The Securities and Exchange Commission (SEC) recently issued its long-awaited proposal for "pay-versus-performance" disclosure. The proposed rules would implement the requirements of Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).

The proposed rules would require public companies—other than emerging growth companies and foreign private issuers—to disclose the relationship between executive pay and a company's financial performance, as measured by cumulative total shareholder return (TSR). The enhanced disclosure would be provided in a specific manner detailed in the proposed rules and is intended to give shareholders a metric for assessing executive compensation relative to financial performance that can be compared across multiple companies and to provide greater transparency.

Approval of the proposed rules was by a divided vote of 3 to 2.¹ Final rules are expected to be adopted later this year (after a public comment period), and issuers likely would be required to comply with the new disclosure requirements for the 2016 proxy season.

The SEC believes that the disclosure of pay-versus-performance would supplement the Compensation Discussion and Analysis (CD&A) as part of a shareholder's evaluation of a company's executive compensation practices, and may provide a useful point of comparison about a compensation committee's approach to linking pay and performance. The SEC also believes that the proposed disclosure may provide relevant information for purposes of director elections by helping shareholders evaluate the directors' oversight relating to executive compensation.

Highlights of the Proposed Rules

• Issuers would be required to present disclosure separately for the principal executive officer (PEO), and as an average for the other named executive officers (NEOs).
• Issuers would be required to disclose the executive compensation actually paid, total compensation as disclosed in the Summary Compensation Table, TSR, and peer group TSR in a standardized table (as set forth below).
• In addition, using the information presented in the new standardized table, issuers would be required to provide a clear description of the relationship between: (1) executive compensation actually paid and the issuer's TSR; and (2) an issuer's TSR and peer group TSR, in each case, for each of the five most recently completed fiscal years.
• The new disclosure would be required to be included in proxy or information statements in which executive compensation disclosure pursuant to Item 402 of Regulations S-K is required (for most companies, this will be the annual proxy statement), but the proposed rules do not mandate any specific location for the new disclosure (so that issuers may decide for themselves where best to present the disclosure).
• Issuers would also be required to "tag" the disclosure in an interactive data format using eXtensible Business Reporting Language, or XBRL.

Pay-Versus-Performance Table

In any proxy or information statement for which executive compensation disclosure under Item 402 of Regulation S-K is required, the proposed rules would require the inclusion of the following new Pay-Versus-Performance Table.

The proposed rules would require disclosure of the compensation actually paid to the PEO, and as an average for the other NEOs. Executive compensation actually paid for a fiscal year would be calculated as the total compensation as reported in the Summary Compensation Table for that year: (1) less the aggregate change in the actuarial present value of pension benefits; (2) plus the actuarial present value of the benefits attributable to services rendered during the applicable fiscal year under all pension plans reported in the Summary Compensation Table; (3) less the grant-date value of any stock and option awards granted during the year that are subject to vesting; and (4) plus the value of vesting of stock and option awards during the year. If, during the last completed fiscal year, an issuer adjusted or amended the exercise price of previously vested options or SARs, or otherwise materially modified such awards, the proposed rules would require the issuer to include the incremental fair value of the modified award. The adjustment additions relating to pensions and equity awards reflect new reporting requirements.

It is important to note that the proposed rules would require that equity awards be considered actually paid on the date of vesting and not at the date of grant as currently required by the Summary Compensation Table. This disclosure would include stock options which are vested but are unexercised. For certain issuers, this new required disclosure may be a more realistic value of the equity awards than the value currently required to be reported in the Summary Compensation Table and shareholders would be able to view the differences in value from the fair value at grant and the value at vesting.

Disclosure of Relationship Between Executive Compensation and TSR

Under the proposed rules, using the values presented in the Pay-Versus-Performance Table, issuers would be required to describe the relationship between: (1) the executive compensation actually paid by an issuer to the PEO and the average of the executive compensation actually paid to the NEOs other than the PEO listed in the Summary Compensation Table; and (2) the cumulative TSR of the issuer, for each of the issuer's completed fiscal years. The disclosure would also include a comparison of the cumulative TSR of the issuer and the cumulative TSR of the issuer's peer group over the same period.

The disclosure about the relationship would follow the Pay-Versus-Performance Table and could be described as a narrative, graphically, or a combination of the two. Using TSR is intended to increase the comparability of pay-versus-performance disclosure across issuers, and to provide a measure of financial performance that is objectively determinable from the share price of the issuer and not open to subjective determinations of performance. Examples of potential disclosures of the relationship between executive compensation and TSR include: (1) a graph providing executive compensation actually paid and change in TSR on parallel axes and plotting compensation and TSR over the required time period; or (2) showing the percentage change over each year of the required time period in both executive compensation actually paid and TSR together with a brief discussion of that relationship.

Issuers also would be permitted to provide supplemental measures of financial performance so long as any additional disclosure is clearly identified, not misleading and not presented with greater prominence than the required disclosure.

Smaller Reporting Companies

Issuers that are "smaller reporting companies" under SEC regulations would be subject to the proposed rules, but would be required to provide only three years of disclosure instead of the proposed five years. Also, a smaller reporting company would not be required to disclose amounts related to pensions for purposes of disclosing executive compensation actually paid. Finally, smaller reporting companies would be required to present absolute TSR but not peer group TSR.

Transition Relief

The proposed rules would permit an issuer to provide disclosure for only three years in the first proxy or information statement in which it provides the new disclosure, and then to add another year of disclosure in each of the two subsequent annual proxy filings that require this disclosure. Smaller reporting companies would initially provide the information for two years, adding an additional year in their subsequent annual proxy or information statement that requires this disclosure.

Comments

The SEC has requested general comments and comments to 64 specific questions. The general public has a period of 60 days following publication of the proposed rules in the Federal Register to provide comments.

Next Steps

The proposed rules represent the SEC's latest rulemaking as required by the comprehensive executive compensation requirements under Dodd-Frank. The proposed rules are not expected to have a significant effect on current executive compensation practices. However, issuers should consider how their executive compensation arrangements and newly required disclosure would be presented in SEC filings, and the effects on investing and say-on-pay and other executive compensation voting. In particular, issuers should consider whether to provide supplemental measures of pay and performance and explanatory disclosure when, for example, TSR is not the optimal measure of performance.

¹ The SEC commissioners who voted against the proposed rules expressed certain objections in their statements, including the focus on TSR as the measure of financial performance, which was one of the major objections. In addition, the commissioners objected to the inclusion of smaller reporting companies in the proposed rules.