U.S. Securities & Exchange Commission Proposes CEO Pay Ratio Disclosure Rules

by Wilson Sonsini Goodrich & Rosati

On September 18, 2013, the Commissioners of the U.S. Securities and Exchange Commission (SEC) issued proposed rules to implement Section 953(b) of the Dodd-Frank Act1 that require public companies to disclose how the compensation of the company's chief executive officer (CEO) compares to the median compensation of employees overall.

The proposed rules require disclosure of:

  • the annual total compensation of the company's CEO;
  • the median of the annual total compensation of all employees (except the company's CEO); and
  • the ratio of that median to the annual total compensation of the company's CEO.

Proponents of the rules believe that the pay ratio disclosure will assist investors (and potential investors) by making available more information about public company compensation practices. Critics of the proposed rules have questioned the usefulness of the pay ratio and stated that issuers with a significant international, seasonal, temporary, or part-time workforce may incur competitive harm when interested parties attempt to compare ratios between companies. Nonetheless, in an effort to reduce compliance costs and burdens on issuers, the SEC has, in most respects, proposed flexible rules that do not take a "one-size-fits-all" approach, and allow each issuer to determine the best methods for disclosure given the issuer's specific situation.

We expect that the SEC will issue final rules sometime in 2014. The full SEC release (Release No. 33-9452) is available at http://www.sec.gov/rules/proposed.shtml.

Questions & Answers

Which issuers will be required to make the pay ratio disclosure?

The pay ratio disclosure generally applies to public companies who file registration statements with the SEC in order to issue securities (i.e., issuers) that are required to provide a summary compensation table for named executive officers under SEC rules.2 The pay ratio disclosure does not apply to:

  • emerging growth companies;
  • smaller reporting companies;
  • foreign private issuers; and
  • issuers under the U.S. - Canadian Multijurisdictional Disclosure System.

The SEC has proposed a transition period for compliance by new issuers that would otherwise be subject to the rule, so that the pay ratio disclosure is not required in a registration statement on Form S-1 for an IPO or in a registration statement on Form 10.

Where will the pay ratio need to be disclosed?

The disclosure would be required in the 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 under the Securities Act and the Exchange Act, and proxy and information statements.3

As noted above, the pay ratio disclosure is not required in a registration statement on Form S-1 for an IPO or a registration statement on Form 10.

How is the median employee determined?

The median employee is an employee that represents the "middle employee," if all employees are ordered by compensation from highest to lowest - that is, half of the employees have higher compensation and half have lower compensation.

The proposed rules do not specify a required calculation methodology for identifying the median employee. Issuers will be permitted to choose from several alternative methods, including:

  • identifying the median employee using the full employee population;
  • identifying the median employee using a statistical sampling4 and/or
  • identifying the median employee by using reasonable estimates.

Who is an employee for purposes of determining the median employee?

The proposed rules state that an "employee" or "employee of the registrant" includes any full-time, part-time, seasonal, or temporary worker 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. Employees include all U.S. and non-U.S. employees.

Registrants are required to exclude all independent contractors, leased workers, and other temporary workers who are employed by a third party, and must also exclude any employee who is not employed by the issuer and its subsidiaries as of the last day of the last completed fiscal year.

How is annual total compensation calculated for purposes of determining the median employee?

Registrants may calculate the annual total compensation for each employee included in the calculation (whether the entire population or a statistical sample) using the method prescribed in Item 402(c)(2)(x) and to identify the median using this method.

As an alternative, registrants may identify the median employee based on any consistently applied compensation measure, and then calculate the annual total compensation for that median employee in accordance with Item 402(c)(2)(x). The proposed rules permit issuers to select the compensation measure that is appropriate to the issuer's own facts and circumstances, so long as it is a compensation measure that is consistently applied (e.g., salary, wages, and tips reported to the Internal Revenue Service (IRS) in Box 1 of Form W-2). The proposed rules permit issuers to 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.

How is the annual total compensation of an employee who was employed for part of the year calculated? What about temporary or seasonal workers?

For employees who were employed only part of the year (because they were hired mid-year or took a leave of absence for part of the year), the issuer may (but is not required to) annualize compensation, 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.

How does an issuer calculate the annual total compensation for the median employee for purposes of the pay ratio?

The issuer must calculate the annual total compensation for the median employee based on Item 402(c)(2)(x) (consistent with the annual total compensation amount that is calculated in the issuer's summary compensation table for named executive officers). Reasonable estimates may be used in certain circumstances to determine the median employee's annual total compensation or any elements of annual total compensation.

If our fiscal year is different than the calendar year, which annual period should be used for purposes of determining the pay ratio?

While an issuer may use the annual period used for payroll or tax records for purposes of determining the median employee, for purposes of determining the pay ratio, total compensation must be determined based on the last completed fiscal year (not the annual period used for payroll or tax records).

How is the annual total compensation for the CEO calculated?

