The U.S. Securities and Exchange Commission (the “SEC”) on August 25, 2022 finalized the “Pay-versus-Performance” disclosure requirements (the “Final Rules”)¹ that originally were proposed on April 29, 2015 (the “Proposed Rules”). The Final Rules will require U.S. public companies to disclose the relationship between the compensation “actually paid” to the company’s named executive officers and the company’s financial performance. The Proposed Rules were discussed in our May 7, 2015 OnPoint.

Key Takeaways

• The Final Rules add new Item 4.02(v) to Regulation S-K and will apply to proxy and information statements for which executive compensation disclosure under Item 402 of Regulation S-K is required for fiscal years ending on or after December 16, 2022. Consequently, the Final Rules will be applicable to the 2023 proxy season.
• The Final Rules require a Pay-versus-Performance disclosure table that differentiates between the principal executive officer (the “PEO”) and other named executive officers (“NEOs”) and shows total compensation, compensation “actually paid” and specified performance metrics for each of the last five completed years.
• The Final Rules also require companies to provide a “clear description” in narrative and/or graphical form of (i) the relationship between executive compensation actually paid to the company’s NEOs and the total shareholder return (“TSR”) of the company and (ii) the relationship between the company’s TSR and the TSR of a peer group chosen by the company over each of the last five completed years.
• The Final Rules significantly diverge from the Proposed Rules in the following ways:
  • For purposes of the Pay-versus-Performance disclosure table, companies will be required to add two new financial performance measures – net income and a “Company-Selected Measure,” and must provide a clear description of the relationships between executive compensation actually paid and these two new measures.
  • Companies now will be required to provide a list of three to seven financial performance measures used to link executive compensation actually paid to the company’s financial performance.
  • Calculation of executive compensation “actually paid” will begin with the total compensation reported in the Summary Compensation Table and be adjusted by the value of certain equity and pension awards in a much more comprehensive fashion than would have been required under the Proposed Rules.
• The Final Rules apply to all U.S. public companies filing proxy or information statements, but will not apply to emerging growth companies, registered investment companies (other than business development companies) or foreign private issuers.
• “Smaller reporting companies” as defined in 17 C.F.R. § 240.12b-2 (“SRCs”) will be subject to reduced disclosure requirements.

DISCUSSION

The Tabular Disclosure Requirement

The Final Rules require the inclusion of a “Pay-versus-Performance” table in all proxy and information statements for which executive compensation disclosure under Item 402 of Regulation S-K is required (the “PvP Table”). The PvP Table requires, for each of the five most recently completed fiscal years (three years, for SRCs and subject to the transition relief discussed below), the following information:

The PvP Table requires disclosure of the compensation “actually paid” to the PEO (column (c)) and the average compensation “actually paid” to the other NEOs as a group (column (e)), in each case, derived (after significant adjustments as discussed below) from the total compensation in the Summary Compensation Table. The PvP Table also requires disclosure of the TSR of the company (column (f)) and its peer group (column (g)) for each of the covered fiscal years. Companies must also report their net income (column (h)) and a Company-Selected Measure (column (i)). The data disclosed in the PvP Table, the footnotes and the relationship disclosures must be embedded inline in interactive data format using machine-readable eXtensible Business Reporting Language (i.e., Inline XBRL).

Compensation “Actually Paid”
The amounts deducted from and added to the total compensation amount in the Summary Compensation Table to arrive at the compensation “actually paid” in columns (c) and (e) of the PvP Table must be discussed in footnotes together with the name of each applicable NEO.

Certain Considerations Relating to Pensions and to Nonqualified Deferred Compensation

The difference between the compensation disclosed in the Summary Compensation Table and the compensation “actually paid” requires a number of pension adjustments, including deducting the aggregate change in the actuarial present value of all defined benefit and actuarial pension plans and adding back the aggregate of (i) the actuarially determined service cost for services rendered by the executive during the applicable fiscal year, and (ii) the entire cost of benefits granted by a plan amendment adopted during the applicable fiscal year that are attributed to services rendered in prior years, in each case, calculated in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”).

Regarding nonqualified deferred compensation, the Final Rules provide that executive compensation “actually paid” includes above-market or preferential earnings on such compensation, whether or not vested.

Equity Considerations

The Final Rules require replacing equity values that are used for purposes of the Summary Compensation Table total with the following:

• For equity awards granted in the covered fiscal year,
  • the year-end fair value of awards that are outstanding and unvested as of the end of that fiscal year, and
  • the fair value as of the vesting date for awards that vest in that same year.
• For equity awards granted in a prior fiscal year:
  • that continue to be outstanding and unvested, the total change in fair value (whether positive or negative) as of the end of the covered fiscal year from the end of the prior fiscal year,
  • that vest in the covered year, the total change in fair value (whether positive or negative) as of the vesting date from the end of the prior fiscal year, and
  • a deduction in the amount equal to the fair value at the end of the prior fiscal year for any awards granted in prior years that are determined to not meet the applicable vesting conditions during the covered fiscal year.
• Add the dollar value of dividends or other earnings paid on stock or options in the covered year prior to the vesting date that are not otherwise reflected in the fair value or included in any other component of total compensation.

