Some good news amid the gloom now that the Securities and Exchange Commission has issued its much-maligned pay ratio disclosure rule: Companies forced to disclose that comparison of CEOs compensation to pay of the median employee could potentially find the final rule less onerous, less confusing, and less costly than the original proposal from two years ago.
“The biggest surprise is that the SEC listened to the concerns that global companies had,” says Steve Seelig, ?executive compensation counsel at Towers Watson. Among the concessions offered in the final, 294-page rule:
Companies need only identify the median employee once every three years, not annually (although the ratio disclosure is still required each year);
Companies can select any date within the last three months of the most recently completed fiscal year for the calculations;
Registrants can exclude up to 5 percent of non-U.S. employees when determining their median employee;
Employees in a foreign jurisdiction with data privacy laws that prohibit pay information from being transmitted can be removed from the metric;
Employees acquired through a merger or acquisition can be excluded from the median employee calculation until the next fiscal year.
Perhaps the most meaningful concession, Seelig says, is that the SEC will allow for geography-based cost-of-living adjustments—essentially, pay differentials to let companies equalize what the wages of an employee in a low-income country would be in the CEO’s home jurisdiction. “Instead of a pay ratio that might be 400-to-1 for a company that has a lot of low wage overseas workers, this could potentially reduce it to something that is similar to a company with only domestic workers, maybe coming down to 250-to-1 or 200-to-1,” he says.
Seelig calls that gesture “a fairly creative approach” that shows the SEC genuinely did try to address business concerns, even though the Dodd-Frank Act left the agency little room to eliminate overseas workers from the calculation outright.
Allowing the same median employee to anchor the ratio for three years (barring some extenuating circumstances) is another important gesture, Seelig says. Chances are the median employee will fluctuate from year to year simply because companies will survey a churning base of workers, so the median number might drop from, say, $40,000 to $30,000—“which of course would then change the ratio and cause all sorts of sturm und drang about the CEO’s pay,” Seelig says. “Not only does this save costs, it helps companies maintain a stable median number for the denominator. Stability in the ratio is something that companies are going to try to maintain as best they can because there will be so much sensitivity when it changes.”
“The biggest surprise is that the SEC listened to the concerns that global companies had.”
Steve Seelig, ?Executive Compensation Counsel, Towers Watson
The evolution of the final rule from its more onerous proposal is definitely good news for anyone with a role in setting or disclosing executive compensation. Be prepared, however, for complications.
“The majority of the commissioners did believe they needed to pass this rule, but they were very concerned about the cost of compliance as contrasted with, frankly, the inability to really highlight benefits,” says Mary Mullany, a partner with law firm Ballard Spahr. “But there are hoops to jump through to take advantage of some of the exceptions.”
Excluding employee data protected by another country’s laws is helpful, she says. Less so is the requirement to obtain a legal opinion from counsel on the inability of the company to obtain or process that information, including a formal acknowledgement of that ban from regulators in the employees’ home country. “Do we really think all our multinationals are going to go hat-in-hand to the regulators in foreign jurisdictions to seek an exemption from their data privacy laws?” Mullany asks.
Likewise, taking advantage of the cost-of-living adjustment requires the preparation and disclosure of both the adjusted and the non-adjusted ratio. The SEC also declined to offer companies the ability to annualize adjustments for temporary and seasonal workers, or to express part-time employees as full-time equivalents, when determining the median employee.
The following is from a Securities and Exchange Commission “fact sheet” regarding the new pay ratio rule.
Methodology for Identifying the Median Employee
To identify the median employee, the rule would allow companies to select a methodology based on their own facts and circumstances. A company could use its total employee population or a statistical sampling of that population and/or other reasonable methods. A company could, for example, identify the median of its population or sample using:
Annual total compensation as determined under existing executive compensation rules; or
Any consistently-applied compensation measure from compensation amounts reported in its payroll or tax records.
A company could 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. To provide context for this adjustment, a company electing to present the pay ratio in this manner must also disclose the median employee’s annual total compensation and the pay ratio without the cost-of-living adjustment.
