Under the microscope

Sweeping executive compensation disclosure rules that go into effect Nov. 7 will put the pay of high-level officers and directors under the microscope for the public to see.
The new regulations will force public companies to disclose valuation and tabulation of all aspects of executive compensation – including stock and option grants, pension contributions, deferred compensation, and all perquisites over $10,000.

The rules, issued by the Securities and Exchange Commission, also require a narrative “compensation discussion and analysis” explaining to shareholders the reasoning and justification for every payment or benefit.

SEC Chairman Christopher Cox said the rules are simply intended “to help investors keep an eye on how much of their money is being paid to top executives who work for them.”

But lawyers advising companies expressed some concerns.

“These rules are the biggest employment boon for compensation consultants since ERISA,” said Brinkley Dickerson of Atlanta-based Troutman Sanders. “There aren’t enough actuaries and analysts to do all the work required, so you better line up your professionals for year-end [reporting] now.”

Some lawyers said the compensation analyses will also require legal professionals, directors and committee members to put in more than the 170 man-hours of additional work predicted by the SEC.

“Directors will have expanded burdens. They’ll have to devote more time to meetings and committee work because of the attention to process and transcription in the rules,” said Josef B. Volman of Boston-based Burns & Levinson.

The rules have many in-house lawyers calling for help already. “There is a lot of angst among those preparing proxies now [for shareholder votes] and we are already going through dress rehearsals using 2005 data,” said Robert M. LaRose of Thompson Coburn in St. Louis. He added that outside costs for leanly staffed small and mid-cap companies – as with Sarbanes – will be far more significant as a percent of revenue.

Brad B. Arbuckle of Michigan’s Miller Canfield suggested the mandate for “more complete, clear and transparent information” would have positive and negative effects. “There will be more time investment and media scrutiny initially, but better gauging of competitive compensation ultimately,” he said.

But Arbuckle said heavy Rule 10b penalties (for transactional fraud) could increase exposures associated with executive compensation disclosures because they are now “deemed” as soliciting materials pertinent to purchasing shareholders.
Herbert F. Kozlov, who has handled both trials and transactions for Reed Smith’s New York City office, agreed.

“Every time there is an important new rule,” Kozlov observed, “it seems plaintiffs’ lawyers have paid close attention and developed another cause of action.”

Kozlov said he is already providing “training assistance” on compliance with the new rules.

Experts said the rules also broaden disclosures regarding “related-party transactions” with management insiders, the independence of compensation committees, and real-time reports of “material changes” in compensation.

One expert called the rules a “mini-Sarbanes” for executive compensation that will make fodder for a variety of shareholder suits.

As a result, Donald A. Glazier of New York-based Integro Insurance Brokers said “now is the time to look at your D&O policies and other coverages.” (See sidebar “Insurance check-up in order” below.)

Compensation disclosures

Dickerson said the reforms “are not Enron driven, for a change, but rather they fill the cracks on what’s not getting reported.” He said the SEC was targeting a growing slice of executive compensation related to pre-negotiated severance agreements, retirement plans, deferred compensation and perquisites.

In fact, the rules mandate seven disclosure tables to cover every conceivable payment or benefit – including non-wage items like executive insurance policies and payments for tax gross-ups. The reforms also require companies to quantify the value of future earnings sources, such as options and various forms of deferred compensation.

Lawyers also called attention to the narrative compensation analysis now required by rule. “This will take a lot of lawyer time, and will probably take as much committee time as the management discussion and analysis [providing overview of the company] for shareholders,” said LaRose of St. Louis.

Dickerson of Atlanta said the required narrative could offend some companies because “it smacks of social engineering,” noting the particular hardships for small clients in providing answers to 15 specific questions on the rationale for pay and benefits.

Kozlov countered that the marketplace will reward companies for making sound decisions in a transparent manner.

Kozlov warned companies to avoid vague boilerplate descriptions, because the “plain English rules” now apply to an area in which “the SEC expects a lot of detail and thought.”

Companies, according to Kozlov, will now have to spend significant time providing rationales for each element of pay, descriptions of the comp committee’s principles and procedures for decision making, as well as disclosure of the relative roles of consultants, executives and others in the process.

Companies will also need to spend a lot of time doing present-value analyses on complex pay packages.

Arbuckle offered: “The HR consultants and financial types will have a field day with this.”

