September 13, 2022 Executive Compensation Executive & Director Pay Design Articles

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Executive & Director Pay Design

Expansive New Pay vs. Performance Disclosure Requirement

On August 25, 2022, the SEC adopted the final “Pay vs. Performance” rule, requiring companies to compare executive compensation to financial performance over a five-year period. The new rules will be effective for the 2023 proxy season and will require significant planning and preparation.

Background of the Rule

The Pay vs. Performance rule, originally proposed in 2015, implements one of the last remaining open compensation-related items of Dodd-Frank, which directed the SEC to adopt rules clearly disclosing the relationship between executive compensation actually paid and the company’s financial performance. Tabular disclosure of executive compensation relative to specified financial measures and TSR is an entirely new requirement, in addition to the existing compensation tables in the annual proxy statement and the CD&A, which typically describe the pay-for-performance metrics chosen by the company.

Rule Overview

The table in each annual proxy statement must disclose NEO compensation for the five most recent financial years, both as disclosed in the summary compensation table and “compensation actually paid.” The table will separately include the CEO’s compensation and an average of the remaining NEOs’ compensation.

The table will additionally include certain performance disclosure, including total shareholder return for the company and its peers (either the compensation peer group used in the CD&A or the peers or industry index selected for the Performance Graph in the 10-K), the company’s GAAP net income as well as an additional performance measure chosen by the company that it considers the most important in determining compensation.

Additional disclosure providing a “clear description” of the relationships between the compensation actually paid presented in the table and the company’s financial performance, along with a description of the relationship between the company’s TSR and the TSR of its peers, is required as well. Finally, companies must list 3-7 financial performance measures used to link executive compensation to performance for the most recent year. Companies can include non-financial measures (e.g., ESG metrics) if they are among the most important measures. 

Pay vs. Performance Table

As outlined above, the following new table is required: 

  1. Principal Executive Officer (PEO) means the Company’s highest ranking executive officer (e.g., Chief Executive Officer, Managing Director, or Managing Executive Director).

Compensation Actually Paid

Compensation Actually Paid is a misnomer.  The name implies that it is what goes into someone’s pocket.  As defined, Compensation Actually Paid is a combination of cash received, perquisites received, pension benefits earned, the year-end fair value of equity granted during the year, and the change in fair value (at vesting or year-end) of equity that was unvested at the beginning of the year.

Compensation Actually Paid

Rule Implementation and Companies Covered

Disclosure will be included in the upcoming proxy disclosure for public companies with fiscal years ending on or after December 16, 2022, however:

  • Only three years of disclosure will be required in the first proxy filing with an additional year added in each of the following two years
  • Newly public companies will only be required to disclose compensation for years in which they were subject to reporting requirements
  • EGCs are exempt entirely

Potential Implications 

The impact of this extensive new disclosure requirement on executive compensation practices and shareholder relations remains to be seen, particularly in light of the already extensive disclosures included in the CD&A and the proxy advisors’ quantitative and quantitative assessments.

However, the rule presents several implications:

  • Pay and Performance Alignment: May “raise the bar” on pay and performance alignment if it attracts attention externally, particularly from activist shareholders or proxy advisors.
  • Coordination Across Functions & Disclosures: HR, Finance, IR, and Legal will want to ensure consistent messaging on key metrics across platforms.  It will be important to review how pay and performance has been discussed in the CD&A and ensure a coherent linkage to this disclosure.
  • Supplemental Tables: Companies may find benefit in adding supplemental tables to tie different disclosures together and/or offer alternative views.  
  • NEO Pay Prominence: Has potential to result in increased prominence of NEO pay in addition to CEO pay, as all NEOs are included in the analysis.
  • Peer Selection: Increases the importance of selecting peers with relevant performance dynamics if compensation peers are used to compare performance.
  • Investors & Activists: Investors will be looking for the link between and pay and performance in the CD&A and the outcomes of this analysis in the proxy.  Investors will also scrutinize the selected measures; it will be important to cross-reference those measures to measures disclosed in incentive plans, earnings updates and investor days.  Activists will look for vulnerabilities to use in their appeals, such as pay and performance disconnects and potentially large values.
  • Proxy Advisors: Proxy advisors could expand or update their quantitative tests using this data.

Next Steps

Companies should take steps now and over the coming months to prepare for the additional extensive disclosure. They can start by ensuring all necessary parties understand the requirements and key issues. It’s critical to involve the finance team early to gather the required data and run the numbers—including determining the financial measures to disclose, the appropriate peer group, and how they will calculate fair values. Companies should also consider drafting the narrative and evaluating the implications of the disclosure early to provide an opportunity to assess selected incentive measures and peer groups as well as any necessary changes to the CD&A.

View the full article as it was originally published.

Michelle Garrett

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