The CEO Pay Ratio Rule: Navigating the Process and Answering the Questions

TRENDS & ISSUES

AUTHORS Perhaps one of the most controversial provisions under the Dodd- Frank Wall Street Reform and Consumer Protection Act of 2010 is the requirement to track and disclose the ratio between a company’s median paid employee and its CEO (often called the CEO Pay Ratio). The U.S. Treasury secretary and top financial regulators will convene and deliver a report by June outlining what they believe is, and what isn’t, working under this rule. In addition, the acting chairman of the Securities and Exchange Commission Deb Lifshey (SEC) sought additional public comments specific to the CEO Pay Managing Director Ratio, which were submitted at the end of March.

While it is possible the CEO Pay Ratio rule will “Any significant either be amended or delayed, companies should changes will still be spending some time preparing for the rule require because any significant changes will require Congressional Congressional action, which typically takes time. action, which At the time of this writing, companies should be takes time.” Sharon Podstupka operating under the assumption that the Principal requirement will go into effect for proxies filed in 2018. Whether your company has hundreds of thousands of employees spread throughout the world or is a smaller domestic business, we recommend a structured approach to ensure organized collection of data and clear presentation of the ratio.

The Basics

When adopted, Dodd-Frank simply required that companies disclose the median annual total compensation of all employees, the CEO’s annual compensation (which was already a required disclosure), and the ratio between the two. More than five years later, the SEC

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April 2017 provided a host of supplemental guidance to help I HEARD THE (BUSINESS) NEWS TODAY, interpret this requirement. Some of the most OH BOY critical points are: Even if you don’t believe that the CEO Pay Ratio . Which employees must be considered? All will ultimately be a required disclosure or that if disclosed, it’s not going to make significant employees means all employees with no waves, companies must still be prepared to exceptions for part-time, seasonal, or react. The likelihood for questions is high and temporary workers, and only limited the range of stakeholders is diverse. While the best case scenario would be very little noise exemptions for independent contractors and around the subject, that’s not a realistic overseas workers. expectation for two key reasons:

1. Pay equity issues are not going away. . When and how often is the calculation Given today’s political and business made? The median employee must generally environments, the subject of pay disparity will draw media attention like moths to a be determined once every three years, and flame. CEO pay levels will continue to can be determined any day within the last make for easy headlines and news channel three months of the fiscal year. panel commentators will have a field day. This means that your internal troops (i.e., corporate communications, public and . Which method can be used to find the investor relations, the C-suite, and board) median paid employee? Companies have must be well prepared for any possible incoming media fire about why your flexibility to choose methodology to identify the company’s CEO, and potentially the other median employee, which can actually named executives, earn exponentially more than the median employee. Remember, complicate the process. The SEC allows anything you say could make front-page companies to use statistical sampling, news. reasonable estimates, or just choose to use 2. New access to published pay data will certain pieces of compensation that are easily cause challenges. While investors may not identifiable (e.g., payroll or W-2 care much about the CEO Pay Ratio, you compensation). However, any methodology can bet that the public will. The media will continue to push the pay inequality used must be explained in the proxy and must controversy and proxy statements will have be reasonable. a new, greater level of visibility—drawing a fresh audience to the Compensation Discussion & Analysis (CD&A). This, . How is the median employee’s pay coupled with pay information websites, is reported? Once the median employee is bound to raise interest from your employees about the fairness of their own identified, the job is still not complete. That pay. To this end, human resources and employee’s pay must be recalculated as if the people managers will need to know how to employee were to be in the summary clearly defend your company’s pay practices, policies, and processes. compensation table (SCT) of a proxy statement. So, what can you do now? First, develop an inventory of anticipated questions and answers by your stakeholder group. Then, decide who . How is the CEO’s pay determined and within your organization is best suited (and can reported? Fortunately, this is the easy part. It be trained) to address them. The bottom line is that regardless of whether the CEO Pay Ratio is simply the total number reported in the SCT. falls on deaf ears or even goes away entirely, it If there are multiple CEOs, their compensation is incumbent on companies to have a response may be combined or the compensation of the strategy or risk being unprepared for the fallout. Weak responses to pay questions can easily CEO in the position on the date the median lead to negative press, misinformed employees, employee is determined may be annualized. and frustrated investors.

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. What other disclosure is required? Other than the pay of the median employee and CEO, a ratio must be reported, along with a brief explanation of how the ratio was calculated. While the rules don’t require much, we suspect companies will spend considerable effort on the message the ratio creates, and in future years, how this ratio compares to those of similar companies.

Where to Start?

Undoubtedly by this point, most companies have given at least some thought about how to gather and statistically analyze the potentially massive amount of data needed to find the median employee. Here is a summary to help streamline and simplify the process: . Identify the team and work plan. As a first step, a working group should be formed that may include—in addition to the HR team, particularly the workforce analytics and compensation professionals—individuals from the company’s legal, IT, accounting, finance, investor relations, and/or corporate communications departments. A special project manager coordinating the work and deadlines is also helpful. Outside advisers (e.g., legal, compensation consultants, public relations, statisticians, etc.) should also be retained and consulted as needed. The project manager should develop timelines and goals with specific dates for drafts, iterative, and final versions of the proxy disclosure.

. Identify the pay data sources. Next, identify where the compensation data is housed for employees throughout the company and develop a plan to centralize the data. Existing systems may need to be modified or developed to capture the necessary data. Non-U.S. jurisdictions may complicate this task.

