Sunlight for Executive Pay — SEC Proposes Substantial Changes to Executive Compensation and Related Disclosure Rules and Clarifies Current Rules

03.30.2006

Updates

The federal securities laws already require clear, concise and understandable disclosure about the amount and type of all compensation paid to chief executive officers and other highly compensated executives of public companies. In recent years widespread and increasing interest in executive pay and the perceived inadequacy of current disclosure spawned frequent front-page headlines and heated rhetoric from members of Congress and shareholder advocates.

To address these concerns, the SEC earlier this year released proposed rules that would significantly change the form and content of this disclosure. The proposed rules also increase disclosure of director compensation and revise disclosure requirements for related transactions, director independence and security ownership of executive officers and directors, as well as the Form 8-K current reporting requirements for compensation arrangements for executive officers and directors.

While none of the new requirements will apply to this year's filings, the SEC proposal also includes immediately applicable interpretive guidance on Perquisites that clarifies current guidance.

This Update provides an overview of the most significant proposed changes, offers practical guidance and, for those who want more depth, includes a more detailed summary of the key elements of the SEC's proposal.

Transition Period and Expected Timing for Final SEC Rules. New rules will likely not be effective until the 2007 proxy season. The SEC is seeking comments on the proposed rules until April 10, 2006, and will likely spend several months deliberating and responding to what are expected to be extensive comments. The proposed rules are likely to undergo some significant modifications in response to the comment process. Under proposed transition rules, after being published in the Federal Register the final rules will apply to:

proxy statements and information statements that are filed 90 days or more after publication;
annual reports on Form 10-K for fiscal years ending 60 days or more after publication;
current reports on Form 8-K for triggering events that occur 60 days or more after publication; and
registration statements that become effective 120 days or more after publication.

The proposed transition rules call for phased-in implementation. Compensation previously reported in compensation tables and related person transaction disclosures would not need to be restated. The new Summary Compensation Table, which like the current table calls for three years of compensation history, would contain disclosure for only one year's compensation for the first year the new rules are in effect, and then an additional year would be added in each of the next two years.

Overview of Significant Proposed Changes

Key elements of the SEC proposal will significantly alter existing executive compensation and related disclosure rules.

New Compensation Discussion and Analysis. A new Compensation Discussion and Analysis, intended to be similar to the Management's Discussion and Analysis section that accompanies financial statements, will replace the current compensation committee report and stock performance graph. The new CD&A will require significant new disclosures regarding compensation objectives and policies, and how the company implements its executive compensation.
Expanded Summary CompensationTable. A significantly expanded Summary Compensation Table will require a new total compensation column that reflects all elements of compensation disclosed in the table, including the grant date fair value of all equity-based awards, earnings on deferred compensation and the annual increase in the actuarial value of any qualified and nonqualified defined benefit pension plan accruals.
New Method for Determining Named Executive Officers. In addition to the chief executive officer, the executive officers named in the Summary Compensation Table will include the chief financial officer, regardless of compensation. The three other most highly compensated executives will be determined based on their total compensation as disclosed in the expanded Summary Compensation Table, rather than on the sum of salary and bonus as under the current rules.
New Narrative Disclosure for Non-Executive Highly Compensated Employees. Following the expanded Summary Compensation Table, a new narrative section will identify by job description, but not by name, and describe compensation earned by up to three non-executive employees, each of whom earned total compensation that exceeded that of any named executive officer.
Reorganized and Expanded Equity and Incentive Disclosure. New tables will require new disclosure regarding performance-based and nonperformance-based equity and cash incentive awards (time-vested options are deemed nonperformance-based), the value of all outstanding awards, and amounts realized through vesting or exercise during the year.
Expanded Disclosure of Perquisites and Other Personal Benefits. The proposal includes interpretive guidance on perquisites that applies immediately under the current rules, as well as to the proposed rules, clarifying the SEC's current expansive interpretation of what constitutes "perquisites and other personal benefits" and how their cost should be calculated. In addition, the proposal will lower to $10,000 the threshold for reporting and identifying perquisites.
Expanded Post-Employment and Change-in-Control Disclosure. New tables and narrative disclosure will be required regarding retirement benefits, deferred compensation contributions and earnings and estimated amounts payable upon termination of employment and a change in control.
Compensation Committee Must Approve Non-Named Executive Officer Compensation. Compensation for executive officers who are not named executive officers will have to be disclosed as a related transaction unless it is approved by the compensation committee (or a group of independent directors).
Expanded Disclosure of Compensation Committee Processes and Procedures. A compensation committee section will disclose committee processes and procedures, including the roles of executive officers and compensation consultants in making recommendations regarding compensation matters.
Revised Related Party Transaction Rules. The SEC proposal will eliminate bright-line tests for disclosure of related party transactions (which will be called "related person transactions") in favor of a principles-based analysis focused on the materiality of the transaction to investors, and the threshold for disclosure will be increased to $120,000 (from $60,000). A company will also have to disclose its policy for reviewing, approving and ratifying related person transactions.
More Specific Director Independence Disclosures. In addition to disclosing whether each director or nominee is independent, a company will also have to describe any relationships or transactions not otherwise disclosed that the board of directors considered in determining that a director is independent.
Revised Form 8-K Filing Requirements. The revamped requirements will focus disclosure on "unquestionably and presumptively material" compensatory arrangements.
All Compensation, Beneficial Ownership, Related Transaction and Corporate Governance Disclosure Required in Plain English. The proposed rules will require companies to draft all executive and director compensation, beneficial ownership, related transaction and corporate governance disclosures in plain English, using the principles that currently apply only to a prospectus.

