With two dissents, SEC proposes pay-for-performance disclosure rules

by Cydney Posner

This morning, by a three to two margin, the SEC voted to propose rules requiring companies to disclose executive pay for performance. The proposal comes five years after passage of Dodd-Frank, which imposed the obligation on the SEC.  Currently, many companies voluntarily provide information that could fit that disclosure imperative, but there is no consistency in definitions, time period or manner of calculation.  Imposition of uniformity as a result of the rulemaking is expected to allow  investors to make better comparisons among companies.

Dodd-Frank Section 953 obligated the SEC to issue rules requiring public companies to disclose in any annual meeting proxy statement “a clear description of any compensation required to be disclosed by the issuer under [Reg S-K, Item 402], including 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 disclosure under this subsection may include a graphic representation of the information required to be disclosed.”

The new proposal would amend Reg S-K section 402 to add section (v), which would require tabular disclosure of compensation “actually paid” to the principal executive officer (PEO) and an average of the compensation actually paid to the other named executive officers (NEOs) for a phased-in five-year period.  Compensation “actually paid” uses the “Total Compensation” measure included in the Summary Compensation Table (SCT), with modifications to the amounts disclosed for pension benefits (reducing the effect of changing actuarial assumptions on pension values) and equity awards (adjusted to reflect the fair value of equity awards on the vesting date, as opposed to the grant date, for awards that vested during the year). The table would also show Total Compensation as shown in the SCT, with footnotes explaining the amounts deducted to arrive at amounts “actually paid,” as well as other assumptions that differ from the information in the financial statements. The table would also show the company’s cumulative total shareholder return (TSR), as well as the TSR of a peer group. Companies would use the same index or peer group used for purposes of the “performance graph” under Reg S-K, Item 201(e), or, if applicable, the companies it uses as a peer group for purposes of CD&A.  TSR would be calculated in the same way that it is calculated for the performance graph, which assumes dividend reinvestment.

The new section would also require companies to describe, in narrative or graphic form or both, the relationship of the compensation actually paid to the company’s financial performance as reflected in its TSR and to describe the relationship of the company’s TSR to the TSR of a peer group.  Optionally, companies could also describe other measures of pay for performance.

The disclosure would not be required for foreign private issuers, registered investment companies and emerging growth companies. Smaller reporting companies would be subject to scaled disclosure. Reporting would be phased in starting with three years of disclosure increasing annually to five years (for smaller reporting companies, starting with two years, increasing to three; for newly reporting companies, starting with one year and annually phasing in the remaining years).  In addition, for the first time in a proxy statement, the proposal would require data tagging, using XBRL, of information provided in the table of pay versus performance data, including footnotes to the table, and also of the description of the relationship between executive compensation actually paid and company performance. Data-tagging would also be phased in for smaller reporting companies.

[Soapbox: But see this news brief,  http://www.cooley.com/67547 for a discussion of a study from Columbia Business School showing that analysts and investors, the intended beneficiaries of XBRL, don’t seem to be using it, and that it “might have been a colossal waste of time.” ]

Chair White and Commissioners Aguilar and Stein viewed the proposal as helping to provide transparency and accountability. Stein was especially enthused about the use of XBRL. commenting on the recent “exponential” growth of executive compensation, Aguilar observed that “we’ve now seen too many instances where managers have received outsized compensation even when companies experience large losses and shareholders suffered. Indeed, one 2013 study found that of the 25 highest-paid CEOs for each year in a twenty-year period ending in 2012, 38% were held by CEOs who led firms that were bailed out or crashed during the 2008 financial crisis, were fired by their firms, or had to pay settlements or fines related to fraud charges. Other studies have found a significant disconnect between the financial performance of companies in the S&P 1500 and the incentive compensation of their executives. In fact, a recent study found that in a three-year period after the 2008 financial crisis, while overall stock-based performance declined for companies in the S&P 1500, total CEO compensation during this same period increased.” [Footnotes omitted.]  He expected the proposed rules to help shareholders hold boards more accountable for their executive pay decisions.

The two dissenting Commissioners, Gallagher and Piwowar, essentially viewed time devoted to this proposal as time wasted.  Both believed that the effort would have been better spent on addressing the causes of the financial crisis.  According to Gallagher, if not spent on the financial crisis, the time should have at least been devoted to matters such as revising the corporate disclosure requirements or the shareholder proposal regime.

