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

WHAT ARE THE NEW RULES ON THE REPORTING OF PERQUISITES?
Perquisites and other personal benefits must be disclosed in the “Other Compensation” column of the SCT unless the aggregate amount of such compensation is less than $10,000. A footnote must identify each perquisite or other personal benefit and, if it is valued at the greater of $25,000 or ten percent of total perquisites and other personal benefits, its value must be disclosed. The proper measure of value of perquisites and other personal benefits is the aggregate incremental cost to the company. The methodology for computing the aggregate incremental cost for the perquisites must be disclosed in a footnote.

There is no comprehensive definition of or bright line test for identifying perquisites. Among the factors to be considered in determining whether an item is a perquisite or other personal benefit are the following:

  • Is an item integrally and directly related to the performance of the executive’s duties? If the answer is “yes,” the item is not a perquisite or personal benefit. If the answer is “no,” then the next question must be considered.
  • Does the item confer a direct or indirect benefit that has a personal aspect that is not generally available on a non-discriminatory basis to all employees? If the answer is “yes,” the item is a perquisite or personal benefit. If the answer is “no,” the item is not a perquisite or personal benefit.

The Adopting Release indicates that the concept of a benefit that is “integrally and directly related” to job performance is a narrow one that captures only items that a company provides because the executive needs them to do the job. The fact that an item has a business purpose or convenience is not sufficient to avoid the characterization of an item as a perquisite or personal benefit where the “integrally and directly related” test is not met.

The Adopting Release provides the following nonexclusive list of examples of items that are considered perquisites or personal benefits under the final rules: club memberships not used exclusively for business entertainment purposes; personal financial or tax advice; personal travel using vehicles owned or leased by the company; personal travel otherwise financed by the company; personal use of other property owned or leased by the company; housing and other living expenses (including but not limited to relocation assistance and payments for the executive or director to stay at his or her personal residence); security provided at a personal residence or during personal travel; commuting expenses (whether or not for the company’s convenience or benefit); and discounts on the company’s products or services not generally available to employees on a non-discriminatory basis.

What are the new rules regarding the disclosure of director compensation?
Director compensation will be reported in tabular format, accompanied by narrative disclosure of additional material information. The Director Compensation Table resembles the SCT but presents information only with respect to the company’s last completed fiscal year. The columns of the table include: Fees Earned or Paid in Cash; Stock Awards; Option Awards; Non-Equity Incentive Plan Compensation; Change in Pension Value and Nonqualified Deferred Compensation Earnings; All Other Compensation; and Total Compensation.

The All Other Compensation column of the Director Compensation Table would include, but not be limited to:

  • all perquisites and other personal benefits if the total is $10,000 or greater;
  • all earnings on compensation that is deferred on a basis that is not tax-qualified;
  • all tax reimbursements;
  • annual company contributions or other allocations to vested and unvested defined contribution plans;
  • for any security of the company or its subsidiaries purchased from the company or its subsidiaries (through deferral of fees or otherwise) at a discount from the market price of such security at the date of purchase, unless the discount is generally available to all security holders or to all salaried employees of the company, the compensation cost computed in accordance with FAS 123-R;
  • aggregate annual increase in actuarial value of all defined benefit and actuarial pension plans;
  • annual company contributions to vested and unvested defined contribution and other deferred compensation plans;
  • all consulting fees;
  • awards under director legacy or charitable awards programs;
  • the dollar value of any dividends or other earnings paid in stock or option awards when the dividend or earnings were not factored into the grant date fair value; and
  • the dollar value of any insurance premiums paid by, or on behalf of, the company for life insurance for the director’s benefit.

Directors may be grouped in a single row of the table if all of their elements and amounts of compensation are identical. In addition to the disclosure specified in the columns of the table, companies would be required to disclose, for each director, by footnote to the appropriate column, the aggregate numbers of stock awards and option awards outstanding at fiscal year end. Following the table, narrative disclosure would describe any material factors necessary to an understanding of the table. Such factors may include, for example, a breakdown of types of fees. Disclosure regarding option timing or dating zpractices may be necessary under this narrative disclosure requirement when the recipients of the stock option grants are directors of the company.

