LITIGATION REPORTER LITIGATION REPORTER Corporate Officers & Directors Liability COMMENTARY REPRINTED FROM VOLUME 22, ISSUE 6 / SEPTEMBER 18, 2006 The SEC s New Executive Compensation Disclosure Rules: Liability Concerns for Officers and Directors By Richard E. Wood, Esq., and Michael J. Missal, Esq.* At an open meeting held July 26, the Securities and Exchange Commission adopted sweeping changes to its disclosure requirements for executive and director compensation, related-party transactions, director independence and other corporate governance matters, and security ownership of officers and directors. The new rules are set forth in a ponderous 436-page adopting release that may presage the bulk of future annualmeeting proxy statements that will be required to comply with the new rules. See SEC Release No. 33-8732. The SEC issued the new rules after considering thousands of comments it received on the proposed rules issued Jan. 27. While the usefulness to investors of the new executive compensation disclosure rules may be open to debate, public companies need to take significant steps to face up to their obligations under the rules. Furthermore, public companies officers and directors need to understand the new rules and their respective responsibilities and potential liabilities under them. This article provides a brief overview of the new rules, discusses the potential liability of officers and directors for violations of the rules, and offers suggestions for officers and directors to meet their obligations and responsibilities and best protect themselves against regulatory or civil liability. Overview of the Final Disclosure Rules The final executive compensation disclosure rules are set forth in Item 402 of SEC Regulation S-K. Item 402 disclosure must be included in proxy statements and may be incorporated by reference into Form 10-K annual reports and other periodic reports required under the Securities Exchange Act of 1934. The new rules provide that all elements of compensation must be disclosed. The two foundational components of the new rules are: The compensation discussion and analysis section, or CD&A, in which the company is to describe, in narrative form, the material factors underlying its compensation policies and decisions; and Tabular disclosure in three broad categories: compensation with respect to the last fiscal year (and the two preceding fiscal years), as reflected in a summary compensation table and supplemented by a table providing certain backup information; holdings of equity-related interests that relate to compensation or are potential sources of future gains; and retirement and other post-employment compensation. The company s named executive officers whose compensation must be disclosed are: Each person who served at any time during the last completed fiscal year as the company s principal executive officer or principal financial officer; The three individuals who were executive officers of the company as of the last day of the most recent fiscal year and whose total compensation for such fiscal year was the highest; and 2006 West, a Thomson business.
Up to two other people who served as executive officers of the company during such year and whose total compensation would have placed them among the three other highest-paid executive officers but for the fact that they were not executive officers of the company as of the last day of the fiscal year. For this purpose, total compensation includes all compensation disclosed in the summary compensation table, except for the increase in the actuarial value of pension benefits and earnings on deferred-compensation accounts. Following the issuance of the proposed rules at the beginning of 2006, the backdating of stock options and similar practices became a widely publicized controversy. In response, the SEC included provisions in the final rules designed to ferret out backdating and other potentially manipulative option practices. Companies will have to provide certain tabular and narrative disclosure about option grants and the company s option-grant policies and procedures, including the timing of option grants in relation to the public disclosure of material information, positive or negative, about the company. The narrative discussion will be required in the CD&A section of the disclosure with respect to the reasons the company selects particular grant dates for awards and the methods the company uses to select the exercise prices and other terms of stock options. One of the more controversial aspects of the final rules is the provision requiring that the CD&A be treated as soliciting material that is filed with the SEC. This is unlike the treatment of the compensation committee report required under the prior disclosure rules, which was considered as furnished rather than filed disclosure. The CD&A will be considered a part of the proxy statement and any other filing in which it is included. As a filed document, the CD&A, like the rest of the executive compensation disclosure, will be subject to the liabilities of Section 18 of the Exchange Act. In addition, to the extent that the CD&A and any of the other disclosures regarding executive compensation are included or incorporated by reference into a 10-K or other periodic report, the disclosure will be covered by the certifications that principal executive officers and principal financial officers are required to make under the Sarbanes-Oxley Act of 2002. Similarly, a company s disclosure controls and procedures will apply to the preparation of the executive compensation disclosure, including the CD&A. The final rules retain the requirement for a compensation committee report to be presented by the individual members of the committee. This report will consist solely of a statement of whether the compensation committee has reviewed and discussed the CD&A with management and, based on this review and discussion, recommended that it be included in the company s annual report on Form 10-K and proxy statement. In contrast to the CD&A, the compensation committee report will be treated as furnished, not filed. In providing the required Sarbanes-Oxley certifications of the information contained in the filed CD&A, the company s principal executive officer and principal financial officer are permitted to rely on the furnished compensation committee report. This ability of the principal