Two of the New SEC PvP CDIs Raise Complicated Interpretative Issues

By Samantha Nussbaum, David Gordon, Michael Abromowitz, Dina Bernstein, Bindu M. Culas, Stafford Schmidt, Kenneth H. Sparling


Last month we blogged that the SEC had just issued 10 new Compliance and Disclosure Interpretations (CDIs) with respect to the application of the new Pay Versus Performance rule (PvP Rule) and the related table (PvP Table).  We said we wanted to continue examining the new CDIs with a view to identifying the CDIs most likely to require changes in how companies were preparing their PvP Table.  We have identified two that warrant further discussion, CDI 128D.18 and CDI 128D.22.  While issuers are, of course, affected by the other CDIs, we think these two may have the greatest impact. 

CDI 128D.18—Retirement eligibility and determining when equity is vested.

Often companies issue equity awards with favorable retirement treatment, providing for acceleration (immediate payout) or continued vesting (no requirement of additional service but payout on the dates that would have occurred if the executive had remained employed).  For purposes of determining compensation actually paid (CAP), there has been a lack of consensus regarding when these awards are considered “vested” in the case of retirement-eligible holders.  This question is significant because the CAP calculation examines the change in the value of outstanding equity awards from the close of the prior year until the close of the following year unless any of the awards have vested during the year, in which case one computes the change in value through the vesting date for such awards (and for awards that are granted and vested in the same year, the change would be the full fair value at vesting).

CDI 128D.18 is short:

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.

This language appears to indicate that, if retirement eligibility is the only vesting condition, vesting occurs for purposes of determining CAP in the year during which the holder first becomes retirement eligible, regardless of whether the holder terminates employment.  For example, if a grant recipient already meeting the applicable definition of retirement (typically a combination of age and years of service) receives a time-based restricted stock unit (RSU) award that contains favorable retirement vesting provisions and there are no additional vesting conditions other than service, then the award is considered vested on the grant date.

However, the CDI also provides that additional “substantive conditions” must be considered in determining when an award vests.  The SEC did not include an exhaustive definition of such “substantive conditions” but noted it includes a “market condition,” and we can think of no reason why financial performance goals could not also qualify as substantive conditions.  Therefore, an RSU with favorable retirement vesting does not become vested for CAP purposes upon retirement eligibility if the award is also subject to the achievement of a market condition, such as a three-year relative total shareholder return goal, provided the payout is tied to actual performance results (if, instead, payout is based on the target award regardless of performance results, then the performance goal is no longer a substantive condition).

It is less clear what else may constitute a substantive condition.  For example, would a required notice period (prior to retirement) or compliance with restrictive covenants constitute such a substantive condition?  Another question is whether a condition is determined to be “substantive” is always the same or depends on the circumstances of the executive.  If a retirement eligible holder is 55 years old, a covenant not to compete might be considered substantive since that holder may potentially seek employment elsewhere, while a holder who is 72 years could generally be considered less likely to pursue post-retirement employment.1  Companies should also consider whether their equity awards contain a requisite minimum service period (usually six to 12 months) following grant, before favorable retirement treatment becomes available.

Another issue is how to value favorable retirement provisions with “pro-rated” vesting.  Pro-rated vesting refers to an equity award design whereby upon a qualifying termination of employment, a holder is entitled to receive continued or accelerated vesting of an award, where the amount of the award eligible to vest is pro-rated by the length of time the holder was employed during the total vesting period, often calculated either by the number of days or number of full months.  Calculating the value of such an award at vesting for a retirement eligible holder could potentially be complex.  For example, a typical RSU award might vest in equal annual installments over four years.  Upon retirement, a holder would vest in the then outstanding RSUs by multiplying the outstanding RSUs by a fraction x/y, where x is days worked since grant date and y equals total days in the vesting period.  For CAP purposes, does an additional amount vest each day, starting on the date the holder first becomes retirement eligible?  

