SEC Adopts Major Overhaul of Executive Compensation Disclosure

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1 650 Page Mill Road Palo Alto, CA PHONE FAX SEC Adopts Major Overhaul of Executive Compensation Disclosure August 2006 Introduction At an open meeting on July 26, 2006, the Securities and Exchange Commission (the SEC ) adopted final rules regarding executive compensation disclosure and related items, including related party transactions, corporate governance matters and Form 8-K triggers related to executive compensation events. The actual written release (Rel. No ) (the Adopting Release ) with the text of the final rules (the New Rules ) was not available until August 11, As of August 28, 2006, the Adopting Release has still not been published in the Federal Register. The rule revisions were initially proposed by the SEC in Rel. No dated January 27, 2006 (the Proposing Release ). As an indication of how important the issue of executive compensation has become, the SEC received over 20,000 comment letters, the most ever received on any rule-making proposal. Many of the comment letters provided excellent suggestions for improvements to the proposed rules, and the SEC made a number of changes in response to comments. Although the New Rules are not immediately effective (see Compliance Dates below), companies should take the opportunity to familiarize themselves with the New Rules now, before the crunch of fiscal year-end is upon them. We have suggested a number of steps that our clients should consider taking in order to get ready for the implementation of the New Rules (see What You Need to Do Now! below). Compliance Dates The annual disclosure regarding executive compensation and related matters (Items 402, 403, 404 and 407 of Regulation S-K) required by the New Rules will apply to the 2007 proxy season. Specifically: For Forms 10-K, compliance is required for fiscal years ending on or after December 15, For proxy statements, information statements and Securities Act registration statements, compliance is required for statements filed on or after December 15, 2006 that include disclosure for fiscal years ending on or after December 15, The SEC has adopted a transition approach that will result in a phased-in implementation of the new Summary Compensation Table and related party disclosures over a three-year period. Companies will not be required to restate compensation or related party transaction disclosures for earlier fiscal years to which the former rules applied. In addition, companies will not be required to present prior years information under the former rules. So, for example, the Summary Compensation Table for a December 31, 2006 year-end company will reflect only executive compensation information for 2006 in accordance with the New Rules; information for prior fiscal years will not have to be presented at all. For the 2007 year-end, such company will present only the most recent two fiscal years in the Summary Compensation Table, and for the 2008 year-end and thereafter, such Company will present three fiscal years in the Summary Compensation Table. To take another example, for a registration statement filed under the Securities Act of 1933 on April 15, 2007 for a calendar-year company, the Summary Compensation Table will cover only 2006 and the related party disclosures required by Item 404 will also cover only 2006, even though

2 the general rule for Securities Act registration statements is that such matters cover the last three fiscal years. With respect to the revisions to Form 8-K, compliance is required for triggering events that occur 60 days or more after publication of the New Rules in the Federal Register. What s New: Changes from the Proposed Rules As noted above, the SEC made a number of changes from the rules as originally proposed in the Proposing Release (the Proposed Rules ). Some of the more significant changes include the following: Stock Option Grant Disclosure. By far the most important change that was made from the Proposed Rules is in the area of stock option grant disclosures. In response to the ongoing scrutiny of stock option grant practices, the SEC has added columns to the equity grants table and has mandated additional narrative disclosures. Both are aimed primarily at ferreting out backdating and spring-loading practices. The additional narrative disclosure that is required by the New Rules will appear in the narrative accompanying the equity grants table, the Compensation Discussion and Analysis (the CD&A ) and the corporate governance disclosures regarding the compensation committee. For a more detailed discussion, see Stock Option Disclosure: Backdating and Spring-loading below. Non-Executive Employees. In response to criticism, the SEC did not adopt the proposal that would have required companies to provide compensation disclosure for up to three highlypaid non-executive employees (often referred to as the Katie Couric provision). The game s not over yet, however, as the SEC has requested further comment on this provision and has suggested some refinements, such as limiting it to large accelerated filers and eliminating employees who have no significant policy-making function. Stay tuned on this one. New Compensation Committee Report. As an attempt to address comments that the CEO and CFO need some basis on which to be able to certify the new filed CD&A, the SEC has added a requirement for a new Compensation Committee Report. This is not to be confused with the current item of the same name. This new version of the Compensation Committee Report will be similar to the Audit Committee Report in that it will be a formulaic recitation responding to two specific questions, will be furnished, not filed, and will appear over the names of the compensation committee members. Performance Graph. In the Proposing Release, the SEC proposed to eliminate the five-year stock price performance graph. On further consideration (and in response to comments that some stockholders find it useful), the SEC decided to keep it, but in a different place. The performance graph will still be required disclosure, but it has been moved to the Annual Report to Stockholders, so it will no longer appear in the proxy statement. Summary Compensation Table. The proposed format for the Summary Compensation