Wooden figures representing executives looking at a dartboard target

Recent SEC Guidance on Pay vs. Performance Disclosures

November 29, 2023

With proxy season starting up, the SEC has issued several new Compliance and Disclosure Interpretations relating to the Pay vs. Performance disclosure.

The SEC issued three rounds of CDIs on this topic: the first was issued back in February, the second in September, followed shortly by another round of CDIs in late November. In this blog entry, I summarize the CDIs that the SEC issued or updated in September and November.

For a review of the fundamental disclosure requirements for the Pay vs. Performance table and narrative, see "A Guide to the SEC’s New Pay-for-Performance Disclosures."

Retirement Provisions

Probably the most controversial and confusing CDI addresses how awards that provide for accelerated or continued vesting upon retirement should be included in compensation actually paid for executives who are eligible to retire (Question 128D.18). A quick refresher: CAP for equity awards is equal to the change in fair value of the award from the start of the year until the end of the year unless the award vests during the year—in which case you calculate the change in value from the start of the year to the vest date.

This brings us to the question addressed by the CDI: If an award provides for accelerated or continued vesting upon retirement and the executive is eligible to retire, is the award vested for purposes of CAP? Under ASC 718, the award would be treated as substantively vested. Likewise, restricted stock and RSUs are considered to be substantively vested for tax purposes.

In September, the SEC issued the following CDI:

Question: Some stock and option awards allow for accelerated vesting if the holder of such awards becomes retirement eligible. If retirement eligibility was the only vesting condition, would this condition be considered satisfied for purposes of the Item 402(v) of Regulation S-K disclosures and calculation of executive compensation actually paid in the year that the holder becomes retirement eligible?

Answer: Yes. However, for awards with additional substantive conditions, in addition to retirement eligibility, such as a market condition as described in Question 128D.16, those other conditions must also be considered in determining when an award has vested.

While that answer isn’t entirely clear, most practitioners interpreted that to mean that the award should be treated as vested if the executive became eligible to retire before the stated vesting date, unless it is also subject to a market condition. This is fine for awards that will be fully accelerated upon retirement, but it would be very problematic for awards in which the acceleration is on a pro rata basis. In that case, a small portion of the award would have to be treated as vested each day—resulting in as many as 365 fair value calculations (366 in a leap year).

In November, however, the SEC revised the response to this CDI. In the question, they changed “only vesting condition” to “sole vesting condition” (as a layperson, this doesn’t in any way change the meaning for me, but maybe it means something to lawyers) and changed the answer to:

Yes. However, if retirement eligibility is not the sole vesting condition, other substantive conditions must also be considered in determining when an award has vested. Such conditions would include, but not be limited to, a market condition as described in Question 128D.16 or a condition that results in vesting upon the earlier of the holder’s actual retirement or the satisfaction of the requisite service period.

Unfortunately, the updated response still is not completely clear. The mere fact that the SEC modified the response seems to indicate that they did not feel the original CDI was being interpreted correctly. The reference to “the earlier of the holder’s actual retirement or the satisfaction of the requisite service period” seems to indicate that other vesting conditions, including possibly service or performance conditions, could cause the award to not be considered vested until the executive retires or these other conditions are fulfilled. Based on my research, this seems to be the prevailing interpretation of the updated CDI (see memos by Infinite Equity, Equity Methods, WTW, and FW Cook).

But there is still room for varying interpretations. What exactly does “must also be considered” mean? Are there situations where an award might be considered vested when an executive is eligible to retire, even if there are additional vesting conditions that must be met? It is possible that some law firms will interpret the CDI differently or that your company’s facts and circumstances could cause the guidance to apply differently. If you have executives who are eligible to retire or nearing this status and hold equity awards that provide for payout upon or after retirement, now is a good time to consult your legal advisors regarding this matter.

Market Conditions

This CDI asks how market conditions affect the determination of CAP (Question 128D.16). There are two issues to consider:

Does the market condition have to be incorporated into the fair value of the award when determining CAP?
Is the market condition treated as a vesting condition when determining CAP?

The SEC’s answer to both questions is yes. Not surprisingly, the fair value of an award with market conditions should be determined using a method that considers those conditions (e.g., the Monte Carlo simulation).

The answer to the second question has two implications. The first is that awards aren’t considered vested for purposes of determining CAP until any applicable market conditions are met. Second, forfeitures due to failures to achieve market conditions reduce CAP (unlike under ASC 178, where these forfeitures do not reduce the expense recognized for an award).

Other Vesting-Related CDIs

Certification of Performance: If an award is subject to performance conditions that have been met as of the end of the fiscal year, but the compensation committee has to certify performance for the award to be paid out, is the award considered vested prior to when the certification is completed? This will be a facts and circumstances determination, but the award is not considered vested if service is required through the certification date. (Question 128D.19)

Unmet Performance/Market Conditions for Outstanding Awards: If an award is subject to performance or market conditions that haven’t been met by the end of the company’s fiscal year, but there is still a possibility that the award will vest if these conditions are met in the future, the change in fair value of the award over the year must be included in CAP. (Question 128D.17)

Determination of Fair Value

When determining CAP, the fair value of equity awards can be determined using a different valuation method than that used for ASC 718 purposes, provided that the fair value is determined in a manner that is acceptable under ASC 718. If the valuation technique differs materially from that used to value the award under ASC 718, the change in valuation technique and rationale should be disclosed. (Question 128D.20)

At the same time, it is never acceptable to use a fair value approach that isn’t permissible under ASC 718. This applies to not only the valuation technique but the determination of valuation inputs. Expected life, in particular, can be difficult to determine for stock options that are in- or out-of-the-money. Shortcuts to determined expected term are not permissible and the simplified method available at grant also may not be permissible for subsequent valuations. (Question 128D.21)

My guess is that, in practice, the simplified method will still be used by companies that don’t have sufficient historical data to develop a more rigorous estimate (e.g., see this memo from Infinite Equity). In some cases, there may be little alternative.

Peer Groups

There are a bunch of CDIs related to peer groups.

If a company uses the peer group from its performance graph for its peer group in its PvP table and uses more than one published industry or line-of-business index in the performance graph, it can choose which one to use in the PvP table. Read the CDI for required disclosures. (Question 128D.24)

Companies can’t use a broad-based equity index as their peer group, even if they grant relative TSR awards in which vesting is conditioned on their performance as compared to such an index. (Question 128D.25)

Market cap based weighting of peer returns is required only if the company is not using a published industry or line-of-business index as its peer group. (Question 128D.26)

If a company is using a custom peer group (rather than a published industry or line-of-business index) and it changes the companies included in the group, it must footnote the changes and compare its cumulative TSR with both the updated peer group and the peer group used for the prior fiscal year. The only exceptions are (a) if a company is removed because it is no longer in the same line of business or industry or (b) the change is a result of pre-established objective criteria. But even for these exception cases, the company still has to describe the changes and basis for them, and disclose which companies were removed from the peer group. (Question 128D.27)

Question 128D.07: I can’t even. There’s no easy way to summarize this question and answer. If you changed the companies in your peer group in your CD&A in 2020, 2021, or 2023, you should read this CDI. As far as I can tell, the rest of you can move on with your lives.