The Securities and Exchange Commission (SEC) recently proposed adding new Item402(v) to Regulation S-K (Item 402(v)) to implement the pay versus performance disclosure requirements of Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Section 953(a)).1
Item 402(v) as proposed by the SEC (Proposed Rule) would require a public company subject to the Proposed Rule (issuer) to disclose in tabular form for each of its last five completed fiscal years:
- two different measures of compensation for its named executive officers (NEOs)—total compensation as disclosed in the issuer’s summary compensation table and compensation “actually paid” (calculated as provided in the Proposed Rule); and
- the cumulative total shareholder return, calculated in accordance with Item201(e) of Regulation S-K (Cumulative TSR),2 of the issuer and a peer group of companies chosen by the issuer from several peer groups specified by the Proposed Rule (Peer Group).
An issuer would also be required to describe clearly for each fiscal year covered by the table (1) the relationship between the compensation “actually paid” to its NEOs and the issuer’s Cumulative TSR and (2) a comparison of the issuer’s Cumulative TSR and that of its Peer Group.
Comments on the Proposed Rule are due by July 6, 2015. Although the SEC may adopt the final version of Item 402(v) in time to make it effective for the 2016 proxy season, the effectiveness of what may prove to be a very controversial rule could be delayed beyond the 2016 proxy season if the SEC receives a large number of negative comments regarding the Proposed Rule. Moreover, if such comments materialize, the final version of Item 402(v) may well look somewhat different from the Proposed Rule. In view of the Proposed Rule’s implications for issuers, issuers should review the Proposed Rule carefully, analyze how their particular disclosures under the Proposed Rule would be perceived by the investment community and consider commenting on the Proposed Rule.
Covered SEC documents and issuers. The Proposed Rule would require the Item402(v) disclosure to appear only in proxy statements or information statements in which executive compensation disclosure is required under Item 402 of Regulation S-K (Item 402).3 Emerging growth companies, registered investment companies and foreign private issuers would not be subject to the Proposed Rule’s requirements.
As the Proposed Rule would require Item 402(v) disclosure only in proxy or information statements in which Item 402 executive compensation disclosure is required, master limited partnerships (MLPs) would generally not be required to provide the Item 402(v) disclosure. An MLP would, however, be required to provide Item 402(v) disclosure in any proxy or information statement in which the MLP must provide Item 402 disclosure (for example, in a proxy statement relating to a unitholder meeting at which unitholders will vote on electing directors or approving an executive or director compensation plan).
Required disclosure. As proposed, Item 402(v) would require subject issuers to include in their proxy and information statements in which Item 402 disclosure is required to appear the following additional disclosures:
- a table (Table) that would include for each of the issuer’s last five completed fiscal years (last three completed fiscal years for smaller reporting companies):
- the total compensation of the issuer’s principal executive officer (CEO) as reported in the “total” column of the issuer’s summary compensation table (SCT Compensation);
- the compensation “actually paid” to the CEO, which compensation would be calculated as described below (Actual Compensation);4
- the average of the SCT Compensation of each of the issuer’s NEOs other than the CEO (Other NEOs);
- the average of the Actual Compensation of the Other NEOs;
- the issuer’s Cumulative TSR; and
- the Cumulative TSR of the issuer’s Peer Group, which Peer Group would be either (1) the companies in the index or in the peer group used in the issuer’s Performance Graph or (2) a peer group of companies discussed in the issuer’s compensation discussion and analysis (CD&A);5
- footnotes to the columns in the Table that set forth the Actual Compensation of the CEO and the average Actual Compensation of the Other NEOs disclosing (1) the amounts deducted and added to the SCT Compensation to calculate the Actual Compensation amounts shown and (2) any assumption made in the valuation of equity awards included in such Actual Compensation amounts that differ materially from the assumptions disclosed in the footnotes regarding the valuation of equity awards included in the issuer’s appropriate summary compensation tables.6
- a “clear” description of (1) the relationship between (a) the Actual Compensation of the CEO and average Actual Compensation of the Other NEOs for each of the fiscal years covered by the Table and (b) the issuer’s Cumulative TSR and (2) a comparison of the issuer’s Cumulative TSR and the Peer Group’s Cumulative TSR for each of the fiscal years covered by the Table. Smaller reporting companies would not need to describe the comparison of their Cumulative TSR to their Peer Groups’ Cumulative TSR.