Practical Tips

What Should Public Companies Be Doing Now to Get Ready? In addition to incorporating the SEC's immediately applicable guidance on perquisites to the 2006 proxy statement perquisites disclosure, companies should also consider the following preparatory steps:

Consider the SEC Proposal When Setting 2006 Compensation. The SEC is proposing significant changes to the form and content of executive compensation disclosure, including grant date FAS 123R fair value of all equity-based awards, earnings on deferred compensation, the annual increase in the actuarial value of any qualified and nonqualified defined benefit pension plan accruals and the expected value of post-employment compensation such as severance and change in control benefits. As companies consider compensation actions this year, they should keep in mind how the compensation will be disclosed under the proposed rules.
Evaluate Policies and Procedures and Improve as Needed. The proposed rules will require greatly expanded disclosure of how and why a company makes its executive and director compensation decisions, including the compensation committee's processes and procedures and the role of executive officers in setting executive compensation. The rules will also require additional disclosure about the company's policies and procedures for reviewing and approving related person transactions. Companies should begin reviewing and updating their policies and procedures now in light of these requirements.
Comply Now With Proposing Release Guidance on Full Disclosure and Perquisites. As expected, the SEC's proposing release contains interpretive guidance that applies immediately under the current rules, as well as to the proposed rules, including that all elements of compensation must be disclosed, even if not called for by a specific rule, and confirming guidance on perquisites. Companies should analyze each item of compensation or benefit of a personal nature and its cost in light of this guidance. In addition, companies should review all elements of compensation and verify that their current compensation disclosure includes them all.
Consider Enhancing Disclosure in Current Year Proxy Statement. In response to investor concerns and in anticipation of final rules, many companies are expanding proxy statement disclosure of executive and director compensation in the 2006 proxy statement beyond that required under the current rules. Companies should consider whether to begin voluntarily complying with some elements of the proposed disclosure rules prior to their effectiveness, keeping in mind that they must comply with all current disclosure requirements and that the final rules will likely include some significant changes from the proposed rules.

New Compensation Discussion and Analysis Section

The new Compensation Discussion and Analysis section represents one of the most significant proposed changes. The CD&A will replace the existing compensation committee report and stock performance graph and provide a comprehensive overview of the material elements of the compensation program for named executive officers, putting into context the numbers and narrative reflected in the subsequent tabular disclosure. The CD&A is required to discuss

the objectives of the company's compensation programs.
what the compensation program is designed to reward, and not reward.
each element of compensation and why the company chooses to pay each element.
how the company determines the amount of each element to pay (including any formula).
how each element fits into the company's overall compensation objectives and affects decisions regarding other elements.

The CD&A is principles-based, and will vary depending on each company's situation. Boilerplate language or mere repetition of information disclosed in the tabular and narrative disclosure that follows will not satisfy the requirement. Disclosure should be specific enough to identify material differences in compensation policies and decisions for individual named executive officers, and should discuss both in-service and post-employment compensation arrangements. The SEC provides examples of appropriate issues for discussion, including:

policies for allocating between long-term and currently paid components of compensation, and between cash and noncash components;
specific company and individual performance measures;
how specific forms of compensation are structured to reflect company performance, and whether awards can be paid when performance fails to meet the specified goals, or reduced or increased in size; and
how prior compensation, accounting and tax treatment, stock ownership guidelines, benchmarking and the role of executive officers affect executive compensation decisions.

Consistent with the current rules, companies will not be required to disclose target levels for performance-related factors or criteria involving confidential commercial or business information if the disclosure will have an adverse effect on the company. However, if a target has been publicly disclosed elsewhere, the company will have to disclose it in the new CD&A as well. The CD&A, unlike the current compensation committee report and stock performance graph, will be treated as "filed" with the SEC rather than "furnished" and will be subject to the general disclosure and liability provisions of the Securities Act and the Exchange Act, including the CEO and CFO certification requirements.

Practical Tip

Apply the SEC's Proposed CD&A Disclosure Principles to Compensation Committee Report for 2006 Proxy Statement. The new CD&A will require a thoughtful discussion of the company's compensation policies. While the proposed rules requiring the CD&A will not take effect until the 2007 proxy season, compensation committees should thoroughly review the company's compensation processes and procedures for setting 2006 executive compensation, considering how the CD&A will describe tally sheet use, internal pay equity analysis and any other tools used to set compensation.

