Executive Compensation Disclosure: Observations on Year Two and a Look Forward to the Changing Landscape for 2009
John W. White
Director, Division of Corporation Finance
Securities and Exchange Commission
New Orleans, Louisiana
October 21, 2008
Thank you Jesse [Brill] and good afternoon. With companies now turning their attention to their 2009 disclosure, I am very pleased to be back with you to share my "second year" observations on executive compensation disclosure and provide you with my thoughts on what I hope we see in the coming proxy season. But first, I'd like to take a moment to touch on some important recent developments that I anticipate will impact the disclosure we see going forward in this area and that I think are simply too important not to address.
Of course, as I speak today, please keep in mind my disclaimer — the views I express today are my own and do not represent the views of the Commission or of any other member of the staff.
Current Market Events and the Emergency Economic Stabilization Act of 2008
As you have no doubt seen, executive compensation has been pushed back into the spotlight (though I'm not sure it ever really left) with the current financial crisis. One of the themes you hear over and over again is the public's concern about the amount of compensation that executives at "Wall Street" firms earned over the years, as their companies were making decisions that ultimately contributed to the crisis we are currently experiencing. And this of course was reflected in the recently-enacted Emergency Economic Stabilization Act of 2008,1 which establishes the Troubled Asset Relief Program. As you are aware, the TARP, as this program is known, contains various provisions requiring financial institutions to meet prescribed standards for executive compensation and corporate governance in the event they sell troubled assets to the U.S. Treasury or participate in the capital purchase program created under the TARP. Nine of our largest financial institutions have already said they will participate in the capital purchase program and sell $125 billion of their senior preferred stock to Treasury, and more are likely to follow. Additional financial institutions will become subject to these executive compensation provisions as they sell troubled assets directly or through auctions to Treasury. Thus it is likely that many, and certainly the largest, of our financial institutions will soon be covered. The rules covering the capital purchase program require that the new executive compensation provisions be in place, and existing executive compensation arrangements modified or terminated (to the extent necessary to comply with the new rules), prior to the closing of the senior preferred stock sales to Treasury. So this is all happening very fast.
These new provisions are substantive requirements applicable to participating companies and their senior executives. As this group well understands, and as I've noted on many other occasions, we at the SEC are focused not on affecting the substance of executive compensation determinations, but rather on the disclosure that is provided concerning that compensation. We are, of course, watching closely as market events and implementation of the program unfold, but I think it is already clear that the TARP and the unusual market events that led up to its enactment will introduce new compensation disclosure challenges. So this is certainly something that companies should, and no doubt are, beginning to gear up for, as are we in Corp Fin.
As this process begins, I would like to offer just a couple of preliminary — and they are truly preliminary — thoughts on the disclosure implications of the TARP, particularly with respect to its limits on executive compensation. For example, for participating financial institutions, the TARP requires the institution to have limits on compensation that exclude incentives for senior executive officers to take unnecessary and excessive risks that threaten the value of the financial institution. Last week, Treasury issued its regulations implementing this and the other executive compensation provisions in the Act.2 For this particular provision, the regulations require the participating financial institution's compensation committee to meet with the senior risk officers of the institution to ensure that the incentive compensation arrangements do not encourage the senior executive officers to take "unnecessary and excessive risks that threaten the value of the financial institution." The committee will need to limit such arrangements if they do so. The committee also will need to meet with the senior risk officers annually. And, most relevant here, the committee will need to certify in the CD&A that it has done all of this. So, CD&A disclosure is the key communication vehicle for investors, as well as taxpayers, on whether and the extent to which the financial institution is complying with the conditions on taxpayer investment in that financial institution.
More generally, as the Commission noted in adopting the current executive compensation disclosure requirements, CD&A was designed "sufficiently broadly to continue operating effectively as future forms of compensation develop, without suggesting that items that do not fit squarely within a 'box' specified by the rules need not be disclosed."3 Many of you have heard me emphasize, more than once, the principles-based nature of executive compensation disclosure under our new rules.4 This approach of "utilizing a disclosure concept along with illustrative examples" also applies to other factors not specifically enumerated in the description of CD&A or elsewhere in Item 402 that may affect the company's compensation program. For example, the Emergency Economic Stabilization Act includes express limitations on executive compensation for participating companies — especially on golden parachutes, and on claiming tax deductions for executive compensation. As I am sure you will be discussing today, the limitation on claiming tax deductions has been expanded greatly, not just to reduce the $1 million cap to $500,000, but also to eliminate the exception for performance-based compensation. So if your company is a participating financial institution, you will need to carefully consider and reflect the new provisions and their ramifications in drafting your CD&A and Item 402(j) disclosure.
