On Oct. 9, 2007, Securities and Exchange Commission (SEC) staff released additional guidance on Compensation Disclosure & Analysis (CD&A) disclosures that will affect many public companies as they prepare 2008 annual reports and proxy statements. We want to remind those affected by the guidance that the SEC expects registrants to incorporate it in 2008.
All companies that have a class of securities registered under Securities Exchange Act Section 12, or that are required to file reports under Exchange Act Section 15(d), are affected. We remind you to be certain that CD&A disclosures in your annual report and proxy include better analysis, are written in “plain English” and meet the SEC staff’s disclosure standards for performance targets, benchmarks and change-in-control agreements.
We recommend that you review the SEC’s Oct. 9, 2007 guidance (available at http://www.sec.gov/divisions/corpfin/guidance/execcompdisclosure.htm) as well as Item 402(b) of Regulation S-K well in advance of this year’s deadlines for filing your annual report and distributing your proxy statement.
The CD&A requirement has been the focus of much discussion since it was implemented in late 2006. The SEC has recently released summaries and observations on that commentary and made it clear that it “will expect registrants to have taken our guidance to heart.” Given that focus by the SEC staff, CD&A will be a significant issue for many public companies in 2008.
Two central themes
The SEC is now looking for CD&A that provides “more direct, specific, clear and understandable disclosure.” This will include: more focus on the analysis aspect of CD&A, and discussions that are more organized, clear, and conveyed in “plain English.”
Better analysis: Registrants should focus more closely on the how and why of compensation policies and on specific compensation decisions, rather than limiting the discussion to compensation program mechanics. In general, when analyzing a compensation policy or decision, best practices include:
- Discussing the policy or philosophy the registrant or the compensation committee is implementing, and why
- Showing what steps have been taken in determining how to implement the policy or philosophy, including research, evaluation and analysis of results
- Discussing which decisions were based on the research, evaluation, and analysis; including how and why those decision were reached
- Describing how the company has implemented the above policies
- Showing how the individual components of an executive's compensation package relate to the other components and the relative amounts derived from these various components
Plain English: Registrants should apply the SEC’s “plain English” standards, as already required by Exchange Act Rules 13a-20 and 15d-30 in their CD&A as well. The SEC’s “A Plain English Handbook” can be found on its website by typing “plain English handbook” into the search box.
The transfer restriction applies both to the option and (until the option is exercised) shares issuable upon exercise of the option.
Clear CD&A: best practices
Best practices for a clear CD&A include:
- Layered disclosure, with tables and charts for complex information
- Shorter and more concise statements of what really matters in the CD&A, the how and why
- Eliminating boilerplate discussion of performance and focusing, instead, on analysis
- Replacing disclosures that simply repeat information from the required compensation tables and, instead, provide analysis of such information
- Deleting discussions of technical language from a compensation plan or employment agreement, and including “plain English” discussions of the material provisions
- Drafting to the layperson, not the registrant's executive, analysts, or legal counsel
Specific disclosure areas
In addition to the general themes discussed in the SEC staff's observations, the release also discussed specific areas of the reports reviewed. These areas included performance targets, benchmarks and change-in-control arrangements. For each of these areas, the SEC staff suggested several disclosures it expects for the upcoming proxy and 10-K seasons.
Performance targets: Registrants should disclose performance targets if material to the decision-making process unless competitive harm would result.1 The SEC staff noted that few registrants disclosed how they analyzed individual performance and how they used performance targets to set compensation. During the first year of implementation of CD&A, the staff used the comment process to require several registrants to clearly specify the way an executive's performance is “translated into objective pay determinations.” In other words, for a specific executive position, what aspects of performance would have the effect of increasing or decreasing discretionary compensation?
Best practices for performance target discussions include:
- Discussing particular performance targets and how those targets relate to executives' performance
- Clearly describing how specific performance translates into compensation
- Discussing how difficult it will be for the executive to reach the performance target (as required by Instruction 4 of Item 402(b) of Regulation S-K)
- Where non-GAAP financial information is used as a performance target, disclosing how the target is calculated (as required by Instruction 5 of Item 402(b) of Regulation S-K)
- Where necessary to give context, discussing particular performance targets in previous years
Benchmarks: The SEC staff observed that many registrants use benchmarking when making compensation decisions. Many of the reviewed reports, however, were deficient in discussing how the benchmarks were actually used in arriving at compensation decisions.
Best practices for benchmark discussions include:
- Discussing why benchmarking is used
- Discussing how benchmarks affect compensation decisions
- Identifying the peers used to establish benchmarks and discussing why these particular companies were selected
- Discussing which of the peers' compensation components were used
- If the compensation committee retains discretion after benchmarking, discussing the nature and extent of that discretion and whether and how it was exercised
Change-in-control: The SEC staff noted that a significant number of registrants could improve their CD&A by discussing and analyzing change-in-control and termination arrangements more thoroughly. For example, many registrants failed to discuss why they used a particular structure for such arrangements or how the arrangement influenced the overall compensation decision for the executive.
Best practices for change-in-control or termination arrangements include:
- Discussing why the registrant included particular change-in-control or termination provisions, including impacts on executives' overall wealth accumulation and whether the provisions are necessary to protect the executive
- Discussing how change-in-control or termination provisions relate to the executives' overall compensation and how those provisions influenced the other elements of the package
- Discussing the potential costs of the arrangements to the registrant
As you draft your CD&A this season, you should pay close attention to the analysis component of CD&A, following the Exchange Act's “plain English” rules and treating the report as a discussion of each aspect of compensation, including the intent behind that aspect, the amounts paid, and the manner and basis for determining both the element of compensation and the amount paid with respect to that particular element.
1 Note that reliance on the “competitive harm” disclosure would require the same analysis that would be required for confidential treatment of other competitive business data.