On September 18, 2013, the Securities and Exchange Commission approved proposed rules requiring the disclosure by public companies of the median annual total compensation of all employees of the company, the annual total compensation of the Chief Executive Officer, and the ratio between the two. Companies would need to disclose this pay ratio in proxy statements, information statements, registration statements and annual reports. The proposed rules are an effort to implement Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Notably, Section 953(b) was heavily criticized in a pre-release public comment period, and the proposed rule was only adopted by the Commission by a three-to-two vote.
Under the proposed rule, covered companies would be required to calculate and disclose:
- the median annual total compensation of all employees of the company, excluding the CEO;
- the annual total compensation of the CEO; and
- the ratio between the two, expressed either as a numerical ratio or in a narrative sentence.
Proponents of the proposed rule hope that pay ratio disclosure will help curb what is seen as exorbitant and growing levels of CEO pay, out of line with pay increases for employees. Opponents question the value of this disclosure item since companies must already disclose total CEO compensation, and view the proposed rules as a "name-and-shame" tactic rather than a tool to allow investors to make wise decisions.
Who is an "employee"?
The reference to "all employees" includes all individuals employed by the reporting company or any of its subsidiaries on the last day of the company's last completed fiscal year. This includes not only full-time workers, but part-time, seasonal, and temporary workers, as well as employees subject to a collective bargaining agreement. Independent contractors, leased employees or others who are employed by a third party are not included.
Companies may choose to annualize the pay of permanent employees who did not work during the entire fiscal year due to, for example, unpaid medical leave. However, companies would not be able to annualize the compensation paid to seasonal or temporary workers, or adjust the compensation of part-time workers to their full-time equivalent. In addition, companies would not be permitted to make cost-of-living adjustments to the compensation paid to non-US workers.
What constitutes "compensation"?
"Annual total compensation" includes all compensation paid to any given employee over the past year. Because many measures of employee compensation may require complex or actuarial calculations -- for example, the value of pension benefits for an individual employee -- companies would be permitted to use "reasonable estimates" in calculating total compensation. Generally, compensation includes base salary, bonuses, grant date fair value of equity awards, and change in pension value, as well as items such as perquisites, tax gross-ups and severance.
Note that if health benefits are offered to all employees, those benefits are not considered "compensation," even though most employees who receive health benefits generally consider them an important part of their compensation.
Who is covered by the proposed rule?
All reporting companies required to disclose executive compensation pursuant to Item 402 of Regulation S-K would need to make pay ratio disclosures, beginning with the first report issued for the company's 2015 fiscal year. Smaller reporting companies, emerging growth companies and foreign private issuers are not covered by the pay ratio disclosure rule. The proposed rule would also not apply to companies filing a registration statement for an initial public offering.
The rule does not mandate a single method of calculating the median employee compensation. Instead, it suggests a few ways by which companies could satisfy the rule, although in all cases companies must use "reasonable estimates." Regardless of the method used, companies would need to disclose not only the methodology used, but also any material assumptions, adjustments, or estimates used when identifying the median employee or determining total compensation. This would include any amount of compensation that was estimated as described above, such as pension benefits, and a description of how that amount was estimated.
Potential methods include:
- Using the Full Employee Population. This is the most straightforward, but also potentially the most burdensome, especially for large companies.
- Statistical Sampling. Companies can potentially investigate the annual compensation for only a representative sample of employees.
- Using "Another Reasonable Method." If companies want to craft another method of calculating median employee compensation, those companies would need to disclose and briefly describe the method used.
Potential Effects of the Proposed Rule
It remains to be seen how comments to the SEC may affect the final rule. As proposed, however, the new rules would at a minimum increase compliance costs for the majority of reporting companies.
Implications and Interpretations
- Under the proposed rules, disclosures would be "filed," rather than "furnished," as some early commenters had suggested. This means that a pay ratio disclosure would be subject to the liability provisions under the Exchange Act and the Securities Act, and would be covered by the Sarbanes-Oxley certifications.
- Compliance with the proposed rules would likely be the most burdensome for companies with large groups of workers receiving different compensation, such as multinational companies or those with a diverse employee base.
- Even though the proposed rules would not take effect until the 2016 proxy season, companies may want to start developing protocols and procedures to centralize compensation data, such as payroll, pension and tax information, well before the rules take effect.
The full text of the SEC release proposing the new CEO pay ratio rule is available here. We expect that the SEC will receive many comments on the proposed rule. Comments are due on or before December 2, 2013, and can be submitted to the SEC here.
This client update is prepared for the general information of our clients and friends. It should not be regarded as legal advice. If you have questions regarding this client update, please contact your principal attorney at Tonkon Torp LLP, or Tom Palmer, Sherrill Corbett, or Claire Brown of our Corporate Finance Practice Group.