Perhaps pushed by the sense of urgency brought on by November’s mid-term elections, the Securities and Exchange Commission has been on a regulatory tear. The agency’s revitalized rulemaking has seen final decisions handed down on rules that were initially mandated more than ten years ago. In this piece, we discuss one of the SEC’s latest, and longest-gestating, directives: Section 14(i), focusing on new pay versus performance disclosure requirements, as required by the Dodd-Frank Act of 2010 and first proposed by the SEC in 2015.
Section 14(i): New Compensation Disclosures
On August 25, 2022, the SEC released its final rules implementing Section 14(i) of the Securities Exchange Act of 1934, which requires companies to provide a clear description of the relationship between executive compensation and company performance. The final rules are effective for any fiscal years ending on or after December 16, 2022 and require companies to include a table in their proxy statement that reports the company’s executive compensation and various measures of corporate performance for the five most recently completed fiscal years, or the three most recently completed fiscal years for smaller reporting companies. The rules are subject to a phasing-in period.
The new table is required to incorporate several specific calculations of executive compensation, including:
- The Summary Compensation Table (SCT) total for the principal executive officer (PEO; usually the chief executive officer),
- The compensation “actually paid” to the PEO,
- The average SCT total for the non-PEO NEOs, and
- The average compensation “actually paid” to the non-PEO NEOs.
Summary Total vs Actually Paid
Compensation “actually paid” includes certain considerations for changes in pension value, above-market or preferential earnings on non-qualified deferred compensation, and changes in the value of equity awards throughout the year. Unlike the equity value reported in the Summary Compensation Table, compensation actually paid accounts for:
- the year-end fair value of outstanding equity awards granted during the year,
- the year-over-year change in outstanding equity awards granted in previous years,
- the vesting date fair value of equity awards that were granted and vested during the year, and
- the change in value of previously granted awards that vested during the year.
Given the SEC’s guidelines on the calculation of compensation actually paid, the new data point is distinct from the SCT measure of total compensation, and it may provide additional insight into the realizable value of equity awarded to the NEOs.
Measuring the Performance Element
In addition to the columns for executive compensation outlined above, the new table will include the following metrics for company performance:
- The company’s total shareholder return (TSR),
- The TSR of the company’s self-selected peer group,
- The company’s net income, and
- A self-selected financial performance metric (other than TSR and net income).
Additionally, each company will be required to report an unranked list of three to seven of the most important metrics that it uses to link executive pay outcomes to company performance. Non-financial metrics may be included in this list, however at least three of the metrics must be financial. While it is yet to be seen, this list may provide investors with a greater understanding of each company’s determination process for executive payouts.
Finally, companies will be required to provide a clear description of the relationship between executive compensation actually paid and company performance (as measured by the metrics outlined above); as well as the relationship between the company’s TSR and the TSR of a self-selected peer group over the required reporting period. These relationships may be described in graphical form, narrative form, or a combination of both.
Glass Lewis Analysis: Preliminary Thoughts
The first examples of the new disclosure will not be available until public companies file proxy statements covering fiscal years ending on or after December 16th, 2022. Thus, the value of the new disclosure is yet to be firmly established.
Nonetheless, detractors are plenty. Some of the public companies we’ve spoken to as part of Glass Lewis’ engagement program contend that the rules are unnecessary. They argue that compensation disclosure has advanced considerably since the original 2015 requirements, and much of the information the new disclosure rules call for is already part of common practice in 2022.
From our perspective, while we recognize that the landscape has shifted since 2015, we believe that standardized reporting requirements may help investors in assessing executive compensation across their portfolio. Moreover, noting that advances in compensation disclosure have not applied and maintained evenly, we are hopeful that the amendments will materially improve the level of context available in evaluating executive pay at smaller reporting companies (SRCs).
