SEC Adopts Final Pay Versus Performance Disclosure Rule

On August 25, 2022, the SEC adopted a final rule implementing a provision of the Dodd-Frank Act of 2010 requiring public companies to provide clear disclosure of the relationship between executive compensation and company financial performance. Notably, the rule departs from the general trend toward “principles-based disclosure” rulemaking, requiring companies to provide new tabular and other prescribed disclosures beginning with the 2023 proxy season.

Key Takeaways:

The new rule generally:

• requires tabular presentation of executive compensation and financial performance for the five most recently completed fiscal years (or shorter period described below);
• requires a “clear description” of the relationship between the compensation and financial measures presented, including prescribed tabular disclosures;
• enhances the disclosure that will factor into the “Say-on-Pay” vote;
• applies to all reporting companies other than emerging growth companies, foreign private issuers, and registered investment companies; and
• permits scaled disclosure for smaller reporting companies (“SRCs”).

Timing and Disclosure Requirements:

Companies must begin to comply with the final rule for proxy and information statements that are required to include executive compensation disclosures for fiscal years ending on or after December 16, 2022.

Required tabular disclosure includes, for the principal executive officer (“PEO”) and, as an average, for the other named executive officers:

• total compensation (obtained from the “Summary Compensation Table” required under Item 402 of Regulation S-K); and
• an adjusted measure reflecting “executive compensation actually paid.”

Required tabular disclosure of financial performance measures includes:

• cumulative total shareholder return;
• cumulative peer group total shareholder return;
• net income (loss); and
• a “Company-Selected Measure” that, in the company’s assessment, represents the most important financial performance measure linking “executive compensation actually paid” to company performance for the most recently completed fiscal year. While this measure (and any other measure presented in the new table) is not subject to the non-GAAP financial measure presentation rules, companies must still disclose how the applicable measure is calculated from the audited financial statements.^[1]

As a supplement to the table, companies must provide a clear description of the relationship between “executive compensation actually paid” and each of the financial performance measures for the fiscal years presented. Companies must also provide a clear description of the relationship between a company’s total shareholder return and that of its peer group. Such descriptions may be provided graphically, narratively, or in combination.

Companies must also provide a “Tabular List” of three to seven financial performance measures that the company has identified as the most important financial performance measures linking “executive compensation actually paid” to company performance for the most recently completed fiscal year. The Company-Selected Measure must be selected from this Tabular List.

Exceptions to the “Tabular List” and “Company-Selected Measure” Requirement:

For companies that use fewer than three financial performance measures to link compensation actually paid to their named executive officers, only measures actually used must be included in the Tabular List. Further, the adopting release suggests companies that do not use any financial performance measures to link executive compensation to company performance, or that only use measures already required to be disclosed in the table, are not required to separately provide either the Tabular List or a Company-Selected Measure.

Other Considerations:

Clear Description Standard

In preparing the pay versus performance disclosure, companies should note that the SEC has indicated its “clear description” disclosure standard permits narratives and “tables or other design elements, so long as the design is not misleading and the required information is clear, understandable, consistent with applicable disclosure requirements, consistent with any other included information, and not misleading” and it is consistent with the “clear, concise and understandable disclosure” standard already applying generally throughout Item 402 of Regulation S-K. This standard should provide flexibility for companies to present their pay versus performance disclosure in ways that best present their executive compensation practices in the context of the requirements of the new rule.

Since the new disclosure will factor into the “Say-on-Pay” vote, companies should also consider whether any related disclosures desired by proxy advisory firms should guide or be incorporated in the new pay versus performance disclosure. Companies should also consider how the new disclosure will impact the drafting of the Compensation Disclosure and Analysis (“CD&A”). Companies that have traditionally included, and will continue to include, disclosures discussing the relationship between shareholder return and CEO pay in the CD&A should either seek to be consistent with their CD&A disclosures, include the pay versus performance disclosure as part of their CD&A, or incorporate by reference the pay versus performance disclosure into the CD&A.

Calculation of “Executive Compensation Actually Paid”

Companies should begin evaluating and preparing calculations for the required “executive compensation actually paid” figure, which is derived from a series of adjustments to “total compensation” from the “Summary Compensation Table.” For example, instead of using aggregate grant date fair value of equity awards, the “paid” value of equity awards for a covered fiscal year is calculated as:

• Fair value^[2] (“FV”) at fiscal year-end of all unvested awards granted during the covered fiscal year; plus
• Aggregate change in FV^[3] (positive or negative, since the beginning of the covered fiscal year) of prior year awards that remain unvested at the end of the covered fiscal year; plus
• Vesting date FV for awards granted and vested in the same year; plus
• Aggregate change in FV (positive or negative, since the beginning of the covered fiscal year through the vesting date) of prior year awards which vested during the covered fiscal year; minus
• FV at prior year-end for prior year awards that failed to meet vesting conditions during the covered fiscal year; plus
• Actual value of dividends or other earnings paid on awards not otherwise included in reported total compensation for the covered fiscal year.

Financial Performance Measures

The financial performance measures selected for the pay versus performance disclosure are likely to overlap with the financial performance measures and key performance indicators (“KPIs”) highlighted in earnings releases and the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of periodic reports. However, the rule expressly states the financial performance measures selected “need not be presented within the registrant’s financial statements or otherwise included in a filing with the Commission” and instead should “represent the most important … measures used … to link” executive compensation to financial performance by a company. Consequently, the “Tabular List” measures selected as most important for linking “executive compensation actually paid” to company performance will likely be the measures used by the company to measure performance under annual and long-term incentive plans. However, companies should carefully consider any discrepancies between the various disclosed measures and how such discrepancies might be viewed by investors or the SEC. To the extent companies begin disclosing new financial performance measures in response to the new rule, they will also need to develop and maintain effective disclosure controls and procedures to process information related to the disclosure of such items to ensure consistency and accuracy, consistent with SEC guidance.^[4]

Transitional Relief, SRC Scaled Disclosures and Other Information:

Companies other than SRCs are initially permitted to provide just three years of information, adding another year in each of the two subsequent annual filings.

SRCs are required to provide just three years of information in total, but are initially permitted to provide two years, adding the third year in the subsequent annual filing.

SRCs are also permitted to omit the peer group total shareholder return information, the Company-Selected Measure, and the Tabular List.

Although the new rule is included under Item 402 of Regulation S-K, the pay versus performance disclosure is limited to proxy and information statements and is not required in other filings requiring disclosure under Item 402 (such as Form 10-K and registration statements under the Securities Act of 1933, as amended).

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Please contact one of the listed authors of this article or your regular Orrick contact if you have any questions regarding the Final Pay Versus Performance Disclosure Rule.