Approved with 3-2 Vote

Commissioners Gallagher and Piwowar Dissent

On April 29, 2015, the SEC proposed its “Pay Versus Performance” disclosure rules as mandated by the Dodd- Frank Act. The proposed rules would amend Item 402 of Regulation S-K to implement Section 14(i) of the Securities Exchange Act of 1934 (the Exchange Act), which directs the SEC to adopt rules requiring issuers to disclose the relationship between executive compensation actually paid and the financial performance of the issuer. The disclosures would not apply to emerging growth companies or foreign private issuers. The proposed rules may be found here.

The SEC approved the proposal in a divided 3-2 vote, with Commissioners Gallagher and Piwowar issuing strong dissents. The comment period for the proposed rules will be 60 days after publication.

Summary of the Proposed Rules

The proposal adopts a prescriptive approach to the disclosure contemplated by the Dodd-Frank Act, which the Commission states is intended to provide comparability across issuers. The disclosure would be required in proxy or information statements in which Item 402 executive compensation disclosure is required. New Item 402(v) would require an issuer to provide, with respect to each of the last five years, a description of:

  1. the relationship between executive compensation actually paid to the issuer’s named executive officers and the cumulative total shareholder return (TSR) of the issuer, and
  2. the relationship between the issuer’s TSR and the TSR of a peer group chosen by the issuer.

Format of the Proposed Disclosure

Item 402(v) would require issuers to provide a table containing the values of the prescribed measures of executive compensation actually paid, TSR for the issuer and TSR for the selected peer group. (See table set out below.) Because the proposed rule is focused on compensation “actually paid” to the executives, the amount of total compensation paid to the executives from the summary compensation table must be adjusted for this purpose. Footnote disclosure is required to disclose the details of those adjustments for each amount disclosed as compensation actually paid in columns (c) and (e).

Click here to view table.

In what would be a first for proxy and information statement disclosures, the relationship disclosure would be required to be provided in interactive data format using eXtensible Business Reporting Language (XBRL). The SEC is seeking comment specifically on whether it should require the data to be tagged in XBRL format, another format, or at all.

In addition to the table and required footnotes, proposed Item 402(v) would require the issuer to describe:

  1. the relationship between the compensation actually paid and the issuer’s TSR, and
  2. the relationship between the issuer’s TSR and peer group TSR.

The proposing release states that this information may follow the table in graphs, narrative form, or a combination of the two.

Executives Covered

As proposed, the executives for whom the new disclosure would be required are the “named executive officers” (NEOs) covered by existing rules, with a separate disclosure for the principal executive officer and an average for the remaining NEOs identified in the summary compensation table.

Compensation “Actually Paid”

Although Section 14(i) does not define the phrase “executive compensation actually paid,” the proposal defines this as total compensation reported in the summary compensation table, adjusted for amounts included for pension benefits and equity awards.

In the area of pension benefits, the rule would require that the issuer deduct the aggregate change in the actuarial present value of the NEO’s accumulated benefits and then add the service cost related to the year.

As to equity awards, amounts reported in the summary compensation table for aggregate grant date value for options and stock awards would be subtracted. In place of that amount, issuers would be required to use the fair value on the vesting date of all equity grants (including options) for which vesting conditions were satisfied during the covered fiscal year. As proposed, equity awards would be considered actually paid on the date of vesting and valued at fair value on that date, regardless of whether the executive exercised rights to actually acquire the equity. The proposing release states the rationale for this position is that once an award is vested, the executive can control how and when the award is monetized which could influence pay-versus- performance disclosure by controlling the year in which the executive receives the compensation. The  release further states, “Changes in the fair value of the award after vesting generally reflect investment decisions made by the executive rather than compensation decisions made by the registrant.” (Page 38)

Measuring Issuer “Performance”

Section 14(i) does not define how an issuer’s financial performance is to be measured. The proposing release notes that the language in the statute requires performance to take into account any change in the value of the shares of stock and dividends of the registrant and any distributions of the registrant. The release states that the decision to use total shareholder return, a term defined in Item 201(e) of Regulation S-K, is consistent with this requirement. The assumption underlying this choice is that using a consistently calculated measure will increase the comparability of pay-versus-performance disclosure across all registrants.

Peer Group

For purposes of determining the TSR for the issuer’s peer group, the proposed rule provides that the issuer must use the same index or issuers used for purposes of the stock performance graph required by Item 201(e)(1)(ii) or, if applicable, the companies it uses as a peer group for purposes of the compensation disclosure and analysis called for by Item 402(b).

Smaller Reporting Companies

The proposal provides for scaled disclosure for the smaller reporting company. Differences from the requirements for other issuers are as follows:

  • Period of disclosures of three years, not five, and a transition period allowing only two years of disclosure in the first year;
  • No requirement for disclosure of amounts related to pensions;
  • No requirement to provide a peer group TSR; and
  • No requirement to tag disclosure in the table in XBRL format until the third year the issuer provides the required pay-versus-performance disclosure.

Transition Period

Companies would generally be required to provide the information for three years in the first proxy or information statement in which they provide the disclosure, adding another year of disclosure in each of the two subsequent annual proxy filings. Smaller reporting companies would initially provide the information for two years, adding an additional year in their subsequent annual proxy or information statement that requires this disclosure.

The Dissent at the Commission

In his remarks at the SEC’s meeting, Commissioner Gallagher expressed several objections to the proposal. Overall, he believed that the SEC should not be focused on this rule when other, more pressing, demands of the Dodd-Frank Act remain unresolved. With respect to the substance of the proposal, Commissioner Gallagher objected to the “prescriptive approach” taken by this proposal. He raised concerns about the definition of “compensation actually paid” as not necessarily the most meaningful definition for all issuers  and requiring in some cases substantial explanation of the numbers required in the table that may be misunderstood by retail investors. He objected to the inclusion of an average for the other named executive officers, arguing that only the CEO compensation should be the subject of this rule. He also objected to the use of TSR as a proxy for “performance” as not necessarily indicative of performance for every company. On balance, he stated his belief that the proposed rule “brings the wrong philosophy to bear.” He expressed doubt that the SEC should be trying to determine how to align executive pay with performance in the first place, and concluded that if required by the statute, the SEC should give issuers flexibility to determine how best to communicate their compensation story to investors, in line with the general principles set forth in the statute. Commissioner Piwowar expressed similar concerns and objections. He indicated that a prior version of the proposal had been a principles-based approach which he could have supported.