Disclosure of Related Party Transactions

What changes has the SEC made to related person transaction disclosure?
The SEC has significantly modified the disclosure currently required by Item 404 of Regulation S-K. These revisions are intended to streamline and modernize related person transaction disclosure through the use of a more principles-based approach. The revisions have four parts:

  • revised Item 404(a) contains a general disclosure requirement for related person transactions, eliminating the distinction between indebtedness and other types of related party transactions;
  • revised Item 404(b) requires disclosure on a company’s policies and procedures for the review, approval or ratification of related person transactions;
  • revised Item 404© requires disclosure regarding a company’s promoters and certain control persons; and
  • new Item 407 consolidates corporate governance disclosure requirements.

Which transactions with related persons must be disclosed?
The new rules eliminate many of the bright-line disclosure thresholds formerly contained in the instructions to Item 404(a) in favor of a broad materiality analysis. More specifically, revised Item 404(a) provides that a company must disclose any transaction since the beginning of the company’s last fiscal year, or any currently proposed transaction, in which the company was or is to be a participant and in which any related person had, or will have, a direct or indirect material interest, if the amount involved exceeds $120,000. The $120,000 minimum is an increase over the former $60,000 threshold. In addition, the SEC retained the materiality standard for disclosure. Materiality of any interest continues to be determined on the basis of the significance of the information to investors in light of all the circumstances. Of particular importance to this determination is the relationship of the related persons to the transaction and with each other, the importance of the interest to the person having the interest and the amount involved in the transaction. As before, not all transactions in excess of $120,000 automatically cross the materiality threshold.

Why is the SEC using “participant” to a transaction rather than “party”?
Revised Item 404 requires disclosure of a transaction only if the company is a “participant.” This differs from the former requirement that the company be a “party” to a transaction. The SEC made this change so that Item 404 would encompass situations in which a company benefits from a transaction but is not technically a contractual “party” to the transaction.

Does revised Item 404(a) now cover indebtedness transactions?
Modified Item 404(a) encompasses transactions involving indebtedness, which was formerly covered separately under Item 404©. Decisions regarding disclosure of indebtedness transactions are made through the same analysis as other related person transactions. Item 404(a) also requires disclosure of all material indirect interests in indebtedness transactions of related persons. For example, disclosure is now required if an executive officer has a material indirect interest in an indebtedness transaction exceeding $120,000 between the company and another entity due to the executive officer’s ownership interest in the other entity. The SEC did not, however, adopt the proposed requirement that companies disclose indebtedness transactions with significant shareholders and their immediate family members.

How broad is the term “transaction” under the revised rules?
The term “transaction” is broadly defined to include, but is not limited to, any financial transaction, arrangement or relationship or any series of similar transactions, arrangements or relationships. The definition includes indebtedness and guarantees of indebtedness.

Who is a “related person” under the revised rules?
The term “related person” means any person who was in any of the following categories at any time during the specified period for which disclosure under Item 404(a) is required: (1) any director or executive officer of the company and his or her immediate family members, and (2) if disclosure is provided in a proxy or information statement relating to the election of directors, any nominee for director and the immediate family members of any nominee for director. In addition, a “related person” also includes a security holder known to the company to beneficially own more than five percent of any class of the company’s voting securities or any immediate family member of such person, when a transaction in which such security holder or family member had a direct or indirect material interest occurred or existed.

Disclosure is required for a person who was a “related person” at any time during the last fiscal year even if they were not a “related person” at the time of the applicable transaction with the company or if the person was no longer a related person at the end of the year. Transactions with persons who have been or who become significant shareholders (or their immediate family members), but are not at the time of the transaction, may be excluded. Disclosure is required, however, if the transaction begins before a significant shareholder becomes a significant shareholder and continues (for example, through the ongoing receipt of payments) after the person becomes a significant shareholder.

