SEC Adopts Final Pay-for-Performance Disclosure Rule

On August 25, 2022, the SEC adopted final rules requiring reporting companies to disclose the relationship between executive pay and company performance (the “Final Rules”). This Alert summarizes some of the key features of the Final Rules, and includes our thoughts on some of the implementation challenges issuers may face. The full text of the adopting release for the Final Rules is available here. 

The Final Rules were adopted to implement Section 953(a) of the Dodd-Frank Act. Section 953(a) required the SEC to adopt a rule requiring reporting issuers to disclose a clear description of compensation information that shows the relationship between executive compensation actually paid and the financial performance of the issuer as measured by taking into account increases or decreases in share price and any dividends or other distributions paid.  

Under the Final Rules, issuers must include a new Pay Versus Performance table and related discussion in proxy or information statements that are required to include executive compensation disclosures for fiscal years ending on or after December 16, 2022. 

Emerging growth companies, foreign private issuers, and registered investment companies are exempt from the new disclosure requirements. 

New Pay Versus Performance Table

The Final Rules add a new Item 402(v) to the existing executive compensation disclosure rules contained in Item 402 of Regulation S-K. Under the Final Rules and Item 402(v), reporting companies will be required to include a new Pay Versus Performance table using the format below in proxy or information statements where executive compensation disclosures are otherwise required:

The disclosures required by each column of the table can be summarized as follows (with smaller reporting companies eligible for scaled disclosure as discussed below):

• Year: Compensation and performance information must be presented for the issuer’s last five fiscal years.

The Final Rules provide limited transition relief, as the table initially will be required to include only three years of compensation and performance information. In addition, in its first year as a reporting company, a newly public issuer is required to provide data for only its most recent fiscal year. In either case, an additional year of data will be included for each year after the first year the disclosure is required until the five-year requirement is fully phased in.
• Summary Compensation Table Total For PEO: Total compensation for the issuer’s principal executive officer (“PEO”) as reported in the Summary Compensation Table for the applicable year is required to be disclosed again in this table. If there were multiple PEOs for any year covered by the table, additional columns (b) and (c) should be added to the table to separately report the compensation for each of the individuals who served as PEO. The issuer should include footnotes identifying the name of each individual included as a PEO in the table.
• Compensation Actually Paid to PEO: The starting point for this column is the total compensation for the issuer’s PEO (or PEOs) as reported in the Summary Compensation Table for the applicable year (the “SCT Total”). The SCT Total amount is then adjusted for each fiscal year in the table to reflect changes in the value of equity awards and pension benefits as follows:
  • Equity Awards. The amounts that were reported in the Stock Awards and Option Awards columns of the Summary Compensation Table for that fiscal year should be deducted from the SCT Total. The following adjustments should then be made:
    • For awards granted during that fiscal year that are outstanding and unvested at the end of that year, add the fair value of the award as of the end of that year.
    • For awards that are granted and that vest during that fiscal year, add the fair value of the award as of the vesting date.
    • For awards granted in any prior fiscal year that are outstanding and unvested at the end of that fiscal year, add the amount of the change in the fair value of the award between the end of the immediately preceding fiscal year and the end of that fiscal year (note that such change in the fair value of the award may be a negative number). For example, in reporting compensation actually paid for fiscal 2022 attributable to the portion of an award that was granted prior to fiscal 2022 and still unvested at the end of fiscal 2022, the issuer should compute (i) the fair value of that portion of the award at the end of fiscal 2022 minus (ii) the fair value of that portion of the award at the end of fiscal 2021, and include that difference (whether positive or negative) in the compensation actually paid to the executive in fiscal 2022.
    • For awards granted in any prior fiscal year that vest during that fiscal year, add the amount of the change in the fair value of the award between the end of the immediately preceding fiscal year and the vesting date (note that such change in the fair value of the award may also be a negative number).
    • For awards granted in any prior fiscal year that the company determines during that fiscal year will not vest, subtract the fair value of the award as of the end of the immediately preceding fiscal year.
    • If any dividends or other earnings are paid on outstanding and unvested awards during that fiscal year, add the dollar value of such dividends or earnings.
    • If an award is materially modified during that fiscal year, add the amount by which the fair value of the award as of the date of the modification exceeds the fair value of the original award on the modification date.
  • Pension Benefits. In addition, the issuer should subtract the change in the actuarial present value of the executive’s benefit under any defined benefit pension plans during the applicable fiscal year from the SCT Total, and should add the aggregate “service cost” (calculated as the actuarial present value of the executive’s benefits under all such plans attributable to services rendered during that year) and “prior service cost” (calculated as the entire cost of the executive’s benefits conferred via a plan amendment during the year that is attributable to services rendered in periods prior to the amendment).  
  • Additional footnote disclosure of the additions and subtractions to the SCT Total described above is also required (with the adjustments for the Non-PEO NEOs described below presented as averages across the entire Non-PEO NEO group for the applicable year). The computation of the “fair value” of equity awards and “service cost” of pension benefits should be made in a manner consistent with the issuer’s financial reporting.
• Average Summary Compensation Table Total for Non-PEO NEOs: The average (not aggregate) total compensation for the issuer’s named executive officers (other than its PEO) (referred to as the “Non-PEO NEOs”) as reported in the Summary Compensation Table for the applicable fiscal year is required to be included here. The issuer should include footnotes identifying the name of each individual included among the Non-PEO NEOs in the table.
• Average Compensation Actually Paid to Non-PEO NEOs: The average total compensation actually paid to the issuer’s named executive officers (other than its PEO) for the applicable year is required to be included here. The compensation actually paid to these executives is determined in the same manner as described above for the issuer’s PEO.
• Total Shareholder Return and Peer Group Total Shareholder Return: The issuer’s cumulative total shareholder return for the applicable year, as well as the cumulative total shareholder return for the applicable year for the issuer’s peer group, is required to be included here. For the peer group, an issuer may either use the same index or peer companies used in the issuer’s performance graph (typically included in the issuer’s 10-K), or the companies used as compensation benchmarking peers and disclosed in the issuer’s CD&A (with footnote disclosure of the companies used if the peer group is not a published industry or line-of-business index). For each year, the amount reported in the table is the return on a fixed investment of $100 in the issuer’s stock (or the stock of the peer companies, as applicable, with the returns of the peer companies determined on a weighted basis using their respective market capitalizations at the beginning of the period) for the period beginning on the last trading day before the earliest fiscal year in the table through the end of the fiscal year for which the total shareholder return is being calculated.
• Net Income: The issuer’s net income for the applicable year is required to be included here.
• Company-Selected Measure. The issuer is also required to identify the metric it considers the most important financial performance measure used to link compensation actually paid to its named executive officers to company performance for the most recent fiscal year (other than total shareholder return or net income) and disclose its actual performance for this metric for each year in the table (renaming the heading of the column to identify this metric). The metric selected by the issuer does not need to be a financial measure under GAAP or otherwise included in the issuer’s financial statements. If the financial measure is a non-GAAP measure, the reconciliation and other requirements of Regulation G and Item 10(e) of Regulation S-K will not apply; however, consistent with current rules applicable to target level disclosures in the CD&A, disclosure must be provided as to how the results are calculated for the metric selected from the issuer’s audited financials. In addition, if an issuer believes there are additional performance measures (including non-financial measures) that are important to describe, an issuer may provide these additional performance measures as new columns in the table as long as the additional disclosures are not presented with greater prominence than the required disclosure and are not misleading or otherwise obscure the required information.
• Smaller Reporting Companies: Smaller reporting companies are required to include only three years of data in the table (as opposed to five years), with the initial filing of the table required to provide only two years of data. Smaller reporting companies are also not required to include the Peer Group Total Shareholder Return or the Company-Selected Measure in the table or make pension-related adjustments in calculating the compensation actually paid to their executives.

