There have been recent proposals to defer or repeal portions of the Dodd-Frank Act, including the CEO pay ratio rule. In fact, a Treasury Department report released on October 6, 2017 recommended that “section 953(b) of Dodd-Frank be repealed and any rules issued pursuant to such provisions be withdrawn.” However, any potential changes to the requirement are not likely to occur before the filing deadline, so companies should prepare to include the disclosure in the next proxy filing.
The rule requires taking into account all employees globally (except the CEO), in order to determine the total compensation paid to the median employee. Employees include full-time, part-time, temporary, and seasonal workers. The compensation of the median employee is then compared to the CEO pay disclosed in the Summary Compensation Table. The final rule published by the SEC does allow for a de minimis exception, which provides that non-U.S. employees can generally be excluded from the calculation if they make up 5% or less of the company’s total employee population. This exemption could prove particularly useful for companies with just a handful of employees outside the U.S.
A company is allowed to choose the effective date of the data set used for purposes of identifying the median employee, as long as the date selected occurs within the last three months of its last completed fiscal year. For a company with a calendar year fiscal year, the effective date of the data used could be as early as October 1, 2017, which would allow more time to run the calculations prior to the proxy disclosure.
Companies have flexibility to choose the methodology to identify the median employee, which can actually complicate the process. The SEC allows companies to use statistical sampling, reasonable estimates, or just certain pieces of compensation that are easily identifiable (e.g., payroll or W-2 compensation). However, any methodology used must be explained in the proxy and must be reasonable.
Once the ratio of CEO pay to that of the median employee is calculated, it will be important to provide an explanation of the calculation methodology, as well as facts and circumstances behind the compensation of the CEO and median worker at the company. ISS (Institutional Shareholder Services) reinforces the importance of providing an explanation to shareholders: "For institutional investors, narrative disclosure on the pay ratio is likely to be the most important aspect of the disclosure mandate as they look to understand the factors impacting CEO and employee pay, the drivers behind the board’s compensation-setting process, and how they reinforce the company’s management strategy."
Shareholders, and potentially the media, will likely be interested in not just the absolute CEO pay ratio, but also how the ratio compares to peers. Unsurprisingly, all else being equal, larger companies are likely to have a higher CEO pay ratio than smaller companies. A study published by ISS on October 6, 2017 compared data from the U.S. Bureau of Labor Statistics to CEO pay data for Russell 3000 companies and found that CEO pay for S&P 500 companies is approximately 172 times greater than the average employee’s earnings, while CEO 2 pay data for companies in the S&P 600 is just 48 times greater (Exhibit 1). The same ISS study predicted vast differences in the CEO pay ratio by industry. The study found that CEOs in the Food & Staples Retailing sector earn 142 times more than the average employee, while bank CEOs’ pay is just 15 times that of a median employee (Exhibit 2).
It will be important for companies to consider how their employees and shareholders will react to the disclosure. Carefully crafted disclosures will assist in minimizing the risk of negative reactions while maintaining compliance with the existing law.
Although the focus of this rule has been on the pay ratio, possibly the most impactful outcome will be the disclosure of the pay of the median employee. Employees are generally aware of relatively high CEO pay levels, as this has been disclosed for years. They may be more interested in how their individual pay compares to the median employee, both within their own company and competing companies. Companies would be wise to consider the pay calculation of the median employee and carefully craft the narrative around the disclosure.
Interest in the CEO pay ratio rule is not limited to shareholders, as state and local governments have also taken a special interest in the CEO pay ratio rule, in the form of new taxes and fees. Portland, Oregon enacted the first rule of its kind when it passed an ordinance in December 2016 that created a surtax of 10% for public companies with a CEO pay ratio of 100:1 or more, with the surtax set to 25% if the ratio exceeds 250:1. The surtax would be levied on business income from activities in Portland, and would be in addition to the existing 2.2% corporate tax rate.
The state of Illinois has proposed an annual fee of $1,500 on any publicly traded company doing business in the state if its CEO pay ratio is 100:1 or more, with the fee increasing to $2,500 if the ratio exceeds 250:1. In addition, Connecticut, Minnesota, Massachusetts, and Rhode Island have all proposed corporate surtaxes if the CEO’s pay exceeds 100 times that of the median worker. Perhaps more surprising is the fact that the proposed laws in Connecticut and Massachusetts are not tied to the methodology in the Dodd-Frank Act, which means that their proposed rules are designed to stand even if the act is repealed.
It would appear that the proposed surtaxes do not take into account company size, industry, or peer comparisons. They are simply based on absolute pay ratio numbers, rather than relative comparisons. This would seem to penalize larger publicly traded companies, as their pay ratio is likely to be greater. In addition, certain industries are more far more likely to exceed the 100:1 threshold that is seen in several states’ proposals.
The communication strategy of the pay ratio is as important as the calculation approach. Issues to consider include where to locate the disclosure in the proxy statement, how much detail or supplemental analysis to include, and the need for company-wide communication on the pay of the median employee contemporaneously with the release of the proxy statement.
Joe Kager, POE Group
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