Navigating Dodd-Frank: proactive steps to compensation disclosure

Corporate Governance Alert

The SEC is in the process of proposing certain changes to the federal proxy rules regarding executive compensation that will require the disclosure of the median of the annual total compensation of all employees of the issuer (excluding the CEO), the annual total compensation of the CEO and the ratio of the median of employee compensation to CEO compensation.

It is expected that these rules, which may pose considerable practical challenges for public companies, will be proposed between April and July of 2011 and are likely to be effective for the 2012 proxy season.

In this article, we briefly review the policy behind new Section 953(b) of the Dodd-Frank Act, examine some of the practical challenges that companies may face in implementing this Section, evaluate possible technical hurdles the SEC is likely to face in implementing it and recommend proactive steps for the board and the compensation committees of public companies.

Hotly debated requirement

This new requirement has been hotly debated on policy grounds. Those favoring the provision note that, while it may not necessarily reign in spiraling CEO pay, requiring this type of disclosure on the gap between executive and rank-and-file compensation should help investors, policy makers and the public understand the forces shaping business and the economy. At the very least, proponents argue that additional disclosure would shed light on compensation practices that tend to indicate corporations are being run for the enrichment of the few at the top and not necessarily for the growth of the company and the benefit of the shareholders.

Detractors claim that the premise behind the policy (that CEOs are overpaid) is false – that the market pays CEOs what they are worth. Indeed, some detractors have suggested that the proposed new disclosure could create an arms race in CEO pay. As executives survey the playing field and discover their ratios are not in line with industry ratios, they may demand higher pay to match the market.

Moreover, some detractors argue that the proposed new disclosures would provide scant information that would allow meaningful comparisons among companies. Ratios could well appear to vary widely among similarly sized companies, or companies in the same industry, due to the way the Section’s particular reporting requirements are structured. For example, a company that outsources most of its low-wage workers could potentially not be required to report the compensation of those outsourced employees and would appear to have a better ratio than a similarly situated company that internalized such functions.

Practical challenges

Companies are likely to face challenges in the practical application of the rules the SEC finally adopts. The issue, simply stated is: how can companies make a calculation when, for the most part, appropriate data is not available? There are a number of difficulties with the statutory mandate from an individual company’s perspective. First, the statutory provision requires a median, not an average, for the annual total compensation of all employees. As any novice statistician can attest, calculating a median requires much more precise data – total compensation for each individual employee – as opposed to the much easier to calculate average, which simply requires data on company-wide compensation divided by the number of employees.

Further, the statute requires data for employee total compensation as defined on July 21, 2010 under Item 402(c)(2)(x) of Regulation S-K. It is unlikely that companies, even those with sophisticated compensation-tracking data, have readily available data on compensation for each employee that precisely tracks the measure of compensation as so defined. In essence, this requires disclosure for a given fiscal year of:

  • cash and non-cash salary and bonuses
  • the fair value of stock and option grants
  • the dollar value of earnings pursuant to non-equity incentive plans
  • the aggregate change in the actuarial present value of defined benefit and actuarial pension plans and earnings on non tax-qualified deferred compensation, and
  • “other compensation.

"Other compensation" is a potential minefield of employee compensation disclosure that includes:

  • perquisites in excess of $10,000
  • gross-ups for tax payments
  • the compensation cost of any company security sold at a discount to market prices
  • amounts paid or accrued in connection with termination of an employee (including for retirement, resignation, severance) or in connection with any change in control of the company
  • contributions by the company to defined contribution plans
  • the dollar value of life insurance premiums paid by or on behalf of the company, and
  • the dollar value of any dividends or earnings paid on stock or option awards that were not factored into the fair value of such awards at their grant date.

This measurement already presents considerable burdens for companies in disclosing compensation for a few named executives. The requirement that this measurement of compensation be determined for each individual employee is, for most companies, staggering.

Note also that this measurement will apparently be frozen in time, while any future changes in the Regulation S-K disclosure requirements will require separate tracking of compensation for executive officers covered by Rule 402.

