The SEC has proposed rules that would require most public companies to provide disclosure in their proxy statements regarding the relationship between their executive compensation and total shareholder return (TSR) for the last five completed fiscal years. The required disclosure would include the following information for the company’s last five completed fiscal years, subject to phase-in provisions and a shorter three-year period for smaller reporting companies:
- a “pay versus performance” table disclosing the following information for each completed fiscal year required to be shown in the table:
- (1) total compensation for the principal executive officer (PEO) and (2) average total compensation for the company’s other named executive officers (NEOs), showing both Summary Compensation Table total compensation and a new measure of compensation “actually paid”; and
- the cumulative TSR of (1) the company and (2) a peer group from the beginning of the period shown in the table through the end of such year; and
- based on the information provided in the table, a “clear description” of the relationship between (1) the compensation “actually paid” to the company’s PEO and the average compensation “actually paid” to the company’s other NEOs and (2) the company’s cumulative TSR for each year, including a comparison of the cumulative TSR of the company and its peer group.
Background and Timing
Dodd-Frank Rulemaking Mandate. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted in July 2010, obligated the SEC to adopt rules requiring most public companies to disclose in proxy materials for annual meetings of stockholders information that shows the relationship between executive compensation actually paid by the company and the company’s financial performance, taking into account any change in the value of the shares of the company’s stock and any dividends or distributions. The SEC has proposed these rules to implement this requirement.
Timing of Final SEC Rules. The Dodd-Frank Act did not specify the date by which the SEC must adopt pay for performance rules, and it is not clear when the SEC will adopt final rules. The proposed rules are subject to public comment through July 6, 2015. It is possible that the SEC could adopt final rules prior to the 2016 proxy season and require companies to begin complying with the final disclosure requirements in their proxy statements for their 2016 annual meetings.
The proposed pay for performance rules would apply to most companies that file proxy or information statements with the SEC. This includes smaller reporting companies, although they would be permitted to provide reduced or “scaled” disclosures, most of which result from existing scaled disclosure requirements for smaller reporting companies under Item 402(m) of Regulation S-K. These are summarized in “Smaller Reporting Companies” below. The proposed rules would not apply to emerging growth companies, foreign private issuers or registered investment companies.
Disclosure Required by the Proposed Rules
The proposed rules would require disclosure of executive compensation and TSR metrics for each of the last five completed fiscal years (three years for smaller reporting companies) in the following new table when fully phased in:
|Pay Versus Performance|
Summary Compensation Table Total For PEO
Compensation Actually Paid to PEO
Average Summary Compensation Table Total for non-PEO Named Executive Officers
Average Compensation Actually Paid to non-PEO Named Executive Officers
Total Shareholder Return
Peer Group Total Shareholder Return
PEO. The proposed rules would require compensation disclosure each year for the person(s) who served as the company’s principal executive officer (PEO) during that year. If more than one person served as PEO during any year, the company would aggregate the amounts paid to each person who served as PEO during that year.
Because the compensation amounts to be reported in column (b) of the table are based on total compensation as reported in the Summary Compensation Table, the PEO compensation reported would include all compensation amounts paid to each person who served as PEO during that year for service in all capacities. Therefore, if an existing officer of the company was promoted to PEO during a particular year, all of that officer’s compensation for the entire year would be included in the PEO compensation reported in the table for that year.
In addition, total compensation would include termination-related compensation paid to a departing PEO, which could include severance payments or accelerated vesting of equity awards that a PEO received in connection with the PEO’s departure.
As a result, the proposed rules would in many cases require disclosure of significantly greater PEO compensation for years in which there is a change in PEOs, which would not necessarily have any correlation to the cumulative change in the company’s TSR or to a company’s own pay for performance practices.
Non-PEO NEOs. The proposed rules would require disclosure each year of the average compensation for all of the company’s named executive officers (NEOs) other than person(s) who served as the company’s PEO during that year. Neither the proposed rules nor the proposing release are completely clear about whether the NEOs to be included in the table would be only the NEOs for the most recent fiscal year or would instead show the NEOs for each respective fiscal year in the row for that fiscal year. We believe that the proposed rules are intended to require the rows for each fiscal year to show the compensation of the persons who were NEOs for that respective fiscal year, regardless of whether they were NEOs for the most recent fiscal year. For example, if a person who was an NEO during 2014 was not an NEO for 2015 or any subsequent year, we believe that this NEO’s compensation for 2014 would continue to be included in average NEO compensation for 2014 for as long as 2014 data was required to be included in the table. Similarly, if an executive officer became an NEO for the first time in 2015, we do not believe that this NEO’s compensation would be included in average NEO compensation for any year prior to 2015.
