Some Aren't Waiting for Final Rules on Pay Ratio Disclosures

A deceptively simple-sounding demand of the Dodd-Frank Act—disclose in the annual proxy statement the ratio of CEO pay to that of the median employee– is causing considerable headaches for compliance officers and company executives.

Although the Securities and Exchange Commission has yet to release the final rules, compensation advisers are telling clients to start now on strategizing their approach to such disclosures and making preparations or those headaches are only going to get worse.

Before tackling the minutiae of the rule, companies must think big picture, says Steve Seelig, a senior executive compensation consultant at benefits consulting firm Towers Watson. It is important for companies to “take a step back and strategically understand what they want to accomplish when coming up with this number,” he says.

A final rule from the SEC on the controversial calculation is likely to arrive this summer, say compensation advisers, giving companies about a six-month window to ramp up processes for collecting compensation data throughout next year for 2016 proxy disclosures.

Seelig suggests some questions to ask now to begin work on complying with the rule. Is year-to-year accuracy and consistency most important? Is having the lowest CEO-worker ratio what matters? How can you minimize the cost of compliance? “Companies need to prioritize what their goals are,” he says. “If you don't establish those parameters up front, and define what is most important, you may head down a road you later need to retrace.”

A strategy-based approach must bring many company stakeholders together, Seelig says. “It is not enough to just have somebody from human resources,” he says. “You need to have somebody from legal who knows about potential litigation risks when putting out any type of new disclosure. You need to know what the CEO and the compensation committee folks think about this.” He says it's also important to involve IT experts early in the process.

Analyzing existing payroll systems is another process ahead-of-the-curve companies are already cracking into, says Pamela Greene, member of the law firm Mintz Levin. “You need to see, technologically, if you will be able to gather the information you need,” she says. “That has to be a first step. Without that information, you can't start calculating.”

This evaluation will help uncover gray areas and missing data, especially for companies with a global work force, Greene says. For example, in the United States a car allowance is a perk added into the total compensation summary of top executives; other countries may not consider it that way, or even track it, creating a problem that will have to be resolved. Pension data, which could skew results, requires particular attention.

Finding the Formula

As a concession to companies, the SEC proposed to let companies develop their own methods for calculating the figures and said it will allow the use of statistical sampling, rather than a person-by-person analysis. Companies can study their workforce, look at where the high-paid and low-paid employees are, and eliminate portions of the workforce from the need to collect data.

This approach means that companies should begin their look into whether they have adequate data collection systems in place, says Amy Wood, a partner in the compensation and benefits practice group at law firm Cooley. “The shift from conceptual to practical is where companies are going to run into trouble, especially if their technology and software don't gather all of the data they are going to need,” she says.

Ronald Bottano, vice president of Farient Advisors, an executive compensation consulting firm, says some of his clients are already evaluating various pay calculations. Some are discovering that even minor adjustments to their formulas produce wide variations. A manufacturing company, for example, could swing between a 250-1 and 200-1 pay ratio depending upon the statistical model they use. “They are not trying to game it,” Bottano says. “That's just the way the numbers work out, and they are struggling with that. A big challenge is finding an approach that is consistent and stable enough to use.”

Those concerns are, in part, because the proposed rule requires companies to provide a detailed description of their chosen methodology. “The SEC wants you to have something that is consistent,” Bottano says. “Companies should be sensitive as to how this will hold up in future years. Will the SEC ask why the ratio changed from year to year?”

Companies may worry about reputational risk, because the rule gives unions and activists an opportunity to critique calculations and engage in “name and shame” tactics.

The proposed pay ratio rule requires pay comparisons to be “filed” with the SEC, rather than “furnished.” It is a technical, yet important, distinction that could lead to fines and class-action litigation. The SEC can impose fines for material misstatements or omissions in disclosures that are filed with it, opening the door for class-action lawsuits by investors. A request that information be furnished, however, triggers no liability under the Exchange Act.

“You need to see, technologically, if you will be able to gather the information you need. That has to be a first step. Without that information, you can't start calculating.”

—Pamela Greene,

Member,

Mintz Levin

One company Bottano works with already discovered a problem that may require additional SEC guidance. The multinational manufacturer of heavy equipment, with a global workforce of more than 40,000 employees, is active with acquisitions and partnerships. It currently has 53 unconsolidated joint ventures and is unclear how to apply the rule to them. Tracking pay across their entire operation involves not just 30 payroll systems within the company, but also those additional 53 where they have no significant influence on compensation.

