Rapid Rulemaking: SEC Update
Long-awaited Pay v. Performance Rules Adopted
By Will Burns, Brandon Bortner, Tina Tsaur, Spencer Young, Camille Yona, Katie Xu
Recently, the U.S. Securities and Exchange Commission (the “Commission”) adopted long anticipated final rules requiring registrants to disclose information regarding the relationship between the actual compensation paid to their executives and the registrant’s financial performance (the “Pay v. Performance Rules”). The Commission believes that these disclosures will “allow investors to assess a registrant’s executive compensation actually paid relative to its financial performance more readily and at a lower cost than under the existing executive compensation disclosure regime.”
In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act, as amended (“Dodd-Frank”), added Section 14(i) to the Securities Exchange Act of 1934, as amended (“Exchange Act”), which mandated that the Commission will require issuers to include in their proxy or consent solicitation material disclosure “[showing] the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions.” Accordingly, in April 2015, the Commission initially proposed the Pay v. Performance Rules, but did not adopt a final rule following the closing of the comment period. Fast-forward over six and a half years later, the Commission reopened the comment period in January 2022 and adopted final rules integrating the public’s comments on August 25, 2022.
Requirements of Final Amendments
The Pay v. Performance Rules add Item 402(v) to Regulation S-K, which introduces new tabular and narrative disclosure requirements in the context of a proxy or information statement. These disclosures will not be required in filings otherwise implicating Item 402 disclosure (i.e., a registrant’s Form 10-K or a registration statement). In addition, Item 402(v) disclosure will not be deemed to be incorporated by reference into other Exchange Act or Securities Act of 1933, as amended, filings in the absence of specific incorporation by reference language. Also, the new disclosures need not be housed within the Compensation Discussion and Analysis (“CD&A”) section of the proxy or information statement; rather registrants have flexibility as to where the new disclosure sits. All reporting companies—except foreign private issuers, registered investment companies, and emerging growth companies—will be expected to comply with these updated disclosure requirements in proxy and information statements required to include Item 402 executive compensation disclosure for fiscal years ending on or after December 16, 2022, subject to scaled requirements for smaller reporting companies (“SRCs”) and an initial phase-in period.
The following provides a general overview of the requirements of new Item 402(v).
Registrants will be required to provide a table disclosing specified executive compensation and financial performance measures for the registrant’s five most recently completed fiscal years (or three years in the case of an SRC). The table will include summary compensation information (i.e., as disclosed in the Summary Compensation Table) and actual compensation information for the registrant’s principal executive officer (“PEO”) and an average of the other named executive officers (“NEOs”), as well as the registrant’s total shareholder return (“TSR”), the weighted TSR of the registrant’s peer group, the registrant’s net income, and an additional company-selected performance measure.
To aid in shareholders’ review and understanding of the data, the rules call for footnote disclosure regarding which NEOs’ compensation is included in the average. Accordingly, investors will be able to determine whether year-over-year changes are attributable to changes in the makeup of the NEOs or other factors. The concept of actual compensation is a new measure introduced by the rule, taking an executive’s total compensation, as reported in the Summary Compensation Table, and adjusting it for equity awards, deferred compensation and pension benefits. The new table will be in the following format: / 
Compensation Actually Paid
Columns (c) and (e) of the new table aim to provide shareholders with a look at the actual compensation paid to executives. To calculate “actual” compensation, a registrant will begin with the summary compensation totals reported in columns (b) and (d) of the new table and make certain adjustments related to pension benefits, deferred compensation, and equity awards. The Commission’s explanation of the actual compensation calculation is lengthy and complex, but in summary:
Pension Benefits Adjustments
The adjustments include:
(a) deducting the aggregate change in the actuarial present value of all defined benefit and actuarial pension plans; and
(b) adding back the aggregate of (i) the service cost and (ii) the prior service cost.
For the purposes of these calculations, the “service cost” is the actuarially derived cost of the executive’s services during the fiscal year and “prior service cost” is the entire cost of benefits granted by a plan adoption or amendment in the covered fiscal year that are attributable to services rendered in periods prior to the plan adoption or amendment.
Deferred Compensation Adjustments
This adjustment includes the addition of above-market or preferential earnings on deferred compensation that is not tax qualified.
Equity Awards Adjustments
These adjustments include:
(a) deducting equity award amounts;
(b) for equity awards granted in the covered fiscal year, adding:
- the year-end fair value if the award is outstanding and unvested at year end;
- the fair value as of the vesting date if the award was granted and vested in the same year;
(c) for awards granted in prior fiscal years, adding or subtracting, as applicable:
- the change in such awards’ fair value since the end of the prior fiscal year, if the award is outstanding and unvested at year end;
- the change in such awards’ fair value from the end of the prior fiscal year through the vesting date, if the award vested during the covered year;
- the fair value of such award as of the end of the prior fiscal year, if the award is forfeited during the covered fiscal year; and
(d) adding the dollar value of any dividends or other earnings paid on stock or option awards in the covered fiscal 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 covered fiscal year.
This aspect of the calculation of actual pay is the most changed from the original proposed rule, as a result of the comments the Commission received. According to the Commission, the resulting final approach as outlined above is the most effective method to accurately capture actual compensation, as it is consistent with the method of consideration for other forms of unvested compensation and general accounting principles overall.