Aside from their distress over time allocation issues, the two also had concerns regarding the proposal.  First, they both viewed the proposal as too prescriptive.  Piwowar indicated that he might have actually been able to support the initial principles-based version that was circulated, but the prescriptive nature of the final proposal — and specifically its use of the single metric of TSR — was not acceptable.  Both Gallagher and Piwowar were dubious that TSR would be an appropriate measure for all companies.  (In her remarks, even SEC Chair Mary Jo White requested comment on whether TSR was the optimal measure.)  Moreover, they viewed a stock price metric as subject to potential “gaming” by management through conducting stock buybacks, cutting R&D to inflate profits and other timing strategies, resulting in an overemphasis on short-term versus long-term performance. Gallagher also argued that TSR was just not an accurate measure, noting that even ISS had moved away from using TSR: “a simple TSR-based comparison is likely to produce an excessive number of false positives. It will show companies where pay seems to be out of alignment with performance, based on this simplistic metric, but where a more nuanced evaluation would show that pay is actually well-aligned with performance. In fact, ISS used to use a single TSR-based metric as an initial screening device for alignment of pay with performance. But ISS recently moved to more sensitive alignment tests, noting that while 30% of companies failed the initial TSR-based screening, more than two-thirds of those companies actually exhibited alignment of pay with performance when analyzed more closely.” [Footnotes omitted.] He worried that less sophisticated investors could end up being misled by the disclosure.  His answer was that the SEC should just admit that it does not have a single answer for this issue and allow companies the flexibility to satisfy the requirement however they choose, so long as they comply with the statute.

[Soapbox: These two Commissioners are certainly not alone in their skepticism about the use of TSR and other stock-based metrics as measures of performance. See for example, this post discussing the “tyranny of TSR,” and the view that the use of TSR as a metric is deeply misguided because factors that affect share price, such as “fund flows, central bank policies, macroeconomics, geo-political risks and regulatory changes are all beyond the control of executive management.”  The article discussed in the post argues that the “best measure of economic value creation is economic profit, i.e. net operating profit minus a capital charge for invested capital. Economic profit, unlike conventional profit, subtracts input cost from output value to get true value creation.”

See also this news brief,  discussing a column by the NYT’s Gretchen Morgenson, contending that metrics such as TSR are problematic because they leave out “a wide array of measures that better capture whether a company’s management is operating in the interests of investors with a long-term horizon.” In addition, it “allows top executives to reap the pay benefits associated with a short-term bullish stock market, which may have nothing to do with their company’s specific business or operations….” In fact, the column contends, perhaps most importantly, that TSR “can rise even after a company has shown an economic loss — a negative return on capital — over an extended period. A focus on stock price, therefore, can mask a longer-term decline in a company’s financial footing.” A consultant cited in the article discussed in the post described companies that had returns on invested capital that were below their cost of capital as  “‘value myths’ because on the surface they are producing gains for shareholders but underneath they are generating negative returns on their investments in plants, equipment, acquisitions or other items.”  And we could even speculate that Professor William Lazonick might agree with two Commissioners in light of his view (discussed in this post) that the increase in stock-based pay for executives has given rise to massive stock buybacks.

Although they might view the data resulting from the use of TSR as inaccurate from opposite sides of the fence (not revealing pay-for-performance alignment where alignment exists versus showing alignment where none exists), the irony that Morgenson and Lazonick could end up on the same side of an issue as Gallagher and Piwowar should not go unnoticed. As a result, it would not be surprising if the SEC received substantial pushback on this aspect of the rule in particular. However, the SEC might feel hamstrung in selecting a significantly different measure in light of the Dodd-Frank mandate to take into account changes in the stock value and any distributions, and combined measures may be too complex to calculate. If the SEC feels compelled to address the issue further, it will be interesting to see how the Commissioners resolve the conundrum. ]

Gallagher also objected to the requirement for compensation data for NEOs other than the PEO.  He argued that PEOs set the tone for compensation and that the other data was unnecessary. Both dissenters also objected to requiring that the rules apply at all to smaller reporting companies.

(Note that, as of this posting, neither the SEC press release nor the proposed rule release has been posted to the SEC website.)

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