On August 5, 2015, the SEC approved a rule to implement the Dodd-Frank Act mandate that public companies disclose the ratio of median pay of all employees to a CEO’s total compensation. While the final rule offers some important flexibility for companies required to comply, it remains controversial as a burdensome requirement that fails to balance compliance costs with potential benefits.

Companies subject to the rule must report the pay ratio for fiscal years beginning on or after January 1, 2017. Thus, the first pay ratio disclosure for calendar-year companies will be made in the 2018 proxy season. Smaller reporting companies, emerging growth companies and foreign private issuers are exempt from the requirement.

Read the SEC press release.

NEW DISCLOSURE REQUIREMENT

The proposed rule amends Item 402 of Regulation S-K to require that U.S. public companies disclose:

  • the median of the annual total compensation of all employees of the company, excluding the principal executive officer (typically the CEO);
  • the annual total compensation of the company’s principal executive officer; and
  • the ratio comparing these two amounts; this ratio may be expressed either numerically (e.g., 50 to 1 or 50:1) or narratively (e.g., 50 times the annual compensation of the median employee).

FINAL RULE CHANGES FROM PROPOSAL

While the final rule is substantially the same as previously proposed, the following changes were made to reduce the burden on reporting companies:

  • Companies are permitted to determine the median employee only once every three years (absent changes reasonably believed to be significant).
  • Companies can specify any date within the last three months of their fiscal year for determining the median employee.
  • Subject to limitations, companies may exclude (1) non-U.S. employees who are employed in jurisdictions where compliance with the rule would violate that jurisdiction’s data privacy laws and (2) up to five percent of total employees that are non-U.S. employees.

DETERMINING MEDIAN PAY

The rule allows companies to select their own method for identifying the median employee for purposes of the pay ratio disclosure. In determining the employees from whom the median is identified, a company may use its total employee population, a statistical sampling or another reasonable method.

A company would be permitted to choose a methodology that is appropriate to its unique facts and circumstances. For example, a company with a large number of employees could take a sample of employees (of a size consistent with the overall distribution of pay across employees) and determine the median employee on the basis of annual cash compensation, compensation reported for tax or payroll purposes or another consistently applied compensation measure.

Once the median employee is identified on this basis, the company must then calculate that employee’s annual total compensation each fiscal year in accordance with S-K Item 402(c)(2)(x) and disclose that amount as part of the pay ratio disclosure.

A company must only determine its median employee every three years unless there has been a change in its employee population or employee compensation that the company reasonably believes would result in a significant change to its pay ratio disclosure. If the median employee remains the same for more than one year, the company must disclose the basis for its reasonable belief and calculate the median employee’s annual total compensation in accordance with S-K Item 402(c)(2)(x) for the pay ratio calculation each year.

EMPLOYEES COVERED

Under the rule, the employee population for purposes of determining the median employee includes all full-time, part-time, temporary, seasonal, U.S. and non-U.S. employees employed by the company and any of its consolidated subsidiaries. This employee population must be determined as of a specified date within three months of the end of the company’s last-completed fiscal year.  

A company may omit the employees of a newly acquired entity from their pay ratio calculation for the fiscal year in which the acquisition becomes effective, but must disclose the approximate number of employees omitted under this provision. Companies must include the acquired employees in their median employee calculation for the first full fiscal year following the acquisition.

FOREIGN EMPLOYEE EXCLUSIONS

A company may exclude non-U.S. employees that are employed in a jurisdiction with data privacy laws that would be violated by compliance with the pay ratio disclosure rule. However, the company must identify any such jurisdictions and laws and obtain and file a legal opinion. An aggregate of up to five percent of total employees who are non-U.S. employees may be excluded under a de minimis exception, provided that all non-U.S. employees in particular jurisdiction must be excluded if any are excluded and any employees excluded due to data privacy laws count against the five percent total.

DISCLOSURE OF METHODOLOGY USED

Companies must describe the methodology used for making all determinations, including material assumptions, adjustments, estimates and any changes in methodology from one year to the next. However, as provided in the instructions, “This disclosure should be a brief overview; it is not necessary to provide technical analyses or formulas.”

ADDITIONAL DISCLOSURE PERMITTED

Companies may present additional ratios or other supplemental information, provided that the supplemental information is not misleading or presented with greater prominence than the required disclosure.

COVERED FILINGS AND ISSUERS

Pay ratio disclosure is required in all Form 10-Ks, registration statements and proxy statements that call for Item 402 disclosure of executive compensation. Smaller reporting companies, emerging growth companies and foreign private issuers are not subject to the disclosure requirement and are provided a one-year transition period after losing exempt status to comply.