Compensation Committee Corner : Executive Compensation Lawyer & Attorney : Winstead Law Firm : Director Liability, Employee Benefit Arrangements

New SEC rules require narrative disclosure of compensation policies and practices that are "reasonably likely" to have a "material adverse effect" on the company. The purpose of this Post is to highlight that implementation (or increased use) of mitigating factors could negate risk assessment disclosure while simultaneously bolstering a company's compensation governance practices.

Background

On December 16, 2009, the SEC adopted final rules (Prior Post) that broaden executive compensation disclosure within proxy statements and annual reports. The new disclosure rules are generally effective February 28, 2010 (Prior Post).

One requirement of the new rules is that a company must provide narrative disclosure of compensation policies and practices that are "reasonably likely" to have a "material adverse effect" on the company. An important point is that no disclosure is required unless the materiality threshold is satisfied (though financial institutions participating in TARP are subject to different requirements).

Mitigating Factors

A risk assessment should be conducted to determine whether the materiality threshold is satisfied. This assessment should (i) focus on individuals (and groups of employees) who could cause risk to the company, and (ii) identify features of compensation programs that could entice executives (or groups of employees) to take risks that might threaten the company's value.

However, these risks (and the subsequent "materiality" analysis) should be balanced against mitigating factors such as:

• stock ownership guidelines that require an employee or director to own a meaningful amount of equity in the company until some future date (e.g., retirement, termination of employment);
• clawback provisions or policies that are more stringent than currently required under Section 304 of the Sarbanes-Oxley Act of 2002; and/or
• compensation limits or caps to ensure an employee's total pay does not exceed acceptable levels.

In addition to helping negate risk assessment disclosure, the above mitigating factors (and others not addressed above) are a form of good compensation governance (and positive CD&A disclosure) that every compensation committee should consider implementing or enhancing this proxy season.

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As publicly held companies prepare for their annual meetings, consideration should be given to whether or not performance goals within certain incentive compensation arrangements should be re-approved by their shareholders.  This is a worthwhile endeavor because failure to comply with Section 162(m) of the Internal Revenue Code of 1986, as amended, could result in a loss of deduction associated with certain executive officer pay.

As background, Section 162(m) generally provides that compensation paid by a public company to a covered employee is not deductible to the extent it exceeds $1,000,000 ("$1mm"); however, an exemption to the $1mm limit applies for performance-based compensation that satisfies certain conditions (the "Exemption").  One such condition is that the material terms of the performance goals must be disclosed and approved by the company's shareholders before the underlying compensation is paid.

However, if the compensation committee has the authority to change the targets under a performance goal after shareholders approved the goals (which is often the case), then ". . . the material terms of the performance goal must be disclosed to and reapproved by shareholders no later than the first shareholder meeting that occurs in the fifth year following the year in which shareholders previously approved the performance goal."  See Treas. Reg. 1.162-27(e)(4)(vi).  In other words, approximately every five years the shareholders would have to re-approve the performance goals in order for the Exemption to apply (i.e., to protect the deductibility of compensation paid to covered employees that exceeds $1mm).  

Shareholder approved performance goals are typically contained within equity incentive plans, long-term incentive plans (LTIPs), annual bonus programs/plans, and in rare instances, employment agreements.  So don't forget to at least consider the issue! 

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Recently the SEC issued interpretative guidance (PDF) on how the effective date of the new proxy disclosure rules (Previous Post) would apply in various factual scenarios.  Though the new proxy disclosure rules are effective February 28, 2010, the interpretative guidance provides the following transition rules:

• An issuer must comply with the new rules if its fiscal year ends on or after December 20, 2009, and its definitive proxy statement is filed on or after February 28, 2010. Under such facts any preliminary proxy statement required to be filed would have to comply with the new rules even if it is filed prior to February 28, 2010.
  
• Under the above facts an issuer's proxy statement must comply with the new rules even if its 2009 Form 10-K is filed prior to February 28, 2010.
  
• An issuer is NOT required to comply with the new rules if its fiscal year ends prior to December 20, 2009. This rule applies even if the proxy is filed on or after February 28, 2010.
  

Addressing voluntary compliance, the interpretative guidance provides that an issuer may voluntarily comply with some or all of the new rules; however, if an issuer desires to comply with amendments to the Summary Compensation Table and Director Compensation Table, then it must comply with all of the new rules relating to the form filed.

Addressing Form 8-Ks, the interpretative guidance provides that new item 5.07 to Form 8-K (generally requiring issuers to disclose the results of a shareholder vote and to have that information filed within four business days after the end of the meeting at which the vote was held) will apply if the annual meeting of shareholders takes place on or after February 28, 2010, even if the proxy was mailed prior to that date.  Annual meetings taking place prior to February 28, 2010 would not have to comply with new item 5.07.

The interpretative guidance may be good news for those issuers with a fiscal year ending prior to December 20, 2009, but who file their proxy (or have their annual meeting) on or after February 28, 2010.

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