SEC Re-Opens Comment Period for Pay vs. Performance Proposed Rules

Daniel Laddin is a founding partner and Louisa Heywood is an analyst at Compensation Advisory Partners. This post is based on their CAP memorandum. Related research from the Program on Corporate Governance includes the book Pay without Performance: The Unfulfilled Promise of Executive Compensation, by Lucian Bebchuk and Jesse Fried; and Executive Compensation as an Agency Problem by Lucian Bebchuk and Jesse Fried.

Five years after the initial rules proposal and comment period, the SEC has re-opened the comment period and proposed new requirements to enhance the pay versus performance disclosure. CAP submitted comments to the SEC on the 2015 Proposed Rules, and this statement can be found here.

Background

To address Section 953(a) of the 2010 Dodd-Frank Act, the Securities and Exchange Commission (SEC) published Proposed Rules in 2015 to address the Act’s stipulation that companies disclose information to show the relationship between actual compensation paid to executives and a company’s financial performance. Disclosure rules currently in place for the Compensation Discussion and Analysis section require companies to describe material information related to executive compensation programs and how pay is determined; however, this information is generally prospective. The proposed rules expand disclosure of how compensation actually paid to executives is determined.

Originally, the 2015 proposed rules to enhance pay versus performance disclosure recommended a supplemental table to show actual compensation paid to the principal executive officer (PEO), average actual compensation paid to the other named executive officers (NEOs) and total shareholder return over the five-year period for the company and its peer group (Exhibit 1). Actual compensation reported in the supplemental table would differ from the summary compensation table (SCT) reported value in that it would reflect the value of equity awards at vest rather than grant and exclude changes in actuarial present value of benefits under defined benefit and pension plans not attributable to the most recent year of service.

Since the rules were first proposed in 2015, performance-based long-term incentive plans have grown in prevalence relative to stock option incentives in the market. Financial performance metrics in performance-based long-term incentive plans are increasing in quantity and variety. The COVID-19 pandemic further impacted metrics used for determining company performance and executive pay. Total shareholder return (TSR) is now rarely the sole metric for evaluating company performance and it no longer captures the full picture of company financial performance. The updated rules published in January 2022 consider these changes in the executive compensation landscape.

Updated Proposed Rules under Section 953(a)

In its update published January 27, 2022, the SEC revised its 2015 proposal to request comment on (1) requiring disclosure of three new financial performance measures in addition to TSR in the supplemental table with clear description of the relationship between the measures and (2) requiring companies to provide a list of the five most important performance measures used to determine compensation actually paid to the executive, potentially in a tabular format (Exhibits 2a and 2b).

The new rules contemplate adding measures of pre-tax net income, net income and a third financial performance measure selected by the company to the table, to be shown in addition to TSR. In response to sentiment that TSR does not capture the full financial picture of a company, and the reality that other metrics are consistently used in long-term performance share programs, the SEC proposes pre-tax net income and net income because they are standard metrics of profitability, are familiar to investors and are GAAP metrics already calculated for prepared financial statements. The company-selected measure is intended to be a financial performance metric that the company finds represents the most important performance metric not already shown in the table for the evaluating the link between compensation actually paid and company performance over the period represented. To complement the data reported in the table, companies will have to substantiate the relationship between pay and performance through a clear description.

In addition to the new financial performance measures reported in the table, the 2022 updated rules propose requiring companies to separately disclose the five (at max) most important company performance metrics that inform actual compensation decisions during the period. The SEC hypothesizes that disclosure of these metrics would provide investors with visibility into which performance measures most strongly impact actual compensation paid and to assess whether compensation programs appropriately incent executives. This component also functions to reduce the risk of misrepresenting or providing an incomplete picture of pay versus performance alignment.

The SEC is soliciting comment on these revised recommendations, with particular focus on the additional financial performance metrics and the tabular disclosure of the five most important performance measures in determining actual compensation.

We support the objective of enhanced transparency and many companies have incorporated the principles in the SEC rules through the disclosure of “realizable/realized pay,” robust discussion of pay for performance philosophy and practices, and detailed disclosure of the rationale for compensation structures and decisions. While the use of GAAP metrics may drive some level of comparability, often companies deviate from GAAP definitions for incentives and the rationale for deviating will be even more critical if/when these rules go into effect.

Appendix

Exhibit 1: 2015 Proposed Rules

Exhibit 2a: 2015 Proposed Rules (2022 Update)

Exhibit 2b: 2015 Proposed Rules (2022 Update)

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