On September 18, 2013, the Securities and Exchange Commission issued proposed rules that would require public companies to disclose the median annual total compensation of all their employees and the ratio of such median to the annual total compensation of their CEO (commonly referred to as the “pay ratio disclosure” requirement).1 This Newsflash is intended to provide a brief overview of the proposed rules. We will be providing a future OnPoint with a more comprehensive discussion. 

The proposed rules would provide public companies with flexibility to determine the median total annual compensation of their employees and calculate the pay ratio in a way that is appropriate for the size and structure of the company. In identifying the median, companies would not be required to use existing proxy statement pay calculation rules to calculate total compensation and would not be required to calculate total compensation for all their employees. Instead, companies would be permitted to use any consistently applied compensation measure (e.g., W-2 wages) and reasonable estimates to calculate the annual total compensation for employees other than the CEO, and companies would be permitted to limit the calculation to a subset of employees selected through statistical sampling or other reasonable methods. Companies would be required to disclose the methodology used to identify the median and any material assumptions, adjustments or estimates used in the median calculations.

After identifying the median, companies would then be required to use existing proxy statement pay calculation rules to calculate total compensation for the median employee and the CEO so that the pay ratio reflects an “apples to apples” comparison. The disclosure would be required to be presented as a ratio of the median pay to the CEO pay, or as a multiple of the CEO pay. For example, if the median of the annual total compensation of all employees is $50,000 and the annual total compensation of the CEO is $500,000, the pay ratio would be disclosed as “1 to 10” or as “the CEO’s annual total compensation is 10 times that of the median of the annual total compensation of all employees.” 

Despite the flexibility provided for in the proposed rules, if they are finalized in their current form they would likely impose a substantial administrative burden. The proposed rules would require including all employees, as of the last day of the company’s last completed fiscal year, in the identification of the median. This means not only full-time, U.S. employees of the registrant, but also part-time, seasonal, temporary and non-U.S. employees, as well as employees employed by subsidiaries. Furthermore, companies would not be permitted to make full-time equivalent adjustments for part-time employees, annualize compensation for temporary and seasonal employees, or make any cost-of-living adjustments for non-U.S. employees. However, the proposed rules would permit (but not require) companies to annualize the total compensation of permanent employees who did not work the full fiscal year.

Companies would be subject to the pay ratio disclosure requirement for their first fiscal year commencing on or after the effective date of the final rules. Assuming the rules will not be finalized before year-end, the first disclosure for calendar year companies would be required in 2016 with respect to 2015 compensation. The pay ratio disclosure requirement would not apply to emerging growth companies, smaller reporting companies or foreign private issuers. A new registrant (e.g., an IPO filer) would not be required to comply until the Form 10-K or proxy statement for its first fiscal year commencing on or after the date it becomes subject to SEC reporting requirements.

The pay ratio disclosure would be required in annual reports on Form 10-K, registration statements and proxy and information statements. As with other executive compensation disclosure, companies would be permitted to satisfy the pay ratio disclosure requirement in Form 10-K by incorporating the information from their subsequently filed proxy statements. Pay ratio disclosure would be considered “filed” not “furnished,” and, therefore, would be subject to liability under the Securities Act and Exchange Act.

Reflecting the controversy that has surrounded Section 953(b) of the Dodd-Frank Act ever since its enactment, the SEC’s decision to issue the proposed rules was by no means unanimous. The 3-2 vote in favor of proposing the pay ratio disclosure involved clear dissent, including the comment from Commissioner Daniel M. Gallagher that “[the] only conceivable purpose [of the proposed rules] is to name and, presumably in the view of its proponents, shame U.S. issuers and their executives” and that “[t]his political wish-list mandate represents another page of the Dodd-Frank playbook for special interest groups who seem intent on turning the notion of materiality-based disclosure on its head.”