Earlier this month, the Securities and Exchange Commission (the “SEC”) voted in a 3-2 split to propose the much anticipated CEO pay ratio rule, which would require disclosure of the ratio of a company’s median employee compensation level to the company’s CEO compensation. 1 As evidence of the contentious nature of the rule, the SEC noted that it received almost 23,000 comments before the rule was even proposed, with corporations and their advisers asserting that the costs of compliance would be much greater than any benefits of disclosure, and investor groups asserting that the disclosure may help inform investment and voting decisions and possibly rein in pay levels. As discussed below, the SEC’s rule proposals are designed to give companies flexibility in identifying the “median” employee and in calculating total employee compensation, as long as the methods and related disclosures comply with certain basic principles and are reasonable and consistently applied.
Comments on the rule are due by December 2, 2013. 2 It is unclear how quickly the SEC will act in finalizing the rule, but the new rule is not expected to take effect before the 2015 proxy season.
Overview of the Proposed Rule
Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”) requires the SEC to amend Item 402 of Regulation S-K to mandate disclosure of (i) the median level of annual total compensation of all employees of the company (excluding the principal executive officer, or CEO), (ii) the annual total compensation of the company’s CEO and (iii) the ratio of the median of the annual total compensation of all employees to the annual total compensation of the CEO.
In the Proposing Release, the SEC acknowledged that “neither the statute nor the related legislative history directly states the objectives or intended benefits of the provision,” 3 ostensibly making its rulemaking more difficult. In fact, dissenting Commissioner Daniel Gallagher has criticized what he called the “name and shame” nature of the rule proposals and what he stated were political motives underlying this Dodd Frank requirement.
Nonetheless, in response to the Dodd Frank mandate, the SEC has proposed new Item 402(u) of Regulation S-K to impose the pay ratio disclosure. As discussed below, calculation of median employee compensation will generally include all employees (regardless of whether part-time, seasonal or foreign, but excluding the CEO) employed on the last day of the registrant’s fiscal year. In its proposals, the SEC has attempted to provide issuers significant flexibility in calculating the median income and has limited the required related disclosure, which some commentators suggest may consist of a single paragraph. As proposed, the pay ratio disclosure must be made whenever Regulation S-K Item 402 disclosures are required in a filing.
Disclosure of the Pay Ratio – Narrative and Numerical Options
The pay ratio may be expressed numerically or narratively under Dodd-Frank. For example, the SEC noted that, if the median annual total compensation is $45,790 and the CEO’s annual total compensation is $12,260,000, the company may express the ratio either as “1 to 268” or narratively as “The PEO’s annual total compensation is 268 times that of the median of the annual total compensation of all employees.” 4
All Employees Generally Covered in the Calculation
The calculation of the median annual total compensation of a company covers “all employees,” including full-time, parttime, seasonal, or temporary workers employed by the company or any of its subsidiaries (including officers other than the CEO), as currently proposed. Independent contractors and temporary workers employed by a third party should not be included in the median income calculation. Notably, and regrettably for issuers with global workforces, the rule proposals do not exclude non-U.S. employees, based on the notion that the flexibility in determining median income (described below) should aid companies in managing potential data privacy and other costs associated with including foreign workers.
The determination of who is an “employee” for purposes of the proposed rule should be made as of the last day of the company’s last completed fiscal year, as is the case with determining the compensation of “named executive officers” for other proxy purposes. If the company has permanent employees (including part-time employees but excluding seasonal and temporary workers) who were not employed for the full fiscal year, the company may choose to annualize the income for such employees – but must make this decision across the board and not make the adjustment for some employees but not others. The income of part-time workers may not be annualized as if they worked full time, and the proposals would not allow accommodations for other adjustments, such as adjustments for jurisdictions with a lower cost of living. In terms of calculating the median annual total income, a company’s fiscal year may clearly impact the disclosure, especially for seasonally driven businesses. For instance, a clothes retailer with a large portion of seasonal employees whose fiscal year ends December 31 would be required to include the non-annualized income for its seasonal workers employed during the holiday season as they would likely still be employed at December 31; however, if that same company’s fiscal year ended June 30, a time when seasonal workers are not generally hired, the number of seasonal workers to include in the calculation may be very low.
