2018 marked the first year of the implementation of the Securities and Exchange Commission’s pay ratio disclosure rule. The rule, which stemmed from the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, requires corporations to calculate and disclose the ratio of their CEO’s total annual compensation to that of their company’s median employee. But while the public gained new insights into corporate compensation, corporate leaders and their teams received a different type of education: how to navigate the SEC’s various guidelines and their organizations’ own payroll systems to successfully adhere to the rule.
“The SEC didn’t lay out an exact template,” explains Executive Compensation & Benefits partner David D’Alessandro. “Companies had to spend a fair amount of time just getting involved in the technicalities of the rule and had to make a host of decisions on how to implement it.”
Both D’Alessandro and Sarah Fortt, a senior associate in Mergers & Acquisitions and Capital Markets, have extensively advised clients on the pay ratio rule. They agree that for corporations, the most labor-intensive aspect of its implementation has been identifying the median employee whose total annual compensation is included in the ratio. For structurally complex firms, the process has been especially challenging.
“Some companies, if all their employees are U.S.-based and they’re all paid on the same payroll system, had a far simpler process to put in place to identify the median employee,” Fortt says. “On the other end of the spectrum, I have clients who had employees around the world. They had employees in subsidiary organizations — some of which were consolidated, some of which were not. They had employees that were paid in payroll systems that were not automated, so it was difficult to collect that data and send it across the world.”
As companies methodically worked to identify median employees and then calculate the ratio, a few key takeaways emerged:
The SEC asked companies to identify their median employees as of a date within the last quarter of their last fiscal year, but didn’t specify an exact date. Critics worried that companies would try to exploit this flexibility in order to lower their ratios — they could, for instance, choose a date right before the hiring of a large number of low-paid, seasonal workers.
But D’Alessandro has found that his clients focused on picking whichever date proved most conducive for their data gathering and measurement efforts. Some preferred to wait until December 31, when they had W2 tax forms with compensation data at their disposal. Others wanted to use base salary information at the very beginning of the quarter to give themselves as much time as possible to crunch the numbers. Companies’ decisions “were really defined by what date was going to be easiest for producing what the SEC is looking for,” he says.
Reasonable assumptions are key.
In its guidance to companies, the SEC stressed the importance of having a complete picture of employee compensation, but also allowed companies to make reasonable assumptions and estimates when comparing employee earnings — a source of relief for companies with multiple payroll systems and incentive pay structures. “A corporation may have different approaches to compensation across different companies or different business units,” Fortt explains. “So they may build in an assumption that most of the people at a given level were getting similar compensation over a particular range of time. They may build that assumption into their model.”
Some shortcuts don’t work.
While making informed assumptions proved invaluable for companies during their compensation calculations, certain shortcuts and exemptions offered by the SEC were less helpful. The commission, for instance, said that companies didn’t have to use compensation data from employees based in foreign countries if those jurisdictions’ data privacy regulations proved prohibitive.
Taking advantage of that exemption, however, meant obtaining a legal opinion from foreign counsel confirming that the privacy regulations did, in fact, apply to the data in question and to how it was being used. “For the most part, it’s not quite as black and white,” says D’Alessandro. Companies often determined that incorporating foreign employee data into their analyses was different from disclosing foreign employees’ compensation outright. The former, they concluded, wouldn’t run afoul of privacy laws. In the end, for many it made more sense to simply include foreign employees’ compensation.
With commentary, less is more.
The SEC allowed companies to provide commentary explaining their final results, an option that might have been tempting for firms determined to give context to investors concerned that ratios were too high (or too low). But D’Alessandro says most of his clients decided to let their results speak for themselves this year. Their ratios, he notes, were generally much lower than those projected by the media.
“A lot of clients said, ‘The press thought these numbers were going to be bigger, but we did what the SEC asked so let’s just roll it out,'” he says. But he adds that companies may provide more commentary in the future. “If the public wants more explanation, companies will listen to that.”
For the next two years, complying with the pay ratio rule will prove simpler for most companies because the SEC allows them (with a few exceptions) to use the same median employee for three years instead of requiring that they undertake the onerous process of identifying one every year. What remains uncertain, however, is how the pay ratio disclosures will influence corporate employees, investors and investor advisory firms. Employees, for instance, could be motivated to request higher salaries or more incentive pay, while advisory firms may incorporate the ratios into the analysis they use to make proxy vote recommendations.
Perhaps the biggest uncertainty? Whether the rule will ultimately serve to reign in CEO pay, as some of its proponents predicted.
“My experience with compensation rules over the last few decades has been that you never know what their long-term effect is going to be,” D’Alessandro says.