Dodd-Frank Pay Ratio Final Regulations
Written By Brad Smith
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was enacted in 2010 and was intended to address shareholder rights and executive compensation practices. The Securities and Exchange Commission (SEC) was directed as part of the Dodd-Frank Act to put in place a requirement that public companies disclose:
• median annual total compensation of all employees, except the CEO;
• annual total compensation of the CEO; and
• the ratio of the median total compensation of all employees to the annual total compensation of the CEO.
On August 5, 2015, five years after the Dodd-Frank Act took effect, the SEC issued a final rule to establish the standards for compliance with the executive pay ratio requirements.
Proxy statements have required the disclosure of the top five paid executives, but there was no requirement on the disclosure of the median workers' pay and/or how such pay compares to the executives. This may sound like an easy modification to the proxy statement, but it is not as easy as you may think.
There were questions which needed to be addressed by the SEC:
First, who to include in the population of "all employees?" This was an issue for a number of reasons including issues related to:
• international employees often paid at lower rates due to cost-of-living and currency differences;
• inclusion of part-time employees in the median calculation; and
• inclusion of workers who did not work for the entire year (and thus didn't have a full year of wages).
Second, how should the "employee" and "chief executive officer" pay be valued? There are standard/cost-of-living differences within the United States and abroad to take into account. In addition, executives often have complex compensation agreements where compensation may be earned, but not paid, etc. A determination has to be made as to what should be included.
The process to turn Congress' mandate into SEC requirements was a progression that had three components: proposed rules, a comment period and the final requirements.
The Pay Ratio proposed rules were intentionally vague; it was intended to be a directive. The SEC did not prescribe a one-size-fits-all catalogue of required disclosures. Instead, the SEC proposed rules requiring the disclosure of the data points that Congress desired and provided corporations the opportunity to make additional disclosures to assist in providing context for the pay ratio data points.
Elements of the proposed rule which are still in place in the final rules include:
1. There would be no prescribed way to determine the total compensation of the median employee. In determining the median employee, a corporation could analyze their entire population, use statistical sampling or any other reasonable method.
2. After the median employee is determined, the corporation must calculate that employee's "Annual Total Compensation." Annual Total Compensation is defined to be the total compensation for the last completed fiscal year.
3. The term employee would include any full-time, part-time, seasonal or temporary employee at any given time. Full-time equivalent adjustments for these employees would not be permitted.
4. A permanent employee who was hired during the year may have his/her total compensation annualized.
Comment Period for the Proposed Rules
Since the proposed rules were introduced in September 2013, the SEC received almost 3,000 comment letters. The SEC referred to the comments several times throughout its release of the final rules and made several adjustments which were a direct result of the comments. The majority of the comments fall under three general concepts:
1. There is the question of whether the disclosures really provide anything that helps investors make investment decisions.
2. There is a significant cost to implement the required disclosures (estimated at over $1B in total for corporations required to disclose such information).
3. The flexibility in the application of the proposed rules, could lead to manipulation.
Changes to the Proposed Rule as a Result of the Comments
1. Two optional exemptions were provided for non-U.S. employees:
a. If foreign data privacy laws do not permit such disclosure, those non-U.S. employees could be excluded.
b. If non-U.S. employees accounted for less than 5% or less of all employees, the corporation could exclude all non-U.S. employees. If there is any exclusion, all non-U.S. employees must be excluded.
If a corporation's population of employees consists of over 5% non-U.S. employees, the corporation may exclude up to 5% of their foreign employees. However, if an employee from a certain jurisdiction was excluded from the analysis, all of the employees from that jurisdiction must be excluded.
Below is a table illustrating how the exemptions may be implemented:
8% of employees are Non-U.S. employees who work from jurisdictions who have privacy laws not allowing disclosure of such information
Yes, exclude all 8%
8% of employees are Non-U.S. with none of them residing in jurisdictions which have privacy laws
Yes, exclude up to 5%
8% of employees are Non-U.S. with 4% residing in jurisdictions which have privacy laws and 4% in jurisdictions with no such restrictions
Yes, all 4%
Yes, up to 1%
Disclosures required when a Non-U.S. exemption is utilized:
• Particular jurisdictions being excluded from the analysis
• Approximate number of employees excluded from each jurisdiction
• The total number of its employees prior to utilizing any exemptions
• The total number of its employees used in the analysis after any exemptions
2. Cost-of-Living Adjustments
The median employees' total compensation may be adjusted to reflect the cost-of-living in the CEO's jurisdiction. Consistency must be used in the application of cost-of-living adjustments.
