Thank you, Jesse (wherever you are) and Alan. A double introduction is a first for me — I am very appreciative.
I am very happy to be here this morning, as you start your two-day conference on the new executive compensation disclosure rules. You have assembled an impressive faculty and have set out an ambitious agenda for yourselves for the next two days.
Tomorrow, the Chief Counsel of my Division, David Lynn, will be joining you, and offering his insights as well. Dave and I, and other representatives of the Commission's staff, are signed up for quite a number of these programs, but we obviously will not be able to be at all the conferences about the new rules. And we will not be physically present at any of the countless presentations that lawyers and compensation specialists will be making to boards of directors and executive officers in the coming months. Nor will we participate in the ensuing disclosure discussions. Nonetheless, there is at least one theme that I hope will permeate all of the conferences, presentations and discussions. And that theme is where I would like to start my own remarks this morning — the meaning and significance of principles-based disclosure.
Before I turn to that, however, I must first remind you that the views I'm going to express today are solely my own, and do not necessarily reflect the views of the Securities and Exchange Commission, or of any members of its staff, other than myself.
In thinking about today's program, I have assumed that many in the audience are lawyers and other compensation and disclosure specialists who will be working diligently this upcoming proxy season to help companies comply with the new rules and to get their disclosures right. The Commission relied tremendously on the overwhelming and very constructive feedback we received from all quarters during the comment period on the rule proposal. And now that the rules have been finalized, we are relying on all of you to help make them work right in practice. Fortunately, in my opinion, the Commission's new rules are rather uniquely structured so that advisors, like you, will be able to make that critical difference. The key to remember — as I articulated in a speech by the same name that I gave last week in New York — is two simple words: principles matter.
Principles, in my view, are an important thread running throughout the Commission's recent rulemaking. And I believe that looking at principles as they apply to various specific areas of the rulemaking is a useful learning tool. In last week's "Principles Matter" speech (which has been posted on the Commission website),1 I looked at two different areas of the new rules — Compensation Discussion & Analysis and perquisites — each through the lens of principles. I also used those two examples in helping to show the critical role that disclosure counsel and advisors can play in a principles-based disclosure world. When you have a chance, I urge you to take a look at those remarks as they are very intertwined with my theme this morning.
This morning, I'd like to look specifically at how principles work in a third area in the recent rulemaking: that is, the disclosure of option grant practices. When I was studying the program that Jesse and his team have put together for this conference, it struck me that no separate panel seemed directly focused on the stock option angle of our new disclosure guidance. So hopefully if I spend a few minutes on that area this morning, I won't be stepping on anyone's toes later in the day. As you may know, this area was extremely important to the Commission, and I actually called it "a release within a release" when we were working on the final rulemaking.2
Principles-Based Disclosure and the New CD&A
There are a wide variety of views on how to explain the term "principles-based". Although everyone seems to have the same general idea of what they're talking about, I think it's important, before we put the term into action, that we have a mutual understanding of what it means. For my part, I find the description that Robert Herz, chairman of the FASB, gave in 2002 to be very useful:
Under a principles-based approach, one starts with laying out the key objectives of good reporting in the subject area, and then provides guidance explaining the objective and relating it to some common examples. While rules are sometimes unavoidable, the intent is not to try to provide specific guidance, or rules, for every possible situation. Rather, if in doubt, the reader is directed back to the principles.3
Now, Bob was talking about accounting and financial reporting, of course, and that's often where we hear the phrase "principles-based". The Commission, however, has embraced it in numerous other places, including the recent executive compensation disclosure rulemaking.
Within this rulemaking, the new CD&A section is probably the place that most often gets tagged with the term "principles-based". Clearly, a solid understanding of principles-based disclosure is vital to preparing and providing investors with a high quality CD&A. If you have read the recent Release, you have been directed by the Commission to look to the existing MD&A (Management's Discussion & Analysis) as a model for understanding the function and operation of the new CD&A. I believe this analogy is very apt. Not only do they share similar acronyms, but more importantly MD&A and CD&A share a commitment to and provide a place for principles-based disclosure.
Last week, I referred to a speech that our former Commissioner Cyndi Glassman gave in March.4 Commissioner Glassman was absolutely right in noting that "[o]f all of our disclosure rules, MD&A may be the most principles-based." So, when approaching the challenge of drafting your company's first CD&A, please don't forget the body of learning that companies already have from their experiences of drafting MD&A. The description of the term "principles-based" that I borrowed from Bob Herz, talks about starting with the "key objectives" of good reporting in a particular area. So what are the key objectives of good reporting (or more specifically, good disclosure) for executive compensation, and especially for the CD&A? CD&A is what gives context to the required tables and the numbers in them.
