other amounts reimbursed during the fiscal year for the payment of taxes; and
- the issuance of any security of the company or its subsidiaries at a discount which is not available generally either to all security holders or to all salaried employees of the company.
The total compensation column (column (j)) must show a dollar value of all compensation received by an NEO, determined by adding the total value of each form of compensation quantified in the previous columns.
In addition to the Summary Compensation Table, the final rules require a narrative description of any additional material factors necessary to an understanding of the quantitative disclosure in the table.
Grants of Equity and Non-Equity Interests
The new rules have established three tables on which the company is required to disclose equity compensation and bonus compensation awarded to the NEOs: the Grants of Plan-Based Awards table, the Outstanding Equity Awards at Fiscal Year-End table and the Option Exercises and Stock Vested table.
Grants of Plan-Based Awards
The Grants of Plan-Based Awards table covers grants made during past fiscal year and consists of the following columns:
(a) name of the NEO
(b) grant date
(c) estimated future payouts under non-equity incentive plan
awards — threshold
(d) estimated future payouts under non-equity incentive plan
awards — target
(e) estimated future payouts under non-equity incentive plan
awards — maximum
(f) estimated future payouts under equity incentive plan
awards — threshold
(g) estimated future payouts under equity incentive plan
awards — target
(h) estimated future payouts under equity incentive plan
awards — maximum
(i) all other stock awards: number of shares of stock or units
(j) all other option awards: number of securities underlying options
(k) exercise or base price of option awards
For the grant date column (column (b)), the grant date determined under FAS 123R is used. This date is defined as the date:
- the award is approved in accordance with the company’s corporate governance requirements (again, by the board, a committee of the board or by management with the relevant authority);
- the option holder does not have the ability to negotiate the terms of option; and
- the terms of the option are expected to be communicated to the option holder in a relatively short period of time.
If the grant date is different from the date the compensation committee took the action to make the award, the discrepancy should be explained in the narrative disclosure following the table.
The estimated future payouts under non-equity incentive plan awards columns (columns (c) through (e), disclose the value of cash-based incentive plans paid out based on achieving threshold performance, target performance and maximum performance. These columns are reported in dollar amounts.
The estimated future payouts under equity incentive plan awards columns (columns (f) through (h)), disclose the number of shares to be paid or vested on the achievement of certain performance goals. Again, estimated payouts are reported at threshold, target and maximum performance.
Columns (i) and (j) report the grants of all other equity awards and options granted during the fiscal year that are paid out or vest based on a time-based vesting schedule or another non-performance based schedule. These columns also are reported in the number of shares subject to the awards.
Column (k) reports the exercise price per share of the options. If the exercise price of the options is not equal to the closing price of the underlying stock on the date of grant, then the company must describe the method it uses for determining the exercise price in the narrative disclosure following the table.
Outstanding Equity Awards at Fiscal Year-End
The Outstanding Equity Awards at Fiscal Year-End table requires disclosure of each option, restricted stock award, restricted stock unit award, performance share award, or other equity-based award that is outstanding with respect to each NEO as of the last day of the fiscal year. This table could be many pages long where NEOs have been with the company for a long time and awards are granted annually. The company can start drafting this table today, well in advance of the proxy filing deadline.
Option Exercises and Stock Vested
The Option Exercises and Stock Vested table requires disclosure of amounts realized by the NEOs with respect to equity awards during the fiscal year.
Retirement Benefits and Post-Employment Compensation Disclosures
First, this section replaces the former pension table with a table regarding defined benefit pension plans and enhanced narrative disclosure. Second, it adds a table and narrative disclosure that disclosures information regarding non-qualified defined contribution plans and other deferred compensation. Lastly, in this section, there will be disclosure of compensation arrangements triggered upon termination and on changes in control.
The pension benefits table consists of the following columns:
- name of the NEO
- plan name
- number of years of credited service
- present value of accumulated benefits
- payments during the last fiscal year
The pension benefits table requires disclosure for all qualified and nonqualified defined benefit plans, but excludes all qualified and nonqualified defined contribution plans. The table is followed by a narrative disclosure of any material factors necessary to understand the benefits payable under the plans.
Nonqualified Deferred Compensation
The nonqualified deferred compensation table consists of the following columns:
- name of the NEO
- executive contributions in the last fiscal year
- registrant contributions in the last fiscal year
- aggregate earnings in the last fiscal year
- aggregate withdrawals/distributions
- aggregate balance at last fiscal year end
The nonqualified deferred compensation table requires disclosure of information under each defined contribution or other plan that provides for the deferral of compensation on a basis that is not tax-qualified. The table is followed by a narrative disclosure of any material factors necessary to understand the benefits payable under the plans.
Other Post-Employment Payments
The last part of this section requires the disclosure of other potential post-employment payments. The rules require disclosure of specific aspects of written or unwritten arrangements that provide for payments at, following, or in connection with the resignation, severance, retirement or other termination (including constructive termination) of an NEO, a change in his responsibilities, or a change in control of the company. The rules require a narrative disclosure of the following information regarding termination and change in control provisions:
- the specific circumstances that would trigger payments or the provision of other benefits;
- the estimated payments and benefits that would be provided in each covered circumstance;
- how the appropriate payment and benefit levels are determined under the various circumstances;
- any material conditions or obligations applicable to the receipt of payments or benefits, including but not limited to non-compete, non-solicitation, nondisparagement or confidentiality covenants; and
- any other material factors regarding each contract, agreement, plan or arrangement.
However, many companies may choose to report this information in a table instead of through a narrative.
In quantifying the estimated payments, the company is to assume that the triggering event took place on the last business day of the company’s last completed fiscal year and the price per share of the company’s securities is the closing market price as of that date.
Compensation of Directors
The new rules expand the requirements for disclosing director compensation as well. Director compensation must be reported in a table similar to the Summary Compensation Table, requiring that the director’s total compensation be reported as a single figure. The new rules also require the disclosure of the director’s cash compensation, equity compensation and other compensation, including, but not limited to, perquisites.
The final rules relating to disclosure requirements for executive compensation are lengthy and complex. Our summary in this article is just that, a summary of the highlights of the new rules. Actual preparation of the proxy disclosure will require input from many sources: the company’s securities counsel, benefits counsel, compensation consultants, actuaries, compensation committee, etc. Our best advice is to start the drafting process as soon as possible and include all of the company’s advisors in the process.
Please contact us if we can be of assistance with the development of the new executive compensation disclosure.