Finalized Rules for Pay-Ratio Disclosure

Public companies will soon have another disclosure to add to their proxies, annual reports and registration statements. On August 5, a divided Securities and Exchange Commission (SEC) finalized its rules for so-called pay-ratio disclosure under the Dodd-Frank Act. The controversial requirement calls for public companies to calculate and disclose a ratio comparing their chief executive’s compensation to the median compensation for other employees.

Debating the pros and cons

The SEC adopted the rule in Release No. 33-9877, Pay Ratio Disclosure, nearly two years after the commission proposed the disclosure requirement. It’s just one of several executive compensation requirements mandated by the 2010 Wall Street reform law. The SEC has mulled implementation of the disclosure requirement after receiving more than 100,000 response letters, both for and against it. 

Proponents of pay-ratio disclosure say the rule will help inform shareholders in say-on-pay votes. Backers of the measure, including investors and labor union groups, see it as a step toward reducing outsized CEO pay packages. They believe that high pay disparities can hurt employee morale and productivity, as well as having a negative effect on a company’s financial performance.

On the other side of the fence are public company executives who contend that the disclosure is merely a distraction from more pressing work. They see it as costly for companies to implement, while providing no real benefit to investors. They argue that details about public company executive compensation are already disclosed in public companies’ proxy statements. So the pay ratio provides no new insight into what executives are making. 

In addition, business groups complained that including foreign workers in pay ratio computations would be costly and misleading. Most companies don’t have payroll systems that track information globally. And differences in the cost of living, compensation practices and foreign exchange rates from country to country could unfairly skew the pay ratio. Some companies also wanted to exclude part-time employees from the ratio, because the comparison between their compensation and that of a CEO who works full time would inevitably be misleading.

Finding a middle ground

The final rule passed with a narrow 3-2 vote. In a nod to those who oppose the pay-ratio disclosure requirement, the final rule allows companies to exclude up to 5% of their non-U.S. workers. Companies are also permitted to adjust the ratio to account for differences in the cost of living between regions, although they must present that data along with the non-adjusted version. The SEC also exempted registered investment companies and smaller filers, including “emerging growth companies” under the Jumpstart Our Business Startups Act of 2012.

To comply with the pay-ratio disclosure requirement, public companies will have to calculate the median compensation of their workforce and present the number in a ratio comparing it to the CEO’s total compensation. In 2018, they will be first required to include the ratio in proxies, annual reports, and registration statements, using 2017 compensation data.

However, in response to complaints about calculating the pay ratio, the SEC will allow companies some flexibility in producing the data. The new rule doesn’t prescribe a specific method for calculating median employee compensation. Instead, public companies can choose a process that fits their structure and compensation programs, as long as they disclose the methodology used to determine the median employee pay and the estimates used in calculating the pay ratio. 

For example, a large company could use a statistically representative sample of its workforce rather than the entire population. Companies also won’t be required to calculate the exact compensation when identifying the median. Rather, a company can apply any “consistently used compensation measure,” such as the amounts reported in payroll or tax records. Companies will still have to calculate annual total compensation, but the SEC will let them use “reasonable estimates” for the calculation. 

Could the pay-ratio disclosure backfire?

Public companies have long been required to disclose CEO compensation. But the median compensation of rank-and-file employees is new information that companies haven’t been required to disclose in the past. Some analysts have hypothesized that disclosing the pay ratio could have the opposite of its intended effect: Instead of raising a red flag when the ratio is too high and pressuring companies to limit executive compensation, stakeholders could be alarmed when the ratio is too low. 

High median employee compensation has the effect of decreasing the executive pay ratio. A low pay ratio could signal to investors that the company is spending too much on rank-and-file employee compensation and isn’t effectively controlling its costs. Stakeholders may be less shocked by high CEO compensation than by weak cost controls on a larger scale. Such inefficiencies could be grounds for CEO termination, thereby providing a disincentive to pay rank-and-file employees more.

Waiting for the last Dodd-Frank rules

The pay-ratio disclosure is among the final pieces of the SEC’s rulemaking responsibilities under Dodd-Frank. According to the SEC’s website, the agency still needs to complete 12 rules for the swaps market, five other executive compensation rules and seven other rules covering a range of reforms. 

Contact your accounting and auditing advisor for the latest developments, including any lawsuits from public companies or congressional actions to repeal this controversial provision of the Dodd-Frank Act. Opponents of executive pay disclosures are unlikely to accept these new rules without a fight.

© 2015