Calculating Actual Compensation. Actual Compensation for each of the CEO and Other NEOs for a fiscal year would be calculated as such NEO’s SCT Compensation for that fiscal year adjusted by:
- deducting the aggregate change in the actuarial present value of the NEO’s accumulated benefit under all defined benefit and actuarial pension plans reported for that fiscal year in column (h) of the summary compensation table;
- adding the service cost attributable to the NEO under all defined benefit and actuarial pension plans reported for that fiscal year in column (h) of the summary compensation table, which service cost would be calculated as the actuarial present value of the NEO’s benefit under all such plans attributable to services rendered during that fiscal year consistent with “service cost” as defined in the Financial Accounting Standard Board’s Accounting Standards Codification (ASC) Topic 715;7 and
- deducting the amounts reported in columns (e) and (f) for that fiscal year in the summary compensation table as stock award and option award compensation and then adding the fair value on the vesting date of all stock awards and option awards, with or without tandem stock appreciation rights (SARs) (including awards subsequently transferred), for which all vesting conditions were satisfied during that fiscal year, which fair value would be calculated in a manner consistent with the fair value measurement guidance in ASC Topic 718.8
Calculating Cumulative TSR. Cumulative TSR for each year in the Table would be calculated in the manner specified by Item 201(e) of Regulation S-K for calculation of the cumulative shareholder returns to be shown in the Performance Graph. As a result, the Cumulative TSR of the issuer shown for each fiscal year in the Table should be the same as the issuer’s cumulative shareholder return disclosed for that fiscal year in the issuer’s Performance Graph covering the five-year period ending with the most recently completed fiscal year covered by the Table.
Transitional disclosure relief. The Table appearing in the first proxy or information statement filed by the issuer after Item 402(v)’s effectiveness would be required to include information for the issuer’s three most recently completed fiscal years only. The issuer’s “annual filing” for each of the next two fiscal years would add disclosure to the Table for the issuer’s fourth and fifth most recently completed fiscal years, respectively. As the Proposed Rule’s provision relating to the transition period is currently written, this transition provision does not appear to afford issuers the benefit of the phase-in for proxy statements relating to special meetings in which disclosure under Item 402 would be required.
Smaller reporting companies required to include Item 402(v) disclosure in a proxy or information statement would be allowed to include disclosure for only the two most recently completed fiscal years in their first proxy or information statement filed after Item 402(v)’s effectiveness.
New issuer relief. Information for fiscal years prior to an issuer’s last completed fiscal year would not be required if the issuer was not required to report pursuant to Section 13(a) or 15(d) of the Exchange Act at any time during that fiscal year (for example, newly public issuers).
No deemed incorporation by reference. The Item 402(v) disclosures would not be deemed incorporated by reference into any filing under the Securities Act of 1933, as amended (Securities Act), or the Exchange Act, unless an issuer specifically incorporates that information by reference into the filing. An issuer that incorporates by reference information from its future proxy statement into its Annual Report on Form 10-K by referring in Part III of Form 10-K to the whole proxy statement rather than to specific sections of the proxy statement should draft the incorporating language to exclude expressly the Item 402(v) disclosure unless the issuer intends for that disclosure to be incorporated by reference in its Form 10-K and any Securities Act registration statements that incorporate its Form 10-K by reference.
Subject to say-on-pay vote. Say-on-pay advisory votes under Exchange Act Rule 14a-21(a) are made with respect to an issuer’s executive compensation as disclosed pursuant to Item 402. As a result, if a proxy or information statement that relates to an annual or other shareholders’ meeting at which a say-on-pay vote will occur contains Item 402(v) disclosure, the say-on-pay advisory vote would relate to all of the Item 402(v) disclosure and the usual Item 402 executive compensation disclosures.
XBRL disclosure. The Item 402(v) disclosure included in a proxy or information statement would have to be formatted under the XBRL interactive data standard and this interactive data would have to be provided as an exhibit to definitive Schedule 14As or Schedule14Cs containing Item 402(v) disclosure.9 Smaller reporting companies would not have to comply with the Proposed Rule’s XBRL requirements until their third proxy or information statement that contains the Item 402(v) disclosure.
Potential Issuer Concerns with the Proposed Rule
The Proposed Rule raises numerous concerns for subject issuers, including the following.