The term “immediate family member” of a related person includes any child, stepchild, parent, stepparent, spouse, sibling, mother-in-law, father-in-law, son-in-law, daughter-in-law, brother-in-law, or sister-in-law, and any person (other than a tenant or employee) sharing the household of any director, nominee for director, executive officer, or significant shareholder of the company. This differs from the former definition in that it adds stepchildren, stepparents, and any person (other than a tenant or employee) sharing the household of any director, nominee for director, executive officer, or significant shareholder of the company.

How has the SEC defined the “amount involved” for purposes of Item 404?
The definition of “amount involved” incorporates two concepts previously in Item 404 regarding calculation of the “amount involved” and clarifies that the amounts must be reported in dollars, even if the amount was set or expensed in a different currency. “Amount involved” means the dollar value of the transaction, or series of similar transactions, and includes: (1) in the case of any lease or other transaction providing for periodic payments or installments, the aggregate amount of all periodic payments or installments due on or after the beginning of the company’s last fiscal year, including any required or optional payments due during or at the conclusion of the lease or other transaction providing for periodic payments or installments; and (2) in the case of indebtedness, the largest aggregate amount of all indebtedness outstanding at any time since the beginning of the company’s last fiscal year and all amounts of interest payable on it during the last fiscal year.

What disclosures are required for related persons transactions?
The revised rules require a company to describe the transaction, including:

  • the person’s name and relationship to the company;
  • the person’s interest in the transaction with the company, including the related person’s position or relationship with, or ownership in, a firm, corporation or other entity that is a party to or has an interest in the transaction; and
  • the approximate dollar value of the amount involved in the transaction and of the related person’s interest in the transaction. A company is also still required to disclose any other information regarding the transaction or related person that is material to investors in light of the circumstances of the particular transaction. A company is no longer required to disclose amounts possibly owed to the company under Section 16(b) of the Exchange Act.

Are there exceptions to the disclosure requirements?
The revised rules provide for categories of exceptions from disclosure under Item 404(a). The first category of transactions involves compensation. Disclosure of compensation to an executive officer is not required under Item 404(a) if:

  • the compensation is reported under Item 402 of Regulation S-K, or
  • the executive officer is not an immediate family member of a related person, such compensation would have been reported under Item 402 as compensation earned for services to the company if the executive officer was an NEO, and such compensation was approved, or recommended to the company’s board of directors for approval, by the company’s compensation committee or group of independent directors performing a similar function.

This may cause many companies to have their compensation committees as a matter of course approve all executive officers’ compensation in order to avoid such Item 404 disclosure obligations. The revised rules also provide that Item 404(a) does not require disclosure of compensation to a director if the compensation is reported under Item 402(k).

The second category of exceptions involves three types of situations, the first two of which involve indebtedness transactions. First, the following items of indebtedness are excluded from the indebtedness calculation and need not be disclosed: amounts due from related persons for purchases of goods and services subject to usual trade terms, for ordinary business travel and expense payments, and for other transactions in the ordinary course of business. Second, if the lender is a bank, savings and loan association, or broker-dealer extending credit under Federal Reserve Regulation T and the loans are not disclosed as no accrual, past due, restructured or potential problems, disclosure under new Item 404(a) may consist of a statement, if correct, that the loans to such persons satisfied the following conditions:

  • were made in the ordinary course of business;
  • on substantially the same terms (including interest rates and collateral) as those prevailing at the time for comparable loans with persons not related to the lender; and
  • did not involve more than the normal risk of collectibility or present other unfavorable features. Another exception provides that a person who has a position or relationship with a firm, corporation or other entity that engages in a transaction with the company is not deemed to have an indirect material interest under Item 404(a) if:
  • the interest arises only: (i) from the person’s position as a director of another corporation or organization that is a party to the transaction; or (ii) from the direct or indirect ownership by such person and all other related persons, in the aggregate, of less than a ten percent equity interest in another person (other than a partnership) which is a party to the transaction; or (iii) from both such position and ownership; or
  • the interest arises only from the person’s position as a limited partner in a partnership in which the person and all other related persons have an interest of less than ten percent, and the person is not a general partner of and does not have another position in the partnership.

