On August 25, 2022, the U.S. Securities and Exchange Commission (SEC) approved final rules on the correlation between executive pay and company performance (pay-for-performance). As discussed in our previous client alert, pay-for-performance rules were originally proposed in 2015 but not adopted and were reopened for public comment in January 2022 (the reopening release). The final rules fulfill rulemaking requirements mandated by Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act). Companies must comply with the new rules in proxy or information statements for fiscal years ending on or after December 16, 2022. Calendar year companies will first need to include this information in their proxy or information statements filed in 2023.

This client alert summarizes the final rules and highlights significant differences between the proposed rules (as modified by the reopening release) and the final rules.

New Item 402(v) of Regulation S-K

The final rules add a new Item 402(v) to Regulation S-K that requires a company's proxy or information statement to include:

• a table of up to five years (three years for smaller reporting companies) of specified executive compensation and company financial performance measures;
• a description of the relationship between executive compensation and company performance, using the information shown in the table; and
• a tabular list of the most important performance measures used by the company to link executive compensation to company performance.

These provisions are each further discussed below.

Pay-for-Performance Table

The table mandated by new Item 402(v) must include:

• Total compensation for the principal executive officer (PEO) and average of total compensation for the named executive officers (NEOs)
• Actual compensation for PEO and NEOs
• Company total shareholder return
• Peer group total shareholder return
• Company net income
• Company-selected measure

Total Compensation for PEO and NEOs

The total compensation to be shown in the table is the total executive compensation reported in the summary compensation table (SCT) for the PEO and an average of the total compensation amount for the remaining NEOs. If there is more than one PEO in a year, there must be separate disclosure for each PEO.

Actual Compensation for PEO and NEOs

As contemplated by the original proposal and reopening release, the final rules provide that the amount to be shown as "actually" paid to executives is the amount in the total compensation column of the SCT adjusted for certain equity and pension amounts. However, in response to significant public comments, the final rules modify the required equity and pension adjustments as follows:

• Equity adjustments. The original proposal deducted the equity award amounts in the SCT and added back the vesting date fair value of equity awards. The final rules continue to deduct the equity award amounts in the SCT but, instead of simply using vesting date fair value, require adjusting for (i.e., add back in or subtract, as necessary) all of the following:
  • the year-end fair value of any outstanding and unvested equity awards granted during the year;
    • For example, if a time-vested restricted stock unit (RSU) was granted in March when the stock price and fair value was $10 per share, but the stock price and fair value double to $20 per share at year-end, this award would be included in the table at $20 per share.
  • the change in fair value as of the vesting date (from the end of the prior year) of any awards that vest during the year;
    • This includes the vesting date fair value of any awards that are granted in the year and vest that same year.
    • For example, if there are four quarterly vesting events when the price and fair value are $20, $22, $18, and $24, these adjustments would be included in the table at $0, $2, -$2, and $4, respectively.
  • the change in year-end fair value (from the end of the prior year) of any outstanding and unvested awards granted in prior years;
  • a deduction for the fair value at the end of the prior year of awards granted in prior years that are forfeited during the year in question because they failed to meet the applicable vesting conditions during the year; and
  • the dollar value of any dividends or other earnings paid on stock or option awards during the year (prior to vesting) that are not otherwise reflected.
  The calculation of compensation "actually" paid, including the adjustments, must appear in a separate footnote to the table, as originally proposed. Although the methodology above sounds relatively straightforward, in practice it is going to require many calculations that are not currently carried out.
  • As a simple example, if a company grants time-based RSUs that vest on a quarterly basis over four years, the company ultimately might need to calculate fair value 21 times in a fiscal year if vesting dates are not all aligned to the same date—even if there are only four vesting dates per year (e.g., the 15th day of the middle month of the quarter). Fair value calculations may be required on each grant date that year, the four quarterly vesting dates, and at year end. This elevated number of calculations is required because there will exist unvested shares from multiple different RSU grants (e.g., by the time year four arrives, unvested shares from grants in each of years one through four will be outstanding).
  • If a time-based award is a stock option that vests on a monthly basis over the same four years, a company eventually might need to calculate fair value 48 times in a year. Because stock option valuations require estimates of the expected life of the option and the expected life of an option depends on how "in the money" the option is, the valuation will require judgment.
  • The complication increases further with performance-based awards. For awards based on total shareholder return (TSR), the fair value at any time will be influenced strongly by the stock price at that time in relation to the targets and if the stock price increases between a grant date and the end of that year, the value used in the "actually paid" column could be significantly higher than the grant date fair value in the SCT. For performance-based awards other than TSR based awards, at each year-end companies will need to make a judgment about the probable outcome of the performance metrics.
  It will be important to ensure that companies have the necessary resources lined up well before proxy season so that the calculations required for the first proxy statement filing will be timely and accurate.
• Pension adjustments. As originally proposed, the change in pension value (if positive) is deducted from total compensation and the actuarially determined service costs for the year are added back in. However, the final rules also add back in the costs of benefits granted in a plan amendment (or initiation) that takes place during the year and is attributed by the benefit formula to services in prior periods (referred to as prior service costs).
  • Prior service costs also include any reduction in benefits related to services rendered in prior periods as a result of a negative plan amendment, which would reduce the amount actually paid.
  • In each case, these adjustments are calculated in accordance with U.S. generally accepted accounting principles (GAAP).
  As with the equity adjustment, the calculation of compensation "actually" paid, including the adjustments, must appear in a separate footnote to the table, as originally proposed. In addition, any assumptions made in the fair value determinations that differ materially from the assumptions disclosed for determining the grant date fair value of the equity awards must appear in a footnote to the table.