Actual Compensation may not reflect the CEO’s or an Other NEO’s actual compensation for a fiscal year. Actual Compensation as calculated pursuant to the provisions of the Proposed Rule may or may not reflect the compensation paid to an NEO for the NEO’s service to the issuer in a particular fiscal year. For example, to calculate the CEO’s Actual Compensation for a particular fiscal year, the amounts of grant date fair value for stock awards included in the CEO’s SCT Compensation for such fiscal year would be deducted from such SCT Compensation and the fair value of all of the CEO’s stock awards that vest during that fiscal year would be added into such adjusted SCT Compensation. The CEO’s Actual Compensation for that fiscal year could include the fair value of shares vesting in that fiscal year that are linked to and were awarded to compensate the CEO for the issuer’s performance in another fiscal year, which fiscal year is not part of the measurement period of the issuer’s Cumulative TSR shown in the Table for the fiscal year in which vesting of those stock awards occurs. The Proposed Rule’s assignment of the value for stock awards or option awards to the wrong fiscal year would cause the Table and other disclosure required by the Proposed Rule to reflect improperly the linkage between the CEO’s Actual Compensation and the issuer’s financial performance. This concern may be heightened when a CEO or Other NEO has time-vested retention awards of stock or options.
Say-on-pay votes may involve additional uncertainties. The disclosure of executive compensation information under the Proposed Rule that is the subject of say-on-pay advisory votes may create uncertainties in addition to those already inherent in any say-on-pay advisory vote. Instead of voting on executive compensation as disclosed in accordance with Item 402 (without Item 402(v) disclosure) and any measures of “real compensation,” “realized compensation” or “realizable compensation” the issuer chooses to disclose in a proxy or information statement, shareholders may well take the Actual Compensation of the issuer’s NEOs into account when deciding how to vote on a say-on-pay proposal. Moreover, when the Actual Compensation appears in a proxy or information statement, some retail shareholders may be uncertain (or more uncertain) about what they are being asked to vote on and how to assess the compensation of the issuer’s NEOs in light of at least two different measures of executive compensation being disclosed in the proxy or information statement.
Where there is a significant “against” vote on a say-on-pay proposal, compensation committees of boards of directors (Compensation Committees), their compensation consultants and managements may be more uncertain about the meaning of such votes than they may have been in the past as shareholders would be assessing executive compensation by reviewing at least two different measures of compensation when deciding how to vote on say-on-pay proposals. Even if the final rule adopted by the SEC excluded Item 402(v) disclosure from consideration in any say-on-pay vote, some shareholders would still be likely to consider the Item 402(v) disclosure when deciding how to vote on say-on-pay proposals. As a result, issuers’ engagement with shareholders on executive compensation matters may become even more important than it has been in the past.
Cumulative TSR may prove to be an inaccurate indicator of financial performance. The Proposed Rule is based on the unreasonable assumption that the stock prices used to calculate the Cumulative TSRs of the issuer and the members of its Peer Group accurately reflect the issuer’s and the Peer Group members’ financial performance for some period and that no extraneous factors affected those stock prices (for example, general market psychology, investor animus toward the issuer or dispositions of large blocks of stock for reasons unrelated to financial performance, such as tax reasons of the investor). Nevertheless, the Proposed Rule does not permit Cumulative TSR to be adjusted to take in account the effects of such events on the issuer’s (or a Peer Group member’s) stock price. In addition, the Cumulative TSRs would not be adjusted for matters such as the influence of share repurchase programs or proposed or pending acquisitions on the Cumulative TSRs of issuers and their Peer Groups.
Moreover, the comparison of an issuer’s Cumulative TSR and its Peer Group’s Cumulative TSR could suffer unfairly if one or more members of the Peer Group were for some reason, such as the occurrence of a cybersecurity event, to have low stock prices at the beginning of the calculation period for the Cumulative TSRs of the Peer Group’s members and then such stock prices, starting from those low levels, were to increase much more significantly than did the issuer’s stock price over that calculation period. Finally, as pointed up by SEC Commissioner Daniel M. Gallagher in a statement regarding his dissent to the SEC’s proposal of Item 402(v), total shareholder return “may be gamed by any of the usual corporate strategies for boosting stock prices in the short term … .”10 As a result, Item 402(v) disclosure could create an inaccurate and unfair reflection of the relationship between the CEO’s and Other NEOs’ Actual Compensation and the issuer’s financial performance or result in an inaccurate and unfair comparison of the issuer’s Cumulative TSR and the Peer Group’s Cumulative TSR, in either instance, potentially misleading shareholders and other investors regarding the true relationship of the issuer’s executive compensation and the issuer’s financial performance and how the issuer’s financial performance for a period compares to the financial performance of the members of the Peer Group for that period.
