New Pay for Performance Rule: The SEC Misses the Mark, Yet Again

After spending seven years as a proposal in limbo, the Securities and Exchange Commission ("SEC") adopted a "Pay Versus Performance" rule in August of 2022, finally meeting the statutory mandate set forth in the Dodd-Frank Act. (Candance Quinn, et. al., Bloomberg Law). As the rule’s name implies, SEC registrants must now disclose the interplay between their executive compensation actually paid and the company's financial performance. (PricewaterhouseCoopers). An additional requirement under the new rule has drawn scrutiny as it opens the door for Environmental Social Governance ("ESG") disclosures to be made. (SEC). This requirement mandates registrants to list three to seven financial performance measures, which the registrant deems most important to its executive’s performance-based compensation. Id.The mandatory financial performance measures may be substituted for non-financial performance measures, such as ESG measures, if the company deems them to be among their “most important” performance measures. The subjective nature of this provision affords registrants broad discretion in how they choose to publicly state their priorities, but has drawn scrutiny from those who question the utility of ESG measures.

While the SEC did not offer comment on why they opened the door for the inclusion of ESG measures, there are context clues. In January of 2022, referencing the rule's proposal, now former Commissioner Allison Herren Lee remarked that, “[t]he modern compensation landscape now encompasses enhanced reliance on performance metrics related to, for example, climate, diversity, and other company-specific ESG goals.” (Allison Herren Lee, SEC). Commissioner Lee's claims are buttressed by data from 2021 which revealed that 25% of U.S. companies included ESG measures in their executive incentive plans, a 9% increase from 2019. (Lydia Beyoud, Bloomberg Law).

Allowing registrants to include ESG metrics as one of their most important factors for formulating executive compensation is not without risks to investors. ESG metrics are seen as opaque by many investors who want companies to be more transparent with how such metrics are formulated. Id. A comment submission in response to the rule's proposal stated it is "common to see companies link executive pay to ESG metrics that are ill-defined or inherently difficult to quantify, which gives companies the ability to increase executive pay even if the executives are failing to increase shareholder value as measured by financial or return metrics." (Will Collins-Dean & Kristin Drake, SEC). The comment submission went further in its analysis of the potential pitfalls of ESG metrics by remarking that unless a company were to disclose the methodology for calculating the metric, it would offer no utility in assessing whether a company is artificially increasing executive pay using ESG factors. Id.

In response to the rule’s approval, SEC Commissioner Hester Peirce, one of the two dissenting votes on the rule, released a statement. (Hester Peirce, SEC). Of particular note in her scathing assessment of the rule, Commissioner Peirce commented that the rule could distort how public companies compensate executives and how investors evaluate companies’ compensation decisions. Id. The Commissioner went on to remark that highlighting particular performance measures could drive compensation decisions rather than merely informing investors as to how registrants make those decisions. Id. This may lead registrants to feel compelled to link their executive compensation to optional non-financial performance measures, such as ESG. Id.

The inclusion of ESG metrics as an executive compensation factor likely poses a risk for registrants as well. The SEC’s Climate and ESG Task Force (the “Task Force”), created in 2021, has wasted no time in bringing a litany of enforcement actions for ESG related violations. (SEC). Notably, the SEC levied a $1.5 million fine against BNY Mellon in May of 2022 for making misleading claims about funds that use environmental and social criteria in their stock selections. (Dean Seal & Amrith Ramkumar, The Wall Street Journal). Currently, there is no statutory definition of ESG, but that has not been an impediment for SEC enforcement of ESG malfeasance. (Jessica Corso, Law 360). In lieu of a finalized rule on ESG disclosures, the Task Force has used the antifraud provisions of the Investment Advisers Act of 1940 to hold bad actors accountable for making material misstatements regarding ESG strategies and climate risk. Id. There is no reason to suggest that the SEC will turn a blind eye to material misstatements regarding executive compensation based on ESG factors.

To many, the rule is emblematic of the criticism the SEC’s Chairman Gensler has received for SEC’s blistering rulemaking pace. (Garrett Bess, The Wall Street Journal). Commissioner Peirce summed up such criticism by noting that the SEC’s timeframe for finalizing numerous rules indicates that Chair Gensler “plans to rush to completion proposals in which commenters have identified deep flaws.” Id. Buried at the bottom of the rule’s adopting release are statements that support such a claim. “While some investors may find the incremental information to be useful, it is unclear to what extent it would be meaningful to investors more broadly.” (Federal Register). The adopting release kneecaps the rule further by stating, “that the potential benefits of the final rules derive primarily from the manner in which the information is presented rather than the disclosure of any significant new underlying informational content.” Id.

The SEC has a three-pronged mission of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation. (SEC). Does this rule, in its final form, further any of these tenets? It appears not. Some may laud the new option to showcase an ESG focus in executive compensation, but the tide may be turning on ESG sentiment. Analysis of United States based ESG mutual funds has shown that they do not offer better returns and the companies in these portfolios have worse track records with labor and environmental laws than their non-ESG counterparts. (Aneesh Raghunandan & Shivaram Rajgopal Harvard Law School Forum on Corporate Governance). Analysis of the new rule has been light on substantive points and heavy on ESG praise, but it may turn out that the ESG disclosure option will be as superfluous as the rule itself.