Table survived nearly intact from the Proposed Rules, with two notable changes. The Total compensation column has been moved to the far right side of the table, which seems sensible since it is the total of all numerical columns that precede it, and amounts relating to pension benefits and earnings on deferred compensation have been broken out of the All Other Compensation column and given a column of their own. The SEC also revised the amount for pension benefits in the Summary Compensation Table to include only the increase in such benefits during the relevant fiscal year (rather than the accumulated value of all pension benefits) and changed the interest on deferred compensation that is disclosable in the Summary Compensation Table to include only above-market interest. Determination of Named Executive Officers. As originally proposed, the named executive officers (other than the principal executive officer and the principal financial officer) would have been determined based on the Total compensation 2

3 column. As adopted, however, the column with pension benefit increases and above-market earnings on deferred compensation will be excluded from this calculation. Since these amounts are more reflective of wealth accumulation and investment decisions than they are of current compensation, this seems to be a better measure for making the determination of who is a named executive officer. We refer to the executive officers for whom disclosure is required by the New Rules as Named Executive Officers. Supplemental Tables. The SEC has combined the proposed Grants of Performance-Based Awards and Grants of All Other Equity Awards tables into a single table entitled Grants of Plan-Based Awards, which results in a fairly busy table. To the extent that a company is required to add even more columns to address the new stock option grant disclosure provisions, it could become extremely unwieldy. The SEC has also simplified the name of the proposed Retirement Plan Potential Annual Payments and Benefits table to read simply Pension Benefits Table. In addition, this table will now show the accumulated benefit as of fiscal year end (determined on an actuarial basis) instead of the annual increase in benefits (which is now in the Summary Compensation Table). To promote comparability between companies, the value will be calculated based on assumptions that are specified in the New Rules. Termination and Change-in-Control Payments. One of the big complaints of commenters about the more detailed disclosures proposed for termination and change-in-control agreements was uncertainty as to how they should be calculated, as it is necessary to make a number of assumptions in order to come up with a dollar value. The SEC has now specified the assumptions that are to be used. Stock Option Disclosure: Backdating and Spring-loading In response to the focus by regulators on stock option grant practices, which initially was a reaction to an academic s investigation of the patterns involved in the timing of stock option grants and which has resulted in SEC investigations and criminal and civil actions against a number of companies, the SEC has greatly increased the scope of information that must be disclosed regarding equity incentive grant practices. The Grants of Plan-Based Awards Table, its accompanying narrative, the revised CD&A and the corporate governance disclosures require significantly enhanced disclosure about the issuer s practices related to the determination of stock option grant dates and exercise prices. Issuers will now need to disclose: The aggregate fair value of grants made during each of the last three fiscal years to each Named Executive Officer (in the Summary Compensation Table, subject to the three-year phase-in) and during the last fiscal year to each director (in the Director Compensation Table), computed under FAS 123R. The grant date used for financial accounting purposes for each option granted to a Named Executive Officer during the last fiscal year (in the Grants of Plan-Based Awards Table). The date the compensation committee approved the grant if it is different from the accounting grant date (in a column added to the Grants of Plan-Based Awards Table). If the exercise price of the option or other price-based award is less than the closing price on the grant date, then the closing price on the grant date must be disclosed (in a column added to the Grants of Plan-Based Awards Table). A description of how the exercise price was determined if it is different from the closing price on the grant date (in the narrative accompanying the tables). A description of how annual award grants are made, including when they are scheduled and how the exercise prices are determined (in the narrative accompanying the tables). 3

4 A description of any grants that were not made in accordance with the description required by the previous bullet point (in the narrative accompanying the tables). A description of any option repricing or material modification of outstanding options (in the narrative accompanying the tables). In addition, there are disclosures regarding option grant practices required by the CD&A and corporate governance disclosures under Item 407, both of which are discussed below. Compensation Discussion and Analysis The new rules require a Compensation Discussion and Analysis as an overview of the compensation objectives and policies for the Named Executive Officers. The SEC intends for the CD&A to appear first in the executive compensation disclosures in the proxy statement and to be immediately followed by the required tables. The CD&A is intended to be the equivalent of an MD&A with respect to executive compensation. Unlike the Compensation Committee Report, which is furnished, the CD&A would be considered filed, subjecting it to potential additional liability under the Securities Exchange Act of 1934 as a filed document. The CD&A should be a principles-based discussion of the goals and objectives behind executive compensation and an analysis of each element of compensation. It should focus on the following questions: What are the objectives of the company s compensation programs? What is the compensation program designed to reward? What is each element of compensation? Why does the company choose to pay each element? How