The SEC's Proposed Pay Ratio Disclosure Requirements: Another Fine Mess

 Among the many measures Congress included when it enacted the sweeping Dodd-Frank Act in 2010 was a provision directing the SEC to require companies to disclose the ratio of CEO compensation to median employee compensation. The statutory provision, incorporated into Section 953(b) of the Act, reflected a perception that CEO compensation had gotten out of line and a hope that increased disclosure might encourage greater pay equity. Now, more than three years later, the SEC has finally gotten around to proposed rules to implement the statutory requirement.

The pay ratio disclosure requirements have produced a great deal of controversy and seem likely to be cumbersome and costly to implement. Whether the disclosure requirements, which will not take effect until 2015 or 2016, will produce any of the intended benefits seems uncertain at best.

Background

At an open meeting on September 18, 2013, and by a vote of 3-2, the SEC approved for the new proposed pay ratio rules for public comment. The SEC’s proposed pay ratio disclosure rule can be found here. The agency’s September 18, 2013 press release about the proposed new rules can be found here. Statement by the two dissenting Commission members, Michael Piwower and Daniel Gallagher, can be found here and here, respectively. The dissenting Commissioners’ comments make for interesting reading. The proposed disclosure requirements would apply to most public companies but will not apply to Emerging Growth Companies as defined under the JOBS Act; smaller reporting companies; and foreign private issuers.

In coming up with rules to specify how companies should calculate and disclose the compensation ratio, the SEC had to decide who does and doesn’t count as an employee, and how median employee compensation is to be calculated.

With respect to the question of who counts as an employee, the SEC’s proposed rule takes an all-inclusive approach. Because Congress required the pay ratio to express the ratio CEO compensation to the compensation of “all employees,” the proposed SEC rule includes all individuals employed by a company and any of its subsidiaries – including any “full-time, part-time, seasonal or temporary worker” as of the last day of the company’s prior fiscal year. Non-U.S. workers are included in the definition. The proposed rule also makes it clear that companies are not permitted to make full-time equivalent adjustments for part-time workers or annualizing adjustments for temporary or seasonal workers.

With respect to the method of calculating median employee compensation, the SEC opted not to mandate a specific methodology but to allow companies the discretion to use the most appropriate method of calculation base on the size and structure of its business and the way it compensates employees. This approach, which has been applauded by larger multinational employers, is intended to provide companies with greater flexibility in complying with the disclosure requirements. Whatever methodology a company uses, it must include in its pay ratio disclosure a brief narrative description of the methodology employed.

The pay ratio disclosure will be required in a company’s annual filing on Form 10-K and any proxy or information statement required under Regulation S-K to include compensation disclosure. Companies will have to comply with the rules in the first fiscal period after the effective date of the rules. Because of the period required for public comment and the likely volume of comments, it seems unlikely the agency will adopt a final rule before the end of 2013. If the rule is adopted in 2014, the earliest that companies with calendar year end fiscal years would have to report the pay ratio would be in their 10-K or proxy statement filings in 2016.

Discussion

While the pay ratio disclosure requirement may have derived from a belief that greater transparency might help to rein in CEO compensation and encourage pay equity, in the end, the pay ratio disclosure may prove to be of at best limited value. As the Troutman Sanders law firm noted in its September 19 2013 memo about the SEC’s new proposed rule (here), “the SEC’s decision to provide a flexible approach to the calculation means that there will not be any meaningful way to compare the pay ratios of peer companies.”

In addition, the ways that different companies staff their operations will also make company to company comparisons difficult. As discussed in a September 20, 2013 Wall Street Journal article entitled “It’s Hard to Slice and Dice CEO Paychecks” (here), companies’ pay ratios “will vary based on differences in how companies deploy their workforces and how they’ll crunch the numbers.” Among other things, the ratios at companies with predominantly U.S. employees will be lower than the ratios for companies with more lower-paid workers overseas. A study cited in the Journal article concludes that larger, more global companies will likely report “significantly higher pay ratios” than smaller, domestically focused firms. Ratios will also be skewed for companies that outsource work or that rely heavily on part-time and seasonal employees.

