On September 18, 2013, the Securities and Exchange Commission (“SEC”) proposed its long awaited rule that would require public companies to disclose the ratio of the compensation of its principal executive officer to the median compensation of all company employees, excluding the principal executive officer.
Proposed Scope of Disclosure
The proposed rule, adopted as required by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), would amend Item 402 (Executive Compensation) of Regulation S-K to add a new disclosure requirement. As proposed, companies would be required to include pay ratio disclosure in the following filings:
- annual reports on Form 10-K;
- registration statements; and
- proxy and information statements.
However, the pay ratio disclosure would not be required to be made by emerging growth companies smaller reporting companies, foreign private issuers and companies that file reports and registration statements under the U.S.–Canadian Multijurisdictional Disclosure System.
Proposed Disclosure Requirements
The proposed rule would add a new paragraph (u) to Item 402 and would require disclosure of:
- the median of the annual total compensation of all employees, excluding the principal executive officer;
- the annual total compensation of the principal executive officer; and
- the ratio of the amount in (A) to the amount in (B), presented as a ratio in which the amount in (A) equals one or, alternatively, expressed narratively in terms of the multiple that the amount in (B) bears to the amount in (A).
Identifying “All Employees”
For purposes of the proposed rule, “all employees” would mean any full-time, part-time, seasonal or temporary worker employed by the reporting company or any of its subsidiaries, including workers employed outside of the U.S., but would exclude independent contractors or “leased” workers.
Adjustments for Partial Year Employment
The proposed rule would allow, but not require, companies to annualize the total compensation of permanent employees that were not employed during the entire year. In contrast, the total compensation of temporary or seasonal workers would not be permitted to be annualized. If a company elects to make an adjustment to annualize one or more employees’ compensation, it must make the adjustment to all permanent employees that were not employed during the entire year.
Identifying the Median
Companies would be able to identify the median of the annual total compensation of all employees by using statistical sampling or by another reasonable method. Additionally, companies would be able to use any consistently identified compensation measure (e.g., cash wages) to determine the median amount. For example, a company could take a random sample of its employees, identify the median employee using any consistently applied compensation measure (e.g., cash wages), and then calculate the annual total compensation for use in the pay ratio disclosure.
While the proposed rule permits using statistical sampling, it does not require the use of a specific method to determine an appropriate sample size. Instead, if a sample is used, the company would develop its own methodology to determine an appropriate sample size, which would be required to be disclosed and consistently used by the company. An appropriate methodology for a company would depend on its specific facts and circumstances, including:
- the size and nature of the workforce;
- the complexity of the organization;
- the stratification of the pay levels across the workforce;
- types of compensation employees receive;
- the extent different currencies are involved; and
- the number of payroll systems the company has and the degree of difficulty involved to integrate them to reliably compile total compensation for all employees.
Determining Total Compensation
The proposed rule defines “total compensation” by reference to Item 402(c)(2)(x), which is the existing definition used to calculate total compensation for named executive officers. Said another way, this is the “total” compensation column in the Summary Compensation Table for NEOs.
Although total compensation for NEOs is generally calculated manually on an individual by individual basis and is generally very time consuming and comprehensive (as the SEC says: “all means all”), a company would be able to avoid calculating “total compensation” for all employees (or even the entire statistical sample of employees) by consistently using a different identified compensation measure (e.g., cash wages) to identify the median amount.
The proposed rule reduces the burden of valuing the additional types of compensation by permitting companies to use reasonable estimates to determine the value of the total compensation (other than for the principal executive officer), or a specific element of total compensation. If estimates are used, the company will be required to disclose that the amount is estimated as well as the methodology used to make the estimate.
Disclosure of Methodology, Assumptions and Estimates
The proposed rule would require the company to briefly disclose the methodology and material assumptions, adjustments and estimates used in the determination of the median of the total compensation of all employees or the calculation of the annual total compensation with respect thereto. However, the company will not be required to disclose the actual formulas or detailed descriptions of methods used.
As discussed above, companies would be required to clearly identify any amounts that are estimated and consistently apply any methodology, assumptions, adjustments or estimates used to identify the median or to determine total compensation, or any specific element of total compensation.
Proposed Effective Date
Companies would be required to comply with the proposed rule with respect to compensation for the first fiscal year commencing on or after the effective date of the rule and would be permitted to omit the pay ratio disclosure from its filings until the filing of its 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.
The proposed rule would introduce a new concept into the executive compensation disclosure that would require companies to develop new compliance procedures. While the proposed rule does permit the use of sampling, estimates and assumptions to comply with its requirements, the proposed rule may still be a significant burden for some companies. Since the proposed rule closely mirrors the specific language of the pay ratio disclosure required by the Dodd-Frank Act, it is unlikely that there would be any easing of the burden on companies to comply in the proposed rule before it becomes final. Further information on this proposed rule can be found in SEC Release No. 33-9452.