On September 18, 2013, in accordance with Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Reform Act”), the Securities and Exchange Commission (the “SEC”) issued a press release and published proposed rules (Release Nos. 33-9452; 34-70443) (the “Proposed Rules”) to require certain publicly-held companies to disclose the median annual total compensation of all employees and the ratio of that median to the annual total compensation of the company’s chief executive officer.

As we have previously commented (see our blog from July 26, 2010 “The Regulatory March to Reform Executive Compensation Practices Takes Another Step Forward”), the Reform Act implemented numerous new laws affecting executive compensation and corporate governance at publicly-held companies. Section 953(b) of the Reform Act directs the SEC to amend Item 402 of Regulation S-K (i.e., the executive compensation disclosure regulations) to require disclosure of the median of the annual total compensation of all employees of an issuer (excluding the chief executive officer), the annual total compensation of that issuer’s chief executive officer and the ratio of the median of the annual total compensation of all employees to the annual total compensation of the chief executive officer (the “Pay Ratio Disclosure”).

After receiving more than 22,000 public comment letters (along with a petition containing more than 84,000 signatories) on the subject over the past several years, the SEC in a divided 3-2 vote adopted the Proposed Rules, which are designed to comply with the statutory mandate and to address commenters’ concerns regarding the potential costs of complying with the disclosure requirement.  The magnitude of public comments, the duration of time it took for the SEC to finally propose rules, and the divided SEC vote indicate the contentiousness of Pay Ratio Disclosures.  Moreover, in March 2013, a bill was introduced in the House of Representatives (H.R. 1135, Burdensome Data Collection Relief Act) which, if enacted, would entirely repeal the Pay Ratio Disclosure requirement.  The House Financial Services Committee supported the bill in June 2013 with a vote of 36 in favor and 21 against.

The Proposed Rules provide some interesting details regarding the implementation of the Pay Ratio Disclosure and seek to address the technical difficulties and burdens that companies would face in achieving compliance.  Of course, the Proposed Rules are yet not effective and in this regard, the SEC has solicited the public for comments in numerous areas of the Proposed Rules in order to help them in their process of adopting final regulations.  Among other things, the Proposed Rules articulate:

• which companies and which SEC filings must contain the Pay Ratio Disclosure;

• how to determine annual total compensation;

• how to identify the median;

• what disclosures must be provided on the underlying methodology, assumptions and estimates used in preparing the Pay Ratio Disclosure; and

• when the Pay Ratio Disclosure requirements would become applicable.

The below provides a brief overview of the Proposed Rules in question and answer format.

What Generally Will The Proposed Rules Do?

If approved, the Proposed Rules will add a new section (u) to Item 402 of Regulation S-K that would require certain publicly–held companies to disclose:

A. the median of the annual total compensation of all employees of the company, except the principal executive officer of the company;

B. the annual total compensation of the principal executive officer of the company; and

C. the ratio of the amount in (A) to the amount in (B), presented as a ratio in which the amount in (A) equals one or, alternatively, expressed narratively in terms of the multiple that the amount in (B) bears to the amount in (A).

Thus, if hypothetically the CEO’s annual total compensation in a fiscal year was $10 million and the median annual total compensation of other company employees was $50,000, then the Pay Ratio Disclosure would be “1 to 200” or alternatively the inverse of such ratio could be narratively described.

The SEC chose to use the defined term “PEO” (principal executive officer), instead of the term “chief executive officer” used in Section 953(b) for consistency with existing Item 402 requirements.

Annual total compensation is intended to mean total compensation for the company’s most recent completed fiscal year, consistent with the time period used for other Item 402 disclosure requirements.  This effectively means that the Pay Ratio Disclosure would need to be updated on an annual basis.  The Proposed Rules also state that the Pay Ratio Disclosure would be considered to be “filed” rather than “furnished” for purposes of the Securities Act of 1933 (the “Securities Act”) and the Exchange Act of 1934 (the “Exchange Act”).

Which Companies Will be Subject to Pay Ratio Disclosure?

The Pay Ratio Disclosure requirements would apply only to those publicly-held companies that are required to provide summary compensation table disclosure pursuant to Item 402(c) of Regulation S-K.  However, companies that are “emerging growth companies”, “smaller reporting companies”, “foreign private issuers” or “MJDS filers” will not be required to provide a Pay Ratio Disclosure in their SEC filings.  MJDS filers are registrants that file reports and registration statements with the SEC in accordance with the requirements of the U.S. - Canadian Multijurisdictional Disclosure System.

Which SEC Filings Will Need to Include the Pay Ratio Disclosure?

The Proposed Rules would require companies to include the Pay Patio Disclosure in any filing that requires executive compensation disclosure under Item 402 of Regulation S-K.  Therefore, the Pay Patio Disclosure would be required in annual reports on Form 10-K, registration statements under the Securities Act and the Exchange Act, and proxy and information statements, when these forms require Item 402 disclosure.

How is the Median Employee Compensation Identified?

The Proposed Rules require companies to calculate the median of the annual total compensation of their employees. The SEC stated that in order to allow the greatest degree of flexibility while remaining faithful to the Reform Act, the Proposed Rules do not specify a required calculation methodology for identifying the median. Instead, the Proposed Rules permit companies to identify the median using their full employee population or by using statistical sampling of employees or another reasonable method.

