As we enter the fourth quarter of 2017, public companies have to add to their year-end checklist the process of gearing up for a newly mandated disclosure in 2018: CEO pay ratio. Pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, this disclosure requires that companies disclose the ratio of a CEO’s compensation to that of the median employee’s compensation.
The last time I wrote about CEO pay ratio disclosure, I speculated that the new administration might abolish this controversial rule. No such luck. In September, the Securities and Exchange Commission Chair Jay Clayton confirmed that the pay ratio rule would be implemented on schedule. This means that in early 2018 issuers will start to provide this disclosure for fiscal years that began on or after January 1, 2017.
Helpfully, the SEC issued new guidance in September that adds more flexibility for compliance. This should help to alleviate some of the administrative burden (and the estimated $1.3 billion in costs) associated with this new disclosure.
It’s not hard to identify a company’s CEO, of course. One of the challenges of the rule, however, is identifying the “median employee.”
According to the rule, the calculation for the median employee includes taking into consideration “any full-time, part-time, seasonal or temporary employees of the registrant or any of its subsidiaries, including any non-US employee.”
The new SEC guidance focuses on the use of “reasonable estimates, assumptions, methodologies and statistical sampling” in order to comply with the rule, for example when identifying the median employee at a company:
The pay ratio rule affords significant flexibility to registrants in determining appropriate methodologies to identify the median employee and calculating the median employee’s annual total compensation. Required disclosure may be based on a registrant’s reasonable belief; use of reasonable estimates, assumptions, and methodologies; and reasonable efforts to prepare the disclosures.
Specifically, the rule permits registrants to use reasonable estimates to identify the median employee, including by using statistical sampling and a consistently applied compensation measure (such as payroll or tax records). The rule also allows registrants to use reasonable estimates in calculating the annual total compensation or any elements of annual total compensation for employees.
The rule further provides that if a registrant changes its methodology or its material assumptions, adjustments, or estimates, and the effects are significant, the registrant must briefly describe the change and the reasons for the change.
Another challenge is how to treat non-US employees. The SEC weighed in on how to use existing internal records, such as tax or payroll records, to satisfy the rule of including non-US employees:
The final rule defines the term “employee” to include US employees and employees located in a jurisdiction outside the United States (“non-US employees”).
In the Pay Ratio Release, we acknowledged that the inclusion of non-US employees would raise compliance costs for multinational companies. To address concerns about compliance costs, the rule permits registrants to exempt non-US employees where these employees account for 5% or less of the registrant’s total US and non-US employees, with certain limitations.
We are clarifying that a registrant may use appropriate existing internal records, such as tax or payroll records, in determining whether the 5% de minimis exemption is available.
Handling independent contractors is another challenge. The interpretive guidance further clarifies how contractors factor into the mix:
For purposes of Item 402(u), the term “employee” or “employee of the registrant” is defined as “an individual employed by the registrant or any of its consolidated subsidiaries.” Item 402(u)(3) excludes from the definition those workers who are employed, and whose compensation is determined, by an unaffiliated third party but who provide services to the registrant or its consolidated subsidiaries as independent contractors or “leased” workers.
In the Pay Ratio Release, the Commission indicated that excluding these workers is appropriate, because registrants generally do not control the level of compensation that these workers are paid.
The guidance went on to say that companies should already apply the appropriate tests of who is an employee or independent contractor by drawing from resources like that of the Internal Revenue Service.
To be sure, this is a welcome update from the SEC. Nevertheless, each company will face challenges when trying to comply with the new disclosure. The technical nature of compliance coupled with the potential for an unfortunate headline means corporations should seek the guidance of their counsel and expert compensation consultants when it comes to drafting this disclosure.
The question still remains: will this type of disclosure provide valuable information to investors? This concern may be amplified if all of the estimates render the final ratio rather inaccurate. Moreover, issuers may be concerned that the inaccuracy could lead to an enforcement action by the SEC. Recognizing this issue, the SEC had this to say in its interpretive guidance:
In light of the use of estimates, assumptions, adjustments, and statistical sampling permitted by the rule, pay ratio disclosures may involve a degree of imprecision. This has led some commenters to express concerns about compliance uncertainty and potential liability. In our view, if a registrant uses reasonable estimates, assumptions or methodologies, the pay ratio and related disclosure that results from such use would not provide the basis for Commission enforcement action unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith.
At the end of the day, investors will have access to ratios that may or may not prove valuable to them. Regardless, all public companies (except emerging growth and foreign private issuers) are now tasked with taking on this new disclosure obligation.