A few weeks ago, in the NASPP Blog entry “CEO Pay Ratio: Planning for Employee Communications,” I wrote about planning to communicate with employees on the topic of the upcoming CEO pay ratio disclosure. Since my initial post on this subject, I’ve come across some helpful content that is further food for thought when contemplating a communication strategy.
I keep hearing that companies have a range of emotions about communicating around the disclosure. In particular the concept of discussing the median employee aspect of the disclosure seems to trigger words like “panicked,” “petrified,” and “concerned.” It seems many companies do worry about how their employees will react to information about the median employee’s compensation.
Two recent blog posts by Margaret O’Hanlon, CCP further explore what you should and shouldn’t say to employees about the CEO pay ratio disclosure (thanks to the CompensationStandards.com’s Advisor’s Blog for leading me to this information.) Some of the ideas O’Hanlon explored are:
In her first post (“Imagine CEO Pay Ratio Communications Going Well“), O’Hanlon suggests that instead of focusing on a panicked state or reluctance to communicate about this (and asking yourself the question “What good can come of this?”), ask yourself “What can I make of this?” Changing your focus should pave the way to different insights.
She also suggests imagining employees approaching the disclosure with the following reactions:
Not immediately overreacting to the numbers
Being willing to listen to the rationale for the numbers with an open mind, even though they are skeptical (or more)
Being able to spend a limited time mulling over with their colleagues what they have heard
Not going on social media to comment on the announcement
Prepare your employees. If you don’t, the CEO Pay Ratio and median employee information is bound to be a shock.
Use end-of-the-year focal review and merit pay communications. Articulate, repeat and reinforce what you do to make sure employee pay is competitive, how your practices are fair and how employee salaries are only one part of your company’s whole reward package.
Use people not technology. Distancing the message from the personal will leave your company open to employee claims that leadership is ducking responsibility. Identify a spokesperson to present the details of the CEO Pay Ratio, back it up with email or intranet information, but be sure that your communication strategy gives employees a chance to discuss their reaction with someone that they can open up to.
O’Hanlon mentions some other important idea in her blogs; they are definitely worth a read.
The CEO Pay Ratio disclosure time frame will be here before we know it, and companies are running out of time to take advantage of some of these proactive communication opportunities. It’s time to get ahead of the disclosure, imagine this going over well with your employees, and take realistic steps in advance to ensure the messaging results in a positive experience for employees, rather than a communication fail.
Remember when I said you should be aware of the new Section 162(m) rules that apply to certain health insurance providers because they indicate the direction Section 162(m) is heading (“CHIPs: More Than a Cheesy TV Show“)? Well, it’s happening. The tax reform package proposed by the House would make some of the same changes to Section 162(m) that already apply to CHIPs.
What Is 162(m) Again?
For those of you who don’t live and breath corporate tax deductions, Section 162(m) limits the tax deduction that companies can take for compensation paid to covered employees (currently the CEO and the top three highest paid executives, not including the CFO—but this is something the proposed legislation would change) to $1 million. A number of types of compensation are exempted from the limit, however, including performance-based pay—this would also be changed by the proposed legislation.
Update to Covered Employee Definition
The proposed tax reform legislation would update the definition of who is a covered employee under Section 162(m) to once again include the CFO. This change has been coming ever since the SEC revised the definition of who is a named executive officer for purposes of the proxy executive compensation disclosures back in 2006. The only thing that is surprising is that it’s taken over ten years for the tax code to catch up (and, actually, it still hasn’t caught up, but it seems pretty likely that this is going to finally happen).
Once a Covered Employee, Always a Covered Employee
The proposed legislation would also amend Section 162(m) to provide that anyone serving as CEO or CFO during the year will be a covered employee (not just whoever is serving in this capacity at the end of the year). Plus, starting in 2017, once employees are covered by the rule, they remain covered employees in any subsequent years that they receive compensation from the company, regardless of their role or amount of compensation they receive. This will prevent companies from being able to take a tax deduction for compensation paid to covered employees simply by delaying the payout until the individuals retire.
This change has been coming for even longer, ever since the SEC updated their definition of named executive officer to include former officers, which happened so long ago I can’t remember when it was (10 points to anyone who can tell me).
Performance-Based Compensation No Longer Exempt
Finally, the proposed legislation would repeal the current exemption for performance-based compensation. This exemption currently applies to both stock options, even if subject to only time-based vesting, and performance awards. Thus, both types of grants would no longer be exempt from the limitation on the company’s tax deduction.
