EXECUTIVE COMPENSATION REPORTING AFTER DODD-FRANK: WHERE WE CAME FROM AND WHERE WE ARE HEADING By Gabriel B. Weiss and Gregory S. Fryer1 For chief financial officers of many public companies, compensation disclosures have become a major headache in planning for the annual meeting and related annual SEC filings. What once was a technical but relatively stable set of disclosure rules has now become a highly active arena for complex regulatory initiatives. “Say-on-pay” is the latest in a series of innovations, courtesy of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. But buckle up – important additional changes are already in the pipeline. This article begins with a timeline that demonstrates the rapid acceleration of rulemaking in the area of compensation disclosure. We then discuss how companies are dealing with “say-on-pay,” with some lessons for smaller reporting companies for the 2013 proxy season. We conclude with a discussion of new rules that are mandated by Dodd-Frank but which have not yet emerged from the Securities and Exchange Commission. PART I: PUBLIC COMPANY REPORTING OF EXECUTIVE AND DIRECTOR COMPENSATION – A TIMELINE The requirement that public companies disclose executive and director compensation dates back almost to the dawn of the Securities Exchange Act of 1934, but more recently has evolved in several distinct phases. The modern era of executive compensation disclosure began in 1982, with the SEC adopting a tabular presentation for executive compensation. To this the SEC in 1992 added a small narrative component (the compensation committee report). The role of narrative disclosures was greatly expanded 14 years later, at least for larger public companies. In 2010 the Dodd-Frank Act served notice of another major shift: compensation would no longer be just a topic of mandatory disclosure by a public company to its shareholders but also a topic for mandatory dialogue with its shareholders. 1938

Proxy statements required to disclose prior year compensation of a nominee to be voted upon, if he or she is among the three most highly compensated persons of the company.

1982-83

Adoption of Item 402, Regulation S-K: This put into place the now-familiar tabular presentation of executive compensation. Initially applied to the five most highly compensated executive officers or directors of the registrant whose total compensation exceeds $50,000 each. These requirements were soon revised to apply to the five most highly compensated executive officers whose cash compensation exceeds $60,000. Adoption of Item 404, Regulation S-K: This put into place uniform rules for disclosing relatedparty transactions involving management, for transactions exceeding a $60,000 threshold.

1992

Extensive changes to Item 402, including: (a) Adoption of a new requirement for narrative discussion of compensation philosophy and practices, through a Board Compensation Committee Report. However, smaller issuers were exempted from these requirements. (b) Covered

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 Mr. Weiss is an associate and Mr. Fryer a partner with Verrill Dana, LLP, with offices in Portland, Maine and Boston, Massachusetts.

  executives redefined to include the CEO and the four other most highly compensated executive officers with more than $100,000 of annual cash compensation. (c) Summary Compensation Table expanded to show three years of information. (d) Adoption of a new requirement for a performance graph showing issuer stock prices vs. peer group stock prices. Sept 2006

Extensive changes to Items 402, 404 and 407, including: (a) Adoption of a new requirement for Compensation Discussion and Analysis narrative (the “CD&A”), plus a Compensation Committee Report regarding compensation committee review of the CD&A. However, small business issuers were exempted from these requirements. (b) Significant reformatting of the tabular presentation of executive compensation, including expanded disclosure of total compensation and expanded disclosure of holdings and exercises regarding prior stock compensation awards. Small business issuers required to include only the CEO and the top two other executive officers, and only for a two-year period. (c) Requiring disclosure of the full grant date fair value (determined pursuant to FAS 123R) of equity-based awards granted in the relevant year, regardless of vesting. (d) Adoption of a new Director Compensation Table. (e) Increase in related-party threshold from $60,000 to $120,000 (of, if less, 1% of average total assets), and an expanded definition of immediate family members. (e) Expanded disclosure of compensation committee practices, including the use of compensation consultants to assist in determining executive and director compensation. In December 2006, the Commission amended Item 402 to alter the reporting of grant date fair market value (moving disclosure of the full grant date value from the Summary Compensation Table to a different table, and exempting small business issuers from having to disclose the full grant date value).

Jan 2008

Adoption of new definition of “smaller reporting company,” i.e., companies with less than $75 million in public float (versus companies with both less than $25 million in float and less than $25 million in annual revenues). Phasing out of the “SB” forms, while maintaining differential treatment of smaller companies.

