United States: SEC ‘pay versus performance’ rule imposes significant new disclosure requirements beginning 2023

In brief

On 25 August 2022, the Securities and Exchange Commission (SEC) released a final rule in the form of new Item 402(v) of Regulation S-K that seeks to shine an ever-brighter spotlight on the link between executive pay and company performance at certain US public companies.

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Overview

Beginning with any proxy statement or information statement filed for fiscal years ending on or after 16 December 2022 (i.e., the 2023 proxy season for calendar year companies), reporting companies (except foreign private issuers, registered investment companies and emerging growth companies) will need to provide a new pay versus performance table accompanied by a narrative and/or graphical explanation of the relationship between executive compensation ‘actually paid’ to the company’s named executive officers and the company’s financial performance, generally for the five most recently completed fiscal years,¹ with scaled disclosures for smaller reporting companies. Item 402(v) disclosure will be treated as ‘filed’ for purposes of the Securities Exchange Act of 1934 and will be subject to the say-on-pay advisory vote under Securities Exchange Act Rule 14a-21(a).

Background

 The Dodd-Frank Wall Street Reform and Consumer Protection Act called on the SEC to adopt final rules to implement a pay versus performance proxy disclosure requirement. In response, the SEC proposed rules on pay for performance in 2015, and seven years later the SEC issued the final rules, on 25 August 2022, by a 3-2 vote.² The final rules adopt a prescriptive approach to providing the requisite disclosure in a consistent format, rather than a more principles-based approach.

New Pay Versus Performance Table

Under Item 402(v) of Regulation S-K, companies will need to disclose the following information in a new table: 

I. Summary Compensation Table Compensation Information. The total compensation for the Principal Executive Officer (PEO) and the average of total compensation for the remaining Named Executive Officers (NEOs) as reported in the Summary Compensation Table. If there is more than one PEO during a fiscal year, separate disclosure is required for each PEO. 

II. Executive Compensation Actually Paid. The “executive compensation actually paid” for the PEO and the average of the “executive compensation actually paid” for the other NEOs. The definition of “executive compensation actually paid” for a fiscal year generally refers to the total compensation as reported in the Summary Compensation Table adjusted as follows: 

A. For all defined benefit and actuarial pension plans:  

• Deduct the change in the actuarial present value of all defined benefit and actuarial pension plan benefits as reported in the Summary Compensation Table for the applicable fiscal year. 

• Add the sum of (i) the actuarially determined service cost for services rendered by the executive during the fiscal year and (ii) in the case of any plan amendment or newly adopted plan during the fiscal year, the prior service cost, which refers to the entire cost of benefits granted (or credit for benefits reduced) pursuant to the amendment or newly adopted plan that is attributed by the plan’s benefit formula to services rendered in periods prior to the amendment or adoption. 

B. For equity awards: 

• Deduct the grant date fair value of equity awards as reported in the Summary Compensation Table for the applicable fiscal year. 

• For equity awards granted in fiscal years prior to the applicable fiscal year, add (or subtract) (i) the change in fair value of awards that are outstanding as of the end of the applicable fiscal year end compared to the end of the prior fiscal year and (ii) the change in fair value of equity awards that vested during the fiscal year as of the vesting date compared to the end of the prior fiscal year, and subtract the fair value as the end of the prior fiscal year of any equity awards that failed to vest during the applicable fiscal year. 

• For equity awards granted during the applicable fiscal year, add the fair value of as of the end of the year (or as of the vesting date if the award vested during the year) and disregard any award that is both granted and forfeited during the year. 

• If dividends are not reflected in the fair value of an equity award as disclosed in the Summary Compensation Table, add the dollar value of any dividends or other earnings paid on equity awards during the applicable fiscal year prior to the vesting date. 

III. Financial Performance Measures. The following financial performance measures, must be included in the disclosure: 

A. The company’s cumulative total shareholder return (TSR) and peer group³ cumulative TSR for each of the fiscal years covered by the table, starting with the earliest fiscal year included in the table through the end of the applicable fiscal year 

B. The company’s net income

C. A ‘company-selected’ financial measure (other than TSR or net income) that the company determines represents the most important financial performance measure it uses to link compensation actually paid to the NEOs to company performance for the most recently completed fiscal year⁴

The new reporting table format will be as follows:

Other Disclosure Requirements

• Explanation of the Relationship Between Compensation and Performance. In addition to the table, the final rules require a clear description (in narrative or graphical format) of the relationship between each financial performance measure (TSR, peer group TSR, net income and the company-selected measure) and the compensation actually paid to the PEO and to the other NEOs over the company’s five most recently completed fiscal years. A description of the relationship between the company’s TSR and the peer group TSR must also be included. 
• Tabular List of Performance Measures. The final rules also require a tabular list of three to seven performance measures (including the company-selected measure) that the company determines are its most important measures to link pay and performance, which may include non-financial measures if considered to be among the most important measures (but only if at least three financial measures are included). The tabular list does not have to be ordered or ranked.  
• XBRL Tagging. Companies will be required to use Inline XBRL to tag their pay versus performance disclosure.

Smaller Reporting Companies

Smaller reporting companies are subject to the following scaled executive compensation disclosure requirements:   

• Generally required to provide three years of pay versus performance disclosure, instead of five (or two years of disclosure for the first filing, instead of three)
• Do not have to disclose pension-related amounts in executive compensation actually paid
• Do not have to disclose peer group TSR or a company-selected measure 
• Do not have to provide a tabular list of financial performance measures
• Do not have to provide Inline XBRL tagging until the third filing in which the pay-versus-performance disclosure is made (instead of the first)

Next Steps

Given these heightened disclosure requirements, covered reporting companies should begin consulting legal, accounting and compensation advisors to ensure they have developed systems and procedures to collect relevant information and comply with the rules of Item 402(v) of Regulation S-K for the upcoming proxy season. For example, companies will need to (i) have systems in place to calculate year-end and vesting date fair values of equity awards and the applicable annual service cost of defined benefit and pension plans for purposes of reporting compensation ‘actually paid’, (ii) determine their peer group for purposes of calculating cumulative peer group TSR, (iii) determine the measure that will be disclosed as the company-selected measure and the additional tabular list of three to seven ‘most important’ performance measures, and (iv) assess the narrative and/or graphical disclosure about the relationship between executive compensation ‘actually paid’ to the company’s NEOs and the company’s financial performance and between the company’s TSR performance compared to that of its selected peer group. Given that the new rules will apply for fiscal years ending on or after 16 December 2022, there is no time like the present to get started.
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¹Under the transition rules, this data is required for three years, rather than five, for the first filing in which the reporting company provides these disclosures, adding one additional year in each of the subsequent two years.
²The Chair of the SEC and the two concurring SEC Commissioners praised the final rule as promoting transparency and accountability to investors. However, the two dissenting SEC Commissioners criticized the final rule as requiring ‘costly, complicated, disclosure of questionable utility’, taking ‘a sweeping and complex prescriptive approach that is not required under the statute’, and using a ‘stale’ economic analysis prepared under the SEC’s 2015 proposed rule (essentially comparing 2015 apples to 2022 oranges) in violation of the Administrative Procedure Act.
³The peer group must be either the peer group used for purposes of the Performance Graph required by Item 201(e) of Regulation S-K or the peer group used in any CD&A disclosure of benchmarking practices. 
⁴If the company-selected measure is a non-GAAP measure, disclosure must be provided as to how the number is calculated from the company’s audited financial statements, but a full reconciliation is not required.