A company also would be permitted to identify its median employee once every three years unless there has been a change in its employee population or employee compensation arrangements that it reasonably believes would result in a significant change to its pay ratio disclosure. Also, within those three years, if the median employee’s compensation changes, the company may use another employee with substantially similar compensation as its median employee.
Identification of Employee Population
A company would be permitted to select a date within the last three months of its last completed fiscal year on which to determine the employee population for purposes of identifying the median employee.
Subject to certain exceptions, the company would be required to include all employees – U.S. and non-U.S., full-time, part-time, temporary and seasonal – employed by the company or any of its consolidated subsidiaries in performing its pay ratio calculation. Individuals employed by unaffiliated third parties or independent contractors would not be considered to be employees of the company.
A company could exclude non-U.S. employees from the determination of its median employee in two circumstances:
• Non-U.S. employees that are employed in a jurisdiction with data privacy laws that make the company unable to comply with the rule without violating those laws. The company would be required to obtain a legal opinion from counsel on the inability of the company to obtain or process the information necessary for compliance with the rule without violating the jurisdiction’s laws or regulations governing data privacy.
• Up to 5 percent of its non-U.S. employees, including any non-U.S. employees excluded using the data privacy exemption. If a company excludes any non-U.S. employee in a particular jurisdiction, it must exclude all non-U.S. employees in that jurisdiction.
Companies would be permitted, but not required, to annualize the total compensation for a permanent employee who did not work for the entire year, such as a new hire. In contrast, full-time equivalent adjustments for part-time workers and annualizing adjustments for temporary and seasonal workers would not be permitted when calculating the required pay ratio.
Despite the added work, Mullany says the exemptions are still valuable. When the proposed rule was released, many of her clients even feared they might need to hire a full-time employee just to work on the pay ratio, she says. “I don’t think that’s true any longer.”
Cue the Outrage
Now, of course, comes the inevitable talk of repealing the rule or challenging it in court. Moves are already afoot in Washington to remove it from the regulatory books. The U.S. Chamber of Commerce immediately foreshadowed its plans with a statement that it will “continue to review the rule and explore our options for how best to clean up the mess it has created.”
“There is certainly a lot of debate to be had as to whether this rule will ever see the light of day, given all the talk about legislative and judicial challenges,” says Andrew Liazos, a partner with the law firm of McDermott Will & Emery who heads the firm’s executive compensation practice.
Liazos takes particular note of the dissenting opinions from Republican commissioners Daniel Gallagher and Michael Piwowar. Their language “sounded like they were right from the brief of a plaintiff’s challenge,” he says. “It’s almost like they were setting the record for a challenge.”
The SEC may even have anticipated the likelihood of legal and political uncertainty. Companies are required to disclose the pay ratio for their fiscal year beginning on or after Jan. 1, 2017, effectively pushing disclosures into the 2018 proxy season and after a new president takes office. Companies face the dilemma of either starting compliance now, or hoping for a Republican administration to repeal the rule. “Can you afford to take all of 2016 to sit on the sidelines? That’s going to be a hard thing to do,” Liazos cautions.
While companies wrestle with the good and bad of the final rule, Richard Morris, a partner at the law firm Herrick Feinstein, suggests tuning out the political rhetoric—which is extensive, by the way; Piwowar denounced the SEC vote last week as “Saul Alinksyian tactics by Big Labor and their political allies.”
“People need to keep this rule in perspective,” Morris says. “You are giving compensation to highly paid executives, and you must be able to provide data as to why you are doing it.”
The rule shouldn’t be viewed in isolation (although that’s exactly what its critics have done) as much as it should be seen as yet another piece in the SEC’s broad spectrum of compensation disclosures, Morris says; it is just another data point to accompany say-on-pay votes and rules on pay for performance and clawbacks for misconduct.
“This gives greater importance to the disclosure that is going to be required when you put out your compensation policy,” he says. “This is what a prudent compensation committee should already be using to evaluate the compensation of their executives.”