Changes to Compensation Tables and Narrative Disclosure

The SEC proposal seeks to improve disclosure of compensation received by the named executive officers in the last completed fiscal year and the two prior years through expansion of the Summary Compensation Table. Two new equity and incentive grant tables, for performance-based and nonperformance-based awards, will supplement the Summary Compensation Table. Following these tables, two additional new tables will show equity-based compensation holdings and gains realized from the exercise or vesting of equity awards. More new tables and narrative disclosure of post-employment compensation complete the proposed changes.

Proposal May Change Which Executive Officers Are "Named Executive Officers." The SEC proposes to significantly change the way named executive officers will be determined. Under the proposal, the principal executive officer and the principal financial officer will always be named, regardless of compensation, and the three other most highly compensated executive officers will be determined based on total compensation for the most recent fiscal year, rather than the sum of salary and bonus as under the current rules. In determining total compensation, the proposals will continue to exclude compensation relating to overseas assignments, but will eliminate the current exclusion for compensation that is "not recurring and unlikely to continue." As is currently the case only for CEOs, under the proposed rules any principal executive officer or principal financial officer who served during the year will be included whether or not serving at the end of the year. In addition, as with the current rules, disclosure will be required for up to two other former named executive officers who would have been included in the table but for the fact that they were not serving at the end of the year.

Revised Summary Compensation Table. The revised Summary Compensation Table will include the dollar value of all compensation earned during the last three fiscal years, whether paid currently or deferred, including the value of current earnings on outstanding awards. Disclosing the value of each type of compensation will facilitate providing total value of compensation for the Total Compensation column required by the proposed rules, which will disclose the aggregate dollar value of all compensation reported for each named executive officer for the year. In addition, the Summary Compensation Table will no longer distinguish between annual and long-term incentive plan compensation — it will show the grant date fair value of all equity awards granted, but the value of non-equity incentive awards will only be reported when earned or paid. The existing All Other and All Other Annual columns will merge.

New Deferred Compensation Footnote. As under the current rules, amounts disclosed in the Summary Compensation Table must include amounts deferred. The proposed rules will require the amount deferred to be disclosed in a footnote to the Summary Compensation Table. The amount deferred will also be disclosed as a contribution in the proposed "Nonqualified Defined Contribution and Other Deferred Compensation Plans Table" described below, which raises the potential of double counting of the same compensation amounts in the two tables.
Report Value of Option Awards, Not Number of Shares. The proposed rules significantly change existing requirements by requiring disclosure of the grant date fair value (in dollars) for all option awards and stock awards granted during the period. The term "stock awards" includes awards that can be settled by issuance of the company's stock or that derive their value from that stock, including restricted stock, restricted stock units, phantom stock, phantom stock units, common stock equivalent units and other similar instruments that do not have option-like features, and also includes awards with performance-based vesting.
Calculate Grant Date Fair Value Using FAS 123R. The SEC proposal requires companies to value stock awards and option awards based on their grant date fair value as calculated under Financial Accounting Standards Board Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment for financial reporting purposes. Although under FAS 123R the companies generally recognize this expense over the vesting period of an award, the SEC proposal requires companies to disclose the entire grant date fair value in the Summary Compensation Table for the year in which the grant is made. In addition, companies must footnote (or may hyperlink to) the relevant FAS 123R valuation assumptions.
Disclose Earnings on Stock and Option Awards. Companies will include in the Stock Awards and Option Awards Columns the value of earnings on outstanding awards. New instructions will require companies to identify and quantify all earnings in footnotes, including earnings paid during the fiscal year, payable during the period but deferred or payable at a later date but earned during the year.
Disclose Non-Stock Incentive Plan Compensation Only When Earned. The SEC proposes to exclude from the Summary Compensation Table the value of non-stock incentive plan compensation in the year the award is granted because there is no currently accepted method of valuing the award (such as FAS 123R) that reflects the performance contingencies. Instead the Summary Compensation Table will include the value of these awards, and earnings on the awards, in the year in which the compensation is earned (i.e., when the relevant performance criteria are satisfied), whether or not payment is made to the named executive officer in that year. Grants of non-stock incentive awards will be disclosed in the supplemental "Grants of Performance Awards Table" in the year of grant.
Amended All Other Compensation Column. Under the SEC proposal, this column will include all compensation not required to be included in any other column. This column must include all compensation — with the exception of perquisites and personal benefits with an aggregate value less than the new $10,000 disclosure threshold — including perquisites, tax gross-ups, amounts paid on account of a termination of employment or change in control and company contributions to a 401(k) or other defined contribution plan. In addition this column will include two new compensation elements: earnings on nonqualified deferred compensation; and the aggregate increase in the actuarial value of pension and supplemental excess retirement plan (SERP) benefits. Companies must include in the table all items of compensation and separately identify and quantify in a footnote each item of compensation that exceeds the new $10,000 reporting threshold. However, companies can exclude from the column the value of perquisites and personal benefits that, when aggregated, is less than the $10,000 threshold.
Lower Threshold for Perquisites Disclosure. Companies must include perquisites and other personal benefits in the All Other Compensation column unless the aggregate annual value of all perquisites for a named executive officer is less than the new $10,000 threshold. If the $10,000 threshold is exceeded, all perquisites and other personal benefits for that named executive officer must be included in the column and identified by specific type (broad categories are not permitted) in a footnote. Companies must also disclose in a footnote the value of any individual perquisite or personal benefit that exceeds the greater of $25,000 or 10% of the total perquisites and other personal benefits of the named executive officer. Consistent with the current rules, the value of any tax "gross-ups" for any compensation, including perquisites, must be included in the column, even if the associated perquisite is not included, or is not identified in a footnote.

