On August 5, 2015, in a 3-2 vote, the Securities and Exchange Commission (“SEC”) adopted a long-awaited and contentious rule that requires most public companies to disclose the ratio of their CEO’s annual pay as compared with the median annual pay of its workers. This so-called “CEO pay ratio rule” was first passed by Congress in 2010 under section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and proposed by the SEC in September 2013.
Even after receiving more than 280,000 comments, concerns remain over the practicality and administrative burden imposed on companies by this final rule. This final rule, which amends Item 402 of Regulation S-K, requires a public company to disclose the median of the annual total compensation of its employees (excluding the CEO), the annual total compensation of its CEO, and the ratio of the median of the annual total compensation of all employees (excluding the CEO) to the annual total compensation of the CEO (the “Final Rule”).
Importantly, public companies must comply with the Final Rule for the first fiscal year beginning on or after January 1, 2017, which means, for most companies, reporting in the 2018 proxy statement (based on 2017 compensation data). However, the Final Rule does not apply to smaller reporting companies, foreign private issuers, Multijurisdictional Disclosure System (“MJDS”) filers, “emerging growth companies” under the Jumpstart Our Business Startups (“JOBS”) Act, or registered investment companies.
Pay Ratio Disclosure Requirements. As stated above, the Final Rule requires disclosure of (i) the median annual total compensation of all employees (other than the CEO), (ii) the annual total compensation of the CEO, and (iii) the ratio of the two amounts. The key terms of the Final Rule are set forth below:
Determination of Median Annual Total Compensation and Disclosure of Methodology. The Final Rule does not require a calculation of the annual total compensation of a company’s entire workforce under the Item 402 rules; instead, in response to concerns, the Final Rule requires a comparison of the compensation of a “median employee” with the compensation of the company’s CEO.
The Final Rule permits a company to identify its median employee 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 company reasonably believes would significantly affect its pay ratio disclosure, the company 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. For example, the company is required to identify the median employee and calculate that median employee’s annual total compensation in year one. In years two and three, however, the company may use that same median employee (or an employee whose compensation is substantially similar to the original median employee based on the compensation measure used to select that median employee) to re-calculate the annual total compensation for that employee without re-identifying the median employee as would otherwise be required under the final rule if it satisfies the above conditions.
The Final Rule does not specify any required calculation methodologies for identifying this median employee in terms of total compensation for all employees. Each company has the flexibility to select a reasonable methodology that is appropriate to the size and structure of its own businesses and compensation practices, such as through examination of payroll or tax records of its entire employee population, or through statistical sampling, and may use annual total compensation under Regulation S-K or another consistent measure. Companies are required to disclose their methodology for determining median annual total compensation of their employees, including any material assumptions, adjustments or estimates used to identify the median, or to determine total annual compensation.
Applicable Employees. For purposes of determining median annual total compensation, “all employees” of the company must be considered, including all U.S. and non-U.S. employees, as well as its part-time, seasonal, and temporary employees. The Final Rule allows a company to select a date within the last three months of its last completed fiscal year on which to determine the employee population for purposes of identifying the median employee. The company does not need to count individuals not employed on that date. Accordingly, companies may avoid fluctuations caused by seasonal employees hired at the end of a year.
The Final Rule provides an exemption to “all employees” for (i) employees in foreign jurisdictions in which it is not possible for a company to obtain or process information necessary to comply with the rule without violating the data privacy laws or regulations of that jurisdiction (the company must obtain a legal opinion to use this exemption); and (ii) a de minimis exemption for up to 5 percent of non-U.S. employees, including any non-U.S. employees excluded using the data privacy exemption. Also, if a company excludes any non-U.S. employee in a particular jurisdiction, it must exclude all non-U.S. employees in that jurisdiction.
Individuals employed by unaffiliated third parties or independent contractors are not considered employees of the company.
Disclosure of Pay Ratio. Once the median employee is identified, both the annual total compensation of such median employee and the total annual compensation of the CEO must be disclosed based on the Item 402 proxy disclosure rules used to calculate CEO pay. The ratio of median annual total compensation of all employees to the annual total compensation of the CEO must be disclosed either as a ratio (where the median employee compensation equals one) or narratively in terms of the multiple that CEO compensation bears to median employee compensation.
When calculating the required pay ratio, the Final Rule prohibits a company from making full-time equivalent adjustments for part-time workers, or annualizing adjustments for temporary and seasonal workers.