We issued a step-by-step guide entitled An Analysis of the SEC’s Pay Versus Performance Rules on December 14, 2022. We prepared that guide to assist our clients as they prepare to implement the SEC’s new “Pay Versus Performance” (“PVP”) rules, which include certain accommodations that lessen the reporting burden for “smaller reporting companies” (“SRCs”) compared to larger companies. Although our comprehensive December 14, 2022 guide includes numerous references to how the PVP rules are different for SRCs, this version of the guide simplifies the analysis for SRCs because it is tailored to the PVP rules as they apply to SRCs. Companies that are not SRCs should refer to the December 14 guide, not this one, which omits the analysis of important provisions in the PVP rules that apply to companies that are not SRCs.

After a twelve-year delay, the SEC adopted rules on August 25, 2022, implementing Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), which added a new paragraph (v) to Item 402 of Regulation S-K. See Exchange Act Release No. 95607 (Aug. 25, 2022). The PVP rules became effective on October 11, 2022, for all companies other than emerging growth companies, registered investment companies, or foreign private issuers. Companies must begin to comply with the PVP rules in proxy and information statements that are required to include compensation disclosures under Regulation S-K Item 402 for fiscal years ending on, or after, December 16, 2022. 

Overview

The PVP rules for SRCs have two components:1

• A standardized table (the “PVP Table”) that contains three years (this first transition year, only two years) of historical compensation information as well as certain performance measures against which compensation information can be compared; and
• Disclosure, which can be narrative or in a graph, that describes the relationship between (a) compensation “actually paid,” which is a number that is derived pursuant to a formula in the PVP rules and listed in the PVP Table; and (b) the performance measures reported in the PVP Table.

The Pay Versus Performance Table

The PVP Table for SRCs must be in the required format set forth below. SRCs are required to provide only two years of information in the first year of compliance, with an additional year added in the second year of compliance.2 In ensuing years, the table will cover three years.

The following template for the PVP Table and related disclosure contains our explanatory footnotes and/or template disclosure where appropriate.

(1) Column (a): Years Required. Subject to the transition provisions described above, SRCs will be required to provide information for the prior three completed fiscal years. Additionally, a company is only required to provide information for years during which it was an Exchange Act reporting company.

(2) Columns (b) and (d): Summary Compensation Table (“SCT”) Information.

• Column (b) shows the amounts for the PEO in the SCT for the applicable year.
• Column (d) shows the average amounts for the non-PEO Named Executive Officers (“NEOs”) in the SCT for the applicable year.

If a company has more than one PEO during a year, the company must add additional columns (b) and (c) in the PVP Table for each PEO. Also, each NEO (including the PEO) for each year must be identified in a footnote to the PVP Table.

The required footnote, depending on executive turnover, could consist of one (or a combination) of one of the following examples:

• Example 1 – no turnover: In both 2022 and 2021, XXX was our Chief Executive Officer and our remaining NEOs consisted of [list].
• Example 2 – turnover: During 2022, our Chief Executive Officers were [CEO #3 and CEO #2]. During 2021, our Chief Executive Officer was [CEO #2]. During 2022, our remaining NEOs consisted of [list]. During 2021, our remaining NEOs consisted of [list]. 

(3) Columns (c) and (e): Determining Compensation “Actually Paid.”3 Columns (c) and (e) represent the total compensation paid to NEOs for the applicable year adjusted by changes in equity award values. These adjustments must then be disclosed in a footnote to the PVP Table. A proposed template for that footnote is set forth below.

First, the compensation “actually paid” to the PEO and the non-PEO NEOs for each year is determined by starting with the amounts set forth in the SCT’s “Total Compensation” column for the applicable year (average of those amounts for the non-PEO NEOs) and adjusting them as follows:

Equity Award Adjustments:

