It's been almost 12 years since Dodd-Frank mandated, in Section 953(a), so-called pay-versus-performance disclosure, but amazingly, no rules have yet been adopted to implement that mandate. Even more amazing, the SEC is still working on it. As expected, on Thursday last week, the SEC announced that it had reopened the comment period on rules, originally proposed in 2015, that would require disclosure of information reflecting the relationship between executive compensation actually paid by a company and the company's financial performance. The reopening of the proposal is due in part "to certain developments since 2015 when the proposing release was issued," particularly, "developments in executive compensation practices." Here is the SEC's original proposing release, fact sheet and the proposal reopening the comment period. According to SEC Chair Gary Gensler in his statement on the reopening of the proposal, "this proposed rule would strengthen the transparency and quality of executive compensation disclosure....The Commission has long recognized the value of information on executive compensation to investors." The questions posed by the SEC in the notice (discussed below) give us some insight into where the SEC may be headed with the proposal. In particular, as noted by Gensler, the 2015 proposal "relied upon total shareholder return as the sole measure of financial performance. Some commenters expressed concerns that total shareholder return would provide an incomplete picture of performance. In this reopening release, we are considering whether additional performance metrics would better reflect Congress's intention in the Dodd-Frank Act and would provide shareholders with information they need to evaluate a company's executive compensation policies." The public comment period will be open for 30 days following publication of the release in the Federal Register.
Summary of the Original Proposed Rules
You may recall that Section 953(a) of Dodd-Frank required the SEC to adopt rules requiring disclosure of information showing the relationship between executive compensation actually paid and the financial performance of the company, taking into account any change in the value of the company's shares and dividends and distributions. As originally proposed, the rules would amend Reg S-K Section 402 to add Section (v), which would require tabular disclosure of compensation "actually paid" to the principal executive officer and an average of the compensation actually paid to the other named executive officers for a phased-in five-year period. The proposed new section would also require companies to describe, in narrative or graphic form or both, the relationship of the compensation actually paid to the company's financial performance as reflected in its total shareholder return and to describe the relationship of the company's TSR to the TSR of a peer group. (See this PubCo post and this Cooley Alert.) The disclosure would be required in any proxy or information statement for which disclosure under Item 402 of Reg S-K was required and would be subject to the advisory say-on-pay vote. However, the disclosure would not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that a company specifically incorporated it by reference. The proposal also required that the disclosure be data-tagged using XBRL.
Pay-versus-performance table. The proposed rules would require tabular disclosure of "total compensation" as shown in the company's Summary Compensation Table, as well as a new measure of "compensation actually paid," for a phased-in five-year period. The company would be required to show these data separately for the principal executive officer and as an average for the other named executive officers. Compensation actually paid would use the total compensation measure included in the SCT, with adjustments to the amounts disclosed for pension benefits and equity awards.
- Pension benefits. For purposes of the calculation of pension benefits actually paid, under defined benefit and actuarial pension plans, only the actuarial present value of benefits attributable to services rendered during the applicable fiscal year would be included.
- Equity awards. For purposes of the calculation of compensation actually paid, equity awards would be considered actually paid on the date of vesting and would be valued at fair value as of that date.
- Footnotes to the table. Companies would be required to disclose in the footnotes the individual adjustments to the amounts reported in the SCT to arrive at compensation actually paid, and, for NEOs other than the PEO, those adjustments would be disclosed as averages.
As originally proposed, companies would be required to use TSR to reflect their financial performance over a phased-in five-year period (three years for smaller reporting companies). Companies, other than SRCs, would also be required to disclose peer group TSR, weighted according to market cap and using the same index or peer group used for purposes of the "performance graph" under Reg S-K, Item 201(e), or, if applicable, the companies disclosed in the CD&A for purposes of disclosing the company's compensation "benchmarking" practices. If the peer group were not a published industry or line-of-business index, the composition of the peer group would need to be disclosed or incorporated by reference from prior filings. TSR would be calculated in the same way that it was calculated for the performance graph, which assumes dividend reinvestment.
