Pay Versus Performance Disclosure: Where Do We Go From Here?

What the Rule Requires

We are now two years into complying with Item 402(v) of Regulation S-K, which was adopted by the Securities and Exchange Commission (SEC) in August 2022 and required new “pay versus performance” disclosure beginning in 2023 proxy statements. The rule applies to all public reporting companies except foreign private issuers, registered investment companies and emerging growth companies. Companies must provide the Item 402(v) disclosure in any proxy or information statement filed for which disclosure under Item 402 of Regulation S-K is required. This disclosure is not required to be included in Form 10-K filings or in registration statements filed under the Securities Act.

At a very high level, the rule requires:

1. A table that shows data points in separate columns for the Principal Executive Officer (PEO) and, on an average basis, for non-PEO Named Executive Officers (NEOs).
1. The data points include Total Compensation from the Summary Compensation Table, Compensation Actually Paid (CAP) as defined in Item 402(v), Cumulative Total Shareholder Return (TSR) and GAAP Net Income.
2. Companies other than smaller reporting companies must also include columns for Peer Group TSR and a Company Selected Measure (CSM), which is a measure designated by the company as the most important financial performance measure used to link compensation actually paid to company performance.
3. The CAP calculation is complex and involves several paragraphs of disclosure in footnotes to the table.
2. An unranked list of the three to seven  “most important” financial performance measures used by the company to link executive compensation actually paid to the company’s NEOs, for the most recently completed fiscal year, to company performance.
3. A description, for the PEO and for the average figure for non-PEO NEOs, of the relationships between CAP and TSR, and CAP and Net Income.
1. Companies other than smaller reporting companies must also describe the relationships between CAP figures for the PEO and non-PEO NEOs and Peer Group TSR.
2. Most companies are presenting this description in graphical form.

Companies must present this data for five fiscal years (three fiscal years for smaller reporting companies). The pay versus performance disclosures are subject to Inline XBRL tagging requirements for numerical data points, as well as for the text-based footnotes and relationship disclosures. The SEC’s Division of Corporation Finance, as well as the Division of Enforcement, are using these data tags to compare disclosures and identify shortcomings.

As noted above, there are significant complexities involved with calculating CAP, particularly with respect to equity valuations. For companies embarking on their first year of pay versus performance disclosure, this can be a significant undertaking. The calculation burden is less onerous in subsequent years.

CAP differs from Total Compensation in the Summary Compensation Table as well as the concept of “realizable pay” that may be used internally in determining compensation amounts. CAP may be distorted by the value of equity awards included in the calculation and may be volatile due to stock price changes for these awards. However, it can be a valuable addition to Total Compensation figures in determining whether pay is aligned with company performance. For most companies, CAP tends to directionally align with long-term stock price performance.

Staff Observations and Guidance

The SEC, proxy advisors and investors took a “wait and see” approach during the first year of disclosure. Following the 2023 proxy season, the Staff of the Division of Corporation Finance shared a number of observations – via comment letters and 30 Compliance & Disclosure Interpretations – to guide disclosure going forward. The staff expects companies to incorporate these observations and reminders into their compliance procedures. Themes include:

