AND COURTLANDT SPEAR

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The Time is Now

Over a decade after the Dodd-Frank Act obligated them with the task, the SEC has adopted pay-versus-performance amendments. Public company filers with fiscal years ending on or after December 16, 2022, now must include additional disclosures relating to pay-versus-performance metrics in their proxy statements.

These disclosures provide additional color on the full scope of executive compensation packages, allowing shareholders to benchmark compensation packages against company performance.

Organizations exempt from this public filing requirement include emerging growth companies, registered investment companies, foreign private issuers, and business development companies.

What is Required?

Changes in the fair value of equity awards issued to Principal Executive Officers (PEOs) and Named Executive Officers (NEOs) from year to year until the award is vested are now required to be presented in the first proxy or information statement that requires this disclosure. This requires valuing unvested awards as of year-end and as of their vesting date, and awards that vest in tranches must be valued on a tranche-by-tranche basis.

Filers must present changes in the fair value of equity awards over the three years before the first proxy or information statement that requires this disclosure. They are also required to disclose another year in each of the two subsequent annual proxy filings.

“Registrants other than SRCs [smaller reporting companies] are required to provide the information for three years in the first proxy or information statement in which they provide the disclosure, adding another year of disclosure in each of the two subsequent annual proxy filings that require this disclosure. SRCs are initially required to provide the information for two years, adding another year of disclosure in the subsequent annual proxy or information statement that requires this disclosure.”

This requirement has significant implications for equity-based awards that are outstanding but have vesting schedules that cover multiple years. The fair value of compensation granted to PEOs and NEOs now needs to be determined and disclosed at grant date, and (eventually) on a rolling five-year basis.

As outlined by the SEC:

The final rules also require the deduction of the equity award amounts reported in the Summary Compensation Table total; however, instead of the addition of the vesting date fair value of stock awards and options, the final rules require the addition (or subtraction, as applicable) of the following:

• The year-end fair value of any equity awards granted in the covered fiscal year that are outstanding and unvested as of the end of the covered fiscal year
• The amount of change as of the end of the covered fiscal year (from the end of the prior fiscal year) in fair value of any awards granted in prior years that are outstanding and unvested as of the end of the covered fiscal year
• For awards that are granted and vest in the same covered fiscal year, the fair value as of the vesting date
• For awards granted in prior years that vest in the covered fiscal year, the amount equal to the change as of the vesting date (from the end of the prior fiscal year) in fair value
• For awards granted in prior years that are determined to fail to meet the applicable vesting conditions during the covered fiscal year, a deduction for the amount equal to the fair value at the end of the prior fiscal year.
• The dollar value of any dividends or other earnings paid on stock or option awards in the covered fiscal year prior to the vesting date that are not otherwise reflected in the fair value of such award or included in any other component of total compensation for the covered fiscal year.

Fair Value of Equity Grants

Determining the fair value of “plain vanilla” option grants may not be as simple as expected. While service-vesting options will typically be valued using the Black-Scholes Option Pricing Model (BSOPM), developing the inputs may be more complicated than expected. Out-of-the-money options, for example, may require a lattice model to incorporate the impact of moneyness and the passage of time on the expected life of the options. With a supportable expected life, updating the other BSOPM inputs (i.e., expected volatility, stock price, risk-free) is usually straightforward.

Determining the fair value of more complex grants will require a valuation expert to provide and document the determination of fair value calculated using more complex modeling tools such as a Monte Carlo simulation-based approach or a lattice model.

Grants requiring more complex modeling will generally have a market performance condition in which vesting is based on:

• Changes in the market value of the company’s stock,
• Company stock performance relative to the stock price performance of a previously selected list of public stocks or an index,
• Or upon achieving return multiples or thresholds and/or specific IRR targets.

These equity grants may be known as:

• Total shareholder return (TSR) based grants
• Restricted stock units (RSUs) vesting on a market condition
• Performance-Based Restricted Stock Units (PSUs)
• Stock Appreciation Rights (SARs)

VRC’s Complex Securities Practice Group can help your organization determine fair value estimates associated with this new SEC filing requirement. Our team offers deep experience valuing complex securities, including credit/debt instruments, derivatives, equity, and structured products. We welcome you to contact article authors Frank Mainville, Kevin Gawron, Courtlandt Spear, or any VRC professional for further expert views and assistance with share-based compensation considerations and other questions you may have.