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.
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).
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.