Federal Securities Lawyer & Attorney : Porter Wright Law Firm : Securities Exchange Law : Serving Ohio, Washington DC, Florida

The SEC is investigating misuse of a 10b5-1 trading plan by Countrywide Financial Corp CEO, Angelo Mozilo, and securities experts continue to predict that such misuse will be the next big securities scandal.

10b5-1 trading plans allow executives to trade stock without worrying about trading on material, nonpublic information, also known as insider trading. The plans are filed with the SEC and specify in advance when stock in an executive’s company will be bought and sold and at what price. The plans cannot be entered at a time when an executive has material, nonpublic information, the idea being that executives should not be able to influence when plans make purchases or sales if the executive has inside information.

Much like option backdating was exposed by an academic study that found option grants tend to occur at optimum times (which suggests insider trading), misuse of 10b5-1 plans has been suggested by a Stanford study that found such plans beat other trades by as much as 6 percent.

Examples of plan manipulation include:

• Starting a plan while aware of insider information;
• Disclosing insider information before a planned trade to maximize profits; and
• Rewriting a plan before upcoming changes in company performance.

These types of manipulation are already illegal, which could mean any impending scandal may need to be solved with better detection of wrongdoing, as opposed to new rules.

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The SEC has published its observations regarding executive compensation disclosure for the first round of proxy statements that were filed under the new executive compensation rules. In summary, two themes were the focus of the report:

1. The Compensation Discussion and Analysis (CD&A) needs more attention to how and why compensation decisions are made; and
2. Companies are encouraged to think about how they present information, including by use of plain English, tables, and graphs.

The full report contains suggestions for improved disclosure and an explanation of the types of comments that the SEC issued. The following are some highlights:

1. Emphasize material information and de-emphasize less important information;
2. In the CD&A, emphasize the how and why of compensation levels and de-emphasize compensation program mechanics;
3. Charts, tables, and graphs not required by the rules were almost always helpful (for example, tables that explain payments upon a hypothetical termination or change-in-control);
4. Disclosure that is clear and concise does not have to be long;
5. Disclose how decisions affecting one element of compensation affected other elements as well; and
6. Explain how subjective performance targets translate into objective pay determinations.

The SEC isn’t the only one concerned with executive compensation. Executive compensation has been mentioned by some of the front-runner candidates for president and recently by President Bush. Specifically, compensation for CEOs of large companies may be a point of discussion in next year’s election.

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As the SEC continues to review the first round of proxy statements filed last spring under the new executive compensation rules, publicly traded companies should consider thinking about how to improve disclosures for next year.

The importance of analyzing compensation decisions, as opposed to merely stating what types of compensation are paid, is evident by the language of the rules for drafting the Compensation Discussion & Analysis (CD&A) section of the proxy statement. The rules require that the following material elements of compensation for named executive officers be discussed, described, and explained:

1. the objectives of the compensation program;
2. what the compensation program is designed to reward;
3. each element of compensation;
4. why the company chooses to pay each element;
5. how the company determines the amount/formula for each element; and
6. how decisions regarding each element fit into the compensation objectives.

 The following are suggestions for improved disclosure, as prompted by the new rules:

• Keep detailed minutes throughout the year regarding not only what compensation decisions are made but why they are made. When compensation decisions are made, the compensation committee should articulate, in writing, as many aspects of elements (1) through (6) above as possible. This allows an understanding of compensation decisions to develop throughout the year as opposed to at the last minute when it comes time to draft the proxy.
• Amend the compensation committee charter to state that the committee will review and discuss disclosures in the CD&A with management and recommend that such disclosures be included in appropriate filings.
• Draft a related party transactions policy. The new rules require companies to explain how such a policy is evidenced if not in writing. This policy will be the responsibility of either the audit committee or the nominating committee and will describe the policies for review, approval, and ratification of any related party transactions required to be disclosed.
• Monitor perks paid to executives and directors throughout the year to avoid embarrassing items that are hard to justify.
• Draft future stock option plans to ensure that a stock option’s exercise price is the same as the company’s stock price on the date of grant. Increased disclosure is required if this is not the case, including a description of the company’s methodology for determining the exercise price.
• Draft future employment agreements in a manner that makes it easy to determine what executive officers will be paid upon a hypothetical termination or change in control. Determining what executives will be paid at termination is a necessary exercise for both public and private companies that use employment agreements, but the provisions that control payments are often unclear.

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The SEC announced last week that the development of “data tags” for U.S. generally accepted accounting principals will soon allow investors and analysts to download financial reports filed with the SEC directly into spreadsheets in Excel. This will allow for instant financial comparisons across entire industries.

Financial reports of public companies are housed in a publicly-accessible SEC database called EDGAR (Electronic Data Gathering, Analysis, and Retrieval system), but the data is not interactive. The newly created data tags correspond to each unique accounting concept. Now that each accounting concept has been tagged, companies can more easily tag their financials and use the tagged information.

The SEC has allowed for the filing of financial reports in interactive data format for over two years. It seems likely that some day such interactive filings will be required to allow for investors and analysts to make sophisticated comparisons.

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