Hot Topics
CEO Pay Ratio Disclosure:
What Would It Take to
Implement the SEC Proposal?
The Securities Exchange Commission (SEC) voted 3-2 on September 18, 2013, to issue a proposed rule to implement Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) that would require most public companies1 to disclose the median of the annual total compensation of its employees and the ratio of the median to its chief executive officer’s (CEO’s) annual pay. The proposed rule notes that for its purposes, the term CEO is synonymous with principal executive officer (PEO), as defined in Regulation S-K, Item 402, Executive
Compensation. Comments on the proposed rules are due on December 2, 2013.
The proposed rules provide that only companies that are required to disclose a summary compensation table in their SEC filing will need to disclose pay ratio
information, and only in filings that already include executive compensation information.
Smaller reporting companies, foreign private issuers, and emerging growth companies with less than $1 billion in revenue would be exempt from the disclosure requirement.
The SEC estimates that approximately 4,000 companies would be subject to this requirement.
Highlights of the proposed rules:
· Companies would be permitted to use a valid statistical sample in determining the median employee.
· Companies would be permitted to select the compensation measure to use in determining the median employee in the sample.
· Once the median employee is identified, companies would be required to calculate the median employee’s total compensation for the year in accordance with Regulation S-K, Item 402(c)(2)(x).
· Companies would then be required to calculate and disclose the ratio of the CEO’s annual compensation for the fiscal year to the median employee’s annual
1 The proposed rule is applicable to select publicly traded companies registered on the NSYE or NASDAQ stock exchanges. The terms “companies,” “public companies,” and “registrants” are used interchangeably throughout this document.
total compensation for the year in the Compensation Discussion and Analysis (CD&A), along with the methodology used to determine the median employee and other assumptions and estimates used to identify the median employee or total compensation (or any elements of total compensation).
We have outlined a practical approach, set forth below, that companies may consider when they are determining how to comply with the pay ratio rule if they are adopted as proposed. This approach is based on our understanding of the proposed pay ratio rule and is provided for the reader’s consideration only.
Step 1: Take a statistical sample of employees
The proposed rule would permit a company to analyze all of its employees or to determine its median employee through the use of a statistical (i.e., random), sample.
For many companies, determining an appropriate random sample of employees will be the most challenging aspect of complying with the proposed rules. In the initial year, the determination is likely to be an iterative process.
A statistically valid random sample of the workforce should consider various factors, including the distribution of compensation data across the organization (e.g., a company with a wider distribution around the mean will likely require a larger sample size than an organization with a narrower distribution). Companies should also consider other factors, including the total number of:
· Employees (full-time, part-time, seasonal, and temporary)
· Geographies
· Lines of business
· Payroll systems.
To illustrate the potential complexity in obtaining a statistically valid sample size, the SEC’s proposed rule notes its analysis of Bureau of Labor Statistics information with a focus on registrants with a single business or geographical unit. The SEC notes that when implementing a “true random sampling…the appropriate sample size [would be]
between 81 and 1,065 across industries, with the average estimated sample size close to 560.” For registrants with multiple business lines or geographical locations, the SEC indicates that a statistical sample could be determined by using more than one
statistical approach, but each approach would require observations and inferences about the mean from each business or geographical unit.
The population should include all full-time, part-time, seasonal, and temporary employees who were employed at the end of the fiscal year by the registrant and its subsidiaries, both U.S and foreign. Independent contractors and temporary workers employed by a third party should not be included in the population. In addition, because the scope of the proposed rule includes non-U.S. employees, companies should
consider the privacy laws of each country in which employees are located before proceeding to Step 2.
Step 2: Determine the median representative compensation measure
Once an appropriate sample of employees is determined, the company will need to select a compensation measure that best reflects its workforce. To allow for flexibility, the proposed rule does not mandate a prescribed compensation measure to be used but permits companies to consider their facts and circumstances. For many companies that do not extend incentive compensation throughout the organization, base salary or
wages plus overtime may be the most appropriate measure of compensation. For others that have annual cash incentives that extend across the company, for example, annual total cash compensation might be the most representative measure of
compensation.
The SEC has also proposed that total compensation does not have to coincide with the end of the registrant’s fiscal year. Therefore, an alternative approach might be to use a tax or payroll information (e.g., W-2 or non-U.S. equivalent). A company may also exclude employees with either extremely high or low salaries from its calculation.
Whichever methodology and assumptions are used to compute total compensation must be applied consistently across the sample and disclosed per the proposed rule.
Based on the selected measure of compensation, companies would determine which employee in the random sample represents the median employee.
We note that companies may annualize the income of full-time employees who have not worked the entire year (e.g., newly hired employees) but they are not permitted to annualize part-time or seasonal employees’ compensation. In addition, companies are not permitted to adjust a non-U.S. employee’s income for cost-of-living differences.
