It’s been 12 years since Dodd-Frank mandated, in Section 953(a), so-called pay-versus-performance disclosure, and amazingly, no rules had been adopted to implement that mandate…until yesterday, when adoption of the final rule crept in “on little cat feet.” Well, ok, there was a press release, but it was still quite a surprise. Yesterday, without an open meeting, the SEC finally adopted a new rule that would require disclosure of information reflecting the relationship between executive compensation actually paid by a company and the company’s financial performance. The SEC proposed a rule on pay versus performance in 2015 (see this PubCo post and this Cooley Alert), but it fell onto the long-term, maybe-never agenda until, that is, the SEC reopened the comment period in January (see this PubCo post).  According to SEC Chair Gary Gensler, “[t]oday’s rule makes it easier for shareholders to assess a public company’s decision-making with respect to its executive compensation policies. I am pleased that the final rule provides for new, more flexible disclosures that allow companies to describe the performance measures it deems most important when determining what it pays executives. I think that this rule will help investors receive the consistent, comparable, and decision-useful information they need to evaluate executive compensation policies.” Commissioners Hester Peirce and Mark Uyeda dissented. 

Here is the fact sheet and the adopting release for the final rule. (I plan to post an update later with more detailed information from the adopting release.) The new rule will become effective 30 days following publication of the release in the Federal Register. Generally, for most companies, the new disclosures will be required for the 2023 proxy season; more specifically, companies will be required to comply with the new disclosure requirements in proxy and information statements that are required to include Item 402 executive comp disclosure for fiscal years ending on or after December 16, 2022.

Summary of new rule

According to the fact sheet, under new Item 402(v) of Reg S-K, companies will be required to provide, in proxy or information statements in which executive compensation disclosure is required, a table disclosing specified executive comp and financial performance measures for the principal executive officer and, as an average, for the other named executive officers, for the five most recently completed fiscal years.

More specifically, the table will include a measure of total comp (taken from the Summary Comp Table), as well as a measure reflecting “executive compensation actually paid,” calculated as prescribed by the rule. In addition, the table will include as financial performance measures “total shareholder return” for both the company and for its peer group, as well as the company’s net income and a financial performance measure selected by, and specific to, the company that the company believes “represents the most important financial performance measure the registrant uses to link compensation actually paid to the registrant’s NEOs to company performance for the most recently completed fiscal year.”

The company will also be required to clearly describe, using the information presented in the table, the “relationships between each of the financial performance measures included in the table and the executive compensation actually paid to its PEO and, on average, to its other NEOs” over the company’s five most recently completed fiscal years, as well as the relationship between the company’s TSR and the TSR of its peer group.

The company will also be required to provide a list of three to seven financial performance measures that the company determines to be its most important measures (using the same approach as used for the company-selected measure). Companies may, but need not, include non-financial measures in the list if they considered those measures to be among their three to seven “most important” measures. This requirement represents a change from January, when the SEC said, in the reopening release, that is was considering whether to require companies to list, in tabular format, “their five most important performance measures used by the registrant to link compensation actually paid during the fiscal year to company performance, over the time horizon of the disclosure, in order of importance.” 

Inline XBRL must be used to tag the pay-versus-performance disclosure; however, SRCs will be permitted to phase in tagging.

The rules will apply to all reporting companies, except foreign private issuers, registered investment companies and emerging growth companies. Smaller reporting companies may provide scaled disclosures.  As noted above, the new disclosures will be required for the 2023 proxy season for most companies. Except for SRCs, companies “will be required to provide the information for three years in the first proxy or information statement in which they provide the disclosure, adding another year of disclosure in each of the two subsequent annual proxy filings that require this disclosure. SRCs will initially be required to provide the information for two years, adding an additional year of disclosure in the subsequent annual proxy or information statement that requires this disclosure.” In addition, an SRC will have until its third filing with pay-versus-performance disclosure, instead of its first, to provide the required Inline XBRL data.

