Tax on CEO Pay Ratios That Are Too High

Back in 2010, stuck in Title IX of the Dodd-Frank Wall Street Reform and Consumer Protection Act, corporate America was blessed with a new requirement -- disclose the ratio of the annual total compensation of the CEO to that of the median-paid employee in the company. It seemed simple enough except that it's not. Here are some reasons:

• Annual total compensation isn't what you think. It's compensation as defined for proxy purposes (Form DEF 14A) and it includes things like increases in value and retirement benefits as well as the value of certain stock compensation.
• The median-compensated employee is the one who is compensated such that half the people in the company are better paid and the other half are not paid as well. So, to determine the median-compensated employee, you have to determine that half the company is paid higher and half is paid lower. (Yes, we can make some simplifying assumptions, but it's still not as simple as just picking a person.)
• Foreign-domiciled employees count and we have to convert currency.
• Part-timers and seasonal employees count and we are not allowed to annualize their pay.

All of this is so that a company can disclose a single number in its definitive proxy statement -- the ratio of pay of the CEO to that of the median employee.

And, then the pain ends, right?

Wrong!

People will see this number. Shareholders will see it, unions whose members the companies employ will see it, institutional investors will see it, shareholder advisory services will see it, and cities and states will see it.

Cities and states you say? Why would these issuers of proxies care about that?

Frankly, for most companies, the financial effects imposed by cities and states will be more of a nuisance than anything else, but Portland, Oregon led the way by imposing a surtax on companies doing business there if there pay ratio is too high. The business tax in Portland, generally, is 2.2% of income derived from Portland business. But, the following surtaxes will apply:

• If a company's pay ratio is at least 100 to 1, but less than 250 to 1, there will be a 10% additional surtax;
• If a company's pay ratio is at least 250 to 1, there will be a 25% additional surtax.

Other cities and several states have proposed similar laws and while some may have passed, I personally am not aware.

As I said, these taxes are not a big deal in the scope of the companies involved, at least not for the most part. At the same time, however, I think we are going to see that companies with pay ratios exceeding 100 are going to be quite common.

To the best of my knowledge, taxes of this sort were first proposed by former Labor Secretary Robert Reich in 2014. Secretary Reich points out that pay ratios in the early 70s averaged about 28, but we should note that statistic as being based almost entirely on full-time American workers. The labor force has changed. And, so has the pay ratio. 

Preparing for Pay Ratio

Could the politically charged pay ratio calculation and disclosure of Dodd-Frank Section 953(b) go away with this year under this Republican Congress? Of course it could. Since companies generally will not be doing this disclosure until early 2018, does that mean they should hope that it goes away and not plan for it? No. The process will be long and data collection will be arduous for many companies. You don't want to get caught unprepared.

For those of you not familiar, I have written on this extensively. And, despite the fact that I think it will be a huge expenditure of effort by issuers of proxies and that I think it will provide little value to shareholders and the public generally, it's still the law and it becomes a requirement in the upcoming proxy season.

In a nutshell, determination of the pay ratio will follow this process:

• Identify the CEO (that should be easy)
• Identify the employee in the controlled group globally whose annual total compensation (a term of art including almost all forms of current and deferred compensation) when ranked sequentially among all employees falls right in the middle of that ranking
• Determine the annual total compensation for the CEO (you're doing this for the proxy already)
• Determine the annual total compensation for the median compensated employee
• Determine the ratio of the two

You may be wondering at this point where the complexities may lie; that is, in what situations are you more likely to want to consider outsourcing this determination than doing it yourself. Consider these as complicating factors:

• You operate in multiple countries
• You sponsor multiple pension plans perhaps in multiple countries
• You provide equity compensation broadly
• You provide other unusual forms of compensation
• You are afraid for whatever reason that your pay ratio will be high enough to garner unwanted negative publicity and you'd like guidance on managing the message

If you do have any of those situations, I'd suggest you consider seeking outside help. After all, this sort of data manipulation and these sorts of calculations are likely not in your core competencies. And, if they're not, I'd love to find a way to make your determination of the pay ratio less painful for you.

Interpretive Guidance Issued, But Pay Ratio Determination Still Difficult

Staff at the SEC recently issued interpretive guidance on the pay ratio rules under Section 953(b) of Dodd-Frank. Regular readers will know that I have written on the pay ratio many times. What many regular readers (those who are used to dealing with benefits issues, for example) may be less familiar with is that the interpretive guidance of staff carries full weight. That is, it's not just a suggestion.

Before digging into the guidance, let's recall what the pay ratio disclosure is. Generally, companies that issue definitive proxies in the US must, beginning with fiscal years starting in 2017, disclose the ratio of CEO compensation to that of the median-compensated employee in the company. And, for those purposes, compensation is that used in the Summary Compensation Table of the proxy. So, it includes (oversimplifying a bit), for example, the value of equity, deferred compensation, and qualified retirement plans provided by the employer.

The employee population for this purpose is not limited to full-time workers or to US workers. So, companies with lots of international employees who are compensated in a variety of different ways may have difficulty with this determination.

If you need a refresher on what the final rule said and how you might handle it, there is useful material here.

Back to the interpretive guidance.

As you may recall, you may determine who your median employee is by using simplified definitions of annual total compensation so long as your facts and circumstances support it. For example, if it's clear that compensation for the median employee will resemble W2 pay, then you can use information from tax or payroll records to determine who the median-compensated employee is. But, if you provide pensions or equity compensation broadly, this may be inappropriate to your situation. In fact, for many companies, determination of who their median-compensated employee is will be the most difficult part of the process.

What staff made clear is that rate of pay (hourly rates or salary) is not reasonable to use as a consistently applied compensation measure (CACM). Staff gave examples where those rates could be part of the process, but in order to make the measure reasonable, companies would need to know how many hours each hourly-paid worker actually worked and for what portion of the year salaried workers were employed.

The interpretive guidance makes clear that in determining the median employee, the population may be evaluated using any date within 3 months of the end of its fiscal year. Once the population as of that date is selected, the employer can go through this process:

• Identify the median employee using either annual total compensation or a CACM ... by
• Selecting a period over which to determine that CACM (the period need not include the selected date so long as based on the facts and circumstances indicate that there will be no significant changes (undefined term, of course) between compensation used and actual compensation for the fiscal year)

It is up to employers to determine, again based on all the facts and circumstances whether furloughed employees should be considered in the population. Employees who were hired during the year or who worked less than the full year due to a leave of absence may have their pay annualized. But, part-time and seasonal employees may not have their pay annualized.

And, finally, the staff weighed in on how to determine who might be or not be an employee for purposes of the pay ratio. Essentially, the determination of whether a worker who is not a common-law employee of the employer should be considered an employee for these purposes is based on, you guessed it, all the underlying facts and circumstances. Primarily, the employer should look to whether it sets the compensation of, for example, contract workers, or if that pay is set by someone else.

So, for example, if the company advertises that it will pay contract telephone callers $15 per hour, then they would be employees for these purposes even if they are not employees for tax purposes. On the other hand, a worker who is brought on board through a temporary staffing agency or for a specific contract is likely not a worker.

