Preparing for new executive comp proxy disclosures: as companies prepare for added disclosure materials to comply with new SEC rules, Financial Executives Research Foundation (FERF) asked experts and preparers to share insights on data-gathering, resources required and in which areas to focus.

In prior years, compensation committee activity has generally slowed slowed down after the middle of December. But, that was before the U.S. Securities and Exchange Commission (SEC) adopted its new rules on Executive Compensation and Related Person Disclosure.

Indeed, this December will be busy for committees, says Richard L. Alpern, a principal at compensation consultant Frederic W. Cook & Co. Likewise, under the direction of the committees, management has been and will continue to be actively gathering data to support the new disclosures. These include, among other items: new tabular disclosure, a Compensation Discussion & Analysis (CD & A) section, perquisites guidance and disclosure about post-termination or change-in-control payments.

From its original proposal in January, through the final rule adoption in August, the SEC has stressed the importance of updating executive and director compensation disclosure. The final release states that the amendments are intended to make proxy and information statements, reports and registration statements easier to understand and provide investors with a clearer and more complete picture of pay given to executives and directors.

Most recently, John White, director of the SEC's Division of Corporation Finance, addressed the specific role of the CFO in compliance: "It is very important to me, and to the commission, that all the necessary players are on board and on the team as these new rules go into effect for the next proxy season. All of you--as chief or principal financial officers--have a special place in that mix," he said.

According to White, CFOs should be involved in the substance of the disclosures, and particularly the new CD & A, refining and adjusting disclosure controls and procedures and working with the compensation committee of companies' boards on its new report.

The Layout: What Has Changed

The rule adopts amendments to compensation disclosures for directors, the CEO, CFO and the three most highly compensated executive officers other than these two officers. Changes apply to any SEC Forms 8-K filed for triggering events that occurred on or after Nov. 7, 2006; to proxy or information statements filed on or after Dec. 15, 2006; and to Forms 10-K and 10-KSB filed for fiscal years ending on or after Dec. 15, 2006.

Compensation disclosure will now begin the CD & A, a narrative on the material factors underlying compensation policies and decisions. The CD & A must be filed with the SEC, which means it is subject to certification by the CEO and CFO, and should reflect the data presented in seven supporting tables.

The first of those is the Summary Compensation table, which has been expanded to include grant date fair value of new stock option awards, changes in pension value and above-market nonqualified deferred compensation earnings and total compensation.

The most notable change, however, is the "Total" column, says Steve Seelig, executive compensation counsel for Watson Wyatt's Research and Innovation Center. He says that companies are making more qualitative decisions as to what goes in each column because of the detailed rules on discretionary versus nondiscretionary disclosures.

For example, in the past, annual bonuses would be in a certain column. Now, Seelig points out, if the annual bonuses are based on pre-established goals, the amounts should be classified in the long-term incentive column, even if an annual payout is made for 2006. Alpern says, "For many companies, there will be very little in the bonus column. The traditional bonus column will be limited to guaranteed or new-hire bonuses."

The grants of plan-based awards table will show the terms of each non-stock and stock incentive-based award made during the current year, including estimated future payouts, depending on whether an executive achieves a threshold, target or maximum target. "You want to describe, based on grant date, what one could earn," Alpern explains.

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The outstanding equity awards table should provide data points on executive stock awards and the market value as of the most recent fiscal year-end. If the exercise price and expiration dates differ for each grant given to the same executive, they cannot be aggregated in the table. This not only differs from current practice, but Alpern notes this literally means more space in the proxy. Thus, if there are nine years worth of outstanding options, there would be at least nine rows to that table. He says technology companies that give quarterly grants "could have 36 rows in their tables."

Also new is the disclosure of the present value of accumulated pension benefits and payments made during the fiscal year. And another major change is the discussion of other potential post-employment payments, which requires a narrative on potential payouts following events such as resignations, severance, retirement or a change in control.

The most considerable change is the huge volume of additional information required, says James B. Lootens, secretary and deputy general counsel at Eli Lilly and Co. For example, he says, "the retirement plan actuarial calculations are completely new for us. In addition, we have outside actuaries working on termination and change-in-control payments."

Finally, the proxy should include a new compensation committee report that would be furnished, not filed like the rest of the required disclosures. This report must state whether the committee has reviewed and discussed the CD & A with management and whether it recommends inclusion in the Form 10-K and proxy.

The Process: Gathering the Data

Experts concur that by this past November, companies should have been well on their way toward drafting the 2007 proxy disclosures. At Eli Lilly, the process started when the rules were originally proposed on January 17. "Clearly, at the time it was too late for us to try to implement the rules from A to Z, but we did voluntarily provide some of the new disclosures in the 2006 proxies based on information already gathered in-house," Lootens says. "The proxy did not dramatically change from the previous year, but it was good preparation for 2007."

This work continued when the company's compensation committee received a mock-up of the 2007 proxy in the fall. The CD & A was initially drafted based on an analysis of the rules, the prior year proxy and records of the compensation committee meetings during which compensation decisions were approved.

Lootens says with all that in front of him, he was "able to work through how I think we can best describe the policies behind the salary, incentive compensation and benefit programs, how they relate to each other and to the underlying compensation philosophy of the company." A team from human resources (HR), legal and financial reporting was also able to draft a rough cut of the tabular disclosures, which were based on 2006 projections. By the time the proxy is filed, he expects a few iterations based on discussions with the compensation committee.

Though the company had a very sound process for some time that included legal, HR and a financial reporting review, Lootens says the company is taking the opportunity to ensure that the process has the same level of discipline, attention to detail and advance planning as that given to Forms 10-K and 10-Q. "With the required certification of these disclosures, we wanted to make sure we had not only a top-quality result, but a process that is documented and defensible to the same degree as with the 10-Q and 10-K."

