Will revealing more be enough? A new SEC executive compensation proposal has sparked debate about just how to go about disclosing more. Financial Executives Research Foundation looks into the potential impact of the new rules.

Call it a tale of two executives who "gave at the office." In 2004, Brad Anderson, the CEO of Best Buy Inc., voluntarily gave 200,000 of his stock options--worth up to $7.5 million--to non-executive employees of the consumer electronics company.

Conversely, in January, Richard Scrushy, former CEO of HealthSouth Corp. was forced to repay the company $47.8 million in bonuses. Though Scrushy was acquitted of criminal charges in connection with a $2.7 billion accounting fraud, the Alabama Circuit Court ruled that the bonuses should not be retained since they were tied to the company's financial performance (which was later found to be misstated).

This latter case, among other examples related to executive compensation at The Walt Disney Co., Tyco International and the New York Stock Exchange, has led to increased focus on executive compensation. Virtually all of the recent corporate scandals in the U.S. were related to executive compensation in one form or another, notes James T. Brady, compensation committee member of the board of directors of T. Rowe Price Group Inc. (He also serves as audit committee chair of T. Rowe Price, Constellation Energy Group, McCormick & Co. Inc. and Aether Systems Inc.)

"Incentive arrangements led people to do things that were counter to the company's goals and not in the best interest of shareholders. I'd be hard-pressed to find a case where executive compensation was not an element," he says.

Since the task of creating these senior executive incentives falls largely to compensation committees of boards of directors, it would seem that boards of directors may be due for some rethinking on managing the process and then better communicating with shareholders what exactly top executives are getting paid.

In the Sarbanes-Oxley era, direction for boards and other decision-makers may be coming from the U.S. Securities and Exchange Commission (SEC) in the form of more disclosure. On January 17, the SEC announced that it unanimously voted to publish proposed rules to amend disclosure on executive and director compensation. In his opening remarks during at the meeting, Chairman Christopher Cox noted that the commission had not undertaken significant revisions to its executive compensation rules in 14 years, and that current rules don't reflect changes that have occurred in the marketplace. "Simply put," he said, "our rules are out of date."

Components of the SEC Proposal

Current proxy disclosures would be refined to include improved narrative disclosure on the compensation of the CEO, CFO and the three other highest paid executive officers, a change from current rules that don't specifically name the CFO. Disclosure is also required for three additional non-executive employees if their pay exceeds that of the top five named executives. The existing compensation committee report and performance graph would be replaced with a Compensation Discussion and Analysis section that focuses on the key factors underlying compensation policies and decisions. Disclosure would be organized into three broad categories:

1) Compensation over the last three years. The current Summary Compensation Table would now include a new total compensation column and a dollar value for stock-based awards measured at grant date, with fair value calculated per FAS 123(R). The All Other Compensation column would now include the accrued increase in the actuarial value of pension plans and non-tax-qualified deferred compensation. The threshold for disclosing perquisites would be reduced to $10,000. And, two supplemental tables would report grants of performance-based and other equity awards.

2) Holdings of outstanding equity-related interest (future gains). The Outstanding Equity Awards at Fiscal Year-End Table would show potential amounts that may be received in the future. The Option Exercises and Stock Vested Table would show amounts realized during the last year.

3) Retirement plans and other post-employment payments and benefits. This section would include two tables: Retirement Plan Potential Annual Payments and Benefits, as well as those payments payable to each named executive officer. The Nonqualified Defined Contribution and Other Deferred Compensation Plans table would disclose year-end balance, the executive and company contributions and earnings and withdrawals that apply to that year. This category would also include disclosure and quantification of payments and benefits (including perquisites) payable on termination or change-in-control.

The proposal also calls for a new table on Director Compensation. This would include, but not be limited to, cash fees, equity or other long-term compensation, perquisites, tax reimbursements, contributions to defined contribution plans, increases in the actuarial value of all defined benefit plans, charitable program awards and insurance premiums. A narrative description of compensation committee procedures for determining executive and director pay, security ownership of officers and directors, as well as director independence, would also be detailed.

Disclosure of related-party transactions would be impacted, as the threshold would change from $60,000 to $120,000. Form 8-K disclosures on employment arrangements would be consolidated and modified. Finally, companies must prepare this information in plain English.

Potential Challenges to the SEC Proposal

While all could agree with the proposal's intent to foster transparency in executive compensation, there are some concerns that are expected to surface during the comment process. First is the potential overstatement of specific pay elements. A stock option, for example, would first be disclosed at fair value at date of grant in the Summary Compensation Table. During the vesting period, the option would be reflected in the Outstanding Equity Awards Table. Once an option is exercised, it would be shown in the Option Exercises Table.

In some situations, both amounts earned and subsequently paid out would be disclosed. Though this raises the risk of double-counting, the proposal states that "the risk inherent in such double disclosure is outweighed by the clearer and more-complete picture it would provide to investors."

Regardless, many say that proxies should address the fact that options granted and disclosed in the summary table may never vest or become exercisable. Further, investors should be able to understand that in some earlier year, an exercised option would have been previously disclosed at date of grant. Accordingly, the proposal encourages companies to use the narrative following the tables (and where appropriate, the Compensation Discussion and Analysis) to explain how disclosures relate to each other.