Well, this clears it up for you, doesn't it? Okay, I thought not. Continue to follow me here for more updates as they come rolling in. Or, let me know if you have questions.

Compensating Executives in a "Challenging" World

The rationale has always gone something like this: if you don't compensate your executives at least equal to their peers and if you don't reward their performance, you will never have a top tier executive group and your company will not succeed.

Is that statement true? Is part of it true?

We're getting much closer to finding out. The big news this proxy season is from shareholder proposals on executive compensation. That's right -- since Say-on-Pay votes are non-binding, shareholder groups are looking to force companies to put components of executive compensation to a binding shareholder vote.

Before getting into a few details, let's understand how most companies are reacting. It's not surprising, but as a group, large corporations do not think their shareholders understand executive compensation. They are seeking to keep these votes off of their proxies. As a precursor to doing so, they request what is known as a "no-action letter" from the Securities and Exchange Commission (SEC). In brief, when a government agency issues a no-action letter, it assures the requestor that it will not take action on a given issue. So, when a company seeks such a letter from the SEC, the company is asking the SEC to confirm that it will not take action, for example, for a failure to place a particular item in its definitive proxy.

One of the most ardent submitters of executive compensation proposals is the largest American labor union, the AFL-CIO. In a statement, the AFL-CIO said, "We opposed compensation plans that provide windfalls to executives that are unrelated to their performance."

On its surface, that seems very prudent. But, it may be a bit trickier in practice.

What makes compensation related to performance? How does one define performance? Is compensation as expressed in the Summary Compensation Table? Is it cash only? Does it include equity? Does it include the (proxy-includable) value of deferred compensation?

Here is how it would strike me.

• Base pay is not related to performance. But, generally, to the extent that such pay is deductible to the employer under Section 162(m) ($1 million pay cap), some observers will not consider it to be egregious. On the other hand, in today's world of pay ratios and calls for increases in rank and file wages, other observers will ask that it be capped at some multiple of either the median pay for the entire company or even that of the lowest-paid employees of the company.
• Bonuses are theoretically related to performance. To the extent that the criteria used to evaluate executive performance and by extension, executive bonuses, are appropriate, so should those bonuses be. To play devil's advocate, however, if an executive knows how her bonus will be calculated, she may take inappropriate risks (for the company) in order to maximize the expected value of her bonus. Similarly, she may find ways to accelerate certain items into the fiscal year in question while deferring others until the next year. 
• Long-term incentives are [nearly] always performance based. In today's world, it is expected that those incentive payouts will be based on the achievement of a set of goals related to metrics deemed appropriate for that executive. Often, there are circuit breakers (elements that if the executive fails to meet a pre-established minimum level of performance, he will not receive a payout or that part of a payout at all). But, long-term incentives are often paid in company equity. This means that compensation will, to a large extent, be tied to share price. As we know, however, share price is not always tied to corporate performance. On any given day, share price may be influenced by such as the state of peace or war in the Middle East, a speech given by the President of the United States, or the rise or fall of housing starts during the last month. 
• What about deferred compensation (here I am referring to traditional deferred compensation plans, either defined benefit or defined contribution)? It's rarely performance based. Theoretically, the company is paying an executive less today for a promise to give them some of that pay in the future. What sorts of plans should be challenged? If an executive voluntarily defers some of their compensation and it grows at a rate tied to some broadly investable index, is that okay? Suppose she has a DB SERP that looks just like the broad-based plan (qualified plan), but without limitations applicable to qualified plans. Institutional Shareholder Services (ISS) is generally fine with this, but major labor unions may not be. And, if that SERP looks very different from qualified plans, even if there is a good reason for it, this may be a situation where no institutional shareholders are satisfied.

What should Boards of Directors and their Compensation Committees do about all of this? ConocoPhillips shareholders are asking that the Compensation Committee develop a program to determine which portions of a bonus should be paid immediately, which portions should be deferred, and what adjustments should be made to those deferrals based on performance.

Perhaps this has some merit. If it does, however, it's a bit of a nightmare for people who need to figure out how to make such a plan 409A-compliant and for those who need to administer FICA tax payments.

On the other hand, if adjustments are to be made based on performance, can't the same executive who is able to manipulate performance metrics in the LTI scenario described above also find a way to manipulate them here? Where there are objective formulas, there are smart people who can figure out how to game the system. Where there are subjective evaluations, Boards will be accused of pandering to the executives of the companies.

More than ever, the Compensation Discussion and Analysis (CD&A) will be very key. Explaining why the mix of objective and subjective factors was chosen can go a long way to appeasing large shareholders. Explaining how levels of compensation were chosen is a must. And, for the first time, we may see companies rationalizing their levels of executive pay as compared to rank and file pay.

With all of these challenges to executive compensation, these are challenging times for Compensation Committees.

Benefits and Compensation After the Elections

Suppose there was a presidential election this year. Just suppose. And, further, suppose that election had a winner. Just suppose.

It is extremely likely that the winner will be someone nominated by either the Democratic Party or by the Republican Party. And, it is not at all unlikely that the party of the winner will keep or gain control of both houses of Congress.

From the standpoint of tax policy, and by extension, benefits and compensation policy, what will this mean for you, the employer or employee? Should you care?

I don't think we're far enough along to do a candidate-by-candidate analysis, but I do think that we are aided by the fact (at least I think it's a fact) that the remaining viable candidates fall generally into a few small buckets from these standpoints (yes, Carly Fiorina will give us a 3-page tax code (no idea what it might say) and Gary Johnson who has declared for the nomination of the Libertarian Party is a Fair Tax proponent). In fact, I think there are at most four such buckets remaining.

Let's identify them from left to right (that is how we usually read):

• The Democratic Socialist (DS) Bucket whose main component, Senator Bernie Sanders (I-VT, but caucuses with the Democrats and running for the Democratic nomination) has recently told us, "Yes, your taxes will go up."
• The Mainstream Democratic (MD) Bucket whose main component, former Secretary of State Hillary Clinton will, according to her website today (it did say something somewhat different on this topic at the end of last year), lower taxes for the middle class (and by extension the lower class) and raise taxes on the wealthy including big business.
• The Traditional Republican (TD) Bucket that includes the likes of [alphabetically] Chris Christie, governor of New Jersey; John Kasich, governor of Ohio; Marco Rubio, junior Senator from Florida; and Donald Trump (yes he is mainstream for this purpose), businessman from New York, which generally would lower tax brackets and flatten, or make less progressive, the tax code.
• The Conservative Republican (CR) Bucket that includes Ben Carson, retired physician from Maryland, and Ted Cruz, junior Senator from Texas which would replace the current income tax structure with a flat tax.

I'm going to make things a little tougher on you here Rather than reiterating these buckets, I'll comment on how different philosophies might affect things.

We all know the health care debate. Sanders wants to move to a single-payer system. Clinton likes the status quo under the Affordable Care Act (ACA). The Republicans with the exception of Kasich want to repeal the ACA and start over again. Kasich, on the other hand, thinks that this is an impractical solution and would keep some portions of the ACA and change others.

On the pension side, Republicans as a group are in favor of self-reliance. This would tend toward a world of nothing but 401(k) (and similar) plans. Their philosophy is that prudent Americans should be able to save enough for their own retirements, especially with the benefits of an employer match. Of course, many of them will be dismayed WHEN they read my blog to know that I disagree with that.

