Speech by SEC Staff:
John W. White
Director, Division of Corporation Finance
U.S. Securities and Exchange Commission
Practising Law Institute Conference
New York, N.Y.
September 6, 2006
Thank you, Scott. It is truly a pleasure to be here at PLI today, at what I believe is the first comprehensive program that's been put together to address the new executive compensation disclosure rules that the Commission approved a little over a month ago.
I realize that there will be many conferences, as well as countless training programs by executive compensation specialists, and by law firms, as the fall progresses. And there will be countless more presentations to boards of directors and officers of public companies about the new rules. Obviously, members of the SEC staff will not be able to be present at most of these.
But I do hope there is a theme that will permeate all of them which is what I would like to talk about this morning. That theme is what I consider to be the most important thread that runs throughout this rulemaking the meaning and significance of principles-based disclosure. Before I turn to that, however, I must first give the standard disclaimer that you have heard so many times before, that the views I'm going to express today are solely my own and do not necessarily reflect the views of the Securities and Exchange Commission or of any members of its staff other than myself.
I realize this may sound like a broken record to those of you who have heard me talk in the past, but I place an incredibly high premium on conferences such as this one and on continuing education programs in general. Simply put, none of us can know everything, and none of us can go it alone. And we really shouldn't try to. PLI should be commended on having assembled such an impressive cast for today's program, and I'm sure you're looking forward as much as I am to learning from our stellar faculty today. But please note your participation today is no less important than theirs. I believe that disclosure counsel and advisors have a critical role to play as the new rules become the norm. And that's precisely because these rules are so principles-based there are far fewer bright line rules than some may have wanted, there are no cookie cutters that can be used to produce good disclosure, there are no computer programs that can generate the right words on the page.
As the SEC Commissioners and various staff members (including myself) have noted repeatedly, executive compensation has changed dramatically in the past decade in its amount, in its form, in its complexity while our related disclosure rules had remained stagnant. I believe that part of what motivated the Commission to update its rules was a recognition of this fact and that our rules need to reflect and respond to the changes in American business and our capital markets. But in the same vein as what I said a moment ago, the Commission cannot do it alone. We relied tremendously on the overwhelming, and very constructive, feedback we received from all quarters during the comment period on the rule proposal. And now that the rules have been finalized, we are relying on all of you to help make them work right in practice.
Companies will greatly benefit from the advice and counsel of intelligent people with sound judgment who understand the significance of principles-based disclosure how to ask the right questions, how to get the right answers and how to translate those answers into disclosure that is clear, understandable and useful to investors. I sincerely hope and anticipate that each of you can be leaders in this considerable effort. I've learned over the years that a key early step in successfully rolling out an important new project and executive compensation disclosure for the 2007 proxy season is such a project is finding your partners and training the guides. If you'll accept the challenge of standing with the Commission on this one, I'd like you to start with a two-word message: principles matter.
The Principle of a Principles-Based System
There are a wide variety of views on how to explain the term "principles-based" although everyone seems to have the same general idea. I personally like the description Robert Herz, chairman of the FASB, gave in 2002:
Under a principles-based approach, one starts with laying out the key objectives of good reporting in the subject area and then provides guidance explaining the objective and relating it to some common examples. While rules are sometimes unavoidable, the intent is not to try to provide specific guidance or rules for every possible situation. Rather, if in doubt, the reader is directed back to the principles.1
Bob was talking about accounting and financial reporting, of course, and that's often where we hear the phrase "principles-based." But it applies equally well to other types of disclosure, and the Commission has embraced it in the recent executive compensation disclosure rulemaking, among other places.
In their study on principles-based accounting a few years ago,2 my predecessors on the SEC staff noted the difficulties of a pure principles-based or "principles-only" system and concluded that some structure is useful. Similarly, in the new rules, the Commission requires some level of tabular presentation both to provide comparability as well as to serve as a framework for an effective principles-based approach. There are a variety of new tables, and the often focused-on Summary Compensation Table has been modified to present all compensation components in dollar amounts and then to add across to a single, aggregate dollar amount for each named executive officer. But even for these tables to work, principles must be followed to determine, and describe, the right entries.
