FAQs on the New SEC Pay-Ratio Rule

On August 5, 2015, the Securities and Exchange Commission released its final pay-ratio rule under the Dodd–Frank Wall Street Reform and Consumer Protection Act (hereafter Dodd–Frank). The announcement comes more than five years after Congress passed Dodd–Frank in July 2010 and nearly two years after the SEC first proposed the pay-ratio rule in September 2013. The release describing the new rule is a 294-page document that will be analyzed and applied in the weeks and months to come. Meanwhile, here are some basic FAQs to help boards and compensation committees understand the implications of this much-anticipated development.

1. What disclosure will the new rule require?

While the release explaining it demands further study, the new rule can be summarized as follows:

• Companies will be required to disclose the ratio of the median pay of all employees, excluding the “principal executive officer” (in most cases, the CEO), to the total pay of that principal executive officer for the most recently completed fiscal year, as disclosed in that year’s summary compensation table. The calculation for median employee pay can be made for any time during the last three months of the year.

The final rule defines employees as “any U.S. and non-U.S. full-time, part-time, seasonal, or temporary worker (including officers other than the [CEO]) employed by the registrant or any of its subsidiaries as of the last day of the registrant’s last completed fiscal year” (p. 216). Like the proposed rule, the final rule allows statistical sampling and estimates as long as these are “reasonable” (p. 14). Although the word reasonable appears at least 100 times in the release announcing the rule, it is not defined because the SEC believes that “companies would be in the best position to determine what is reasonable in light of their own employee population and access to compensation data.”[1]The ratio would have to appear in any filing that requires executive compensation disclosure, including 10-K annual reports, registration statements, and proxy statements. The SEC final rule specifically mentions the compensation discussion and analysis (CD&A) and the summary compensation table. “In this manner, the pay ratio information will be presented in the same context as other information that shareholders can use in making their voting decisions on executive compensation” (p. 39).

2. When will the new rule go into effect?

Companies must begin reporting the new data in the first fiscal year beginning on or after January 1, 2017. The pay ratio will appear in the 2018 proxy statement disclosing compensation for 2017. After that, companies will be required to update the disclosure at least once every three years.

3. To whom will the new rule apply?

The new rule will apply to all U.S. public companies but exempts smaller reporting companies (defined as having a public float of less than $75 million) and emerging growth companies (defined as a having total annual gross revenues of less than $1 billion during their most recently completed fiscal year). It also exempts foreign companies (including Canadian companies listing in the United States) and investment companies (mutual funds). The rule also contains an exemption for U.S.-based global companies that cannot access the median pay data due to foreign data-privacy laws. New public companies would not need to comply with the new rule until their first annual report and proxy statement after they register with the SEC.

4. What aspects of the rule are likely to raise concerns in boardrooms?

In a comment letter filed on December 1, 2013, NACD expressed concerns that the rule defined the term employees too broadly. We encouraged the SEC to increase the flexibility of the pay-ratio rule by permitting the use of industry averages, by defining employees as full-time U.S. employees, and by permitting supplemental notes to correct any distortions caused by the use of “total pay” figures. The SEC’s final rule does not specifically authorize the use of industry averages, although it appears to permit their use to supplement company-based data. Nor does the final rule exclude part-time workers or foreign workers, allowing an exclusion of only up to 5 percent of a non-U.S. workforce.

In combination, these factors in the final rule may cause the ratio of median employee to CEO pay to appear relatively small in industries that employ part-time or non-U.S. workers. Over time an industry pattern may emerge, but initially there could be a hit to reputation. Boards can start now in preparing for potential impact on company reputation and employee morale.

5. What do boards and committees need to do in the short term?

First, board members should become familiar with the requirements of the new rule, with help from their compensation committees and their compensation advisor. Then they will be in a position to ask informed questions. Compensation committees can begin by asking their chief human resources officer (CHRO) and chief financial officer (CFO) the following questions:

• Do we have the information available to calculate the two numbers required for the ratio so that the board can begin its analysis? What technical and definitional issues, if any, may arise in this calculation, and what support might you need to resolve those issues? What is your rough estimate of the cost of calculation (e.g., staff time, data systems requirements, and/or third-party analysis)?
• Will you work with an external compensation firm or other external consultant (such as a payroll expert) to determine the ratio?
• Can the external advisor estimate the ratios of peer companies on the basis of publicly available data? What are the pros and cons of having the company’s consultant collaborate with the board’s compensation advisor in calculating such estimates?