A literal reading of the CDI might suggest this is the case.  Whether companies adopt this approach and capture up to 365 separate vesting dates per year (which could be the result for an executive who becomes retirement eligible on the first day of the year), or whether it is permissible to use a more simplified approach, such as treating all awards vesting during a month as vesting on the same date and including an explanatory footnote, is a topic that warrants additional examination.

In light of Question 128D.18, companies should review the approach they took last year with respect to the treatment of equity held by retirement-eligible employees to determine if any changes are needed going forward.  They should also consider whether any required changes going forward include modifying prior fiscal year calculations in the PvP Table or whether footnote disclosure is sufficient to explain the change in approach and possible discrepancies in the reported values. 

CDI 128D.22—What has to be disclosed if the value of long-term performance awards has changed since the grant date because the probable outcome of financial performance metrics has changed?

CDI 128D.22 increases our uncertainty with respect to what type of footnote disclosure the PvP Rule requires in the case of performance stock units (PSUs) with a financial metric when (1) calculations need to be made of fair value on a date subsequent to the grant date and (2) the probable outcome is no longer target.2  Specifically, we worry that the SEC is saying that a company does not have the ability to say nothing.  We think the easiest way to understand the issue may be to start with an example.

Suppose Executive E is granted 1,000 PSUs in early 2022 when the stock price is $100.  Assume the financial metric is net income per share and payout occurs at the end of three years based on aggregate net income per share.  Assume that target payout occurs if cumulative net income per share is $30, payout declines on a linear basis to 50% (500 shares) if cumulative net income per share is $24, and payout raises to 200% (2,000 shares) as cumulative net income per share rises to $50.

At the end of 2023 the company has to calculate the fair value of E’s award at 12/31/23 in order to include in the PvP Table any change from the 12/31/22 value.  Assume the fair value of the award was $100,000 on 12/31/22.  Assume the stock price is now $120 on 12/31/23.  Can the registrant simply treat the award as now worth $120,000 (i.e., the target number of PSUs (1,000) times the stock price on 12/31/2023 ($120))?  It depends. 

Specifically, Item 402(v)(iii)(C)(3) requires that the fair value of the award at 12/31/23 be “based upon the probable outcome of such [performance] conditions as of the last day of the year.”  The issue is thus whether there has been a change in the company’s assumption at grant that the probable outcome was performance at target (in our experience this is almost universally the assumption).  The accounting rules require a reassessment of probable outcome and, if the company has recomputed probable outcome for the purposes of its financial statements, it is difficult to see why the SEC would not think the recomputed outcome needs also to be taken into account for the PvP Table.  For example, suppose cumulative net income per share after the first two years is $30 (the total for 2022 and 2023) and the budget for 2024 is $15 of net income.  It is not difficult to imagine that the probable outcome is now treated as $45, which would result in a fair value of $210,000 (175% x 1,000 shares x $120), increasing CAP by $110,000.3

Item 402(v)(4) requires footnote disclosure of “any assumption made in the valuation that differs materially from those disclosed as of the grant date of such equity awards.”  Our experience is that many companies took the position in 2023 that no footnote disclosure was required in circumstances similar to our example.4  One theory was the view that the 175% assumption was not a “materially different assumption” because the language in the PvP Rule was intended only to encompass situations where a completely different valuation framework was used.  Alternatively, some companies took the position that no disclosure was required because of the disclosure exception for competitive harm found in Instruction 4 to Item 402(b).

While CDI 128D.22 focuses on the application of the exception for competitive harm, we think its implications may extend to both rationales.

