Practical Guidance on Executive Compensation Disclosure
By: ELIZABETH M. DUNSHEE
April 2008
The Securities and Exchange Commission (SEC) has released comment letters relating to last year’s executive compensation disclosure, specifically highlighting a need for greater analysis of information. The staff’s observations guide public companies when preparing this year’s proxy statements, especially the Compensation Discussion and Analysis (CD&A).
Presentation Requirements for Executive Compensation Disclosure
In organizing disclosure, the SEC continues to expect plain English and “layered disclosure.” Layered disclosure refers to providing disclosure in layers, allowing the reader to explore varying levels of detail. An executive overview can be useful in setting up layered disclosure, but it is critical that it is truly an “executive overview” rather than an actual summary. Because disclosure should be short, crisp, and clear, companies should present material information more prominently, while de-emphasizing less important information. For example, companies should emphasize in the CD&A how and why they established certain compensation levels, while providing less discussion on compensation program mechanics.
SEC Observations and Comments on the CD&A
Focus on Analysis
The SEC’s primary CD&A comment focused on companies providing more analysis. Companies should discuss how they arrived at the particular levels and forms of compensation for named executive officers and why they pay that compensation, giving investors an analysis of the results of the compensation decisions. Although the value of total compensation should be a key underlying factor in compensation decisions and provides a starting point for analysis, compensation disclosure requires more. Companies should also describe material principles underlying policies and decisions, as well as the most significant factors relevant to such analysis.
The SEC reminded companies that disclosure is required only where material, which means that a company’s decision to discuss each of the example elements in Item 402 of Regulation S-K, or additional elements that are not listed, should be based on whether such elements are important to that company’s executive compensation policies and decisions. The SEC also observed that although the CD&A is required to cover the last fiscal year and actions taken after the last fiscal year, situations arise when disclosure of the prior year, current year, or other years should also be included, for example, in the case of a multiyear compensation plan, targets that varied materially from year to year, or when achievement in prior years affects the current year.
Disclosure of “Material Information” That Affects Executive Compensation
Item 402 provides a non-exhaustive list of information that may be material to executive compensation. As noted, companies should omit or de-emphasize discussions of immaterial elements. The SEC staff and other experts have provided observations relating to a few of the items on this list:
Philosophies and decision-making processes. The SEC reminded companies to focus on substance rather than mechanics. Each company should include a discussion of how it analyzed information and why the analysis resulted in the numbers presented in the tabular disclosure. When drafting this discussion, a company should consider its business strategy as disclosed in the Management Discussion and Analysis (MD&A). Providing a complete picture of who is involved in the decision-making process (which is also relevant to corporate governance disclosure) is also critical. If a consultant is involved, consider whether to disclose the consultant’s role in determining the amount and form of compensation, the scope of the consultant’s assignment, including a description of other business performed for the company, and the compensation committee’s assessment of the consultant’s independence.
Compensation components. Companies should discuss how the amounts paid or awarded under each element may have affected other elements and how total compensation delivered from all the elements affected decisions regarding amounts paid or awarded. Tally sheets assist in tracking the amounts awarded under each element of compensation, each executive’s total compensation, and each executive’s accumulated wealth. A compensation committee’s awareness of this information facilitates both decision-making and disclosure. If a company discloses its use of tally sheet information, it should explain the tally sheet information content and how it affected the compensation committee’s decision on compensation awards.
Benchmarks. Companies should explain how they use comparative compensation information, how the comparison affects compensation decisions, and whether the company retains discretion on how to use comparative information, for example, whether it is benchmarking to a different point or range or not benchmarking at all. If there’s discretion, disclose the nature and extent of the discretion and whether or how the company exercised the discretion. Finally, a company should identify specific companies to which it is comparing itself and the compensation components used in the comparison. It should explain specifically where its compensation falls within the range when vague or broad ranges of data are used.
