SEC Proposes Pay Ratio Disclosure Rule

SEC Proposes Pay Ratio Disclosure Rule

September 23 2013

Executive Summary
CEO Pay Ratio CoverOn September 19, 2013, the Commissioners of the SEC voted three-to-two, along party lines, to propose a rule implementing the pay ratio disclosure mandated under Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Proposed Rule”).  The Proposed Rule will require U.S. reporting companies (excluding emerging growth companies, smaller reporting companies and foreign private issuers) to include in their proxy statements the ratio of the median annual total compensation of all employees to that of the CEO’s.

For the first time, U.S. reporting companies will need to disclose the annual total compensation for an employee other than named executive officers and directors.  The utility of the disclosure required under the Proposed Rule is hotly debated even amongst the five SEC Commissioners.  There are disparate perspectives on whether this pay ratio will provide meaningful insight into a company.

In part due to the controversial nature of the Proposed Rule, and the potential burdensome costs on U.S. reporting companies of implementing this mandate, the Proposed Rule provides companies significant flexibility in developing the disclosure required by this Rule.  As a result, the Proposed Rule does not require a specific approach that a company must use when identifying the median employee and allows issuers to use reasonable estimates when calculating annual total compensation of the median employee.

The commissioners and the SEC Staff have asked for extensive, detailed and data-heavy comments to the Proposed Rules, including responses to the 69 questions specifically asked by the Staff.  Comments will be due 60 days after publication of the proposal in the Federal Register.

We will be submitting a comment letter in response to the Proposed Rule and we welcome any thoughts, comments or concerns that you would like to share with us as we prepare our response.  Please contact Nora McCord at 212-488-5400.

Proposed Rule
Under this Proposed Rule, Item 402 of Regulation S-K would be amended to require:
(A) The median of the annual total compensation for all employees of the registrant, except the principal executive officer of the registrant;
(B) The annual total compensation of the principal executive officer of the registrant; and
(C) The ratio of the amount in (A) to the amount in (B), presented as a ratio in which the amount in (A) equals one or, alternatively, expressed narratively in terms of the multiple that the amount in (B) bears to the amount in (A).

Median Annual Total Compensation for All Employees

Which employees must be included in this calculation?
According to the release, all employees means all employees.  The company must include employees employed as of the fiscal year end when identifying the median employee, including full-time, part-time, seasonal and/or temporary workers employed by the company or any of its subsidiaries within the U.S. and abroad.

The Proposed Rule allows significant flexibility in determining which group of employees will be considered.  The company may look at all employees within the company and its subsidiaries, may use a statistical sampling method, or may use other reasonable methods to identify a representative subgroup of employees.

How is the median employee calculated?
Once the group of employees is selected, the employees will be ranked using either the employees’ annual total compensation, as calculated for the CEO in the company’s annual proxy statement, or by using another compensation measure that is consistently applied to all employees that are included in this group.  SEC Staff does not mandate a specific measure as they believe that “a consistently applied compensation measure would result in a reasonable estimate of a median employee at a substantially reduced cost [to the company].”  (See page 45 of the Release.)  For example, companies may choose to rank employees based on compensation amounts reported in its payroll or tax records, which may not correspond to the company’s fiscal year end.

It is important to note that while compensation for part-time or seasonal workers cannot not be annualized, the company may annualize compensation for full-time employees who were employees for less than the full year.

Once the employees in the selected group are ranked, the median employee will be identified for purposes of the pay ratio calculation.

How is annual total compensation calculated for the median employee?
The annual total compensation is to be calculated in accordance with the total compensation calculation used for named executive officers in the Summary Compensation Table.  This compensation will need to be calculated on a fiscal year end basis.

Unlike the calculations for the named executive officers, when calculating the median employee’s total compensation or elements of his total compensation the company may use reasonable estimates.  A company will need to identify estimated amounts and the methods used in reaching these amounts.  Despite the lack of precision resulting from the use of reasonable estimates, the

SEC Staff articulated that “the use of reasonable estimates would not diminish the potential usefulness of the pay ratio disclosure as a general point of comparison of [CEO] pay to employee pay within a company.”  (See page 52 of the Release.)

Pay Ratio Disclosure
The pay ratio disclosure will need to state the annual total compensation for the median employee, the annual total compensation for the CEO (as calculated for the company Summary Compensation Table in the annual proxy statement) and the multiple that the CEO compensation bears to the median employee compensation.  The company will need to briefly summarize the assumptions, methods and process used in identifying the median employee and or in determining any element of total compensation.

Where to Disclose the Pay Ratio
As a general rule of thumb, a company will need to include the pay ratio disclosure whenever it discloses the summary compensation tables; provided, however, updated pay ratio information must be filed no later than 120 days after the end of such fiscal year.

Effective Date
It is likely that most companies will not need to include this disclosure until they file their 2016 proxy statements.  Under the instructions to the Proposed Rule, a company would need to include the pay ratio disclosure with respect to the company’s first fiscal year commencing on or after the effective date of the rule.  For example, if the Proposed Rule (or some version thereof) becomes effective in 2014, a company with a December 31st fiscal year end would be required to include the disclosure relating to compensation for fiscal year 2015 in its proxy or information statement for its 2016 annual shareholder meeting.

Our View
We believe that there is limited utility, if any, in the disclosure that would be required by the Proposed Rule.  Will interested parties truly be able to glean any significance from disclosing the ratio of the compensation of a full-time CEO to the compensation of the median company employee, which may include, among others, temporary workers in third-world countries with vastly different costs of living?  Without being able to annualize the compensation of a temporary worker or properly adjust the compensation of a part-time employee, the ratio seems to be comparing apples to oranges.  Furthermore, given that interested parties will undoubtedly attempt to compare ratios between companies, we believe that this disclosure may result in competitive harm, particularly for companies with significant international, seasonal or part-time workforces.

Given the opposing views expressed by the SEC Commissioners at the time the Proposed Rule was released, coupled with the multitude of questions embedded throughout the Release on both broad and technical issues, it appears that the SEC Staff may be open to modifying certain aspects of the Proposed Rules.

Contacting Steven Hall & Partners
This publication is provided by SH&P as a service to clients and colleagues.  The information contained in this publication should not be construed as legal, tax or accounting advice.  Please call any of our consulting staff listed below, or any member of our staff with whom you have consulted in the past.  If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Kathie Mulroe (212-488-5400; kmulroe@shallpartners.com).

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