Total Shareholder Return and Peer Group TSR
Under the new rules, registrants will generally be required to report TSR and weighted peer group TSR in columns (f) and (g) of the table (SRCs are exempt from providing peer group TSR data). Although there were differing opinions among commenters after the proposed rules were released, the Commission concluded that these measures would allow for one consistently calculated measure for all registrants, which would increase comparability between companies. In addition, when considered in conjunction with the other measures of performance discussed below, the Commission believes that TSR disclosure will be useful in assessing the relationship between executive pay and company performance. To the extent that there is misalignment between executive compensation and the TSR data presented, the Commission believes potential “lengthy explanatory disclosures to explain any misalignments between compensation and TSR” to be “the types of disclosures intended by the language of Section 14(i)” and will guide investors to understand the relationship between the registrant’s pay and performance.
For the purposes of the new table, TSR will be calculated in the same manner as it is for the purposes of registrants’ stock performance graph (i.e., Item 201(e) disclosure), and should utilize a fixed investment of one hundred dollars as a measurement point. The peer group used to calculate weighted peer group TSR can be either the peer group used for the preparation of a registrant’s stock performance graph or the peer group a registrant utilizes for benchmarking in its CD&A. Certain footnote disclosures regarding peer group composition or year-over-year changes might be required.
Net income will be required to be disclosed in column (h) of the new table. The Commission believes net income to be closely related to how companies determine compensation, as well as a standard measure already generally used and understood. In addition, the inclusion of net income in the table provides additional insight on a registrant’s financial performance which would grant investors a clearer picture than TSR data alone.
Company-Selected Measure and List of “Most Important Performance Measures”
In column (i) of the table, registrants must report a company-selected financial performance measure that the registrant believes constitutes the most important factor linking its executive compensation to performance for the prior fiscal year. This measure should be included in the registrant’s new narrative discussion regarding certain delineated significant financial performance measures utilized in its executive compensation (see the New Narrative discussion below for additional detail).
Like other aspects of the executive compensation disclosure regime, the Pay v. Performance Rules require registrants to provide additional color explaining their tabular disclosures. Here, registrants will be required to provide a “clear description” of (i) the relationships between each of the financial performance measures included in the new table and the executive compensation actually paid to its PEO and NEOs and (ii) the relationship between the registrant’s TSR and its peer group TSR, all within the time horizon applicable to the registrant. The Commission advises this disclosure should be presented “in the format that most clearly provides information to investors about the relationships, based on the nature of each measure and how it is associated with executive compensation actually paid,” which could be in narrative or graphical format or a combination of the two./ 
In addition, the rules call for registrants to provide an unranked list of three to seven of the “most important financial performance measures” used to connect executive compensation actually paid to the company’s performance (the “Tabular List”)./  The Tabular List can be broken down into separate lists for a registrant’s PEO and NEOs or further segregated for each NEO individually. The company-selected measure included in the new Item 402(v) table must be included in the Tabular List and should be the “most important” performance measure “linking” actual executive compensation for the last fiscal year to the registrant’s financial performance over that time. This disclosure is geared toward enabling investors to assess more effectively which performance measures have the greatest impact on executive compensation.
What to Expect
Reporting companies subject to these final rules should pay close attention to the requirements that will soon be implemented so as to avoid being caught flat-footed when they become effective. Most registrants with fiscal years ending on December 31, 2022 will be subject to the Pay v. Performance Rules and will need to account for the new rules in their proxy and information statements for 2023 through inclusion of the new Item 402(v) disclosure. However, rather than requiring disclosure over the entire five-year look back from the outset, registrants will initially be required to provide disclosure covering the prior three years and thereafter to provide disclosure for an additional year. Since SRCs are subject to a scaled lookback period, they will initially be required to provide disclosure for the last two fiscal years.
Given the complexity and novelty of these requirements, reporting companies that are subject to the Pay v. Performance Rules should allocate ample time to understanding and ensuring proper implementation of the new rules in their upcoming filings so as to avoid potential legal liability that could arise from non-compliance. Not only do the requirements require the preparation of novel calculations, which could prove time-consuming for a registrant’s human resources and accounting functions, registrants will need to give thought to which financial measures should be included in the Tabular List. Finally, a registrant should be prepared to craft an appropriate explanation of its executive compensation decisions in the narrative disclosure, including supplemental clarifying information, to the extent that the registrant’s executive compensation does not appear aligned with its actual performance.
 Section 14(i) to the Exchange Act
 Adjustments include subtracting the actuarial present value of defined benefit and actuarial pension plans and the addition of certain actuarially determined service costs, taking into account prior service cost.
 Asterisks indicate portions of the table from which smaller reporting companies are exempt. The company-selected measure should be specifically named in column (i).
 Weighted peer group TSR should be calculated per Item 201(e) of Regulation S-K.
 To the extent that a registrant does not consider at least three financial performance measures, the registrant is only required to disclose the financial performance measures actually utilized.
 Significant non-financial performance measures can also be included in this list so long as at least three financial performance measures are included (or fewer, if less than three are utilized).
 If the most important financial measure is already included in the table, the registrant should select the second most important financial measure as the company-selected measure.