Dec 2009

Further changes to Items 402 and 407, including: (a) New requirement to disclose risks posed by compensation policies and practices that are “reasonably likely to have a material adverse effect” on the company. Does not apply to smaller reporting companies. (b) The Summary Compensation Table and Director Compensation Table must disclose the expected and maximum aggregate grant date fair value of awards (thereby reversing the December 2006 revisions and extending this requirement to smaller reporting companies). (c) Expanded disclosure of fees paid to compensation consultants, where fees for ancillary services exceed $120,000 per year.

July 2010

Dodd-Frank Wall Street Reform and Consumer Protection Act amends the Securities Exchange Act in several important respects to mandate new SEC rulemaking on compensationrelated topics, including: Adds new Section 14A to require periodic shareholder voting on executive compensation; and shareholder voting on grants of golden parachutes in connection with merger transactions. Adds new Section 10C to require that compensation committees meet enumerated standards of independence; that a compensation committee have authority and a sufficient budget to hire its own compensation consultant and other advisors; and that compensation committees consider enumerated factors affecting independence of compensation consultants and other advisors. Adds new Section 10D to require issuers to adopt and enforce policies on clawbacks of incentive compensation in cases where the issuer restates its financial statements. Adds new Section 14(i) to require issuers to disclose information that shows the relationship between executive compensation actually paid and the financial performance of the issuer; and to require issuers to disclose the ratio between total CEO compensation and the median compensation paid to all other employees. Adds new Section 14(j) to require issuers to disclose whether their directors and officers are permitted to purchase derivatives that allow them to hedge against decreases in the market value of issuer stock granted to them or otherwise held by them.

Jan 2011

Amendments of proxy rules to require shareholder “say-on-pay,” “say-on-frequency” and “say-ongolden parachute” votes, which need not be binding. (a) The vote on executive compensation (say-on-pay) must be held at least once every three years. (b) The vote on how often the say-on-

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  pay vote should occur (one, two or three years) must be held at least once every six years. The proxy statement must explain the general effect of these votes, including whether the vote is purely advisory and non-binding. (c) A vote on golden parachute compensation must be held whenever the issuer is soliciting shareholder approval of an acquisition, merger, or sale of all or substantially all of its assets. Smaller reporting companies were temporarily exempted from “sayon-pay” and “say-on-frequency” votes until 2013, but were not exempted from “say-on-golden parachute” votes. As part of these amendments, the SEC also revised S-K Item 402 and tender offer rules to require expanded disclosure of golden parachutes in the context of acquisition transactions, etc. June 2012

Adoption of new Rule 10C-1 defining standards for compensation committee independence. In October and November of 2012, the SEC published notices of proposed listing standards submitted by NYSE, NASDAQ and other securities markets to implement these requirements. In January 2013 the SEC approved the proposed standards, as amended.

April 2012 saw some evidence that the regulatory pendulum may be slowing. With rare bipartisan support, Congress passed (and the President signed) the Jumpstart Our Business Startups (JOBS) Act, which cut back on some of the recent compensation regulations2 – but only for companies that go public after December 8, 2011. This liberalization, however, does not provide any relief for companies that were already public. The mandates of Dodd-Frank have outstripped the SEC’s capacity to adopt the required new rules. The SEC has yet to promulgate (or even propose) its new rules on: * Disclosure of issuer policies on hedging by directors and employees; * Mandatory clawbacks of incentive compensation in cases where the issuer restates its financial statements; * Disclosure of executive pay versus performance; and * Disclosure of the ratio of CEO pay to median employee compensation. Of these topics, the last three promise to be complex and highly controversial. PART II: DODD-FRANK’S EFFECT ON DISCLOSURE PRACTICES To date, the most significant effect of Dodd-Frank on issuer compensation disclosures has been its mandate that public companies hold shareholder advisory votes on executive pay. The SEC took quick action on these provisions, adopting say-on-pay rules3 within six months after DoddFrank was enacted and requiring such votes for shareholder meetings occurring after January 20, 2011. Say-on-pay votes (and the related say-on-frequency votes) are not binding on the issuer or its board. However, the issuer must promptly disclose the votes cast by shareholders on these questions, and then must ultimately disclose its decision on how often say-on-pay votes will actually be held in the future.4 Larger issuers have now been through at least one proxy season for which                                                                2

The JOBS Act gives “emerging growth companies” up to six years of relief from “say-on-pay” and “say-on-frequency” requirements (but not from the “say-on-golden parachutes” provisions), and from required disclosures of executive pay vs. performance and of the ratio of CEO compensation to median compensation. 3

SEC Release No. 34-63768, January 25, 2011.

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Disclosure of the board’s actual decision on timing must be made within about five months after the date the say-onfrequency vote was held. Form 8-K, Item 507(d).