. Determine the median employee. This is probably the most complex step and will require a judgment call in some circumstances. Factors to consider include:

 What is the company’s goal? Interestingly, we have observed that many of our clients have different goals in computing this compensation for the median employee. The initial reaction has been to use data, carve-outs, and statistical sampling in an effort to find the highest paid median employee (and thus reduce the difference between the CEO and median employee to show better alignment between the top and middle of the company). As time passed, we worked with more and more clients who preferred to have the median number be as low as possible. While at first blush it seemed counterintuitive, the rationale was well founded. These companies cared more about the employee perception of being paid more or less than the median employee. The lower the median employee’s pay, the better the employee population may feel about their own compensation. While everyone knows the CEO will make a lot more than most of the company, most employees are more concerned about how their pay compares with other employees.

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 Which employees are included? The list is very inclusive, covering all full-time, part-time, seasonal, and temporary workers employed by the company or any of its consolidated subsidiaries both in the United States and overseas. Even furloughed employees may be counted in some circumstances. It excludes independent contractors and leased employees whose pay is not determined by the company. Up to five percent of employees may be excluded in some overseas jurisdictions or due to data privacy laws. However, taking advantage of these carve-outs is not that simple, and counsel should be consulted as to additional requirements if these exemptions are utilized.

 What date will be used? Companies may choose any date within the last three months of their last completed fiscal year to determine the employee population to use to identify the median employee. Individuals who are employees on this date are included and everyone else is excluded, which may significantly affect companies, such as retailers, that hire seasonal or temporary employees. In addition, companies must choose an appropriate time period for collecting the compensation data that will determine the median employee. They do not need to use a time period that includes the date on which the employee population is determined nor is it required to use a full annual period. For example, they may use annual total compensation from a company’s prior fiscal year so long as there has not been a change in the employee population or employee compensation arrangements that would result in a significant change of pay distribution to its workforce.

 What measure of compensation will be used to rank employees? The SEC provided companies with some degree of flexibility to determine the median employee but requires what it calls a “consistently applied compensation measure” (CACM) that reasonably reflects the annual compensation of employees that can be used to identify the median employee. For example, companies may use base, bonus, or equity grants, or any combination of the three. Alternatively, they may use W-2 box three Medicare wages. There are also other discretionary considerations: the pay of those who were employed less than the full year may be annualized; cost of living adjustments are available for non-U.S. jurisdictions; and exclusions for mergers and acquisitions are possible. Companies may also use various statistical sampling methodologies to limit the population included. But bear in mind, any approach used would need to be described in the proxy, which might add further complexity to the disclosure. Similarly, whatever CACM is ultimately used must be described in the proxy and must be reasonable. It must try to include all significantly widely used elements (e.g., equity grants cannot be excluded if they are widely used). If time permits, model out different measures of pay before choosing. Once a measure is finalized, the data must be consolidated and sterilized, stripping out all identification of the actual employee as the disclosure only requires pay data, not the name or position of the median individual.

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. Determine the median employee’s compensation. Once identified, the median employee’s compensation is recalculated using the same rules used to report named executive officer (NEO) compensation in the SCT.

. Determine the CEO’s annual compensation. This amount will be taken straight from the SCT, but may be adjusted in the event that there were more than two CEOs during the year.

. Calculate the pay ratio. This is presented as a ratio in which the annual total compensation of the median employee is equal to 1 (i.e., 200:1 or 1:200) or narratively in terms of the multiple that the CEO’s annual compensation bears to the median employee amount (i.e., 200 times larger than the median employee’s annual total compensation).

. Draft the proxy narrative and develop a communication strategy. The last step is likely the most important. Decide where in the proxy statement the CEO Pay Ratio will appear and how much discussion will be provided about the methodology and meaning. While the most interested parties are likely the press and shareholders, companies must also keep in mind the impact on employees. Contemporaneous with the regulatory disclosure, companies must also consider the in-house corporate communications aspect of now providing data on the pay of the median employee.

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About the Authors

Deborah Lifshey is a managing director in the New York office, where she specializes in advising clients on compensation matters from a legal perspective including securities disclosure, taxation, corporate governance issues, negotiation contracts, and reasonableness opinion letters. She is a graduate of the Industrial and Labor Relations School at Cornell University and the University of Florida College of Law, and served as a federal clerk for the Honorable Judge Susan H. Black on the Eleventh Circuit Court of Appeals. Prior to joining Pearl Meyer, Ms. Lifshey practiced at Fried, Frank, Harris, Shriver & Jacobson, where she specialized in executive compensation, ERISA matters, and corporate transactions, and at Holland and Knight, where she specialized in employment litigation matters.

Sharon Podstupka is a principal in the New York office of Pearl Meyer. She is a key member of the firm’s Thought Leadership team and is focused on executive and broad- based employee pay communication consulting. She works closely with her clients in a wide range of industries to develop internal communications that educate and engage people in their pay programs. Ms. Podstupka also has extensive experience in developing critical shareholder communications that clearly explain pay-for-performance in the context of today’s challenging say-on-pay environment. Her key areas of expertise are communication strategy, stakeholder management, and content development.

About Pearl Meyer

Pearl Meyer is the leading advisor to boards and senior management on the alignment of executive compensation with business and leadership strategy, making pay programs a powerful catalyst for value creation and competitive advantage. Pearl Meyer’s global clients stand at the forefront of their industries and range from emerging high-growth, not-for-profit, and private companies to the Fortune 500 and FTSE 350. The firm has offices in New York, Atlanta, Boston, Charlotte, Chicago, Houston, London, Los Angeles, and San Francisco.

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