Dodd-Frank Executive Compensation Rules: SEC Proposes Rules for CEO/Employee Pay Ratio Disclosure

by Reed Smith

On September 18, 2013, the Securities and Exchange Commission voted 3-2 to propose a new rule implementing section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This rule, requiring a public company to disclose the ratio of the median annual total compensation of all employees to the annual total compensation of the chief executive officer (the "Proposed Rule"), has been highly controversial. There has been significant concern over the practicality and administrative burden that could be imposed on companies by a requirement to calculate the median annual total compensation of all employees.

The Proposed Rule would amend Item 402 of Regulation S-K, but would not affect the 2014 proxy season and would not apply to smaller reporting companies, foreign private issuers, or "emerging growth companies" under the Jumpstart Our Business Startups ("JOBS") Act. If the final rule becomes effective in 2014, a company will be first required to make the pay ratio disclosure in its 2016 proxy statement (based on 2015 compensation data).

Pay Ratio Disclosure Requirements

The Proposed Rule would require certain public companies to disclose under Item 402 of Regulation S-K: (i) the median annual total compensation of all employees (other than the CEO), (ii) the annual total compensation of the CEO, and (iii) the ratio of the two amounts. It does, however, include some flexibility to address some of the concerns raised over its application. The key terms of the Proposed Rule are set forth below.

  • Applicable Employees. For purposes of determining median annual total compensation, "all employees" must be considered, including all part-time, temporary, seasonal and non-U.S. employees of a company and its subsidiaries who are employed as of the last day of the company’s fiscal year. Companies are permitted (but not required) to annualize the total pay for a permanent employee who did not work a full year (e.g., new hires). However, companies are not permitted to make full-time equivalent adjustments for part-time employees, annualizing adjustments for temporary and seasonal employees, or cost-of-living adjustments for non-U.S. workers.
  • Determination of Median Annual Total Compensation and Disclosure of Methodology. The Proposed Rule does not require a calculation of the annual total compensation of a company’s entire workforce under the Item 402 rules; instead, in response to concerns, the Proposed Rule requires a comparison of the compensation of a "median employee" to the compensation of the company’s CEO. The Proposed Rule does not specify any required calculation methodologies for identifying this median employee in terms of total compensation for all employees. Each company has the flexibility to select a reasonable methodology that is appropriate to the size and structure of its own businesses and compensation practices, such as through examination of payroll or tax records of its entire employee population or through statistical sampling, and may use annual total compensation under Regulation S-K or another consistent measure. Companies are required to disclose their methodology for determining median annual total compensation of their employees, including any material assumptions, adjustments or estimates used to identify the median or to determine total annual compensation.
  • Disclosure of Pay Ratio. Once the median employee is identified, both the annual total compensation of such median employee and the total annual compensation of the CEO must be disclosed based on the Item 402 proxy disclosure rules used to calculate CEO pay. The ratio of median annual total compensation of all employees to the annual total compensation of the CEO must be disclosed either as a ratio (where the median employee compensation equals one) or narratively in terms of the multiple that CEO compensation bears to median employee compensation.

There is a 60-day comment period with respect to the Proposed Rule. Disclosure will be required for the first fiscal year commencing on or after the effective date of any final rule. However, a company will be permitted to omit the disclosure until the filing of its 10-K relating to that fiscal year or the proxy statement for its next annual meeting of shareholders following the end of such year.

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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