Description of Relationship Between Compensation Actually Paid and Performance

In addition to the Pay Versus Performance table, the Final Rules require that the issuer provide a clear description of the relationship between the compensation actually paid to the issuer’s PEO and other named executive officers and each of the performance measures reported in the table (i.e. the issuer’s cumulative total shareholder return, the issuer’s net income, the issuer’s “Company-Selected Measure” and any additional performance measures presented by in the table). The description should cover each of the five (or fewer) years covered by the Pay Versus Performance table.  Issuers are also required to include a comparison of the issuer’s cumulative total shareholder return to the cumulative total shareholder return achieved by the issuer’s peer group during each of the years covered by the Pay Versus Performance table. The required disclosures may be provided as a narrative, graphically, or a combination of the two. For example, the SEC would permit this disclosure requirement to be satisfied by presenting a graph providing executive compensation actually paid and change in the financial performance measure(s) (i.e., total shareholder return, net income or the “Company-Selected Measure”) on parallel axes and plotting compensation and those measures over the required time period. The SEC would also permit use of a narrative or tabular disclosure showing the percentage change over each year of the required time period in both executive compensation actually paid and the financial performance measures together with a brief discussion of how those changes are related.

Tabular List

The Final Rules also require that issuers (other than smaller reporting companies) provide an unranked list of at least three, and not more than seven, financial performance measures it considers most important in linking the compensation actually paid to its executives for the most recently completed fiscal year with company performance.  If less than three performance measures were used by the issuer to link executive compensation with company performance, then the issuer need not disclose three measures but must disclose all such measures actually used. The issuer may also include non-financial performance measures it uses to link executive compensation to company performance so long as it satisfies the above requirements as to financial performance measures, and no more than seven measures total are included on the tabular list. The measure selected by an issuer and presented as the issuer’s “Company-Selected Measure” in the Pay Versus Performance must be a financial measure included in the tabular list.

Issuers may present the list in three different ways: (i) one list applicable to all of the issuer’s named executive officers; (ii) two separate lists, with one applicable to the issuer’s PEO and one for the remaining named executive officers; or (iii) a separate list for each of the issuer’s PEO and the other named executive officers.  Issuers will not be required to provide the methodology used to calculate the measures in the tabular list (including the measure selected as the “Company-Selected Measure”), although issuers should consider whether such disclosure would be helpful to investors to understand the measures included or the list or to prevent the disclosure from being confusing or misleading.  

