The SEC has adopted a final “pay ratio” rule required by Section 953(b) of the Dodd-Frank Act.  In general, the “pay ratio” rule requires public companies to disclose the median of the annual total compensation of all employees of a registrant (excluding the chief executive officer), the annual total compensation of that registrant’s chief executive officer, and the ratio of the median of the annual total compensation of all employees to the annual total compensation of the chief executive officer.

The disclosure is required in any annual report, proxy or information statement, or registration statement that requires executive compensation disclosure pursuant to Item 402 of Regulation S-K.

The disclosure requirement does not apply to emerging growth companies, smaller reporting companies, or foreign private issuers.

Public companies must comply with the final rule for the first fiscal year beginning on or after January 1, 2017.

Pay Ratio Disclosure

Specifically, the final rule requires disclosure of:

  • the median of the annual total compensation of all employees of the registrant (except the registrant’s chief executive officer, which the rule refers to as the PEO) (A);
  • the annual total compensation of the registrant’s PEO (B); and
  • the ratio of the amount in (B) to the amount in (A), presented as a ratio in which the amount in (A) equals one, or, alternatively, expressed narratively in terms of the multiple that the amount in (B) bears to the amount in (A).

As noted, the final rule permits registrants to choose one of two options to express the ratio. Registrants may disclose the pay ratio with the median of the annual total compensation of all employees equal to one and the PEO’s compensation as the number compared to one.  For example, if a registrant’s median annual total compensation for employees is $50,000 and the annual total compensation of the PEO is $2,500,000, the PEO’s compensation is 50 times larger than the median employee’s compensation. The registrant may describe the pay ratio as 50 to 1 or 50:1. Alternatively, registrants may disclose the pay ratio narratively by stating how many times higher (or lower) the PEO’s annual total compensation is than that of the median employee. For example, the registrant may state that “the PEO’s annual total compensation is 50 times that of the median of the annual total compensation of all employees.”

“All Employees” Covered Under the Rule

Types of Employees

The final rule defines “employee” to include a registrant’s U.S. and non-U.S. employees, as well as its part-time, seasonal, and temporary employees.  Because the definition refers to workers “employed by the registrant,” workers who provide services to the registrant or its consolidated subsidiaries as independent contractors or “leased” workers are excluded from the definition as long as they are employed, and their compensation is determined, by an unaffiliated third party.

Employed on Any Date Within Three Months of the Last Completed Fiscal Year

The final rule defines “employee” as an individual employed on any date of the registrant’s choosing within the last three months of the registrant’s last completed fiscal year. The final rule also requires registrants to disclose the date used to identify the median employee.

The SEC believes permitting registrants to choose a date within the last three months of their last completed fiscal year is appropriate because it provides registrants with some flexibility and could permit them additional time to identify their median employee in advance of their fiscal year end.

Employees Located Outside the United States

The final rule’s definition of “employee” includes a registrant’s U.S. and non-U.S. employees.  However, the final rule includes two exemptions:

  • an exemption that applies when a foreign jurisdiction’s data privacy laws or regulations are such that, despite its reasonable efforts to obtain or process information necessary to comply with the rule, a registrant is unable to do so without violating those laws or regulations, and
  • a de minimis exemption.

Foreign Data Privacy Law Exemption

The final rule includes an exemption to the general requirement that non-U.S. employees be included in the pay ratio disclosure when a jurisdiction’s data privacy laws or regulations are such that, despite a registrant’s reasonable efforts to obtain or process information necessary to comply with the rule, it is unable to do so without violating those laws or regulations.

To prevent any potential manipulation, the rule requires the registrant to exercise reasonable efforts to obtain or process the information necessary for compliance with the final rule. As part of its reasonable efforts, the registrant must seek an exemption or other relief under the applicable jurisdiction’s governing data privacy laws or regulations and use the exemption if granted.

If a registrant excludes any non-U.S. employees in a particular jurisdiction under the data privacy exemption, it must exclude all non-U.S. employees in that jurisdiction. Additionally, the registrant must list the excluded jurisdictions, identify the specific data privacy law or regulation, explain how complying with the final rule violates the law or regulation (including the efforts made by the registrant to use or seek an exemption or other relief under such law or regulation), and provide the approximate number of employees exempted from each jurisdiction based on this exemption.

