Speech by SEC Staff:
Executive Compensation Disclosure: Observations on the 2009 Proxy Season and Expectations for 2010
Deputy Director, Division of Corporation Finance
U.S. Securities and Exchange Commission
The 4th Annual Proxy Disclosure Conference: Tackling Your 2010 Compensation Disclosures
San Francisco, California
November 9, 2009
Thank you, Jesse, for that kind introduction, and good morning. I'm very glad to be here with you today to share my thoughts on the current state of executive compensation disclosure under the Commission's rules and to talk about what we expect to see in the 2010 proxy season.
First, though, I need to remind you that the views I express today are my own, and do not necessarily represent the views of the Commission or other members of the staff.
Over the last several years, executive compensation has been subject to much debate. It seems that people from Main Street to Wall Street — and everywhere in between — have an intense interest in the topic. And with the ongoing challenges in the economy, there seems to be even more focus on executive compensation and its link to corporate accountability. Nearly every day there is a headline claiming that underperforming companies are overpaying their executives.
There is no reason to believe that the scrutiny of executive compensation practices at public companies will subside anytime soon. It is in a company's best interest to communicate clearly and effectively about its executive compensation and the Commission's disclosure requirements are designed to help you do that. While I'm not sure clear and transparent disclosure can trump emotion when it comes to money, it can't hurt.
The SEC's role in this area is not to regulate how companies compensate their executives, but rather to see that investors have the critical disclosure they need to make informed investment and voting decisions. The Compensation Discussion and Analysis is essential to providing investors with meaningful insight into the compensation policies and decisions of the companies in which they choose to invest. The CD&A is where a company tells its story about why it made the decisions it made.
The Division's Disclosure Program
As a starting point, I thought it might be helpful to mention briefly the role of the Division's disclosure review program.
The Sarbanes-Oxley Act of 2002 requires that we review each reporting company at least once every three years.1 It's a well-known fact that we review a substantial number of companies more frequently — and a large number of them every year. To place the scope of this program in context, in each of the last three fiscal years, we have reviewed the disclosure of more than 5,000 companies.
While many of our reviews are focused on a company's financial statements and related disclosure, we also remain focused on a company's non-financial disclosure, including its executive compensation disclosure. Our review of executive compensation disclosure is part of our normal review process and we continue to allocate significant resources to reviewing these disclosures. I'm sure many of you have received comments from us on your executive compensation disclosure during the past two years. If we have not reviewed your filings in either of the last two years, the chances are very good that we're planning to do so this year.
Observations on 2009 Executive Compensation Disclosure
The Division has provided you with a report on the state of executive compensation disclosure at this conference over the past few years. When John White spoke to you in October 2007, he encouraged companies to start with a "clean slate" in drafting their CD&As2 and take to heart the guidance the staff provided on executive compensation disclosure.3 A year later, he reported that our comments on executive compensation disclosure mirrored those of the first year — companies needed to provide enhanced disclosure of their analyses and enhance their disclosure of performance targets and benchmarking.4 Throughout this time, the Division has continued to provide companies with specific comments on their disclosure, reports on comment themes, and disclosure guidance in the form of Compliance and Disclosure Interpretations.
So, following what seems to have become a tradition, here I am in 2009 providing observations about executive compensation disclosure.
Following the end of the 2009 proxy season, we decided to take a look back at our comments and the state of issuers' disclosure. We wanted to identify common comment areas, understand how companies were responding to our comments, and evaluate whether we could improve the consistency of our comments and review of responses to those comments.
In looking back over the comments we issued, we noticed a couple of things. First, we found that we're pretty consistent in the comments we issued on executive compensation disclosure. Second, we noticed a pattern: companies we had previously reviewed continued to provide enhanced executive compensation disclosure and address the primary themes of comments as we identified in our 2007 report. Since 2007, these companies have enhanced their analyses and disclosure about performance targets and benchmarking, and as a result, we did not issue many comments to them. This doesn't mean that these companies couldn't improve their disclosure, but, for the most part, it appears that they have been paying attention to the disclosure requirements and our comment themes.
As for the companies we had not previously reviewed, we found that we issued a substantial number of comments addressing our common comment themes, even though we have made those themes public since October 2007.
