By Kevin Douglas and Andrea Orr
Kevin Douglas, a member of Bass, Berry & Sims, PLC, Nashville, Tenn., has significant experience advising public companies in preparation of periodic reports, proxy statements and earnings releases and other corporate and securities matters. He also assists with SEC reporting and corporate governance work for public company clients, securities offerings and general corporate guidance.
Andrea Orr, an associate of Bass, Berry & Sims, PLC, Nashville, Tenn., focuses her practice on corporate and securities law including corporate governance matters, mergers and acquisitions and securities offerings. Prior to joining the firm, Andrea was vice president and corporate counsel at HealthSpring (acquired by Cigna in 2012), where she ensured compliance with SEC and NYSE rules and regulations.
On Sept. 18, 2013, the Securities and Exchange Commission (“SEC”), following a narrow three-to-two vote of the commissioners, proposed new rules1 to require the disclosure by public companies of the ratio of CEO pay to median employee pay. The pay ratio disclosure, mandated by Section 953(b)2 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), has been the topic of extensive commentary and debate, both in favor and against such disclosure, since the time that Dodd-Frank was signed into law by President Barack Obama over three years ago.
Prior to the issuance of the proposed rules, the SEC had received more than 20,000 public comment letters relating to Section 953(b).3 This article summarizes the background leading up to the SEC's proposal and analyzes the key features of the CEO pay ratio disclosure rules as proposed.
Under those rules, total compensation consists of numerous components, including salary, bonus, stock and option awards, long-term incentive pay, changes in pension value and perks, each of which is calculated in the specific manner required by the SEC.
Since Dodd-Frank's enactment, Section 953(b) has been the subject of intense scrutiny and debate and has garnered a significant amount of media attention. Supporters of the mandated disclosure, including unions and labor advocates, claim the CEO pay ratio constitutes material information for investors, particularly in light of the widely reported increase in income disparity in the U.S. between CEO pay and that of rank-and-file workers and the corresponding impact such disparity may have on employee morale and productivity (and thus corporate profitability).4
In contrast, business organizations, major law firms, and other pay ratio opponents (including certain House Republicans who have sought to repeal Section 953(b) in its entirety),5 argue that the pay ratio would provide little to no insight for investors regarding comparable pay practices at public companies, because the data used will primarily correlate to the size and composition of a company's workforce, rather than to the size of the CEO's pay or the company's financial performance.
In this regard, opponents note that, even within a single industry, median employee pay can vary based on numerous factors, including differences in organizational structures, geographical distribution of employees and degree of reliance on seasonal and outsourced workers. Opponents also argue that any benefit to investors from the pay ratio disclosure is far outweighed by the difficulties and time-consuming exercise of calculating median employee pay, especially for companies with large diverse workforces, multiple payroll and other compensation systems and global operations.
Nevertheless, the proposed rules were sharply criticized by the two dissenting SEC commissioners, with Commissioner Michael Piwowar stating that the rule “unambiguously harms investors, negatively affects competition, promotes inefficiencies, and restricts capital formation.” Several key aspects of the proposed pay ratio rules are discussed in greater detail below.
Although the SEC acknowledged the compliance cost and comparability concerns for including non-U.S. employees in the identification of the median, under the proposed rules, the median would cover all employees (other than the CEO), without carve-outs for categories of employees. The SEC did, however, offer some relief to companies by proposing a bright-line calculation date for determining covered employees--the proposed rule defines “employee” as an individual employed on the last day of a company's last completed fiscal year. This proposed calculation date would eliminate the need to monitor changes in a company's workforce throughout a fiscal year for purposes of the pay ratio disclosure and is consistent with the calculation currently used to determine a company's named executive officers for compensation disclosure purposes. The proposed rules would also permit, but not require, companies to annualize compensation for all permanent (but not temporary or seasonal) employees who were employed for the full fiscal year.
The SEC did, however, determine that Section 953(b) does not set forth a methodology for identifying the median, nor does Section 953(b) direct the SEC to adopt a specific methodology for doing so. To offer the greatest degree of flexibility, the SEC therefore chose not to propose a required calculation methodology. Rather, the proposed rules would permit companies to identify the median employee by reference to all employees captured by the “employee” definition discussed above or, alternatively, through the use of a sampling technique or other statistically reasonable method.
In the case of sampling, the SEC declined to endorse any specific sampling approach, noting only that the size of a sample population needed for reasonable sampling may be less than 100 or more than 1,000, depending on a company's overall distribution of compensation. Under either approach, a company would be able to identify a median employee (representing the boundary between the highest paid 50 percent and the lowest paid 50 percent) based on any consistently applied compensation measure, such as cash compensation, total direct compensation or compensation amounts reported in payroll or tax records, including compensation that is reported to the Internal Revenue Service on Form W-2 and any foreign equivalent.
