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Sarbanes Oxley : Auditing : Executive Compensation
Implications of Sarbanes Oxley for Executive Compensation
Compensation committee members are expected to bring in diverse professional background and sophisticated compensation and finance knowledge and expertise.
By
Linda Zong
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Linda Zong
Royal Caribbean Cruise Lines
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On July 30, 2002, President George Bush signed the Sarbanes-Oxley Act of 2002 (the "Act") written by Senator Paul S. Sarbanes and Congressman Mike Oxley, with the intent to set up the high financial and ethical standards for corporate America. Although the majority of the eleven parts of the act is related to accounting practices and board governance, the Act contains a number of provisions relating to executive compensation and employee benefits. Specifically, the Act provides the following:
• Pension fund blackout periods: Plan administrators of individual account plans (for example, 401(k) plans) must give 30 days advance notice of any blackout period;
• Insider trading rule: Insiders cannot trade in company stock during certain blackout periods;
• Prohibition of personal loans to executive officers and directors;
• Forfeiture of bonus and profits due to earnings restatement
I. Pension Fund Blackout Period Notification
Under Title 3 - Corporate Responsibility, the act sets up guidelines for pension fund black out periods. According to Section 306 (a), Title 3, each issuer needs to provide notice of impending individual account plan blackout periods to directors and executive officers, and directors, executives and officers are not allowed to trade company stock during a blackout period. The profits made by trading during blackout will be revoked. A 30 days notice of a blackout period needs to be provided to plan participants unless it conflicts with ERISA or if an unforeseeable event prevents such notice.
The notice must include: (1) the reasons for the blackout period, (2) identification of the investments and other rights affected, (3) the expected beginning date and length of the blackout period, and (4) a statement that individuals should evaluate the appropriateness of their current investment decisions in light of their inability to direct or diversify assets credited to their accounts. The notice must be in writing or sent by electronic transmission, provided that such transmission is reasonably accessible to the participant.
Effective January 26, 2003, the Department of Labor (the ?DOL?) issued separate regulations under Section 306(b) of the Act and amended the Employee Retirement Income Security Act of 1974, requiring the plan administrators to provide advance notice to individual account plan participants and beneficiaries of a blackout period, whose rights under the plan will be temporarily suspended, limited or restricted by the blackout period. The plan administrator is also required to notify the issuer of the impending blackout period so that the issuer may provide the notices required pursuant to Section 306(a).
Accordingly, Sarbanes-Oxley exerts indirect impact on benefits from the governing perspective with the blackout notification and the loan prohibition. Many companies, both public and private, are examining the governance of their benefit plans by reviewing the plan sponsors and the risks and liabilities.
II. No Insider Trading During Blackout Periods
Effective January 26, 2003, this Section 306 of the Act imposes insider-trading liability on directors and executive officers who trade in company securities during temporary company retirement plan blackout periods. The provision prohibits an issuer?s directors and executive officers from directly or indirectly acquiring or transferring during an individual account plan blackout period any equity security of the issuer acquired in connection with the director?s or executive officer?s service or employment when rank-and-file employees are prohibited from doing so in their employer-sponsored retirement plan accounts. If a prohibited sale occurs, the profit is recoverable by the issuer.
Section 306(a) equalizes the treatment of corporate executives and rank-and-file employees with respect to their opportunity to engage in transactions in issuer equity securities during an individual account plan blackout period. The rules in Section 306 of the Act address perceived abuses of insider trading in blackout periods at Enron and other corporations. Although the SEC has said it does not intend to provide guidance on the ambiguities in executive compensation issues caused by new provisions of Sarbanes-Oxley, companies should also consider whether they need to amend their existing compensation and retirement plans to reflect the new blackout period rules.
With the new requirements on issuers, plan sponsors and plan administrators imposed by Section 306 (a) and 306 (b) of the Act, companies should designate individuals responsible for the administration and maintenance of individual account plans to incorporate applicable restrictions into plan documents, update insider trading policies to reflect the new notice requirements and restrictions, check the indemnification provisions in plan documents and contracts with administrative service organizations to ensure compliance. These steps should be undertaken promptly with the assistance of legal counsel to ensure compliance with these new rules.
