New guidance on the CEO pay ratio rule, released last week by the Securities and Exchange Commission, brings significant relief to companies concerned about the possible high costs of compliance.
It does nothing, however, to answer persistent questions as to whether a company’s disclosure of its pay ratio — a comparison of its CEO’s compensation with that of its median-paid employee — provides value for investors. Indeed, if anything the guidance may result in inaccurate disclosures.
The pay ratio rule is slated to take effect for fiscal years of SEC registrants beginning after Dec. 31, 2017, meaning that the first disclosures will be made in early 2018.
Many companies, particularly multinationals, have complained that the effort to gather workforce compensation information in order to calculate the pay ratio will be unduly burdensome.
“On an aggregate basis, for purposes of financial statements, companies know what their employee costs are,” says Steve Seelig, executive compensation counsel for Willis Towers Watson and an adviser to large companies on pay matters.
“But they may not have a direct line of sight to how people are paid in foreign jurisdictions,” Seelig adds. The older a company is, the more likely it is to have that line of sight, but it may not if it’s been very acquisitive or has local management for its operating companies in different countries, he says.
In large part, the SEC guidance alleviates much of that concern. It gives companies wide discretion to use “reasonable estimates, assumptions, and methodologies” in making their pay ratio calculations. The commission specifically endorses the use of statistical sampling. In fact, the guidance states that “required disclosure may be based on a registrant’s reasonable belief” and acknowledges that given the discretion extended to registrants, disclosures “may involve a degree of imprecision.”
A pay ratio disclosure could actually be significantly imprecise without inviting an SEC enforcement action. The guidance states that the commission will not pursue such actions against a company “unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith.”
The guidance also notes that companies may rely on data in their human resources information systems in making the calculation. Some companies, Seelig notes, were wary of doing that, since they didn’t necessarily trust the accuracy of the information in such systems.
Further, the guidance addresses concerns that the person whose pay is found to be at the exact median for a company may have inconsistent earnings from year to year and therefore would not afford an appropriate comparison to CEO pay. (Hourly workers and those who are paid commissions, for example, usually see some degree of fluctuation in their annual earnings.) In such an event, the company may select another employee whose pay is near the median.
A revised definition of who should count as an employee for purposes of making the pay ratio calculation provides additional relief for companies. Those who work for unaffiliated third parties that provide services to a registrant are excluded from the calculation, unless the registrant determines what they are paid.
“The guidance makes clear that people who are not treated as employees for tax purposes don’t have to be included for purposes of calculating the pay ratio,” Seelig notes.
It is tempting to view the lenient guidance as a symptom of the times, given the Trump administration’s antipathy for what it regards as excessive regulation and its appointment of an SEC chairman, Jay Clayton, with similar views.
Regardless of the motivation, the relaxed standard for calculating pay ratios certainly does not make them more comparable from company to company.
To be sure, the SEC has stated that the purpose of the pay ratio is not to facilitate such comparisons but “to allow shareholders to better understand and assess a particular registrant’s compensation practices.” Still, it’s very possible that those with the highest ratios will suffer negative consequences such as unwanted press coverage, protests, boycotts, or negative ad campaigns. Those responsible for such actions may or may not take into account that pay ratio norms will naturally be quite different from industry to industry, but companies have a clear financial interest in how their calculations turn out.
Seelig, for his part, opines that the guidance won’t have a big impact on reported pay ratios. “If they were required to present every single piece of pay data versus using these simplified approaches, it really wouldn’t change their median pay that much,” he says.
That’s only part of the story, though. “How you view the ratio, its value to shareholders, and whether it has useful comparative value were questions that existed before these changes were made, and they still exist,” Seelig points out.