Cumulative TSR may be an inappropriate measure of an issuer’s financial performance or by which to demonstrate the effective linkage of executive compensation to the issuer’s financial performance. Many issuers with performance-based cash and equity compensation elements in their executive officer compensation packages use performance measures other than the issuer’s Cumulative TSR or the Cumulative TSR relative to the Peer Group’s median or mean Cumulative TSR to determine whether their executive officers would receive performance-based pay at all and, if so, how much performance-based pay they would receive pursuant to particular cash-incentive or equity-incentive awards. Most Compensation Committees carefully choose the performance measures and performance targets for such awards, and choose performance measures and targets that the Compensation Committees conclude reflect those metrics of the issuer’s financial performance that properly reflect how the issuer’s executive officers’ performance affects long-term shareholder value. However, no matter how well the Compensation Committee chooses such performance measures or how well an issuer performs against those performance measures, the issuer’s performance may not be appropriately reflected in one or both of the issuer’s stock prices used to calculate the Cumulative TSR to be shown in the Table for a fiscal year.
Unfortunately, the Proposed Rule is not a principles-based rule that gives an issuer the ability to pick a proper measure to demonstrate the true linkage of the issuer’s financial performance and the issuer’s executive compensation in the required disclosures. The SEC notes in the Release that issuers would not be precluded from including supplemental measures of financial performance or compensation in the disclosures under the Proposed Rule if such supplemental disclosure is not misleading and not presented more prominently than the required disclosure.11 As a result, if the final rule is not radically different from the Proposed Rule, disclosure in issuers’ CD&As or disclosures in proxy statements using such supplemental indicators of financial performance and measures of compensation may be necessary to provide an accurate depiction of the relationship between the issuer’s executive compensation and the issuer’s financial performance and to reflect a proper comparison of the financial performance of the issuer and its Peer Group. Unfortunately, issuers may also find themselves having to decide whether to explain in their proxy statements why the performance measures they use in the performance-based compensation for their executive officers more appropriately reflect the issuer’s financial performance than does Cumulative TSR or being silent on the matter lest the Hamlets in the investment community accuse the issuer of protesting too much.
Compensation Committees and boards may feel pressure to adopt Cumulative TSR as the sole or a major performance measure for the performance-based compensation elements in the issuer’s executive compensation package. Some institutional shareholders already view total shareholder return (TSR) as the proper indicator of financial performance for performance-based compensation and question issuers who do not use TSR as the performance measure for their performance-based compensation programs. Moreover, Institutional Shareholder Services currently uses TSR as a measure of performance in its proxy voting guidelines regarding, among other things, its voting recommendations on say-on-pay proposals. The SEC may have been influenced by these factors when it decided that Cumulative TSR would be the performance measure on which the Item 402(v) disclosures would focus. Obviously, a change to TSR as a performance measure for an issuer’s performance-based compensation may be a change for the worse for numerous issuers. Any Compensation Committee considering making that change should consider carefully whether such change is consistent with the committee’s fiduciary duties and reflects the proper exercise of the members’ business judgment in the management of a very important aspect of the affairs of public companies.
The Cumulative TSRs in the Table may reflect Cumulative TSRs for periods that do not match the periods for which performance was measured to award the performance-based compensation included in the SCT Compensation and the Actual Compensation in the Table. Performance periods used in awards of performance-based compensation vary among issuers as do the vesting periods and, thus, the frequency of payouts under performance-based awards. The performance cycles on which the payouts under such awards are based may be longer or shorter than periods for which Cumulative TSRs to be shown in the Table are calculated. Moreover, an issuer’s executive compensation package can include a performance-based compensation award tied to short-term performance and a performance-based award tied to long-term performance. The methodology for calculating Actual Compensation does not take such situations into account. With the potential for a mismatch in performance measurement periods that the Proposed Rule would create, the information required to be disclosed by the Proposed Rule that reflects such a mismatch may serve to mislead and confuse investors more than to enlighten them as to the relationship of an issuer’s executive compensation program to the issuer’s financial performance.
