On August 5, 2015, the Securities and Exchange Commission (“SEC”) adopted rules, as directed by Congress in Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Section 953(b)”), to require disclosure of the median of the annual total compensation of all employees of a registrant, excluding the Chief Executive Officer (the “CEO”), the annual total compensation of the registrant’s CEO, and the ratio of those two amounts (the “Rules”).
In enacting Section 953(b), Congress chose not to divulge the purpose or objectives of the mandated disclosure. In adopting the Rules, the SEC labored mightily to fill that hole,stating in the adopting release (Securities Act Release No. 33-9877; Securities Exchange Act Release No. 34-75610; the “Release”) that “we believe Section 953(b) was intended to provide shareholders with a company-specific metric that can assist in their evaluation of a registrant’s executive compensation practices . . .,” referring to “Congress’s apparent goal of giving shareholders additional executive compensation information to enhance the shareholder engagement envisioned by” the say-on-pay rules, and referring to “what we perceive to be the purpose and intended benefits of” the disclosure required by Section 953(b). The SEC said that its belief regarding Congress’s intent was informed not only by the context of Section 953(b), but by comments the SEC received in response to the earlier version of the Rules that it proposed in September 2013 (long after the passage of Section 953(b)).
The SEC Commissioners voted 3-2 in favor of adopting the Rules. Dissenting Commissioner Daniel M. Gallagher challenged the majority’s expressed viewpoint on the purposes of Section 953(b) and the Rules, observing that “the purpose of this rule is not to inform a reasonable investor’s voting or investment decision,” but to “address . . . perceived income inequality.” He noted that this objective was beyond “the province of the securities laws or the Commission.” Similarly, Commissioner Michael S. Piwowar stated that Section 953(b) “has nothing to do with protecting investors, ensuring fair, orderly, and efficient markets, or facilitating capital formation,” and that “the pay ratio disclosure is a blatant attempt to limit executive compensation.” Both dissenting Commissioners nonetheless thanked the SEC’s staff for working assiduously to carry out the task imposed on it by Congress.
Legislation to repeal Section 953(b) has been introduced in Congress, and litigation challenges to Section 953(b) and the Rules are widely anticipated. In a rare second dissent issued on August 7, 2015, Commissioner Piwowar essentially outlined several legal arguments that future litigants might raise to challenge the Rules.
Unless and until the legislation and rules are repealed or overturned, however, registrants will need to comply with the Rules. We set forth below a brief summary of how the Rules work, followed by observations about their cited benefits and costs, registrants’ disclosure options, and what may be next.
How The Rules Work
The Rules amend Regulation S-K by adding a new Item 402(u) to join the existing executive compensation disclosure rules. This new Item will require a covered registrant to disclose:
- The median of the annual total compensation of all its employees, except the CEO;
- The annual total compensation of its CEO; and
- The ratio of those two amounts.
These new disclosures may appear innocuous at first glance, but a closer look reveals that they can be rife with toilsome details that will likely require registrants to implement costly administrative measures to ensure compliance.
Determining the Median Employee. In order to disclose the median annual total compensation of all of its employees, a registrant must first determine who represents its “median employee” (i.e., the individual employee whose compensation is at the median level of all employees, excluding the CEO). In determining its median employee, a registrant must generally account for all individuals that it (or any of its consolidated subsidiaries) employs. This includes every full-time, part-time, seasonal and temporary worker—whether employed in or outside the United States.
However, the Rules provide two exceptions that allow a registrant to exclude certain non-U.S. employees in selecting its median employee. First, a registrant may exclude non-U.S. employees employed in jurisdictions where obtaining the necessary compensation information would violate local data privacy laws, subject to rigorous requirements regarding attempted compliance and for demonstrating that a privacy law violation would necessarily occur. Second, a registrant may rely on a de minimis exemption, which allows it to exclude up to 5 percent of its non-U.S. employees. Any non-U.S. employees excluded under the data privacy exemption will count against the number of employees that may be excluded under the de minimis exemption. If it excludes any non-U.S. employee from a particular jurisdiction under either exemption, then that registrant must exclude all its non-U.S. employees from that same jurisdiction.
Additionally, a registrant may omit any individuals who became employees as a result of a business combination or acquisition during the fiscal year reported on, so long as the registrant identifies the acquired business and discloses the approximate number of new employees. Lastly, a registrant is not required to include independent contractors or persons employed by and “leased” from an unaffiliated third party.
