Commentary on SEC’s Newly Released Compliance & Disclosure Interpretations

Written By: Deidre Salisbury, Liz Stoudt

On September 27, 2023, the SEC released 9 new Compliance & Disclosure Interpretations (“C&DIs”) that provide clarification on the new Pay Versus Performance rules (Questions 128D.14 – 128D.22). 

These new C&DIs primarily focus on the details for vesting requirements and valuation techniques to calculate Compensation Actually Paid (“CAP”). Many of the questions and answers are related to the technical aspects of the rule’s applications. 

Below is a summary of these interpretations along with commentary from Infinite Equity:

Question 128D.14 | Awards Modified by Equity Restructuring

Awards modified in connection with an equity restructuring, such as a spin-off, should be included in the calculations.

Infinite Equity Commentary: This guidance was expected as these awards are included in the Outstanding Equity Awards at Fiscal Year-End table in the proxy.  Thus, any outstanding and unvested awards during a covered fiscal year need to be valued at the beginning of the fiscal year of the transaction and at the earlier vest date, or at the end of that fiscal year to determine its impact to CAP.  The complexity of this particular C&DI is that the valuation of the beginning of the fiscal year is based on a different company’s stock than the valuation at the end of the fiscal year (e.g., an RSU granted by Company ABC at the beginning of the year and an RSU converted to Company DEF at the end of the year).

Question 128D.15 | Awards Granted Prior to IPO

In periods prior to an initial public offering (“IPO”), the change in fair value should be based on the fair value as of the end of prior fiscal year and not determined based on other dates, such as from the date of IPO. 

Infinite Equity Commentary: The fair value prior to IPO is typically based on a 409A valuation at or close to the fiscal year end. While this guidance is not unexpected, it does create a disconnect between the TSR of a newly public company, starting as of the registration date, compared to CAP measured as of the end of the fiscal year prior to IPO. We encourage you to read more about considerations for newly public companies in Navigating PvP for Public Companies.

Question 128D.16 | Market Conditions

Awards with market conditions should be included in the calculations until the market condition is satisfied. Similarly, the amount of the fair value at the end of the prior fiscal year should be deducted for awards that fail to meet the market condition during the covered fiscal year if it results in forfeiture of the award.

Infinite Equity Commentary: Market conditions should be re-valued until the end of the performance period using an appropriate valuation technique. If the final payout is 0%, the value at the end of the prior fiscal year will effectively be deducted.

Question 128D.17 | Failure to Meet Vesting Conditions

If an award did not meet vesting conditions during the year because the performance or market conditions were not met, but there is still potential for the award to vest in the future, then they should still be included in the calculations. The fair value should not be subtracted from CAP as if it failed to vest.

Infinite Equity Commentary: Awards should continue to be valued as long as they remain outstanding and unvested. All market conditions and options will require an appropriate valuation technique.  

  • Market conditions will be valued based on the grant date fair value, and no reversal for CAP will occur unless and until the final payout is determined.  
  • Performance conditions will be valued based on management’s expectation to vest, consistent with the expense accrual as of the end of each fiscal year.  If the expectation to vest at year end is 0%, then a reversal could occur for CAP in that year to the extent the expectation was greater than 0% at the beginning of the year.  The company would continue to reassess the expectation until the end of the performance period and adjust CAP accordingly.

Question 128D.18 | Retirement Eligibility

Retirement eligible awards should be considered vested once other substantive vesting conditions are achieved. If retirement eligibility is the only vesting condition, then the award should be considered vested on the grant date. 

Infinite Equity Commentary: An award should be considered unvested and outstanding until the executive has an “unconditional right” to the award, which we agree exists once an executive is retirement eligible and there are no other performance conditions present. Infinite Equity provides additional considerations regarding vesting and retirement eligibility, which can be found in When is the “Vesting Date”

Question 128D.19 | Performance Award Vesting

Performance awards that require employment through the certification date should continue to be included in the calculations through the certification date. 

Infinite Equity Commentary: Performance awards typically vest at the end of the performance period or require service through a certain date, either based on the certification date or additional service-based requirements. Award agreements should be reviewed carefully to determine if the final vesting date is at the end of the performance period or some later date and remeasured through that date.

Question 128D.20 | Valuation Technique

A valuation technique may vary from the methodology on the grant date as long as it is compliant with ASC Topic 718. A change in valuation technique from the grant date would require disclosure of the change and the reason if such technique differs materially.

Infinite Equity Commentary: We typically recommend that our clients retain the original grant date valuation methodologies, but update for current assumptions and the passage of time. We believe this approach is not materially different from the grant date valuation and consistent with ASC Topic 718.

Question 128D.21 | Valuation Technique

It is never acceptable to value awards based on methods not prescribed by GAAP. Valuations must always be compliant with ASC Topic 718.For example, the expected term assumption to value options should not be determined using a method that is not acceptable under GAAP, such as a “shortcut approach” that simply subtracts the elapsed actual life from the expected term assumption at the grant date. Similarly, the expected term for “plain vanilla” options should not be determined using the “simplified” method if those options do not meet the “plain vanilla” criteria at the re-measurement date, such as when the option is now out-of-the-money.

Infinite Equity Commentary: We typically recommend that our clients retain the same valuation model type as the grant date, but update assumptions based on conditions as of the respective valuation date. This is most pertinent for options, where the expected term assumption methodology may not be appropriate for a re-valuation.

Additional considerations for the expected term assumption can be found  here and a more detailed analysis for in-the-money options versus out-of-the-money options is here. However, we disagree with the guidance that the “simplified” method is not appropriate for this disclosure. While ASC 718 does define a “plain vanilla” option as one that is at-the-money, as a practical matter, companies do use this method to re-value options that are modified when they are no longer at-the-money.

Typically, there is a lack of exercise behavior to rely upon and this forms the basis for management’s best estimation of exercise behavior. Additionally, the complexity and multitude of other methods to determine an expected life for an option that is no longer at-the-money will muddy the fair values used to determine CAP and make these disclosures harder for investors to compare across companies. The “simplified method” allows for a repeatable and comparable method across company disclosures, which may be of more value to investors.

Question 128D.22 | Performance Award Assessment

It is not required to disclose detailed quantitative or qualitative performance assessments for outstanding performance awards to the extent the information is confidential. However, as much information as possible should be provided, as well as a discussion of how the material difference in assumptions affects how different it will be for the executive to achieve. 

Infinite Equity Commentary: We recommend our clients use the same assessment of performance conditions that was used for expense amortization purposes as of the valuation date, but limit the disclosure of these assumptions when they include confidential, non-public information.  Many companies may welcome this guidance as they are not expected to disclose sensitive information, but rather provide some discussion of how the performance condition impacts fair value.

What’s Next

The new C&DIs address some of the complexities and nuances of the Compensation Actually Paid calculation that companies encountered in producing the first year’s disclosure. Many of the selected topics require deep technical understanding of ASC Topic 718 as well as the Pay Versus Performance Disclosure Rules. 

Infinite Equity continues to monitor all guidance put forth by the SEC and are available to answer any questions that assist companies with producing compliant PVP disclosures. Contact us for more information on the new PvP rules, heading into Year 2, or clarity on best practices.

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