The Securities and Exchange Commission (SEC), in a contentious open meeting and pursuant to a 3-to-2 party-line vote, recently proposed to add new Item 402(u) to Regulation S-K to implement the pay ratio disclosure requirements of Section 953(b) (Section 953(b)) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).¹ 

Consistent with Section 953(b)’s requirements, proposed Item 402(u) would require certain public companies to disclose in specified filings:

• the median² of the annual total compensation of all employees of the issuer, except the issuer’s principal executive officer (i.e., the issuer’s chief executive officer or the individual acting in a similar capacity) (PEO);

• the annual total compensation of the issuer’s PEO; and

• the ratio of the foregoing compensation amounts.

The median annual total compensation for all employees and for the PEO would be calculated as provided in Item 402(c)(2)(x) of Regulation S-K (Item 402(c)(2)(x)), which requires disclosure of a named executive officer’s total compensation in the summary compensation table required by Item 402(c) of Regulation S-K.

The comment period for the proposed rulemaking will remain open until at least December 2, 2013. The comments are likely to be numerous, with proponents of the Dodd-Frank Act requirements perhaps weighing in against certain of the proposed rule’s provisions as vociferously as issuers and their allies typically do on such costly and controversial proposed disclosure requirements.

Even if the proposed rule were to be adopted and become effective in 2013, subject issuers are not expected to be required to make pay ratio disclosure in 2014. The SEC has indicated that the first required pay ratio disclosure would be reported with respect to compensation for the first fiscal year of an issuer commencing on or after the effective date of the final rule. In light of the 60-day comment period and the likelihood of numerous comments, it seems unlikely that the proposed rule would be effective prior to the first quarter of 2014 at the earliest. In the event of an adoption in that quarter, an issuer with, for example, a June 30 fiscal year-end would likely have to make its first pay ratio disclosure with respect to compensation for the fiscal year ending June 30, 2015 and to make that disclosure in its annual report on Form 10-K (10-K) or proxy statement, as appropriate, filed in 2015. Likewise, in the event the effective date of the proposed rule occurs in the first quarter of 2014, a calendar year issuer would be required to make its first pay ratio disclosure with respect to fiscal year 2015 compensation and to make that disclosure in its 10-K or proxy statement, as appropriate, filed in 2016.

Issuers Subject to the Proposed Rule

Under the proposed rule, those public companies that are required to provide compensation disclosure pursuant to Item 402 of Regulation S-K in filings with the SEC would be required to make pay ratio disclosure. Emerging growth companies, smaller reporting issuers, foreign private issuers and issuers filing under the U.S.-Canadian multijurisdictional disclosure system would not be required to make pay ratio disclosure in any SEC filing.

Identifying the Employee with the Median Annual Total Compensation

The proposed rule would impose a major new task on subject issuers—identifying for each fiscal year for which pay ratio disclosure is required their employee (Median Employee) whose annual total compensation is the median annual total compensation of all of the issuer’s employees (Median Compensation). Issuers that would be subject to the proposed rule should take note of several important aspects of the proposed rule relating to making the annual identification of the Median Employee and determination of Median Compensation.

The term “employee” includes employees other than full-time employees. The term “employee” would mean every employee as of the last day of the issuer’s fiscal year as to which the pay ratio disclosure is to be made, including any and all full-time and part-time employees and temporary and seasonal workers then employed by the issuer or one of its subsidiaries. Both U.S. and foreign employees, named executive officers other than the PEO and other officers would be included in the employee population. Independent contractors, “leased” workers and other temporary workers employed by a third party would not be considered “employees.”

