On December 16, 2009, the US Securities and Exchange Commission adopted several amendments to the proxy disclosure rules which will affect the content of 2010 proxy statements. This Legal Alert summarizes the new requirements added by these amendments. The SEC subsequently clarified that the new rules are effective with respect to definitive proxy statements and other reports filed on or after February 28, 2010, with respect to fiscal years ending on or after December 20, 2009.

Disclosure Concerning Compensation Practices As They Relate to Risk Management

The SEC has added a new paragraph to Regulation S-K 402, which requires disclosure of risks arising from compensation policies and practices. For example, the substantial increase in the origination of unsound sub-prime mortgage loans has been blamed in part on compensation practices that encouraged increased loan originations without regard to loan quality.

Based upon this perception, new Regulation S-K 402(s) requires a discussion of compensation policies and practices for employees, including non-executives, as they relate to risk management and risk taking. The discussion, however, is only required to the extent that the risks arising from the practices are “reasonably likely to have a material adverse effect on the registrant.” The SEC suggests that disclosures may be required with respect to compensation policies and practices:

• at a business unit that carries a significant portion of the registrant’s risk profile,

• at a business unit that has compensation policies and practices significantly different from other units within the registrant,

• at a business unit that is significantly more profitable than other units within the registrant,

• at a business unit where compensation expense is a significant percentage of the unit’s revenues, or

• that vary significantly from the overall risk and reward structure, such as when bonuses are awarded upon the accomplishment of a task while the income and risks extend over a significantly longer period of time.
  

This requirement is specifically not part of the required CD&A, and unlike other compensation disclosure requirements, does not require a discussion of historical compensation practices. Instead, it requires forward-looking disclosure about material risks. Further, unlike other required compensation disclosures, it is not limited to executive compensation but applies to any compensation practice posing risks reasonably likely to have a material adverse effect. A registrant, however, is not required to make an affirmative statement that the risks arising from its compensation policies and practices are not reasonably likely to have a material adverse effect.

It is doubtful that many registrants will desire to admit that the risks associated with their compensation practices are reasonably likely to have a material adverse effect on the company. Indeed, similar to several SEC rules adopted following the enactment of the Sarbanes-Oxley Act, the disclosure requirement appears calculated to encourage issuers to alter compensation practices in order to avoid the need for risk disclosure. Accordingly, affected registrants have an opportunity between now and the date of the required compensation disclosure (whether appearing in an annual report on Form10-K or proxy statement) to examine and revise their compensation practices to the extent that they are concerned that they would otherwise be required to disclose that a compensation policy or practice exposes the registrant to a risk reasonably likely to have a material adverse effect. Initial analysis appears to indicate that the financial services industry and other industries where variable compensation comprises a material portion of issuer operating expenses are the most likely to be effected by this rule.

Changes to the Summary Compensation and Director Compensation Tables

The SEC believes there is some conflict between the requirement to disclose the value of all compensation paid and the requirement to disclose the value of prospective equity awards granted. Regulation S-K 402(c) has been amended to require disclosure of the aggregate grant date fair value of equity awards in columns (e) and (f) of the summary compensation table. (Currently the rule requires the disclosure of only the dollar amount recognized for financial statement reporting purposes with respect to the fiscal year, in accordance with FAS 123R.) To the extent that the amount of the award will vary based upon performance, the registrant is not required to disclose the maximum value of the award in the table, but instead is required to disclose the value of the “probable” outcome in the table and to disclose the maximum value in a footnote. A corresponding change is made to the tables disclosing Grants of Plan-Based Awards and Director Compensation.

This change is likely to increase the amounts reported in the year of grant. It also may result in more variation in the identity of the executive officers included in the summary compensation table, either due to “new hire” or “one-time” multi-year awards. The SEC suggests that if a significant executive officer is displaced from the table as a result of either of these events, the registrant should consider also including the compensation for that executive officer, enlarging the group of executives included in the table.

Unlike most changes to compensation disclosure, which are applied only prospectively, this change is required to be applied retroactively. To the extent that this change affects the presentation of compensation received by a named executive officer in a prior year included in the table, the prior year disclosure must be revised. If an executive included in the most recent year’s disclosure also was included for the second prior year but not the immediate prior year, that executive’s compensation for the immediate prior year must also be added to the table. Note, however, that the change does not require the inclusion in the table of an executive who was omitted from the table based upon the prior rules.

Additional Director and Nominee Disclosures

For the first time in many years, the disclosure with respect to the background of directors and officers has been revised. These changes will require revisions to existing forms of Directors and Officers Questionnaires.

Experience. The amendments require registrants to disclose for all directors and nominees the specific experience, qualifications attributes or skills that lead to the conclusion that the person should serve as a director. If an individual is chosen because of a particular qualification, attribute or experience related to a specific committee, this should also be disclosed. Unlike the disclosure of prior employment, this new requirement is not limited to five years. This disclosure must appear every year and includes directors not up for reelection in the particular year.

Prior Directorships. The amendments require registrants to disclose for all directors and nominees the public company directorships they have held during the past five years, even if they no longer hold such position. The current rule only required the disclosure of current directorships.

“Bad Acts.” The amendments extend the disclosure with respect to prior “bad acts” from five years to 10 years and add as additional “bad acts” legal proceedings in which a director or nominee was subject to:

• an order, judgment, decree or finding relating to the violation of (i) any federal or state securities or commodities law or regulation, (ii) any law or regulation respecting financial institutions or insurance companies or (iii) any law or regulation prohibiting mail fraud, wire fraud or fraud in connection with a business entity. (This does not include a settlement of a civil proceeding.)

