The SEC last week finally proposed rules mandated by Dodd-Frank providing for disclosure of the relationship between compensation actually paid to executives and company financial performance. While it is important to remember that Congress, not the SEC, initiated this rulemaking (meaning that the staff probably wishes it didn’t have to be sidetracked by this issue), the SEC had considerable flexibility in crafting its proposal. In this case, it may have missed the mark.
What was proposed?
The proposed rule would amend Regulation S-K by adding a new Item 402(v) that requires additional disclosures in proxy statements in which Item 402 executive compensation disclosure is required (basically any time directors are being elected). The amendment would require:
- that the disclosed executive compensation be calculated by starting with total compensation from the Summary Compensation Table (SCT), then modifying it (a) to exclude the present value of benefits under defined benefit and actuarial pension plans that are not attributable to the applicable year of service and (b) to include the value of equity awards at vesting rather than when granted (which adjustments are designed to conform to the statute’s “executive compensation actually paid” phrasing);
- that company and peer financial performance be measured using total shareholder return (TSR), as defined in Item 201(e) of Regulation S-K;
- a prescribed table showing executive compensation actually paid, SCT total compensation, company TSR and peer TSR;
- the separate presentation of the principal executive officer and average compensation of the remaining named executive officers;
- disclosure of the relationship over the past five years between (a) executive compensation actually paid and company TSR and (b) company TSR and peer group TSR; and
- that the new disclosure be tagged as XBRL data.
Although applicable to all categories of filers, the proposed rules are somewhat less stringent in several respects for smaller reporting companies.
The proposal does not mandate a particular location in the proxy statement for the new disclosure, although the staff notes that it “generally expects” such disclosure to be included with the other executive compensation disclosures (though not necessarily within the CD&A).
A phase-in period would allow companies to provide the new disclosures for three fiscal years, instead of five, in the first applicable year and then add an additional year in each of the next two annual proxy filings.
The staff says that these new disclosures would “give shareholders a new metric for assessing a registrant’s executive compensation relative to its financial performance” and “may provide a useful point of comparison for the analysis provided in the CD&A about a compensation committee’s approach to linking pay and performance.”
Here’s the problem…
The proposal was approved by the SEC on a three-to-two vote, which is a less-than-ringing endorsement. In separate dissenting statements, Commissioners Piwowar and Gallagher each noted the proposal’s biggest flaw: its reliance on one-year TSR as the sole measure of company financial performance. They noted that one-year TSR can encourage excessive focus on quarterly financial numbers and short-term thinking. For example, management might be tempted to prioritize leverage, R&D reductions or stock buybacks to strengthen short-term stock performance at the expense of the shareholders’ and company’s long-term interests.
Furthermore, one-year TSR may not accurately measure management’s performance. For example, in many cases TSR can be driven by market moves, sector opportunities and commodity prices. Even ISS several years ago backed off of one-year TSR as the sole measure of management performance, adopting instead longer-term, more sensitive alignment tests.
To be fair, the proposal does allow a company to provide narrative discussion of the relationship between TSR and executive compensation when it believes its particular circumstances warrant such disclosure. That narrative could, therefore, include discussion of other more relevant measures of financial performance (such as return on assets, return on equity and growth in earnings per share) in order to explain a seeming compensation/performance disconnect. Nevertheless, such a narrative is likely to be seen as the company simply making excuses for poor performance, rather than a legitimate explanation, and is unlikely to have the impact of the mandated tabular disclosure.
There is nothing wrong, of course, with a company intentionally linking executive compensation to TSR if its compensation committee determines that such an approach makes the most sense. Rather, the point is that rational investors would likely prefer to be presented with the company’s methodology for linking executive compensation and financial performance (whether to TSR or otherwise), than a single arbitrary measure of financial performance that may bear little relationship to the company’s circumstances.
The comment period for the proposal ends 60 days after its publication in the Federal Register, which is expected to occur any day now. (Note, however, that the staff routinely considers all comments received before the SEC takes action, even if submitted after the deadline.)
As always, it is impossible to predict how quickly the SEC will act to propose revisions or to adopt final rules. Conceivably, final rules could be in place in time for 2016 proxy statements, though that may depend somewhat on the volume and nature of the comments received.