Overview
On August 25, 2022, the Securities and Exchange Commission (the “SEC”) announced that it adopted a final rule requiring companies to disclose information that is intended to reflect the relationship between compensation paid to executives and the company’s financial performance — the so-called pay-versus-performance rule (the “Rule”). Originally proposed in April 2015 in response to a mandate under Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Rule adds a new item under Regulation S-K, Item 402(v).
Under Item 402(v), companies will be required to include the disclosures called for by the Rule in all proxy or information statements in which executive compensation disclosures under Item 402 of Regulation S-K are required. There are three primary components to the disclosure requirements under the Rule: (i) a pay-versus-performance table; (ii) additional disclosure of the relationships between the pay-versus performance table and compensation paid to named executive officers; and (iii) a list of the company’s most important financial performance measures.
The Rule applies to all reporting companies other than emerging growth companies, foreign private issuers, and registered investment companies. Smaller reporting companies (“SRCs”) are permitted to comply with certain reduced disclosure requirements, which are described below. The Rule is effective on October 11, 2022, and will apply to proxy or information statements required to include Item 402 disclosures with respect to fiscal years ending on or after December 16, 2022. Consequently, a calendar-year company will be required to comply with the Rule’s new disclosure requirements in its proxy or information statements filed in 2023.
The Rule’s disclosure requirements and certain preliminary takeaways for reporting companies are summarized below. For additional information, please see the fact sheet and the final rule published by the SEC.
Pay-versus-Performance Table
The pay-versus-performance table (the “Table”) requires that companies disclose, for each of the last five completed fiscal years (subject to certain transition rules described below): (i) (a) the total amount of compensation reported for the principal executive officer (the “PEO”) in the Summary Compensation Table (the “SCT”) and (b) the total amount of compensation “actually paid” to the PEO; (ii) (a) the average total amount of compensation reported for the other named executive officers who are not the PEO (the “Other NEOs”) in the SCT and (b) the average total amount of compensation “actually paid” to the Other NEOs; and (iii) the company’s performance with respect to certain performance measures, which are described in more detail below.
Under the Table, companies are required to disclose the following performance measures: (i) the total shareholder return (the “TSR”) for both the company and the company’s peer group, with TSR calculated by dividing (a) the sum of dividends paid during the measurement period, assuming dividend reinvestment, and the difference between the company’s stock price at the end and the beginning of the measurement period, by (b) the company’s stock price at the beginning of the measurement period; (ii) the company’s net income; and (iii) a financial performance measure chosen by the company (the “Company-Selected Measure”), which should be the measure that the company determines is the “most important financial measure” used to link executive compensation “actually paid” to company performance.
Below is the form of the Table contained in the final rule published by the SEC.
Compensation “Actually Paid” Calculation
Under the Rule, compensation “actually paid” is defined as the total amount of compensation reported in the SCT, with adjustments made to the amounts reported for the following two categories: (i) pension values; and (ii) equity awards. More specifically, to determine compensation “actually paid,” the total amount of compensation reported in the SCT for the PEO and the Other NEOs is adjusted to: (i) (a) deduct the total aggregate change, if any, in the actuarial present value of all defined benefit and actuarial pension plans and (b) add the aggregate service cost for the applicable year and the “prior service cost” under such plans, each calculated in accordance with GAAP; and (ii) revalue equity awards to reflect year-end, or year-over-year, changes in fair value. As such, the calculation of compensation “actually paid” includes not only amounts paid, but also amounts earned. Note that SRCs are not required to adjust for pension amounts in order to determine compensation “actually paid.”
Note that the foregoing adjustments for pension and equity compensation costs to the compensation “actually paid” calculation involve a complicated analysis, so please contact a member of the V&E team if you would like additional information.
Performance Measures
Default Measures (TSR; Net Income). Companies must disclose their cumulative TSR for each fiscal year calculated based on the value of a fixed investment of $100 (which is the same calculation used to prepare the “Performance Graph” that companies (other than SRCs) are required to include in their Form 10-K pursuant to Item 201(e) of Regulation S-K). The company must also disclose the cumulative TSR of the company’s peer group (which should be the same peer group used for purposes of Item 201(e) of Regulation S-K or the peer group used in the Compensation Discussion & Analysis (“CD&A”) section of the applicable proxy or information statement) for each fiscal year calculated based on the value of a fixed investment of $100. The company is further required to disclose the company’s net income, calculated in accordance with GAAP, for each fiscal year. Note that SRCs are not required to present cumulative TSR for the SRC’s peer group.
Company-Selected Measure. Companies must select a financial performance measure that is not otherwise represented in the Table that the company has determined represents the “most important financial measure” used by the company to link executive compensation “actually paid” to company performance for the last completed fiscal year. The company is permitted to include other voluntary measures in addition to the Company-Selected Measure, but is not permitted to select a non-financial performance measure as the Company-Selected Measure. On the other hand, if the company either does not use any financial performance measures to link pay and performance, or if the company only uses measures that it has already disclosed (e.g., TSR and net income), then the company is not required to disclose a Company-Selected Measure for this purpose. Note that SRCs are not required to provide the Company-Selected Measure.
