Contrary to rumor and wishful thinking, the Securities and Exchange Commission’s pay-ratio rule probably won’t meet its demise any time soon.

The upcoming 2018 proxy season is the first time companies will have to comply with the rule requiring that companies disclose, in their proxy statements, a calculated ratio comparing the pay of their median employee to that of the annual compensation of the CEO.

Critics have pushed back against the rule on both conceptual grounds—viewing the data demand as part of a name-and-shame campaign by unions, media, and activists—and logistical ones, especially for multinationals facing cost of living and pay differentials in low-income countries, various inflation rates, and currency fluctuations.

The rule has had a target on its back since Day One, even more so with the election of President Trump, who has urged repeal as part of his deregulatory efforts.

In February, while serving as the SEC’s acting chairman, Commissioner Michael Piwowar launched his own attack, announcing that the rule, which he says is causing “unanticipated compliance difficulties,” was under reconsideration.

“Issuers are now actively engaged in the implementation and testing of systems and controls designed to collect and process the information necessary for compliance,” he wrote. “However, it is my understanding that some issuers have begun to encounter unanticipated compliance difficulties that may hinder them in meeting the reporting deadline.”

“Investors are going to ask management questions anyway, and providing the voluntary disclosure or other disclosures may be helpful to brunt any blow back to he extent that there is some.”
Jay Knight, Partner, Bass, Berry & Sims.

In order to better understand the nature of these difficulties, Piwowar sought public input on “any unexpected challenges that issuers have experienced as they prepare for compliance with the rule and whether relief is needed.”

Among the comments, as submitted on Aug. 25, is an attack on the rule by Alex Edmans, a professor of finance at the University of London. While now in the United Kingdom, Edmans was formerly based in the United States as a tenured finance professor at Wharton.

He testified in the U.K. Parliament’s inquiry into corporate governance and has been “heavily involved in the debate on pay ratios in the U.K.,” he wrote.