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  these votes have been required. Smaller reporting companies were not required to hold such votes in 2011 or 2012, but will be required to do so in 2013. The “say-on-golden parachutes” provisions are another noteworthy addition under DoddFrank. In any proxy statement, information statement, or tender offer statement that describes a proposed business combination, tender offer, or the like, the issuer must make extensive disclosures – both tabular and narrative –about any agreements or understandings by which executives of the acquiring company or the target company will receive any type of compensation (whether present, deferred or contingent) that is based on or otherwise relates to the proposed transaction. If the shareholders are being asked to vote on or consent to the transaction itself, then the issuer generally must seek an advisory vote on any parachute compensation being paid by that issuer.5 Unlike the say-on-pay rules, these requirements for say-on-golden parachutes have been in effect for both larger issuers and also smaller reporting companies. Under the Sarbanes-Oxley Act enacted in 2002, companies with shares listed on a national securities exchange must assure that their audit committees meet certain “independence” standards promulgated by that exchange. Similarly, Dodd-Frank imposes independence standards on compensation committees of listed companies. Pursuant to SEC rules adopted in June 20126, the New York Stock Exchange and NADAQ each promulgated proposed independence standards and practices for compensation committees. The SEC approved the NYSE and NASDAQ rules (as amended) in January 2013. For most companies, these heightened standards and practices become fully effective in 2014, although portions of the new rules take effect on July 1, 2013. Smaller reporting companies are largely exempt from these new requirements. It should be noted, however, that for all issuers (regardless of size) the SEC’s new disclosure rules about compensation consultant conflicts of interest are already in effect.7 How are companies reacting to the SEC’s say-on-pay rules? It does appear that many companies have altered their CD&A disclosures in order to enhance executive compensation disclosures and put their compensation practices in the best light. Many of these changes relate to formatting – the inclusion of executive summaries, additional tables and graphs, and bullet-point lists – in order to improve the readability of the CD&A. Other companies have altered the content in more fundamental ways, to offer better explanations of why their boards consider the prior year’s compensation amounts and structure to be reasonable in size and well-suited to the companies’ particular needs. In so doing, those companies have heeded the advice of commentators who view the CD&A as a key document for seeking favorable shareholder action on these matters.8 The sayon-pay requirements are also proving to be a significant incentive for management to reach out to

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 There is a limited exception in cases where the issuer included full-blown parachute disclosures in connection with a prior say-on-pay vote, and is not proposing any increase in such compensation. Also a target issuer need not seek a vote on parachute payments to be made to its executives by the acquiring company. SEC Rule 14a-21(c).  6 SEC Release No. 34-67220, June 20, 2012. See also SEC Release Nos. 34-68639 and 34-68640, January 11, 2013 (approving NYSE and NASDAQ proposals). 7 Regulation S-K, Item 407(e)(3)(iv). These increased disclosure requirements apply to proxy statements and information statements for all shareholder meetings after January 1, 2013. 8

E.g., Romanek, Broc, The Corporate Counsel, July-Aug. 2010 (Vol. XXXV, No. 4); p. 11.

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  shareholders (especially institutional shareholders) on compensation and governance topics generally. On the question of frequency, data compiled by GMI Ratings for Russell 3000 index companies9 during the 2011 proxy cycle demonstrate a strong preference among shareholders for annual votes on compensation, even when management recommended two- or three-year cycles. Of those companies recommending the maximum three years, 37% saw their shareholders accept the recommendation but fully 48% saw shareholders vote instead for one-year periods. Of those proposing a two-year period, 20% received votes in support of those recommendations but fully 62% received a majority of votes for one-year periods. Where the one-year period was recommended, shareholders approved this 84% of the time, with only 0.07% opting for a three-year frequency instead. As for the say-on-pay vote, a number of high-profile issuers have failed to obtain majority approval from their shareholders. Occidental Petroleum and Motorola, to name just two, had their executive compensation proposals voted down in annual meetings. It is interesting to note that these companies (as well as others that presented unsuccessful say-on-pay agendas) were not necessarily the targets of public resentment over bonuses issued in the wake of the 2008 financial crisis. Nor was the negative vote a result of activist shareholder campaigns aimed at reducing executives’ pay. PART III: FURTHER CHANGES IN THE PIPELINE Understandably, CFOs are spending a lot more time on compensation disclosures and shareholder management issues as a result of the say-on-pay requirements. CFOs should keep in mind, however, that several important new compensation disclosure requirements are likely to appear in 2013 and 2014. Companies may wish to consider making voluntary changes now to address these subjects. Hedging. Dodd-Frank requires the SEC to amend its proxy rules to require disclosures of whether the company allows its directors or employees to purchase financial derivatives (e.g., forward contracts, equity swaps, collars, etc.) designed to hedge against decreases in the market price of company shares. S-K Item 402 currently requires discussion of whether the company has a policy about hedging by its executives. The new requirements will extend to all directors and employees. Companies that don’t prohibit such hedging may need to explain whether hedging would be consistent or inconsistent with the intended objectives of its stock-related compensation programs, an awkward disclosure at best. To date the SEC has not published any proposed rules relating to this Dodd-Frank requirement. Clawbacks. Dodd-Frank requires the SEC to impose clawback requirements through the national securities exchanges. In the case of an issuer that is “required to prepare an accounting restatement due to material noncompliance with any financial reporting requirement under the securities laws,” the issuer must recover from any current or former executive officer who, during the prior three years, received incentive-based compensation (including stock options awarded as

