Despite attempts to delay or eliminate the CEO pay ratio disclosure rule, most U.S. public companies will be required to comply with the rule beginning with their 2018 proxy statement. The CEO pay ratio disclosure rule will require companies to disclose the median annual total compensation of all employees (other than the CEO), the annual total compensation of the CEO and the ratio of these two amounts. The CEO pay ratio disclosure rule was mandated by The Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, and the final rule was adopted by the Securities and Exchange Commission (“SEC”) in August 2015 and codified as Item 402(u) of Regulation S-K.
The rule is effective for the first fiscal year that commences on or after January 1, 2017. Smaller reporting companies, emerging growth companies and foreign private issuers are exempt from the pay ratio disclosure rule. During early 2017, then-Acting SEC Chair, Michael S. Piwowar, requested public input on the pay ratio rule and instructed the SEC to reconsider the implementation of the rule based on public input. In addition, the Financial CHOICE Act of 2017, passed by the U.S. House of Representatives on May 4, 2017, would have repealed the statutory basis for the pay ratio disclosure rule. However, on September 15, 2017, William Hinman, Director of the SEC Division of Corporation Finance, confirmed that implementation of the pay ratio rule would not be delayed.
In the adopting release for the pay ratio rule, the SEC expressly sought to provide flexibility for implementation of the rule. The instructions to Item 402(u) provide that companies may use reasonable estimates both in methodology used to identify the median employee and in calculating the annual total compensation of the median employee. A company may choose to identify its median employee using a consistently applied compensation measure (for example, cash wages) or through the use of statistical sampling. In addition to disclosure of the actual pay ratio, companies are required to disclose the methodology used to identify the median employee, including any material assumptions, adjustments or estimates used to identify the median employee or to determine total compensation as part of the disclosure. Companies may select any date within three months prior to the end of the last completed year as the determination date. Once the median employee is identified, companies can use the same median employee for three years so long as there are no significant changes to the compensation arrangements that would result in a significant change to the ratio.
Companies may exclude non-U.S. employees from the pay ratio calculation in two circumstances: first, under the “de minimus” exemption, employees in foreign jurisdictions may be excluded to the extent those employees comprise 5% or less of total employees; and second, under the data privacy exemption, employees may be excluded if the data privacy laws in a foreign jurisdiction would prohibit compliance with the rules. Both exemptions are subject to limitations, so companies should consult counsel before relying on either exemption to exclude any non-U.S. employees.
The SEC has issued two sets of guidance to assist companies in implementing the pay ratio rule – one on October 18, 2016 and the second on September 21, 2017. In the September 21, 2017 guidance, the SEC confirmed that companies may combine multiple methodologies for purposes of identifying the median employee. For example, a company with a global workforce may use internal records (such as the company’s tax or payroll records) for U.S. employees but employ statistical sampling or other reasonable methods to analyze compensation for its non-U.S. workforce. The SEC’s September 2017 guidance also confirmed that companies may describe the pay ratio as an estimate and that if a registrant uses reasonable estimates, assumptions or methodologies, the pay ratio and related disclosure that results from such use would not provide the basis for SEC enforcement action unless the disclosure was made without a reasonable basis or other than in good faith.
Once a preliminary calculation of a company’s CEO pay ratio is prepared, the calculations and accompanying disclosure should be previewed with the CEO and the company’s compensation committee. Companies should also review peer group compensation programs to see if any elements of the company’s workforce or unique pay practices might create disparities in the method of calculation and results of the company’s pay ratio compared to peers. While it is not expected that institutional investors will rely on the results of CEO pay ratio calculations in the first year when making voting decisions, significant outliers in a particular industry may attract unwarranted attention.
Public companies should also prepare an internal and external communication plan to either pro-actively communicate the results of the CEO pay ratio disclosure or respond to inquiries in a consistent manner. The CEO pay ratio disclosure rule is referred to by many critics as the “pay shaming” rule because, even if a CEO is paid less than CEOs in her peer group, the CEO’s salary is still likely to be a significant multiple of the company’s median employee. Employees may use the CEO pay ratio disclosures to raise questions about employee pay equity, particularly in companies with a large number of employees paid by hourly wage, businesses with a high number of seasonal employees or international businesses with a large percentage of international workers in low-wage economies. Labor unions will also be interested in the CEO pay ratio disclosures and likely will benchmark companies in a particular industry against one another. Finally, companies should consider the impact of local media reaction. As with any controversial disclosure, it is better to tell your own story than to react to someone else’s.
