The SEC's Proposed Pay Ratio Rule: What it Could Mean for Your Upcoming Filings

Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) mandates the Securities and Exchange Commission (SEC) to amend Item 402 of Regulation S-K (Item 402) to require certain companies to disclose the ratio of annual total compensation paid to their chief executive officers (CEOs) to the median annual total compensation of all other employees (excluding the CEOs).  On September 18, 2013, the SEC approved—by a narrow 3-2 vote of its commissioners—to propose a new rule (Proposed Rule) that implements the pay ratio disclosure as mandated by Section 953(b) of Dodd-Frank.  The key provisions of the Proposed Rule are as follows:

• Which companies are subject to the Proposed Rule?  The Proposed Rule applies to all companies that are already required to provide summary compensation table disclosure under Item 402, except (i) emerging growth companies (under the JOBS Act), (ii) smaller reporting companies and (iii) foreign private issuers. 

• In which filings should a company include its pay ratio disclosure?  The disclosure required by the Proposed Rule would be included in all annual reports, proxy statements, information statements and registration statements that already require executive compensation disclosure.

• How will a company calculate the median annual total compensation of its employees (excluding its CEO)?  One of the most debated aspects of the Proposed Rule is that for a company to calculate its pay ratio, it must account for the annual total compensation of all of its employees (as of the last day of the last fiscal year).  For the purposes of this analysis, the company must consider part-time, temporal and seasonal employees, as well as international employees and employees of subsidiaries. Recognizing the challenge of determining the compensation of such a potentially large group, the SEC provides two alternative methods of calculation:

1. Statistical sampling.  A company may take a reasonable statistical sample of all of its employees (considering the facts and circumstances), calculate the annual total compensation for the last completed fiscal year for each employee in the sample, and identify the employee with the median annual total compensation in the sample; or
2. Consistently Applied Compensation Measure.  A company may use a consistently applied alternative definition of compensation, including (but not limited to) annual cash compensation, annual direct compensation or annual W-2 compensation. Once the company identifies the employee with the median annual total compensation, it could then calculate the annual total compensation under the Item 402 definition for that particular employee.

• When should a company subject to the Proposed Rule begin disclosing its pay ratio?  The Proposed Rule would require a company to provide pay ratio disclosures for its first fiscal year commencing on or after the effective date of the final rule.  While the effective date of the final rule has not been determined, most commentators believe that it will become effective sometime in 2014.  If that prediction is accurate, a company with a calendar fiscal year would first be required to include the new disclosures in its annual report for the 2015 fiscal year or proxy or information statement filed in 2016 for the annual meeting held in 2016.  Of course, a company may always voluntarily comply with SEC rules at an earlier time.  Finally, the Proposed Rule creates a transition period for a private company going public, allowing it to avoid making pay ratio disclosure on Forms S-1, S-11, and 10.  In that case, the SEC would allow the company to omit this disclosure until (i) the Form 10-K covering the first fiscal year commencing on or after the company becomes subject to the Exchange Act of 1934 or, if later, (ii) the filing of a proxy or information statement for its next annual meeting of shareholders (or written consents in lieu of a meeting) following the end of such fiscal year.

In spite of its apparent simplicity, the Proposed Rule is one of the most controversial provisions of Dodd-Frank.  As previously mentioned, the SEC commissioners were sharply divided in their decision to adopt the Proposed Rule, and their divergent views reflect the rift among public commentators.  The proponents argue that the Proposed Rule furthers the purpose of Dodd-Frank and holds CEOs “accountable,” while granting companies significant flexibility in how they choose to derive their pay ratios.  Critics, meanwhile, argue that the Proposed Rule is overly burdensome and potentially expensive to comply with.  The public may provide comments to the SEC regarding the Proposed Rule until December 2, 2013.

If you have any questions about the Proposed Rule or if you would like to learn more about the issues covered in this alert, please contact your Smith Anderson securities lawyer.