He added: “You have to get your compensation information done earlier now to vet it through the internal control procedures of Sarbanes” because the compensation reports now constitute filed statements of the company. “The [narrative] analysis could get a little awkward since compensation is now covered by CEO and CFO certification and those officers will want to check the comp committee’s work.”

“The old way was to provide the lightest possible descriptions of compensation, but the new rules require much more disclosure,” Arbuckle explained.

Dickerson said one of the difficult tasks will involve identifying and valuing all relevant perqs. “It’s tough to know if a secretary spends 30 or 40 percent of their time on personal matters for an executive,” he remarked.

The SEC has clarified some perquisite definitions, he noted, but in-house counsel must take into account state laws on use of corporate assets when thoroughly describing all perqs in a public document. (See sidebar “Identifying Perquisites” below.)

The rules also call for disclosures on option dating practices – requiring some explanation for any exercise price dated other than the day of granting, he noted.
Lawyers also flagged disclosures required about “restricted” stock given to promoters for taking a company public, and they pointed to significant details required for disclosure of post-employment compensation agreements. Even the material non-monetary terms of the post-employment contract will now be on display.

Another possible concern for small companies relates to disclosure for the highest paid non-executives. While such requirements are lesser for small companies, they more jealously guard their contractual arrangements with top salesmen or other specialists for good reason. “The elements of compensation paid to an employee at a smaller company may fairly be considered competitive information in many circumstances,” said Volman.

Boards and committees

Experts agreed the rules will mean more work for boards and committees and some sticky wickets for those who advise them.

“It used to be that board members went into executive session for compensation decisions and few minutes were taken, but now you will need to describe the decision-making process in some detail,” said LaRose. Involvement of outside counsel may be desirable, he said, if an in-house lawyer is a subject of review or is concerned about interjection between the comp committee and the executives.

Volman predicted smaller companies will find it harder than ever to procure experienced board members because of increased time demands, and rules in a growing number of organizations that require exclusive service to and focus on one board.

Dickerson agreed.

“These rules will impose added demands on directors who are already working harder than ever before,” he said. “Directors are burned out on all day meetings and they are becoming annoyed.”

He cautioned smaller companies in particular to “watch out for churn-and-burn schemes being pushed as necessities by consultants.” By way of example, he recalled one consultant seeking $25,000 from a client just to study what directors should be paid. With the help of some investment banking connections, Dickerson simply tallied the compensation packages for directors at comparable companies to come up with a functional, though less elaborate answer.

“Small companies should [also] ask whether they need to run up costs with overpaid advisors, or can they simply state they based their decisions on the judgment of a wise group of directors who took all of the factors into account,” Dickerson suggested.
But Kozlov cautioned that while “small company shareholders are likely to accept the decision of 12 wise men, the SEC might ask if that is compliance.”

Heightened scrutiny

Companies must get ready for scrutiny from the media, regulators, shareholders, watchdog groups and even executives.

“There will be a high level of scrutiny on these disclosures with more shareholder watchdog groups who hold tighter views of appropriate executive compensation,” said Volman. “The media will undoubtedly focus on any companies outside the normal spectrum.”

LaRose said executives often don’t bother to add up their benefits, but the average shareholder can do it easily now by going to the total compensation column of the summary table. “Nobody has to do the math or the research now, and this plays right into the hands of shareholder activists and plaintiffs’ lawyers,” he said.

Some experts speculated the disclosures will be used in shareholder derivative suits to recover money allegedly overpaid or corporate assets misused, and others predicted that Rule 10b actions will result from any failures to disclose material information about management compensation.

But LaRose also predicted some positive consequences resulting from increased transparency and clarity. “Misunderstandings by the media happen all the time and this should reduce the [instances] of getting it wrong,” he said.

Kozlov said disclosures may help directors in proving that they discharged their duty of care. “The duty of care is the duty to be well-informed, and now it will be easier to get the information you need [about competitive compensation],” he asserted.

He also predicted one unintended consequence: “It will be easier for CEOs to argue they are under-compensated because their competitors are paid more elsewhere.”

Governance disclosures

The reforms will affect corporate governance to some extent as well.

“These rules require disclosures that drill down into independence,” Kozlov said, noting they will require disclosures about nominating or audit committee members who don’t meet applicable legal tests for “independence.”

Corporate transactions with parties who are related to management or major shareholders also get some increased scrutiny.

