3 Steps for companies to get ready for SEC’s new CEO compensation disclosure rule

Photo courtesy of teralaser on Flickr

Photo courtesy of teralaser on Flickr

Rob Swystun, Pristine Advisers

Not everyone believes the Securities and Exchange Commission’s latest rule that requires companies to disclose the pay ratio between their chief executive officer and their median employee will be useful.

The rule, mandated under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), is meant to provide investors with more information when performing Say on Pay votes.

However, CEO and founder of executive compensation and performance advisory firm Farient Advisors,  Robin Ferracone, says in a blog post on Forbes that she and her colleagues don’t believe this new disclosure rule will add any value for investors for two reasons:

  • There are too many variables in any given business’ workforce, meaning they are not comparable across companies.
  • A year-over-year change in the ratio is likely going to be more sensitive to changes in CEO compensation rather than median employee compensation and changes to CEO compensation can already be obtained through other disclosures.

Not even built-in flexibility from the SEC, meant to make it easier for companies to calculate everything, will make the new disclosure rule any better. Ferracone outlines the flexibility the SEC added to the rule as:

  • The ability to exclude up to 5% of non-U.S. employees when determining the median employee;
  • The ability to exclude non-U.S. employees when foreign data privacy laws would stop companies from obtaining the necessary information for calculating the pay ratio;
  • The ability to choose any date during the last three months of a company’s fiscal year to determine the median employee;
  • The ability to use the same median employee for three years, unless there has been a change in the employee population or compensation arrangements that would significantly impact the pay ratio.

Some companies will be exempt from the disclosure, including:

  • Emerging growth companies;
  • Smaller reporting companies;
  • Foreign private issuers;
  • Registered investment companies; and
  • Registrants filing under the U.S.-Canadian Multijurisdictional Disclosure System.

Everyone else is required to include the pay ratio disclosure in their annual report or proxy statement for fiscal year 2017.

Compliance

To comply with the new rule, Ferracone suggests getting started soon, as there will be a lot of calculations to do.

1.  Find the Median – Step one is obviously to identify the median employee. Each company can choose a method for identifying this employee based on their own circumstances using reasonable methods like annual total compensation or any consistently applied measure like tax and payroll records.

Companies can use total employee population or a statistical sampling for finding their median employee or other reasonable methods, but they must briefly explain how they did so, including material assumptions, adjustments and estimates.

2.  Calculate the Compensation – Next is to calculate the total compensation for the median employee and the CEO. Companies can use reasonable estimates in doing so. Ferracone gives the example of using estimates to identify an amount that approximates the aggregate change in actuarial present value of an employee’s defined pension benefit.

As mentioned before, companies can use the same employee for three consecutive years, but the compensation must be calculated each year.

3. Calculate the Ratio – Once companies have the median employee’s total compensation figured out, they’ll need to figure out how much less it is than the CEO’s and express that accordingly, which also has some built-in flexibility. If a CEO’s total compensation is $5 million and the median employee’s is $50,000, the CEO is receiving 100 times as much as the employee, which can be expressed as 100 to 1, 100:1 or via prose like “the CEO’s total compensation is 100 times that of the median compensated employee.”

Among Ferracone’s recommendations is for companies to get a jump on figuring everything out well in advance of the mandated reporting date of January 1, 2017. She also says that because there is no rule requiring a full explanation of the ratio, in her professional opinion, she and her colleagues believe companies will likely keep the narrative around the ratio to a minimum unless they really have some explaining to do.

Whether this new rule will help reign in outlandish CEO compensation, only time will tell. But, as it’s going to be mandatory, companies might as well get a head start on it.

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