Practical Tip

What Is a Perquisite? SEC's New Interpretive Guidance Effective for 2006 Proxy Statements. Neither the current rules nor the SEC proposal defines "perquisite" or personal benefit. However, the SEC proposal includes immediately applicable interpretive guidance to help companies identify perquisites and other personal benefits. According to the SEC, an item is not a perquisite or personal benefit "if it is integrally and directly related to the performance of the executive's duties" and is a perquisite or personal benefit "if it confers a direct or indirect benefit that has a personal aspect, without regard to whether it may be provided for some business reason or for the convenience of the company, unless it is generally available on a non-discriminatory basis to all employees."

The release emphasizes that the exception for benefits that are "integrally and directly related" to job performance will be interpreted narrowly and gives a few examples. Identifying an expense as "ordinary" or "necessary" for tax purposes — or treating the benefit as for the benefit or convenience of the company, facilitating job performance or having a "business purpose" — does not mean the item is not a perquisite. For example, personal use of a company airplane or security provided at a personal residence or during personal travel pursuant to a company security policy, or commuting expenses (even if for the company's convenience or benefit), are still benefits of a personal nature, and are perquisites.

Consistent with current guidance, perquisites and other personal benefits should be valued based on the aggregate incremental cost to the company. The release confirms that companies may not use the SIFL rate used for tax purposes, or the cost of first-class airfare, as a method of computing the aggregate incremental cost of personal use of company aircraft.

Disclose Increase in Pension Value as All Other Compensation. The All Other Compensation column will also include the aggregate annual increase in the actuarial value of tax-qualified and nonqualified defined benefit and actuarial plans accrued during the year, including supplemental plans and each other nonqualified plan that provides for retirement benefits payments, or will be paid primarily following retirement. Company contributions to defined contribution plans will continue to be disclosed in the All Other Compensation column.
Disclose Earnings on Deferred Compensation as All Other Compensation. In addition, the All Other Compensation column will include the value of all earnings on compensation deferred on a non tax-qualified basis (and not just for the portion that is "above market," or preferential, as required under the current rules).

Practical Tips

2006 Proxy Statement Summary Compensation Table Must Include All Columns Required Under Current Rules. While the SEC has indicated that a company may add columns to the current table to enhance disclosure, including a total column and a column to show the fair value of stock options granted, a company may not remove or alter columns required by the current rules.

Consider Adding Perquisite Table as Footnote to 2006 Proxy Statement Summary Compensation Table. To enhance perquisite disclosure, some companies are voluntarily including a table disclosing the value of perquisites and other personal benefits. The SEC solicited comments on whether rules should require a table showing all the different types of compensation included in the All Other Compensation column. In addition, some companies are enhancing disclosure by explaining in a footnote the methodology they use for valuating perquisites, especial personal aircraft use.

Narrative Disclosure Required for Highly Compensated Non-Executive Employees. The SEC will require narrative disclosure following the Summary Compensation Table for up to three non-executive employees, each of whom earned total compensation during the last completed fiscal year which exceeded that of any named executive officer. Companies must disclose compensation amounts and job descriptions for such individuals, but not their names or job titles.

New Supplemental Annual Grant Tables. The proposed rules will add two new tables to supplement the Summary Compensation Table and replace the existing stock option grant and long-term performance award tables: the Grants of Performance-Based Awards Table and the Grants of All Other Equity Awards Table. The tables distinguish between awards by type and by whether they are performance vested or time vested.

New Grants of Performance-Based Awards Table. The Grants of Performance-Based Awards Table will disclose performance-based stock awards, performance vested options and SARs and non-stock (cash) incentive awards granted during the last completed fiscal year. An award will be performance-based if it is subject to a "performance condition" or "market condition" within the meaning of FAS 123R. Awards that qualify as performance-based under Internal Revenue Code Section 162(m) requirements may not necessarily be viewed as performance-based for purposes of this table. If an award provides a single potential payout, that amount should be reported as the target amount. Companies will include multiple awards made under different plans, or with different terms, on separate lines in the table. This new table will retain much of the information currently available in the Long-Term Incentive Plan Awards table.
New Grants of All Other Equity Awards Table. The new Grants of All Other Equity Awards Table will disclose all option or stock awards with no performance conditions granted during the last completed fiscal year, including, for example, time-vested stock options, stock appreciation rights (SARs), restricted stock or restricted stock units. This table replaces the current Options/SARs Grants table. Companies will disclose multiple awards made under different plans, or with different terms, on separate lines in the table.