Clinton is much tougher to figure out on this. But, we can look to her stated tax policy and work our way back. When taxes on high earners and large corporations increase, so does the value of tax deductions. So, under a Clinton presidency, we might expect to see more high earners and profitable corporations accelerate contributions to benefit plans in order to accelerate tax deductions. Could this result in somewhat of a rebirth of defined benefit (DB) plans? Theoretically, it should, but in practice, I would expect that even if that rebirth occurs, it will be very limited.

Sanders would prefer to see a single government-run retirement system for everyone; that is, we would have expanded Social Security and Medicare with smaller benefits and less availability for those who have been the highest earners. In this scenario, although I personally don't see Congress going along with it, the prevalence of employer-provided retirement plans could decline significantly. On the other hand, it would not be antithetical to his philosophy to see a DB requirement in much the same way that the ACA leaves employers with a health care requirement. Could we see pay or play here?

With regard to executive compensation (nobody is saying much about broad-based compensation other than to say that under their Presidency, there will be more and better jobs and pay will increase rapidly), we have another large rift between the candidates. Here, one of the biggest elements is the view of what has probably been President Obama's second signature bill, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank). (Why couldn't they have given the law a short name like Fred so that I don't have to test my typing skills every time I cite the law?) 

Sanders is a huge fan of Dodd-Frank. That said, he doesn't think the law has gone far enough. He has said many times that the reinstatement of Glass-Steagall should have been part of Dodd-Frank. Sanders, much like Senator Warren (D-MA) as well as former Senator Dodd (D-CT) and former Representative Frank (D-MA) believes that one of the most important parts of Dodd-Frank is Title IX, the section on executive compensation. Sanders is a huge proponent of tieing levels of executive compensation to that of the rank and file and of their companies as well as generally limiting executive compensation. Under a Sanders presidency, do not be surprised to see a presidential proposal that would limit CEO compensation for example to a pay ratio as defined in Section 953(b) of Dodd-Frank to something like 10.

Clinton is also a Dodd-Frank fan. But, there is a big difference here. Secretary Clinton has long had both ties and obligations to the large Wall Street banks. She periodically invokes Glass-Steagall, but knows that its repeal allowed Goldman Sachs, for example, to grow into the financial giant that it has. At the same time, though, Clinton, who I believe is still far more likely than not to be the Democratic nominee, knows that the Democratic platform will be influenced by the likes of Sanders and Warren. Expect that the compromise will be in the form of promises to scale back executive compensation. As broad-based plans in which executives participate tend to be exempt from similar scrutiny, those higher-paid individuals may look to solutions that have been proposed over time in this blog.

On executive compensation, Republicans are fairly united. All, that I am aware, would push for the repeal of Dodd-Frank and for no more (or fewer) restrictions on executive compensation. As free market proponents, they would tell us to let the fair markets determine how top executives should be paid. All that said, proposals like that will be anathema to most (perhaps all) Democrats and unless the GOP were to gain a filibuster-proof majority in the Senate, such proposals are not likely to become law. However, as Republicans without exception are looking to lower the top marginal tax rates as well as corporate tax rates, look for more emphasis on current compensation and perhaps less emphasis on deferral opportunities.

As the 2016 election process matures and there are fewer candidates, we'll be able to dig deeper. In the meantime, you have my opinion. What's yours?

And, if you think my opinions have any merit, let me help you address what will be coming with the 2016 elections.

How The SEC Got DB Plans All Wrong

Yesterday, I wrote that the SEC contributed to the downfall of defined benefit (DB) plans. I promised to explain in more detail in a future post.

Well, the future is now (I wonder if anyone else ever used that line before).

As readers of this blog well know, for about 10 years, issuers of proxies under the auspices of the Securities and Exchange Commission have been required to disclose compensation for their five highest paid employees. This compensation has been disclosed in a little beast known as the Summary Compensation Table and in more detail in several other places.

Some of the disclosure makes sense. For example, the salary that an individual actually receives is what it is. There is no disputing that. Similarly, the matching contribution that an individual receives in her 401(k) plan or in the nonqualified analog is what it is.

Some of the disclosure makes less sense. Fingers point to the defined benefit disclosures.

What the rules ask be disclosed as compensation with respect to a defined benefit plan (qualified or nonqualified) is the increase, if any, in the actuarial present value of accrued benefits from one measurement date to the next. That seems simple and reasonable enough on its face, but that is exactly where, how, and why the SEC went wrong.

Let's make up some Illustrative numbers for Well Paid Executive who we will refer to as WPE.

• Total pension accrued benefit as of 12/31/2014: $1,000,000
• Total pension accrued benefit as of 12/31/2015: $1,100,000
• Actuarial present value "factor" as of 12/31/2014 using 2014 discount rates and 2014 mortality table: 11.00
• Actuarial present value "factor" as of 12/31/2015 using 2014 discount rates and 2014 mortality table: 11.50
• Actuarial present value "factor" as of 12/31/2015 using 2015 discount rates and 2015 mortality table: 12.50

So, the actuarial present value of WPE's defined benefit as of 12/31/2014 was 11*1,000,000 or $11,000,000. 

The actuarial present value of WPE's defined benefit as of 12/31/2015 was 12.50*1,100,000 or $13,750,000.

The compensation due to defined benefits that must be reported for WPE was 13,750,000 - 11,000,000 or $2,750,000.

But, this is not an apples to apples comparison. Really Big Company (RBC) did not actually compensate WPE for the fact that interest rates on bonds declined during the year. RBC also did not actually compensate WPE for the fact that the Society of Actuaries had finished a new mortality study. 

The actuarial present value of WPE's defined benefit as of 12/31/2015 using 2014 actuarial assumptions was 11.50*1,100,000 or $12,650,000. This means that the increase, on an apples to apples basis, in the actuarial present value of WPE's defined benefits was 12,650,000 - 11,000,000 or 1,650,000. The other 1,100,000 was due to changes in actuarial assumptions and DOES NOT REFLECT THE AMOUNT THAT RBC PAID WPE DURING 2015.

The SEC's methodology has thrown proxy disclosures out of whack. In light of Dodd-Frank and its Say-on-Pay requirement and Pay Ratio Disclosure requirement, the SEC methodology puts an inappropriate burden on companies sponsoring DB plans. For some, this may signal a reason for them to exit that space ... for all the wrong reasons.

How to Handle Your Pay Ratio Disclosures

This is an article that I wrote for Bloomberg BNA that was published last Friday, August 21. Note that you may not reproduce this article without express written permission from BNA.


Reproduced with permission from Pension & Benefits Daily, 162 PBD, 08/21/2015. Copyright 2015 by The Bureau of National Affairs, Inc. (800-372-1033)
 http://www.bna.com


Pay Ratio Rule: Practical Tips for Making the Best of a Bad Disclosure Day

 BY JOHN H. LOWELL

Introduction
I t’s been about five years since Congress passed and President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. In response to the financial crisis that escalated in 2008, legislators sought to put more controls on primarily the larger financial institutions that do business in the U.S. But, buried in this law was a little-debated provision sitting in Section 953(b). It has become known as the ‘‘pay ratio’’ rule.

