The SEC’s New CEO/Employee Pay Ratio Rule

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Taken from Chapter 3, “Executive Compensation for Emerging Growth Companies,” Thomson Reuters, 2014, Gartrell, Garth; Lapidus, Steven; Frank, Michael; Gartrell, Josephine

In September, 2013, the SEC proposed to amend Item 402 to add the Dodd-Frank Act Pay Ratio Disclosure requirements[1] to require certain registrants[2] to disclose the median of the annual total compensation of all employees (excluding the Principal Executive Officer (“PEO”)), the annual total compensation of the PEO, and the ratio of the median of the annual total compensation disclosed for all employees to the annual total compensation of the PEO (collectively referred to as the “Pay Ratio Disclosure”).[3]  Pay Ratio Disclosure would be required in annual reports on Form 10-K, registration statements under the Securities Act and Exchange Act, and proxy and information statements (collectively, “Applicable Forms”) to the same extent that each form requires compliance with Item 402.[4]  Pay Ratio Disclosure should be reported in the CD&A and Summary Compensation Table of the proxy.[5]

“Registrant” for Purposes of Pay Ratio Disclosure.  For purposes of Pay Ratio Disclosure, “registrant” means any company that is required to provide summary compensation table disclosure pursuant to Item 402(c).  Excluded from the term “registrant” are: emerging growth companies,[6] smaller reporting companies,[7] foreign private issuers and MJDS filers.[8]

Pay Ratio Disclosure not Limited to NEOs.  Until Dodd-Frank’s Pay Ratio Disclosure requirements, compensation disclosure in the Applicable Forms was limited to NEO and director compensation.[9]   However, Pay Ratio Disclosure requires registrants to track total compensation information for “all employees of the registrant” as registrants must for NEOs, in compliance with Item 402(c)(2)(x) of Regulation S-K.[10]  For purposes of Pay Ratio Disclosure, “all employees of the registrant” means any employee of the registrant or any subsidiary (including any full-time, part-time, temporary, seasonal and non-U.S. employee) that was employed on the last day of the company’s prior fiscal year.[11]   Registrants are also permitted, but not required, to annualize total compensation for all permanent employees who were employed on the last day of a registrant’s fiscal year, but were employed for less than the full fiscal year.[12]  However, the following types of adjustments are expressly prohibited: full-time equivalent adjustments for part-time employees, annualized adjustments for seasonal or temporary employees, and cost of living adjustments for non-US employees.[13]

Calculations Required for Employees under Pay Ratio Disclosure.  Once the median employee is identified using a consistently applied compensation measure[14], Pay Ratio Disclosure requires the following calculations for the identified median employee[15] (rather than NEOs only[16]):

  • The dollar value of base salary[17] (cash and non-cash) earned by the named executive officer during the fiscal year covered;[18]
  • The dollar value of bonus (cash and non-cash) earned by the named executive officer during the fiscal year;[19]
  • For awards of stock, the dollar amount recognized for financial statement reporting purposes with respect to the fiscal year in accordance with FAS 123R;[20]
  • For awards of options, with or without tandem SARs, the dollar amount recognized for financial statement reporting purposes with respect to the fiscal year in accordance with FAS 123R;[21]
  • The dollar value of all earnings for services performed during the fiscal year pursuant to awards under non-equity incentive plans as defined in paragraph (a)(6)(iii) of [Item 402], and all earnings on outstanding awards;[22]
  • The sum of the amounts specified in paragraphs (c)(2)(viii)(A) and (B) of [Item 402] as follows:

o   The aggregate change in the actuarial present value of the named executive officer’s accumulated benefit under all defined benefit and actuarial pension plans (including supplemental plans) from the pension plan measurement date used for financial statement reporting purposes with respect to the registrant’s audited financial statements for the prior completed fiscal year to the pension plan measurement date used for financial statement reporting purposes with respect to the registrant’s audited financial statements for the covered fiscal year; and

o   Above-market or preferential earnings on compensation that is deferred on a basis that is not tax-qualified, including such earnings on nonqualified defined contribution plans; [23] and

  • All other compensation, regardless of the amount, for the covered fiscal year that the registrant could not properly report in any other column of the Summary Compensation Table, including, but not limited to:

o   Perquisites and other personal benefits, or property, unless the aggregate amount of such compensation is less than $10,000;

o   All “gross-ups” or other amounts reimbursed during the fiscal year for the payment of taxes;

o   For any security of the registrant or its subsidiaries purchased from the registrant or its subsidiaries (through deferral of salary or bonus, or otherwise) at a discount from the market price of such security at the date of purchase, unless that discount is available generally, either to all security holders or to all salaried employees of the registrant, the compensation cost, if any, computed in accordance with FAS 123R;

o   The amount paid or accrued to any named executive officer pursuant to a plan or arrangement in connection with:

