Thu, Mar 9, 2023

SEC’s New Pay Versus Performance Disclosure Requirements

Kroll’s Valuation specialist comments on SEC’s rule aimed at providing more insight into the relationship between executive compensation and a company’s performance.

The SEC recently issued a rule aimed at providing more insight into the relationship between executive compensation and a company’s performance. As a part of the new “Pay vs. Performance” (PvP) disclosure requirements, SEC registrants (with the exception of foreign private issuers, emerging growth companies and registered investment companies other than business development companies) must compute the year-to-year change in the fair value of equity awards, which is used to derive the “compensation actually paid” to executives, as defined by the rule. The disclosure requirements apply to proxy statements and begin for fiscal years ending on or after December 16, 2022 (i.e., 2023 proxy season). Newly public companies in the scope of the rule are only to provide disclosures for the years they are considered a reporting entity.

PvP Disclosures Require Additional Valuations

Prior to the new SEC rule, awards subject to equity accounting only needed to be valued as of the grant date for U.S. Generally Accepted Accounting Principles (GAAP) purposes (unless the award is modified). The new SEC disclosure requirements necessitate the fair value measurement of equity grants for executives on an annual basis until vesting occurs (or forfeiture), generally using the same methodology and assumptions as under U.S.GAAP.

Disclosures need to be made individually for the principal executive officer (PEO) and as an average for named executive officers (NEOs).

The transition allows companies to provide the disclosure for three years (instead of five) in the first applicable filing and include an additional year in the next two annual filings. Smaller reporting companies (SRCs) may provide two years of data (instead of three) in the first applicable filing and add a year in the subsequent filing.

Post-Grant Date Valuation Considerations

Post-grant date re-valuations are considerably more complex than grant date valuations, with certain aspects outlined below:

  • Number Valuations Needed for Each Grant:
    • Upon transition, a three-year lookback requires the fair value change in 2020, 2021 and 2022, thus necessitating a 2019 valuation to establish a starting value.
    • Most grant dates do not sync up with fiscal year end. Therefore, a grant with a three-year vesting schedule usually requires four valuations (grant date for U.S. GAAP and three subsequent year-ends valuation for PvP disclosures) in addition to the final measurement date calculations.
  • Changes in Index Constituents: When the stock price performance of the subject company needs to be compared to that of the constituents of an index, changes in the composition of the index over the lifecycle of the grant need to be considered for the re-valuations. The required adjustments for the additions and deletions of constituents can differ by agreement. Therefore, a precise implementation of the specific legal terms is required for each grant.
  • Dividends and Stock Splits: Dividends and stock splits impact the stock price return calculations and post-vesting dividend adjustments. Historical dividend information and stock split events need to be carefully researched to ensure accurate valuation. These events may also impact the grants made during a year differently due to the timing of the events.
  • Performance vs. Market Conditions: Market conditions impact fair value, as in U.S. GAAP. Performance conditions do not impact fair value for U.S. GAAP but affect the compensation expense; for PvP disclosures, the probability of the condition occurring is assessed as of the last day of the fiscal year and is considered in the fair value measurement. For a grant with performance only or performance and market conditions, no expense will be recorded under U.S. GAAP until the performance condition is probable of being met. By analogy, for PvP purposes, if the performance condition is deemed not probable of being satisfied as of a re-measurement date, no re-valuation is needed.
  • Re-Valuation Requirements Beyond the Derived Service Period: Market conditions do not have a pre-defined vesting schedule (e.g., restricted stock that vests when the stock price reaches a certain level). For U.S. GAAP purposes, the grant date fair value is expensed over a derived service period. However, it is possible to have fully expensed outstanding grants for which vesting has not occurred. For PvP purposes, these grants need to be re-valued until vesting occurs (i.e., they become exercisable) despite being fully expensed under U.S. GAAP.
  • Expected Life for Time-Based Vesting Grants: A simplified mid-point method can be used for at-the-money plain vanilla grants as of the grant date. However, over the lifecycle of a grant, the award can be in- or out-of- the-money as of the re-valuation dates. Therefore, a more in-depth analysis may be required to determine the expected life of the grant.

In conclusion, the PvP disclosures require re-valuation of historical equity grants as of multiple dates in time for the 2023 proxy season. Post-grant valuations carry significant additional complexity. We recommend a collaborative approach with valuation specialists early in the process to allow sufficient time for discussions, research and modeling to meet the disclosure requirements on a timely basis.

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