The registrant must also obtain a legal opinion that opines on the inability of the registrant to obtain or process the information necessary for compliance with the final rule without violating that jurisdiction’s laws or regulations governing data privacy, including the registrant’s inability to obtain an exemption or other relief under any governing laws or regulations. The legal opinion must be filed as an exhibit with the filing in which the pay ratio disclosure is included.

De Minimis Exemption

Under the de minimis exemption, registrants whose non-U.S. employees make up 5% or less of their total U.S. and non-U.S. employees may exclude all of them when identifying their median employee. If such a registrant chooses to exclude any non-U.S. employees under this exemption, it must exclude all of them. A registrant with more than 5% non-U.S. employees may also exclude non-U.S. employees up to the 5% threshold; provided that, if such a registrant excludes any non-U.S. employees in a particular foreign jurisdiction, it must exclude all the employees in that jurisdiction. The registrant may not pick and choose which employees to exclude in any one jurisdiction.

The final rule also requires a registrant using the de minimis exemption to provide certain disclosures. If the registrant excludes any non-U.S. employees under the de minimis exemption, it must disclose the jurisdiction or jurisdictions from which employees are being excluded, the approximate number of employees excluded from each jurisdiction under the de minimis exemption, the total number of its U.S. and non-U.S. employees irrespective of any exemption (data privacy or de minimis) and the total number of its U.S. and non-U.S. employees used for its de minimis calculation.

Cost-of-Living Adjustment

The final rule allows registrants the option to make cost-of-living adjustments to the compensation of their employees in jurisdictions other than the jurisdiction in which the PEO resides when identifying the median employee (whether using annual total compensation or any other consistently applied compensation measure), provided that the adjustment is applied to all such employees included in the calculation.  If the registrant chooses this option, the compensation of such employees will have to be adjusted to the cost of living in the jurisdiction in which the PEO resides. Further, if the registrant uses a cost-of-living adjustment to identify the median employee, and the median employee identified is an employee in a jurisdiction other than the one in which the PEO resides, the registrant must use the same cost-of-living adjustment in calculating the median employee’s annual total compensation and disclose the median employee’s jurisdiction. If a registrant does not make cost-of-living-adjustments to its employees when identifying the median employee, the registrant is not permitted to make cost-of-living adjustments to the median employee’s annual total compensation if the median employee is an employee in a jurisdiction other than the jurisdiction in which the PEO resides.

The final rule requires registrants to briefly describe any cost-of-living adjustments they used to identify the median employee or to calculate annual total compensation, including the measure used as the basis for the cost-of-living adjustment, and disclose the country in which the median employee is located. Additionally, the final rule requires that any registrant electing to present the pay ratio using a cost-of-living adjustment must also disclose the median employee’s annual total compensation and pay ratio without the cost-of-living adjustments. To calculate this pay ratio, the registrant will need to identify the median employee without using any cost-of-living adjustments.

Employees of Consolidated Subsidiaries

The final rule defines “employee” to include only the employees of the registrant and its consolidated subsidiaries.  The proposed rule had used a more expansive definition.

Acquisitions

The final rule also permits registrants that engage in business combinations and/or acquisitions to omit the employees of a newly-acquired entity from their pay ratio calculation for the fiscal year in which the business combination or acquisition occurs. In these cases, a registrant does not have to include these individual employees in its median employee calculation until the first full fiscal year following the acquisition. Registrants that exclude employees as a result of a business combination must disclose the relevant acquired business and the approximate number of employees that are excluded from the pay ratio calculation.

Any PEO Compensation in the Last Full Fiscal Year

The proposed rule did not discuss the compensation information that would be required if one or more of a registrant’s PEOs served only part of a fiscal year.  The final rule allows a registrant a choice of two options in calculating the annual total compensation for its PEO in situations in which the registrant replaces its PEO with another PEO during its fiscal year. In these situations, the registrant must disclose which option it chose and how it calculated its PEO’s annual total compensation. First, a registrant may take the total compensation calculated pursuant to Item 402(c)(2)(x) of Regulation S-K, and reflected in the Summary Compensation Table, provided to each person who served as PEO during the year and combine those figures. This figure would constitute the registrant’s annual total PEO compensation.

Alternatively, a registrant may look to the PEO serving in that position on the date it selects to identify the median employee and annualize that PEO’s compensation. For example, if the registrant chooses October 15 as the date to determine its median employee, the registrant would calculate the compensation of the person serving as PEO on that date and annualize that PEO’s compensation. If the person was PEO for six months and received $100,000 of total compensation, the registrant would use $200,000 as the annual total compensation of its PEO.

Additional Information is Permissible

An instruction to the final rule states that registrants may present additional ratios or other information to supplement the required ratio, but are not required to do so. The instruction states also that, if a registrant includes any additional ratios, the ratios must be clearly identified, not be misleading, and not be presented with greater prominence than the required ratio. Additional pay ratios are not limited to any particular information, such as pay ratios covering U.S. and non-U.S. employees.

Annualizing Permanent Employees is Permissible, but Other Compensation Adjustments are Prohibited

Annualization involves taking the compensation of an employee who worked for only part of the registrant’s fiscal year and projecting that compensation as if the employee worked the full fiscal year at the schedule that the employee worked for the portion of the year the employee worked. Annualization is allowed under the rule for full-time and part-time employees who did not work for the registrant’s full fiscal year for some reason, such as they were employees who were newly hired, on leave under the Family and Medical Leave Act of 1993, called for active military duty, or took an unpaid leave of absence during the period. Annualization is only allowed for permanent employees; it is not allowed under the final rule for seasonal or temporary employees.

A full-time equivalent adjustment involves taking the compensation of a part-time employee and projecting what the employee would have made if the employee were employed on a full-time basis. Full-time equivalent adjustments are prohibited under the final rule under all circumstances.

Identifying the Median Employee

Once Every Three Years

The final rule allows a registrant to identify the median employee whose compensation will be used for the annual total compensation calculation once every three years unless there has been a change in its employee population or employee compensation arrangements that it reasonably believes would result in a significant change in the pay ratio disclosure. If there have been no changes that the registrant reasonably believes would significantly affect its pay ratio disclosure, the registrant must disclose that it is using the same median employee in its pay ratio calculation and describe briefly the basis for its reasonable belief.

If the registrant is using the same median employee, it must calculate that median employee’s annual total compensation each year and use that figure to update its pay ratio disclosure each year.

Using Annual Total Compensation, Another Consistently Applied Compensation Measure, Statistical Sampling, Reasonable Estimates, or Other Reasonable Methods

The final rule does not specify any required methodology for registrants to use in identifying the median employee. Instead, the final rule permits registrants the flexibility to choose a method to identify the median employee based on their own facts and circumstances. To identify the median employee, registrants may use a methodology that uses reasonable estimates. The median employee may be identified using annual total compensation or any other compensation measure that is consistently applied to all employees included in the calculation, such as information derived from tax and/or payroll records. Also, in determining the employees from which the median is identified, a registrant is permitted to use its employee population or statistical sampling and/or other reasonable methods. In any event, the final rule requires a registrant to briefly describe the methodology it used to identify the median employee and any material assumptions, adjustments (including any cost-of-living adjustments), or estimates it used to identify the median employee or to determine total compensation or any elements of total compensation, which shall be consistently applied. The registrant also must clearly identify any estimates used.

The final rule permits registrants to use a consistently applied compensation measure, such as information derived from tax and/or payroll records, in determining the employees from which the median is identified as long as the registrant discloses the compensation measure used. For purposes of calculating the annual total compensation amounts when using a consistently applied compensation measure, the final rule permits registrants to use a measure that is defined differently across jurisdictions and may include different annual periods as long as within each jurisdiction, the measure is consistently applied. A registrant, however, would not be permitted to use an entirely different type of measure across jurisdictions that would not be consistently applied. The final rule does not require registrants to use any specific compensation measure when identifying the median employee.  After the median employee is identified, registrants must calculate that median employee’s annual total compensation in accordance with Item 402(c)(2)(x) of Regulation S-K.

