The SEC’s new pay-versus-performance rule changes will present myriad challenges – and potential opportunities – to public company management teams and boards. Most publicly listed US companies must begin making these disclosures in their 2023 proxy statements.
This creates a major new workstream during a demanding season when calendar-year companies and their outside advisers are already frenetically busy preparing for the annual financial disclosure process, year-end performance assessment and compensation cycle and related reporting and investor communications.
Add to that the challenges and uncertainty in the macroeconomic climate, paired with the speed at which corporations are expected to adapt, and compliance with the new requirements becomes even more complex. The mandate is just around the corner and there is much for management teams and boards to understand and consider.
The finalized pay-versus-performance rule changes, announced on August 25, will require most public companies to include in their upcoming proxy statement new disclosure in the form of two new tables and a narrative that sets forth how compensation paid to the CEO and other top executives tracks with a range of performance metrics, some mandated by the SEC and a few selected by the company.
Pay-versus-performance reporting in the upcoming proxy will track the standard three-year look-back for other compensation items. But over the following two years, issuers will need to phase in five years’ worth of reporting, which is a departure from current disclosure conventions.
Some of the required information, including how to calculate ‘compensation actually paid’, will be calculated differently from before. This will be most significant in how the value of equity awards and pensions are calculated in the newly required pay-for-performance tables.
In one of the new tables, issuers will be required to report on company performance based on several new performance metrics: company total shareholder return, relative shareholder return and company Gaap net income. Companies will have to report on these going back three years initially and eventually five years. In addition, they will have to select one performance criterion they view as most important in their compensation decision-making and disclose their performance based on that metric.
Who is affected, and when?
The pay-versus-performance rule changes apply to the vast majority of US-listed companies. Emerging growth companies, registered investment companies and foreign private issuers are exempted. Smaller reporting companies are subject to reduced disclosure requirements. The covered compensation information includes a company’s principal executive officer and averages of compensation for other named executive officers.
The changes are effective for upcoming proxy statements for those issuers whose fiscal years end on or after December 16, 2022 – the vast majority of companies.
Given the narrow window in which to complete the new disclosures, a group of 15 law firms and consulting firms, including Paul Weiss, recently wrote a letter to the SEC asking for a six to 12-month extension. Preliminary indications do not suggest a delay is likely, so companies can take action to get their ducks in a row for the upcoming proxy season.
What has caught many off-guard is the sweeping and prescriptive nature of the new rules and the speed with which companies are expected to follow them.
The mandate to make such rules dates from the Dodd-Frank Act, which included a statutory requirement that a company provide a ‘clear description’ of ‘information that shows the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account any change in the value of the shares of stock and dividends of the issuer and any distribution’. A proposed rulemaking was released seven years ago.
But after 12 years, and with no final rule forthcoming until this past August, companies are feeling a bit on the back foot, given that in many cases they have six months or less to comply. A change like this one will demand a significant investment of time to implement accurately.
One of the biggest challenges will be coming up with data to accurately determine compensation actually paid (Cap). Rather than showing equity award values on the grant date or at their value based on current stock prices, as required for existing disclosures, companies will have to estimate their accounting values at the end of the year (or upon vesting or forfeiture, if earlier) and compare that with the value of the grant at the start of the year. This is an entirely new way of evaluating the value of awards, and one that is not consistent with how awards are reflected in the SEC’s required financial reporting disclosures.
The accuracy of these calculations is important to get right – and that takes time. For example, the Cap calculation of equity awards alone could require more than 80 new valuations per year of compensation disclosure, and more than 240 calculations for the three-year table required in the first year.
The number of new calculations needed increases by many multiples for companies that have monthly or quarterly vesting. And companies that have experienced changes in executive leadership in the past three years will see those complexities compounded.
Another issue of concern to management teams and boards is whether the new disclosures will be confusing to investors and cause them to revisit decisions made in previous years, because the new tables will require compensation decisions made in one year to be brought forward for a five-year period.
Under current reporting rules, investors’ and proxy advisory firms’ primary focus is on evaluating decisions made in the current reporting year. But the new rules require compensation decisions made in one year to be brought forward under new calculations, which may be confusing to investors and cloud the evaluation of say-on-pay votes.
New rules signal and SEC shift
In recent years we have seen a growing number of companies tie ESG to executive compensation. But the new rules dictate that the company-selected performance metric for the tabular disclosure must be a financial metric.
Under the changes, companies are required to pick the single-most important metric they use to guide decisions on executive compensation. That’s a difficult decision for many companies. The SEC has indicated that it must be a financial performance metric: total shareholder return, Ebitda revenues, cash flow or the like.
The SEC’s primary focus on financial rather than ESG metrics is notable at a time when there has been significant focus by proxy advisory firms on the use of ESG metrics in setting compensation. Companies will still be able to discuss the importance of ESG and sustainability performance metrics. In addition to choosing the single-most important financial performance metric, companies must also include between three and seven additional performance measures they deem important. Some of these additional factors may be non-financial indicators, such as ESG-related data.
Therefore, companies have an opening to consider whether to include ESG and sustainability data. It may be useful to keep in mind that proxy advisory firms will likely pay close attention to the metrics the company chooses to include as well as those that are not included.
Coming developments for executive compensation
Looking ahead, the SEC’s rapid rollout of the rule changes signals the commission’s desire to complete the remaining Dodd-Frank rulemakings. One of the biggest remaining open issues is a proposed executive compensation clawback rule, which would mandate that executives repay certain compensation to their companies in the event of a financial restatement. Many companies already have policies in place, but it is likely that SEC rules would be more prescriptive. Rules on that front are likely to be next up.
Finally, the rule changes signal a willingness by the SEC to be more prescriptive in its requirements than in the recent past. Rather than deferring to corporate filers on how to make executive compensation decisions more transparent, the new rules show a preference for a rules-based regime.
Although the rules require quick action this proxy season from management teams, boards and their outside advisers, they also present an opportunity for public companies to consider the priorities that are truly material to their business – and to use executive compensation as a tool to signal the factors they consider as important to long-term success.
Jean McLoughlin is a partner and co-chair of the executive compensation group at Paul Weiss Rifkind Wharton & Garrison. Kyle Seifried is a partner in the firm’s corporate department