Only limited adjustments of compensation would be permitted to determine Median Compensation. An issuer would be permitted, but not required, to annualize the total compensation of its permanent employees who were employed for less than the full fiscal year (such as permanent employees who were hired after the beginning of the fiscal year or employees who were on an unpaid leave of absence). If, however, the issuer annualizes the compensation of any permanent employee, it must annualize the compensation of all permanent employees. The proposed rule would not permit an issuer to annualize the compensation of temporary and seasonal workers. Depending on an issuer’s facts and circumstances, an issuer could, but would not be required to, annualize the actual compensation of a permanent part-time employee who worked for only a part of the fiscal year (such as an employee who is permanently employed for three days a week, but was hired after the beginning of the fiscal year, or who took an unpaid leave of absence under the Family and Medical Leave Act during the fiscal year).

An issuer would not be permitted to adjust employee compensation if the adjustment would cause the pay ratio disclosed to not reflect the actual composition of the issuer’s workforce or compensation practices. As a result, the proposed rule would not permit the issuer to adjust the compensation of part-time workers to reflect the compensation they would have received had they worked on a full-time basis or to make cost-of-living adjustments for non-U.S. workers. Moreover, permanent part-time employees and temporary and seasonal workers could not be “combined” to reflect a few such employees working, in the aggregate, the number of hours worked by a full-time employee as a single full-time equivalent employee with higher annual total compensation.  

The SEC recognizes that issuers with large numbers of foreign workers in low wage economies would have their pay ratios adversely affected by the inclusion of such foreign workers in their employee populations for purposes of the proposed rule. Nevertheless, the SEC has chosen to do nothing in the proposed rule to allow issuers to address such a problematic circumstance or the adverse effect on their pay ratios of currency exchange rates used to convert wages paid in local currencies into U.S. dollars for purposes of determining their Median Compensation. As a result, issuers with large numbers of part-time employees and temporary, seasonal, and foreign workers on their payrolls on the last day of a fiscal year could find themselves disadvantaged disproportionately to their competitors under the proposed rule.

The PEO is excluded. The PEO would not be taken into account in determining the Median Compensation.

Issuers would have some flexibility in determining the Median Compensation.When the Dodd-Frank Act was enacted, issuers and others immediately identified the central difficulty and expense driver of compliance with Section 953(b) and, as it turns out, with the proposed rule: identifying the employee that earns in the reporting period the median annual total compensation of the annual total compensation of all of the issuer’s employees other than the PEO.³ The SEC had received a large number of comments from interested persons in anticipation of the SEC’s implementation of Section 953(b)’s requirements, which is widely viewed as another of the “name and shame” provisions of the Dodd-Frank Act. As a result of the many comments pointing out the significant difficulties and inordinate expense that issuers with large employee populations and multinational work forces would face in complying with the proposed rule, the SEC has attempted to give issuers some flexibility in identifying their Median Employee and determining their Median Compensation for a fiscal year in order to lower the issuer’s compliance burden and costs, both in management time and out-of-pocket expenses of internal labor and external advisers.

The proposed rule does not include any “prescriptive requirements” for the methodology used to identify the Median Employee, but allows each issuer to select a methodology that is appropriate for its size, structure and compensation practices. Under the proposed rule, an issuer would be permitted to use:

• a methodology that uses reasonable estimates to identify the Median Employee, and reasonable estimates to calculate the annual total compensation or any elements of total compensation of employees other than the PEO;

• its total employee population or statistical sampling or other reasonable methods to determine a group of its employees from which to identify the Median Employee; and

• annual total compensation or any other compensation measure that is consistently applied to all employees included in the calculation of employees’ annual total compensation, such as amounts derived from payroll or tax records, to identify the Median Employee. If such other measure is used to identify the Median Employee and the issuer records that measure on a basis other than the issuer’s fiscal year, such as the employees’ tax year, the issuer would be permitted to use that annual period in identifying the Median Employee.

The use of an alternative methodology for identifying the Median Employee would permit an issuer to identify the Median Employee without calculating the annual total compensation of every one of its employees in accordance with Item 402(c)(2)(x). The SEC has suggested that, if the Median Employee is identified by certain of such methodologies, only the Median Employee’s annual total compensation would need to be computed in accordance with Item 402(c)(2)(x) for calculation and disclosure of the pay ratio.

