Get Ready for the SEC’s Game-Changing Compensation Rules
March 5 2007 by Dennis Morris - David Doody
Timing is everything.
Following the splashy headlines about two high profile CEO departures at Home Depot and Pfizer with exit packages in the $200 million range, new SEC proxy rules are sure to bring even greater emphasis to the issue of CEO pay. After all, thanks to new transparency measures, CEO pay packages may appear 50 to 60 percent higher than previously disclosed.
To get a better picture of the potential impact, one need only review the charts of CEO pay packages at General Electric and Exxon. Drawing on 2005 public records, it’s easy to see the contrast between the pre- and post-SEC ruling Summary Compensation Tables-and to identify the dilemma these new transparency rules will create.
Clearly, companies should be developing an action plan so that desired changes to compensation programs can be completed in time for the next proxy disclosure. While changes may not apply to the current group of highly compensated executives, any changes for current executives and future plans will need to be made under the new, more stringent regulations.
The new rules apply to proxy statements filed in 2007 and define the “top five executives” as the CEO, CFO and the next three most highly paid officers, which may not be the same top five highest paid for Section 162 purposes. As we enter the spring proxy season and companies face the challenge of getting a handle on the Commission’s massive 436-page document on this latest round of regulations, here are seven “red flag” areas on which to focus.
Red Flag #1: Detailed
Disclosure of Compensation Philosophy & Governance Replacing the Compensation Committee Report with the Compensation Discussion & Analysis (CDA) report requires a more comprehensive narrative on executive compensation philosophy. The firm’s approach to marketplace benchmarking and the business rationale for each compensation element must be detailed.
Now, companies must explain what factors are considered when increasing or decreasing each compensation element and provide the reasons for differences in the programs offered to the top five executives. The report must disclose the business rationale for selecting the terms for stock options and the timing of option grants, and also its policy for recapturing compensation previously awarded when performance results are restated. Imagine if the New York Stock Exchange was required to provide a detailed explanation of former CEO Dick Grasso’s compensation and retirement package; the whole Grasso compensation scandal may have been averted.
Companies with no formal compensation philosophy, or gaps in their existing compensation policies, need to address these issues. Additionally, in an accompanying Compensation Committee Report, the committee must discuss practices and procedures and other governance disclosures used in conducting its business, as well as the methodology for the review and approval of compensation programs. The report must also discuss delegation of authority, CDA review and approval of disclosures in the proxy, as well as the role executive officers and outside compensation consultants played in the compensation process.
The bottom line? Companies must review their approaches for determining compensation levels and check and reinforce committee governance practices. Developing a working draft of the CDA and governance disclosures, including identifying any gaps, can help.
Red Flag #2: Responsibilities placed on CEOs & CFOs
The SEC is placing a new level of responsibility on CEOs and CFOs for the accuracy and completeness of the CDA and accompanying tabular reports. These disclosures must be “filed,” not “furnished,” with the annual report and proxy statements and are subject to the full force SEC regulations. Companies must substantiate the quality of internal reporting and controls regarding executive compensation programs. Examples include the administration of stock options, largely in response to the recent abuses related to “backdating” and “springloading” of options. From here on, CEOs and CFOs will be required to play a more active role in defining the compensation philosophy and process.
Red Flag #3: Transparencies in Values of Total Compensation for Each Executive
The new tabular and narrative disclosure breaks down into three broad categories: compensation of “named executive officers” over the last three years, holdings of outstanding equityrelated interests received as compensation-which are the source of future gains and retirement plans-and deferred compensation and other postemployment payments and benefits, including severance, change-in-control benefits, perquisites and stock option granting practices. The revised definition of total compensation includes salary, bonus and the full value of equity grants. It is this value of total compensation, excluding pensions and deferred compensation, that will determine which officers enter the top five category for disclosure.
Due to the new disclosure procedures, the total compensation values for these top five may be quite large, particularly for the CEO, if the compensation package is heavily weighted toward equity grants, supplemental retirement benefits and incentive compensation. The numbers, in fact, may appear significantly larger than actual compensation earned or levels presently expected by the compensation committee because the new rules require disclosure of projected compensation that would be paid as of the end of the fiscal year under retirement, termination and change in control provisions, as well as at the earliest eligible dates.
Companies will need to calculate reportable values and investigate ideas for restructuring total compensation and improving disclosure as these values will be subject to close scrutiny by the press and investors.