III. Executive Loan Prohibition
In an amazing display of broadly drafted legislation, Section 402 of the Sarbanes-Oxley Act of 2002 (Act) amends section 13 of the Securities Exchange Act of 1934 (1934 Act) by adding a new subsection (k) to prohibit public companies from extending credit, or merely arranging for the extension of credit, directly or indirectly, to their directors and executive officers of public companies. Section 402 in Title 4 reads like this: ?It shall be unlawful for any issuer directly or indirectly, including through any subsidiary to extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or executive officer (or the equivalent thereof) of that issuer.?
Title 4 Section 402 explains that current loans can be left alone, while any changes to the terms on or after July 30th is illegal. The Act provides specific exemptions for loans extended to executive officers and directors as part of an issuer?s regular business. In effect, these exemptions are only available to issuers who are financial institutions and, in certain instances, only U.S.-based financial institutions. As a result, the act forbids executives receive loans from their employer with the exceptions of loans that are no more generous than what?s commonly offered to the public. The stock purchases and sales of directors, officers and principal shareholders must be disclosed.
In interpreting the Act's provision, issuers should focus on the broad definition of "executive officer" under the securities laws, which refer to so-called Section 16 reporting officers who must regularly report to the SEC concerning their stock holdings. In general, an "executive officer" includes a president, certain vice presidents, and any other officer who performs a policy making duty. Executive officers of subsidiaries are not generally deemed to be executive officers of the issuer unless they are involved in policy-making decisions for the issuer.
The breadth of the Act's provision would most likely prohibit part or all of the executive loan programs, including sign-on loans, salary advances, relocation loans, loans for cashless exercise of stock options, loans to purchase restricted stock, personal use of a corporate credit card, and split-dollar life insurance policies. This last item as split-dollar life insurance policies used to be a significant financial benefit to executives and their heirs and is now subject to intense lobbying to limit the law's scope by clarifying amendments to the law.
With the elimination of the executive perk in the forms of company loans, the company needs to consider whether any of their existing compensation and benefits plans covering directors and executive officers should be amended to comply with this prohibition of personal loans. However, since it is possible that some exemptions may be granted, companies should review all of their executive compensation arrangements to identify any transaction that may be covered due to the broad language of Section 402 and the serious consequences of a violation.
IV. Bonus and Profit Forfeiture due to Financial Reporting Restatement
In addition, as with Section 402, also effective immediately, Section 304 of the Act requires a public company's CEO and chief financial officer to forfeit bonus or other incentive compensation (including profits realized from the sale of any company securities) during the 12-month period following the issuance of a financial statement that must be restated due to "material noncompliance" as a result of "misconduct" in preparing financial reports.
There are still remaining issues with profit forfeit provision such as the definition of the 12-month period following the filing of the financial statement embodying the financial reporting requirement resulting in the restatement, the difference between mere negligence, gross negligence and willful misconduct, the covered individuals at the time of the filing of non-complying statements, at any time during the 12-month period following their filing, at the time of the issuance of the restated financials, or a combination of all three and the tax consequences of any required repayments by an executive to the company, as well as whether the covered compensation applies to amounts received from the issuer or from any controlled group member, such as a management services subsidiary; When the deferred bonus and equity-based compensation are considered received, at the time of deferral or the actual payment, or upon option exercise or restricted share vesting;
Although the Act gives the SEC authority to exempt from Section 304 such persons, as it deems necessary and appropriate, such exemption can be rare given the current political and business climate. Therefore, to comply with the Act, companies should consider the possibilities to amend their compensation plans covering executives and officers, attempting to resolve any of the ambiguities embedded in the interpretation of the Act. For example, companies could consider specifying a level of misconduct triggering the repayment obligation, or specifying that the repayment obligation applies only to individuals who held the top executive and officer positions at the time of the filing of non-complying statements.
Next Steps
On the first anniversary of the landmark Sarbanes-Oxley Act, which tightened corporate governance and accountancy regulation in the US after a wave of corporate scandals, Mr. William H. Donaldson, Chairman of U.S. Securities and Exchange Commission said executive compensation remained as "one of the great as-yet-unsolved problems" in corporate America. "We are in the period of an in-flight correction, if you will," he said. One area of concern is executive compensation. Executive pay and bonus schemes were often tied to earnings per share and other narrow financial measures during the bull market, which appears to have induced some executives to tamper with their accounting to reap greater personal rewards. "There is a lot more to management than simply earnings-per-share," Mr. Donaldson said, noting non-financial measures such as customer satisfaction and product quality. He said he hoped measures to enhance the independence of corporate boards and shift power away from chief executives would help to change executive pay practices.
