By Larry Portal and Sydney Hilzenrath

In response to growing concern from the investor community regarding executive compensation practices, the Securities and Exchange Commission (SEC) recently released details of its proposal to modify and expand the disclosure requirements for executive and director compensation and other corporate governance matters. These proposed regulations are intended to clarify disclosure requirements and make executive and board compensation arrangements more transparent to investors. They will also make requirements more comparable.

The proposal would affect all public companies, including REITs, and their investors. Investors would receive significant amounts of new material from the new proxy format and should be prepared for an information deluge. The SEC is broadening the disclosure requirements in an attempt to formalize the process in the same manner as other public filings and to give investors a clear sense of how executives are being compensated.

No specific date has been set for the new rules to go into effect; however, the new rules are expected to be in place before the end of 2006 and to affect the 2007 proxy filing season. The proposal has a 60-day comment period and will not become effective with respect to proxy statements until 90 days after the new requirements are ultimately adopted. New requirements would be phased in on a going-forward basis and would not require companies to restate disclosure relating to prior fiscal years.

Modifications to Executive Compensation Disclosure

Under the proposal, the current Compensation Committee Report and Performance Graph in the proxy statement would be replaced by a new section, the Compensation Discussion & Analysis (CD&A), which would be more detailed than its predecessor. The new disclosure would be a detailed summary of each element in a company's compensation program.

The CD&A is expected to cover specific items previously undisclosed, including the objectives of the company's compensation program, a description of each component of compensation, the rationale for that component, the methodology used to determine each component's amount (e.g., policies for allocation between long-term and current compensation) and finally, how each component fits into a company's overall compensation objectives.

More Reported Employees

The proposal would provide a significant change to the composition of the named executive officers (NEO) for whom compensation disclosure is required. This would provide investors a better understanding of how other executives working for REITs and other public companies are being compensated.

Currently, companies must provide such information for the chief executive officer and the next four top compensated executive officers. However, the proposal would cover any employee who served as principal executive officer or principal financial officer at any time during the fiscal year, plus the next three most highly compensated executive officers who were serving at the end of the fiscal year.

Narrative disclosure of total compensation would be required for up to three employees whose total compensation for the fiscal year was greater than that of any of the named executive officers. Also, disclosure would be required for up to two more individuals who would have been in the top three in terms of total compensation, but were no longer serving as executive officers at the end of the year. As a result, companies could be required to disclose the compensation arrangements for as many as ten officers.

Another significant change would be the methodology used to determine who qualifies as a NEO. NEO status would be based on total compensation for the prior year as opposed to the current practice of basing the determination on just salary and bonus.

Under the new rules, any deferred compensation or retirement benefits would impact executives' NEO status. Any non-recurring items (e.g., sign-on bonuses) could no longer be excluded from the total compensation amount. This means that companies would have to track each executive's pay carefully-including everything from perquisites to restricted stock grants-as an employee might move in or out of NEO status on an annual basis. Complying with these requirements would be additional work for companies, but investors and shareholders should benefit from understanding their executive compensation.

Revisions to the Summary Compensation Table (SCT)

The new SCT would have an immediate and significant impact on nearly all REITs whose executives hold large amounts of restricted stock and receive dividends on those shares of stock. Under the new guidelines, stock awards would include all grants of stock including performance-based shares, which are quite common in the REIT industry and which are not required to be disclosed in the table under the current rules.

The newly proposed compensation tables required to be disclosed in the proxy would be organized into three broad categories: compensation with respect to the last three fiscal years, holdings of equity-based interests that relate to current compensation or are potential sources of future compensation, and retirement and other post-employment compensation.

The SCT would disclose each component of compensation, including a new total compensation figure. Total compensation would aggregate all other disclosable compensation components.

The SCT would be supported by supplemental tables (Grants of Performance-Based Awards Table and Grants of All Other Equities Table) and a narrative that discusses material factors necessary to make the presentation clear and understandable.

Additionally, earnings on stock awards, such as dividends and dividend equivalents, would be included in a new stock awards column of the SCT. This modification could have a significant impact on the amount reported as total compensation for REIT executives, whose company shares are currently paying dividends in the 4 percent to 6 percent range.

Investors should exercise caution when comparing the SCT to the supplemental tables as there is the possibility for double-counting to occur.

Other SEC Revisions The SEC proposal also addresses other compensation, governance and disclosure matters including: Director Compensation. The proposal would revise discussion of director compensation by adding a new director compensation table. Among other items, the table would require disclosure of perquisites, the earnings on outstanding awards, consulting fees and awards under director legacy and similar charitable awards programs. Form 8-K Disclosure of Executive Compensation Arrangements. The current Form 8-K disclosure requirements of executive compensation arrangements would be significantly reduced. As revised, only material employment arrangements for NEOs and directors, as well as material amendments, would need to be disclosed on Form 8-K. Related-Party Transactions. The SEC would streamline the disclosure of related-party transactions, making the disclosure principles-based and increase the threshold for reporting such transactions to $120,000. Additional Disclosures. The proposal would consolidate and enhance corporate governance disclosure. In particular, the new statement would require a description of any transactions or relationships that were not required to be disclosed as related-party transactions but were considered by the board of directors in determining director independence. This would assure investors that there are no inherent conflicts of interest.

The Bottom Line

REITs should conduct a thorough review of current compensation policies and practices and evaluate them in light of the new disclosure proposals. For some REITs, a complete overhaul of the compensation program may be necessary. For others, the evaluation will force them to examine their compensation philosophy and develop a comprehensive explanation of how and in what form executives are compensated. However, the effort should be worthwhile because the new requirements would create one bottom line compensation number to more effectively compare compensation practices across different firms.

Compensation committees risk being criticized if they are unable to demonstrate strong pay-for-performance relationships and the proxy narrative must be compelling to satisfy shareholders and critics.

It's time to start planning for the 2007 proxy season. REITs should conduct a thorough review of current compensation policies and practices, evaluating them in light of the new disclosure proposals in order to keep up to date and stay ahead of changes.