Latham & Watkins Tax Department. SEC Proposes New Compensation Disclosure Rules

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1 Number 499 January 31, 2006 Client Alert Latham & Watkins Tax Department SEC Proposes New Compensation Disclosure Rules What Companies Need to Know for the 2006 Proxy Season Although the Proposed Rules will not be effective for the 2006 proxy season, we expect that the release of the Proposed Rules will cause companies to evaluate, and perhaps revise, the compensation disclosure in their 2006 proxy statements. On January 27, 2006, the Securities & Exchange Commission (SEC) published proposed rules (Proposed Rules) relating to executive and director compensation disclosure required in public company proxy statements and certain other SEC filings. 1 The text of the Proposed Rules may be found at rules/proposed.shtml. This Client Alert briefly describes the terms of the Proposed Rules and sets forth suggested disclosure practices that companies may wish to consider in connection with the preparation of their 2006 proxy statements. In addition, this Client Alert provides an update regarding Internal Revenue Code Section 162(m) issues that many public companies will need to take into account when preparing their 2006 proxy statements. The Proposed Rules have been released in the wake of widespread institutional stockholder concerns related to compensation disclosure issues, recent SEC enforcement actions regarding executive compensation practices and increasing media scrutiny of executive compensation issues. Accordingly, although the Proposed Rules will not be effective for the 2006 proxy season, 2 we expect that the release of the Proposed Rules will cause companies to evaluate, and perhaps revise, the compensation disclosure in their 2006 proxy statements. In addition, the Proposed Rules include interpretive guidance regarding the disclosure of perquisites (perks) provided to directors and certain officers. Our description of suggested best practices set forth below considers this interpretive guidance and what companies may wish to do in order to comply with it. The Proposed Rules The terms of the Proposed Rules are consistent with the terms previously disclosed in the SEC press release that accompanied the SEC s unanimous approval of the Proposed Rules at its January 17, 2006 meeting. Conceptually, the Proposed Rules are intended to help stockholders understand the total value of compensation received by directors, senior executive officers and certain other employees. Specific terms of the Proposed Rules include the following: Named Executive Officers. The Proposed Rules revise the definition of Named Executive Officer (NEO) to require the inclusion of a company s Principal Financial Officer (PFO), regardless of the amount of compensation paid to the PFO. Thus, under the Proposed Rules, the NEO group will consist of the PFO, the Principal Executive Officer (PEO) 3 and the next three most highly paid Latham & Watkins operates as a limited liability partnership worldwide with an affiliate in the United Kingdom and Italy, where the practice is conducted through an affiliated multinational partnership. Copyright 2006 Latham & Watkins. All Rights Reserved.

2 executive officers. By contrast, the current rules require the inclusion of the CEO and the next four most highly paid executive officers (which may or may not include the PFO). The Proposed Rules base the most highly paid determination on total compensation, rather than on only base salary and annual bonus, as per the current rules. Non-Executive Officer Disclosure. In a departure from past-practice, the Proposed Rules require companies to provide a narrative description of the total compensation paid to up to three non-executive employees during the most recent fiscal year if the total compensation of such employees exceeds that of any NEO. Companies will not be required to disclose the names of such non-executive employees, but will be required to describe their job positions. We expect that this requirement may be subject to a significant amount of commentary. Under the current rules, no disclosure is required for this group. Moreover, we expect that companies may have concerns about the effect of this disclosure internally (among their own employees) and externally (among their competitors). Compensation Discussion and Analysis. The Proposed Rules require a narrative description of a company s most significant compensation policies and decisions in a section entitled Compensation Discussion and Analysis (CD&A). The CD&A section will replace the currently required Board Compensation Committee Report and the Performance Graph, and will include disclosure of the most important factors in determining compensation without using boilerplate or repeating the more detailed information in the tables. 