Similarly, the Business Roundtable, an organization of CEOs of leading US corporations committed to improving public policy, recently released some new principles on executive compensation that would more closely link CEO pay with performance, and promote a greater role for independent compensation committees, as part of its ongoing commitment to ensure that best practices in corporate governance are adhered to. As said by Franklin D. Raines, Chairman and CEO of Fannie Mae and Chairman of the Roundtable's Corporate Governance Task Force: "Executive compensation should reward success and not reward failure." "Independent directors should create and approve the pay packages of CEOs and senior executives, and they have a responsibility to understand those pay packages inside and out." "CEOs and other senior executives should build and maintain a significant equity investment in their companies to ensure their interests are aligned with long-term shareholders." [1]
Accordingly, many public companies have been modifying their executive compensation packages to align with Sarbanes-Oxley and corporate governance directives. The following are my own recommendations for the public companies to revamp their executive and equity compensation practices to comply with Sarbanes-Oxley disclosure and loan prohibition provisions in order to ensure pay for performance in the tightened corporate governance environment. Some of these recommendations are aligned with the principles and commentaries on executive compensation released in November 2003 by the Business Roundtable.
• Provide More Timely and Thorough Disclosure to Shareholders and SEC
Corporations should provide timely, complete, accurate and understandable disclosure to stockholders and SEC (the Securities and Exchange Commission) concerning all significant elements of executive compensation in their compensation committee reports included in the proxy statement in the annual report. For example, advance public disclosure is required for senior officers of any plans to dispose of the securities of the public company for which they work. The beneficial ownership reports for ?insiders? are mandated to be filed electronically with SEC to meet the shorter filing deadlines for Forms 3, 4 and 5 under amended SEC Section 16(a) required by the Sarbanes-Oxley Act.
Disclosure about a corporation?s executive compensation programs should address the type and amount of executive compensation as well as the economic impact of the executive compensation (such as stock options dilution effect, future benefits projects and the linkage between the executive incentives and corporate goals and strategy) and any ?material revisions? to the executive compensation programs. The executive compensation disclosure should reveal the total rewards to the executives including the executive benefits, deferred compensation plans and supplemental executive retirement programs (SERPs) as well as the payout agreements under various scenarios including severance, retirement and termination with or without cause.
• Design Balanced Performance-Based Long-Term Equity Compensation
With the executive loan prohibition provisions in the Sarbanes-Oxley Act, the loans for cashless exercise of stock options will no longer become available, which will affect the corporations? previous favor of using stock options as key equity compensation tools. In addition, the stock options expensing pressure imposed by FASB (Financial Accounting Standards Board) and the already high stock options dilution level further work against the stock options. Moreover stock options fail to include the downside risk when performance is not optimal. In order to incorporate downside business risk into compensation design and link pay to performance, compensation professionals should discourage or limit the use of stock options and opt for a variety of performance-based equity compensations such as performance-vested stock options, performance share units, stock appreciation rights (SARs) and restricted stock grants that are payable in the company?s stock or cash once pre-established targets are met.
To comply with the prudent corporate governance requirement, executive and equity compensation should be designed to link pay with corporate performance. It should be closely aligned with corporate goals and strategies and the long-term interests of stockholders by including significant performance-based criteria related to long-term stockholder value that reflect both upside potential and downside risk, including sales growth, profit gains, improved efficiency, market share, customer satisfaction and innovation, etc. Executive incentives should be tied not only to the business accomplishments, but also to senior management?s individual accomplishments.
In order to foster pay for performance corporate culture, compensation committees should encourage or require executives to build and maintain more prevalent long-term equity investment in the corporation. A multi-year perspective needs to be incorporated to measure accomplishment over several years. For instance, some gains realized from option exercises and stock sales may be the result of options granted over many years and several year? appreciation in the underlying stock. The executive compensation programs should clearly depict the relationship between pay and performance. Payment of equity-based compensation should not be made unless pursuant to a shareholder approved plan.
• Create Independence, Diversity and Expertise in Compensation Committee
With the increased duties and responsibilities of the compensation committee members to ensure compliance with Sarbanes-Oxley Act, the SEC reporting and corporate governance, the compensation committee should be composed entirely of independent directors, either as a committee or together with the other independent directors or retained third-party counsel, to determine the compensation of the top corporate executives. In addition, having the compensation committee hire the compensation consultant?much the way audit committees now hire the independent auditors?would lead to more independent executive compensation plan proposals. Only independent directors are allowed to participate in the approval process of the executive compensation at the board level.