Most of you are not from financial institutions, so let's talk for a moment about non-participating companies. This new Congressionally-mandated limitation on having compensation arrangements that could lead a financial institution's senior executive officers to take unnecessary and excessive risks that could threaten the value of the financial institution obviously applies on its face only to participants in the TARP. But, consider the broader implications and ask yourself this question: Would it be prudent for compensation committees, when establishing targets and creating incentives, not only to discuss how hard or how easy it is to meet the incentives, but also to consider the particular risks an executive might be incentivized to take to meet the target — with risk, in this case, being viewed in the context of the enterprise as a whole? I'll let you think about what Congress might want. We know what our rules require. That is, to the extent that such considerations are or become a material part of a company's compensation policies or decisions, a company would be required to discuss them as part of its CD&A. So please consider this carefully as you prepare your next CD&A.
Also, more broadly speaking, I expect that current market events are already affecting many companies' compensation decisions and thus should be affecting the drafting of their upcoming CD&A's. Regardless of whether your company participates in the TARP and consequently finds itself having to make new material disclosures, you should not merely be marking up last year's disclosure. Instead, you should be carefully considering if and how recent economic and financial events affect your company's compensation program. For example, have you modified outstanding awards or plans, or implemented new ones? Have you reconsidered the structure of your program, or the relative weighting of various compensation elements? Have you waived any performance conditions, or set new ones using different standards? Have you changed your processes and procedures for determining executive and director pay, triggering disclosure under Item 407? These questions and more should be addressed as you consider disclosure for 2008.
We also are looking at how we will shape our Corporation Finance review program for 2009 in light of recent market events, including the new executive compensation provisions in TARP and continued investor interest in executive compensation. As you know, our selective review program is guided by Section 408 of Sarbanes-Oxley, which requires that we review all public companies on a regular and systematic basis, but in no event less frequently than once every three years. The Act also sets out criteria for us to consider in scheduling these regular and systematic reviews, including considering companies that "experience significant volatility in their stock price," companies "with the largest market capitalizations," and companies "whose operations affect any material sector of the economy." As you also will recall, in 2007 we did a targeted review of the executive compensation disclosure under our then-new rules for 350 companies of all sizes.
Our plan for 2009 will be responsive to current conditions. In 2009 we will select for review and review the annual reports of all of the very largest financial institutions in the U.S. that are public companies. This group will include the nine large financial institutions that have already agreed to participate in the Treasury's capital purchase program. Our reviews will include both the financial statements and the executive compensation disclosures of these companies. We also intend to monitor the quarterly filings on Form 10-Q and current reports on Form 8-K of these companies.
And finally, though there is a lot to be focusing on in this area, I want to be certain that we don't lose sight of the role of interactive data in all of this, as it certainly is an important part of where the future lies for compensation disclosure.
Second Year Disclosure
With that, let me return to what I thought I'd be talking about today when I accepted the invitation last spring to be here — that being to discuss what we saw in the second year of company disclosures under the new executive compensation disclosure requirements.
Last year when I was with you we were in the midst of our targeted reviews of 350 public companies' executive compensation disclosure and had just completed our report on what we saw in the first year of disclosures under the new rules.5 This year, although we did not undertake a coordinated and targeted review of executive compensation and related disclosure, we did analyze companies' executive compensation disclosure in connection with the Division's traditional review program. Accordingly, where a filing containing executive compensation and related disclosure was selected for review, that material was examined and commented upon as appropriate during the course of our review. And this will continue to be the case. In this regard, there are many companies that did not receive comments in connection with our 2007 focused review or during our reviews in 2008, but this does not mean that their disclosure has been exempted from review or that Corp Fin has shifted priorities away from reviewing executive compensation disclosure in general. We are continuing to apply significant resources to ensuring that investors obtain quality disclosure about executive compensation and, to this end, the comment letters we most recently issued cover many of the themes and topics that were the subject of the October 2007 report.
