The SEC recently proposed its long-anticipated pay ratio disclosure rule. The rule, which was mandated by the Dodd-Frank Act, would require most public companies to disclose, annually, the ratio of the compensation of its principal executive officer to the median compensation of all of the company’s employees. The proposed rule is designated as new paragraph (u) to Item 402 of Regulation S-K.
What Would Be Required To Be Disclosed?
Item 402(u) would require disclosure of:
- The median annual total compensation of all employees of the company, other than the principal executive officer;
- The annual total compensation of the principal executive officer, which already is required to be disclosed; and
- The ratio of the foregoing two amounts.
When disclosing the ratio, Item 402(u) would require the median annual total compensation to be expressed as “1,” or, alternatively, expressed narratively in terms of the multiple that the principal executive officer’s compensation bears to the median. Using the example in the SEC’s proposing release, if the median annual total compensation is $45,790 and the annual total compensation of the principal executive officer is $12,260,000, then the pay ratio disclosed would be “1 to 268.” Alternatively, the ratio could be expressed narratively as “the principal executive officer’s annual total compensation is 268 times that of the median of the annual total compensation of all employees.”
When Would Disclosure Be Required?
Except as indicated below, pay ratio disclosure would be required in any annual report on Form 10-K, proxy or information statement or registration statement under the Securities Act that requires executive compensation disclosure pursuant to Item 402 of Regulation S-K.
Disclosure would be required beginning with the first fiscal year after the effective date of Item 402(u). A company would not be required to disclose pay ratio information with respect to its most recently completed fiscal year to which the rule applies until the filing of its Form 10-K for that fiscal year or, if later, the timely filing (i.e., within 120 days after fiscal year-end) of its proxy statement. By way of example, if Item 402(u) becomes effective in 2014, a company with a calendar fiscal year would be required to include pay ratio information for fiscal year 2015 in the proxy statement for its 2016 annual meeting. Similarly, a company with a calendar fiscal year that is not subject to the proxy rules would be required to include pay ratio information relating to compensation for fiscal year 2015 in its Form 10-K for that year, which would be due during the first quarter of 2016.
Although the SEC sought public comment before the issuance of its proposing release, proposed Item 402(u) remains subject to a 60-day comment period. As part of the comment process, in its proposing release, the SEC requested input on 60 specific questions and it is expected that the SEC will receive a significant number of comments on the proposed rule. It is highly unlikely that the SEC will adopt a final rule until 2014.
Emerging growth companies, smaller reporting companies, foreign private issuers and MJDS issuers would be exempt from complying with Item 402(u).
Applicability to New Registrants
For newly public companies that are not otherwise exempt from compliance, Item 402(u) would apply beginning with the first fiscal year commencing on or after the date that the company becomes subject to SEC reporting requirements.
How Is the Median Employee Determined?
Methods for Identifying the Median Employee
Proposed Item 402(u) does not prescribe a specific method for identifying the median employee. Instead, a company would be permitted to choose that method which is most appropriate to its size, structure and compensation practices. For example, a company could identify the median employee using its full employee population, a statistical sampling or another reasonable method.
To the extent that a company decides to determine the median employee through sampling, Item 402(u) does not prescribe specific estimation techniques or confidence levels. In its proposing release, the SEC indicated that it believes that companies will be in the best position to determine what is reasonable in light of their own employee population and access to compensation data. The SEC noted that the variance of underlying compensation distributions can materially affect the sample size needed for reasonable statistical sampling. In its economic analysis, the SEC estimated that the appropriate sample size for companies with a single business or geographic unit will vary between 81 and 1,065 employees across industries, with the average estimated sample size being approximately 560 employees. For companies with multiple business lines or geographic units, the SEC indicated that it believes that reasonable estimates of the median could be arrived at through more than one statistical sampling approach. All approaches, however, would require drawing observations from each business or geographical unit with a reasonable assumption on each unit’s compensation distribution and inferring the company’s overall median based on the observations drawn.
Since identifying the median involves finding the employee in the middle, it may not be necessary to determine the exact compensation amounts paid to employees that are above or below the median. Instead, just noting that the employees are above or below the median would be sufficient for finding the median employee.