On its surface, the pay ratio rule seems innocuous. Filers of proxies are to disclose the ratio of the compensation of the median-paid employee of the company to that of the CEO. However, as many have learned, this may be more difficult and more inflammatory than it seems.

In early August 2015, the Securities and Exchange Commission issued a final rule, effective for proxies for fiscal years beginning after 2016, explaining exactly who needs to disclose this ratio and how this is to be done. To its credit, the SEC tried its best to satisfy the needs of those who view this ratio as an important data point for a company and to satisfy companies that complained of potentially large expenditures to produce what they view as a seemingly meaningless number.

If what you need are the technical details specific to your company as to how these calculations are to be done, you can find summaries all over the Internet. Securities or executive compensation counsel will be more than happy to help you. What you may have more difficulty finding are explanations of how to prepare for that 2018 proxy season and what strategies your company may employ as permitted by the final rule.

Key Elements

Before we dive into that, it’s important to review some of the key elements of the final rule, particularly in places where either the SEC has made changes from the proposed rule or where it has afforded employers certain options.

• While the statute tells us that the number disclosed shall be the compensation of the median employee divided by that of the Principal Executive Officer (CEO for our purposes), both the proposed and final rules specify that it is in fact the reciprocal of that (a positive integer is intended). 
• Generally, all employees of the parent company and subsidiaries included in the consolidated financials must be included, but:  
• who is an employee may be determined as of any representative date within three months of the end of the fiscal year; 
• compensation for full-time employees may be annualized, but part-time, temporary and seasonal workers’ pay may not be annualized; 
• workers from countries with privacy rules that may preclude obtaining the necessary data may be excluded (if you exclude one worker from a country, you must exclude all of them); and 
• companies may exclude all workers from additional countries up to a total of 5 percent of the total company employee population. In doing so, first the employees excluded due to privacy laws are counted. If that gets the company to 5 percent or more, then there are no more exclusions. If not, then additional countries may be excluded so long as the total of privacy exclusions and selected exclusions does not exceed 5 percent of the total number of employees of the company. 
• Determination of the median-paid employee has been simplified: 
• solely for purposes of determining who is the median employee, the company may look to compensation amounts from payroll or tax records; and 
• once a median employee is chosen, the company may use the same employee as the median for two more years so long as there have not been changes to the company’s population or pay practices significant enough to make that determination unreasonable. 
• Companies may apply cost-of-living adjustments to equalize pay between countries. s Companies may add to their disclosures so long as the additions are no more prominent than the required disclosure. All that gives companies some useful options, but with options comes analysis to determine what to do and where the data will come from. 
• Determine which countries the company operates in. For those countries, determine: 
• whether privacy laws preclude obtaining necessary data, 
• what percentage of employees is excluded due to privacy laws, and  
• if less than 5 percent, are there other countries that it would be possible and beneficial to exclude? 
• What will it take to get payroll or tax records from all the countries? Alert people responsible for them in each foreign country now as to what you will need. 
• Consider whether the value in using cost-of-living adjustments outweighs the cost of doing so. For some countries, good cost-of-living data may be very difficult to obtain. For others, while the national cost-of-living index may be high or low, the cost in the areas in which your employees work may be very different.
• Consider the benefits of sampling employees rather than using the whole population. Based on the descriptions of sampling techniques described by the SEC in both the proposed and final rules, for most companies, this exercise will not be worth the trouble of understanding the sampling techniques. 

Perhaps the most important decision that a company will make regarding the pay ratio is what it chooses to disclose. Some companies won’t have to worry about it every year, but in some years these pay ratios are going to be very large. Even if the company’s board of directors feels certain that CEO compensation at their company is reasonable, the optics will be bad.

Good consultative thinking can be very helpful here. Let’s consider a few possible situations.

Examples

Company A – Many Seasonal Employees.

Company A (calendar-year filer) does significant business around the holidays. In fact, its workforce is typically about three times as large between September 15 and January 15 as it is the rest of the year. Because of that, the median-paid employee of Company A is likely to be a seasonal employee (recall that companies are not permitted to annualize the compensation of seasonal employees). Additionally, those seasonal employees likely never meet the requirements to participate in most of Company A’s benefit programs including its pension plan. This pay ratio is going to be high. Company A should consider making an additional disclosure showing a comparison of the compensation of its CEO to that of its median full-time employee. While this won’t change the required number, it will improve the optics significantly.

Company B – U.S. Pension Only.

Company B is a multinational organization with significant employees in countries around the globe. Most of the U.S. workforce is well-paid, making it unlikely that the median employee will be from the U.S. Company B has provided both a broad-based and a nonqualified pension plan in the U.S. for many years. In most of the countries in which it operates, providing pensions is not the norm and doing so would make Company B less competitive. Because the increase in the actuarial present value of accrued pensions is part of the calculation of ‘‘annual total compensation,’’ the pay ratio is going to be larger than Company B might like and its board thinks the required ratio is not representative. Company B should consider providing a ratio for the U.S. only and a ratio without regard to pensions as supplemental disclosures.

Company C – Excellent Performance Leads to Larger-Than-Usual Incentive Payouts.

Because of extraordinary performance over the period ending Dec. 31, 2016, Company C’s executives received much larger-than-normal cash incentive payouts (short-term incentive) and equity grants and awards (long-term incentive) in 2017. The pay ratio here is going to be very high, but the board’s rationale is that the CEO deserved it. There may be many readers of the pay ratio who don’t agree. Perhaps they won’t look at the reasons for the high pay ratio, but simply the number itself.

Company C might consider a number of options. First, there might be a narrative describing why certain elements of compensation were as high as they were. Second, Company C might disclose what the pay ratio would have been had the company (and CEO) merely met goals for the year rather than exceeding them. Third, Company C might disclose what the pay ratio would have been had its CEO received his average incentive payouts for the last three years or five years. Any or all of these will help to lend some perspective to the otherwise high pay ratio.

Company D – Varying Global Economies.

Company D has its operations primarily in the U.S. and in South America. It provides broad-based and nonqualified pensions in virtually every country in which it operates. During 2017, the economy in South America was vastly different from that in the U.S. As a result, while interest rates dipped in the U.S., they rose significantly in every country in South America in which Company D operates. This combination produced massive increases in pension values in the U.S. (for executives and for rank-and-file), but decreases (zero for annual total compensation purposes) in all of South America. Since pensions are a significant portion of actual compensation for Company D’s South American employees, their compensation will appear understated for 2017 while the CEO’s compensation will appear overstated.

Company D should consider several additional disclosure options:

• Disclose a ratio for its U.S. employees only,  
• Disclose a ratio assuming that pension discount rates had not changed in any country, or 
• Disclose a ratio without regard to pensions. 

Company E – Highly Diversified Global Business.

Company E is probably the most complex situation we will face. In the last few years leading up to and including 2017, it has generated a significant part of its revenue and most of its profits from its financial services division, which operates mostly in the U.S. Its CEO has to operate like the leader of a large bank and is therefore compensated commensurate with that. But, as a hedge against cyclical issues, Company E also operates in a variety of other industries and in multiple countries. The industries that are the most labor-intensive also employ the majority of their workers in low-paid third world countries. And, to the extent that Company E is involved in those industries in the U.S., its workers are largely unionized.

