Proposed Dodd-Frank Pay Versus Performance Rules
Written By Brad Smith
The Dodd-Frank Act was enacted in 2010 and was intended to address shareholder rights and executive compensation practices. The Securities and Exchange Commission (the “Commission”) was directed as part of the Dodd-Frank Act to put in place a requirement that public companies disclose in their proxies information that shows the relationship between executive compensation actually paid (including change in value of long term incentives, dividends and distributions) and the financial performance of the company. This portion of the Dodd-Frank Act has come to be known as the Pay Versus Performance disclosure requirements.
On April 29th, some five years after Dodd-Frank took effect, the Commission issued a proposed rule to establish the disclosure requirements for Pay Versus Performance. The Commission is accepting comments on the proposal through July 7th.
The current regulations in place contain requirements for the disclosure of executive compensation and more principles-based disclosure requirements regarding the relationship between pay and performance.
The Pay Versus Performance proposal released by the Commission would require:
• Disclosure of the relationship between executive compensation actually paid to the company’s Named Executive Officers (NEOs) and the cumulative total shareholder return (TSR) of the company.
• Disclosure of the relationship between the company’s TSR and the TSR of a peer group chosen by the company, over the company’s five most recently completed fiscal years.
• Data be provided in an interactive data format using XBRL.
A prescribed table will be utilized that will include:
• Executive compensation actually paid
• The executive compensation to be used in this analysis would be the executive compensation currently disclosed in the Summary Compensation Table, modified to exclude changes in present value of benefits in pension plans, and to include the value of equity awards at vesting rather than when granted.
• Executive compensation as currently disclosed in the Summary Compenstion Table
• Company TSR
• Peer group TSR
The data must be presented separately for the Principal Executive Officer (PEO) and the other NEOs must be presented as an average.
For smaller reporting companies, the three most recent fiscal years are to be presented, and for other companies, five years must be presented. In addition, there is a phase-in period during initial implementation.
See below for a discussion of the special rules for smaller reporting companies and the phase in rules.
Pay Versus Performance is a required disclosure “in any proxy or consent solicitation material for an annual meeting of the shareholders.”
A clear, concise explanation of the NEO pay versus the company TSR and the company TSR versus the peer TSR is entailed. This is an important part of the requirements as it would disclose the relationship between executive compensation and company performance. There is no authoritative guidance in the proposed rules on where (in the proxy) this is required to be disclosed.
In Column (a) small filers would be required to disclose 3 years of data (resulting in 3 rows). Other filers would be required to disclose 5 years of data (resulting in 5 rows).
In Column (b) the compensation amount for the PEO required to be disclosed in the Summary Compensation Table would be presented. The Summary Compensation Table discloses total compensation for the PEO.
In Column (c) the compensation actually paid to the PEO would be disclosed for each year presented. The compensation actually paid would be equal to the Summary Compensation Table with two potential adjustments to arrive at compensation actually paid (i) pension benefits and (ii) equity awards. The adjustments would, for pension benefits, exclude changes in present value of benefits in pension plans and, for equity awards, consider equity awards compensation as they vest rather than when they are granted.
In Column (d) the average compensation amount for the non-PEO NEOs is required to be disclosed in the prescribed table above. The Summary Compensation Table discloses total compensation for the NEOs.
In Column (e) the average compensation actually paid to the non-PEO NEOs would be disclosed for each year presented. The compensation actually paid would be equal to the Summary Compensation Table with two potential adjustments to arrive at compensation actually paid (i) pension benefits and (ii) equity awards. The adjustments would, for pension benefits, exclude changes in present value of benefits in pension plans and, for equity awards, consider equity awards compensation as they vest rather than when they are granted.
In Column (f) the TSR would be disclosed for each year presented. TSR is defined as the total amount returned to investors (increase in stock price plus dividends).
In Column (g) the TSR for the Company’s peer group would be disclosed for each year presented. An alternative approach to the peer group is using an index TSR.
Application to Smaller Reporting Companies
Covered companies currently are not required to disclose pension accruals in their Summary Compensation Table; therefore, they are not required to make the pension adjustment for purposes of Pay Versus Performance. Additionally, smaller reporting companies will have one less column. Pay Versus Performance will not require smaller reporting companies to disclose peer group TSR (column g).
Phasing In the Disclosure Requirements
For regular reporting entities there would be a three-year phase-in of the table. In the first year, three years of data would be presented. Each year thereafter another year of data would be added to the prescribed table. Smaller reporting companies would have a two- year phase-in period. They would present two years in the first year and add another year of data in the second year.
• The “actual compensation paid” to NEO’s seems to be a better way to disclose pension compensation rather than the amount disclosed in the Summary Compensation Table. NEO’s do not have control over fluctuations in present value calculations and, therefore, their compensation should not be impacted by those changes. While the recognizing of compensation when equity awards vest may make sense in some ways, it may prove to be difficult to compare to TSR. Most NEOs receive equity awards on an annual basis that vest over a period of three to five years. Therefore, grants from prior year(s) when the company performed well in comparison to TSR could be vesting in a year when the company did not have a strong TSR. This could unintentionally lead to short vesting schedules which would be a departure from recent trends/ best practices.
• In some instances a NEO who is newly hired may receive a signing bonus which would not be tied to current performance, but instead used to attract a key NEO.
• The mandate to utilize TSR to measure performance by all companies could add complexity and length to their already cumbersome disclosure requirements. Many companies do not include TSR as part of their incentive design and may feel that it is not necessarily an indicator of their annual and/or long-term financial strategic objectives. If they elect to maintain their current performance indicators, they will need to maintain their disclosures of those metrics within the Compensation Discussion and Analysis (CD&A) as well as TSR explanations as part of this requirement.
• If companies measure performance to deliver variable compensation in ways other than TSR, disclosing the correlation between pay and TSR could prove to be very difficult. Pay Versus Performance may unintentionally promote companies to use TSR to measure performance for the delivery of variable compensation.
• Many companies switch peer groups on a regular basis to analyze executive compensation for CD&A disclosure. If the same peer group is to be used for the CD&A (not required under the proposal) then it could prove difficult to provide multi-year TSR for a changing peer group.
In conclusion, the jury is still out on just how important NEO compensation is to most investors. TSR is likely the most important measure for investors, meaning investors are looking at returns provided by a company and trying to determine if they are going to get value out of the stock. However, most investors are not likely to make buy/sell determinations based on NEO compensation relative to TSR.