The SEC’s New Executive and Director Compensation and Related Party Disclosure Rules: A Guide for Companies and Compensation Committees - Part I

At an open meeting held on July 26, 2006, the Securities and Exchange Commission (SEC) adopted sweeping changes to its disclosure requirements for executive and director compensation, related party transactions, director independence and other corporate governance matters, and security ownership of officers and directors. The SEC issued the new rules after considering the over 20,000 comments it received on the proposed rules that were issued by the SEC on January 27, 2006. The adopting release containing the final rules (Adopting Release) is a massive 436-page document. The Adopting Release was issued on August 11, 2006 and can be found by clicking here. This Alert summarizes the final rules in a question and answer format and provides suggested compliance guidelines and procedures to assist companies and their compensation committees in complying with the new requirements. K&LNG is issuing a separate Alert addressing the provisions of the Adopting Release relating to changes in the disclosure of new or modified executive compensation arrangements under the Form 8-K reporting requirements, which have an earlier effective date than the other provisions of the Adopting Release.

Executive and Director Compensation Disclosure

What approach to the disclosure of executive compensation programs and practices has the SEC taken in the final rules?
SEC Chairman Cox has repeatedly emphasized that it is not the SEC’s role to judge whether particular executive compensation packages are “right” or “fair” or to place limits on executive compensation. The fundamental objective of the SEC’s new disclosure rules is to clarify and demystify compensation and make it intelligible to the lay reader. By making pay practices transparent, it is hoped that compensation committees and shareholders will have the information they need to better monitor and regulate companies’ executive pay practices.

The final rules provide that all elements of compensation must be disclosed. The two foundational components of the new rules are (1) the Compensation Discussion & Analysis (CD&A;) section in which the company is to describe, in narrative form, the material factors underlying the company’s compensation policies and decisions, and (2) tabular disclosure in three broad categories: (a) compensation with respect to the last fiscal year (and the two preceding fiscal years), as reflected in a Summary Compensation Table (SCT), and supplemented by a table providing certain backup information, (b) holdings of equity-related interests that relate to compensation or are potential sources of future gains, and© retirement and other post employment compensation.

How do the final rules differ from the rules as initially proposed by the SEC?
The SEC adopted the rules substantially as proposed but with a number of modifications. The key changes are as follows:

  • Detailed disclosure will be required with respect to the company’s stock option grant practices and procedures, particularly regarding the timing of option grants and the manner in which the exercise price of options is determined.
  • Some types of payments reported in the SCT as “Bonus” under the prior rules will now be reportable as “Non-Equity Incentive Plan Compensation.”
  • Changes in pension values and earnings on deferred compensation plans will not be included in the “Total Compensation” column of the SCT and will not be taken into account in determining which executives are to be included in the SCT.
  • Under the proposed rules, the SCT would have been required to include all earnings on deferred compensation for each of the persons included in the tables. The final rules require the inclusion only of above-market or preferential deferred compensation earnings.
  • The final rules reinstate a requirement for a Compensation Committee Report, over the names of the individual members of the compensation committee, that will consist simply of a short statement with regard to the committee’s review of and recommendation with respect to the CD&A.;
  • The final rules also reinstate the requirement of a Performance Graph, but provide that it will be included in the annual report to security holders issued in connection with annual meetings at which directors are to be elected rather than as part of the executive compensation disclosure.
  • The so-called “Katie Couric” rule is eliminated. This proposed rule would have required the company to include in the SCT up to three additional individuals whose total compensation was greater than that of any of the other individuals includable in the tables but who were not executive officers of the company during the last completed fiscal year. A modified, substantially narrowed version of this rule will be reproposed for public comment.

When do the final rules become effective?
The new rules will be phased in over a three-year period. Filings required to include executive compensation disclosure and disclosure required by Item 404 of Regulation S-K that are made after December 15, 2006 will have to apply the new rules with respect to fiscal years ending after December 15, 2006. The company will not be required to restate its compensation data for prior years to comply with the new rules.

