Counsel to reporting companies should carefully consider the SEC’s proposed pay ratio disclosure rule, because it may significantly increase your company’s compliance costs and may require substantial time and resources to configure your data retrieval systems in a way to optimize your eventual reporting obligations. On Sept. 18, 2013, the Commissioners of the SEC voted 3−2 along party lines to propose new regulations mandated by Section 953(b) of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act that requires certain U.S. public companies to disclose the median of the total annual compensation of all its employees (excluding the company’s principal executive officer or PEO) and the ratio of that median to the total annual compensation of its PEO. The proposed rule is controversial for a number of reasons, as evidenced by the newest commissioner of the SEC who stated, “[The SEC] should not be spending money and limited resources on any rulemaking that unambiguously harms investors, negatively affects competition, promotes inefficiencies and restricts capital formation.”

The proposed regulations would come in the form of a new paragraph in Item 402 of Regulation S-K (paragraph 402(u)) and would require all issuers, excluding emerging growth companies, smaller reporting companies and foreign private issuers, required to disclose executive compensation pursuant to Item 402 of Regulation S-K to further disclose the median of the annual total compensation of all employees and the ratio of that median to the annual total compensation of the PEO. Annual total compensation is to be determined for the fiscal year of the issuer in accordance with Item 402, the same criteria used to determine annual total compensation of executives that such issuer is currently required to disclose. The proposed law would capture all employees of the issuer and its subsidiaries, including full-time, part-time, temporary, seasonal and, perhaps most controversially, non-US employees. An “employee” for purposes of the regulation is defined as an individual employed as of the last day of the issuer’s last completed fiscal year.

The new regulation has been applauded by unions and other labor advocates. At present, public companies are required to provide extensive information about the compensation of their PEO and other named executive officers but are not, however, required to disclose compensation information for other employees. Such disclosure, advocates of the new rule argue, will assist investors in evaluating the company’s compensation scheme and help reign in excessive executive pay. The proposed rules come at a time of renewed national concern over income inequality and executive compensation. According to Equilar, an executive compensation analysis firm, median compensation for the country’s top 200 executives was $15.1 million in 2012, an increase of 16 percent over the previous year.

Critics of the law lament the high cost of compliance that may arise from the proposed disclosure rule in both time and money as many companies employ complex payroll, benefits and pensions systems, often with the assistance of multiple outside vendors and do not manage the relevant data in a manner that can efficiently be used for the calculation required under Item 402(c) of Regulation S-K. Accumulating and analyzing the relevant data (in some cases manually) will be a vast and expensive undertaking for most issuers, critics argue, and is difficult to justify in light of the marginal benefit of the disclosure to investors, if any. Critics also point to the impact on an issuer’s competitive position in the market place. Issuers subject to this reporting requirement may be providing information about their cost structure to competitors not subject to the proposed rule, especially reporting multinationals competing with foreign non-reporting competitors.

In response to such criticism, the SEC has decided not to proscribe the method as to how the median employee in terms of compensation is identified. The proposed regulation would allow issuers to determine the method appropriate for the issuer for determining the median total annual compensation of its employees taking into consideration factors such as the size of the company, the number of its employees, and the complexity and global nature of the issuer. Issuers with a large number of employees may consider a random statistical sampling of employees, estimates and the use of any other consistently applied compensation measures appropriate for the issuer, provided that the issuer briefly discloses the methodologies and material assumptions applied in arriving at the pay-ratio. For example, as an alternative method to providing total annual compensation for all employees, it would be reasonable, according to the SEC, for a company to use existing payroll and tax data for the calendar year to determine who is the median employee of the issuer, and then, once the median employee is selected, determine that median employee’s total annual compensation for the fiscal year in accordance with Item 402(c) of Regulation S-K in the same way as determined for the other executives whose total annual compensation is already reported by the issuer. 

Your company will be required to comply with the proposed rule’s reporting obligations in its Proxy Statement or 10-K for the company’s first full fiscal year commencing after the adoption of the final pay-ratio rules. However, in light of the expected substantial compliance costs and the lack of clearly defined benefits of the proposed rule, commentators expect challenges to the rule which may delay its implementation.

In 1992, the SEC adopted a revised set of executive compensation proxy disclosure rules. The regulatory changes were adopted in response to complaints that executive compensation had become excessive, and in the hope that the new regulation could produce an increased shareholder awareness that would make executives more accountable to the shareholders. The new disclosures ushered in an era of higher executive compensation in the U.S. Will this proposed rule have a similar unintended consequence on executive compensation and the salaries of employees across the board? How will it affect reporting companies’ hiring of lower wage employees, when workers providing services to the issuer through a contractor or through work that has been outsourced will not be included in the analysis?