Despite Concessions, Pay Ratio Disclosures Pose Many Challenges

While very few companies are cheering the Securities and Exchange Commission's proposed “pay ratio” rule, issued last week, some are applauding the SEC's plans to leave the exact method of calculating the ratio up to companies.

Some say, however, that the flexibility offered by the SEC may create more problems than most companies realize.  

“With that flexibility comes a compliance perspective to get it right,” says Andrew Liazos, a partner at the law firm of McDermott Will & Emery who heads its executive compensation practice. “How am I going to get comfortable that one of these alternatives actually works, and do we want to stick out our neck here?”

As stipulated by the Dodd-Frank Act, the SEC's rule proposal would require that companies produce a median compensation figure for all workers, domestic and overseas. This calculation will be reported as a ratio to CEO pay. It was approved on Sept. 18 by a 3-2 vote, with dissenting Republican commissioners Daniel Gallagher and Michael Piwowar arguing that the requirements not only go beyond the SEC's core responsibilities they are also of dubious value.

Similarly, concessions by the SEC to allow for more flexibility haven't won't over some compensation experts. “The core of the problem with this ratio hasn't changed,” says David Wise, senior principal and executive compensation specialist at Hay Group. “This is, by and large, a meaningless statistic that shareholders won't get anything useful from. It is designed to embarrass boards and executives about the competitive market for executive pay.”

Public comments from industry groups, companies, law firms, and executive compensation professionals suggests many don't see the value of the rule as currently proposed and argue that it is too complex and too costly, and it will result in inaccurate comparisons.

Those in favor of the rule say it offers a tool for combating the pay disparity and out-sized executive compensation that contributed to the financial crisis. SEC Commissioner Luis Aguilar, a supporter of the proposal, said the rule is a necessary compliment to other Dodd-Frank Act rules focused on curbing excessive executive compensation, such as “say-on-pay” shareholder advisory votes and listing standards for compensation committee independence.

The proposal did offer some concessions to companies in an attempt to make compliance easier. “While the SEC did not accept requests to limit the pay ratio disclosure only to full-time U.S. employees, the proposed rules attempt to address some of the potential administrative burdens of the provision in other ways,” says J. Shane Starkey, executive compensation partner of the law firm Thompson Hine. For example, the proposed rules would permit companies to:

Use “reasonable estimates” to identify the median and to calculate the annual total compensation of employees other than the CEO;

Use statistical sampling or “other reasonable methods” to determine the employees from which the median is identified;

And use any compensation measure (consistently applied to all employees included in the calculation) to identify the median.

The proposed rule also doesn't prescribe a specific methodology for companies to use when calculating their “pay ratio.” Instead, companies have the flexibility to determine the median annual total compensation of employees in a way that “best suits their particular circumstances.” The initial rule, however, stops short of spelling out how alternatives like “statistical sampling” would actually work.

“We've seen so much litigation lately regarding disclosures in proxies regarding executive compensation. Do you want to have a lawsuit against you because someone thinks you took too many liberties calculating it?”

—Andrew Liazos,

Partner,

McDermott Will & Emery

The lack of specificity could cause problems for companies and also require them to seek outside help. “If you are the compliance officer for the company, do you really want to have someone inside the organization who is not a statistician making this call?” Liazos asks. “We've seen so much litigation lately regarding disclosures in proxies on executive compensation. Do you want to have a lawsuit against you because someone thinks you took too many liberties calculating it?”

Cost vs. Benefit

The SEC's rule covers all employees, including full-time, part-time, temporary, seasonal, and non-U.S. workers. The calculation must include everyone employed as of the last day of the company's prior fiscal year. Although pay for part-time or seasonal workers cannot be annualized, companies can annualize compensation for full-time workers employed for less than a year. Companies also have the option to supplement their disclosures with a supplemental narrative discussion or additional ratios.

