Deep Throat famously told Bob Woodward and Carl Bernstein to “follow the money.”

Twenty thousand people agree, at least when it comes to compensating high-level executives. That is the (record) number of comments received by the Securities and Exchange Commission prior to its promulgation of massive revisions for executive compensation disclosure.

Under the new rules, it will be easier to “follow the money,” because registrants are now required to deliver a detailed road map.

In-house counsel will receive copious analyses, and invitations to live and web seminars, explaining the new rules.

My goal here is a simplified overview: What happened? When do I have to worry about it? What do I do next?

SEC action

On Aug. 11, the SEC issued revised and expanded compensation disclosure rules, and asked for further comment on certain proposals. Persons charged with detailed preparation of disclosure will need to carefully study the final release (www.sec.gov/rules/final/2006/33-8732.pdf), and many important details are omitted in this article, but listing the new disclosure scheme is simple – long, but simple.

The highlights are noted below.

Coverage: The new rules cover the principal executive officer, principal financial officer, and three other highest paid executives.

CDA: A new Compensation Discussion and Analysis requires the company to describe, in the 10-K, the principles of compensation – what is important and how is it measured.

Compensation Committee Report: The committee must disclose whether it has discussed the CDA with management and recommended its inclusion in the 10-K.
Performance Graph: Reversing its position, the SEC has retained the graph comparing registrant’s performance to its peers, moving it into the annual report.

Seven Detailed Tables: The new rules require tables on the following: (1) A three-year summary compensation table, including a calculation of total compensation, for the five identified executives; (2) grants of plan-based awards, including non-equity grants; (3) outstanding equity awards at year-end, on a disaggregated (grant-by-grant) basis; (4) options exercised and stock vested tables showing profits realized; (5) pension benefits table, showing accumulated benefits; (6) non-qualified deferred compensation table, showing all earnings; and (7) one-year director compensation table.

Phasing: Although the total compensation table will cover three years, past years may be omitted if reported under the old rules, granting a de facto three-year phase-in for previously reporting registrants.

Stock Option Details: Not surprisingly, given current backdating and related issues, registrants must disclose whether there is a practice of coordinating grants with the release of information; whether the same approach is used for non-executive grants; who called the shots (management or board); how the exercise price was fixed (on July 28, the PCAOB issued a CPA alert concerning option accounting, putting an audit ratchet into the regulatory scheme.)

Perks: The disclosure trigger has dropped from $50,000 to $10,000. The SEC also provided guidance in defining a perquisite.

Revised related party transaction disclosure: While doubling the disclosure trigger to $120,000, the rules call for disclosure of the review policies for self-dealing transactions.

Director Independence Reporting: This reporting requirement is enhanced, and must be disclosed in relationship to SEC and Exchange requirements.

8-K: The reporting scheme is amended as it relates to named executive officers, no longer requiring reports of immaterial transactions.

Plain English: This applies most everywhere.

Effective dates

The rules apply generally to 10-Ks, proxies and ’33 Act registrations filed on or after Dec. 15, 2006, for fiscal years ending on or after that date. Be sure to confirm because there are numerous details.

Registrants can avoid disclosing specific performance targets used to fix executive compensation if disclosure would cause competitive harm. Staff comments suggest the SEC will be stringent in insisting upon proof of injury.

The SEC asked for further comment upon a re-written “Katie Couric” rule, designed to elicit compensation information for up to three highly paid employees who earned more than any of the named executives (the formal request for comments was not posted until early September at www.sec.gov/rules/proposed/2006/33-8735.pdf). The rule would apply only to larger accelerated filers (over $700 million of market capitalization), and would not apply if the recipient had no policy role (thus excluding famous figureheads used in marketing). The SEC also asked whether to require disclosure of the recipients’ names.

Next steps

If counsel is responsible for drafting actual disclosure, it is vital to review the adopting release and new rules now. There is much to learn, and since all year-end registrants file on the same timetable, counsel can’t wait to see what others have done.

Counsel in a supervisory role should take immediate action on numerous fronts. Weil Gotshal & Manges had an excellent briefing on this (Aug. 1, “Weil Briefing”), and I base the following checklist on it.

Foremost, you need to communicate with management, your board, and your compensation committee and educate them on what is required. Their tasks are different and more extensive. Notably, the compensation committee will need to attack two major areas: Articulating the principles driving executive compensation, and making uniform the method, timing and pricing of option grants.

Immediately address disclosure controls, for two reasons. First, accelerated 8-K filing requirements are effective in October, not at year end. Second, the CDA will be deemed filed rather than “furnished,” becoming a liability document covered by CEO and CFO certifications under SOX 302 and 906.

Because the CDA and other materials are “filed,” SOX 404 mechanisms, relating to internal control over financial reporting, will need revision.

You should revise D&O questionnaires for preparing your 10-K.

And you should re-analyze the definition of “non-employee director” under SEC Rule 16b-3, to ensure that non-employee directors retain their status in light of changes to the “related person” definitions (thereby exempting options from 16b short-term trading penalties).

It’s important to confirm the identity of your three most highly paid executive officers under Internal Revenue Code 162(m) (deductibility of compensation issues). Calculating compensation to identify executive officers is different from calculating disclosable compensation in the “summary compensation table.”

You need to review related party transactions in light of revised self-dealing and director independence requirements.

Also, check company procedures and codes of ethics relating to approval of related party transactions.

Generate retirement compensation tables, showing payments under various termination and change in control scenarios.

Review the compensation committee’s charter, to addresses all new requirements including generating the CDA and the compensation committee report.

Finally, adjust corporate timetable for compensation and option decisions, gathering information and preparing disclosure documents. For many companies, the SEC estimate of “170 additional hours to prepare the amended [10-K] disclosure in year one” seems optimistic, as the disclosure rules affect the compensation committee, the audit committee, persons preparing the disclosure documents, and time needed for the board’s pre-filing review.

Larger questions to consider

Will these new disclosures assist investors? They are only disclosures, not substantive controls. Is it naïve for the SEC to expect that heightened disclosure, coupled with upgraded “filed” status, will help?

The post-SOX business environment (not disclosure rules) may alter management sensibilities. Enhanced disclosure may prove more a symptom of a moderated compensation mentality, rather than its causative element.

Stephen M. Honig is a member of Duane Morris’ corporate department in the firm’s Boston office. You can reach him at [email protected].