Executive Pay Compliance: SEC, Dodd-Frank, SOX, and IRS Explained

What are the legal and compliance requirements related to executive compensation for publicly traded companies?

At the federal level, the Securities and Exchange Commission (SEC) defines what executive pay items must be disclosed to shareholders or filed with the SEC. The SEC also has oversight responsibility for financial accounting, which is more directly controlled by the Financial Accounting Standards Board (FASB), a privately funded organization that promulgates rules on financial accounting to be followed by organizations and independent financial auditors. HR should consult with legal counsel to ensure compliance with the latest iteration of the laws related to executive compensation.

SEC Disclosure Requirements

The SEC requires in-depth disclosure of executive compensation, pursuant to rules that are designed to accomplish the following:

• Provide shareholders with a clear and concise report of all the compensation paid to an organization’s principal executive officer, principal financial officer, highest-paid executive officers, and directors.
• Clarify and explain the reasoning underlying fundamental compensation decisions.

The U.S. Securities Act, the Securities Exchange Act, and the Investment Company Act require certain companies to file public disclosures with the SEC.

In the Compensation Discussion and Analysis (CD&A) section of a public company’s proxy statement, the SEC requires detailed disclosure of three categories of executive compensation:

• Compensation for the past fiscal year: This includes a Summary Compensation Table, which reports current and deferred compensation for named executive officers. It details salary, bonus, stock and option awards, non-equity incentive plan compensation, changes in pension value, and other compensation.
• Holdings of equity-related interests: This includes disclosures of equity-based compensation that could result in future gains, such as unvested stock awards, unexercised options, and other equity interests. These are typically presented in tables like the Outstanding Equity Awards at Fiscal Year-End Table and the Option Exercises and Stock Vested Table.
• Retirement and other post-employment compensation: This includes pension benefits, nonqualified deferred compensation plans, and potential payments upon termination or change in control, such as severance or accelerated equity vesting.

These disclosures provide shareholders with a transparent view of executive compensation practices, including current pay, future potential gains, and post-employment benefits.

Employers must disclose compensation policies for nonexecutive officers if the policies create risks that are reasonably likely to have a material adverse effect on the company. 

In disclosing executive compensation, organizations (other than small-business issuers as defined under the law) are initially required to provide a narrative overview of the compensation program maintained for named executive officers. The CD&A must address all material elements of the organization’s compensation arrangements, including the following:

• The objectives of the company’s compensation program and what the program is designed to reward.
• Each element of compensation.
• How the employer chooses to pay each element of compensation.
• How the employer determines the amount for each element.
• How the element of compensation and the organization’s decisions regarding that element fits into its overall compensation strategies and affects decisions regarding other elements of compensation.

Pay Ratio Disclosure. The SEC in 2015 adopted a final rule mandated by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) that requires a public company to disclose the ratio of the compensation of its CEO to the median compensation of its employees. The rule provides shareholders with information they can use to evaluate a CEO’s compensation and requires disclosure of the pay ratio in registration statements, proxy and information statements, and annual reports that call for executive compensation disclosure. Companies were required to provide disclosure of their pay ratios for their first fiscal year beginning on or after Jan. 1, 2017. 

The rule does not apply to smaller reporting companies, emerging growth companies, foreign private issuers, multijurisdictional disclosure system (MJDS) filers, or registered investment companies. The rule does provide transition periods for new companies, companies engaging in business combinations or acquisitions, and companies that cease to be smaller reporting companies or emerging growth companies. 

Say-on-Pay Votes. The say-on-pay rule requires public companies subject to the proxy rules to provide their shareholders with an advisory vote on the compensation of the most highly compensated executives.  Say-on-pay votes must be held at least once every three years. 

Clawbacks. In 2015, the SEC proposed the Exchange Act Rule 10D-1 that would direct national securities exchanges and national securities associations to establish listing standards requiring issuers to have policies for the recovery of erroneously awarded compensation, commonly referred to as clawbacks. Under the final rule, issued on Oct. 26, 2022, “incentive-based compensation” includes bonus payments and equity (stock) awards based on meeting a financial measure. Publicly traded companies are required to adopt and comply with a clawback policy, as well as disclose the policy and any activity related to it in the annual report filed with the SEC.