Meanwhile, compensation committee members are expected to bring in diverse professional background and sophisticated compensation and finance knowledge and expertise. Periodic rotation of compensation committee members and the committee chair can be beneficial to the committee effectiveness. The bottom line is: the compensation committee members should have, and be perceived to have the ability to exercise independent judgment free from any conflict of interests. The duties and responsibilities of the compensation committee should be set forth in a writer compensation committee charter.
• Comply with IRS (Internal Revenue Service) Executive Compensation Audit
To join the forces in the wave of corporate governance reform, the IRS recently initiated a study to examine executive compensation issues with respect to corporate tax compliance. The IRS (Internal Revenue Service) asked corporate tax departments from the selected two dozen large corporations to supply copies of the tax returns of corporate executives in order to ascertain that income has been properly calculated and to verify the year of the inclusion corresponds to the year of the corporate deduction.
The broad areas of review include nonqualified deferred compensation (including compliance with Code 404(a) (5), application of employment taxes, the applications of constructive receipt, economic benefits, offshore and rabbi trusts); stock-based compensation (including restricted stock, statutory and non-statutory options, stock appreciation rights and phantom stock); the million-dollar cap on deductible compensation under code 162 (m); code 280G golden parachutes and the amount exceeding the safe harbor limit; split dollar life insurance (including the amount of income transferred to an employee as the insurance and whether the value of term protection has been included in income); listed transactions of compensatory options transferred to family limited partnerships as described in IRS Notice 2003-47, 2003-30 IRB132; listed transactions under employee leasing asset protection plans as described in IRS Notice 2003-22, 2003-18 IRB 851; Fringe benefits? compliance with Code 132 and whether the value of taxable perks is included in income.
This new IRS initiative on executive compensation tax compliance audit is a strong echo to the stringent financial earnings report requirements with punishment of bonus or profit forfeiture set up in the Sarbanes-Oxley Act. The compensation professionals need to work with corporate tax, accounting and finance professionals to ensure that the executive compensation tax returns are in compliance with IRS corporate return requirements and that the executive compensation expenses are properly disclosed in the financial statements.
In Conclusion
Being a visible landmark piece of legislation, Sarbanes-Oxley certainly raised the bar for corporate governance in response to the recent corporate scandals. The regulatory and listing changes of the Sarbanes-Oxley Act and new stock exchange listing and approval requirements from the NYSE and NASDAQ have made significant impact on executive compensation and benefits. The corporate governance reform led by the Sarbanes-Oxley act has been strongly advocated by major groups such as The Conference Board, The National Association of Corporate Directors, The Business Roundtable, CalPERS and TIAA-CREF. While Sarbanes-Oxley governs publicly traded organizations, the FDIC (Federal Deposit Insurance Corporation) has urged non-publicly traded institutions to accept these new guidelines as well.
In order to comply with all these new regulations and principle, corporations should strive for the stringent requirement of Sarbanes-Oxley for more accountability for notifying, receiving and reporting equity-based executive compensation programs governed by the inside trading rules, loans prohibitions and the bonus and profits forfeiture provisions. The generic winning formula is a balanced, performance-based and long-term approach to executive and equity compensation is suitable for any organization that can be achieved by blending equity awards to include stock options, restricted stock grants and stock appreciation rights that encourage pay for performance. However, each company should tailor the formula in the revamping process of its own executive and equity compensation programs by finding its own optimal mix of the equity types and vesting schedules to fit its own unique corporation size, industrial and competitive position, business cycle and other specific characteristics.
Endnote
[1] Press Release, 11/17/2003, The Business Roundtable Issues New Principles To Guide Companies In Setting Executive Compensation, Business Roundtable
Linda Zong
Royal Caribbean Cruise Lines
I'm currently a Senior Compensation Analyst with Royal Caribbean Cruise, Ltd in Miami, FL. I hold MBA degree from University of Maryland with Fellowship honor and MA in Economics and Trade, as well as CCP (Certified Compensation Professional), CBP (Certified Benefits
Professional), GRP (Global Remuneration Professional) designations from Word at Work, former American Compensation Association. I used to work for General Motors China operation in Shanghai.
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