Finally, disclosure under Item 404(a) is not required under three other types of circumstances. First, disclosure is not required as to any transaction where the rates or charges involved in the transaction are determined by competitive bids, or the transaction involves the rendering of services as a common or contract carrier, or public utility, at rates or charges fixed in conformity with law or governmental authority. Second, disclosure need not be provided if the transaction involves services as a bank depository of funds, transfer agent, registrar, trustee under a trust indenture, or similar services. Third, disclosure need not be provided pursuant to Item 404(a) if the interest of the related person arises solely from the ownership of a class of equity securities of the company and all holders of that class of equity securities of the company received the same benefit on a pro rata basis. This final exception would obviate the need to disclose a related person receiving over $120,000 in dividends on company stock in a year where those dividends are paid on the same terms as for all other stockholders.

What must companies disclose about their policies and procedures for approval of related person transactions?
The SEC has adopted a new requirement that companies must describe the material features of the company’s policies and procedures for the review, approval or ratification of transactions with related persons that are reportable under Item 404(a). The description must include the material features of the policies and procedures necessary for an understanding of them. Examples of the features that may be described, depending on the circumstances, include the following:

  • the types of transactions that are covered by such policies and procedures and the standards to be applied pursuant to the policies and procedures;
  • the persons or groups of persons on the board of directors or otherwise who are responsible for applying the policies and procedures; and
  • whether such policies and procedures are in writing and, if not, how such policies and procedures are evidenced.

In addition, Item 404(b) requires that companies specifically disclose any transactions required to be reported under Item 404(a) where the company’s policies and procedures did not require review, approval or ratification or where such policies and procedures were not followed. Item 404(b) does not, however, require disclosure for any transaction that occurred at a time before the related person had the relationship that would trigger disclosure under Item 404(a) if the transaction did not continue after the related party had that relationship.

What must companies disclose about transactions with promoters and control persons?
Companies must now disclose the identity of promoters and their transactions with those promoters if the company had a promoter at any time during the last five fiscal years. The disclosure must include:

  • the names of the promoters;
  • the nature and amount of anything of value received by each promoter from the company and the nature of any amount of consideration received by the company; and
  • additional information regarding any assets acquired by the company from a promoter.

The above disclosure is required in Securities Act registration statements on Form S-1 or Form SB-2 and on Exchange Act Form 10 or Form 10-SB. This disclosure requirement is a departure from the former rules which required such disclosure only if a company had been organized within the last five years. The new rules also require the same disclosure that is required for promoters for any person who acquired control, or is part of a group that acquired control, of an issuer that is a shell company.

How has the SEC changed corporate governance disclosure?
The SEC has consolidated under new Item 407 of Regulation S-K the disclosure requirements regarding director independence and related corporate governance. New Item 407 consolidates corporate governance disclosure requirements previously located in several places under the former rules and the company’s principal markets’ listing standards.

What must companies disclose regarding director independence?
If a company is an issuer with securities listed, or for which it has applied for listing, on a national securities exchange or an automated inter-dealer quotation system of a national securities association which requires that a majority of the board of directors be independent, Item 407(a) requires that the company disclose the directors and director nominees it identifies as independent (and committee members not identified as independent) using a definition of independence that it uses for determining compliance with the applicable listing standards. Similarly, if the company is not a listed issuer, the company must disclose the directors and director nominees it identifies as independent (and committee members not identified as independent) using a definition for independence for directors (and for committee members) of a national securities exchange or national securities association specified by the company. A non-listed issuer must apply the selected independence definition consistently to all directors and must use the independence standards of the same national securities exchange or national securities association to determine the independence of members of the compensation, nominating and audit committees.