At one time, this might have spelled the curtailment of performance-based awards. But these days, there is so much pressure on companies to tie pay to performance for executives that I don’t see this having much of an impact of pay practices. It does mean that a fairly sizable portion of executive pay will no longer be deductible for many public companies.
Not Final Yet
As I noted in yesterday’s blog, this legislation has a ways to go before it is final. You can rely on the NASPP to keep you in the know, even if it means I have to write blogs on Sunday night. Check out our alert for law firm memos providing more analysis.
There’s been much buzz around the first round of CEO Pay Ratio disclosures, to occur beginning in the upcoming proxy season. While many companies are busily preparing for the disclosure itself, attention must also be given to other important tasks that stem from the disclosure – like preparing to communicate with the media, shareholders and internal employees.
According to a recent Willis Towers Watson poll, while most companies said employee reaction to the Pay Ratio disclosure is a concern, 48% of respondents said they had not taken any action to prepare for employee communications. Willis Towers Watson summarized their findings as follows:
“Despite the concern, nearly half (48%) of respondents haven’t considered how or even if they will communicate the pay ratio to employees. Only 14% have created a detailed communication plan to educate employees, and a similar number are not planning to say anything to employees. Just 16% are prepping managers to be able to discuss the results of their pay ratio with employees, although 39% are preparing leadership to respond to employees’ questions.
This gap between concern and communication comes as the SEC pay ratio disclosure rule’s implementation date in early 2018 quickly approaches.”
We are entering a time of year when many stock plan administrators and corporate compensation professionals spruce up their employee communications. There are year-end tax withholding and reporting communications, some companies provide communication around annual compensation, new benefits, and other information. Many companies may be thinking that they will communicate about the CEO Pay Ratio disclosure after the disclosure is made, if at all. May I suggest that now is the time to start laying the groundwork for those communications. If you’re already going to be communicating to employees about various aspects of their compensation and benefits, this is a prime opportunity to raise more awareness about what they have, why they have it, and the basis for their current compensation. Here are some ideas to consider in crafting a communication strategy around the disclosure (now is not too early to think about this!):
Use existing planned communications to include messaging about the CEO Pay Ratio before the disclosure.
Communicating pre-proxy filing is going to lend a key opportunity to share information about the basis and rationale for current pay before employees digest the actual CEO Pay Ratio figures. Education about existing compensation and corporate compensation philosophies ahead of time could aid in providing the employee the means to better understand why they may fall above or below the median, rather than leaving it to “surprise” them and filling an information void with imagination or assumption. Additionally, employees will have access to data about peer companies at the same time you do, likely well before you have time to craft further communications post-disclosure. Without a foundation of information and understanding in place to foster a belief that their current pay is fair, employees may be more likely to perceive differences to peer companies as negative.
Plan for post disclosure communications that will incorporate comparisons with other companies into your broader pay story.
You won’t know about the ratio of peer companies until after the disclosures are made. Once you have that information in hand, it will be time integrate that information into your own messaging to employees. Pay is most often not just about dollars in a paycheck and employees will need to hear more about about what makes their pay package fair compared to peer companies that may have different CEO Pay Ratios. Is there a large equity component? Does your company’s ESPP discount stand out above other companies? Are there other benefits that need to be considered in understanding the overall package – including the parts not incorporated into the Pay Ratio calculation?
With year-end communications on the horizon, this is a great opportunity to integrate messaging that will help employees understand their bigger compensation picture.
When I posted the results of the NASPP’s quick survey on the CEO pay ratio, the data I got the most questions on were the results for how companies are handling independent contractors in the calculation. When we conducted that survey, the SEC’s guidance seemed to indicate that some individuals that are treated as contractors for other purposes might be considered employees for purposes of the CEO pay ratio. That has now changed.
The SEC’s Original Position
The SEC’s original position was that the final rules permitted the exclusion of workers who are employed by and have their compensation set by an unaffiliated third party (e.g., leased employees). A CDI issued by the SEC in October 2016 clarified that some workers who are considered nonemployees for tax purposes might be considered employees for purposes of the CEO pay ratio.
We believe it would be consistent with Item 402(u) for a registrant to apply a widely recognized test under another area of law that the registrant otherwise uses to determine whether its workers are employees.
In addition, the CDI issued on this question in 2016 has been withdrawn and the new guidance seems to suggest that reliance on the determination of employee status for tax purposes is sufficient to establish employment status for the CEO pay ratio.
The July-August issue of The Corporate Counsel notes that in addition to the test used under the US tax code (which is fairly complex) companies might rely on the determination under the Fair Labor Standards Act (FSLA) or other laws.
