How new SEC rules impact compensation committees’ 2023 agendas
Two of these rules – those on pay versus performance and clawbacks – were mandated by the Dodd-Frank Act. They do not represent new concepts as they were initially proposed by the SEC in 2015. In addition, the changes to the insider-trading rules codify some of the existing best practices related to Rule 10b5-1 plans and introduce new executive compensation disclosures related to insider trading.
These three rules not only create important new disclosure obligations for public companies but also expand oversight obligations of the compensation committee of a public company.
PAY VERSUS PERFORMANCE
Section 953(a) of the Dodd-Frank Act mandated that the SEC require disclosure of ‘information that shows the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions.’
The SEC has fulfilled this mandate by adding Item 402(v) to Regulation SK, which requires public companies (other than emerging growth companies or foreign private issuers) to provide pay-versus-performance information in tabular form for the five last completed fiscal years in proxy or information statements in which executive compensation disclosure is required.
In addition to including information from the ‘total’ column of the summary compensation table, which combines executive compensation numbers in the proxy statement, for the principal executive officer – the CEO – as well as average summary compensation table ‘total’ for the company’s other named executive officers included in the summary compensation table, the new Item 402(v) table requires the calculation of compensation actually paid to the CEO, as well as average compensation actually paid to named executive officers who are not the CEO, by deducting or adding certain elements of the executive compensation to the ‘total’ numbers from the summary compensation table.
Although calculations of the compensation actually paid to executives are complicated, they are not the most intricate part of the new pay versus performance rules.
In addition to these calculations, the company must provide a ‘clear description (graphically, narratively or a combination of the two) of the relationships’ between: (i) the executive compensation actually paid by the company to the CEO and the average of the executive compensation actually paid to the named executive officers other than the CEO disclosed in the pay versus performance table; and (ii) each of the following performance measures that are also disclosed in such table:
- The value of the fixed investment of $100 based on the cumulative total shareholder return (TSR) as of the end of the reported year of the company and its peer group
- The company’s net income
- The company-selected measure.
Disclosure provided by the company must also include a tabular list of at least three, and up to seven, financial performance measures, which in the company’s assessment represent the most important financial performance measures used by the company to link compensation actually paid to the company’s named executive officers, for the most recently completed fiscal year, to company performance. The company-selected measure that is presented in the table is a financial performance measure included in the tabular list that is not otherwise required to be disclosed in the table.
The company-selected measure and the tabular list are interesting additions to the executive compensation disclosure mix, which give the compensation committee an opportunity to review measures already used to evaluate performance and consider alternatives to determine which are the best metrics to use for this purpose.
Benchmarking in this area may prove to be very difficult in the initial year of the implementation of the required disclosures. In addition, since the use of the peer group TSR is required in the new table, the compensation committee may want to take a critical look as to which companies are included in the company’s peer group for executive compensation purposes.
In addition, given the focus in the rule on the link between compensation actually paid to the named executive officers and performance measures, the compensation committee should pay additional attention to the narrative description of such relationship following the new table to make sure that it accurately reflects the committee’s priorities and the company’s compensation philosophy described in the compensation discussion and analysis section required by the SEC rules.
The SEC implemented Section 954 of the Dodd-Frank Act by adopting Rule 10D-1, which directs national securities exchanges to prohibit the ‘listing of any security of an issuer that is not in compliance with the requirements’ relating to the recovery of erroneously awarded compensation. Under the new Rule 10D-1, national securities exchanges must require each listed company to:
- Adopt a written policy providing that the company will recover reasonably promptly the amount of erroneously awarded incentive-based compensation, otherwise known as a clawback or recovery policy
- Comply with such a recovery policy for all incentive-based compensation received by executive officers on or after the effective date of this listing standard
- Provide disclosures required in the applicable SEC filings.
