On Sept. 18, 2013, the Securities and Exchange Commission (SEC) proposed long-delayed rules (the Proposed Rules) implementing the controversial chief executive officer (CEO) “pay-ratio” disclosure requirement under Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act). Section 953(b) of the Act requires each public company (other than an emerging growth company) to disclose:
- the median annual total compensation of all employees (other than the CEO) (“A”);
- the CEO’s annual total compensation (“B”); and
- the ratio of A to B.
The disclosure will be made under Item 402 of Regulation S-K in annual proxy statements, annual reports and registration statements. The text of the Proposed Rules can be found here.
Concerns Over Section 953(b)
The pay-ratio disclosure requirement in Section 953(b) has been heavily criticized by employers and executive-compensation professionals as unduly burdensome. The focus of much of the criticism has been the requirement that employers use “annual total compensation” for the last completed fiscal year, as defined in Item 402 of Regulation S-K, to perform the ratio calculation. Annual total compensation as defined in Item 402 requires many complex inputs, including the grant-date fair value of individual equity compensation awards and the year-to-year change in the actuarial present value of qualified and nonqualified pension benefits based on certain assumptions. Companies spend considerable time determining annual total compensation for just five individual officers each year in order to complete the required summary compensation table for top-paid officers. The prospect of having to perform the same determination for hundreds or thousands of employees each year to determine the employee with the median annual total compensation was daunting.
Summary of Proposed Rules
To ease the Section 953(b) disclosure burden, the Proposed Rules would provide two methods for determining the median of the annual total compensation of a company’s employees:
- Under the first alternative, a company may take a statistical sample of its total employees, calculate the annual total compensation for the last completed fiscal year for each employee within the sample and then use the employee with the median annual total compensation in this sample. The size of the statistical sample would need to be reasonable under each company’s facts and circumstances, taking into account, e.g., the distribution of employee compensation around the mean and the various business units and geographical locations of the employees.
- Under the second alternative, a company may identify the median employee using a consistently-applied alternative definition of compensation — such as annual cash compensation, annual direct compensation (salary plus performance-based pay) or annual W-2 compensation (or the equivalent for non-U.S. workers) — and then calculate the annual total compensation under the Item 402 definition for that employee. Companies with a non-calendar year fiscal year would be permitted to use the calendar-year wages reported for tax and payroll (i.e., W-2 or its non-U.S. equivalent) for this purpose.
The Proposed Rules would also allow companies to use reasonable estimates in calculating the annual total compensation for the median employee (but not the CEO). For example, a company may reasonably estimate the change in the actuarial present value of the pension benefit of an employee who is a participant in a multiemployer pension plan or the value of perquisites or personal benefits the employee receives. Benefits under government-mandated pension plans for non-U.S. employees would not be deemed compensation for this purpose. Companies would be permitted (but not required) to include the value of broad-based welfare benefit plans or perquisites with an aggregate value of less than $10,000 on a consistent basis if desired.
Companies would be required to briefly disclose their methodology, assumptions and estimates for determining the annual total compensation of the median employee. The SEC has emphasized that long, overly-technical discussions of the methodologies, assumptions and estimates would be counterproductive and would not be required.
The Act exempts emerging growth companies from the pay-ratio disclosure requirement, and under the Proposed Rules smaller reporting companies and foreign private issuers would be similarly exempt.
The disclosures required by Section 953(b) would have to be made in a company’s annual proxy statement and other filings in which executive compensation disclosures are required to be made, such as registration statements. However, companies undergoing an initial public offering would not be required to disclose the pay ratio in their initial registration statements. In addition, companies would not be required to update the pay ratio after the end of a fiscal year until they file their annual report for that year, or annual proxy statement if it is filed later than the annual report (as is typically the case).
The pay ratio itself would be required to be disclosed as either a ratio of the median annual total compensation to the CEO’s annual total compensation, with the median annual total compensation equal to 1 (e.g., 1 to 10), or as a multiple (e.g., the CEO’s annual total compensation is ten times the median annual total compensation of all employees).
The Proposed Rules would confirm that the ratio covers only employees, not independent contractors or leased employees, but the SEC has declined to allow non-U.S. employees to be excluded as well. Under the Proposed Rules, all employees of a registrant and its subsidiaries who are employed on the last day of the registrant’s fiscal year, including part-time employees, seasonal employees and temporary employees, must be taken into account. However, companies would be allowed (but not required) to annualize the compensation for permanent employees who were hired or took an unpaid leave of absence during the calculation year. Annualizing compensation for temporary or seasonal employees, converting part-time employee compensation to full-time equivalent compensation or making cost-of-living adjustments for employees (such as non-U.S. employees) would be prohibited. This means that the ratio may be unfairly skewed for companies that hire many part-time or seasonal employees at the end of a year.
The first disclosures would not be required until after the end of a company’s first fiscal year beginning after the Proposed Rules are finalized. Assuming Proposed Rules are not finalized until 2014, the first required disclosures for companies with calendar year fiscal years would not begin until 2016 and would be based on 2015 compensation.
Observations
Under the Proposed Rules, affected companies would have a reasonable transition period in which to prepare for the pay-ratio disclosures and significant flexibility in implementing the disclosure. However, as with any regulatory proposal, the SEC may modify the Proposed Rules (including transition periods) in response to comments.
Assuming the final rules are adopted substantially in the form of the Proposed Rules, during the transition period companies may want to experiment with different statistical sampling methods and different alternative compensation definitions to determine which methods yield which ratios. Companies who wish to take the statistical sampling approach may wish to engage internal or external experts in statistical sampling methods. This is especially important, as the Proposed Rules would require that any methodology be consistently applied and disclosure of any changes would be required.
It can be expected that some companies may, due to investor interest, voluntarily disclose the pay ratio in filings prior to the mandatory effective date. Companies may wish to consider doing a “dry run” of the calculations for their 2014 or 2015 proxies, and disclosing the ratio if they feel it is appropriate. Since the Proposed Rules may change when finalized, an early voluntary disclosure may be different from the later required disclosure, which may not be viewed as helpful.
It is possible that Institutional Shareholder Services, Inc. and other institutional shareholder advisory groups will develop proxy voting guidelines based on the pay-ratio disclosure. For example, such guidelines might provide “against” or “withhold” recommendations on say-on-pay votes or on the election of compensation committee members for ratios that exceed certain peer-group parameters. The annual updates of these advisory groups should continue to be monitored for developments in this area.
Based on experience with the current disclosure rules, there can be substantial variation in the CEO’s total compensation under Item 402 from year-to-year. The variation can relate both to items in the company’s control (performance awards and equity grants) and outside the company’s control (change in discount rates for pensions). By contrast, it is likely that the compensation for the median employee will not vary as much. Thus, a company may have to report widely-varying pay ratios over time.
McGuireWoods will be closely monitoring the rulemaking process and will provide additional updates regarding the status of the Proposed Rules. For additional guidance in the meantime, please contact any of the authors, Jeffrey R. Capwell, Rakesh Gopalan, Steven D. Kittrell, Jane Whitt Sellers and G. William Tysse, or any other member of our executive compensation or securities compliance teams.