The corporate disclosure crowd may be fretting these days over the still-pending “CEO pay ratio rule” from the Securities and Exchange Commission, but the SEC’s vote last week to adopt pay-for-performance disclosure might actually have the more far-reaching repercussions.

The SEC proposed pay-for-performance rules that will require all public companies to disclose the relationship between the compensation paid to each named executive officer and the total shareholder return (TSR) for the company. That relationship will also need to be compared to those of the company’s peers. The rules are required under Section 953 of the Dodd-Frank Act.

The pay ratio disclosure rule—still trapped in regulatory limbo, its release date unknown—gets more press as being difficult to calculate and an invitation to squabbles with investors or union activists eager to compare the CEO’s compensation to that of the median worker. Pay-for-performance rules, however, are likely to spark fights about whether the company is using the right performance metrics year after year.

“Companies have been trying to change their compensation systems to reflect a more performance-based element to earnings,” says Michael Hermsen, a partner at law firm Mayer Brown and a former SEC attorney. “People will now be able to very clearly see how one relates to the other. You will see more shareholders focusing on this disclosure than the pay-ratio disclosure, because this one presents a longer view and will either support or refute those who say a company is not paying for performance.”

The proposed rule requires a company to disclose executive pay and performance information for itself and a corporate peer group in a table or graph and tag all that data in the eXtensible Business Reporting Language interactive data format. It is the SEC’s first XBRL requirement beyond financial statements.

Disclosures will be based upon “realized pay”—that is, compensation data already disclosed in Summary Compensation Tables required for proxy statements, with adjustments for pensions and equity awards. The latter is considered paid on the date of vesting and at fair value on that date, rather than fair value on the grant date as required in Summary Compensation Tables. Companies will also report their total shareholder return (TSR), and that of their peers, to allow comparisons. They are required to disclose this information for the last five fiscal years; smaller reporting companies are only required to provide disclosure for the last three fiscal years. 

“With this new SEC guidance in hand, companies can no longer avoid telling their pay-for-performance story,” says Steve Seelig, ?executive compensation counsel at Towers Watson. “This disclosure is unlikely to alter pay designs or say-on-pay voting results, since institutional shareholders and proxy advisers already use sophisticated pay-for-performance models to assess company pay.”

The first reaction to the proposal among compensation experts is mixed.

“How useful is this information really going to be? Large companies, for years now with say-on-pay votes, have come up with their own ways of looking at pay for performance,” says Andrew Liazos, head of the law firm McDermott Will & Emery’s executive compensation group. “To what degree is that system really broken at this point?”

A more generous view comes from Dayna Harris, vice president of executive compensation consultancy Farient Advisers. The SEC’s choice of realized pay (rather than realizable pay) as the fundamental metric was a logical move, she says, adding that the approach to equity awards was also a well-considered compromise.

“One of the challenges with realized pay is matching the timing of the long-term incentives with the performance period you are looking at,” she says. “Stock options can be very distorted if based on when someone chose to exercise them, because that could be eight years after they were granted. You have the potential for a big mismatch there and a huge number because it is done all at once, instead of spread over the years.”

“How useful is this information really going to be? To what degree is that system really broken at this point?”
Andrew Liazos, Partner, McDermott Will & Emery

The SEC, wisely in Harris’ opinion, is not going to call for an accounting of when options are exercised, rather when they are vested. “That puts them into a timeframe that’s closer to the grant date and not at the choice of the executive,” she says. “That took some of the sting out of the timing issue with realized pay, even if it still can be off if companies have long vesting periods for their stock options.” The five-year reporting period will help even out the data over time, she adds.

Getting the Metrics Right

One crucial question: Is TSR an appropriate standard for measuring performance?

“It is a metric many companies use in their performance-based compensation, so that’s helpful,” says Mary Mullany, a partner with law firm Ballard Spahr. “It is also something that all companies can use to compile the information for the peer group they need to compare themselves to. For companies that don’t use TSR now, it will be harder.”

Falling into that category, she says, are “near-revenue” life sciences and pharmaceutical companies and tech startups.  “Why couldn’t it have been a rule saying to pick the financial metric you use in your compensation? If you don’t do that the default is TSR,” she says.