The competitive harm exception in Instruction 4 provides:

Registrants are not required to disclose target levels with respect to specific quantitative or qualitative performance-related factors considered by the compensation committee or the board of directors, or any other factors or criteria involving confidential trade secrets or confidential commercial or financial information, the disclosure of which would result in competitive harm for the registrant. The standard to use when determining whether disclosure would cause competitive harm for the registrant is the same standard that would apply when a registrant requests confidential treatment of confidential trade secrets or confidential commercial or financial information pursuant to Securities Act Rule 406 (17 CFR 230.406) and Exchange Act Rule 24b–2 (17 CFR 240.24b-2), each of which incorporates the criteria for non-disclosure when relying upon Exemption 4 of the Freedom of Information Act (5 U.S.C. 552(b)(4)).  A registrant is not required to seek confidential treatment under the procedures in Securities Act Rule 406 and Exchange Act Rule 24b–2 if it determines that the disclosure would cause competitive harm in reliance on this instruction; however, in that case, the registrant must discuss how difficult it will be for the executive or how likely it will be for the registrant to achieve the undisclosed target levels or other factors.

Exactly how this language was to apply, if at all, to the PvP Table, was never clear since the instruction focused on target levels of performance while the PvP Table focuses on changes in assumptions about the actual level of performance (generally from target to below or above target).  Our experience, however, was that some companies interpreted this language to insulate them from any footnote disclosure of changes in assumptions if revealing the new assumptions raised competitive concerns.

While it is hard to tell what is now required if a company was relying on the competitive harm exception, it seems clear that CDI 128D.22 requires some type of footnote disclosure if the company was relying solely on the competitive harm exception and the probable performance outcome is now significantly different than target.  The CDI states:

A registrant is not required to disclose detailed quantitative or qualitative performance condition for its awards under Item 402(v)(4) to the extent such information would be subject to the confidentiality protections of Instruction 4 to Item 402(b) of Regulation S-K.  However, the registrant must provide as much information responsive to the Item 402(v)(4) requirement as possible without disclosing the confidential information, such as a range of outcomes or a discussion of how a performance condition impacted the fair value.  In addition, consistent with Instruction 4 to Item 402(b), the registrant should also discuss how the material difference in the assumption affects how difficult it will be for the executive or how likely it will be for the registrant to achieve undisclosed target levels or other factors.

Exactly what is required is unclear.  In our hypothetical example, the probable outcome is now a 175% payout.  Depending on other disclosures with respect to the PSU structure, perhaps the projected 175% could be revealed without competitive harm (this might be possible if the company has not yet revealed the actual numbers for target and maximum payout); alternatively, perhaps a range of payouts would suffice, given the CDI’s reference to a “range of outcomes.”  Perhaps a company could state that the PSU has a variety of potential payout percentages, and a higher payout is now expected.  Or maybe all that is required is a statement that target payout was assumed as of the end of 12/31/22, but as of 12/31/23 payout significantly above target was assumed. 

Of course, none of this matters if a change in the probable payout assumption is not equivalent to using a “materially different assumption.”  The CDI does not directly address this question.  We find it challenging, however, to read the CDI and conclude that the SEC is thinking that no disclosure is needed when the payout percentage materially shifts.  The CDI refers to discussing “how the material difference in the assumption affects how difficult it will be for the executive…to achieve undisclosed target levels.”  So, while the CDI is in response to the competitive harm exception, it heightens our concern that the SEC will eventually conclude that some type of disclosure is required whenever there is a significant change in fair value due to a change in the projected payout percentage.

In conclusion, much like the case with CDI 128D.18, while CDI 128D.22 continues the task of clarifying the PvP Rule, there still remain significant areas of uncertainty where further SEC guidance would be of benefit.

1Such an approach would be analogous to IRS regulations under section 83 of the Internal Revenue Code defining a different concept--a “substantial risk of forfeiture.” The regulations state “An enforceable requirement that the property be returned to the employer if the employee accepts a job with a competing firm will not ordinarily be considered to result in a substantial risk of forfeiture unless the particular facts and circumstances indicate to the contrary. Factors which may be taken into account in determining whether a covenant not to compete constitutes a substantial risk of forfeiture are the age of the employee, the availability of alternative employment opportunities, the likelihood of the employee's obtaining such other employment, the degree of skill possessed by the employee, the employee's health, and the practice (if any) of the employer to enforce such covenants.”

