Tag Archive: Securities and Exchange Commission

Applying the SEC’s Newest Guidance on Pay Ratio Disclosures

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  Alexandra R. Lajoux

“It ain’t over ‘til it’s over.” Truer words were never spoken when it comes to the new pay ratio rule.

A key chapter in pay regulations closed August 5, 2015 when the U.S. Securities and Exchange Commission (SEC) issued its final rule on the pay ratio disclosure mandated by the Dodd–Frank Wall Street Reform and Consumer Protection Act. This final rule capped a two-year comment period intended to resolve many thorny issues around exactly when and how to calculate the two numbers involved in the rationamely median employee compensation/CEO compensation. (To see NACD’s comment letter, visit the NACD Resource Center on Corporate Governance Standards and click on our Comment on Pay Ratio.)  The NACD comment letter, like some others, noted that the “annual total compensation” figure can be misleading, and suggested solving this problem by asking the SEC to permit the use of industry averages, to limit employees to full-time domestic employees, and to permit supplemental notes. In its final rule, the SEC did not make these changes but did address concerns about total annual pay by allowing companies to use any “consistently applied compensation measure” (CACM) to calculate median annual compensation for employees.

This concept of a CACM led to questions, however. So on October 18, 2016, the SEC’s Division of Corporation Finance addressed them by updating its C&DI for Regulation S-K, one of the 32 “Compliance and Disclosure Interpretations” (C&DIs) the staff maintains on its most complex regulations. Although the five questions raised are technical rather than strategic, and represent only a tiny fraction of the many issues raised by the final rule overall, they still merit board attention. Therefore, this blog presents, in simplified English, the five ratio-relevant Q&As in the newly updated C&DI (codified under Section 128 C) and provides a key question and a final “takeaway” for boards.

Summary of the SEC’s Five Questions and Answers

Summary of Question 1: If a company does not use annual total compensation to identify the median employee, how should it choose another consistently applied compensation measure (CACM) to do so?

Summary of Answer 1: SEC’s updated C&DI assures companies that a CACM can be any measure that “reasonably reflects the annual compensation of employees,” but asks that companies explain their rationale for the metric they choose. An appropriate CACM will depend on “particular facts and circumstances,” says the SEC. For example:

  • Total annual cash compensation can work as a CACM, unless the company has also made a wide distribution of annual equity awards for the same period.
  • Social Security taxes withheld would likely not be an appropriate CACM unless all employees earned less than the Social Security wage base.

Summary of Question 2: May a registrant exclusively use hourly or annual rates of pay as its CACM?

Summary of Answer 2: No. Although an hourly or annual pay rate may be a component used to determine an employee’s overall compensation, the use of the pay rate alone generally is not an appropriate CACM to identify the median employee.

Summary of Question 3: When a registrant uses a CACM to identify the median employee, what time period may it use?

Summary of Answer 3: The SEC’s answer to this question says that the company must select a date within three months of the end of its most recent fiscal year to determine the population of employees from which to identify the median employee. The CACM need not be contemporaneous. In fact, it can come from the prior fiscal year, as long as there has not been a material change in the registrant’s employee population or employee compensation arrangements—that is, a change that would “result in a significant change of its pay distribution to its workforce.”

Summary of Question 4: What about furloughed employees?

Summary of Answer 4: The SEC’s response clarifies that the final rule identifies four classes of employees: full-time, part-time, temporary, and seasonal. It does not define or even address furloughed employees, because a furlough could have different meanings for different employers. It is a matter “facts and circumstances” and provides additional guidance on the matter.

Summary of Question 5What about independent contractors? Under what circumstances can their pay be included in the CACM for the employee?

Summary of Answer 5: The final rule had stated that “leased” workers are excluded from the definition of employees “as long as they are employed, and their compensation is determined, by an unaffiliated third party.” The SEC’s answer preserves this distinction, and gives some flexibility. In determining when a worker is an “employee,” the company “must consider the composition of its workforce and its overall employment and compensation practices.” So a company should include workers whose compensation it (or a subsidiary) determines “regardless of whether these workers would be considered ‘employees’ for tax or employment law purposes.”

NACD Takeaway
Are you familiar enough with compensation patterns in your company to know whether a chosen CACM “reasonably reflects” the compensation in your company? If not, you may wish to meet with the officer responsible for employee pay below the executive level to get a better sense of this important issue.

