“Pay Versus Performance” Rule Increase Disclosure Obligations for Public Firms

Brandon Gantus, Lori Goodman, and Nicole Foster are partners at Freshfields Bruckhaus Deringer LLP. This post is based on their Freshfields memorandum. Related research from the Program on Corporate Governance includes Stealth Compensation Via Retirement Benefits and Paying for Long-Term Performance (discussed on the Forum here), both by Lucian Bebchuk and Jesse Fried.

On August 25, 2022, the U.S. Securities and Exchange Commission (the SEC) issued final rules on the “pay versus performance” disclosure. These rules, which were in process for over seven years, dramatically expand the information that public companies will be required to disclose regarding the relationship between their executive compensation and the company’s financial and stock price performance.

Under the final rules, most public companies are required to provide in their annual proxy statement or other information statement covering executive compensation:

  • a table featuring their executive compensation (both as reported in the summary compensation table (SCT) and adjusted to represent amounts actually paid), their net income, their total shareholder return (TSR), the TSR of their compensation peer group, and a financial performance measure chosen by the company (the Company-Selected Measure), generally over the last five most recently completed fiscal years;
  • a clear description of the relationship between the compensation actually paid to their executives and the financial metrics disclosed in the table as well as the relationship between the company’s TSR and the compensation peer group TSR; and
  • a table (the Tabular List) of the most important performance measures used by the company to link compensation actually paid to the executives to company performance.

These new disclosures must be included with proxy statements or other information statements that cover executive compensation for fiscal years ending on or after December 16, 2022. For most public companies, including calendar-year public companies whose fiscal year ends on December 31, this disclosure will be required beginning with their next annual proxy statement to be filed with the SEC in 2023.

Considering this short timeline and the significant obligations created by these new rules, companies are strongly encouraged to quickly familiarize themselves with these rules and begin working with their outside advisors to prepare for these burdensome disclosure requirements, including educating board members on the scope and potential impact of the final rules.

I. Background

Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 added Section 14(i) to the U.S. Securities and Exchange Act of 1934, as amended, which required public companies to disclose in their annual proxy statement information that shows the relationship between executive compensation actually paid and the financial performance of the company.

In 2015, the SEC published proposed rules on “pay versus performance” disclosure, but until recently, no further action was taken on this rule.

In January 2022, the SEC reopened the comment period to solicit additional information on the proposed rules in light of subsequent developments and intervening events. In its reopening release, the SEC asked several new questions signaling the possibility of significant enhancements to the rules that could increase the compliance burden for public companies.

On August 25, 2022, the SEC issued the final rules that create new Item 402(v) of Regulation S-K requiring the “pay versus performance” disclosures described below. The final rules largely incorporate (and, in some cases, expand upon) the proposed rules and themes raised in the SEC’s January 2022 reopening release.

II. Key Provisions of the Final SEC Rules on “Pay versus Performance” Disclosure

“Pay Versus Performance” Table

Under the final rules, public companies must include the following “pay versus performance” table in their proxy statement or information statement disclosing executive compensation. This table is intended to show the relationship between the compensation of the company’s Chief Executive Officer (CEO) and its other named executive officers (NEOs) and the financial performance and TSR indicated below for the company’s five most recently completed fiscal years.

As indicated in the table above, SRCs are subject to reduced disclosure obligations, including only needing to show the required information for the company’s three most recently completed fiscal years.

In addition, to ease the transition to these new requirements, the first year the company is required to provide this disclosure, the table only needs to cover three (or two, in the case of SRCs) fiscal years. Thereafter, the company is required to provide disclosure for an additional year in each of the two subsequent annual filings in which the disclosure is required. Companies are not required to disclose for any fiscal years in which they were not a reporting company under U.S. securities laws.

If more than one person serves as CEO in a given fiscal year, additional columns will need to be added to the table for each person serving as CEO for the fiscal years presented.