Preparation Process Variations

Generally speaking, the process for preparing disclosures may vary from company to company. Paula Cholomondeley, a director on multiple public company boards, has seen various approaches initiated by data generated by human resources. "A consultant, usually engaged by the compensation committee, will then work with human resources to lay out the disclosures. Some companies also have the information reviewed by their internal or external auditor for accuracy."

David Sugar, a senior consultant with Hewitt Associates, a human resources outsourcing and consulting services firm, describes a "triumvirate approach," where processes are owned by the general counsel, with specific delineated responsibilities for finance and human resources. At smaller companies, however, there will likely be only one leader, either the general counsel or finance.

The bottom line, says Donald Kalfen, also from Hewitt Associates, is that the process should be collaborative. "You should approach compliance [with the new rules] as a defined project that needs to be completed. With any project management process, companies should be aware of who owns the process and be able to marshal all resources necessary." He says there should be a liaison between management and the compensation committee that ensures the disclosures--particularly the CD & A--properly reflect the committee's decisions.

The CD & A: Tying It All Together

According to the SEC rule, the CD & A is meant to provide material information about the compensation objectives and policies for named executive officers, without resorting to boilerplate disclosure. The rule also provides a listing of non-exclusive examples that Seelig encourages companies to include, if relevant. Many of the examples provided by the SEC will be material to the discussion, he says, and adds, "I would start with a complete, comprehensive write-up on each, then pare it back to ensure it is in plain English and that it is not redundant."

Of these examples, Cholomondeley says, one adequate description of pay for performance is a key issue from a compensation committee perspective. "Where those of us on committees have a challenge is how to disclose to shareholders what performance metrics and target levels were used without giving away company strategy."

Disclosures may seem more straightforward, Sugar adds, for those companies with a regimented compensation model that includes specific formulas, amounts or reasons for granting bonuses. But, companies with more subjective compensation models are faced with a greater challenge.

Should a company determine that performance-related factors involve confidential trade secrets, target levels can be excluded if disclosure would result in competitive harm. However, the company must discuss the difficulty for the executive or the company to achieve the undisclosed target, which might be a greater challenge than providing the disclosure.

Kalfen adds the CD & A must be carefully crafted so that it is understood that the total compensation amounts disclosed in the Summary Compensation table consist of current cash items, such as annual salary, stock option and other equity grants that may never be realized and pension accruals, which will not be paid out until a future date."

How Will Readers React?

Readers--the press and institutional investor community among them--will no doubt react to the potentially large numbers disclosed. Sugar says there will be particular focus on pension disclosures and other deferred compensation that in some cases may have accumulated under tenure of many years, as well as disclosures of potential compensation related to change in control. Companies need to be prepared to deal with this potential fallout and think about how to explain it.

Ira Kay, global director of Executive Compensation Consulting at Watson Wyatt Worldwide, says that a company's individual compensation story, rather than its size, is a key factor. "The best story is one where a company performed well, thus yielded high pay for the executives that reached their median targets."

The next story, he says, would be "where executives received low pay because a company did not perform well. The worst story is one where, due to compensation elements such as time-vested restricted stock, executives receive high pay even though the company was low-performing; this scenario will have to be defended."

The Take-Aways

Experts advise companies not to underestimate the time, thinking and resources involved in the process. Seelig also emphasizes the effort needed for calculating termination payments under multiple scenarios (change in control versus resignation) as of several points in time. Though these do not have to be shown in a tabular format, Kay says, companies will find that using a table is the best approach. Should a company opt to use narratives in its final disclosures, at the minimum, it should show this information to the compensation committee in the tabular format, Kay adds.

As the overall process is streamlined going forward, companies should also consider real-time write-ups of decisions taken at all future committee meetings for expedited approval by the committee so that it will be ready for incorporation in the year-end proxies.

Also, though compensation committees and management often use the same consulting firms for compensation work, some companies, such as Eli Lilly, reviewed their draft disclosures with the compensation committee's independent consultant. "This is not a per se requirement," Lootens notes, "but it is becoming common and will avoid any appearance of conflicts of interest."

Should compensation committees engage independent consultants, Cholomondeley says people have to understand the cost. "If the only work a consultant is doing for a company is for the compensation committee, that company will get a different fee structure," she explains. "This is acceptable for large companies, but may be another financial burden for small companies."

Seelig compares the preparation of disclosures to writing a college essay. After providing an outline of what information is needed, create the prose in plain English to explain the details. "The biggest struggle, as with any college paper, is how to start."

For most, the greatest challenge will be the CD & A. "It's hard to get a subjective narrative right if the disclosure rules are unclear in many respects," Kalfen states. "You really just have to give it your best shot. The SEC knows that there are gray, ambiguous areas.

"Disclosures can be refined through several proxy seasons. Right now, when in doubt about a disclosure, just include it. If the components of a compensation program do not fit in the 'boxes' provided, make a good faith disclosure so that an individual investor can understand its meaning."

Cheryl de Mesa Graziano, CPA ([e-mail]), is Vice President-Research and Operations for Financial Executives Research Foundation (FERF).

RELATED ARTICLE: takeaways

* The new SEC rules on Executive Compensation and Related Person Disclosure apply to 8-Ks filed for triggering events on or after Nov. 7, 2006; proxy or information statements filed on or after Dec. 15, 2006; and to Forms 10-K and 10-KSB filed for fiscal years ending on or after Dec. 15, 2006.

* CFOs should be involved in the substance of the disclosure, particularly in the new CD & A, refining and adjusting disclosure controls and procedures and working with the compensation committee on the new report.

* Experts stress not to underestimate the time, thinking and resources involved in the data-gathering process.