Compensation committees have traditionally focused on executive compensation, leaving employee compensation to management. In the past few years, however, several factors have combined to broaden the committee’s purview, including concerns about pay disparity, and the new requirement to disclose compensation risk. Therefore, more compensation committees are overseeing enterprise-wide pay. For example, in its 2016 proxy statement, WPX Energy disclosed that in the past year “With the oversight of our Compensation Committee, we conducted a risk assessment of the Company’s human capital with a focus on enterprise-wide compensation programs.” (Emphasis added.)

The key word in all of these questions and answers is “reasonably.” It is exactly the right word for compensation committees to use as they oversee this disclosure, as well they should.


Alexandra R. Lajoux is chief knowledge officer emeritus at the National Association of Corporate Directors. 

Directors Can Add Valuable Perspective to SEC’s View of Sustainability

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The sustainability information in CSR reports is not, from our perspective, “investment-grade;” that is, it is not necessarily material, not industry specific, not comparable, and not auditable.

Business news headlines on any given day highlight the importance of sustainability issues such as resource scarcity, climate change, population growth, globalization, and transformative technologies. In today’s world, management of these and other sustainability risks and opportunities influences corporate success. Thus, understandably, investors are increasingly requesting information on how companies are managing these factors.

Aulana Peters

Aulana Peters

A concept release from the Securities and Exchange Commission (SEC) on disclosure effectiveness includes a lengthy discussion of sustainability disclosure. In the release, the SEC states that it is “interested in receiving feedback on the importance of sustainability and public policy matters to informed investment and voting decisions.” We hope that the SEC’s request for input on sustainability issues signals an understanding that the information investors consider “material”—much like the world around it—is changing. As a result, corporate disclosures should also evolve to provide investors with the information they need to make informed investment and voting decisions.

Sustainability issues are increasingly important to a company’s financial condition and operating performance, and thus merit the attention of its board. At more than 55 percent of S&P 500 companies, the board oversees sustainability, according to the Investor Responsibility Research Center Institute. Such boards are to be applauded for taking a more holistic view of risk oversight, and for getting out in front of global challenges.

This shift in focus by investors and the business community is driven by a growing recognition that sustainability issues are business issues, not only born of social or political concerns. One recent study found that when companies focus their efforts on managing material sustainability factors—namely, those critically linked to their core business—they outperform their peers with significantly higher return on sales, sales growth, return on assets, and return on equity. They also show significantly improved risk-adjusted shareholder returns.

Clearly, the board plays a key role in developing a company’s capacity to create long-term value and in safeguarding its assets. In this regard, a board’s careful consideration of information on material sustainability factors would help it to fulfill its oversight responsibilities, by assisting it in understanding, prioritizing, and monitoring business-related risks and opportunities.

For example, a board should regularly consider how its company measures, manages, and reports its material sustainability risks. A pharmaceuticals company might consider how it is addressing a $431 billion counterfeit drug market, where mitigation strategies in an increasingly complex, global supply chain could stem or reverse the loss of consumer confidence and company revenues, and prevent up to 100,000 deaths each year (see Roger Bate’s 2012 book Phake: The Deadly World of Falsified and Substandard Medicines). The plunging stock price and loss of goodwill suffered by Chipotle Mexican Grill after outbreaks of E. coli and norovirus at its restaurants demonstrate the way in which a failure to manage sustainability risk factors can seriously damage a company’s reputation and shareholder value.

Moreover, sustainability issues not only raise risks, but also present opportunities that can and should be taken into account by the board as it considers development and implementation of the company’s strategic goals.

Sustainability issues may have a material impact on a company’s ability to achieve such goals. For automakers, a strategy that incorporates fuel-efficient technologies and alternative fuels can help the company capitalize on legal and consumer trends regarding fuel economy and emissions in a market where car ownership is projected to triple by 2050.

Elisse Walter

Elisse Walter

Sustainability issues directly affect a company’s financial condition and operating performance. Therefore, it is not surprising that investors are increasingly demanding more effective and useful sustainability information. Many companies have made efforts to meet this demand through disclosures in corporate social responsibility (CSR) reports, by responding to questionnaires, or otherwise engaging with investors. The sustainability information in CSR reports is not, from our perspective, “investment-grade;” that is, it is not necessarily material, not industry specific, not comparable, and not auditable. To that point, a 2015 PwC study found that 82 percent of investors said they are dissatisfied with how risks and opportunities are identified and quantified in financial terms; 74 percent of the investors polled said they are dissatisfied with the comparability of sustainability reporting between companies in the same industry.

