On September 18, 2013, the SEC issued a rule proposal that would implement the "pay ratio" disclosure requirement mandated by Section 953(b) of the Dodd-Frank Act. The proposal would amend Item 402 of Regulation S-K to require companies to disclose:

The requirement would be set out in a new paragraph (u) of Item 402.

Taking into consideration feedback from public comments, including concerns over the significant cost of implementation, the SEC proposed a flexible approach designed to lower compliance costs while remaining consistent with the Dodd-Frank Act's requirements.

The proposed pay ratio disclosure requirement would apply to reporting companies that are required to provide summary compensation disclosure under Item 402(c) of Regulation S-K. The following categories of companies would not be required to make pay ratio disclosure:

The proposal would require companies to first disclose the pay ratio for a completed fiscal year in either their annual report on Form 10-K for that year or their proxy statement for the next annual stockholders meeting, as long as the proxy statement was filed within 120 days after the end of the fiscal year. The pay ratio disclosure would also need to be included or incorporated by reference in any other registration statement, proxy statement or other report requiring executive compensation disclosure filed thereafter.

Public companies would begin making pay ratio disclosure following the first fiscal year that begins on or after the effective date of the final rule. Therefore, for example, if the rule becomes effective in 2014, a company with a December 31 fiscal year end would be required to make the disclosure for fiscal year 2015 in its Form 10-K for 2015 due in 2016 or proxy or information statement for its 2016 annual meeting.

In addition, a previously non-reporting company would not be required to make pay ratio disclosure in a registration statement on Form S-1 or S-11 for an IPO or in a Form 10. Instead, the company would be required to make pay ratio disclosure for the first fiscal year beginning on or after the date the company becomes a reporting company. Therefore, for example, if the proposal becomes effective in 2014 and a company with a December 31 fiscal year end completes an IPO in 2015, the company would be required to make the first disclosure in its Form 10-K for the year ending December 31, 2016 or its 2017 proxy or information statement.

Under the proposal, "all employees" of the company includes individuals employed by the reporting company or any of its subsidiaries (as defined in Rules 405 under the Securities Act and 12b-2 under the Exchange Act) as of the last day of the company's last completed fiscal year. Full-time, part-time, temporary, seasonal and non-US employees are covered, including officers other than the PEO. Independent contractors or "leased" or other temporary workers employed by a third party are not covered.

Companies would be permitted, but not required, to annualize total compensation for permanent employees who did not work during the entire year, such as new hires or those who took an unpaid leave of absence. However, companies would not be permitted to:

The proposal does not set out a uniform methodology to use in identifying the median of the annual total compensation of employees. Instead, companies would be allowed to select a methodology that is appropriate based on the size and structure of their business and the way the company compensates employees. Companies can identify the median using:

For example, a company could identify the median by calculating annual total compensation of each employee using either its full employee population or a statistical sample of that population. Alternatively, the company could first identify a median employee based on any consistently applied compensation measure, such as amounts reported in payroll or tax records and then calculate that median employee's annual total compensation. If a company uses an alternative approach to identify the median, it must:

Companies may use reasonable estimates when calculating the median.

Once the median employee is identified, the company would calculate and disclose that employee's annual total compensation in accordance with Item 402(c)(2)(x) of Regulation S-K. Companies would be permitted to use reasonable estimates in calculating the annual total compensation or any element of total compensation for employees other than the PEO. For example, companies would be permitted to use reasonable estimates when valuing:

"Annual total compensation" would mean total compensation for the last completed fiscal year, consistent with the time period used for other Item 402 disclosure requirements.

The proposal would require the ratio of the median employee annual total compensation to the PEO's annual total compensation to be expressed either:

So, for example, if the median annual total compensation is $45,790 and the annual total compensation of the company's PEO is $12,260,000, then the pay ratio would be 1 to 268. This could also be expressed narratively as "the PEO's annual total compensation is 268 times that of the median of the annual total compensation of all employees."

Under the proposed rule, companies would need to disclose:

Companies would also be permitted, but not required, to supplement the pay ratio disclosure with a narrative discussion or additional ratios.

If a company changes its methodology, or its assumptions, adjustments or estimates, from the prior year and the results of the changes are material, the company must also:

Disclosure under the proposed rule would be considered filed (as opposed to furnished) for purposes of the Securities Act and Exchange Act, meaning it would be subject to applicable liability provisions (including Section 18 of the Exchange Act and, when incorporated by reference into a registration statement, Section 11 of the Securities Act) and would be covered by Sarbanes-Oxley certifications.

The SEC is accepting comments on the proposal until December 2, 2013.

For more information on executive compensation disclosure, see Practice Note, Proxy Statements: Executive Compensation. For information on provisions of the Dodd-Frank Act relating to executive compensation, see Practice Note, Summary of the Dodd-Frank Act: Executive Compensation.