Practical Tips

Companies Can Voluntarily Improve Disclosure About Restricted Stock Awards in 2006 Proxy Statement. Although the current Options/SARs Grants table includes only options and SARs, companies can enhance disclosure prior to effectiveness of the new rules by adding information regarding restricted stock and restricted stock units to this table, for example, by adding a column for restricted stock and restricted stock unit awards. A company must retain the current Options/SARs Grants table caption, but may add, on the next line, a subtitle to indicate that the table includes disclosure of restricted stock and restricted stock units.

New Narrative Disclosure Required Following Compensation Tables. The SEC proposal will require companies to provide a narrative description of any additional material factors necessary to an understanding of the information disclosed in the Summary Compensation Table, Grants of Performance-Based Awards Table and Grants of All Other Equity Awards Table.

The material factors will depend on the company's circumstances, but may include:

the material terms of each named executive officer's employment agreement;
any repricing or other material modification during the last fiscal year of any outstanding option, SAR or other equity-based award (such as extending exercise periods, changing vesting or forfeiture conditions, changing or eliminating applicable performance criteria or changing the bases upon which returns are determined);
the material terms of any performance-based award, including the applicable performance conditions, the vesting schedule and whether dividends will be paid;
a material waiver or modification of a specified performance target, goal or condition to payout for any amounts earned during the year under a non-stock incentive plan; and
information regarding defined benefit and deferred compensation plans, such as the material assumptions used to determine the increase in actuarial value.

New Tables Disclose Equity Holdings and Value Realized. The SEC proposal requires companies to disclose the named executive officers' holdings of equity-based interests that relate to compensation or are potential sources of future compensation. These new tables, and the accompanying narrative disclosure, focus on equity interests awarded in prior years that remain outstanding (i.e., unvested or unexercised), as well as the gain realized on vesting or exercise. These tables will replace the current Option Exercises and Year-End Option Values.

New Outstanding Equity Awards at Fiscal Year-End Table. The Outstanding Equity Awards Table will disclose the market value at fiscal year-end of all previously awarded and outstanding equity grants, including grants disclosed in the new Grants of Performance-Based Awards Table and Grants of All Other Equity Awards Table. Footnotes will disclose the vesting and expiration dates of options and SARs (separately identifying those that are exercisable and unexercisable) and the vesting dates for other stock and incentive plan awards. If an award expires after fiscal year-end but before the filing date, the footnote will also disclose whether the option expired or was exercised.
New Option Exercises and Stock Vested Table. The Option Exercises and Stock Vested Table will present information on the gain realized on equity-related interests through exercise of options and SARs and stock award vesting. It will include the total value of gain realized, as well the grant date fair value previously reported in the Summary Compensation Table (which the SEC hopes will alleviate the double-disclosure problem).

Practical Tip

Companies Should Use Narrative Disclosure to Explain When Disclosed Compensation Was Previously Reported. Although the SEC has tried to make clear in its tables where compensation has already been disclosed, the increased disclosure requested by the proposals will create a serious double-counting problem. Companies should use narrative disclosure — in addition to any required footnotes or columns — to explain clearly where compensation required to be reported has been disclosed earlier and does not constitute additional compensation.

Changes to Post-Employment Compensation Reporting. The SEC proposal also calls for significant changes to post-employment compensation disclosure, including retirement and deferred compensation plans and payments triggered by a change in control. The new disclosure is organized into three distinct sections: retirement benefits; deferred compensation; and other post-termination payments.