1. Presentation
   1. In the table itself, make sure to use the exact headings that the rule dictates. If a company is providing supplemental disclosures, review the adopting release for how to approach that. Only one metric can be designated as the CSM.
   2. Remember to identify the PEO and each NEO included in the table, and the years for which such persons are included, and include their full annual compensation in the calculation of Compensation Actually Paid (g., if they were promoted to an NEO role mid-year, include full-year compensation).
   3. Include separate columns in the table for the PEO’s total compensation and the average compensation for the non-PEO NEOs.
   4. Include the CSM in the tabular list of three to seven most important financial performance measures.
   5. Make sure to include the required “relationship” disclosure as a separate element of your disclosure. It is not sufficient to simply say there is no relationship.
   6. Remember to comply with iXBRL tagging requirements.
   7. Plain English is appreciated by the staff and investors. The staff also takes note when poor presentation or unclear graphics obscure relevant information.
   8. Footnote disclosure does not need to be repeated for prior-year information that is included in the table, unless material to an investor’s understanding.
2. Calculations
   1. Ensure that table footnotes reflect that equity awards granted in prior years that vest during the year are valued as the difference between the fair value as of the end of the prior fiscal year and the vesting date, not the “year over year” change.
   2. If a company uses a non-GAAP CSM, it must clearly disclose how that measure is calculated from the GAAP financials.
   3. CDI 128D.10 explains that stock price is not considered a CSM if the company does not use it as a metric in executive awards, even if it has a significant impact on the amounts reported in the pay versus performance table. In other words, if the only impact of stock price on compensation is through changes in the value of share-based awards, then stock price is not a CSM. However, if stock price is a market condition for vesting or is used to determine the size of a bonus pool, it may be considered a CSM.
   4. Clearly describe the methodology for calculating the CSM, and ensure it is calculated in the same way for each year in the table. CDI 128D.22 confirms that companies are not required to disclose confidential information when disclosing performance conditions that affect valuation assumptions for the CSM. In this instance, a company should disclose a range of outcomes or discuss how a performance condition affected fair value, as well as how difficult it will be to achieve the target level of performance.
   5. Under CDI 128D.18, if an executive becomes “retirement eligible” with respect to an equity award that has a “double trigger” for accelerated vesting (i.e., vesting accelerates if the holder is retirement eligible and the person must actually retire to receive or exercise the award, or a market condition must be satisfied), then the award is not considered vested for purposes of calculating CAP just because the person has become retirement eligible. The award is considered vested for CAP purposes on the earlier of the contractual vesting date, or actual retirement.
   6. Make sure to involve an accountant in the CAP calculations as well as the narrative disclosures. Their expertise is relevant to equity award valuations, defining financial performance measures, ensuring appropriate reporting of net income, considering the impact of retirement eligibility and other conditions on equity awards, and assessing permissible valuation techniques. Satisfaction of performance-based vesting conditions is based on facts and circumstances. Valuations must be made in accordance with ASC 718, which can be complex.
3. Peer Groups
   1. The TSR peer group must match either the industry group used for Regulation S-K in the 10-K performance graph or the compensation peer group disclosed in the CD&A. A company may not use the broad-based equity index it uses to determine the vesting of performance-based equity awards based on relative TSR as its peer group for purposes of Item 402(v)(2)(iv).
   2. If a company uses more than one published industry or line-of-business indices for purposes of the stock performance graph under Item 201(e)(1)(ii), it may choose which index to use for pay versus performance disclosure. The company should include a footnote disclosing which index was chosen.
   3. The peer group must be disclosed in a footnote if it is not a published industry or index. In this situation, the returns of each component issuer of the group must be weighted according to the respective issuers’ stock market capitalization at the beginning of each period for which a return is indicated.
   4. If a company chooses to use a different published industry or line-of-business index than it used for the immediately preceding fiscal year, it is required under Item 402(v)(2)(iv) to explain, in a footnote, the reason(s) for this change and compare the company’s cumulative TSR with that of both the newly selected peer group and the peer group used in the immediately preceding fiscal year. CDI 128D.07 explains that if using the CD&A peer group in pay versus performance disclosures, if there is a year-over-year change to the peer group, a company must continue to present peer group TSR for the peers included in the applicable prior-year(s) CD&A, as well as the new peer group for all years covered in the pay versus performance table.

How Proxy Advisors and Investors Are Using This Disclosure

Some advisors have predicted that proxy advisors and institutional investors will soon incorporate pay versus performance data points into their models for evaluating the alignment between executive pay and company performance, which are used to guide say-on-pay recommendations and votes. That is already true in at least one instance. Glass Lewis’s 2024 Voting Guidelines state:

We have revised our discussion of the pay-for-performance analysis to note that the pay-versus-performance disclosure mandated by the SEC may be used as part of our supplemental quantitative assessments supporting our primary pay-for-performance grade.

Institutional Shareholder Services (ISS), which is a proxy advisor whose voting recommendations many institutional investors rely on, is not expressly using Item 402(v) data in its model at this point. Instead, it is continuing to focus on Total Compensation as set forth in the Summary Compensation Table, with ancillary consideration to “realizable pay” as defined by ISS. In its quantitative screen, ISS compares total compensation to TSR, peer group pay and ISS’s proprietary Financial Performance Assessment, which looks at Economic Value Added (EVA) metrics. ISS will continue to assess the pay versus performance disclosures and may use them as a factor in the future.

Large asset managers, such as BlackRock, Fidelity, State Street Global Advisors and Vanguard, are very focused on the long-term alignment between company performance and executive compensation. However, their voting guidelines tend to be open ended with respect to the information that is considered. They likely are reviewing pay versus performance disclosures to inform say-on-pay voting decisions, but at this point, there is no hard and fast framework linking these data points to say-on-pay voting decisions.