SideBar
In connection with the original proposal, the SEC had contended that using TSR as a measure of financial performance was advantageous because it was objectively determinable from share prices. Moreover, the SEC maintained, using TSR should increase the comparability across companies and reduce burdens on companies and shareholders because companies were already required to determine TSR and shareholders were already familiar with it. However, then-Commissioners Daniel Gallagher and Michael Piwowar, who dissented on the proposal, were dubious that TSR would be an appropriate measure for all companies, and, in her public statement, even then-SEC Chair Mary Jo White requested comment on whether TSR was the optimal measure to use here. The two dissenters viewed a stock price metric as potentially inaccurate, insufficiently nuanced and subject to potential "gaming" by management through conducting stock buybacks, cutting R&D spending to inflate profits and other timing strategies, resulting in an overemphasis on short-term performance to the detriment of long-term performance. Gallagher also argued at the time that TSR was just not an accurate measure: "a simple TSR-based comparison is likely to produce an excessive number of false positives. It will show companies where pay seems to be out of alignment with performance, based on this simplistic metric, but where a more nuanced evaluation would show that pay is actually well-aligned with performance." He worried that less sophisticated investors could end up being misled by the disclosure. His answer was that the SEC should just admit that it does not have a single answer for this issue and allow companies the flexibility to satisfy the requirement however they choose, so long as they complied with the statute. (See this PubCo post.)
Those views were largely echoed by critics of reliance on TSR from both ends of the political spectrum. In addition to concerns regarding possible manipulation of stock price, some critics argued that TSR was not an appropriate measure because it varied for reasons that were well beyond the control or influence of the company's executives, including factors such as central bank policies, macroeconomics and global politics. In addition, critics suggested that stock price-based metrics could mask a decline in a company's economic value. A more accurate performance measure, some critics contended, would be economic profit, i.e., net operating profit minus a capital charge for invested capital. (See this PubCo post.) A letter from Public Citizen cited in the SEC's original proposing release recommended the use of four performance measures: total shareholder return, return on assets, return on equity and growth in EPS. And former NYT columnist Gretchen Morgenson contended that metrics such as TSR were problematic because they left out "a wide array of measures that better capture whether a company's management is operating in the interests of investors with a long-term horizon." In addition, it "allows top executives to reap the pay benefits associated with a short-term bullish stock market, which may have nothing to do with their company's specific business or operations...." In fact, her column contended, perhaps most importantly, that TSR "can rise even after a company has shown an economic loss—a negative return on capital—over an extended period. A focus on stock price, therefore, can mask a longer-term decline in a company's financial footing." (See this Cooley news brief.)
Companies would be permitted to supplement the required disclosure by providing measures of "realized pay," "realizable pay" or other appropriate measures of compensation paid, as well as supplemental measures of financial performance, so long as any additional disclosure was clearly identified, not misleading and not presented with greater prominence than the required disclosure.
Description of relationship of compensation to performance. Following the table, the proposed rules would also require a description, in narrative or graphic form or both, of the relationship of compensation actually paid to executives as shown in the table compared to the company's financial performance as reflected in its TSR, as well as a description of the relationship of the company's TSR to the TSR of the peer group.
Application to certain companies. In addition to reduced reporting periods (discussed above), smaller reporting companies would also be subject to scaled disclosure. Because they do not disclose pension amounts in the SCT, smaller reporting companies would not be required to disclose amounts related to pensions for purposes of calculating compensation actually paid. Similarly, because they are not required to present a performance graph or a CD&A, they would not be required to include peer group TSR in the pay-versus-performance table. The SEC proposed applying the rule to all reporting companies except foreign private issuers, registered investment companies and emerging growth companies.
SideBar
The original proposal drew the ire of two dissenting then-commissioners, Daniel Gallagher and Michael Piwowar, both of whom rejected the proposal largely because they viewed it as too prescriptive, and particularly because of its prescription to use TSR as the financial performance metric, as discussed above. Both dissenting Commissioners would have much preferred a principles-based version of the rule. Commissioner Gallagher's preferred alternative, as expressed at the open meeting to consider the proposal, was "to admit that we have not solved the very difficult question of how to align executive pay with performance. Perhaps because we shouldn't be involved in that determination in the first place. But if we are forced to take it on, then we should give issuers the flexibility to determine how best to communicate their compensation story to investors, provided they meet the general principles set out in the statute." Gallagher also objected to the requirement for compensation data for NEOs other than the PEO. He argued that PEOs set the tone for compensation and that the other data was unnecessary. Both dissenters also objected to requiring that the rules apply at all to smaller reporting companies.