New Retirement Plan Benefits Table. The SEC is proposing a new table (to replace the existing pension plan disclosure required by the current rules) that will show the estimated annual retirement payments under defined benefit plans for each named executive officer, followed by narrative disclosure. A separate line will be required for each retirement plan in which a named executive officer participates, including each tax-qualified defined benefit plan (including cash balance plan) and SERP. Defined contribution plans are not covered by this table. If the named executive officer is not yet eligible to retire, the dollar amount of annual benefits will be computed assuming that the named executive officer continued to earn the same amount as reported for the company's last fiscal year. If the credited years of service under any plan differ from the actual years of service to the company, a footnote will disclose the difference, and any resulting benefit increase.
New Narrative Disclosure of Retirement Plan Benefits. Following the Retirement Plan Benefits Table, a company will be required to discuss any material factors necessary to an understanding of each plan in the table, which may include:
- the material terms and conditions of benefits available under the plan, including the plan's retirement benefit formula and eligibility standards, and early retirement arrangements;
- if the executive or company may elect a lump sum distribution, the amount of such distribution that will be available as of the end of the company's last fiscal year, disclosing the valuation method and material assumptions applied in quantifying such amount;
- the specific elements of compensation, such as salary and various forms of bonus, included in applying the benefit formula, identifying each such element;
- the reasons for each plan if there is participation in multiple plans; and
- company policies with regard to such matters as granting extra years of credited service.
New Nonqualified Deferred Compensation Table. The Nonqualified Deferred Compensation Table will include contributions, earnings and balances under nonqualified defined contribution and other deferred compensation plans. To avoid double counting earnings on nonqualified deferred compensation that will also be disclosed in the Summary Compensation Table, the SEC proposes that the company disclose, in a footnote to the Nonqualified Deferred Compensation Table, the extent to which amounts reported were reported in the Summary Compensation Table for prior years. This will complement the proposed instruction to the Summary Compensation Table that will require footnote disclosure of amounts payable but deferred.
New Narrative Disclosure of Nonqualified Deferred Compensation. The Nonqualified Deferred Compensation Table will also be followed by narrative description covering the material factors necessary to an understanding of the plan, which may include:
the types of compensation permitted to be deferred, and any limitations on deferral;
the measures for calculating interest or other earnings under the plan (including whether such measure(s) are selected by the named executive officer or the company and the frequency and manner in which such selections may be changed) and the interest and any other measures applicable during the company's last fiscal year; and
material terms with respect to payouts, withdrawals and other distributions.
Revised Termination and Change-in-Control Protections Narrative Disclosure. The proposed rules will require narrative disclosure of the specific aspects of any written or unwritten arrangement that provides for payments at, following or in connection with the resignation, severance, retirement or other termination (including constructive termination) of a named executive officer, a change in his or her responsibilities or a change in control of the company (and eliminates the current $100,000 disclosure threshold). The disclosure will fall within the safe harbor for forward-looking statements. Companies should disclose:
specific circumstances that will trigger payment(s) under the termination or change-in-control arrangements or the provision of other benefits, including perquisites;
estimated payments and benefits that will be provided in each termination circumstance (even if the payments or amounts are uncertain), whether they will or could be lump-sum or periodic, their duration, by whom they will be provided and the material assumptions underlying the company's estimates;
specific factors used to determine the appropriate payment and benefit levels under the various circumstances that will trigger payments or provision of benefits;
any material conditions or obligations applicable to the receipt of payments or benefits, including non-compete, non-solicitation, nondisparagement or confidentiality agreements, including the duration of such agreements;
tax gross-ups, including golden parachute excise tax payments; and
any other material features necessary for an understanding of the provisions.

Expanded Director Compensation Disclosure. The SEC proposal calls for significantly expanded director compensation disclosure to more closely mirror disclosure required for executive officers.

New Director Compensation Table. The proposed rules include a new Director Compensation Table that significantly expands the disclosure of director compensation by requiring tabular disclosure of compensation earned by each director for the last fiscal year similar to that required for named executive officers in the Summary Compensation Table. Companies may group directors in a single row if all of the elements and amounts of their compensation are identical. The All Other Compensation column of the Director Compensation Table will include all compensation not reported in the other columns, and generally follow the instructions for the Summary Compensation Table.
Supplement New Director Compensation Table With Footnotes and Narrative. No supplemental annual tables will be required for directors. However, companies will also disclose, for each director by footnote to the appropriate column, the same information on outstanding equity awards at fiscal year-end called for by the Outstanding Equity Awards at Fiscal Year-End Table for named executive officers. The proposal will also require narrative disclosure of any material factors necessary to an understanding of the Director Compensation Table, such as breakdown of the types of fees.

Other Proposed Compensation Disclosure Changes. In addition to the specific changes to executive officer and director disclosure discussed above, the SEC proposal will require companies to disclose several other new items.

Disclose Pledges of Company Stock in Beneficial Ownership Table. The proposed rules will for the first time require disclosure of the number of shares pledged as security by each named executive officer and director, and for all directors and officers as a group, in footnotes to the beneficial ownership table.
All Executive Officer and Director Compensation Must Be Disclosed, Even if Also Disclosed as a Related Person Transaction. The proposed rules will require that the compensation disclosure include the value of all transactions between a company and a third party where the primary purpose is to compensate a named executive officer or director, even if the transaction is reported as a related person transaction.
Must Disclose Relocation Benefits. The proposed rules will require companies to disclose relocation plan benefits even where the plan applies on the same terms to all salaried employees.

SEC Proposal Updates Relationships and Related Person Transactions Disclosure Requirements

In addition to the extensive proposed changes to compensation disclosure, the SEC has also proposed significant amendments to Item 404 of Regulation S-K, which requires disclosure of relationships and transactions between insiders and the company. The proposed new rules revise the current disclosure requirements and add a new requirement regarding disclosure of the company's policies and procedures for approving related person transactions.

