Thought Leadership 08.26.15
The SEC’s Pay Ratio Disclosure Rule is unlikely to be repealed—public companies should plan to comply.
Among several provisions affecting executive compensation, the CEO pay ratio disclosure rule was included in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Section 953(b) amended Item 402 of Regulation S-K and directed the U.S. Securities and Exchange Commission (SEC) to issue regulations that would require public companies to disclose the pay ratio between the company’s median employee and the company’s chief executive officer or other principal executive officer. Emerging growth companies, smaller reporting companies and foreign private issuers are exempt from the rule.
The pay ratio disclosures will be “filed,” not “furnished,” and will therefore be subject to Sarbanes‑Oxley Act certifications by the CEO and CFO and subject to potential securities laws liabilities.
The SEC finalized the regulations on August 5, 2015, with an effective date of October 19, 2015, and they require compliance for the first fiscal year beginning on or after January 1, 2017. Under the final rule, a public company must begin including pay ratio disclosure in its annual proxy statements for the 2018 season, or in its Form 10-K if it does not file a proxy statement.
A recent survey by TheCorporateCounsel.Net reported that less than 40 percent of responding public companies had started preparations for their pay ratio disclosures.
Summary of the Rule
The CEO pay ratio disclosure rule requires each public company to disclose:
The final rule is generally consistent with the proposed rule, with a number of revisions that were intended to preserve the disclosure of information reflecting the pay ratio while minimizing the expected costs and unintended consequences of the required disclosure.
For example, employees in certain countries may be excluded from the calculation upon a showing of prohibitive data privacy laws, and the final rule includes a de minimis exemption, which permits a public company to exempt non-U.S. employees where these employees account for five percent or less of the company’s total U.S. and non-U.S. employees, with certain limitations. The final rule permits public companies to make certain cost-of-living adjustments for the compensation of employees in foreign jurisdictions to identify the median employee and calculate the annual total compensation.
Several other items were addressed in the final rule including:
One of the key concepts introduced by the SEC in this rule is a Consistently Applied Compensation Measure (CACM). Although not exhaustive, the SEC offered some examples that qualify as a CACM for purposes of the calculation. (See the Regulatory Interpretation and Guidance discussion below.)
The Financial CHOICE Act. In June 2017, the U.S. House of Representatives passed the Financial CHOICE Act (H.R. 10), by a 283-186 vote, largely along party lines. One of the provisions of the legislation, co-sponsored by House Financial Services Committee Chairman Jeb Hensarling (R-TX), would repeal Section 953(b) of the Dodd-Frank Act, which directed the SEC to amend its rules to require the pay ratio disclosure. However, the lack of bipartisan support will make it extremely difficult to pass through the Senate on a filibuster-proof vote. Most observers believe it is unlikely that the Senate will approve the Financial CHOICE Act in its current form, if at all, before the 2018 proxy season.
SEC Reconsideration. In February 2017, then-Acting SEC Chair Michael Piwowar launched a 45-day request for comment on the pay ratio rule, seeking input from companies about “any unexpected challenges” that they may have experienced in preparing to comply with the rule. He also directed the SEC staff to “reconsider the implementation of the rule based on any comments submitted and to determine as promptly as possible whether additional guidance or relief may be appropriate.” To date, the SEC has received approximately 14,000 “form” letters in support of the rule and over 200 comment letters from various interested parties, including individuals, professors, corporations, pension funds, asset managers, law firms and trade associations.
It is uncertain whether the SEC, under the new SEC Chair Jay Clayton, will repeal the rule, delay the compliance date, or otherwise limit compliance with the rule. The SEC’s unilateral ability to repeal the rule is questionable.
Regulatory Interpretation and Guidance
Despite opposition, public companies should prepare to comply with the rule. In October 2016, the SEC’s Division of Corporation Finance issued guidance in five compliance and disclosure interpretations (C&DIs) to assist companies in preparing for compliance with the rule.
In August 2016, Mercer conducted a survey of over 100 companies in 12 industries and found that the CEO-to-median-employee pay ratio is less than 200:1 for the majority of respondents that have estimated a ratio. These estimates are significantly lower than the AFL-CIO’s 335:1 average ratio for 2015 that is frequently cited.
In addition, three-quarters of respondents have already determined a method to identify the median employee or are considering one of more methods. Sixty percent of respondents have estimated their ratio with more than half reporting ratios under 200:1 and only 20 percent reporting ratios of more than 400:1. Lastly, ratios vary by industry. Those with low ratios tend to have more professional staff, and those with high ratios tend to have more part-time, temporary and less-skilled employees. Sectors with the lowest ratios are in banking/financial services, technology and non-financial services. The highest ratios are in retail, wholesale and consumer goods.
Depending on the circumstances, the process to identify a public company’s median employee, calculate that employee’s annual total compensation, calculate the pay ratio, and prepare any accompanying narrative disclosure can be a significant and time-intensive undertaking. Several factors can influence the result, including whether a company has a large, global workforce or different payroll systems across multiple divisions or subsidiaries. Since a repeal or delay of the pay ratio rule currently appears unlikely, public companies should continue to prepare or—for those that have not yet started—begin to prepare the methodology they will use to calculate their CEO pay ratio disclosure well in advance of drafting their 2018 proxy statements. In addition, companies may want to consider the impact on its workforce of disclosing the compensation of the company’s median employee.
Public companies should consider the following steps:
We will continue to monitor the implementation of the rule and provide an update as it becomes available. For further information about the rule, please see our prior Client Advisory dated August 26, 2015.
The authors would like to thank summer associate Matthew H. Lewis for his contribution to this alert.