• Deduct the amounts that were set forth for that year in the SCT’s “Stock Awards” and “Option Awards” columns.
• Include amounts (which could be positive or negative) for such stock awards and option awards during that year, determined as follows:
  • For any awards granted during that year that, as of the end of that year, remain outstanding and unvested, add an amount equal to the fair value of those awards as of the end of that year.
  • For any awards granted during that year that vested in the same year, add an amount equal to the fair value of those awards as of the vesting date.
  • For any awards granted at any time before that year that, as of the end of that year, remain outstanding and unvested, add (or subtract, if negative) an amount equal to the change in fair value of those awards as of the end of the year (measured from the end of the prior year).
  • For any awards granted at any time before that year for which all applicable vesting conditions were satisfied at the end of or during that year, add (or subtract, if negative) an amount equal to the change in fair value of those awards as of the vesting date (measured from the end of the prior year).
  • For any awards granted at any time before that year that failed to meet the applicable vesting conditions during that year (i.e., were forfeited), subtract an amount equal to the fair value of those awards as of the end of the prior year.
  • For any unvested awards on which dividends or other earnings were paid during that year that were not otherwise included in the SCT’s “Total Compensation” column for that year, add the amount of such dividends or other earnings.

Modified Awards – If at any time during the last completed fiscal year, the exercise price of options or SARs held by a NEO has been amended or adjusted, whether through amendment, cancellation or replacement grants, or by any other means, or the award has otherwise been materially modified, the changes in fair value included pursuant to the adjustments described above must take into account the excess fair value, if any, of any such modified award over the fair value of the original award as of the date of such modification.

“Fair value” is determined under ASC Topic 718.

• For option awards, the company must use a model consistent with the fair value methodology used to account for share-based payments in the company’s financial statements in accordance with GAAP.
• For performance awards, the company must take into account the probable outcome of the performance conditions as of the measurement date.

Vesting Date Determination – For a time-based award, the vesting date simply is the date on which the award vests. For performance-based awards, the vesting date will depend upon whether continued service is required beyond the end of the performance period. If continued service is required, the vesting date will be after the performance period. If continued service is not required, the vesting date will be the last date of the performance period, which will be 12/31 for performance periods tied to a calendar year. Deferred awards are treated as vested in the year of vesting rather than the year of payment. For awards with retirement vesting, the vesting date should be confirmed following a review of the applicable award agreement.

Footnote Disclosures to PVP Table – As mentioned above, the rules require that the PVP Table be accompanied by footnote disclosure of the adjustments described above that are made to arrive at compensation “actually paid” to the NEOs for each year represented in the PVP Table. The footnote, with respect to the amounts added relative to stock and option awards, must disclose material changes (including changes in the probability of achievement of performance awards from year to year) in assumptions made in the calculation of fair value from those disclosed as of the grant date of such equity awards.

For clarity, a separate table may be required. Such a footnote could appear as follows [NOTE – omit rows with respect to adjustments that are not applicable to a particular company]:

[FN] The following table[s] set forth the adjustments made during each year represented in the PVP Table to arrive at compensation “actually paid” to our NEOs during each of the years in question:

(4) Column (f): Company Total Shareholder Return (“TSR”). Calculating the data for this column will be an additional burden on SRCs because SRCs, since 2006, have not been required to provide the “performance graph” that is required by Item 201(e) of Regulation S-K. The performance graph generally is found in a non-SRC company’s annual report to shareholders required by Exchange Act Rule 14a-3(b) or its Annual Report on Form 10-K. SRCs will now have to make calculations of TSR that are similar – but not identical – to the calculations required for a performance graph. The calculation for each year is based on a fixed investment of $100 from the beginning of the earliest year in the PVP table through the end of each applicable year in the table, assuming reinvestment of dividends. For most SRCs, the calculation will begin at Dec. 31, 2020 and, in the first year, extend through Dec. 31, 2022. In the following years, 2023 will be added so that the PVP Table will include three years of data. Thereafter, each year, the oldest year will drop off and the most recent year will be added. 

(5) Column (g): Net Income. In this column, provide the company’s net income for each year.

Pay Versus Performance Relationship Disclosures

Companies must use the information in the PVP Table to provide a “clear description” (graphically, narratively or a combination of the two) of the relationship over each of the years in the PVP Table between the compensation “actually paid” to the PEO and the average compensation “actually paid” to the non-PEO NEOs (columns (c) and (e) of the PVP Table) to each of the following metrics:

• The company’s cumulative TSR (column (f) of the PVP Table); and
• The company’s net income (column (g) of the PVP Table).