New Rules Create Broad Principles-Based Disclosure. The proposed new rule is intended to be "principles-based," and some bright-line tests have been removed. The new rule establishes a "general statement of the principle for disclosure, followed by specific disclosure requirements and instructions." Under this general principle, disclosure is required of any transaction in the past fiscal year (or past three fiscal years in the case of registration statements) or any currently proposed transaction in which

the company is a "participant" (as opposed to the current rules where the company must be a "party"),
where the amount involved exceeds $120,000 (increased from the current $60,000 threshold), and
in which any related person had, or will have, a direct or indirect material interest.

New Definitions for Related Person Transactions. The SEC is proposing new definitions for "materiality," "related person" and "transaction."

Materiality. The proposing release states that "materiality" will "continue to be determined on the basis of the significance of the information to investors in light of all the circumstances and the significance of the interest to the person having the interest," citing Basic v. Levinson and TSC Industries v. Northway. The SEC notes that the $120,000 threshold is not a bright-line materiality standard. Transactions in excess of the dollar threshold will continue to be subject to a materiality analysis to determine whether the related person has a direct or indirect material interest. The proposed rules also clarify that where a person has a position or relationship with another entity that does business with the company, that person will not be deemed to have an "indirect material interest" in a transaction if the interest arises solely from the person's position as a director and/or through the ownership of less than a 10% equity interest in that entity.
Related Person. A "related person" will mean any of the company's executive officers, directors, any nominee for director and any immediate family member of the foregoing, including for the first time stepchildren, stepparents and persons (other than an employee or tenant) sharing the household of a related person.
Transaction. The term "transaction" will have a broad scope and eliminate the distinction in the current rules between indebtedness and other related person transactions.

Must Disclose Non-Named Executive Officer Compensation as a Related Person Transaction Unless Approved by Compensation Committee. One of the SEC's more significant changes will eliminate an instruction that permitted companies to omit from disclosure as a related person transaction items that have been disclosed or were permitted to be omitted from disclosure under the executive and director compensation disclosure rules. Under the SEC proposal, compensation actually reported for named executive officers or directors may still be excluded, but compensation for executive officers who are not named executive officers may be omitted only if:

the compensation would be reportable if the executive officer were a named executive officer;
the compensation is approved by the company's compensation committee (or another group of independent directors performing a similar function); and
the executive officer is not an immediate family member of a related person.

Must Disclose Procedures for Approving Related Person Transactions. The SEC proposal will require companies to disclose the material features of their policies and procedures for reviewing, approving or ratifying reportable transactions with a related person, including:

the types of transactions covered, and the standards of review applied;
the persons, or groups of persons, on the board of directors or otherwise, responsible for applying the policies and procedures; and
whether the policies and procedures are in writing and, if not, how they are evidenced.

Under the proposed rules, companies must also identify related person transactions for which the company's policies and procedures did not require review, approval or ratification, or for which the policies and procedures were not followed.

Practical Tips

Changes to Related Person Transaction Rules May Affect Which Directors Can Serve on the Compensation Committee. The proposed changes to related transaction rules may affect which directors are "nonemployee directors." Certain acquisitions and dispositions of company stock are exempt from the provisions of Section 16(b) if, among other things, they are approved by a committee of at least two nonemployee directors. A director is not a nonemployee if the director has an interest in a transaction or is engaged in a business relationship that is required to be disclosed as a relationship or related transaction under the current rules or receives compensation from the company for services other than as a director in an amount that exceeds the dollar threshold for related transaction disclosure. The change from a rules-based to a principles-based approach and the elimination of some bright-line exclusions may result in some directors no longer qualifying as nonemployee directors, while others who did not previously qualify, may qualify under the new rules, especially in view of the increased dollar threshold. Companies should keep these issues in mind as they review related person transaction disclosure issues under the proposed rules.

Code of Business Conduct and Audit Committee Charter May Already Contain Related Person Transaction Policies. Many companies listed on the New York Stock Exchange and Nasdaq currently have codes of business conduct that address conflict of interest transactions and have policies and procedures regarding approval of related person transactions by audit committees or other committees of independent directors. These types of policies and procedures will need to be described under the SEC proposal, and companies should review them in light of the proposed disclosure requirements.

SEC Proposes Expanded Corporate Governance Disclosure

The SEC proposal will add a new Item 407 of Regulation S-K that consolidates the SEC's existing disclosure requirements related to director independence and corporate governance, including disclosures related to director attendance at board and committee meetings, the company's director nomination process, the composition, functions, charter and financial expertise of the company's audit committee, compensation committee interlocks, shareholder communications, director and committee member independence and compensation committees.

Must Identify Independent Directors and Non-Independent Committee Members. The SEC proposal will require companies to identify each director and nominee who is independent, using applicable listing standards. A company will also need to identify any member of the compensation, nominating and audit committees who is not independent (current SEC rules only require companies to identify their independent directors, although the NYSE and Nasdaq each require listed companies to disclose this information in their annual report or proxy statement).

