February 11, 2010

Executive Compensation Disclosures and the Comment Process

Executive Compensation Disclosures and the Comment Process

On Monday, November 9, 2009, Shelley Parratt, Deputy Director of Corporation Finance at the U.S. Securities and Exchange Commission (SEC), spoke at The 4th Annual Proxy Disclosure Conference in San Francisco, and discussed her views on the upcoming 2010 disclosures relating to executive compensation for public companies.

Frequently we hear or read about company executives receiving large compensation and incentives for running an underperforming company. These incentives are often based upon achieving predetermined performance targets. Shareholders are demanding more disclosures regarding these compensation incentives. This disclosure can be used to determine if executives are making riskier decisions to achieve higher bonuses. This article discusses the SEC’s constant quest for more detailed disclosures, which will benefit shareholders but could cause substantial competitive harm to the registrant.

The SEC has indicated that it does not want to control or advise registrants on their compensation processes and decisions, but wants more transparent disclosure of executive compensation. Registrants in the past have taken the less-disclosure-the-better approach. They want to disclose the least amount of information possible until the SEC issues requirements or guidelines for them to follow, or until an SEC comment letter arrives in their mailbox. This lack of transparent disclosures has prompted the SEC to release a statement indicating that businesses should not wait for guidelines to be established, but to be proactive in providing more relevant disclosures to shareholders.

Analysis, performance targets, and benchmarking procedures are what the SEC is looking for in the disclosure. Shareholders argue that there has been too much boilerplate language included in the compensation disclosures. Registrants should discuss the specific qualitative factors it considered and clearly lay out the way that these qualitative inputs are ultimately translated into objective compensation determinations.

When executives have incentive based compensation plans, they may take on unnecessary risk in order to achieve a performance target. This risk requires adequate disclosure and should answer questions such as; Are incentives more corporate or individually driven? Will executives still receive bonuses even if targets are not met? Is the board’s decision more subjective than objective?

The criteria chosen for benchmarking should also be discussed in the disclosure. To what extent did the registrant utilize the gathered data? Is it simply for comparison or were complex metrics used? Some registrants have had difficulty applying the benchmarking disclosure principles when information they used included hundreds of companies. The SEC’s Division of Corporation Finance published Compliance and Disclosure Interpretation (“C&DI”) 118.05, which provides a basic definition for benchmarking. C&DI 118.05 states that benchmarking “generally entails using compensation data about other companies as a reference point on which — either wholly or in part — to base, justify or provide a framework for a compensation decision. It would not include a situation in which a company reviews or considers a broad-based third-party survey for a more general purpose, such as to obtain a general understanding of current compensation practices.” This guidance should help businesses in the future to better utilize, disclose, and compare competitive data.

Disclosures related to an executive’s bonus may be based on the performance of a new product or service introduced in the current year, which may be a disadvantage to a registrant. The SEC does not want registrants to stop offering these types of incentives as a result of the disclosure requirement. The SEC will allow the omission of performance targets if the inclusion of those targets would cause competitive harm to the registrant. To allow the omission, the registrant must submit a confidential treatment request. During the SEC’s review, if a registrant has not filed this request and does not disclose these performance targets, the SEC will ask for an explanation. The SEC has generally permitted the omission of these performance targets when registrants adequately explained the reasons for the omission. If the performance target is approved for omission, the next step is to disclose how likely this performance target has of being successfully reached.

The Division of Corporation Finance has submitted a proposal to the Commission which focuses on the current requirements and how incentives can bring executives to make riskier business decisions driven by performance targets in mind. Registrants should begin to discuss and plan how they are going to disclose these risk factors because the proposal could be passed for the 2010 proxy statement season. If the proposal is passed for the 2010 season, it will be a main focus in the review process of the Commission. Since these disclosure discussions began a few years ago and yearly updates have been released, they expect registrants to have a thorough understanding of the rules and apply them correctly. Registrants that do not comply with the disclosure requirements may be required to amend their filings.

This year’s disclosures need to be more meaningful and transparent. Registrants must explain how incentives were determined and why they were granted. Information on analysis, performance targeting, and benchmarking must all be disclosed as well.