The life of the law has not been logic, it has been experience: Oliver Wendell Holmes
The first year returns are coming in on the SEC’s new executive compensation disclosure regime and the results are that, while the Commission is generally pleased, there is more work to be done on disclosing more and better analysis. An SEC staff review of the executive compensation disclosure of 350 public companies reveals overall very positive results, with most companies having either met or exceeded the Commission's high hopes for better disclosure. That said, SEC officials call for increased analysis in the new Compensation Disclosure & Analysis section.
As one could expect, a great deal of SEC concern in the first year disclosures is centered on the CD&A. Generally, the SEC staff found that in many cases the CD&A could have done a better job of explaining how particular levels and forms of compensation were determined, as well as why companies pay what they pay.
According to Corporation Finance Director John White, the biggest failure of the first year disclosures is that meaningful analysis was often missing from the CD&A. In order to cure the problem, the staff suggested that companies make some items more prominent by emphasizing material information and de-emphasizing less important information. Specifically, the CD&A should emphasize why the company established the compensation levels, and de-emphasize compensation program mechanics.
Further, CD&A is meant to be a narrative overview at the beginning of the compensation disclosure, putting into perspective the numbers in the tables that follow it. Thus, companies placing compensation tables before the CD&A should relocate those tables so that they would follow the CD&A.
The SEC staff found that a significant number of companies could improve their analyses of how and why they made certain executive compensation decisions. Adding or enhancing analysis does not necessarily mean lengthening disclosure, the staff explained. Rather, careful drafting consistent with plain English principles can result in a more concise and effective discussion.
John White offered advice on drafting the CD&A. The first thing to do is ask every key participant from the compensation committee chair on down to turn in one page of analysis. Then give each participant a copy of the SEC staff report so that they see SEC concerns about missing analysis. Then ask for bullets reflecting what the participants see from their perspective as the key hows and whys, including the key analytic tools used by the compensation committee, the findings that emerged from the analysis, and the resulting actions taken impacting executive compensation.
While fully recognizing that there is a learning curve, the SEC expects companies to take the staff’s guidance to heart as they enter the second season under the new executive compensation regulations; and the Commission’s expectations will be higher.
Director White provided a roadmap for companies as they embark on the second year of executive compensation disclosure. First, he cautioned them not to let the second year’s disclosures be simply a mark-up of the first year. Instead, he advised taking a step back and asking some very important questions. Companies should determine what information is material to their investors as they examine the compensation of company executives and make their voting and investment decisions. Similarly to be determined are the material elements of individual executive and corporate performance that are considered in setting executive compensation. Further, the relationship between the objectives of the compensation program and the different elements of compensation must be decided, as well as the material factors relating to compensation decision-making.
After conducting that exercise, companies should focus on two important aspects of disclosure: analysis and presentation. Regarding analysis, the focus must be on how and why the firm reached the compensation decisions made in the CD&A. Far from providing a laundry list of facts, the disclosure must analyze the elements of the decision-making.
A final thought: The CD&A is modeled on the Management Discussion and Analysis section of the financial statements, which is designed to allow investors to see the company through the eyes of management by providing an analysis of the company’s business. The MD&A mandate was adopted by the SEC in 1980 and there is still back and forth between Commission staff and the financial reporting community on how to get it right.