A Shift in Administration = A Shift in Position?
The SEC notes in Release No. 33-10415 that the shift in their position is due to concerns expressed by commenters. I don’t doubt that this is the case, but I also wonder if it is partly attributable to the Trump administration’s pro-business agenda. Obviously, one way for companies to improve their CEO pay ratio is to contract out lower paid positions (e.g., in gig-economy type arrangements). The SEC’s original position was an obstacle to this approach; the new position is much less so.
P.S.—I removed the chart on how companies are handling contractors from the quick survey results (in case you are wondering why you can’t find it). Now the that SEC’s position has been changed, companies are likely changing their approach and I don’t think our data on this particular question is reliable.
Now that the NASPP Conference is over and we’ve just about concluded our Meet the Speaker series for this year, it’s time for me to get back in the habit of writing blog entries. Today I have some quick updates on the CEO pay ratio disclosure.
SEC Won’t Delay the CEO Pay Ratio Disclosure
Readers will recall that earlier this year, the SEC solicited comments on whether to delay implementation of the CEO pay ratio disclosure (see “What’s Going on With the CEO Pay Ratio” for a summary of the comments received). Based on comments made by the SEC Director of Corp Fin back in September, however, it doesn’t look like a delay is going to happen. Here’s what Broc Romanek had to say about it in his blog:
It’s big news—although not surprising if you’ve been paying attention. At the ABA Annual Meeting, Corp Fin Director Bill Hinman said that the SEC won’t be delaying the implementation of pay ratio (as always, speaking for himself & not the Commission). Bill also mentioned that Corp Fin would be issuing guidance on the pay ratio rules at some point in the near future. It’s still possible that Congress could delay—or repeal—the pay ratio rule. But I wouldn’t make that bet…
Speaking of a Repeal
In a 232-page report issued in October, the Treasury Department calls for the repeal of the CEO pay ratio, among a host of other reforms. Unfortunately, this requires Congressional action so don’t hold your breath (and don’t stop your preparations for making the disclosure).
SEC Issues Guidance on Calculating the Ratio
We posted an alert on this back in September but in case you missed it, the SEC has issued some significant and helpful guidance on calculating the CEO pay ratio. Key areas addressed by the guidance include:
Use of reasonable estimates
Reliance on internal records to determine compensation
Determining whether contractors need to be included in the ratio
Relief and examples for companies that want to use statistical sampling to determine the median employee
Today I have part 2 of my series reporting the results of the NASPP’s quick survey on how companies are preparing for the CEO Pay Ratio. In this infographic, I look at the various decisions companies have to make as they identify their median employee. Want to know more? See Part 1 and the full survey results.
The infographic is interactive; hover over the graphs to see the data labels. Can’t see the infographic? Click here to view it on a separate web page.
There aren’t a lot of companies rushing to disclose their CEO pay ratio before they have to, but in his blog on CompensationStandards.com, Mark Borges of Compensia highlights a few that he has found (“More CEO Pay Ratio Disclosures“).
Not surprisingly, none of the disclosed ratios are excessive; for all but one, the CEO’s pay is less than 20 times the median employee’s pay. Companies with excessive ratios probably aren’t keen on making the disclosure early. This week (today and Thursday), I have a few highlights from the disclosures, starting with the companies with the two lowest ratios. (I’ve linked each company’s name to its relevant proxy statement; you can find the disclosures easily by searching on the phrase “pay ratio” in the proxies.)
Adam Resources & Energy’s ratio is impressively low at 5.7 to 1. Their median employee pay was about $70K but their CEO made only $400K, hence the low ratio (they do not appear to issue equity to their executives). They note in the disclosure that they have 654 employees, most of whom are truck drivers (they are in the oil and gas industry and transport liquid chemicals). They also note that they annualized pay for employees who only worked part of the year and they excluded employees on leave.
The proxy further notes that they excluded their 401(k) and medical benefits from the ratio—and with a ratio of 5.7:1, why not? Including those benefits will increase the pay disclosed for the median employee and employees comparing themselves to the median probably won’t think to include those components in their own compensation. But for companies that don’t have the luxury of such a low ratio, including those components might help bring down their ratio since the 401(k) and medical benefits are likely to be higher percentage of the median employee’s pay than the CEO’s pay.
NovaGold is in gold mining and has only 13 employees, including their CEO, which must make it pretty easy to find their median employee. Because they have an even number of employees, they note that they averaged the compensation for the sixth and seventh employees to come up with the median compensation (this also handily allows them to avoid disclosing the actual compensation of any one of their employees—potentially a concern with there being only 12 of them).
