SIGNIFICANT TWEAKS IN SEC S ADOPTION OF AMENDMENTS TO EXECUTIVE COMPENSATION AND CORPORATE GOVERNANCE PROXY DISCLOSURE RULES. Charmaine L.

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1 SIGNIFICANT TWEAKS IN SEC S ADOPTION OF AMENDMENTS TO EXECUTIVE COMPENSATION AND CORPORATE GOVERNANCE PROXY DISCLOSURE RULES Charmaine L. Slack * We saw 2009 commence with an aggressive stance taken by many against what had evolved as common executive compensation practices of most public companies, often described as excessive. Many still hold the belief that these compensation practices were a major cause of the economic and financial crises that surfaced in late 2008 and believe steps should be taken to reign in executive compensation. As 2009 progressed, initiatives against these practices continued to unfold. They ranged from significant legislation from Congress for Troubled Assets Relief Program recipients intended to curb perceived abuses in executive pay to principles and guidelines pronounced by the Department of the Treasury that had the objectives of encouraging sound risk management and more tightly aligning a company s compensation practices with the interests of its shareholders. Other initiatives included directives from proxy advisors and institutional shareholders on appropriate forms of compensation, as well as proposals from the Securities and Exchange Commission (the SEC ) that had, in part, the goals of ensuring that investors have the information necessary to make sound investment decisions, providing greater transparency, as well as increasing accountability for corporate directors. Two weeks prior to the close of 2009, the SEC went a step further by adopting its final rule amendments 1 regarding enhanced proxy disclosure released in July 2009 (the Proposed Rules ). 2 The Final Rules are effective February 28, 2010 and generally adopt the proposed amendments, with a number of significant tweaks and clarifications. 3 This paper briefly highlights some of the key modifications and clarifications made to the Proposed Rules by the * Copyright 2010, Charmaine L. Slack, All Rights Reserved. The views set forth herein are the personal views of the author and do not necessarily reflect those of the law firm with which the author is associated. Charmaine L. Slack is a partner in the Employee Benefits and Executive Compensation practice of the international law firm Jones Day in New York. Ms. Slack concentrates her practice in the area of executive compensation and advises senior management, boards of directors, and compensation committees of public and private entities on a wide variety of executive compensation and equity arrangements and related corporate governance matters. She is a graduate of Pace University and Harvard Law School and has an LL.M. in Taxation from New York University. 1 See SEC Release No , 17 CFR Parts 229, 239, 240, 249 and 274 Proxy Disclosure Enhancements; Final Rule (the Final Rules ), available at 2 A summary of the Proposed Rules is provided in the Jones Day Commentary Proposed Changes to Proxy Disclosure Regarding Executive Compensation and Corporate Governance, August On December 22, 2009, the SEC issued Compliance and Disclosure Interpretations as to how the effective date of the Final Rules applies to proxy statements, Form 10-Ks, Form 8-Ks and registration statements filed at or around the time of the effective date. December 20, 2009 is the pivotal fiscal year-end date. For example, if a company s fiscal year ends before that date, its 2009 Form 10-K and related proxy statement would not be required to be in compliance with the Final Rules, even if filed on or after February 28, 2010.

2 SEC in adopting the Final Rules that companies should consider as they begin or continue to prepare for the upcoming proxy season. Compensation Risk Disclosure under the Final Rules The Proposed Rules requiring a company to disclose how the company s overall compensation policies and arrangements could affect the company s risk and management of that risk were generally adopted as proposed. In response to comments received, however, the SEC made a couple of significant tweaks to the Proposed Rules by: more clearly establishing a standard by which a company can assess whether any risks created by its compensation policies and practices for all employees warrant disclosure (a reasonably likely to have a material adverse effect on the company threshold (the Reasonably Likely Threshold )); not requiring the expanded risk disclosure and analysis that applies to all employees to appear in the Compensation Discussion and Analysis (the CD&A ), where discussion of a company s compensation policies and practices regarding its named executive officers might have been confused with the new risk disclosure regarding policies and practices applicable to the broader employee base (i.e., avoiding an apples and oranges type disclosure); and excluding smaller reporting companies from this new disclosure (since, among other reasons, those companies typically do not have the types of compensation policies and practices that the Final Rules are ultimately aiming to address). Initial Observations. By implementing a higher threshold for disclosure regarding the relationship between risk and a company s compensation policies and practices for all employees, including those who are non-executive officers, the SEC has addressed one of the primary concerns about the Proposed Rules expressed by several commentators that left many scratching their heads. As modified, the SEC anticipates that application of the Reasonably Likely Threshold will avoid potentially voluminous and unnecessary disclosure that could have resulted if the Proposed Rules had been adopted without modification. The Reasonably Likely Threshold is similar to the disclosure threshold set forth in the Management Discussion and Analysis rules that require risk-oriented disclosure of known trends and uncertainties that are material to [a] business, a disclosure standard companies have grown accustomed to considering. With the change made by the Final Rules, a company should be better able to take a more holistic approach to the assessment of its compensation policies and practices in determining whether they pose a material adverse risk to the entire company and therefore fall within the Reasonably Likely Threshold. In reaching a determination, the Final Rules allow a company to evaluate its compensation policies and practices across groups and divisions. Where certain arrangements mitigate or balance incentives on a whole, consideration may be given to whether any disclosure would be warranted under the Reasonably Likely Threshold