2CDI 128D.22 and the exception for competitive harm (discussed below) apply with equal force to long-term incentives with a payment based on market conditions, such as stock options and PSUs with a payout based on relative total shareholder return.  While the CDI may eventually be interpreted to require additional disclosures with respect to these types of awards, we will not focus on these types of long-term incentives.  Additional disclosure may take up more space in the PvP section of the proxy, but in our experience the disclosures themselves don’t involve data that companies are uncomfortable in disclosing.

3In that regard, our understanding is that some companies may still compute fair value for financial statement purposes based on a target payout assumption, at least sometimes basing that treatment on the rationale that the difference in overall corporate net income due to this changed assumption is so small that it is immaterial for purposes of the financial statements.  We have seen nothing indicating this rationale is considered conclusive for PvP Table purposes.

4We note that determining whether the company has changed its estimate of probable outcome may not be possible by just examining the numbers in the PvP Table--the PvP Rule allows data to be provided on an aggregate basis for categories of equity, for example, the total change in value from 12/31/22 to 12/31/23 of all unvested awards of an executive can be disclosed as one number.  So, it can often be impossible to determine from one number if there has been a change in probable outcome. 

Samantha Nussbaum

 Samantha Nussbaum has consulted on behalf of public and private companies, compensation committees, and senior management on all aspects of executive compensation. Samantha’s consulting and legal background includes advising on executive compensation in the context of mergers and acquisitions, spin-offs, and initial public offerings; executive employment, severance, and change in control agreements; equity incentive plans; deferred compensation; and securities laws, including reporting and disclosure implications.

Portrait of David Gordon, Managing DirectorDavid Gordon
Managing Director

Dave Gordon’s practice as an executive compensation consultant covers a variety of industries, including extensive experience with financial institutions and utilities. Based on his years of experience as an executive compensation lawyer, he acts as the senior resource on numerous technical issues for the Firm. He frequently acts as an expert witness.

Michael Abromowitz

Michael Abromowitz consults on all aspects of executive and board compensation including executive compensation benchmarking, annual and long-term incentive program design, peer group development, and executive severance and change-in-control plans.

Dina Bernstein

Dina Bernstein has extensive experience advising on all aspects of executive compensation, working with companies on an ongoing basis, as well as in the context of mergers and acquisitions, spin-offs, initial public offerings, and other corporate events. Dina provides guidance to private and public companies across various industries regarding cash and equity incentive compensation arrangements, employment, severance and change in control agreements, overall compensation program design, pay governance practices, taxation, stock exchange listing requirements and securities regulation compliance.

Portrait of Bindu M. Culas, PrincipalBindu M. Culas
Managing Director

Bindu Culas has over 20 years of executive compensation experience. She works across industries with domestic and foreign public companies, pre-IPO companies and privately-held companies. She has deep expertise in designing annual and long-term incentive programs, structuring equity plans and award vehicles, navigating talent attraction, motivation and retention challenges through business cycles, and advising on governance and investor considerations. Previously, Bindu was a partner at Linklaters LLP and she is well versed in the complex regulatory, compliance and tax aspects of executive compensation.

Portrait of Matt Lum, ConsultantStafford Schmidt

Stafford Schmidt is a CPA and has years of experience in this capacity. He currently provides consulting services in various areas of compensation matters, specializing in director compensation, executive compensation trends, peer group development, and annual and long-term incentive program design.

Portrait of Kenneth H. Sparling, PrincipalKenneth H. Sparling
Managing Director

Ken Sparling’s assignments have been with both public and privately-held companies in various industries. His consulting engagements focus on all aspects of executive and board compensation including annual and long-term incentive programs, employment agreements and change-in-control arrangements. 


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