Over the last few years, SRCs have been exempt from providing a comprehensive discussion of their compensation policies and practices. While some SRCs have met the needs of their shareholders by continuing to include a complete Compensation Discussion and Analysis section in their proxy statement, we generally find that most SRCs’ compensation disclosure under the current regime is poor and does not facilitate shareholders’ ability to vote on the Say on Pay proposal in a thoroughly informed manner. This is costly for investors who, lacking clear disclosure, must expend additional time and effort in order to fulfill their fiduciary responsibilities. The new disclosure rules stop far short of reinstating a Compensation Discussion and Analysis section requirement for smaller reporting companies, of course. Yet after years of bare bones disclosure, shareholders may get a fair degree of additional context around pay practices; for example, via discussion of key metrics in determining executive pay outcomes.
Comparing Pay-for-Performance Analyses
In adopting the final rules, the SEC stated that this new reporting mandate will make the types of pay versus performance analysis done by proxy advisors like Glass Lewis or compensation consultants equally accessible to all investors in a consistent manner. However, there are some important distinctions between the different analyses.
Measuring Compensation: Whereas Glass Lewis’ Pay-for-Performance Model analysis is a snapshot of long-term granted pay relative to peers, the new disclosure rules provide a review of how reported and “actually paid” executive pay evolved over time without consideration of the peer compensation data used by the company or its compensation consultant to set pay levels.
Measuring Performance: The SEC rule only considers TSR performance on a relative basis; peer data for other metrics is excluded. The Glass Lewis analysis, in contrast, provides a snapshot of relative performance for all metrics used in the analysis. Also, to promote comparability, the Glass Lewis Pay-for-Performance Model uses a standardized rubric to determine the applicable metrics from a list of four (in addition to TSR), rather than mirroring each company’s disclosed key metrics.
The SEC’s new rules may succeed in bringing this type of analysis to the broader population — but in a distinctly different manner compared to the Glass Lewis methodology. It may also provide additional quantitative considerations for Glass Lewis’ analysis. In the absence of actual disclosure, the specifics remain to be seen. What is clear, however, is the new rules will not change Glass Lewis’ Pay-for-Performance methodology for the 2023 proxy season.
Public Company Concerns: Aligning the Timeframe & Lack of Clarity
Perhaps not surprisingly, our conversations with public companies on the matter show a lack of enthusiasm for the new disclosure requirements. An S&P 500 company we met with is considering using an index for comparison instead of a self-selected group of peers, but said the rules weren’t clear on whether this would be acceptable.
Apart from confusion as they prepare for compliance, some of the public companies we’ve engaged with conveyed their belief that the new compensation disclosure requirements will be misleading. In particular, they questioned why the SEC rules require awards based on prior year performance, but granted in the current year, to be reported alongside current year performance. These companies believe that awards based on the performance of the prior year should be considered compensation related to the prior year only, regardless of when they are granted.
This is largely an issue of perception, as most companies review the prior year’s performance to determine grant levels for the current year and continue to view awards as compensation for the year in which they are granted. Regardless, as with other types of compensation information, viewing compensation over a longer period of time such as the five years required by the new rules may help to smooth out any perceived risk of disconnect.
Integrating the New Disclosures: Wait and See
In conversation with our institutional clients following the release of the rules, we heard that granted pay, as used in Glass Lewis’ Pay-for-Performance methodology, is generally considered to be the strongest indicator of the compensation committee’s intentions. When assessing intended compensation levels, change in value of outstanding awards over time and the ending value of realized pay are both subject to too many variables outside of a company’s control. As such, we do not expect the availability of data on compensation actually paid to immediately have a fundamental impact on how most investors assess Say on Pay votes. However, the institutional investor clients we spoke to remain open to integrating this data point into their analysis, so long as its utility is demonstrated to them.
As such, the SEC’s new disclosure rules may, in time, provide another useful quantitative perspective on executive pay in the U.S. market, complementing the Summary Compensation Table total figure, granted pay as calculated under the Glass Lewis methodology, and realized pay as calculated by our partners at Diligent.