The United Kingdom’s Department for Business, Energy and Industrial Strategy has published a response to a “green paper” on corporate governance reform released in November 2016 seeking views on reform measures.
Notable among the reforms, planned for implementation by June 2018 with draft legislation headed to Parliament by March, are new executive pay demands and disclosures. The consultation period, which included business outreach, ended in February.
The report calls for the introduction of a pay ratio reporting requirement for quoted companies comparing the pay of the chief executive officer with that of pay in the wider UK workforce.
“The UK has long been regarded as a world leader in corporate governance, combining high standards with low burdens and flexibility,” the response, released in late August, says. “It is an important part of what makes the UK such an attractive place for both businesses and investors. We want to build on these strengths and reinforce the vital relationship of trust between businesses and the communities they serve.”
Section 1 of the consultation response sets out the government’s plans for reform in relation to executive pay, “which has risen faster than corporate performance.”
“The green paper consultation provided convincing evidence to support the case for further, targeted reform,” it says.
The government intends to invite the Financial Reporting Council to revise the UK Corporate Governance Code to:
Be more specific about the steps that premium listed companies should take when they encounter significant shareholder opposition to executive pay policies and awards (and other matters);
Give remuneration committees a broader responsibility for overseeing pay and incentives across their company and require them to engage with the wider workforce to explain how executive remuneration aligns with wider company pay policy (using pay ratios to help explain the approach where appropriate); and
Extend the recommended minimum vesting and post-vesting holding period for executive share awards from three to five years to encourage companies to focus on longer-term outcomes in setting pay.
The Financial Reporting Council (FRC) is the UK’s independent regulator responsible for promoting high quality corporate governance and reporting to foster investment. It sets the UK Corporate Governance and Stewardship Codes and UK standards for accounting and actuarial work; monitors and takes action to promote the quality of corporate reporting; and operates independent enforcement arrangements for accountants and actuaries. As the Competent Authority for audit in the UK the FRC sets auditing and ethical standards and monitors and enforces audit quality.
Secondary legislation, as detailed in the response, will require quoted companies to:
Report annually the ratio of CEO pay to the average pay of their UK workforce, along with a narrative explaining changes to that ratio from year to year and setting the ratio in the context of pay and conditions across the wider workforce; and
Provide a clearer explanation in remuneration policies of a range of potential outcomes from complex, share-based incentive schemes.
Plans also call for maintaining a public register of listed companies encountering shareholder opposition to pay awards of 20 percent or more, along with a record of what these companies say they are doing to address shareholder concerns.
In addition to these proposals, the government will take forward its manifesto commitment to commission an examination of the use of share buybacks to ensure that they cannot be used artificially to hit performance targets and inflate executive pay.
The public register of listed companies where a fifth of investors have objected to executive annual pay packages, billed as the world’s first, will be set up in the autumn and overseen by the Investment Association, a trade body that represents UK investment managers.
Section 2 of the response sets out three key proposals for reform to strengthen the voice of employees, customers and wider stakeholders in boardroom decision-making.
“The green paper consultation revealed strong support for action to strengthen the stakeholder voice,” it says. “This was seen as an important factor in improving boardroom decision-making and delivering better, more sustainable business performance.”
Section 172 of the Companies Act 2006 already requires the directors of a company to have regard to these wider interests in pursuing the success of the company, but a large number of respondents thought that this aspect of the legal framework could be made to work more effectively through improved reporting, code changes, raising awareness and more guidance.
The government therefore intends to: introduce secondary legislation to require all companies of significant size (private as well as public) to explain how their directors comply with the requirements of section 172 to have regard to employee and other interests.
The FRC will be invited to consult on the development of a new Code principle establishing the importance of strengthening the voice of employees and other non-shareholder interests at board level as an important component of running a sustainable business.
As a part of developing this new principle, the government will invite the FRC to consider and consult on a specific Code provision requiring premium listed companies to adopt, on a “comply or explain” basis, one of three employee engagement mechanisms: a designated non-executive director; a formal employee advisory council; or a director from the workforce.
Section 3 sets out two proposals for reform regarding the corporate governance of large privately-held businesses, in addition to the new requirements in relation to section 172.
The government intends to invite the FRC to develop a voluntary set of corporate governance principles for large private companies under the chairmanship of a business figure with relevant experience; and introduce secondary legislation to require companies of a significant size to disclose their corporate governance arrangements in their Directors’ Report and on their website, including whether they follow any formal code.
This requirement will apply to all companies of a significant size unless they are subject to an existing corporate governance reporting requirement. The government will also consider extending a similar requirement to Limited Liability Partnerships of equivalent scale.
The report also included recommendations for improving the ethnic, gender and social diversity of boards. These issues were not ones on which the green paper sought views because action to address them was being taken forward separately.
Section 5 of this response document, however, sets out the steps that the government and others are taking to improve boardroom diversity and responds to the Committee’s recommendations in this area.
In a statement, FRC said it welcomes the government’s response to its green paper on corporate governance reform and will use the feedback to help inform the development of its consultation on a fundamental review of the UK Corporate Governance Code later this year.
As the 25th anniversary of the UK Corporate Governance Code approaches later in 2017, the FRC has committed to carry out a fundamental review of the Code’s current structure to ensure it promotes trust and integrity in business.
The FRC believes an updated UK Corporate Governance Code, working alongside the government’s proposed Industrial Strategy, “will stand the UK economy and society in good stead well into the future.”
“The UK’s deserved reputation for good corporate governance, earned over the last 25 years, has underpinned British business success,” said Stephen Haddrill, FRC’s CEO. “How we develop the framework will be key to boosting competiveness, transparency and integrity in business particularly after Brexit. Successful and sustainable business are not just good for the economy, they support wider society by providing jobs and helping to create prosperity.”
SOURCE: Department for Business, Energy and Industrial Strategy

Among his observations:

Pay ratios give the impression of being comparable across companies when they are not. The ratio will automatically vary across industries and so is not comparable. Even within-industry comparisons are misleading.

A firm that outsources its operations or moves them overseas will have a lower ratio (versus the U.S. workforce) than a firm that has a strong domestic U.S. workforce.

A firm that chooses to replace low-paid jobs with automation will have a lower ratio than one that does not.

High-growth firms naturally have higher pay ratios than mature firms.

Pay ratios will inevitably be compared across companies, generally leading to misleading conclusions, which will not improve public or investor understanding of the dynamics of executive pay.

CEOs may be less willing to hire low-paid workers, instead to outsource or automate.

CEOs may compensate their workers with cash salary, rather than on-the-job training or superior working conditions since only the former affects the pay ratio.

