On August 5, 2015, the Securities and Exchange Commission (“SEC”), by a 3-to-2 vote, adopted a final rule requiring companies to disclose the pay ratio between their chief executive officer and their median paid employee, as mandated by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). The final rule is intended to provide investors with yet another piece of information to consider when exercising their Say on Pay (“SOP) votes. Amidst the criticism that the rule would place undue burden on companies having to comply with this disclosure requirement, the SEC added some flexibility to the proposed version of the rule including:
- An ability to exclude up to 5% of non-U.S. employees when determining the median employee;
- An ability to exclude non-U.S. employees when foreign data privacy laws would prohibit companies from obtaining the information necessary to calculate the pay ratio;
- An ability to choose any date during the last three months of a company’s fiscal year to determine the median employee; and
- An ability to use the same median employee for three years unless there has been a change in the employee population or compensation arrangements that would significantly impact the pay ratio.
As did the proposal, the final rule provides companies with substantial discretion to choose a reasonable method in identifying the median employee, including the use of statistical sampling or any consistently applied compensation measure such as payroll or tax records. The final rule also allows companies to apply a cost-of-living adjustment to the compensation measure used to identify the median employee. If a company applies this adjustment, it would need to use the same cost-of-living adjustment in calculating the median employee’s annual total compensation and disclose the pay ratio with and without the cost-of-living adjustment.
Under the final rule, emerging growth companies, smaller reporting companies, foreign private issuers, registered investment companies and registrants filing under the U.S.-Canadian Multijurisdictional Disclosure System are exempt from the disclosure requirement. Covered companies are required to include the pay ratio disclosure in their annual report or proxy statement, as applicable, for fiscal year 2017.
As a first step to compliance, companies must identify the median compensated employee from their workforce. The final rule permits companies the flexibility to choose a method to identify the median employee based on their own facts and circumstances and use a methodology that uses reasonable estimates in doing so. For example, the median employee may be identified using annual total compensation or any consistently applied compensation measure (e.g., tax and payroll records). Also, in determining the employees from which the median is identified, companies are permitted to use their total employee population or statistical sampling and/or other reasonable methods. Regardless of how the median compensated employee is identified, the final rule requires companies to briefly describe the methodology they used to identify the median employee and any material assumptions, adjustments (including any cost-of-living adjustments), or estimates they used to identify the median employee.
Next, companies must calculate the total compensation for both their median employee and their CEO (as shown in the Summary Compensation Table). The final rule permits companies to use reasonable estimates in calculating the total compensation of their median employee. For example, companies may use reasonable estimates in determining an amount that approximates the aggregate change in actuarial present value of an employee’s defined pension benefit. As noted above, the final rule allows companies to identify the median employee every three years, but requires total compensation for that employee to be calculated each year.
Finally, companies must calculate and express the ratio of their median employee’s total compensation to their CEO’s total compensation. The final rule permits companies to choose one of two options to express this ratio. For example, if a company’s median total compensation for employees is $50,000 and the CEO’s total compensation is $5,000,000, the CEO’s compensation is 100 times larger than the median employee’s compensation. The company may describe the pay ratio as 100 to 1 or 100:1. Alternatively, the company may disclose the pay ratio narratively by stating that “the CEO’s total compensation is 100 times that of the median compensated employee.”
While we commend the Commission for making the changes to the proposed rule to add flexibility and reduce costs of compliance, we do not believe that the pay ratio disclosure will add value for investors. First, there are so many variables in how a company conducts its business and designs its workforce around its business model that the ratio cannot reliably be compared across companies. Second, a year-over-year change in the ratio is likely to be sensitive primarily to changes in CEO compensation, which can already be readily obtained through other disclosures.
NEXT STEPS FOR ISSUERS
While there is some time before companies need to report their pay ratio in their annual reports or proxy statements, Farient recommends that companies take proactive steps now to be compliant with the rule. These steps include:
- Assess your company’s systems capability to collect consistent compensation information
- Test compensation definitions (e.g., salary, or W-2 compensation) for availability and accessibility of data that could be used to identify the median employee
- Determine the appropriate method for identifying the median employee based on the company’s structure, number of employees, location of employees, etc.
- Test sampling methodologies such as sampling across geographic locations or across primary business units
- Mock up and evaluate pay ratio calculation
- Establish a protocol by which the pay ratio is calculated and is confirmed as part of your governance process
- Evaluate whether the pay ratio will have any bearing on pay, workforce, or other decisions
- Determine how the pay ratio will be discussed in the proxy, including whether an alternative pay ratio (e.g., using full-time employees only) will be disclosed to enhance understanding of the data
As a matter of course, companies will need to determine how much narrative around the pay ratio they feel is appropriate in order to truly enhance understanding. In some cases, more will be better, but in other cases, more will be less, with some companies not wanting to dignify the ratio with any narrative at all except the bare minimum required. Our view is that companies will want to minimize the discussion around the pay ratio, unless they really have some explaining to do.