“The policies for review and approval of ‘related transactions’ must be disclosed and that is new and different,” said Arbuckle. “The people in internal controls will be more concerned about brother-in-law deals, and how it might play in print.”

Arbuckle also said the “related party” rules will require more “materiality analysis” because they require disclosure of any transaction of at least $120,000 in which a “related person has a material interest.” There is no bright-line test for materiality, but the disclosure of $10,000 in perqs may provide some clue of the SEC’s view, he said.

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Insurance check-up in order

Now is a good time to do a risk management and insurance checkup related to executive and director performance, according to Donald A. Glazier, an attorney and principal with New York-based Integro Insurance Brokers.

“When these new [executive comp disclosure] rules go into effect, look out for a revitalized industry in plaintiffs’ shareholder derivative suits,” said the veteran risk analyst.

Glazier said shareholder watchdog groups and institutional investors played a major role in producing a record number of more than 20,000 public comments on the recent reforms.

“They are looking at these rules very closely,” he warned.

“Senior management, comp committee members, directors and consultants are all potentially subject to scrutiny under the new rules,” he said. “If you are relying on the judgment of any of them you may want to check that all of them are adequately insured.”

Glazier also suggested in-house counsel “should be aware of provisions in D&O [director and officer] policies that provide exclusions [from coverage] for illegal remuneration.” He added that plaintiffs will likely be examining new disclosures to see if state laws regarding abuse of assets or improper remuneration are triggered.

“This is a good time to check if your limits are adequate,” he suggested, adding that sound coverage is a function of many variables, including peer analysis, the likely cost of getting out of a shareholder suit, and other considerations.

“People should also be aware that a D&O insurance application incorporates by reference all SEC filings,” said Glazier, who noted executive compensation disclosures are now deemed as filings under the new rules. “Carriers are often looking for a way out on large insurance claims, so it is especially important to dot your I’s and cross your T’s on disclosures now.”

Glazier also raised the specter of plaintiffs’ lawyers in future years looking at a history of narrative analyses for inconsistency. Thus, company rationales provided for awarding compensation should not shift with the winds of company fortunes in a way that could look self-serving for executives in hindsight.

Disclosures of D&O premiums may even be an issue under the new perquisite rules. “The A-side coverage of a policy is for non-indemnifiable matters, and that aspect of coverage certainly could be viewed as conferring some personal benefit,” he said.

Glazier added that at least one public comment submitted to the SEC even argued that premiums assessed on a company may have some bearing on the quality of management, and warned that plaintiffs may look at premiums as risk indicators as well.
“But premiums,” according to Glazier, “do not necessarily reflect the underwriters’ judgment of risk.” Market factors and other variables play a role in premiums too, he explained.

The risk expert also advised in-house lawyers to consider the need for “employed lawyers” policies because D&O insurance will cover them only for their performance as executive officers and not for their legal practice while wearing a lawyer hat.

“One thing is for sure,” said Glazier. “Counsel will need an extra set of kid gloves for dealing with [compensation] issues that affect both shareholders and senior management.”

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Identifying Perquisites

The Security and Exchange Commission’s executive compensation disclosure reforms have substantially lowered the minimum thresholds for reporting perquisites. The new rules do, however, provide some additional guidance on the definition of a “perquisite.”

According to the agency, “an item is not a perquisite if it is integrally and directly related to the performance of an executive’s duties,” but is a perq if it provides “a direct or indirect benefit that has a personal aspect, without regard to whether it may be provided for some business reason… unless it is generally available on a non-discriminatory basis to all employees.”

Furthermore, the concept of a benefit that is not a perq by virtue of being “integrally and directly related” to job performance is a narrow one.

The SEC has suggested that special office space or reserved parking spaces may qualify, but perquisite exemption “does not extend to items that [merely] facilitate job performance, such as use of company aircraft, yachts… or additional clerical or secretarial services devoted to personal matters.”

Whether a company should pay for an expense is a function of state law regarding use of corporate assets, but perquisite disclosure requirements are now triggered by different and broader concepts.

With that in mind, Brinkley Dickerson of Atlanta-based Troutman Sanders has conducted an exam of 200 recent proxy statements to identify various types of perqs that companies have reported under prior more lenient rules.

The list that Dickerson created does not likely include the widest possible range of smaller perquisites, but it is a good “teaser” for counsel trying to identify executive perqs now.

According to Dickerson, the possible perquisites of which counsel should be aware of and should consider for disclosure include: