The Securities and Exchange Commission (SEC) has adopted a final rule requiring publicly traded corporations to disclose, to the SEC and shareholders, the ratio of CEO compensation to the "median compensation" of the corporation's employees (except the CEO).

While this disclosure requirement is mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), signed into law in 2010, it is only being implemented now, and will be effective for public corporations for the calendar year 2017 (or for fiscal years beginning during 2017).  This disclosure must be set out in registration statements, proxy and information statements, and annual reports that call for executive compensation disclosure. 

The SEC takes the position that this disclosure requirement will provide shareholders of publicly traded corporations information that will be helpful when they are voting under the "say-on-pay" rule. The say-on-pay rule, adopted in January 2011, provides shareholders with an opportunity to approve or disapprove (in a nonbinding vote) compensation paid to key executives. 

While the new SEC compensation disclosure rule provides some flexibility in determining the pay ratio, the essence of this disclosure is a comparison of the CEO's compensation to the compensation paid to the corporation's "median" employee.  The required disclosure will include:  (1) the median of the annual total compensation of all employees (other than the CEO), (2) the annual total compensation of the CEO and (3) the ratio of those two amounts.  For example, a corporation whose median employee earns $85,000 per year and whose CEO is paid $3,000,000 annually, will, therefore, have to disclose that its CEO's compensation is more than 35 times the median employee's compensation. 

The SEC's rule provides flexibility intended to make this calculation easier than might otherwise have been the case.  A company will, for example, be permitted to select its methodology for identifying its median employee and that employee's compensation. The rule allows companies to make the median employee determination only once every three years.  Companies are also permitted to exclude certain non-U.S. employees when determining their median employee compensation. 

The rule exempts from the disclosure requirement certain companies, such as smaller reporting companies and emerging growth companies.  It also provides a transition period for new companies and for companies involved in certain corporate transactions. 

Nevertheless, there is a high likelihood that the disclosure requirement will create shareholder relations challenges and increase the incidences in which shareholders vote "no" under the say-on-pay rule.  The rule will likely cause companies to spend time managing what, in many instances, will be considered an embarrassing disclosure of CEO compensation that may appear excessive.  Helpfully, though, the SEC's rule will also permit the company to provide a narrative discussion and explanation of the compensation ratio.  The rule requires that any such further information submitted to the shareholders not be misleading or presented with greater prominence than the required pay ratio disclosure.

The Republican majority Congress could change the disclosure rule before it is implemented.  Nevertheless, we recommend that companies subject to these requirements consider developing a reasonable methodology for identifying its median employee and for calculating the annual total compensation for its median employee, using the same rules that will apply to the chief executive officer's compensation. 

Additionally, a company may want to consider choosing a date within the last three months of its last completed fiscal year in which to determine the employee population for purposes of identifying the median employee, and examining now what this disclosure will look like once required.

Congress may make other changes.  It may revise section 953(b) of the Dodd-Frank Act or its application to remove certain factors of compensation from consideration in satisfying the pay ratio rule (using the clawback rules, for instance, to balance such a change).  Nevertheless, registered companies should consider how to comply with the rule now and, if it changes, make adjustments as appropriate.  Reporting will be required under the rules as currently adopted, and shareholders will pay attention to compliance.