  • Any termination, including without limitation through retirement, resignation, severance or constructive termination (including a change in responsibilities) of such executive officer’s employment with the registrant and its subsidiaries; or
  • A change of control of the registrant;

o   Registrant contributions or other allocations to vested and unvested defined contribution plans;

o   The dollar value of any insurance premiums paid by, or on behalf of, the registrant during the covered fiscal year with respect to life insurance for the benefit of a named executive officer; and

o   The dollar value of any dividends or other earnings paid on stock or option awards, when those amounts were not factored into the grant date fair value required to be reported for the stock or option award in column ( l ) of the Grants of Plan-Based Awards Table required by paragraph (d)(2)(ix) of this Item.[24]

 

Flexibility in Calculations.  Despite the detailed information that registrants must collect to comply with Pay Ratio Disclosure[25], registrants are allowed certain amounts of flexibility under the proposed rules in determining which employees require the calculation in order to determine the median employee.[26]

Methods for Determining the Median Employee.  The proposed regulations allow at least two methods for determining the Annual Total Compensation of the median employee.  In addition, the proposed regulations allow registrants to use reasonable estimates and statistical sampling[27] in calculating the annual total compensation for employees (other than the PEO) so long as registrants using estimates or statistical sampling consistently apply the same compensation measure.[28]

Calculate the Annual Total Compensation for All Employees then Identify Median.  Registrants may calculate annual total compensation for all employees, a statistical sample or other reasonable method using Item 402(c)(2)(x).[29]  Following completion of the calculation, registrants may identify the median employee.[30]  In determining the median using statistical sampling, registrants may choose the statistical method that each deems appropriate based on each registrant’s size and business structure; i.e., no prescribed “one-size-fits-all” approach applies.[31]

Identify Median Employee then Calculate Annual Total Compensation. Identify the median employee based on any consistently applied compensation measure.[32]  Once the median employee is identified, calculate annual total compensation for that median employee in accordance with Item 402(c)(2)(x).[33]

Ratio may be Presented in Two Forms.  Once the annual total compensation of the median employee and the annual total compensation of the PEO are calculated, Pay Ratio may be presented in two alternative forms.[34]  Registrants may present it as a ratio in which the median employee’s annual total compensation equals one.  Alternatively, registrants may choose to express the ratio as a narrative in terms of the multiple that the PEO’s annual total compensation bears to the amount of the median employee’s annual total compensation.  Notably, no narrative regarding the

disclosed ratio is required, although registrant’s may include one if they feel it would be helpful to explain the ratio to stakeholders.[35]

Proposed Compliance Dates

Registrants.    The proposed compliance date for registrants that file proxy statements is each “registrant’s first fiscal year commencing on or after the effective date of the rule, and, as proposed, a registrant would be permitted to omit this initial pay ratio disclosure from its filings until the filing of its annual report on Form 10-K for that fiscal year or, if later, 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 year.”[36]

Registrants not Subject to Proxy Filing Requirements.  A registrant with a fiscal year ending on December 31 that is not subject to the proxy rules or does not file a proxy or information statement in connection with an annual meeting of shareholders would be required to include pay ratio information relating to compensation for its fiscal year in its Form 10-K covering that fiscal year, which would be due in the first quarter of the following fiscal year.[37]

New Registrants that do not Qualify as Emerging Growth Companies.    New registrants are not exempt from Pay Ratio Disclosure.  They are required to include the ratio “for the first fiscal year commencing on or after the date the registrant becomes subject to the requirements of Section 13(a) or Section 15(d) of the Exchange Act, and, as proposed, the registrant would be permitted to omit this initial pay ratio disclosure from its filings until the filing of its Form 10-K for such fiscal year or, if later, 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.”[38]

 

 

 

 

 

[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §953(b), 124 Stat. 1376 (2010) 2010), as amended by Public Law No. 112-106, sec. 102(a)(3), 126 Stat. 306, 309 (2012) (codified at 12 U.S.C.A. §5301); 17 C.F.R. §229.402(u) (proposed Sept. 2013) [hereinafter, “Dodd-Frank Act”].

[2] Section 102(a)(3) of the Jumpstart Our Business Startups Act (the “JOBS Act”) amended Section 953(b) of the Dodd-Frank Act to provide an exemption for registrants that are emerging growth companies as that term is defined in Section 3(a) of the Exchange Act.

[3] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §953(b), 124 Stat. 1376 (2010) 2010), as amended by Public Law No. 112-106, sec. 102(a)(3), 126 Stat. 306, 309 (2012) (codified at 12 U.S.C.A. §5301); 17 C.F.R. §229.402(u).