Red Flag #4: New Severance and Change in Control Obligations
This appears the most burdensome task and will likely require a significant amount of data gathering, including employment agreements, plan documents, severance arrangements and change-in-control documentation.
Moreover, recent reports of “outsized” severance packages for exiting CEOs at Home Depot, the New York Stock Exchange and Disney are fueling the interest of government reform activists in this area.
Under the new rulings, a company must compute and disclose values for its top five executives, as well as projected numbers for severance-including the value of pensions and all other benefits, perquisites, accelerated vesting and tax gross-ups- under various employment termination scenarios. Here again, values may appear quite large, particularly for the CEO.
Furthermore, these complex calculations must be accompanied by the company’s rationale for providing these benefits. Therefore, it might be wise for management to investigate ideas for restructuring benefits and reducing reportable values.
Red Flag #5: Equity Incentive Grants and Plan Design
The original ruling required that the full value of an equity grant-including a future award payable in equity-be included in the value of total compensation, even if the grant was earned over a period of years or subject to performance vesting conditions.
The reportable value was based on the maximum amount of equity that may potentially be vested. (Cash-based incentives are not exposed to this treatment, but are disclosed as non-equity compensation.) The full value of equity- based compensation is valued consistent with the company’s approach to FAS 123R’s “fair value” method.
A revised ruling issued this past December softened the original “allin” approach. Now, the value of equity incentives includes only the amount that is earned/vested during the year as reported under FAS 123R. This revised approach provides a more accurate portrayal of pay.
To address recent issues related to option backdating and spring-loading, companies must now complete disclosure of the terms of stock option grants and stock appreciation rights. To this end, companies must consider changes to plan design, grant practices and valuation assumptions that lead to compliant plan reporting. Due diligence includes the need to double-check grant practices for stock options and appreciation rights.
Red Flag #6: Perquisites
Under the SEC’s new, broader definition of perquisites-with a revised, lower disclosure threshold of $10,000 instead of $50,000-companies must be sure to evaluate current policies and investigate ideas for restructuring or reducing reported perquisite values. With shareholders decrying executive use of corporate jets, paid country club dues and paid-for financial planning services, documenting the values of such perks is critical.
This area carries a high risk of reporting errors, and companies need to ensure that internal reporting and controls are substantiated.
Red Flag #7: Deferred Compensation and Retirement Benefits
Going forward, nonqualified deferred compensation tables will show details of executive deferrals, company contributions, investment alternatives, total balances and distribution terms. Recordkeeping must be accurate and timely, and show individual pension/SERP values as well as the annual increase in those values. Details for each program must be separately disclosed and include narrative footnotes that outline the terms of each plan, its business purpose and certain specific plan provisions.
Here again, values may be proportionally large, particularly for long-service executives. For executives near retirement, the annual pension value could comprise a significant percentage of salary and bonus. The first year of disclosure may be the most significant, with annual changes fluctuating with interest rate and actuarial assumptions thereafter. Therefore, companies need to calculate values and improve methods to clarify disclosure. Also, reviewing the current plan may be warranted in light of the complex calculations that result from provisions such as early retirement, severance and change in control.
Source : Strategic Apex Group, Executive Compensation Consulting
To prepare for the 2007 proxy season companies must be proactive and CEOs and CFOs need to become more actively involved with compensation philosophy and the related processes. Steps to consider include comparing notes with counterparts at peer companies, modeling tables, identifying opportunities for improved disclosure and creating a draft of the new CDA report.
The key is to identify and address gaps in your program as soon as possible. Gathering the various plan documents for review and committing the plan and practice descriptions to paper will uncover potential issues. This also creates a forum for a review. Areas for special attention include: cash-based versus equity-based incentives, performance-based versus employment-based vesting provisions, maintenance versus restructure of perquisites and severance and change-in-control benefits and plan provisions.
When pencil is finally put to paper to create the tables, give special attention to calculating the value of severance and change-in-control benefits. Understand the assumptions used for these calculations, as well as those used to value stock options and other equity-based compensation. Some may be out of date, so close examination may highlight ways to mitigate higher-than-expected reported values while maintaining the same economic value for executives. It is also prudent to reconsider benefits in light of current market practices.
Ultimately, awareness and management of these seven red flags will position your company to respond strategically to the new rules.
Dennis Morris is a senior vice president of MullinTBG, the nation’s largest provider of nonqualified executive benefits. David Doody is a partner at Strategic Apex Group, a MullinTBG alliance partner (www.MullinTBG.com).