On September 18, 2013, the Securities and Exchange Commission (“SEC”) proposed a rule that would require most public companies to disclose, annually, the ratio of the median of the annual total compensation of all of the company’s employees to the annual total compensation of the company’s principal executive officer. This rule is mandated by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  The comment period on the proposed rule ends 60 days after the proposing release is published in the Federal Register.

While the pay ratio disclosure is mandated by the Dodd-Frank Act, the statute sets no deadline for the SEC to act, and there are legitimate questions about the usefulness of the proposed disclosure to investors. In this respect, the proposed rule is, arguably, yet another example of using SEC disclosure rules to advance public policy goals not squarely rooted in the SEC’s historic mission of protecting investors.  Further, despite steps taken by the SEC to reduce compliance costs for companies, the proposed rule would, if enacted, certainly increase the costs and time required for companies to accurately prepare their executive compensation disclosures, including the likely need for many companies to retain outside advisors to assist in the statistical sampling and compilation process.

The Proposed Rule

The proposed rule would require annual disclosure of (i) the median annual total compensation of all employees other than the principal executive officer (the “PEO”), (ii) the annual total compensation of the PEO and (iii) the ratio of the two amounts.  “Total compensation” for this purpose would be calculated in accordance with Item 402(c)(2)(x) of Regulation S-K, which generally provides that “total compensation” is the sum of an individual’s salary, bonus, stock awards, option awards, non-equity incentive plan compensation, change in pension value,  nonqualified deferred compensation earnings, and all other compensation, including perquisites.

The ratio may be expressed in either of two ways:  (1) by reference to the number 1 for the median employee compensation, for example, “the ratio of the PEO’s total annual compensation to the median annual total compensation of all other employees is 150 to 1”; or (2) as a multiple, for example, “the PEO’s annual total compensation is 150 times the median annual total compensation of all other employees.”

This new disclosure would be required in a company’s annual report on Form 10-K, registration statements under the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”), and proxy and information statements, to the extent such forms require executive compensation disclosure pursuant to Item 402 of Regulation S-K.

As proposed, the required pay ratio disclosure would be calculated once per year, as of the end of the company’s fiscal year, and would not need to be disclosed until the filing of the company’s annual report on Form 10-K for that last completed fiscal year or, if later, the filing of a definitive proxy statement relating to its next annual meeting of shareholders after such year-end.  In all cases, however, the year-end pay ratio disclosure must be disclosed within 120 days after the end of the company’s fiscal year.  

Determining the Median Annual Total Compensation of All Employees

The proposed rule would not mandate a specific methodology for calculating the median annual total compensation of all employees; rather,  each company would have discretion to use the most appropriate method of calculation based on the size and structure of its business and the way it compensates employees.  Whichever methodologies are used, the proposed rule would require the calculation to cover all persons (other than the PEO) employed by the company or any of its subsidiaries on the last day of the most recent fiscal year, wherever located in the world, including full-time,  part-time, seasonal and temporary employees.  The proposed rule would allow, but not require, companies to annualize the compensation of permanent employees that were not employed for the entire fiscal year, such as new hires (but if the company annualizes the compensation of any such employees, it must annualize it for all such employees).  However, the proposed rule would not permit full-time equivalent adjustments for part-time workers, annualizing adjustments for temporary or seasonal employees, or cost-of-living adjustments for non-U.S. workers.  The SEC contends that such adjustments could reduce comparability of disclosure across companies.

One way for a company to determine the median annual total compensation of all employees other than the PEO is to determine the total compensation of each employee in accordance with Item 402(c)(2)(x) of Regulation S-K, and then identify the median value (i.e., the point between the lower half and the upper half of the range of values).  Recognizing that certain elements of total compensation under Item 402(c)(2)(x) require complicated calculations, the SEC has proposed to allow companies to use other methodologies that make use of reasonable estimates to identify the median, as well as reasonable estimates to calculate any of the elements of total compensation (other than for the PEO).  Two specific, alternative methodologies that companies may use to identify the median employee are statistical sampling and a consistently applied compensation measure other than “total compensation.”

Under the proposal, a company may identify the median employee by analyzing only a statistical sampling of the total employee population, as long as the sampling method used is reasonable.  The SEC notes that what constitutes a reasonable sampling methodology (including sample size) will depend on a variety of factors, such as the variance of underlying compensation distributions (i.e., how widely employee compensation is spread out or distributed around the mean), and variation in the type of employees across business units and geographical regions.  Within a chosen employee sample, the SEC notes that companies could remove from the sample employees that have extremely high or extremely low pay, since the search for the median focuses on identifying the employee in the middle of the range.

The proposed rule would also permit companies to identify the median employee not by calculating “total compensation” for all employees, but by using any other compensation measure that is consistently applied to all employees included in the calculation, such as salary and wages or comparable amounts derived from the company’s payroll or tax records.  The proposed rule also provides that, where the annual period for payroll or tax recordkeeping is different from the company’s fiscal year, the company may nevertheless use its payroll and tax information to identify the median employee.

After the median employee has been identified, the company would then need to calculate the “total compensation” of the median employee in accordance with Item 402(c)(2)(x) of Regulation S-K.  The proposed rule would allow companies to use reasonable estimates to calculate any of the elements of total compensation for such employee.  Such estimates might be especially useful when calculating items such as the grant date value of stock awards and option awards or change in pension value.

Additional Disclosure Regarding Methodologies Used

The proposed rule would require companies to “briefly” disclose (and consistently apply) any methodology used to identify the median, as well as any material assumptions, adjustments or estimates used to identify the median, or to determine total compensation or any element of total compensation.  Further, any amounts that are estimates would be required to be clearly identified.

More specifically, in the proposing release the SEC stated that if statistical sampling is used, a company would be required to disclose the size of both the sample and the estimated entire employee population, any material assumptions used in determining the sample size, which sampling method (or methods) 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 businesses or geographic segments.  Further, where a company uses a compensation measure other than annual total compensation to identify the median employee compensation, the company would be required to disclose the compensation measure used and calculate and disclose the annual total compensation for that median employee.

Issuers Not Subject to the Proposed Rule

As proposed, the pay ratio disclosure rule would not apply to: (i) emerging growth companies (as defined in Section 3(a) of the Exchange Act); (ii) smaller reporting companies (as defined in Item 10(f)(1) of Regulation S-K); (iii) foreign private issuers (as defined in Rule 405 under the Securities Act) that file annual reports and registration statements on Form 20-F; and (iv) companies that file annual reports and registration statements on Form 40-F in accordance with the U.S.-Canadian Multijurisdictional Disclosure System.

Compliance Date and Transition Issues

Companies would first be required to provide pay ratio disclosure for the first fiscal year commencing on or after the effective date of the proposed rule.  Given that the comment period for the proposed rule terminates 60 days after the proposing release is published in the Federal Register, and based on the expected quantity and detail of comment letters to be submitted on the proposed rule, we believe it will be challenging for the SEC to adopt a final rule before the end of 2013.  If the pay ratio rule takes effect in 2014 in the form proposed by the SEC, it would require December 31 fiscal year reporting companies to disclose the first pay ratio information for the 2015 fiscal year, which would be included in their proxy statements for their 2016 annual meeting of shareholders.