• a sanction or order of any self-regulatory organization (basically a stock exchange or FINRA), any “registered entity” under the Commodity Exchange Act (basically a commodity exchange) or a similar organization that has disciplinary authority over its members or persons associated with its members.
  

New Disclosures Concerning Board “Diversity,” “Leadership Structure” and Role in “Risk Oversight”

Several new items have been added to S-K 407 pertaining to corporate governance matters.

Diversity. S-K 407(c)(2)(vi) has been amended to require disclosure whether the nominating committee (or the board) considers “diversity” in identifying nominees for director. If the committee or board has a policy with respect to “diversity,” it must describe how the policy is implemented and how the committee or board assesses the effectiveness of the policy. Note that the rule does not define “diversity,” and the SEC expressly leaves it to the registrant to define the term, deciding whether it means different viewpoints, experience, education, skill or other individual qualities or concepts such as race, gender and national origin.

Leadership. S-K 407(h) has been added, requiring a description of the “leadership structure” of the board, such as whether the same person serves as chairman and CEO, and if so whether the board has a “lead independent director” and the role of this person. This rule appears, once again, to be some effort to influence conduct by requiring potentially undesirable disclosure (i.e., an explanation as to why it is appropriate for the same person to serve as chairman and CEO).

Risk Oversight. S-K 407(h) also adds a requirement to disclose the board’s role in “risk oversight,” such as how the board administers its oversight function (such as through the whole board, the audit committee or another committee) and whether persons who supervise risk management report directly to the board or the applicable committee.

New Disclosure Concerning Compensation Consultants

The expanded compensation disclosure requirements and increased focus on compensation practices have resulted in substantial increased employment of compensation consultants in connection with making (and justifying) compensation decisions. Over the past several years, the SEC has called for increasing disclosure about the identity and role of these consultants in determining the amount or form of executive and director compensation. The SEC has adopted extensive additions to S-K 407(e)(iii) requiring additional disclosure with respect to compensation consultants.

• If the board or compensation committee has engaged a compensation consultant to provide advice on the amount or form of executive and director compensation, the consultant also provides other, non-executive compensation consulting and the fee for these other services exceeds $120,000, all fees paid to the consultant must be disclosed. Disclosure is also required if the decision to engage the consultant for the other services was made or recommended by management and whether the board or committee has approved the non-executive compensation consulting services.

• If the board or committee has not engaged a compensation consultant, but management has engaged a consultant to provide advice on the amount or form of executive and director compensation, the consultant also provides other, non-executive compensation consulting and the fee for these other services exceeds $120,000, all fees paid to the consultant must be disclosed.

• Fee disclosure for compensation consultants that work with management are not required if the board has its own compensation consultant.

• Services involving broad-based non-discriminatory plans or the provision of information, such as surveys that are not customized for the company or are customized based upon parameters not developed by the consultant, are not treated as executive compensation consulting services for the purposes of these new rules.

Initial reports indicate that, in anticipation of this disclosure requirement, some boards and committees are terminating relationships with existing compensation consultants and hiring independent compensation consultants. Again, the new requirement appears to be designed to influence conduct by requiring potentially undesirable disclosure if the registrant’s practices do not conform to the standard specified by the rule.

New Disclosure in Form 8-K Reporting Voting Results

Currently the results of any shareholder vote is required to be reported in Form 10-Q (or Form 10-K for votes held in the fourth quarter). Form 8-K has been amended by the addition of Item 5.07, requiring that the results of a shareholder vote be reported in Form 8-K within four business days after the vote is held, and the requirement has been removed from Form 10-Q and Form 10-K. The required disclosure is substantially the same as the prior required disclosure, with some clean-up of the drafting of the prior provisions. Note that Form S-3 was not amended to add this item to the list of items not affecting timely filing, so a failure to timely file a report on Form 8-K with respect to this item would affect a registrant’s ability to utilize Form S-3. Also note that written Form 8-K disclosure controls should be amended to add this new requirement.

Continuing Compensation Disclosure Issues

In addition to the new rules, the SEC staff has emphasized in recent statements several areas of compensation disclosure which will receive continued scrutiny during 2010. In particular, watch out for:

Depth of CD&A analysis. The SEC staff has reiterated that CD&A disclosure that only discloses the amount or percentage change in a compensation amount is inadequate. If an executive’s salary was increased by, for example, five percent, it is not sufficient to disclose this change without discussing how the amount of the increase was determined (as the SEC says, explain why it was not four percent or six percent).

Focus on disclosure of performance goals. The SEC staff continues to focus on the requirements of S-K 402 (b),(d), (e) and (f), which require the disclosure of performance goals, unless the requirement would call for the disclosure of competitive business information eligible for confidential treatment. Many registrants have received comments objecting to the omission of specific performance goal disclosure.

Increased requirements of amendments rather than prospective changes. The SEC staff has also stated that, in its view, registrants have had sufficient time to become familiar with the requirements of S-K 402, and the staff, in providing comments on compensation disclosure, expects increasingly to require amendments to proxy statements, even after the annual meeting has been held, and to reduce the instances in which comments may be addressed in composing the following year’s disclosure.

Conclusion

Arent Fox is continuing to follow actively developments in the compensation and corporate governance disclosure areas and to advise on compliance with the new requirements. If you would like additional information on any of these new requirements and their application to your particular disclosure concerns, please contact:

Jeffrey E. Jordan
jordan.jeffrey@arentfox.com
202.857.6473