Heads Up—SEC releases proposal on pay versus performance
This Heads Up discusses the SEC's recently issued proposed rule, "Pay Versus Performance," which would require a registrant to disclose the relationship between executive compensation actually paid and the financial performance of the registrant. Intended to improve shareholders’ ability to objectively assess the link between executive compensation and company performance, the proposal raises a number of interesting questions and challenges.
The SEC recently issued a proposed rule1 that would amend Regulation S-K, Item 402,2 to implement a mandate under the Dodd-Frank Act3 requiring a registrant to disclose the relationship between executive compensation actually paid and the financial performance of the registrant. The proposal, which is intended to improve shareholders’ ability to objectively assess the link between executive compensation and company performance, raises a number of interesting questions and challenges.
In the proposal, the SEC has requested comments on 64 questions. Thus, it is unclear what the final rule will look like and when it will be issued (although if finalized before year-end, it may be effective for the 2016 proxy season). What is clear, however, is that shareholders, employees, and the media will heavily scrutinize the disclosures a registrant provides under the final rule. Comments on the proposal are due by July 6, 2015.
The proposal requires a registrant to present a tabular disclosure for each of its last five completed fiscal years. Under the proposed transition provisions, the registrant would initially disclose only three years of information but would include an additional year of data in each of the two subsequent annual filings (to satisfy the five-year requirement). The proposal provides the following example of the required tabular disclosure:
Many companies may find it challenging to determine (1) where to present this disclosure and (2) how to integrate it into the other extensive compensation disclosures already required by SEC rules. The proposal acknowledges that placement of the disclosure in the compensation discussion and analysis (CD&A) section of a filing would suggest that the relationship of pay to total shareholder return was a factor in establishing compensation, which may not be the case. Therefore, under the proposed rule, companies retain the flexibility to place the required disclosure wherever they believe it is most appropriate in the proxy. In addition, companies may continue to compute and present other performance measures, such as realizable compensation (as defined), that will allow them to “tell their own story” elsewhere in the CD&A.
The attached Heads Up discusses specific aspects of the following tabular disclosures:
- Executive officers
- Summary compensation table totals
- Compensation actually paid
- Total shareholder return
In addition to providing the tabular disclosure, a registrant would be required under the proposal to clearly describe the relationship between the following:
- The executive compensation actually paid to the NEOs and the registrant’s TSR.
- The registrant’s TSR and the peer group’s TSR.
Attempting to explain the relationship between paid compensation and TSR (or lack thereof) will be quite challenging because most compensation decisions do not revolve around TSR. Further, the lack of alignment between the TSR measurement period (fiscal year) and the vesting period of the majority of long-term incentive plans (under whose terms, in most cases, awards vest in February/March for calendar-year companies) may magnify this challenge and encourage boards to shift vesting schedules closer to year-end to increase the overlap between the timing of the performance period and award valuation.
The proposal indicates that this description should follow the tabular disclosure; however, it does not specify the format of the description and states that it could be narrative, graphic, or a combination of both. For example, it could consist of “a graph providing executive compensation actually paid and change in TSR on parallel axes and plotting compensation and TSR over the required time period.” Alternatively, a registrant could describe the relationship by “showing the percentage change over each year of the required time period in both executive compensation actually paid and TSR together with a brief discussion of that relationship.”
The proposal also requires registrants to electronically tag the disclosure by using eXtensible Business Reporting Language (XBRL) and to include the interactive data files “as an exhibit to definitive Schedule 14A . . . or definitive Schedule 14C” (as applicable). Specifically:
- Each amount included in the tabular disclosure would be tagged separately.
- Block-text tags would be applied to:
- Footnotes to the tabular disclosure describing (1) the adjustments made to compute the executive compensation paid and (2) any material differences in the valuation assumptions used for equity awards.
- The description of the relationship between (1) executive compensation actually paid and the registrant’s TSR and (2) the registrant’s TSR and the peer group’s TSR.
Foreign private issuers, emerging growth companies, and registered investment companies would be exempt from the requirements.
Because of the potential sensitivity associated with any disclosures about executive compensation, registrants affected by the proposal should review their past compensation practices and assess whether the proposed requirements would appropriately convey to investors the relationship between their executive compensation practices and company performance. One way of doing so might be to model the proposed disclosures by using data for the past several years. Modeling might reveal possible unintended consequences of the proposal or the need to develop a strategy for communicating to investors the effects of specific aspects of the disclosures. Because the proposal requests comment on virtually all aspects of its provisions, registrants will have the opportunity to express their concerns and recommend improvements or disclosure alternatives.
1 SEC Proposed Rule Release No. 34-74835, Pay Versus Performance.
2 SEC Regulation S-K, Item 402, “Executive Compensation.”
3 The proposed rule would implement Section 14(i) of the Securities Exchange Act of 1934, as added by Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
4 Principal executive officer.
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