The pay ratio rule has moved into the second year of compliance and has been having a strong impact on CEO pay ratio requirements. Now is a good time for companies to assess whether there have been any changes in their company that would warrant having to review or revise the calculations for CEO pay ratio requirements, which would have a subsequent effect on their disclosures.
The CEO pay ratio requirements refer to item 402(u) of Regulation S-K. For a large number of companies, this will be the first year that the CEO pay ratio rule applies to them. Those companies will need to review the rules very carefully to ensure that they are in compliance all the way around.
Other companies will be going into the second year of compliance. The vast majority of companies shouldn’t have to make any changes for 2019. Nevertheless, it’s a good time for those companies to review the rules again as a double-check to be sure nothing has changed.
A small number of companies may have had significant enough changes in compensation arrangements, the employee population or the median employee circumstances that they’ll need to identify a new median employee for the purpose of the 2019 CEO pay ratio requirements.
Refresher on the CEO Pay Ratio Disclosure
Shareholders and others have long been concerned about the high rates of pay for CEOs and other high-ranking executives. Often, CEOs are paid high salaries and receive other perks for the leadership work that they do and the high degree of responsibility that they agree to take on. However, in many cases, shareholders and others felt that certain CEOs were overpaid and that their salary and other benefits didn’t align well enough with how well they performed at their jobs. The CEO pay ratio requirement is an attempt by the Securities and Exchange Commission (SEC) to bring CEO pay rates into some sort of reasonable measure and to ensure that companies are getting their money’s worth in the performance of the CEO, which has a direct impact on the company’s success. As of this year, most public companies will have to review the annual total compensation of their employees on Form 10-K and definitive proxy statement and disclose the median. In addition, they’ll have to disclose the annual total compensation for the CEO.
The SEC acknowledges that the process of making employee pay rate medians and CEO pay rate disclosures is a time-consuming process. It’s not something that they expect companies to do every year necessarily. To ease the burden of the process, the SEC notes that most companies will only need to identify the median employee every three years. After that, all they need to do is calculate the total compensation for that employee each year. This guidance applies as long as the company didn’t experience any significant changes in pay or the employee population that the company believes would result in a significant change to its pay ratio disclosure.
Assessing Changes in Employee Compensation Arrangements
Companies that have experienced a change in their employee compensation arrangements over the most recent fiscal year that they have reason to believe may yield a substantial change to their pay ratio disclosure are not allowed to use the previous years’ information. They must go through the process of identifying a new median employee.
To date, the new rule doesn’t outline what exactly constitutes a change in compensation arrangements. The SEC hasn’t issued any direct guidance on their expectations for what constitutes the need for a new median employee. There is speculation that adding a new compensation element to its employee compensation program, such as changing the annual incentive plan or changing how they grant equity awards, would be the types of actions that would disallow a company from being able to use the same median employee the following year.
Another situation that might prompt a company to have to change their median employee rate is if they make substantial or systematic changes to compensation plans for a single category of employees, such as engineers. These issues could be factors as long as companies reasonably believe that the issues will have a significant impact on their pay ratio disclosures.
Assessing a Change in Employee Population
Companies that have had significant changes in their employee populations over the last completed fiscal year will need to go through the process of identifying a new median employee if they believe that it would result in a significant change to their pay ratio disclosure.
Applicable changes might include a substantial increase or decrease in their employee population either because of a major acquisition or a general workforce reduction. Again, the SEC doesn’t provide any guidelines as to how large or small a change in workforce population would apply.
Particularly in high-growth technology companies where growth is more likely, companies are more likely to see a change in population than a change in employee compensation arrangements. Companies should consider this factor carefully.
Change in Median Employee Circumstances
Another factor in whether a company needs to make a change in the median employee has to do with circumstances around that employee. Setting aside issues related to compensation plans and the population of the employees, if there’s a change for the median employee, such as they left the company, the company gave them a substantial promotion and pay raise, or there was some other change in their compensation, the company should reassess the median employee. What’s different in this situation is that the company could choose to select a different employee as the median employee from the original identification process that has similar compensation measures as the original median employee.
Companies also need to disclose whether they chose to use the same median employee or a different one and explain their reasons for doing so. The SEC doesn’t believe that most companies will need to change the median employee for three years, in most cases. As always, each company has to assess its own facts and circumstances.
Finance or audit committees need a secure online space where they can work on identifying the median employee and what facts and other information that they used to support their decision. In subsequent years, they also need to store documents and data to support whether they used the same employee or chose a different person, and why they made that decision. These are excellent reasons to start using a highly secure board management system like Diligent Boards and the suite of governance tools that comprise Governance Cloud.