executive officer and principal financial officer to rely on the report was apparently a concession by the SEC to concerns about the implications of making the CD&A a filed disclosure. Many comments submitted to the SEC on the proposed rules asserted that requiring certification by principal executive officers and principal financial officers with regard to the executive compensation disclosure, including particularly the CD&A, would inappropriately insert these officers into the compensation committee s deliberative process, potentially calling into question the committee s independence. The SEC asserted that: Some of these objections may reflect a misconception of the purpose of the compensation discussion and Analysis. Although the compensation discussion and analysis discusses company compensation policies and decisions, the compensation discussion and analysis does not address the deliberations of the compensation committee and is not a report of that committee. Consequently, in certifying the compensation discussion and analysis, principal executive officers and principal financial officers will not need to certify as to the compensation committee deliberations. The final rule itself presents a quite different picture. Much of the CD&A is in fact a report on the philosophy and actions of the compensation committee. The CD&A may be a statement by the company, but it is quite clearly a statement about the compensation committee. For example, among the matters required to be addressed in the CD&A are: The specific items of corporate performance taken into account in setting compensation policies and making compensation decisions; How specific forms of compensation are structured and implemented to reflect these items of performance, including whether discretion can be or has been exercised; and Company policies and decisions regarding the adjustment or recovery of payments if the relevant registrant performance measures upon which they are based are restated or adjusted in a manner that would reduce the size of a payment. 2 2006 West, a Thomson business.
It is difficult to understand how management will be able to address these policies and decisions of the compensation committee without address[ing] the deliberations of the compensation committee or at least the content of those deliberations. The CD&A requirement places the principal executive officer and the principal financial officer rather awkwardly in between two competing concerns: their own potential liability for false or misleading statements in the CD&A and the compensation committee s need for independence in its actions and decisions. As a response to the recent corporate scandals, the enactment of Sarbanes- Oxley, and the adoption of new governance rules by the New York Stock Exchange and Nasdaq, public companies have made great strides in enhancing the independence of their compensation committees. Best practice in the current environment insulates the compensation committee from intrusion and influence on the part of the company s executives. The executive compensation disclosure rules give executives a new reason to look closely over the shoulders of the compensation committee members. Potential Liability of Directors and Officers For Violations of Disclosure Rules Exchange Act Liability Provisions The increased complexity of the executive compensation disclosure rules places even greater compliance burden on company officers and directors and commensurately increases their potential exposure for violations of Exchange Act reporting and disclosure rules. A violation of the executive compensation disclosure rules may lead to liability under several provisions of the Exchange Act and the related SEC rules. The proxy fraud rule, set forth in Rule 14a-9 of the Exchange Act, prohibits with respect to any proxy materials: Any false or misleading statements regarding any material fact; or Any omission of a material fact necessary to prevent a statement from being false or misleading or to correct earlier statements that have since become false or misleading. The culpability standard under Rule 14a-9 does not require fraudulent intent. Negligence can result in liability for those involved with the issuance of proxy statements. As a matter of law, preparation of a proxy statement by corporate officers and other insiders containing materially false or misleading statements may constitute negligence. A director who did not directly participate in the preparation of a proxy statement may nonetheless be liable if he or she knew, or in the exercise of due diligence should have known, that the proxy statement contained false or misleading statements. Where the false or misleading statement or omission with respect to executive compensation relates to the purchase or sale of a security, there may be liability under Section 10(b) of the Exchange Act and SEC Rule 10b-5 thereunder. These provisions prohibit the use of any manipulative or deceptive device in connection with the purchase or sale of a security. However, for liability to arise under these provisions, it must be proven that the officer or director acted with scienter, a mental state involving intent to deceive, manipulate or defraud. Merely negligent errors are not within the scope of liability under these provisions. Under the new rules, all executive compensation disclosure, including the CD&A, will be contained in or incorporated by reference into one or more documents that are considered filed for Exchange Act purposes. Section 18(a) of the Exchange Act provides that any person who makes or causes to be made any false or misleading statement in any document filed with the SEC is liable for damages to any person who, in reliance upon such statement, purchased or sold a security at a price that was affected by such statement. An officer or director may avoid liability under Section 18(a) by showing that he or she acted in good faith and had no knowledge that there was a false or misleading statement or omission. The Exchange Act liability provisions apply, of course, to the company issuing the proxy statement as well as any parties directly involved in the preparation and issuance of the proxy statement. Under Section 20 of the Exchange Act, company officers, directors and other controlling persons may also be liable for Exchange Act violations in which they did not directly participate. Officers