  • “Compensation Actually Paid” Determination

The “compensation actually paid” to the CEO and, on average, the other NEOs equals the amount in the total compensation column in the SCT, subject to the following adjustments:

  • a pension adjustment to include actuarial service cost instead of the change in pension value; and
  • an equity award adjustment to deduct the equity award values from the SCT for the most recently completed fiscal year and instead calculate equity award value for that year by applying the following principles:

In this context, fair value is calculated consistent with the fair value methodology used to account for share-based payments in the company’s financial statements under generally accepted accounting principles (GAAP). For performance-based equity awards, the change in fair value as of the end of the most recently completed fiscal year is based upon the probable outcome of such conditions as of the last day of that fiscal year.

The final rules on equity award adjustment for this calculation meaningfully deviate from the proposed rules (which required valuing equity awards based on fair value only on the vesting date). The final rules are expected to create significant burdens on the company to run these calculations.

  • “Company-Selected Measure” Definition

The “Company-Selected Measure” is determined by the company and should represent the most important financial performance measure (that is not otherwise required to be disclosed in the “pay versus performance” table) used by the company to link compensation actually paid to the NEO for the most recently completed fiscal year to company performance. This measure must be included in the Tabular List and quantified in the “pay versus performance” table. This measure can change from year-to-year. See “Tabular List” discussion below.

Explanatory Disclosure to “Pay versus Performance” Table

Public companies must also include additional disclosure to explain the data presented in the “pay versus performance” table and the relationship between:

  • The compensation actually paid to the CEO and, on average, its other NEOs and each of the company’s TSR, net income, and Company-Selected Measure for the fiscal years presented in the table; and
  • The company’s TSR and the peer group’s TSR for the fiscal years presented in the table.

This explanatory disclosure may be presented through graphs, narrative description, or a combination of the two. The company may group any of these explanatory disclosures as long as any combined description of the multiple relationships is clear.

Tabular List

Public companies also must provide a Tabular List in their proxy statement or information statement disclosing executive compensation. This list generally must include an unranked list of between three and seven performance measures that the company believes are the most important performance measures used by the company to link compensation actually paid to the executives to company performance during the company’s most recently completed fiscal year.

At least three of these performance measures must be financial performance measures.

However, if the company has fewer than three financial performance measures to link compensation actually paid to their executives for the most recently completed fiscal year to company performance, the Tabular List only needs to include the actual measures that were used, if any. This clarification is expected to provide helpful relief for many newly public companies, particularly those in the life sciences industry who generate minimal or no revenue, and whose business is primarily focused on drug-development and distribution and less on financial performance.

At the company’s discretion, the Tabular List may be one combined list, one list for the CEO and one list for all other NEOs, or a separate list for the CEO and each NEO. Companies may cross-reference other parts of the proxy (e.g., CD&A) where performance measures are otherwise described.

Covered Companies

These disclosure requirements apply to all U.S. listed public companies, except emerging growth companies, registered investment companies, and foreign private issuers. In addition, as noted above, SRCs are subject to reduced disclosure requirements under this rule.

Supplemental Disclosure Permitted

Companies generally may provide additional pay-versus-performance information beyond what is specifically required, so long as doing so would not be misleading and would not obscure the required information.

III. Key Takeaways and Action Items

Administratively Burdensome Obligations for Satisfying Disclosure Requirements

The computations required to complete the new “pay versus performance” table are likely to present meaningful challenges for most companies, including:

  • The equity award adjustment calculation that is required to determine the “compensation actually paid” to the CEO and other NEOs involves unorthodox calculations and comparisons that most companies historically have not performed. These calculations require producing and monitoring historical values for equity awards granted over several prior fiscal years that the company likely has not been tracking for its executives.
  • Many companies have not historically tracked their TSR or the TSR of their compensation peer group, and even if they have, they may not have performed the TSR calculations as the final rules prescribe. As a result, companies will need to perform these complex calculations for several prior fiscal years to satisfy their disclosure obligations.