Company E has considered sampling to simplify the process. However, upon an examination of the rules, Company E realizes that it will have to do samples of each of its industry groupings in each country in which it operates. While it might reduce the number of employees that it has to evaluate, the expense of getting through the samplings outweighs the gains.

Company E realizes that its pay ratio is going to look very high. Philosophically, it is fine with that as its board feels certain that it is justified. But with multiple union contracts coming up for bargaining, Company E also knows that the unions will use the pay ratios to wage multiple media campaigns against Company E and its CEO.

In its disclosures that will go along with its required pay ratio disclosure, Company E needs to consider all of this. Here are some of the disclosures that Company E might make:

• U.S.-only pay ratio, 
• Disclosure of median pay for a typical employee in each of the U.S. unions with a breakout highlighting the company’s large expenditure on union pensions,  
• Salaried-employee-only pay ratio, or 
• Additional pay ratio compared to the union employee’s median pay encompassing elements not normally included in annual total compensation such as health care expenditure. 

Each of these additional disclosures has a cost associated with producing it. But, in Company E’s view, not producing ratios like this may be more costly than the hard costs to generate them.

Now What?

If you happen to be a part of one of the fortunate companies for whom this disclosure will neither be a calculational nor public relations problem, then your job should be easy. If, on the other hand, your company is closer to one of these more problematic situations, then you might have your work cut out for you.

Chances are that most in your company will not focus on this until after the end of fiscal year 2017. That may be okay, or it may not. Developing some of the ratios that we’ve discussed may be time-consuming and data-intensive. Trying to do that at the last minute may not be advisable.

Similarly, for a number of companies, this will be more than a calculation. It will be a strategy. Given the potential cost in investor relations and perhaps a battle over say-on-pay, it might be wise to have someone independently thinking about these issues. While using consultants haphazardly can create problems that were never there instead of solving them, here using a consultant who has thought through the issues and can help your company do the same would likely be money well spent.

You know that your company pays both rank-and-file and executives appropriately. Now you have to ensure that you manage the message so that all the interested observers know that as well.

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.

Proxy Hysteria Coming For Companies With DB Plans

You read it here first. During the upcoming proxy season, there is going to be hysteria over the executive compensation disclosures in proxies for companies with defined benefit (DB) plans, especially those with nonqualified plans for their named executive officers (NEOs).

What's going on? As part of an NEO's compensation, filers are required to include the increase in the actuarial present value of DB plans. The actuarial present value is a discounted value of the anticipated payment stream just as it was a year earlier. While there are many assumptions that actuaries select in determining an actuarial liability, two, in particular, have changed for many companies from 12/31/2013 to 12/31/2014. One is the discount rate which will have decreased by somewhere in the neighborhood of 100 basis points and the other is the mortality assumption. Late last year, the Society of Actuaries (SOA) released its newest mortality study and many companies elected to adopt the new tables.

The effect of the change in discount rate will vary, largely on the age of the NEO in question, but it's not unreasonable to think that for most NEOs that just that discount rate change will have increased the actuarial liability attributed to them by 8%-12%. Yes, Americans are living longer. Mortality assumptions should be updated from time to time. But, for proxy purposes, the year of the update causes an additional spike in the liability attributed to the individual NEO, perhaps an additional 5% depending upon age and gender.

So consider an NEO whose 2013 compensation included $1,000,000 due to the increase in the actuarial present value of accrued pension benefits. If that person is still an NEO at the end of 2014, he or she will have had an increase in liability due to surviving one more year (interest and mortality totaling perhaps 6%), an increase due to increases in included compensation (a large bonus could have increased even 3-to-5 year average compensation by 25% (recall that in the case of a 5-year average that 2014 which was a good year for many businesses replaces 2009 which was a dismal year for many businesses)), and increases due to changes in discount rates and mortality assumptions.

So, with no changes in compensation practices, our NEO who had $1,000,000 of compensation attributable to him or her in 2013 might see that turned into an increase of $1,500,000 in 2014.

There will be outrage. Proponents of the pay ratio rule of Dodd-Frank Section 953(b) will point to these increases and say that the rank-and-file got 2%-4% increases. The media will not understand what happened. Congress, and this might be the year that it matters as the new Republican control has suggested that it will try to repeal some parts of Dodd-Frank, will not understand.

But those people who chose to read my ramblings will get it. Companies that foresee the issue can address it. It can't be solved in its entirety, but it can be managed.

I know how.

Do you?

Possible Delay of Pay Ratio Regulations -- Practical or Political?

Right before Thanksgiving, the House Committee on Financial Services sent a letter to the Chair of the SEC asking that guidance on the so-called Dodd-Frank Pay Ratio rule (Section 953(b)), and therefore implementation as well be delayed. The letter called this implementation a low priority. No similar correspondence has come from the Senate or any of its committees.

Gee, what a surprise that is. House committees are controlled by Republicans currently while Senate committees are in the hands of Democrats for few more weeks. Dodd-Frank was another bill and then law praised by Democrats and loathed by Republicans. The letter points out that the law does not specify a time by which the SEC must promulgate a rule on this issue. Additionally, the letter tells the SEC that the pay ratio disclosure has little value and that knowing the pay ratio for publicly traded companies back in the 2006-2008 timeframe would have done nothing to avert the financial crisis.

Let's regroup for a moment. For those who don't know, Section 953(b) of the Dodd-Frank law requires that registrants disclose a single number -- the ratio of the pay of the median-paid employee in the company to that of the CEO. Pay for this purpose is pay as defined in the executive compensation section of the proxy. I have argued that while such relative information may be useful to some that this calculation is the wrong one and needlessly burdensome. Last year, the SEC issued a proposed rule on the pay ratio calculation. While it provides a means of simplification for many companies, companies that do take advantage of the sampling techniques proposed will not find them simple by any means.

So, is the single number valuable? I don't think so. If one insists that such a comparison is valuable, then to me, it would be far more instructive to show CEO compensation and a chart of commonly held jobs within the company showing a compensation range for actual or hypothetical full-time employees(if no full-time actual employees exist for such job classifications) for each of those jobs alongside the CEO compensation.

Advocates of the pay ratio point out companies in the fast food industry. They note that CEOs make many millions of dollars while most fast food workers earn minimum wage or only slightly more. In this case, is the pay ratio valuable? To me, it's not. Running a multi-billion dollar business and defining its strategy to compete and grow has no similarities to monitoring a drive-thru window. Comparing the compensation of two such individuals makes no sense to me.

Currently, the SEC has three Democrats and two Republicans. The Chair is a Democrat. The commissioners still have meaningful Dodd-Frank work to do whether they make 953(b) a priority or not.

I don't know what they will do, but thus far, they have not shown a predisposition to act quickly on ensuring that the pay ratio is disclosed for registrants.

Public Plans, Beware What Your Actuary Can and Cannot Do

Thick laws create strange results. Consider for example the relatively new final SEC rule on registration of municipal advisers. As well as I can tell, the intent of this provision (Section 975) of the Dodd-Frank law was to ensure that those who are advising municipalities on things like bond offerings and investments. It never looked to me that actuaries were the target.

