On September 18, 2013, by a 3-2 vote, the SEC adopted proposed rules requiring most public companies to disclose the ratio of the Chief Executive Officer’s annual compensation to the median annual compensation of all other employees of the company. The highly controversial disclosure rules were mandated by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. If final rules become effective in 2014, most public companies with calendar year-ends would be required to disclose the CEO pay ratio disclosures in early 2016 with respect to compensation earned in 2015.

The proposing release can be found here.

Thousands of comments were posted regarding the implementation of Section 953(b) prior to the proposed CEO pay ratio rule being published. In crafting its proposed rule, the SEC took into account many of the concerns voiced in those comments about the expense and difficulty of complying with the literal language of Section 953(b). In response, the SEC’s proposed rule grants considerable flexibility to individual companies to determine how to satisfy the disclosure requirements in light of their own circumstances. Nevertheless, significant issues remain and compliance with the CEO pay ratio rule is likely to be expensive for many companies, and challenging for most.

Section 953(b) is notable for its brevity. In its proposed rule, the SEC attempted to address many considerations not specified in Section 953(b), including:

  • How does a large company determine the median pay of thousands of employees around the world
  • Will public companies have to perform, for every single employee, the same complex pay calculations that they currently perform for the compensation disclosure of the CEO, CFO and the few, other highest-earning “named executive officers?”
  • Must foreign employees, part-time employees and employees who did not work a full year be included? If so, how will public companies account for their compensation in the context of Section 953(b)’s focus on “total annual compensation?”
  • How often and in what filings should the disclosure be made?
  • Are smaller reporting companies, including emerging growth companies, and foreign private issuers exempt?

Despite the SEC’s efforts to address many of the practical issues commenters have raised, significant issues remain. Although the CEO pay ratio disclosure will be time consuming and potentially expensive to provide, there is little consensus as to whether the disclosure is useful to investors.

Proposed Rule Considerations
The proposed rule adds a new paragraph (u) to Item 402 of Regulation S-K requiring disclosure of:

  • the median of the annual total compensation of all employees of the registrant, except its principal executive officer (CEO);
  • the annual total compensation of the CEO; and
  • the ratio of the CEO’s compensation to the median compensation amount.

Which companies must make pay ratio disclosure?
The proposed rule applies to reporting companies other than “emerging growth companies,” “smaller reporting companies” and “foreign private issuers.” Newly public companies are not immediately subject to the disclosure requirements.

On which forms must the disclosure be made?
The proposed pay ratio disclosure would be required in annual reports on Form 10-K, proxy and information statements, and registration statements under the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”), to the same extent that the requirements of these forms require compliance with Item 402 of Regulation S-K.

To the extent that Item 402 of Regulation S-K currently permits a company to delay disclosure of a portion of its CEO’s salary or bonus because such amount is not calculable at the filing date, the SEC’s proposed rule would also allow the company to omit the CEO pay ratio and median compensation amount until the CEO’s total compensation could be calculated.

Which employees must be included in the calculation of median annual compensation?
“All employees of the registrant” would be defined to mean all individuals employed by a company or any of its subsidiaries and would include any “full-time, part-time, seasonal or temporary worker” as of the last day of the company’s prior fiscal year. The SEC clarified that the definition for “all employees of the registrant” shall not include any carve-outs for categories of employees, including non-U.S. employees. In contrast, workers who are not employed by the registrant or its subsidiaries, such as independent contractors or “leased” workers or other temporary workers who are employed by a third party would not be covered.

In determining annual total compensation, companies would not be permitted to make full-time equivalent adjustments for part-time workers, annualizing adjustments for temporary or seasonal workers or cost-of-living adjustments for non-U.S. workers.

What does “total compensation” mean and how is it calculated?
“Total compensation” is defined by reference to Item 402(c)(2)(x) of Regulation S-K. Under the SEC’s proposed rule, a company will only be required to calculate and disclose such information for a single, possibly hypothetical, “median employee.” Moreover, each company may identify its “median employee” based on any consistently applied methodology for estimating annual compensation, but the methodology must be reasonable under the circumstances and disclosed. Large and small companies could face widely different challenges and degrees of difficulty in determining the median compensation of their workforces. For instance, it may be reasonable for an employer with thousands of employees to use statistical sampling or another reasonable method to determine its median compensation amount in lieu of using detailed data for each individual in its entire workforce. By contrast, a statistical approach might not be reasonable for a company with a smaller number of employees, but the SEC did not provide guidance regarding the number of employees above which statistical analysis might become reasonable.

Once the registrant identifies the “median employee” based on the selected compensation measure applied to each remaining employee in the sample, the company would calculate that employee’s annual total compensation in accordance with Item 402(c)(2)(x) and disclose that amount as part of the pay ratio disclosure.

What does “annual” total compensation mean and how often must it be updated?
Annual total compensation means compensation for a company’s most recently completed fiscal year. The proposed rules would not require a company to update pay ratio disclosure continually throughout the year, or, for example, when a new registration statement is filed.

Is the CEO pay ratio disclosure considered “Filed” or “Furnished”?
The CEO pay ratio disclosure will be deemed to be “filed,” not “furnished.” Among other things, information that is considered “filed” is subject to the full range of liability provisions of the Securities Act and the Exchange Act and is within the scope of the certifications made by each company’s principal executive and principal financial officers. By contrast, information that is considered “furnished” is not within the scope of the certifications and is only subject to liability under anti-fraud provisions of the securities laws.

