Why it matters

In a split vote, the Securities and Exchange Commission (SEC) adopted a final rule requiring public companies to disclose the "pay ratio" between the chief executive officer's (CEO) annual total compensation and the median annual total compensation of all other employees in the company. The controversial rule—the SEC released a proposed version in September 2013 that drew almost 300,000 comments—provides some flexibility to companies, including the allowance of a statistical sample of the total employee population and the ability to identify the median employee once every three years. Companies must disclose the methodology used for identifying the median employee's compensation, and the total compensation for both CEOs and the median employees must be calculated in the same manner. Mandated by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the pay ratio rule will take effect the first full fiscal year beginning on or after January 1, 2017, meaning disclosures will first appear in 2018. A renewed focus on any perceived "disparity" in CEO pay as compared to pay for others in a public organization will put increased pressure on Boards of Directors and Compensation Committees to justify the rate of CEO pay. For nonpublic institutions, the potential for such disclosures to "trickle down" poses similar risks.

Detailed discussion

When the Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010, the statute imposed an obligation on the SEC to establish a rule requiring the disclosure of the ratio of the compensation of CEOs to the median compensation of employees.

Specifically, Section 953(b) directed the SEC to amend Item 402 of Regulation S-K to require companies to disclose the median of the annual total compensation of all employees of the company (except the CEO), the annual total compensation of the CEO, and the ratio of the median annual total compensation of all employees of the company (except the CEO) to the annual total compensation of the CEO, or the pay ratio.

Intended to help inform shareholders when voting on "say on pay," the rule requires disclosure of the pay ratio in registration statement, proxy and information statements, and annual reports where executive compensation is disclosed. Disclosure of pay ratios will begin the first fiscal year beginning on or after January 1, 2017.

Whom does the rule cover? All companies required to provide executive compensation disclosure under Item 402(c)(2)(x) of Regulation S-K must comply, meaning all public companies, with some exceptions, will provide disclosure.

To address concerns about the cost of compliance, the agency said it attempted to provide companies with flexibility about the reporting requirements. Companies are permitted to select the methodology used for identifying the median employee and that employee's compensation, using statistical sampling of the employee population or other "reasonable methods," the SEC said. A cost-of-living adjustment to the compensation measure used to identify the median employee is permissible if the same adjustment is used in calculating the employee's annual total compensation and if the company also discloses the total compensation and pay ratio without the cost-of-living adjustment.

Median employee identification need only occur once every three years (absent a change to the employee population), with a determination date chosen within the last three months of a company's fiscal year. The company should include all employees—in the United States and beyond the borders, full-time and part-time, temporary and seasonal—it and its consolidated subsidiaries have on payroll.

Accompanying the disclosure should be a brief statement describing the methodology used to identify the median employee as well as any material assumptions, adjustments, or estimates used.

Some exemptions apply. Non-U.S. employees from countries where data privacy laws prohibit such information sharing are exempt from the rule, while certain types of reporting companies (such as registered investment companies, smaller reporting companies, emerging growth companies) do not need to comply. Transition periods are also provided under the rule for new companies or a smaller reporting company that grows, for example. And pay-ratio information does not need to be disclosed in reports that do not require executive compensation information, such as quarterly reports.

Each of the Commissioners filed a statement with the release of the pay-ratio disclosure rule. While Luis A. Aguilar praised the new rule as "another step to fulfill its congressional mandate to provide better disclosure for investors regarding executive compensation at public companies," Commissioner Daniel M. Gallagher disagreed. The SEC adopted "a nakedly political rule that hijacks the SEC's disclosure regime to once again effect social change desired by ideologues and special interest groups," he said, and unlawfully compelled corporate speech.

To read the SEC's Final Rule, click here. We will be providing more detailed analysis of the pay-ratio rules in the coming weeks.