In theory, executives should be paid more when their companies’ stocks perform well — and less when their companies experience losses. But that’s not always the case in the real world. One of the reforms from the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) that has yet to be implemented is a proposed rule requiring public companies to disclose the compensation paid to executives relative to the company’s stock market performance. Public company investors hope it will provide enhanced information and give them a larger say in setting executive compensation packages, but the proposal is somewhat controversial.
Calls for greater transparency
Dodd-Frank is the most far-reaching Wall Street reform in U.S. history. The overarching goals of these reforms were to prevent the excessive risk-taking that led to the financial crisis of 2008 and to build a more stable, transparent financial system going forward. Accordingly, Dodd-Frank added Section 14(i) to the Securities Exchange Act of 1934 and instructed the Securities and Exchange Commission (SEC) to add the pay vs. performance requirement to Item 402 of Regulation S-K.
For years, investor advocacy groups have also pushed the SEC to require public companies to disclose more information about executive pay. “Transparency of executive pay enables shareowners to evaluate the performance of the compensation committee and board in setting executive pay, to assess pay-for-performance links and to optimize their role of overseeing executive compensation through such means as proxy voting,” said Ann Yerger, Executive Director of the Council of Institutional Investors, during a 2009 congressional hearing.
The SEC’s answer
In an effort to improve transparency about public companies’ executive compensation practices and policies, the SEC has decided to propose a requirement to disclose the relationship between executives’ compensation and the company’s financial performance. The recent SEC proposal — Release No. 34-74835, Pay Versus Performance — will be subject to a 60-day comment period.
If the proposed rules are finalized, public companies will be required to disclose in their proxy or information statements the relationship between the compensation paid to executive officers and the total shareholder return of the company. The relationship between the company’s shareholder return and the shareholder return of other companies from the same industry will also have to be disclosed. The SEC defines shareholder return as a combination of stock performance plus reinvested dividends compared to the returns from the broader stock market.
The SEC wants companies to calculate the compensation paid to the principal executive officer using the figures disclosed in the proxy filing’s summary compensation table as a starting point and adjust the amounts for pensions and stock awards. Pension amounts will be adjusted by deducting the change in pension value reflected in the table and adding an actuarial estimate of the cost of the executive’s services during the year.
In addition, the proposal calls for stock awards to be valued on the date they vest and not the date they were granted, which SEC rules currently require for a proxy’s compensation table. Both amounts would be disclosed in the new table.
Companies will be required to disclose the information for three years with a two-year phase-in, by which time five years of data will have been provided. The SEC proposes to have the information supplied in the interactive data format called the eXtensible Business Reporting Language (XBRL). This is the first time the SEC is requiring the use of XBRL outside the financial statements.
One area of controversy is the differing standards for small public companies. Under the existing requirements, smaller companies already are exempt from providing a performance graph or a compensation discussion and analysis in their proxy filings. Under the proposal, such companies won’t be required to compare their shareholder returns against other companies in the same industry. They also won’t be required to comply with the XBRL tagging requirement for three years. Some investors criticized the proposal for holding smaller companies to a lower standard. Arguably, shareholder returns are a meaningful performance metric, regardless of company size.
Another controversy involves the extent of the disclosure requirements. Two SEC Commissioners who voted against the proposal criticized it for asking companies to provide too much detailed information overall. But professional services firm Towers Watson contends that the proposal won’t change executive compensation plans or say-on-pay voting results. Institutional investors and proxy advisors already use sophisticated models to evaluate executive compensation. The expanded disclosures required under the recent SEC proposal just provide another resource to help shareholders evaluate performance.
Sidebar: Improving income statement transparency
Private companies aren’t off the hook when it comes to improving the transparency of reporting executive compensation. This is one of the biggest line items on the income statement, especially for small and midsize private companies. Over the summer, the Financial Accounting Standards Board (FASB) plans to meet with its Private Company Council to discuss plans for amending the accounting for stock compensation as it affects private companies.
The FASB will also review the findings from its research staff about potential improvements to income statements. The board is looking at ways to provide investors with more details about the frequency of transactions that are reported in the income statement. This initiative was originally part of a broader project on financial statement reporting that began in 2014.