The SEC intends that the proposed rule would allow issuers to choose a method of identifying the Median Employee that works best for, and is appropriate to, the issuer’s particular facts and circumstances. The Release identifies those facts and circumstances as including variables such as:

• the size and nature of the issuer’s workforce;

• the complexity of its organization;

• the stratification of pay levels across the workforce;

• the type of compensation its employees receive;

• the extent to which different currencies are used to pay employees;

• the number of tax and accounting regimes involved;

• the number of payroll systems the issuer has; and

• the degree of difficulty of integrating payroll systems to readily compile total compensation information for all employees.

The SEC expects whatever methodology an issuer adopts and uses to be “reasonable” and that such methodology will be used consistently in a particular fiscal year’s identification of the Median Employee. Neither the proposed rule nor the SEC’s discussion in the Release prescribes or suggests a standard of reasonableness by which an issuer’s methodology would be judged.

As noted above, issuers would be permitted to use reasonable estimates to determine the annual total compensation or any elements of the total compensation of employees other than the PEO. This latitude extends to the determination of the Median Compensation to be disclosed. The price of this flexibility is that an issuer using estimates in this manner would be required to identify the disclosure based on estimates as such in the pay ratio disclosure and briefly describe the estimation methods the issuer used to develop the information. Again, neither the proposed rule nor the SEC’s discussion in the Release prescribes or suggests a standard of reasonableness by which an issuer’s estimates would be judged.

The proposed rule does not require a particular type of statistical sampling be used by issuers, suggest a methodology favored by the SEC, or establish a safe harbor type of statistical sampling. The SEC does, however, indicate in the Release that a reasonable determination of sample size would depend on the “underlying distribution of compensation data.” Moreover, it notes that reasonable estimates of the Median Employee for an issuer with multiple business lines or geographical units could be arrived at through more than one statistical sampling approach, but that all approaches require drawing observations from each business or geographical unit with a reasonable assumption on each unit’s compensation distribution and inferring the Median Employee based on all of those observations. Moreover, the SEC indicates that identification of the Median Employee by statistical sampling would not require a determination of the exact compensation of every single employee included in the sample, as the issuer could identify employees in the sample having extremely low or extremely high pay and not calculate their exact amounts of compensation. This view suggests, however, that the compensation of all other employees in the statistical sample would have to be calculated in accordance with Item 402(c)(2)(x) to identify the Median Compensation.

In discussing the use by issuers of the flexible approach of the proposed rule, the SEC notes that a particular single measure, such as salary and wages (including overtime), could be used to identify the Median Employee. As a result, an issuer would be permitted to use the income for its employees reported to the Internal Revenue Service on Form W-2 for U.S. employees and equivalent reports for non-U.S. employees to identify its Median Employee. The SEC has chosen to allow this methodology for identifying the Median Employee despite the fact that the annual total compensation of the Median Employee identified by this method would be calculated for the fiscal year for which the pay ratio disclosure is made and not, for example, the tax year of the employee identified as the Median Employee by reference to the W-2 reported income of the issuer’s employees.

As would be readily apparent from the foregoing, the SEC has proposed an approach to the identification of the Median Employee that allows an issuer to approximate the Median Employee. While a statistical sampling or estimation method of identifying the Median Employee is likely to come close to the mark in identifying the actual Median Employee, that method may not result in the identification of the actual Median Employee that would be identified if the issuer calculated the annual total compensation for every employee under Item 402(c)(2)(x). In a moment of pragmatism, the SEC has said that in the matter of the identity of the Median Employee, as in horseshoes and hand grenades, close counts. Unfortunately, activist proponents of pay ratio disclosure may attack the SEC’s proposed rule as not being good enough and push the SEC to have the final rule require issuers to determine the Median Employee by calculating the annual total compensation for every employee in accordance with Item 402(c)(2)(x).