Pay Versus Performance – Format and XBRL

The PVP disclosures must appear with, and in the same format as, the rest of the disclosure required to be provided pursuant to Item 402 of Regulation S-K (i.e., executive compensation disclosure). In addition, the PVP disclosures must be provided in an Interactive Data File in accordance with Rule 405 of Regulation S-T and the EDGAR Filer Manual, provided that an SRC is not required to comply with these XBRL requirements until the third filing in which it provides PVP disclosure.

Pay Versus Performance – Filed Status

Although the PVP disclosures are “filed” (and therefore subject to liability under Section 18 of the Exchange Act) rather than “furnished,” they will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the company specifically incorporates them by reference. Accordingly, unless incorporated by reference into a Securities Act registration statement, the PVP disclosures will not be subject to liability under Section 11 of the Securities Act. The SEC noted that while subjecting these disclosures to Exchange Act Section 18 “may create an incremental risk of litigation, . . . Section 18 does not provide for strict liability with respect to ‘filed’ information.”

What You Need to Do Now

Most importantly, START PREPARING — NOW! The PVP disclosures will be required in proxy statements that include executive compensation disclosures for fiscal years ending on, or after, Dec. 16, 2022 — i.e., for most companies, during the 2023 proxy season.

Compensation committees, compensation consultants, valuation and legal advisors, and other internal constituencies (HR, accounting, and finance) all should be aligned on steps necessary to create the PVP disclosures.

Prepare for new or different calculations in arriving at compensation “actually paid” and in determining TSR. The adjustments to total compensation that the company uses in determining compensation “actually paid” will require additional calculations and evaluations to complete the disclosure.

• While the fair value computations required with respect to share-based payments will use the same methodology that is used in the tables already included in the proxy statement, the compensation “actually paid” table that requires determining the values based on vesting dates and year-end dates (as opposed to grant dates) is new, and so is accounting for fluctuations in the value of grants made in prior years. Companies will need to allow additional time for their internal finance and accounting teams to understand and prepare these new valuations. This preparation may result in a complex and time-consuming process, particularly for companies that make frequent equity grants, because it will require an analysis of each grant’s initial value, vesting schedule, subsequent year-end value, any forfeitures, and any dividends.
• 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.” While required on a periodic basis for financial statement reporting, projecting outcomes in compensation disclosure is uncharted territory. 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, confidential non-public information regarding the company may have a material impact on the probable outcome of a vesting condition, and companies will have to determine whether and to what extent to disclose that information.
• Many companies, particularly SRCs, might not have tracked their TSR in the past. Even those that have done so might not have performed the TSR calculations as required by the PVP disclosure rules. Accordingly, companies will need to perform these relatively complex calculations with respect to several prior fiscal years to satisfy their disclosure obligations.

Determine how to “clearly” disclose the relationships between pay and performance. Companies must assess the data presented in the PVP Table and decide on an approach to discuss the relationship between compensation “actually paid” and company performance (e.g., TSR and net income) as reflected in the table. The new PVP rules do not mandate a particular format for this disclosure. Formats suggested in the SEC’s release include: (a) a graph providing executive compensation actually paid and change in the financial performance measure (TSR and net income) on parallel axes and plotting compensation and such measure(s) over the required time period; and (b) disclosing the percentage change over each year of the required time period in both executive compensation actually paid and the financial performance measure, together with a brief discussion of that relationship. In either event, companies should be prepared to include additional narrative explanation when there is an apparent disconnect between the particular performance metric and the compensation paid to executives.

Start preparing a mock-up of the disclosures now. Data for both 2022 and 2021 that are necessary to calculate the disclosures should now be available; therefore, companies should proceed with creating a general mock-up of the PVP Table and related disclosures (e.g., adjustments to arrive at compensation “actually paid”). This process will help identify the persons/groups necessary to the process and will assist in determining whether relationship disclosure should be graphic, narrative, or a combination of the two. Perhaps most importantly, in this first year of compliance, it will provide an opportunity for a more focused review of these disclosures outside the ordinary (and often hurried) 10-K/proxy process.

1 An SRC is not required to provide the “Tabular List” of three to seven financial performance measures.
2 An SRC is not required to include a column in the PVP Table for “Peer Group Total Shareholder Return.” Because an SRC is not required to produce a Tabular List of three to seven financial performance measures, it also is not required to include a column in the PVP Table for a “Company-Selected Measure.”
3 SRCs are not required to make pension plan adjustments for “service cost” and “prior service cost” that are required to be performed by other companies.