3 Importantly, based on responses received to its request for comment, the SEC departed from its request that could have required a company to make an affirmative statement in its CD&A that it had no broad-based compensation policies where any risk that could arise from such policies would be reasonably likely to have a material effect (presumably positive or negative) on the company. However, notwithstanding these important modifications, companies should not be too quick to conclude that no disclosure is necessary. Although providing no additional disclosure may be the end result chosen by a vast majority of companies, they will still need to undertake a review of their compensation policies and practices to assess what degrees of risk, if any, exist within, or may be caused by, these arrangements individually and as a whole. This review could occur in a variety of ways and also may necessitate an evaluation of the company s enterprise risk management and oversight practices and policies. At a minimum, senior management and boards of public companies should consider how risk may play an intended or unintended role in their compensation policies and practices and develop a framework by which any such risk can be managed to avoid surprises. A comprehensive evaluation of a company s enterprise risk management and oversight practices and policies may be necessary as part of its corporate governance practices to determine whether the proper systems are in place to not only collect information, but critically assess, monitor, leverage and incorporate the information into the company s risk management and oversight systems. Consideration also may need to be given to whether its risk management team is receiving information from all relevant sources. To the extent a company s processes did not previously include gathering information from those with a deep understanding of the company s compensation policies and practices, incorporation of such individuals may be advisable going forward. The SEC generally retained the non-exhaustive list of situations where a company s compensation arrangements potentially could create material adverse risks for the company, as well as the examples of the types of issues that a company may need to address if disclosure is warranted. For companies that determine that some level of risk disclosure is necessary, they should give careful consideration to how to accomplish this in a manner that provides meaningful and relevant information, using the examples specified in the Final Rules as guidelines. As the SEC has highlighted on a number of occasions, transparency is key, with particular focus on incentive arrangements that shareholders would consider most relevant. Refreshingly, any such disclosure will not be a part of the CD&A but instead will be a separate new section of disclosure under Item 402(s) of Regulation S-K. The debate about the relationship between appropriate levels of compensation and risk is far from over but, at least some of the extremes, as they relate to risk disclosure, have been tapered back for now. Board Leadership Structure and Risk Oversight The Final Rules adopt the proposed amendments requiring disclosure of the board s leadership structure and its role in overseeing the company s risk management process but finetuned the focus in some respects. There are no major surprises here. The Final Rules generally cleaned up some language in the proposed rules (i.e., the use of board leadership structure rather than company leadership structure and risk oversight instead of risk management ) to better capture the role of a company s board. The SEC continued to stress one of its goals in the disclosure rules of increased transparency for investors by requiring the what, how and - 3 -

4 why of a company s board leadership structure (i.e., informed disclosure surrounding the roles of its CEO, chairman, and if applicable, lead independent director) and that its role in risk oversight be disclosed. Initial Observations. The Final Rules do not mandate a separation of the chairman and CEO roles as has been advocated in different arenas. It is likely that pressure from a company s investor base and other corporate governance advocates to restructure its board leadership may continue. However, by providing disclosure that not only complies with the Final Rules but also affords a company an opportunity to tell its story as to why its chosen leadership structure best serves the interests of the company, disclosure under the Final Rules may help alleviate that pressure. The SEC recognizes that a board s risk oversight duties extend way beyond those that may be associated with executive compensation. In this environment where everyone s risk tolerance is being reconsidered and reassessed, the importance of a holistic approach to risk management will continue to be a significant focus. Recent legislation containing risk oversight and assessment features, in some instances to be carried out by Federal banking and other regulators, highlights this focus. 4 The Board of Governors of the Federal Reserve System also issued guidance on October 27, 2009 designed to help ensure that incentive compensation policies at banking organizations do not encourage excessive risk-taking and are consistent with the safety and soundness of the organization. Reporting of Options and Other Equity Awards The Final Rules substantially incorporated, but with some refinement, the Proposed Rules to amend Item 402 of Regulation S-K to revise the Summary Compensation and Director Compensation Tables to require disclosure of the aggregate grant date fair value of awards made during the year (instead of the amount recognized during the year for purposes of the financial statements) computed in accordance with Financial Accounting Standards Board Accounting Standards Codification Topic 718 (formerly FAS 123R), Compensation Stock Compensation, as the better reflect[ion of] the compensation committee s decision[s] on equity awards. New instructions to the tables have been added under the Final Rules to clarify that disclosure of performance awards should be based on the probable outcome of the performance conditions as of the grant date (i.e., a value consistent with the grant date estimate of compensation cost to be recognized over the service period, excluding the effect of forfeitures ) 5 rather than on a maximum performance value basis. The SEC acknowledged that the new instructions would provide a more appropriate indication of how a company s compensation committee considers vesting conditions based on performance when granting performance awards. However, the SEC has not completely disregarded the maximum performance concept, as the Final Rules require a footnote to the compensation tables indicating the potential 4 See Title II of the Wall Street Reform and Consumer Protection Act of 2009 (H.R. 4173) passed by the House on December 11, 2009 and the Restoring American Financial Stability Act of 2009, a bill introduced by Senate Banking Committee Chairman Christopher Dodd on November 10, Whether an award constitutes a performance award for purposes of the Final Rules would be based on whether the awards would be subject to performance conditions as defined in the Glossary to FASB ASC Topic

