As proxy preparation season approaches, the SEC’s new pay versus performance (PVP) disclosure rules will present new and unique challenges for many public companies.

For example, small reporting companies will not be exempt from the disclosure requirements because they are exempt from providing a compensation, disclosure and analysis section (CD&A) in their proxy statement. Without a requirement to prepare a CD&A, a number of these companies do not have experience presenting performance measures in granular detail in their disclosures.

In advance of preparing this new PVP disclosure, compensation committees and legal teams should begin to work through a number of considerations and factors.

Compensation Actually Paid (CAP)

Arguably, the most challenging component of the PVP disclosure is the computation of CAP. In short, CAP is calculated by taking the total column in the summary compensation table (SCT) and adjusting it with new methodologies for calculating the values for the equity awards and pension benefits.

Equity Award Calculations

Instead of grant date fair values for option and stock awards granted in the covered year (i.e., the year being disclosed), CAP requires companies to compute a value to be attributed to all outstanding equity awards held by named executive officers as follows:

• For awards granted during the covered fiscal year that are outstanding and unvested – the fair value as of the end of the covered fiscal year is added.
• For awards granted in prior years and based on vesting status as of the end of the covered fiscal year – add or subtract the values as listed in the table below:

• For all awards, add the dollar value of any dividends or other earnings paid that is not otherwise included in total compensation for the covered fiscal year.

These additional values will require a significant amount of new calculations and evaluations to be run to complete the disclosure. While the rules require the fair value to be computed using the same methodology to account for share-based payments, generating the values based on vesting dates and year-end is new and so is accounting for grants in prior years. Companies will need to factor in additional time for their internal finance and accounting teams to get aligned on these new valuations.

Another challenge will be determining changes in fair value for performance awards based on the “probable outcome of such conditions as of the last date of the fiscal year.” Projecting outcomes is new territory in compensation disclosure. Companies will have to evaluate how much detail to include in their disclosures of the fair value assumptions used to derive these values versus confidentiality concerns regarding such information. For example, there may be confidential information regarding a product or regulatory approval that has not been made public, but the company projects that this event will have a material impact on the probable outcome of a vesting condition.

              Pension Values

Instead of the change in actuarial present value included in total compensation in the SCT, CAP requires the inclusion of the change in service cost between the covered year and the prior fiscal year.  (Footnote 18 of the SEC’s adopting release states, “Service cost is defined in FASB ASC Topic 715 as the actuarial present value of benefits attributed by the pension plan’s benefit formula to services rendered by the employee during the period. The measurement of service cost reflects certain assumptions, including future compensation levels to the extent provided by the pension plan’s benefit formula.”)

This amount must also reflect the value of plan amendments made during the covered fiscal year and be computed in conformance with GAAP. Similar to the changes in equity value above, the underlying data for running this computation is readily assessable but the calculations are new as they will apply to a subset of employees. Since this set of calculations is new, it will be key for the finance team members to coordinate with any third-party actuaries on these values with ample lead time to provide details to the compensation committee.

Total Shareholder Return (TSR) and Net Income

While several new calculations are required to compute CAP for the PVP table, as discussed above, the underlying data for computing TSR is readily assessable and net income is pulled straight from GAAP financials. Further, according to shareholder advisory firms, 50% of companies already use TSR as a performance measure in their compensation scheme. Some key components to evaluate in relation to the disclosure of TSR and net income are:

• How dividends and buybacks impact the computations and whether any explanatory narrative should be included to highlight any significant corporate event that affects TSR or net income.
• Any material deviations from how TSR or net income are calculated under the terms of performance awards issued to the named executive versus how those measures will be calculated for purposes of PVP disclosure requirements.
• Any historic criticism from key shareholders and proxy advisory firms.
• How to properly frame the net income disclosure for companies who continuously operate at a loss due to where such a company is in its corporate life cycle.

Company Selected Measures

Most Important Financial Measure

The PVP table requires companies, other than small reporting companies who may take advantage of scaled disclosure requirements, to disclose the most important financial performance measure in linking its performance for the covered fiscal year with the CAP disclosed in the table. If a company uses TSR and/or net income as its most important financial performance measure, then its next most important measure should be included in the table.