The annual total compensation for the CEO is calculated in the same manner as it is calculated for purposes of the issuer's summary compensation table for named executive officers.

How is the ratio of the median employee's compensation to the compensation of the CEO expressed?

The proposed rules provide that the 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 268") 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 268 times that of the median of the annual total compensation of all other employees").

Will an issuer have to disclose how it determined the median employee or the estimates used in calculating annual total compensation?

Yes, the proposed rules require that the methodology, and any material assumptions, adjustments, or estimates used to identify the median or the annual total compensation of employees, be described. 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.

Does an issuer have to explain the ratio?

No, an issuer is not required to include a narrative discussion of the pay ratio, the median employee's annual total compensation, or any supplemental information. An issuer is only required to disclose the ratio and, as described above, material assumptions, adjustments, or estimates used.

An issuer may choose to provide additional information (including other ratios) to supplement the required pay ratio, but any additional information should be clearly identified, not be misleading, and not be presented with greater prominence than the required pay ratio.

We expect that, because the determination of the median employee is not limited to U.S. employees or to full-time employees, issuers with significant international employees or a number of lower-paid or part-time workers will want to consider presenting a variety of other pay ratios to appropriately place the required pay ratio disclosure in context.

Does an issuer have to provide an explanation of its compensation practices?

No, companies are permitted to, but are not required to, supplement the required disclosure with a narrative discussion, if they wish to do so.

Where would the pay ratio disclosure be located in a filing?

The pay ratio disclosure would be placed with other executive compensation disclosures, such as the summary compensation table and the compensation discussion and analysis (CD&A).

Is the pay ratio disclosure deemed "filed" or "furnished" for SEC purposes? Is the information covered by the certifications filed with Exchange Act filings?

Similar to other Item 402 information, the pay ratio disclosure would be considered filed, not furnished, and therefore subject to certain liability provisions under the Securities Act,5 the Exchange Act,6 and officer certifications under Sarbanes-Oxley Act.7

What is the effective date for the pay ratio disclosure?

The SEC will seek public comment on the proposed rules for 60 days. Issuers would be required to comply with the new rules for the first fiscal year beginning after the effective date of the final rules.

For example, if the final rules are adopted in 2014, as expected, an issuer with a calendar year fiscal year generally would be required to include the disclosure in its proxy statement or Form 10-K filed in 2016 for the 2015 fiscal year (i.e., the 2016 proxy season).

For newly public companies, a transition period would be available. Newly public companies would not be required to provide pay ratio disclosures until the first fiscal year commencing on or after the date the company becomes subject to the reporting requirements under Section 13(a) or Section 15(d) of the Exchange Act. Newly public emerging growth companies would not be required to provide pay ratio disclosures until they lose their emerging growth company status.

When and how often does an issuer have to perform the pay ratio analysis?

The pay ratio disclosure will need to be updated after the completion of a fiscal year, but not until the issuer files its annual report for that completed fiscal year or, if later, the filing of a definitive proxy statement or information statement relating to an annual meeting of shareholders following the end of such year. In any event, the pay ratio disclosure must be made no later than 120 days following the end of the issuer's fiscal year.

In order to promote comparability from fiscal year to year, the issuer must explain diversions and adjustments to prior methodologies and assumptions.

What should issuers be doing now?

Issuers may wish to identify possible methodologies for calculating the pay ratio and prepare a preliminary estimate of the pay ratio. Going through this process will help inform compensation committees with respect to their executive compensation decisions, assist internal administrators in identifying processes that will be necessary to collect the information required to determine the pay ratio, and give issuers a general sense of their pay ratio. The burden and expense of updating systems and developing processes to collect information will be significant, especially for issuers that do not have centralized systems or who have personnel in many jurisdictions.

Issuers should also be on the lookout for pay ratio guidelines adopted by proxy advisory firms, such as Institutional Shareholder Services (ISS) and Glass, Lewis & Co.

1 The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The pay ratio disclosure would be codified in Item 402(u) of Item 402 of Regulation S-K (Item 402) under the proposed rules.

2 Item 402(c).

3 The pay ratio disclosure must appear in any SEC filing described in Item 10(a) of Regulation S-K that requires disclosure of executive compensation under Item 402.

4 The issuer should use a statistical sample that is appropriate for its size and structure. The proposed rules provide that the size of the required employee sample will often relate to the degree of employee pay variance around the median. For example, the SEC estimates that an issuer with a low variance may require a sample size of only 100 employees, while an issuer with a high variance may require a sample size of 1,000 employees. The SEC also noted that large global enterprises may need to utilize larger sample sizes and use more complex statistical sampling.

5 Sections 11 and 12 of the Securities Act of 1933, as amended (the Securities Act).

6 Section 18 of the Securities Exchange Act of 1934, as amended (the Exchange Act).

7 Section 302 of the Sarbanes-Oxley Act of 2002 (the Sarbanes-Oxley Act).

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.

© Wilson Sonsini Goodrich & Rosati | Attorney Advertising

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