SEC gift to corporations: Changes CEO pay Reporting Rule

SEC Changes Reporting Rule on Bosses Pay
By Floyd Norris
The New York Times
Wednesday 27 December 2006

The Securities and Exchange Commission, in a move announced late on the last business day before Christmas, reversed a decision it had made in July and adopted a rule that would allow many companies to report significantly lower total compensation for top executives.

The change in the way grants of stock options are to be explained to investors is a victory for corporations that had opposed the rule when it was issued in July, and a defeat for institutional investors that had backed the S.E.C.'s original rule.

"It was a holiday present to corporate America," Ann Yerger, the executive director of the Council of Institutional Investors, said yesterday. "It will certainly make the numbers look smaller in 2007 than they would otherwise have looked."

Christopher Cox, the commission chairman, said yesterday that he viewed the decision as "a relative technicality" that improved the rule. When the rule was adopted in July, Mr. Cox said it was aimed at providing information that would allow shareholders to "make better decisions about the appropriate amount to pay the men and women entrusted with running their companies."

In announcing the new rule on Friday, he said "the new disclosure requirements will be easier for companies to prepare and for investors to understand."

As controversy has grown over rising executive pay, it has been hard to even get agreement on the total value of compensation for top executives. The rules passed last summer required companies to disclose more information and to compile it in a summary compensation table that is expected to become the standard by which corporate pay is compared.

The new rule changes the way grants of stock options will be measured in that summary table.

Under the old rule, if a company awarded an options grant valued at $15 million to an executive this year, the full amount of $15 million would show up in the summary compensation table.

Under the new rule, which takes effect immediately, the amount reflected in the table would be much smaller, with the remaining part of the $15 million included in later years, as the executive qualifies to exercise the options.

Under some circumstances, the options grant might not be reported at all in the first year, even if the executive would otherwise have been the company's highest paid executive had the full value of the option grant been included.

The new rule is intended to make the disclosures identical to the way companies report options expenses in their financial statements, under accounting standard 123R, as approved by the Financial Accounting Standards Board.

In an interview yesterday, Mr. Cox said the change reflected what the commission had intended to do when it adopted the original rule in July. "My understanding all along was that we were going to follow the 123R model," he said. "It came out differently from that when we adopted it."

The fact it came out differently was disclosed by the S.E.C. at the time. The commission pointed out that some companies had wanted to time the disclosures in accordance with the accounting rule, but said the other approach "is more consistent with the purpose of executive compensation disclosure."

But on Friday, the S.E.C. said it now believed that the change would provide "a fuller and more useful picture of executive compensation than our recently adopted rules."

While practices vary, stock options often vest - meaning they may be exercised - over a period of three to five years after they are granted. The options can be canceled if the employee leaves the company before they vest.

For most executives, the accounting rule says the expense should be spread over the period from the grant to full vesting. So if options vest over five years, the expense would be reported over that period.

In the $15 million example, if the options vested over a five-year period, the summary compensation table would reflect a cost of $3 million per year. In the first year, the cost might be lower if the options were issued relatively late in the year, and could be almost nothing if they were issued just before the end of the company's fiscal year.

But the new rule could create confusion because it would treat options issued to some executives - those eligible for retirement - differently.

If an executive were eligible to retire when the option was granted, and could keep the option if he or she did retire, then the entire option grant would be expensed immediately and listed in the summary table in the year it was granted.

But if the executive is not eligible for retirement, then the expense is spread out over the several years it takes for the options to vest.

That makes it possible that two executives with identical pay packages would have very different disclosures, making the one eligible for retirement seem to be much better compensated. "This will muddy the waters," Ms. Yerger said.

Asked about that, Mr. Cox conceded it was an anomaly. But he said there were anomalies under the other rule as well. John White, the director of the commission's division of corporation finance, pointed to the fact that the rule adopted in July could lead to reporting of compensation that would never be received.

"The anomaly that the commission was most concerned with was that if an executive leaves the company before the options vest, the full amount of the option still was reported in compensation disclosure when, in fact, nothing was received," said Mr. White, who became director of the division in March, after the previous rules were proposed but before they were adopted.

He said that some companies issued options that had so-called cliff-vesting, in which all options vested after five years, and were forfeited if the executive left before that time. Under the new rule, expenses would still be reported for the first years, but then a negative amount would be reported in the year the executive left, reversing the earlier reported figures. There was no such reversal in the July rules.

The commission adopted the new rule in an unusual way, making it take effect immediately even though the commission had not announced that it was considering a change and had not sought public comment.

An S.E.C. spokesman pointed to two other rules adopted that way in recent years. Both were intended to comply with new federal laws that were about to take effect.

One, in 2000, stated that e-mail messages from mutual funds could satisfy rules requiring that information be given to customers in writing. The other, in 2001, established rules for complying with the Gramm-Leach-Bliley Act allowing mergers of financial companies.

Mr. Cox said there was no time to seek comment if the change announced Friday was to take effect in time to affect proxies issued in coming months. He said it would be confusing if companies reported one way in 2007 and then changed in 2008.

The rules adopted in July were intended to deal with widespread complaints that it was difficult to discover all elements of pay packages for top executives. Besides providing the summary table, the disclosures will provide new information in a number of areas, including retirement benefits.

The disclosures will be made for a company's chief executive, chief financial officer and the three other highest paid executives, as indicated by the summary table. For those on the list, all option grants will be disclosed, so even if the summary table leaves out much of the value of options granted to a chief executive, investors could see the terms of the grant and consider it in assessing how well the executive was paid.

Under the July rule, a large options grant to an executive could propel him or her onto the disclosure list. But under the rule adopted Friday, such a grant might not put the executive in that group, meaning there would be no disclosure of that executive's pay that year.

Over time, of course, most executives whose pay is being disclosed would have the same total reported under either rule. Under the new rule, options that were granted in prior years, but vested in 2006, will show up in next spring's disclosures.

The reduction in reported pay is likely to be the largest at companies that accelerated the vesting of options in 2005 to avoid reporting them as an expense at all when the new accounting rule went into effect. Executives at those companies will not have as many old options vesting as they normally would have, and thus will be able to report lower pay.

The commission said it would take public comments on the latest change for 30 days, but it added that the new rules were now final.

When the commission considered the issue earlier this year, David C. Chavern, a vice president of the United States Chamber of Commerce, urged it to take the step it rejected in July and adopted on Friday, saying that to do otherwise would overstate compensation, since options would not have been earned when they were reported, and might later be canceled.

Whenever the value of the options shows up in the summary table, the value shown will be the estimated value of the option at the time it was granted. Years later, when the options vest, the stock price could be much higher or lower than it was when the option was issued, making the options much more valuable - or all but worthless - by the time they show up in the summary compensation table at the old value.