Company and Peer Group Performance Disclosure

The Final Rules adopt the use of TSR and peer group TSR in columns (f) and (g) of the PvP Table, to be calculated in the same manner as for the stock performance graph disclosure that is required under Item 201(e) of Regulation S-K. The Final Rules clarify that the measurement period to be used is from market close on the last trading day before the earliest fiscal year in the PvP Table through the end of the fiscal year for which TSR is being calculated. The closing price at the beginning of the measurement period must be converted into a fixed investment of $100 dollars in the company stock (or the stocks represented by the peer group).

Peer Groups

A company (except for an SRC, which is not subject to the peer-group requirements) may use either the same peer group that it uses for purposes of its stock performance disclosure or its Compensation Discussion and Analysis (“CD&A”) disclosure. If the peer group is not a published industry or line-of-business index, the identity of the members of the peer group must be disclosed. The TSR of each member of the peer group must be weighted according to its stock market capitalization at the beginning of each period for which TSR is disclosed. The rules for changing members of the peer group from year to year are similar to the rules for changes to the stock performance graph disclosure under Item 201(e) of Regulation S-K.

Net Income

The Final Rules require companies to disclose net income in column (h) of the PvP Table, along with a clear description of the relationship of net income to the executive compensation actually paid.

Most Important Performance Measures

The Final Rules require an unranked list of between three and seven financial performance measures, which in the company’s assessment represent the “most important” financial metrics used to link executive compensation to company performance. A company may include non-financial performance measures on the list, provided that such measures are among the company’s most important performance measures. However, in all cases, the list should be based only on the most recently completed fiscal year. Companies may, but are not required, to provide two separate lists, one for the PEO and a second for all other NEOs. Companies may also provide a separate list for each NEO. Companies are not required to provide the methodology used to calculate the measures, although the SEC suggests in the preamble to the Final Rules that a description of the methodology may be appropriate if necessary to prevent the disclosure from being confusing or misleading.

While the performance measures list need not be ranked, the Final Rules require companies to disclose a “Company-Selected Measure” in the PvP Table, which is the “most important” financial performance measure that the company uses (other than TSR and net income, which are already required to be disclosed on the PvP Table). The “Company-Selected Measure” may also be a non-GAAP financial measure, but disclosure must be provided as to how the number is calculated from the company’s audited financial statements.²

A Clear Description

In addition to the data points regarding executive compensation and company performance required to be included in the PvP Table, the Final Rules require a clear description of the relationship between executive compensation and company performance and the relationship between company TSR and peer group TSR. The disclosure regarding these relationships must be located following the PvP Table and may be described narratively, graphically, or as a combination of the two.

Flexibility as to Content and Location

In general, companies made include additional disclosure not prescribed by the Final Rules, such as additional columns to the PvP Table, so long as any additional disclosure is clearly identified as supplemental, not misleading, and not presented with greater prominence than the required disclosure.

Recognizing that companies may not necessarily consider the information included in the Pay-versus-Performance disclosure when making decisions about executive compensation, the Final Rules provide companies flexibility in determining where in the proxy or information statement to provide the disclosure required.

Effective Dates and Applicability; Transition Relief

The Final Rules will require the new disclosure in all proxy and information statements for fiscal years ending on or after December 16, 2022. Therefore, the Fiscal Rules will be applicable for the fast-approaching 2023 proxy session for all calendar-year public companies. Companies may provide the required disclosure for three years, instead of five years, in the first filing in which it provides the disclosure, and may provide disclosure for an additional year in each of the two subsequent annual filings in which the disclosure is required. Information for fiscal years prior to the last completed fiscal year will not be required if the company is a new registrant (i.e., the company was not required to report pursuant to Section 13(a) or 15(d) of the Exchange Act at any time during that year).

Next Steps

Affected companies are likely to need significant time and effort to gather the data and craft the disclosure required by the Final Rules, especially for the first year of implementation. Accordingly, they may wish to begin before the usual proxy preparation timeline to determine their “most important” three to seven performance measures, determine which peer group to use, gather the necessary data and craft their “clear description” of the relationship between executive compensation and company performance.

Footnotes

1. The SEC adopted the Final Rules to implement Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
2. This is consistent with the CD&A requirements for non-GAAP financial measures