The new rules mandate the clawback of incentive-based compensation from those current and former executives of the company who served as an executive officer at any time during the performance period for the incentive-based compensation that is being recovered if the company is required to prepare an accounting restatement due to the material non-compliance of the company with any financial reporting requirement under the securities laws. A company’s obligation to recover erroneously awarded compensation is not dependent on if or when the restated financial statements are filed.
The company’s recovery policy must apply to all incentive-based compensation received by any executive officer at any time during the three completed fiscal years immediately preceding the date the company is required to prepare an accounting restatement.
The amount of incentive-based compensation that must be subject to the company’s recovery policy is the amount of incentive-based compensation received that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the restated amounts and must be computed without regard to any taxes paid. The company is prohibited from indemnifying any executive officer or former executive officer against the loss of erroneously awarded compensation.
The SEC also added Item 402(w) of Regulation SK to require a public company to disclose information about its recovery of erroneously awarded compensation, including the amount of erroneously awarded compensation attributable to the accounting restatement, any estimates that were used in determining the amount and the amount that remains to be collected at the end of the last completed fiscal year.
In addition, for each current and former named executive officer from whom, as of the end of the last completed fiscal year, erroneously awarded compensation had been outstanding for 180 days or longer since the date the company determined the amount the individual owed, the company would need to disclose under Item 402(w) the dollar amount of outstanding erroneously awarded compensation due from each such officer.
Many public companies have previously adopted clawback policies on a voluntary basis. Subject to stock exchanges adopting listing standards mandated by the SEC, the compensation committee should ask management to review these policies and outline for the committee the changes the company would need to implement considering the new clawback rules adopted by the SEC.
For example, officers covered by the new rule include former officers of the company, as well as a broader set of officers, which will have to be reflected in the policy. In addition, this review should take into consideration the types of compensation and restatements covered under the SEC rule so that the committee could determine whether to include a broader set of compensation types in the policy and whether other misconduct or bad acts beyond restatements should be included in the policy.
The committee may also want to consider whether it needs to revise the compensation mix so that the amount of compensation covered by the clawback requirements is reduced for certain officers. The revisions to the policy should also reflect how the recovery process would work. Some companies are imposing mandatory deferral periods or holding periods for incentive-based compensation.
Finally, the compensation committee should ensure the appropriate grant documents for compensation covered by the new or revised clawback policy include adequate provisions for the recovery of compensation, if necessary. Without contractual requirement, recovery may prove especially challenging for individuals no longer serving as officers of the company when the clawback is required.
INSIDER TRADING RULES
The SEC has adopted amendments to Rule 10b5-1 and added a related Item 402(x) of Regulation SK, under which public companies will need to annually disclose their policies and practices related to the timing of awards of options in relation to the disclosure of material non-public information (MNPI).
This includes how the board determines when to grant such awards, whether the board or compensation committee takes MNPI into account when determining the timing and terms of such awards and whether the company timed the disclosure of MNPI to affect the value of such executive compensation.
In addition, public companies will need to disclose, in a new executive compensation table set forth in Item 402(x)(2) of Regulation SK, any awards of options to named executive officers in the period beginning four business days before the filing of a Form 10Q, Form 10K or Form 8K that discloses MNPI (subject to limited exceptions) and ending one business day after the filing of such report. Compensation committees should discuss the company’s equity grant procedures with management and evaluate any adjustments that would be necessary to comply with the new requirements.
As with any new requirements, additional time and care would be required to develop and draft new disclosures mandated by the pay-versus-performance, clawback and insider trading rules. There is no telling how these new disclosures will be interpreted by the proxy advisory firms, activists or other key stakeholders or how these new disclosures will impact the say-on-pay vote. Given these new disclosure requirements, as well as policy additions or modifications, additional compensation committee oversight will be necessary.
Yelena Barychev is a corporate governance and capital markets partner at Blank Rome and co-lead of the firm’s ESG team. Jane Storero is the senior corporate governance counsel at LTSE Services