Based on this review, we're left with one simple conclusion. The reason for ongoing comments in these areas is not because companies do not understand the disclosure requirements — to the contrary, we believe that there is a general understanding of the rules. Rather, it seems that many are reluctant to address these comment themes until we provide specific comments requesting enhanced disclosure. Anecdotal evidence suggests the same — that companies may be disinclined to disclose detailed compensation information and prepare a rigorous analytical discussion of compensation practices until we ask them to do so in a review.
So where does that leave us? I hate to sound like a broken record, but once again, I must remind you to take a proactive approach to improving your CD&A disclosure. There's no need to wait for us to comment on your disclosure — after all, it is your disclosure. More importantly, your obligation to comply with our requirements is the same whether or not we review and comment on your disclosure. And even if we do not review your disclosure, your shareholders are reading it and are making voting and investment decisions based on it. That should be reason enough to motivate you to make your disclosure as good as it can possibly be.
That said, I'd like to mention two topics where companies should focus their attention in the coming year — analysis and performance targets.
In 2007, John White asked "Where's the Analysis?" and two years later, we often still can't find it. While many companies have improved their discussions of how and why they made the decisions they did, far too many companies continue to describe — in exhaustive detail — the framework in which they made the compensation decision, rather than the decision itself. The result is that the "how" and the "why" get lost in all the detail.
I'm not saying that you shouldn't provide a discussion of the framework. Our rules require a company to discuss how it determined compensation amounts for each material element of executive compensation, and the framework can be a useful tool to provide context for that disclosure. While the framework may provide context to investors, the CD&A should not be so technical and process-oriented that it obscures the explanation of what the compensation is designed to reward. A company's analysis of its compensation decisions should present shareholders with meaningful insight into its compensation policies and decisions, including the reasons behind them. Where analysis is lacking, shareholders are often left with a pages-long discussion that is heavy on process but does not explain the reasons why the named executive officers were compensated as they were.
I can't stress the "analysis" part of the Compensation Discussion and Analysis enough. Factual statements about what the company or compensation committee did or did not do are not enough. It isn't sufficient for a company to state that its compensation committee used tally sheets, wealth accumulation analyses, or internal pay equity analyses in making compensation decisions. The company should discuss how the committee used these tools to determine compensation amounts and structures, and explain why it reached its decisions. If a committee's pay determinations were simply subjective decisions, the company should say that. Otherwise, it isn't sufficient for a company to state simply that the committee made compensation decisions based on unspecified qualitative factors. A company should discuss the specific qualitative factors the committee considered and, as we put it back in 2007, "clearly lay out the way that qualitative inputs are ultimately translated into objective pay determinations."5 Remember, your disclosure should tell your story and the story isn't complete without the analysis.
I don't want to leave you with the impression that the state of analysis in CD&A disclosure is abysmal. I do want to leave you with the impression that we think there are areas in which companies can and should improve. In the current economic environment, with the increased scrutiny on executive compensation, there is no better time to take a hard look at how you could improve your company's disclosure. This may be as simple as improving communications between the company's compensation decision-makers and the drafters of CD&A. Or it could be as simple as starting over with a blank sheet of paper.
We've heard that investors are becoming more and more frustrated by the increase in boilerplate language and CD&A length. We hear repeatedly that there is too much unnecessary bulk and we encourage you to see where you can shorten your disclosure by deleting unnecessary background and process-oriented information. The quality of your analysis is not measured by its length. We urge you to step back and make sure the real story is coming through loud and clear.
Those of you who have attended this program in the past know that a speech about executive compensation disclosure isn't complete without a discussion of performance targets. We issue more comments on performance targets than any other executive compensation disclosure item. When you say you pay for performance, we look for disclosure that will help your shareholders understand how your pay programs achieve that goal.
Investors feel strongly that companies should disclose performance targets and we want to make sure that companies understand our disclosure requirements on this critical topic. Let's start with the basics. When it comes to performance targets and disclosure, a company must first determine whether corporate or individual performance targets are material to its compensation policies and decisions. Making this determination often involves difficult judgment calls and, depending on the circumstances, we may question your conclusions.