Differences in compensation policies and decisions among executive officers. Disclosure of policies or decisions for different officers may be grouped together only if the policies or decisions are materially similar. If this applies, a company should explain the differences in amounts awarded to each of the named executive officers.
Change-in-control arrangements. Companies should disclose why they structure the material terms and payment provisions in change-in-control and termination arrangements as they do, and discuss how potential payments and benefits under these arrangements may have influenced decisions regarding other compensation elements. Again, tally sheets may be helpful, because accumulated wealth amounts may affect decisions regarding termination arrangements. Even if they do not, it is useful to show that the compensation committee was aware of the amounts.
For clarity, companies should consider using tabular disclosure with total potential payments for each named executive officer under each different triggering scenario. If implemented, such a table should include total amounts that the company would be required to pay, including gross-ups and all other taxes payable by the company. During the drafting process, if the company discovers that its disclosure about termination and change-in-control arrangements is long and complex, the compensation committee should reevaluate the provisions and consider whether to simplify them.
Performance targets. The SEC staff placed particular emphasis on this element during its review. Companies should disclose how they use targets and analyze qualitative individual performance to set compensation and make decisions and whether specific individual performance goals play a role in the analysis. If a company presents a non-GAAP financial figure as a performance target, it should disclose how it would calculate that figure. Finally, if target results for compensation purposes are inconsistent with routine guidance about results, a company should draft clearly to avoid investor confusion.
Like other elements of executive compensation, the staff noted that disclosure of performance targets is only required where material. If the company uses performance targets, however, and does not disclose them, it should state why it is not providing such information. An assessment of the facts and circumstances related to the plan’s design and operation is required to determine disclosure.
For example, specific performance targets may not be material to Matrix Plans in all circumstances. Matrix plans are typically designed to include the following:
- A range of performance points, for example, a range of earnings and return on equity numbers, at which the targeted payout amount would be paid, and
- A smooth schedule of payment amounts for the degree of performance.
Disclosure of the specific targets envisioned by the compensation committee when designing the plan would not necessarily aid investors’ understanding of the degree of difficulty in attaining that payout level. If disclosure of performance targets is not material, consider disclosing this information:
- The matrix of payouts,
- The target bonus payout amount (for example, 120 percent of base salary),
- The actual bonus payout amount, and
- A historical presentation of performance trends.
Some situations exist in which disclosure of performance targets in a Matrix Plan may be necessary:
- When the likelihood of particular performance outcomes is significantly greater than the likelihood of other performance outcomes,
- When the compensation committee focused on particular outcomes, rather than using them merely as a starting point, and
- When business factors exist that motivated the compensation committee to construct formulas to result in a payout curve that is steep or flat at particular points.
- Regardless of the type of performance plan, disclosure should provide investors with sufficient information to assess the degree of difficulty inherent in the plan.
SEC Tips for Preparing the CD&A
To draft the CD&A effectively, John White of the SEC’s Division of Corporate Finance suggests that every key participant —including compensation committee chair and representatives from accounting, human resources, compensation consultants, and management—annually submit one page reflecting the material hows and whys of his or her decisions. These submissions may include the compensation committee’s key analytic tools, findings that emerged from the analysis, and resulting actions that affected executive compensation in the last year. Mr. White also suggests that companies consider having media personnel review the draft disclosure to spot ambiguity and disclosures that would generate attention, or to perhaps simplify the language. Finally, to facilitate the drafting process in the future, compensation committees should consider meeting with company counsel to discuss the background and rationale behind the SEC’s compensation disclosure requirements. This would serve to enhance the committee’s understanding for future decision-making and equip it to create a better record.
If you need assistance with preparing the CD&A portion of your company’s proxy statement, please call Liz Dunshee or any other member of the Fredrikson & Byron Securities Practice Group at 612.492.7000.
Takeaway
The SEC’s primary CD&A comment focused on companies providing more analysis, and the SEC reminded companies to focus on substance rather than mechanics.