SEC adopts pay-versus-performance disclosure rules

Valuation considerations for affected companies

Nov 11, 2022
Financial management Financial consulting SEC matters Technical accounting

Updated SEC rules require disclosure of actual executive compensation paid

On Aug. 25, 2022, the Securities and Exchange Commission adopted amendments to its rules to require registrants to disclose information reflecting the relationship between executive compensation actually paid by a registrant and the registrant’s financial performance. The rules implement a requirement mandated by the Dodd-Frank Act.

The new pay-versus-performance rules expand existing rules by requiring registrants to disclose how the compensation actually paid to principal executive officers (PEOs) and named executive officers (NEOs) over the previous five fiscal years relates to the financial performance of the registrant and its peers over that period.

Who is affected?

Disclosure rules apply to all reporting companies other than foreign private issuers, registered investment companies and emerging growth companies. Smaller reporting companies will be subject to scaled-back disclosure requirements.

When is this effective?

The new rules will apply to any proxy and information statement where shareholders are voting on directors or executive compensation that is filed in respect of a fiscal year ending on or after Dec. 16, 2022. Most registrants that are subject to the new rules will be required to include the new disclosure in their 2023 proxy statements.

What is required to be disclosed?

There are three new elements of disclosure:

1. Prescribed tabular disclosure: Tabular disclosure of total compensation for the PEO and the average for the other NEOs for the five most recently completed fiscal years.

In the first year of disclosure, only three fiscal years will be required in the table, with an additional fiscal year added in each of the following two annual proxy filings (i.e., year one includes three years of disclosure, year two would include four years of disclosure, and year three and subsequent years would require five years of disclosure). For small reporting companies (SRCs), the initial disclosure will include two fiscal years with an additional fiscal year added in the subsequent annual proxy filings.

The rules require the following tabular disclosure:

The SEC included specific instructions for each of the columns in this table. Special attention should be paid to columns (c) and (e). These columns require adjustments which will require year-end fair-value calculations using the same method the company uses for share-based payments reflected in the U.S. GAAP financial statements. Additionally, column (c) requires fair value as of the vesting date. For more on this, see valuation considerations below.

2. Comparative disclosure: Disclosure describing the relationships between the executive compensation actually paid to the PEO and the average executive compensation actually paid to the other NEOs and the financial performance measures, as disclosed in the table. The discussion must also include a comparison of the total shareholder return (TSR) of the company to the peer group TSR.

3. Tabular list of performance measures: A tabular list of three to seven unranked financial performance measures selected by the company to link executive compensation actually paid to the NEOs to company performance during the most recent fiscal year.

Valuation considerations

As noted above, the new rules require adjustments to calculate compensation actually paid to PEOs and NEOs. In the first year of disclosure in the proxy, the associated valuation requirements to be compliant could be significant and complex. Issuers are required to perform three years of historical valuations at the beginning and end of each period, effectively four years of valuations, and calculate new fair values that are not required under U.S. GAAP. Equity awards may include service, performance and/or market conditions. These valuations may require sophisticated modeling that can account for specific features of the awards.

For issuers that have varying vesting terms and off-cycle grants, the number of computations and required valuations can be substantial. An important distinction is vested-versus-unvested options, and when the vesting occurred. The guidance mandates that in addition to annual reporting requirements, the date and fair value at vesting need to be disclosed and valued. For example, issuers with quarterly or monthly vesting would require a valuation at each vesting date, increasing the number of required valuations from four to 12. Furthermore, unvested awards issued in prior periods will require a valuation in order to report the change in fair value over the prior period.

Even for “plain vanilla” options, there may be additionally complex considerations that need to be considered for previously granted options.

One such consideration includes the moneyness and its impact on early exercise behavior and expected life. It is important to remember previously granted options are no longer at-the-money. Simplifications regarding expected life (i.e., SAB 110) are no longer available. This might warrant a more sophisticated model besides the widely used Black-Scholes model, such as a lattice model, to capture the expected life and early-exercise behavior.

The rules also require footnote disclosure of any valuation assumptions that materially differ from those disclosed at the time of grant on both the annual and vesting dates.

RSM contributors

  • Arlene Towarnicke
  • Brian Healy

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