4 Importantly, the CD&A section will be considered filed by the Company rather than furnished over the names of the Compensation Committee members and thus will be subject to more stringent liability standards under applicable securities laws. Summary Compensation Table. Under the Proposed Rules, the Summary Compensation Table (SCT) will contain the following nine columns with respect to compensation received by NEOs during the company s three 5 most recently completed fiscal years: (1) Name and Principal Position, (2) Year, (3) Total Compensation, (4) Salary, (5) Bonus, (6) Stock Awards, (7) Option Awards, (8) Non-Stock Incentive Plan Compensation and (9) All Other Compensation (including perks). All compensation figures set forth in the SCT will be provided in dollars (rather than in numbers of shares or other units). Two supplemental tables will set forth Grants of Performance- Based Awards and Grants of All Other Equity Awards (these tables are supplemental to the SCT and are separate from the tables described in the Equity Interests section, below). o Total Compensation. The Total Compensation column will report a dollar amount of all compensation received by an NEO in a given fiscal year. The amount set forth in this column will be equal to the sum of all of the other columns in the SCT. o Dollar Value of Equity Awards. The grant date fair value of all equitybased awards granted to an NEO will be set forth in this column. Under the Proposed Rules, such awards are to be valued in accordance with the requirements of Financial Accounting Standards Board s Statement of Financial Accounting Standards 123(R) (the new financial accounting rules governing equity-based compensation awards). o All Other Compensation (Including Perks). The All Other Compensation column is a catch-all intended to include all compensation not otherwise included in a column in the SCT. Compensation that may be included in this column with respect to a given fiscal year includes the amount of: (1) actuarial increases in 2 Number 499 January 31, 2006

3 the NEO s benefits under taxqualified and non-qualified defined benefit pension plans (including supplemental executive retirement plans), (2) company contributions and earnings credited to the NEO under defined contribution plans that are not tax-qualified (including non-qualified deferred compensation plans), (3) any Section 280G or other tax gross-up payments and (4) all perks and personal benefits provided to the extent the aggregate value of all such perks is in excess of $10,000. The $10,000 threshold for perk disclosure would replace the current threshold of $50,000 (or 10 percent of the NEO s annual base salary and bonus, if less). Equity Interests. The Proposed Rules would require two new equity-based compensation tables. o Outstanding Equity Awards at Fiscal-Year End Table. This table would require disclosure of equitybased compensation awards outstanding at year end. It is intended to provide a method of estimating potential amounts realizable by each NEO with respect to outstanding equity-based awards. o Option Exercises and Stock Vested Table. This table would require the disclosure of amounts realized on the vesting and exercise of any equity-based compensation awards in the latest fiscal year. Post-Employment Benefits. The Proposed Rules would expand required disclosure regarding postemployment payments and benefits. o Retirement Benefits. The Proposed Rules would replace the current Pension Plan Table with two new tables: - Retirement Plan Potential Annual Payments and Benefits Table. This table would set forth the amount of the annual benefits payable under any and all defined benefit plans to each NEO upon retirement. - Non-Qualified Defined Contribution and Other Deferred Compensation Plans Table. This table would set forth the amount of all executive and company contributions, and all earnings and withdrawals, under any nonqualified defined contribution and other deferred compensation plans in the latest fiscal year. It would also set forth the year-end balance of any such plans. o Change in Control and Severance Payments. The Proposed Rules require specific narrative disclosure of the amount of any payments that may be made to an NEO in the event of a change in control of the company. Similarly, the Proposed Rules require specific narrative disclosure of the amount of any payments that may be made to an NEO in the event of the NEO s termination of employment or other change in responsibilities. It is unclear at this time how certain payments, such as Section 280G gross-ups, are to be valued for these purposes, although the Proposed Rules allow for reasonable estimates so long as the material assumptions underlying such estimates are disclosed. Director Compensation. The Proposed Rules require disclosure of directors compensation in tabular format. This new Directors Compensation Table is analogous to the SCT for NEOs, although only compensation relating to the most recent fiscal year (rather than the three most recent fiscal years) is included. Form 8-K. The Proposed Rules revise the Form 8-K rules to limit the compensation-related actions that must be disclosed by a company within four business days after occurrence to those that relate to (1) the departure of directors or certain executive officers, (2) the election of directors, (3) the appointment of certain officers and (4) the compensatory arrangements 3 Number 499 January 31, 2006