If using payroll or tax records (which the SEC purposefully did not define or limit), a company would be able to use the same annual period that it uses in such records, rather than its fiscal year, to the extent such periods differed. The proposed rules additionally permit the use of reasonable estimates to identify the median employee; however, the SEC declined to prescribe what a reasonable estimate might entail.
Once a company has calculated the total annual compensation for the median employee, it would then be required to disclose such amount, along with the CEO's total annual compensation and a ratio (which may be expressed narratively as a multiple) of the median employee amount to the CEO amount.
If a company uses a sampling technique, the SEC expects it to disclose the size of the sample as compared to the entire employee population, any material assumptions used to determine sample size, the sampling method used and how such method accounted for separate payrolls or significant issues arising from multiple business or geographical segments, if applicable. Consistent with the approach taken by the SEC in other disclosure contexts, the proposed rule would require companies to briefly describe and explain the reasons for any changes in methodology or material assumptions, adjustments or estimates from the prior year's calculations, to the extent the effects of such changes are material.
By proposing only a brief discussion of pay ratio methodology, assumptions and estimates, the SEC appears to be somewhat sensitive to the additional costs associated with mandating a more extensive narrative of the pay ratio components or the inclusion of supplemental information regarding compensation structures and polices, neither of which is required by the text of Section 953(b). It is likely, however, that the length (and therefore cost) of such disclosure will vary significantly between companies depending on the methodology used and the number of estimates involved. In addition, in some cases, companies may choose to provide supplemental information to provide context for a high ratio. The SEC made it clear that the inclusion of supplemental information, including additional ratios (as long as clearly identified as such and not presented with greater prominence than the required ratio), is permitted.
Assuming a substantial number of comments will be submitted, final pay ratio disclosure rules are unlikely to be adopted until 2014. Under the proposed transition period, companies would be required to comply with the pay ratio disclosure rules for the first fiscal year beginning after the effective date of the rules. If the final rules are adopted in 2014, a company with a calendar year fiscal year would thus be required to include the disclosure in its Form 10-K or proxy statement filed in 2016 (referencing 2015 fiscal year information).
In proposing a lengthy transition period, the SEC recognized that many companies, particularly those with multiple payroll systems, will need a long transition period, coupled with a “test year,” to implement systems necessary to identify and verify the median of the annual total compensation of all employees.
When these rules come into effect, it is unclear how they will be utilized by institutional investors or proxy advisory firms or will otherwise impact the stockholder voting landscape. We expect that most institutional investors will find the rules to be of limited utility, and that most institutional investors, as well as proxy advisory firms, will continue to give greater focus to another internal pay equity metric, the ratio of CEO total compensation to the total compensation of other named executive officers.
Nevertheless, whether or not any significant changes are made to the final rules, we believe that these rules likely are here to stay, and public companies should begin to consider how they will comply with the rules' mandates, while being mindful that certain details of the rules could be altered in the final rulemaking process.
For example, public companies may want to begin to give consideration regarding their ability to calculate median total employee compensation utilizing their current payroll systems and/or what statistical sampling techniques they might utilize under the rules, particularly public companies that have large or transnational operations. In addition, public companies that will be impacted by the proposed rules should give consideration to submitting comments on aspects of the rules relevant to them, such as whether foreign or seasonal workers should be taken into account in connection with the calculation of the total median employee compensation.
1 Pay Ratio Disclosure, SEC Release Nos. 33-9452; 34-70,443 (proposed Sept. 18, 2013) (to be codified at 17 C.F.R., pts. 229, 249), available athttp://www.sec.gov/rules/proposed/2013/33-9452.pdf.
2 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, sec. 953(b), 124 Stat. 1376, 1904 (2010).
3 Comments on Executive Compensation: Title IX Provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, http://www.sec.gov/comments/df-title-ix/executive-compensation/executive-compensation.shtml.
4See Elliot Blair Smith & Phil Kuntz, CEO Pay 1,795-to-1 Multiple of Wages Skirts U.S. Law, BLOOMBERG, Apr. 30, 2013, http://www.bloomberg.com/news/2013-04-30/ceo-pay-1-795-to-1-multiple-of-workers-skirts-law-as-sec-delays.html; Lawrence Mishal & Natalie Sabadish, CEO Pay in 2012 was Extraordinarily High Relative to Typical Workers and Other High Earners, ECON. POL'Y INST., Issue Brief No. 225 (June 26, 2013), available at http://www.epi.org/files/2013/ceo-pay-2012-extraordinarily-high.pdf.
5See Burdensome Data Collection Relief Act, H.R. 1135, 113th Cong. (2013), available athttp://beta.congress.gov/bill/113th/house-bill/1135.
6 Daniel M. Gallagher, Comm'r, SEC, Dissenting Statement of Commissioner Daniel M. Gallagher Concerning the Proposal of Rules to Implement the Section 953(b) Pay Ratio Disclosure Provision of the Dodd-Frank Act (Sept. 18, 2013), available athttp://www.sec.gov/News/Speech/Detail/Speech/1370539815919.
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