does the company determine the amount for each element? How does each element fit into the company s overall compensation objectives? The SEC wants companies to avoid boilerplate disclosure. If the compensation policy for a particular executive officer, such as the Principal Executive Officer, is materially different from the other Named Executive Officers, his or her compensation should be discussed individually. The SEC envisions that the CD&A would differ from the narrative discussions following the compensation tables by providing more general discussion of compensation philosophy, rather than an elaboration of the specifics of particular elements of compensation. The New Rules provide examples of what should be discussed, but they do not mandate particular disclosure. The SEC cites the following examples of appropriate CD&A discussion: Policies for allocation between long-term and current compensation and between cash and non-cash compensation. How compensation is structured to take into account elements of the company s performance and the executive s individual performance. Whether the company engaged in benchmarking to set compensation. How the determination is made as to when stock options or other equity compensation awards are granted. Policy decisions to waive or modify performance goals. The impact of tax and accounting treatment on elements of compensation (including equity award grants). 4

5 Policies regarding adjustments of compensation elements if performance measures are subsequently restated. The rationale for selecting a particular event to trigger payment under a post-termination agreement. The CD&A should cover the prior fiscal year and any actions taken regarding executive compensation after the last fiscal year end, as well as policies the company will apply on a going-forward basis. Companies are not required to disclose target levels with respect to specific quantitative performance factors, such as revenue, profit or earnings targets, if disclosure would cause competitive harm to the company. Stock Option Grant Practices. The New Rules require a discussion in CD&A of matters related to stock option compensation, particularly as they relate to the timing and pricing of stock option grants. The SEC, which is clearly trying to flush out practices such as backdating, spring-loading and bullet-dodging, cites the following examples of the information that may be material to the investor: Reasons a company selects particular grant dates for stock options. Methods a company uses to select the terms and conditions of awards, such as the exercise price of stock options, including: any practice of determining the exercise price based on a stock price for a date other than the accounting grant date; and the use of formula prices. Existence of a program or plan to coordinate the timing of the grant of stock options to executives in coordination with the release of material non-public information. Whether the Board or a committee may grant options when it has material non-public information. Whether the company times the release of material non-public information for the purpose of affecting the value of executive compensation (including equity award grants). Practices followed in determining the exercise price of stock options that may increase the likelihood of granting in-the-money options. The delegation of authority to grant options. The role of executive officers in option grant timing. Certification of the CD&A and the New Compensation Committee Report. A company s disclosure controls and procedures apply to the preparation of CD&A and it will be included in materials certified by the CEO and CFO. The CD&A is not a report of the compensation committee, but the CEO and CFO may look to the new form of Compensation Committee Report in providing their certification. The compensation committee Report will require the compensation committee to state: Whether the compensation committee reviewed and discussed the CD&A with management. Whether the compensation committee recommended that the CD&A be included in the company s Form 10-K, proxy statement or information statement. While there is a certain awkwardness in having the CEO and CFO certifying the discussion of their own compensation, the SEC concluded that it is appropriate. Companies will need to adjust compensation committee processes and proxy preparation timelines to accommodate the drafting of the CD&A and its review by the compensation committee in time to permit the Compensation 5

6 Committee Report to respond affirmatively to the two required questions listed above. Executive Compensation Tables and Accompanying Narrative Disclosure The New Rules fundamentally maintain the tabular approach to disclosing executive compensation, but add requirements for additional accompanying narrative to provide context for and explanation of the tables. Unlike the CD&A, which focuses on broader topics regarding objectives and implementation of executive compensation policies, this narrative disclosure should focus on and provide specific context to the quantitative disclosure in the tables. The New Rules organize the compensation tables and related narrative disclosure into three broad categories: Compensation for the last three fiscal years, as reflected in a revised Summary Compensation Table, plus a supplemental Grants of Plan-Based Awards Table, which provides further details for current earnings and awards. Holdings of equity-related interests that are compensatory or potential sources of future compensation. Retirement and other post-employment compensation. Table Format. We have attached an Appendix to this Client Alert that sets forth the required format for each of the tables. Note that an Instruction to Item 402 mandates that the applicable fiscal year be specified in each table other than the Summary Compensation Table (which includes the fiscal year in a column of the table). Named Executive Officers. The New Rules change the definition of Named Executive Officer to include the Principal Financial Officer in addition to the Principal Executive Officer, plus the three other most highly compensated executive officers and up to two former executive officers. Instead of using salary plus bonus as the current rules do, the New Rules use total compensation, reduced