10 Consensuses on CEO Pay Ratio Planning

James D.C. Barrall is a senior fellow at The Conference Board Center and a visiting scholar and senior fellow in residence at the Lowell Milken Institute for Business Law and Policy at the UCLA School of Law. This post is based on a Conference Board publication by Mr. Barrall. Related research from the Program on Corporate Governance includes The Growth of Executive Pay by Lucian Bebchuk and Yaniv Grinstein.

More than seven years after the enactment of the Dodd-Frank Act, the CEO pay ratio rule is finally set to require approximately 3,500 U.S. companies to disclose their 2017 ratios of their CEOs’ pay to that of their median employees in their 2018 proxy statements.

Capping the SEC’s valiant efforts in its 2013 proposed and 2015 final rule to make a poor statute workable and relatively cost effective, on September 21 the SEC and its staff issued three pieces of very helpful interpretive guidance ((i) the SEC’s interpretive guidance, (ii) the Division of Corporation Finance’s calculation guidance, and (iii) the updated Reg. S-K Item 402(u) C&DIs, collectively, the “September Guidance,”) [See related Governance Center blog posts here and here.] which succinctly state that companies have significant flexibility in using reasonable methodologies, estimates and assumptions for calculating employee compensation and identifying their median employees and may use their existing internal tax, payroll and other records to do so.

The September Guidance also permits companies to mix and match estimates and methodologies based on each company’s facts and circumstances (with helpful examples), makes it expressly clear that the CEO pay ratio is intended to be only a reasonable estimate and provides extremely valuable relief for companies that engage independent contractors or leased employees.

While many larger multi-national companies with complex workforce and compensation arrangements have been working diligently for years at considerable expense to design systems and establish methods for collecting their pay data and calculating their CEO pay ratios, it is clear that many companies have waited until this fall to start their work. Some of these companies have studied the rule and concluded that they would be able to gather the necessary data relatively easily. Others had done little or nothing, hoping that the statute would be repealed or the rule delayed, which unfortunately has not happened. In this very uncertain environment, substantially all companies and their advisors have been talking, watching and listening carefully to see how other companies are planning to address all of the calculation, disclosure and messaging issues floating in the CEO pay ratio ether.

Based upon my interactions over the last several months with approximately 20 companies which have been thought leaders in studying and commenting on the rule and in making early and robust efforts to determine how to comply, as well as on many discussions with executive compensation lawyers and consultants. I have distilled 10 consensuses on how leading companies are planning to comply. While companies differ widely in how they engage and compensate workers and while it has always been clear that the CEO pay ratio rule would generate a cacophony of generally non-comparable numbers (and even more so after the September Guidance), I believe that knowing leading company approaches and concerns will help companies comply with the rule, will help establish some guidelines in the marketplace of proxy disclosures and will reduce the risk of a company’s being an outlier whose disclosures will be called into question by the ever diligent media or others. Here they are (I hope that they are helpful to you):

1. Dealing with Independent Contractors and Leased Employees. The SEC’s September Guidance makes it clear that notwithstanding strong indications to the contrary in the final rule and a withdrawn C&DI, independent contractors and leased employee are not deemed to be “employees” of a company for the purposes of the ratio testing if the company has determined that they are not employees of the company using a widely recognized tax or labor law test for distinguishing employees from non-employees. This has lifted a huge burden for many companies which engage independent contractors and lease workers from other employers and generally means that most companies should be able to exclude independent contractors and leased employees from their data gathering and calculation efforts. If a company is not able to do this, at least with respect to U.S. employees, it likely has bigger problems than CEO pay ratio compliance.

