Last week, the Securities and Exchange Commission (“SEC”), by a 3-2 vote, adopted the final CEO pay ratio rule, [1] which was initially proposed by the SEC in September 2013,[2] and originally mandated by Congress under Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The statute mandates that the SEC amend Item 402 of Regulation S-K to require a registrant to disclose (i) the median of the annual total compensation of all its employees (except for the CEO or any equivalent position), (ii) the annual total compensation of the CEO and (iii) the ratio of these two amounts. The final rule attempts to provide shareholders with a company-specific metric that can assist in their evaluation of a registrant’s executive compensation practices, and provides some additional flexibility from the proposed rule in an effort to reduce compliance costs.

The Pay Ratio

Under the final rule, a registrant must disclose the median of the annual total compensation of all its employees (except that of the CEO), the annual total compensation of its CEO and the ratio of these two amounts. The disclosure may be presented as a ratio, e.g., “1 to 100,” or expressed narratively as a multiple, e.g., “The annual total compensation of the CEO is 100 times that of the median of the annual total compensation of all employees.” Total compensation for all permanent employees (full-time or part-time) employed by the registrant for less than the full fiscal year may be annualized by the registrant, but total compensation for temporary or seasonal employees may not. The pay ratio 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.

Compliance Date

Registrants must comply with the final rule’s pay ratio disclosure requirements for the first full fiscal year beginning on or after January 1, 2017. For example, a registrant with a fiscal year that ends on December 31 will have to include the pay ratio disclosure in its Annual Report on Form 10-K for the year ended December 31, 2017 (or incorporate that information by reference in its proxy statement). 

Data Privacy and De Minimis Exemptions for Employees

With certain limited exceptions, a registrant must account for and include all individuals employed by the registrant or any of its consolidated subsidiaries, whether full-time, part-time, seasonal or temporary, in calculating the annual total compensation of its employees. Workers who are employed, and whose compensation is determined, by an unaffiliated third party, but who provide services to the registrant or its consolidated subsidiaries as independent contractors or “leased” workers, are not counted as “employees” for purposes of the disclosure.

The final rule permits a registrant to exclude non-U.S. employees from the pay ratio calculation under two circumstances:

  • First, non-U.S. employees located in jurisdictions whose data privacy laws or regulations would prevent the registrant from obtaining or processing the information necessary to calculate the pay ratio may be excluded. Importantly, this exception is subject to the requirement that the registrant exercise “reasonable efforts” of compliance to use, or to seek to obtain, an available exemption or other relief from, the applicable data privacy laws. The registrant must also identify and explain the jurisdiction and laws involved, why compliance is in issue, and the approximate number of employees exempted as a result, and such disclosure must be accompanied by a legal opinion from counsel opining as to the inability of the registrant to comply with the final rule requirements without violating the applicable data privacy laws of the foreign jurisdiction. All affected employees of a particular non-U.S. jurisdiction must be excluded from the pay ratio calculation if compliance with the disclosure requirement is not possible due to the data privacy laws and regulations of that non-U.S. jurisdiction.
  • Second, where the registrant’s non-U.S. employees make up 5% or less of the registrant’s total employees, the registrant may exclude all (but not less than all) of the registrant’s non-U.S. employees under this de minimis exemption. If the registrant’s non-U.S. employees exceed 5% of its total employees, it may exclude up to 5% of its total employees who are non-U.S. employees (in this case, however, if a registrant excludes any non-U.S. employees in a particular jurisdiction, it must exclude all non-U.S. employees in that jurisdiction). Importantly, a registrant must count any non-U.S. employee exempted under the data privacy exemption against the availability for the de minimis exemption (for example, if the number of employees excluded under the data privacy exemption equals or exceeds 5% of the registrant’s total employees, the de minimis exemption will not be available).

Identification of the Median Employee

Whereas the proposed rule defined “employee” as an individual employed as of the last day of the registrant’s fiscal year, the final rule permits registrants to use (and disclose) any date within the last three months of its last completed fiscal year to identify its median employee. If the selected date changes from the date used in the prior year, the registrant must disclose the change and briefly explain the reason(s) for the change.

Whereas the proposed rule required registrants to identify the median employee every year, the final rule allows registrants to identify the median employee 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 to its pay ratio disclosure). In situations in which there has been no change in a registrant’s employee population or employee compensation arrangements, but it is no longer appropriate to use the identified median employee (for example, because the employee is no longer employed by the registrant, or because the employee’s compensation changes significantly during the three year period), the registrant may use another employee whose compensation is substantially similar to the original median employee based on the compensation measure used to select the original median employee.

As with the proposed rule, the final rule allows registrants discretion in selecting a methodology to identify the median employee that works best based on their own facts and circumstances. A registrant may identify the median employee by analyzing its total employee population, by using a statistical sampling of that population or by any other reasonable method. Additionally, a registrant may identify the median employee using annual total compensation as determined under existing executive compensation rules, or any other compensation measure that is consistently applied to all employees included in the calculation, such as information derived from the registrant’s tax and/or payroll records.

In identifying the median employee, registrants are permitted to make cost-of-living adjustments to the compensation of employees in jurisdictions other than the CEO’s resident jurisdiction to adjust compensation to the cost-of-living in the CEO’s resident jurisdiction. If a registrant elects to do so, and the median employee is not employed in the CEO’s resident jurisdiction, the registrant must use the same cost-of-living adjustment in calculating the median employee’s annual total compensation, disclose the median employee’s jurisdiction and disclose the median employee’s annual total compensation and pay ratio without using the cost-of-living adjustment. The registrant must also briefly describe the cost-of-living adjustments used to identify the median employee and to calculate the median employee’s annual total compensation.

Registrants may use reasonable estimates both in the methodology used to identify the median employee and in calculating the annual total compensation (or any elements thereof) for employees other than the CEO.  However, registrants must disclose the methodology used to identify the median employee, and must briefly describe 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 thereof), which shall be consistently applied. Once the registrant’s median employee has been identified, the final rule requires that total compensation for the median employee (as with total compensation for the registrant’s CEO) be calculated using the requirements of Item 402(c)(2)(x) for purposes of generating the pay ratio.

Disclosure of Supplemental Information

Registrants may present additional information and ratios to supplement the required pay ratio, but any such additional information must be clearly identified, not misleading and not presented with greater prominence than the required ratio.

Disclosure for Multiple CEOs

In situations in which the registrant replaces its CEO with another CEO during its fiscal year, the registrant may either: (i) take the total compensation, as reflected in the Summary Compensation Table, provided to each person who served as CEO during the year and combine those amounts, or (ii) annualize the compensation of the CEO serving in such position on the date the registrant selects to identify the median employee.

Exempted Registrants

As with the proposed rule, emerging growth companies, smaller reporting companies, foreign private issuers, registered investment companies and registrants filing under the U.S.-Canadian Multijurisdictional Disclosure System are exempt from complying with the pay ratio disclosure requirements of the final rule. Emerging growth companies and smaller reporting companies must comply with the final rule for the first fiscal year beginning on or after the date they cease being an emerging growth company or smaller reporting company, as applicable, but not for any fiscal year prior to January 1, 2017.