At an open meeting held on December 16, 2009, the Securities and Exchange Commission ("SEC") approved a set of proposed rules to enhance the information provided to shareholders in company proxy statements regarding a number of risk oversight, compensation, board leadership and composition and other corporate governance matters. The SEC approved the final rules by a 4-to-1 vote, with Commissioner Kathleen Casey dissenting. The SEC released the text of the final rules on the same date they were adopted, with the 129 page adopting release available here.
The new rules have an effective date of February 28, 2010, except that a rule change on how equity awards are reported in the Summary Compensation Table applies to all companies with fiscal years ending after December 20, 2009. Because all of the rule changes other than the equity reporting rule call for enhanced disclosures, companies presumably could, but would not be required to, voluntarily comply with all of the new rules even if they file their definitive proxy statements before February 28, 2010.
The final rules were proposed in July 2009. However, based on the more than 130 comment letters that the SEC received on the proposals, the final rules reflect a number of changes that result in clearer and more precisely defined, but in some cases broader, disclosure standards than what the SEC had initially proposed. Among the more significant changes from the rule proposals are the following:
- Director qualifications. The final rules require disclosure concerning the specific experience, qualifications, attributes or skills of directors and director nominees that led to the conclusion that the person should serve as a director. The proposed rules would have required this disclosure to, in addition, address how these factors related to directors’ service on board committees.
- Compensation Practices and Risk Management. The proposed rules would have required disclosure in the Compensation Discussion and Analysis of any compensation policies and compensation practices applicable to employees (whether or not they are executive officers) if they created risks that "may have a material effect" on the company. The final rule requires disclosure of employee compensation policies and practices that create risks only if they "are reasonably likely to have a material adverse effect on the company." Further, pursuant to the final rule, this disclosure will not be part of the Compensation Discussion and Analysis, but instead will be a new and separate disclosure requirement.
- Diversity Considerations in the Director Nomination Process. In the rule proposals, the SEC asked whether it should amend its rules to require disclosure of additional factors that a nominating committee considers when selecting someone for a position on the board, such as diversity, and whether it should amend the rules to require additional or different disclosure related to board diversity. The rules as adopted require disclosure of whether, and if so how, a nominating committee considers diversity in identifying nominees for directors. Moreover, in what may be a regulatory first for disclosure of the inner workings of a board, if a nominating committee has a policy with regard to consideration of diversity, the rules require disclosure of how the policy is implemented, as well as how the nominating committee assesses the effectiveness of the policy.
- Stock and Option Awards. The proposed rules required reporting of all stock and option awards granted during the fiscal year at the full grant date fair value. The final rule includes an instruction clarifying that the value of performance-based stock and option awards is the value at grant date based on the probable value of these awards at grant (that is, typically the "target" value).
A summary of the new rules is set forth below. This summary is based on information provided at the SEC’s open meeting and an expeditious review of the final rule text, and therefore may not reflect nuances addressed in the adopting release and the text of the final rules.
Compensation Policies and Practices as They Relate to Risk Management
The executive compensation disclosure rules (Item 402 of Regulation S-K) are amended to require that companies discuss and analyze their compensation policies and practices for all employees, not just executive officers, if the compensation policies and practices create risks that are "reasonably likely to have a material adverse effect" on the company. The disclosure will not appear in companies’ Compensation Discussion and Analysis, but instead will be a separate compensation-related disclosure. As proposed, the new rule also includes a list of examples of issues that a company may need to address for the business units or employees when disclosure is required under the new rule. Smaller reporting companies are not subject to this new disclosure requirement.
Other than changing the materiality threshold and the location of the disclosure, the new rule otherwise is substantially the same as what was proposed. However, the SEC staff (the "Staff") indicated that the intent of the rule is to provide information that is most relevant for investors with a focus on compensation policies that could create financial risks. The Staff further noted that, in assessing whether disclosure is required, companies can take into account controls and other elements that may mitigate the probability or potential impact of compensation policies that might otherwise create risks. While these standards assist in focusing on the issues that may trigger disclosure under the new rule, in order to be able to assess whether disclosure is required, it seems likely that many companies will need to undertake a comprehensive compensation risk assessment.
Additional Director and Officer Disclosure
The director and officer biographical disclosure rules (Item 401 of Regulation S-K) are amended to require that companies provide disclosure about:
- The experience, qualifications, attributes and skills of directors and director nominees that led to the conclusion that the person should serve as a director at the time the disclosure is made, in light of the registrant’s business and structure;
- All public company directorships held by directors and director nominees during the past five years (as opposed to just current directorships, as required under the current rules); and
- The involvement of directors, director nominees and executive officers in legal proceedings during the prior ten years (as opposed to five years, as required under the current rules). The list of legal proceedings covered by the rule has also been expanded to include involvement in mail or wire fraud or fraud in connection with any business entity, proceedings based on violations of federal or state securities, commodities, banking or insurance laws and regulations, or any settlement to such actions and disciplinary sanctions or orders imposed by a stock, commodities or derivatives exchange or other self-regulatory organization. Disclosure of settlements of a civil proceeding among private parties is not required.