Statements of Commissioners

Chair Gensler. In addition to his comments quoted above, in his statement, Gensler indicated that he was “pleased that the final rule provides for new disclosures, describing which performance measures a company deems most important when determining what it pays executives. When we reopened the proposal, we asked about requiring companies to name and rank the five most important factors they used for this determination. Based on public comment, the final rule includes a more flexible requirement, allowing companies to disclose the three to seven most important measures in an unranked list.”

Commissioner Peirce. In her dissenting statement, Peirce characterizes the rulemaking as lacking in clarity and “unnecessarily complicated.” While the statute “mandates a ‘clear description’ of executive compensation’s relationship to performance,” she contends, the rule is really a “mish-mash of prescribed elements” that “will elicit costly, complicated, disclosure of questionable utility.”  She would have preferred a “principles-based approach [that] would have allowed companies to provide a ‘clear description’ of the pay-performance relationship tailored to their circumstances.” She cites, as an example of the complexity, the “complicated formula for determining compensation ‘actually paid’ to the executive officers, including some metrics that most companies ordinarily would not calculate.” 

Given that companies already provide a detailed CD&A, the primary benefit of the new rule, she suggests, is “in the new presentation of information that generally is already disclosed elsewhere and the comparability the Commission hopes the tabular presentation will produce. But, the fundamental variation across companies’ compensation practices and the underlying assumptions some of the disclosures necessitate will render the new presentation anything but clear and comparable.” Instead, she argues, the “tabular approach masks the variety of approaches companies take to linking pay and performance…. Moreover, the table includes measures that may not be relevant for a particular company, which will be useless at best and confusing at worst for investors.” The SEC has acknowledged, she observed, that, “among companies and investors, there ‘continues to be no consensus around the best approach to analyzing the alignment of pay and performance. . . .’” a view reinforced by the public comments. 

In addition, the new metrics and the related complexity will drive costs higher, costs that will be disproportionately greater for smaller companies. For example, the requirement to identify the company’s “most important” performance measure may be “a difficult task for many companies that take nuanced approaches to compensation.”

More significantly, she expressed her concern that

“this rulemaking could distort how public companies compensate executives and how investors evaluate companies’ compensation decisions. Shining a spotlight on specific performance measures could drive compensation decisions instead of simply informing investors about how companies make those decisions. Companies may feel compelled to tie their executive pay to the prescribed financial performance measures or to incorporate non-financial performance measures, such as environmental, social, and governance metrics. The highlighting of particular metrics also might influence how investors analyze the relationship between pay and performance. A principles-based approach would have enabled us to follow one commenter’s wise counsel to ‘leave judgements as to how to incentivize executives to compensation committees and how to evaluate company performance to investors.’”

She concluded that, “[w]hen Congress instructs the Commission to act, we should do so. Congress told us over a decade ago to adopt a pay versus performance rule. I would have supported a principles-based rulemaking that efficiently implemented Congress’s directive without unnecessary additions.”

Commissioner Caroline Crenshaw.  Crenshaw’s statement indicates that the new rulemaking is really about creating transparency with regard to executive pay. Dodd-Frank was enacted following the global financial crisis of 2007-2008, which “put the lack of transparency into stark relief, as executives received multimillion-dollar pay packages for short-term gains that contributed to disastrous results.”

There have also been many developments in pay practices since the rules were first proposed in 2015. For example, she observes that,

“in 2010, more pay was based solely on financial measures such as profitability, revenues, and measures of cash flow. But, as several commenters noted, the underlying performance measures that are used to determine executive pay in today’s market for executive compensation encompass a broader mix—both quantitative and qualitative; financial and nonfinancial.  Further, roughly 70% of executive pay plans consider nonfinancial measures, and these can include employee engagement, customer service, and safety. Investors and other stakeholders commented on this rule to assert that a complete picture of executive pay and performance would include disclosure of both financial and nonfinancial measures used by a registrant to pay executives.”