Pay Versus Performance. The SEC issued a final rule on Sept. 8, 2022, along with a fact sheet summarizing its provisions, that significantly expanded executive pay disclosures by publicly traded U.S. companies. The disclosures require detailed information about the performance metrics companies use to determine executive compensation payouts. The rule implements requirements under  the Dodd-Frank Act and wer effective for the 2023 proxy season. In 2023, the SEC issued a "draft taxonomy guide” for tagging disclosures.

Sarbanes-Oxley Act

The Sarbanes-Oxley Act, also known as SOX, became law in July 2002 and introduced major changes to the regulation of corporate governance and financial practice. SOX contains sweeping provisions relating to corporate governance and accounting reforms, executive compensation, and employee benefits. Some highlights are:

• Public companies may not make personal loans to their directors and executive officers.
• Insiders cannot trade in company stock during certain blackout periods.
• Plan administrators of individual account plans, such as 401(k)s, must give a 30-day advance notice of any blackout period. 
• CEOs and CFOs must repay certain compensation if earnings are restated.
• Penalties are increased for Employee Retirement Income Security Act (ERISA) violations.

ERISA

A fundamental question employers must ask themselves is whether their executive compensation plans are covered by ERISA. If so, certain disclosure and reporting procedures are mandated, and administrators of the plan may be deemed fiduciaries subject to individual liability.

A nonelective retirement plan maintained in conjunction with a qualified retirement plan may provide for benefits under the qualified plan’s formula, to the extent they cannot be provided by the qualified plan because of the limitations of Section 415 of the Internal Revenue Code. This plan is called an “excess benefit plan,” and it is exempt from ERISA coverage. Therefore, it is a contract subject to state contract law. Any other nonelective, unfunded retirement plan that covers a select group of highly compensated employees is known as a top-hat plan and is subject to ERISA.

If an excess benefit plan is amended to provide benefits that are restricted because of the compensation limitation of Section 401(a)(17) of the Internal Revenue Code, the plan will become a top-hat plan because it is no longer limited to excess benefits.

Other executive compensation arrangements may be subject to ERISA enforcement if they are found to provide welfare benefits of the type covered by ERISA. Regardless of whether the arrangement provides for welfare or retirement benefits, the initial inquiry often focuses on whether the arrangement is a “plan.” Given the broad scope of ERISA’s definition of a plan, benefits provisions contained in employment agreements or memoranda are likely to be enforceable under ERISA. 

In a recent court case, a former Booz Allen Hamilton executive did not have a viable ERISA claim under the company’s employee stock purchase plan because the plan’s primary intended purpose was not to provide retirement or deferred income.

Internal Revenue Code R

Section 409A of the Internal Revenue Code defines coverage for nonqualified deferred compensation (NQDC) plans. For deferral decisions to be in compliance, the election to defer must have been made in the year before the year in which services were performed, within 30 days after first becoming eligible or within six months before the end of a performance-based compensation plan of at least 12 months.

Distributions may be made only for the following reasons:

• Separation from service.
• Disability.
• Death.
• Date specified on election date.
• Change in company ownership. 
• Unforeseen emergency causing financial hardship (with amount limited to the amount of the emergency need).
• Termination of the plan.

When an executive receives the deferred amount, it is taxed as ordinary income. An exception is if the deferral is shares of stock and the executive made an election in accordance with Internal Revenue Code Section 83b within 30 days of being informed of the award. In this situation, the executive would be taxed at the time of deferral at the current value of the stock and long-term capital gains tax on the increase in stock value when received. However, the executive forfeits the paid tax if they are unable to collect the deferral. Furthermore, employers are not required to allow executives to make a Section 83b election or even to defer income.

Internal Revenue Code Section 162(m) generally prohibits tax deductions by publicly traded companies on the portion of pay for “covered employees” that exceeds $1 million per year. Covered employees are the CEO, the chief financial officer, and the three next-highest-compensated individuals.

Employers should consult with their legal counsel and tax advisors on matters pertaining to golden parachutes and executive pay. The SHRM toolkit on designing executive compensation has additional information.