On April 29, the SEC announced that it had voted 3-2 in favor of proposing new rules requiring increased disclosure on the link between company performance and executive compensation. The proposed rules would implement a requirement mandated by Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. According to the SEC press release, the proposed rules would, “provide greater transparency and allow shareholders to be better informed when they vote to elect directors and in connection with advisory votes on executive compensation.”
What the Rules Would Do
If implemented as written, the new rules would require a new section in the compensation disclosure section of a company’s proxy or other relevant filing. The section would have to include a table showing the compensation paid to the company’s “principal executive officer,” as already disclosed in the summary compensation table; however, in the section that would be added under the proposed rules, this total compensation figure would be adjusted to reflect compensation “actually paid.” Amounts included in the summary compensation table for pension and equity awards would be adjusted. The table would also include the average compensation paid to the other named executive officers in the summary compensation table, using the new methodology. The compensation disclosure would have to be for the previous five years.
The new rules would also require each company to include in the table its total shareholder return (TSR), using a specified definition of TSR, on an annual basis, also over a five-year look-back period. Additionally, the company would have to disclose TSR for each of the companies in its peer group, using the peers the company identified in either its stock performance graph or in its compensation discussion and analysis (CD&A).
Companies would also be required to tag the data interactively using eXtensible Business Reporting Language (XBRL).
Finally, using the information presented in the table, companies would have to describe the, “relationship between the executive compensation actually paid and the company’s TSR, and the relationship between the company’s TSR and the TSR of its selected peer group.” The company could fulfill this requirement through a narrative, a graphic representation showing the relationships, or some combination of the two.
Smaller reporting companies would only be required to provide the new disclosure for a three-year look-back period, and would not be required to disclose any peer TSR information.
Treatment of Pensions and Equity Awards
The difference between the amounts reported in the new disclosure table and the summary compensation table would stem from changes in the reporting of pension and equity award values. Pensions would be adjusted by subtracting the change in value to the pension, as reported in the summary compensation table, and then adding back the, “actuarially determined service cost for services rendered by the executive during the applicable year.”
To determine the disclosure in the new table, under the term “actually paid,” equity awards would not be disclosed until the day of vesting, and the value would be determined by fair value on the day of vesting, in addition to disclosure of the fair value on the grant date. If the vesting date valuation assumptions are materially different from those in the company’s financial statements as of the grant date, then the company would be required to disclose the new fair value assumptions, as well.
Timing of New Rules
If the new rules receive final approval, all companies would have a phase in period. Most companies would be required to meet the new disclosure requirements in the next required filing, but they would only be asked to disclose the data with a three-year look-back period in the first relevant filing after the rules come into effect, adding a year of disclosure each subsequent filing for the next two filings, until the five-year look-back requirement is met.
Smaller companies would only be initially required to include two years’ of disclosure, adding the third year in the next relevant filing.
What the Rules Wouldn’t Do
As currently described, there are a few key points that the rules do not address.
Many companies craft long-term incentive plans with three year performance periods for payouts. The SEC rules require a five-year look-back period for comparing pay and performance, which may leave open some room for interpretation as to how the relationship between performance and pay over the disclosure period is best described effectively. This applies to options with three-year vesting periods, as well as performance-vesting awards with three-year performance periods.
Additionally, the performance period and pay period as required by the disclosure may not align, on an annual basis, with the company’s actual performance and pay periods, especially for companies with awards that do not vest at the calendar year end.
While the rules require the use of TSR as a performance metric, there is no requirement against using an additional performance metric, which some companies may find is more appropriate to their respective situation. Companies may choose to highlight pay for performance with other measures, such as earnings or return on invested capital, to draw attention to metrics believed to be more reflective of long-term performance and value creation.
Finally, the rules do not specify how companies would be required to treat the disclosure of compensation paid to multiple CEOs in a year where a company changed CEOs, and they also do not cover additional pay given in those years, as part of the payments to either the incoming or outgoing CEO.
Next Steps
If the rules receive approval from the Commission for publication, they will be published, and a 60-day comment period will open. –Rob Yates, ISS U.S. Research
