On August 5, 2015, the Securities and Exchange Commission (“SEC”) adopted rule amendments to implement Section 953(b) of the Dodd-Frank Act, requiring that public companies disclose the “pay ratio” between its CEO’s annual total compensation and the median annual total compensation of all other employees of the company. The new rule, located in Item 402(u) of Regulation S-K, is effective in the first full fiscal year commencing on or after January 1, 2017, and the initial pay ratio disclosure will be required in the company’s first annual meeting proxy statement following the conclusion of such year.

Below is a short guide that will assist companies in preparing for pay ratio disclosure.

Does pay ratio apply to my company?

Pay ratio applies to all companies required to provide summary compensation table disclosure pursuant to Item 402(c) of Regulation S-K. Smaller reporting companies, emerging growth companies, foreign private issuers, multijurisdictional disclosure system filers and registered investment companies are exempt.

What is the required disclosure?

Companies must disclose (1) the annual total compensation, but not the identity, of the employee whose compensation falls at the mathematical median of compensation for all employees of the company (except the CEO), (2) the annual total compensation of the CEO and (3) the ratio of (1) to (2) (the “pay ratio”). The total compensation may be calculated consistent with Item 402(c)(2)(x) of Regulation S-K or the company can use its own methodology provided the disclosure contains the material assumptions, estimates, adjustments and exclusions (including relating to cost-of-living, non-U.S. employees, business combinations and acquisitions) used in the identification of the median employee and the calculation of that employee’s annual total compensation.

How is the ratio presented?

The Ratio must be presented as either:

  1. a ratio in which the median compensation equals one; or
  2. a narrative in terms of the multiple that the CEO compensation bears to the median compensation.

For example, if the Median Compensation is $100 and the CEO compensation is $1,000, the ratio can be presented as: (1) 10 to 1, (2) 10:1 or (3) “The CEO compensation is ten times the median compensation.”

How do I determine who the median employee is?

The median employee may be identified:

  • using the company’s entire employee population or by means of statistical sampling and/or other reasonable methods;
  • once every three years, assuming no significant changes in either (a) the median employee’s circumstances or (b) the company’s compensation levels or employee composition;
  • using any date within the last three months of the last completed fiscal year;
  • using annual total compensation or any consistently applied compensation measure;
  • by making cost-of-living adjustments for employees in jurisdictions other than the jurisdiction in which the CEO resides.

In determining who the median employee is, companies must include all full-time, part-time, seasonal, temporary and non-U.S. employees of the company and its consolidated subsidiaries. Independent contractors and “leased” workers providing services to the company are excluded from the definition as long as they are employed by an unaffiliated third party and their compensation is determined by such party. Companies may exclude:

  • employees employed in a foreign jurisdiction in which the laws or regulations governing data privacy are such that, despite reasonable efforts to obtain or process the necessary information, the company is unable to do so without violating such data privacy laws or regulations
  • a de minimis number of non-U.S. employees (up to five percent of the company’s global workforce, including any employees excluded under the foreign data privacy law exemption)

What reports require the pay ratio disclosure?

Companies must include disclosure in any annual report on Form 10-K, proxy or information statement or registration statement that requires executive compensation disclosure pursuant to Item 402 of Regulation S-K.

What pay ratio disclosure is required if my company files a registration statement before filing its proxy?

A company does not need to update its pay ratio disclosure until it files its annual report on Form 10-K or, if later, its proxy statement or information statement for its next annual meeting of shareholders.

How does my company comply with the rule if it transitions from being a smaller reporting company or an emerging growth company after January 1, 2017?

Companies that cease to be smaller reporting companies or emerging growth companies are not required to provide the pay ratio disclosure until they file a report for the first fiscal year after they cease to be a smaller reporting company or emerging growth company.

How does my company comply with the rule if it acquires new employees through a business combination during any part of the fiscal year?

The rule permits companies that engage in a business combination or acquisition to omit the employees of a newly-acquired entity from their pay ratio calculation for the first fiscal year in which their business combination or acquisition occurs.

Should my company begin providing pay ratio disclosures before the first reporting period in which such disclosures are required?

You may if you choose to do so. A number of companies began voluntarily providing pay ration disclosures in their 2016 proxy statements. By going through the disclosure process before the pay ratio reporting period begins, companies are able to address a number of key issues that require management consideration well in advance of the reporting period. Additionally, companies that voluntarily report ahead of the reporting period get the benefit of SEC Staff review of their pay ratio disclosures before the disclosures are mandated. At the very least, companies should start thinking about issues that will go into developing the pay ratio disclosures. First, what method will the company adopt in determining the median employee? Second, how will annual compensation be determined? If the company will not follow Item 402 of Regulation S-K in determining annual compensation, what methodology will the company use and what material assumptions, estimates, or adjustments are required? What accompanying disclosures are needed in the pay ratio disclosure to provide the appropriate context needed to make the disclosure helpful to investors? We believe it is prudent for all companies to begin implementing and testing their procedures to support these disclosures now, if they have not already done so, regardless of whether the company plans to elect early compliance. This will allow any unforeseen difficulties that arise in the company’s implementation process to be addressed in a deliberate manner, without the pressure of looming disclosure deadlines.