• If a cost-of-living adjustment is made to determine the median employee, it must be done uniformly across the entire organization for all employees who reside outside the CEO's jurisdiction.
• If a cost-of-living adjustment is made to determine the median employee then the same methodology must be used in disclosing the median employees' total compensation.
A disclosure is required if a cost-of-living adjustment is used, briefly describing:
• The cost-of-living adjustment used in determining the median employee;
• The cost-of-living adjustment used in determining the median employees' total compensation, including the measure used as the basis for the cost-of-living adjustment; and
• The median employees' total compensation without the cost-of-living adjustment and the ratio relative to the CEO's pay of that figure.
3. Employees of Consolidated Subsidiaries
All employees who are employed by subsidiaries which are consolidated in the registrants' financial statements should be included in the calculation of the median employee.
4. Employed on any date within three months of the last completed fiscal year
The measurement date used to determine the median employee must be within the last three months of the end of the fiscal year. Whatever date is used to determine the median employee must be disclosed. The measurement date must be consistent in subsequent years or an additional disclosure is required to provide an explanation for reasoning for the change in measurement date.
5. Identifying the median employee once every three years
In an attempt to curb the cost of the analysis involved in calculating the median employee, the SEC's final rule allows corporations to make that determination only once every three years provided there have not been significant changes in their employee population or employee compensation arrangements that would significantly impact the pay ratio disclosure. If there is such a change the median employee must be re-identified.
The median employee would be identified in year one and then that employee or an employee in a similar position would be used for the next two years. The registrant must calculate that employee who has been identified as the median employee's total compensation on an annual basis.
6. Initial compliance date
The pay ratio requirement does not apply to emerging growth companies, smaller reporting companies, or foreign private issuers. The disclosure must be made for any fiscal year beginning on or after January 1, 2017. For calendar year reporting companies, the first pay ratio disclosure will not be required until the proxy filed in 2018 – more than two years away.
7. Transition period for new registrants
There is no delay in reporting requirements for newly registered corporations.
8. Additional transition periods
Registrants which are no longer considered smaller reporting entities or emerging growth companies must provide their pay ratio disclosure in the first fiscal year they cease that status. Omission of newly acquired employees (through acquisition) is allowed in the first fiscal year following the acquisition.
• The rules have sparked a lot of debate among lawmakers, trade associations, union leaders, corporate leaders, politicians and other interested parties. Since the proposed release, there has even been a substantial amount of dissension among the SEC rule makers themselves.
• Central to the debate is the value and impact of the disclosed information to investors. Our view is that investors themselves will not be too concerned about pay ratio, similar to the lack of concern about the magnitude of executive pay expressed in the significant say on pay approval rates.
• We believe the pay ratio disclosure was promulgated by a Congress hoping to shine a light on the issue of pay equality with the objective of reigning in executive pay, not necessarily providing investors with relevant data.
• In its release, the SEC acknowledged "we do not believe that precise conformity or comparability of the pay ratio across companies is necessarily achievable given the variety of factors that could cause the ratio to differ." Yet, given the social objectives for those that pushed for the pay ratio disclosure, comparing the ratio among the issuers is precisely the objective. Pressure will certainly be brought to bear on those Boards and CEOs with high ratios. Whether this can help with the issue of pay equality is not clear. Could you imagine a time when CEO pay is managed within acceptable ranges of pay ratio?
What should issuers do now?
Although the first required pay ratio disclosure is more than two years away, it is likely that issuers will encounter difficulties in preparing for the disclosure. Accordingly, issuers should do the following:
• Explain to the compensation committee that these rules are now final and note when they will be effective.
• Identify and test possible methodologies for calculating the pay ratio and prepare a preliminary estimate of the pay ratio.
• Determine whether data privacy rules will prevent sharing the employee information necessary to calculate and disclose the pay ratio so that there is sufficient time to get an exemption or other relief or obtain employee consent, if appropriate, or an opinion of counsel, if necessary.
• Update systems and develop processes to collect the required information.