Pay Ratio Rule Explained ... In Plain Pithy English

Yesterday, the Securities and Exchange Commission (SEC) approved by a 3-2 vote along party lines a proposed rule implementing the pay ratio rule of Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Only here are you likely to see an explanation of the rule in words that you can understand and use. And, be forewarned, there is nothing in the rule that either serves to reform Wall Street or to protect consumers. In case you missed that, let me repeat in different words: the rule serves no useful purpose.

That said, I commend the commissioners and their staff for their efforts in crafting a rule that seems to well follow the statute while removing significant burden on companies in complying. I do not believe that the two dissenting votes object so much to the way the rule was crafted as they do that the rule was crafted at all.

Some of you will need some background on the rule. For those who don't, to refresh, 953(b) requires an issuer [of proxies] to disclose the ratio of the compensation as defined in Item 402(c)(2)(x) of Regulation S-K for the median-compensated employee in the company to that same definition of compensation for the CEO.

So, what does the proposal say? And, why, John, do you of all people, since you have clearly been anti-953(b) commend the commissioners and their staff?

The rule allows for significant simplification in the process. That said, multinational companies with decentralized payrolls may still spend millions of dollars complying with 953(b), but that still pales when compared with what they might have spent.

Disclosure Items

The rule requires the disclosure of three specific items:

1. Compensation for the median-compensated employee in the company
2. Compensation for the CEO (or PEO if you like the SEC vernacular better)
3. The ratio of 1 to 2, expressed as 1 to some integer, e.g., 1 to 377

Where a company uses sampling techniques, simplifying processes, or other estimation techniques (to be discussed later), the company is to describe these techniques, processes, assumptions, and methods in enough detail to be understandable to an investor, but not necessarily to satisfy an economist or statistician.

The issuer, at its discretion, may include other disclosures with it to assist an investor or potential investor in understanding the ratio. Such disclosures should be provided on a reasonably consistent basis. In other words, if in year 1, the issuer uses wiggle words to explain why the pay ratio is 1 to 999, then in year 2, the issuer should use similar verbiage to explain why the pay ratio is now 1 to 17.

Calculation of Compensation

As for other purposes in the proxy such as the Summary Compensation Table, compensation is to be calculated using the methods in 402(c)(2)(x). Without confusing the reader, this includes cash as well as the value of certain equity compensation and the increase in the present value of accumulated pension benefits, among other things. While the issuer (company) will already have calculated this for the CEO, the calculation for the median employee, hereafter referred to as Jane Doe, will also use the same methodology. So, to the extent that Jane is granted stock options and participates in one or more employer-sponsored pension plans (government-mandated plans are generally excludible), that must be included as part of compensation. 

Additionally, all disclosures are to be done in US dollars. Therefore, to the extent that (and I pity the poor company) Jane is paid in foreign currency, the value of such currency must be converted to US dollars. No adjustments may be made for cost-of-living differences in foreign geographies.

Who Gets Counted and How

All employees of the employer on the last day of the fiscal year are to be counted (leased employees and temporary employees of contractors may be excluded). Permanent full-time employees who worked less than the full fiscal year may have their compensation annualized. Part-time, seasonal, and temporary employees may not have their compensation annualized. And, as should now be clear unless you have slept through my first few paragraphs, foreign employees must be counted.

Simplifying the Process

This is where the SEC made us proud (hey, I was proud of them for this, but I guess I shouldn't put words in your mouth). Frequent readers will recall that I described 953(b) as a legislated disaster. (Actually, I need to thank Mary Hughes, my editor at Bloomberg/BNA for coming up with that description.) I am going to get a bit technical for a moment as I explain why to those people who have been hiding behind the rock in my blog.

Section 953(b) requires that companies disclose compensation for their median-compensated employee. Suppose a company has 999 employees. Then, the median-compensated employee (you remember her, Jane Doe) is the 500th highest-compensated. In order to determine who that is, the company would have to determine the compensation (402(c)(2)(x)) for each employee in the company. Currently, that is a by-hand process for the five employees usually disclosed in the Summary Compensation Table of the proxy. Doing it for another 1,000 or so would not be a worthwhile operation. Remember, for many companies, many employees will have many elements of compensation that take many hours to determine and that is way to many manys to be justified in the spirit of reforming Wall Street or protecting consumers.

The proposed rule allows companies to use sampling methods and and alternative forms of compensation in determining the median employee. For example, a company with only US employees, but having 250,000 of them might sample by selecting only those employees whose Social Security Numbers end in 22, 55, or 88. This seems unbiased and would still tend to produce a group of 7,500 people or so. I could go through the math for you (but, you're very welcome, I will refrain) to show you that the compensation of the median-compensated employee of the 7,500 will not vary significantly from that of Jane Doe. Further, in then determining the median of the 7,500, the company may (if it is appropriate for that company) use a convenient measure such as W-2 compensation specifically to determine which employee is the median-compensated one. Then, the company must determine 402(c)(2)(x) compensation for the CEO and that one other person.

Effective Date

I am used to reading IRS regulations. They usually tell you when you must comply with a regulation and they tell you using words (it may the only place they use such words) that you and I can understand. The SEC has chosen to do otherwise. In fact, after reading through their description three or four times, I am still not convinced that the actual rule says what their description of their own rule says. In other words, it is really confusing.

That said, I will use the SEC's own example. If the final rule were to become effective in 2014 and the issuing company had a fiscal year ending on December 31, then such issuer would need to comply for the 2015 fiscal year meaning that the pay ratio disclosure would need to be provide by 120 days after the end of 2015.

Request for Comments

Again, I praise the SEC. They actually want to get this right. They asked 69 questions requesting comments. While I don't entirely agree with their choice of questions, their willingness to ask them and to seek good answers is laudable. 

I will be commenting. I would encourage other interested parties to comment as well.

How Should Issuers Prepare?

The good news is that issuers have lots of time to prepare. It sounds to me as if you won't have to be disclosing pay ratios for another 30 months or so. That's a lot of time. It gives you time to get your ObamaCare ducks in a row before you think about this.

But, pay ratio disclosure will come. Here is a non-exhaustive list of things I think you should do.

• Figure out all the payrolls that you have company-wide
• Determine a measure of compensation that is (or something comparable is) reasonably and readily available such as W-2 or the foreign equivalent(s)
• Understand all the places and to whom equity compensation is issued
• Understand all the defined benefit (including cash balance) plans out there as well as nonqualified deferred compensation
• Prepare your foreign payroll administrators for the eventual need
• Develop a sampling method that is appropriate for your company (need help?)

You Have Questions?

The regulation and explanation combined are 162 pages. It's not exciting reading and in fact, does not have a good plot. I tried to present a readable and understandable summary here, but there's obviously much more. 

If you do have questions, you can ask me.

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