Executive Compensation & Benefits Alert | May.20.2015
The SEC recently released its proposed "pay for performance" rules under one of the last remaining executive compensation requirements mandated by the Dodd-Frank Act. This new "pay for performance" rule requires companies1 to disclose the relationship between the actual compensation paid to their named executive officers and the company's financial performance as measured by total shareholder return (TSR).
While numerous other writings have focused on the technical requirements of the proposed rules, this alert focuses on the new "pay for performance" table which would be required to be included in a company's proxy statement and best practices to address the additional requirement of a description of (i) the relationship between executive compensation actually paid versus the company's TSR and (ii) the relationship between the company's TSR versus the TSR of its peer group.
The proposed rules give flexibility to describe these relationships in either narrative or graph form (or both). There will inevitably be some narrative description, but as a best practice, we think the use of charts will tell a better story and be easier for shareholders to visualize and understand and thus, should be used to help illustrate the narrative description. We have provided sample charts below which companies may consider using in their proxy statements to satisfy these new proposed disclosure rules (if adopted).
Set forth below is the new table which will be required to be included in a non-exempt, large public issuer's proxy statement based on the proposed rules, which has been populated using hypothetical numbers. Even though the proposed rules provide for a two-year phase-in period, the table includes the full five years of compensation and TSR for illustration purposes.
Since it may be difficult to understand the link between pay and performance simply based on the compensation and TSR amounts in the table above, the below chart, which compares changes in Chief Executive Officer (CEO) and average non-CEO, named executive officer (NEO) actual compensation to TSR over the same five-year period, provides a useful illustration of the extent to which pay aligns with performance.>
Based on the proposed rules, executive compensation actually paid is total compensation as disclosed in the Summary Compensation Table (SCT), modified to exclude changes in actuarial present value of benefits under defined benefit and actuarial pension plans which are not attributable to the applicable year of service, and to include the value of equity awards at vesting rather than when granted. Depending on a company's specific facts and circumstances, there may be material differences between compensation as reported in the SCT and compensation actually paid. In such a case, it may be appropriate to include the following chart which compares SCT compensation (not actual compensation) to TSR.
To address the proposed requirement that a company compare its TSR to the TSR of its peer group, the below chart provides a useful visual comparison. Based on the hypothetical inputs, there is a tight correlation.
* The chart above assumes an initial investment of $100 at the beginning of 2011.
The hypothetical amounts in the new SEC table result in illustrative charts which show a favorable relationship between NEO pay and absolute and relative company TSR. If, on the other hand, the relationship is not as favorable as this hypothetical situation, or even if it is, but a company's compensation committee focused on operational results in determining pay, then a company may wish to include the following table as an optional chart to support its compensation decisions.
* 100% reflects the break-even point for TSR and full satisfaction of target operational goals
The proposed new table and its focus on the new disclosure concepts of actual pay and TSR will force companies to enhance their CD&A disclosure to explain the role of actual pay and TSR in their decision making. For example, where actual pay is lower than SCT compensation, a company may want to explain how and why the pay they actually deliver is less than what is reflected in the SCT. In addition, if actual pay levels are high while TSR is also high, a company may want to justify the higher pay levels based on the level of shareholder return. Conversely, where actual pay is high while TSR is low, but operational results are positive, a company may want to explain that while TSR is low, compensation decisions were driven by operational performance which is weighted more heavily than TSR. While not possible to address all the potential permutations in this alert, the new table will force companies to better describe and justify the decisions of compensation committees.
The new SEC table is quite similar to the comparisons of pay and TSR which Institutional Shareholder Services (ISS) currently uses in its CEO pay and 5-year absolute TSR graph, the CEO relative degree of alignment test and the disclosure of other NEO compensation. With the emphasis on pay and TSR by ISS and the SEC, we think many issuers may decide to use TSR as a performance goal for long-term equity incentives. TSR may be used in the form of an add-on goal to existing operational goals or as a modifier or multiplier to operational goals. The latter may be the best way to acknowledge the role of TSR as an element of pay for performance, but not the most important component.
While the SEC's proposed rules do not provide any indication when the new disclosure requirements will be effective, below are a few things you should consider to prepare for future pay for performance required disclosures:
For additional information on the topic, please contact any member of Orrick's Compensation and Benefits Group.
1 All publicly traded companies would be subject to these new rules except for "emerging growth companies," foreign private issuers and registered investment companies.