Regulators have required publicly traded companies to reveal the size and structure of their executive compensation plans since 1994. But the quality of that disclosure often has proved unsatisfactory. So, in an effort to correct that, companies are now facing the first major effort by regulators to enhance corporate candour about compensation.

Following a similar initiative from the U.S. Securities and Exchange Commission, in early 2007 the Canadian Securities Administrators proposed an overhaul of executive compensation reporting in Canada. After two comment periods, the CSA released the final version of the rule in mid-September. It is due to take effect at the end of this year, subject to ministerial approval in British Columbia and Ontario.

The CSA notes that since executive compensation disclosure requirements were first imposed in 1994, compensation practices have become increasingly complex, and the current disclosure format gives investors fragmented information, “which makes it difficult for inves-tors to assess the total compensation paid to executive officers.”

The new rule aims to improve compensation disclosure by expanding what’s required to be disclosed and attempting to make it more useful to investors by altering the format of that disclosure. Most important, it forces firms to put an “all in” number on the compensation for their executives once cash, stock-based pay and other perks and payments are included. The rule will also require that: all equities-based compensation be valued at cost; firms disclose more about executives’ retirement benefits and possible termination payments; firms include useful explanations of the rationale behind executive pay packages; and there is more complete disclosure of director compensation.

The new reporting format should improve transparency for investors, as the current disclosures aren’t just difficult to understand; in some cases, they are simply wrong. Investment Executive annually looks at the disclosure of companies in the financial services industry — firms that are presumably good with numbers. But even in this sector, it’s not uncommon to find disclosure that is incomplete, doesn’t make sense or is downright contradictory.

Indeed, the regulators, which review continuous disclosure filings from a variety of sectors, find these problems as well. The CSA’s latest report on its compensation disclosure review program, released in mid-August for the period ended March 31, involved 854 compensation disclosure reviews (442 full reviews and 412 reviews targeted at a specific issue). Among the common failings uncovered in the reviews were unsatisfactory executive compensation disclosure and deficiencies in the disclosure of stock-based compensation.

Hopefully, the new requirements will make companies more forthcoming. Now that companies are required to put a bottom-line number on total executive compensation, they will be forced to be more conscientious in their reporting. Firms that don’t bother to include required information in the existing format — leaving it up to shareholders to cobble it together from incomplete numbers — will have to come up with a total compensation figure. Moreover, increased regulatory attention in this area may push companies with poor disclosure into greater compliance.

Shareholders in large firms that have very complex compensation models should also benefit. Although most of these firms do a relatively good job of their disclosure, under the new format, shareholders will have an easier time getting a complete picture of the total cost of executive pay, as well as a better understanding of the rationale for those compensation packages.

In general, it appears that investors view the changes as an improvement that will give them greater insight into corporate performance and governance. “As you will surely hear from many buy-side participants,” says Victoria-based British Columbia Investment Management Corp. in its comment on the latest version of the rule, “we are generally very pleased with the 2008 proposal and we hope that the rules will make compensation decisions more understandable and transparent for investors.”

Not only will the new rules require more quantitative disclosure, they also impose added qualitative requirements. Indeed, one of the key failings with the existing compensation disclosures is a lack of genuine explanation of the reasoning behind them. Many firms resort to boilerplate language that suggests they pay for performance, with little explanation as to what constitutes performance, how that performance is measured and how that, in turn, is tied to executive pay. From the outside, it often appears that executive pay simply marches relentlessly higher, irrespective of corporate performance.

@page_break@The new rules demand that companies provide greater explanation and also require them to reveal the specific performance targets that are used to calculate executive pay. This is the provision in the new rule that has proved to be the most controversial, with firms complaining that under this measure, they will be required to give up too much useful information to their competition by revealing specific performance targets.

For instance, the Canadian Bankers Association had argued in its comment on the latest version of the rule that requiring disclosure of executive performance targets could mean that the head of a particular business unit would be forced to reveal the unit’s targets, which is information that would otherwise not be made public.