As the Commission stated in the Adopting Release:
The purpose of the Compensation Discussion and Analysis disclosure is to provide material information about the compensation objectives and policies for named executive officers without resorting to boilerplate disclosure. The Compensation Discussion and Analysis is intended to put into perspective for investors the numbers and narrative that follow it.5
The rules do provide six questions that CD&A must answer, as well as 15 examples of topics a company might consider addressing. Those examples are neither exhaustive nor mandatory. A company (and those drafting its disclosure) must determine what is material to the company. What do the company's investors need to know? They must then craft the appropriate disclosure that is responsive to those questions and is tailored to the company's particular facts and circumstances.
Disclosure of Options Practices
So how does that broad description of the objectives of CD&A apply to options disclosure? Within the Release, right up front, the Commission took special care to talk about the application of its new rules for CD&A to option grant practices.6 Principles clearly play a critical role here. In addition to detailed, new tabular disclosure requirements about option grants and their value (which you will be hearing more about in the panels later today that deal with the tables), the Commission is now requiring clear, principles-based narrative disclosure in the CD&A about a company's programs, plans and practices pertaining to option grants to executives.
As you all know, there has been a lot of media and other attention paid recently to various option grant practices, using labels like "backdating," "spring loading" and "bullet dodging". Those terms mean different things to different people. The Commission did not use any of them in the Release, and I will not be using them today. Rather, the Commission talked about two separate, general categories of options practices — (1) those relating to the timing of option grants and (2) those related to the pricing of option grants (or setting exercise prices).
Before looking at these practices, I believe it is important to note upfront that the Commission's new rules (and the guidance in the Release) are prospective. The Commission did not comment on past practices in the Release. I also believe it is important to remember that the Commission was very careful to highlight that it was not speaking to the substance of executive compensation, in either form or amount, in any way. As our Chairman, Chris Cox, stated at the Open Meeting when the new rules were adopted, "It is not the job of the SEC to judge what constitutes the "right" level of compensation for an executive or to place limits on what executives are paid."7 Our concern is with disclosure.
So let's turn now to the option practices and disclosure guidance in the Release. With regard to the first category of practices I mentioned a moment ago — timing practices — the Commission explained that these involve the granting of options in coordination with the release of material non-public information. Timing may be in coordination with the release of positive or negative material information, and it might take place by delaying or accelerating the information release, or by delaying or accelerating the option grant. There are a lot of different permutations and combinations there, but they all boil down to option grant "programs, plans or practices" that require appropriate disclosure and discussion under the new rules and the guidance in the Release.
The second general category of option grant practices relates to "pricing." Pricing practices involve establishing a strike price for an option grant that is different from the stock's closing market price on the date of grant. Generally speaking, the exercise price of an option grant is the closing market price of the underlying stock on the grant date. Companies may, however, establish different exercise prices provided they comply with the applicable disclosure requirements and follow the correct accounting. The Release provides guidance about two methods for establishing a different exercise price — by setting the exercise price based on (1) the stock's price on a date prior to the grant date, or (2) a formula, often using some combination of the stock's price at various times on the grant date or during a time window before (and sometimes after) the grant. As long as the option grants are properly disclosed and the company accounts for them correctly, there is nothing per se wrong with following one of those practices.
What does proper disclosure look like, then, if a company chooses to engage in either timing or pricing practices with regard to its option grants to its executives? As I said before, there are some fairly detailed new tabular disclosures that companies must provide. Moreover (and this is what I want to focus on today), in keeping with a principles-based system, the Commission provided in the Release several questions and examples in order to help companies craft the right disclosure in their CD&A specifically about option grants.
The very first question for special consideration that the Commission poses in the Release is, "Does a company have any program, plan or practice to time option grants to its executives in coordination with the release of material non-public information?"8 This question is only a suggestion, and as I alluded to earlier, it should not be considered either mandatory or exhaustive. It does, however, deserve careful consideration. Think in principle about what it means to "time an option grant in coordination with the release of material non-public information."
The most obvious example of a timing practice might involve a company that times its options grants to precede the release of a positive earnings or new product announcement, with the expectation that the company's stock price will enjoy a boost when that announcement comes out and the option recipient will likewise benefit from his options being quickly, or more substantially, "in the money".
The principle also applies, though, to a company that delays an option grant, or accelerates a news release, to ensure that negative information is fully absorbed by the market before an option grant is awarded. People may assert that delaying an option grant until after all information is in the market (even if that means the stock price goes down) somehow "smells different" than accelerating an option grant to precede a positive news announcement (which would be anticipated to then boost the stock's price). But for the Commission's new disclosure rules and guidance, those two situations are really two sides of the same coin. If they exist, they both are "programs, plans or practices" related to option grants, and they both may need to be disclosed and discussed appropriately.