So what did we see in 2008 and what did we comment on most? You will not be surprised when I tell you the primary areas of comment are familiar ones: (1) the need for more analysis, (2) disclosure of performance targets, and (3) disclosure relating to benchmarking.
The first of these, analysis, is of paramount importance and as such I want to both start with it and end with it. In short, our work here is not done. Last year the title of my remarks was "Where's the Analysis?" and this year, in far too many instances, we're still looking. This lack of analysis flows through companies' CD&As, including in their discussions of the two other areas I mentioned — performance targets and benchmarking. So let me talk about these for a moment and come back to the analysis point.
Performance Targets. Performance targets were a significant topic in our staff report and also in my remarks at this program last year. As you likely know, the disclosure requirements applicable to performance targets are principles-based. In preparing its disclosure, a company must determine whether performance targets are a material element of its compensation policies and decisions and, if they are material, provide disclosure in accordance with Item 402 of Regulation S-K. This was our largest area of comment in the first year, so it is not surprising that in our second year we continued to issue a very significant number of comments relating to the disclosure concerning, or omission of, performance objectives. For example, where companies omitted from their CD&A the performance objectives that are tied to a named executive officer's incentive compensation, we have continued to request that the filer justify the omission in light of the appropriate standard set forth in Instruction 4 to Item 402(b). Although the Commission does not require formal requests for confidential treatment of this information under Exemption 4 of FOIA, we consistently ask filers to provide us with legal analysis setting forth the reasons why it believes competitive harm would ensue through disclosure. And we are reminding companies that these analyses should be tailored to the facts and circumstances surrounding the company and competitive environment of the industry in which it operates and should demonstrate the nexus between disclosure and the potential for competitive damage to result.
In putting together their disclosure in this area, companies must remember to return to the underlying principles-based standard — I cannot emphasize enough that rote disclosure based on a superficial reading of the rules will not carry the day here. We've all seen press over the past months suggesting that companies are still not providing the disclosure contemplated by the rules, and in many cases our reviews bear this out. So I urge companies to redouble their efforts, and to really learn from the guidance that is out there — and there is a great deal available to you in terms of applying the standards. In addition to our report and my remarks last year and today, I also would urge you to look to our updated and revised Compliance and Disclosure Interpretations (C&DIs),6 which include some new interpretations. For example, C&DI 118.047 addresses how a company determines if it may omit disclosure of performance target levels under Instruction 4 to Item 402(b). If the performance targets are material in the context of the company's executive compensation policies or decisions, then the only basis for omission is a reasonable showing that disclosure would cause substantial competitive harm. We've made an attempt to distinguish qualitative/subjective individual performance goals from quantitative/objective performance goals and recognize the different disclosure issues associated with discretionary-type awards based on subjective criteria. Although there is no requirement to provide quantitative targets for what are inherently subjective or qualitative assessments, should a company determine that such disclosure is not required it should clearly lay out the way that qualitative inputs are ultimately translated into objective pay determinations.
If a company does conclude there is a sufficient basis to omit performance target disclosure because it determines that disclosure would result in competitive harm, then disclosure regarding the degree of difficulty associated with achievement or non-achievement of the omitted performance objective is mandatory. This disclosure should be as detailed as possible so as to clearly address the criteria for determining undisclosed target levels and it must directly establish the connection between the achievement of the performance objective and the characteristics of the incentive payment to which the goal applies. In other words, if a company advances a pay-for-performance philosophy, it should provide meaningful disclosure that describes the degree to which the performance goals or metrics were sufficiently challenging or appropriate in light of that compensation philosophy, and how achievement of the objectives actually rewarded performance. This may entail a discussion of the extent to which incentive amounts were determined based upon a historical review of the predictability of achievement of the performance objectives and possibly a discussion of the relationship between historical and future achievement of the performance standard. Investors should be provided with a clear impression of the arduousness or ease associated with achievement of the undisclosed target levels or other factors.
