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The SEC's Final Rules on Executive Compensation - What to Do Now

Thelen Reid & Priest LLP


Thomas J. Igoe, Jr., Ira H. Jolles, Michael J. Connolly, Benjamin I. Delancy, Eulalia M. Mack

On August 11, 2006, the Securities and Exchange Commission (SEC) released its changes to its rules on executive compensation and related party disclosure. The final rules are intended to provide a clearer and more complete picture of the total compensation earned by a company's principal executive officer, principal financial officer and the three highest paid executive officers, and by members of its board of directors, together with better information about important financial relationships between companies and their executive officers, directors, significant shareholders and other related persons.1

Companies must comply with the new disclosure requirements in Forms 8-K for related triggering events that occur on or after 60 days after publication in the Federal Register and in Forms 10-K and 10-KSB for fiscal years ending on or after December 15, 2006. Companies other than registered investment companies must comply with these disclosure requirements in registration statements filed under the Securities Act of 1933 or the Securities Exchange Act of 1934 (Exchange Act) and in any proxy or information statements filed on or after December 15, 2006 that are required to include Items 402 and 404 disclosure for fiscal years ending on or after December 15, 2006.2

Reporting companies should begin now as part of their disclosure controls and procedures, to implement the tracking and reporting mechanisms that will be necessary to collect the data required for compliance with the final rules, and to review, describe, summarize and document their executive compensation policies, plans, practices and agreements.

Much has been and will be written with respect to the details of the final rules. However, at this time we think it is useful to highlight for our clients and friends in the registrant community some of their important elements.

The Executive Compensation Disclosure and the Compensation Discussion and Analysis Will be "Filed" and Not Merely "Furnished"

The final rules require a "principles-based" comprehensive narrative overview at the beginning of the compensation disclosure, which explains the material elements of a company's compensation for named executive officers, including the post-termination (e.g., termination and retirement) components as well as the in-service components.3

The CD&A will be filed with the Commission and will be considered soliciting material, part of the proxy statement and part of any other filing in which it is included and subject to Regulations 14A or 14C and the liability provisions of Section 18 of the Exchange Act. Moreover, to the extent that the CD&A, like any other disclosures regarding executive officer and director compensation, are included or incorporated by reference into a periodic report (such as Form 10-K), it would be covered by the certifications that principal executive and financial officers are required to make under the Sarbanes-Oxley Act.

The CD&A should provide material information about the compensation objectives and policies for named executive officers, putting into perspective the numbers in the tables and narratives that follow it. It should address the objectives of the company's compensation program, what is rewarded, each element (and the rationale for each element) of compensation, the manner in which the amount for each element (including the formula, if applicable) is calculated and the interrelationships between elements and company decisions about each element.

We believe that the CD&A should be prepared in a manner similar to that of the Form 10-K itself, including appropriate inquiry, review and documentation to support the statements made in the CD&A. Consequently, company records should include those management and board of directors (including board committee) determinations necessary to support the creation and implementation of those policies. Furthermore, according to the SEC, the scope of the CD&A is not limited to the last fiscal year, but may also require discussion of "post-termination compensation arrangements, on-going compensation arrangements, and policies that the company will apply on a going-forward basis." In some situations, discussion of prior years may be required to provide context for the disclosures being made. In such matters, management will need to have confidence that the history of these matters and policies, and their review and approval by the board, where applicable, are supported by appropriate documentation in the company's files, including board and committee minutes. To the degree that a review of the files suggests gaps, this exercise provides a further opportunity to supplement and complete the record.

Of course, the chief executive and financial officers should also be able to look for support for their certifications from the new Compensation Committee Report, which is to be furnished under the final rules.

A New Compensation Committee Report Will be "Furnished"

The final rules require a new Compensation Committee Report under which the compensation committee is required to disclose whether it has reviewed and discussed the CD&A with management and whether it has recommended to the board of directors the inclusion of the CD&A in the company's annual report and/or proxy or information statement. Although this report will be required to be included or incorporated by reference into a company's annual report on Form 10-K, it will be considered as furnished, not filed, so it will not be considered soliciting material, will not be part of the proxy statement or part of any other filing in which it is included and will not be subject to Regulations 14A or 14C and the liability provisions of Section 18 of the Exchange Act. The Compensation Committee Report will not be covered by the chief executive and financial officers' certifications.

Stock Options Disclosure

The recent attention to questions and concerns surrounding the issuance and dating of stock options is reflected in the SEC's Release and in the final rules. The SEC's Release makes clear that the "federal securities laws . do require full and fair disclosure of compensation information to the extent material or required by [SEC] rule."4 The final rules now require both tabular and narrative disclosure with respect to a company's use of stock options as a component of executive compensation.

In the tabular disclosure, companies will be required to disclose the full grant date fair value of the named executives' options computed in accordance with FAS 123R, the grant date, the exercise price and the expiration date. If the exercise price is less than the closing market price of the stock on the grant date, then the market price on the date of grant will need to be disclosed as will information about grant dates that differ from the dates on which the compensation committee or board of directors took action.

In addition to the narrative disclosure related to the tabular information, companies will be required to discuss their option-related plans, practices and programs in the CD&A. If material, information about the methods and the reasons for grant date determinations and the methods used to select grant terms such as the exercise price (including formula-based methodologies) will need to be disclosed and discussed in the CD&A. The practice of timing option grants in coordination with the release of material non-public information would also require full disclosure in the CD&A because, in the SEC's view, the existence of such a program, plan or practice would be material to investors. The disclosure would include, if applicable, that the board of directors or compensation committee may grant options during times when the board or committee possesses material, non-public information. According to the SEC's Release, it may also be necessary to consider disclosing how such information is taken into account in deciding to make option grants or the amount of such grants.5

While the SEC suggests that it does not seek to encourage or discourage the use of stock options in executive compensation or certain aspects of the programs and practices that have developed with respect to the use of option compensation,6 the level of required disclosure may be anticipated to have a dampening effect on their future use.

