The SEC's Proposed Rule on Disclosure of Pay versus Performance

In May 2015 the U.S. Securities and Exchange Commission (SEC) issued proposed rules, pursuant to the Dodd-Frank Act, for disclosure of pay versus performance. The Dodd-Frank Act requires disclosure of “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 proposed rules require a 5 year tabular disclosure of pay, TSR and peer group TSR where pay is the compensation reported in the Summary Compensation Table (SCT) with adjustments for equity compensation and pension value. For equity compensation, values at grant are removed and fair values at vesting are added. This paper shows that the SEC’s interpretation of “compensation actually paid” undermines the matching of pay and performance that is a basic requirement of meaningful pay for performance analysis. For the median S&P 1500 CEO, TSR explains 58% of the variation in pay using mark to market (or “realizable”) pay, but only 12% using the SEC’s pay measure. The SEC’s “fair value” pay measure is no more correlated with TSR than SCT pay, i.e., grant date pay. The paper proposes an alternative, and reasonable, interpretation of “compensation actually paid” that does not undermine the matching of pay and performance, i.e., compensation actually paid is all SCT pay except performance shares that have failed to vest or are likely to fail to vest and stock options that are out of the money. TSR explains 19% of the variation in this pay measure. Unlike the SEC’s “fair value” pay measure, this grant date pay measure should not mislead investors into thinking it fully captures the alignment created by changes in the value of unvested equity compensation.