As prescribed by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the Securities and Exchange Commission (“SEC”) proposed an amendment to Item 402 of Regulation S-K, to be codified as Item 402(u). This amendment requires disclosure of a ratio of the total annual compensation of an issuer’s chief executive officer and the total annual compensation of the issuer’s median employee, excluding the chief executive officer. The full text of the proposal can be found here.
In the proposal, the SEC does not prescribe a specific method of identifying the median employee compensation of the issuer, but instead provides “instructions and guidance designed to allow registrants to choose from several alternative methods to identify the median, so that they may use the method that works best for their own facts and circumstances.”
Methods of Identifying the Median
Item 402(c)(2)(x) Compensation Determination. In a plain reading of the proposed amendment, the clearest way to comply with the determination of finding the median employee would be to determine the total annual compensation of each employee of the registrant under the terms set forth in Item 402(c)(2)(x) and then determine the median employee. This method would also truncate the process because there would be no need for a second calculation since the total annual compensation of the median employee would already be calculated. This is unlike the Statistical Sampling or Total Direct Compensation methods which require a two-step calculation process, which are described below.
Total Direct Compensation. In response to concerns over the cost of determining every employee’s compensation under Item 402(c)(2)(x), the SEC agreed to allow determination of median compensation using total direct compensation. This would include metrics such as annual salary, hourly wages, performance-based pay, or pay as indicated on IRS Form W-2. The SEC states that reduced costs would result from the use of the total direct compensation method. The SEC, however, directly disavowed allowance of earnings estimates from the U.S. Department of Labor’s Bureau of Labor Statistics as not being consistent with Section 953(b) of the Dodd-Frank Act.
Statistical Sampling. In the proposal, the SEC discussed statistical sampling as a valid method of identifying the median. As with total direct compensation, the proposal states that statistical sampling may lead to reduced compliance costs. However, in allowing the use of statistical sampling, the proposal states that the sample size required would vary depending upon the circumstances of the registrant. This variation would change the costs of performing the calculation. Once a sample has been determined, the proposal indicates that an exact compensation determination of each employee is not required. Instead, a registrant may identify outliers, either highly compensated or lowly compensated employees, and label them as above the median and below the median, while concluding that the median is not among the statistical sample.
Determination of Total Compensation
After the median employee has been identified by the issuer by one of the proposed methods or another reasonable way, the issuer must calculate the total annual compensation of the employee identified.
Section 953(b) mandate to use Item 402(c)(2)(x). The SEC noted that many commentators are concerned about the cost of going through a full Item 402(c)(2)(x) compensation analysis for the median employee, but such analysis is the prescribed manner for calculating total annual compensation by Section 953(b) of the Dodd-Frank Act. The proposal does indicate, however, that the registrant would have to disclose the total annual compensation of only the median employee in accordance with Item 402(c)(2)(x), even if the registrant elected to identify the median employee by calculating every employee’s compensation under that standard.
Reasonable Estimates of Item 402(c)(2)(x). In recognition of the costs and challenges of calculating the total annual compensation of a regular employee under Item 402(c)(2)(x), the SEC explicitly allows the use of reasonable estimates in determining any of the applicable elements of the median employee under Item 402(c)(2)(x). The SEC believes that this will not diminish the value of the metric, but if estimates are used, they must be clearly identified as an estimate amount and also include a description as to how that estimate was obtained.
As a final note, the SEC proposal requires disclosure of the method used to determine the median employee and total annual compensation and requires further that the method prescribed be applied consistently from one year to the next.
Key Issue and Why
The calculation of median employee compensation is crucial to the proposed amendment to Item 402. Many commentators have expressed their concern over the utility of such a metric, especially when faced with the potential costs of calculation.
For a summary of the proposed rule, see here.