If the company is a listed issuer whose securities are listed on a national securities exchange or in an interdealer quotation system which has requirements that a majority of the board of directors be independent, and also has exemptions to those requirements (for board or committee member independence) upon which the company relied, the company must disclose the exemption relied upon and explain the basis for its conclusion that such exemption is applicable. Similar disclosure is required for those companies that are not listed issuers but would qualify for an exemption under the listing standards selected. In addition, small business issuers listed on exchanges where at least half of the members of the board of directors, rather than a majority, are required to be independent must comply with the disclosure requirements specified in Item 407(a).

Under new Item 407, a company must also disclose whether the adopted definitions of independence are posted on the company’s web site, or include the definitions as an appendix to the company’s proxy materials at least once every three years. If a company materially amends its independence definition, the new definition must be included as an appendix to the company’s next proxy materials. If a company’s independence definitions are not on the company’s web site, or included as an appendix to that year’s proxy statement, the company must disclose in which of the previous fiscal years the definitions were last included in the proxy materials. In addition, if the audit committee charter is posted on the company’s web site, it no longer needs to be delivered to security holders.

Item 407 also requires, for each director or nominee identified as independent, a description of any transactions, relationships or arrangements not disclosed under Item 404(a) that were considered by the board of directors in determining whether the applicable independence standards were met. This disclosure must be made on a director by director basis, with separate disclosure of categories or types of transactions, relationships or arrangements for each director and director nominee. The description must be sufficiently detailed so that the nature of the transactions, relationships or arrangements is readily apparent.

The Item 407 independence disclosures must be provided for any person who served as a director of the company during any part of the year for which disclosure must be provided, even if the person no longer serves as a director at the time of filing the registration statement or report or, if the information is in a proxy statement, if the director’s term of office as a director will not continue after the meeting.

What new disclosures are required regarding compensation committees?
In addition to the disclosures currently required regarding audit and nominating committees, Item 407 requires similar new disclosures regarding compensation committees. For instance, a company must state whether the compensation committee has a charter, and if it does make the charter available through its web site or proxy materials in one of the ways that audit and nominating committee charters may be made available. Item 407 also requires that a company describe its processes and procedures for the consideration and determination of executive and director compensation, including:

  • the scope of authority of the compensation committee (or persons performing the equivalent functions);
  • the extent to which the compensation committee (or persons performing the equivalent functions) may delegate any authority to other persons, specifying what authority may be so delegated and to whom;
  • any role of executive officers in determining or recommending the amount or form of executive and director compensation; and
  • any role of compensation consultants in determining or recommending the amount or form of executive and director compensation, identifying such consultants, stating whether such consultants are engaged directly by the compensation committee (or persons performing the equivalent functions) or any other person, describing the nature and scope of their assignment, the material elements of the instructions or directions given to the consultants with respect to the performance of their duties under the engagement.

In addition, the disclosure formerly required under Item 402 regarding compensation committee interlocks and insider participation in compensation decisions is now consolidated in Item 407.

Has the SEC eliminated proxy disclosure of directors resigning or not standing for re-election?
For registrants other than registered investment companies, the previous proxy disclosure requirement regarding directors that have resigned or declined to stand for re-election has been eliminated because it is no longer necessary as it is required to be disclosed on Form 8-K. For registered investment companies which do not file Form 8-K, the disclosure requirement has been moved to Item 22(b) of Schedule 14A.

What are the “plain English” requirements of the new rules?
Companies must prepare their executive and director compensation, related person transactions, beneficial ownership and corporate governance disclosures included in Exchange Act reports using plain English principles. The plain English guidance consists of a series of “dos” and “don’ts” as follows:

  • Plain English Dos

Present information in clear, concise sections, paragraphs and sentences, using short sentences, definite, concrete, everyday words, the active voice, descriptive headings and subheadings and a tabular presentation or bullet lists for complex material, and in designing the presentation of the information, include pictures, logos, charts, graphs, schedules, tables or other design elements so long as the design is not misleading and the required information is clear, understandable, consistent with applicable disclosure requirements and any other included information, drawn to scale and not misleading.