by the sum of the increase in pension values and above-market nonqualified deferred compensation earnings for the last fiscal year, to determine which executive officers are the most highly compensated executive officers, subject to an exception from disclosure if their adjusted total compensation is less than $100,000. Summary Compensation Table. The New Rules maintain the Summary Compensation Table as the principal disclosure vehicle concerning executive compensation. The Summary Compensation Table now requires for the first time that a total compensation figure for each of the last three fiscal years (subject to the phase-in provisions described above) for each Named Executive Officer appear in the last column in the table. In order to facilitate this, the New Rules require that awards of options, stock appreciation rights and similar equity-based compensation instruments that have option-like features be disclosed in dollar values based on the grant date fair value of the award determined pursuant to FAS 123R, rather than simply disclosing the number of securities underlying an award. The revised Summary Compensation Table includes the following columns: Salary and Bonus Columns The New Rules do not make any significant changes regarding the disclosure of salary and bonus, each of which has its own column. However, the New Rules provide that if receipt of any amount of compensation is currently payable but has been deferred for any reason by either the executive officer or the issuer, the amount so deferred must be included in the appropriate column in the year earned and disclosed in a footnote to the applicable column. In addition, where salary or bonus for the last fiscal year cannot be calculated as of the most recent practicable date prior to publication of the proxy statement or other report containing executive compensation disclosure, the company must disclose this fact in a footnote to the applicable column. Subsequently, a Current Report on 6

7 Form 8-K under new Item 5.02(f) will be triggered by a payment, decision or other occurrence as a result of which either of such amounts become calculable in whole or part. Stock Awards and Option Awards Columns The Stock Awards column discloses the dollar value of stock-related awards, including restricted stock, restricted stock units, phantom stock, phantom stock units, common stock equivalent units or other similar instruments that do not have option-like features. Valuation is based on the full grant date fair value of the award determined pursuant to FAS 123R it is not amortized over the vesting period. The Option Awards column discloses options, stock appreciation rights and similar equity-based compensation instruments that have option-like features. Again, under the New Rules, the dollar value is calculated as the grant date fair value of the award as determined pursuant to FAS 123R. The number of shares underlying stock and option awards and other details regarding such awards will be disclosed in the Grants of Plan-Based Awards Table, which supplements the Summary Compensation Table and is discussed below. Non-Equity Incentive Plan Compensation Column The Non-Equity Incentive Plan Compensation column reports all amounts earned during the fiscal year pursuant to non-equity incentive plans, including performance-based awards under a plan that are not tied to the performance of the company s stock. Unlike stock and option awards discussed above, which must be included in the Summary Compensation Table in the year they are granted, non-equity incentive plan awards are only included once they have been earned. In the year of grant, a non-equity incentive plan award will be disclosed in the supplemental Grants of Plan- Based Awards Table. In many cases, this will be a year prior to the year that compensation under such award is earned and reported in the Summary Compensation Table. Changes in Pension Value and Nonqualified Deferred Compensation Earnings Column The New Rules add a column not discussed in the Proposing Release. This column consists of above-market earnings on deferred compensation and increases in pension values during the fiscal year. As originally proposed, these items would have been included in the All Other Compensation column. All Other Compensation Column The requirement to disclose All Other Compensation is designed to ensure that no element of compensation is omitted from the table. Any element of compensation that does not appropriately fit into another column (with the exception of certain de minimis perquisites) is required to be reported under the All Other column, including life insurance premiums, tax gross-ups, discount stock purchases, termination and change-in-control payments, certain stock dividends, and perquisites and other personal benefits. Each item of compensation included in this column (other than a perquisite) that exceeds $10,000 must be separately identified and quantified in a footnote. The only exception to the all means all requirement is that perquisites and other personal benefits are not required to be included in the All Other Compensation column unless the aggregate amount of such compensation is greater than $10,000. Once this aggregate threshold for perquisite disclosure has been met, each perquisite or other personal benefit with a value (based on incremental cost to the company) greater than $10,000 must be identified by type in a footnote and any that exceeds the greater of $25,000 or ten percent of the Named Executive Officer s total perquisites and other personal benefits must be separately quantified and disclosed in a footnote. 7

