On September 18, 2013, the SEC proposed the long-awaited and feared pay ratio rules. The proposed rules embodied in the new Item 402(u) of Regulation S-K implement the mandate of Section 953(b) of the Dodd-Frank Act to disclose the ratio of the median of annual total compensation of all employees (excluding the CEO) to the annual total compensation of the CEO.
In the proposed rules, the SEC provided registrants with a lot of flexibility in terms of various calculations that should be performed. However, the SEC conceded that permitting registrants to select a methodology for identifying the median, rather than prescribing a specific methodology, could enable a registrant to “alter the reported ratio to achieve a particular objective with the ratio disclosure, thereby potentially reducing the usefulness of the information.”
What is the Proposed Disclosure Requirement?
The proposed Item 402(u) follows Section 953(b) of the Dodd-Frank almost verbatim, but provides some color on how to express the required ratio (see item (iii) below). It requires a registrant to disclose:
(i) the median of the annual total compensation of all employees of the registrant, except the principal executive officer (PEO) of the registrant;
(ii) the annual total compensation of the PEO of the registrant; and
(iii) the ratio of the amount in (i) to the amount in (ii), presented as a ratio in which the amount in (i) equals one or, alternatively, expressed narratively as the multiple that the amount in (ii) bears to the amount in (i).
To clarify the presentation point in item (iii) above, the SEC provided the following example: “if the median of the annual total compensation of all employees of a registrant is $45,790 and the annual total compensation of a registrant’s PEO is $12,260,000, then the pay ratio disclosed would be “1 to 268” (which could also be expressed narratively as ‘the PEO’s annual total compensation is 268 times that of the median of the annual total compensation of all employees’)”.
Companies would be required to describe the pay ratio information in registration statements, proxy and information statements, and annual reports that must include executive compensation information as set forth under Item 402 of Regulation S-K.
Emerging growth companies, smaller reporting companies and foreign private issuers will not be subject to the proposed rules.
Who Is Considered an Employee under the Proposed Rules?
The term “employee” under the proposed rules is fairly broad and includes any full-time, part-time, seasonal or temporary U.S. or non-U.S. worker employed by the registrant or any of its subsidiaries (including officers other than the PEO) as of the last day of the registrant’s last completed fiscal year. However, independent contractors or “leased” workers or other temporary workers who are employed by a third party, will not be covered. For example, if the registrant pays a fee to a management company or an employee leasing agency that supplies workers to the registrant, and those workers receive compensation from that other company, they will not be counted as employees of the registrant for purposes of Item 402(u).
This last day of the fiscal year calculation date for determining who is an employee under Item 402(u) will not capture seasonal or temporary employees that are not employed at year-end, which creates an interesting dilemma. Such calculation date enables a registrant with a significant amount of such workers to calculate a median that does not fully reflect its workforce, and, theoretically, some registrants could try to structure their employment arrangements to reduce the number of workers employed on the calculation date.
The SEC proposed to permit, but not to require, companies to annualize the total compensation for a permanent employee who did not work for the entire year (for example, new hires or employees on an unpaid leave of absence). However, full-time equivalent adjustments for part-time workers, annualizing adjustments for temporary and seasonal workers, or cost-of-living adjustments for non-U.S. workers would not be permitted.
How to Find the Median?
The most feared consequence of the rules implementing Section 953(b) of the Dodd-Frank Act was that, in order to identify the median, the company would need to determine total compensation amounts for every single employee. However, this is not the case with the proposed rules, which are very flexible and allow a registrant to use (i) a methodology that uses reasonable estimates to identify the median, and (ii) reasonable estimates to calculate the annual total compensation or any elements of total compensation for employees other than the PEO. Moreover, in determining the employees from which the median is identified, the registrant may use not only its total employee population, but also statistical sampling or other reasonable methods. The SEC also proposed a practical approach to identifying the median by allowing registrants to use not only annual total compensation for the purposes of such determination, but also any other consistently applied compensation measure, such as compensation amounts reported in its payroll or tax records, as long as the registrant briefly discloses the compensation measure that it used as well as Item 402(c)(2)(x) total compensation for that median employee. Also, in a fairly rare move, the SEC provided in the proposing release sample disclosure related to the compensation measure used by a company: “We found the median using salary, wages and tips as reported to the U.S. Internal Revenue Service on Form W-2 and the equivalent for our non-U.S. employees.”
