At long last, proxy statements and certain other filings in 2018 will contain the much-anticipated pay ratio disclosures of public companies. The pay ratio rules, which were adopted under the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act, became effective on October 19, 2015, but only require disclosures for fiscal years beginning on or after January 1, 2017 (which means that, for most public companies, the information will appear for the first time in proxy statements filed in 2018). Under the rules, public companies are required to calculate and disclose a ratio that compares the annual total compensation of their “median employee” to that of their CEO.
The pay ratio rules require disclosure of three specific amounts:
- The median of the annual total compensation of all employees of the registrant (other than the CEO).
- The annual total compensation of the CEO.
- The ratio of the first amount to the second amount.
The final rule includes a great deal of flexibility in determining median employee compensation for these purposes. For example, the median employee may be identified using statistical sampling and estimates using consistent compensation measures, and the registrant may select any determination date within the last three months of the fiscal year. In addition, the rules include a de minimis exemption for excluding certain non-U.S. employees and permit cost-of-living adjustments for the compensation of employees in jurisdictions other than the jurisdiction in which the principal executive officer resides.
The SEC also has offered additional guidance through two rounds of Compliance and Disclosure Interpretations (C&DIs), the first issued in October 2016 and the second in September 2017. These C&DIs were a welcome source of guidance for practitioners and registrants alike grappling with dense rules. The October 2016 C&DIs focus on the identification of the median employee. The second group of C&DIs focus on a variety of topics, from the use of a consistently applied compensation measure to the inclusion of furloughed employees in the employee population, and includes two very helpful statements.
“Under the rules, public companies are required to calculate and disclose a ratio that compares the annual total compensation of their ‘median employee’ to that of their CEO.”
First, the SEC stated that, due to the use of estimates, assumptions, adjustments and statistical sampling permitted by the rule, pay ratio disclosures may involve a degree of imprecision. Second, the C&DI provides 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 an SEC enforcement action unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith. Together, both give companies a great deal of comfort as they compile their pay ratio disclosure.
Since the SEC’s adoption of the final rules in August 2015, the pay ratio rules have been the source of much debate and anxiety, but the flexibility embedded in the rules and guidance, along with the SEC’s acknowledgment that the calculations involve a degree of imprecision, allowed many companies to breathe a sigh of relief. However, this flexibility did not assuage the concern of most, if not all, companies regarding the manner in which investors and employees may view and use this information.
In fact, this flexibility may have increased that concern. For example, how will investors compare the ratio of a retail company with greater numbers of seasonal workers to an industrial company with a more static workforce throughout the year? Comparisons between companies within the same industry seem inevitable, but will nevertheless involve a great deal of variation. For example, some companies may choose to make cost-of-living adjustments, while others may not. Similarly, companies may, but are not required to, annualize compensation for permanent employees when calculating the ratio.
With inputs varying greatly, comparisons between companies, whether they are in the same industry or not, may very well be of little practical value to investors. This sentiment is further evidenced by indication from ISS that pay ratios will not have any impact on its analysis or vote recommendations in 2018. Similarly, Glass Lewis has indicated that it intends to include the pay ratio as a data point in its proxy paper but does not intend to incorporate the pay ratio into its assessment and analysis of say-on-pay proposals.
To address this concern, many companies are considering including statements in the disclosure advising the reader that, given the different methodologies that public companies will use to determine an estimate of their pay ratio, the estimated ratios should not be used as a basis for comparison between companies. Notwithstanding such cautionary statements, the pay ratio disclosure will surely attract the attention of the media. Companies would be well-advised to coordinate with their investor relations and human resources departments to proactively develop answers to the questions that are undoubtedly headed their way.