SEC Finalizes Pay Ratio Rule -- Read the Plain English Description Here

Wednesday, after much controversy over the last five years, the Securities and Exchange Commission (SEC) released its final rule under Dodd-Frank Section 953(b) sometimes known as the Pay Ratio Rule. I have friends who are executive compensation attorneys and if you need legal advice on this rule, I can recommend any number of them to you, but I am going to write about it from a practical standpoint in plain English. What happened?

First, I'd like to commend the SEC. The statute on this rule has been very controversial. The SEC, in my opinion, has taken an approach that remains largely faithful to the exact wording of the statute and fully faithful to the intent of the statute (I'm not here to argue if the statute is worthwhile) while at the same time being sensitive to the concerns of employers with regard to the potential cost of compliance. It's rare that a government agency handles such a quandary this well.

Back in 2013, the SEC released a proposed rule on this topic. Since that time, the SEC received 287,400 comments on the proposed rule. More than 285,000 of them were form letters, but that still means that roughly 2,000 people took the time to write customized comments. To the credit of the Commissioners, they appear to have considered every last one of them. What they have crafted is practical, assuming that you find the result of the work practical.

What does the rule say? Here we go.

In its definitive proxy, each registrant shall disclose three items (at least since the rule says that the disclosure may be augmented):

• The pay (as defined for proxy purposes) of the PEO (generally known as the CEO or Chief Executive Officer),
• The pay (same definition) of the median-compensated employee of the employer, and
• The ratio of the first item to the second expressed as some number (integer will work) to 1.

Identifying the median compensated employee can be a very costly process. Consider a company with 1001 employees. The median compensated will be the one whose compensation is more than that of 500 others and less than that of 500 others. In order to determine this (by the letter of the law), one would need to determine the annual total compensation (that's the proxy compensation) or ATC for each of the 1001. They would need to be ranked and then we would find the 501st person. That is a lot of work.

The final rule allows for two significant simplifications for purposes of determining the median employee:

• Companies may choose to use sampling techniques in order to reasonably determine who the median paid employee is, and
• Companies may use and consistently applied measure of compensation from payroll or tax records.

While the first of those may be more trouble than it is worth, the second should be a big help to lots of companies.

Further, once a company establishes a median employee, it may use that same employee for three years provided that there have not been significant changes (undefined term) in the compensation practices or the makeup of employees. If that employee terminates, then the company may reasonably select a similarly situated employee as a replacement.

Many commenters were concerned about the disclosures for multi-national companies especially those with significant numbers of employees in lower cost-of-living countries. Certainly, for example, $50,000 per year goes further in Kyrgyzstan than it does in the US. The final rule allows companies to adjust (on a nation-by-nation basis) compensation for cost-of-living differences.

Calculating proxy compensation can be cumbersome. It includes other than just cash compensation. So, for companies with defined benefit plans and broad-based equity compensation arrangements, it is entirely possible that multiple outside experts would need to be engaged. While that remains the case, the final rule allows companies to make reasonable estimates of components of compensation.

The statute makes clear that an employee is every employee worldwide, whether full-time, part-time, temporary, or seasonal of the controlled group. The final rule allows for all of these simplifications or adjustments:

• A determination date applied consistently within 3 months of the end of the fiscal year
• Only subsidiaries included in the consolidated financial statements need be considered
• Employees where data may be unattainable due to national (or EU) privacy rules may be excluded
• De minimis numbers of employees (up to 5% in total) may be excluded on a country by country basis

Let's look in more detail at those last two. Suppose the number of employees excluded under the privacy rule exception exceeds 5%. Then you are done with your exclusions. On the other hand, if your privacy exclusions are exactly 2% of your total population, then you may exclude other countries whose total employee population is less than an additional 3% of your total population. If, for example, you can't find another country with fewer than 3% of your total employees, then you are done with your exclusions.

In preparing these disclosures, companies will make lots of assumptions, simplifications, and estimates. All must be disclosed.

In somewhat of a gift to employers, additional disclosures and ratios are permitted, but not required so long as the additional disclosures and ratios are no more prominent than the required ones. I think this could be useful.

Consider a company with its management team and sales force in the US, but the bulk of its production facilities in third world countries (I'm not weighing in on whether this is a good or responsible practice or not). Because manual labor is particularly inexpensive in Burkina Faso, for example, Everybody's Favorite Company (EFC) has an extremely high pay ratio, say 10000 to 1. Its CEO had total compensation of $10 million and most employees in Burkina Faso earned only $1000. And further, EFC can't find cost-of-living data for Burkina Faso, so it is not able to do that adjustment. EFC is perhaps rightfully concerned about its pay ratio disclosure, so it elects to do a second pay ratio disclosure limited specifically to US employees. In this case, the ratio declines to 100 to 1.

A second company with a December 31 fiscal year end, everest.com, does a massive holiday business. As a result, Everest has a high pay ratio reflective of its hiring each year of seasonal employees. In fact, in a typical year, Everest has more than twice as many employees from September 1 through December 31 than it does the rest of the year. As a result, Everest reports a pay ratio of 750 to 1. Everest doesn't like this, so it chooses to determine an additional ratio of all but seasonal employees. The company is much more pleased to find that this ratio is only 175 to 1.

Generally, companies are required to report the pay ratio for any fiscal year beginning on or after January 1, 2017 (there are exceptions for certain new filers and emerging companies). This means that the first required disclosures (companies are encouraged to disclose before then) will generally be in the early months of 2018.

The final rule is long and complex. There are many legal issues around it and for those you should contact an attorney. 

There are also issues that are far more consultative in nature. They will generally require quantitative acumen, actuarial knowledge, and comfort with executive compensation, as well as a focus on business issues. For those, you should just click here.