8 The New Rules also provide guidance regarding how a company should analyze whether something is a perquisite or other personal benefit. The SEC in the Adopting Release takes the view that an item that is integrally and directly related to performance of the executive duties will not be considered a perquisite or personal benefit. Conversely, an item will constitute a perquisite or personal benefit if it is not integrally and directly related to the performance of the executive s duties and if it confers a direct or indirect benefit that has a personal aspect, without regard to whether it may be provided for some business reason or for the convenience of the company, unless generally available on a non-discriminatory basis to all employees. The SEC makes it clear that, if the integrally and directly related standard is met, the personal aspect of an item is irrelevant. The Adopting Release gives a number of examples that would require disclosure as perquisites or personal benefits, as well as examples of other types of All Other Compensation that should be included in this column. Grants of Plan-Based Awards Table. Grants of plan-based awards, including both equity awards and non-equity incentive awards under plans, showing the details of estimated future payouts are to be disclosed in the Grants of Plan-Based Awards Table. Disclosure in this table complements Summary Compensation Table disclosure of grant date fair value of stock awards and option awards by disclosing the number of shares of stock or units comprising or underlying the award. This supplemental table shows the terms of grants made during the last fiscal year, including estimated future payouts for both equity incentive plans and non-equity incentive plans, with separate disclosure for each grant. Additional columns must be added to the table regarding equity award timing and pricing in certain circumstances, as discussed in Stock Option Disclosure: Backdating and Spring-loading above. Narrative Disclosure to Summary Compensation Table and Grants of Plan-Based Awards Table. The New Rules require a company to provide a narrative description of any additional material factors necessary to an understanding of the information disclosed in the foregoing tables. The narrative required to be included will vary depending on the facts and circumstances applicable to each company. The Adopting Release gives a number of examples of the type of information that is contemplated, to the extent that it is material and necessary to an understanding of the accompanying tables: Descriptions of the material terms of employment agreements. Descriptions of each repricing or other material modification of any outstanding option or other equity-based award during the last fiscal year. Disclosure of the terms and conditions of awards shown in the Grants of Plan-Based Awards Table. Explanation of the level of salary and bonus in proportion to total compensation. Equity Compensation Tables. The New Rules require two tables for disclosure of exercises and holdings of previously granted equity-based compensation, an Option Exercises and Stock Vesting Table and an Outstanding Equity Awards at Fiscal Year-End Table. These tables require disclosure of the number of securities underlying awards that were exercised during the fiscal year and those that are still outstanding, as well as their market value and vesting information. The Outstanding Equity Awards at Fiscal Year-End Table is intended to provide information about potential future amounts of compensation that a Named Executive Officer might realize. The Option Exercises and Stock Vesting Table will show the value already realized upon exercise of options or vesting of stock awards Post-Employment and Change-in-Control Compensation. The New Rules substantially change the tabular and narrative disclosure required with respect to post-employment and 8

9 change-in-control compensation as compared to the current rules. Post-Employment Compensation A newly redesigned Pension Benefits Table requires the disclosure of the actuarial present value of each Named Executive Officer s accumulated benefits under each defined benefit pension plan. This is in stark contrast to the current rules, which require disclosure of estimated benefits payable generally based on years of service and ending salary. Each plan in which a Named Executive Officer participates must be listed in a separate row on the table, which means that tax-qualified retirement plans and non-qualified retirement plans will be disclosed separately. If any pension benefits are paid to a Named Executive Officer during the fiscal year, those amounts must be reported on the table as well. As with all of the tables required by the New Rules, the table must be accompanied by narrative disclosure that describes the material information necessary to understand the tabular information. This includes the material terms of the plans and any early retirement rules. Non-Qualified Deferred Compensation A separate new table requires the disclosure of substantially more information regarding deferred compensation plans that are not tax-qualified than is currently required. The new table requires disclosure for the last fiscal year of: total contributions by the executive; total contributions by the issuer; total earnings on the deferred compensation; total withdrawals; and the account balance at fiscal year end. The required disclosure accompanying this table is rather extensive, requiring a description of how earnings are calculated, the material terms of the underlying plans, and quantification of the extent to which amounts reported in this table are reported in the Summary Compensation Table. Other Post-Employment Payments Some of the more significant changes to the executive compensation disclosure rules are in the area of termination and change-in-control arrangements. In addition to a description of the material terms of such arrangements, the New Rules require quantification and significant narrative disclosure with respect to any payments that may be required by such arrangements in connection with resignation, retirement, termination or a change in control of the company. The issuer must disclose: Specific circumstances that would trigger payments or provision of benefits; Estimated payments due in each circumstance (including timing and form of payment); How payment and benefit levels are determined under the various circumstances; Any acceleration of vesting or payments; and Any conditions that apply before payments are received (e.g., non-competition provisions or liability releases). Interestingly, even if the amount of payments is uncertain, the issuer must still provide quantitative disclosure about the amount of the payments or benefits that may become due under postemployment and change-in-control arrangements (estimating, if necessary; for health benefits, estimates must be done in compliance with FAS 106). For purposes of calculating amounts under this section, the New Rules require that the amounts be calculated assuming that the event triggering payments occurred on the last business day of the issuer s last completed fiscal year and that the price per share of issuer stock is the closing market price on that date. 9

