More than meets the eye: new SEC disclosure proposals flying under the radar

Sometimes, important changes take place and no one pays much attention. This is exactly the case with the new disclosure proposals from the SEC. It is hard to believe that any proposed changes in what public companies must tell the investing public would fly under the radar. The fact that this is what happened with the July 10 announcement is testament to the intense workload faced by governance professionals and the almost constant regulatory change taking place on Capitol Hill.

While most corporate secretaries and general counsel are at least aware of the changes, it is only now that many are starting to realize exactly how much work is going to be involved if the proposals become law. ‘This is one of those sleeper releases because there are a number of places where there are going to be surprise results when you get into the details of the rules,’ cautions AJ Kess, partner at Simpson Thacher & Bartlett.

So what are these changes? Most of them relate to compensation disclosure, although other parts of the proxy statement, 8K and annual report will also be affected. The SEC says it is trying to enhance disclosure regarding compensation and corporate governance and clarify some of the rules governing proxy solicitation.

In brief, the proposal will result in: new compensation discussion and analysis (CD&A) disclosure regarding risk and its relationship to compensation policies and practices; revised treatment of equity awards in the summary compensation table and the director compensation table; discussion of directors’ and nominees’ qualifications and attributes that make them suitable to serve on the board, including additional biographical disclosure; new disclosure about board leadership structure and the role of directors in risk management; additional disclosure about compensation consultants and their level of independence; accelerated reporting of voting results from the annual meeting; and clarifications to the proxy solicitation rules.

The proposed rule changes, if adopted, will take effect for proxy filings for the fiscal year-end after December 15, 2009, meaning nearly all listed companies will be required to comply in 2010. The SEC is accepting comments on these rule changes until September 15, 2009.

‘As far as the new disclosures go it is definitely a mixed bag,’ says Pat McGurn, special counsel at RiskMetrics. ‘Some of the changes are really just fine-tuning – like the changes to the compensation summary tables and the move to grant date valuation for stock options – but others will create a little controversy.’

Moving the goalposts
The options changes may be relatively straightforward for companies to implement but they will create some problems, says Frank Marinelli, counsel at Simpson Thacher. ‘The SEC was trying to solve one problem, which was that the summary compensation table bore little resemblance to what a person actually earned because it was an accounting concept,’ he explains. ‘The commission replaced this with a new rule, which is something of an improvement, but it may not really align with how compensation decisions are made.

‘In the proposal, the SEC says it is trying to address the problem that companies were starting to disclose separate summary compensation tables because in the CD&A they were trying to show how compensation decisions were made. This could well still be the case.’

That’s all set to change, and the grant date value of the equity award will be taken onto the table in one year. This will create a few challenges. ‘Which year will the award go in?’ asks Marinelli. ‘What happens if in February 2009 you awarded someone a grant with respect to 2008 performance? Under the proposed rule, this would form part of the 2009 data even though it was part of the 2008 pay. On the other hand, suppose at the beginning of the year you set performance targets for the named executive officer (NEO) to achieve and, if he or she achieves them, he or she will receive the awards. Often these will take the form of cash and equity. The cash element will get reported in the current year but the equity will come in the year the awards are granted. This means that decisions made in one year may result in compensation being accounted for the following year, when performance could be very different from when the initial decision was made.’

Another problem is that a large one-off option grant to a person who is not an NEO could, under the new rules, result in that person making enough to be an NEO. ‘This is something you would want your comp committee to be aware of when making comp decisions,’ counsels Marinelli. What this means is that the committee, and the corporate secretary, may prepare disclosure for the people they think will be NEOs only to have a new name added. This will be a serious issue if it happens at the last minute, so the comp committee really needs to evaluate the impact of this rule early.

Because the summary compensation table reports NEO compensation for the last three completed fiscal years, the proposed changes create transition issues and will require the recalculation of compensation reported for prior years in ways that might differ substantially from the amounts that were previously reported in the summary compensation table.

Such differences are particularly likely when FAS 123R expense has been hit by fluctuations in a company’s stock price, the forfeiture of previously granted equity awards or the improbability of achieving performance targets.

A larger challenge will be the new compensation risk disclosure. A company must assess any material risk associated with its compensation policies and practices. In order to make this disclosure, it must carry out an in-depth analysis.

Sleeping giant
A bigger sleeper may well be the idea of disclosing those compensation practices and processes that could lead to material risk. This has been receiving a lot of attention due to the Troubled Asset Relief Program (TARP) but it extends to compensation for all employees and all companies, not just those receiving government funds. As Marinelli explains, ‘It is not just financial risk the SEC is talking about but long-term risk associated with strategic business decisions. It is not clear in the release exactly what the commission is looking for here.’

Even if a company determines there is no risk associated with its compensation practices, it may feel it necessary to tell shareholders this and include an affirmative statement in the CD&A. Kess suggests that, in this case, the company may ‘wish to support such an affirmative statement by discussing the aspects of compensation that the compensation committee reviewed in concluding that the company’s compensation policies and practices do not create any material risks.’

The disclosing of material compensation-related risk presents a number of problems, not least of which is the materiality standard. There is considerable ambiguity in the SEC’s language, and determining materiality will likely require difficult judgments. ‘Business units responsible for a disproportionate share of the company’s risk profile, that have different compensation structures, higher compensation expenses or greater profitability than other business units, or that have risk and reward structures that differ meaningfully from other units within the company, could trigger additional CD&A disclosure requirements,’ says Kess.

