Down Market Brings Major Changes to CD&As

For most companies, 2008 was not business as usual. That means this year’s compensation disclosures won’t be business as usual either.

Thanks to the dismal economy, public companies can expect regulators, shareholders, and activists to pore over this year’s proxy disclosures, particularly the Compensation Discussion & Analysis section mandated since 2006. Even for businesses that didn’t have an awful year (there must be at least one or two out there), corporate secretaries and others involved in drafting the CD&A should expect plenty of additional work.

Borges

The foremost challenge, says Mark Borges, a principal at compensation consulting firm Compensia, will be explaining how recent market events have affected compensation programs—particularly annual and long-term incentive plans.

“I’ve seen some CD&As that look like they were drafted in a time warp,” he says. “Companies have to frame the discussion in the context of what’s going on and how it has impacted their pay decisions.”

Littenberg

Michael Littenberg, a partner in the law firm Schulte Roth & Zabel, rattles off a litany of possible concerns: changes to outstanding awards or plans; implementation of new plans; new award grants; waivers of conditions for performance-based pay; changes in the process of determining how executive and director pay are set. All, he says, should be elaborated in the CD&A. “This year’s CD&A, in many respects, will be a fairly substantial rewrite.”

Another small but vital detail to disclose: exactly when pay decisions were made in 2008, since many companies did respectably well until September and then fell off a cliff with the rest of the market. Ronald Mueller, a partner in the law firm Gibson, Dunn & Crutcher, says many compensation committees made decisions much later than normal because of the downturn, and that should be noted.

Mueller

Mueller says an increasingly common trend this year is for issuers to start their CD&A with a summary of major compensation decisions during the year, and how those decisions tie into corporate performance. “Whether they had good year or a bad year, more and more companies are doing that,” he says.

Even companies that made no changes to their pay plans in 2008 ought to consider discussing how their pay programs will operate going forward and outline any changes that will be made in response to the financial crisis, Borges says.

Risky Business

An allegedly central part of this year’s CD&A will be discussion of how the company’s pay policies do not tempt executives to take excessive risks that might threaten the business. That requirement is now explicit in the recently passed American Recovery and Reinvestment Act and applies to all companies taking government bailout money. But more broadly, the Securities and Exchange Commission has been pressuring all public companies to make such disclosures since it revamped federal proxy rules in 2006.

Last fall, for example, former SEC Corporation Finance Director John White urged all compensation committees to consider the risks posed by their companies’ incentive compensation arrangements and discuss them in their 2009 CD&A.

Barrall

But Jim Barrall, head of the executive compensation practice at the law firm Latham & Watkins, cautions compensation committees to tread carefully—such disclosures, he says, provide fodder for lawsuits from shareholders and others. Unless the company has actually done a rigorous analysis of those risks, Barrall counsels companies to say nothing at all or only say they will consider the risk issue in 2009.

“[C]ompanies should resist the temptation to make sweeping and politically correct assertions that they have concluded that their plans do not encourage undue or excessive risk taking, unless they have in fact seriously studied these issues with their professional advisers and documented their analysis and conclusions,” he says.

“Do the analysis first ... Don’t wait for the [SEC] staff to come back and ask you to justify it.”

— Michael Littenberg,

Partner,

Schulte Roth & Zabel

Meanwhile, companies must still heed all the other proxy disclosures that the SEC staff has complained about since the 2006 overhaul. Chief among them: the analysis part of the CD&A. “In a down economy, people expect and want more thoughtful analysis,” Littenberg says.

Indeed, the recession may even open the way for compensation committees to give a more frank presentation of their thinking. “In some respects, that discussion is easier,” Borges says. “The financial crisis gives companies a ready-made explanation for what they’re doing, even if they don’t like what they have to say.”

Other Problems

Disclosure of performance targets has been another bone of contention with the SEC. Its proxy disclosure rules allow a company to withhold such information if the company can argue that publishing it would cause competitive harm, but SEC staff have previously faulted companies for claiming that exit clause too often.

That will “still be the biggest sticking point” with the SEC, Mueller says. He expects more companies to move to comparative performance measures, rather than absolute targets.

If companies do intend to argue competitive harm, Littenberg and others stress the importance of conducting a fresh analysis tailored to their company. In other words, “Do the analysis first,” Littenberg says. “Don’t wait for the [SEC] staff to come back and ask you to justify it.”

SUPERIOR DISCLOSURE

Compensia’s Tips for Better Disclosure in 2009

1. ThekeytoaneffectiveCD&Aisexplainingthereasoningbehindyourcompensationpoliciesanddecisions.

2. Your incentivecompensationarrangementsshouldbe

thecenterpieceofyourCD&A;besuretodiscussin

detailhowtheyfurtheryourbusinessobjectives.

3. Giveninvestorskepticismabouttherigorofpeergroup

selection,thoroughlyandclearlyexplainhowyouchose

yourpeercompanies.

4. Incentivecompensationarrangementscanencourage

riskybehavior—besuretodiscusshowyoucalibrate

therisk/rewardrelationship.

5. Highlightyourcompensationrecoverypolicyinyour

CD&A:whoitcovers,whenit’striggered,andwhether

recoveryismandatoryordiscretionary.

6. Whenaddressingpost-employmentcompensationin

theCD&A,focusonthepurposeofyourarrangements

andhowtheyfitintoyouroverallexecutivecompensationprogram.

7. Whenitcomestothetaxdeductibilityofindividual

compensationelements,bespecificaboutwhatwas

deductible(andwhatwasnot);avoidgeneralities.

8. Useatabletodiscloseanditemizeexecutiveperquisites;avoidtheappearanceofobfuscation.

9. Besuretoexplainhowyouestimatedthepaymentand

benefitamountspotentiallypayableuponatermination

ofemploymentorachangeincontrolofthecompany.

10.TheDirectorCompensationTableisjustliketheSummaryCompensationTable:Besuretosupplementitwith

thedetailsofhoweachcompensationelementworks.

Source

Compensia: Enhancing Your 2009 Exec Comp Disclosure (Jan. 5, 2009).

Borges says the SEC staff “has taken a fairly hard line” on the issue, and companies that intend to rely on the competitive harm exception should expect to a call from the SEC staff asking for an explanation. “It requires a rigorous analysis and demonstration to the staff that the harm the company would suffer is real and not theoretical,” he says.

Still, Borges notes that performance targets may be less of a problem this year, since those targets only have to be disclosed if they’re material—and for many companies they’re not, because the executive missed his or her goal and didn’t get the extra compensation.

Benchmarking pay against peer companies is also likely to remain under the microscope. SEC rules require companies to disclose their peer companies when benchmarking against peers is a material part of their compensation plans. Experts recommend that companies refer to an SEC staff interpretation published last summer that clarifies the staff position on what constitutes “benchmarking.”

The same goes for other prior informal and formal SEC guidance, including the October 2007 paper titled “Staff Observations in the Review of Executive Compensation Disclosure,” based on an SEC review of CD&A disclosure of 350 public companies.

Barrall also recommends that companies use their CD&A to explain why any part of their pay plans might fall under what RiskMetrics and other proxy advisory firms consider “poor practices.” That can prevent headaches with shareholder activists who might mount a proxy challenge or cause trouble at the annual meeting.

“Companies should examine their pay practices against the various lists of poor pay practices, kill any that they can’t defend, and carefully and clearly describe what they have and why they have it,” Barrall says. For example, companies that pay tax gross-ups (always unpopular with activists) should clearly state the amount of the payments and explain the business argument for keeping them.

“A little clear and proactive CD&A disclosure and advocacy can avoid needless problems later,” he says.