5 maximum value for an award assuming the highest level of performance conditions is probable. As with the Proposed Rules, the Final Rules require disclosure of awards granted during a company s fiscal year for which the disclosure is being provided, and the SEC opted not to modify the disclosure requirements to reflect grants for services performed during the last completed fiscal year. In addition, the SEC suggests that, in cases where an executive officer is not included in the Summary Compensation Table as a named executive officer as a result of the grant of large, one-time, multi-year awards to other officers that caused them to instead be included as name executive officers for the most recently completed fiscal year, the company consider including disclosure about the compensation for that excluded executive officer as a supplement to the required disclosure. The SEC also has suggested that companies provide supplemental tabular disclosure of grants of post-fiscal year-end equity awards where the disclosure would assist shareholders in better understanding the CD&A. The SEC did not adopt the following Proposed Rules: to amend the instruction that would allow companies to not report forgone salary and bonus at a named executive officer s election in the respective columns of the Summary Compensation Table and instead report the non-cash awards received in lieu of the compensation in the column most applicable to the form of award elected; 6 and to rescind the requirement to report the full grant date fair value of each equity award in the Grants of Plan-Based Awards Table and as a footnote to the Director Compensation table. 7 Initial Observations. In attempting to address the historical struggle of determining the proper disclosure for options and other equity awards in the compensation tables, the Final Rules reflect the SEC s focus on requiring disclosure that is intended to give shareholders better insight into factors that compensation committees consider when setting short- and long-term compensation for their named executive officers. The SEC has addressed concerns about whether the rules could change a company s payout or grant process by suggesting supplemental disclosure where full grant date fair value disclosure may not tell the complete story. This change may necessitate additional focus by some companies on the grant date for their equity awards and the value of those awards on such date, especially performance-based equity awards. Only time will tell whether a general consensus will evolve as to whether the Final Rules regarding disclosure of options and other equity awards (performance based or otherwise) facilitate a better understanding of this compensation mix. 6 See Instruction 2 to Item 402(b). 7 The SEC mentions in the Final Rules that comments received on other initiatives to improve executive compensation disclosure could be considered for future rules. These could include rules regarding disclosure of compensation for each executive officer, as opposed to just the named executive officers; eliminating the instruction providing that performance targets can be excluded based on a valid competitive harm justification; making the CD&A part of the Compensation Committee Report and requiring the report to be filed; additional disclosure regarding hold to retirement and/or claw back provisions; and internal pay ratios

6 Compensation Consultants Disclosure With regard to disclosure related to potential conflicts of interest affecting compensation consultants, the Final Rules introduced a distinction not contained in the Proposed Rules based on whether the consultants were engaged by the board or by management. The Final Rules adopted a modified version of the Proposed Rules and provide certain limited exceptions to the rule requiring disclosure of fees and other related information where compensation consultants provide services to a company in addition to those of executive compensation consulting. Whether or not disclosure of a company s compensation consultants will be required will turn, subject to a minimum $120,000 fee threshold, on: whether the board, compensation committee or equivalent function has engaged its own compensation consultant to advise on the amount and form of executive and director compensation; whether a decision to engage the compensation consultant for additional services was made, or recommended by, management and, if so, whether approved by the board; if the board has not engaged its own consultant, whether a compensation consultant (and any affiliates) provide both executive compensation and additional services to the company; and whether the board and management have separate compensation consultants advising each party. The Final Rules make clear, in response to a number of comments, that certain compensation-related services such as those that only provide non-company specific information (e.g., non-customized surveys, etc.) and those that are broad-based and apply to nondiscriminatory plans generally are of the type that will not be regarded as executive compensation consulting services that warrant disclosure under the Final Rules. Note, however, that the exception for non-specific information in surveys and similar materials will not apply in instances where a consultant provides advice or recommendations in connection with such information. The SEC noted that it did not propose and is not now adopting: required disclosure of the nature and extent of additional services provided by a company s compensation consultants (an acknowledgement that this type of disclosure could effect competitive harm); disclosure of consulting fees based on a percentage of revenues received from a company; and any additional disclosure regarding various matters about potential conflicts of interests that could add significant length to disclosure or place additional burdens on companies. Initial Observations. In the SEC s view, the Final Rules will enable investors to better assess any potential conflicts that a company s compensation consultants may have regarding executive compensation recommendations. The SEC nevertheless stresses that disclosure does - 6 -