Their ratio is 13.5 to 1 and their median employee’s pay is around $400K, making them a company of fairly well-paid employees (well, at least half of the employees). Their disclosure includes a list of pay components that were included in the calculation. Besides the obvious (salary, bonuses, equity), they also included 401(k) match, ESPP match, life insurance premiums, auto allowance, and reimbursement of executive physicals.
Stay tuned: on Thursday I’ll look at two more early disclosures.
The glimmer of hope that the CEO Pay Ratio will be delayed or repealed continues to dim (although it hasn’t been completely snuffed out yet).
The SEC Delay
The comment letters submitted to the SEC about delaying the effective date were overwhelmingly opposed, although most were form letters and not nearly as many were received as on the proposed regs. More importantly, the SEC may not currently have enough commissioners to effect a delay. Although a new chair has been appointed, in his recent Equity Expert Podcast with us, Steve Seelig of Willis Towers Watson explains that three commissioners are needed for a quorum. The SEC currently has only three total commissioners (including the chair); a commissioner could prevent a matter from being voted on just by not showing up for the vote. One of the current commissioners is a Democrat (and even worked with Senator Dodd at one point) and may not be supportive of a delay.
Steve noted, however, that even if a delay can’t be effected, the SEC staff could issue interpretive relief that would make it easier to calculate the ratio). Steve had a lot of insightful things to say about the ratio; the podcast is definitely worth a listen.
The Financial Choice Act
The Financial Choice Act has already passed through the House Financial Services Committee, only a month after it was introduced by Jeb Hensarling (R-TX). This act would dismantle or weaken many provisions of the Dodd-Frank Act, including a full repeal of the CEO Pay Ratio. But even with the quick passage through committee, this act has a ways to go and the odds of it passing are still low.
The option was granted to IBM’s CEO and is for a total of 1.5 million shares, granted in four tranches. Each tranche cliff vests in three years and has a different exercise price, ranging from $129.08 to $153.66 (premiums ranging from 5% to 25% of FMV).
The option was granted in January of last year, about a month before IBM’s stock price hit its five-year low. IBM’s stock price recovered to the point where all four tranches were in the money around mid-July and the option has mostly been in-the-money since then. IBM’s stock is now trading at around $160 (down from a three-month high of around $180). Either the options were very effective at motivating IBM’s CEO or IBM didn’t set the premiums high enough (or both).
The option doesn’t vest until January 2019 and we all know what can happen to any company’s stock price in that period of time, so there’s no guarantee that the option will still be in-the-money when it vests. The option has a term of ten-years, however, so if it isn’t in-the-money, there’s still plenty of time for the stock price to recover before it expires.
A History of Premium-Priced Options
This isn’t IBM’s first foray into premium priced options. From 2004 to 2006, IBM granted a series of stock options to its executives that were priced at a 10% premium to the grant date market value. In 2007 they dropped the practice and granted at-the-money options, then they ceased granting options altogether. This is the first option IBM has granted since 2007.
The Valuation Mystery
The reason I was asked to comment on the option is that the value IBM reported for the option (which is also the expense IBM will recognize for it) is significantly less than amount that ISS determined the option was worth. IBM reported that the option has a grant date fair value of $12 million but, according to the Bloomberg article, ISS puts the value at $29 million.
It’s not unusual for there to be variations in option value from one calculation to the next, even when all calculations are using the same model and the same assumptions. But a variation this large is surprising. Both IBM and ISS say they are using the Black-Scholes model, so the difference must be attributable to their assumptions. If I were to guess which assumption is causing the discrepancy, my guess would be expected term. The dividend yield and interest rate aren’t likely to have that much of an impact and it seems unlikely that there would be significant disagreement as to the volatility of IBM’s stock.
Why Price Options at a Premium?
The idea behind premium-priced options is to require execs to deliver some minimum amount of return to investors (e.g., 10%) before they can benefit from their stock options. It’s an idea that never really caught on: only 3% of respondents to the NASPP/Deloitte Consulting 2016 Domestic Stock Plan Design Survey grant them.
I’ve never been a fan of premium-priced options. I suspect that most employees, including execs, assign a very low perceived value to them (or assign no value to them at all), so I doubt they are the incentive they are supposed to be. And the reduction in fair value for the premium is less than the amount by which the options are out-of-the money at grant and far less than the reduction to perceived value, which makes them a costly and inefficient form of compensation.