Principles-based disclosure is not a new concept at the Commission. And as you help companies understand how to meet their new principles-based compensation disclosure obligations, you are not at a loss for past learning. Former Commissioner Cyndi Glassman noted in a speech last March (which I would commend to everyone), that "[o]f all of our disclosure rules, MD&A may be the most principles-based."3 As such, companies have already been challenged, especially in the past several years, to tell a compelling story with their MD&A's, to make that story relevant, qualitative and contextual, and to avoid mere quantitative disclosure that just repeats the data that is already in the financial statements. Commissioner Glassman referred to an "elevator analysis" that is, "x" went up and "y" went down which is, as she said, "descriptive, but not very informative." If you've been doing your MD&A right, you have not ended your drafting when the elevator doors open and you already have a good idea what principles-based disclosure means and what it should look like. As the Commission noted in the Adopting Release, MD&A is an especially good starting point for the new, equally principles-based, Compensation Discussion & Analysis, or CD&A. I'll return to this important subject in just a moment.
I have referred to the principles-based theme as a thread that runs throughout the executive compensation disclosure rulemaking, and if you study the Release carefully, you will see that the phrase appears in multiple places. As a concept, I believe it runs even deeper than just the places that are expressly labeled as such. But calling something principles-based is only a start. For it to have the meaning and impact that it should requires that those who are making the necessary disclosures embrace the concept as much as the regulators who have promulgated the standards.
So what does it mean that key components of executive compensation disclosure are principles-based, and how does that intersect with the role of disclosure counsel and advisors who are charged with the important job of shepherding a company through these new requirements? Going back to Bob Herz's description, what are the key objectives of good reporting in these areas? And I would add to that: how does ascribing to a principles-based approach both help answer the hard disclosure questions and also produce a better end-product for investors?
I'd like to try to answer these questions by looking at a couple of specific examples in our new rules. And in each case, I hope you will see that the principles do matter.
Compensation Discussion & Analysis
Descriptions of the new Compensation Discussion & Analysis section may be the current, favorite home of the term "principles-based". And I believe that is telling and appropriate. Just as CD&A is at the heart of the Commission's recent rulemaking, its principles-based foundation is at the heart of what quality disclosure in this area should be. CD&A is what gives context to the required tables and the numbers in them. As Chairman Cox explained at the Open Meeting at which the Commission adopted the new disclosure rules, CD&A "will give companies an opportunity to explain their compensation policies, and to share with investors how they arrived at the particular levels and forms of compensation for their highest paid executives."4
The Commission went on to explain in its Adopting Release:
The purpose of the Compensation Discussion and Analysis disclosure is to provide material information about the compensation objectives and policies for named executive officers without resorting to boilerplate disclosure. The [CD&A] is intended to put into perspective for investors the numbers and narrative that follow it.5
The rules do provide six questions that CD&A must answer, and I'm sure we'll be hearing more about those in the panel that follows. The rules also provide 15 examples of topics a company might consider addressing in its CD&A. Those examples are neither exhaustive nor mandatory. It is the company, and those drafting its disclosure, that must determine what is material to the company and those making investment and voting decisions. They must then craft the appropriate disclosure that is responsive to those questions and is tailored to the company's particular facts and circumstances.
As I have said, CD&A is at the heart of principles-based compensation disclosure, and we could probably spend hours talking about how that might work, how it should work. But I'd like to look at CD&A from one specific, narrow (but important) vantage point and to think about how its principles-based design should make the right questions easier to identify and the answers easier to develop.
In the Release, the Commission describes the time period CD&A must cover the last fiscal year. But then the Commission explains that
[CD&A] may also require discussion of post-termination compensation arrangements, on-going compensation arrangements, and policies that the company will apply on a going-forward basis. [CD&A] should also cover actions regarding executive compensation that were taken after the last fiscal year's end. Actions that should be addressed might include, as examples only, the adoption or implementation of new or modified programs and policies or specific decisions that were made or steps that were taken that could affect a fair understanding of the named executive officer's compensation for the last fiscal year. Moreover, in some situations it may be necessary to discuss prior years in order to give context to the disclosure provided.6
What does that mean? Well, going back again to Bob Herz's description, we know that one disclosure objective with the CD&A is to provide perspective and context for investors in understanding the rest of the company's executive compensation disclosure. So what additional disclosure, talking about other years, might be necessary or helpful to give that perspective and context, given the general requirement to cover the last fiscal year? That's where principles matter.
We all know that the end of a year may be a fairly arbitrary date that is no different than any other day. Or it may not be. But the point is that I can't answer that for your company. Only you can. There's no bright line in CD&A that says if something happens on January 1, after year-end, then it doesn't matter. Same if it happens on February 1. Or if it happened two years ago.
