SEC Issues Proposed "Pay Ratio" Disclosure Rules

On September 18, 2013, the U.S. Securities and Exchange Commission issued proposed rules amending Item 402 of Regulation S-K, as required by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

If adopted, the Proposed Rules would require public companies to disclose, in any filing that requires executive compensation disclosure under Item 402, including annual reports on Form 10-K, registration statements and proxy and information statements:

• The median of annual total compensation for all employees of the company other than the principal executive officer (“PEO”) for the last completed fiscal year;
• The annual total compensation of the PEO for the last completed fiscal year; and
• The ratio of the two amounts.

The disclosure of the pay ratio may be presented as a fraction (e.g., “1 to [the appropriate multiple]”), or may be expressed in narrative form (e.g., “the PEO’s annual total compensation is X times that of the median of the total annual compensation of all employees”).

Effective Date

Companies would be required to provide initial pay ratio disclosure for the first fiscal year commencing on or after the effective date of the final rule.  As an example, if the final rule is issued in January 2014, companies with calendar year fiscal years would be required to provide the pay ratio disclosure for 2015 in the annual report on Form 10-K filed in 2016 or the proxy statement for the 2016 annual meeting (if the proxy statement is filed within 120 days of the fiscal year end).

Comment Period

The SEC has asked for comments on a number of specific aspects of the Proposed Rules.  The comment period ends December 2, 2013.

Determination of Employee Population

To determine the median of annual total compensation for all employees, companies must first identify the employee population that will be used to identify the median employee.  Companies must include in the employee population all employees of the company and any subsidiary of the company (defined as an affiliate controlled by the company directly or indirectly through one or more intermediaries), including all full-time, part-time, temporary, seasonal and non-U.S. employees who were employed as of the last day of the company’s prior fiscal year.  Workers who are not employed by the company or its subsidiaries, including independent contractors, “leased” employees or other temporary workers employed by a third party, should be omitted.

Identification of Median Employee; Methodology; Compensation Measure

Next, companies must determine the total annual compensation of employees in the employee population and select a median employee from such population.  The Proposed Rules do not require companies to use a specific methodology to identify the median employee, though the SEC has made it clear that any methodology used should be consistently applied.  Companies are permitted to calculate compensation and identify the median employee using any of the following:

• The full employee population;
• A statistical sample of the employee population; or
• Any other reasonable method.

In determining the median employee, companies may calculate compensation using total annual compensation as determined under the existing rules in Item 402 of Regulation S-K or any consistently applied compensation measure that would result in a reasonable estimate of the median employee, such as compensation amounts reported in payroll or tax records. 

If a company uses amounts reported in payroll or tax records, the company may use the same annual period used in such records, even if different from the company’s fiscal year.  Under the Proposed Rules, companies may annualize the total compensation of permanent employees who were employed for less than the full fiscal year.  Companies may not, however:

• Make full-time equivalent adjustments for part-time employees;
• Annualize compensation for temporary or seasonal workers; or
• Make cost-of-living adjustments for non-U.S. employees.

With respect to non-U.S. employees, companies generally would not be required to disclose the currencies, exchange rates and conversion methodologies used in determining their annual total compensation, but the rates and conversion methodologies should be consistent with those used for the named executive officers included in the summary compensation table. 

Compensation of Median Employee

Once the median employee has been identified, such employee’s total annual compensation must be calculated and reported using the definition of “total compensation” in Item 402(c)(2)(x) of Regulation S-K.  Companies may use reasonable estimates in calculating any element of total compensation for the median employee and in determining the annual total compensation for the median employee.

Disclosure Requirement

Under the Proposed Rules, companies would be required to briefly disclose the methodology used to identify the median employee, including the compensation measure used and any material assumptions, adjustments or estimates.  The narrative disclosure is intended to be a brief overview and disclosure of technical analyses or formulas is not required.  

If a company estimates total annual compensation, the resulting disclosure would need to be clearly identified as an estimated amount and include a brief description of the estimates used by the company.  If a company changes its methodology from a prior period and the effects of such change are material, the company must briefly describe the change, the reasons for the change and the expected impact on the median and the ratio. 

General Exemptions; Transition for Newly-Public Companies

The Proposed Rules would not apply to:

• Emerging growth companies;
• Smaller reporting companies;
• Foreign private issuers; or
• Canadian MJDS filers that file annual reports and registration statements on Form 40-F.

In addition, the Proposed Rules provide for a transition period for newly public companies. The pay ratio disclosure would first be required for the fiscal year commencing on or after the date the company becomes subject to the reporting requirements of the Securities Exchange Act of 1934.  Accordingly, a company would not be required to include pay ratio disclosure in the registration statement filed in connection with its initial public offering.