Which executives of the company must be included in the tabular and narrative disclosure of executive compensation?
The company’s named executive officers (NEOs) whose compensation must be disclosed are (1) each person who served at any time during the last completed fiscal year as the company’s principal executive officer or principal financial officer, (2) the three individuals who were executive officers of the company as of the last day of the most recent fiscal year and whose total compensation for such fiscal year was the highest, and (3) up to two other persons who served as executive officers of the company during such year and whose total compensation would have placed them among the three other highest paid executive officers but for the fact that they were not executive officers of the company as of the last day of the fiscal year. For this purpose, “total compensation” includes all compensation disclosed in the SCT except for the increase in the actuarial value of pension benefits and earnings on deferred compensation accounts. Only executives whose total compensation exceeds $100,000 are required to be included.

Under the proposed rules, the accompanying narrative would have required disclosure for up to three employees who were not executive officers during the last completed fiscal year, but whose total compensation was greater than that of any of the NEOs. This provision will be revised and reproposed for public comment. The new proposal will be similar to the original proposal except that it will exclude employees having no responsibility for significant policy decisions within the company, a significant subsidiary, or a principal business unit, division or function. This requirement would only apply to large accelerated filers.

What are the new rules on disclosure of the company’s stock option grant practices?
Following the issuance of the proposed rules at the beginning of 2006, the backdating of stock options and similar practices became a widely-publicized controversy. In response, the SEC included in the final rules provisions designed to ferret out backdating and other potentially manipulative option practices. The significance of the backdating issue to the SEC is highlighted by the fact that a discussion of the stock option disclosure rules is placed at the very front of the Adopting Release. According to the SEC, it is not the purpose of these rules to discourage the use of stock options or prohibit any particular option grant practices but only to require appropriate disclosure of such practices, whatever they may be.

Companies will have to provide certain tabular and narrative disclosure about option grants and the company’s option grant policies and procedures, including the timing of option grants in relation to the public disclosure of material information, positive or negative, about the company. The tabular disclosure with respect to option grants will be required to include:

  • The grant date fair value of options granted during the fiscal year, as determined under Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (FAS 123-R);
  • A separate table providing disclosure of equity awards, including the grant date as determined pursuant to FAS 123-R (generally the day the decision is made to award the option as long as recipients of the award are notified promptly);
  • The closing market price of the stock on the grant date if it is greater than the exercise price of the option; and
  • The date the compensation committee or full board of directors took action to grant the award if that date is different than the grant date.

If the exercise price of an option is not the grant date closing market price per share, the disclosure must include a description of the methodology used for determining the exercise price.

Additional narrative discussion will be required in the CD&A; section of the disclosure with respect to the reasons the company selects particular grant dates for awards and the methods the company uses to select the exercise prices and other terms of stock options. The company will be required to address the following questions with regard to option grant timing:

  • Does the company have a program, plan or practice to time option grants to its executives in coordination with the release of material nonpublic information?
  • How does any program, plan or practice to time option grants to executives compare to the company’s program, plan or practice, if any, with regard to option grants to employees more generally?
  • What was the role of the compensation committee in approving and administering such a program, plan or practice and how did the board or compensation committee take the timing of disclosure of material nonpublic information into account when determining whether and in what amount to make those grants?
  • Did the compensation committee delegate any aspect of the actual administration of a program, plan or practice to any other persons?
  • What was the role of executive officers in the company’s program, plan or practice of option timing?
  • Does the company set the grant date of its stock option grants to new executives in coordination with the release of material nonpublic information?
  • Does the company plan to time, or has it timed, its release of material nonpublic information for the purpose of affecting the value of executive compensation?

Similar requirements will apply if the company has a program, plan or practice of setting option exercise prices based on the stock’s price on a date other than the actual grant date or if exercise prices are set using formulas based on average prices (or lowest prices) during a specified period.

K&LNG;’s detailed Alert on the option backdating issue can be found by clicking here.

What is the purpose of the Compensation Discussion and Analysis (CD&A;) and what information is required in the CD&A; and the new Compensation Committee Report?
The required executive compensation disclosure will begin with the CD&A;, a narrative providing a general overview of executive compensation policies, programs and practices of the company. Analogous to the MD&A; relating to the company’s business and financial condition, the CD&A; is a discussion and analysis of the components of pay for the company’s NEOs and the material factors underlying the company’s compensation policies and decisions.