Also problematic is the company's current strategy of acquiring independent dealer networks. “The company does acquisitions continually, and it could be a huge headache for it if they take place near the end of the reporting period,” Bottano says. “The SEC is asking the company to disclose something when it may not yet have insight into the integration of the HR systems.” His hope is that the SEC, in the final rule, will allow an integration period for bringing those employees in-house. That suggestion was made in a recent comment letter submitted by several leading companies, including Best Buy, Tyco, Microsoft, and Johnson & Johnson.

Business-specific dilemmas may warrant additional narratives that accompany required pay ratios. “Companies can present supplemental disclosures beyond what is required,” Wood says. Some, she expects, will calculate a supplemental pay ratio that, for example, separates its global workforce from domestic employees. This might help explain a non-competitive ratio to investors and critics.

COMPANIES PUSH BACK

Below are excerpts from a Dec. 17, 2013, comment letter, which details concessions sought by leading companies.

Beyond internal preparations, companies continue efforts to influence the final pay ratio rule forthcoming from the Securities and Exchange Commission. Signing a Dec. 17. letter seeking concessions to the pay ratio rule were general counsel representing: Best Buy, Bristol-Myers Squibb, Cigna, Eli Lilly, H&R Block, Intel, Johnson & Johnson, McGraw Hill Financial, Medtronic, Microsoft, Mondelez International, Morgan Stanley, Pfizer, Tyco, UnitedHealth, United Parcel Service, Verizon, and Xerox.

The letter makes numerous suggestions for easing the compliance burden:

“It is crucial that the final rules afford companies a significant degree of flexibility in identifying the median employee. We urge the Commission to adopt final rules that allow for at least the amount of flexibility as in the proposed rules for companies to identify the median employee, including using appropriate estimates, assumptions and sampling.”

“The information… should be furnished to, rather than filed with, the Commission. Absent this, there should be some type of ‘safe harbor' to exclude this information from the information that is certified pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act.”

“The pool of employees from which companies need to identify the median employee should not include part-time, seasonal and temporary employees, and we agree that leased employees should not be included, as proposed.”

“The pool of employees should include employees of a given company's consolidated subsidiaries, but not employees of unconsolidated subsidiaries. Parent companies typically will not have the same level of access to the data of its unconsolidated subsidiaries, as they do to the data of their consolidated subsidiaries.”

“Companies should have discretion to choose the reference date they use for purposes of identifying the median employee for a given year.”

“The transition provisions should provide for compliance to begin ‘for the first fiscal year commencing on or after the Jan. 1 following the effective date of the rule….', so as not to require companies whose fiscal year's end earlier than Dec. 31 to include the pay ratio disclosure in their 2015 proxy statements.”

Source: SEC.

Any narrative, required or supplemental, could be as controversial as the number itself because of the focus on process, warns Alan Johnson, managing director at Johnson Associates, a compensation consultant. “If you are a visible company, you will get crucified if you do it wrong,” he warns.

Governance Issues

The pay ratio rule also raises governance issues that should be evaluated as preparations are made, Bottano says. How much influence, for example, should compensation committees have into the development of the process? It may prove an important consideration if proxy advisory firms, such as ISS and Glass Lewis, eventually evaluate pay ratios and consider the figures in how they advise clients to cast say-on-pay votes.

Both say they have no current plans to do so, but that could change in the future. “Some investors are going to be interested in this, even if it is just the ones who focus on the social responsibility,” Wood says. “Once the proxy advisers start doing custom research for them, it is unlikely they won't work pay ratios into their recommendations. It may not be a determining factor in say-on-pay recommendations or director elections, but it certainly seems like something they will at least take note of.”

The lack of standardized calculations, however, make “apples-to-apples comparisons among companies” very difficult, Wood says. “Proxy advisory firms won't be able to have an objective policy or cut-and-dry way to say a certain ratio is an issue.”

Johnson cautions against company politics influencing pay ratio calculations. “When the CEO says, ‘I don't like the number 302, can we make it 200, can you go back and scrub the data?' the answer must be no,” he says. “Compliance and others working on this must resist the temptation to obey orders and produce a more attractive number.”