Monday, May 15, 2006

Executive Compensation Disclosure -
Cliff Notes Version of SEC Proposed Rule Change

The Securities and Exchange Commission received over 750 comment letters on its proposal to mandate greater disclosure of executive and director compensation. The extensive commentary is not surprising given the 300-page length of the SEC proposed rule. Then again executive compensation is a flash point for investors who have tired of corporate implosions even as senior officers rake in raises and perks. A quick look at just a few of the comment letters reveals the deep distrust and irritation the investment community harbors against multi-million dollar compensation packages that appear to have no connection to value added. For most of us reading the entire 300-page document is not an effective use of the "regular 24/7." Accordingly we went looking for a “Cliff Notes” version of the proposed rule change.

First we looked at a few of the comment letters from the accounting community and others who appeared to have a strong accounting and governance background. The comment letters can be viewed at
WWW.SEC.GOV and are displayed in order of receipt. We cite the date and the commentator as a guide to find the original letter on the SEC’s comment page.

We were surprised that some commentary simply offered more anecdotal evidence of the need for SEC action - keeping the flames of righteous indignation burning! For example, the April 14th comments (resubmitted on April 20th in case we did not get it the first time) from Creative Investment Research, Inc., a social investing advisor, offered a twenty page diatribe on “the excessive nature” of executive compensation, using bold lettering to bring attention to what Creative considers particularly egregious examples. It was their conclusion that the capital markets are “deeply flawed,” and at one point in the letter recommended the adoption of Dutch-auctions for IPOs. The good folks at Creative apparently endorse the rule change but made no specific comments on whether its provisions represent an improvement over the status quo.

To get the substance of wisdom, we had to look further. Comments submitted May 2nd from the Joint Committee on Employee Benefits, American Bar Association provided excellent points on the implementation of the proposed rules, pointing out where possible discrepancies might arise and suggesting improvements in disclosure format.

The Ernst and Young letter dated April 10th provides a good outline of the problems associated with measuring share-based compensation, a matter which was already a point of contention in the adoption of stock-based compensation expense rules. The E&Y letter points out where discrepancies might arise if the proposed disclosure rule is adopted as written and offers some suggestions to make the new requirements consistent with the FASB Standard 123 on Share-based Payment that went into effect at the beginning of January 2006.

We also took notice when reading the April 13th letter from Legg Mason Capital Management. No slouches in the ways and means of the capital markets, Legg Mason’s corporate government committee found a few flaws in the proposed rules that could limit the ability of analysts to anticipate compensation changes. The critical component is the proposed “Compensation Discussion & Analysis” section, which as proposed, may help a company to hide behind the excuse of “competitive harm” to avoid disclosing performance targets that trigger bonus compensation. Legg Mason’s view is that the disclosure of performance targets rarely results in competitive harm and asked the Commission to make such disclosures mandatory. The Legg Mason group had a number of other very helpful suggestions to improve the proposed rules, making their letter a particularly useful short-course on compensation disclosure.

For the audio-oriented, Compliance Week recently staged a web cast with Ronald Mueller, a former SEC staffer. Mueller is now a partner of Gibson, Dunn & Crutcher LLP, a Washington, D.C.-based law firm specializing in corporate law and is the author of “A Practical Guide to SEC Proxy and Compensation Rules,” making him more or less the go-to guy for companies seeking advice on how to comply with the SEC’s mandates. The web cast is aimed at the corporate officer audience and offers the nitty-gritty on compliance. Nonetheless, the presentation also provides financial professionals with an advance look at changes in the content of SEC filings if the rule is adopted as proposed. Importantly, Mueller also provides some practical words on potential duplicity that could trip up users as they calculate typical financial measures.

The Mueller web cast is available at
WWW.COMPLIANCEWEEK.COM and we encourage interested parties to listen in. While detailed, Mueller’s discussion brings home the message that the rule changes are all-encompassing and will make available a plethora of new information on the cash and non-cash compensation that is going to executives and directors. It will be far easier under this rule to observe and quantify the extent to which these control persons are dipping, double-dipping and triple-dipping into the honey pot.

The SEC is not expected to act on the compensation disclosure rule change until later in 2006. Thus we have plenty of time to get acquainted with the proposal before it goes effective. Indeed, additional comments may be possible when the formal adoption proceedings are scheduled. One area where we expect further scrutiny is in regard to small cap companies. So far the commentary is general in nature as the user community has yet to drill down to the extra challenges that typically befall smaller public companies when the SEC waves its regulatory wand.

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