The SEC refers to the CD&A; requirement as being “principles-based,” in that the final rules identify the disclosure concept and provide several illustrative examples, but do not provide a blueprint or approved model for the CD&A.; Each company must then determine how the principles reflected in a particular example apply to its circumstances. In general, the CD&A; must discuss (1) the objectives of the company’s compensation programs, (2) the outcomes the compensation program is designed to reward, (3) each element of compensation, (4) why the company chooses to pay each element of compensation, (5) how the company determines the amount (and, where applicable, the formula) for each element of compensation, and (6) how each element and the company’s decisions regarding that element fit into the company’s overall compensation objectives and affect decisions regarding other elements.

The CD&A; is to address important aspects of compensation for the last fiscal year, and may also include discussion of policies and arrangements that will be applicable in the future. It should also cover executive compensation actions that were taken after the last fiscal year’s end, and it may be necessary to discuss prior years in order to give context to the disclosure provided. If policies or decisions for a particular NEO, such as the principal executive officer, are materially different than those of others, that NEO’s compensation should be discussed separately. As noted above, a company’s policies, programs and practices regarding the award of stock options and other equity-based instruments to compensate executives may have to be discussed in the CD&A.;

The final rules also include a list of fifteen examples of the issues that would potentially be appropriate for the company to address in its CD&A.; The application of each example must be tailored to the particular company. The list of examples is not exclusive. Each company must assess the materiality to investors of the information that is identified by the example in light of the particular situation of the company. Some examples may not be material to a particular company, and in that case no disclosure would be required in response to those examples. The examples are as follows:

  • The policies for allocating between long-term and currently paid out compensation;
  • The policies for allocating between cash and non-cash compensation, and among different forms of non-cash compensation;
  • For long-term compensation, the basis for allocating compensation to each different form of award (such as relationship of the award to the achievement of the registrant’s long-term goals, management’s exposure to downside equity performance risk, correlation between cost to registrant and expected benefits to the company);
  • How the determination is made as to when awards are granted, including awards of equity-based compensation such as options;
  • What specific items of corporate performance are taken into account in setting compensation policies and making compensation decisions;
  • How specific forms of compensation are structured and implemented to reflect these items of the registrant’s performance, including whether discretion can be or has been exercised (either to award compensation absent attainment of the relevant performance goals or to reduce or increase the size of any award or payout), identifying any particular exercise of discretion, and stating whether it applied to one or more specified NEOs or to all compensation subject to the relevant performance goals;
  • How specific forms of compensation are structured and implemented to reflect the NEO’s individual performance and/or individual contribution to these items of the registrant’s performance, describing the elements of individual performance and/or contribution that are taken into account;
  • Company policies and decisions regarding the adjustment or recovery of awards or payments if the relevant registrant performance measures upon which they are based are restated or otherwise adjusted in a manner that would reduce the size of an award or payment;
  • The factors considered in decisions to increase or decrease compensation materially;
  • How compensation or amounts realizable from prior compensation are considered in setting other elements of compensation (e.g., how gains from prior option or stock awards are considered in setting retirement benefits);
  • With respect to any contract, agreement, plan or arrangement, whether written or unwritten, that provides for payment at, following, or in connection with any termination or change-incontrol, the basis for selecting particular events as triggering payment (e.g., the rationale for providing a single trigger for payment in the event of a change in control);
  • The impact of the accounting and tax treatments of the particular form of compensation (including but not limited to tax code Section 162(m) and tax consequences to the NEOs and to the company);
  • The company’s equity or other security ownership requirements or guidelines (specifying applicable amounts and forms of ownership), and any registrant policies regarding hedging the economic risk of such ownership;
  • Whether the registrant engaged in any benchmarking of total compensation, or any material element of compensation, identifying the benchmark and, if applicable, its components (including component companies); and
  • The role of executive officers in determining executive compensation.