What the markets have lacked, until now, are standards that can guide companies in disclosing material sustainability information in a format that is decision-useful. These standards must be industry specific. Sustainability issues affect financial performance differently depending on the topic and the industry. Therefore, investors need guidance on which sustainability issues are material to which industries, and they need industry-specific metrics by which to evaluate and compare the performance of reporting companies.

The Sustainability Accounting Standards Board (SASB), an independent 501(c)(3) nonprofit, was created to address this market inefficiency. The mission of SASB is to develop and disseminate industry standards for sustainability disclosure that help public corporations provide material, decision-useful information to investors via MD&A and other relevant sections of SEC filings such as the Form 10-K and 20-F. SASB’s standards are formulated with broad market participation and draw upon metrics already used by the corporate community. They will continue to evolve, as our world, and thus material sustainability issues, change.

Investors want to place their funds in entities that have good prospects for the future. To do so, they evaluate the information that is material to a company’s prospects. Not all that information rests in the financial statements that reflect a company’s current financial condition. We believe that, in today’s world, risks and opportunities not yet reflected in a company’s financial statements influence its success.  And, the information that is “material” to investors—much like the world around it—has changed.

To help companies disclose material sustainability information, the capital markets need standards for disclosure of sustainability information that are created by the market, specific to industry, and compatible with U.S. securities law.

The management and disclosure of sustainability issues merits the attention of directors. The public comment period for the SEC’s disclosure effectiveness concept release runs through July 21. This is an important opportunity for publicly held companies and their directors to be heard on these critical issues, and to stress the importance of a market standard that serves investors while not overburdening issuers.

Aulana Peters was an SEC Commissioner from 1984-1988. Elisse Walter was the 30th chair of the SEC. Peters and Walter serve on the SASB board of Directors.

Surviving a Restatement: Ten Pitfalls to Avoid

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Bradley J. Bondi

In 2013, the Securities and Exchange Commission (SEC) formed the Financial Reporting and Audit Task Force to detect fraudulent or improper financial reporting, and since then has brought more than 300 issuer reporting and disclosure cases. One area of focus is a company’s restatement of financial statements and company actions connected with the restatement.

The audit committee plays an important role in navigating a restatement—from investigating errors and their origins to overseeing the restatement process. A mishandled restatement can lead to a prolonged SEC investigation, increased exposure to liability in civil litigation, loss of confidence by lenders, and potential delisting by an exchange.

To survive a restatement, audit committees should avoid the following pitfalls.