What this rule does in practice is to impose an obligation on companies to conduct a broad-scale compensation analysis in conjunction with the preparation of the CD&A regardless of whether the board considered such elements when making pay decisions.

While McGurn and other advisory professionals support more in-depth analysis and reporting of compensation, they question what the short-term value of this proposal will be.

‘The TARP company disclosures this year were next to useless from an investor perspective,’ says McGurn. ‘They hit late, so that played a part. I think what came out is that most companies were not looking at the problem. I think it is going to be an evolutionary issue and it will take a few years for companies to really understand what they are looking at and for the disclosures to fully take shape.’

Poor planning
Apart from a tendency toward boilerplate disclosure and a lack of understanding on behalf of companies, the new disclosures will also be problematic for investors and advisers. McGurn understands this. ‘It doesn’t seem as though the SEC has prioritized any of this,’ he says. ‘At some point in time it may have to do this and give issuers and investors a little more time to absorb the changes and figure out what it all means. Right now, from an investor perspective, there are a lot of people operating at low staff levels, so it has the potential to weigh down the entire process.’

Ed Durkin, president of the United Brotherhood of Carpenters and Joiners’ pension fund, recently stated that his fund doesn’t support widespread say-on-pay votes at companies. This is mostly because he feels the fund and many other investors lack the resources to fully analyze the disclosures and therefore cannot make informed decisions, ‘and this doesn’t do anyone any good.’

While the compensation-related proposals are taking much of the focus, there are other important elements in the proposal. The SEC is also asking for expanded director biographies including background, experience, skills, competencies and attributes. Experts agree it is not clear exactly what the SEC is looking for here or if it’s really going to push companies to comply.

An interesting note hidden in the release, says Kess, ‘is the attributes part of the bio. Is diversity an attribute and something that the SEC and activists are going to be looking for? Does it make a difference to board appointment? Is this ‘attribute’ language a political theme or objective, and what does it really mean?’

The real question is: if these proposals go through as expected in time for 2010, can companies realistically be expected to comply as well as deal with all the other things on their plate right now?

‘I think we are in for another round of what I call ‘reform fatigue’, like we saw following the implementation of SOX,’ says McGurn. ‘There really is a lot this year for an issuer to have to handle, between say on pay, broker votes being out, ballot access potentially coming online, all the compensation rules and now board and director bios. There is all the risk management stuff, too. Until we get a little more clarity, it is going to be a real planning nightmare for everyone.’

The way the timetable is right now, it will be early November before any of these rules are in place, so there is going to be very little time to figure out how to deal with all these issues in time for the next meeting season.

We are looking at a real risk of information overload, and it feels like something has to give at this stage. At some point in time the SEC is going to have to deal with that heightened anxiety level. There is likely to be more shareholder action next year, and the big question remains: is all this really possible?

There is an opportunity for issuers to really craft their disclosures to show how thoughtful they are. For the most part the system works wonderfully, and this will be a great opportunity to articulate why. If issuers can get to specifics and write about why they do the things they do, they will come across as being thought leaders in the field of governance. 

SEC disclosure proposal

Broad-based pay disclosure
Companies will be required to provide information about their compensation policies beyond the named executive officers in the compensation discussion and analysis if ‘risks arising from those compensation policies or practices may have a material effect on the company.’

Disclosure should focus on the relationship between the general compensation policy and risk, but will not include compensation data for individuals outside of the named executive officers. Specifics that may be disclosed include the general design philosophy of the compensation as it relates to risk, any risk assessments used in connection with structuring compensation policies, and changes in a company’s risk profile and how they might impact compensation.

Equity award values in summary compensation table
The summary compensation table and the director compensation table will include the grant-date fair value of equity awards made during the year as opposed to the expensed accounting value. The grant-date fair value will include the aggregate value of all stock or option awards, including performance awards, currently disclosed in the grants of plan-based awards table and valued in accordance with FAS 123R.

Shareholder voting results
The requirement to report shareholder voting results is proposed to be changed from 10Q and 10K filings to 8K filings. This will increase the timeliness of the delivery of voting results to within four business days of the vote. For contested elections where voting results are not finalized within four days, preliminary voting results may be disclosed in the 8K filing.

Director qualifications and bios
Additional details will be required for individuals nominated for election or reelection to the board of directors. Specifically, the SEC is requesting more information regarding individuals’ experience, qualifications, attributes or skills that qualify them to serve on the board or specific committees of the board.

In addition, the proposal requires disclosure of all other public company boards served on by the director in the last five years and disclosure of any legal proceedings from the last 10 years.

Company leadership structure
Companies will be required to discuss their current leadership structure and why this structure is best for the company. In particular, they must discuss whether or not the CEO and chairman roles are held by the same person and why this structure was chosen. If the CEO and chair roles are not split, companies must disclose whether they have a lead independent director and the specific roles and responsibilities of that person.

Board’s role in risk management
Companies will be required to provide additional information about the board of directors’ role in the company’s risk management. Disclosure should detail specific processes, roles and responsibilities of the board in connection with monitoring and managing the company’s risk.

Consultant conflicts of interest
Enhanced consultant disclosure will be required when a company receives executive or director compensation advice and other consulting services from one consulting firm or affiliated consulting firms during the last fiscal year.

If a consulting firm provides additional services on top of executive compensation consulting, the company will be required to disclose the fees paid for the consultant’s executive compensation services and the aggregate fees paid for all other services provided by that consultant.

In addition to fees, companies must also disclose the nature of the other services provided by consultants and whether or not they were recommended or reviewed by management or approved by the board.

Source: Equilar