The first of many pay ratio proxy disclosures are appearing, a requirement created by a new Securities and Exchange Commission (SEC) rule effective for the first fiscal year beginning on or after January 1, 2017. The disclosure creates an interesting dilemma for compensation committees, which must decide how to react to disclosure comparisons with peer companies. The press already has prominently cited data predicting what ratios will be for particular industries, and pay critics and state legislatures are poised to seize upon negative perceptions of CEO pay for their own purposes.
The compensation committee’s role in pay ratio review
When management presents its CEO pay ratio, how should a committee react? We suggest a limited role of reviewing the disclosure for the upcoming proxy. Typically, compensation committees perform certain activities such as reviewing CEO performance and setting CEO pay which is mandated by their charters with minimum requirements dictated by their listing exchange.
Our experience indicates that SEC counsel generally likes to keep these charters focused, although we have seen some with more detail about additional responsibilities, and some that expand the committee’s role based on a company’s unique circumstances.
We have seen recent examples of charters having expanded along with new SEC disclosure requirements. For instance, about eight years ago the SEC began requiring companies to disclose whether their compensation policies and practices create risks that are reasonably likely to have a material adverse effect on the company. Management typically presented the results of its compensation risk review to the compensation committee, which was then asked to sign off on whether an affirmative disclosure was required in the proxy. Consequently, a number of companies amended their compensation committee charters to explicitly require the compensation committee role to review the incentive pay programs and report to the full board whether they encourage unnecessary risk-taking.
We view the CEO pay ratio disclosure quite differently. While compensation committee actions are the direct source of the pay ratio numerator’s value, we would argue that the committee already understands how CEO pay will be presented for the proxy year because it is required to review the tabular disclosures and Compensation Discussion and Analysis (CD&A), which it then signs off on with its Compensation Committee Report.
What is new is that the committee now gets to see the median pay number for its employees calculation based upon pay decisions that are out of its hands. Certainly, as a strategic matter, the full board will have discussed with management its approach to paying the workforce among many other strategic issues. Based upon current committee charters we have reviewed, we don’t see that there are any references to workforce pay issues. Viewed through this narrow lens, for the initial disclosure on 2018 proxies, we don’t see that current charters would require compensation committees to take any formal action on the pay ratio disclosure, other than to review its results.
Companies must also consider where they place the pay ratio disclosure in the proxy. Most companies we have spoken with are not including the disclosure as part of the CD&A, which means that it will not be an item the compensation committee would sign off on in its report.
Placement in the proxy and the level of review are certainly matters to discuss with SEC counsel, but we would certainly account for:
- The unwitting expansion of the compensation committee’s authority
- A clear statement in committee agendas that the committee’s role is not expanded beyond that intended
- Legal concerns regarding expansion of fiduciary liability under Delaware law
- The extent to which the committee’s pay ratio activity should be embodied in the committee charter.
The dangers of embracing peer group comparisons
We are well aware that when compensation committees are presented with their company pay ratio disclosure for the first time, board members immediately want to know how their company compares with its peers, an understandable reaction since they are now confronting a new disclosure and want to better understand it in context. But, is that context relevant to the committee’s ongoing executive pay setting activities? Or as a quote attributed to Mark Twain aptly puts it, “Everybody talks about the weather, but nobody does anything about it.”
The initial intent of the pay ratio disclosure was to expand the debate about executive pay to raise questions about pay fairness and equality that could prompt compensation committees to tamp down on management pay. The law’s proponents, encouraged by the press, might seek to create a vibrant debate where peer companies are pitted against one another to argue that their pay ratio reflects their concern for workers. Companies must be ready to rationally explain their employee value proposition, rather than entering into a debate about dueling pay ratios they cannot win.
We would submit that a focus on peer pay ratio comparisons plays into pay critics’ hands. Compensation committees need to focus on why their pay ratio appears as it does, not on peer comparisons. The SEC agrees, and stated in its adopting release it does “not believe a purpose of the rule is to facilitate comparisons among registrants,” and that because of the flexibility provided to companies in calculating the ratio, “there are significant limitations to using the pay ratio information for comparative purposes.”
Here are our perspectives on how companies and compensation committees should handle these pay ratio questions:
- Should you include peer pay ratios in the proxy? It will be very difficult for companies to include any type of peer comparison in the 2018 proxy, simply because relevant data will not yet be published. Yet, the temptation will exist for late filers or 2019 filers to consider including these comparisons in their disclosure. As noted, peer comparisons further the work of pay critics even if a good ratio reflects well on your company.
- What if your good ratio turns bad? A fantastic pay ratio for the current year does not mean it will look as good in future years. SEC counsel will likely advise you that once you compare your ratio with peers, you should continue to do so for future years even though the ratio may look worse.
- Would pay ratio comparisons conflict with your disclosure? We’ve already noted that the SEC clearly indicated that comparisons across companies are not meaningful for shareholders. To reinforce this notion, many companies are considering a disclaimer in their disclosure, similar to that used with non-GAAP financial disclosures, which instructs shareholders that pay ratio comparisons may not be an accurate comparison among companies. Companies will want to remain consistent in their thinking on this issue. If they include a disclosure, they should not then turn around and embrace peer comparisons.
- Will employees focus on the ratio, or on median pay? We believe that the typical reaction of most workers will be that their CEO pay ratio seems high, regardless of how it compares to peers. The typical worker will be laser focused on the median pay level for its industry or geography, or why they might be paid below median. Arguments that your company has a better ratio than peers, and is therefore a better place to work, really won’t help assuage employees. But discussions about how the company pays market rates and drilling down into more geographic-centric median pay levels certainly can help provide some reassurance. We’ve blogged before about how to focus on workforce concerns ("The Do’s and Don’ts of CEO Pay Ratio Communications", Executive Pay Matters, September 12, 2017).
- Will the ratio influence executive pay decisions? Compensation committee consideration of peer pay ratios raises a CD&A disclosure question of whether the compensation committee used that information in a material way that requires the comparison to be disclosed in subsequent year proxies. Specifically, it flags how the committee looked at the pay ratio league table, and whether it influenced its pay setting decisions, requiring the pay ratio table to be disclosed in the CD&A. This is a potential trap for the unwary that should be thought through.
A conscious and informed decision is needed
Some of these questions merit a discussion with SEC counsel as well as the compensation committee chair and the committee about the treatment of the pay ratio. It may be the case that the committee believes the ratio is under its pay setting purview, in which case many of the points made above would be moot. But this should be a conscious and informed decision, and the committee should understand its current and future role as soon as possible.
Steve Seelig, Puneet Arora and Bill Kalten are regulatory advisors specializing in executive compensation in Willis Towers Watson’s Research and Innovation Center. Email firstname.lastname@example.org, email@example.com, firstname.lastname@example.org or email@example.com.