A final point on performance targets that I'd like to emphasize is the importance of critically assessing, at the time disclosure decisions are being made, whether or not there is a sufficient legal basis for excluding the disclosure. I emphasize the need for sufficient preparation so that when Corp Fin asks, you have a solid response ready. Conducting a contemporaneous written analysis will help you to present a more persuasive case that competitive harm would result from disclosure. Moreover, a contemporaneous effort to construct your competitive harm analysis may better inform your conclusion as to whether you have a proper basis for omitting the disclosure. Making a general result-oriented conclusion at the time of filing and then later, only after an inquiry from the staff, asking your lawyers to perform a competitive harm analysis, is not an effective way to carry out your disclosure obligations. The staff has significant and substantive experience applying the analysis relating to the FOIA standard and we expect companies to substantiate a legitimate position rather than merely provide generalized support for a casual determination that some sort of harm might result from disclosure. Indeed, without making a reasonable determination that the company would suffer competitive harm, the company has no basis to omit the incentive target at the outset.
Benchmarking. Again, this was an important topic in our report and in my remarks last year, so it should not be a surprise to this group that I am returning to it. Where a company benchmarks a material element of compensation, we expect it to identify the companies that comprise the peer group used for benchmarking purposes. We also expect meaningful disclosure that provides insight into the basis for selecting the peer group, and the relationship between actual compensation and the data utilized in benchmarking or peer group studies. These were significant areas of comment again in 2008. In many cases, the benchmarking methodologies that companies are using still are not sufficiently clear nor have companies adequately explained how they are utilizing the data collected from their analyses of peer group pay. The composition of the comparison groups and the extent to which companies are setting their compensation levels to remain competitive with a peer group is essential disclosure and critical for many companies when describing how their compensation programs work or how they arrived at specific compensation decisions.
Over the past year we heard from a number of groups on the perceived difficulty in applying the benchmarking disclosure principles — particularly where a company may have looked at surveys that included data on hundreds of companies. In an effort to provide further clarity about our expectations in this area, the Division published C&DI 118.05,8 which provides a general definition of benchmarking for purposes of Item 402(b)(2)(xiv). In that C&DI we clarify that benchmarking "generally entails using compensation data about other companies as a reference point on which — either wholly or in part — to base, justify or provide a framework for a compensation decision. It would not include a situation in which a company reviews or considers a broad-based third-party survey for a more general purpose, such as to obtain a general understanding of current compensation practices." Hopefully, looking forward, this guidance will facilitate a more transparent and robust discussion of competitive data, the companies against which companies compared compensation, and the extent to which peer group data was studied and reflected in the structuring of compensation practices and specific compensation decisions. And if not, we welcome your further thoughts in this area — as I noted, we issued this C&DI after hearing from companies and their advisors, so the goal here is to be responsive where there is a need for guidance.
Analysis. Returning to analysis. To start with the positive, we have seen improvement in this area and it is clear that many companies have tried to provide meaningful disclosure explaining the rationale for their executive compensation policies and decisions. The most successful have implemented comprehensive overhauls of last year's disclosure model that effectively refocused their disclosure — in other words, they've started with the clean slate, the blank sheet of paper, that I suggested last year. Yet, many others have missed the opportunity to transform their presentation into the useful analytical discussion that should be the essence of the CD&A. Rather than moving forward toward better quality disclosure, they are merely treading water. Again, as was the case last year, the "how and the why" are missing in explaining the connection between the company's philosophies and processes and the numbers the company presents in its tabular disclosure.
The improvements we observed vary in scope depending on the size of the company and the complexity of the compensation arrangements and, while of course there is no one-size-fits-all disclosure model, it is evident that many filers of all sizes have accepted the challenge associated with improving the form and content of their executive compensation disclosure. For those that did choose to embrace the CD&A as an invitation to provide all categories of investors with the critical information necessary to understanding executive pay, we applaud your efforts. Through a more effective assessment of threshold materiality issues and a conscientious attempt to eliminate boilerplate and unnecessary narrative disclosure, these filers capitalized on the opportunity to convert their CD&As from an impenetrable disclosure document to the crisp and informative analytical discussion that is the centerpiece of this presentation.
