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13 Oct. 2017 | Comments (0)
On Governance is a new series of guest blog posts from corporate governance thought leaders. The series, which is curated by the Governance Center research team, is meant to serve as a way to spark discussion on some of the most important corporate governance issues.
If there is one common observation from compensation consultants and securities lawyers regarding the recent SEC CEO pay ratio disclosure rule guidance, it is: be ready to comply before the end of this calendar year. Despite what you may have read about a possible delay or reconsideration, it’s not happening any time soon, if ever.
But if there is a silver lining for public companies, it is that the SEC and its Division of Corporation Finance will be flexible in the enforcement of the pay ratio rules regarding such areas as defining an independent contractor, determining a consistently applied compensation methodology (CACM), and statistical sampling. Its new guidance includes three pieces: an interpretative release from the SEC that clarifies the basis for excluding independent contractors, the ability to use existing records and the flexibility to use different methodologies to identify the median employee; SEC staff guidance that includes examples of reasonable estimates and statistical methodologies; and updated Division of Corporation Finance Compliance and Disclosure Interpretations (C&DI) that relax prior C&DIs on independent contractors.
Before I share with you the observations from a handful of client memos, a quick refresher on the Dodd-Frank Act law. The SEC was charged with the task of issuing regulations requiring public companies to disclose the ratio between the CEO’s compensation and that of a median employee to focus attention on income disparity within public companies.
While Dodd-Frank became law in 2010, it wasn’t until August 2015 when the CEO pay ratio rule was adopted by the SEC. After President Trump was elected in 2016 and the SEC was left with just two commissioners following former Chair Mary Jo White’s departure in January 2017, Acting Chair Michael Piwowar directed the SEC staff to reconsider the implementation of the rule. However, Jay Clayton, who was nominated and later confirmed as chair, did not follow through on this directive. Instead, the SEC issued the September 21, 2017, guidance.
Advice from compensation consultants and law firms
Here are samples from client memos related to the SEC’s CEO pay ratio disclosure rule guidance:
The compensation consultant issued a September 29, 2017, client alert that stated that “the fact that is now highly unlikely Congress will take any steps to repeal the Pay Ratio Rule prior to the compliance deadline, companies should begin assessing their pay ratio strategy now and anticipate that it could take months to prepare the disclosure.” The firm made the following observation about the independent contractor definition: “Expansion of the independent contractor definition should provide much needed relief to those companies having difficulty determining whether or not pay was set by them. In our experience to date, those companies struggling to find data on individuals deemed to be independent contractors can more comfortably exclude these individuals under the new guidance. In other words, if a company was finding it nearly impossible to track down information about all of its contracts with individuals not typically considered ‘employees,’ chances are such individuals would not be categorized as ones intended to be included in the pay ratio calculation.” It also concluded that “tracking all assumptions and considerations will be perhaps the most important facet in the early stages of the process.”
This compensation consultant released a client memo on October 5, 2017, that included the following advice: “Just in case anyone has not yet started computing their pay ratio, it is time to get going.” The firm then included five principles it believes public companies should use as a starting point for determining its CEO pay ratio. They are:
Principle One: The SEC intends to be forgiving in this first year of compliance. There are lots of gray areas in the regulations. As long as a company picks an interpretation that makes some sense (and explains it clearly in the proxy), we do not think there will be a problem. If there are various ways to interpret the SEC guidance and one is more reasonable than the other, that does not mean you cannot use the other one.
Principle Two: Does a company want the median employee to have high or low pay? Initially everyone assumed that the goal was to implement the rules in a way that resulted in choosing a median employee with the highest possible pay so as to hopefully lessen negative public reaction to a high pay ratio. We are finding the opposite in many cases: some employers worry about employees discovering they are paid below median.
Principle Three: Apply the KISS (“keep it simple stupid”) rule, the design rule coined at the Lockheed Skunk Works to remind engineers that simple systems work best. Follow this in the first year unless circumstances require otherwise.
Principle Four: Use October 1 as your determination date and make it work. The rules permit a company to select its employees by looking at employees on the payroll on any date from October 1 through December 31, 2017.
Principle Five: Pick a simple CACM to compute the compensation of your employees. We think the simplest periods over which to compute compensation are the nine months ending September 30 or calendar 2016. We think the simplest measures are W-2 compensation or cash compensation. Pick one of these combinations (the foreign rule does not have to be the same as the domestic rule). Ignore equity compensation.
The law firm’s Executive Compensation and ERISA group issued a brief client memo on September 26, 2017, that synopsized the SEC’s three pieces of guidance on the what it termed “the CEO/median employee pay ratio disclosure requirement.” The firm included two main observations in the memo:
The SEC also stated its view that, so long as a company’s pay ratio disclosure is based on reasonable estimates, assumptions and methodologies, it would have no basis for an enforcement action unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith.
The Rule remains in effect and requires most companies to provide pay ratio disclosure for the first fiscal year beginning on or after January 1, 2017, with the result that most companies will begin making disclosures in early 2018. While companies should continue to prepare for compliance with the Rule, companies should take some comfort in the flexibility the new guidance provides.
In its September 22, 2017, client memo the law firm cited excerpts from five issues included in the SEC guidance:
Flexible framework does not increase likelihood of non-compliance
De Minimis Exception for Non-U.S. Employees Can Be Based on Internal Records.
Identifying the Median Employee
Determining the Pool of Employees from Which the Median Employee Is Identified
The law firm issued a seven-page September 25, 2017, client memo that included some background on the pay ratio rule and a FAQ on the following issues addressed in the guidance – independent contractors, significant flexibility, median employee, non-U.S. employees, use of reasonable estimates, assumptions and methodologies, and statistical sampling, and enforcement. The memo also included some implications and observations. Below are excerpts from that:
“The SEC repeatedly reiterated the significant flexibility afforded by the pay ratio disclosure rule in this most recent guidance from the Commission and the Staff. This latest guidance, such as the clarification related to independent contractors, should alleviate some compliance costs and administrative burdens of companies.
That said, the core rule remains in place and, at this point, there is little chance that it will go away altogether, unless Congress intervenes (which seems highly unlikely in the short term, at least).
… companies are advised to carefully think through the methodology they employ to identify the median employee and how they will calculate the pay ratio, how this information will be disclosed in their proxy statement and what communications, if any, they will want to prepare to address the concerns that their shareholders and broader stakeholders may have.”
The views presented on the Governance Center Blog are not the official views of The Conference Board or the Governance Center and are not necessarily endorsed by all members, sponsors, advisors, contributors, staff members, or others associated with The Conference Board or the Governance Center.