The Rules allow for some flexibility in determining the set of employees from which a registrant would identify its median employee. A registrant may use its total employee population, a statistical sampling of that population, or other reasonable methods. Registrants will also have flexibility in determining the median compensation level. For example, a registrant could identify its median employee by using any compensation measure that is consistently applied to all of its employees (e.g., salary and wage information from its payroll or tax records), instead of having to calculate the “annual total compensation” for each employee. Registrants may also make a cost-of-living adjustment to the compensation of employees in jurisdictions other than the jurisdiction in which the CEO resides so that each employee’s compensation is adjusted to the cost of living in the CEO’s jurisdiction. Additionally, registrants may annualize the total compensation for permanent employees who did not work for the entire year (e.g., new hires). However, registrants are prohibited from making full-time equivalent adjustments for part-time employees or annualizing the compensation of temporary or seasonal workers.
A registrant may peg its median employee determination to any date within the last three months of its last completed fiscal year. While a registrant must disclose the determination date that it selected, there is no requirement to explain why it selected that date. But if that determination date changes from the prior year, the registrant must explain briefly the reason for the change.
Identifying the median employee can be a tedious task. But fortunately for a registrant, it needs to make this determination only once every three years, unless there has been a change in its employee population or compensation arrangements that it reasonably believes would result in a significant change to its pay ratio.
Calculating Annual Total Compensation. Registrants must use the existing executive compensation disclosure rules in calculating the "total compensation" for the last completed fiscal year for both its median employee and CEO. Registrants may use reasonable estimates when calculating any elements of compensation for the median employee. If a registrant has multiple CEOs in a fiscal year, it may either aggregate the compensation paid to each CEO during that year or annualize the compensation paid to the CEO who served on the date used to identify the median employee.
Presenting the Information. The Rules allow registrants to present the pay ratio numerically, with 1 representing the median employee’s pay (e.g., “X to 1” or “X:1”), or narratively (“The annual total compensation of our CEO is X times the median employee pay”), but registrants may not express the pay ratio as a fraction with 1 representing the CEO’s pay.
Registrants may supplement the pay ratio with additional information, such as a narrative discussion or additional ratios, but there is no requirement to do so. Aside from the instruction that “[a]ny additional information shall be clearly identified, not misleading, and not presented with greater prominence than the required ratio,” the Rules do not provide guidance with respect to this supplemental information.
The Rules also require a registrant to describe briefly the various methods, material assumptions, adjustments, and estimates—many of which are described above—that it used in explaining or arriving at its pay ratio and the underlying compensation amounts.
Scope and Timing of Compliance
Affected Filings. A registrant must disclose the pay ratio information in each filing that requires the executive compensation information called for under Item 402 of Regulation S-K. These filings include:
- Registration statements;
- Proxy and information statements; and
- Annual reports.
Registrants will not need to include the pay ratio information in any filings that do not require executive compensation disclosures (e.g., current and quarterly reports).
Timing. Registrants will be required to make these new disclosures for their first fiscal year beginning on or after January 1, 2017. For example, a registrant whose fiscal year is the calendar year would be required to disclose its pay ratio for the first time in its Form 10-K filing for its 2017 fiscal year or in its proxy statement for its 2018 annual meeting.
Exempt Companies. The Rules apply only to those registrants that are required to provide executive compensation disclosures under Item 402(c)(2)(x) of Regulation S-K. Accordingly, the Rules do not apply to:
- Smaller reporting companies;
- Foreign private issuers;
- U.S.-Canadian Multijurisdictional Disclosure System filers;
- Emerging growth companies; and
- Registered investment companies.
Smaller reporting companies and emerging growth companies graduating from that status generally must begin reporting for the first full fiscal year after the fiscal year in which their status changed.
