What to Consider When Strategically Implementing the SEC’s New Pay for Performance Rule
September 19, 2022 | Pillsbury Winthrop Shaw Pittman LLP
Thanks to Jonathan M. Ocker and Benjamin T. Gibbs
- Due to its reliance on accounting values and emphasis on unvested equity, we expect the new disclosure to become a “check-the-box” exercise appearing as a self-contained section after the last compensation table alongside the CEO pay ratio.
- Calendar year issuers should immediately begin pulling together the data for inclusion in their spring 2023 proxy.
- Issuers can offset the shortcomings of the new required disclosure by reinforcing their pay v. performance story with additional graphical and tabular disclosure of pay delivered in the Compensation Discussion & Analysis (CD&A) section of the proxy statement.
Major Rule Changes
The specifics of the SEC’s new rule have been widely reported, but at a high level the SEC’s new pay versus performance rule, adopted August 25, 2022, requires a new table and narrative/graphical disclosure comparing “actually paid” compensation against company performance.
To make this comparison, companies must disclose or include in their disclosure:
- “Compensation actually paid,” which, among other items, is a version of the summary compensation table totals adjusted to reflect the change in value of unvested equity awards over the course of a year and the actuarial value of any benefits accrued under any pension plans that year (including amendments).
- Company and peer group one-to-five-year cumulative total shareholder return (TSR), subject to the below transition rule.
- Net income over each of the past five years (peer group not required), subject to the below transition rule.
- The company’s most important financial metrics (other than TSR or net income) with no peer group comparison.
- Narratives explaining the relationship between pay and performance for the above metrics.
- Narratives explaining the top three-to-seven performance metrics impacting compensation, including: (i) the company’s most important financial metric disclosed in the new table and (ii) two other financial metrics (if used). The other metrics, up to a total of seven, may be non-financial metrics.
- Non-required tabular disclosure on pay versus performance may be included going forward, provided it is “clearly identified as supplemental” and may not be “presented with greater prominence than the required disclosure.”
- The data must be tagged for eXtensible Business Reporting Language (XBRL).
Transition Period and Rules for Smaller Reporting and Emerging Growth Companies: The SEC also adopted a “ramp up” transition period which allows issuers to limit the disclosure in next year’s proxy to the past three completed fiscal years (the past two years for smaller reporting companies). After that, the number of years reported will increase by one in each subsequent annual proxy.
Smaller reporting companies are subject to an abbreviated version of the above rules as well (e.g., reporting only the past three fiscal years; no reporting of the company’s peer group TSR, most important financial metrics or pension values; no XBRL tagging).
Emerging growth companies are not subject to the new rule.
A hypothetical table (ignoring the transition rule and focusing only on CEO compensation) shows the disconnect between the summary compensation table and the new disclosure.
Just as some companies add disclosures/graphics in the compensation discussion and analysis (CD&A) to reflect the compensation committee’s thinking on grant values that are different from the accounting grant values presented in the summary compensation table, we expect an expansion of “realized/realizable” pay disclosures to put in context the required new disclosure of the accounting-based “compensation actually paid.”
Of note in the above example, while the change in summary compensation table values each year tends to highlight the increase in grant size, the “actually paid” column is disproportionately impacted by unvested equity, inflating the reportable “actually paid” figure in growth years.
The above example also illustrates the impact of negative stock growth on reported compensation. As seen in the 2022 and 2018 figures above, when unvested equity loses value (or is forfeited) the reported amount of “actually paid” compensation is correspondingly reduced.
Impact and Implementation
The new disclosure shortcomings make the disclosure unhelpful to investors and compensation committees. It is of limited utility because it compares annually fixed compensation outcomes to annually adjusted cumulative TSR, does not accurately reflect the way compensation committees assess, measure and grant pay (or the way executives value their pay), and does not tie company performance to the correct compensation performance periods.
Compensation Assessments: The SEC’s formula for “compensation actually paid” values equity using risk-adjusted accounting models and assumptions regarding performance (rather than actual performance), not real pay delivered (i.e., the amount of value an executive can realize upon the exercise of an option or sale of a vested-equity position). Real pay delivered is the focus of executives and compensation committees, and a better indicator of executive compensation outcomes generally and pay versus performance alignment specifically.
Of note in the above example, the reportable value of an option granted an exercise price equal to grant date fair market value will: (i) often be a not insignificant percentage of the option’s exercise price at grant, (ii) significantly outweigh the option’s intrinsic value (i.e., the difference between the option’s exercise price and the stock’s value) for most of the option’s term and (iii) may swing more wildly than the stock price in a given year.
Performance Period Mismatch: There are two ways in which the table fails to accurately align the disclosed compensation and the relevant performance periods:
- First, it is typical for a company to vest performance equity in the year after the end of the performance period. However, unvested equity continues to impact the amount of “compensation actually paid” until it vests. This means that performance awards will continue to impact disclosed compensation outcomes even after the end of their given performance period.
- Second, the required performance metrics measure performance over arbitrary periods of time (up to five-year cumulative TSR and annual net income). These arbitrary periods will likely never align with the company’s compensation performance period and, in so far as the TSR calculation changes each year as described below, any marginal alignment with the company’s preferred performance period will be fleeting.
Fixed Compensation Outcomes versus Yearly Adjusted Cumulative TSR: The TSR measurement periods are tied to the first year reported in the proxy and, therefore, changes in each year’s proxy. However, the reported compensation for each year is static between proxies. This means that the link between a given year’s pay and performance will fluctuate between proxies.
As a result of the above shortcomings, we expect the new table to become a “check-the-box” exercise, similar to the CEO pay ratio, and recommend inserting that disclosure in a box with the compensation tables toward the back of the proxy statement.
Companies should consider mitigating the new table’s shortcomings by adding a “real pay delivered” or “earned pay” column which more accurately demonstrates compensation outcomes. This voluntary disclosure more closely mirrors how compensation committees and executives assess pay and would mirror the “compensation actually paid” column, but it would be visually marked as supplementary and adjusted to reflect the compensation committee’s approach to determining pay based on realizable and realized pay over a specified timeframe. For this purpose:
- Performance equity is valued by multiplying the share price on vesting or year-end by either the number of earned shares (if after the performance period ends) or the number of shares if earned at target (if during the performance period); and
- Options are valued based on their intrinsic value or exercise value at year-end.
Whether or not a new column is added, companyies should continue to highlight their compensation story in the CD&A, demonstrating strong pay versus performance alignment using graphics and meaningful compensation figures. The new rule complicates and heightens the need to craft a clear and compelling story in the CD&A of how executive pay is tied to and drives positive company performance, not only to overcome interpretive challenges created by the new table but also to stand out in an environment where private and public actors are increasingly focused on pay versus performance.
To be prepared for the inevitable proxy trolls who may scour the new table, consultants, who do not do so already, may begin to provide the compensation committee with running tallies of accumulated gains. The compensation committee should review a draft of the disclosure in advance of proxy season and as part of their strategic review of the entire CD&A and year-end CEO pay.
If a company has not adopted best practice graphics or reviewed its peer group’s approach to compensation disclosure, this next proxy season presents an opportunity to hit the ground running.
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