The required disclosure will necessitate detailed review and consideration of existing programs and practices by boards of directors and management, as well as significant documentation to support the Sarbanes-Oxley certifications that will apply to the information disclosed as part of the filed CD&A.

Revisions to Form 8-K and the Periodic Report Exhibit Requirements

Under the final rules, the SEC has eliminated the reporting of employment compensation arrangements under Item 1.01 of Form 8-K but broadened the scope of Item 5.02,7 to capture the information previously required under that item as well as additional information regarding material employment compensation arrangements involving named executive officers that prior to the amendment fell under Item 1.01. The SEC intends that these changes will inform investors about specified material events and developments, but without the level of information necessary to comply with Item 402 in the Form 10-K, and will avoid disclosures that fall below the "unquestionably or presumptively material" threshold of information that Form 8-K was designed to elicit on a real-time basis.

The new Form 8-K rules may lessen the burdens on companies with respect to their reporting obligations. However, the expanded list of officers covered by the rule and the often difficult determinations about materiality will require revisions to applicable disclosure controls and procedures and thoughtful consideration of other possible organizational or reporting implications.

Conclusions

The final SEC rules on executive compensation disclosures pose a challenge to boards of directors and managements to articulate and explain integrated and rational executive compensation policies together with their implementation. Thorough preparation is essential to the creation, documentation and implementation of executive compensation policies to provide the basis for thoughtful and complete disclosures. We believe that it is not too early to begin to respond to that challenge.8


1 SEC Release Nos. 33-8732; 34-54302; IC-27444; File No. S7-03-06, at 9. The final rules are available from the SEC website (http://www.sec.gov/rules/final.shtml) and, as indicated above, will be published in the Federal Register shortly. We note that while there is no fundamental change in the final rules from the proposed rules, especially in terms of the SEC's emphasis on the disclosure and narrative explanation of named executive officers' total compensation, the final rules do make numerous changes in the proposed rules. Most of these changes are based on the over 20,000 comments the SEC received with respect to its executive compensation rules proposal. These changes include consolidation and other modifications to the required tables, including the Summary Compensation Table, and additional clarifying examples with respect to some disclosure requirements. The changes also modify existing instructions or provide additional instructions, including modified parameters for determining the named executive officers, modified or clarified assumptions regarding certain computations, additional clarifying discussion and guidance with respect to perquisites and modifications to the scope of the related party transaction disclosures. Initially, information for years prior to the most recent fiscal year to which the rules apply will not be required. In the next two subsequent years, reporting companies will phase-in information about prior years that are covered by the rules. Thereafter, companies will be required to present data from the most recent three fiscal years in the Summary Compensation Table. We also note that the SEC continues to differentiate between small business issuers and other issuers. The requirements on small business issuers are somewhat less extensive. Under amended Item 402-SB, small business issuers are not required to provide the CD&A and are relieved of providing some of the tables except for the Summary Compensation Table, the Outstanding Equity Awards at Fiscal Year-End Table, and the Director Compensation Table together with related narrative disclosure. In addition, small business issuers need only provide such information for the two most recent fiscal years (and not the three most recent as required under Item 402-SK) and only for the principal executive officer and the two most highly compensated officers other than the principal executive officer (as compared to the principal executive and financial officers and the next three most highly compensated officers as required under Item-402-SK).

2 In addition, registered investment companies must comply with these disclosure requirements in initial registration statements and post-effective amendments that are annual updates to effective registration statements on Forms N-1A, N-2 (except those filed by business development companies) and N-3, and in any new proxy or information statements, filed with the Commission on or after December 15, 2006.

3 Although, as proposed, the CD&A would have eliminated the currently required Performance Graph and the prior Compensation Committee report, the final rules retain the use of the Performance Graph and require a new Compensation Committee Report. Retention of the Performance Graph was noted to be significant across the broad spectrum of comments received by the SEC. Persuaded by this sentiment, the SEC decided to retain the Performance Graph but not as part of the executive compensation disclosure. In other words, it will not be part of the CD&A and will be furnished and not filed. It will be required under a new Item 201(e) of Regulation S-K.

4 SEC Release, at 20.

5 SEC Release, at 25.

6 SEC Release, at 20-27.

7 Prior to the amendment, Item 5.02 required disclosure within four business days of the appointment or departure of directors and specified officers, a brief description of the material terms of any applicable employment agreement and a description of any disagreements between the company and the executive.

8 In addition, the SEC has used the release of the final rules to re-propose a new rule with respect to the need to disclose the compensation of the three highest paid, non-executive policymaking employees. The SEC has invited comments on the re-proposed rule, including responses to some specific questions.

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ΒΈ2006 Thelen Reid & Priest LLP. This article has been published as an information service to clients and friends of Thelen Reid. Please recognize that the information is general in nature and must not be relied upon as legal advice. We would be pleased to discuss this information with you and its application to your specific situation, and welcome your comments and suggestions.

Thomas J. Igoe, Jr.
212.603.2110
tigoe@thelenreid.com

Ira H. Jolles
212.603.8958
ijolles@thelenreid.com

Michael J. Connolly
973.660.4403
mconnolly@thelenreid.com

Benjamin I. Delancy
202.508.4081
bdelancy@thelenreid.com

Eulalia M. Mack
212.603.2517
emack@thelenreid.com