New Disclosures Not Expected to Be Required Until 2016 Proxy Season Issuers May Use Estimates and Statistical Sampling

Summary

On September 18, 2013, in a 3-2 vote, the SEC voted to propose rules implementing the controversial pay ratio requirement pursuant to Section 953(b) of the Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). The proposed rules are available here.

The proposed rules require registrants to disclose:

  • the median of the annual total compensation of all employees of the registrant (excluding the principal executive officer);
  • the annual total compensation of the registrant’s principal executive officer (which is already required to be disclosed); and
  • the ratio between these two amounts

Total compensation continues to be defined in the same way as it is for executive officers pursuant to Item 402 of Reg. S-K even though companies do not collect such information for all employees. Many commenters have objected to the rule arguing that it provides no economic benefit to investors and would be difficult and costly to calculate.

While complying with the Dodd-Frank mandate, the SEC sought to address concerns about potential costs and burdens by providing flexibility, including the use of estimates and statistical sampling. Moreover, the SEC proposed that the rules would not apply until after the end of an issuer’s first fiscal year commencing after effectiveness of the rules. As a result, the required disclosure would not likely be required in proxy statements until the 2016 proxy season.

The disclosure would be required in proxy statements or annual reports on Form 10-K, as well as registration statements or other filings that require compliance with S-K Item 402. The rule would not apply to emerging growth companies, smaller reporting companies or foreign private issuers.

Discussion

The proposed rules would amend Item 402 of Reg. S-K by adding new Rule 402(u). Under the rules, as part of the pay ratio disclosure, companies must first:

  • identify the median employee and
  • calculate that employee’s annual total compensation

The proposed rules do not prescribe an exact methodology; instead, the rules were drafted to provide companies with significant flexibility in complying with the requirement while still fulfilling the DoddFrank mandate. The rules allow use of reasonable estimates to identify the median and to calculate annual total compensation (or any element of total compensation).

Median Employee

Employee defined

The term “employee” refers to all employees employed as of the last day of the last completed fiscal year and includes full-time, part-time, seasonal and temporary workers, as well as any foreign employees, employed by the company or its subsidiaries. Directors, independent contractors, “leased employees” and workers employed by a third-party are not covered.

Identifying the median employee

Companies may choose to identify the median compensation using either:

  • their full employee population, or
  • by using statistical sampling, or
  • another reasonable method

When using a statistical method, companies may compute annual total compensation for each employee included in the calculation (with the entire population or statistical sample) to identify the median employee. Alternatively, companies may identify the median employee based on any consistently applied compensation measure (which could include amounts reported in payroll or tax records or other information already tracked and compiled for such purposes) and then calculate annual total compensation for that employee. Registrants must disclose the compensation measure used. Registrants using this method may even use the same annual period utilized by these records even if the records are kept on a basis other than the registrant’s fiscal year. The SEC notes that companies may not need to determine exact compensation amounts for every employee in a random sample, since identifying the median may not require calculating amounts for those with extremely low or high pay.

Annual Total Compensation

The rules define annual total compensation in accordance with the existing extensive executive compensation rules, specifically Item 402(c)(2)(x) of Reg. S-K. However, companies will have some

flexibility in calculating total annual compensation of employees. The proposed rule would also allow reasonable estimates when

  • calculating the annual total compensation, or
  • any element of total compensation

Annualization

Companies will be permitted to annualize compensation for all permanent employees (e.g. newly hired employees or unpaid leave of absence) on the last day of the fiscal year. However, annualizing would not be permitted for seasonal or temporary workers, or to adjust a part-time employee as if he or she were a full-time employee. Similarly, cost-of-living adjustments would not be permitted for non-U.S. workers.

Compensation elements

The SEC noted that registrants should interpret “salary” as required under Reg. S-K to mean “wages plus overtime” as applicable.

The SEC also recognized that certain elements may raise new valuation issues outside of the executive compensation context. For example, information may not be available within the time frame required in order to determine the change in actuarial value of defined benefit obligations. In those cases, registrants could reasonably approximate the value.

The SEC noted that, when calculating annual total compensation for the median employee, companies may, if they choose, include personal benefits or perquisites (even if less than $10,000) or compensation under 401(k), health or other non-discriminatory plans – even though such amounts are typically excluded in summary compensation tables. However, for consistency in that case, those amounts would need to be included in the CEO’s total compensation for purposes of the pay ratio computation, and registrants must explain any differences from the summary compensation table.

By contrast, the SEC believes that any accrued benefit under a government-mandated pension plan would not be considered compensation, because it is provided by the government and not the employer.

Additional Considerations

Disclosure of methodology and assumptions

Companies must briefly disclose their methodology and discuss any material assumptions, adjustments or estimates used to identify the median or determine total compensation or any elements of total compensation. For example, if statistical sampling is used, companies should disclose the sample size, sampling method, and how different geographic locations or segments were addressed. To promote comparability, if assumptions or methodologies are changed in the next year, companies should describe the change, the reasons for the change and estimate the impact.

Location; Supplemental disclosure

Pay ratio information must be disclosed in the proxy or in the company’s annual report on Form 10-K in the same manner as the summary compensation table and related disclosure.

Companies are permitted to supplement the required disclosure with a narrative discussion if desired. They may also present additional ratios. Any additional ratios must be clearly identified, not misleading and not presented with greater prominence than the required ratio.

What’s Next

The SEC received over 22,000 comment letters in advance of the proposal. The SEC sought to address these concerns by providing significant flexibility. However, it is seeking additional comments as to whether it struck the right balance. As a result, the proposal may elicit substantial further comments. Both Commissioners Gallagher and Piwowar, who voted against the proposed rule, requested that the public submit “detailed, data-heavy comments” that provide “realistic estimates of the costs of compliance with the proposed rule.” Comments will be due 60 days after publication of the proposal in the Federal Register.

If approved, companies must begin complying with the proposed Item 402(u) for the first fiscal year commencing on or after the effective date of the rule, and, as proposed, companies would be permitted to omit the initial pay ratio disclosure from its filings until the filing of the company’s annual report on Form 10-K for that fiscal year or, if later, the filing of a proxy or information statement for its next annual meeting of shareholders following the end of such year. In any event, the initial pay ratio disclosure must be filed no later than 120 days after the end of such fiscal year.

For example, if the rule becomes effective in 2014, a calendar year company would first be required to include pay ratio disclosures for fiscal year 2015 in its proxy statement for its 2016 annual meeting of shareholders. A newly public company would first be so required with respect to compensation for the first fiscal year beginning after its registration statement becomes effective (as the proposal would allow new registrants to delay compliance and not include pay ratio disclosures in the IPO registration statement).