10 To the extent that the benefits available to Named Executive Officers are available generally to all salaried employees (as would be the case with a so-called tin parachute ), they need not be disclosed in this section. Director Compensation Table. The New Rules require tabular disclosure of director compensation for each director, together with narrative discussion of all of the elements of director compensation. The Director Compensation Table follows a format very close to that of the Summary Compensation Table, but substitutes a Fees Earned or Paid in Cash column for the Salary and Bonus columns. Certain Relationships and Related Party Transactions Disclosure Revised Reg. S-K Item 404 Significant revisions were made to Item 404 of Regulation S-K, which requires disclosure of certain relationships and related party transactions. Instead of using an overall rules-based approach, revised Item 404 contemplates a principles-based approach, with some rules-based elements retained. Under the new principles-based approach, a reporting company will have a greater responsibility to determine whether particular transactions rise to the level of related party transactions requiring disclosure. However, the SEC also revised certain elements of the rulesbased approach, including raising the transaction value threshold for required disclosure from $60,000 to $120,000. Basic Related Party Transactions Disclosure. Item 404(a) requires a company to provide disclosure regarding any transaction between the company and a related party (or in which a related party has a direct or indirect material interest) since the beginning of the company s last fiscal year, or any currently proposed transaction, if the amount involved exceeds $120,000. In addition, disclosure is required for indebtedness transactions meeting this threshold with any related person (however, significant stockholders and their immediate family members are excluded from the indebtedness disclosures). Policies and Procedures. Item 404(b) requires disclosure regarding the company s policies and procedures for the review and approval or ratification of related party transactions. The disclosure must include the types of transactions covered by the policy, the standards to be applied, the persons who are responsible for applying the policies and procedures and whether the policies are in writing. Also, the company is required to identify any transactions reported under Item 404(a) where the company s policies and procedures do not require review, approval or ratification or where such policies and procedures have not been followed. Promoters. Item 404(c) requires disclosure regarding transactions with promoters if the company had a promoter at any time during the last five fiscal years, regardless of when the company was organized (i.e., disclosure of promoter transactions is required even if the company was organized more than five years ago). Definition of Related Person. Item 404(a) defines related person as any person who was in any of the following categories at any time since the beginning of the company s last fiscal year: Any director or executive officer of the company; Any nominee for director, when the Item 404 disclosure is being presented in a proxy statement relating to the election of the nominee (a Nominee ); Any security holder known to the company to beneficially own more than 5% of any class of the company s voting securities (a 5% Stockholder ); and Any immediate family member of a director, executive officer, Nominee or 5% Stockholder. Note that an immediate family member means any child, stepchild, parent, stepparent, spouse, sibling, motherin-law, father-in-law, son-in-law, daughterin-law, brother-in-law or sister-in-law, and any person (other than a tenant or employee) 10

11 sharing the household of any director, Nominee, executive officer or 5% Stockholder. Item 404(a) requires disclosure of transactions involving the company and a related person that occurred anytime since the beginning of the last fiscal year, regardless of whether such person was only a related person for part of the fiscal year. In other words, the person need not have been a related person at the time of the transaction. However, the SEC excluded transactions with 5% Stockholders and their immediate family members from required disclosure unless the person was a 5% Stockholder at the time of the transaction with the company. The current rules do not clearly indicate whether such disclosure is required if a person was not a related person at the time of the transaction or was no longer classified as a related person at the end of the fiscal year. Many practitioners have advised in the past that a transaction with a related party need only be disclosed under the current version of Item 404 if the person was in fact a related person at the time of the transaction. Clearly this is no longer the case under the New Rules, except for 5% Stockholders. Corporate Governance Disclosures New Reg. S-K Item 407 New Item 407 of Regulation S-K consolidates under a single disclosure item various current disclosure requirements regarding director independence and other corporate governance matters. In addition, the disclosure requirements have been updated to reflect the SEC s current requirements and those of applicable listing standards. Item 407(a) requires disclosure regarding the independence of directors, including whether each director and nominee for director is independent, as well as a description of any transaction, relationship or arrangement not disclosed under paragraph (a) of Item 404 that was considered when determining whether each director and nominee for director is independent. Listed companies must identify which directors are independent for the purpose of satisfying the majority independence requirements of the relevant stock exchange (including Nasdaq) and whether any member of the compensation or nominating committee is not independent. The independence disclosure is required for any person who served as a director