With the flexibility that would be afforded by the proposed rule, issuers would be allowed to choose differing measures to identify their Median Employee and different methods of estimating annual total compensation or elements of annual total compensation. As a result, comparisons of pay ratios among issuers may, in many, if not most, instances, be of questionable accuracy and value. The SEC recognizes that is the case, but views such a factor as not outweighing the overall benefit of the flexibility given to issuers.

Determining total compensation. The total compensation of an employee, including the PEO, would be determined in accordance with Item 402(c)(2)(x),⁴ which requires and provides for the calculation of the annual total compensation of an issuer’s named executive officers included in the summary compensation table required by Item 402(c) of Regulation S-K, by substituting the term “employee” wherever the term “named executive officer” appears in Item 402. As a result, the proposed rule would require the issuer to identify its employee who received the median annual total compensation of all employees of the issuer (other than the PEO) calculated in accordance with Item 402(c)(2)(x) and the proposed rule for purposes of making this disclosure. If the rules for calculating compensation for purposes of Item 402(c)(2)(x) are amended in the future,⁵ the requirement of Section 953(b) that the annual total compensation of all employees for purposes of this disclosure requirement be determined based on Item 402(c)(2)(x) as in effect on July 20, 2010⁶ could cause the issuer to disclose two different total annual compensation amounts for the PEO, (1) the total compensation amount as disclosed in the summary compensation table, and (2) the PEO’s total compensation computed under the version of Item 402(c)(2)(x) as in effect on July 20, 2010, unless the SEC decides it has the authority to give, and gives, issuers relief in this regard. As a result, it may become necessary for issuers to explain the reasons for the different PEO compensation amounts appearing in the filing and the drivers of the differences.

Required Disclosure

Scope of disclosure. The proposed rule would require the issuer to disclose:

• the annual total compensation paid to the Median Employee during the issuer’s last completed fiscal year;

• the annual total compensation of the PEO during the issuer’s last completed fiscal year; and

• the ratio of the foregoing compensation amounts.

Pay ratio disclosure alternatives. The proposed rule would give issuers two choices for disclosing the pay ratio:

• in the classic fashion, with the annual total compensation of the Median Employee being shown as “one” (e.g., if the Median Employee’s annual total compensation were $75,000 and the PEO’s annual total compensation were $7,500,000, the ratio could be disclosed as “1:100” or “1 to 100”); or

• by stating the PEO’s annual total compensation as a multiple of the Median Employee’s annual total compensation (e.g., if the amount of the Median Employee’s annual total compensation were $75,000 and the PEO’s annual total compensation were $7,500,000, the ratio could be disclosed, for example, as: “the PEO’s annual total compensation is 100 times that of the median of the annual total compensation of all employees”).⁷

Issuers would be permitted to present additional ratios to supplement the required pay ratio. Any additional ratios disclosed would have to be clearly identified, not be misleading, and not be presented with greater prominence than the required pay ratio.

Additional narrative disclosure of methodologies and material assumptions, adjustments or estimates. Issuers would be required to briefly disclose any methodology used to identify the Median Employee and any material assumptions, adjustments, or estimates used to identify the Median Employee or to determine total compensation or any elements of total compensation, and identify any estimated amounts. For example, an issuer with only U.S. employees that identifies its Median Employee by reference to the income reported for each of its employees to the Internal Revenue Service for federal income taxation purposes would be required to disclose its use of that methodology. This narrative disclosure should be a “brief overview” and would not need to include technical analyses or formulas. If an issuer makes a change in its methodology for determining the Median Employee or its material assumptions, adjustments, or estimates from those used in its pay ratio disclosure for the prior fiscal year and the effect of any such change is material, the issuer would be required to briefly describe the change and the reasons for making the change and give an estimate of the impact of the change on the Median Employee and Median Compensation and the pay ratio from the prior fiscal year.