Current Commissioner Hester Peirce dissented on the reopening proposal for similar reasons, likewise arguing for more flexibility in the proposal. While she agreed that the proposal should be reopened, she did not agree with the approach taken:
"Instead of fixing critical shortcomings of the 2015 Proposing Release, the re-opening release doubles down on a flawed proposal and raises the prospect of additional disclosure requirements. These supplemental requirements would increase the burdens of public company reporting, but seem likely to be of dubious use to investors. The re-opening release recognizes at some level that more discretion and flexibility is needed than the 2015 Proposing Release afforded, but that recognition oddly manifests itself in a flurry of new prescriptions. The additional requirements raised in this release go well beyond the statutory mandate of Section 953(a), are not responsive to the comment file, and do not seem warranted in light of current executive compensation practices related to company performance."
In her statement on the reopening, Commissioner Allison Herren Lee observed that financial incentives
"drive how executives perform in their role as fiduciaries to companies and their shareholders. Understanding what those incentives are and whether they are actually working—that is, if and how they link to company performance—is critical for investors in evaluating a company's compensation practices. The Dodd-Frank mandate for a rule requiring companies to disclose the relationship between executive compensation actually paid and the financial performance of the company is among the most useful, straightforward, and commonsense provisions in that law."
In the years since Congress imposed the mandate, she said, "executive compensation—and the gap between pay for executives and everyday workers—has grown tremendously. Investors need to understand if that growth is concomitant with the value created. In other words, are shareholders getting their money's worth? That question, central to good corporate governance, is what this proposed disclosure seeks to address." In this context, she cited a study showing "average annual CEO compensation increasing from 2009 to 2020 by 130.3 percent, and the CEO-to-worker pay ratio increasing during the same time period by 97.7 percent." She also noted that a number of companies now incorporate performance metrics related to ESG, and it would be helpful to learn whether the increased flexibility contemplated in the reopening release would facilitate investor analysis of the use of these metrics. In addition, she sought comment on whether scaled reporting for SRCs, included in the original proposal, should be retained or recalibrated given the expansion of the definition of SRC to apply to 45% of all reporting companies.
Similarly, Commissioner Caroline Crenshaw encouraged comments on the use of ESG measures in comp packages, including "whether there is sufficient insight into the methodologies behind the measures on which ESG compensation targets are based. Separately, similar questions arise about the use of targets based on measures of performance with qualitative or discretionary inputs...." She also sought input on whether to scope in SRCs.
Requests for Public Comment
In the release, the SEC requested comment on a number of specific areas, which seem to be a pretty good indication of where it may be going on this proposal. Notably, the majority of questions relate to different types of performance metrics.
Additional performance measures. The release observes that, as noted above, the SEC selected TSR as the performance measure because it could be consistently calculated, could increase comparability, was objectively determinable and already required to be calculated. Now, however, in light of concerns by commenters on the original proposal, the SEC is looking at additional performance metrics beyond just total shareholder return.
In particular, the SEC is now considering requiring disclosure in the table (and in the related discussion) of three additional measures: pre-tax net income, net income and a measure selected by, and specific to, the company. The first two are GAAP measures that the SEC believes "are additional important measures of company financial performance that may be relevant to investors in evaluating executive compensation" and may reduce the burden of analysis for investors. The third measure—the company-selected measure—would represent, in the company's determination, "the most important performance measure (that is not already included in the table) used by the registrant to link compensation actually paid during the fiscal year to company performance, over the time horizon of the disclosure." The SEC believes that this measure could elicit "additional useful disclosure" while reducing the risk raised by commenters of misrepresentation that could result from application of the "one size fits all" benchmark. A note to the release cites a staff review of the CD&As of around 20 of the largest Fortune 500 companies, which identified "over 100 unique performance measures, almost all of which were company-specific or adjusted measures."