The proposed rule will also require the disclosure of any transactions, relationships or arrangements not otherwise disclosed that were considered by the board of directors in determining that a director was independent. This requirement was intended to coordinate with an enhancement the NYSE recently proposed to its listing standards. Under the current rules, companies are allowed to exclude information with respect to any director who no longer serves as a director at the time the proxy statement is filed. The SEC has not incorporated this exclusion into new Item 407, which covers any individual who served as a director during the year for which disclosure is provided.

Additional Disclosure of Compensation Committee Practices and Procedures. The SEC proposal will also require additional disclosure regarding a company's compensation committee and its members, similar to the information currently required with respect to audit and nominating committees. These disclosures will include:

for a company without a compensation committee, an explanation of why it does not have a committee and an identification of each director who participates in the consideration of director and executive officer compensation;
whether the compensation committee has a charter and, if so, where shareholders can find a copy; and

a narrative description of the compensation committee's processes and procedures for the consideration and determination of executive and director compensation, which will include a description of:
the scope of the authority granted to the committee;
the extent to which the committee may delegate its authority to other persons;
the role of any executive officer in determining or recommending the amount or form of executive and director compensation; and
the role of any compensation consultants in determining or recommending the amount or form of executive compensation, identifying the consultants, stating whether they are engaged directly by the committee, identifying the nature and scope of their assignment, the material elements of the instructions or directions given to the consultants with respect to their engagement, and identifying any executive officer the consultants contacted in carrying out their assignment.

SEC Proposal Updates Form 8-K to Conform to Disclosure Changes

In addition to the significant changes proposed for compensation disclosure, the SEC proposal will also modify existing requirements to disclose compensation arrangements on a current report on Form 8-K.

Existing Item 1.01 of Form 8-K requires companies to disclose, within four business days, the company's entry into a compensation arrangement, or into any material amendment to such arrangement, with a named executive officer or director, and with other executive officers unless immaterial in amount or significance. Among other things, existing Item 5.02 of Form 8-K requires a company to disclose specific information, within four business days, if a director is elected or resigns, retires or is removed, or if any of the specified principal officers is appointed or retires, resigns or is terminated: principal executive officer; president; principal financial officer; principal accounting officer; and principal operating officer (or persons performing similar functions).

The proposed amendments to Form 8-K will exclude employment and compensation arrangements from material definitive agreements under Item 1.01 and require companies to disclose the material terms of compensation arrangements with directors and specified executive officers under Item 5.02 instead, and extend to Item 5.02 the safe harbor from Section 10(b) liability.

Must Disclose Departure of Named Executive Officers. Under the SEC proposal, a company must disclose the departure or retirement of any of the executive officers covered by the new rule, which include the specified principal officers under existing Item 5.02 of Form 8-K and any executive who was a named executive officer for the company's most recent fiscal year.
Must Disclose Material Terms of Compensation Arrangements With Newly Appointed Directors and Covered Officers. If a company appoints a new director or covered officer, the new rules will require a brief description of any material plan, contract or arrangement to which the director or covered officer is a party or in which he or she participates, and any grant or award to such director or covered officer.
Entering Into or Materially Amending Material Compensatory Arrangements With Named Executive Officers Will Still Trigger Form 8-K. Under the SEC proposal, a company will still disclose entry into, or material amendment of, a material compensatory plan, contract or arrangement with its named executive officers for the company's most recent fiscal year. In addition, a company will still disclose material grants or awards made under such a plan, contract or arrangement to a named executive officer unless they are consistent with the terms of previously disclosed plans or arrangements and they are disclosed the next time the company provides annual compensation disclosure (in its annual report on Form 10-K or annual meeting proxy statement).

SEC Proposal Will Apply to Small Business Issuers, But Generally Not to Foreign Private Issuers

Proposed Rules Will Apply to Small Business Issuers. The new related person transaction disclosure rules will apply to small business issuers, except that

the disclosure threshold for related person transactions will be the lesser of $120,000 and 1% of the average of the company's total assets for the last three fiscal years, and
they will not have to disclose policies and procedures for reviewing related person transactions.

The new compensation disclosure rules will also apply to small business issuers, with the following key exceptions.

Less Information Required for Revised Summary Compensation Table. The revised Summary Compensation Table will only cover two fiscal years, instead of three, and will only require information for the principal executive officer and the two other most highly compensated officers. Except for the Outstanding Awards at Fiscal Year-End Table, the other supplemental tables for executive compensation are not required.

No Compensation Discussion and Analysis Required. The proposed CD&A disclosure will not apply to small business issuers.

SEC Proposal Will Not Change Requirements for Foreign Private Issuers. The proposed rules will not change the requirements for compensation and related person transaction disclosure for foreign private issuers who file annual reports on Form 20-F.

Additional Information

You can find a copy of the full text of the SEC proposal at http://www.sec.gov/rules/proposed/33-8655.pdf. You can find discussion of other recent SEC rules and other topics of interest on our website.

Sunlight for Executive Pay — SEC Proposes Substantial Changes to Executive Compensation and Related Disclosure Rules and Clarifies Current Rules

Contacts

Related Services

Practices