Notwithstanding this improvement, we still commented heavily on the need for filers to concentrate their CD&A into an informative analytical discussion of:
the material elements of compensation;
how companies arrived at the varying levels of compensation; and
why they believe their compensation practices and decisions fit within their overall objectives and philosophy.
In too many cases, companies failed to provide informative analysis on one or many levels, thereby depriving investors of critical information on fundamental compensation practices and decisions. This resulted in comments from Corp Fin seeking to elicit enhanced disclosure and redirect the filer's focus to the core analytical principles associated with faithful application of the disclosure provisions.
As we indicated in the October 2007 report, the disclosure principles require that filers provide the necessary links that allow investors to decipher the information contained in the compensation tables through a useful and readable description of the material factors underlying the compensation decisions for named executive officers. In an effort to emphasize the significance of this mandate, we continued to encourage companies to:
explain and place in context each of the specific factors considered when approving particular pieces of each named executive officers' compensation package;
analyze the reasons why the company believes that the amounts paid are appropriate in light of the various factors it considered in making specific compensation decisions; and
describe why or how determinations with respect to one element impacted other compensation decisions.
In many instances, we observed that filers were unable to effectively apply these concepts. Such shortcomings resulted in noticeable deficiencies when it came to providing concise quantitative or qualitative disclosure that captured how companies arrived at and why they paid the compensation awarded under a specific program or plan.
For example, if company performance was considered, we commonly encouraged filers to present a complete picture of the extent to which minimum, target, or maximum levels of performance goals were achieved and how achievement of the various company performance objectives resulted in specific payouts under the applicable compensation program or plan. To the extent that a discussion of the comparison between actual results and the performance objectives used to establish compensation does not correspond with actual payouts because pay was influenced by an exercise of discretion, we commonly requested companies to provide appropriate qualitative disclosure of the reasons for the use of such discretion and how it affected actual pay. We have learned that where pay-for-performance is at issue, there is no substitute for robust disclosure of actual results, evaluation of how those results translated into specific compensation, and why the compensation awarded was consistent with the company's overall compensation objectives.
As another example, where individual performance was a significant factor in determining compensation, we encouraged companies to identify specific contributions and to contextualize those achievements for purposes of demonstrating how they resulted in specific compensation decisions. While we do not require quantitative targets for what are inherently subjective or qualitative assessments, we expect insightful disclosure of how qualitative inputs are translated into objective pay determinations.
Finally, to the extent there is a relationship between payouts from different elements of compensation, we asked companies to provide clear descriptions of the correlation between each element of compensation and how compensation decisions regarding one element impacted levels of compensation derived from other elements. Unfortunately, I must repeat a refrain from my remarks to this audience last year. We continue to detect an absence of useful disclosure addressing the extent to which compensation committees are reviewing each element of compensation individually or whether committees are engaging in a collective evaluation of all components of executive pay when establishing the various forms and levels of compensation. The absence of such a discussion impairs the ability of investors to decipher the extent to which particular components of compensation are determined in a vacuum and which elements and levels of pay are linked to assessments of total compensation or amounts that remain realizable from prior compensation.
These are some of the most common shortfalls in analysis that we observed this year — and ones that we had hoped companies would have addressed after absorbing our guidance in this area. Of course, the analysis that we envision depends on many factors, including the nature of the company, the category of compensation being discussed, and the specific criteria considered for awarding the particular levels of compensation. So we encourage all companies and their advisors to continue to work to develop improved disclosure strategies that will enhance the analysis that is their compensation story. And we will continue to remind companies to do this by seeking better analysis where we find that it is lacking.
So with that, let me close by emphasizing that we've really made a significant attempt to provide companies with clear expectations relating to the quality of executive compensation disclosure under the new disclosure requirements and I hope my observations today will again highlight the fact that, notwithstanding the number of comment letters, speeches, and published guidance that is out there, many companies have a long way to go before perfecting the disclosure that meaningfully conveys their compensation story. And in the coming year, many of you will also have the new challenge of crafting meaningful disclosure reflecting the effects of market turmoil and the new legislation. So I urge companies of all sizes and their advisors to reread our report from last year, my remarks from last year, the new C&DI's we published earlier this year, and these remarks. Then return to that blank sheet that I talked about last year and strive for ever-better disclosure in this important area. Thank you for your time and attention.