Companies and their finance teams would be well-advised to begin collecting the necessary information for making these disclosures.

Potential Inconsistency Between Company Business Goals and Results of “Pay versus Performance”

The new “pay versus performance” disclosure emphasizes the company’s performance in net income and TSR (on an absolute and relative (as compared to its compensation peer group) basis)). For many public companies, these metrics historically have been de-emphasized in favor of other criteria designed to drive the growth in the business. For example, it is not uncommon for high-growth technology companies to weight “top-line” metrics (e.g., revenue or EBITDA) in their incentive compensation program in order to incentivize growth and expansion of the business. Similarly, early-stage life science companies are often focused on drug development and distribution. In each case, these companies may have little to no net income, but provide competitive executive compensation that rewards achievement of key business milestones.

The results of the “pay versus performance” disclosure for these and other public companies could lead to confusion among investors regarding the executive’s pay as compared to how the company performs against metrics that its board (and, in many cases, its investors) identify as important for the business.

The inclusion of a “Company-Selected Measure” in the “pay versus performance” table is expected to mitigate the effects of this issue. However, it remains to be seen how strongly investors will weigh the “Company Selected Measure” particularly since companies have the ability to change the measure from year to year.

Uncertain Impact on Executive Compensation Design and Objectives

The final rules require public companies to disclose items that, in many cases, they have not publicly disclosed, including:

  • The relationship of their executive compensation to net income and TSR; and
  • The identification of the most important performance measures used in setting compensation for the most recently completed fiscal year.

It remains to be seen whether these disclosures will change executive compensation design and the metrics that public companies use to incentivize and reward their executives.

  • Will public companies that have not historically used net income or TSR in their incentive compensation plans start incorporating one or more of these metrics to better align their executive compensation with achievements of these metrics?
  • Will companies identify environmental, social, and corporate governance (ESG) metrics in their Tabular List? While ESG initiatives have been a focus of institutional investors in recent years, many public companies, particularly technology companies, have been slower to incorporate ESG metrics into their incentive compensation plans given the challenges of identifying the appropriate ESG metrics and potential accounting ramifications. The Tabular List disclosure presents an opportunity for companies to highlight their ESG goals and achievements without using them as metrics in their incentive compensation plans.
  • Will investors react to these additional disclosures by providing more feedback to companies on their compensation programs and design that could further alter the process and structures of executive compensation?

Potential Institutional Investor Reaction

Many institutional investors and proxy advisory firms (e.g., ISS and Glass Lewis) are likely to favor the additional disclosure that these rules require because they provide more information to investors. It remains to be seen how these investors and advisory firms will react to companies’ “pay versus performance” disclosures.

  • How will the disclosures impact their votes and recommendations on proxy proposals on board members, “say on pay,” and other compensation-related proposals?
  • Will these investors and advisory firms designate preferred performance measures (financial and/or non-financial) that companies should use as being the “most important” for purpose of the Tabular List?
  • Will these investors and firms prescribe ranges of ratios between executive compensation and the performance disclosed in the “pay versus performance” table that they deem appropriate?

Additional Burdens on Compensation-Setting and Determinations Process for Board Members

The final rules also are expected to create additional burdens for boards of directors and compensation committees:

  • While the new rules do not require that the “pay versus performance” disclosure be included in the compensation discussion and analysis section of the proxy statement, the new disclosures will nonetheless require careful review and oversight by board members each year before they are included in the company’s proxy statement or other information statement.
  • As part of the new disclosures, the company is required to make subjective assessments of the “most important” performance measures to include in the Tabular List and, from this list, to identify the “Company-Selected Measure” to include in the “pay versus performance” table. For many boards and compensation committees, these will be new decisions, and will add another layer to an already-complex process of setting and determining executive compensation. Given that these determinations will be expected as soon as the next proxy statement, public companies are encouraged to begin speaking to their board and compensation committees, and their advisors, soon so that they can make these new decisions in a timely manner.
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