In the case of a large bank, for example, this rule could result in its investment dealer subsidiary disclosing information about its specific objectives rather than simply saying that the overall bank seeks to grow profits by 10%, without revealing the source of that expected growth. The critics say this could give unwanted insight to rival firms and possibly conflicting messages to analysts and investors.

Others worry that the disclosure of performance targets could alter pay practices by causing firms to abandon the business-specific targets they have used to drive corporate performance and shift them to more remote measures, such as overall earnings, in order to avoid revealing more closely held goals.

Moreover, the CBA comment letter warned, there aren’t precise formulas for deriving pay from performance. Executive pay relies on many subjective criteria and, it argues, it is “unworkable” to explain these sorts of decisions.

“We appreciate that a meaningful link between pay and performance is sought,” the CBA comment letter says. “However, in the context of these disclosures, it will prove both impractical and imprecise and will risk causing competitive harm.”

However, the CSA is sticking to its guns on this issue. In the final rule, it states that even though concerns about the inclusion of performance targets “may be justified in some cases, we do not believe that they support a general exclusion for the disclosure of forward-looking performance goals.”

Instead, the rule includes an exemption from disclosing these targets for firms that believe it would harm their business to do so. But firms that make that claim will then have to reveal the extent to which executive pay is derived from the undisclosed information and estimate how likely it is that the secret target will be achieved. The CSA says that it believes this exemption “strikes an appropriate balance between the interests of users in receiving this disclosure and the concerns of companies.”

Although public companies and their advocates have argued against the requirement to reveal specific performance targets, institutional investors are generally in favour of the move. In its comment, Toronto-based Canada Pension Plan Investment Board indicates that it is pleased with the performance target disclosure requirement and says that it would prefer that there be no exemption in the rule.

However, the CPPIB notes, the facts that the CSA plans to scrutinize the use of the exemption and that companies will be required to reveal how much of an executive’s pay is tied to any undisclosed targets “suggests that it will be difficult for issuers to abuse the exemption.”

Indeed, the CSA notes, regulators closely monitor new rules in the first year after they are implemented to ensure that they are working as intended, adding that the requirement to disclose performance targets and the use of the exemption from that requirement “will be a prominent part of this monitoring process.” If necessary, the CSA may issue a staff notice providing additional guidance in this area.

Although investors should be pleased that the CSA is holding its ground on performance targets, some of the other changes investors have advocated have not been adopted.

BCIMC called for, among other things, greater disclosure about the role of compensation consultants that issuers use to set executive pay; disclosure of the company’s policy for clawing back executive pay in the event of a future financial restatement; and certification by the members of the compensation committee of the compensation disclosure — much in the same way that CEOs and chief financial officers must certify their financials.

The Canadian Coalition for Good Governance, a Toronto-based group primarily comprising large institutional investors, echoed BCIMC’s call for greater insight into the role of compensation consultants. It also sought disclosure of minimum shareholding levels for executives and directors, and the attainment of those levels; information on the funding status of supplementary employee retirement plans; and that regulators require firms to make these disclosures interactive by adopting extensible business reporting language (known as XBRL) tags.

For the most part, the CSA is not adopting such suggestions — in some cases simply rejecting them; in others, noting that they go beyond the scope of the rule or may be covered by other rules.

Although investors appear to be quite happy with what the regulators have done to improve transparency, the downside to this greater insight into executive pay practices will be even longer proxy circular documents, which are more expensive for companies to produce and more unwieldy for shareholders to wade through.

Calgary-based energy firm Nexen Inc., in its comment on the CSA rule, estimates that compliance with the new rules will add about 1,200 to 1,800 hours of work among its legal, governance, human resources and accounting departments, along with senior management. “We encourage greater attention to the balance between the value of specific disclosures,” the Nexen comment says, “and the associated costs to reporting issuers and shareholders.”

The CSA maintains that the benefits of the new regime outweigh the costs. And investors may not have a great deal of sympathy with the plight of overworked managers. After all, that’s why they get paid the big bucks. IE