The final rule requires that registrants provide their pay ratio disclosure using the compensation of their median employee.  According to the SEC, “median” is “the middle number in a sequence, or the average of the two middle numbers when the sequence has an even number of numbers.”  The final rule permits a registrant to select another employee as the median if that employee is within a 1% variance of the median and the original employee has anomalous compensation characteristics that would result in a pay ratio that did not accurately reflect the relationship between the compensation practices for a typical employee and the compensation of the PEO.

Calculating Annual Total Compensation

The final rule requires that “total compensation” for both the median employee and PEO be calculated using the requirements of Item 402(c)(2)(x) of Regulation S-K, which is the “total” column in the Summary Compensation Table.  The final rule permits registrants to use reasonable estimates in calculating the annual total compensation of their median employee, including any elements of the total compensation, under Item 402(c)(2)(x) of Regulation S-K.

Under the final rule, registrants must clearly identify any estimates used. Additionally, registrants must have a reasonable basis to conclude that their estimates approximate the actual amounts of Item 402(c)(2)(x) compensation, or a particular element of compensation under Item 402(c)(2)(iv)-(ix), that are awarded to, earned by, or paid to the median employee.

The application of the definition of total compensation under Item 402(c)(2)(x) to employees who are not executive officers could understate the overall compensation paid to such employees. Item 402 captures all of the various compensation components received by a named executive officer, excluding certain limited items like benefits under non-discriminatory plans and perquisites and personal benefits that aggregate less than $10,000. By excluding certain benefit plans and perquisites that do not exceed the $10,000 threshold, however, the rules may understate the median employee’s actual total compensation. To address this, the final rule permits registrants, at their discretion, to include personal benefits that aggregate less than $10,000 and compensation under non-discriminatory benefit plans in calculating the annual total compensation of the median employee. To be consistent, however, the PEO’s total compensation used in the related pay ratio disclosure must also reflect the same approach to these items used for the median employee. The registrant must also explain any difference between the PEO total compensation used in the pay ratio disclosure and the total compensation amounts reflected in the Summary Compensation Table, if material.

Disclosure of Methodology, Assumptions, and Estimates

The final rule, consistent with the proposal, requires registrants to briefly describe and consistently apply any methodology used to identify the median and any material assumptions, adjustments (including any cost-of-living adjustments), or estimates used to identify the median or to determine total compensation or any elements of total compensation. The final rule also requires a registrant to clearly identify any estimates used. For example, when statistical sampling is used, registrants must describe the size of both the sample and the estimated whole population, any material assumptions used in determining the sample size and the sampling method (or methods) is used. Additionally, although the required descriptions must provide sufficient information for readers to evaluate the appropriateness of the methodologies used, registrants are not required to include any technical analyses, formulas, confidence levels, or the steps used in data analysis.  Registrants must also disclose if they changed from using the cost-of-living adjustment to not using that adjustment and if they changed from not using the cost-of-living adjustment to using it.

Meaning of “Annual”

The final rule defines “annual total compensation” to mean “total compensation” for the registrant’s last completed fiscal year.  The SEC is not permitting registrants to select any annual period or the year prior to the last completed fiscal year to calculate total compensation.

As discussed above, registrants may use compensation amounts derived from the information derived from their tax and/or payroll records for the same annual period used in those records to identify their median employee. Registrants using the information derived from tax and/or payroll records to identify the median employee are still required to calculate the Item 402(c)(2)(x) total compensation for that median employee for the registrant’s last completed fiscal year, rather than the annual period used in the payroll and/or tax records because identifying the median is a separate process from calculating total compensation.

“Filed” not “Furnished”

The final rule treats the pay ratio disclosure, as with other Item 402 information, as “filed” for purposes of the Securities Act and Exchange Act, and, therefore, subject to potential liabilities under those statutes, including Exchange Act Section 18 liability.