                                                               9 GMI Ratings report dated as of October 12, 2012. The report included data pertaining to 2,655 companies of the Russell 3000.

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  compensation) whatever portion of that compensation exceeds what would be paid to him or her under the accounting restatement. Because the forfeiture arises without regard to fault of the particular officer, the definitions here will be important, complex, and controversial. In contrast to the rules on compensation committees, it seems unlikely that the SEC will allow much flexibility in the way each securities exchange chooses to implement these forfeiture requirements. For CFOs and compensation committees alike, the clawback rules may affect their views on the design of incentive compensation and will make even more unpleasant the task of deciding whether a prior error requires an accounting restatement. To date the SEC has not published any proposed rules relating to this Dodd-Frank requirement. Pay versus Performance. Dodd-Frank requires the SEC to adopt rules by which each public company must disclose in its annual proxy statement information that “shows the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions.” That disclosure “may include a graphic representation of the information required to be disclosed,” which suggests some kind of comparison against the shareholder return “performance graph” required under Item 201(e) of Regulation S-K. The SEC will need to define what compensation (beyond salaries and annual cash bonuses) is “actually paid” and thus is supposed to be covered (stock and option awards during the three-year reporting period, regardless of vesting or exercise? long-term incentive payments actually received in the prior three years, regardless of the date of grant?) The SEC also will need to decide whether “the financial performance of the issuer” refers only to historical returns to shareholders or also is to include relevant accounting metrics (e.g., changes in sales or earnings). Although the scope of this statutory mandate remains unclear, everyone agrees that issuers will no longer simply be able to state that their objective is to “align executive pay with shareholder interests”; rather, issuers will need to more clearly describe how the alignment is supposed to work in theory and whether that alignment was achieved in practice. To date the SEC has not published any proposed rules relating to this DoddFrank requirement. CEO versus Median Compensation. Finally, one more looming Dodd-Frank rule has made many companies wary: the requirement to disclose median employee compensation. Under this requirement, registration statements and annual proxy statements must disclose the median of the total annual compensation of all employees of the issuer except its CEO, the CEO’s total annual compensation, and the ratio of those two figures. For purposes of these calculations, “total compensation” will be determined in accordance with rules currently in place for the Summary Compensation Table, and thus will include not only cash compensation but also stock-related awards, accruals under incentive compensation plans, retirement plan accruals and other deferred earnings, perquisites (unless less than $10,000 per year), severance compensation accruals, and so forth. This “pay equity” disclosure can be extraordinarily difficult to calculate with precision, especially for large companies with employees in multiple countries. For smaller companies, this disclosure could reveal competitively sensitive information. As could be expected, the notion of publicizing a company’s ratio of median employee compensation to the CEO’s compensation has generated much outcry from business groups due to the sensitivity of the information and the potential for unfavorable publicity. To date the SEC has not published any proposed rules relating to this Dodd-Frank requirement. * * *

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  Clearly, the accelerating pace of new compensation disclosure rules will continue to be a challenge for public company CFOs for years to come. It remains to be seen whether the DoddFrank initiatives will represent the high water mark of regulatory scrutiny of compensation decisions, or whether this is just the harbinger of more to come. Staying on top of the evolving regulations is no easy task, and complying with the final rules will consume significant time, energy and resources. Understanding that the compensation disclosure playing field has drastically changed — and is continuing to change — is merely the first step. The necessary follow-up steps, years in the making, will be to implement up-to-date disclosure policies and procedures that will satisfy regulators and, one hopes, enhance the company’s relationships with shareholders.

Contact the Authors Gregory S. Fryer, Partner [email protected] (207) 253-4402

Gabriel B. Weiss, Associate [email protected] (207) 253-4418

 

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