August 1, 2006

New Compensation Rules Raise Many Complexities

Mark Borges continues to work wonders on his “Compensation Disclosure Blog” on Here is one of his latest: “Although we won’t see the final rules for several more days, it hasn’t stopped me from attempting to parse the SEC’s eight-page press release and related materials to try to figure out what they will look like. Here are a couple of items that I’ve identified that seem a little, shall we say, curious.

NQDC Earnings

It appears that final rules will only require disclosure of above-market or preferential earnings on nonqualified deferred compensation in the Summary Compensation Table. So far, so good. It didn’t seem to me (and many others) appropriate to treat all earnings on NQDC as compensatory and subject to disclosure. The final rules go on, however, to exclude these above-market earnings (along with changes in the actuarial present value of accumulated pension benefits) from total compensation when determining a company’s most highly-compensated executive officers.

That seemed to be the right result when all earnings were being included in total compensation; I’m not sure it’s still necessary when only the above-market portions are considered. After all, everyone agrees these amounts are compensatory. I think companies may have caught a break here.

Earnings on Equity Awards

The final rules do not require disclosure of earnings (such as dividends and dividend equivalents) on outstanding equity-based awards where the earnings are already factored into the grant date fair value of the awards. This result is likely to be controversial. In fact, I’ve already heard some observers suggest that this could lead to underreporting and, perhaps, even encourage the use of this benefit.

The concern stems from the belief that the incremental portion of a stock award’s fair value representing the future dividend stream is relatively small compared to the actual dividends that an NEO will receive during the award’s vesting period. The change in the final rules appears to be in response to commenters who pointed out that, by requiring dividends to be reported in the SCT, these amounts were being included twice – once as part of the fair value calculation and then again when the dividends were paid. The SEC made a policy choice to eliminate the doublecounting. This covers one issue, but leads to other nuances.

For example, what happens where a company issues an award on dividend-paying shares, but the recipient is not entitled to dividends (or equivalents) during the vesting period? SFAS 123(R) seems to say that the fair value of a share that does not participate in dividends during the vesting period is less than that of a share that fully participates in dividends. Will a company be able to reduce the value disclosed in the SCT in this instance? SFAS 123(R) says yes – you reduce the share price of the award by the discounted present value of the dividends expected to be paid on the shares during the vesting period to determine fair value. Presumably, companies would be permitted to make this adjustment.

The larger lesson here is that options may not be the only instrument where computing fair value is going to involve some work. In talking about the proposals over the past few months, I frequently said that, for most equity-based awards (other than options), the amount to be reported in the SCT would equate to the award’s market value on the grant date. I’m starting to see that this may not always be the case.

These rules are getting complicated, and they aren’t even out yet.”

Act Today!
Mark is a key speaker at our two-day conference: “Implementing the SEC’s New Executive Compensation Disclosures: What You Need to Do Now!” He will participate on four separate panels dealing with the new CD&A, retirement pay disclosures, the revised Summary Compensation Table and the tricky world of perks.

August E-Minders is Up!

The August issue of our monthly newsletter is available.

Cumulative Voting and California’s Majority Vote Bill: CalPERS’ Perspective

Below is a rebuttal from CalPERS to last week’s blog from Keith Bishop:

CalPERS appreciates the opportunity to respond to Keith Bishop’s analysis of SB 1207, currently being considered by the California Legislature. SB 1207 does not weaken the cumulative voting provisions currently contained in California’s General Corporation Law or conflict in any way with Government Code Section 6900. In fact, SB 1207 supports the ability of all companies to adopt or preserve cumulative voting, including those companies that opt into a majority voting rule. SB 1207 does this by allowing a company to utilize majority voting for uncontested elections and cumulative voting for contested elections. There is no “fundamental incompatibility” in a system that accords a corporation the opportunity to choose between majority voting for one kind of election and cumulative voting for another.

SB 1207, as currently drafted, changes only one aspect of director elections: it provides a listed corporation with the ability to implement majority voting in “uncontested” elections. The bill does not change the existing process for contested elections (i.e. directors who receive the highest number of votes are elected; if a shareholder has elected cumulative voting, each shareholder may multiply the number of votes to which the shareholder’s shares are entitled by the number of directors to be elected, and distribute the votes among the candidates as the shareholder sees fit; subject to the ability of a listed corporation to eliminate cumulative voting under Section 301.5(a)). This approach provides corporations with maximum flexibility in addressing director elections, while also preserving to the fullest extent possible California’s tradition of cumulative voting.

Those who propound a “fundamental incompatibility” argument would require a corporation to make an “either/or” choice between majority and cumulative voting. In other words, they would permit California corporations to adopt majority voting in uncontested elections only if they were willing to eliminate cumulative voting in all elections, whether contested or uncontested. We think that choice is best left to each corporation and its shareholders. Corporations already have the ability under Corporations Code Section 301.5 to opt-out of cumulative voting if they wish to do so. There is no reason to force a choice.

Put another way, is there a reasonable justification as to why the Corporations Code should, as a matter of law, prevent a corporation from selecting a majority voting system for uncontested elections and a cumulative voting system for contested elections? We think the answer is “no.” Each system serves different purposes, and both can co-exist quite well. The policy goal of majority voting is to provide a means for shareholders to vote against incumbent directors. The purpose of cumulative voting is to ensure minority representation on a board.

While the policy purposes may overlap, they don’t necessarily conflict. Given California’s historic policy and the current practice of most California corporations favoring cumulative voting, we believe that the approach of letting each corporation and its shareholders determine whether to adopt majority voting for uncontested elections (as opposed to an “either/or” choice between majority voting and cumulative voting) represents a strong reason to support SB 1207. Delaware has adopted such an approach, and we believe this approach is in the best interest of California corporations and their shareholders.

With regard to the removal issues raised by Mr. Bishop, we believe that his concerns are overstated. SB 1207 does not amend Corporations Code Section 303 relating to removal. Thus, the protections afforded directors elected or supported by a group of minority shareholders remain intact: no director may be removed without cause if the votes cast against the director’s removal would be sufficient to elect the director if voted cumulatively at an election at which the same number of votes were cast.

Further, candidates in contested elections would not be impacted by majority voting since majority voting does not apply in contested elections. Only candidates in an uncontested election must achieve the affirmative vote of a majority of votes cast. In such an election, a minority shareholder whose candidate would not gain a majority of votes cast may be required to force a contested election in order to maintain a board seat. However, as a practical matter, when a company knows that a minority shareholder is assured a board seat through cumulative voting, it often nominates that shareholder’s candidate to avoid the contest.

Thus, while it is possible that a scenario could arise where a minority shareholder is required to force a contested election, we think this would be rare. In our view, Mr. Bishop’s concern with the removal of cumulatively-elected directors is not so significant to prevent corporations from being given the option to select majority voting, and does not further the argument that SB 1207 either is inconsistent with or undermines cumulative voting.