Executive Compensation to Take
Center Stage

by Robert Walter, JD
Pursuit, October 2006

The Security Exchange Commission's (SEC's) forthcoming final rules on executive compensation portend wholesale changes in compensation disclosure practices. This is a "hot" enforcement topic at the SEC and the Department of Justice, and regulatory and media scrutiny of executive pay and benefits promises to reach new heights in 2007 and beyond. The review and preparation of compensation-related disclosure in business and industry, or in consulting and public practice, will assume a new importance in financial reporting, compliance, and governance activities.

Proposed Rules on Executive Compensation
The SEC proposed the new rules on Jan. 27, 2006 in Release No. 33-8655. This 350-page release covers four main categories: comprehensive information on executive and director compensation, related-party transactions, corporate governance, and revisions to Form 8-K. An SEC commissioner recently stated that adoption of final rules imminent. Because reporting changes are extensive and expected before next year's annual report season, public companies should prepare now to implement appropriate procedures, systems, and reporting regimes. Here is an overview of some of the disclosure requirements.

Organizations will have to disclose total compensation for the CEO, CFO and the three other of the highest compensated executive officers, known as named executive officers (NEOs). Total compensation includes salary and bonus, the present value of stock options granted in the year, increases in pension plan balances, and deferred compensation that is not tax-qualified. Additionally, the compensation paid to three most highly compensated non-executive employees also must be disclosed if those persons are paid more than any of the NEOs.

• Organizations must include a new section titled "Compensation Discussion and Analysis" (CD&A) in their annual meeting proxy statement. A compensation committee report and stock performance graph are no longer adequate. According to the SEC, this new section is to be a management discussion and analysis equivalent pertaining to compensation.
  
• This section will be considered "filed" with the SEC if the CD&A is included in a periodic report and carries disclosure liability under the Federal securities laws.
  
• This section will be subject to Sarbanes-Oxley certification requirements.
  
• This section must clearly communicate the objectives and goals of executive compensation.

Perks Under Greater Scrutiny
Disclosures pertaining to perquisites, or "perks," will increase dramatically due to a lowering of the materiality threshold to $10,000. Perks received will be disclosed in footnotes and must be specifically called out if the perk is valued at $25,000 or 10 percent of an officer's total perks, whichever is greater. New tables on stock, option, retirement, and defined contribution compensation, are also required, as well as severance payment disclosure and information about NEO pledge of stock as loan collateral. Finally, transactions with related parties will now carry a materiality threshold of $120,000 rather than $60,000 - one of the few instances in which the new rules call for less, rather than more, disclosure.

New Rules for Directors and Consultants
Disclosure of the compensation committee's processes for setting executive and director compensation will be expanded, and will be similar to that required for audit and nominating committees. There will also be new disclosure concerning the role of compensation consultants in determining or recommending the amount or form of executive and director compensation. This includes whether the committee retained the consultants directly, the nature and scope of the consultants' assignment, material instructions or directions given to consultants, and any executive officer the consultants contacted in performing their duties. New Item 407 of Regulation S-K mandates disclosure of the independence of each director or director nominee, relationships not otherwise disclosed that were considered by the board when making the independence determination, and the identity of nonindependent members of the audit, nominating, and compensation committees.

Although the final rules will differ from what the SEC initially proposed, it is certain these rules will substantially change disclosures. Those who are employed by or engaged as consultants to public companies must have a solid understanding of these new rules. This expertise will enable practitioners to assist clients and ensure compliance with the letter and the spirit of the new rules.