Companies are not required to disclose specific target levels with respect to quantitative or qualitative performance factors considered in setting executive pay, but they will have to disclose the performance factors themselves unless they can satisfy the burden of proving that the factors involve confidential commercial or financial information, the disclosure of which would have an adverse effect on the company. The standard applicable when determining if disclosure would have an adverse effect on the company is the same one that applies when companies request confidential treatment of information for purposes of other SEC disclosure rules. If a performance target has otherwise been disclosed publicly, disclosure in the CD&A; could not be avoided under this exception. Further, if performance targets are not disclosed in reliance on this exception, the company must discuss how difficult it will be for the executive or how likely it will be for the company to achieve the undisclosed target levels or other factors, and if the SEC or its staff reviews the disclosure, the company may be required to demonstrate that the exclusion was warranted, and to disclose the information if the SEC or its staff determines that the standards applicable to the exception are not met.

The final rules reinstate a requirement for a Compensation Committee Report to be presented over the names of the individual members of the compensation committee. This report will consist solely of a statement of whether the compensation committee has reviewed and discussed the CD&A; with management and, based on this review and discussion, recommended that it be included in the company’s annual report on Form 10-K and proxy statement.

What is the legal status of the CD&A; and the Compensation Committee Report?
The CD&A; will be considered “filed” with the SEC. Therefore, it will be subject to Regulations 14A or 14C and to the liabilities of Section 18 of the Securities Exchange Act of 1934, as amended (Exchange Act). In addition, to the extent that the CD&A; (and any of the other disclosure regarding executive officer and director compensation) is included or incorporated by reference into a periodic report, the disclosure would be covered by the certifications that principal executive officers and principal financial officers are required to make under the Sarbanes-Oxley Act of 2002 (SOX).

Unlike its predecessor under the prior rules, the old Compensation Committee Report, the CD&A; is a “company document.” The CD&A; is not deemed authored or furnished by or the responsibility of the compensation committee. By contrast, the Compensation Committee Report will be treated as “furnished”, not “filed.” In certifying the information contained in the “filed” CD&A;, the company’s principal executive officer and principal financial officer are permitted to rely on the “furnished” Compensation Committee Report.

What are the requirements for tabular and supplemental narrative disclosure of executive compensation?
The required compensation disclosure consists of six tables, with supplemental narrative disclosure explaining the information in the tables, and narrative disclosure regarding severance and other post employment benefits. The required tables are as follows:

THE SUMMARY COMPENSATION TABLE
The SCT reports the compensation of each NEO over the last three completed fiscal years whether or not actually paid out. The SCT will include the following columns:

  • Salary

This column is largely unchanged from the prior rules. Deferred salary must be included in the column and quantified in a footnote. A similar rule applies to the deferral of compensation reportable in any other column of the SCT.

  • Bonus

A significant change has been made to the bonus column. Under the prior rules, companies typically reported in this column compensation under almost all cash-based “annual performance plans.” Under the new rules, the bonus column will include compensation under performance based cash plans only if earned upon satisfaction of a performance target that was not preestablished and communicated to the executive or if the outcome was not substantially uncertain. Incentive plan compensation not reportable in the bonus column will be reportable in the SCT as non-equity incentive plan compensation.

  • Stock Awards

This column discloses the dollar value of stockrelated awards that derive their value from the company’s equity securities or permit settlement by issuance of the company’s equity securities, such as restricted stock, restricted or phantom stock units and other similar instruments that do not have option-like features. The value of such awards is measured by the grant date fair value, computed under FAS 123-R.

  • Option Awards

This column shows the dollar value for all stock options, stock appreciation rights (SARs) and similar stock-based compensation instruments that have option-like features, measured by the grant date fair value, computed under FAS 123-R. If options are repriced, only the incremental fair value must be reported. The assumptions underlying such fair value calculations must be set forth in a footnote referencing the discussion of them in the notes to the company’s financial statements or the discussion of relevant assumptions in the company’s MD&A.; It is important to note that for both stock and option awards, the full grant date fair value must be reported in the SCT even though for accounting purposes the cost of the award may be spread over the vesting period of the award. This rule will have the effect of skewing the reported compensation of any executive who receives a large grant in a particular year. The Adopting Release states that if a company does not believe that the full grant date fair value of stock or option awards reflects compensation earned, awarded or paid during a fiscal year, it can provide appropriate explanatory disclosure in the accompanying narrative section.

