The SEC has proposed amendments to Item 402 of Regulation S-K to implement Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which directed the SEC to amend its executive compensation disclosure rules to require public companies to disclose:

  • The median of the annual total compensation of all its employees except the company’s principal or chief executive officer (CEO);
  • The annual total compensation of its CEO; and
  • The ratio of the two amounts.

The SEC refers to this disclosure, which would be required in new paragraph (u) of Regulation S-K Item 402, as “pay ratio” disclosure.

Where would the pay ratio disclosure appear?

The pay ratio disclosure would be required in any annual report, proxy or information statement or registration statement that requires executive compensation disclosure pursuant to Item 402. As a result, at a minimum, the disclosure will appear each year in a public company’s annual meeting proxy statement and will be included or incorporated by reference into its Form 10-K annual report. Emerging growth companies, smaller reporting companies and foreign private issuers would be exempt from the requirement to provide the pay ratio disclosure.

How would the pay ratio be disclosed?

The pay ratio would have to be expressed either as a ratio in which the median employee compensation is equal to one, or narratively in terms of the multiple that CEO compensation bears to the median. If the CEO total compensation is $10,000,000 and median employee total compensation is $50,000 then the pay ratio would be expressed as 1 to 200 or narratively as “the CEO’s annual total compensation is 200 times that of the median of the annual total compensation of all employees.”

How would the median employee compensation be determined?

The new rule would not specify any required calculation methodologies for identifying the total median employee compensation. Instead, it would allow companies to select a methodology that is appropriate to the size and structure of their own businesses and the way they compensate employees. Companies could calculate the total compensation of all employees using the same methodology as required for the summary compensation table and then identify the median compensation using that method. Alternatively, companies could identify the median employee in terms of total compensation for all employees, using any consistently applied compensation measure, and then calculate the annual total compensation for that employee.

Companies would be permitted, but not required, to annualize the total compensation for a permanent employee who did not work for the entire year, such as new hires. In contrast, full-time equivalent adjustments for part-time workers, annualizing adjustments for temporary and seasonal workers, or cost-of-living adjustments for non-U.S. workers would not be permitted under the proposed rule.

Which employees’ compensation would be included in determining the median?

The calculation would include any individual employed by the company or any of its subsidiaries as of the last day of its last completed fiscal year. This would include any full-time, part-time, seasonal or temporary worker employed by the company or any of its subsidiaries on that day (including officers other than the CEO) within or outside the United States.

How would “total compensation” be calculated?

For the CEO, total compensation would be calculated based on the definition used for purposes of the total compensation figure disclosed in the summary compensation table in the annual meeting proxy statement (Item 402(c)(2)(x) of Regulation S-K). Median employee total compensation would be calculated using the same definition of “total compensation” for the last completed fiscal year. Methodologies for including or excluding certain amounts, such as perquisites valued at less than $10,000, would need to be the same as the methodologies used in determining CEO total compensation. In determining total compensation, all references to “named executive officer” in Item 402 would be deemed to refer instead to “employee” and, for non-salaried employees, references to “base salary” and “salary” may be deemed to refer instead to “wages plus overtime.” The proposed rule would allow companies to use reasonable estimates when:

  • Calculating the total employee compensation,
  • Calculating any element of total employee compensation, or
  • Determining the total compensation of the median employee.

Will companies have to disclose their methodology, assumptions and estimates?

Companies would be required to briefly disclose and consistently apply any methodology used to identify the median and any material assumptions, adjustments or estimates used to identify the median or to determine total compensation or any elements of total compensation, and must clearly identify any estimated amount. According to the SEC, this disclosure should be a brief overview; it would not be necessary to provide technical analyses or formulas. If a company changes methodology or material assumptions, adjustments or estimates from those used in its pay ratio disclosure for the prior fiscal year, and if the effects of any such change are material, the company would be required to briefly describe the change and the reasons for the change, and provide an estimate of the impact of the change on the median and the ratio.

When would the pay ratio disclosure first be required?

The proposing release provides for a transition period once final rules are adopted, allowing companies to omit the first year. So if the final rule is adopted and becomes effective in 2014, which seems likely given the 60-day comment period on the proposed rule, then companies would first be required to disclose the pay ratio information in the 2016 annual meeting proxy statements with regard to 2015 fiscal year information.