Imagine a hypothetical where five years ago, a company was going through a particularly difficult time, and an executive agreed to work at minimum wage until the company turned itself around. That turn-around happened last year, and the company's Board rewarded her with a handsome compensation package. The compensation might even seem disproportionate to what this executive did last year, or to the company's peers. I believe most companies in that situation would be happy, perhaps even eager, to explain in their CD&A the context for last year's apparently oversized compensation. The principle would be the same, though, if the numbers and the story went another way. Perhaps this executive endured her pay cut throughout all of last year, but the company turned around in February and the Board just awarded her a substantial bonus or pay raise. It happened after the year end, but it might be invaluable context to understanding the executive's compensation for the year in question. How ever the facts play out, the disclosure outcome, in principle, should be the same tell investors the story, completely and fairly, in the context of understanding what was going on with your compensation programs. Let your investors know why the company did what it did, and what effect you expect that to have.
So applying this principle, if something that happened five years ago, or two years ago, is not material to an understanding of your compensation last year, then you do not need to talk about those prior years, or agonize over the excerpt I read a few minutes ago, that CD&A is not limited to the past fiscal year. On the other hand, if something that happened several years ago, or something that happened early this year, before your proxy is prepared, is relevant or necessary to a fair understanding of the year in question, then you do need to talk about it. The same could be true with regard to something that everyone expects to happen next year. The principle that must be applied demands this, and it should in turn guide your analysis and make the requisite disclosures more obvious.
To move on to another example, how do the principles help us understand perquisites disclosure? After all, the phrase "principles-based" does not roll off the tongue quite as often with talk of perks as it does with CD&A, but I believe it should. In the recent Release, the Commission once again declined to provide any bright-line rules as to what constitutes a perquisite or personal benefit. As the Commission said,
"We continue to believe that it is not appropriate for Item 402 to define perquisites or personal benefits, given that different forms of these items continue to develop, and thus a definition would become outdated."7
The principle, however, will not become outdated.
Perquisites are an important piece of executive compensation. Subject to a de minimis exception provided in the rules, companies need to disclose to investors the perquisites they provide executives, and their value. For clarity, the Commission has retained its position that the value of a perquisite is its aggregate incremental cost to the company. But it's up to you to figure out what that is.
As to what is a perquisite, the Commission has provided interpretive guidance for analyzing and answering this question. In this regard, as I am sure you have read, a company should engage in a two-step analysis:
- An item is not a perquisite or personal benefit if it is integrally and directly related to the performance of the executive's duties.
- Otherwise, an item is a perquisite or personal benefit if it confers a direct or indirect benefit that has a personal aspect, without regard to whether it may be provided for some business reason or for the convenience of the company, unless it is generally available on a non-discriminatory basis to all employees.
Key phrases in this analysis include "integrally and directly related to the performance of the executive's duties", "direct or indirect benefit that has a personal aspect", and "generally available on a non-discriminatory basis to all employees." You may lament the fact that I cannot give you a hard and fast definition of any of those phrases, but if you let the principles guide you, you will not run astray.
One area of perks analysis that has received considerable attention in recent years is that of executives' personal usage of corporate aircraft. Within that area is a fairly narrow question of whether the costs of a "deadhead" flight leg must be included in the calculation of the perk's value. A deadhead flight leg is when a plane flies essentially empty typically in order to return to its home base, such as the corporate headquarters.
So the corporate aircraft may take an executive and her family out to Colorado for a ski vacation and then return to corporate headquarters in Virginia. As far as I know, everyone would agree that the flight from Virginia to Colorado was a perquisite for the executive. And it should be valued and disclosed in keeping with the Commission's rules.
With regard to the deadhead leg, I assume that flight from Colorado to Virginia is not cost-free. Perhaps your pilot and flight crew are on salary and the cost of employing them does not change at all based on flight legs. Or alternatively, perhaps they're paid by the hour, or by the mile, and so the flight from Colorado to Virginia does cause the company to incur additional costs. Every company probably has added fuel costs to fly the plane back home, even empty. There might also be added landing fees, or weather report fees, and so on. Many of these incremental costs could easily vary from company to company, depending on the facts and circumstances.
And it could be more complicated. What if instead of flying back home empty, the plane flew on to Texas to pick up another executive from a business trip? Colorado is closer to Texas than Virginia is, so presumably that might change the company's calculation of its aggregate incremental costs. What if the plane had to fly empty to France to pick up another executive from a business meeting? It would have flown empty from Virginia to pick up the other executive in France in any event, but Virginia is closer to France than Colorado is. Again, the costs might change.