Similarly, they might consider asking the following two questions of the independent firm that advises the board on CEO and senior management pay:

• What information, if any, is currently available on estimated ratios of employee/
  CEO pay for our industry peers so we know where we stand?
• If you will be working with the company’s external advisor in collecting relevant data and/or preparing estimated ratio information (if one is retained by CHRO/
  CFO), would such activity be perceived as compromising your independence under current SEC rules? If so, how can we proactively counteract such a perception?

Having gained insights from these initial questions, directors might want to consider the following:

• How comprehensive and compelling are our current published disclosures about our pay philosophy? Have we clearly communicated the link between our strategy, pay plan design, and pay outcomes?
• Does our pay philosophy include employee pay beyond the executive level? Are there opportunities to address this issue in a more detailed way? For example, does our published pay philosophy specifically discuss the issue of pay distribution patterns and/or “fairness”? If not, is this something we might consider addressing?[2]
• What information, if any, have we received from surveys regarding employee satisfaction with compensation levels?
• What feedback, if any, have we received from our major shareholders about our compensation plan and our pay-for-performance track record? If we have heard concerns, what have we done to resolve them?
• If the early estimated ratio for total pay appears out of proportion to any available estimates for our peers and/or industry, how should we interpret this discrepancy? What would this tell us about the structure of our reward system?
• What would be the impact of early voluntary disclosure?

6. What implications might this new rule have for D&O liability?

Any new disclosure rule immediately triggers potential director liability, absent a safe harbor provision. Although shareholder lawsuits against companies are often triggered by weak stock prices, the putative grounds for lawsuits are usually based on alleged disclosure violations, particularly in changes-of-control.[3] For more on D&O litigation, see the May–June 2015 issue of NACD Directorship.

7. Is the new rule likely to be challenged?

It is possible that trade groups such as the U.S. Chamber of Commerce may try to get the rule vacated by a federal court. In a statement released via e-mail on August 5, David Hirschmann, president of the Chamber’s Center for Capital Markets Competitiveness, stated, “We will continue to review the rule and explore our options for how best to clean up the mess it has created.” In the past this type of cleanup has meant legal action. In July 2011, the Chamber joined the Business Roundtable to successfully vacate a proxy access rule under Dodd–Frank that would have mandated a particular form of shareholder access to director nominations via the proxy ballot. Similarly, in April 2014, the National Association of Manufacturers and others succeeded in getting a court to declare an aspect of the conflict minerals rule under Dodd–Frank to be a violation of free speech.

8. What long-term impact might the new rule have on human capital at corporations?

Compliance with the new rule is important, but the core issue for companies remains the same: developing a pay structure, at all levels of the organization, that is aligned with the firm’s strategy and aimed at long-term value creation. Sustained corporate performance is based in large part on human talent, and compensation is one of the key factors in motivating employees. Furthermore, payroll and benefits represent a significant percentage of capital allocation at many companies. For these reasons, among others, many boards will likely take a greater interest in pay at lower levels, and they will want independent verification of a wider band of pay practices. More broadly, a growing number of boards are stepping up their oversight of management’s talent development activities across the organization. For guidance, directors can turn to the Report of the NACD Blue Ribbon Commission on Talent Development.

9. What resources does NACD have to help compensation committees cope with this and other current compensation matters?

The following NACD resources may be helpful:

• The Report of the NACD Blue Ribbon Commission on the Compensation Committee (May 2015)
• The NACD compensation webinar series.
• NACD’s recent comment letter on the proposed ”pay-versus-performance” rule (July 10, 2015)
• The latest Compensation Committee Chair Advisory Council brief, “Pay-for-Performance Communication: Current Trends and Considerations for Directors” (posted June 29, 2015)
• Preparing the CD&A: Priority Considerations for Boards (January 2015)

NACD will continue to monitor the pay-ratio disclosure issue and other Dodd–Frank compliance matters as they evolve, providing further guidance and perspective on these and related matters.

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[1] “Consistent with the proposal, the final rule does not specify any required methodology for registrants to use in identifying the median employee. Instead, the final rule permits registrants the flexibility to choose a method to identify the median employee based on their own facts and circumstances“ (p. 113). “The proposed rule did not prescribe specific estimation techniques or confidence levels for identifying the median employee because we believed that companies would be in the best position to determine what is reasonable in light of their own employee population and access to compensation data” (p. 98).

[2] Note: “Fairness” was one of the five principles of pay recommended by NACD in the Report of the NACD Blue Ribbon Commission on Executive Compensation (2003), and was also cited in the more recent Report of the NACD Blue Ribbon Commission on the Compensation Committee (2015).

[3] Josh Bradford, D&O Claims Trends: Q2 2015, Advisen Ltd., July 2015.