Financial Reform Act: SEC Proposes CEO Pay Ratio Disclosure Rules


Recently, the SEC, by a vote of 3 to 2, proposed long-delayed and controversial rules to implement the “CEO pay ratio” disclosure mandated under the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The proposed rules, voted in on September 18, 2013, would require U.S. public 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 CEO. 

Companies would have to comply with these new requirements for the first fiscal year beginning after the effective date of the final rules.  Assuming, as is likely, that the SEC adopts these new rules sometime in 2014, the new pay ratio disclosure would first be required for calendar year companies for the 2015 fiscal year, and disclosed in the proxy statement for the 2016 annual shareholders meeting. 

Smaller reporting companies, emerging growth companies and foreign private issuers would be exempt from the proposed requirements.  Newly public companies would not be required to provide the pay ratio disclosure until the first fiscal year beginning on or after the date they go public.

This update summarizes key aspects of the requirements of the proposed rules.  The proposing release is available here and the commissioners’ statements are available here

The Proposed Rules

New Pay Ratio Disclosure

Under the proposed rules, a new Item 402(u) of Regulation S-K would require companies to disclose

  • the median of the annual total compensation of all employees, excluding the principal executive officer;
  • the annual total compensation of the principal executive officer; and
  • the ratio of the two amounts.  

The proposed rules require the ratio to be expressed either as a ratio in which the median employee’s annual total compensation is equal to one, or narratively in terms of the multiple that the CEO’s total annual compensation bears to the median employee’s total annual compensation.  For example, if the median employee’s total annual compensation is $40,000 and the CEO’s total annual compensation is $12 million, the ratio could be described as 1 to 300, or the ratio could be described as the CEO’s compensation is 300 times the median of all employees’ annual total compensation.

Pay Ratio Disclosure Required in Form 10-K/Proxy Statement and Registration Statement

The pay ratio would first be disclosed for each completed fiscal year in that year’s annual report on Form 10-K. 

  • Can Incorporate Pay Ratio Disclosure by Reference to Proxy Statement.  Like the rest of the Form 10-K Part III disclosure, the pay ratio disclosure may be incorporated by reference to the annual proxy or information statement filed within 120 days after the end of the fiscal year.  Registration statements filed after the end of the fiscal year, but before 120 days after the end of the fiscal year, that require summary compensation table disclosure under Item 402(c) of Regulation S-K could be declared effective without an updated disclosure, but must include or incorporate by reference the pay ratio disclosure for the prior fiscal year, if it was required for the prior fiscal year.
  • Pay Ratio Disclosure Will Be “Filed.”  As with most of the other Item 402 executive compensation disclosure, pay ratio disclosure will be deemed “filed” and not “furnished” for purposes of liability under the Securities Act of 1933 and Securities Exchange act of 1934.
  • Must Update Pay Ratio Disclosure Annually.  The pay ratio disclosure would be updated annually based on compensation amounts for the registrant’s last completed fiscal year. 

Broad Definition of “Employees” Includes Non-U.S. and Part-Time Workers

The proposed rules broadly define the categories of employees that must be included in the identification of the median employee.  In addition to full-time U.S. employees, companies must include part-time, temporary, seasonal and non-U.S. employees who are employed by the company or any of its subsidiaries worldwide on the last day of the company’s fiscal year.  Independent contractors or leased employees are not included.  Companies cannot annualize for part-time, temporary or seasonal workers or make cost-of-living adjustments for non-U.S. workers, but may annualize for permanent employees who did not work during the entire year, such as new hires or employees who took an unpaid leave of absence. 

  • SEC Requests Comments on Proposed Definition of “Employees.”  The commission recognizes the burden the broad scope of this statutory requirement will place on issuers, and has asked for comments on whether there are other methods of complying with the statutory mandate to include “all employees,” and whether the flexibility permitted by the rule, discussed below, adequately addresses data privacy and other concerns for companies with a global workforce.