“For some executives, you may be trying to incentivize them to do different things,” Hermsen says. “For one executive, that might be growth of sales in Europe as opposed to growth of the company as a whole, and TSR may not be that helpful of a measure.”

What if a company brings in a highly compensated turnaround specialist to lead a company out of its stock price doldrums? The analysis will be far from simple or direct, Liazos says.  


The following is from a “fact sheet” the SEC issued along with its proposed Pay Versus Performance rule.
The proposed disclosure would be required in proxy or information statements in which executive compensation disclosure is required.  Companies would be required to disclose, in a new table, the following information:

Executive compensation actually paid for the principal executive officer, which would be the total compensation as disclosed in the summary compensation table already required in the proxy statement with adjustments to the amounts included for pensions and equity awards. The amount disclosed for the remaining named executive officers identified in the summary compensation table would be the average compensation actually paid to those executives;

The total executive compensation reported in the summary compensation table for the principal executive officer and an average of the reported amounts for the remaining named executive officers;

The company’s total shareholder return on an annual basis, using the definition of total shareholder return (TSR) included in Item 201(e) of Regulation S-K, which sets forth an existing requirement for a stock performance graph;

The TSR on an annual basis of the companies in a peer group, using the peer group identified by the company in its stock performance graph or in its compensation discussion and analysis.
The disclosure would be required for the last five fiscal years, except that smaller reporting companies would only be required to provide disclosure for the last three fiscal years. Companies would also be required to tag the disclosure in an interactive data format using eXtensible Business Reporting Language, or XBRL.
Using the information presented in the table, companies would be required to describe the relationship between the executive compensation actually paid and the company’s TSR, and the relationship between the company’s TSR and the TSR of its selected peer group. This disclosure could be described as a narrative, graphically, or a combination of the two.
Pension amounts would be adjusted by deducting the change in pension value reflected in that table and adding back the actuarially determined service cost for services rendered by the executive during the applicable year. Equity awards would be considered actually paid on the date of vesting and at fair value on that date, rather than fair value on the grant date as required in the summary compensation table. 
The rules would apply to all reporting companies except for foreign private issuers, registered investment companies and emerging growth companies, which are exempt from the statutory requirement.
Source: SEC.

Another potential requirement causing concern is the required use of XBRL. “Big companies have had enough difficulty implementing it for financial statements, even with huge staffs,” Hermsen says. “Small companies don’t have the staff or money to be able to deal with this.”

“The SEC is bowing to pressure from [proxy advisory firms] to focus on fundamental fairness of executive compensation,” John Martini, chair of Reed Smith’s executive compensation practice, says of the proposed rule. “The purpose of the disclosure laws is not to promote fairness in executive compensation. Those rules are intended to prevent investors from being misled. The SEC has overstepped its mandate by a long shot.”

“Fairness has nothing to do with materiality at all,” he says.

Martini suspects that the methodology selected by the SEC will encourage greater short-term compensation, contrary to the goal of investor advocates. “By using ‘actual pay’ in their calculation, rather than pay as currently reported in the Summary Compensation Table, the SEC has inadvertently changed the focus in the proxy to what will often be a much lower ‘pay’ amount—thereby leaving room for companies to increase executive compensation in the near term,” he says. “As everyone focuses on that graph rather than the Summary Compensation Table, there’s going to be more breathing room for certain executives to bulk up their pay. It’s going to be a huge unintended consequence.”

Companies will need to consider supplemental disclosures that offer the nuance that narrative graphs and charts cannot convey. “Companies where TSR disclosure doesn’t work will be compelled to give supplemental disclosure,” Liazos says. “Here’s what the SEC says we have to disclose to you, but here, in the real world, is how it really works.”

“I imagine this is going to be in the Compensation Discussion and Analysis portion of the corporate proxy portion of the proxy,” Mullany says, recalling the frequent advice of SEC officials to “not forget about the ‘A’ in CD&A.”

“Every company will need to determine if the required disclosure best tells their story, or whether alternative explanations would help paint a more accurate picture, given their performance versus the market and their industry,” Seelig says.