When must companies provide CEO pay ratio disclosure?
The SEC’s proposal would require a company subject to the rule to begin complying with proposed Item 402(u) no later than the company’s first fiscal year commencing on or after the effective date of the rule. Thus, if the final rule were to become effective in 2014, a company with a fiscal year ending on December 31 would be first required to include CEO pay ratio disclosure in its Form 10-K annual report covering fiscal year 2015, or if the company is subject to the proxy rules, the company could omit the CEO pay ratio disclosure from its Form 10-K and file it together with other executive compensation disclosure in the company’s proxy or information statement for its 2016 annual meeting of shareholders (or written consents in lieu of such a meeting).

Among the SEC’s specific requests for comment, it highlights the question of whether transition periods should be different for different types of companies. For example, the SEC asks whether companies with a workforce below a certain size (e.g., fewer than 1,000 employees) should have a shorter phase-in period than others. Conversely, the SEC asks whether there should be a longer phase-in for multinational companies, a separate transition period for business combinations after the rule becomes effective, or a separate transition period for companies that cease to be smaller reporting companies.

When are new registrants required to provide the disclosure?
To avoid increasing the burdens of preparing disclosure for an initial public offering (or a registration statement on Form 10) the SEC’s proposed CEO pay ratio rule would permit new registrants to delay compliance until they file executive compensation disclosure for the first fiscal year commencing on or after the date they become subject to the requirements of Section 13(a) or Section 15(d) of the Exchange Act. In other words, newly public companies subject to the CEO pay ratio disclosure rule would be permitted to omit the CEO pay ratio disclosure until the filing of their Form 10-K for the first full fiscal year starting after they become public companies or, if later, the filing of a proxy or information statement for their next annual meeting of shareholders (or written consents in lieu of a meeting) following the end of such fiscal year. Newly public companies that also qualify as emerging growth companies would continue to be exempt from disclosure.

Challenges for Issuers
The proposed rules present issuers with a multitude of challenges if the rules were to be adopted as proposed. Fundamentally, both the determination of a company’s employees and the calculation of annual compensation present significant, practical questions for issuers.

Who is an employee?
This question raises multiple issues related to the practical implementation of the proposed rules. The inclusion of seasonal, temporary and non-U.S. employees raises time and cost issues that have been central to the debate on Section 953(b). Gathering data for thousands of employees across multiple jurisdictions, paid in multiple currencies, many of whom may be temporary workers, will likely be time consuming and costly for companies. Further, companies will need to undertake an analysis under the laws of various foreign jurisdictions to determine which workers are “employees” under applicable law and not third-party contractors. As those concepts may not be clearly defined under local law, the disclosure may require companies to make judgment calls that may be subject to later scrutiny.

We anticipate that the broad scope of the term “employee” will be strongly contested by opponents of Section 953(b) as unduly costly and burdensome and with limited value to the final ratio of the median employee compensation to CEO compensation. While the methodology adopted by the SEC may ease the cost of implementing the proposed rule by allowing certain estimates and statistical analyses, the inclusion of temporary, seasonal and non-U.S. employees is likely to create a significant burden on companies. The SEC acknowledged that few, if any, companies currently maintain payroll and other information systems that capture all of the data needed to determine “total compensation” under Item 402(c)(2)(x), but did not provide any relief in the rule other than through the length of the transition periods. Thus, compliance with the rule as proposed would require many companies to develop new, or significantly modify existing, systems for gathering the necessary data on a global scale.

How is total compensation to be calculated?
Certain elements of total compensation will pose valuation issues for employees that do not typically arise in the context of compensation for executive officers. For example, the SEC noted that, in the case of pension benefits provided to union members in connection with a multi-employer defined benefit pension plan, commenters expressed concern that the participating employers typically do not have access to information from the plan administrator that would be needed to calculate the aggregate change in actuarial present value of the accumulated benefit of a particular individual under the plan. While the SEC stated its belief that the use of reasonable estimates in determining an amount that reasonably approximates the aggregate change in actuarial present value of an employee’s defined pension benefit would be appropriate, that does not eliminate the concerns of how an employer gains enough information to make a reasonable estimate and how much information will form the basis of such reasonable estimate.

Personal benefits that aggregate to less than $10,000 for a median employee may be excluded from the calculation. This should provide some limited relief to companies seeking to determine total compensation for such employee.

Total compensation also raises interpretive issues for companies with non-U.S. employees in terms of how to value unique types of compensation given only in certain countries. While the SEC acknowledged this potential issue, it left the determination with the company’s management, which must make a reasonable estimate utilizing the consistent methodology described above. This places a significant burden on management to make reasonable determinations regarding a potentially large number of disparate compensation arrangements over multiple foreign jurisdictions in determining a reasonable estimate of total compensation for a hypothetical “median employees,” and makes any such determinations open to second-guessing and scrutiny by the SEC and activist shareholders.

Given Congressional efforts to repeal Dodd-Frank Section 953(b), on the one hand, and the thousands of public comments in support of CEO pay ratio disclosure on the other hand, it is difficult to predict whether the rule will come into effect, let alone what form the rule will take if it does ultimately become effective. In addition, as the SEC acknowledges, the CEO pay ratio disclosure may be deceptively simple—implying comparability where it doesn’t exist—and could general potentially misleading interpretations or conclusions.

Nevertheless, as proposed, compliance with the CEO pay ratio rule would require considerable additional time, effort and expense for all covered public companies. Consequently, issuers that may be subject to the CEO pay ratio disclosure rule should carefully consider how the rule could impact their disclosure procedures, particularly with respect to collecting and analyzing data on “total annual compensation of all employees” and determining the median of such compensation.