On August 5, 2015, the Securities and Exchange Commission (the “SEC”) voted 3-2 to adopt the final “pay ratio” disclosure rule. This long-awaited, controversial rule is issued pursuant to Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, close to five years after its enactment. The pay ratio rule requires disclosure of the reporting company’s CEO’s annual total compensation, the median annual total compensation of substantially all employees other than the CEO and the ratio between the two amounts. The final pay ratio rule is similar to the proposed rule, with certain changes intended to alleviate compliance costs and to provide companies with additional time to prepare for the disclosure.

Highlights of Final Pay Ratio Rule

All reporting companies (with a few exceptions discussed below) are required to disclose for fiscal years beginning on or after January 1, 2017:

  • The annual total compensation of the CEO;
  • The median of the annual total compensation of all of the company’s employees, excluding the CEO; and
  • The ratio between these two amounts.

General Compliance Date

Reporting companies are required to report the pay ratio disclosure for their first fiscal year beginning on or after January 1, 2017. For calendar year companies, this means that the first pay ratio disclosure (relating to compensation paid in 2017) will be made in the 2018 proxy season.

Exceptions to General Compliance Date

Two key exceptions to the general compliance date are:

IPO Companies. A new reporting company is required to include the pay ratio disclosure for its first fiscal year commencing after the company (i) has been subject to the SEC’s reporting requirements for twelve months beginning after January 1, 2017 and (ii) has filed one annual report. In an example provided in the final rules, if a newly public company completes its IPO on March 1, 2017, the pay ratio disclosure pertaining to compensation paid in its 2018 fiscal year would be required in its Form 10-K for 2018 and its 2019 proxy statement.

Emerging Growth and Smaller Reporting Companies. Emerging growth companies, smaller reporting companies and foreign private issuers are exempt from the pay ratio rule. An emerging growth company, smaller reporting company or foreign private issuer is required to provide the pay ratio disclosure for the first full fiscal year completed after exiting such status (but not for any fiscal year commencing before January 1, 2017). For example, if a calendar year emerging growth company loses its status as such as of January 1, 2018, it will need to include the pay ratio disclosure with respect to compensation paid in 2018 in its Form 10-K for 2018 and its 2019 proxy statement.

  1. Identify the Employee Population

A company must first identify the employee population out of which it will determine the median annual total compensation. The final pay ratio rule requires that a company consider the annual total compensation of all of its employees (other than the CEO), including worldwide full-time, part-time, temporary and seasonal workers employed by the company and its “consolidated subsidiaries.” However, a company may exclude independent contractors and “contract workers” employed by an unaffiliated third party, though to do so, the company must not be able to determine the worker’s compensation. This suggests that a company would be required to include an independent contractor that is retained directly by the company, rather than through a third party (we assume that this will be the subject of many comments). The employee population may be determined and measured as of any date within the last three months of a company’s fiscal year. Note, however, that if the date changes year over year, a company will need describe the rationale for the change.

The final rule provides two important exemptions from the employee population for non-U.S. employees:

Data Privacy Exemption. A company may exclude non-U.S. employees in a jurisdiction where employee data privacy laws would preclude the company from complying with the pay ratio rule.

To rely upon the Data Privacy Exemption, a company would need to exclude all employees in that jurisdiction. A company would also need to demonstrate that it used reasonable efforts in its attempts to comply with the pay ratio rule, which include seeking an exemption from the foreign country’s privacy law. The company would be required to obtain (and file) a legal opinion regarding its inability to comply with the rule and disclose its rationale for relying upon the exemption, the excluded jurisdiction and the number number of employees excluded.

De Minimis Exemption. If non-U.S. employees comprise 5% or less of all of a company’s employees, all of the non-U.S. employees may be excluded. To use this exemption, however, the company must exclude all of its non-U.S. employees.

Pursuant to the De Minimis Exemption, if non-U.S. employees comprise more than 5% of all of a company’s employees, a company may exclude up to 5% of all of its employees that are non-U.S. employees. However, to rely upon the De Minimis Exemption, a company would need to exclude all employees from any excluded jurisdiction (it cannot pick and choose employees to exclude within a jurisdiction). This means that if a jurisdiction accounts for more than 5% of the company’s total employees, employees of that jurisdiction cannot be excluded (unless they can be excluded by the Data Privacy Exemption). Also, any employees excluded by the Data Privacy Exemption would count towards the 5%. Thus, employees excluded by the Data Privacy Exemption are not subject to the 5% cap, but if the 5% cap is met by employees excluded by the Data Privacy Exemption, no additional non-U.S. employees may be excluded.