To identify the most important financial measure, companies will need to review their long-term and short-term incentive plans to find synergies. If companies do not apply a formal weighted system to their performance measures in setting compensation, it may be helpful for the compensation committee and their counsel to do the following:

1. Review historical compensation committee materials to determine if there has been any informal weighting.
2. Work closely with the company’s compensation consultant to evaluate their compensation framework. This measure should be carefully evaluated since the year-to-year changes could result in complex disclosure around the reasoning for the shifts.

              Performance Measures Table

In addition to including a company-selected measure in the PVP table, companies other than small reporting companies who may take advantage of scaled disclosure requirements will also be required to include a table identifying three to seven performance measures as part of the pay versus performance disclosure.

The company-selected measure in the PVP table must be included and the remaining factors must be the other most important measures used to link compensation actually paid to a company’s named executive officers with the company’s performance in a covered fiscal year. Generally, at least three of these measures must be financial performance measures. However, a company is permitted to disclose less than three if the table includes all other measures used if any. The measures do not need to be listed in order of importance.

Companies should review their equity plans, award agreements, incentive plans and employment agreements to identify the performance components utilized in those instruments to guide setting compensation. A few items to closely evaluate are:

• Whether there are material deviations from GAAP used to calculate those performance measures. If so, we would recommend providing a narrative or graphical disclosure illustrating the reasoning or detailing the relevant nuances of the methodology used in such computations.
• If different measures are applied to the PEO versus other named executive officers, a company should consider including multiple tables, provided each table must still include at least three to seven financial performance measures.
• Companies should also consider whether including supplemental graphs highlighting year-over-year performance over specified periods (i.e., three years or six years) will highlight where the company has outperformed its peers.
• If the Company’s performance is not in line with its peer group or specified industry, companies should consider including a narrative disclosure detailing outside factors (i.e., labor shortages, specific supply chain issues or events that impact only certain parts of the world).
• Companies should identify where the size of new hire grants significantly increases CAP in certain years.

Peer Groups

One of the central focuses of the pay versus performance rules is how companies measure up to their respective peer groups. Peer groups are usually limited by industry and the other common selection criteria include revenue, talent, size, competitors, geography, assets, employees, profitability and market cap. Presently, several companies do not factor TSR or net income as a focal point for identifying the peer group.

The pay versus performance rules require a company’s peer group to consist of either of the following:

1. The same index or issuers used by the company for its performance graph in the 10-K.
2. The peer group disclosed in the company’s CD&A.

To the extent that the peer group is not a published industry or line of business index, the identity of the issuers composing the group must be disclosed in a footnote.

In addition, if a company opts to switch to a different peer group in a subsequent fiscal year, an additional footnote is required detailing the following:

1. The reason for the change.
2. A comparison of the company’s cumulative total return with that of both the newly selected peer group and the peer group used in a previous year.

Companies should carefully consider which peer group to use because the disclosure obligations could become onerous if members of the peer group change often or if the company decides to shift peer groups from year to year.  Anyone preparing these new disclosures will need to draft to build symmetry with the peer group disclosure in the CD&A. Companies could use supplemental tables to showcase how the disclosures relate or highlight the factors that create seemingly inconsistent results.

Smaller reporting companies may take advantage of the scaled rules that permit them to omit the peer group column from the table and their PVP narrative. However, these considerations should remain a focus for these companies as they could shift out of small reporting company status sooner than anticipated and historical data will need to be provided and detailed in subsequent proxy statements.

Compensation Consultants and Legal Counsel

Over the last decade, many companies have designated key members of their in-house legal, finance and HR teams to coordinate and draft the executive compensation disclosure in the proxy. This new disclosure may necessitate more input from the company’s compensation consultant and outside counsel.

Compensation committees and their counsel should update their proxy preparation timelines for soliciting feedback from compensation consultants in anticipation of needing more extensive input from their consultants than in past years. In addition, direct lines of communication should be established with the appropriate internal and external team members preparing the disclosure to ensure the correct team member evaluates all relevant and accurate data.

The requisite data to prepare the pay versus performance disclosure for fiscal years 2020 and 2021 is already readily assessable to initiate the process. Priority should be given to identifying the peer group that will be used and the financial performance measures that will be identified as the most important measures for setting compensation in those fiscal years.