As another variant, the principle applies equally to a company that times its options grants to either precede or follow, as appropriate, a known (or anticipated) upcoming, material announcement from a third party — such as an FDA announcement that it has either approved or denied a critical drug application on which the company has pinned its hopes. In all these situations, remember the principle and don't let your analysis, or your disclosure, end with the most obvious example or overly simplistic answers.
Let's look at another question. The second illustrative question that the Commission posed in the Release is, "How does any program, plan or practice to time option grants to executives fit in the context of the company's program, plan or practice, if any, with regard to option grants to employees more generally?"9 Our newest Commissioner, Kathy Casey, first raised the excellent point that the requisite context for understanding option grants to executives may go beyond the executive suite itself. While it's true that the Commission's disclosure rules pertain to executive compensation, it's not good enough to ask only the simple questions, to keep your blinders on, to not think outside the box. Does your company have a program, plan or practice for option grants which it follows with regard to all of its employees generally? Or is this a special situation that applies only to executives, or only to select executives? The answers to those questions may well inform or shine extra light on how a company follows such a practice, what benefits the company receives from it, or what effect it has on the executive recipients. Or, it may not. But the point of principles-based disclosure is that companies, and their advisors, need to figure that out, and to make sure they're disclosing the relevant, material information about their companies' particular facts and circumstances. Again, remember the key message here — principles matter. And give your investors the material disclosure they want, need and deserve.
The Release talks at length about timing and pricing practices with regard to options specifically. Those are two critical analytic elements, but please don't lose sight of the overarching principles in this sense either. If other practices relating to option grants are developed in the future — as they undoubtedly will be — they will also be covered by these principles-based disclosure requirements, even though the Release doesn't name them, and we may not (any of us) yet know what they are.
Similarly, the Release has an entire section that speaks about "options", but you should understand that the principles the Commission has promulgated undoubtedly apply to other equity awards, such as stock appreciation rights (SARs) and restricted stock that operate in the same field. Leaning again on my friend Mr. Herz, think about the key objectives of good reporting in this area, and the principles will guide your disclosure. As the Release expressly states, companies should consider their own facts and circumstances, and include all relevant material information in their corresponding disclosures. The questions and guidance in the Release are only a start. Use your disclosure to provide the necessary context and perspective about your company, for your investors.
Conclusion
Obviously we stand at a fairly unique juncture at which tremendous media and law enforcement attention is being paid to companies' option grant practices. It's not clear to me how the public, or history, will end up judging past practices. At the same time, the Commission has outlined a clear path for how these issues should be addressed going forward. No one has drafted a CD&A before, or crafted disclosure in light of the Commission's recent guidance on disclosure of option grant practices. I, at least, am not aware of any company that has otherwise used its proxy disclosure to provide its investors with a clear understanding of what the company is doing, and what it's achieving, with its option grants. I hope you will see your company's next proxy statement, therefore, as an opportunity "to get it right the first time." And I hope you will help America's public companies seize that opportunity. Each of you has an invaluable role to play in guiding and assisting your clients and your companies in answering that call. Remember, the two-word message of this morning: principles matter.
Thank you very much for giving me the opportunity today to share a few of my thoughts with you on the new rules. I hope you find the next two days to be both enjoyable and rewarding.
Endnotes
1 "Principles Matter," John W. White, Director, Division of Corporation Finance, U.S. Securities and Exchange Commission, September 6, 2006, available at http://www.sec.gov/news/speech/2006/spch090606jww.htm.
2 SEC Release No. 33-8732A, "Executive Compensation and Related Party Disclosures," August 29, 2006, (the "Release"), available at http://www.sec.gov/rules/final/2006/33-8732a.pdf.
3 "Remarks before the Financial Executives International Current Financial Reporting Issues Conference," Robert H. Herz, November 4, 2002.
4 "Remarks before the Tenth Annual Corporate Counsel Institute: Priorities and Concerns at the SEC," Cynthia A. Glassman, Commissioner, U.S. Securities and Exchange Commission, March 9, 2006, available at http://www.sec.gov/news/speech/spch030906cag.htm.
5 Release at p. 29.
6 Release at pp. 18-27.
7 "Introductory Remarks at the SEC Open Meeting," Christopher Cox, Chairman, U.S. Securities and Exchange Commission, July 26, 2006, available at http://www.sec.gov/news/speech/2006/spch072606cc.htm.
8 Release at p. 26.
9 Id.