Item 402(u) would not require a company to use a specific compensation measure, such as cash compensation or total direct compensation, when identifying the median employee. A company may use the same calculation methodology that it is required to use for calculating the annual total compensation of its named executive officers. Alternatively, the company may identify the median employee based on any other consistently applied compensation measure, such as compensation amounts reported in payroll or tax records. For purposes of identifying the median employee, a company may use the same annual period used in the payroll or tax records from which the compensation amounts are derived, even if that period is different than its fiscal year. A company would be able to use reasonable estimates when determining the median employee.
When determining the median employee, the methodology and any material assumptions, adjustments and estimates, such as currency translations or annualizing newly hired employees, should be consistently applied.
Employees Included in the Determination
For purposes of determining median compensation, all employees of the registrant and its subsidiaries as of the last day of the most recently completed fiscal year would be required to be included. Full-time, part-time, temporary, seasonal and non-U.S. employees that are employed on such day must be included. In contrast, independent contractors or leased or other temporary workers who are employed by a third party would be excluded.
Companies would be permitted, but not required, to annualize the total compensation for permanent employees who did not work for the entire year, such as new hires or employees who took unpaid leaves of absence during the year. However, the compensation of seasonal or temporary employees would not be permitted to be annualized. Companies also would not be permitted to adjust the compensation of part-time employees to a full-time equivalent or apply cost-of-living adjustments for non-U.S. workers.
How Is Annual Total Compensation of the Median Employee Determined?
Once the median employee has been identified, for purposes of calculating the pay ratio, the company would be required to use for that employee the same methodology that it used for determining total compensation for the principal executive officer. The same time period — the company’s fiscal year — also would be required to be used.
However, Item 402(u) would permit a company to use reasonable estimates when calculating annual total compensation or any element of total compensation of the median employee, such as pension benefits or unique types of employee compensation given only in certain countries.
The principal executive officer’s annual total compensation would continue to be calculated in accordance with current SEC rules.
What Information Would Be Required To Be Disclosed?
In addition to the disclosure of the pay ratio, Item 402(u) would require that the methodology — and any material assumptions, adjustments or estimates used to identify the median employee or to determine total compensation or any elements of total compensation — be briefly disclosed. In addition, any estimated amounts would need to be clearly identified as such.
The proposing release notes that the disclosure of the methodology and any material assumptions, adjustments and estimates used should provide sufficient information for a reader to be able to evaluate the appropriateness of the estimates. For example, according to the proposing release, when statistical sampling is used, the company should disclose the size of both the sample and the estimated whole population, any material assumptions used in determining the sample size, which sampling method is used and, if applicable, how the sampling method deals with separate payrolls, such as geographically separated employee populations, or other issues arising from multiple business or geographic segments. The overview is not required to include technical analyses or formulas.
If a company changes its methodology or material assumptions, adjustments or estimates from those used in the previous year and the effect of the change is material, the company must briefly describe the change and the reasons for it and provide an estimate of the impact of the change on the median and the ratio.
Item 402(u) would not require a narrative discussion beyond the proposed brief description of the calculation methodology. For example, a company would not be required to include supplemental disclosure about its employment practices or the composition of its workforce, although some companies may decide to include this type of information to give context to the ratio.
Companies may, but are not required to, present additional ratios to supplement the required ratio.
How Would Pay Ratio Disclosure Be Treated Under the Anti-Fraud Rules?
Like other Item 402 information, the pay ratio disclosure would be considered “filed” for purposes of the
Securities Act and the Exchange Act and, accordingly, would be subject to potential liability thereunder for material misstatements or omissions in the disclosure.
What Should We Be Doing Now?
Companies should continue to monitor the progress of the proposed rule. In addition, companies with workforce or compensation attributes that were not addressed in the proposing release and that might raise particular issues under the rule should consider whether they want to submit comments during the comment period.
Otherwise, given the uncertainty that still surrounds the rule and the anticipated effective date, it is premature for companies to start taking steps toward developing a calculation methodology or gathering and crunching data. And, in any case, once the final pay ratio rule takes effect, most companies are likely to outsource the heavy lifting of determining the median employee to outside consultants.
Ultimately, the question is how will investors and other constituencies use pay ratio information — such as in connection with say-on-pay or director voting — and the additional messaging that companies will need to develop to address those challenges?