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Aug 17, 2015

Giving investors some credit on how they will use pay ratio disclosures

Though compliance with SEC rule is expected to be onerous and costly, it likely won't have much impact on how investors weigh pay plans

Nearly two years after first proposing one of the most controversial rules mandated by the Dodd-Frank Act, the SEC adopted the final version of the pay ratio disclosure rule last week. After the SEC staff sifted through thousands of comment letters, the rule is much as it was expected to be, but it includes some intriguing things that got me thinking about how the Commission thinks about these matters.

The final rule reins in the definition of ‘employee’ put forth in the proposed rule by including only employees of the company and its consolidated subsidiaries. So this excludes those employed by subsidiaries that are affiliates the company controls directly or indirectly through one or more intermediaries, as subsidiary is defined in the amended versions of the Securities Act of 1933 and the Securities Exchange Act of 1934, according to a Gibson Dunn client alert.

What I find most interesting about the final rule is that it requires a company to select an actual employee to represent its median employee’s total compensation against which that of the company’s CEO will be measured, rather than to simply calculate a median pay level by crunching its workforce compensation data. This selection is to be made once every three years.

Howard Berkenblit, partner at Sullivan & Worcester and leader of its capital markets group, says he was surprised the SEC ‘seemed to contemplate this as a real person, not just a statistic.’ He muses about whether that person would know he has been so designated and perhaps might receive an award or some other recognition as Median Employee.

Speculating about the purpose of choosing an actual employee to represent the median compensation level, Berkenblit says, ‘My guess is it’s to give a little more accountability and to emphasize that there needs to be some backup for who exactly that person is and how you got there.’ He doubts the SEC staff had any political agenda in mind such as putting a face to the median compensation level in order to draw more attention to the disparity between his or her pay and that of the CEO.

Having a real person represent the median employee compensation may make it more onerous for companies to figure out, Berkenblit adds. ‘I haven’t had a chance yet to go over the details with my clients, but my guess is as they get into it, it’s going to be hard because no one’s going to quite fit [the description]. Every employee is going to be slightly different in terms of what makes up their total compensation. Most of the pieces will be the same – salary and equity – but it may be hard to find that person who falls in the middle with the right pieces.’

In his dissenting statement at a meeting to adopt the final rule, Commissioner Daniel Gallagher said what the SEC could have done differently is to ‘have limited the scope of the rule to full-time, US employees,’ adding that ‘the Commission has ample definitional authority, interpretive authority, and exemptive authority to do so,’ particularly in light of the statute’s failure to include a relevant definition of the term ‘employee’.

‘Excluding employees from other countries and part-time or seasonal employees would eliminate a substantial amount of noise in the quality of the median employee data,’ Gallagher said.

I asked Matt Orsagh, director of capital markets policy for CFA Institute, whether he believes restricting the rule in that way would have helped investors make more useful comparisons between the pay ratios of different companies within the same industry. He said it might have done, but wonders: ‘So many multinational companies would have most of their employees outside the US, so how useful is it then?’

Its usefulness is doubtful anyway, he says, when you consider different business models among companies in the same industry that compel one company to locate just 20 percent of its employees in the US or other developed countries with higher costs of living and higher salaries, versus another company that chooses to have 80 percent of its workforce in the US or similar countries.

‘Those are things you have to adjust for if you’re an analyst or a fund manager. The folks I talk to in the institutional investor world that controls most of these [say-on-pay] votes are sophisticated enough to understand that,’ Orsagh says. ‘They think it’s interesting, but it’s not going to radically change how they do their work. If a company has poor pay practices -- if CalPERS is voting against them or the New York Comptroller’s Office or BlackRock is voting against them – it’s not because of one piece of information. It’s because of a preponderance of evidence that they see that there’s a problem.’

One investor told Orsagh she will use pay ratio disclosure not to assess a company at any one point in time but to see if over time it may have a problem. ‘If, after five years, a company is way out of whack with its competitors and it has other compensation issues, then it may be an issue,’ says Orsagh.

David Bogoslaw

Associate Editor and Online features producer for Corporate Secretary