FAQs on the SEC’s Pay vs. Performance Disclosure Rule A Deeper Dive

Below we answered several common questions that have arisen as companies prepare for the Pay vs. Performance Disclosure (PvP) requirements.

Peer Groups

1. What factors go into selecting a peer group?
   • The new PvP rules require disclosure of both company TSR and “peer group” TSR in the table, along with a description of the relationship between the company’s TSR and that of its peer group. For these purposes, companies may look to either (1) the industry comparators/index used in the 10-K performance graph or (2) the proxy-disclosed peer group used to disclose benchmarking practices.
   • Interestingly, the SEC has informally indicated that the compensation peer group may only be used if the company uses the peer group for “true benchmarking” rather than as only one factor in making pay decisions. If the SEC issues formal guidance on this point, using the compensation peer group may become undesirable for most companies.
   • Considering the above as well as the disclosure implications of year over year peer group changes (see below), in our experience to date, companies are almost exclusively looking to the 10-K performance peer group. With this in mind, we’d recommend taking a closer look at this year’s 10-K peer group to ensure it is correct, making any changes in advance of the first PVP proxy disclosure.
2. What should companies do if peer groups change year over year (if using something like the compensation peer group)?
   • Under the PvP rules, changes in peer groups YoY must be reflected and explained in footnote disclosure to the PVP table. TSR comparison to the prior peer group must be provided in addition to the new peer group disclosure. What’s unclear under the rules is whether minor changes to the peer group–for example, in the event of a peer acquisition or similar transaction–will need to be disclosed and the extent of such disclosure. As noted above, this may be another reason companies gravitate toward using an index disclosed in the 10-K.

Table Columns

1. What disclosure is required when there are multiple CEOs in the same year?
   • In cases where a company’s CEO retires or is terminated mid-year, the company will be required to include separate columns in the PVP table for each CEO (for a total of four CEO columns).
   • For years included in the table where the company had only one CEO, the additional columns will be empty.

Foot Notes

1. What do we need to know about the footnotes to the PVP table?
   • While the PVP table and the calculations involved have received significant focus and attention, the rules also require extensive footnote disclosure, particularly around reconciling the Summary Compensation Table compensation with “CAP” numbers. The rules do not prescribe any specific form for this reconciliation; however, many companies may choose to include tabular footnote disclosure detailing amounts added to and subtracted from Summary Compensation Table compensation. For NEOs other than the PEO, this reconciliation will be on an average basis, which may introduce additional complexity in certain scenarios.
2. What footnote disclosure depth is required regarding PSU interim performance?
   • In addition to requiring a reconciliation of SCT and CAP numbers, the PVP rules also require that any difference in assumptions used for equity award valuation for calculating SCT compensation and CAP be disclosed. Interestingly, in the case of PSUs, this may have the effect of disclosing additional detail about where PSU performance is tracking that is not disclosed elsewhere in the proxy statement. Grant date fair value—used for SCT calculations—typically assumes target performance, while year-end fair value—used for CAP calculations—will reflect updated performance expectations. It’s not yet clear, however, to what extent specific disclosure detailing the performance expectations used to determine fair value for the CAP calculations is necessary.

Company-Selected Measure (CSM)

1. Can non-GAPP metrics be used as a CSM, and if so, is reconciliation to GAAP metrics required?
   • The CSM to be included in the PVP table must be a financial performance metric but may be a GAAP or a non-GAAP metric. If the CSM is a non-GAAP measure, the company must describe how the number is calculated from the audited financial statements (consistent with the requirement when target levels of non-GAAP financial metrics are disclosed in the CD&A).
   • Non-financial measures like number of accounts or ESG-related measures are not allowed in the table, even as an extra measure. Additional tabular disclosure in the footnotes is permitted, but we suggest if it’s that important it is included in the CD&A. Non-financial measures may also be included in the additional tabular list of “most important” performance measures (as discussed below).