I don't know how it looked to the SEC. What I do know is that the final rule specifically exempted "retirement board" members from SEC registration. What I also know is that it did not exempt actuaries.

Why do I care and why might you care? It looks as if there are two situations where actuaries will be subject to registration as municipal advisers and if they are, they will be subject to all the attendant SEC rules:

• If your actuary performs an actuarial study in which the actuary sets any of the investment return assumptions or
• Makes any recommendation about how the governmental entity might address an unfunded liability including advice about the issuance of a municipal financial (debt) product,

 the actuary must register with the SEC.

It seems strange to me that municipal officials serving on retirement boards would be exempted, but actuaries may not be.

I guess it's not the first time that a government agency has confused me.

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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Pay Ratio Here, I Fear

The did it. By an overwhelming 3-2 vote, strictly along party lines (tsk, tsk), the Securities and Exchange Commission approved a proposed rule under Dodd-Frank Section 953(b). The two dissenters, Commissioners Gallagher and Piwowar, both issued scathing condemnations of both the statute and the proposed rule while the other commissioners praised it for the assistance that it will provide to investors and potential investors.

The rule has not been published yet, or at least, I can't find a copy, but I did take some good notes, so my readers get an early summary with surprisingly enough, some cynicism from your faithful blogger.

Issuers will need to provide three numbers:

1. Compensation (Rule 402(c)(2)(10)) for the median-paid employee
2. Compensation of the CEO
3. The ratio of 1 to 2

Despite this being what the law calls for, #3 is stupid. For those who are not sure what I just said, #3 is stupid. Suppose I told you that the ratio of compensation of the median employee to the CEO is .0073. What would that number mean to you unless you are mathematically facile? Is that a good number or a bad number? Should you be happy?

I repeat, #3 is stupid. The ratio should have CEO pay in the numerator and be an integer.

Haters of the statute did get a few breaks:

• Companies may determine the median employee via statistical sampling. After doing this, they must determine the 402(c)(2)(10) compensation of that median employee rigorously. Despite commentary from Commisioner Piwowar to the contrary, this is a huge concession to issuers.
• Compensation of permanent full-time employees may be annualized.

On the other side, there are these provision:

• Part-time, temporary, and seasonal employees pay may not be annualized.
• Compensation of global employees must be currency converted.

And, on the I'm not sure until I see the actual regulation side,

• There is no rule to say how statistical sampling must be done, but it must be reasonable and consistent.
• The dispersion of pay should be a significant contributing factor in determining the sample size for statistical sampling.

I understand that the novel which shall be heretofore known as the Dodd-Frank pay ratio rule is quite voluminous. Stay tuned here to get the most easily readable and entertaining reports on what it says.

The Need For Honest Debate

It's that time again, it's time for a rant. But, I hope that it will be instructional as well. I'm going to talk about our need for honest debate in our legislative process. And, because this is a blog that, at least in theory, deals with benefits and compensation, I'll use benefits and compensation issues to illustrate my point.

For those who are wondering, the antagonists here are the large part of the 535 (that's the usual number) elected officials who in combination are the voting members of Congress. The protagonists, if there are any are the other 315 million or so of us who get to live by what the 535 come up with.

Let's start with nearly everyone's favorite whipping boy, the Affordable Care Act (PPACA, ACA, or ObamaCare). We all know what happened. President Obama really wanted to reform the US health care system. At various times, he indicated that he wanted to move toward a single payer system. Many of his fellow Democrats among the 535 also wanted a single payer system, but knowing that was unlikely to get enough support to become law, they settled for a bill that eventually became PPACA. The Republicans banded together to vote against it, unanimously. My distinct impression is that most didn't care what was in it. It was to be a landmark piece of Democrat-sponsored legislation and Republicans were voting against it. My distinct impression was also that most Democrats didn't care what was in it either. It was going to be a win against Republicans, so Democrats voted for it. As Nancy Pelosi (D-CA) famously said (and I am going to include the whole quote so that it is not taken out of context):

You've heard about the controversies within the bill, the process about the bill, one or the other. But I don't know if you have heard that it is legislation for the future, not just about health care for America, but about a healthier America, where preventive care is not something you have to pay a deductible for or out of pocket. Prevention, prevention, prevention -- it's about diet, not diabetes. It's going to be very, very exciting. But we have to pass the bill so that you can find out what is in it, away from the fog of the controversy.

Did Ms. Pelosi know what was in the bill when she voted for it? She probably had a general idea, but didn't know the specifics. How about the other 534? I'd wager that most of them had neither read more than a page or two, at most, of the legislation and had not been briefed on it by anyone who had read it.

Where was the debate? Where was the opportunity for individual members of Congress to discuss the good parts and the bad? Even among the most ardent Republicans who voted against the bill, I suspect it would be difficult to find many who think that mandatory preventive coverage and coverage of kids up to age 26 are bad things. On the other hand, the medical device tax that was inserted deep in the bill's bowels as a revenue raiser would probably not get support today from more than a few Democrats who voted for the bill.

Suppose the bill had truly been debated. Suppose the good parts had been picked out as the foundation for a bill that might have gotten some bipartisan support. Suppose the parts that virtually all of us can agree don't make sense had been left out. What would debate have taught us? It would have confirmed that our health care system needed some reform. It would have confirmed that providing health care coverage to millions of uninsured costs money. It's not budget neutral. It's certainly not helpful to the budget. But, we didn't have good, honest debate and we eventually have learned what was in the bill.

Dodd-Frank was another bill that was passed without a whole lot of what I might refer to as crossover voting. That is, a few Republicans voted in favor and a few Democrats voted against. But, to call it bipartisan is a bit of a stretch. The bill was massive. Many who voted for or against had a pet little provision in there that triggered their votes.

The bill was supposed to clean up Wall Street and protect consumers. I know this to be true because of the full name: The Dodd-Frank Wall Street Reform and Consumer Protection Act. Names of laws don't lie, do they? Say it ain't so.

Somehow, it became important to get Title IX in there -- the part on executive compensation. And, Senator Robert Melendez (D-NJ) managed to sneak in what regular readers know to be my personal favorite, the pay ratio provisions in Section 953(b).

I've communicated with a few people who follow Capitol Hill closely, Congressional reporters. None of them are sure how this provision actually got into the bill. They all agree that it was not debated. What happened?

Implementation of Section 953(b) will require some simple mathematics, or arithmetic if you prefer. Senator Menendez, the purported author of the section was a political science major before attending law school He was also a member of a Latin fraternity. He first entered politics at the ripe old age of 20.

I looked hard. I cannot find any evidence of Senator Menendez' mathematical prowess or of his knowledge of executive compensation. Perhaps that is why Section 953(b) is so incredibly messed up -- bad enough that I have written about it enough times to finally learn how to type the word ratio without placing an n at the end of it even though my fingers seem to prefer to type ration.

To the credit of the 535, Dodd-Frank was debated ... as a bill. But, it's tough when you have a bill that, at least in one printing, contains about 3200 pages to debate every provision. Section 953(b) escaped debate. It became part of the law.

