Implications of the SEC’s proposed CEO pay-ratio disclosure rule

As required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, on September 18, 2013, the Securities and Exchange Commission (“SEC”) voted 3-2 in favor of a new proposed rule that would require companies to disclose: (1) the median of the annual total compensation of all employees of the issuer, excluding the issuer’s CEO (or the equivalent); (2) the annual total compensation of the issuer’s CEO (or the equivalent); and (3) the ratio of those two amounts.

Based on a review of the proposed rule and following semi-public comments of Keith Higgins, Director of the Division of Corporation Finance at the SEC, the following summarizes key points and considerations in the proposed rule. For a more detailed analysis of the proposed rule and other related topics, please join us for another installment in our eLunch webinar series on November 21, 2014, entitled “Action Items to Prepare for the 2014 Proxy Season.” For more information, or to sign up, please contact [email protected]. 

Overview

Likely to be first effective for the 2016 proxy statement, for calendar year-end companies. The rules are to be effective for the first fiscal year beginning on or after the effective date of the final rules. Therefore, if the final rules are effective in 2014 (which appears most likely), they will be effective for the 2015 fiscal year and reported in the 2016 proxy statement. However, some shareholder activists have announced their intention to pressure certain corporations to make this disclosure in 2014. 

The proposed rule would not apply to emerging growth companies, smaller reporting companies, or foreign private issuers.

The comment period for the proposed rule runs for 60 days following publication of the rules in the Federal Register. Comments are due on or before December 2, 2013, and may be submitted via the online form available for the Pay-Ratio rule at the following page: http://www.sec.gov/rules/proposed.shtml.

Identifying the Median Employee

All employees are to be included for purposes of determining the median. All full-time, part-time, temporary, seasonal, and non-U.S. employees employed by the company or any of its subsidiaries as of the end of the most recent fiscal year are to be included. Companies are given the flexibility to annualize the total compensation for a permanent employee who did not work for the entire year. Companies are not given the ability to make full-time equivalent adjustments for part-time workers, to make annualizing adjustments for temporary and seasonal workers, or to make cost- of-living adjustments for non-U.S. workers. Directors, independent contractors, and leased employees are not to be included.

Flexibility exists to determine the median. Due to concerns about the burdensome cost and amount of time any such pay-ratio disclosure would entail, the SEC has proposed rules that do not expressly specify any required calculation methodologies for identifying the median employee in terms of total compensation for all employees. Accordingly, the SEC has provided “instructions and guidance designed to allow registrants to choose from several alternative methods to identify the median, so that they may use the method that works best for their own facts and circumstances.” Companies may use total compensation (as computed under the Summary Compensation Table rules) to determine the median employee, but may also use any other “consistently applied compensation measure,” such as salary and wages, or amounts reported in payroll or tax records, such as W-2 “salary, wages and tips” and the non-U.S. equivalents.

Statistical sampling is allowed to determine the median employee. The SEC acknowledges that statistical sampling may reduce costs of compliance for companies, but that the reduction in costs will vary depending on each company’s particular circumstances. For example, a company with low wage variances may be able to use a sample size of 100 employees whereas a company with high wage variances may need to use a sample size of 1,000. The SEC does not mandate a particular sampling approach, acknowledging that companies may find that certain statistical sampling approaches are more suitable to their organizational structure than others.

Disclosure Obligation

The ratio of the total compensation of the median employee to that of the CEO must be disclosed. Total compensation of each is to be determined under the Summary Compensation Table rules, though companies would be permitted to use reasonable estimates when calculating annual total compensation or any element of total compensation of the median employee. The ratio must be shown as that of the median employee to the CEO, but can also be disclosed in a narrative that describes the ratio of the CEO to the median employee.

Disclose methodology and material assumptions. Companies must 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 clearly identify any estimated amount). It is not 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 year, and if the effects of the change are material, the company shall describe the change, the reasons for the change, and an estimate of the impact of the change on the median and the ratio.

The proposed disclosure would be mandated in any annual report, proxy, information statement, or registration statement that requires executive compensation disclosure pursuant to Item 402 of Regulation S-K. The proposed disclosure requirement would be detailed in a new paragraph (u) of Item 402. If the proxy statement is not filed within 120 days of the fiscal year-end, the pay-ratio disclosure (as with the other Item 402 disclosure) would need to be included in the 10-K or 10-K/A filed before the 120-day deadline.

Conclusion

The proposed rule is subject to comment for a 60-day period ending on and including December 2, 2013. More than 28,000 comments have been submitted to the SEC on the proposed rule as of mid-October. One comment letter was recently submitted by a group of organizations, including the U.S. Chamber of Commerce, requesting the extension of the comment period by 60 days to allow companies more time to respond adequately to the SEC’s numerous, detailed requests for comment contained in the proposed rule. It is not clear whether the requested extension will be granted. In order for companies to provide meaningful comments to the SEC, they should consider a careful study and simulation of the detailed steps necessary to calculate the ratio. This is especially true for companies with significant non-U.S. locations, multiple payroll systems, or other attributes that will make the data collection and analysis required by the proposed rule challenging. Stay tuned for further developments.