“To illustrate their argument with an analogy, Justin Verlander [of the Detroit Tigers] is not clearly more talented than Babe Ruth, but is paid far more because baseball is now a multi-billion-dollar industry, due to a global marketplace,” Edmans wrote. “Even if Verlander is only slightly better than the next best striker, this can have a huge effect on the Detroit Tigers’ profits.

“Just as the baseball industry has got much bigger, so have firms. Firms also now compete in a global marketplace, and so it is worth paying top dollar for top talent.”

Industry feedback. John Hayes, chairman and CEO of Ball Corporation and chairman of the Business Roundtable’s Corporate Governance Committee, also wrote in last month with his suggestions.

“The rule should be changed to exclude employees located outside of the U.S. in determining the median employee,” he wrote. “Doing so would create a more consistent common denominator in the many variables that exist in formulating the ratio.”

Another suggestion: non-full time employees should be exempt from the rule “to provide some protection against distorted results.”

“Including employees located outside of the U.S. complicates the determination of the median employee and provides many opportunities for variances, making the ratio more confusing to the Main Street investor,” Hayes wrote.

In July, Douglas Currault, deputy general counsel and corporate secretary for mining company Freeport-McMoRan, detailed the challenges his multinational company has faced. Not the least of these is that the definition of “employee” in the final rule includes all employees of a registrant and its consolidated subsidiaries, wherever located.

“While there are two limited exceptions that allow for exclusion of certain non-U. S. employees, use of the data privacy exception is itself time consuming and expensive, and use of the de minimis exception only provides minimal relief for a company with global operations like ours,” he wrote. “We believe that only employees located in the U.S. should be included for purposes of the calculation.”

This, he wrote, “would significantly reduce compliance costs; one study determined that permitting registrants to exclude non-U. S. employees would reduce compliance costs by 47 percent.”

Currault explained that his company has offices and operations in 19 different foreign jurisdictions, each with its own unique compensation structure.

“Similar to other global companies, in order to pay competitive compensation in each jurisdiction in which we operate, we have specific compensation programs that vary from country to country,” he wrote. “Even determining what constitutes ‘base pay’ varies between jurisdictions and presents significant challenges from a methodology and consistency perspective in light of customary and/or legally required pay practices in foreign countries.”

The result: “hundreds of human hours in response to this disclosure requirement, with the vast majority of that time focused on gathering and assessing information in foreign jurisdictions.”

Some welcome concessions. The good news, such as it is, is that the SEC has offered concessions that are intended to make compliance with the rule a little easier.

Companies, it says, need only identify the median employee once every three years, not annually. They can also 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 also be excluded from the median employee calculation until the next fiscal year.

Among the most meaningful of concessions was that the SEC will allow statistical sampling for determining the median employee. The Commission also provided 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.

Companies and counsel should pay attention to developments coming out of Washington and the SEC, but not have unrealistic expectations, says Jay Knight, former Commission staff member, now a partner at law firm Bass, Berry & Sims.

“It is almost as challenging to remove a rule as it is to put one in place,” he says. “Given all the dynamics and the make-up of the Commission still evolving, companies should proceed with things the way they are now, with the rule in effect.”

“There are possibilities of transition guidance or some kind of reprieve, but I don’t think companies should rely on that in order to continue to delay making whatever adjustments they need to make, or getting ready to have the needed disclosures put in,” he adds.

The SEC could have been very prescriptive in how companies calculate the ratio. Instead, Knight says, it allows flexibility for companies and it isn’t a one-size-fits-all rule.

“It cuts both ways,” he cautions. “You want flexibility, but with it disclosures could grow because you have to disclose what you have done. The section on the pay ratio could be a paragraph. or five pages. For companies, it will take some time to understand what their process is, what analogies they need to make, and what needs to be disclosed.”

Additional disclosure may better explain the ratio to investors and help dilute reputation risk.

“There will be some crafting of language around the ratio itself, disclosing why the number is the way that it is,” Knight says. “You are not limited in terms of providing voluntary disclosure. If companies have a unique situation they think needs to be disclosed to investors, to explain the number, they should assess whether it is helpful.”

“Investors are going to ask management questions anyway, and providing the voluntary disclosure or other disclosures may be helpful to brunt any blow back to he extent that there is some,” he adds.