Generally, the proposed rules enable a company to use the methodology that would work best for its particular facts and circumstances, including, among others, such variables as:
- the size and nature of the workforce;
- the complexity of the organization;
- the stratification of pay levels across the workforce;
- the types of compensation the employees receive;
- the extent that different currencies are involved;
- the number of tax and accounting regimes involved;
- the number of payroll systems the registrant has and the degree of difficulty involved in integrating payroll systems to readily compile total compensation information for all employees.
The proposed rules require a brief disclosure and consistent application of (i) the methodology used to identify the median, and (ii) any material assumptions, adjustments or estimates used to identify the median or to determine total compensation or any elements of total compensation. Companies also have to clearly identify any estimated amounts. The SEC explained that when statistical sampling is used, registrants should disclose the size of both the sample and the estimated whole population, any material assumptions used in determining the sample size, which sampling method (or methods) is used, and, if applicable, how the sampling method deals with separate payrolls such as geographically separated employee populations or other issues arising from multiple business or geographic segments.
Under Regulation S-K, a registrant is permitted to omit disclosure of the salary or bonus in the summary compensation table if it is not calculable through the latest practicable date. In such case, a registrant must include a footnote to the summary compensation table disclosing that fact and provide the date that the amount is expected to be determined. In addition, once determined, such amount must be disclosed under Item 5.02(f) of Form 8-K. A company relying on this accommodation would then have to disclose that the pay ratio is not calculable until the PEO’s salary or bonus is determined. The SEC also proposed that once the PEO’s total compensation is determined, the pay ratio disclosure will be provided under the same Item 5.02(f) of Form 8-K.
When Should We Start Complying with Pay Ratio Disclosure?
The SEC proposed that a registrant must begin to comply with Item 402(u) for the registrant’s first fiscal year commencing on or after the effective date of the rule. For example, if the final rules become effective in 2014, a registrant with a fiscal year ending on December 31 will be first required to include pay ratio information relating to compensation for fiscal year 2015 in its definitive proxy or information statement for its 2016 annual meeting of shareholders (or written consents in lieu of such a meeting). If such proxy or information statement is not filed within 120 days of the end of 2015 (i.e., April 30, 2016), the registrant would need to file its initial pay ratio disclosure in its Form 10-K for 2015 or an amendment to that Form 10-K.
In addition, the proposed requirements permit new registrants that do not qualify as emerging growth companies, which are exempt from the proposed rule, to delay compliance, so that pay ratio disclosure would not be required in a registration statement for an initial public offering or a registration statement on Form 10. Instead, such registrant would be required to first comply with proposed Item 402(u) for the first fiscal year commencing on or after the date the registrant becomes subject to the requirements of Section 13(a) or Section 15(d) of the Exchange Act.
What Should We Do Now?
It is clear from the examples provided by the SEC in the proposing release that the SEC does not expect Item 402(u) to be effective for the 2014 proxy season. If approved as proposed, the new rule will not even apply to the 2015 proxy season, and companies with a calendar year end will need to start providing pay ratio disclosure only in 2016 for the year ending December 31, 2015. Nevertheless, companies should begin getting ready for the new disclosure in 2014 and 2015 by figuring out which assumptions or methodologies would work for their businesses, testing the statistical sampling that they would like to use or working through the issues posed by international data privacy laws in case of multinational companies.
 The term “principal executive officer” includes all individuals serving as the registrant’s principal executive officer or acting in a similar capacity during the last completed fiscal year, regardless of compensation level. See Item 402(a)(3)(i) of Regulation S-K.
 The SEC acknowledged that data privacy laws in various jurisdictions could have an impact on gathering and verifying the data needed to identify the median of the annual total compensation of all employees at multinational companies. However, registrants in this situation would be permitted to estimate the compensation of affected employees.