  • Non-Equity Incentive Plan Compensation

This column reports the dollar value of all incentive plan awards not reported in the stock awards or option awards columns, e.g., compensation under a cash performance plan based on financial measures other than stock value. Earnings on outstanding non-equity incentive plan awards are also included in this column and identified and quantified in a footnote. Such compensation is reported in the year when the relevant specified performance criteria are satisfied and the compensation is earned, whether payment is actually made in that year or is deferred to a later year. In other words, unlike equity incentive plan awards, which are reported based on grant date value when awarded, no equity incentive plan awards are reported when earned. The term “earned” is used loosely (if not misleadingly) here, as the Adopting Release indicates that awards for which the relevant performance condition has been satisfied must be reported even if they remain subject to forfeiture conditions (such as conditions requiring continued service or conditions that provide for forfeiture based on future company performance). The confusion which this approach will likely engender (treating as “earned” an amount that has not yet really been earned) will have to be addressed in a footnote or the narrative disclosure accompanying the SCT.

  • Change in Pension Value and Nonqualified Deferred Compensation Earnings

This column reports the annual change in the actuarial present value of accumulated pension benefits under each retirement plan, including tax qualified defined benefit plans and supplemental employee retirement plans (SERPs), but excluding 401(k) and other defined contribution plans. The change is to be calculated from the pension plan measurement date used for the company’s audited financial statements for the prior completed fiscal year to the pension plan measurement date used for the company’s audited financial statements for the covered fiscal year. Footnote identification and quantification of the full amount of each element is required. In addition, this column must include above-market or preferential earnings on nonqualified deferred compensation. The above market 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.

  • All Other Compensation

This column shows the aggregate amount of all other compensation not reported in the other columns of the table. Each item of compensation included in this column, except for perquisites which are addressed in the next Q&A;, that exceeds $10,000 must be separately identified and quantified in a footnote. This column includes the following items: - perquisites (the next Q&A; below addresses the guidance the SEC has provided to assist companies in identifying and determining the reporting value of perquisites); - 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; - any earnings on stock awards or option awards that are not included in the grant date fair value computation for those awards; - the dollar value of any insurance premiums paid by the company with respect to life insurance for the benefit of an NEO; - “gross-ups” or other amounts reimbursed during the fiscal year for the payment of taxes; and - the compensation cost computed in accordance with FAS 123-R for any company security purchased from the company or its subsidiaries at a discount from the market price of such security at the date of purchase, unless that discount is available generally either to all security holders or to all salaried employees of the company.

  • Total Compensation

In this column, the total of the compensation shown in each of the columns will be shown.

GRANTS OF PLAN-BASED AWARDS TABLE
This table supplements the SCT and will be accompanied by narrative disclosure that will help explain the compensation information presented in the table. The table will include the terms of grants made during the current year, on a grant-by-grant basis, including estimated future payouts for both equity incentive plans and non-equity incentive plans. The table must also show the FAS 123-R grant date of options, the closing price of the stock on the grant date if greater than the option exercise price, and the date on which the compensation committee or board took action to grant the award if different than the grant date. If the exercise price of an option is not the grant date closing market price per share, a footnote or the accompanying narrative must describe the methodology for determining the exercise price.

Following the SCT and the Grants of Plan-Based Awards Table, narrative disclosure is required to give context to the information in the tables. The narrative must discuss any additional material factors necessary to an understanding of the information disclosed in the tables. The material factors may, for example, include descriptions of the material terms in the NEOs’ employment agreements that may have a bearing on the tabular information. Other material factors may include information about the repricing, extension of exercise periods, change of vesting or forfeiture conditions, change or elimination of applicable performance criteria, change of the bases upon which returns are determined, or any other material modification of options or other equity based awards during the last fiscal year.

The narrative will also describe, to the extent material and necessary to an understanding of the tabular disclosure, award terms relating to information provided in the Grants of Plan-Based Awards Table. This could include, for example, a general description of the formula or criteria to be applied in determining the amounts payable, the vesting schedule, a description of the performance-based conditions and any other material conditions applicable to the award.

OUTSTANDING EQUITY AWARDS AT FISCAL YEAR END TABLE
This table will show information regarding outstanding awards under stock option, SAR, restricted stock incentive and similar plans, including such information as the amount of securities underlying exercisable and unexercisable options, the exercise prices and the expiration dates for each outstanding option (rather than on an aggregate basis). The table also discloses the numbers and market values of non vested stock and equity incentive plan awards.

