The Securities and Exchange Commission has proposed rules mandating disclosure of a company's CEO-to-median employee pay ratio, as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted in July 2010. The SEC issued the proposed rules on September 18, 2013, more than three years after Dodd-Frank was signed by President Obama. The proposed rules were approved by a three-to-two vote among the SEC commissioners.

The SEC noted that the proposed rules are intended to satisfy the requirements of Dodd-Frank while providing flexibility to lower the costs of compliance with the new rule.

Which companies are subject to the pay-ratio disclosure requirement?

All companies that are required to report a summary compensation table under Item 40(c) of Regulation S-K are subject to the pay-ratio disclosure requirement. Companies qualifying as emerging growth companies, smaller reporting companies and foreign private issuers are not subject to the rule.

Where does the disclosure appear?

The pay-ratio disclosure must appear in any SEC filing that requires disclosure of executive compensation information under Item 402 of Regulation S-K. The primary document for this disclosure is the proxy statement. However, Form 10-K and various registration statements also require this information, which can usually be satisfied by incorporating the proxy statement by reference.

When is the new pay-ratio disclosure required to be reported?

Companies will need to provide the pay-ratio disclosure with respect to compensation for the first fiscal year commencing on or after the effective date of the rules. Comments on the proposed rule will be due 60 days after the rule is published in the Federal Register. As a result, it seems unlikely that final rules will be approved in 2013. If the rules become effective in 2014, companies with a December 31 fiscal year end would first be required to disclose the pay ratio in their proxy statements that report on 2015 compensation and are filed in 2016.

What must be disclosed?

The proposed rules require disclosure of the following:

  1. The median of the annual total compensation of all employees of the company other than the principal executive officer (see Note 1 below)
  2. The annual total compensation of the principal executive officer (see Note 2 below)
  3. The ratio of (A) to (B) (see Note 3 below) 

Note 1 – Calculation of median of the annual total compensation of all employees other than the principal financial officer: The proposed rules require companies to determine the "median employee" and then determine the annual total compensation of the median employee. The proposed rules provide the following:

  • Which employees? Employees include all employees, including part-time, seasonal, temporary and non-U.S. employees; however, it does not include independent contractors or "leased" employees.
  • Employed as of when? The employees included in the calculation include all individuals employed as of the last day of the company's last completed fiscal year.
  • How is the "median employee" identified? The "median employee" is determined by calculating the median of the annual total compensation of all employees other than the principal executive officer. This calculation does not require companies to calculate the total compensation of all employees in accordance with the summary compensation table rules. Rather, the proposed rules permit companies to choose the methodology for identifying such median of annual total compensation, including a more readily available measure such as compensation amounts reported in payroll or tax records (such as Form W-2 income), as long as the company discloses the measure used. Similarly, the rules permit companies to use the same annual period that is used for payroll or tax records, even if it differs from the company's fiscal year. In addition, the proposed rules permit companies to use an alternative method, such as statistical sampling or estimates applied consistently to identify the median employee. The SEC indicated that this would permit companies to exclude employees with extremely low or high pay as not relevant to the median.

In the case of permanent employees hired mid-year or on a leave of absence for part of the year, their compensation may be (but need not be) annualized. However, the proposed rules preclude companies from adjusting part-time employee pay to a full-time equivalent, annualizing temporary or seasonal employees' pay and making cost-of-living adjustments for non-U.S. workers.

  • How is total annual compensation calculated? Once the median employee is identified, his or her compensation would need to be calculated in accordance with the total compensation rules of the summary compensation table, provided that reasonable estimates of certain pay elements are permitted for determination of the median employee's compensation (so long as the estimations are described). The rules note that when calculating the total compensation of the median employee, the company could include the total value of all perquisites (even though the SEC rules permit companies to exclude perquisites under $10,000); however, the company would need to include all perquisites provided to the CEO in the denominator (even if the company does not report them in the summary compensation table).
  • How is methodology explained? The disclosure of the company's methodology, including assumptions, adjustments and estimates used, should provide enough information for an investor to evaluate the appropriateness of the calculation. For example, if statistical sampling is used, the company should disclose the sample size, the size of the whole population, the sampling method and how differences in systems or geographies were handled. Changes in assumptions, adjustments or estimates from one year to the next should also be identified, including the reason for the change and the estimated impact of the change on the median and the ratio.

Note 2 – Calculation of CEO's annual total compensation: The calculation of the annual total compensation of the principal executive officer is calculated consistent with the total compensation amount reported in the summary compensation table.

Note 3 – Calculation and reporting of the ratio: The ratio can be reported as a ratio where (A) equals 1, such as "the ratio of the median of the annual total compensation of all employees other than the CEO to the annual total compensation of the CEO is 1 to 100," or as a narrative explaining the multiple, such as "the CEO's annual total compensation is one hundred times the median of the annual total compensation of all employees."

The SEC specifically acknowledged that the variability in calculations afforded by the more flexible approach toward calculating the pay ratio will limit comparability across companies. The SEC expressed the view that comparability was not necessary, and the primary purpose was to evaluate the CEO's compensation within his or her own company. In fact, the SEC release states that "precise comparability across companies may not be relevant and could generate potentially misleading interpretations or conclusions." While this is undoubtedly true, it is unlikely to prevent governance rating agencies, proxy advisory firms and the media from comparing ratios. The two SEC commissioners who voted against the rule suggested that the costs will still be significant, with limited benefits to investors, and potential harm to competition, efficiency and capital formation.

What level of liability attaches to the pay-ratio disclosure?

The information will be deemed "filed" for liability purposes, and will similarly be covered by the CEO and CFO certifications.

What should companies do now?

The effectiveness of the final CEO-to-median employee pay-ratio rule is still a couple years away. The SEC is soliciting comments on many particular questions related to the new rule. As a result, the final rule may reflect further changes. In the meantime, companies may wish to identify possible methodologies for calculating the pay ratio, and prepare a preliminary estimate of the pay ratio, calculated in accordance with the proposed rules, in order to get a general sense of the company's pay ratio, as well as processes that will be necessary to collect the information required to determine the pay ratio.