4 of directors and certain officers. These revisions provide useful clarity and should help reduce much of the Form 8-K static that has resulted under the current rules from companies filing Forms 8-K with respect to compensation-related matters that are arguably not material. Corporate Governance; Related Party Transactions. The Proposed Rules rationalize the director independence and other corporate governance rules and revise the related party disclosure rules by, among other things, increasing the related party threshold from $60,000 to $120,000. Plain English. The Proposed Rules require that all disclosure be provided in plain English Proxy Season New Disclosure Considerations Why Revise Compensation Disclosure Practices in 2006? As mentioned above, the Proposed Rules are not expected to be effective with respect to companies that file their proxy statements during the spring 2006 proxy season. However, the Proposed Rules provide a strong indication of the SEC s current views in this area and the publicity surrounding the release of the Proposed Rules may give rise to expectations of increased compensationrelated disclosure on the part of stockholders. In addition, even absent the Proposed Rules, several recent events have caused many public companies to review their executive compensation disclosure practices in connection with the 2006 proxy season. Such events include, among other things, the continued escalation of institutional stockholder activism related to executive compensation, 6 the impact of recent SEC enforcement actions regarding executive compensation disclosure 7 and increased plaintiffs bar activity alleging inadequate disclosure of executive compensation. 8 Moreover, heightened press scrutiny of executive compensation has increased the desire of some companies to use comprehensive proxy disclosure in order to tell their story and explain the context of the company s executive compensation practices, thereby preventing (or at least minimizing) the likelihood that individual executive compensation practices will be misreported or reported out of context in the press. In addition, companies that disclose more than the minimum in their 2006 proxy may receive a certain amount of credit for being an early adopter of best disclosure practices (although not as much as in years past expectations have clearly been raised in this area). Also, we expect that compensationrelated disclosure in 2007 proxy statements will be heavily scrutinized and previously undisclosed compensation practices will be criticized. Therefore, disclosing compensation practices in the 2006 proxy may help pre-empt criticism in Finally, since the Proposed Rules are not yet effective, companies may have more leeway to work out administrative and disclosure kinks related to the Proposed Rules in 2006 and thus avoid such problems in Suggested Best Practices for 2006 Compensation-Related Disclosure We believe that companies should consider including the following compensation-related disclosure in their 2006 proxy statements. Since the Proposed Rules are not yet effective, we expect disclosure practices to vary widely this year. Each public company will need to evaluate potential disclosure in light of its individual circumstances and many companies may conclude that they should hold off on significantly overhauling their compensation disclosure practices until the Proposed Rules are finalized. However, we do not believe that it is sufficient for companies to merely update the numbers from last year s 4 Number 499 January 31, 2006

5 proxy in the 2006 proxy statement without considering the following disclosure alternatives: Perks. The Proposed Rules contain interpretive guidance from the SEC regarding factors to consider in determining whether an item is a perk. Under the Proposed Rules, if an item is integrally and directly related to the performance of the executive s duties, it is not a perk. If, however, the item confers a direct or indirect benefit that has a personal aspect (without regard as to whether the benefit may be provided for some business reason or for the convenience of the company), it is a perk unless it is generally available on a nondiscriminatory basis to all employees. 