  • Plain English Don’ts

Avoid the following: legal jargon and highly technical business and other terminology; frequent reliance on glossaries or defined terms as the primary means of explaining information, defining terms in the glossary or other section of the document only if the meaning is unclear from the context and using a glossary only if it facilitates understanding of the disclosure; legalistic or overly complex presentations that make the substance of the disclosure difficult to understand; vague “boilerplate” explanations that are imprecise and readily subject to different interpretations; complex information copied directly from legal documents without any clear and concise explanation of the provision(s); and disclosure repeated in different sections of the document that increases the size of the document but does not enhance the quality of the information.

What steps should company management be taking to ensure the company’s compliance with the new rules, and what steps should the compensation committee take to ensure it is fulfilling its role in the disclosure of executive and director pay?
During the open meeting at which the new rules were adopted, the SEC staff observed that the prior disclosure rules adopted in 1992 had remained stagnant despite dramatic changes in pay practices and that company disclosures had drifted toward boilerplate and legalese that was not helpful to most investors. The staff assured the Commissioners that it would not tolerate such shortcomings in the future. The SEC staff can be expected to more closely monitor executive compensation disclosures, particularly in the initial year or two for which the new rules will be in effect, and in appropriate instances to require the rewriting of sections, particularly the CD&A;, that do not meet the letter or spirit of the new rules.

The issuance of the new rules presents a good opportunity for companies to review the respective roles of management and the compensation committee in determining the design and disclosure of executive and director pay. A starting point for this analysis is the CD&A.; The CD&A; is a “company document” that must include a discussion and analysis of the material factors underlying compensation policies and decisions reflected in the data presented in the tables. This is not intended to be a theoretical discussion – it should reflect the actual policies and decisions of the company through its compensation committee. Accordingly, the committee must engage in a process, during its meetings and discussions on key compensation decisions, that supports the explanation ultimately contained in the CD&A.; It is not advisable to begin fashioning a rationale for prior decisions only as the CD&A; is being prepared after the close of the fiscal year.

Suggested action steps for the company and the compensation committee include:

  • Educate management and the board regarding the requirements of the new rules. The principal executive officer, the principal financial officer, the company’s General Counsel and the members of the compensation committee in particular must become familiar not only with the general thrust of the new requirements but with the details to an extent sufficient to effectively discharge their compliance responsibilities. Outside counsel and

consultants may be helpful to this education effort.

  • Define the respective roles of management, the compensation committee and the full board in ensuring the company’s compliance with the executive compensation requirements. To the extent necessary, adjust the charter of the compensation committee to reflect the new disclosure landscape.
  • Determine which company departments and personnel are needed to compile the compensation data for the tables and narrative disclosures and those who will be responsible for ensuring that the data is properly reported in the tables and narrative.
  • Identify and retain special outside expertise (e.g., legal, accounting and actuarial) whose assistance will be required.
  • Identify, at least preliminarily, the executives who will have to be included in the tables and prepare mock-ups of the CD&A;, the tables and the narrative disclosure based upon the most recent information available. It may be helpful in this regard to review the 2006 proxy filings of companies that have attempted to comply with some or all elements of the proposed rules.
  • Focus in particular on items that will be more visible under the new rules, such as perquisites and termination and change in control payment arrangements, and consider whether any changes to such arrangements are appropriate in anticipation of increased public scrutiny of them.
  • Review existing stock option grant procedures and adjust them, as appropriate, to conform with “best practices.”
  • This effort to prepare the mock-ups will help to identify the processes and procedures that will be necessary to assemble the information for the tables and other disclosure. To the extent possible, these processes and procedures should be codified in written compliance guidelines.

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