On Aug. 25, 2022, the Securities and Exchange Commission (SEC) adopted a new rule requiring public companies (subject to some notable exceptions, described below) to disclose, in proxy statements and information statements that contain executive compensation disclosure, “pay versus performance” data for the chief executive officer and other named executive officers. The final rule, which is intended to enable investors to more readily assess executive compensation actually paid relative to the company’s financial performance, applies to disclosure for fiscal years ending on or after Dec. 16, 2022. In effect, this means that most proxy statements for 2023 annual meetings of stockholders are required to comply with the new rules. Emerging growth companies, registered investment companies and foreign private issuers are exempted from the disclosure requirements, and smaller reporting companies are entitled to provide alternative scaled disclosure.
The final rule requires disclosure for each of the five most recently completed fiscal years (three for smaller reporting companies), but phases in the five-year requirement. Three years of disclosure is required in the first annual proxy filing in which the final rule applies to a company (generally the 2023 annual proxy filing), followed by four years of disclosure in the second year (generally the 2024 annual proxy filing) and five years of disclosure in subsequent years. For smaller reporting companies, two years of disclosure is required in the first annual proxy filing to which the final rule applies and three years of disclosure is required in subsequent years.
The final rule adopted by the SEC requires disclosure with respect to a company’s principal executive officer (PEO) and its other named executive officers as a group (the NEO Group). Three principal elements of disclosure are required:
- A table setting out for each applicable year specified compensation information for the company’s PEO and NEO Group, including average compensation for the NEO Group, as well as the company’s total shareholder return (TSR), net income and a performance measure selected by the company
- A description (which may be in narrative and/or graphical form) of the relationship between PEO and NEO Group compensation and certain performance metrics
- Except for smaller reporting companies, an unranked list of up to seven of the most important financial performance measures used by the company to link executive compensation to company performance (which, similar to the second element, may be disclosed in narrative and/or graphical form)
These elements are discussed below in turn.
Pay Versus Performance Table
A company has discretion to place the Pay Versus Performance Table anywhere in the proxy statement.
The table shows, for each of the PEO and the NEO Group, the total compensation reported on the Summary Compensation Table and the compensation “actually paid,” TSR for the applicable year for both the company and a peer group, and the performance for the year under the performance measure (the Company-Selected Measure) that the company considers the most important measure in linking executive compensation and company performance.
Compensation Actually Paid. The compensation actually paid (columns (c) and (e)) is based on the total compensation (columns (b) and (d)), as adjusted with respect to compensation related to pension benefits and equity compensation. The adjustments are intended to more accurately reflect the compensation actually earned during the applicable year. For example, with respect to a stock option or stock award, the Summary Compensation Table includes a one-time disclosure of fair value as of the grant date. In contrast, the new table will show the value of new awards as well as incremental changes in value for previously awarded grants. This is accomplished by replacing the Summary Compensation Table amount with (a) the fair value as of the end of the year of grant; and (b) as of the end of subsequent years until the award vests, any positive or negative change in fair value.
Company-Selected Measure. The Company-Selected Measure in column (i) represents the results for the applicable year of the financial performance measure that, in the company’s assessment, is the most important performance measure not otherwise disclosed in the table that is used by the company to link compensation actually paid to performance.
Additional details with respect to the table are set out in the Appendix to this Alert.
Relationship of Compensation to Performance
In addition to the information disclosed on the Pay Versus Performance Table, companies are required to provide clear descriptions, which may be presented in a narrative and/or graphical form, of the relationships between (A) compensation actually paid to the PEO and the average compensation actually paid to the NEO Group (table columns (c) and (e)) and (B) the following three financial performance measures:
- the cumulative TSR of the company, together with a clear description of the relationship between the company’s TSR and the TSR of the company’s peer group
- the net income of the company
- the Company-Selected Measure
in each case, over the company’s five most recently completed fiscal years (or three or four years, for reports during the first two years that the final rule is applicable).
The final rule mandates disclosure of an unranked list of at least three and no more than seven of the most important financial performance measures used by the company in the most recently completed fiscal year to link PEO/NEO compensation with company performance. A company that considers fewer than three such financial performance measures is only required to disclose the number of measures it actually considers (and a company that does not use any financial performance measures to link executive compensation to company performance is not required to include a list).
The list of performance measures may include nonfinancial performance measures, provided that the company discloses at least three (or fewer, if the company uses fewer) of the most important financial performance measures and provided that the list does not include more than seven performance measures in all.
The company may provide one list of performance measures, a separate list for each of the PEO and the NEO Group, or separate lists for each named executive officer.
