In August 2022, the Securities and Exchange Commission (SEC) adopted a new set of rules governing the disclosure of corporate pay to top executives, along with a comparison of the pay to the registrant’s performance. The new rules capped a seven-year-long process in fulfilling a statutory requirement of the Dodd-Frank Act. Accordingly, registrants will now need to provide detailed information in a format dictated by the SEC, with potential liability for failing to abide by these new disclosure requirements.
The Dodd-Frank Act required the SEC to issue rules that more clearly disclosed executive compensation and compared it to the financial performance of the company. Specifically, Congress was concerned that the relationship between executive pay and performance was weakening and becoming a significant concern for shareholders.
The SEC initially proposed these updated rules in 2015, beginning a long process until they were recently finalized. In light of the passage of time, the Commission reopened the public comment process earlier this year to allow additional public comment on the proposed rules. Now, the rules become effective for fiscal years that end after December 16, 2022.
Specifically, the main focus of the pay versus performance rule requires registrants to report the information in tabular form, making it easier for shareholders to directly compare pay and performance. The information is not required to be disclosed in an annual report, nor must it be included in registration statements. Instead, the rule only requires that this information be provided to shareholders when there is a proxy vote or consent solicitation material for an annual shareholder meeting.
The SEC was chiefly focused on the “say for pay” votes that shareholders get to make. Although shareholders do not have the right to determine executive compensation, they have the ability to cast an advisory vote. These votes happen at least once every three years, even though they are more ceremonial than substantive. Currently, a company named Institutional Shareholder Services makes its own influential recommendations that many shareholders follow.
In the past, the SEC required disclosure of executive compensation in a section of the proxy statement titled “Compensation Discussion & Analysis.” The SEC’s intent with the new rule was to make the information both more transparent and readily comparable. The Commission wanted shareholders to be able to make a more informed decision when they cast any vote. The Dodd-Frank Act contained numerous provisions that required additional compensation reporting, such as a mandate that the registrant provides the ratio of CEO compensation to that of the median employee.
The Dodd-Frank Act did not require a specific format for compensation disclosures, so the SEC’s new rules are intended to provide concrete guidance. Registrants must follow a specific format as set forth by the agency in the rulemaking. Here, the SEC stated that it specifically had opted for a prescriptive rulemaking, disallowing registrants from taking a principles-based approach. Otherwise, in the SEC’s view, investors would not be able to make an informed comparison between issuers.
Although the table issuers must use appears simple, in practice, it is anything but. The table requires issuers to include the following information in a side-by-side format:
The aspect over which the issuer has discretion is selecting a financial performance measure that it feels best links its financial performance to the compensation paid to its non-executive officers. It is mandatory to report a measure, although the issuer has some flexibility (for now) regarding which one.
The issuer must go beyond the information it presents in the required table. The new rules require a section in which the issuer gives a clear description of the relationship between the financial performance measures and the total actual compensation paid to the non-executive officers. Further, the issuer has the right to present supplemental narratives to describe the connection between corporate performance and executive compensation, so long as it discloses that these are voluntary and supplemental.
The new SEC rules can carry potential landmines for issuers. They must be careful about the information they report. The SEC can always comment on the report when it has doubts about the information provided. Most importantly, the issuer can be subject to liability based on the report. If it contains deceptive information, the issuer can be liable for proxy fraud, even though these tables are not a part of financial statements.
Therefore, companies will need to devote extensive resources to comply with these new rules and monitor how the SEC is interpreting and enforcing them. Registrants will need the advice of a securities lawyer both to understand and implement the new rules and to track potential new obligations. Companies will need to devote thought to what metrics they select and how to present a unified message in the reporting.
These new rules are a manifestation of the SEC’s recent bent towards broad-based rules that will impose additional obligations on registrants. Regardless of the amount of investment the issuers must make to comply with these rules, Institutional Investor Services may still make its own recommendations on shareholder votes regarding executive pay. However, the trend is moving toward an even greater amount of issuer disclosure—a trend being driven by the SEC.