SEC’s Comp Letters Threaten ‘Armageddon’

The alarming letters the SEC has sent hundreds of companies to rebuke them for their disclosures on executive compensation are raising the possibility that companies will be forced to make costly and embarrassing changes to their annual reports.
“The million-dollar question is: ‘It is OK if you send a harsh letter, but will you make us file amended 10-Ks?’ That would be Armageddon,” says Michael Melbinger, partner and chair of the employee benefits and executive compensation practice at Winston & Strawn.
The comment letters, which were sent to 300 companies — reportedly including Pfizer, General Electric and Coca-Cola— could lead to 10-K amendments if the SEC is not satisfied with companies' responses on how they complied with the new disclosure rules. Not only would this provide fodder for the media, but it could also deal a blow to companies' efforts to issue new stock and recruit executive talent
For its part, the SEC has expressed a desire for dialogue with companies regarding compliance missteps with an eye toward 2008 revisions. However, "even though proxies are out and meetings have been held, executive compensation information is incorporated into Form 10-Ks, so amendments are a possibility,” said John White, head of the SEC’s Division of Corporate Finance, at an August 14 American Bar Association conference in San Francisco.
The SEC’s main criticisms of attempts at compliance have been directed at the lack of plain English and relevant analysis; the failure to include specific performance targets (see related story); and a dearth of information regarding the CEO’s level of involvement in the pay-setting process. All these deficiencies counteract the primary goal of the disclosure rules: to shed light for investors on the rationale behind executive pay.
The letters are also raising concerns over the level of detail the commission wants relative to what was required by the new rules.
So far, a half-dozen SEC comment letters reviewed by Mark Borges, principal at Mercer Human Resource Consulting, show the government scrutinizing companies over a lack of performance target information in current-year incentive plans, not just the most recently passed fiscal year, the consultant’s blog reveals.
As a potential sign of rising SEC aggressiveness, some companies were asked “to total the amounts payable to” the named executive officers upon a change in control, the blog explains. “Some comments appear to go beyond what I understand to be required by the rules… While the disclosure may be desirable, I don’t believe that it is required,” Borges writes.
In a comment letter recently sent to Pfizer, the SEC asks the drug maker’s board to better explain the work performed by its independent pay consultant and to explain how its comp committee uses tally sheets, The Wall Street Journal reported on August 31.
If such queries lead to amended 10-Ks, boards will face more that just embarrassment.
A company with a pending 10-K amendment is unable to issue new stock via a shelf registration, or SEC Rule 415. Shelf registrations are strategically valuable because they give companies that have completed all required regulatory paperwork a two-year period to offer new securities. This approach is useful when a sudden economic downturn makes the timing of a planned stock offering unfavorable.
On the recruitment front, 10-K amendments pose a challenge to companies looking to move quickly to hire top executive talent. Because pending restatements cloud the outlook of the company’s compensation programs, a candidate may be reluctant to join up.
With SEC comment letters making their way to boardrooms, and with more reportedly on the way, directors want to know whether their reasons for not disclosing potentially sensitive corporate information such as performance targets will be accepted by the commission. “Everybody is waiting to see what will happen,” says Paul Dorf, managing director at executive compensation consultancy Compensation Resources.
Here’s how an amended 10-K could play out: The SEC sends a comment letter to a company that declined to disclose targets. In the letter, the regulator asks the board why it declined to offer such specifics. After back-and-forth communication, the board and the SEC conclude that the rationale for withholding the targets — a confidentiality provision that protects companies from disclosing competitive information — failed to hold water. As a result, the company is forced to amend its 10-K to ensure that detailed targets are included.
Inevitably, the SEC will find that some companies deliberately withheld relevant information, potentially resulting in amendments, says Dorf.
Charles Elson, a director at AutoZone and HealthSouth and head of the University of Delaware’s corporate governance center, expects the dialogue between companies and the SEC to continue until there’s a collective understanding about what constitutes compliance with the new rules. Such discord should be expected in the program’s first year, he adds.
“They are all over the place,” Elson says of the new disclosures. “When you dramatically make such a change, until a template has arrived, you are going to have [varied] responses.”