The required disclosures regarding experience, qualifications, attributes and skills of directors applies to directors who are not standing for re-election but will continue to serve following the annual meeting. Although this disclosure requirement was adopted as part of the rules addressing the business experience of directors, the disclosures presumably will reflect the input and assessment of a board nominating committee, or full board, in reaching a "conclusion" that a person is qualified and appropriate to be nominated or to serve as a director. Thus, we expect that companies may take a variety of approaches in providing this disclosure, with some including it in the directors’ and nominees’ biographical information and others addressing it in a format similar to the current requirement to describe, for each director or nominee, factors that were considered by the board in determining that the director is independent.
Diversity Considerations in the Director Nomination Process
The disclosure requirements applicable to board nominating committees (Item 407(c) of Regulation S-K) are amended to require disclosure of whether, and if so how, a nominating committee considers diversity in identifying nominees for director. If the nominating committee or the board has a policy with regard to the consideration of diversity in identifying director nominees, the rule requires disclosure of how this policy is implemented and how the nominating committee or the board assesses the effectiveness of its policy. The Staff noted that the rules do not define "diversity," so that companies can develop and disclose their own standards and address matters such as diverse business experience.
Board Leadership Structure and Risk Oversight
A new governance disclosure under Item 407 of Regulation S-K and Schedule 14A requires a discussion of:
- A company’s board leadership structure, including whether the company has combined or separated the chief executive officer and chairman position;
- If one person serves as both chief executive officer and chair of the board, whether the company has a lead independent director and the specific role of such director in company leadership; and
- Why the company believes its structure is the most appropriate for the company at the time of the filing.
The Staff emphasized that this rule is aimed at increasing transparency for shareholders and is not intended to influence a company’s decision regarding its board leadership structure. Although the rule does not expressly call for disclosure regarding the role of a lead independent director when a company has a board chair that is not the principle executive officer, even if that board chair is not independent (such as when a former executive serves as board chair), some companies may find it useful to provide disclosure in that context as well.
The new rule also requires disclosure of the extent of the board’s role in the risk oversight of the company, including a description of how the board administers its oversight function, such as through the whole board, a separate risk committee or the audit committee. The effect of the risk oversight function on the board’s leadership structure also is required to be discussed, such as how the risk oversight function is coordinated if different aspects of it rest in different board committees. The Staff clarified that the new rule was aimed at risk oversight, not risk management (in contrast to the wording of the rule as initially proposed), and that the focus is on where within the board the function rests.
Reporting of Voting Results
An item is added to Form 8-K requiring companies to disclose the voting results from shareholder meetings within four business days after the end of the meeting at which the vote was held. This replaces the requirement to disclose voting results in Forms 10-K and 10-Q and will result in more timely disclosure. An instruction is added to the new Item of Form 8-K that if final results are not known within four business days of the meeting, then preliminary voting results must first be filed and an amended Form 8-K must be filed within four business days of the availability of the final results of the shareholder vote. In addition, there is an exception to the four day deadline for reporting results of contested elections under certain circumstances.
The more prompt disclosures resulting from this rule change likely will heighten shareholder and media attention on companies’ annual meetings and voting results, and in some circumstances may increase the pressure on boards to promptly address shareholder concerns that are expressed through and reflected in voting results.
Disclosure About Compensation Consultants
The governance disclosures applicable to board compensation committees (Item 407 of Regulation S-K) are supplemented to require enhanced disclosure of fees paid to certain compensation consultants that provide advice to the board or compensation committee regarding executive or director compensation and also provide other services to the company.
If the board or compensation committee has engaged its own compensation consultant and the consultant or its affiliates provides other services to the company (not involving the amount or form of executive and director compensation) in excess of $120,000 during the fiscal year, then the company is required to disclose:
- The aggregate fees paid for advising on the amount or form of executive and director compensation and the amount paid for the additional services;
- Whether the decision to engage the consultant or its affiliates for such additional services was made by or recommended by management; and
- Whether the board or compensation committee approved the other services.
If the board or compensation committee has not engaged its own compensation consultant, but management has retained a consultant to advise on amounts or forms of executive compensation and the consultant or its affiliates provides other services to the company in excess of $120,000 during the fiscal year, the company is required to disclose the aggregate fees paid for advising on executive compensation and for the other services.
