As we previously commented more than seven years ago (see our blog from May 4, 2015, “Finally! SEC Proposes New Pay for Performance Disclosure Regulations”), on April 29, 2015, in accordance with Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Reform Act”), the Securities and Exchange Commission (the “SEC”) issued a press release and published proposed regulations (Release No. 34-74835) (the “Proposed Rules”) to require specified publicly-held companies to disclose the relationship between their financial performance and the compensation that is actually paid to their named executive officers (”NEOs”).
Finally, on August 25, 2022, after more than seven years since those Proposed Rules were released and after considering many comment letters from the public, the SEC issued a press release, a fact sheet and published final regulations (Release No. 34-95607) (the “Final Rules”) which for fiscal years ending after December 15, 2022 will require certain publicly-held companies to disclose the relationship between their financial performance and the compensation that is actually paid to their NEOs.
As we observed in our blog from July 26, 2010 “The Regulatory March to Reform Executive Compensation Practices Takes Another Step Forward”, the Reform Act implemented numerous new laws affecting executive compensation and corporate governance at publicly-held companies. Section 953(a) of the Reform Act directed the SEC to establish a rule which requires disclosure in any proxy or consent solicitation material for an annual meeting of shareholders of the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions (the “Pay Versus Performance Disclosure”).
The below provides a brief overview of the Final Rules for the Pay Versus Performance Disclosure in question and answer format.
What Generally Will The Final Rules Do?
The Final Rules add a new section (v) to Item 402 of Regulation S-K that require certain public reporting companies to describe the relationship between the executive compensation actually paid by the company to its NEOs and the financial performance of the company over a specified time horizon and to disclose each of the following in a prescribed tabular format. Below is a summary of the disclosures that would appear in the required table.
- the Summary Compensation Table (“SCT”) total compensation, along with the compensation actually paid, for the issuer’s principal executive officer (“PEO”);
- the average SCT total compensation, along with the average compensation actually paid, for the issuer’s non-PEO NEOs;
- the issuer’s cumulative total shareholder return (“TSR”), as determined in accordance with Regulation S-K Item 201(e);
- the issuer’s peer group of companies’ TSR, as determined in accordance with Regulation S-K Item 201(e);
- the issuer’s net income; and
- a measure chosen by the company and specific to the company (“Company-Selected Measure”) as a measure of company financial performance.
As noted above, the PEO’s compensation is the actual compensation paid to such PEO whereas for the other NEOs, the disclosed value is the average of compensation actually paid to all non-PEO NEOs for each fiscal year.
The Final Rules state that the Pay Versus Performance Disclosure will not be deemed to be incorporated by reference into any filing under either the Securities Act of 1933 or the Securities Exchange Act of 1934 (the “Exchange Act”) except to the extent that the issuer affirmatively does incorporate it by reference.
What Does the Pay Versus Performance Disclosure Table Look Like?
Below is the Pay Versus Performance table that companies will need to include in required filings which must contain Pay Versus Performance Disclosure.
Pay Versus Performance
|Value of||Initial Fixed|
|$100 Investment Based On:|
|Year||Summary Compensation Table Total for PEO||Compensation Actually|
Paid to PEO
Smaller Reporting Companies (“SRC”) are exempt from items that are marked with an asterisk. The Company-Selected Measure column header would be replaced with the title of the actual selected measure (e.g., Total Revenue if total revenue was the Company-Selected Measure). The TSR values in the table are calculated based on a fixed investment of one hundred dollars.
Utilizing the information in the Pay Versus Performance table, the issuer would also need to include a narrative (which could consist of or include graphs) that provides a clear description of the relationship between the compensation actually paid to the NEOs with the company’s cumulative TSR, company net income, and the Company-Selected Measure. For non-SRC issuers, this discussion would also need to include a comparison of the cumulative TSR to the peer group TSR.
A company that is not a SRC also will be required to provide an unranked list consisting of three to seven of the most important performance measures (some which can be non-financial but generally at least three performance measures must be financial) used by the company to link executive compensation actually paid to the registrant’s NEOs during the last fiscal year to company performance (“Tabular List”). Companies must select the Company-Selected Measure from the performance measures included in this Tabular List, and it must be a financial performance measure and the most important measure (other than TSR or net income). The Tabular List can be one list or it can be multiple lists covering either (i) the PEO and other NEOs or (ii) the PEO and each other NEO separately.
Companies will need to separately tag each value disclosed in the table, block-text tag the footnote and relationship disclosure, and tag specific data points (such as quantitative amounts) within the footnote disclosures, all in Inline XBRL. The discission will need to provide clear, concise, and understandable disclosures which comport with the SEC’s Plain English rules.
Which Companies Will be Subject to Pay Versus Performance Disclosure?
The Pay Versus Performance Disclosure requirements generally apply to publicly-held companies that are subject to the reporting requirements of sections 13(a) or 15(d) of the Exchange Act. However, Emerging Growth Company issuers, foreign private issuers and registered investment companies would not be subject to the Pay Versus Performance Disclosure requirements.
Which SEC Filings Will Need to Include Pay Versus Performance Disclosure?
The Final Rules require issuers to include the Pay Versus Performance Disclosure in the issuer’s proxy or information statement filings that require executive compensation disclosure under Item 402 of Regulation S-K. The Pay Versus Performance Disclosure would be subject to the issuer’s say-on pay advisory vote on disclosed executive compensation.
Which Employees are Included in the Pay Versus Performance Disclosures?
