Close but no cigar

Few people appreciate having their honest efforts and hard work criticized by others.  And corporate secretaries are no different from the majority. A short six or seven months after most US companies filed expanded proxy and annual reports under the SEC’s revised compensation disclosure rules, the Commission has released a report detailing what it sees as problems with the Compensation Discussion and analysis (CD&A) that were filed by public companies over the course of 2007.

In the report that was issued October 9, the SEC summarizes the common themes from comment letters sent to 350 companies. The full letters have been scheduled to be released within 45 days of the summary report.

This latest in compensation retrospectives that has been put forth by the SEC serves up many important indicators as to the dominant areas of common deficiency and also gives a good idea as to where any potential regulatory changes may be focused for the 2008 season and beyond. In a somewhat unusual move for the SEC, accompanying the comment letters is advice on how companies could improve the areas in which they are considered deficient.

In an irony that will not be lost on many corporate secretaries who read the report, complexity, length and a general lack of plain English were common criticisms. Yet, in spite of this oft-referred to criticism the SEC’s own report tipped the scale at approximately 4,500 words: that’s almost three times the length of this article.

Although the large number of comments that were issued by the SEC may appear to be a problem, companies should not despair. Most companies seem to be doing things in the same way that they have always been doing them and it is clear from the report that there is a high level of consistency with regards to the formats adopted.

The right information

There were a number of recurrent themes among the letters issued to companies, but the single issue that generated the most concern at the SEC was the unwillingness of companies to effectively disclose performance criteria and how they are used to calculate payments to executives. One of the main objectives of the revised rules for executive compensation disclosure was to push companies to give a succinct definition of performance measures and how they were derived. Failure to do this, according to the SEC, prevents investors from understanding how pay is set and why some of the numbers are so high.

The contradiction inherent to this criticism is that, while companies are asked to disclose performance criteria, the SEC also gives them a very easy way out should they decide they do not want to reveal that data.

The SEC explains that rather than simply providing a greater volume of information, the new disclosure rules were designed to give a good picture of the ‘how and why’ of each company’s disclosure. What they found is that many companies took the ‘I don’t exactly know what they want so I will just give them everything’ approach.

This, in many cases, made disclosures far longer and also far more complex, effectively defeating the aim of making compensation more understandable. And though the SEC has provided some more insight into this area, the situation remains a very difficult one.

Comments on companies’ use of plain English, or lack of it, did indeed prove to be a common theme among the SEC letters. Companies were encouraged to increase the use of charts and tables to help tell the story. Supporting this concept, the revised rules state that ‘clearer, more concise presentation ... can facilitate more informed investing and voting decisions in the face of complex information about these important areas.’ The SEC continues, ‘the purpose of the CD&A is to provide material information without resorting to boilerplate disclosure.’

While this is a noble ideal, company secretaries point out that simply is not realistic. Compensation is extremely complex with many various options packages, bonuses, pension plans, restricted stock and fringe benefits being combined with basic salary. In order to give an accurate explanation of all these elements it becomes necessary to provide a great deal of information.

Some of the main suggestions the SEC make to help overcome the information onslaught are: determine which information is more material and place the emphasis on this while putting less focus on the not so material, avoid long discussions of the various mechanics of compensation programs and instead focus on how compensation levels are determined and why the company sees this as appropriate.

Target practice

The SEC looked deeply into certain components of performance targets, which prevailed as the most common topic among the letters, feeling that companies really only went ‘part of the way’ to achieving good disclosure in this area. Almost all of the 350 companies that received letters alluded to using some form of performance element when calculating executive compensation. The metrics used were mostly generic, company-based performance targets such as earnings per share, non-specific revenue or sales growth, EDITDA, or other operational targets.

The problem, according to the SEC, is that most companies failed to provide detailed explanation about the use of these elements in evaluating performance and what target levels were achieved.

While the SEC was disappointed with the level of performance metrics in determining pay they should hardly be surprised. Companies do not want to release this information and are easily able to avoid doing so because of the ‘competitive harm’ clause of the rules. This allows a company to exclude certain details in its disclosures that it feels would offer competitors an advantage – thus leading to a reduced ability to compete.

SEC director of corporation finance, John White, speaking at a conference in San Francisco, said the SEC is ‘disappointed’ at the detail of disclosure and ‘finds it difficult to understand how companies used targets or considered qualitative individual performance to set compensation and make decisions.’

It is estimated that half of all large US companies filing CD&A in 2007 did not disclose targets. Almost none provided meaningful detail about targets use in performance and pay structure assessment.

Corporations claim that disclosing specific targets is potentially damaging to the business. By revealing sales targets in a new market it could be argued that competitors will be able to see what the strategic business objectives are and thus use the harm loophole to avoid disclosure.

The SEC argues that while there are legitimate situations where the ‘competitive harm’ clause can be used it is not designed as a blanket-out clause. It also requests that, where a company cites competitive harm, that it provide supporting material to prove that the information could in fact cause harm. Some companies have responded that this is the same thing as disclosing in the first place.

Tower of success

Benchmarking is also resulting in a significant number of comments. The rules say that if a company bases part of its disclosure policy on a peer benchmark and it is considered a material part of the final policy then they must identify the benchmark and its components. Generally the SEC felt this was not done adequately and made numerous comments requesting improved disclosure in this area going forward. Some companies argue that this information may also fall under the ‘competitive harm’ loophole.

In spite of the high number of comment letters resulting from the 2007 disclosure season, the SEC says it does not have any plans to change the rules. John Nestor, a spokesman for the Commission says they will be looking for more compliance with the spirit of the rules and for positive improvements based on the comment letters. And he explains that, even if the SEC were to go ahead and decide to change the rules to mandate stricter compliance, any changes would not be in place in time to be effective for the 2008 proxy season.

He also points out that, where a company received a comment letter, they were generally willing to provide the additional information or clarification and he hopes that this will lead to less comments being issued next year.

Companies, however, are not so sure and many feel that until the SEC goes through with forcing more compliance with the rules that most will continue to exploit loopholes and provide the existing level of information. One corporate secretary explained, under condition of anonymity, that most companies ‘view the disclosure as a waste of time and a huge pain.’ He when on to comment that, since it generally falls to the office of the general counsel or corporate secretary to produce the reports, they will be viewed as legal documents and the language and level of disclosure will reflect that.

While the proxy form is a legal document and must require certain elements it is also a communication tool and this should be taken into consideration when writing the language. The SEC and shareholder groups are looking for more of a balance between disclosure as a legal tool and an effective vehicle for communication. Maybe the 2008 season will be a small step n this direction.