Additionally, changes in stock option plans could further complicate disclosures. For example, Derrick P. Neuhauser, senior manager, Executive Compensation and Employee Benefits at BDO Seidman, says that some companies are now looking at stock options awards linked to a specific measure, such as comparison of stock price against companies within the same industry. Disclosure would have to clearly address that this type of instrument may never be realized.

A potentially more problematic area relates to change-in-control payments. To quantify amounts payable upon change-in-control would be very speculative, says James F. Reda, corporate governance specialist and co-author of Compensation Committee Handbook. Change-in-control payments are typically 1 percent to 3 percent of a transaction amount, which is normally based on stock price. One would have to make certain assumptions about stock price at the disclosure date, he says, but, when the triggering event occurs, the actual stock price would probably increase--resulting in a different value.

Neuhauser comments that contracts with change-in-control provisions often provide for pension plan credits for additional years in service. From a preparer perspective, this puts the CFO in the position of quantifying payments based on multiple scenarios that, again, may never occur. Calculations may have to consider tax gross-up payments and, Reda adds, there may be several different documents that have change-in-control provisions.

As noted previously, disclosure may be required for three additional non-executive employees. Jill Kanin-Lovers, who chairs the compensation committees of Heidrick & Struggles and Alpharma Inc., is ambivalent about the change. "Back in the days when I was in human resources [as an HR executive at Avon Products Inc., IBM Corp. and American Express Co.], there were people in the sales-force who could make a fortune. Compensation could go out the door in different ways, not to the proxy five." She says compensation committees never looked at non-executive pay then. "We never reviewed sales plans." Now, she ponders, "Would the charter of the compensation committee have to be expanded to do this?"

Additional Responsibilities for Compensation Committees

In his opening statement, Cox said the proposal is "about wage clarity, not wage controls," and there appears to be general agreement that the proposal will allow better visibility into and control over whether or not executives are truly being paid for performance.

"I'm delighted that Chairman Cox has taken this as an initial focus," says Roger W. Raber, president and CEO of the National Association of Corporate Directors (NACD), who supports the disclosure in lieu of regulation or legislation over compensation. "I'm not in favor of putting caps on compensation. If an executive gets $50 million, for example, [boards should] look at the shareholder value and make sure they are connected."

Kanin-Lovers believes that the proposal will force compensation committees to look at pay elements in their entirety. She says that retirement benefits, in particular, were sometimes viewed separately. Those serving on compensation committees, try as hard as they can to have the proxy be transparent. With new rules, she says, "We will have to get educated as a committee to understand what the SEC wants [rather than] just plugging in numbers year after year," which will likely encourage companies to start from scratch.

However, Kanin-Lovers dismisses the notion that full disclosure would create a "me-too syndrome" that would further raise pay levels. People already know what others are getting, she notes, but at least now they would be "comparing something that is accurate." That said, she stresses the importance of data that is clear and understandable.

For some compensation committees, the proposal would only strengthen the practices that do work. Terry Allison Rappuhn, corporate director and compensation committee member of Genesis Health-Care, agrees that the transparency promoted by the SEC proposal is a real advantage. She says that Genesis' ethical obligation to effectively use its resources to care for people is reflected in its compensation policies. Since the company was formed only in December 2003, it was able to foster transparency by following NACD best practices such as using independent consultants, rather than ones used by management, to assist with developing and reviewing its compensation plans.

Timing, Applicability and Implementation

The complete 370-page proposal is open to a 60-day public comment period following publication in the Federal Register (which did not occur by press time). Depending on the specific form filed (10-K, 8-K, etc.), the new rules, if adopted, would become effective anywhere between 60 days to 120 days after publication. Most estimate that the rules would not be in full force until Spring 2007.

Generally speaking, however, some changes are likely to be voluntarily adopted this year. Indeed, as cited in The Wall Street Journal, some larger companies have already included voluntary proxy disclosures that may align with the new rules. Pfizer Inc. provided disclosure on executive perks, including the methodology used to value benefits such as use of corporate aircraft. Meanwhile, Wachovia Corp.'s Summary Compensation Table gave a dollar value for 2004 option grants, along with a total compensation figure for each top official. The company told the Journal that any changes as a result of new rules would not be substantial.

Though it may not be as easy as it sounds, the bottom line, say experts, is to keep it simple. A compensation committee should not be approving something it does not understand. "Too many times, boards have relied almost solely on compensation consultants and compensation surveys," argues Brady. "While they are capable of providing good information, they should not be viewed as the last word."

Board members, he says, should ask compensation committees the following: "At the end of day, regardless of what other companies give, when you look at compensation arrangements for a certain executive at a specific company--given the performance of that company--are you satisfied that this is fair?" If they can say "yes," Brady says, "I'm OK; I don't need any other info than that."

Cheryl de Mesa Graziano, CPA ([e-mail]), is Vice President of Research and Operations for Financial Executives Research Foundation (FERF). A more detailed analysis of the proposal is available on FEI's website.

RELATED ARTICLE: takeaways

* The SEC proposed new rules for disclosing executive and director compensation, the first revision in 14 years.

* The rules would mandate improved narrative on the CEO, CFO and the three other highest paid executive officers. Also, disclosure is required for three additional non-executives if their pay exceeds that of the top five.

* Disclosure would be organized into three broad categories: Compensation over the last three years; holdings of outstanding equity-related interest (future gains); and retirement plans and other post-employment payments and benefits.

* If approved, the rules become effective in Spring 2007.