2. Concentrating on the “Median-able” Employee Range. The September Guidance affirmed what many of the thought leaders figured out on their own, namely that most of the data gathering and compensation analysis exercise should be focused on employees close to the median, not those who are clearly at the bottom or the top of the pay spectrum. Employees outside the “median-able” range are relevant to the median only with respect to their ranking, not their compensation. Here the September Guidance makes it clear that employees can be eliminated from data gathering and detailed consideration based upon reasonable estimates of their compensation using the Company’s existing records. This means, for example, that relatively low paid employees can be counted and then set aside, as can senior officers who may be covered by equity and other compensation plans which do not cover employees near the median. While this approach may not be particularly useful for companies that can easily gather actual compensation data from centralized data bases (as is the case for many smaller companies with U.S.-only payrolls), it is very valuable for multi-national companies engaged in multiple lines of business with large and far flung workforces.

3. Using the De Minimis Exemption for Non-U.S. Employees. The rule’s permitted de minimis exemption for companies that have less than 5 percent of their employees outside of the U.S. (or in a particular country) excludes such employees from the calculation. It can be very helpful, especially if compensation data is difficult to obtain in one or more of those countries. Excluding such employees from the analysis may drive the median up or down, conversely affecting the CEO pay ratio, which should be taken into account, as discussed below.

4. Not Using the Foreign Data Privacy Exemption. The rule’s permitted exemption for non-U.S. employees whose compensation data cannot be obtained without violating foreign data privacy laws is probably of little or no use to most companies. All companies that have considered this exemption with whom I have spoken (and many executive compensation lawyers and consultants) have concluded that while foreign privacy laws may preclude local subsidiaries and operations from transmitting private information about employees and their compensation, they generally do not prohibit the collection and transmittal of anonymized data which does not disclose information about named individual employees. Moreover, the legal opinion and other requirements which must be satisfied in order for a company to avail itself of this exemption (as well as the likely second guessing by others it likely would trigger) probably make it not worth trying to use, even if it arguably may be available.

5. Using CACMs. While some companies, especially those with most of their employees in the U.S. or with generally centralized and good compensation data bases, may be able to use actual total or close to total compensation of their employees to identify their median employee, many companies will find it very helpful to use a “consistently applied compensation method” (“CACM”) as allowed by the rule in order to identify their median employee, before having to determine the actual total compensation of that employee to calculate the ratio. Under the final rule and the September Guidance, the most likely CACMs based on existing databases are taxable compensation (such as Form W-2s in the U.S.) as determined in each employing jurisdiction (even if it is determined differently different jurisdictions) or some measure of cash compensation (such as a salary, or base salary plus annual target or actual bonus). Use of CACM is perhaps the most powerful tool offered by the rule and the September Guidance for companies to save time and money in this exercise.

6. The Median May be the Message. The initial reaction by companies and commentators to the enactment of the CEO pay ratio rule was to be most concerned about having a high CEO pay ratio. However, as companies have thought more about it, many companies have concluded that disclosure of the CEO pay ratio number will not be big news to most constituencies, given that the CEO pay of all companies subject to the rule is already well-publicized and processed. And people can guess what those ratios are with reasonable accuracy by those interested in the issue. Accordingly, after running trial calculations and thoughtful consideration by cross-functional teams, many companies (especially those in highly competitive labor markets) have decided that the disclosure of the median employee’s pay may be of greater concern than disclosure of their CEO ratio. Unlike CEO pay, median employee pay has not been the subject of SEC or generally other kinds of disclosure and this new data may be used by some employees, particularly at companies with relatively high median pay, to question why their pay is less than that of the median employee or possibly than that paid by the company’s labor market competitors. Other potential consequences of disclosing median pay are that it might be used by activists or other investors to argue that a company’s cost structure is out of line or that a company is offshoring too many jobs or not paying its employees living wages. Companies need to take these considerations into account based on their particular circumstances and use the flexibility provided by the rule to identify their median employee and plan their messaging as is most appropriate.

