The SEC Proposes Pay Versus Performance Disclosure Rules
Five years after receiving its Congressional mandate in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), the SEC has proposed rules that require public companies, other than emerging growth companies and foreign private issuers, to disclose in the annual meeting proxy statement the relationship between executive compensation actually paid and the company’s financial performance. The purpose of the rule, according to the SEC, is to elicit additional disclosure that provides greater transparency and allows shareholders to be better informed when they vote to elect directors and in connection with their advisory votes on executive compensation.
This proposal is separate from the pay ratio disclosure rule proposed by the SEC in September 2013 and not yet adopted, which would require companies to disclose the pay disparity in the form of a ratio between a company’s CEO pay and that of its median employee. See our previous Public Company Alert in this regard here. Unless the SEC moves at an unusually rapid pace, however, it seems unlikely that either the pay for performance or pay ratio proposal will be in play for the 2016 proxy season.
Proposed Item 402(v) of Regulation S-K
Proposed Item 402(v) of Regulation S-K would require a company to provide a clear description of (1) the relationship between executive compensation actually paid to the company’s named executive officers (NEOs) and the cumulative total shareholder return (TSR) of the company, and (2) the relationship between the company’s TSR and the TSR of a peer group. Specifically, the proposed amendments would require that:
- The total compensation disclosed in the Summary Compensation Table be used in calculating the executive compensation actually paid, modified to exclude changes in actuarial present value of benefits under defined benefit and actuarial pension plans, and include the value of equity awards at vesting rather than when granted;
- Companies provide the executive compensation actually paid, total compensation as disclosed in the Summary Compensation Table, TSR, and peer group TSR in a prescribed table for each of the last five fiscal years;
- The executive compensation disclosure be presented separately for the principal executive officer and as an average for the remaining NEOs identified in the Summary Compensation Table;
- For smaller reporting companies, the disclosure of the relationship between executive compensation actually paid and TSR cover the company’s three most recent fiscal years, without requiring any disclosure of peer group TSR; and
- The disclosure be provided in “tagged” data format using eXtensible Business Reporting Language (XBRL).
The SEC proposed that the new Item 402(v) disclosure would only be required in a company’s proxy or information statement, which is consistent with Congress’s mandate that such pay for performance disclosure be provided in solicitation material for an annual meeting of the shareholders. Consequently, this disclosure would not be required to be included in, or deemed incorporated by reference into, a company’s annual report on Form 10-K or in registration statements that otherwise require Item 402 compensation information.
The pay versus performance table below requires disclosure of the relationship between executive compensation paid to its NEOs, its TSR and the TSR of a peer group. The peer group must be either the peer group used in its stock performance graph or the peer group discussed in the company’s Compensation Discussion and Analysis (CD&A).
Click here to view table.
A clear description of the relationship between pay and performance must accompany the table in narrative or graphic form, or both. Companies also would be permitted to provide supplemental measures of financial performance, so long as any additional disclosure is clearly identified, not misleading and not presented with greater prominence than the required disclosure. The SEC believes that the disclosure of the relationship between pay versus performance would supplement a company’s CD&A, but the proposed rule does not require that it be included in any particular section of the proxy statement.
The values in the Pay Versus Performance Table would have to be tagged in eXtensible Business Reporting Language (XBRL), and any related footnotes would have to be block text tagged. In a move that may signal a coming trend, this would be the first time the SEC’s interactive financial data requirements would be applied to proxy statements. Proponents argued that providing the information in XBRL format will unlock far greater value from the information and allow for information to be easily compared across companies. Smaller reporting companies, however, will not have to comply with the XBRL requirement until their third annual filing.
Companies would initially be required to provide pay versus performance disclosure only for the three most recently completed fiscal years. In each of the two subsequent years, an additional year of disclosure would be added so that companies would provide pay versus performance disclosure for the full five-year period in their third proxy statement requiring the disclosure. New registrants would not need to provide pay versus performance disclosure for any years in which it was not a reporting issuer under the Exchange Act, similar to the phase in of summary compensation table disclosures.
Smaller reporting companies would need to provide information for two years initially, adding the additional year in their next annual proxy or information statement that requires executive compensation disclosure. Finally, smaller reporting companies would be required to present their TSR, but not a peer group TSR.
These new pay versus performance disclosures will likely add to the cost and time of preparing a company’s executive compensation disclosures. For those companies that have historically used TSR as a compensation metric for performance, however, this additional disclosure will likely not be unduly onerous. Conversely, companies that do not utilize TSR as a performance metric will want to consider the potential effect such disclosures will generate. Companies should also consider whether they may want to provide supplemental measures of performance and explanatory disclosure when, for example, TSR is not the optimal measure of performance. Moreover, companies will want to consider their peer group compositions and whether their group will create disclosure issues if the proposed rule is adopted in substantially its current form.
It may also be useful for a company to prepare a draft Pay Versus Performance Table based on the proposed rules so that adequate disclosure controls and procedures can begin to be developed with respect to the additional information needed. For example, companies will need to start tracking vesting date valuations for equity awards for the table.
Of course, if adopted, the proposed rules would make it easier for investors to determine whether NEO compensation is in lock-step with a company’s stock performance, if not its financial performance. On the other hand, imposing a “one-size-fits-all” standard for calculating a company’s performance may not fairly present the link between performance and compensation for all companies, particularly those whose good financial results have not been recognized by the market or whose stock performance have been negatively affected by external market forces outside the company’s control. Establishing pay-for-performance metrics could impose additional pressure on companies who lag behind their peers in this area to change their practices.
As the pay versus performance disclosure does not need to be incorporated into the Form 10-K, companies will want to modify the disclosure in Part III of their Form 10-K to avoid unintentionally incorporating those disclosures by reference if the proposed rule is adopted in its current form. Also, the interactive financial data requirement means that the XBRL exhibit would need to be filed with the proxy statement and posted on the company’s website, requiring a few additional steps for those involved in the proxy preparation process and perhaps necessitating the involvement in the proxy preparation process of accounting staff who are familiar with XBRL.