New SEC disclosures: Relationship of pay and performance

On Aug. 25, 2022, the SEC released final rules for a new “Pay Versus Performance” disclosure that was originally required in the Dodd-Frank Act of 2010. The disclosure, which will be effective for fiscal years ending on or after Dec. 16, 2022, will take the form of an additional table that will be included in future proxy statements. See the SEC’s Final Rule for detailed requirements.

As a part of the new disclosure, companies will need to report compensation and financial calculations that have not been previously required, including:

• Compensation actually paid (columns “c” and “e” above)
• An average of compensation for non-CEO named executive officers (columns “b” and “d” above)
• Company and peer group total shareholder return (columns “f” and “g” above)
• A company-selected measure that represents the strongest link between organizational pay and performance (column “i” above)

With the 2023 proxy season fast approaching, many companies are well underway in their initial reporting preparations. Although complete compensation and financial performance may not be known for 2022, companies can begin calculating results for 2020 and 2021, which will be required in initial filings. Companies that have not yet started, or are wondering what elements to prioritize, should focus their attention on the following areas.

Compensation actually paid

The most surprising difference between the SEC’s proposed regulations in 2015 and the final rules is a new compensation “actually paid” calculation. Though salaries and cash bonuses will be valued the same for both the summary compensation table and compensation actually paid columns, the methodology for calculating equity and pension values will be vastly different.

Compensation actually paid is a bit of a misnomer that generally calculates the fair value of awards granted in the year being reported or the change in value of equity awards granted in years prior to the reporting year. The table below summarizes the valuation procedure depending on when awards where granted:

Companies will likely have the most difficulty in conducting the high number of valuations each year, which will happen any time an award vests or is outstanding at year-end, or for performance-based equity subject to financial or operational conditions. To address these potential challenges, companies should gather 2020 and 2021 compensation data to determine if there are any reporting gaps, and then outline the responsibilities for each of their HR, finance and outside valuation or compensation consulting advisors in calculating compensation actually paid values. Doing a few dry runs on 2020/2021 data will give companies confidence in quickly turning around values for 2022 after the year has concluded.

Selecting a peer group or industry index

As shown in columns “f” and “g” in the sample SEC “Pay Versus Performance” table, companies will be required to report their total shareholder return (TSR) relative to their peer group disclosed in their Compensation Discussion and Analysis disclosure, or an industry/line-of-business index that is included in Item 201(e) of Regulation S-K.

While existing peer groups used for compensation benchmarking purposes may provide the strongest alignment with companies’ financial size and business focus, strong share price performance from just one or two peers may cause reporting that shows a large disconnect between company and peer performance. Additionally, companies will be required to disclose any changes to their peer group and report TSR information for the peer group as if no changes had occurred, which could lead to lengthy footnotes each year.

Using an industry or line-of-business index may be a preferred route for many companies due to the reduced reporting requirements and the greater stability inherent in indices that have hundreds of companies.

Company-selected performance measure

A final item from the regulations that surprised many outside observers is the inclusion of a required company-selected measure that represents, as the SEC release states, the “most important financial performance measures used by the registrant to link executive compensation actually paid during the fiscal year to company performance.” Companies have a wide degree of latitude to select generally accepted accounting principles (GAAP) metrics or non-GAAP measures and are able to include multiple company-selected measures in the table so long as they are not “misleading” or do not “obscure the required information.” In addition to the quantitative values required in the company-selected measure column, companies will also need to describe the relationship between their selected metric and compensation actually paid.

Companies should thoroughly consider the most appropriate company-selected measure to use and how that measure relates to their existing compensation plans. Early evaluations from companies indicate the most heavily weighted metric in an annual or long-term incentive plan may be an appropriate starting point. Companies should carefully consider selecting any metrics that are not already included in an incentive plan and prepare to provide substantial disclosure for why their company-selected measure is not part of the existing compensation plan should they choose to do so.

Conclusion

The finalized pay-versus-performance regulations require significantly more calculations and disclosures than the SEC’s originally proposed rules in 2015. The SEC has, however, exempted emerging growth companies, registered investment companies, and foreign private issuers from the new rules, and provided smaller reporting companies reduced requirements, such as not requiring peer group TSR or a company-selected measure.

The SEC has also implemented a two-year transition period where initial filings will only require the three prior fiscal years, increasing to the required five years over time. Management should start their calculations early to ensure they identify the data points, processes and analyses that will be needed for their pay-versus-performance tables.