SEC Proposes Pay Ratio Disclosure Rule

The Securities and Exchange Commission (SEC), in a contentious open meeting and pursuant to a 3-to-2 party-line vote, recently proposed to add new Item 402(u) to Regulation S-K to implement the pay ratio disclosure requirements of Section 953(b) (Section 953(b)) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).1

Consistent with Section 953(b)'s requirements, proposed Item 402(u) would require certain public companies to disclose in specified filings:

the median2 of the annual total compensation of all employees of the issuer, except the issuer's principal executive officer (i.e., the issuer's chief executive officer or the individual acting in a similar capacity) (PEO); the annual total compensation of the issuer's PEO; and the ratio of the foregoing compensation amounts. The median annual total compensation for all employees and for the PEO would be calculated as provided in Item 402(c)(2)(x) of Regulation S-K (Item 402(c)(2)(x)), which requires disclosure of a named executive officer's total compensation in the summary compensation table required by Item 402(c) of Regulation S-K.

The comment period for the proposed rulemaking will remain open until at least December 2, 2013. The comments are likely to be numerous, with proponents of the Dodd-Frank Act requirements perhaps weighing in against certain of the proposed rule's provisions as vociferously as issuers and their allies typically do on such costly and controversial proposed disclosure requirements.

Even if the proposed rule were to be adopted and become effective in 2013, subject issuers are not expected to be required to make pay ratio disclosure in 2014. The SEC has indicated that the first required pay ratio disclosure would be reported with respect to compensation for the first fiscal year of an issuer commencing on or after the effective date of the final rule. In light of the 60-day comment period and the likelihood of numerous comments, it seems unlikely that the proposed rule would be effective prior to the first quarter of 2014 at the earliest. In the event of an adoption in that quarter, an issuer with, for example, a June 30 fiscal year-end would likely have to make its first pay ratio disclosure with respect to compensation for the fiscal year ending June 30, 2015 and to make that disclosure in its annual report on Form 10-K (10-K) or proxy statement, as appropriate, filed in 2015. Likewise, in the event the effective date of the proposed rule occurs in the first quarter of 2014, a calendar year issuer would be required to make its first pay ratio disclosure with respect to fiscal year 2015 compensation and to make that disclosure in its 10-K or proxy statement, as appropriate, filed in 2016.

Issuers Subject to the Proposed Rule

Under the proposed rule, those public companies that are required to provide compensation disclosure pursuant to Item 402 of Regulation S-K in filings with the SEC would be required to make pay ratio disclosure. Emerging growth companies, smaller reporting issuers, foreign private issuers and issuers filing under the U.S.-Canadian multijurisdictional disclosure system would not be required to make pay ratio disclosure in any SEC filing.

Identifying the Employee with the Median Annual Total Compensation

The proposed rule would impose a major new task on subject issuers—identifying for each fiscal year for which pay ratio disclosure is required their employee (Median Employee) whose annual total compensation is the median annual total compensation of all of the issuer's employees (Median Compensation). Issuers that would be subject to the proposed rule should take note of several important aspects of the proposed rule relating to making the annual identification of the Median Employee and determination of Median Compensation.

The term "employee" includes employees other than full-time employees. The term "employee" would mean every employee as of the last day of the issuer's fiscal year as to which the pay ratio disclosure is to be made, including any and all full-time and part-time employees and temporary and seasonal workers then employed by the issuer or one of its subsidiaries. Both U.S. and foreign employees, named executive officers other than the PEO and other officers would be included in the employee population. Independent contractors, "leased" workers and other temporary workers employed by a third party would not be considered "employees."

Only limited adjustments of compensation would be permitted to determine Median Compensation. An issuer would be permitted, but not required, to annualize the total compensation of its permanent employees who were employed for less than the full fiscal year (such as permanent employees who were hired after the beginning of the fiscal year or employees who were on an unpaid leave of absence). If, however, the issuer annualizes the compensation of any permanent employee, it must annualize the compensation of all permanent employees. The proposed rule would not permit an issuer to annualize the compensation of temporary and seasonal workers. Depending on an issuer's facts and circumstances, an issuer could, but would not be required to, annualize the actual compensation of a permanent part-time employee who worked for only a part of the fiscal year (such as an employee who is permanently employed for three days a week, but was hired after the beginning of the fiscal year, or who took an unpaid leave of absence under the Family and Medical Leave Act during the fiscal year).

An issuer would not be permitted to adjust employee compensation if the adjustment would cause the pay ratio disclosed to not reflect the actual composition of the issuer's workforce or compensation practices. As a result, the proposed rule would not permit the issuer to adjust the compensation of part-time workers to reflect the compensation they would have received had they worked on a full-time basis or to make cost-of-living adjustments for non-U.S. workers. Moreover, permanent part-time employees and temporary and seasonal workers could not be "combined" to reflect a few such employees working, in the aggregate, the number of hours worked by a full-time employee as a single full-time equivalent employee with higher annual total compensation.

The SEC recognizes that issuers with large numbers of foreign workers in low wage economies would have their pay ratios adversely affected by the inclusion of such foreign workers in their employee populations for purposes of the proposed rule. Nevertheless, the SEC has chosen to do nothing in the proposed rule to allow issuers to address such a problematic circumstance or the adverse effect on their pay ratios of currency exchange rates used to convert wages paid in local currencies into U.S. dollars for purposes of determining their Median Compensation. As a result, issuers with large numbers of part-time employees and temporary, seasonal, and foreign workers on their payrolls on the last day of a fiscal year could find themselves disadvantaged disproportionately to their competitors under the proposed rule.

The PEO is excluded. The PEO would not be taken into account in determining the Median Compensation.

Issuers would have some flexibility in determining the Median Compensation. When the Dodd-Frank Act was enacted, issuers and others immediately identified the central difficulty and expense driver of compliance with Section 953(b) and, as it turns out, with the proposed rule: identifying the employee that earns in the reporting period the median annual total compensation of the annual total compensation of all of the issuer's employees other than the PEO.3 The SEC had received a large number of comments from interested persons in anticipation of the SEC's implementation of Section 953(b)'s requirements, which is widely viewed as another of the "name and shame" provisions of the Dodd-Frank Act. As a result of the many comments pointing out the significant difficulties and inordinate expense that issuers with large employee populations and multinational work forces would face in complying with the proposed rule, the SEC has attempted to give issuers some flexibility in identifying their Median Employee and determining their Median Compensation for a fiscal year in order to lower the issuer's compliance burden and costs...