To my mind, most companies will typically need to engage in a facts and circumstances analysis to determine the aggregate, incremental cost of a corporate aircraft perk, including any deadhead legs. But countless well-educated and intelligent people have debated this one and come to different answers as to whether the cost of the deadhead leg even needs to be considered at all. I think that stops too short. In my view, if a deadhead flight leg causes a company to incur incremental costs, those must be included in the calculation of the perk's value.
Aside from aggregate incremental cost, there is no firm rule in the Commission Release, or from the staff, on valuing corporate aircraft usage, let alone deadhead flight legs. There are, however, principles, and companies should not play games with these questions or their answers to them and the disclosures that go with them. I would encourage someone faced with this issue to think through the analysis above carefully, and remember the goals of a principles-based system. What is the disclosure objective? Provide your investors with the value of the perquisites your company accords its executives, based on their aggregate incremental costs. And provide your investors with the material information they need in order to understand that valuation, its context, and the particular facts and circumstances of those perquisites. Remember, principles matter.
I have tried to use a couple of different examples to illustrate the importance of principles-based disclosure. There are, of course, many other examples that arise from the recent rulemaking that we could look at-disclosure of option grant practices and disclosure of related party transactions are two that I particularly like and which I hope I will have the chance to address in future forums like this one. I would certainly encourage everyone to think about those two topics carefully in the context of principles-based disclosure.
But, as we all learn to be guides in this principles-based world, let's go back, for a moment, to the fundamentals of principles-based disclosure. Remember the Bob Herz quote. He explained that there is not a specific rule for every possible situation, but there is a principle. As we've seen with perks, there's no bright line rule about deadhead flight legs and what to do with them in calculating a perk's value. But there is a principle.
You may all recall a speech about executive compensation disclosure that my predecessor, Alan Beller, gave two years ago often referred to as the "all means all" speech even though it never actually uses those words. In his remarks, Alan noted, and I quote, "in the area of executive compensation, management's retort to advice to make additional disclosure may too often be 'Where does it say we have to disclose that?'"8 Well, depending on the item, there still may not be express words in the rules requiring specific disclosure. But now you will have something to point to, and something to say if asked Alan's question: you will explain that it's the principles that matter. To the extent that management is still looking for a flashing sign, the Commission has made it clear that, at least in some regards, they must now look to the principles. I hope that executives at America's public companies will heed and appreciate this, as you, as their advisors and counsel, help them craft the disclosure that their investors have long deserved, and which the Commission now demands.
I do have one final disclosure thought to leave with you. I believe it's equally useful (and important) to apply a basic principle of good disclosure to everything you draft. In any of these areas, the disclosure should be clear and concise and provide meaningful information to investors that is easy to understand. The substance and content of your disclosure need to be principles-based; the presentation does as well. It needs to be in Plain English.
Plain English is a phrase, like "principles-based", that may get thrown around a lot. It's important to remember what it really means though. It does not mean "dumbing down". It does not require stripping your disclosure of depth or context. It does mean presenting complex information in a clear and concise manner that is understandable to a broad audience. It takes time to write well, to write disclosure that is understandable and useful to investors. Take that time. Use the active voice, and speak directly. Write for investors, not lawyers.
I started my remarks today by talking about the new Compensation Discussion & Analysis section. Obviously, no one has drafted one of these before. There's no boilerplate out there, no precedents to mark up and reuse. If you're used to getting pressure to "match up" your disclosure to the disclosure of your company's peers or competitors, that won't exist this first year. You have a chance to start with a clean slate in that sense. Take it, and make a difference. And as you're working on those CD&A's for the first time, I hope you will remember my remarks this morning and what I've said about principles-based disclosure.
As we all look ahead to the upcoming proxy season, I am sincerely heartened and enthusiastic about the chances of witnessing a sea change in the quality, and usefulness, of executive compensation disclosure. I believe that the groundwork the Commission has laid in adopting its new principles-based disclosure standards has considerably advanced the interests of investors. That vision will not reach fruition, however, without the partnership of America's companies in stepping up and providing the public with their own principles-based disclosures. That's where we need your help, and I hope we have given you a standard, and examples, to cite to your skeptical clients. Remember the message that should be conveyed: the principles matter.