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Moody''s Investor Service

New rules from the SEC enhance disclosure and provide greater insights into boardand management decisions.

Improved disclosure of executive pay enhances the credit rating process. As compensation structures often steer management behavior, they can have direct consequences on credit quality. Moody’s therefore welcomes the Securities and Exchange Commission’s (SEC) new disclosure rules on executive pay, which enhance disclosure in several areas.

The rules give investors greater insight into board decision making, the dynamics of board management and how performance incentives influence management behavior and retention of top-level executive talent. The most striking expansion in pay disclosures from the new rules, which came into effect in 2007, relates to four areas: equity grants, the value of executive pensions, severance and/or change-of-control payments. Also welcome is the new compensation, discussion and analysis section for executive pay. That said, adjustments are required to the disclosed total pay figures to make them meaningful.

Here are the main enhancements in the reports – items Moody’s keeps an eye out for in credit analysis, and Moody’s adjustments to total pay.

1. More visibility into severance, change-in-control payouts. This is an area where the SEC has greatly improved disclosure. Traditionally, companies disclosed the material terms of severance or change-of-control arrangements but rarely the potential payout. Disclosures were sufficiently vague that it was very difficult to estimate potential payouts.

   Under the new Disclosures, firms must provide more detail as to the potential value of voluntary or involuntary severance and change-in-control payouts. Companies must disclose the potential payout as if it had been made at the end of the last calendar year. The new rules provide companies with a fair degree of discretion as to how to present these disclosures.

   So far, we have seen three types of disclosures: 1) a separate table for each named executive officer, showing the various types of payouts depending on what triggered the payout; 2) a table covering the named officers, by type of payout, e.g., “for cause” dismissal; or 3) narrative, nontabular disclosures.

   Due to the weakness of past disclosures, we do not yet have adequate bencharks to help identify outlier payouts. As we gather more data, such outliers will become more apparent. In the meantime, we will look for unusual payout terms, such as:

   • Cash severance payouts in excess of three times salary plus bonus;
   • The inclusion of equity in severance payout calculations; and
   • “Single-trigger” or other unusual change-in-control payout provisions.

2. More visibility into defined benefit plans: The enhanced disclosure surrounding the actuarial present value of the accumulated defined benefit pension plans for executives is also a significant improvement over prior years. In the past, investors had to wade through opaque actuarial tables to estimate annual payouts. Often this proved difficult. Investors also had little insight into the effect on potential liabilities of board decisions to award additional years of service to an individual’s pension entitlement.

   Under the new rules, companies have to provide, for each named executive officer, the present value of accrued benefits for each individual’s defined benefit plans and provide narrative disclosures on any extraordinary items, such as additional-years-of-service awards.

   Moody’s has yet to determine what constitutes outlier defined benefit plan values or deferred pay balances, as past disclosures have been weak. We have not commented much on this element of pay as estimations and comparisons have been difficult. Going forward, we will focus our analytical attention on CEOs in the top quartile. CEOs in the top quartile of the 1,616 companies that filed their proxy statements as of April 26, 2007, had $6.2 million and $3.4 million, respectively, for their accumulated defined benefit plan value and deferred compensation account balance (source: Equilar, Inc.). We will refine this analysis as more data becomes available.

3. Need for Moody’s adjustments to total pay. Traditionally, Moody’s has focused much of its analytical attention on the total pay of the five named executive officers who are covered by the SEC rules, particularly the CEO. We have taken the view that the best way to evaluate total pay, and therein the quality of board decision making surrounding executive pay, is to evaluate total pay from the perspective of, “What did the board decide to give to the executives in a given year?”

   One of the major elements of the new SEC pay disclosures is a revised summary compensation table (SCT). For the first time, a total pay number must be disclosed by companies, along with greater detail on what the SEC considers to be key elements of total pay. The SEC’s decision to mandate total pay disclosures with a view to making it easier for investors to analyze and compare pay across companies is a positive development. However, in deciding upon the mandatory disclosures in the SCT, the SEC has not chosen to mandate disclosures that illuminate what the compensation committee decided to pay executives in a given year, but has chosen instead to base disclosure on the cost of pay for that year under the financial accounting rules.

   As a result, a number of critical adjustments to the executive pay disclosures can deliver a more meaningful and useful– though still not optimal – total pay figure:

   • Base salary. The base salary column in the SCT remains unchanged from prior years, so we use the reported figure.
   • Other compensation. We use the full “all other compensation” figure.
   • Annual bonus payouts. Under the new rules, organizations must differentiate between discretionary or guaranteed bonus payouts (disclosed in the bonus column) and payouts that are the result of formulaic, performance-based annual incentive plans (disclosed in the nonequity incentive plan compensation column). Moody’s aggregates all annual bonus payouts into one figure. Where disclosures make it possible, we remove from the bonus figure any payouts from multiyear cash-based incentive plans.
   • Stock awards/stock options. We use the full FASB Statement 123(R) grant date fair value of stock awarded and options granted, as disclosed in the grants of plan-based awards tables, instead of the figures disclosed in the SCT stock awards and options awards columns.
   • Multiyear incentive plans. Moody’s aggregates the payout from multiyear cash-based incentive plans (where it can be differentiated from annual payouts in the nonequity based incentive plan compensation column) and the target value of equity-based, multiyear incentive plans, as disclosed in the grants of plan-based awards table. This may be viewed as a suboptimal way to evaluate long-term incentive plans (LTIPs), but without improvements to disclosures, it is the best approach possible.
   • Change in defined benefit value and above-market deferred pay contributions. Moody’s does not include the annual change in value of the defined benefit plan(s) or above-market or preferential earnings on deferred compensation in our pay analysis, as these contributions are heavily influenced by the terms and assumptions in the overall plans and are less tailored to the individual than the other elements of pay.

