Dear Public Companies: Have Yourself a Simple Little Pay Ratio
As 2018 quickly approaches, blood pressures might be rising at public companies. Outside and in-house counsel alike are contemplating what has to be done in order to disclose the CEO pay ratio for the first time – from finalizing the calculation methodology, to planning for internal and external communications, to drafting the disclosure that will accompany the ratio. But, we would advise companies to take a deep breath and relax, as the general consensus among governance and compensation practitioners is that companies should keep the CEO pay ratio simple. This client alert briefly summarizes how experts have advised that companies focus on simplicity with respect to five pay ratio specifics:
Take advantage of the flexibility afforded by the SEC when determining your median employee: The guidance provided by the SEC on September 21, 2017 emphasizes that companies have significant flexibility under the pay ratio rules with respect to identifying their median employee. First, companies are permitted to use any “widely recognized test,” such as those required for employment law or tax purposes, in order to determine if a worker is an employee or an independent contractor under the rules. It appears that most companies will use the “tax test,” which determines if someone is an employee by asking if the company issued a W-2 to the individual. Secondly, the SEC clarified in the September guidance that companies can eliminate employees with salaries on the high and low ends from their calculations by using reasonable estimates of their compensation based on the company’s existing records. A common example given by experts is that if your company only grants equity to the most highly-compensated quartile of employees, you can exclude equity grants from your calculation of annual total compensation because the grants will not affect the identification of your median employee. The consensus is that you should focus on finding an employee who is representative of the median and whose compensation will likely remain stable in the future. Finally, we believe that the most common “consistently applied compensation measures” (CACMs) that will be used to identify the median employee are (i) base salary, (ii) base salary plus cash bonus and (iii) W-2 compensation.
Do not go overboard with your proxy disclosure: The pay ratio rules require companies to disclose their calculation methodology and any material assumptions, adjustments or estimates used to calculate the pay ratio, and there has been much discussion regarding what additional disclosure companies should provide. There appears to be a relatively clear consensus that there is no need to provide a technical analysis of how a company identified the median employee, and that it is sufficient to state, for example, that you used statistical sampling. Companies should consider providing context for the pay ratio if the company expects to be an extreme outlier among its peers or there are nuances about the company’s business that investors need to understand. A common example given by experts is that if your company hired a new CEO in 2017 who received a large, one-time recruitment equity grant that inflated his or her compensation, you should note this. In this case, you could add a supplemental ratio and present, for example, a ratio based on the CEO’s compensation excluding this equity grant. However, companies should resist the urge to explain too much, as you do not want to appear defensive, create an issue where none exists or become a disclosure outlier.
Institutional Shareholder Services (ISS) issued a position paper on October 6, 2017 advising companies to focus on their narrative disclosures and consider comparing their pay ratios to those of their peers (for example, by explaining that their ratio might appear high due to significant use of part-time labor). A number of practitioners and compensation consultants have disagreed with this advice, arguing that companies who include too much disclosure regarding their strategic decisions in an effort to make a comparison to their peers might face negative reactions from their employees. These experts point to the pay ratio adopting release in which the SEC states that “we believe the final pay ratio rule should be designed to allow shareholders to better understand and assess a particular registrant’s compensation practices and pay ratio disclosures rather than to facilitate a comparison of this information from one registrant to another.” Finally, the SEC adopted new C&DI 128C.06 in September that permits companies to say that the ratio is a “reasonable estimate calculated in a manner consistent with Item 402(u),” and the consensus is that all companies should include this disclosure. Companies should also state that the pay ratio is a disclosure required by the SEC and, because the rules allow for the use of assumptions and estimates, the ratio may not be comparable among companies.
Include the pay ratio disclosure after the compensation tables: This disclosure should not appear in the Compensation Discussion and Analysis (CD&A) because the company’s compensation committee presumably did not take the pay ratio into account when determining the named executive officers’ compensation. We agree that the pay ratio should not be subject to the compensation committee report certification requirements and expect that the most popular location for the ratio will be after the compensation tables. Some companies also plan to include the disclosure immediately following the compensation committee report and before the compensation tables. Although the rules do not require companies to include a separate heading for the pay ratio disclosure, most companies are expected to do so using “Required CEO Pay Ratio Disclosure” or “Pay Ratio Disclosure.” This heading will appear in the table of contents for the proxy statement, but most companies will not include the ratio itself in the proxy statement summary, if a summary is used. Including the pay ratio after the CD&A or the compensation tables will permit companies to cross reference information from the CD&A, which could be useful when explaining your CEO’s pay or elaborating on any anomalies in your compensation program for the year. Companies should include a brief overview of their compensation philosophy and any highlights from the CD&A in the pay ratio disclosure in case readers go directly to the pay ratio disclosure.
Preparing FAQs will likely be sufficient employee communication: Experts have advocated for a wide range of employee communications – from all-employee videos, to small team meetings, to just preparing FAQs. A consensus appears to be forming around preparing management and company leaders to answer questions from employees, usually in the form of providing them with FAQs and ensuring that they can explain to employees what the pay ratio is, why the company is disclosing it and how it was calculated. While some companies will be proactive and educate employees about the pay ratio before it is published in the proxy statement, others have countered that this approach might encourage people who otherwise might not have looked at the ratio to do so. Even companies who decide not to proactively communicate with their employees before the pay ratio is disclosed should go ahead and plan how they will respond to questions and comments from social activists, investors and the media, as well as employees. The consensus is that companies should respond by explaining their own methodology and ratio, not by comparing their ratio to those at other companies.
Do not worry if your pay ratio is above the industry median presented by ISS: In its position paper issued on October 6, 2017, ISS presented an “outside-in look at pay ratios” by calculating median CEO pay as a multiple of average employee earnings by industry. ISS used data on average employee earnings from the U.S. Bureau of Labor Statistics (BLS) and data on CEO pay for Russell 3000 companies. The “Food & Staples Retailing” industry had the highest CEO pay multiple of 143, followed by “Consumer Services” with 122 and “Food Beverage & Tobacco” with 113. The “Banks” industry had the lowest multiple of 15. ISS noted that the size of the company had a significant impact on the CEO pay multiple, as the median CEO pay multiple of S&P 500 companies was five times the median CEO pay multiple of Russell 3000 companies, excluding S&P 1500 companies. At a national compensation conference in October 2017, the sentiment was for companies to ignore the ISS figures, as many expect the compensation of median employees to average between $40,000 and $50,000 and the pay ratios to average between 250:1 and 300:1.
The difference between the ISS and practitioner projections is likely due to the following: ISS used the mean of annual employee earnings, which is higher than the median; the BLS statistics on average earnings include the CEO’s compensation in the employee data set; the BLS statistics are not seasonally adjusted and only include U.S. employees; and the BLS statistics do not include non-cash benefits, so ISS assumed that wages are only 69.6% of employee compensation. At the national compensation conference mentioned above, practitioners noted that two voluntarily-disclosed pay ratios of 275:1 and 347:1 would likely be more indicative of average pay ratios in 2018. Additionally, the Economic Policy Institute published a report on July 20, 2017 entitled “CEO pay remains high relative to the pay of typical workers and high-wage earners”, disclosing that the average CEO pay multiple at the top 350 companies by revenue in 2015 was 219.7, decreasing from 411.3 in 2000. The consensus is that the CEO labor market remains constricted and that the primary concern of companies should be recruiting and retaining the talent necessary for their companies to succeed, not how compensating a potential candidate might affect the company’s CEO pay ratio.