Thus, a company would not necessarily need to determine exact compensation amounts for each employee in order to identify the median employee compensation.  For example, companies would be permitted to exclude certain employees that have extremely low or extremely high pay because they would fall on either end of the spectrum of pay and, therefore would not be the median compensated employee.  Additionally, in another effort to accommodate companies, the annual compensation would not necessarily need to be the actual compensation for the fiscal year, but could instead be the same annual period that the company uses for its payroll or tax records.

As such, the Proposed Rules permit companies to determine the median using a variety of different methods, such as:

• calculating total compensation for each employee applying Item 402(c)(2)(x) in order to determine the median;

• identifying the median employee based on any consistently applied compensation measure and then applying 402(c)(2)(x) to determine the annual total compensation for such median employee; and/or

• using reasonable estimates in calculating annual total compensation for non-PEO employees.

Once a company identifies its median compensated employee, the company would then calculate that employee’s annual total compensation in accordance with Item 402(c)(2)(x) of Regulation S-K and use that total amount for the Pay Patio Disclosure.

The Proposed Rules also do not prescribe what a “reasonable estimate” would entail because the SEC expressed the belief that it would depend on the company’s particular facts and circumstances and that individual companies would be in the best position to determine what is reasonable in light of their own employee population and access to compensation data.  The instructions also permit a company to identify its median employee based on any consistently applied compensation measure, such as compensation amounts reported in its payroll or tax records, as long as the company briefly describes the measure that it used.

Given the flexibility allowed in performing the calculations, the Proposed Rules require that the company’s selected methodology and any material assumptions, adjustments or estimates used to identify the median be briefly disclosed and consistently applied, and any estimated amounts be clearly identified as such.

Which Employees are Included in Determining the Median Compensated Employee?

The Proposed Rules state that an “employee” or “employee of the company” includes any full-time, part-time, seasonal or temporary worker employed by the company or any of its subsidiaries (including officers other than the PEO) on the last day of the company’s fiscal year. This would include non-U.S. employees.  Workers who are not employed by the company or its subsidiaries, such as independent contractors or “leased” workers or other temporary workers who are employed by a third party, would not be covered.

What if an Employee is not Employed During the Entire Fiscal Year?

The Proposed Rules include an instruction that states that total compensation may be annualized for all permanent employees (other than those in temporary or seasonal positions) who were employed for less than the full fiscal year.  Such annualizing of compensation is limited to permanent employees. In addition, as proposed, the instruction would not permit a company to annualize some eligible employees and not others.

How are the Methodology, Assumptions and Estimates to be Disclosed?

As noted above, the Proposed Rules provide that companies must briefly disclose the 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 companies must clearly identify any estimated amount as such.

Companies’ disclosure of the methodology and material assumptions, adjustments and estimates used should provide sufficient information for a reader to be able to evaluate the appropriateness of the estimates.

The Proposed Rules include an example covering the use of statistical sampling and state that companies 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 (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 business or geographic segments.

In addition, if a company changes its process over time and such changes are material, then the company would be required to briefly describe the change, the reasons for the change, and must provide an estimate of the impact of the change on the median and the ratio.  The instructions specify that companies provide a brief overview and make it clear that it is not necessary to provide technical analyses or formulas.

When Could The Pay Ratio Disclosure Requirement Become Effective?

The Proposed Rules provide that companies will have to comply with the Pay Ratio Disclosure with respect to compensation for the company’s first fiscal year commencing on or after the effective date of the final rules.  So, if the final rules became effective in 2014, then companies with a calendar year fiscal year would not need to include the Pay Ratio Disclosure until its Form 10-K reporting on fiscal year 2015 or its proxy statement that is filed in 2016 covering compensation for 2015.

Companies (which are not emerging growth companies) that newly become subject to public company reporting requirements would not be required to include the Pay Ratio Disclosure in a registration statement on Form S-1 or S-11 for an initial public offering or a registration statement on Form 10 and instead would have a delayed one year transition period before having to provide the Pay Ratio Disclosure.   For example, if the final rules become effective in 2014, a company with a fiscal year ending on December 31^st that completes its initial public offering in October 2016 would not be required to include a Pay Ratio Disclosure in any filing until it files its definitive proxy or information statement for its 2018 annual meeting of shareholders (or written consents in lieu of such a meeting), which would include Pay Ratio Disclosure relating to 2017 compensation amounts.

Of course, companies would be permitted to begin compliance earlier on a voluntary basis.

What’s Next?

As noted above, the Proposed Rules contain many requests by the SEC for comments on the provisions of the Proposed Rules.  Comments on the Proposed Rules will need to be submitted within 60 days after the publication of the Proposed Rules in the Federal Register.  Therefore, companies wishing to influence the outcome of the final regulations are urged to review the Proposed Rules and timely submit any comments. 

Companies may also wish to examine their internal compensation accounting systems and consider evaluating what methodology they may want to implement and what steps they will need to take in order to comply with the Pay Ratio Disclosure requirements.