In other words, reported pay ratios will likely say as much or more about the size and business approach of the reporting company than it will about the company’s executive compensation practices. Indeed, there is every possibility that attempts to discern meaning from the pay ratio disclosure could, as the SEC itself said in its proposal, lead to “potentially misleading conclusions and to unintended consequences.” At best, as Commissioner Daniel Gallagher said in his dissenting statement, “the pay ratio computation that the proposed rules would require is sure to cost a lot and teach very little.”

As the Covington & Burling law firm noted in its September 19, 2013 memo about the proposed rule (here), the pay ratio disclosure requirement in the Dodd-Frank Act is “yet another example of Congress using the SEC to advance public policy goals not squarely rooted in the SEC’s historic mission of protecting investors.”

However, it is not as if there are no winners here; as Covington notes in its memo, the new rule will “certainly increase the costs and time required for companies to accurately prepare executive compensation disclosure” and will likely include the need “for many companies to retain outside advisors to assist in the statistical sampling and compilation process.”

So in the end, the congressionally mandated disclosure requirement is unlikely to produce meaningful information for investors to use in comparing companies but is likely to prove a boon for costly outside consultants. And I am just guessing here, but I suspect among the groups that will manage to extract a profit from the new requirements are plaintiffs’ attorneys.

Any time something is required to be disclosed there is an opportunity for plaintiffs’ lawyers to allege that the disclosure was incomplete or out of compliance with requirements. I think you can set a watch on it – during the first year after the disclosure requirements go into effect, there will be litigation in which plaintiffs’ lawyers contend that the pay ratio disclosure misled investors or was implemented in a way intended to deceive investors about the company’s executive compensation.

Along with “say on pay” and conflict minerals disclosure, the pay ratio disclosure requirement is yet another burden that Congress imposed on U.S. reporting companies in the Dodd-Frank Act. Somewhere along the line there needs to be some objective assessment of whether the putative value of these requirements that Congress is piling on to companies justifies the burdens the requirements impose on companies.

And Now -- A Word About K&R: As part of my work in the management liability insurance arena, I am frequently called upon to help with the placement of kidnap and ransom (K&R) insurance. Despite my frequent involvement with placement of the insurance, and notwithstanding my more than three decades in the business, I have never actually been involved in a K&R claim. Frankly, other than as is required for the placement of the insurance, I generally don’t think about the product much at all.

I had my consciousness raised about K&R insurance earlier this year when I attended an educational event sponsored by one of the leading global insurers. The insurer was in the process of rolling out a new K&R insurance product and had invited to the session the security consultants whose services they would use for any K&R policyholder that experienced a kidnapping or hostage incident. The consultants’ description of their role – particularly their role in communicating with captors and negotiating the amount and process for payment of the ransom – was absolutely fascinating.

I had occasion to think about K&R insurance again while reading this past week’s issue of the Economist. An article entitled “A Holy Mess” (here) describes the September 6, 2013 kidnapping of Nigeria’s Anglican archbishop. The article goes on to explain that these kinds of abductions have become all too common in the country. During the first half of 2013, Nigeria had the most kidnap attempts in the world, accounting for 26% of all incidents globally. Mexico was second with 10% and Pakistan third with 7%.

The abductors obviously hope to be able to use the hostage as a means to extract a ransom payment. One of the things that the security consultants had said in the presentation I attended earlier this year is that while the captors’ initial demands may be outlandish, the amount of the actual ransom payments often is quite modest. The magazine article confirms this point, noting that “Captors usually start with huge demands before being haggled down. Settlements of $12,000 to $30,000 are standard, though there have been instances of people getting away with as little as $600.”

The services available under the provisions of the K&R policy, including in particular the services of security consultants to manage an abduction crisis, may well prove to be indispensable for the company and for the individuals involved. This is also an area where a more general risk mitigation approach can be helpful. As the magazine article notes, “a flashy car and swanky suit can enough to catch a villain’s eye.”

In any event, K&R insurance may not be a product that often attracts a significant amount of attention, but in certain situations it can prove to be critically important. Though, as the magazine article highlights, there are countries where the risks are particularly great, a K&R policy should be a part of every company’s insurance program, even for those companies whose personal do not travel to the riskiest countries.

