Navigating the CD&A for Your Next Proxy

Now that the first proxy season following the SEC’s overhaul of executive compensation rules is long over, publicly traded companies would be smart to focus on one thing: next year’s proxy. This may seem excessive given that compliance costs for most companies are already high, but beware-an SEC review of 2007 proxy statements will soon report that not everyone got it right the first time. Obviously, some innocuous mistakes were expected given the new, complicated requirements, but that has not stopped murmurs from the SEC that overall disclosure was lackluster. An SEC report on the first compliance cycle is due out this fall, and public companies, as well as companies considering going public, should take notice.

In the meantime, companies have an excellent opportunity to improve the recording of how and why compensation decisions are made, which is otherwise known as the “analysis” portion of the newly required Compensation Discussion & Analysis (CD&A) section of the proxy. A strong CD&A starts with the compensation committee keeping excellent minutes throughout the year regarding not only what compensation decisions are made, but why they are made. This is especially true for any company that entrusted outside counsel with the drafting of the most recent CD&A and armed them with only the SEC periodic reports for the previous year and the compensation committee meeting minutes.

Year-long attention to compensation disclosure was difficult in 2006 because the final rules dictating thoughtful, narrative disclosure of executive compensation decisions were not final until late August, with an additional auditing tweak in late December. But, any pass given by the SEC this year for last year’s disclosure mistakes will be harder to obtain the second time around. Companies should start improving now. The focus should be not only on the CD&A, as was the focus during this past proxy season, but other aspects of the proxy as well, including the narrative descriptions accompanying the executive and director compensation tables and the tables themselves. Now is also the time to revise the ancillary documents that are described in the proxy statement, such as the board committee charters, employment agreements, and the related party transactions policy.

Compensation Discussion and Analysis

Currently, the public, along with government officials and investors, are skeptical of board decisions underlying executive compensation. No company wants to lend any credence to these views by drafting a boilerplate CD&A. The best way for a company secure in its compensation decisions to respond to this distrust of the compensation process is to present its compensation decisions in a complete and meaningful CD&A.

Companies can improve the CD&A by focusing on their analysis of compensation decisions. The importance of analyzing decisions, as opposed to merely stating what types of compensation are paid, is evident by the language of the CD&A rules. The new rules require that the following material elements of compensation for named executive officers be discussed, described, and explained:

(1) the objectives of the compensation program;

(2) what the compensation program is designed to reward;

(3) each element of compensation;

(4) why the company chooses to pay each element;

(5) how the company determines the amount/formula for each element; and

(6) how decisions regarding each element fit into the compensation objectives.

To give weight to its maxim that no two CD&A sections will be the same, the SEC has also provided no less than 15 examples of material information to be disclosed in the CD&A as applicable. The only way a company can ensure this material information will be properly covered, along with the six required material elements above, is to monitor the how and why of each compensation decision throughout the year. When compensation decisions are made, the compensation committee should articulate, in writing, as many aspects of elements (1) though (6) above as possible. This forced articulation allows the CD&A to grow over time as each decision is made. By doing this, a company creates a living record of its compensation procedures for the previous year.

Committees

An additional step in any proxy statement revamp is to strengthen the documents relied upon by the board committees in preparing the proxy statement. These documents include the committee charters and various written policies, including the related-party transactions policy.

For example, the compensation committee charter needs to be amended to include a reference to annual approval of the CD&A, and either the audit committee charter or the nominating committee charter should describe a written, related-party transactions policy. The proxy rules allow for each of the charters of the compensation, audit, and nominating committees to be disclosed by posting them on a company’s website. This rule encourages the existence of committee charters, which are required by the large securities exchanges for certain key committees. Posting to the website facilitates easier access by investors and the public, but companies need a heightened sensitivity to the contents of these charters and how to amend them in the context of the new proxy rules. At a minimum, the compensation committee charter should indicate that the compensation committee will review and discuss disclosures in the CD&A with management and recommend that such disclosures be included in appropriate filings.

If committees have written policies in addition to their charters, these policies should also be reviewed in the context of the new proxy rules. Specifically, companies should draft a written, related-party transactions policy because the new rules require companies to explain how such a policy is evidenced if not in writing. This policy will be the responsibility of either the audit committee or the nominating committee and will describe the policies for review, approval, and ratification of any related-party transactions required to be disclosed. This description should include the types of transactions that are covered and the standards used for approval.

Tables and Narrative Descriptions

While the new heart of the proxy statement may be the CD&A, the brain continues to be the compensation tables and accompanying narrative descriptions. The new tables in particular are where investors, reporters, analysts, and even executive compensation consultants must eventually turn to decipher who is earning what. The SEC is obviously working to make the information presented in these tables easier to understand, and companies should start looking now to next year’s proxy as a way to show the SEC and investors that they too are committed to transparent disclosure.

While companies are safe to strictly comply with the new executive compensation rules, they should also take cues from the new rules for how to obtain optimum governance and disclosure. For example, the new rules indicate that companies should be monitoring perks paid to executives and directors on a frequent basis, not just looking back over the past year and trying to determine who booked time in the corporate jet. The goal is not just to have accurate disclosure, but also to avoid embarrassment in the form of perks that are hard to justify.

A second item of advice that can be gleaned from the SEC is that companies should increase focus on the new rules designed to discourage option backdating. In an effort to curb management’s temptation to backdate options, the SEC now requires additional disclosure if a stock option’s exercise price is different than the stock price on the date of grant. Specifically, an extra column must be added to the Grants of Plan-Based Awards Table showing market price on the grant date if the exercise price is lower. And, if the exercise price is not the grant date closing market price, the company must describe its methodology for determining the exercise price. It may not be practical to amend shareholder-approved option plans that do not set the option exercise price on the grant date (many use the closing price on the date preceding the grant date), but this should be considered for future stock option plans.

Finally, anyone who drafted a proxy statement for this last compliance cycle knows that one of the most time-consuming sections was the explanation of what named executive officers will be paid upon a hypothetical termination or change-in-control. The disclosure is designed to prevent investor shock and public outrage when the CEO leaves after poor performance and still walks away with millions. Determining what executives will be paid if they leave is a necessary exercise for both public and private companies that use employment agreements, but the provisions that control these payments are often confusing and unclear. No company should renegotiate employment agreements simply to make this process easier; however, future employment agreements should be drafted with these disclosures in mind.

Get Started

Preparation for the proxy statement is no longer a per annum event, and companies should encourage procedures designed to improve thinking about and collecting compensation decisions. Despite higher compliance costs, benefits have come from the new compensation disclosure rules, including more descriptive disclosure and a clearer presentation of compensation data. As the SEC works to evaluate whether disclosure has been appropriate and whether the current rules are having their desired effect, companies should work toward impressing investors with optimum disclosure and compliance procedures. The best way for a company to accomplish its compensation disclosure goals continues to be providing the proxy statement drafter with the tools needed to write a comprehensive, painfully thorough description of how and why compensation decisions are made.