The proposed rules would require companies to present two different compensation metrics for each of PEO compensation and NEO average compensation. The first metric would be Summary Compensation Table total compensation for the applicable year. The second metric would be compensation “actually paid” for the applicable year. Compensation “actually paid” is a new metric that would be calculated as follows:
Total compensation from Summary Compensation Table
- grant date fair value of equity awards
+ vesting date fair value of equity awards vesting during the year
- change in actuarial present value for defined pension plans
+ present value of benefit under benefit pension plans attributable to service rendered during the year
Compensation "actually paid"
As shown above, compensation “actually paid” starts with total compensation as currently reported in the Summary Compensation Table and adjusts this amount to reflect (1) the value of equity awards vested (as opposed to granted) in a particular year and (2) the value of defined benefit pension plan benefits attributable to service rendered (as opposed to the change in the value of the benefits that occurred) during the year.
Equity Award Adjustments. To calculate compensation “actually paid” for a particular year, companies would subtract the grant date fair value of equity awards granted during the year, as currently shown in the “Stock Awards” and “Option Awards” columns of the Summary Compensation Table, from total compensation for the year. These amounts would be replaced by the fair value on the vesting date of all equity awards for which all applicable vesting conditions were satisfied during the year.
Vesting date fair value would be a new calculation for companies, since current SEC rules do not require this valuation. The vesting date fair value of Stock Awards would in many cases likely match the amounts disclosed in the Option Exercises and Stock Vested table currently required by SEC rules. The vesting date fair value of Option Awards would be a completely new calculation. In addition to the vesting date fair values shown in the new table, the proposed rules would require companies to disclose the amounts of the grant date and vesting date fair values added or subtracted, as applicable, in footnotes to the new table, as well as any assumptions the company makes in the vesting date valuation that differ materially from the assumptions disclosed in footnotes to the Summary Compensation Table relating to the grant date fair value.
Defined Benefit Pension Plan Adjustments. The proposed rules would also require companies to adjust defined benefit pension plan amounts included in the Summary Compensation Table, if any, when calculating compensation “actually paid.” The change in the actuarial present value for all defined benefit pension plans reported in the Summary Compensation Table would be deducted from total compensation. These amounts would be replaced by the actuarial present value of the executive’s benefit under all such plans attributable to services rendered by the executive during the applicable year. The proposed rules would exclude the portion of the total change attributable to changes in interest rates and other various actuarial assumptions that involve benefits accrued in prior years. Similar to the equity award adjustments, the proposed rules would require companies to disclose the defined benefit pension plan amounts added or subtracted, as applicable, in footnotes to the new table.
Company/Peer Group TSR
The proposed rules would require companies to disclose the cumulative TSR of the company and a peer group from the beginning of the period shown in the table through the end of each fiscal year during the period.
TSR. TSR would be calculated in the same manner and over the same measurement period currently required by Item 201(e) of Regulation S-K for the stock performance graph that SEC rules require in annual reports to stockholders. As a result, TSR is to be calculated assuming the reinvestment of dividends into additional shares of stock at the same frequency with which dividends are paid during the year. The amounts disclosed in the table for each year would be the cumulative TSR as of the end of that year based on the investment of a fixed amount, stated in dollars, in the company’s or the peer group’s stock, as applicable, at the closing price on the last trading day before the earliest year in the table.
Peer Group.The proposed rules would permit companies to use either (1) the peer group or published industry or line-of-business index used in its stock performance graph included in its annual report to stockholders or (2) if applicable, the peer group of companies it uses for purposes of its Compensation and Disclosure Analysis (CD&A). If the peer group is not a published industry or line-of-business index, the company must disclose the identity of the companies comprising the group and the returns of each company must be weighted according to each company’s stock market capitalization at the beginning of the period. The company must use the same methodology in calculating both the company’s TSR and the peer group’s TSR. Consistent with Item 201(e) of Regulation S-K, where a published industry or line-of-business index is utilized as the peer group, we would expect the use of a comparable methodology to satisfy this requirement as precise details regarding the methodology of the index (e.g., the manner in which it handles the reinvestment of dividends) may not be readily accessible.
Clear Description of Relationship of Compensation Actually Paid to TSR
The proposed rules would require companies, using the information provided in the new table, to provide a “clear description” of the relationship between (1) the compensation “actually paid” to the company’s PEO and the average compensation “actually paid” to the company’s other NEOs and (2) the company’s cumulative TSR for each year shown in the table, including a comparison of the cumulative TSR of the company and its peer group.
The SEC indicated in the proposing release that this relationship “could be described as a narrative, graphically, or a combination of the two.” As a result, companies could use charts or graphs to illustrate this relationship, either with or without accompanying narrative text. Given the manner in which companies determine executive compensation amounts and measure company performance, we anticipate that there may be many instances when executive compensation “actually paid” under the proposed rules for a particular year would not bear a meaningful relationship to the TSR data that the new rules would require for that year, even in cases where a company has an executive compensation program that strongly aligns executive compensation and the company’s performance. The proposed rules may therefore lead to further enlargement of companies’ proxy statements with additional boilerplate disclosure, while also presenting a considerable risk of confusion about how the company evaluates executive compensation and company performance.