In response to these new market developments, as well as public comments, “the final Pay Versus Performance rule made a change from what was proposed to permit companies to include nonfinancial performance measures in a list of their three to seven ‘most important’ measures and also disclose such measures in a table as they see fit. By contrast, financial measures are required to be disclosed if companies are linking pay and performance to them. It remains to be seen whether companies will make sufficient disclosures to investors through permissive inclusion of nonfinancial measures versus requiring disclosure on the same footing as financial measure.”

Commissioner Uyeda.  Uyeda’s primary concerns, as expressed in his dissenting statement, were largely procedural. First, like Peirce, he expressed some exasperation at the lapse of 12 years to final rulemaking: “Although this provision lacks a statutory deadline, it is unacceptable for more than twelve years to elapse before fulfilling a Congressional mandate.” But his real gripe was with the failure, in his view, to comply with the APA and issue a re-proposal: “no provision of the Dodd-Frank Act exempts the Commission from having to comply with the Administrative Procedure Act. Rather than taking the more appropriate route of re-proposing the pay versus performance rule with updated data and analysis, the Commission bypassed having an effective notice-and-comment process as required by the Administrative Procedure Act in favor of a procedural shortcut.”

The release reopening the comment period “did not update any economic analysis, benefits and costs discussion, or analysis required by the Paperwork Reduction Act and the Regulatory Flexibility Act. In contrast, the 2015 Proposal included nearly 34 pages of economic analysis assessing the impact of the proposed rule. Thus, the public, in providing new comments on the rule, could only respond to a seven-year old economic analysis. The use of stale information is particularly puzzling given the Commission’s stated focus on obtaining robust economic data.” It was also inconsistent, he contends, with staff guidance on economic analyses.  He notes, for example, that the economic analysis in the 2015 proposal was especially “problematic because the data on the use of executive stock grants and stock options grants in that release was from 2010 and 2012, while other data on the vesting of options grants ranged from 1997–2008. The Adopting Release, in contrast, includes economic analysis reflecting more recent trends in executive compensation from 2020. Most notably, the 2020 data indicates a significant move away from the use of stock options and pension plans as a form of executive compensation.” That data, he contends, might have made a difference to the public. 

Nor was any economic analysis provided regarding the new regulatory alternatives included in the reopening release. He quotes (with apparent approval) a comment from the Chamber of Commerce that a re-proposal would have been a more appropriate approach. While the adopting release asserts that the reopening release “discussed the potential benefits and costs of the additional disclosures even in the absence of a standalone economic analysis” and made inquiry about new developments, that, in his view, was “insufficient.”  The SEC, he asserts, “should have gathered any known data and moved forward in the form of a re-proposal. Moreover, given the short 30-day comment period, the public’s ability to generate their own economic analysis was limited at best and illusory at worst.”

Finally, he maintains that the analysis dramatically understates the cost burden of compliance by using $400 per hour as an estimate of the average cost of outside professionals; however, he points out, the SEC “first started using the $400 per hour in 2006—over sixteen years ago—and it is not credible that the cost for professional legal advice has remained flat since that time.” While he was unable to support this rule, had the SEC “re-proposed this rule for public comment after updating the stale data and economic analysis, I would have been open to supporting the adoption of a final rule.”

Commissioner Jaime Lizárraga.  As the newest SEC commissioner, Lizárraga kept his statement brief. In his view, a “key factor driving the 2008 global financial crisis was the stark misalignment of incentives that led executives to take excessive, catastrophic risks. Congress initially addressed this problem by directing the U.S. Treasury Secretary to subject all recipients of taxpayer-assistance to executive compensation restrictions as a condition of such assistance. The Dodd-Frank Act then addressed the absence of a disclosure standard by requiring the Commission to undertake today’s rulemaking, which will now bring much-needed transparency, comparability, and clarity into the relationship between executive compensation and a company’s financial performance.” This rulemaking, he contended, together “with other Dodd-Frank Act financial stability provisions, this rulemaking will reduce the likelihood of future taxpayer bailouts.”

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