August 31, 2022
August 31, 2022
On Aug. 24, 2022, the US Securities and Exchange Commission (SEC) voted 3 to 2 to pass a long-pending rule on “pay vs. performance.” While the rule’s title may seem like old news, the new requirements in the rule could cause boards and CEOs themselves to see performance in new ways.
In some respects, the new rule, which was first proposed in 2015 in the aftermath of Dodd-Frank, is old hat. Public company directors today already understand that they should pay CEOs and senior executives based on their performance. In fact, this has been the case for at least 30 years, ever since the 1992 rule (published in 1993) requiring public companies to report their CEO’s compensation for the most recent fiscal year, as well as the “relationship between executive compensation and the registrant’s performance.”
Directors also know full well the importance of explaining the pay-for-performance link to investors. Consider the 2006 rule that required a compensation discussion and analysis and compensation tables in the proxy statement, and the 2011 rule that required companies to obtain shareholder approval of executive pay plans in a precatory (nonbinding) shareholder vote called “say on pay.”
With all these pay-for-performance disclosure rules already in place, what is new here? A comprehensive explanation is beyond the scope of this brief article (for that I recommend this), but here are two important changes:
First, whereas in the past, companies had some discretion in defining performance, now they are given an absolute requirement to disclose comparative data on cumulative total shareholder return (TSR).*
Second, and arguably most valuably, the new rule will cause companies to clarify their own definitions of performance. During the original comment period in 2015 and the renewed comment period in 2022, a number of commenters, including NACD, objected to emphasis on TSR as the most important measure of performance. (NACD’s comments sent in 2015 and 2022 are cited 18 times in the rule.) Accordingly, the final rule states the following (p. 77): “To address commenters’ concerns with respect to the proposal to use TSR and peer group TSR as the sole measures of performance (such as causing companies to adjust their compensation programs to more heavily rely on TSR), we are also requiring registrants to include net income and a Company-Selected Measure as performance measures in the tabular disclosure, and also permitting companies to voluntarily include additional measures of their choosing in the table, as suggested by some commenters.” (Emphasis added.)
In the end, the final rule has combined the originally proposed TSR disclosures plus others that critics suggested. As explained in the SEC press release of August 25, companies must now provide a table showing “specified executive compensation and financial performance measures” for the most recent five years for the company, showing total shareholder return (TSR), the TSR of peers, company net income, and a financial performance measure chosen by the company. The rule defines financial performance measures as “measures that are determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, any measures that are derived wholly or in part from such measures, and stock price and total shareholder return.” (p. 86, footnote 336).
Importantly, companies will also “list of at least three, and up to seven, financial performance measures,” which “represent the most important financial performance measures” the company uses to pay its executive officers (p. 224). This requirement, reflecting views of NACD and others, shows that the SEC is willing to take a flexible approach to performance. The release even says that companies are permitted to “include nonfinancial performance measures in that list” (p. 88)—something NACD had advocated.
The new rule will obviously add to the disclosure burdens of public companies, but this burden is something they have always born with the help of expert staff and advisors. The real risk the rule proposes is the possibility that boards will judge CEO and senior executive performance based on TSR alone rather than based on the drivers of TSR as captured in other metrics. Boards should use the new rule as a tool for broadening, not narrowing, their appreciation of executive and company performance. With a possible new rule on executive clawbacks around the corner (thanks to a reopened comment periods), renewed attention to performance measures has become all the more important.
Alexandra R. Lajoux is the chief knowledge officer emeritus at NACD.
*Note: Cumulative TSR is defined in the original 2015 proposed rule release, which states that “cumulative total shareholder return is calculated by ‘dividing the (i) sum of (A) the cumulative amount of dividends for the measurement period, assuming dividend reinvestment, and (B) the difference between the registrant’s share price at the end and the beginning of the measurement period; by (ii) the share price at the beginning of the measurement period,’” per p. 45, footnote 85 of the proposed rule, citing The Code of Federal Regulations.
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