The periods to be covered by the Table create risk of improper disclosure. By the Table covering a period longer than the period covered by summary compensation tables, a greater risk would exist that the Table and the related descriptions required by the Proposed Rule would reflect compensation paid to multiple CEOs and Other NEOs. As a result, the Cumulative TSR for a period that reflects the job performance and influence of both a prior CEO and the current CEO in that period might not properly reflect the linkage of the current CEO’s pay with the issuer’s performance during that period. Where such a circumstance existed, the disclosures required by the Proposed Rule could confuse shareholders about the job performance of the current CEO or Other NEOs, requiring the issuer to decide whether to include additional disclosure to explain the problem with the required disclosure and the linkage of the current CEO’s or Other NEOs’ compensation to the issuer’s financial performance as reflected in the Cumulative TSR for each measurement period so affected.
Imprudent policies and practices at Peer Group companies that positively affect the Peer Group’s Cumulative TSR for a period may result in a comparison of Cumulative TSRs that is unfairly unfavorable to the issuer. A Peer Group’s Cumulative TSR may benefit from practices at the Peer Group’s constituent companies that inflate their respective Cumulative TSRs. For example, dividend policies among members of a Peer Group that lead to dividends at a generous, but imprudent, level can cause that Peer Group’s Cumulative TSR to be higher than the Cumulative TSR of a more prudent issuer. The prudent issuer’s lagging Cumulative TSR can lead to a false impression of the relationship of the issuer’s financial performance and its executive compensation and the issuer’s financial performance versus that of the issuer’s Peer Group. As a result, some issuers may find themselves having to analyze the Cumulative TSRs of the members of their Peer Group to understand why the Peer Group’s Cumulative TSRs were as they were and having to explain in their proxy statements the factors causing the Peer Group’s Cumulative TSRs in the Table to outstrip those of the issuer.
The description of the relationship between the Actual Compensation for the CEO and Other NEOs in the Table and the issuer’s Cumulative TSR shown in the Table may tell a different story than that told by the CD&A. When describing the relationship of their CEO’s and Other NEOs’ Actual Compensation in the Table to Cumulative TSR for each fiscal year in the Table, some issuers may feel they have to describe why that relationship was not an accurate indication of the linkage between the issuer’s financial performance and its executive compensation while the CD&A discussion in the same proxy statement, which reflects a strong linkage between the issuer’s executive compensation and the issuer’s financial performance, accurately describes that linkage. Such a situation may well lead shareholders, especially those fixated on TSR as the best measure of financial performance, to give less credence to the discussion in the CD&A even though, as indicia of the issuer’s financial performance, the performance measures used in the issuer’s performance-based compensation programs and, thus, discussed in the CD&A are better than or at least equivalent to the issuer’s Cumulative TSR for the fiscal years in question.
The Proposed Rule’s requirements for including the Peer Group’s Cumulative TSR in the Table and a description of the comparison of the issuer’s Cumulative TSR and the Peer Group’s Cumulative TSR shown in the Table go beyond Section 953(a)’s requirements. Section 953(a) does not require the Proposed Rule or the final rule to include a comparison of the issuer’s and the Peer Group’s Cumulative TSR, and the Proposed Rule’s requirement for such a description is clearly outside the scope of Section 953(a)’s requirements. The requirement for this description introduces into SEC filings for the first time an explicit and formal requirement for an issuer to compare in a discussion its performance as indicated by a particular performance measure against the performance of some peer group of companies.
The Proposed Rule’s provisions create the potential for disclosures that may confuse and misinform shareholders and others in the investment community and cause numerous problems for issuers. If the final rule is substantially similar to the Proposed Rule, shareholders focusing on the information included in a proxy statement pursuant to the final version of Item 402(v) may decide how they will vote on the election of directors, especially members of Compensation Committees, and on say-on-pay proposals based on information that confuses or misinforms them and results in those shareholders voting in a manner different from how they would have voted in the absence of the Item 402(v) disclosure. Issuers should consider commenting on the Proposed Rule to ensure all their concerns with the Proposed Rule’s provisions are fully aired with the SEC.