The rules are considerably more focused than the original proposals in defining when the additional disclosures are required, and contain exceptions for services provided by compensation consultants in connection with broad-based, non-discriminatory plans and providing surveys that are not customized for a particular company, or that are customized only according to parameters set by someone other than the compensation consultant.
Disclosure of Stock and Option Awards in the Summary Compensation Table and Director Compensation Table
The Summary Compensation Table and Director Compensation Table disclosure requirements (Item 402 of Regulation S-K) are amended to require companies to report the value of stock and option awards made during the fiscal year based upon their aggregate grant date fair value, as determined in accordance with applicable financial accounting standards (FASB Accounting Standards Codification Topic 718, which formerly was referred to as SFAS 123R), rather than reporting the dollar amount recognized as an expense for financial statement reporting purposes for the fiscal year. The rule includes an instruction clarifying that the value of performance-based stock and option awards is the value at grant date based on the probable outcome of the performance condition, assessed as of the grant date of the awards (typically, the "target" award value); the maximum potential value must appear in a footnote.
Companies with a fiscal year ending on or after December 20, 2009 will use this value to identify the current year’s named executive officers (as defined in Item 402 of Regulation S-K), and will be required to apply this method to recompute the value of compensation disclosed reported for those named executive officers in the Summary Compensation Table for the last two fiscal years, to the extent that compensation information for those years is required with respect to the named executive officer.
What Companies Should Do Now
While the rules adopted by the SEC are in many respects similar to those that were proposed in July, the uncertainty over the form the final rules would take has led many companies to delay in preparing for these new rules. In light of the relatively short effective date and the scope of information that companies will need to gather and assess in order to prepare disclosures in response to the new rules, the coming months will place a burden on companies and their boards. Among things that companies should immediately address are the following:
- Revise director and executive questionnaires to capture information regarding past legal proceedings and (for directors) past directorships, and to capture information that will be assessed by the nominating committee or board in articulating the qualifications of directors and director nominees;
- Determine whose "conclusions" regarding the directors’ and nominees qualifications are going to be discussed in the proxy statement (for example, the nominating committee or the board), develop a process and schedule appropriate time for the individuals’ experience, qualifications, attributes or skills to be formally evaluated and for the appropriate disclosures to be developed. While commenters have expressed concerns regarding the possibility of boilerplate or "Lake Wobegon" disclosures in this context, it can be expected that any activist shareholders evaluating the potential of a proxy fight or "vote no" campaign will closely focus on disclosures that are made in response to this new rule;
- Determine whether the enhanced compensation consultant disclosures will apply, and if so initiate the process to identify and gather information on all engagements by the company and its subsidiaries (worldwide) of the consultant and any of its affiliates. Compensation committees may also want to establish procedures for "pre-approving" additional services provided by their compensation consultants, similar to the procedures used by audit committees for approval of non-audit services;
- Develop a process and schedule sufficient time for the nominating or governance committee and for the full board to formally assess the board leadership structure and any board policies for the consideration of diversity in board composition, including assessing the effectiveness of those policies; and
- Assess the effect of grant date fair value reporting of equity awards on the determination of the company’s named executive officers.
While it can be expected that the Staff may again conduct a broad review to assess and comment on disclosures made in response to the new rules, as it did three years ago, companies and boards should also be aware that the Staff has reiterated its determination to continue to evaluate compliance with the existing executive compensation disclosure rules, especially in the context of disclosing performance goals used in determining the amount of executive compensation awarded to named executive officers.
In a November 2009 speech, Shelley Parratt, the SEC deputy director who oversees the review of all public company filings, reiterated the message that a company should disclose, in its Compensation Discussion and Analysis, performance targets that are material to its compensation policies and decisions. With respect to the threshold determination of whether a performance target is material, Ms. Parratt stated that "[t]he fact that a performance target was not met or was otherwise disregarded may be a factor to consider in the materiality determination, but it is not a dispositive one." Ms. Parratt explained that in most cases, including cases where no payouts are made, companies should disclose performance targets. Ms. Parratt went on to address disclosure of performance targets where a company has determined such targets to be material, unless such disclosure would cause substantial competitive harm. She explained that, while the Staff paid particular attention to competitive harm comments and responses with respect to 2009 disclosures and accepted omission of specific targets where companies adequately explained the nexus between disclosure and potential harm, the Staff has "yet to see" the competitive harm standard satisfied with respect to disclosure of performance targets tied to company-wide financial results that have been publicly reported. In a discussion of what to expect from the comment process in 2010, Ms. Parratt advised that, instead of addressing disclosures in future filings, the Staff will require companies to prepare amended filings if the Staff determines that a company’s disclosures (or lack of disclosures) do not materially comply with the proxy rules.