Other Considerations and Adjustments
Transition Rules. For the first proxy or information statement in which the Table is disclosed (which, as noted above, will be the proxy or information statement filed in 2023 for calendar-year companies), companies are only required to provide disclosure in the Table for the last three completed fiscal years (or, if fewer, the number of such fiscal years in which the company was a reporting company under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)). In the second proxy or information statement in which the Table is disclosed, companies will add another year and hence will be required to provide disclosure in the Table for the last four completed fiscal years. Finally, in the third proxy or information statement in which the Table is disclosed, companies will add the final year and hence will be required to provide disclosure in the Table for the last five completed fiscal years. Note that SRCs are permitted to provide disclosure in the Table for the last two completed fiscal years (instead of three) in the first proxy or information statement in which the Table is disclosed and a maximum of the last three completed fiscal years (instead of five) in subsequent proxy or information statements.
Multiple PEOs. If more than one person served as PEO during the covered fiscal year, then companies must report each PEO separately in the Table in different columns, with such additional disclosure provided for any applicable year in which more than one person served as PEO.
Additional Disclosure
Accompanying the Table, companies must include additional disclosure (which could consist of a narrative description, a graphic description, or a combination of both) that uses the information in the Table to clearly describe the relationship between: (i) executive compensation “actually paid” to the PEO and (ii) the average executive compensation “actually paid” to the Other NEOs, in each case as compared to the company’s: (a) cumulative TSR; (b) net income; and (c) the Company-Selected Measure. Additionally, companies must also include a comparison of the company’s cumulative TSR and the cumulative TSR of the company’s peer group over the last five completed fiscal years (or, if applicable, such fewer number of years covered in the Table).
If, in addition to the Company-Selected Measure, the company includes other voluntary performance measures in the Table, then the additional disclosure must also describe the relationship between executive compensation “actually paid” to the PEO and the Other NEOs with the additional performance measure across the last five completed fiscal years (or, if applicable, such fewer number of years covered in the Table).
List of Most Important Financial Performance Measures
Companies must also include a tabular, unranked list of three to seven financial performance measures that the company determines are the “most important” measures used to link executive compensation “actually paid” to its PEO and the Other NEOs for the last completed fiscal year to company performance (the “Tabular List”). The Tabular List may include both financial and non-financial performance measures, but must include at least three financial performance measures (or, if fewer, the number of financial performance measures used by the company).
In selecting measures for the Tabular List, companies should use the same approach used to select the Company-Selected Measure. Though companies are not required to disclose the methodology used to calculate the measures included in the Tabular List, the company should consider whether disclosing such methodology might aid investors in understanding the measures included or could prevent a confusing or misleading Tabular List.
Companies may present the Tabular List in one of the following three ways: (i) one tabular list; (ii) two separate tabular lists (one for the PEO and one for the Other NEOs generally); or (iii) separate tabular lists for the PEO and each of the Other NEOs. Regardless of the manner in which companies choose to present the Tabular List, as noted above, the Tabular List must include three to seven performance measures that the company believes are its most important measures used to link compensation “actually paid” to company performance.
Inline XBRL
While not a substantive legal point, it is worth noting that the Rule requires companies to tag the new disclosures in inline eXtensible Business Reporting Language (“XBRL”), which is the first time inline XBRL will apply to proxy or information statement disclosures. Specifically, the company must separately tag each value disclosed in the Table, block-text tag the footnote and relationship disclosures, and tag specific data points (such as quantitative amounts) within the footnote disclosures.
Note, this inline XBRL requirement is limited to the Item 402(v) disclosures — it does not extend to the other Item 402 disclosures contained in the proxy or information statement.
Preliminary Takeaways
Given the short window before the Rule will apply for the first time, companies should determine whether the Rule is applicable to the company’s proxy or information statement to be filed in 2023. If a company is in fact subject to the Rule, the company should consider the current reporting systems and the steps required to collect the necessary data inputs for calculating compensation “actually paid,” particularly with respect to the historical pension and equity award adjustments. Additionally, the company should begin internal discussions regarding the Company-Selected Measure, with the understanding that the measure used should focus on the last completed fiscal year. For the additional disclosure accompanying the Table and the Tabular List, companies (including compensation committees) may want to consider prior CD&A disclosures on the relationship between pay and performance, the impact those prior disclosures might have on preparing disclosures under the Rule, and any changes that the company might find desirable to implement in anticipation of the disclosures required by the Rule. Companies should also be aware that because the Rule has been implemented as Item 402(v) of Regulation S-K, disclosures in respect of the Rule are part of the advisory say-on-pay vote required under Exchange Act Rule 14a-21(a), as such vote is based on the company’s Item 402 disclosures generally.
Contacts
If you have any questions regarding the foregoing, including how the compensation disclosures contained in your proxy or information statement to be filed in 2023 are impacted, please contact any of the following Vinson & Elkins attorneys.