9 With respect to 2006 proxy statements, we suggest that companies review current compensation and benefits practices to ensure that all perks are being properly included and valued when determining whether the applicable thresholds are met. In particular, we suggest that companies make sure that the aggregate incremental cost is utilized to value each perk provided to an NEO and include a discussion of how this cost is calculated. This issue commonly arises in connection with the personal use of company aircraft by an NEO. The interpretive guidance makes it clear that amounts attributed to an NEO for federal income tax purposes pursuant to the Standard Industry Fare Level (SIFL) rules generally do not constitute the aggregate incremental cost to the company of the NEO s personal use of the company aircraft and thus should not be used for purposes of perk disclosure (unless, independently of the tax characterization, such amounts are equal to the incremental cost). If no perks are provided to executives, we believe it is best practice to state this explicitly in order to eliminate any ambiguity. In light of recent SEC enforcement actions and the general sensitivity surrounding the issue of executive perk disclosure, companies may also wish to disclose executive perks below the current $50,000 (or 10 percent of base salary and annual bonus) threshold, even though it is not required under current rules. This may be done by utilizing the $10,000 threshold contained in the Proposed Rules or by disclosing all perks provided to executives, regardless of aggregate value (and companies should also keep in mind that under current rules all perks provided to directors must be disclosed). In order to present perk disclosure in an organized fashion, companies may wish to consider including a table listing the type of perk and its value for each NEO. Such a table would typically be included in a footnote to the Other Annual Compensation Column of the SCT. We note, however, that the Proposed Rules do not require that perks be disclosed in tabular format, although the SEC is soliciting comments as to whether such tabular disclosure of perks would be appropriate. Retirement and Deferred Compensation Plans. Companies may wish to consider including one or both of the retirement plan tables required by the Proposed Rules in their 2006 proxy statements. Such disclosure should be viewed positively by those in the investor community who are dissatisfied with the current lack of retirement plan disclosure for NEOs. Because the disclosure required by the Retirement Plan Potential Annual Payments and Benefits Table requires valuation estimates and may be controversial, companies may wish to include only the Non-Qualified Defined Contribution and Other Deferred Compensation Plans Table in their 2006 proxy statement. We see no issue with including one table but not the other in 2006 proxy statements. 5 Number 499 January 31, 2006

6 In addition, to the extent that a company does not have retirement plans with disfavored features (such as guaranteed above-market interest credits), we believe that it is best practice to state that this is the case in order to eliminate any ambiguity. Even if such disclosure is not included in the 2006 proxy, we suggest providing the Compensation Committee with all of the information required by the two retirement plan tables provided in the Proposed Rules if the Compensation Committee has not previously seen all such information compiled in one place. Total Compensation/Tally Sheet Disclosure. Unless the SEC issues specific guidance to the contrary, we do not believe that it will be best practice for 2006 proxy statements to modify the SCT by adding the Total Compensation column (or to otherwise include disclosure under any column other than those required under existing rules). In addition, we believe that for 2006, the SCT should continue to list the number of shares underlying option or stock appreciation right (SAR) awards, consistent with current disclosure rules (rather than listing the value of such awards as provided by the Proposed Rules). In general, disclosure tables should not be modified without SEC guidance permitting such modifications. However, companies may still wish to provide a narrative statement or separate chart setting forth the total annual compensation for each NEO. Furthermore, we believe that it is best practice for the Compensation Committee to use a tally sheet in connection with evaluating and setting executive compensation and that the use of such a tally sheet should be discussed in the Board Compensation Committee Report. Director Compensation. We suggest that companies consider including the Directors Compensation Table in their 2006 proxy statements even though not required for 2006 by the Proposed Rules. We expect that this disclosure will generally not be controversial and we believe that most companies will find that it makes sense to present director fees and other compensation disclosure in this format. Change in Control and Severance Payments. At this point, we do not believe that most companies will wish to include the change in control and severance payment disclosure required by the Proposed Rules in their 2006 proxy statements in part because valuation issues will prove too troublesome. For example, we believe that the SEC will need to provide further