Location of Pay Versus Performance Disclosure

The Final Rules provide issuers flexibility to decide where to locate the new Pay Versus Performance disclosures within the proxy or information statement.

Inline XBRL Tagging

The disclosures required by the Final Rules must be provided in Inline XBRL format, with separate tagging of each value disclosed in the Pay Versus Performance table, block-text tagging of footnote disclosures and the relationship disclosure, and specific tagging of quantitative amounts within the footnote disclosures. The Inline XBRL data would be required to be provided as an exhibit to the definitive proxy or information statement filed with the SEC, and would be the first proxy statement disclosures required to be provided in XBRL format.

Compliance with the Inline XBRL requirements will be required immediately with an issuer’s first disclosures containing pay-versus-performance disclosure, except that smaller reporting companies are eligible for a phase-in period requiring compliance with the third filing providing pay-versus-performance disclosure.     

OMM Comments

Our thoughts on some of the key features of the Final Rules and implementation challenges issuers may face are highlighted below.

• Start Early. We expect that preparation of the Pay Versus Performance section will require significant time and resources, particularly in the first year when issuers will need to compute and provide three years of data in the table and provide a “clear” description of the relationship between executive compensation actually paid and company performance over that period. As adopted, the Final Rules require issuers to include these disclosures in their executive compensation disclosures for fiscal years ending on or after December 16, 2022 i.e., for the upcoming 2023 proxy session. 
• Calculating the Value of Equity Awards “Actually Paid”: The methodology in the Final Rules for valuing equity awards in determining compensation actually paid to executives requires issuers to determine the “fair value” of equity awards at various times while the award is outstanding (for example, at the end of each fiscal year while the award is unvested and then, when the award vests, on the vesting date). This will impose an additional burden on issuers who typically determine the fair value of awards only on the grant date. For stock options, this approach will require issuers to value the options on these different dates using a Black-Scholes or similar binomial pricing model, even though issuers are generally not otherwise required by the SEC’s disclosure rules or GAAP accounting rules to perform this calculation or disclose this information.
• Pension Calculations. For issuers with defined benefit pension plans, the Final Rules requires the change in the present value of these pension benefits attributable to “service cost” to be included in the amount of compensation actually paid (rather than using the change in the actuarial present value of pension benefits otherwise used to value compensation for purposes of the Summary Compensation Table). “Service cost” is the actuarial present value of each named executive officer’s pension benefits attributable to services rendered during the applicable fiscal year plus, if the pension plan was implemented or amended during the year, the entire cost of benefits during the applicable year that are attributed by the new arrangement or the amendment to services rendered in prior fiscal years. While this service cost is typically calculated to report the change in pension benefits that is currently required to be reported in the Summary Compensation Table, the service cost is not otherwise currently required to be separately disclosed by issuers.
• Extensive Footnote Disclosures. The Final Rules require that issuers provide significant supplemental information in footnotes to the Pay Versus Performance table. For example, issuers are required to provide the names of each of their named executive officers over the five years covered by the table, and detail on each of the amounts deducted from and added to the SCT Total for the PEO and the average SCT Total for the Non-PEO NEOs in computing compensation actually paid for each year. The specific companies included in the issuer’s peer group and/or the reasons for any changes to the peer group used in a prior year may also need to be disclosed. 
• “Clear” Description of Relationship Between Compensation Actually Paid and Company Performance. Issuers will need to assess the data presented in the Pay Versus Performance table and decide on an approach for discussing the relationship between compensation actually paid and company performance as reflected in the table. The Final Rules provide flexibility to combine narrative and graphic presentations for this discussion.
• Potential Overlap with “Realized Pay” and “Realizable Pay” Disclosures: In recent years, some issuers have elected to voluntarily include alternative compensation tables in their proxies disclosing their executives’ “realized pay” or “realizable pay.” Because of the overlap between these two compensation concepts and the concept of compensation “actually paid” in the Final Rules, issuers that have included realized or realizable pay disclosures in the past will need to determine whether those disclosures should be retained and, if so, how they will synch up with the new Pay Versus Performance table.
• Multiple PEO Issues: The Pay Versus Performance rules proposed by the SEC in 2015, would have required issuers who had more than one PEO serving in any fiscal year to aggregate their total compensation and report it as one amount. The approach in the Final Rules requiring that each PEO’s compensation be reported separately helps address the concern that aggregate reporting could overstate PEO compensation (for example, due to non-recurring payments such as severance for the outgoing PEO or a signing bonus for the incoming PEO). However, the requirement in the Final Rules to add columns to the Pay Versus Performance table for each PEO will add complexity. 

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Jeff Walbridge, an O’Melveny partner licensed to practice law in California, C. Brophy Christensen, an O’Melveny partner licensed to practice law California, Robert Plesnarski, an O’Melveny partner licensed to practice law in the District of Columbia and Pennsylvania, Shelly Heyduk, an O’Melveny partner licensed to practice law in California, Chris Del Rosso, an O’Melveny partner licensed to practice law in California and New York, and Warren Fox, an O'Melveny senior counsel liscensed to practice in California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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