Filings to Include Pay Ratio Disclosure

A subject issuer would have to include the pay ratio disclosure in each SEC filing in which the issuer is required to include executive compensation disclosure pursuant to Item 402 of Regulation S-K, including registration statements under the Securities Act of 1933, as amended, and Exchange Act of 1934, as amended (Exchange Act), and 10-Ks and proxy and information statements filed under the Exchange Act. However, the disclosure would not be required in registration statements on Form S-1 or S-11 relating to an issuer’s initial public offering or a Form 10 registration statement filed under the Exchange Act if the issuer has not previously been required to file periodic reports under the Exchange Act.

Timing of Pay Ratio Disclosure

As currently anticipated by the SEC, a subject issuer would be required to make pay ratio disclosure with respect to compensation for its first fiscal year commencing on or after the effective date of the final rule. Although not required in their initial public offering registration statements, newly public issuers would be required to include the pay ratio disclosure in the relevant reports for the first fiscal year commencing on or after the date on which they first become subject to the Exchange Act’s periodic report filing requirements.

Pay ratio disclosure for a completed fiscal year would not be required to be disclosed until (1) the filing of an issuer’s 10-K for such fiscal year or (2) if later, the filing of the issuer’s definitive proxy or information statement relating to its next annual shareholders’ meeting following the end of the completed fiscal year so long as that definitive proxy or information statement is filed not later than 120 calendar days after the end of the fiscal year. If the issuer intends to include the pay ratio disclosure in its proxy or information statement, but its definitive proxy or information statement would not be filed with the SEC by the 120-day deadline, the issuer would have to amend its 10-K to include the pay ratio disclosure by no later than the 120-day deadline. A filing made after the end of the most recently completed fiscal year and before such a 10-K or definitive proxy or information statement is filed would need only include pay ratio disclosure relating to the fiscal year immediately prior to the most recently completed fiscal year (if that fiscal year is one as to which the pay ratio disclosure must be made).

Issuers may currently rely on an instruction to Item 402(c) to exclude their PEO’s salary or bonus for the last completed fiscal year from their summary compensation table disclosure if that salary or bonus is incalculable through the latest practicable date prior to the pertinent filing date. Issuers relying on this instruction would not be able to include pay ratio disclosure in a filing in which related compensation disclosure is required, but would be required to disclose in that filing that the pay ratio for that fiscal year is not calculable until the PEO’s salary or bonus, as the case may be, is determined and the date on which issuer expects to determine the PEO’s actual total compensation for that fiscal year. The issuer would then have to provide the pay ratio disclosure for such fiscal year in the current report on Form 8-K under Item 5.02(f) that the issuer is required to file to disclose the PEO’s salary or bonus once it is determined.

Practical Considerations

Considering the specific requirements of the Dodd-Frank Act and the intensity of both the support for and opposition to the pay ratio disclosure requirement, it is difficult to predict how closely the final pay ratio disclosure rule will resemble the proposed rule. Although the final pay ratio disclosure rule may differ from the proposed rule, we discuss below some practical considerations that we believe issuers are likely to face once a final rule is adopted.

Issuers with employee populations that are large and have complex compositions face significant compliance challenges. Issuers with a large number of employees, most of whom are hourly wage workers, face disclosing what will appear to be disparities in pay that will be extraordinarily unfavorable to the rank-and-file worker. Multinational issuers with significant numbers of employees in foreign labor markets in which average wages are significantly lower than those in the United States will face even more unfavorable comparisons. Moreover, the requirement that part-time employees and temporary and seasonal workers who are employees on the last day of the pertinent fiscal year be considered in determining the Median Compensation will only further and more unfairly exaggerate the comparison reflected in the pay ratio.