In this regard, 2009 presented a host of public company compensation challenges. We saw instances where boards set performance targets that ultimately were not met, and as a result, bonuses were not awarded. We also saw instances where a board abandoned or ignored performance targets — the board awarded bonuses in an exercise of discretion rather than based on the established performance targets. These situations raised the question of whether the targets in question were material to the company's compensation policies and decisions.
The fact that a performance target was not met or was otherwise disregarded may be a factor to consider in the materiality determination, but it is not a dispositive one. Even where it does not result in an actual payout, a performance target may be material if, based on the company's specific facts and circumstances, it plays an important role in the way the company incentivizes its management.6 Moreover, where a company pays its executives incentive compensation even though the relevant targets were not met, it can suggest that the targets, and compensation, are not sensitive to risk since the compensation is paid without regard to the risk outcome. In the absence of disclosure about those targets, we question whether shareholders are presented with the complete picture with which they can judge whether the board is acting in their best interests. Accordingly, in most cases, we would expect to see companies disclose and discuss such targets in their CD&A.
Where a company determines that certain performance targets are material, then it must specifically — and if applicable, quantitatively — disclose the targets, unless such disclosure would cause it substantial competitive harm.
Many companies use commercially-sensitive metrics in determining incentive compensation for their executive officers, and they are reluctant to disclose specific performance targets. They are concerned that competitors could use the information to harm the company's business. We do not want our rules to drive compensation committees to tie pay to the wrong measure simply to avoid competitive harm that would come from disclosure of the measure. To address these concerns, our rules seek to balance full disclosure with commercial realities. Companies may omit specific quantitative or qualitative performance-related targets, even where they are material to compensation policies and decisions, if disclosing them would likely cause competitive harm to the company.7
The standard that applies in this context is the same standard that would apply if a company were to file a formal request for confidential treatment of trade secrets or commercial or financial information contained in a material contract exhibit to a Securities Act or Exchange Act filing.8 The touchstone of this standard is that the information must be confidential and disclosure of it would likely "cause substantial harm to the competitive position of the person from whom the information was obtained."9 However, we've heard there is some confusion about the application of this standard to justify omitting a performance target. I'd like to try to clear up that confusion.
To justify omission of material performance targets based on the likelihood of competitive harm, a company must engage in the same analysis as it would in the context of a formal confidential treatment request. In our filing reviews, if a company's disclosure indicates that it uses performance targets in its compensation programs and it does not disclose those targets, we will likely ask it to explain its basis for omitting the targets. In a surprising number of instances, we find that companies failed to develop a thorough legal analysis prior to filing.
We understand that there's concern that we have applied a more rigorous competitive harm standard to compensatory arrangements than we have to material contracts. We have not intended for this to be the case. I'm not sure why people have the impression that the staff "goes easier" on confidential treatment requests relating to material contracts than on competitive harm arguments relating to performance targets. We apply the same standard to each analysis — even if we may review one kind of request more frequently than another. If you believe we are inappropriately concluding that your situation does not qualify for the exclusion, you should not hesitate to request reconsideration of your facts and circumstances. We include detailed instructions on how to seek this reconsideration on the SEC website.10
In our review of our comments on 2009 disclosure and the responses to those comments, we paid particular attention to competitive harm comments and responses. In a number of cases, the staff engaged in a thorough evaluation of competitive harm arguments in the comment and response process. When we reviewed those comments and responses, we found that where companies adequately explained the nexus between disclosure of the subject performance target and the potential for resulting competitive harm, we accepted the response and agreed with the omission of the specific target.
That said, it is often more difficult for companies to persuade us that disclosure of performance targets will result in competitive harm after the company has disclosed the amounts. This is especially true for targets that are tied to company-wide financial results that are publicly reported — such as targets tied to company-wide earnings per share. In this regard, we have yet to see any persuasive analyses explaining how competitors could pull together sufficiently-specific information about a company's future operations and strategy from the disclosure of these types of targets to cause the company competitive harm. Accordingly, absent highly unusual circumstances, companies should plan to disclose these kinds of performance targets if material to their compensation policies and decisions.