Additional Measures List

1. What information must be included in the 3-7 supplementary metrics list?
   • Companies are required to disclose a tabular list of 3-7 “most important” performance measures used to link compensation to performance. The list may include non-financial measures as well, where three (or fewer, if the company uses fewer than three financial measures) financial measures have already been included on this list. The requirement is to provide only an unranked list of the measures themselves; the target or actual performance achievement levels need not be disclosed. While the rules do not require companies to disclose the reasons these measures are highlighted or any explanation of how the measures relate to executive compensation, it may be helpful to include a brief explanation.
2. Do companies need to incorporate the most important financial metric (Company-Selected Measure) in the 3-7 measures?
   • Yes- the Company-Selected Measure included in the PVP table must also be included on the 3-7 supplementary metrics list.
3. How many performance metrics will companies likely include in the additional tabular disclosure?
   • While it’s hard to know precisely how many metrics companies will disclose and practice is likely to vary, this list should be consistent with what is already disclosed in the CD&A and investor materials. If metrics have been previously communicated and are not included on this list, investors may question why specific metrics were chosen while others were not. Conversely, if metrics are included on this list and not reflected in the CD&A or other investor materials, that’s likely to raise questions as well. In addition, several shareholders have indicated they will be particularly focused on what metrics companies include on this list. Consistency with your other messaging around key business metrics/measures of success will be important.
4. Are companies likely to disclose non-financial metrics, and if so, what sort of non-financial metrics are likely to be disclosed (e.g., ESG metrics)?
   • As noted above, while best practice has yet to develop, we expect the list disclosed to be consistent with measures disclosed in the CD&A and investor materials, including non-financial metrics.
5. Can the list include more than seven metrics?
   • No, the final rules limit the list to seven metrics. Additional metrics may be referenced in the narrative disclosure or discussed in the CD&A.

Potential Unintended Consequences

Questions have come up regarding scenarios that may give rise to unintended consequences or potentially skewed disclosure, including:

1. Newly public company with NEOs with different vesting schedules (for example, a founder with immediately vested equity and a management team with large grants at IPO with multi-year vesting).
   • In this relatively common scenario for newly public, founder-controlled companies, the PVP disclosure for the CEO and the remaining NEOs will be strikingly different, with the CEO’s award value remaining consistent from the grant date onward and the equity values of the management team fluctuating significantly as stock price fluctuates (and potentially even resulting in negative compensation values for years such as 2022). In this scenario, companies may wish to include additional narrative disclosure providing context for this disparity.
2. Choosing a Company-Selected Measure for pre-revenue biotech or similar companies.
   • Companies such as pre-revenue biotech companies typically do not have compensation programs with incentives that pay out based on financial metrics,
     as they do not have meaningful financial results.
   • Incentives in such cases are largely weighted towards stock options and bonus payouts based on the achievement of clinical milestones. While many of these companies may be either emerging growth companies entirely exempt from PVP requirements
     or smaller reporting companies exempt from the requirement to provide a Company-Selected Measure, some will not fall into either category and will be required to provide a Company-Selected Measure under the rules.
   • However, if the company does not use financial performance measures to link compensation “actually paid” to company performance (or uses only measures disclosed in the table), then the company is not required to disclose a Company-Selected Measure but must disclose this fact.
   • Alternatively, it’s possible that “stock price” as a measure independent from TSR may be included as a “Company-Selected Measure” for companies in this category, subject to additional SEC guidance as to whether the stock price will be viewed as a measure distinct from TSR.
3. More than five NEOs in any given year due to new hires, promotions, retirements or other terminations mid-year.
   • Suppose a company has more than five NEOs in any given year due to terminations or retirements mid-year. In that (common) case, the average NEO compensation may be lower relative to other years (given the larger denominator). This may raise questions, particularly if the average compensation is (artificially) lower in one year, and may be an instance where additional narrative or footnote disclosure explaining the factors driving these numbers will be helpful. Note that this may not be the case in the event the departing NEOs receive severance payments or new hires/promotions receive new hire bonuses or equity grants, in which case average pay may instead be higher for years with mid-year NEO departures and hires.

Future of PVP Disclosure

1. How do we anticipate the PVP disclosure to evolve over the next few years?
   • While our perspectives may evolve as other regulations are instituted, and investor and proxy advisor reactions to public disclosures occur, we expect that most 2023 disclosures will adhere to the “letter of the law” and provide little more. Over the next couple of years, we’re likely to see key metrics converge by industry and best practices for disclosure emerge, with disclosure practices becoming more uniform. We may also see proxy advisors begin to incorporate disclosure and data into their current (or new) quantitative tests and potentially some additional rule clarifications and evolution. Ultimately, we’d expect to see steady state disclosure expectations emerge from stakeholders and companies, with a regular process in place for capturing and disclosing data readily.

View the full article as it was originally published.