It is not enough to determine the average annual total compensation of all employees other than the PEO as that would not necessarily also be the Median Compensation of all employees other than the PEO. As a consequence, issuers with a large number of employees may face significant logistical problems with producing the information necessary to determine the Median Compensation if they choose to calculate all employees’ annual total compensation to do so. Such logistical problems may be compounded if groups of their employees whose base pay or hourly wages are the same receive different amounts of overtime pay and different bonuses, equity awards, and other, non-base compensation. In spite of the fact that an issuer would be taking a snapshot of its employee population as of the last day of its fiscal year, it would likely be unrealistic for such an issuer to attempt to calculate the annual total compensation in accordance with Item 402(c)(2)(x) for each of its employees. Those issuers would want to consider a method for identifying the Median Employee other than calculating every employee’s annual total compensation every year if alternative methods for identifying the Median Employee are available in the final rule.

Where there are a number of issuers with large employee populations within the same industry, those issuers should consider working with their trade associations to develop a reasonable methodology for identifying their Median Employees, such as a model for statistical sampling or other reasonable methodology that could be broadly adopted by their members. Such methodologies and models could be vetted with the staff of the SEC’s Division of Corporation Finance (Staff) to avoid the Staff questioning the reasonableness of an issuer’s methodology and to allow the issuers using that methodology to disclose that they are using a methodology that is an industry standard methodology.

Issuers with large employee populations and for whom statistical sampling represents a viable and a relatively cost-effective methodology for identifying their Median Employees should work with their industry associations and other groups to engage the Staff and comment on the proposed rule in a manner to attempt to preserve, if not expand, the flexibility given to issuers in the proposed rule. In light of the non-prescriptive, somewhat issuer-oriented nature of the proposed rule, issuers would be best served not to have the proposed rule made more specific or to try to have the final rule provide more “certainty” as to what constitutes a reasonable methodology for identifying a Median Employee or determining the Median Compensation.

Issuers will be exposed to liability for materially inaccurate pay ratio disclosure.The pay ratio disclosure would be “filed” with the SEC rather than “furnished”, and, as a result, disclosure of annual total compensation of the person identified as the Median Employee by those alternative means that is materially different from the annual total compensation of the actual Median Employee as calculated under Item 402(c)(2)(x) could result in liability for the issuer. As a result, issuers using an alternative means to identify the Median Employee or determine the Median Compensation will want to take care that their methodology will produce an identification of a Median Employee or determination of a Median Compensation that is not materially inaccurate or otherwise misleading and that is demonstrably “reasonable” under their particular facts and circumstances.

Issuers should start considering the logistics of compliance with the pay ratio disclosure rule. An issuer’s counsel and human resources department should commence identifying any problems that may exist in identifying the issuer’s Median Employee or determining its Median Compensation. For example, issuers will need to consider how data privacy laws in various domestic and international jurisdictions could affect or restrict the gathering, transfer and verification of the data needed to identify their Median Employee or determine their Median Compensation. Issuers with large employee populations should review their accounting, payroll, and other information systems to understand whether those systems will allow them to capture the necessary data to produce the required disclosure without modifying their information systems, to produce the information to perform the statistical sampling, to make reasonable estimates, or to take other reasonable measures to identify their Median Employee or to determine their Median Compensation. Moreover, those issuers that may want to use a measure such as their employees’ income as reported on Forms W-2 to identify their Median Employee should consider testing whether the use of that measure would produce a result that will be materially accurate in the context of the anti-fraud rules of the federal securities laws. In addition, issuers that may want or need to use statistical sampling to identify their Median Employee should consider engaging a professional statistician to help the issuer design the statistical sampling methodology that the issuer will use for that purpose and to gain an understanding of the type of information and other resources that will be needed for the issuer to conduct such statistical sampling. The lead time for obtaining the necessary information or setting up information systems to produce the information and to conduct such tests and for designing and implementing a statistical sampling program could be long.

