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Pay Ratio Disclosure: Lemonade from Lemons

    Client Alerts
  • August 11, 2015

Well, the SEC’s new pay ratio rules are finally out. We’ve all known they were coming for quite some time, dating all the way back to their origin in 2010—Dodd-Frank’s Section 953(b) mandate—followed by the SEC’s proposed rule back in September 2013. And while certain shareholder activists and corporate governance advocacy groups are no doubt pleased, it is hard to find much positive to say from the company perspective. Nevertheless, I’ll try:

  • It could have been worse,
  • Don’t miss an employee-relations opportunity, and
  • “Hope springs eternal”.

short summary of the new rules…

The new rules state that all companies required to provide executive compensation disclosure under Item 402(c) of Regulation S-K (which excludes smaller reporting companies, foreign private issuers, emerging growth companies, MJDS filers and registered investment companies) must provide new executive compensation disclosure regarding:

  • the median of annual total compensation of all employees,
  • the annual total compensation of the CEO, and
  • the ratio of those two amounts.

Companies may identify the median employee using their own methodology, which may include the total employee population, statistical sampling or another reasonable methodology. For example, a company may use annual total compensation under the current executive compensation rules or some other consistently-applied compensation measure reported in its payroll or tax records.

A company may apply cost-of-living adjustments based on the locations of its employees, though it must also disclose the median employee’s non-adjusted annual total compensation and pay ratio in order to provide context for that adjustment.

In contrast to the SEC’s proposal and perhaps the most significant practical concession by the SEC, the final rule allows a company to identify the median employee once every three years, rather than annually, unless a change has occurred that it reasonably believes would result in a significant change to its pay ratio disclosure.

The median employee’s annual total compensation must be calculated using the same rules as those applicable to the CEO’s compensation, though reasonable estimates may be used when calculating any elements of annual total compensation.  Companies may, but are not required to, annualize total compensation for employees who did not work a full year, but may not make annualizing adjustments for part-time, temporary or seasonal workers.

The total employee population may be based on a date within the last three months of its recently completed fiscal year selected by the company. While the company must include all employees in its population determination, it may exclude:

  • Non-U.S. employees in a jurisdiction where compliance with the new rules would violate data privacy laws so long as the company receives a legal opinion to that effect,
  • Up to 5% of its non-U.S. employees, including those excluded using the data privacy exemption,
  • Employees added through a business combination or acquisition for the fiscal year in which the transaction occurred, and
  • Persons employed by unaffiliated third parties or independent contractors.

The new disclosures:

  • Are required to include a description of the methodology, material assumptions, cost-of-living adjustments and estimates used to identify the median employee,
  • May, but need not, include any supplemental narrative or ratio disclosures (provided with no greater prominence) that the company would like to include for context or color regarding the mandatory pay ratio disclosures, and
  • Must be included in any reports or filings required to contain the executive compensation information specified in Item 402 of Regulation S-K (for example, registration statements, proxy statements and annual reports).

Companies must report the pay ratio disclosure for their first fiscal year beginning on or after January 1, 2017. This means that, for calendar-year companies, the new disclosure is not required until 2018.

An employee relations opportunity…

Companies are understandably concerned that these disclosures may become a public relations nightmare as investors, governance advocacy groups and the media attempt to use them to their respective advantages. Likewise, there is understandable concern that the disclosure could negatively impact employee morale.

Wise companies will use this pay ratio information as catalyst to educate their employees regarding the process followed to evaluate and determine executive compensation. Many employees have no concept of the amount of effort put into creating compensation structures that reward performance, encourage behaviors that inure to all stakeholders’ benefit and allow the company to hire and retain top executives. This is an opportunity to engage with employees in a frank and open way on a sensitive subject that has been around for a long time. At a minimum, it gives companies a chance to show that they take such concerns seriously and are not afraid to discuss executive compensation with the rank-and-file.

Employee engagement could take the form of internal explanatory materials geared specially to the employees and perhaps Q&A sessions with the CEO and other senior personnel. Your internal human relations and communications personnel will, no doubt, have additional ideas. In any case, ignoring the issue may only make it worse.

“Hope springs eternal”…

Finally, though I doubt that Alexander Pope had the SEC’s pay ratio rules in mind when he penned this famous line back in 1734, it may well apply in this case. The long lead time between adoption of the final rules and implementation will give Congress plenty of time to follow through on various rumblings to repeal this aspect of Dodd-Frank and negate the related SEC rulemaking. (In fact, conspiracy theorists might argue that this was precisely the reason for the SEC’s extended timeline, though there appears to be no hard evidence to support that view.) Likewise, there is plenty of time for the new rule to be challenged in court, just as several other recent SEC rules have been.

So, begin planning for 2017, but keep your fingers crossed in the meantime. There is at least a small chance that this eventually goes away.