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Charting performance: the SEC's new disclosure rules.

As a matter of policy, the SEC disclaims responsibility for any private publications by any of its employees. The views expressed herein are those of the authors and do not necessarily represent the views of the Commission or any of its staff.

The Securities and Exchange Commission's new executive compensation disclosure rules, adopted in October, have two key purposes: to provide shareholders with highly formatted, easily understood information regarding a company's executive compensation policies and practices, and to ensure that members of boards of directors, ultimately responsible for setting such compensation, can be held fully accountable at the corporate ballot box by an informed shareholder electorate.

Under the new rules, the lengthy descriptions of compensation plans previously mandated will be replaced with a series of tables outlining each item of compensation awarded, earned, or paid in a given fiscal year to the company's chief executive officer and the four other most highly paid executive officers. Board compensation committees also must furnish, over the names of each committee member, a report of the rationale for the compensation disclosed.

Accompanying these disclosures will be a linear graph reflecting long-term trends in corporate performance as measured by total shareholder return (stock price plus dividends). Based on this graphic illustration, shareholders should be better equipped to evaluate the adequacy of the compensation committee report discussing the relationship of executive pay to the company's performance.

The performance graph compares annual changes in the company's five-year cumulative total shareholder return, calculated on a dividend-reinvested basis, with returns for the same period on both a broad equity market index and an industry or peer-group index. For purposes of the industry comparison, companies may select either a published industry or line-of-business index, or construct an index of peer entities selected in good faith. The new rules make clear that companies have broad discretion in determining a peer comparison; for example, the comparison may be made to as few as one entity and to foreign as well as domestic companies.

To chart the requisite annual changes in cumulative total return, the company should calculate the fluctuations in the dollar value of a hypothetical investment made at the beginning of the five-year period, or "measurement point," in a class of its registered common stock and in each of the two comparative indices. In constructing the line representing its own return, for example, the company first would convert its stock price at the measurement point into a base amount (e.g., $100). Each subsequent fiscal year-end point plotted (or other more frequently plotted points), thus represents the value of that initial investment at each point, assuming that dividends are reinvested, To the extent feasible, the company should use comparable methods of presentation and assumptions in connection with all total return calculations.

Companies in the Standard & Poor's 500 Composite Stock Index must use that index as a performance indicator for the broad equity market. Any company not included in the S&P 500 is free to select any index of stocks traded on the same exchange or market on which the company's stock is traded, or that have comparable market capitalization. A word of caution: Return on any broad market index selected must be calculated on a dividend reinvested basis.

If a company elects to create an index of peers rather than use a published industry or line-of-business index or, based on a reasonable belief that it has no peers, substitutes a self-constructed index of entities with similar market capitalization, certain additional disclosure is required. Specifically, the company must identify each component entity in the index and weight each such entity's return by market capitalization.

A change in any of the comparative indices used--whether the published broad market and industry/line-of-business indices or a self-constructed index--will require the company to explain the basis for the change and to provide comparisons of its five-year return with returns on both the new index and the index used in the preceding fiscal year. Generally, a change in any company-constructed index (e.g., substitution of peer companies) is equivalent to selection of a different index, thus triggering the requirement to compare the company's return with returns on both the old and new indices. Presentation on the old basis is not mandatory, however, if the information omitted is no longer available to the company or, in the case of a peer index, an excluded entity no longer is in the same industry or line of business.

Comparisons of corporate performance based on measures other than total shareholder return, such as return on average common shareholders' equity, may be presented in addition to the mandatory disclosure based on shareholder return. But remember that the compensation committee report must discuss the link between any such measure and executive compensation.

A number of those affected by the new rules expressed concern during the rule-making process about the possibility of liability resulting from compliance with the new graph requirement, particularly on the choice of index or the selection of peers. In response, the new rules give the required comparisons of performance the same legal status that they give to the company's annual report. Because neither the graph nor the compensation committee report is "soliciting material" or "filed" with the SEC, they are not subject to the liability provisions of Sections 14 and 18 of the Securities Exchange Act of 1934. The SEC has emphasized that companies should "not be subjected to litigation concerning their selection of a peer company or industry index for inclusion in the Performance Graph, since no single other company or industry index will be perfectly comparable to a given issuer."

The new rules are applicable to all proxy and information statements filed on or after January 1, 1993. Small-business issuers--U.S. and Canadian companies with less than $25 million in revenue and a total public float of less than $25 million--are exempt from the performance comparison and certain other requirements of the new rules. And they can continue to use the old rules until May 1, 1993.

The SEC's new executive compensation disclosure rules, particularly the performance graph and compensation committee report, provide companies the opportunity to dispel much of the public confusion about the need for competitive executive compensation that often resulted from the lengthy disclosures mandated by the prior rules. By requiring companies to simplify the disclosures of how, how much, and why top executives are paid, the new executive compensation disclosure rules will help shareholders analyze the board's effectiveness in incentivizing management to achieve optimum corporate performance. In the final analysis, shareholders who are dissatisfied with what they learn about executive compensation should act through their power to elect directors, not through litigation.

Ms. Dixon is chief of the Office of Disclosure policy of the Securities and Exchange Commission. Mr. Corso is deputy chief of the SEC's Office of Tender Offers.
COPYRIGHT 1993 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Executive Compensation in the Spotlight
Author:Corso, Gregg W.
Publication:Financial Executive
Date:Jan 1, 1993
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