Compensation committees should be considering the nature of the pay ratio disclosure and whether other pay comparisons should be made. Compensation committees should be made aware of the proposed rule and briefed about the work faced by the issuer in complying with the proposed rule’s requirements, especially in connection with their next meetings to consider their next executive compensation decisions. While the pay ratio disclosure requirement should not drive compensation decisions, it is a matter that compensation committees should consider, especially in connection with their review and consideration of the issuer’s executive compensation disclosure and say-on-pay vote.

Moreover, the pay ratio disclosure requirement may prompt consideration of making disclosure of other pay comparisons. Since before the enactment of the Dodd-Frank Act, commentary has suggested that institutional investors who are not social activists, as well as proxy advisors, are more interested in the disclosure of the differentials in the compensation of the PEO and the compensation of the other named executive officers and other senior managers of issuers than they are in the pay ratio disclosure mandated by the Dodd-Frank Act. That interest focuses on whether the differences in responsibility and work between the chief executive officer and other senior managers are fairly reflected in the differences between the chief executive officer’s and the other senior managers’ compensation and whether the compensation of these executive officers reflects appropriate succession planning. Non-social activist institutional investors and proxy advisors also have an interest in seeing in proxy statements an analysis of the role that internal pay equity between the chief executive officer and other named executive officers plays in the compensation decisions made with respect to the chief executive officer and the other named executive officers. Issuers should consider the prudence and possible benefits of making such other disclosures.

Dealing with the adverse effects of the pay ratio disclosure. The ratio of PEO compensation to the median annual total compensation of all other employees of an issuer is but another exceedingly blunt, and largely uninformative, instrument of disclosure. In the Release, the SEC makes numerous references to commenters advancing the fanciful notion that the pay ratio disclosure will be an indicator of employee morale or the issuer’s investment in human capital. In point of fact, pay ratio disclosures are more likely to affect employee morale adversely than they are to give even marginally accurate indications of employee morale. It is likely that various factions within the investment community, especially activist investors with an anti-management agenda, will make comparisons of the pay ratios of various issuers. In spite of a probable lack of comparability among the pay ratios disclosed by issuers, guileful activists can be expected to use such comparisons against the issuers who are the targets of their agendas. As a result, without adequate explanation by the issuer, the pay ratio disclosure has great potential to create rancor among an issuer’s less sophisticated shareholders, as well as tensions between the PEO and the rank-and-file employees of the issuer, especially when the disparity shown in the ratio changes in favor of a PEO from one year to the next. Issuers may find the pay ratio disclosure is a potential lightning rod for shareholder activists and proxy advisors in connection with the say-on-pay vote. Moreover, this disclosure will be another factor that heightens an issuer’s risk that proxy advisors will recommend “no” votes against compensation committee members standing for re-election at the annual meeting if any real, or even apparent, pay inequity is not effectively addressed or explained by the issuer. Consequently, as the time of the first pay ratio disclosure comes nearer, an issuer will want to engage its investor relations and human resources groups to address how to combat the possible adverse publicity regarding, and employee and other reactions to, the issuer’s pay ratio disclosure.

Issuers should consider commenting on the proposed rule. Issuers may wish to consider commenting on those aspects of the proposed rule as to which they can expect the SEC to have some basis for changing the proposed rule in issuers’ favor. Such aspects include matters such as (1) the SEC’s unnecessary insistence that employees of subsidiaries of the issuer be included in the population for identifying the Median Employee and determining the Median Compensation when the Dodd-Frank Act addresses only the issuer’s, and not its subsidiaries, employees, and (2) the SEC’s refusal to allow issuers to adjust the pay of all part-time employees and temporary or seasonal workers to reflect the compensation they would have received were they full-time employees. If preparing a comment letter on the proposed rule, an issuer should recall that, however wasteful of corporate resources and shareholder assets the requirements of the proposed rule would be, the Dodd-Frank Act requires the SEC to amend Item 402 of Regulation S-K to implement Section 953(b)’s requirements. Comments on the proposed rule should be focused on those matters that the SEC can influence through the terms of the proposed rule without ignoring the express requirements of the Dodd-Frank Act.

