Andrew MacDougall, Sandra Cohen, James Lurie, Matthew Sadofsky
May 7, 2015
On April 29, 2015, the Securities and Exchange Commission (SEC) proposed long-awaited pay-for-performance rules that would require most U.S. public companies to disclose the relationship between compensation “actually paid” to the company’s named executive officers (NEOs) and the company’s “financial performance.” As discussed in this Osler Update, the proposed rules mandated by Section 953(a) of the Dodd Frank Wall Street Reform and Consumer Protection Act (Dodd Frank) establish a somewhat prescriptive, as opposed to principles-based, approach to disclosing the relationship between executive compensation and company performance. As a result of the SEC’s use of the total shareholder return (TSR) metric for “financial performance” defined for purposes of preparing the already required five-year stock price performance graph, the proposed rules may have the effect of increasing company and investor focus on stock price movements over short-term periods and potentially reinforce further the use of this metric in awarding performance-based incentive compensation. The SEC is requiring these disclosures to assist shareholders when they are deciding whether to approve NEO compensation through the “say on pay” advisory vote, when making decisions on a compensation plan in which NEOs participate and when voting on the election of directors.
Historical Pay-For-Performance Voluntary Disclosures
In response to demands from investor and investor advisory firms to better demonstrate the relationship of corporate performance to compensation actually realized by a company’s CEO based on the compensation decisions of the board of directors, and in anticipation of the SEC adopting rules to show such impact as mandated by Dodd Frank, a number of U.S. and Canadian public companies had already provided supplemental voluntary disclosure regarding the CEO’s realized or realizable pay over a period of three to five years. However, there has been no agreed upon consistent method for calculating and disclosing such amounts or how to compare such amounts to company performance. The SEC’s proposed rule does not address these practices.
The disclosures required by the proposed rules would not be applicable to Canadian companies that are foreign private issuers or to “emerging growth companies” as defined by the SEC. Despite inconsistencies in methodology for calculating and disclosing realized or realizable pay, Canadian companies which voluntarily provide such information on a supplemental basis are unlikely to change their approach in light of the SEC’s proposed rule.
The Required Disclosure
The proposed rule, which would impose uniform definitions and methodologies for determining “financial performance” and compensation to be reported as “actually paid,” would amend Item 402 of Regulation S-K by adding new Item 402(v). This would require most reporting companies to include a new “pay-versus-performance table” in any proxy and information statements for which executive compensation disclosure under Item 402 is required.
For each of the last five completed fiscal years (three years in the case of a smaller reporting company), the pay-versus-performance table would include columns presented in the following order:
- total compensation of the company’s principal executive officer (generally the CEO) as reported in the Summary Compensation Table (the SCT)
- compensation “actually paid” to the principal executive officer, with footnote disclosure detailing each adjustment made to total compensation as reported in the SCT for purposes of calculating the amount “actually paid”
- average total compensation of the company’s named executive officers other than the principal executive officer (the Other NEOs”), based on total compensation amounts reported in the SCT
- average compensation “actually paid” to the company’s Other NEOs, with footnote disclosure detailing each adjustment made to reported total compensation for purposes of calculating the amount “actually paid”
- company’s cumulative total shareholder return (TSR), which would constitute “financial performance” for purposes of the proposed rules, using the same definition of and methodology for calculating TSR set forth in Item 201(e) of Regulation S-K that is used for preparing the stock performance graph required included in the company’s annual report
- cumulative TSR of the company’s peer group (not required for smaller reporting companies), using either (i) the same peer group presented in the annual report stock performance graph or (ii) the peer group reported in the Compensation Discussion and Analysis (CD&A) for purposes of disclosing executive compensation benchmarking practices, including the identity of the issuers comprising the group if the selected peer group is not a published line of business or industry index
The SEC was aware that interest in pay-for-performance disclosure has historically been focused on the compensation of the CEO, but concluded that it was bound by Dodd Frank to address the Other NEOs. It has proposed using the average Other NEO compensation in order to minimize the extent of additional disclosure and reduce variability due to changes in the identities of, and numbers of, Other NEOs from year to year.
The proposed rules would also require, immediately following the foregoing table, narrative and/or graphical disclosure that would clearly describe in plain English, for each year covered, the relationship between (i) compensation “actually paid” to the principal executive officer and the Other NEOs and (ii) the cumulative TSR of the company, as well as a comparison of the cumulative TSR of the company to that of its selected peer group. The proposed rules would allow the company the flexibility to determine the most effective way of presenting these additional narrative disclosures. Disclosure could include, for example, a graph providing executive compensation actually paid and change in TSR on parallel axes, plotting compensation and TSR over the required time period. Alternatively, disclosure of the relationship could include showing the percentage change year over year in both executive compensation actually paid and TSR, together with a brief discussion of that relationship.
Companies may choose to supplement the disclosure required by proposed Item 402(v) by providing pay-versus-performance disclosure based on another appropriate measure of financial performance, such as “realized pay” or “realizable pay,” if they believe it provides useful information about the relationship between compensation and the registrant’s performance as long as the supplemental disclosure is not misleading and not presented more prominently than the required disclosure.
