What drove the SEC to overhaul its rules to make compensation disclosure more complete and transparent was investors’ perception that management and shareholder interests were not aligned with respect to executive compensation, and that disclosure under the old rules was frequently incomplete or not clear. The first examples of disclosure under the new rules were included in registration and proxy statements filed in late 2006 and early 2007. Despite the new rules’ mandate that disclosure be "clear, concise and understandable," some observers believed the proxy statement disclosures during the first year under the new rules were anything but straightforward. In general, the disclosures included a greater quantity of information than previously, but observers criticized the complexity and length of the disclosures. Others, includingSEC Chairman Christopher Cox, have argued that the average investor is unlikely to have the motivation or ability to wade through long, jargon-filled disclosures.
In August and September of 2007, the SEC provided comment letters to 350 of the largest companies following a review of their disclosures under the new rules. On October 9, 2007, the SEC also released a report synthesizing its comment letters and outlining the principal areas of disclosure that it believes require improvement.
The SEC’s comment letters and report indicate areas of disclosure on which the agency is focused. They should guide companies as they prepare for the upcoming 2008 proxy statement season. The primary areas of SEC comment were:
Compensation discussion and analysis. The analysis calls for a comprehensive discussion of the key factors underlying compensation policies and decisions relating to a company’s top executives. The compensation and disclosure analysis should, while including specific required elements, put the compensation that is disclosed in the rest of the proxy statement into context, be written in plain English and avoid "boilerplate." In its comment letter and report, the SEC focused primarily on the compensation and disclosure analysis, indicating that companies generally needed to improve both the substance of the disclosure and manner of presentation. With respect to substance, the SEC indicated that the analysis must be focused on "how" and "why" companies arrived at specific decisions and policies regarding executive compensation and not merely on description of processes and amounts.
Manner of presentation. One of the SEC’s goals for the new rules was for proxy statements to offer information to investors in a form that is easy to understand. The SEC encouraged companies to include executive summaries, tables, charts and bullet-point disclosures to aid the reader’s understanding. The SEC also reiterated the importance of plain-English principles and urged companies to replace boilerplate and complex, technical language with more specific analysis presented in a simple way.
Performance targets. The new rules require companies to disclose corporate and individual performance targets if the targets are a material element of the company’s compensation policies and decisions, unless disclosure would result in competitive harm. The SEC found that disclosure in this area was particularly lacking, and issued more comments on performance targets than any other disclosure topic. Where performance targets appeared material but were not disclosed, the SEC asked companies to include the targets or demonstrate that disclosure of the targets could cause competitive harm. Where companies omitted targets on the basis that including them would cause competitive harm, the SEC frequently asked for more specific disclosure of the difficulty or likelihood of attaining target-level performance.
Benchmarking. For companies that disclose that they have used compensation information from other companies to determine their own compensation levels, the SEC requires that companies identify the benchmark and, if applicable, its components. The SEC asked companies to include a more detailed explanation of how they used comparative compensation information and how that comparison affected compensation decisions. For instance, companies should disclose which other companies were used for benchmarking and why they were selected.
How the new rules have affected compensation practices
Some companies are changing their executive compensation practices because of the new disclosure requirements. Common areas of change include:
Redesigning perquisite programs. The new rules highlight perquisites and personal benefits offered to executives by requiring identification and quantification of more perquisites than previously had been the case. As a result, some companies have re-examined the perquisites they offer and have sought to eliminate or modify them to avoid disclosure or to make their programs more acceptable to investors. From a procedural perspective, some companies have also implemented more systematic controls and methods of tracking the aggregate incremental costs of perquisites.
Pay for performance. Companies have long maintained that they pay executives based on performance. Because the new rules increase the visibility of performance targets and bonus formulas, some companies have placed renewed emphasis on ensuring that the amount of compensation paid to executives is linked closely to corporate and individual performance.
Change-in-control and post-termination benefits. In response to the increased visibility under the new rules of payouts to executives following a change of control or termination of employment, some companies have re-examined and modified their change-in-control and post-termination programs. Because changes to these programs have recently been required to comply with the new Section 409A tax rules on deferred compensation, some companies have taken the opportunity to implement other changes.
Outlook for second-year disclosure
Although many companies struggled with the substantial requirements of the new rules in the first year of proxy statements, disclosures should improve in the second year now that processes for providing this information are in place and the SEC has provided further guidance. These rules were the first significant revisions in the area of executive compensation disclosure in more than 10 years and, in the SEC’s own words, represented a "thorough rethinking" of the previous regime. Therefore, gray areas and difficulties in making changes are to be expected. Companies should look to the SEC’s comment letters and report as a guide to improve disclosure in the second year.