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A Divided SEC Proposes CEO Pay Ratio Disclosure Rules

September 23, 2013

On September 18, 2013, a divided SEC voted 3-2 to propose rules requiring U.S. public companies to disclose the ratio of the annual total compensation of the CEO to the median annual total compensation of all employees, better known as “pay ratio” disclosure.1 The Staff considered nearly 23,000 comment letters prior to issuing the proposal, and has included in the proposal many additional requests for public comment. There is a 60-day public comment period after publication in the federal register.

It is generally expected that final rules will not be adopted until 2014 and will not be effective until 2015. This means that a company with a December 31 fiscal year end must include pay ratio disclosure for fiscal year 2015 in its proxy statement for the 2016 annual meeting of stockholders. The new rules will not apply to foreign private issuers, MJDS filers, emerging growth companies or smaller reporting companies. Newly public companies that do not fit into one of these categories will have a one year grace period following an IPO before becoming subject to the rules.

Background

Section 953(b) of the Dodd-Frank Act, enacted in July 2010, requires the SEC to amend executive compensation disclosure rules to require reporting companies to disclose:

  • The median of the annual total compensation of all employees, except the CEO;
  • The annual total compensation of the CEO; and
  • The ratio of the median of annual total employee compensation to the annual total compensation of the CEO.

Until now, companies have not been required to disclose detailed compensation information for employees other than the CEO or the other named executive officers.

Summary of Proposal

The proposed rules amend Item 402 of Regulation S-K to include a new paragraph (u). The SEC stated throughout the proposal that it drafted the rules to provide “significant flexibility” to companies in meeting this new and potentially burdensome disclosure requirement.

Some key highlights of the proposal include:

  • Flexibility in Determining the Median Employee. There is no required methodology to calculate the median employee. Rather, a company is free to select a methodology that is appropriate to its size and structure. For example, a company could identify a median employee by applying a consistent compensation measure (i.e. salary plus bonus, using payroll records), or could calculate the “total compensation” (as defined under Item 402(c) of Regulation S-K) for each employee included in the calculation, and then determine the median. Companies may use statistical sampling, or may include in the calculation the entire employee population.
  • Use of Reasonable Estimates. Once the median employee is identified, the company must calculate that employee’s total compensation as is determined under Item 402(c) of Regulation S-K. This means including salary, bonus, stock and option awards, change in pension value, non-equity incentive plan compensation, nonqualified deferred compensation earnings and all other compensation for the last completed fiscal year. Companies may use reasonable estimates in these calculations.
  • All Employees Covered. Full-time, part-time, temporary, seasonal and non-U.S. employees (whether employed by the company or a subsidiary) employed as of the last day of the prior fiscal year must all be considered in the calculation. Companies may annualize the total compensation for an employee who did not work for the entire year, but may not adjust for part-time, temporary or seasonable workers, or make cost-of living adjustments for foreign workers.
  • Disclosure of Methodology, Assumptions and Estimates Required. Companies must include disclosure of the methodology and any material assumptions, adjustments or estimates used to determine the median employee and/or to calculate the median employee’s annual total compensation. For example, if a company uses payroll records to determine the median employee, the company would be required to disclose that methodology. If statistical sampling is used, the sample size, the estimated entire population size and any assumptions used in determining sample size must be disclosed. If estimated amounts are used (whether used in calculating the median employee or annual total compensation), the company must disclose which amounts were estimated and the methods used for the estimation. Companies may, but need not supplement their disclosure with additional discussion or other ratios.
  • Required in SEC Filings that Require Item 402 Information. The pay ratio disclosure, which may be expressed as a ratio or by narrative, will be required in all SEC filings that must already include executive compensation information under Item 402. These include registration statements, proxy and information statements, and annual reports. Companies may decide where within the filing to include the new information. There is no requirement to include pay ratio disclosure or to update pay ratio disclosure with respect to its last completed fiscal year until the filing of a company’s annual report or proxy or information statement. Pay ratio disclosure will be deemed “filed”, not “furnished”, for purposes of the Securities Act and Exchange Act and subject to the potential liabilities thereunder.

Conclusion

While the proposed rules provide some welcome flexibility, compliance is still likely to require the expenditure of significant resources, especially for large, multinational companies. It remains to be seen whether such disclosure will prove helpful to investors in understanding a company’s compensation philosophy and decision making.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Cerveny-Laurie
OBrien-Michael
Larcano-Liz

1 http://www.sec.gov/rules/proposed/2013/33-9452.pdf

This article was originally published by Bingham McCutchen LLP.