It is bad law. Despite what the AFL-CIO says, Section 953(b) is bad law. There, I said it. Perhaps it should have been debated. Perhaps Ms. Pelosi should have said that [we] have to debate the bill so that we can put useful provisions in it. Perhaps I am dreaming.

Pay Ratio Rules are Coming

I've written about it many times. It lives in Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. It's the pay ratio requirement. If this is new to you, you can get the background on it here. The New York Times wrote about it recently and finds no evidence as to how or why Senator Menendez (D-NJ) added that section into the Act. Perhaps this site maintained by AFL-CIO was a motivating factor.

I write about this again because of the rumor mill surrounding the SEC (I know, you can't find it in the supermarket tabloids).This rumor mill tells me that the SEC will provide its first guidance on this and other [Dodd-Frank] Title IX issues next month (September 2013).

Suppose you are an employer subject to Title IX (generally an SEC registrant), what should you do and what should you look out for?

If you are in the simplest of all situations-- that is, no employees outside of the US, no part-timers, no seasonal employees, no equity compensation, no defined benefit plans and no perquisites, your job is easy. CEO compensation and that of other employees is going to look a lot like W-2. You might even have a centralized payroll system on which you can run a report and easily determine who the median-paid employee in the company is. This could be a 30-minute exercise.

Oh, you're not in that simplest of all situations? It's going to be more complicated then. You will be faced with the exciting prospect of currency conversions, actuarial present value calculations, Black-Scholes calculations, gathering of data from multiple payroll feeds, and determination of the value of other benefits on which you usually don't place a price tag.

We think that one of the reasons that the SEC has taken three years to provide rules on much of Title IX is that they have not been able to figure out what makes sense. After having received thousands of comment letters, many suggesting simplifying procedures, apparently they are close. We will see soon what the rules look like.

In the meantime, if you fall into the group of companies that has one or more of the "problem areas", you will want to see what the rules say and see how they will affect your company. When the rules are published, you can read my analysis here. It may not cover every legal detail as the ones from law firms do, but I hope that it will give you practical advice.

And, now or then, if you'd like to get a head start on how to deal with this, e-mail me and we can discuss how to handle your situation.

It's not going to be pretty, I'm afraid.

More on the Dodd-Frank Pay Ratio

I've written many times on the Dodd-Frank pay ratio rule found in Section 953(b) of that voluminous law. You can read about it here if you haven't before. Recently, and I can't tell from the online version what the date was, the Washington Post wrote on the topic. The 1104 online comments to the Washington Post article tell me that there are certainly a lot of opinions on this.

Interestingly, nobody seems to have consulted an actuary or any type of retirement consultant. Why does this matter? The most variable calculations of the lot that can go into the 953(b) pay ratio calculation are defined benefit. They can be qualified plan or nonqualified in the US and they can be executive or broad-based in other countries. Each will be different and each will use different actuarial assumptions.

Last week, the Economic Policy Institute (EPI) declared that the average chief executive officer last year made 273 times what the average employee made. Is average a mean, a median or something else? Does EPI know how the 273 was calculated? Do the values for the average employee include the same components that the CEO calculations do? I would be willing to wager a lot that the answer to the last question is no. The reason for that is that such calculations do not exist for the average worker. However, most reporters, unless of course they read my blog will never work this out.

I understand what Section 953(b) was supposed to do. Like so many other provisions of ultra-long laws, however, their intent and their drafting are often very different.

Unfortunately, we will probably have guidance soon.

Plaintiff's Bar -- The Good, The Bad, and The Ugly

Collectively, they are known as plaintiff's bar. These are the attorneys who gear their practices toward representing plaintiffs in civil litigation. As I see it, they fall into three categories:

• The group who represent plaintiffs in litigation where the plaintiffs in question have clearly been wronged. While it's not where I am going to focus here, consider, for example, the made-up case where plaintiff goes to a restaurant (think Japanese steak house) where the chefs put on a show for their diners. They toss food. They flip spatulas. I have never seen a diner get hurt in one of these situations. But, in this fictional situation, one chef decides to fling diners' food to them on razor sharp knives. One diner gets up to leave because he is frightened and just as he does, a knife flies astray and hits him blade first in the back, seriously injuring him. The restaurant's insurer says that the diner assumed a risk when he sat down at the hibachi grill. I don't have legal training, but the lay person in me thinks he needed an attorney to right this wrong.
• The group who represent plaintiffs who have probably not been wronged, but where there might be a court that will find for plaintiffs and award massive damages. As an example, consider the spate of cash balance plan lawsuits that were filed. Typically, the issue was age discrimination. Whether or not there actually was age discrimination in designs was a matter of opinion. As a group, actuaries are well-trained to opine on this issue. Being one of these actuaries and being one who knows many others, I've not personally found one yet who thinks that cash balance plans are inherently age discriminatory. But, the attorneys filing the suits know that all they need is one big win and the payoff for them will be huge. I disagree with these attorneys, but it is possible that they are right and I am wrong.
• Finally, there is the group who seek out plaintiffs to file lawsuits where there is never any thought of wrongdoing. All they are doing is hoping that defendants will think it is less expensive to settle the lawsuits than to defend them. Since the attorneys in such situations don't, in my opinion, even care if there is any wrongdoing, I view this as the worst of all situations.

Yes, I have an example for you. As regular readers of this blog know, Dodd-Frank and its older brother Sarbanes-Oxley have imposed significant requirements on issuers of proxies to disclose executive compensation. Most companies have worked hard to ensure that their disclosures are, at a minimum, adequate. A meaningful percentage of them have gone above and beyond in their disclosures providing information to shareholders beyond that which is required and providing excellent supporting rationale for their compensation decisions.

So, what's the litigation here?

A group of attorneys made the startling (well not really) discovery that if you could find a way to stop a company from holding its annual shareholder's meeting that all proverbial hell would break loose. I wrote about this here. What they claim is that disclosure of executive compensation in the proxy is inadequate for the shareholder to make an informed decision regarding say-on-pay or some other vote on which their client could weigh in.

We apologize for this brief commercial interruption before returning you to your regular program. In my profession, I work with a lot of people who do understand compensation. Many of them are also shareholders in companies so that they get to cast their votes on these matters. As part of the small group who could actually make sense of these disclosures, how many of them actually take the time to review the executive compensation disclosures in proxies? A very unscientific review of data that I did on this group (this means that I observed, asked a few people and took a guess) suggests that fewer than 10% of this group actually reviews the executive compensation disclosures carefully enough to opine on its reasonableness. Most institutional shareholders outsource the review and even the firms to whom they outsource such review are working far more from checklists than they are from hard analysis of the data.

So, there's no case, right?

That's not the point. A well-timed lawsuit can cause a company problems. Put yourself in the position of a company and decide how you would react when you learn that plaintiffs have gone to court seeking an injunction to prevent you from holding your annual shareholder's meeting (for those even less legally informed than me, this means that a court would prohibit that meeting from taking place). You are probably left with just a few options, all costly and none foolproof:

• Fight the injunction and hope you win
• Settle to make plaintiffs and their attorneys go away, so to speak
• File significantly enhanced disclosures with the SEC and provide them to shareholders on a timely enough basis

The attorneys for plaintiffs are betting that most companies will choose what's behind door number two. That is, they are betting that companies will opt to settle for an amount of money whereby those attorneys will recover their expenses plus perhaps 35%-40% of the remaining settlement. That makes it profitable litigation for those attorneys.

