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In late 2006, the U.S. Securities and Exchange Commission (SEC) completed an ambitious program to overhaul the executive-compensation and related-person disclosure requirements. The SEC’s revised rules were intended to provide investors with a more clear and complete picture of director and executive compensation and to make disclosures easier to understand by requiring the text to be written in “plain English.” As compensation techniques have evolved and often become more complicated, it has become increasingly difficult for shareholders to obtain a complete and clear understanding of how companies are paying their executives. And as overall pay levels have mounted, the materiality level of compensation decisions has significantly increased. Arguably, these considerations made the SEC’s overhaul of the disclosure requirements somewhat overdue. With the 2007 proxy season largely behind it, the SEC published the results of its review of the disclosure of 350 public companies for compliance with the new rules on executive compensation disclosure on Oct. 9. Each of these companies has received a comment letter, which will be published along with the company’s response on the SEC’s EDGAR system within 45 days after the SEC completes its review of the company. No additional rule-making is expected in 2007, as both the SEC and the market are digesting the experience of the first proxy season under the new rules. But as companies now begin to prepare their next annual filings, they should draw on the lessons learned this year to improve their disclosure and to avoid attracting unwanted attention from the SEC and the popular press. This article highlights the significant issues raised in the Staff Observations and otherwise by the SEC in its comment letters, and provides insights into best compensation disclosure practices based on trends observed in a privately conducted survey of the proxy statements of the largest 100 public companies. To the extent that a company determines that its performance targets are a material element of its compensation policies, the executive-compensation disclosure rules require companies to list the specific performance criteria taken into account in setting compensation. Regulation S-K, Item 402(b)(2). The rules require that target levels of specific performance-related factors be disclosed, unless the targets involve confidential commercial or business information that would result in competitive harm. If the targets are not disclosed, a company must indicate that it is omitting the disclosure on account of confidentiality concerns and instead discuss how difficult it will be for an executive, or how likely it will be for the company, to achieve the undisclosed target level, factor or criteria. The applicable standard that must be met to permit the nondisclosure of this information due to confidentiality concerns is the same standard used for requesting confidential treatment under the SEC’s existing rules. Instruction 4 to Item 402(b) of Regulation S-K. Throughout the 2007 proxy season, the SEC has commented that very few companies have disclosed details regarding their performance-based compensation, particularly their specific performance targets. In the Staff Observations, the SEC indicated that it issued more comments regarding performance targets than on any other aspect of the new disclosure requirements. The privately conducted survey reveals that only 45 of the top 100 companies disclosed the specific targets under the performance metrics used to determine the annual bonuses paid to their named executive officers. Similarly, while many companies disclosed that their compensation committees considered individual performance in setting pay, very few disclosed how they analyzed individual performance, according to the Staff Observations. Compliance with the requirements regarding disclosure of performance criteria appears to have caused the most significant issues in preparing the 2007 proxy statements. Many issuers have stated that disclosing their “internal” compensation performance goals will enable competitors to understand their compensation philosophy, which could, in turn, cause them significant competitive harm in hiring and retaining talented executives. The SEC, however, has expressed concern that too many companies are improperly applying the confidentiality standard. The SEC has noted that if performance forecasts and actual levels of achievement of goals (e.g., earnings per share or total return to shareholders) are already disclosed to the public in the company’s financial statements and other public filings, then the compensation performance targets must also be disclosed even if they differ from the public forecasts. Differences between the targets for payments of performance-based compensation and market guidance utilizing the same metrics are likely among the items that the SEC intended to highlight when enacting the enhanced disclosure rules. In the Staff Observations, the SEC staff indicated that there may be a need to discuss prior years’ targets � including information regarding whether the targets were achieved � when discussing the current year’s targets. The SEC has frequently commented on company disclosure regarding the use of discretion in setting compensation levels. Companies should disclose whether their compensation committee has discretion over compensation elements or whether the amounts are paid on a formulaic basis. The SEC also is seeking a discussion of the cases in which discretion might be used and whether discretion has actually been exercised. Compensation analysis The centerpiece of the new executive-compensation disclosure rules is the section called “Compensation Discussion and Analysis” (CD&A). This requirement calls for a principles-based discussion and analysis of an issuer’s compensation policies and the decisions reflected by the data provided in the compensation tables. A well drafted CD&A should present the company’s compensation philosophy and decision-making process, and it should also describe why