SEC’s pay ratio rule offers flexibility

Author: Zoe Thomas | Published: 11 Aug 2015
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The Securities and Exchange Commission’s (SEC) final rule for disclosing the pay ratio between CEOs and their median employee gives companies a good amount of flexibility in a calculation that some claim offers investors little useful information.

The rule was required by the Dodd-Frank Act, but its creation was not viewed as a priority by regulators in the face of other market concerns.

Unions and labour supporters have backed the rule as a way to give investors more detail about the pay conditions of companies’ workforces. But opponents argue the ratio has no connection to the company’s health or prospects (from an investor perspective), and that the numbers will not offer a good comparison even within industries.

The final version of the rule provides a number of options in determining the median employee and disclosing the ratio. And compliance is not required until 2017, giving public issuers an opportunity to test statistical sampling methods and set up systems for calculating the ratio.

"Whether you think it’s a good idea or bad idea it’s coming, so companies have to get ready for it," said Michael Segal, a partner at Wachtell Lipton Rosen & Katz. "The SEC gave significant flexibility in how companies comply and the first thing they should do is determine how they will use that flexibility."

The median

The bulk of this flexibility centres on determining a company’s median employee.

The rule permits statistical sampling, which is likely to be the method opted for by most companies. Those that already have departments capable of handling this process will be able to generate some cost saving. For most though, outside resources will be needed.

KEY TAKEAWAYS

  • The SEC has released the final version of a rule requiring companies to disclose the pay difference between their CEO and median employees;
  • The rule was mandated by Dodd-Frank and offers public issuers significant flexibility in determining the median employee;
  • Opponents question the usefulness of disclosing the ratio, arguing it doesn’t give investors a good depiction of the health of a company;
  • Supporters say it sheds light on conditions of the workforce.

Businesses with large numbers of overseas employees or seasonal labour could be hardest hit by the complexity of calculating this ratio. To that end, the SEC included measures to allow for the exclusion of up to five percent of overseas staff. It also allowed issuers to choose any day, within 90 days of its fiscal year end, to determine this calculation. This gives companies more options to determine a time which best reflects normal staff levels.

Companies also have leeway to define compensation for the purpose of deciding the median employee. For most US employees, taxable compensation will be the simplest, but for other jurisdictions with different taxation processes it could be more complicated. The SEC is allowing those with cross-border payrolls to do some cost of living deductions if necessary.

All of these decisions must be expressly and clearly laid out in the company’s proxy statement.

"One principle, throughout this rule, is as you make these choices you need to disclose them; there’s no hiding what’s being done on this," said K&L Gates partner, Jim Earle.


The SEC gave significant flexibility in how companies comply and the first thing they should do is determine how they will use that flexibility


When a median employee is identified, that person – barring exceptional circumstances – can be used in the comparison for three years.

Presenting the ratio

At this point, a second calculation has to be made of the median employee’s income, under the same SEC rules for disclosing executive pay.

Perks, such as bonuses and share options must be included, but benefits that are given equally to all employees, like healthcare in the US, can be excluded. However some companies may want to keep these benefits in as they will be a larger proportional boost to the media employee than to the CEO.

In total, the rule could significantly extend the pay disclosure section of the proxy document. In addition to the description about how the median employee was identified, the statement can include other ratios as a reference or comparison.

Ratio usefulness

The SEC has said these numbers are not intended to be used as a comparison between companies. But investors and proxy advisors are likely to consider the ratios at least against others within a given sector.

Activists in particular could use the number as a pressure point to force change.

Other rules around executive compensation, including say on pay were also dismissed as unnecessary for ensuring shareholders received the best value. That particular rule, however, has turned out to be an important aspect of proxy voting and forced executive teams to engage with shareholders.

"Say on pay hasn’t changed compensation programs dramatically, but it made [executives] think and reach out to shareholders," said Earle.

One potential risk that arises from disclosing the pay ratio, Segal said, is the possibility for shareholder litigation.

"The rule requires narrative disclosure by companies as to how they use the flexibility given by the SEC in determining the median employee, but could this be another target of plaintiff’s lawyers claiming disclosure inadequacies once the rules come into effect? The answer is it could be."

It will be serval years until there are accepted standards for calculating these ratios. Companies are likely to spend some time between now and the effective date testing methods.

See also

EC’s say-on-pay proposal is flawed

POLL: boards must prioritise shareholder engagement

US disclosure overload hurts retail investors