guidance on the valuation of 280G gross-up payments before potential change in control payments may be uniformly valued between companies. However, when preparing the 2006 proxy, we suggest that, in accordance with current rules, companies review the narrative disclosure of NEO employment, severance and change in control arrangements to make sure that such disclosure fully and accurately describes the payments and benefits that may be provided under such arrangements. Named Executive Officers. If a company s PFO is not an NEO under the current rules, the company may wish to add the PFO as an additional NEO in the 2006 proxy, although we do not believe that it is necessary to do so. However, in such a case, the PFO should not replace any existing NEO (so if the PFO is included, the proxy tables would generally include the CEO, PFO and the next four (not three) most highly paid executive officers of the company). Compensation Discussion and Analysis. Until the Proposed Rules are finalized, companies should continue to prepare the Board Compensation Committee Report and the Performance Graph. However, when preparing the Board Compensation Committee Report, the Compensation Committee may wish to evaluate 6 Number 499 January 31, 2006

7 whether it is appropriate to augment its traditional discussion of compensation matters with additional narrative disclosure regarding the nexus between company performance and executive compensation or any other disclosure that would be required in the CD&A under the Proposed Rules. Equity Award Tables. We do not believe that it will be appropriate for most companies to include the new equity award tables until the Proposed Rules are finalized Proxy Season Section 162(m) Considerations The Internal Revenue Service (IRS) has announced that it is undertaking a comprehensive audit initiative focusing on the compensation arrangements of senior executive officers at public companies. Pursuant to this initiative, the IRS has identified non-compliance with Section 162(m) of the Internal Revenue Code (Section 162(m)) as a major problem and as an audit priority (see the Section 162(m) Audit Technique Guide on the IRS s Web site at ns/article/0,,id=134874,00.html). Accordingly, as public companies enter the 2006 proxy season and set their qualified performance based compensation (QPBC) goals for 2006, there is no better time to review the status of their QPBC plans and the quality of their operational compliance. Section 162(m) generally limits a public company s deductions for compensation paid to its CEO and the next four most highly paid executive officers to $1 million per year for each officer. 10 However, QPBC paid pursuant to a bonus plan or other plan which pays compensation only if the company attains objective performance targets established and certified in advance in accordance with Section 162(m)- required procedures is not included in the 162(m) limit. Companies that maintain bonus or other incentive plans that are designed to pay QPBC should annually review the form and operation of their plans each proxy season to ensure that awards made under the plans constitute QPBC and are in compliance with 162(m). Additionally, companies should remember that under Section 162(m), stockholders must approve the goals pursuant to which QPBC is paid at least every five years. Finally, compensation plans which are effective before a corporation becomes publicly held may be subject to special transition rules which defer the application of Section 162(m) for a period of time after the corporation becomes publicly held. Adoption of material plan amendments can truncate this transition period. Conclusion Although the Proposed Rules described in this Client Alert will not be effective for the 2006 proxy season, companies may nevertheless wish to review and update the compensation-related disclosure in their 2006 proxy statements, especially in light of the interpretive guidance given by the Proposed Rules and the IRS 162(m) audit initiative. 7 Number 499 January 31, 2006

8 Endnotes 1 The Proposed Rules amend several SEC rules and regulations, including, most importantly, Item 402 of Regulation S-K Standard Instructions for Filing Forms Under the Securities Act of 1933, Securities Exchange Act of 1934 and Energy Policy and Conservation Act of 1975 (17 C.F.R ) (Item 402 of Reg. S-K). The current rules regarding executive compensation disclosure required in annual proxy statements and other SEC filings are largely found in Item 402 of Reg. S-K. 2 The Proposed Rules are subject to a 60-day comment period beginning on the date the Proposed Rules are published in the Federal Register. The SEC has proposed that, following their adoption, the Proposed Rules will become effective for proxy statements that are filed at least 90 days after publication of the final rules. The SEC does not currently intend that companies re-state compensation disclosure for fiscal years covered by current rules. Instead, the first proxy filed after the Proposed Rules become effective will include information for only the most recent fiscal year (and the second proxy will include information for the two most recent fiscal years). Thus, the Proposed Rules would be phased in over time. Other aspects of the Proposed Rules become effective at different times. For example, the Form 8-K revisions become effective for triggering events that occur at least 60 days after publication of the final rules. As used in this Client Alert, the term 2006 proxy statement refers to proxy statements filed in 2006 prior to the time the Proposed Rules become effective. 