compensation decisions were made. But in his recent speech titled “ Where’s the Analysis?” given on Oct. 9, John W. White, the director of the SEC’s Division of Corporation Finance, lamented the lack of analysis of companies’ compensation policies and decisions in their disclosures. The private survey reveals that many issuers provided granular details of the components of their compensation programs in the CD&A, but have not provided a complete picture of why certain elements of compensation were used or indeed appropriate. As recently noted by RiskMetrics Group/ISS Governance Services: “[B]y presenting a holistic picture � the compensation report demonstrates the links between pay and performance, rather than merely asserting them. The closer reports come to this ideal, the more they will earn the trust of investors in the soundness of the compensation plan, the integrity of its implementation and in the judgment of the board.” RiskMetrics Group, Proposed Best Practices in Executive Compensation Disclosure, October 2007, at 10. Similarly, the SEC has noted that many companies have either forgone narrative disclosure accompanying the tables or repeated the contents of the CD&A in the narrative or footnotes accompanying the tables. This only serves to increase the length of the proxy disclosure without giving insight into the analysis behind the compensation decisions. Plain English requirements The new executive-compensation disclosure rules were meant to simplify and clarify the information presented to investors. However, the SEC has acknowledged that many companies did not do an adequate job of explaining technical concepts in language that is easily understood. The SEC encourages the use of charts, tables and bullet-point disclosure, with titles and subtitles providing a framework for the disclosure and illuminating key themes. The SEC also recommends the use of executive summaries to focus the compensation discussion and to highlight key company-specific issues. Many of the SEC’s comment letters noted the inadequacy of the descriptions of change-in-control and termination arrangements. Often, companies did not provide a rationale for this aspect of their compensation packages in their CD&As, nor did they describe how this element fits into the company’s overall compensation objectives and affects decisions regarding other compensation elements. In addition, the SEC encourages the required quantification of severance and change-in-control benefits to be presented in tabular format, which is not specifically required by the text of Item 402 of Regulation S-K. Many of the SEC’s comment letters requested that companies present a total figure, summing the elements that are payable in various termination circumstances. Process issues According to the Staff Observations, many of the SEC comment letters to companies requested more information on the compensation-setting process. Some letters requested a specific explanation of the role of the chief executive officer (CEO) and other executives in establishing compensation levels � especially their own. Some of the letters were so specific as to seek information on whether the CEO attended compensation committee meetings or met with the committee’s compensation consultants. Many other letters focused on the role of compensation consultants in setting compensation levels, requesting disclosure regarding who had hired the consultant and whether the consultant performs other services for the company. This information was sought for each compensation consultant who provides advice to any of the constituencies that touch on executive compensation decisions. Another area that provided common fodder for SEC comments was the use of peer benchmarking: Often, the SEC sought more information on the targeted percentile of survey data and an explanation of why the targeted percentile was appropriate for the company; sometimes, the SEC requested that the company provide details on the peer group membership. Other comments included requests to explain why and how the other executive officers’ compensation was different from the CEO’s. Internal pay equity seems to be a hot-button issue among institutional investor groups of late, and their interest in this information was reflected in some of the SEC’s requests for further information. The SEC staff has also inquired as to whether the compensation committee considers the multiple by which a named executive officer’s compensation is greater than that of other employees generally. While many companies felt that the first year under the new disclosure regime created a significant compliance burden, in some ways the second year likely will provide more challenges. Companies will have to address the SEC’s comments that are particular to their situations, as well as the common comments previously reported. In his “Where’s the Analysis” speech referenced above, John White of the SEC challenges companies not to let next year’s disclosures merely amount to a mark-up of this year’s disclosures, but to focus on what would truly be material to the shareholders deciding whether to invest in the company. While acknowledging that all subject companies struggled this first proxy season under the new rules, the SEC will expect more from issuers going forward, and the agency’s comments are likely to be less forgiving. One hopes that the Staff Observations will help guide companies to improve the quality of their disclosure. Companies should begin preparing their 2008 proxies now, armed with the rules and other SEC guidance, with an open mind and a sharp pencil. Doreen E. Lilienfeld is a partner in the executive compensation and employee benefits group of New York’s Shearman & Sterling. The privately conducted survey referenced in this article is the Shearman & Sterling Survey of 2007 Trends in Corporate Governance of the Largest U.S. Public Companies � Director and Executive Compensation. Mark Beatty, Amy Gitlitz, Adam Kaminsky, Kirath Raj, Elizabeth Roseman and Brenda Zelin, associates at the firm, contributed to the survey.

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