7. The Importance of Being Reasonable, and of Documenting It. In a very important provision, the September Guidance states that the CEO pay ratio is required only to be a reasonable estimate and that the SEC does not intend to engage in enforcement actions with respect to its disclosure unless a company does not have a reasonable basis for the disclosure or provides it in bad faith. This should give companies substantial comfort and, more importantly. encourage them to expressly state in their proxy disclosures that the CEO pay ratio information is provided pursuant to the SEC’s guidance under Item 402(u) of Regulation S-K and is the company’s reasonable good faith estimate. This also means that companies should maintain careful records of the methodologies, estimates, assumptions and exemptions used by them to calculate their CEO pay ratio, in order to facilitate annual review as required by the rule and to document the company’s reasonableness and good faith in case the SEC or the shareholder plaintiffs’ bar ever decide to make it an issue. In addition, companies which are relying on employees in far-flung jurisdictions to gather the necessary information might want to obtain additional comfort by having the providers certify that the information they have provided is complete and accurate.

8. Where to Locate the Disclosure in the Proxy. The SEC’s rules do not state where the CEO pay ratio disclosure should be included in proxies (or even require that it be provided under a particular heading). The overwhelming consensus of thought leaders is that unless a company’s Compensation Committee takes the CEO pay ratio into account in determining its executive officer compensation (which would be unusual, at least in 2017), there is no need to include it in the proxy CD&A, which is subject to certification by the Compensation Committee in its proxy report, but rather to include it after the CD&A with the tables and other disclosures required by Item 402. Moreover, given that the rule is required by subsection (u) of Item 402 (after subsection (t), relating to golden parachute compensation), a very logical place to put it, especially for companies taking a minimalist approach to their disclosure, would be at the very end of the compensation tables and other required disclosures.

9. Less Proxy Disclosure is Generally Better. The strong consensus of the thought leading companies and their advisors is that, especially in the first year of this disclosure, companies should take a minimalist approach to disclosing their CEO pay ratios by stating what the rule requires, namely, to disclose the total compensation of the CEO and of the median employee and the ratio of the two, and to “briefly” describe the methodology used to identify the median employee and any “material” assumptions, adjustment or estimates used to identify the median employee or determine compensation. This should be enough for most companies in 2018 and companies should only say more after careful consideration of the pros and cons of doing so. Possible exceptions to this approach have been noted by and for companies which have a large number of non-U.S. employees with very low wages and which may decide to disclose a supplemental U.S.-only pay ratio and for companies with unusually high CEO pay in 2017 on account of extraordinary retention or other awards which might justify discussion. Additional disclosure of context or telling of a company’s story about the ratio also might make sense in situations where companies are unusually concerned about the medians or ratios being substantially out of line relative to industry peers, or which might trigger adverse reactions by employees, unions or customers. And even in such cases, probably the less said the better, in order for the company not to sound defensive, trigger unintended consequences or be a disclosure outlier which would attract media and other attention.

10. Consider and Be Prepared for Supplemental Messaging. Most of the thought leaders do not intend to publish supplemental proxy materials or even non-proxy materials relating to their CEO pay ratios. While some companies are concerned about how their employees might view their pay relative to the company’s median or to that of competitors, and some are concerned about possible impact on their brands, the best way to deal with these kinds of issues is outside of the proxy process, as part of a company’s regular general communications with employees, investors and customers. To the extent that companies which have such concerns are not already communicating with the affected constituencies they should consider starting to do so, or at least determine that their proxy disclosures will not be inconsistent with any such future communications. However, any companies that have any concerns with possible adverse reactions (or even about receiving questions) from their employees, employee unions, investors, or customers should prepare FAQs that discuss the salient issues and provide talking points and should establish protocols in advance for monitoring reactions from the media (including social media and the local press) and important customers. All of this should be done on a cross-functional basis, with input from the board, senior management, HR, IR, PR and line supervisors of potentially concerned employees in order to make sure that all possible concerns are identified and all parties are prepared to respond to issues that might arise. Companies preparing supplemental communications or FAQs also should determine whether they constitute proxy solicitation materials that would need to be filed with the SEC.

Finally, in deciding all of the above issues and selecting their CEO pay ratio computational and disclosure methodologies for their 2018 proxies, companies should make certain that these approaches are sustainable and are likely to usable for the foreseeable future without substantial modifications.

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