SEC proposed rules on CEO pay ratios: What employee benefits professionals need to know

Reprinted with permission from Employee Benefit Review - December 2013

On Sept. 18, 2013, the Securities Exchange Commission (“SEC”) issued long-awaited (and controversial) proposed rules regarding the disclosure of what is commonly referred to as the “CEO pay ratio.” This disclosure, which is required pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), will apply to the proxy statements of most U.S. public companies. This article will provide an overview of the new rules from an employee benefits prospective (as opposed to for a securities lawyer).

Background

The relevant provision of the Dodd-Frank Act requires a public company (other than an “emerging-growth company”) to disclose in its proxy (1) the median of the annual total compensation of all employees, except the CEO, (2) the annual total compensation of the CEO, and (3) the ratio of the first number to the second number.

From the time of passage, the business community noted that there were many problems with this requirement. For example, first, the calculation of total compensation for a single employee can be incredibly time consuming, and the statute could appear to require this number to be calculated for all employees (how else would the median employee total compensation be determined?). As a reminder, annual total compensation includes base salary (or wages plus overtime for non-salaried employees), bonus, grant-date fair value for equity awards, changes in pension value and “all other compensation” under the SEC rules. Second, the statute refers to all employees, which would seem to include part-time, temporary, seasonal and even non-U.S. employees. Finally, the ratio itself is not user-friendly. Most people would easily understand that the CEO makes X times more than the median employee, but the statute flips that around so that the number to be reported is a fraction (i.e., if the CEO pay is 100 times the pay of the median employee it would be reported as 0.01, while if the CEO pay is 200 times that of the median employee it would be reported as 0.005 – everyone understands the difference between 100 to 1 and 200 to 1, but .01 compared to .005 can be confusing, to say the least).

The Proposed Rules

The SEC has proposed a number of rules aimed at simplifying compliance with these CEO pay ratio requirements. Importantly, a company may choose to identify the median employee (i.e., the employee who has the median annual total compensation of all employees) using its full employee population or by using statistical sampling or another reasonable method. However, in identifying the number of employees, a company must consider all full-time, part-time, seasonal or temporary employees, including foreign employees and employees of its subsidiaries. Independent contractors and “leased” employees are not included. For this purpose an employee is an individual employed as of the last day of the company’s last completed fiscal year. While there is a proposed instruction that allows (but does not require) employers to annualize compensation for all permanent (but not temporary or seasonal) employees who were employed for less than the full fiscal year, employers may not make a cost-of-living adjustment for foreign employees.

Companies do not need to calculate the actual summary compensation table amount for every single employee. Instead, they need to use an appropriate, consistently applied methodology to determine who the median employee is and then calculate the summary compensation table number for that individual. In determining the methodology the SEC indicated that the following items should be considered:

• the size and nature of the workforce;
• the complexity of the organization;
• the stratification of pay levels across the workforce;
• the types of compensation the employees receive;
• the extent that different currencies are involved;
• the number of tax and accounting regimes involved;
• the number of payroll systems the employer has and the degree of difficulty involved in integrating payroll systems to readily compile total compensation information for all employees;

Companies must also briefly describe the methodology used and the material assumptions that were applied.

The pay ratio disclosure is required for public filings that must include an Item 402(c) disclosure. In general, this would mean annual reports on Form 10-K and proxy and information statements. The disclosure itself should be brief and consistent with the statutory provision. In other words, the annual total compensation of the median employee and of the CEO will be disclosed, along with the ratio of the two amounts (as well as a description of the methodology and assumption used in the calculations).

With respect to the odd way in which the statute requires the ratio to be presented, the proposed rules would allow the ratio to be disclosed either as, for example, 1 to 100 or 1 to 200, or in narrative form, such as the CEO’s annual total compensation is x times that of the median annual total compensation of all employees.

Companies should keep the disclosure brief and avoid overly technical or detailed descriptions of the pay ratio and related calculations. Relevant information to be disclosed could include whether compensation for permanent employees was annualized and how currency translations were handled. Companies must disclose any changes in the method or assumptions from those used in a prior year that result in a material change to the ratio, as well as the reason for the change and its estimated impact on the numbers. Finally, companies are permitted to supplement the required disclosure with a narrative description or additional ratios provided that such information is clearly identified and not misleading and not presented with greater prominence than that of the required ratio. So, for example, a company may want to disclose that it has a comparatively large number of foreign employees.

The proposed rule will not apply for the upcoming 2014 proxy season and does not apply to foreign private issuers, smaller reporting companies or emerging-growth companies. The SEC has identified a large number of issues for public comment and has requested in-depth responses, so this process is far from complete.

Comments on the proposed new rules are due no later than Dec. 2, 2013 (60 days after the date that the rules were published in the Federal Register). Some of the areas on which the SEC requested comments are:

• Whether the pay ratio disclosure should be required in filings that do not currently require Item 402 disclosure, including whether such disclosure would be meaningfully helpful to investors?
• Should smaller reporting companies or foreign private issuers be subject to the rules, and if so, should a modified version of the rules apply?
• Are there alternative ways to comply with the statutory requirement of covering “all employees” that could reduce compliance costs, particularly with respect to cross-border issues and part-time employees?
• Should there be separate ratios for U.S. employees and for non-U.S. employees?
• What data privacy laws, and similar laws, could impact the gathering of the data necessary to comply with the new rules?
• Should the employees of subsidiaries be included, particularly subsidiaries that do not consolidate their financial statements with the employer?
• How should “leased employees” and other temporary employees be treated?
• Will employers change their corporate structure or employment arrangements to alter the number of employees covered by the rules?
• Are there any competition concerns raised by the rules?

Next Stage

Given the number of questions that the SEC is seeking comments on, it appears that actual number-crunching is still a ways off for most companies. However, there are a number of action items for human resource professionals in particular to start considering.

First, primarily since foreign employees are to be considered, it will be important to get a good sense for all of the payroll systems a company (and each subsidiary) maintains and how to convert any foreign compensation and benefits into the U.S. equivalent.

Second, companies should start discussing with their legal counsel and compensation consultants what sampling methods might be appropriate, as well as what costs and benefits of choosing one method vs. another are for their specific situation.

However, since it is clear that there are still a lot of open issues, it probably makes the most sense to identify the data gaps and take steps to resolve them without undergoing a full calculation until the rules are finalized. Instead, the public comments and various discussions of what best practices are should be monitored, so that companies are best positioned to comply when the rules become final.

If you have any questions about this topic, please contact Employee Benefits chair Lori Jones.