Cited Benefits and Costs
The SEC enumerated in the Release a number of perceived benefits of the Rules (several of which would appear to validate the dissenting Commissioners’ observations regarding the actual purpose of Section 953(b) and the Rules):
- They provide “new data points” that “shareholders may find relevant and useful when exercising their [say-on-pay] voting rights . . . further facilitating shareholder engagement in executive compensation decisions”;
- Congress directed the SEC to promulgate the Rules and “[t]hus . . . it [is] reasonable to rely on Congress’s determination that the rule will produce benefits for shareholders” (i.e., the Rules are beneficial because Congress said so);
- The Rules will “assist investors in their ability to evaluate the [C]EO’s compensation in the context of the registrant’s overall business . . . .”;
- The mandated disclosure “could provide insight into the effectiveness of board oversight and sound board governance”;
- Some “commenters noted that they incorporate social and governance issues, like pay equity, as part of their investment decisions”; and
- As “ancillary benefits that may arise” (as identified by commenters),
- The disclosure “could offset an upward bias in executive compensation resulting from . . . benchmarking” CEO pay against the pay of other CEOs;
- The pay comparison could be used by shareholders to “approximate employee morale and/or productivity” or “analyzed as a measure of a . . . registrant’s approach to managing human capital”;
- The disclosure could reveal “large pay disparities within a corporation” that “contribute to an unethical culture . . . . " (citing one commentator); and
- The information “may be used to address a broader policy concern relating to income inequality and income mobility.”
The SEC did not, anywhere in the 294 pages of the Release, assert a belief that the information required by Section 953(b) and the Rules is material to a reasonable investor for purposes of making investment or voting decisions.
The SEC’s enumeration of the benefits of imposing the Rules is followed by its analysis of the Rules’ costs. The SEC concluded that the aggregate initial compliance costs for registrants would be approximately $1.3 billion, or an average of approximately $368,159 per covered registrant. Ongoing compliance costs were estimated at an aggregate of approximately $526 million per year, or an average of approximately $148,000 per covered registrant.
With respect to unquantified and indirect costs, the SEC stated that “it is unclear whether the final rule would impact the capital formation of U.S. capital markets in a significant way.” The SEC cited as other possible indirect costs:
- A competitive disadvantage for registrants covered by the Rules relative to registrants not covered by the Rules and non-registrants;
- Competitive compliance cost disadvantages among registrants covered by the Rules depending on their relative size, business type, and level of integration of payroll and benefits systems;
- Competitive disadvantages in hiring or retaining a CEO if the Rules result in pressure to reduce CEO pay;
- Incremental external costs, including adverse effects on sales, brand damage, and increased public relations costs; and
- Registrants possibly altering their pay or workforce structures to reduce their pay ratios in ways that affect segments of their workforces adversely, or curtailing expansion of business operations into lower-cost geographies.
While the SEC acknowledged that these costs could arise, it stated that it “cannot quantify them and lack[s] sufficient data to analyze them.”
Registrants' Disclosure Options
The scope of disclosure required by the Rules, as distinct from the effort and cost necessary to produce it, is limited and relatively straightforward, as described above. The Rules, however, explicitly permit registrants to “present additional information, including additional ratios, to supplement the required ratio.” The Rules require any such information to be “clearly identified, not misleading, and not presented with greater prominence than the required ratio.”
We anticipate that some registrants may disclose only the pay ratio and related required methodology descriptions, with no explanation of what the ratio may or may not signify, whether because they believe the disclosure is unimportant or for other reasons. There may be registrants at the other end of the spectrum that determine that other ratios or descriptive information are needed, to explain, justify or defend what they fear would otherwise be perceived as an inappropriate ratio. Still other registrants may attempt to explain the significance, for any rational comparative pay analysis, of various types of information that the Rules do not require – for example, fundamental concepts of the sources of value, or the link between the value created by the executive’s or median employee’s discharge of his or her respective responsibilities and the amount of compensation paid to the executive or that employee, respectively. (With perhaps ironic significance, the Rules admonish registrants not to disclose any personally identifiable information about the median employee, which may in many cases preclude or greatly complicate any such discussion.)
Assuming that the Rules remain effective, the variation in disclosures will likely prove interesting, as will the outcome of challenges to disclosures beyond those explicitly required.
What May Be Next
We have referred above to legislation introduced in Congress to repeal Section 953(b) and to possible litigation challenges to Section 953(b) and the Rules. If the Rules remain effective, we anticipate litigation challenging boards on the pay ratios disclosed, the methods of determining those ratios, and the pay ratio disclosures made by registrants. In this context, unlike the legislation and rules adopted for say-on-pay disclosure and voting, there is no safe harbor provision in Section 953(b) or the Rules explicitly negating any implication that the Rules impose additions to or other changes in the fiduciary duties of covered registrants or their boards of directors.
If the Rules remain effective, there also would be little logical impediment to demands for similarly targeted disclosure that lacks demonstrable materiality for rational investors making voting and investment decisions. But perhaps we should not borrow trouble; enough seems to come along on its own.