Calculation of “Actually Paid” Compensation
Compensation that is “actually paid” to a named executive officer, or “executive compensation actually paid,” would be equal to the individual’s total compensation as reported in the SCT, adjusted to account for amounts included that are specifically attributable to pension benefits and equity award valuations in order to more accurately capture compensation actually paid to the named executive officer in the applicable fiscal year.
Specifically, reported total compensation as set forth in the SCT would be adjusted to: (i) deduct the reported change, if any, in the actuarial present value of accumulated benefits under defined benefit and pension plans (column h of the SCT) based on changes in interest rates, executive age, and other actuarial inputs and assumptions (which may introduce significant volatility into this measure); (ii) add back the actuarial present value of service costs for services rendered in the applicable fiscal year (not required for smaller reporting companies); and (iii) replace the reported grant date fair values of option and restricted stock awards (columns e and f of the SCT) with vesting date fair values of option and restricted stock awards, if any, for which vesting conditions were satisfied during the applicable fiscal year, computed in accordance with the Financial Accounting Standards Board Accounting Standards Codification Topic 718, thereby treating equity awards as “actually paid” on the date of vesting.
The proposed rule provides that the term “executive compensation actually paid” should include all compensation actually paid, regardless of whether the compensation is awarded based on the registrant’s financial performance. Accordingly, other compensatory amounts included in total compensation as reported in the SCT, such as incremental amounts triggered from a termination of employment or change of control payments during the financial year, perquisites, signing bonuses, etc. would not be excluded in determining the amount “actually paid.” As a result, inclusion of these non-performance based compensation amounts may affect the comparability of yearly amounts and add a degree of variability to the analysis, potentially necessitating further explanatory disclosure, as many of such items result from unusual events or changes in NEOs.
When and Where the Disclosure is Required
The additional disclosures described above would be required in any proxy and information statements for which executive compensation disclosure under Item 402 of Regulation S-K is required. Accordingly, the proposed disclosure would be required in proxy and information statements for meetings at which directors are to be elected or shareholder approval is sought for any bonus, profit sharing, pension or retirement plan, or other contract or arrangement in which a director, nominee or executive officer will participate, or the granting or extension to such persons of options, warrants or rights to purchase securities on a pro-rata basis. The proposed rules, however, would not require the pay-for-performance disclosures in a company’s Form 10-K or registration statements filed pursuant to the U.S. Securities Act of 1933, as amended, and would not be deemed to be incorporated by reference into its periodic reports or registration statements except to the extent specifically incorporated by reference.
The proposed rules do not require a specific location within the proxy or information statement for this new disclosure. While the disclosure item is related to the CD&A because it would show the historical relationship between executive pay and registrant financial performance, and may provide a useful point of comparison for the analysis provided in the CD&A, the SEC noted that including this disclosure in the CD&A might suggest that the company considered the disclosed pay-versus-performance relationship in its compensation decisions, which may not be the case. Thus, the proposed rules provide flexibility for companies in determining where in the proxy or information statement to provide the disclosure required by proposed Item 402(v).
Transition Period for Compliance
Following the adoption of this proposal, companies subject to the rules would be afforded a transition period for compliance, with the initial proxy or information statement to include three years (instead of five) of disclosure, with an additional year of disclosure to be included in each of the next two proxy or information statements for which executive compensation is required. A newly reporting registrant would be required to provide the pay-versus-performance disclosure for only the most recently completed fiscal year in any proxy or information statement in its first year as a reporting company, and in the two most recently completed fiscal years in any proxy statement or information statement in its second year as a reporting company. This treatment is consistent with the phase-in period for new reporting companies in their SCT. For smaller reporting companies, the initial proxy or information statement would be required to include two years of disclosure and an additional year of disclosure would be required in the following year.
To facilitate analysis over time and comparison across companies, the pay-versus-performance table, accompanying footnotes and narrative or graphical disclosures described above would be required to be tagged and electronically formatted using eXtensible Business Reporting Language (XBRL). Additionally, the interactive data files would need to be included as an exhibit to the proxy or information statement filed with the SEC. The XBRL file would not be required for small reporting companies.
Generally, gathering the numerical disclosures that would be required under the proposed rules will, for the most part, involve adapting and repackaging information that has already been gathered and used for other reporting purposes. However, companies should be aware that it may be challenging to provide narrative disclosure about the relationship between compensation “actually paid” and “financial performance,” as well as the comparison of the company’s TSR to that of its peer group. This may be especially important where, for example, the company’s compensation practices focus on performance factors that are not readily translated into or comparable to short-term changes in stock price or where certain compensation philosophies or strategies differ from that of other members of its peer group. Companies may want to begin preparing for implementation of the proposed rules as there is a possibility that the rules could become effective for the 2016 proxy season.
The comment period on the proposed rule ends 60 days after the proposing release is published in the Federal Register.
For further details, see the SEC Release No. 34-74835.
This Osler Update is for general informational purposes only and is not to be construed as legal advice. Please contact the authors of this Osler Update if you wish to assess the impact of these developments on your specific circumstances.