What should companies do?

There is no great answer, but it seems a good tact to prepare for this sort of litigation.

• Enhance your disclosures proactively. That is, make yourself a less vulnerable target. 
• Have a team internally that understands the issues and that can be mobilized to combat the opposition. This should probably be composed of internal people and have outside counsel in the loop.
• Make your disclosures convincing. Describe how you developed your practices and why they are appropriate for your company in your industry and your geography.

And, yes, there is a fourth thing that you can do that some may think is as useful as the first three: hope you don't get sued.

Suppose You Couldn't Have Your Annual Shareholder's Meeting

In 2010, Congress passed and President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) into law. Billed as a reaction to the financial crisis and abuse by the financial services industry of the public trust, Dodd-Frank has been more ... much more. Whether that more and much more has been good for the public or for anyone else is a matter of opinion. My opinion, as it is with most laws is that there were good parts, and there were less good parts. But, as is often their wont, Congress attacked a problem with far too broad-reaching a weapon.

Many of the more controversial provisions of the nearly 3000 page law lie in Title IX dealing with executive compensation and paramount among those may be the Shareholder Say on Pay (SSOP). Under these provisions, shareholders have the opportunity to weigh in, albeit in a non-binding fashion, on executive compensation proposals.

As is often the case with such provisions, plaintiff's bar views provisions such as these as an opportunity to litigate the matters. In one case, in California, in order to get a temporary injunction lifted, a company was forced to delay the implementation of their executive compensation proposal, file a revised and more detailed definitive proxy (Form 14A) and pay plaintiff's attorneys more than half a million dollars.

Suppose they hadn't done this. Then a state judge in California was precluding the company from conducting its annual meeting.

And, this was not because the executive compensation package was viewed as being outlandish, but simply over a few provisions that MAY not have been worded perfectly.

The Cynic In Me Says Watch Out For the Health Insurance Industry

Yesterday, I attended the Traveling Seminar in Atlanta put on by the Conference of Consulting Actuaries. Well, actually, I instructed for part of the day and attended for part of the day. It's a really good day of continuing education and I would highly recommend it even if I am one of the instructors. You can read more about here so that you can see why perhaps you should attend a Traveling Seminar next year.

But, that's not my point in this post. I'll get to that in a second. One of the four sessions yesterday was on health care in the US, essentially health care reform, PPACA, or whatever glorious name you might choose to attach to it. As I listened, I noticed some analogues between the Dodd-Frank Act that was intended to keep the financial services industry in check and PPACA which among other things appears intended to keep the health insurance industry in check.

So, I digress. Dodd-Frank created lots of new rules. In fact, 2800 pages or so of legislation has a tendency to do this. Among other things, it restricted some of the practices of the banking industry that lawmakers had judged were pretty nefarious. The banking industry saw that its profits, especially on the retail side were declining. So, what did the banks do? They started to put more and different fees in place. Some of them, such as the $5 per month (that was usually the number, I think) fee for using your debit card even once, faced public uproar and outrage and were repealed. But, they are finding other ways that will not be so in your face. If you ever find out about them, you won't like them, but chances are that you can't find out whether they are in your bank's disclosures or not.

So, what does that have to do with PPACA? Well, the more I listened to yesterday's presentation, the more I heard about health insurers losing some of their margins. And, many of them have shareholders to report to. And, those shareholders expect profits. And, the profits may be ready to decline. So, my message to you is that since the health insurers can't easily deal with declines in their profits, they'll have to get them back somewhere ... somehow.

So, ladies and gentlemen, I don't know how they will do it. But, hold onto your wallets. The insurers need their profits. They are in business, after all, to make money.

How Companies Can Piss Off Shareholders

I thought this might be a provocative title for a blog post: "How Companies Can Piss Off Shareholders". Frankly, if you are expecting a full discourse on all the ways this can be done, you've come to the wrong place. The seminal piece on this is undoubtedly the ISS (Institutional Shareholder Services) 2011-2012 Policy Survey Summary of Results. And, for that matter, if you really want a more thoughtful analysis of the entire survey, I would direct you to Mike Melbinger's latest blog post on this topic.

ISS would never say anything like the title of this post. And, Mike Melbinger, while I love his blog, tends to be more politically correct than yours truly. If you came here to read about this, then you are looking to see someone fall. Knives in the back are fair game. So are sucker punches below the belt. Here, the only rules are the Truth According to Me (apologies to John Irving and T.S. Garp).

So, between the strategically chosen dates of July 6 and August 26 of 2011 (after people came back from celebrating our nation's birthday and before they left to celebrate labor (the kind that you get paid for, not the kind that causes expectant mothers to scream)), ISS asked a whole bunch of questions of both investors (institutional shareholders) and issuers (companies that issue proxies to their shareholders).

Before getting into the nitty gritty, though, I feel the need to digress. Has a body as educated and seemingly intelligent as ISS not made it through 3rd grade math? In their introductory remarks, ISS notes that "[M]ore than 335 total responses were received. A total of 138 institutions responded. ... 197 corporate issuers responded ... ." I got out my handy-dandy calculator which in my case sits somewhere north of my neck (traditional calculators have a tendency in my world to hide themselves under stacks of paper, but my calculator always seems to live in about the same place, covered with some hair in strategically chosen places) and added 138 to 197. Hmm? The total was 335. It was not more than 335. Come on, ISS, this is simple stuff. Editors, though, have a problem with starting sentences with a number, so they use silly terms like more than to mean exactly.

OK, enough on that rant ...

In any event, ISS does an outstanding job with their report. Right up front, they summarize key findings. And, for the upcoming proxy season, the #1 governance issue cited by 60% of investor respondents and 61% of issuer respondents is Executive Compensation. Said differently: if a company wants to piss off its shareholders, the #1 way is to compensate its executives in a manner or amount that does not align with shareholder goals. Other top issues for shareholders were Board independence, shareholder rights, and risk oversight, in that order. For companies, the only issue other than executive compensation receiving more than a 30% vote was risk oversight.

Later on, ISS drills down (I've never used that term in writing before, but I felt the need today). Some of the findings that I found interesting were these:

• 62% of investors find it very relevant (negatively so) when executives are paid significantly higher than their peer group.
• 88% of investors find it very relevant if pay levels have increased disproportionately to the company's performance.
• While issuers generally do not feel compelled to respond to a say-on-pay vote until the dissenting vote has approached or reached 50%, nearly half (48%) of investors feel that an issuer should provide an explicit response when the no votes reach 20% or even less.

Institutional shareholders are very serious about say-on-pay. Companies that ignore this are seeing two phenomena -- contested elections of Directors and shareholder lawsuits against the Board of Directors. 

For companies that may be headed down a path of compensation that could get a lot of no votes, they need to do a lot of planning and explain their decisions up front. Right up there near the top of problematic pay practices are egregious SERPs. Sometimes, they are justifiable, and other times, ...

Caveat enditor!