Even with the ability to use statistical sampling, the rule remains onerous, says Michael Dorff, a professor at Southwestern Law School who specializes in executive compensation and corporate governance. “If the SEC requires companies to calculate the median worker's salary on a global basis, many companies will have a great deal of difficulty doing so,” he says “The expense is unlikely to be worth the benefits of the rule, which are likely to be minor.”

Liazos also expressed concern that collecting all that cross-border compensation information could run afoul of much stricter privacy laws in other nations.

Another central concern is that the result of all the mathematical gymnastics will be figures that will be hard to compare across companies, yielding little benefit to investors and others. Companies are organized differently and have very different employee populations, says Wise. A comparison across two companies will only be meaningful if they “are identical down to the employee roster” and the ratio could penalize companies in the retail or restaurant space, which traditionally employs large numbers of lower-wage workers.

OFFERING FLEXIBILITY

The following, from the Securities and Exchange Commission's proposed “pay ratio” rule, details efforts to provide reporting companies more flexibility in providing their compensation data.

We believe that it is appropriate for the proposed rules to allow registrants flexibility in developing the disclosure required by the statute.

For example, registrants would be able to choose from several options in order to provide the disclosure. Registrants may choose to identify the median using their full employee population or by using statistical sampling or another reasonable method.

In doing so, the proposed requirements would allow registrants to choose a statistical method to identify the median that is appropriate to the size and structure of their own businesses and the way in which they compensate employees, rather than prescribing a particular methodology or specific computation parameters.

Registrants may calculate the annual total compensation for each employee included in the calculation (whether the entire population or a statistical sample) and the principal executive officer (PEO) to identify the median using this method.

As an alternative, registrants may identify the median employee based on any consistently applied compensation measure and then calculate the annual total compensation for that median employee.

The proposed requirements also would permit registrants to use reasonable estimates in calculating the annual total compensation for employees other than the PEO, including when disclosing the annual total compensation of the median employee identified using a consistently applied compensation measure.

We believe that this flexible approach is consistent with Section 953(b) and could ease commenters' concerns about the potential burdens of complying with the disclosure requirement We do not believe that a one-size-fits-all approach would be prudent, given the wide range of registrants and the disparate burdens on registrants based on factors such as their type of business and the complexity of their payroll systems.

Source: SEC.

“The ratios among retailers to CEOs are likely to be much higher than they will be for investment banking CEOs,” Wise says. “That has nothing to do with the CEO pay; the median worker pay is much higher at the banks. Ask any shareholder if they are more concerned about retail executive pay or investment banking executive pay and they are going to choose the latter. But to look at the ratio, you would think the opposite should be true.”

Another, more reasonable, alternative would be to compare executive pay with shareholder returns, say some critics of the proposal. Dorff also suggests highlighting the percentage of the company's net earnings being absorbed by the senior management team. This would “emphasize something directors and shareholders really care about—the bottom line.” Such alternatives, however, despite an ongoing public comment process, are unlikely given the Congressional mandate the SEC faces.

Another concession in the proposed rule is that companies would not be required to disclose pay ratio information in reports that do not require executive compensation information, such as quarterly reports. As provided by the JOBS Act, the rule would not apply to “emerging growth companies” with total annual gross revenues of less than $1 billion during its most recently completed fiscal year.  The proposal also includes a transition period for newly public companies.  Initial compliance would be required for the first fiscal year commencing on or after the date the company becomes subject to the reporting requirements.

For others, compliance deadlines remain fuzzy. A company would be required to report the pay ratio with respect to compensation for its first fiscal year commencing on or after the effective date of the final rule. A 60-day comment period will precede the final rule. Given the outpouring of public comments that preceded the proposed rule, and its request for feedback on more than 60 items, it is unclear when the final rule will go into effect, Liazos says.

In light of legislative efforts to undo the requirement by some members of Congress and the vociferous opposition of two SEC Commissioners, Liazos expects a bumpy road ahead. “It will be an incredibly high hurdle for the SEC to have this effective for next year,” he says, adding that unless there is pressure by proxy advisers or other influential groups, “it looks like the earlier this disclosure would be required for many public companies would be the 2016 proxy season.”