   Figure 1 shows that Moody’s pay components and total pay figure can differ markedly from those reported by the company. It is difficult to predict how often reported figures will be below or above those used by Moody’s because of the effect of the Statement 123(R) accounting values.

   

4. Identification of grants of in-the-money stock options, target/maximum grant-based plan awards. The grants of plan-based awards tables provide useful information beyond providing data used for adjusting total pay figures in the summary compensation table. Companies continuing to award “in the money” stock options must identify these awards and explain the methodology used to price the options. These disclosures can be viewed as useful, given the stock option backdating scandal that engulfed more than 150 U.S. companies in 2006. This table also highlights threshold, target and maximum payout levels for cash-based and equity-based incentive plans, which provides some indication of future potential awards.

5. More detail on outstanding equity awards and value of vested or exercised stock. The SEC increased the level of disclosure on outstanding equity awards held by executives. Companies now must disclose: 1) each outstanding unexercised option (on a grant-by-grant basis), unvested stock awards and long-term equity incentive plan awards that have not paid out (on an aggregate basis) in the outstanding equity awards table; and 2) the amount realized from exercised options and the value of vested equity awards in the option exercises and stock-vested table.

   We will continue to evaluate the reasoning behind large stock option exercises by senior executives. To the extent executives are exercising options because the options are nearing the end of their term, there’s no need to spend much time on such analysis. However, where the exercises highlight upcoming executive retirements, it’s useful to focus on the quality of management succession planning, particularly when it involves the CEO. Similarly, when there appears to be no obvious reasoning, we may probe as to whether senior management is losing confidence in the company’s future performance.

6. More detail on deferred pay accounts. Firms that have deferred compensation arrangements for executives now must provide much greater disclosure as to the nature of these arrangements, the annual contributions and withdrawals to such arrangements and the aggregate value of year-end account balances.

   We will use these disclosures in a targeted way. Where the aggregate value is significant in an absolute sense, we will analyze terms of the arrangements to assess how favorable the terms are compared with peers and consider what this suggests regarding the quality of the board decision-making process.

7. More comprehensive picture of the pay philosophy. Beginning in 2007, companies must include a compensation discussion and analysis section (CD&A) as part of their executive pay disclosure, which is designed to give investors more explanation and insights into a board’s rationale for its decisions on top-level executive pay.

   It is hoped the additional focus on explaining pay will encourage firms to:

   • Outline the overall pay philosophy;
   • Show the link between pay, strategy and performance;
   • Illustrate the behavior the board wants to see from management, due to its compensation-related incentives;
   • Portray more clearly and precisely the structure of short-term and long-term compensation;
   • Simplify comparative analysis of one company’s executive pay against its peers; and
   • Identify unusual or unexpected elements of executive pay.

The new requirements provide companies with significant discretion on what to include in the CD&A. This discretion diminishes the potential usefulness of the CD&A. In particular, at a minimum, companies should have to disclose the exact performance metrics that drive short- and long-term payouts, along with the weightings for each metric. Performance metrics are used in awarding annual bonus payouts and, in an increasing number of cases, for long-term awards as well. In Moody’s executive pay analysis, we seek to consider the implications of performance metrics for long-term value creation, successful execution of strategy, and likely impacts on bondholder interests. We view some performance metrics as less bondholder-friendly than others.

Suggestions for Improving Disclosure

There is room for additional improvement in the disclosure of executive pay. For example, the disclosure of severance and change-in-control payout figures should be in a standardized tabular format and there should be disclosure of the aggregate value of in-the-money exercisable and unexercisable stock options.

For improving the CD&A, it’s suggested that companies should disclose performance metrics and their weightings, along with a narrative on the peer group used by the compensation committee for benchmarking purposes, and also including a narrative on CEO pay and performance.

Additional suggestions for improving the SCT include:

• Disclose all annual incentives in one bonus column, with footnotes differentiating formulaic, performance-based payouts from those that were discretionary or guaranteed;
• Include the full Statement 123(R) grant date fair values in the stock awards and options award columns, instead of the Statement 123(R) cost being expensed that year;
• Disclose all payouts from multiyear incentive plans in one column, regardless of whether the plan is cash- or equity-based; and
• Remove the annual change in defined benefit plan values and above market or preferential earnings on deferred compensation from the SCT.

With these improvements to the SEC’s disclosure rules, companies will be in a position to deliver greater transparency to the investor community.