Of Thee I Sing: I travel a lot for work. Fortunately, my extensive work-related travel does not require me to journey to any of the more notorious kidnapping hotspots. Those who follow this blog regularly know that I have enjoyed the opportunity over the last 24 months or so to visit some pretty great places – including, for example, Amsterdam, Barcelona, Munich and Beijing. However, I wouldn’t want to leave readers with the impression that my travel itineraries only include these kinds of glamorous destinations. My work requirements much more frequently require travel to many notably less glitzy locales.

Much of my day-to-day business comes from the Great Lakes and Ohio River Valley regions. I am much more likely to be in Ohio, Michigan, Pennsylvania and Indiana than I am in some foreign spot. Just this past week, I found myself in Elkhart, a surprisingly pleasant town in northeastern Indiana. The town went through some rough times during the economic downturn, but the local manufacturing businesses are definitely rebounding. The two-story brick storefronts that line the main street have been well-preserved. Parklands protect both banks of the St. Joseph River as it rolls through the center of town. I had lunch one day while there on the terrace of an upscale restaurant overlooking the river and the park. The town overall has a feel of friendly, slower-paced prosperity. My overall impression was that Elkhart would be a very nice place to live.

I have learned to be more attentive to the virtues of places like Elkhart. In part this is just the result of having lived a long time and gained perspective on life. But in part it is a result of a conversation I had a few years ago while I in a taxi cab trying to make my way into Chicago from O’Hare airport. The traffic was particularly heavy and my cab was barely moving. As we inched along, I struck up a conversation with the cab driver, who turned out to be a naturalized U.S. citizen of Pakistani origin. The cab driver told me about how he had left his home country and traveled to the U.S. some two decades before and how he had made a life for himself here.

The conversation took an unexpected turn when the cab driver asked me where I was from. When I told him I live in Ohio, he said to me that Ohio is the most beautiful state in the entire country. Now, I am a pretty big Ohio booster, but not even I am going to try to claim that Ohio is our country’s most beautiful state. I asked him why he thought Ohio was so beautiful, and he said that all you have to do is travel around the western part of the state. I asked him what he meant, and he said you have to understand that he comes from a crowded, hot and dry country. He said that when he travels to Ohio, he sees big, green, open, fertile, prosperous fields stretching all the way to the horizon. What could be more beautiful, he asked, than rich, fruitful, bountiful fields producing food that will feed thousands of people?

The cab driver was just getting started. He went on to say that he thought that a lot of Americans have no idea how fortunate they are to live in their country. He said the thing that he values the most is that people treat each other with dignity and respect. He said that of course there are people who have said hateful things to him because of his appearance or his accent. There are, he noted, ignorant fools everywhere. But generally everyone else is respectful. He described in tones of wonder how, when he visits his sons’ school, the teachers – the teachers! – say to him “Yes, sir “and “No, Sir.” He said that the teachers say to him that they want his sons to get the best education they can get – and they mean it. He added that it is the same if you go into a store. The store clerks are courteous and ask if they can help you. They say “yes, sir” and “no, sir” and they thank you for coming into their store.

It has now been several years since my ride with the talkative cab driver, but I reflect on his comments frequently. When I travel though Ohio’s and Indiana’s farmlands now I make a point to notice that the fields really are quite beautiful – particularly in late September when the trees lining the fields are starting to show their fall colors.  And when I travel to places like Elkhart now, I do notice that in fact just about everyone is very friendly and courteous.

We are, after all, a nation of immigrants. Just about everyone’s family is from somewhere else. My wife and I each have a grandparent who immigrated to this country (in my case, two). Just the same, it does take some perspective to see how fortunate we are to be here. I am grateful that I had the chance to talk to the cab driver. I still am not prepared to argue that Ohio is the most beautiful state in the country, but I am glad I had a chance to see Ohio and this country through his eyes. It isn’t just that I learned what it means to him to be an American. It is that I learned a little bit more about what it means for all of us to be Americans.

I have, upon reflection, developed a theory about the cab driver. I now suspect that he tells every passenger that their state is the most beautiful state in the country.

Coincidentally, there was an article about Elkhart in the Saturday Wall Street Journal magazine supplement, WSJ Money. The article (here) describes how a reclusive resident who recently passed away unexpectedly left a fortune worth over $150 million to the town.

Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.

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