Flexibility in Determining the Median and Total Employee Compensation
In an attempt to relieve the disclosure burden on issuers, the SEC has proposed a very broad rule in terms of the methods companies may use to calculate the median total annual income of its employees. The rule proposals do not specify any required calculation methodology for identifying the median or require companies to determine the exact compensation for each employee. Rather, the appropriate method for determining a company’s median annual total compensation will depend on a variety of variables including the size and nature of the workforce, the complexity of the organization, the stratification of pay levels, the types of compensation provided, the number of currencies involved, the number and types of tax and accounting regimes involved and the nature and complexity of payroll systems. Permissible approaches in calculating the median annual total compensation include:
- Determination of total compensation for each employee using existing Item 402(c)(2)(x) of Regulation S-K;
- Use of reasonable estimates; or
- Use of statistical sampling (assuming that the sample size is reasonable in light of the underlying distribution of compensation data).
In addition, the SEC suggests that taking an income sample from a large population of employees would be one permissible method of determining the median. As proposed, a company may also exclude employees with either extremely high or low salaries from its calculation. Regardless of the manner of calculation, the methodology should be consistently applied and must be disclosed in such a way that the reader can evaluate the appropriateness of any estimates. No other narrative discussion regarding the ratio is required but would be permitted if a company chose to do so (e.g., to provide supplemental ratios).
Further, the proposed rule does not require companies to use a specific compensation measure (e.g., cash compensation or total direct compensation) but rather leaves it open-ended for each company to consistently apply the compensation measure it believes is reasonable in light of its business structure. Because tax or recordkeeping can differ from a company’s fiscal year, the proposed rule also allows the company to use the same annual period that is used in the payroll or tax records from which the compensation amounts are derived in calculating this amount.
Disclosure Required Whenever Other Item 402 Disclosure Required
The proposed rule requires disclosure of the CEO pay ratio in any SEC filing that requires Regulation S-K Item 402 executive compensation disclosures, including annual reports, proxy/information statements and registration statements. However, the SEC currently proposes that the pay ratio will not be required to be updated until a company files its annual report or definitive proxy statement, provided the pay ratio is filed with the SEC no later than 120 days after the end of a company’s fiscal year. Supplemental Form 8-K reporting of the pay ratio would be required, consistent with current rules, where salary or bonus is not calculable as of the latest practicable date in connection with a proxy statement or other filing. The pay ratio disclosures would be deemed “filed,” rather than “furnished,” and thus would be subject to federal securities laws liability.
Emerging Growth Companies, Smaller Reporting Companies and Foreign Private Issuers Excluded
As proposed, the pay ratio disclosure would not apply to emerging growth companies, smaller reporting companies or foreign private issuers. New registrants would also be permitted to delay pay ratio disclosure until completion of the first fiscal year on or after the date the registrant becomes subject to Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934.
Ripe for Challenge?
In the Proposing Release, the SEC goes into great detail regarding the costs and benefits of the disclosure, particularly with regard to the possible lack of comparability between companies with different business structures. The cost estimates the SEC has received are also sobering – approximately $100,000,000 for a multinational company based on one estimate provided. Given the recent court cases challenging SEC rulemaking related to conflict mineral and resource extraction disclosure, along with the initial opposition many large companies have voiced against this disclosure, the pay ratio disclosure requirement is likely to draw third party scrutiny and possible challenge. The unsettled environment and influence of industry opposed to the measure is also underscored by the fact that the House Committee on Financial Services voted to strike down the disclosure in June 2013, although the matter has yet to make it to the House floor for a vote.