Aside from these difficulties, companies are currently faced with uncertainty in determining who counts as an employee. Will part-time employees count? What about hourly-wage and temporary employees? Or employees who work only part of the year? In addition, companies are awaiting guidance as to the appropriate exchange rate for translating compensation for employees based outside of the United States.

[Finally, the Dodd-Frank Act requires that this disclosure be made in every Exchange Act filing, not just the proxy statement for an annual meeting. This raises a question: will companies be required to update the information more than annually? In short, the legislation has the potential to add enormous compliance costs and a significant administrative burden for disclosure well beyond that currently required, on an issue which many feel is a red herring, at best.

Possible technical hurdles for rulemaking

As noted above, some of the logistical challenges that companies are certain to face in implementing the new disclosure requirements under Section 953(b) of the Act cannot be mitigated through the rulemaking process. Very likely, the Act will require some technical corrections to cure this problem.

Frequency of filings

The SEC should consider whether the disclosure required by Section 953(b) is really necessary in every Exchange Act filing. The SEC may be willing to seek a technical correction to the Act to require this disclosure only in a company’s proxy statement or annual report.

Definition of compensation at a fixed point in time

It is unfortunate that the definition of compensation to be used for calculating employee compensation would be based on a disclosure rule in existence at a fixed point in time. The definition of compensation applicable to executives under Item 402 of Regulation S-K is likely to evolve over time. At a minimum, fixing this disclosure based on the rules in effect in July 2010 will require companies to track executive compensation by two different methods if the compensation rules evolve. Perhaps the drafters of the Act were concerned about watered-down disclosure of executive compensation, but this concern seems unwarranted given current disclosure trends. The SEC may request a technical correction to the Act concerning the definition of employee compensation to track any potential changes in the definition of executive compensation in Item 402 of Regulation S-K.

Calculating the median, easing the compliance burden

Calculating the median compensation for all employees will certainly be an expensive challenge, although it is not technically impossible. The intent of the Act was expressly to capture the median and not some other statistical measure. A rough calculation of CEO pay compared to average employee compensation can generally already be made for most companies based on the proxy and the financial statements. While a technical correction to the Act to require some other statistical measure aside from the median may be desirable (and this will become clearer as we learn how much effort and expense will be expended on the calculation by companies large and small), it remains to be seen whether this will be the subject of a technical corrections request. The fix would be most helpful if it is made before companies engage in the expensive work to generate systems to collect the required data.

Other technical corrections through regulation

The SEC may be able to clarify through rulemaking the definition of employee, issues relating to the exchange rate for foreign employees’ compensation and the time at which calculation of compensation should be made.

Do not underestimate the requirements

While we cannot predict the final content of any legislative amendments or the final SEC rules relating to Section 953(b) of the Act, companies can undoubtedly be proactive in addressing the new requirements on multiple fronts. First, companies should engage in the rulemaking process during the SEC’s notice and comment period. As noted above, it is likely that any SEC rules on this Section are expected to be issued between April and July of 2011. Companies should digest the proposed rules and coordinate with legal counsel, both to determine the application of the proposed rules and to craft meaningful comments that can be presented to the SEC to help shape the final rules.

Second, companies should categorize various types of employee compensation, and, to the extent feasible, develop systems for assembling individual employee compensation data based on the definition of compensation currently found in Item 402(c) of Regulation S-K. How this data may finally be used will depend on the final rules, but if a company has the systems available to pull the compensation data for individual employees in a form contemplated by Item 402(c), the company will be in much better position to provide the relevant disclosure when the time comes, no matter the form of the final rules.

Companies should not underestimate the potential work involved in making the calculation of median employee compensation, but should begin the process of developing systems to assemble the required data in order to be in position to comply with their disclosure obligations when the rules become effective.

For more information about the impact of these disclosure requirements on your company, please contact:

Sanjay Shirodkar

See our reports on breaking developments around Dodd-Frank here.