_{1. See Pay Ratio Disclosure, Securities Act Release No. 33-9542; Exchange Act Release No. 34-70443 (Sept. 18, 2013), 78 Fed. Reg. 60560 (Oct. 1, 2013), available athttp://www.gpo.gov/fdsys/pkg/FR-2013-10-01/pdf/2013-23073.pdf (Release).}

_{2. If Congress and the SEC have used the term “median” with its usual meaning, the median annual total compensation of all employees (other than the chief executive officer) would be the compensation of that employee or employees as to which half of the other employees (other than the chief executive officer) have annual total compensation less than and the other half of the other employees (other than the chief executive officer) have annual total compensation greater than the annual total compensation of the employee or employees at the median.}

_{3. Except to use the term “principal executive officer” rather than “chief executive officer (or any equivalent position),” the SEC has parroted the language of Section 953(b)(1)(A) in proposed Item 402(u)(1)(i), which sets forth the employee median compensation to be compared to the PEO compensation in the pay ratio. Nevertheless, in doing so, the SEC seems to have chosen to ignore the literal meaning of Section 953(b)(1)(A), which reads, as does Item 402(u)(1)(i), “median of the annual total compensation of all employees … .”  In light of the clear meaning of this phrase in Section 953(b) and Item 402(u), this phrase would require a comparison of the aggregate amount of all compensation paid to all of the issuer’s employees for the last completed fiscal year, not just the compensation of the single employee whose annual total compensation is the median annual total compensation paid to the issuer’s employees.  Obviously, the drafters of Section 953(b) meant something different from what they wrote and, much like Humpty Dumpty in Lewis Carroll’sThrough the Looking Glass, Congress, the SEC, and the activist proponents of pay ratio disclosure would pretend that the language in Section 953(b) and Item 402(u) means exactly what they say it means and ignore the actual meaning of the language of Section 953(b).} 

_{4. Section 953(b) requires annual total compensation of employees (but not the PEO) to be calculated in accordance with Item 402(c)(2)(x) as in effect on the date prior to the enactment of the Dodd-Frank Act, or July 20, 2010, and does not permit a change in the method of calculation if Item 402 is amended in a manner that affects Item 402(c)(2)(x). The SEC recognizes the issue this Dodd-Frank Act requirement creates, but, noting that no substantive amendments have been made to Item 402(c) since July 20, 2010, proposes to defer addressing the issue present in the proposed rule until future amendments of Item 402(c) are considered.} 

_{5. Certain provisions of Item 402(c)(2) that dictate how to calculate the amount of certain elements of the total compensation amount to be disclosed pursuant to Item 402(c)(2)(x) may involve calculations based on the generally accepted accounting principles set forth in the Financial Accounting Standards Board’s Accounting Standards Codification’s Topic 718 (ASC Topic 718). A literal reading of the statutory language would suggest that issuers would have to use the principles in ASC Topic 718 as in effect on July 20, 2010 to calculate total compensation for this purpose.  As a result, unless the SEC gives some relief on the matter of which version of Item 402(c)(2)(x) controls the calculation of annual total compensation for purposes of the proposed rule, future changes in ASC Topic 718 would serve only to compound the problem inherent in the mandate that a static set of disclosure requirements be used to calculate total compensation for purposes of the pay ratio disclosure.}

_{6. Although the SEC may helpfully keep a copy of the provisions of Item 402 as in effect on July 20, 2010 posted, if Item 402(c) is amended in the future, corporate counsel and other corporate advisers would want to maintain a copy of Item 402 as in effect on July 20, 2010, as well as any commentary on, and interpretative guidance for, that version of Item 402 on which they have depended in the past.}

_{7. See Release at 60565, where the SEC suggests this form of language, which, given the intended meaning of the statement, suffers from the same syntactical flaw we discuss in endnote 3 above.}