and directors have a complete defense to such liability, however, if they can show they acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action. Only material statements or omissions may give rise to Exchange Act liability. To prove that a statement or omission is material, it is not necessary for an investor to show that the information would have caused the investor to change his or her vote. It is sufficient for the investor to show only that the information would have been viewed by the reasonable investor as having significantly altered the total mix of information available about the matter. TSC Indus. Inc. v. Northway Inc., 426 U.S. 438, 449 (1976). For many large companies, the compensation paid to executives will not, in dollar terms, be a material amount in relation to the company s assets or revenues. Even if the dollar amount of executive compensation is material in the aggregate, there is probably only a relatively small risk that compensation will be misreported by a material amount. However, the dollar value of a reporting violation is not the sole determinant of the violation s materiality. The 2006 West, a Thomson business. 3
General Electric and Tyson Foods enforcement actions described below, neither of which involved a material dollar amount, demonstrate that executive compensation disclosures are viewed with a seriousness that is not necessarily in proportion to the amount of money involved. The need for attention to detail in executive compensation disclosure is further illustrated by the decision of the U.S. Court of Appeals for the 3rd Circuit in Shaev v. Saper et al., 320 F.3d 373 (3d Cir. 2003). That case was a shareholder derivative action involving a proxy statement issued by Datascope Corp. that solicited shareholder approval of an amendment to the company s management incentive plan that determined the bonus compensation to be awarded to Datascope s president. The proxy statement asserted that shareholder approval of the amendment was necessary to ensure that bonuses paid under the amended plan would be deductible by Datascope under Section 162(m) of the Internal Revenue Code (the $1 million annual tax deduction limit on executive compensation). The 3rd Circuit found that the proxy statement discussion of the plan amendment contained affirmative statements that were false or misleading and omitted material information, in violation of Rule 14a-9, and fell short of the disclosure required under Treasury regulations in order to secure the desired tax deduction. Perhaps more importantly, the court rejected the defendants argument that whether the bonus was tax-deductible was immaterial because the deduction would represent a small figure in comparison with Datascope s $300 million in revenues. According to the court, the materiality of the required disclosure is not dependent on the quantity of money involved but on its purpose of informing the stockholders. As discussed above, the entirety of the executive compensation disclosure, including the CD&A, will be subject to the CEO and CFO certification requirements of Sections 302 and 906 of Sarbanes-Oxley. This obligates the CEO and CFO to ensure that adequate disclosure controls and procedures are in place and increases the potential liability of the CEO and CFO for errors in executive compensation disclosure. Enforcement of the Exchange Act Disclosure Requirements Enforcement of the disclosure requirements of the Exchange Act may take a number of forms, including actions by the SEC, the U.S. Department of Justice and private litigants. SEC Enforcement The SEC can be expected to scrutinize compensation disclosures for compliance with the new rules, particularly in the first year or two following the effective date of the new rules. Section 21 of the Exchange Act gives the agency broad authority to investigate actual or potential violations of the proxy rules and other Exchange Act requirements. Among other things, the SEC may bring an action to enjoin such violations or refer the matter to the U.S. attorney general for possible criminal prosecution by the Justice Department. While the statutory authority of the SEC is limited to enjoining continued or threatened solicitation of proxies in violation of the rules, courts have been willing to use their equitable powers to go beyond the statute and prevent the use of illegally obtained proxies. Therefore, the SEC may seek the correction of proxy statements, the adjournment and rescheduling of shareholder meetings, and the resolicitation of proxies. The SEC has used its broad powers in the context of executive compensation disclosure. For example, the agency announced Sept. 23, 2004, that it instituted and settled enforcement proceedings against General Electric Co. The SEC found that from 1997 to 2002 GE failed to fully and accurately describe in proxy statements and annual reports the retirement benefits of ex-ceo Jack Welch. GE settled the proceedings by consenting to the entry of an order by the SEC that it cease and desist from violating the proxy solicitation and periodic reporting provisions of the federal securities laws. In another instance, the SEC announced April 28, 2005, that it had settled enforcement proceedings against Tyson Foods Inc. and its former chairman and CEO, Don Tyson. The SEC charged that in proxy statements filed with the SEC from 1997 to 2003, Tyson Foods made misleading disclosures of perks and personal benefits provided to Don Tyson both before and after his retirement as senior chairman in October 2001. Tyson Foods and Don Tyson were ordered to cease and desist from causing any violations and any future violations of these statutory provisions and rules. Criminal Prosecution Section 32 of the Exchange Act authorizes the Department of Justice to criminally prosecute individuals who willfully violate any provisions of the Exchange Act, including the proxy disclosure rules, or who willfully and knowingly make, or cause to be made, any false or misleading statement in a document required to be filed under the Exchange Act. The potential criminal sanctions include fines of up to $1 million or imprisonment for up to 10 years, or both. Private Actions There is an implied private right of action for injunctive relief for violations of the proxy fraud rule. The Shaev case discussed above is one example of such an action. 4 2006 West, a Thomson business.