A final point I'd like to make on this topic is that when a company concludes that it may omit a performance target because disclosure would cause it competitive harm, it must disclose with meaningful specificity how difficult or likely it would be for the company or executive to achieve the undisclosed target.11 A statement that the target is intended to be "challenging" is insufficient absent more detailed information. A company should provide support for the level of difficulty it asserts, which could include, for example, a discussion of the correlation between historical and future achievement of the relevant performance metric.
What to Expect from the Comment Process in 2010
Now that I've told you what we found in our review of staff comments on 2009 executive compensation disclosures, let me turn to our expectations for 2010 disclosures.
To begin with, the Division is currently reviewing the comment letters submitted on the Commission's recent proposal to enhance proxy disclosure, including that related to compensation.12 In the proposal, the Commission focuses on the current requirement to discuss how compensation relates to risk and proposes to expand CD&A to address how a company's overall compensation policies for its employees may create incentives that can affect the company's overall risk.13 You should start thinking about how you would gather the additional information necessary to make the proposed disclosures because the proposed risk disclosure enhancements may well be in place for the coming proxy season. If this proposal is adopted, you can expect the new disclosure to be of interest to us in our reviews. Of course, the staff and Commission will carefully review the comment letters before the Commission decides on final rules.
In our first several years of reviewing disclosures under the existing rules, we wanted to encourage compliance generally by issuing futures comments14 to give companies and their advisors time to understand and apply the new requirements to their circumstances and compensation practices. As companies have been digesting and applying the rules, we too have been enhancing our understanding of how they apply to various facts and circumstances. As we enter our fourth year of disclosure, our expectations for quality disclosure are heightened and we will reflect this in our comments.
What does that mean for you? It means that after three years of futures comments, we expect companies and their advisors to understand our rules and apply them thoroughly. So, any company that waits until it receives staff comments to comply with the disclosure requirements should be prepared to amend its filings if it does not materially comply with the rules.
What should you focus on this year? Well, it's no secret where we think companies can improve disclosure — I think we've been pretty clear about it in our comments, reports and speeches — but let me remind you one more time. First, please focus on making your disclosure more meaningful and understandable. When a company explains its compensation decision-making processes but does not explain why it made the compensation decisions it made, we will ask for enhanced disclosure of the analysis. When a company states that it determined a material element of compensation based on the achievement of performance targets, we will ask for specific disclosure of the targets and the actual achievement level against the targets, or for the company to provide us with an explanation of how such disclosure would cause it competitive harm. And if disclosure of material performance targets is not required, we will insist on meaningful degree of difficulty disclosure. When a company refers to a peer group used for benchmarking purposes, we'll ask for the names of the peer group companies and how you selected them, and where actual awards fell relative to the benchmark. Companies and their advisors should take care to address these themes as they draft next year's executive compensation disclosure. Now is the time to undertake an earnest attempt to prepare the best possible executive compensation disclosure consistent with the principles set forth in the rules.
As a principles-based disclosure requirement, the CD&A provides companies with wide discretion on how to address those principles. As such, companies should think broadly and not limit their disclosure to the non-exclusive examples the Commission provided in Item 402(b) of Regulation S-K. Where additional disclosure would be material to an understanding of a company's compensation policies or decisions, a company should provide that disclosure. While our principles-based disclosure requirement doesn't specifically require companies to disclose all aspects of their compensation programs, in these economic times with the attention shareholders are paying to executive compensation, a company should evaluate evolving materiality concerns with a view towards complete and transparent executive compensation disclosure.
In closing, our goal in our review process is to help public companies provide investors with high-quality executive compensation disclosure that complies with both the letter and the spirit of the Commission's disclosure requirements. Don't wait for us to prod you into undertaking a good-faith effort to comply with the principles set forth in our disclosure requirements. Any company that waits until it receives staff comments to comply with the disclosure requirements should be prepared to amend its filings if we raise material comments. Now is the time to engage in a rigorous analysis to develop meaningful, coherent and comprehensive executive compensation disclosure.
While the SEC staff may appear to serve as your editor from time to time, the CD&A is your story to tell, not ours. Read our guidance. Read the publicly-available comment letters. Take a fresh look at the disclosure requirements. Pay attention to what the market is looking for. Your disclosure will be better if you do.
Thank you again for inviting me to join you today.