The Final Rules provide that the issuer’s PEO and the other NEOs are to be covered by the Pay Versus Performance Disclosures. For SRC issuers, these would be the NEOs determined under Item 402(m)(2) of Regulation S-K. For issuers which are not SRC issuers, these would be the NEOs determined under Item 402(a)(3) of Regulation S-K. If more than one person served as PEO during a fiscal year then the disclosures for such persons would be individually reported for each applicable year.
What Fiscal Year Compensation is Utilized?
The Final Rules provide that the total compensation value as reported in the SCT for each officer is the starting point for determining the compensation values that are used in the Pay Versus Performance Disclosures provided that the following adjustments to equity compensation and pension values need to be implemented.
- The adjustments to defined benefits/pensions and equity compensation amounts are made to their starting total compensation amounts in order to derive the compensation that was “actually paid” to the NEO for the applicable fiscal year and these adjustment amounts would also be reported as footnotes to the Pay Versus Performance Disclosure table. The aggregate change in actuarial present value of the officer’s accumulated benefit under defined benefit and actuarial pension plans would be deducted;
- The “service cost” would be added back and this is calculated as the actuarial present value of each NEO’s benefit under all such plans attributable to services rendered during the covered fiscal year and “prior service cost”, calculated as the entire cost of benefits granted (or credit for benefits reduced) in a plan amendment (or initiation) during the covered fiscal year that are attributed by the benefit formula to services rendered in periods prior to the amendment;
- The grant date fair market value estimates for equity compensation awards (e.g., stock options, stock appreciation rights, restricted stock units, and restricted stock) would be deducted;
- The following items would be added back for equity compensation awards: the fair value as of the end of the covered fiscal year of all equity awards granted during the covered fiscal year that are outstanding and unvested as of the end of the covered fiscal year PLUS the amount equal to the change as of the end of the covered fiscal year (from the end of the prior fiscal year) in fair value (whether positive or negative) of any equity awards granted in any prior fiscal year that are outstanding and unvested as of the end of the covered fiscal year PLUS for equity awards that are granted and vest in the same year, the fair value as of the vesting date PLUS the amount equal to the change as of the vesting date (from the end of the prior fiscal year) in fair value (whether positive or negative) of any equity awards granted in any prior fiscal year for which all applicable vesting conditions were satisfied at the end of or during the covered fiscal year MINUS for any equity awards granted in any prior fiscal year that fail to meet the applicable vesting conditions during the covered fiscal year, the amount equal to the fair value at the end of the prior fiscal year; PLUS the dollar value of any dividends or other earnings paid on stock or option awards in the covered fiscal year prior to the vesting date that are not otherwise included in the total compensation for the covered fiscal year.
If the exercise price of a stock option or stock appreciation right was reduced or otherwise repriced, then the excess fair value of the modified award over the fair value of the original award (determined as of the date of modification to the award) must be taken into account as well.
Executive compensation actually paid will also include above-market or preferential earnings on deferred compensation that is not tax qualified.
What Time Periods are Covered by the Pay Versus Performance Disclosure Requirements?
The Final Rules provide that SRC issuers would report on the three most recently completed fiscal years and other issuers would report on the five most recently completed fiscal years. Pay Versus Performance Disclosures would only need to include fiscal years for which the issuer was a reporting company under sections 13(a) or 15(d) of the Exchange Act.
As part of a phase in transition period, non-SRC issuers if desired could cover only the most recently completed three fiscal years, instead of five fiscal years, in their first filing providing the Pay Versus Performance Disclosure and then only four fiscal years in their second annual Pay Versus Performance Disclosure filing. SRC issuers may also if desired cover only the most recently completed two fiscal years in their first filing providing the Pay Versus Performance Disclosure before including three fiscal years in subsequent filings.
Where Would the Pay Versus Performance Disclosures Appear?
The Final Rules do not prescribe a particular location for the Pay Versus Performance Disclosures although it is expected to appear along with the other Regulation S-K Item 402 executive compensation disclosures. If the Pay Versus Performance Disclosures are contained within the issuer’s Compensation Discussion & Analysis (“CD&A”) section, then the issuer should be aware that such inclusion could imply that the Pay Versus Performance information was considered in making executive compensation decisions. So, an issuer that decided to include Pay Versus Performance Disclosures in the CD&A section would presumably want to expressly address the role of the Pay Versus Performance information in making executive compensation decisions.
What are the Measures of Performance?
The Final Rules provide that companies would utilize TSR as one of the performance metrics to which the paid executive compensation would be compared. As noted above in the What Generally Will The Final Rules Do? section, TSR would be the same TSR that is utilized by the issuer in responding to the Regulation S-K Item 201(e) requirement. Non-SRC issuers must also report on the TSR for their peer group of companies. This peer group would be either the same peer group of companies used in Regulation S-K Item 201(e) or would be the peer companies that the issuer uses in its CD&A for reporting compensation benchmarking. The identity of the peer companies would need to be disclosed if the peer group is not a published industry or line-of-business index. The returns of each peer company would be weighted according to their respective stock market capitalization at the beginning of each period for which a return is indicated.
Additionally, company net income along with the Company-Selected Measure would also be included as performance metrics that would be reported in the Pay Versus Performance table and covered in the related discussion. SRCs would not need to provide information on peer group TSR, the Company-Selected Measure, the Tabular List, or disclose amounts related to pensions.
As noted above, the Final Rules are effective for fiscal years ending after December 15, 2022 which means that companies whose fiscal year is the calendar year will need to include the required Pay Versus Performance information starting in their 2023 annual proxy statement. As the requisite disclosures do require detailed technical information, companies may wish to commence examining their internal compensation accounting systems and consider what steps they will need to take in order to comply with the Pay Versus Performance Disclosure requirements.
If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988’; firstname.lastname@example.org.
This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.