during any part of the fiscal year for which disclosure must be provided, even if the person no longer serves as a director or the director s term of office will not continue after the meeting. The New Rules also revise the current required disclosures regarding the audit committee and nominating committee to eliminate duplicative committee member independence disclosure and to update the required audit committee charter disclosure requirements. Accordingly, the audit committee charter is no longer required to be delivered to security holders once every three years if it is posted on the company s website. The SEC has also adopted new disclosure regarding the compensation committee. Item 407(e) focuses on the company s corporate governance structure that is in place for considering and determining executive and director compensation. Companies must disclose whether the compensation committee s authority is set forth in a committee charter and, if so, state the company s website address at which a current copy of the charter is available, or if not so posted, attach the charter to the proxy statement once every three years. Companies are also required to describe their processes and procedures for the consideration and determination of executive and director compensation. This description, which must cover both equity-based and non-equity-based compensation, needs to include: The scope of authority of the compensation committee. The extent to which the compensation committee may delegate any authority to 11

12 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. Any role of compensation consultants in determining or recommending the amount or form of executive and director compensation, the name of such consultants, who engaged them, the nature and scope of their assignment and the material elements of the instructions given to the consultants. Note that the first three bullets above will require, inter alia, discussion of these matters as they relate to stock option granting practices. As adopted, the New Rules delete the proposed disclosure requiring identification of any executive officer whom the compensation consultants contacted in carrying out their assignment. The 407(e) disclosures are not intended to be redundant to the CD&A disclosures. The SEC has stated that, while the CD&A disclosures focus on the company's compensation policies and objectives and seek to put the quantitative disclosure regarding executive compensation into perspective, the 407(e) disclosures focus on the corporate governance structure under which executive compensation decisions are made. Disclosure of Pledges and Director s Qualifying Shares Revised Reg. S-K Item 403(b) The SEC has adopted amendments to the management share ownership table required by Item 403(b) of Regulation S-K. As amended, Item 403(b) now requires footnote disclosure of the number of shares pledged as security against outstanding obligations by Named Executive Officers, directors and director nominees. The SEC has required this disclosure because the beneficial ownership of such pledged shares may be subject to material risks or contingencies that do not apply to other shares. This footnote disclosure requirement does not extend to 5% Stockholders under Item 403(a) so long as such stockholders are not also members of management. Note, however, that pledges of shares by stockholders of the company must be disclosed in the event that the pledges may result in a change of control of the company. The amendment also requires inclusion of beneficial ownership of a director s qualifying shares, which was not previously required. Although some commentators suggested that Item 403 be amended to require disclosure of hedging arrangements by directors or Named Executive Officers, the SEC did not adopt these suggestions. The SEC noted that information concerning these transactions is required to be reported under Section 16(a) and therefore is generally publicly available within two business days after the occurrence of the transaction. Special Rules for Specific Types of Issuers The description of the New Rules presented above assumes that the issuer is not one of the types of issuers for whom special rules apply. We briefly describe below some of these special rules. Small Business Issuers. The SEC has continued to make distinctions between the executive compensation disclosures required by Item 402 of Regulation S-K and those required by Item 402 of Regulation S-B for small business issuers. Due to extensive disclosure requirements for public companies that are not small business issuers and the disproportionate burden the disclosure requirements may have on small business issuers, the SEC made the following distinctions: The only tables required by small business issuers are the Summary Compensation Table, the Outstanding Equity Awards at Fiscal Year-End Table and the Director Compensation Table. The Summary Compensation Table only covers the two most recent fiscal years and will be phased in over the next two years. 12

13 Small business issuers will only be required to provide information for the principal executive officer and the two other most highly compensated officers (plus up to two former executive officers). Small business issuers will not be required to include pension plan disclosure in the Summary Compensation Table. Additional narrative disclosure will be required, to the extent that it is material, regarding the material terms of defined benefit and defined contribution plans and other post-termination compensation, in lieu of tabular or footnote disclosure. Small business issuers will not be required to provide a CD&A, the related Compensation Committee Report or the Performance Graph. In addition to Item 402 amendments, the SEC also amended the Items 404 and 407 of Regulation S-B to bring it into conformity with Items 404 and 407 of Regulation S-K, with the following distinctions: The threshold for related person transaction disclosure has been changed from $60,000 to the lesser of $120,000 or one percent of the average of the small business issuer s total assets at year-end for the last three completed fiscal years. Item 404 of Regulation S-B will continue to require only two years of related party transaction disclosure (as opposed to three years under Item 