7 not necessarily imply the existence of a conflict of interest for a compensation consultant and that it does not automatically mean that there are no other circumstances that might present such a conflict. The main focus of the Final Rules is facilitation of information that will allow investors to consider whether a company s compensation consultant s advice on executive compensation could be influenced by the consultant s desire to be retained for other services. Reporting of Voting Results Timely disclosure is the driver for this portion of the Final Rules. As with the Proposed Rules, the Final Rules require disclose of shareholder voting results on Form 8-K within four business days after the end of the meeting at which the vote was held rather than in the next Form 10-Q or Form 10-K. This requirement is further expanded in the Final Rules to require companies to disclose preliminary voting results on a Form 8-K within four business days if definitive voting results are not yet available. An amended report on Form 8-K then will be required within four business days after the final voting results are known. Enhanced Director and Nominee Disclosure The Final Rules implement the Proposed Rules regarding enhanced disclosure with respect to director and nominee qualifications with a number of changes. 8 The Final Rules require disclosure, on an annual basis, of the particular experience, qualifications, attributes or skills that the board has determined qualify each director and nominee (whether or not up for reelection) to serve, given the company s business and structure. The Final Rules also: do not eliminate the disclosure requirements in Item 407(c)(2)(v) of Regulation S-K regarding the minimum qualifications and qualities or skills used by a nominating committee to determine who can serve on the board; do not require disclosure of the specific experience, qualifications or skills that qualify a person to serve as a member of any committee; delete the reference to risk assessment skills as a specific example of the type of information that should be disclosed, in order to provide more flexibility; expand the reporting period for directorships at public companies and registered investments companies for directors and nominees to the past five years (generally adopted as proposed); introduce additional types of (and a ten-year reporting period for) legal proceedings listed under Item 401(f) of Regulation S-K that must be disclosed if they involve directors, Final Rules. 8 Investment companies registered under the Investment Company Act of 1940 are also subject to these - 7 -

8 executive officers and nominees and are material to an evaluation of their abilities or integrity; 9 and amend Item 407(c) of Regulation S-K to require disclosure regarding how a nominating committee considers diversity in identifying nominees for director, if at all (if a diversity policy exists, the company is required to disclose how the nominating committee or board implements the policy, including how it assesses the policy s effectiveness). Initial Observations. In this case, less is not better. The SEC is aiming for boardroom transparency in an effort to provide investors with more meaningful disclosure that will inform their voting decisions regarding directors and director nominees. As noted in the View from the Boardroom segment of the Jones Day Commentary entitled Executive Compensation: Fundamental Change is Here, Are You Prepared?, 10 boards will need to become even more proactive and adept in their exercise of good corporate governance, including governance applicable to the companies executive compensation and related practices. This will not all occur overnight, but with each applicable legislation enacted, regulation adopted and guideline issued, the message being delivered is generally consistent provide better, more meaningful information, transparency and a better understanding of the oversight role of the board. There are many that are intending to give a stronger voice to investors via new laws, rules and regulations. One of the many questions that boards and senior management will need to address is whether they are providing the right mix of this information at an appropriate level of meaningful detail. Boards and senior management should continue to become more educated about the various disclosure and other requirements and limitations that are being implemented or modified that may have an impact on the entire enterprise and begin to evaluate the applicable policies and practices to assess whether, and to what extent, any change will be necessary. There are, and will be, many views and interpretations regarding what the Final Rules should mean or require in practice. One thing remains consistent, one size does not fit all. Each company is unique, and therefore its approach to executive compensation, risk oversight and management should be as well. Preparation and planning is paramount. Charmaine L. Slack New York, NY Direct Dial: Fax: cslack@jonesday.com 9 These additions include (1) any judicial or administrative proceedings resulting from involvement in mail or wire fraud or fraud in connection with any business entity; (2) any judicial or administrative proceedings based on violations of federal or state securities, commodities, banking or insurance laws and regulations, or any settlement to such actions; and (3) any disciplinary sanctions or orders imposed by a stock, commodities or derivatives exchange or other self-regulatory organization. 10 May

9 The foregoing should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general informational purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the author, to be given or withheld at the author s discretion