Step 3: Calculate annual total compensation for your median employee
Once the median employee from Step 2 has been identified, companies must gather relevant compensation data and make necessary assumptions to calculate the median employee’s annual total compensation in accordance with Regulation S-K, Item
402(c)(2)(x). The SEC clarifies that compensation elements should follow the
instructions in Item 402(c)(2)(x) consistent with the calculation of the PEO’s total annual compensation. To the extent the company provides benefits such as health care, bus passes, housing, and employee discounts, it is permissible to include these elements in the median employee’s annual total compensation. Each company will need to
determine whether to include such “personal benefits” and perquisites in the calculation of the median employee’s annual income (i.e., a company may want to include them because their inclusion should improve the pay ratio). However, if they are included in the median employee’s annual total compensation, companies also would be required to include these items in the calculation of the PEO’s annual total compensation.
We note that the proposed rules would permit reasonable assumptions (e.g., multiemployer pension) in estimating the annual total compensation. The SEC has proposed not to include government-mandated pensions and other benefits in annual total compensation, even if those benefits are funded by the employer through social taxes.
Step 4: Calculate the ratio of the median employee’s total annual compensation to that of the PEO
The SEC’s proposal would require the pay ratio calculation to be determined by dividing the PEO’s annual total compensation by the median employee’s annual total
compensation. The pay ratio may be disclosed either numerically or narratively. For example, if the ratio of the CEO’s pay to the median employee’s pay is 100 to 1, it can be expressed as “1 to 100” or “the PEO’s annual total compensation is 100 times that of the median of the annual total compensation of all employees.”
Step 5: Prepare disclosure
The SEC’s proposal does not mandate where to place the pay ratio disclosure. Given the interest in this disclosure, companies will want to consider a separate section to the CD&A entitled “Pay Ratio.” The SEC suggests the disclosures avoid the inclusion of technical details such as the degree of confidence, statistical formulae, and steps used in the data analysis. However, the disclosures should contain enough information to enable a reader to evaluate whether the estimates are appropriate. For example, companies should disclose the sampling technique, if applicable, used to determine the median employee. In addition, each company should identify and disclose other key assumptions used, such as:
· The measure of compensation used to identify the median employee
· How annual total compensation was calculated if it deviates from the Item 402(c)(2)(x) definition
· The estimates used (e.g., to calculate the increase in the present value of pension or the incremental cost of housing)
· In subsequent years, material changes in methodology and/or assumptions and the impact on the ratio.
Above all, the disclosure should be concise.
Other considerations
· Be sure the sampling methodology and key assumptions are robust, repeatable, and well documented.
· The resulting pay ratio is unlikely to be useful for external (i.e., peer) comparisons, given the differences in methodology and assumptions used by different issuers, as well as differences in workforces.
· The trend in the ratio over time is likely to be watched closely, as an unexplained increase could lead to pay disparity concerns.
· It may be beneficial to disclose certain characteristics of the median employee to provide context for the ratio (e.g., geography, full- or part- time status, salaried or hourly rate).
· Companies may want to add a U.S. employee and/or full-time employee ratio to eliminate some of the distortions that may arise when using the median of the entire workforce.
NOTE: The SEC proposes that the addition of supplemental ratios and
information is permissible, but, consistent with other disclosures under the SEC’s rules, such measures need to be “clearly identified, not misleading, and not presented with greater prominence than the required ratio.”
Concluding thoughts
According to the SEC’s proposal, the pay ratio rules would be required for the registrant’s last completed fiscal year beginning with the first fiscal year that
commences on or after the date that the final rules are approved. For most calendar- year companies, if the rules are finalized in 2013, the pay ratio must be disclosed in the 2015 Form 10-K or definitive proxy statement.2 If the rules are finalized in 2014, as anticipated, the pay ratio will be required to be disclosed in a company’s 2016 Form 10- K or definitive proxy statement.3 If the SEC adopts a rule substantially similar to its proposal, and a company expects it will use a statistical sample of employees, we encourage it to consider establishing a methodology early on based on the current employee population, as we anticipate that the process for the initial year of compliance will be quite iterative and complex for some companies.
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2 As noted in the proposed rule, “General Instruction G(3) of Form 10-K … allows the information required by Part III of Form 10-K (including Item 402 information) to be incorporated by reference from the
registrant’s definitive proxy statement…if that statement involves the election of directors and is filed not later than 120 days after the end of the fiscal year covered by the annual report. If a definitive proxy statement or information statement is not filed in the 120-day period (or is not required to be filed by virtue of Rule 3a12-3(b) under the Exchange Act), the Part III information must be filed as part of the Form 10-K, or as an amendment to the Form 10-K, not later than the end of the 120-day period.”
3 The proposed rule’s transition provisions also discuss whether and how the pay ratio requirements would apply in certain circumstances such as (1) if a bonus is not calculable when Item 402 disclosures are due, (2) in relation to a company’s initial registration statement, and (3) in relation to a registration statement that will be filed after a registrant’s year-end.