Alternative Methods for Identifying the Median Employee

To provide companies flexibility and address concerns about the cost of compliance raised by numerous commentators, the proposed rules do not prescribe a particular methodology for identifying the median employee, or provide any safe harbor methodologies.  Instead, the SEC provides instructions and guidance designed to allow companies to choose from several alternative methods, described below, to arrive at the method that works best for them, using the basis of the size and structure of the company’s business and its compensation practices.

  • Reasonable Estimates.  The proposed rules do not prescribe specific estimation techniques or confidence levels for calculating an estimated median, but instead state that a company must determine what is reasonable in light of the company’s employee population and access to compensation data.  The proposing release identifies a number of variables that a company may take into consideration.
  • Statistical Sampling.  The proposed rules permit a company to identify its median employee using the company’s entire employee population or statistical sampling or other reasonable method.  The proposing release notes that the sample size needed for a reasonable statistical sampling will be affected by how widely compensation is distributed around the mean, and that companies with multiple business units could use more than one sampling approach.
  • Consistently Applied Compensation Measure.  Companies may, but are not required to, use total compensation as calculated under Item 402(c)(2) of Regulation S-K to identify the median employee.  As an alternative to using total annual compensation as calculated under Item 402(c)(2) of Regulation S-K, companies may identify the median employee using a consistently applied compensation measure.  Acceptable measures include payroll or tax records, or other reasonable measures, such as total cash compensation, or total direct compensation, such as annual salary, hourly wages and any other performance-based pay.
  • SEC Requests Comments on Proposed Flexible Approach.  The SEC specifically requests comments on several aspects of this portion of the proposed rules, including whether the proposed rules are sufficiently specific, and the compliance costs of the various alternatives.

Calculating Total Compensation for the Median Employee

Once a company identifies its median employee, the company must calculate total compensation for that employee under Item 402(c)(2) of Regulation S-K.  Because applying rules designed for executive compensation to a non-executive presents significant challenges, the proposed rules permit a company to use reasonable estimates in determining total compensation, or any elements of compensation for the median employee, and to make certain other adjustments.

Must Disclose Methodology 

Companies must consistently use and briefly describe the methodology used to calculate total annual compensation for the median employee and any material assumptions, adjustments or estimates used to identify the median employee or to calculate the total annual compensation, or elements of total annual compensation of employees, and must clearly identify any estimated amounts.

Relief for Emerging Growth Companies, Smaller Reporting Companies, Foreign Private Issuers and Newly Public Companies

The proposed rules specifically exclude emerging growth companies, as defined in the JOBS Act; smaller reporting companies, as defined in Item 10(f)(1) of Regulation S-K); foreign private issuers, including those that file on Form 10-K; and companies that file in accordance with the requirements of the U.S.-Canadian Multijurisdictional Disclosure System or MJDS.

Companies filing an initial public offering could exclude the pay ratio disclosure in a registration statement on Form S-1 or Form 10.  These companies would instead provide the pay ratio disclosure for the first fiscal year beginning on or after the date the company becomes subject to the reporting requirements of the Securities Exchange Act of 1934.

What Companies Should Do Now

Consider Commenting on the Proposed Rules 

Comments on the proposed rules will be due December 2, 2013.  In the proposing release, the SEC requested comments on more than 60 specific issues to help the commission evaluate the approaches taken in the proposed rules.  During the open meeting at which the SEC adopted these proposed rules, the commissioners also strongly encouraged issuers, investors and other stakeholders to submit robust comments on the potential impacts of these proposed rules.  The dissenting commissioners encouraged detailed and “data-heavy” comments, along with realistic estimates of the costs of compliance.  Companies should consider submitting comments individually or through their legal counsel or an industry group. 

Explore Proposed Methods for Complying with Pay Ratio Disclosure

If adopted as proposed, the pay ratio rules will provide companies with considerable flexibility in identifying the median employee.  Companies should begin considering now the methodologies and assumptions they will use to make this determination, including whether they will need to retain outside advisors to assist in a statistical sampling and compilation process.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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