Earlier this month, the SEC adopted amendments to Item 402 of Regulation S-K in accordance with Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This rule comes more than five full years after Dodd-Frank became law.
What companies and filings are affected? The rule applies to all registrants subject to the requirements of Section 13(a) or 15(d) of the Exchange Act, except for foreign private issuers, smaller reporting companies, and emerging growth companies in any filings (including registration statements (other than in an initial public offering), proxy and information statements, and annual reports) that require executive compensation disclosure pursuant to Item 402 of Regulation S-K (“Covered Registrants”).
When does the rule take effect? The rule becomes effective 60 days after publication in the Federal Register, but compliance with the rule is not required until the later of (i) the first fiscal year following the year in which the Covered Registrant became subject to the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and (ii) the Covered Registrant's first fiscal year commencing on or after January 1, 2017. Generally, a Covered Registrant will first include pay ratio disclosure in its proxy or information statement for its 2018 annual meeting (or its annual report for its 2017 fiscal year if it does not file a proxy statement).
What does the rule require? The rule requires disclosure of the compensation paid to the employee whose compensation represents the median compensation paid to all employees (except the company’s Principal Executive Officer) of the Covered Registrant as determined in accordance with the rule, the total compensation of the Covered Registrant’s Principal Executive Officer, and the ratio of the two.
- Identifying the Median Employee. A Covered Registrant must identify its median employee only once every three years, provided that there has been no change in its last completed fiscal year with respect to its employee population or compensation arrangements that it reasonably believes would result in a significant change to its pay ratio disclosure. If such a change has occurred, the Covered Registrant must re-identify its median employee for such fiscal year. In identifying its median employee, a Covered Tegistrant must choose a date of determination that falls within the last three months of its last completed fiscal year and, subject to certain permitted exceptions, must take into account all individuals employed by the Covered Registrant or any of its consolidated subsidiaries as of such determination date, whether as full-time, part-time, seasonal, or temporary workers. Certain employees located in jurisdictions outside the United States may be excluded from the determination of the median employee. The rule also provides, subject to applicable thresholds, de minimis exemptions with respect to the inclusion of employees in the calculation of median compensation and the exclusion of any employees added to the workforce through business combinations or acquisitions of businesses for the fiscal year in which the transaction becomes effective. Further, a Covered Registrant may use reasonable estimates and methods, including cost-of-living adjustments and statistical sampling, in identifying its median employee.
- Calculating Annual Total Compensation. Though a Covered Registrant may only be required to identify its median employee once every three years, it must calculate total compensation for the median employee annually. The final rule permits Covered Registrants to use reasonable estimates and methodologies, including cost-of-living adjustments and statistical sampling, in calculating the annual total compensation or any elements of total compensation for employees other than the CEO. Further, Covered Registrants may annualize the total compensation for all permanent employees, whether full-time or part-time, that were employed for less than the full fiscal year, but may not annualize the total compensation for employees in temporary or seasonal positions or make a full-time equivalent adjustment for any employee.
- Additional Disclosure. In addition to the measures described above, a Covered Registrant must disclose the date selected for identifying its median employee, the estimates and methodologies used in identifying its median employee and calculating annual total compensation, including any exclusions of employees, cost-of-living adjustments, and other material adjustments, assumptions, estimates or exclusions, and any changes to such date, estimates and methodologies from the prior year’s disclosure. Covered Registrants may present additional information to supplement the required pay ratio disclosure, provided that any additional information is clearly identified, not misleading, and not presented more prominently than the required pay ratio disclosure.
What, if anything, is interesting about the adoption of the rule? This rule took five years to pass in large part of the controversy surrounding the disclosure that the rule would require. The SEC release contains a summary of Section 953(b), and the depth into which it delves into legislative history of Dodd-Frank and the existing regulatory regime around disclosure of executive compensation, is an interesting window into how the SEC is operating under the requirements of Dodd-Frank. Opponents of the rule cited studies showing that shareholders were not interested in pay ratio disclosure. The SEC’s response is that the required disclosure supplements pay-for-performance disclosure and may be useful to investors in deciding how to vote on required say-on-pay advisory votes.
What do I need to do now? If your company is subject to periodic reporting requirements under Section 13(a) or 15(d) of the Exchange Act, your company is not an emerging growth company, a smaller reporting company, or a foreign private issuer, and you are either involved with your company’s SEC reporting function or serve on the compensation committee, you may want to review your company’s internal process for generating the data required to make the disclosures under the rule. Fortunately, if your company does not have sufficient infrastructure in place, your company will have some time to develop it.