3 Under current proxy disclosure rules the PEO is referred to as the Chief Executive Officer (CEO). 4 The Proposed Rules set forth an extensive list of examples of issues that might be appropriate to discuss. 5 We note that the SEC has solicited comments as to whether disclosure of compensation for the last three fiscal years is necessary or whether disclosure of only the last completed fiscal year would be sufficient in light of the availability of historical information from other sources. Because stockholders generally have the ability to access historical information easily via the SEC s EDGAR system and other information gathering services, we believe that including information for only the latest fiscal year would be sufficient. 6 Institutional Shareholder Services (ISS), for example, has adopted for the 2006 proxy season a formal policy recommending withholding votes from compensation committee members if a company has poor compensation practices. In addition, ISS is strongly encouraging companies to provide better and more transparent disclosure related to CEO pay and is encouraging the use of a tally sheet setting forth all elements of the CEO s compensation in one table. See ISS U.S. Corporate Governance Policy 2006 Updates, released on November 17, See, e.g., In the Matter of Tyson Foods, Inc., SEC Release (April 28, 2005) (proceeding against Tyson Foods and its former Chairman and CEO regarding failure to adequately disclose perks received by such former Chairman and CEO); In the Matter of Walt Disney Company, SEC Release (December 20, 2004) (proceeding against Walt Disney for failure to adequately disclose family and business relationships related to certain directors); and In the Matter of General Electric Company, SEC Release (September 23, 2004) (proceeding against General Electric regarding failure to fully and accurately disclose retirement benefits provided to its former CEO). 8 See, e.g., Shaev v. Datascope Corp. (3d. Cir. 2003) (shareholder derivative suit alleging, among other things, that inadequate proxy disclosure regarding certain executive compensation matters constituted the making of false and misleading statements). 9 The Proposed Rules provide that the concept of perks should not be interpreted artificially narrowly to avoid disclosure. In addition, the interpretive guidance provides that the tax treatment of an expense is not determinative as to whether the expense provides a perk for disclosure purposes. Thus, an item that is an ordinary or necessary expense for federal income tax purposes may still be a perk that needs to be disclosed. Examples of items identified in the interpretive guidance that would be perks include: (1) club memberships not used exclusively for business entertainment purposes; (2) personal financial planning or tax advice; (3) personal travel using company-owned vehicles or otherwise financed by the company; (4) personal use of company property; (5) housing or living expenses (including relocation assistance); (6) security during personal travel; (7) commuting expenses; and (8) discounts on company products not 8 Number 499 January 31, 2006

9 generally available to employees. Examples of items identified in the interpretive guidance that would not be perks include: (a) business travel; (b) business entertainment; (c) security during business travel; and (d) itemized expense accounts limited to business purposes. 10 Note, the definition of covered employee under Section 162(m) includes (1) the individual serving as CEO at the end of the taxable year and (2) any employee if the compensation of such employee is required to be reported to shareholders under the Securities Exchange Act of 1934 by reason of such employee being among the four highest compensated officers for the taxable year (other than the CEO) and the applicable regulations similarly refer to the four highest compensated officers (other than the CEO). Thus, if the Proposed Rules revise the definition of NEO to include PEO, PFO and next three most highly compensated executive officers (rather than CEO and next four) it would appear that the group of Section 162(m) covered employees could be different then the group of NEOs unless clarifying guidance is provided under Section 162(m). 9 Number 499 January 31, 2006

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