Proposed CEO Pay Ratio Disclosure Rules: Another Piece of the Dodd-Frank Puzzle

by Epstein Becker & Green
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Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") requires certain public companies to disclose how the compensation of the company's chief executive officer ("CEO") compares to the compensation of employees generally. The disclosure must include (i) the CEO's annual total compensation, (ii) the median of the annual total compensation of all employees other than the CEO, and (iii) the ratio of (i) over (ii).

Like many of Dodd-Frank's requirements, disclosure of the CEO pay ratio was not required until implementing regulations were issued. On September 18, 2013, the U.S. Securities and Exchange Commission ("SEC") published the applicable proposed regulations.[1]

The pay ratio disclosure requirements have elicited a fair amount of controversy and criticism, mostly due to a perceived high cost of calculating the ratio as compared to the value to investors of the information provided by the disclosure. In recognition of the complexity and cost that many public companies will face in complying with the disclosure requirements, particularly those with a significant global presence, the SEC's proposed regulations provide some flexibility in the methodology that may be used by an issuer in making the pay ratio calculations. However, there will still be challenges for many issuers to properly comply with the requirements.

Companies Required to Disclose

CEO pay ratio disclosure under Section 953(b) of Dodd-Frank generally applies to public companies that are required under SEC rules to provide a summary compensation table of named executive officers. This does not include "emerging growth companies," smaller reporting companies, and foreign private issuers. CEO pay ratio disclosure would be required in an issuer's annual report on Form 10-K (or the issuer's proxy statement for its annual stockholders meeting if compensation information is incorporated by reference), registration statements, and proxy and information statements. Disclosure is not required on Form S-1 for an IPO or in a registration statement on Form 10.

The Pay Ratio

The pay ratio must be expressed as a ratio in which the annual total compensation of the median employee is equal to one (e.g., "1 to 300") or expressed in terms of the multiple that the CEO's annual total compensation bears to the median employee's annual total compensation (e.g., "the CEO's annual total compensation is 300 times that of the median of the annual total compensation of all other employees").

Calculating the Pay Ratio

Employees Counted. A "median employee" is an employee as to whom half of the employees have higher compensation and half have lower compensation. For these purposes, almost all U.S. and non-U.S. employees, including any full-time, part-time, seasonal, or temporary workers, who are employed by the issuer and any of its subsidiaries (including officers other than the CEO) as of the last day of the prior fiscal year must be counted. However, independent contractors, leased workers, and other temporary workers who are employed by a third party are excluded. An issuer with a large global employee population may need to take into account the annual compensation of employees in various jurisdictions that may be subject to data privacy rules. An industry that relies significantly on part-time, seasonal, or temporary workers also may end up having a higher pay ratio than determined for similarly situated industries that are primarily dependent on full-time employees.

Issuers are not required to use any particular calculation method to identify the median employee. A median employee can be identified using (i) the issuer's full employee population, (ii) a statistical sampling of the employee population, or (iii) another reasonable method.

Compensation Used in Identifying the Median Employee. Annual total compensation for each employee included in the calculation (whether the entire population or a statistical sample) may be determined by identifying "total compensation" as prescribed in Item 402(c)(2)(x) of Regulation S-K or the issuer may choose a method to identify the median employee based upon its particular facts and circumstances, provided that the compensation measure is consistently applied (e.g., salary, wages, and tips reported to the Internal Revenue Service in Box 1 of Form W-2). Issuers may use the same annual period that is used for payroll or tax records to identify the median employee, even if the period differs from the issuer's fiscal year. An issuer may annualize the compensation of employees who work only part of the year (because they were hired mid-year or took a leave of absence for part of the year), but the issuer may not annualize compensation for seasonal or temporary employees, apply a cost-of-living adjustment, or make full-time equivalency adjustments for part-time employees. If an issuer chooses to annualize compensation, it must do so for all permanent employees. Reasonable estimates of components of compensation may also be used.

The Ratio. Once identified, the median employee's annual total compensation then must be determined and disclosed in accordance with Item 402(c)(2)(x) of Regulation S-K, in the same manner as is the CEO's compensation. Total compensation must be determined based on the issuer's last completed fiscal year (not the annual period used for payroll or tax records).

Other Disclosures

Issuers will be required to disclose the methodology and any material assumptions, adjustments, or estimates used to identify the median or the annual total compensation of employees. Issuers also must briefly disclose, and consistently apply, any methodology used to identify the median employee, and any estimated amounts must be clearly identified with sufficient information for a reader to evaluate the appropriateness of the estimates. It is not necessary, however, for an issuer to provide dense or technical analyses or formulas.

No narrative discussion of the pay ratio, the median employee's annual total compensation, or any supplemental information is required. An issuer is required to disclose only the pay ratio and, as described above, material assumptions, adjustments, or estimates used.

An issuer may provide additional information (including other ratios), such as a narrative discussion, to supplement the required pay ratio; however, any such additional information should be clearly identified, not be misleading, and not be presented with greater prominence than the required pay ratio. The issuer will be required to explain changes and adjustments to prior methodologies and assumptions that were previously used to calculate the pay ratio.

Effective Date

The SEC is seeking public comment on the proposed rules for 60 days from the issue date (i.e., until December 2, 2013). When the rules are finalized, issuers will generally be required to comply with them for the first fiscal year beginning after the effective date of the final rules.

Newly public companies would not be required to provide pay ratio disclosures until the first fiscal year commencing on or after the date that the company becomes subject to the reporting requirements under Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934.

The pay ratio disclosure will need to be updated when the issuer files its annual report for a completed fiscal year or, if later, when filing a definitive proxy statement or information statement relating to an annual meeting of shareholders following the end of such year, provided that the disclosure must be made no later than 120 days following the end of the issuer's fiscal year.

It seems inevitable that pay ratio guidelines will be adopted by proxy advisory firms, such as Institutional Shareholder Services ("ISS") and Glass, Lewis & Co.

 

IRS Circular 230 Disclosure

To ensure compliance with certain IRS requirements, we inform you that any tax advice contained in this publication is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code.

ENDNOTE

[1] The SEC release (Release No. 33-9452) containing the proposed regulations is available at http://www.sec.gov/rules/proposed.shtml.

 

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