For example, if a company has employees in the U.S. (84% of total), France (12% of total) and Canada (4% of total), the company could exclude all Canadian employees under the De Minimis Exemption and no French employees under the De Minimis Exemption (it could not exclude only the 1% comprised of French employees). If, however, the company could exclude the French employees under the Data Privacy Exemption, it could exclude all French employees under such exemption. In this case, it would not be able to exclude any Canadian employees because the French employees (representing 12% of total employees) would be counted toward the De Minimis Exemption and the company would have surpassed its 5% maximum.

The company would need to disclose the exemption, the excluded jurisdictions, the number of employees excluded from the employee population, and the total number of its U.S. and non-U.S. employees.

Also, a company may exclude employees that became employees as a result of an acquisition for the fiscal year in which the acquisition occurs. Such employees must be included in future years. The company would need to disclose the exemption and the number of employees excluded from the employee population.

  1. Identify the Median Employee

General Methodology for Identification. After identifying the employee population, a company must next identify the employee with the median total annual compensation from within the employee population. To do so, a company may establish a methodology based on its own facts and circumstances, including using the entire population, a statistical sampling or other reasonable methods. A company may use either total compensation as determined in accordance with Item 402(c)(x) of Regulation S-K (the requirements of the Summary Compensation Table) or any other measure that is consistently applied (for example, pay roll or tax records). In doing so, a company may use cost of living adjustments, but if so, the company must use it to both identify the median employee as well calculate such employee’s compensation. A company may also annualize the compensation of permanent full-time or part-time employees who are not employed for the full fiscal year, but a company may not annualize the compensation of temporary or seasonal workers even when compensation is annualized for other employees. Each method used must be disclosed.

Timing of Identification. A company need only identify the median employee once every three years unless there are changes to the company’s employee population or compensation that would reasonably result in a significant change. Importantly, even though the median employee need only be identified once every three years, the annual total compensation of such median employee must be calculated each year based on such employee’s total annual compensation for each of the three years. The final rule provides flexibility to substitute a similar employee in the event the previously identified median employee ceases to be employed or has a significant compensation change. For example, if a company identifies the median employee in year one and such employee is no longer employed by the company in year two or such employee gets a large promotion in year two, the company can substitute a new median employee that had similar compensation to the median employee in year one.

  1. Calculate Annual Total Compensation 

After both the employee population and the median employee are identified, a company must calculate the annual total compensation of the median employee and its CEO for the applicable fiscal year. The annual total compensation of each must be determined in accordance with Item 402(c)(2)(x) of Regulation S-K. A company may use reasonable estimates (with disclosure) as needed.

  1. Disclosure & Filings

The pay ratio may be disclosed as a numerical ratio in which the compensation of the median employee is one (CEO to median employee = XXX to 1). Alternatively, it may be disclosed narratively (the CEO’s annual compensation is XXX times the median employee’s annual compensation).  An example from the final rules states that if the median total annual compensation is $50,000 and the CEO’s total annual compensation is $2,500,000, the disclosure can be made only in one of the following two ways:

  • As a ratio—“50 to 1 or 50:1”
  • As narrative—“The CEO’s annual total compensation is 50 times that of the median of the annual total compensation of all employees.”

As described above, a company must also describe the methods used to identify the employee population, the median employee and calculate the annual total compensation, including any material assumptions or estimates. Likewise, a company will need to disclose any material change from the methodology, assumptions or estimates used in prior years.A company may, but is not required to, supplement its pay ratio disclosure with narrative description or additional ratios. In both cases, the supplemental disclosure must be clearly identified, not misleading and not more prominent than the required ratio disclosure.

The pay ratio disclosure for the most recently completed fiscal year must be made no later than 120 days after the end of such fiscal year. The disclosure is required to be “filed” (rather than “furnished”) in annual reports on Form 10-K, registration statements and proxy and information statements when these filings require executive compensation disclosure under Item 402(c)(2)(x) of Regulation S-K. As discussed above, newly public companies have a transition period before they are required to provide the pay ratio disclosure, so the pay ratio disclosure is not required in Form S-1, Form S-11 or Form 10.

Next Steps

We note that there has been vocal dissent to the final pay ratio rule. Likewise, Congress has introduced legislation to repeal Section 953(b) of the Dodd-Frank Act, which mandates the pay ratio rule. However, we recommend companies begin preparing to comply with the rule and suggest companies consider the following next steps.

  • Determine when the company will need to begin making the pay ratio disclosure. For emerging growth companies and smaller reporting companies, this date will depend on when the applicable transition rules end for such companies (as described above).
  • Consider whether and to what extent foreign employees may be excluded from the employee population.
  • Discuss the timing and costs of the pay ratio analysis with compensation advisors or other advisors and keep the compensation committee informed of the status of the company’s discussions and steps taken for compliance.

Additional Information

The SEC’s Fact Sheet describing the final rules can be found here: http://www.sec.gov/news/pressrelease/2015-160.html

The SEC release of the final rules can be found here: http://www.sec.gov/rules/final/2015/33-9877.pdf