SEC’s Proposed CEO Pay Ratio Disclosure Rule: What You Need to Know

On September 18, 2013, the Securities and Exchange Commission (SEC) released its proposal for additional executive compensation disclosure that, if adopted, will require U.S. domestic public companies to calculate and disclose in certain SEC filings (1) the annual total compensation of the company’s chief executive officer (CEO), (2) the median annual total compensation of all employees of the company, excluding the CEO, and (3) the ratio of those two amounts (collectively, the CEO Pay Ratio Disclosure).

Background

Controversy has surrounded section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) since it was enacted by Congress. The law directed the SEC to amend Item 402 of Regulation S-K to require the additional executive compensation-related disclosure in the form of the pay ratio disclosure. The SEC’s proposed CEO Pay Ratio Disclosure rule implements the Dodd-Frank Act requirements, clarifies certain ambiguities in section 953(b) and provides guidance on how the CEO Pay Ratio Disclosure may be calculated and disclosed.

The SEC appears to have struggled to settle on a proposal to implement this Dodd-Frank Act requirement. It has been over three years since the SEC became obligated to amend its executive compensation disclosure rules to include CEO pay ratio disclosure and during that time has received over 20,000 comment letters. The SEC release highlights the fact that neither the Dodd-Frank Act nor its legislative history states what objectives or benefits the requirement is intended to provide and sets out the SEC’s concerns regarding the potential costs of complying with such a requirement. As a result, the SEC determined that the proposed rule should provide a flexible approach toward implementing the requirement, even at the expense of comparability from issuer to issuer.

Which Issuers and Filings Are Affected

The proposed CEO Pay Ratio Disclosure would be required in a public company’s annual report, proxy or information statement and in certain registration statements filed under the Securities Act of 1933, as amended, that require disclosure of executive compensation under Item 402 of Regulation S-K. The proposed disclosure requirements to be set forth in a new Item 402(u) of Regulation S-K would be applicable only to U.S. domestic registrants and would not apply to foreign private issuers, emerging growth companies or smaller reporting companies.

New U.S. domestic registrants would be entitled to a proposed transitional exemption so that CEO Pay Ratio Disclosure would not be required in a registration statement on Form S-1 for an initial public offering or a registration statement on Form F-10. Instead, the registrant would be required to first comply with the pay ratio disclosure rule for its first fiscal year commencing on or after the date the registrant became subject to the requirements of section 13(a) or section 15(d) of the Securities Exchange Act of 1934, and, as proposed, the registrant would be permitted to omit this disclosure from its filings until its Form 10-K was filed for such fiscal year or, if later, a proxy or information statement is filed for its next annual meeting of shareholders following the end of such fiscal year.

Although foreign private issuers would not be required to provide CEO Pay Ratio Disclosure, any Canadian issuers that are foreign private issuers in the United States and that choose to satisfy executive compensation disclosure requirements under Canadian securities laws in accordance with Item 402 of Regulation S-K will need to provide CEO Pay Ratio Disclosure in accordance with any final rule once it becomes effective.

Following is a summary of certain key provisions of the proposed rule.

Employees Included in Calculation

In the proposed rule, the SEC defines “employees” to include all full-time, part-time, seasonal, temporary and non-U.S. workers employed by the company or any of its subsidiaries, including officers other than the CEO, as of the last day of the company’s last completed fiscal year. Independent contractors, “leased” workers and other temporary workers employed by a third party are not included to the definition of “employee” for purposes of the proposed rule. The SEC further clarifies that the definition of “employees” shall not include any carve-outs for specific categories of employees, such as non-U.S. employees.

Identifying the Employee Whose Annual Total Compensation Is the Median of All Employees

The SEC does not specify any required calculation methodologies for identifying the employee whose annual total compensation is the median for all employees other than the CEO (the median employee). Companies may identify the median by using a number of different methods, such as calculating total compensation for each employee under existing executive compensation rules or using reasonable estimates and/or statistical sampling. For example, the SEC release notes that a company with a large number of employees could take a statistically relevant random sample of employees to determine the medium employee, or any other consistently applied compensation measure, such as compensation amounts reported in its payroll or tax records, to determine the medium employee.

For permanent employees, other than temporary or seasonal employees, companies may perform their analysis using annualized total compensation, rather than using actual compensation for all such employees who did not work for the entire year. Despite this flexibility, the SEC release also states that companies would not be permitted to make certain adjustments or assumptions, such as full-time equivalent adjustments for part-time workers, annualizing adjustments for temporary or seasonal workers and cost-of-living adjustments for non-U.S. workers.

Calculating the Annual Total Compensation of the Median Employee

Once the company identifies the median employee, on the basis of the selected compensation methodology, the company would calculate, as described below, that employee’s annual total compensation in accordance with existing executive compensation rules under Item 402 of Regulation S-K and disclose that figure as part of the CEO Pay Ratio Disclosure so that the pay ratio comparison would be presented generally on a consistent basis. Companies may use reasonable estimates to calculate the annual total compensation, or any elements of that compensation, for the median employee. This flexibility does not apply to the calculation of the total annual compensation of the CEO, which generally would be the CEO’s total compensation figure appearing in the company’s Summary Compensation Table.

Disclosure of Methodology

The proposed rule would require companies to briefly disclose and consistently apply any (1) methodology used to identify the median employee, and (2) material assumptions, adjustments or estimates used to identify the median employee or to determine total compensation or any elements of total compensation, which should be designed to enable a reader to evaluate the appropriateness of the estimates. If a company changes methodology or material assumptions, adjustments or estimates from those used in its CEO Pay Ratio Disclosure for the prior fiscal year, and if the effects of any such change are material, the company must briefly describe the change and the reasons for the change, and must provide an estimate of the impact of the change on the median and the ratio.

Disclosure of CEO Pay Ratio

The proposed rule specifies that the CEO pay ratio must be expressed either (1) as a ratio in which the calculated median annual total compensation of all employees is equal to one or (2) in narrative form in terms of the multiple that the CEO total compensation figure bears to the median annual total compensation of all employees. For example, if the median annual total compensation of all employees of a company is $50,000 and the annual total compensation of the company’s CEO is $10 million, the CEO Pay Ratio Disclosure would be “1 to 200” or, as expressed in narrative form, “the CEO’s annual total compensation is 200 times that of the median annual total compensation of all employees.” Companies would also be permitted, but not required, to supplement the required disclosure with a narrative discussion or additional ratios.

Effective Date of Proposed Rule

A public company subject to the proposed rule would not be expected to include the CEO Pay Ratio Disclosure in its filings until its first fiscal year commencing on or after the effective date of the final CEO Pay Ratio Disclosure rule. Thus, if a final rule were to become effective in 2014, a registrant with a fiscal year ending on December 31 would be first required to include the pay ratio disclosure for fiscal year 2015 in its proxy or information statement for its 2016 annual meeting of shareholders.

Next Steps

The comment period on the proposed rule ends 60 days after the publication in the Federal Register, which is expected to be in late November 2013.

Companies should consider what methodology they will use to calculate the “median annual total compensation of all employees of the company (excluding the CEO)” and what system upgrades and compliance controls will be necessary (as well as their cost) in order to gather and analyze the information necessary to calculate the amount. Further, companies may want to consider the potential disclosure implications of the proposed new requirement, including how such disclosure may need to be integrated with its current Compensation Discussion & Analysis, as well as the potential effect of such disclosures on employees, shareholders and proxy advisory firms.

For further details, the SEC Release No. 33-9452 is available here.