Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted on July 21, 2010, requires the Securities and Exchange Commission to amend Item 402 of Regulation S-K to require disclosure of the median of the total annual 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 total annual compensation of all employees of an issuer (excluding the chief executive officer) to the annual total compensation of that issuer’s chief executive officer. This provision of the Dodd-Frank Act has caused great anxiety for many public companies over the last three years. Companies have expressed much concern that the rule required by Section 953(b) would be extremely burdensome, imposing difficult and expensive recordkeeping and analysis requirements with respect to a company’s entire employee population. On the other hand, many shareholders and investor advocates have spoken out in support of Section 953(b). High passions on both sides of this issue resulted in the SEC receiving, prior to the issuance of the proposed rule, over 22,000 comment letters and a petition with nearly 85,000 signatures.

The strongly divergent views expressed on the idea of a pay ratio disclosure rule may explain why the Commission took over three years to finally propose, on September 18, 2013, the revisions to Item 402 of Regulation S-K required to implement Section 953(b). Some observers have also suggested that the delay was attributable in part to the fact that the Commission and its staff did not share Congress’s enthusiasm for this new disclosure requirement.

The Commission appears to have worked hard in drafting its rulemaking proposal to provide issuers with flexibility in how to approach the required pay ratio calculations. Nonetheless, we expect the proposal to receive a high volume of comments from issuers who continue to feel that the rule will impose an undue burden on issuers and will result in disclosure that is not meaningful to investors. Comments on the rulemaking proposal are due on December 2, 2013, which means that Commission adoption of final rules cannot be expected until sometime in 2014. Given this timeline and the fact that the proposed rules state that a company would be required to report the pay ratio with respect to compensation for its first fiscal year commencing on or after the effective date of the final rule, calendar-year companies will not be required to provide the pay ratio disclosure until they file their proxy statement or Form 10-K in early 2016.

Summary of Proposed Rule 402(u)

The Commission’s pay ratio proposal would add a new paragraph (u) to Item 402 that would require registrants to disclose:

(i) the median of the annual total compensation of all employees of the registrant, except the principal executive officer (PEO) of the registrant;

(ii) the annual total compensation of the PEO of the registrant; and

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

Disclosure of the ratio in (iii) could take any of the following forms:

• “PEO pay is X times the median employee pay.”

• “The PEO’s annual total compensation is X times that of the median of the annual total compensation of all employees.”

• “The pay ratio is 1 to X.”

The rule proposal goes on to define certain terms used above and to require disclosures around the calculation of the ratio.

“median”

The Commission’s proposal states that the rule is intended to be flexible, therefore it does not prescribe a specific methodology for identifying the median. Approaches that could be used by registrants include, for example:

• Using reasonable estimates to determine the value of various elements of total compensation in order to identify the median employee. The SEC recognizes that using estimates may be necessary for valuing types of compensation for which the company may not have complete information, such as union pension plan benefits, or personal benefits such as housing or government-mandated pension plans for non-U.S. employees.

• Using statistical sampling to identify a “median employee” by taking a random sample of employees and determining either the exact compensation of the employees in the sample, or to identify employees as above or below the median, in order to find the employee in the middle of the pay spectrum.

The registrant must briefly disclose the methodology and any material assumptions, adjustments or estimates used to identify the median and must describe any changes in methodology year-to-year and the reasons for the changes, and provide an estimate of the impact of the changes on the median and the ratio. Any discussion should be limited to a brief overview; the registrant does not need to provide technical analyses or formulas.

If the registrant uses estimated compensation figures to determine the median, the disclosure would need to clearly identify any estimated amounts and include a brief description of the methods used. If the registrant uses statistical sampling, the disclosure should state the size of the sample and the estimated whole population, which sampling method was used and how the method accounts for separate business or geographic segments. While a small sample size may be appropriate in certain situations, for a larger business, the sample, and any assumptions or inferences used in the calculations, must draw upon observations from each business or geographical unit. Any sample can, however, exclude employees on the high and low extremes of the sample.

Whatever method the registrant uses to identify the median, it must be consistently applied. For example, the registrant could use total direct compensation (i.e., annual salary, hourly wages and any other performance-based pay) or cash compensation to identify a median employee, so long as the method is identified and used consistently throughout the calculations.

“annual total compensation”

Once the median employee is identified, the registrant must calculate annual total compensation and disclose the information required under Item 402(c)(2)(x) as it relates to the median employee (replacing references to “named executive officer” with “employee” and, where necessary, references to “base salary” and “salary with “wages plus overtime”). The registrant must also briefly disclose and consistently apply the methodology and any material assumptions, adjustments or estimates used to calculate the total compensation or any elements of compensation.

Total annual compensation must be calculated for the last completed fiscal year period. Proposed instructions to the rule would permit registrant to use the same annual period already used in payroll, tax or other records for determining the median employee, but the annual compensation amount must be calculated for the last completed fiscal year.

When determining the median, the registrant may annualize the compensation for all permanent employees who were employed for less than the full fiscal year, and are employed on the calculation date described above. In some cases it may be appropriate for the registrant to annualize a permanent part-time employee’s compensation (i.e., a permanent employee works three days a week and takes a leave of absence during the year). However, the proposed rule does not permit adjustments for temporary or seasonal employees or cost-of-living adjustments for non-U.S. workers.

“all employees…except the PEO”

The principal executive officer, or PEO, is the same individual already defined in Item 402(a)(3). “All employees” is intended to include any full-time, part-time, seasonal or temporary worker employed by the registrant or any of its subsidiaries, which is consistent with Item 402(a)(2) and Instruction 2 to Item 402(a)(3), and includes U.S. and non-U.S. employees. “All employees” does not include independent contractors, “leased” workers, or temporary workers employed by a third party, but does include officers other than the principal executive officer.

The calculation date for determining who is an employee is the last day of the registrant’s last completed fiscal year, the same date used in Item 402(a)(3)(iii) for determining the identity of the three most highly compensated executive officers.

How and When to File:

Under the proposed rule, issuers would be required to include the pay ratio disclosure in filings, such as the Form 10-K and proxy statements, that already require Item 402 disclosures. The rule would only apply to issuers that are required to provide the summary compensation table pursuant to Item 402(c) and would not apply to emerging growth companies, smaller reporting companies, foreign private issuers or multijurisdictional disclosure system filers. The pay ratio disclosure will be considered “filed” rather than “furnished” for purposes of the Securities Act and Exchange Act.

The pay ratio disclosure would not be required to be updated either (i) until the registrant files its proxy statement for its annual meeting of shareholders; or (ii) no later than 120 days after the end of the registrant’s fiscal year (as provided in General Instruction G(3) of Form 10-K). Any filing made after the end of the fiscal year but before the filing of the Form 10-K or proxy statement, must include or incorporate by reference the registrant’s most recent pay ratio disclosure.

If a registrant relies on Instruction 1 to Item 402(c)(2)(iii) and (iv) to omit disclosure of the salary or bonus of a named executive officer if it is not calculable, the registrant can also omit the pay ratio disclosure (with the appropriate footnote disclosing the omission and providing the date that the compensation will be determined). The registrant would then need to include its pay ratio disclosure in the Form 8-K that included the omitted salary or bonus information pursuant to Instruction 1 described above.