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What The SEC's Proposal On Pay For Performance Means For Companies Going Forward

This article is more than 8 years old.

Finally, after five years of waiting, the SEC issued new rules a few weeks ago on the link between pay and performance disclosure. The rules, which are in accordance with Section 953(a) of Dodd-Frank, will require companies to disclose the relationship between compensation “actually” paid to executives and the financial performance of the company measured by total shareholder return (TSR).  My colleagues at Farient and I took a closer look at the SEC’s pending pay for performance rule to determine whether these rules are reasonable and what they’ll mean for companies going forward.

The Rules At A Glance

The rule is designed to provide greater transparency and to better inform shareholders voting on the executive compensation plans. The rules require:

  1. An additional table in the proxy report, which includes data on compensation and company performance
  2. An explanation of the data in either a narrative and/or graphical format

Specifically, the table must show compensation data for the CEO and an average for all other NEOs. For the first year the rule is in effect, the SEC will require three years of data; in the second year, four years of data; in the third year and five years of data. Finally, the disclosure must reflect the amount of compensation the CEO and NEOs are “actually” paid.

Defining Actual Compensation

According to the SEC, “actual” compensation should be considered “vested” compensation. Using this interpretation, “actually” paid equals:

Summary Compensation Table (SCT) total compensation
Minus: The change in pension value
Minus: The grant date equity value
Plus: The pension value applicable to that year of service
Plus: The fair value as of the vesting date for equity

Pension Value added back should be the actuarially determined service cost for services rendered in the applicable year, as defined by the Financial Accounting Standard Board’s (FASB) Accounting Standards Codification (ASC) Topic 715. This excludes changes in interest rates, the executive’s age and other actuarial inputs regarding previously accrued benefits.

Equity Value added back is the fair value (as of the vesting date) for equity vesting in that year, consistent with fair value measurement guidance in FASB ASC Topic 718. This means that options will be valued at their fair market value, in accordance with an option pricing model at the date of vesting as opposed to grant date value, which does not provide an accurate view of total compensation.

Highlighting The New Rules

To help companies envision what the rules would mean for them, below we’ve provided an illustration of what the new proposed table and accompanying graphical representation might look like:

Illustrative Pay for Performance Table (2012 – 2014)

The pay for performance information should help companies improve transparency and investors’ understanding of the executive pay programs. If, however, a company believes this increased transparency will have a negative impact on its Say on Pay vote, it should determine whether and how best to modify the compensation program’s design.

Leveling The Playing Field For Companies And Investors

While there are always plusses and minuses to any proposal, my colleagues and I believe the SEC’s proposed rules are reasonable. For starters, they will force companies to explain and demonstrate the link between pay and performance. This is a good thing for investors and will become increasingly important as activist investors continue to make waves.

We also appreciate that the SEC will ultimately require five years of compensation data, as it can often be difficult to demonstrate the link between pay and performance when looking at an individual year. Analyzing pay vs. performance over the longer term will help explain anomalies and solve this problem. Since companies have three years before they must disclose five years of compensation, they have time to ease into these new requirements.

In addition, the SEC is correct to measure performance through TSR and relative TSR, as these are the indicators investors rely on for determining their performance. Of course, companies can always discuss additional measures if they feel as though TSR and relative TSR don’t tell the full story.

Finally, since options are considered at their fair market value, as opposed to intrinsic value, companies will not be advantaged or disadvantaged by which long-term incentive vehicles they offer. Similarly, since total compensation is considered, a company’s pay mix won’t affect its perceived performance.

That doesn’t mean the proposal is without its downsides. A significant issue with the proposed rules is that the time horizon of the pay measured will not necessarily match the time horizon over which performance is delivered. Second, those companies using measures that drive shareholder value (rather than using shareholder value, like TSR or relative TSR, directly) may experience a lower correlation of awards to value in any given period, compared to those using shareholder value directly.

Despite the negatives, the SEC’s proposed rules to Section 953(a) of Dodd Frank will go a long way towards increasing transparency and helping to illustrate the crucial link between pay and performance.