There is also a private right of action for violations of Rule 10b-5, and Section 18(a) of the Exchange Act expressly creates a private remedy for false or misleading statements or omissions with respect to filed reports. Steps to Take to Protect the Interests Of Officers and Directors CEOs and CFOs are understandably anxious to understand and meet their obligations before they make their required certifications under Sarbanes-Oxley. Compensation committees also recognize that there is increased attention and focus on their activities. Given the breadth and complexity of the new rules, it will take some time, however, for the interpretation of them to be fully analyzed and appreciated. Nevertheless, there are a number of steps that companies should take promptly to meet their obligations and protect the interests of their officers and directors. Some of the more significant ones are listed below. Compensation Narrative There are extensive and complex requirements in the new rules concerning the narrative for director and executive compensation. Companies should ensure that all relevant departments, including finance, legal, benefits, human resources and other appropriate management, work closely together to determine the proper CD&A and other compensation narratives. The assistance of outside counsel and compensation consultants can be helpful in preparing the disclosure. This process is likely going to take significant time, so companies should address this issue as soon as possible. Most companies are preparing mock-ups of this disclosure now even though final 2006 compensation figures are not yet available. Calculation of Compensation The new rules require companies to calculate and categorize compensation in numerous ways. Companies should begin to gather the documentation necessary to undertake those calculations. In addition, depending on the sophistication of the compensation system, it may be necessary to retain outside experts or consultants to assist in the calculations (e.g., actuaries to perform pension calculations). Disclosure Controls Many violations derive from the failure of a company to have reasonable controls or to implement properly those controls. Given the additional obligations called for by the new rules, companies should review their current disclosure controls and make any modifications as are deemed necessary and appropriate. In addition, the controls should be tested to ensure that the policies and practices are being followed. One valuable disclosure control would be to prepare and maintain a comprehensive checklist of all the narrative and tabular disclosure requirements of the new rules. While the rules themselves may be a bit abstruse, they are amenable to conversion into a checklist or series of questions that, if comprehensive, could help ensure that the compensation disclosure meets all of the applicable requirements. Related-Party Procedures The new rules impact related-party transactions and appear to be a reaction to the issues present in some of the SEC s more high-profile corporate-fraud actions. Companies should review their related-party policies, as well as their director and officer questionnaires, to determine whether they meet the criteria set forth in the new rules. As part of this review, companies should ensure that these policies are being monitored and enforced. Stock-Option Grants The processes and procedures related to the issuance of stock-option grants should be immediately reviewed. It is likely that some review has already taken place given the regulatory attention in this area. However, a more thorough analysis should be done taking into consideration the new disclosure obligations. It may be that practices that pass legal muster do not always have the appearance of propriety or send a favorable message about the company s governance practices when fully exposed to investor scrutiny. * Richard Wood is a partner at the law firm Kirkpatrick & Lockhart Nicholson Graham LLP. Mr. Wood focuses his practice on executive compensation, including the corporate governance, tax, ERISA and federal securities law aspects of executive compensation programs. He can be reached at rwood@klng.com. Michael J. Missal is a partner at the law firm of Kirkpatrick & Lockhart Nicholson Graham LLP and is the practice area leader of the firm s regulatory practice. He was formerly a senior counsel in the Securities and Exchange Commission s Division of Enforcement and focuses his practice at K&LNG on securities enforcement matters and internal investigations. He can be contacted at mmissal@klng.com. 2006 West, a Thomson business. 5