Periods Covered and Phase-In
The proposed rules provide a phase-in period for all companies that would be subject to the proposed rules. Companies that are not smaller reporting companies would provide the new compensation disclosure for a period of three fiscal years in the first proxy or information statement that is subject to the proposed rules, and would add another year of disclosure in each of the two subsequent annual proxy or information statements that require this disclosure. After the phase-in period, the proposed rules would require companies to provide the disclosure information for the five most recent fiscal years. As described under “Smaller Reporting Companies” below, smaller reporting companies are subject to different requirements for periods covered and transition relief.
IPO/Newly Public Companies. The proposed rules would not require this disclosure for years prior to the last completed fiscal year if the company was not subject to SEC reporting requirements at any time during that year. As a result, an IPO or other newly public company that was not otherwise exempt as an emerging growth company would be required to provide disclosure only for its most recent fiscal year in each of its first two years as a reporting company (i.e., in the first year, the company would report information for the portion of the year in which it went public even though it wasn’t public for the entire year, and in the second year the company would only be required to provide disclosure relating to its first full year as a public company). Thereafter, the company would provide an additional year of disclosure for each year until the company was reporting information for the full period required by the proposed rules.
Location of New Disclosure
The proposed rules do not specify a specific location for the proposed disclosure, which would give companies flexibility to determine an appropriate location for the proposed disclosure in the proxy or information statement.
Filings that Must Include the Proposed Disclosure
The proposed rules would require pay for performance disclosure in any proxy or information statement that includes executive compensation disclosure under Item 402 of Regulation S-K, whether or not directors will be elected. Although the proposed rules do not explicitly limit the filings in which the new disclosure is required, the proposing release is clear that the proposed rules are intended to apply only to proxy and information statements. Accordingly, the new disclosure would not be required, for example, in Form 10-K annual reports or registration statements that otherwise generally require Item 402 disclosure to be included.
The proposed disclosure would not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that a company specifically incorporates it by reference. The proposed disclosure would be included in the compensation disclosures covered by the non-binding say on pay stockholder vote. Because the proposed rules would apply only to proxy or information statements filed with the SEC, some companies that would otherwise be subject to the proposed rules, such as certain limited partnerships, would not need to provide disclosure under the proposed rules in some or all years because they do not file either proxy or information statements every year.
Under the proposed rules, companies would be required to tag the pay for performance disclosure, including any footnote disclosure, in an interactive data format using eXtensible Business Reporting Language (XBRL). Companies would be required to tag the values shown in the pay versus performance table, and to separately block-text tag the required footnote disclosure to the table and the required disclosure regarding the relationship between the compensation “actually paid” to the company’s executives and TSR. This is the first time that the SEC has required XBRL tagging in proxy statements.
Smaller Reporting Companies
Smaller reporting companies would be subject to the proposed rules, but the required disclosure would be reduced in the following manner, consistent with the scaled disclosure requirements that currently apply to smaller reporting companies:
- Compensation information would be required for the PEO and the two other NEOs;
- Only three years of information is required (as opposed to five years) and, in a company’s first year of disclosure under the proposed rules, only two years of information is required;
- No peer group TSR would be required, nor would a comparison of the cumulative TSR of the company to that of its peer group;1
- Because total compensation for smaller reporting companies does not include the change in the actuarial present value for defined benefit pension plans pension values, compensation “actually paid” would not include these amounts; and
- XBRL tagging would not be required until the third proxy or information statement that includes pay for performance disclosure.
Because the final requirements and effective date of the pay for performance rules are uncertain, companies may choose to defer any action to evaluate the potential impact of the proposed rules. However, companies that are particularly interested in staying abreast of potential disclosure developments in this area may wish to begin considering how the proposed rules could affect their existing compensation-related disclosures and how they would comply with the proposed rules if the SEC adopts the proposed rules in their current form, including preparation of sample disclosure to flush out any potential issues.
1 The proposing release is clear that smaller reporting companies would not be required to present a peer group TSR, although the proposed rules only explicitly exempt smaller reporting companies from including a comparison of the cumulative TSR of the company to that of its peer group in its disclosure of the relationship between executive compensation and the company’s TSR.
Daniel P. AdamsPartner
Michael J. MinahanPartner
Marian A. TseRetired Partner
Ettore A. SantucciPartnerCo-Chair of Debt Capital Markets, Co-Chair of REITs and Real Estate M&A
Bradley C. WeberPartnerCo-Chair, Capital Markets
John O. NewellCounsel