Smaller Reporting Companies
The final rules permit (but don’t require) smaller reporting companies to comply with a reduced set of disclosures. Under the rules, smaller reporting companies may:
- Limit disclosure in the Pay Versus Performance Table to three fiscal years (two in the first filing for which the disclosure is required)
- Omit the adjustments related to pensions for purposes of determining compensation actually paid
- Omit peer group TSR, omitting both column (g) in the Pay Versus Performance Table and the description of the relationship between compensation actually paid and the company’s TSR and between the company’s TSR and and the peer group TSR
- Omit the Company-Selected Measure in the Pay Versus Performance Table (column (i))
- Omit the list of the three to seven most important financial performance measures used by the company to link PEO/NEO compensation with company performance
The final rule requires companies to include the pay versus performance disclosures in their proxy statements1 for fiscal years ending on or after Dec. 16, 2022. Accordingly, companies should begin planning and implementing necessary processes and procedures to collect the information necessary to comply with the final rule. In particular, companies should, in conjunction with their compensation committees and compensation consultants, as appropriate:
- Educate themselves on the scope of the final rule and the required disclosures
- Implement a process to calculate the compensation actually paid to the PEO and other NEOs and compute the historical “compensation actually paid” amounts for 2020 and 2021 (2021 for smaller reporting companies)
- Determine the three to seven most important performance measures used to link executive compensation to company performance and select from this list the Company-Selected Measure to be included in the Pay Versus Performance Table
- Review whether their performance metrics should be revised or updated in light of the final rule
- Consider how the pay versus performance disclosures, including the relationship of compensation actually paid to TSR, relate to existing compensation disclosures, including the current CD&A
- Consider what additional disclosure may be warranted in light of the final rule
- Review disclosure controls and procedures to ensure that there are sufficient resources in place to generate the pay versus performance disclosures and comply with the final rule
Companies may find that preparing an initial draft of the disclosure, including an initial draft of the Pay Versus Performance Table, before their annual proxy disclosure process commences, will (i) help identify information that is not currently tracked and is necessary in order to comply with the final rules; (ii) assist in assigning appropriate internal resources to collect and compile required information and draft the new pay versus performance disclosures; and (iii) allow senior executives, the compensation committee and the board of directors sufficient time to focus on these new disclosures and provide timely feedback.
Pay Versus Performance Table
- Smaller reporting companies are not required to include columns (g) and (i) or any disclosure for years 4 and 5 (the items marked with an asterisk).
- The Summary Compensation Table totals for the company’s PEO in column (b) are the same as disclosed in column (j) of the Summary Compensation Table.
- The average Summary Compensation Table totals for the non-PEO NEOs in column (d) are the average of the amounts is closed in column (j) of the Summary Compensation Table for non-PEO named executive officers.
- The compensation actually paid in columns (c) and (e) are the amounts reported in columns (b) and (d), adjusted as follows, with explanations of the adjustments in footnotes to the table:
For pension benefits:
• Subtract the aggregate change in the actuarial present value of all defined benefit and actuarial pension plans included in the Summary Compensation Table.
• Add the sum of these two items:
• Actuarially determined service cost for services rendered during the year, using the same methodology as used in the company’s financial statements under GAAP
• The entire cost of benefits granted in a plan amendment (or initiation) during the year that are attributed by the benefit formula to services rendered in periods prior to the plan amendment (or initiation)
For equity awards:
• Add the sum of these five items:
• Year-end fair value of any equity awards granted during the year that are outstanding and unvested as of the end of the year
• The amount of change as of the end of the year (from the end of the prior year) in fair value of any awards granted in prior years that are outstanding and unvested as of the end of the year
• The fair value as of the vesting date of awards that are granted and vested in the same covered fiscal year
• An amount equal to the change as of the vesting date (from the end of the prior year) in fair value for awards granted in prior years that vest during the year
• Any dividends or other earnings paid on stock or option awards during the year prior to the vesting date that are not otherwise reflected in the fair value of such award or included in any other component of total compensation for the year
• Subtract the sum of these two items:
• The grant date fair value of options and stock awards listed on the Summary Compensation Table granted during the applicable year
• An amount equal to the fair value at the end of the prior year any awards granted in prior years that are determined to fail to meet the applicable vesting conditions during the year
- The TSR and the peer group TSR disclosed in columns (f) and (g) are generally calculated in the same manner as under Item 201(e) of Regulation S-K. The cumulative TSRs of the company and its peer group are measured from market close on the last trading day before the company’s earliest fiscal year presented in the table, through and including the end of the fiscal year for which the figure is being calculated, and should be presented in terms of a $100 investment in the company’s stock.
- A company may use either the same peer group used for purposes of Item 201(e) of Regulation S-K or a peer group used in the CD&A for purposes of disclosing compensation benchmarking practices. If 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. If the company selects or otherwise uses a different peer group from the peer group used by it for the immediately preceding fiscal year, the reasons for the change should be explained in a footnote, and a comparison should be presented of cumulative total return with that of both the newly selected peer group and the peer group used in the immediately preceding fiscal year.
1 Executive compensation disclosure, including pay versus performance information, may be incorporated by reference into a company’s annual report on Form 10-K from the definitive proxy statement if it is filed within 120 days after the end of the fiscal year covered by the Form 10-K. However, if the definitive proxy statement is not filed by such time, the executive compensation disclosure must be filed as part of Form 10-K or an amendment to Form 10-K.