[4] SEC Release Nos. 33-9452, 34-70443, supra at note 1; p. 15-16, 67-69.

[5] SEC Release Nos. 33-9452, 34-70443, supra at note 1; p. 14.

[6] SEC Release Nos. 33-9452, 34-70443, supra at note 1; p. 13 (citing 15 U.S.C. 78c(a)).

[7] Id. (citing Item 402(l). Smaller reporting companies are permitted to choose compliance with either the scaled disclosure requirements or the larger company disclosure requirements on an “a la carte” basis. As discussed in the scaled disclosure adopting release, the staff evaluates compliance by smaller reporting companies with only the Regulation S-K requirements applicable to smaller reporting companies, even if the company chooses to comply with the larger company requirements. See Smaller Reporting Company Regulatory Relief and Simplification, Release No. 33-8876 (Dec. 19, 2007) [73 FR 934], at 941.)

[8] Id. (stating “’MJDS filers’ refers to registrants that file reports and registration statements with the Commission in accordance with the requirements of the U.S.- Canadian Multijurisdictional Disclosure System (the “MJDS”). The definition for “foreign private issuer” is contained in Exchange Act Rule 3b-4(c) [17 CFR 240.3b-4(c)]. A foreign private issuer is any foreign issuer other than a foreign government, except for an issuer that, as of the last business day of its most recent fiscal year, has more than 50% of its outstanding voting securities held of record by United States residents and any of the following: a majority of its officers and directors are citizens or residents of the United States, more than 50% of its assets are located in the United States, or its business is principally administered in the United States.”

[9] Item 402(c), Instruction 1.

[10] Dodd-Frank Act §953(b)(2).

[11] SEC Release Nos. 33-9452, 34-70443, supra at note 1; pp. 25, 31.

[12] Id. at 34-36.

[13] Id. at 35-36.

[14] Whatever compensation measure is used must be briefly described in the proxy; e.g., “We found the median using salary, wages and tips as reported to the U.S. Internal Revenue Service on Form W-2 and the equivalent for our non-U.S. employees.”  Id. at 46, 59.

[15] Alternatively, registrants may calculate annual total compensation for all employees, and use the calculations to identify the median employee.  However, this would generally be much more costly.  Id. at 44-45, 51.

[16] For purposes of Pay Ratio Disclosure, “NEO” is replaced in Item 402 with “Employee”.  Id. at 53.

[17] For non-salaried employees, references to “base salary” and “salary” in Item 402 may be deemed to refer instead, as applicable, to “wages plus overtime.”  Id. at 53.

[18] SEC Release Nos. 33-9452, 34-70443, supra at note 1, p. 8; See Executive Compensation, 17 C.F.R. §229.402(c)(2)(iii) (Item 402) (Aug. 12, 2011); See also Instructions to Item 402(c)(2)(iii) and (iv).

[19] Id. at §229.402(c)(2)(iv); See also Instructions to Item 402(c)(2)(iii) and (iv).

[20] Id. at §229.402(c)(2)(v); See also Instructions to Item 402(c)(2)(v) and (vi).

[21] Id. at §229.402(c)(2)(vi); See also Instructions to Item 402(c)(2)(v) and (vi).

[22] Id. at §229.402(c)(2)(vii); See also Instructions to Item 402(c)(2)(vii).

[23] Id. at §229.402(c)(2)(viii); See also Instructions to Item 402(c)(2)(viii).

[24] Id. at §229.402(c)(2)(ix); See also Instructions to Item 402(c)(2)(ix).

[25] The methodology used to calculate total compensation for employees for purposes of Pay Ratio Disclosure differs from the currently required calculations for disclosure, accounting and tax purposes.  See SEC Release Nos. 33-9452, 34-70443, supra at note 1; p. 8-9.

[26] SEC Release Nos. 33-9452, 34-70443, supra at note 1; p. 12.

[27] Id. at 60 (stating, “when statistical sampling is used, registrants should disclose the size of both the sample and the estimated whole population, any material assumptions used in determining the sample size, which sampling method (or methods) is used, and, if applicable, how the sampling method deals with separate payrolls such as geographically separated employee populations or other issues arising from multiple business or geographic segments”).

[28] Id. at 13, 39-40, 54, 59 (stating that “the methodology and any material assumptions, adjustments or estimates used to identify the median be briefly disclosed and consistently used, and any estimated amounts be clearly identified as such.”).

[29] Id.

[30] Id.

[31] Id. at 12-13.

[32] SEC Release Nos. 33-9452, 34-70443, supra at note 1; p. 13.

[33] Id.

[34] Id. at 20.

[35] Id. at 62-63.

[36] Id. at 76.

[37] Id. at 77.

[38] Id. at 81.

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