THE OPTION EXERCISES AND STOCK VESTED TABLE
This table will show the amounts received upon exercise of options or similar instruments or the vesting of stock or similar instruments during the most recent fiscal year.

THE PENSION BENEFITS TABLE
This table will require disclosure of the actuarial present value of each NEO’s accumulated benefit under each pension plan and the number of years of service credited to each NEO under the plan, computed using the same assumptions (except for the normal retirement age) and measurement period as used for financial reporting purposes under generally accepted accounting principles. A separate line of tabular disclosure is required for each plan in which an NEO participates that provides for the payment of specified retirement benefits, or benefits that will be paid primarily following retirement. Benefit calculations should reflect the current compensation of the NEOs. “Normal retirement age” means the normal retirement age defined in the plan, or if not so defined, the earliest time at which a participant may retire under the plan without any benefit reduction due to age. The table also shows the amount of any pension benefits paid to an NEO during the last completed fiscal year.

Narrative accompanying the table must describe any material factors necessary to an understanding of each plan disclosed in the table. Examples of such factors 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; the specific elements of compensation, such as salary and various forms of bonus, included in applying the benefit formula, identifying each such element; regarding participation in multiple plans, the different purposes for each plan; and company policies with regard to such matters as granting extra years of credited service.

THE NONQUALIFIED DEFERRED COMPENSATION TABLE
This table will require disclosure with respect to nonqualified deferred compensation plans of amounts of executive contributions, company contributions, withdrawals, all earnings for the year (not just the above-market or preferential portion) and the yearend balance. To avoid double counting, the company must quantify in a footnote the extent to which (1) amounts in the contributions and earnings columns are reported as compensation in the year in question, and (2) other amounts reported in the table in the aggregate balance column were reported previously in the SCT for prior years. The table would be followed by a narrative description of material factors necessary to an understanding of the disclosure in the table. Examples of such factors include: the type(s) of compensation permitted to be deferred, and any limitations (by percentage of compensation or otherwise) on the extent to which deferral is permitted; the measures of calculating interest or other plan earnings (including whether such measures are selected by the NEO or the company and the frequency and manner in which such selections may be changed); quantifying interest rates and other earnings measures applicable during the company’s last fiscal year; and the material terms with respect to payouts, withdrawals and other distributions.

NARRATIVE DISCLOSURE CONCERNING TERMINATION AND CHANGE IN CONTROL PAYMENTS
The company will have to provide a narrative description of any arrangement that provides for payments or benefits at, following, or in connection with any termination of an NEO, a change in responsibilities, or a change in control of the company, including quantification of these potential payments and benefits assuming that the triggering event took place on the last business day of the company’s last fiscal year and the price per share was the closing market price on that date. The narrative must include the following information regarding termination and change in control provisions:

  • the specific circumstances that would trigger payment under the termination or change in control arrangements or the provision of other benefits (references to benefits include perquisites);
  • the estimated payments and benefits that would be provided in each termination circumstance, and whether they would or could be lump-sum or annual, disclosing the duration and by whom they would be provided;
  • the specific factors used to determine the appropriate payment and benefit levels under the various circumstances that would trigger payments or provision of benefits;
  • any material conditions or obligations applicable to the receipt of payments or benefits, including but not limited to non-compete, non-solicitation, non-disparagement or confidentiality covenants; and
  • any other material features necessary for an understanding of the provisions.

The item contemplates disclosure of the duration of non-compete and similar agreements, and provisions regarding waiver of breach of these agreements, and disclosure of tax gross-up payments. A company is required to provide quantitative disclosure under these requirements even where uncertainties exist as to amounts payable under these plans and arrangements. In the event that uncertainties exist as to the provision of payments or benefits or the amounts involved, the company would be required to make reasonable estimates and disclose material assumptions underlying such estimates in its disclosure. In such event, the disclosure would be considered forward-looking information as appropriate that falls within the safe harbor for disclosure of such information.

See the continuation on Part II

Kirkpatrick & Lockhart Preston Gates Ellis LLP - United States

  • Delta Airlines
  • Localiza