Company Total Shareholder Return

As in the proposal, the pay-for-performance table must include the company's TSR, determined substantially the same as determined for the stock performance graph (Item 201(e) of Regulation S-K). The final rules clarify that both company TSR and peer group TSR (discussed below) should be calculated based on a fixed investment of one hundred dollars at the measurement point. The final rules also clarify that the measurement period is from the market close on the last trading day before the company's earliest year shown in the table through and including the end of the year for which TSR is being calculated. Accordingly, the TSR for the first year in the table will be the TSR over that first year, the TSR for the second year will be the cumulative TSR over the first and the second years, and so on.

Peer Group Total Shareholder Return

As proposed, the pay-for-performance table must include the TSR of the company's peers (weighted based on starting stock market capitalization for the measurement period), comprising either the peer group in the company's stock performance graph or the peer group for purposes of the company's compensation discussion and analysis. Smaller reporting companies would be exempt from this peer return requirement.

Company Net Income and Company-Selected Measure

The inclusion in the table of company net income and a company-selected measure was suggested for consideration in the reopening release. Both are included in the final rules. A third measure suggested for consideration in the reopening release, pre-tax net income, was not included in the final rules.

Net income must be calculated according to GAAP. The company-selected measure (which will not be required for smaller reporting companies) is a measure chosen by the company as its most important financial performance measure for compensation actually paid for the most recently completed year and not already included in the table. If the company-selected measure is a non-GAAP measure, it will not be subject to the normal non-GAAP rules (similar to the treatment of performance targets in a compensation discussion and analysis); however, information must be provided as to how the number is calculated from the company's audited financial statements.

The company may, but is not required to, include additional columns to the table for other performance measures it considers important. These measures need not be financial but must not be misleading or given greater prominence than the required disclosure and must be labelled as supplemental.

Pay-for-Performance Description

In addition to the pay-for-performance table required under new Item 402(v), the final rules require a pay-for-performance description to accompany the table. Using the information in the table, companies must discuss the relationship of actual executive compensation during the past five years (or three years, for smaller reporting companies) to the company's TSR and the relationship of the company's TSR to that of its peer group, all as originally proposed. In view of the additional two company financial measures added to the table in the final rules (net income and a company-selected measure), companies must also describe the relationship between the executives' actual pay and these company financial performance measures as set forth in the table. This disclosure could be in a narrative, a graphic, or a combination of the two.

If the company has added any additional performance measures to the table, the relationship of actual executive compensation to those measures must be discussed as well.

Tabular List of Most Important Financial Performance Measures

The new rules also require companies to list three to seven of the most important financial performance measures used to link executive compensation actually paid to company performance (the tabular list). The tabular list will not be required to be ranked, which is a departure from the reopening release suggestion that they be listed in order of importance. The final rules include flexibility in the number of performance measures (three to seven), rather than the five measures contemplated in the reopening release. With respect to the determination of which measures are the most important, the final rules provide that the company should look to the most recent fiscal year (rather than over the timeline of all past years included in the table). The final rules do not require companies to provide the methodology used to calculate the measures included in the tabular list.

Although the company-selected measure in the table must be financial and included in the tabular list of most important financial performance measures, the company may also include non-financial measures as among its most important performance measures in the tabular list, as long as it includes at least three financial measures.

The tabular list may be presented in one of three different ways: one list for all NEOs, including the PEO; one list for the PEO and one for the remaining NEOs; or one list for the PEO and one for each NEO. If separate lists are provided, each must contain the requisite three to seven financial performance measures.

Smaller reporting companies are not required to provide a tabular list.

Inline XBRL

The final rules require companies to separately tag each number in the Item 402(v) pay-for-performance table, block-text tag the footnote disclosure and relationship description, and tag quantitative or other specific data points in the footnotes, all in Inline XBRL (iXBRL). For additional information on iXBRL, see the SEC's published C&DIs.

Smaller reporting companies are only required to provide the required iXBRL data beginning in the third filing in which it provides pay-for-performance disclosure, instead of the first.

Applicability

Foreign private issuers, registered investment companies, and emerging growth companies are not subject to the new pay-for-performance requirement. As discussed above, smaller reporting companies are subject to scaled disclosure.

The pay-for-performance disclosures are not required in filings other than proxy or information statements that include executive compensation information, even if Item 402 disclosure is otherwise required in a filing (e.g., a Form S-1). As proposed, the final rules provide that information would not be deemed to be incorporated by reference into any other filing, unless the company does so specifically. In addition, the SEC will not mandate the location of this disclosure within a proxy or information statement in which it is included.

Compliance Timetable

The new rules are effective 30 days after publication in the Federal Register. Companies will need to comply with the new rules in proxy or information statements for fiscal years ending on or after December 16, 2022. Accordingly, calendar year companies will need to include the pay-for-performance table and accompanying disclosure in their proxy or information statements filed in 2023.

In the first proxy or information statement that includes the disclosure, companies will be required to provide the information for three years only, with an additional year of information in each of the two subsequent proxy or information statements that require this disclosure. Smaller reporting companies may provide two years of information in their first filing, with an additional year in subsequent proxy or information statements.

Next Steps

Companies should begin now to prepare for inclusion of the pay-for-performance requirements in proxy statements in 2023. In particular, affected companies should:

• Review the new rules and compliance timing with internal teams and external advisors who prepare and advise on proxy statement executive compensation disclosure to understand the work required in advance of next year's proxy season.
• Consider which performance measures will be included in the tabular list of most important performance measures.
• Gather the necessary resources to calculate the equity adjustments well before proxy season—as discussed above, the required calculations may be burdensome in many cases.
• Consider how the new rules affect disclosure controls and procedures at your company.