On August 25, 2022, the SEC announced the long-anticipated adoption of pay versus performance (“PVP”) disclosure rules.
The rules are effective for fiscal years beginning on or after December 16, 2022, which frankly feels rushed, leaving calendar year companies scrambling a bit to address this in their upcoming 2023 proxy statement. The implementation may feel slightly hurried, but what a long, strange trip it’s been for the PVP rule. First required under Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) way back in 2010, the SEC finally proposed a PVP rule in 2015. Receiving significant pushback on what was seen as a rigid rule with little benefit or insight beyond what was already disclosed in the CD&A, it was basically tabled until late 2021 / early 2022, when a comment period was opened and the rule was finally adopted.
What is this Rule Exactly?
The final rule has three primary disclosure requirements:
1. A new table which discloses, on an annual basis:
- the pay for the PEO (principal executive officer) and average pay for the other NEOs, as measured in two manners: the Summary Compensation Table total, and a new calculation dubbed “Compensation Actually Paid”;
- total shareholder return (“TSR”) for the company and for its chosen peer group[1];
- the company’s Net Income; and
- the company’s performance on a self-selected financial measure.
Note: for 2023, companies will be required to disclose 3 years of information; for 2024, four years of information; and finally in 2025 and beyond, five years of information. As expected, Smaller Reporting Companies (SRCs) will have pared-down requirements.
2. A description of the relationship between actual compensation and each performance measure disclosed in the table, which could be in a narrative or graphical format (or both!)
3. A tabular list of 3 to 7 performance measures that are “most important” in determining compensation actually paid in the past year. These measures can include financial as well as non-financial metrics (diversity goals or other ESG-related goals, for example)
What is Compensation Actually Paid?
“Compensation Actually Paid” is a bit complicated, and actuaries, equity valuation experts, and others will need to be involved. Starting with the disclosed data in the Summary Compensation Table, adjustments are made to the valuation of equity, pension benefits, and deferred compensation, as follows:
The Big Question: Will PVP Disclosure Prove to Be Useful?
At this point… we think the jury is still out. These requirements are intended to greatly improve transparency and standardize the calculations and presentation of this data, thereby providing investors with consistent, comparable information from all companies. Ideally, the end result is better-informed voting decisions. But as we know, sometimes standardization comes at the cost of nuance; and many will note the burden of further disclosure, namely the calculation of Compensation Actually Paid. It’s undoubtedly more complicated than dropping a grant date fair value into the Summary Compensation Table, as equity awards need to be re-valued at the end of each year or at the time of vesting.
Perhaps like the CEO Pay Ratio disclosure, the utility of the PVP disclosure will begin to grow over time. In the first year of this disclosure, however, we expect PVP disclosure will not be widely influential on institutional investors or the proxy advisors, each of which will have little time to incorporate this new data into their quantitative pay and performance models.
Ultimately, the usefulness of this disclosure will be determined by the market. Do investors feel better informed? Does the disclosure properly identify pay and performance disconnects? As issuers engage with institutional investors this Fall, we recommend asking investors for their thoughts on the new disclosure – in particular, how they will be using the new disclosure to evaluate and/or compare executive compensation plans.
Immediate Action Items
1. Assemble the Team!
The PVP disclosure will be time-intensive, requiring a coordinated effort by numerous parties. Companies need to start assembling their team, which may include:
- internal (finance/accounting, HR, legal, among others)
- external (governance consultants and equity valuation experts, in particular)
2. Get Started Now!
Again, the exercise of assembling this new disclosure will be time-intensive. But steps can be taken to ease this burden:
- Start with 2020 and 2021 calculations, which can be done now
- Create a pro-forma template for 2022 calculations, using stock price assumptions and vesting dates for equity from prior years
- Draft narrative/graphical disclosures to determine the most effective method of disclosure
- Begin to identify the “most important” three to seven measures for determining executive compensation. Determine which of these metrics will be used in the table
- Determine which peer group to use for TSR
3. Tell Your Story – Disclose and Engage!
This new disclosure is not the perfect solution to displaying pay and performance alignment, though it may prove over time to be far superior to other, current methodologies. Still, there is no final passing or failing grade. The data in the PVP table and in the narrative and/or graphical descriptions will be subject to interpretation by each investor. Therefore, it is still tremendously important to focus efforts on telling your compensation story through two primary avenues – the narrative of your CD&A, and in ongoing shareholder engagement, which may be even more vital in the wake of these new PVP disclosure rules.
[1] Companies can opt to use the same peer group (usually an index) that they use in the performance graph in the 10-K, or can utilize the compensation peer group disclosed in the CD&A (which would need to be market-cap weighted)
