An open frontier

Is the corporate governance pendulum finally swinging back? Well, not quite. While the pace of reform has inevitably slowed, corporate governance reform still has plenty of momentum left. One example: the SEC’s new proposal on executive compensation disclosure. Unveiled in a January speech by SEC chairman Christopher Cox, it’s the most sweeping overhaul of executive compensation disclosure rules in more than a decade.

Clearly, critics have been clamoring for more detailed disclosure, and in his speech Cox called the existing rules ‘out of date.’ Adding further impetus are the courtroom dramas playing out with overpaid executives, as compensation has been front and center in many of these high-profile cases, most notably the New York Stock Exchange and Tyco International.

If adopted, the proposed rules would likely go into effect for the 2007 proxy season. Among the changes: refine existing tabular disclosure, expand perquisites to cover anything above $10,000 and provide improved narrative disclosure, known as the ‘compensation discussion and analysis,’ an MD&A for compensation. The disclosure would cover CEOs, CFOs and the three other highest paid executive officers and directors.

‘Up until now, the information provided was on a high level in table format with lots of footnotes,’ says Michael Sferratore, content specialist and product manager at Reuters. ‘Tables are easy to follow, but the footnotes vary and the level of disclosure varies from company to company. Overall, the proposal is another means of offering transparency to investors. We’ve seen such enhanced transparency in stock option expensing, and we may see it with the improved pension cost disclosure that Fasb is working on. So this is another variable to show investors what exactly the compensation package looks like.’

Reuters already tracks executive compensation as part of its product offering, and Sferratore says the firm will adjust its collection process to take advantage of changes in disclosure. ‘Overall, I think pay should be tied to performance, and this makes that relationship easier to evaluate,’ he explains. ‘Oftentimes, we read about compensation after a scandal, so being proactive and illustrating to investors what the board has chosen for compensation, including perks and retirement and health benefits, is important.’

Immediate impact

The SEC issued an interpretive release on perks as part of the new proposal, and companies are meant to start following it immediately. A few are even going ahead with some enhanced compensation disclosure in anticipation of next year’s new rules, but most are taking a wait-and-see approach while the SEC gathers comments on the proposal.

‘The changes do look substantial,’ says Kristina Veaco, assistant general counsel and assistant corporate secretary at McKesson Corporation. ‘The enhanced disclosure requirements are more significant than what we’ve had in the past, and I think the new compensation discussion and analysis will be interesting in the final rule. I’ve discussed the proposal with our general counsel, but it’s really too early to make any serious assessment of the impact.’

While much of the focus has been on the content of proposed new disclosure, there’s a great deal to be said for how the SEC plans to change the form as well. As with other initiatives, this comes back to simplification and a move toward more plain English.

Addison, a New York-based design company that focuses on corporate literature, has been working to help companies simplify their MD&As, especially with plain English, which the SEC has explicitly noted is lacking in many reports.

‘The SEC is not just suggesting a chart of top executives and what they’ve made the last three years,’ explains Elliott Saltzman, managing director at Addison. ‘They’re also saying they want what basically amounts to an MD&A on executive compensation. They want you to look back and say what the rationale was for the compensation and discuss stock options, for example.’

To fulfill the requirements of the rules, assuming the proposal is passed, companies will have to address this issue of simplification. Saltzman notes two parts to the process. ‘There’s the plain English aspect, and then there’s the design and layout of the information,’ he says. ‘We look at what appears to be the most important aspects of the information. Figures and dates can often be put into a chart – for example, a paragraph that really should just be a chart because it’s all numbers. It’s a tremendous way to make this disclosure clearer.’

Then what?

The big question for executives getting ready to bare all is what investors will do with the information. Some investors have never paid much attention to executive compensation; others, a lot of attention. And they’re already making it clear just what their intentions are for the next proxy season.

Christopher Wiles, senior director for large-cap core and growth equity management at Allegiant Funds in Cleveland, says he has always reviewed executive compensation as part of his analysis of companies. ‘It only becomes an issue relative to performance and ownership structure,’ he explains. ‘You have guys who’ve founded firms who take little compensation given their stake in the company, and you have those who are underperforming making several million a year.’

Wiles says any additional disclosure is welcome, and the SEC proposal would be an improvement. Companies will have to show perks, for example, which usually don’t get shown. ‘I’m not sure how significant that will be, however, given that most abuses are in the dollar numbers,’ he notes. ‘A corporate jet isn’t going to add much to that overall dollar value. An extra $2 million in options, that’s another story. So the real abuses are more in options and cash. But more is better – disclosure, that is.’

In the UK, executive compensation disclosure is already far ahead of the US. In fact, the SEC’s proposal doesn’t even call for the same level of detail on options grants as in the UK. American companies do not have to note which options are ‘in the money,’ for example.

‘There’s always been a good deal more attention paid to executive compensation by institutions here in the UK compared to the US,’ says Carol Inman, assistant company secretary at BG Group. Her company files a Form 20F (annual report for foreign issuers) with the SEC, and like other foreign issuers, she’s keen to see the SEC’s final rule. But she doesn’t expect any major changes in BG Group’s disclosure, considering the already strict UK requirements.

‘Our remuneration report is put together by the group company secretariat and human resources,’ Inman explains. ‘We also publish it on our web site, and we try to use the same format each year. The report is about five or six pages on policy and contains tables detailing remuneration and share interests for all directors. Additionally, this year the annual report will include disclosure of remuneration of key management personnel as a group, as required by the International Financial Reporting Standards.’

Aiming higher

The most significant difference between the SEC’s proposed rule and current UK requirements is that UK investors get to vote on executive pay – and that’s exactly what activists are pushing for in the US.

In fact, a few of the comment letters on the executive pay disclosure proposal have expressed fear that some companies may go private rather than provide the level of disclosure that the SEC is calling for. But that isn’t stopping proponents from not only voicing their support, but calling for additional provisions to the proposal as well.
 
‘The voting component is the part that’s missing,’ explains Richard Ferlauto, director of pension and benefit policy for the AFSCME union of government employees. ‘What the SEC is doing is necessary but not sufficient for shareholders. We want to see a mechanism not only for seeing what’s happening, but also for communicating back to boards. In our comment letter, we’re suggesting such a mechanism for shareholders.’

Indeed, Ferlauto notes that the AFSCME is already filing proxy proposals on this very issue. ‘We’re filing proposals on a company-specific basis that would establish that requirement,’ he says. ‘It’s the first time we’re doing it this year. As for the current SEC proposal, which we support, I would hope there’s enough shareholder momentum behind it to be passed as is, without any watering down.’