Observations on the SEC’s Proposed Pay Versus Performance Rule
The SEC has issued a proposed rule to require companies to disclose the relationship between executive compensation and the financial performance of a company. The details of the proposed rule have been well publicized, and a summary is included to provide context for the discussion which follows. In the discussion I intend is to highlight potential aberrations in the proposal.
The proposed rules would require companies to disclose in a new table the following information:
- Executive compensation actually paid for the principal executive officer, which would be the total compensation as disclosed in the summary compensation table already required in the proxy statement with adjustments to the amounts included for pensions and equity awards. The amount disclosed for the remaining named executive officers identified in the summary compensation table would be the average compensation actually paid to those executives.
- The total executive compensation reported in the summary compensation table for the principal executive officer and an average of the reported amounts for the remaining named executive officers.
- The company’s total shareholder return on an annual basis, using the definition of total shareholder return, or TSR, included in Item 201(e) of Regulation S-K, which sets forth an existing requirement for a stock performance graph.
- The TSR on an annual basis of the companies in a peer group, using the peer group identified by the company in its stock performance graph or in its compensation discussion and analysis.
Using the information presented in the table, companies would be required to describe the relationship between the executive compensation actually paid and the company’s TSR, and the relationship between the company’s TSR and the TSR of its selected peer group. This disclosure could be described as a narrative, graphically, or a combination of the two.
What aberrations may exist? First, there may be no link at all between executive pay and TSR. This isn’t necessarily a governance faux pas. Executive pay may well have increased because of improved financial metrics the compensation committee chose wisely to reward while the stock price declined because of general market conditions beyond the executives’ control. Sure, the SEC invites the company to explain the reasons and to submit alternative measures of performance, but that will be hard to do without making it look like an apology. Perhaps this will engender a trend to tie incentives to TSR to make the discussion easy and that may not universally by the best thing for companies to do.
Turnover in the executive ranks will likely penalize the company in the pay versus performance table, even if it is for the benefit of the company. The proposed rules are pretty clear that where more than one person served as CEO for the year you have to disclose the total compensation “for the persons who served as CEO.” This isn’t just an aggregation of amounts paid during the period of the year during which the person served as CEO or an average of the two amounts paid to the two CEOs. For the departing CEO, it will include all amounts earned during the fiscal year (S-K 402(a)(4)), including retirement earnings and any severance (S-K Item 402(c)(ix)(D)(1)). For the incoming CEO, it will include any signing incentives or earnings while serving in another capacity at the registrant. For the other named executive officers, similar principles apply, particularly where there is turnover in the CFO position (because both would be named executive officers, but here at least you get to effectively divide by two) or for those swept in by the two “additional individuals” who would have had NEO status if still employed at the end of the year (S-K 402(a)(3)(iv)).
When disclosing the TSR of a peer group, registrants are permitted to choose between issuers and indexes used for the company’s stock performance graph required by S-K Item 201(e)(1)(ii) or the “peer group” for purposes of the CD&A set forth in S-K Item 402(b). The CD&A rules do not technically refer to a “peer group” and it is most likely a reference to companies disclosed for purposes of benchmarking. Further the peer group must be capitalization weighted. To my knowledge, most companies do not weight for capitalization when engaging in benchmarking, which could lead to some departure in the index from decisions of the compensation committee. If the peer group for the stock performance graph is used, that also must be capitalization weighted, apparently in all circumstances according to Instruction 7 of the proposed rule. The stock price performance graph does not require capitalization weighting for published industry or line-of-business indexing, although those published indexes may be capitalization weighted.
The proposed rules require a “clear description” of a comparison between the company’s cumulative total shareholder return and cumulative total shareholder return of the company’s peer group. This seems to call for a good deal of speculation, as issuers cannot have an in depth knowledge of what drove stock price returns for any number of companies that will ultimately span a five year period.
Adjustments for Equity Awards
The proposed rules require the grant date fair value of the equity awards in the summary compensation table be deducted from total compensation, and the fair value on the vesting date for all stock and option rewards in any given year be added back when calculating “compensation actually paid.” For many, this will be a welcome adjustment given what is perceived to be unrealistically high values assigned to such awards in the summary compensation table. It will also lead to some surprises. For instance, I surmise that even an underwater option which vests has a fair value, given the value can rise during the remaining term of the option, even though realization of that amount is uncertain at best. In-the-money options which vest will probably have a higher fair value than the spread between the exercise price and stock price, as an option on the shares for the remaining term itself has value.
How equity based multi-year performance awards which vest in any given year will play out is an open question. The underlying metrics for vesting may not be tied to TSR, leading to a departure. Multi-year equity based performance awards which vest in the earliest of the reported period will be based on success metrics for prior years not reflected in TSR for the earliest period, perhaps skewing results.
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