The SEC is also considering whether to require companies to list, in tabular format, "their five most important performance measures used by the registrant to link compensation actually paid during the fiscal year to company performance, over the time horizon of the disclosure, in order of importance." This concept may have been designed to be responsive to commenters who suggested that companies identify, "in addition to TSR, the quantitative metrics or key performance targets companies actually use to set executive pay." Although some of this information may otherwise be included in CD&A, the SEC believes that identifying the "performance measures that drove recent compensation actually paid may help address concerns that using only TSR may mislead investors or provide an incomplete picture of performance."
In its request for comment, the SEC asks whether companies should be required to disclose pre-tax net income and net income in addition to TSR. Specifically, would inclusion of these measures alleviate concerns previously raised by commenters about using only TSR or would it overly complicate the disclosure limiting its usefulness? Should companies also be required to discuss these measures? Or should the SEC be more flexible and, instead of requiring additional financial performance measures, allow companies to elect to disclose those measures if they believed that disclosure would be beneficial for them? Are there other measures that should be required?
The SEC also requested comment on whether mandated disclosure of a company-selected measure would be useful to investors. Should the SEC use a different definition for the company-selected measure? For example, should it be defined as "the most important measure used by the registrant in a performance or market condition in the context of an incentive plan"? Should it relate only to financial performance or could it relate to any measure that could be disclosed in CD&A, such as ESG metrics? What computations or considerations would be required to determine the measure and should companies be required to disclose the methodology? Should the SEC define "most important," and, if so, how? In addition, what "disclosure should be required if different measures are important in different years or if different measures determine compensation actually paid for the different NEOs"? Would aggregating the NEOs for purposes of determining the most important measure be difficult? Should "most important" instead be determined only by reference to the CEO? Should the same measure be required for all years in the table or could it change from year to year, in which case, should disclosure be required for all of the company-selected measures identified in the table?
Similar questions are raised with regard to determining the five most important performance measures. However, the SEC also asks whether it should "either in addition to or in lieu of the Proposed Rules and the disclosure of the additional measures we are considering, revise Item 402 of Regulation S-K to explicitly require registrants to disclose all of the performance measures that actually determine NEO compensation?"
The SEC also inquired whether it should require the use of Inline XBRL rather than XBRL to tag the proposed new disclosures.
SRCs. The SEC is also considering how the proposal should apply to SRCs. The SEC had proposed permitting SRCs to provide scaled disclosure, such as omission of peer group TSR. Pre-tax net income and net income are already required under GAAP; should the SEC require disclosure for SRCs about pre-tax net income or net income, or would other measures be more useful? SRCs are not required to provide a CD&A, making disclosure of a company-selected measure and a list of their five most important performance measures new disclosure obligations. Nevertheless, these measures "are by definition measures that the company already uses to link compensation actually paid to financial performance." The SEC seeks comment on whether it should require SRCs to include disclosure about those measures? As noted above, about 45% companies subject to the proposal would be SRCs, compared to about 40% in 2015 when the proposal was originally released. The SEC asks whether it should reconsider applying the scaled requirements to SRCs altogether.
Commenters. The SEC noted that some commenters observed that "the definition of compensation actually paid may result in some misalignment between the time period to which pay is attributed and the time period in which the associated performance is reported, but they generally disagreed on whether and how to revise the definition to improve such alignment." The SEC inquires whether there is an alternative approach that would reduce the risk of misalignment? Commenters also advised that the pension benefits calculation and the calculation of the fair value of options at the vesting date would be challenging. The SEC asks whether there is "an alternative measure of the change in pension value attributable to the applicable fiscal year that is better representative of the 'actually paid' amount of pension benefits for an executive and would reduce the burden of computing compensation actually paid while preserving the benefits of the measure for investors?" Similarly, the SEC asks whether there were ways to mitigate the challenges associated with the option value calculation. Commenters also questioned which time periods should be disclosed in the TSR portions of the table. The SEC asked whether and how it should clarify the time periods.
Other changes. Finally, the SEC asked whether there were any other developments (including with respect to executive compensation practices) since the release of the proposal that could have some impact on the proposal, such as changes in qualitative measures in executive comp packages, developments in ESG-related comp metrics, changes in market practices with respect to disclosures or changes in "the methodologies and estimates used to analyze the economic effects"?
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