404 of Regulation S-K). For purposes of applying the definition of a related person to determine whether disclosure of a transaction is required prior to that person having a relationship that resulted in their classification as a related person, a one-year time period should be used (rather than a two-year time period). New Item 407 of Regulation S-B will continue to exclude small business issuers from Compensation Committee Interlocks and Insider Participation disclosure, but will otherwise be substantially identical to Item 407 of Regulation S-K. Foreign Private Issuers. A foreign private issuer will continue to be deemed to be in compliance with Item 402 of Regulation S-K if it provides (i) the information required by Items 6.B. and 6 E.2. of Form 20-F and (ii) more detailed information if it is otherwise made publicly available. The SEC has clarified that treatment of foreign private issuers parallels that under Form 20-F and that this shows the appropriate deference to a foreign private issuer s home country requirements. Under Item 404 of Regulation S-K, a foreign private issuer will continue to be deemed in compliance if it provides the information required by Item 7.B. of Form 20-F. However, more detailed disclosure is required if such information is otherwise made publicly available or required to be disclosed by the issuer s home jurisdiction or a market in which its securities are listed or traded. The exhibit instructions to Form 20-F, the form used by foreign private issuers for their annual reports in place of a Form 10-K, has been modified to only require filing of employment and compensatory contracts and plans with management or directors if the foreign private issuer is required to publicly file such document in the issuer s home country or has otherwise publicly disclosed it. Business Development Companies. Under the New Rules, business development companies are subject to the same executive compensation disclosure requirements as operating companies. Business development companies are now required to include all of the disclosures required by Item 402 of Regulation S-K for the same Named Executive Officers as operating companies However, a business development company will no longer be required to include compensation from the fund complex or disclosure regarding 13

14 members of the advisory board and certain affiliated person of the company. Registered Investment Companies. Items 7 and 22(b) of Schedule 14A have been revised to reflect the changes made by the New Rules with respect to operating companies, which has been accomplished via cross-references to the appropriate paragraphs of new Item 407 of Regulation S-K. However, the substance of these rules remains the same. In addition, the New Rules raise the threshold for disclosure of certain transactions with an interested person of an investment company from $60,000 to $120,000. What You Need to Do Now! Although the New Rules (other than the Form 8-K revisions) won t be effective until SEC filings containing executive compensation disclosure for fiscal years ending on or after December 15, 2006 are made, we strongly suggest that you not wait until then to dig into these new disclosure requirements. Here are a few specific suggestions of things that we believe you should start doing now. Get Educated. There s no time like the present to start familiarizing yourself with the New Rules. Avoid Nasty Surprises. Nobody, especially not CEOs, CFOs and compensation committees, wants this year s proxy statement to be a nasty surprise. To avoid this possible scenario, you should consider preparing a mock-up of last year s executive compensation disclosures to show how they would look under the New Rules. Do Due Diligence on Your Option Grant Process. Many companies have already been forced to examine their prior option granting practices due to governmental investigations. Some companies have voluntarily initiated such a review without any direct external impetus. If your company has not already done so, we suggest that you take the opportunity now to review your stock option grant process. For calendar-year companies, whatever the process has been during 2006 will be under a microscope when you prepare the proxy statement for your 2007 annual meeting. Consider whether you should make any changes in your stock option grant practices going forward based on heightened regulatory and stockholder concerns about potential improprieties and evolving best practices. Disclosure of questionable past practices in the proxy statement will be much more palatable if you can state that your company did a review and has implemented more stringent procedures. Take a close look at the SEC questions that must be answered about stock option grant policies and procedures now, and if you don t like the way the answers look, consider changing your procedures. Focus on the Compensation Committee. It is very important that you educate the members of your compensation committee about the New Rules and the disclosures that they will require. Go through the SEC s list of questions that should be addressed in the CD&A. Remember that you will need to be able to answer those questions for every element of compensation. For many companies, this will mean that the compensation committee needs to review and revisit the overall objectives of the company s compensation program and consider how each specific element addresses the overall stated objectives and fits into the big picture of compensation. Now would also be a good time to review the compensation committee charter and, if appropriate, update it. Examine Disclosure Controls and Procedures. The New Rules require the calculation of a number of new amounts, both for the tables and the narrative disclosure. Make sure that your systems and your disclosure controls and procedures permit you to capture the necessary information for the new disclosures. It would also be a good idea to make sure that your controls and procedures are designed to recognize the Form 8-K triggering events relating to executive compensation and to communicate the necessary information about such events quickly to the right person. Prepare a Tally Sheet. Institutional investors have been asking for tally sheets showing all elements of executive compensation for a while 14