  1. Engaging inexperienced counsel and advisors for investigation. A restatement is commonly precipitated or accompanied by an independent investigation overseen by the audit committee. Proper investigation of accounting errors is critically important, and inexperienced counsel could fumble the investigation—and restatement—from the beginning by incorrectly scoping the investigation, failing to obtain the relevant information, or losing credibility with regulators.Four qualities are essential for counsel tasked with conducting independent investigations into accounting errors.
    • First and foremost, counsel must be independent from management. Counsel must not have done prior work for the company or have any significant ties to the management.
    • Second, counsel should be experienced with conducting independent investigations for boards and board committees.
    • Third, counsel should understand accounting and disclosure issues, and have experience with the nuances of accounting investigations. Nonetheless, counsel should also be expected to engage experienced, outside forensic accountants to aid in the investigation.
    • Finally, counsel and their team must be respected by regulators and have a reputation of conducting appropriately thorough and complete investigations.
  2. Forming a special committee when the audit committee might suffice. While a special committee might be necessary in certain rare investigative circumstances, the board should avoid forming one if its audit committee is composed of independent and disinterested directors who are suited for the task. A special committee must be disbanded at some point (usually once the investigation is completed and before the restatement process begins), and the disbanding could become a complicated news item.In contrast, if the audit committee oversees the investigation, then, once the investigation is complete, the audit committee can pivot back to its normal role, which would include overseeing the actual restatement process. Investigations overseen by the audit committee also benefit from the positive relationship that the chair usually has with the company’s outside accounting firm.
  3. The run-away or open-ended investigation. Incorrectly scoped investigations can lead to burdensome legal fees, continued business disruptions, and inadequate investigatory results. Importantly, an independent investigation does not mean that counsel is independent of the client. The “client”—i.e., the audit committee—should discuss the scope and budget of the investigation with outside counsel and together tailor the investigation to the circumstances.
  4. Failing to keep auditors apprised of the investigation and errors found. Keeping auditors in the dark regarding the progress and results of the investigation could delay the restatement and result in the resignation of the auditor. The audit committee’s counsel should maintain a good relationship with the company’s auditors and keep them appropriately apprised of the investigation through periodic calls or meetings. If the auditor is conducting a shadow investigation, this dialogue will aid it in confirming that appropriate remedial measures occur (e.g., a restatement) and that the company’s professional practice group, risk, or forensic functions are informed.
  5. Indecisiveness and inability to reach conclusions. Indecisiveness can delay the investigative process, allow misconduct to persist unchecked, and create the damaging perception among investors, regulators, and the plaintiffs’ bar that the company’s problems extend beyond financial reporting. To minimize these effects and maximize potential cooperation credit, the audit committee, in conjunction with counsel, should reach conclusions concerning accounting errors as promptly as possible.
  6. Waiting too long to deal with wrongdoers. Once an investigation has made conclusions about individual conduct, any wrongdoers should be disciplined and, when necessary, removed from their position—either by terminating their employment or forcing their resignation. When determining cooperation credit, the SEC and Department of Justice (DOJ) will focus on whether the responsible individuals are still with the company, and, if so, whether they are still in the same positions. Removing wrongdoers clears the path for the audit committee to share investigation results with management so it can correct errors and implement remedial actions.
  7. Not self-reporting findings to the SEC. Whenever a restatement is made, the SEC will inquire whether the underlying accounting error was intentional. It also may inquire about the root cause of the error; how, when, and by whom it was discovered; the reporting periods impacted; how the error is being corrected; and the impact on the company’s financial control environment.The SEC expects a registrant to voluntarily share the results of its investigation. If the SEC learns of misconduct from a source other than the company, or if the company fails to make its investigative findings available to the SEC, the company could become ineligible for cooperation credit associated with self-reporting. The incentives in the SEC’s whistleblower bounty program provide additional motivation for companies to be proactive in promptly and thoroughly self-reporting.
  8. Audit committee micromanagement of the restatement. Management is ultimately responsible for financial reporting, and the audit committee must maintain its supervisory role and refrain from stepping into the role of management to correct errors. Once an accounting error has been identified, it must be assessed to determine whether the affected financial statements are materially misstated. Quantifying the errors is a critical step in determining materiality, and Staff Accounting Bulletin (SAB) 108 contains guidance.The audit committee counsel should assist management, as appropriate, in understanding the nature of the errors and how to correct them. This is also a good time for the audit committee to request that management re-evaluate the enterprise-wide risk assessment process and the design and effectiveness of internal controls over financial reporting.
  9. Failing to remediate. If accounting errors lead to a restatement, then the company may have deficiencies in internal controls. In addition, inadequate or ineffective internal controls often raise issues that should be investigated by the audit committee relating to the certifications by the CEO, CFO, and outside auditor. Failure to remediate gaps in internal controls and to address certification issues provides the opportunity for additional misconduct and could damage the company’s credibility with regulators. The SEC in particular will focus on what steps the company took upon learning of the misconduct or control weaknesses, whether the company took immediate corrective action, and what new and more effective internal controls or procedures the company plans to adopt to prevent a recurrence. When documenting remedial actions, the company should avoid characterizing them as other than what they are—improvements in internal control procedures. This neutral approach might help to mitigate potentially harmful collateral impacts in civil litigation.
  10. Creating an unnecessarily detailed SAB-99 materiality analysis. Shareholder class actions inevitably follow restatements. The audit committee should resist the impulse to create an unnecessarily detailed SAB-99 materiality analysis that will be discoverable in litigation against the company and could provide a roadmap for private plaintiffs. To the extent additional details regarding the materiality analysis are necessary, oral discussions with auditors are often sufficient.

Bradley J. Bondi is a partner with Cahill Gordon & Reindel LLP. He advises financial institutions and global corporations, boards of directors, audit committees, and officers and directors of publicly-held companies in significant corporate and securities matters, with particular emphasis on internal investigations and enforcement challenges, including those related to restatements. Michael D. Wheatley, a litigation associate at Cahill, assisted with this article.

Jonathan T. Marks, CPA, CFE, a managing director with Navigant Consulting, Inc. in its global disputes and investigations practice, and Michael Pesce, an associate director with Navigant, contributed to this article.