On August 25, 2022, the SEC adopted a final rule aimed at providing more insight into the relationship between company performance and executive compensation, which will require SEC registered issuers (with the exception of emerging growth companies, registered investment companies other than business development companies, and foreign private issuers) to compute the year-to-year change in fair value of equity awards granted to named executive officers until their vesting date, as a part of the new ‘Pay Versus Performance’ disclosures.
The fair value changes computed per above, among other compensation-related adjustments, will be used to derive “compensation actually paid” for named executive officers for the period of the disclosures, while also presenting and discussing its relationship to certain company financial performance metrics over the same period.
While the SEC recognizes that requiring fair value calculations for each equity award at a date other than the grant date may be burdensome for some issuers, particularly those that have compensation programs with numerous and complex equity grants, the final rules are not adopting a safe harbor or simplified assumptions other than those generally accepted under U.S. GAAP.
Highlights: SEC Rule on Pay Versus Performance Disclosures
Objective: To make it easier for shareholders to assess a registrant’s decision-making with respect to its executive compensation policies.
Applies to: All registered issuers, except for emerging growth companies, registered investment companies other than business development companies, and foreign private issuers.
The disclosure is to be made in proxy or information statements in which executive compensation disclosure is required (specifically under Item 402 of Regulation S-K, with the new requirements constituting Item 402(v)).
Compliance Date: Fiscal years ending on or after December 16, 2022, i.e., effective for 2023 proxy or information statements requiring Reg. S-K Item 402 disclosures.
Format, Substance and Period of Disclosures: A registrant must disclose, in a tabular format, executive compensation (pay) and the following financial measures (performance): Total Shareholder Return (TSR) of the registrant; TSR of the registrant's peer group; net income; and a Company-Selected Measure (CSM) deemed most important in linking pay to performance, for the five most recent completed fiscal years (three years for SRCs, or Smaller Reporting Companies).
The table will include a disclosure of total compensation for executives (based on a Summary Compensation Table (SCT) already required by Item 402 of Regulation S-K) and a new “compensation actually paid” measure, as defined by the rule, for the Principal Executive Officer (PEO) individually and for all other Named Executive Officers (NEOs) as an average. The computation of “compensation actually paid” requires certain adjustments to be made to various items, including pension benefits (not discussed herein) and equity awards.
Computing “compensation actually paid” will require vesting date and year-end measurement of outstanding and unvested equity awards, as of the respective valuation dates. Post-vesting changes in fair value are not considered—to distinguish a registrant’s compensatory decision from an executive’s (post-vesting) investment decision.
Based on the tabular disclosures, the registrant is required to clearly describe the relationships between the executive "compensation actually paid" and each of the performance measures, as well as the relationship between the registrant's TSR and the TSR of its selected peer group. These descriptions may also be provided in narrative, graphical or combined narrative and graphical format. A registrant will also be required to provide a list of three to seven performance measures (which could include non-financial measures) that it determines are its most important performance measures for linking executive "compensation actually paid" to company performance.
Registrants are required to tag the disclosures using Inline XBRL.
Scaled-back Disclosures: Available to SRCs with respect to some of the information presented, the period of disclosures, Inline XBRL tagging and transition provisions.
Period Covered by Disclosures: Provide five years of disclosures for non-SRCs and three years for SRCs.
Transition: Non-SRCs may provide the disclosures for three years (instead of five) in the first applicable filing and provide an additional year in each of the two subsequent annual flings. SRCs may provide two years of data (instead of three) in the first applicable filing and add a year in the subsequent filing.
Tabular Disclosures Required by the Pay Versus Performance Rule
For awards subject to performance (non-market based) vesting conditions, the change in fair value is calculated based upon the probable outcome of such conditions as of the end of the fiscal year.
Adjustments must also include compensation related to amendments, cancellations, replacements or other modifications, by taking into account the excess fair value of any such modified awards over the fair value of the original award as of the modification date.
Key Valuation Takeaways
Post-grant date equity awards valuations involve an elaborate and dynamic process:
- Fair value amounts must be computed consistent with the method used to account for share-based payments under U.S. GAAP (ASC 718, Compensation—Stock Compensation).
- The valuation of options and awards with market conditions may involve complex calculations.
- The degree of moneyness of the options at different valuation dates may affect the choice of—and may necessitate a change in—the valuation method over time.
- Inputs and assumptions must be reassessed at each valuation date, including, for example, changing index constituents for index-linked awards.
- During the vesting period, changes in the constituents of the relevant index for the computation of peer group TSR will also need to be considered.
- Historical dividends need to be factored in for the TSR calculations. This is not a complexity equity awards valuation analyses need to capture for the purpose of grant date measurements.
- Dividends paid during the reporting period need to be considered in the valuation analysis for awards with dividend catch-up features.
- Upon transition, three years of disclosures are required for non-SRCs, which would call for multiple valuation dates during fiscal 2022, 2021, and 2020, and would also include fiscal year end 2019 to establish beginning values for outstanding and unvested awards. Similarly, two years of disclosures are required for SRCs, which would call for multiple valuation dates during fiscal 2022 and 2021, and would also include fiscal year end 2020 to establish beginning values for outstanding and unvested awards.
- Tracking features of equity awards and the post-grant date evolution of valuation inputs through multiple valuation dates will require meticulous documentation, especially for programs with complex equity grants.
- Footnote disclosure of any valuation assumptions that materially differ from those disclosed at the time of grant is required.
- Like U.S. GAAP, when multiple awards are being valued in a given year, the rule permits disclosure of the range of the assumptions used or a weighted-average amount for each assumption.
