The U.S. Securities and Exchange Commission "SEC", in a 3-2 vote, recently adopted final rules implementing “CEO pay ratio” disclosure requirements (the “Rules”). The Rules were proposed in 2013 and mandated by Congress pursuant to Section 953(b) of the Dodd-Frank Act, and require public companies to disclose how their principal executive officer’s pay compares to that of all company employees. Companies will be required to begin complying with the Rules during a company’s first full fiscal year beginning on or after January 1, 2017  (the 2018 proxy season for calendar fiscal year companies). The full text of the Rules is available here.

Before adopting the Rules, the SEC solicited comments on the proposed pay rules. Despite considerable negative feedback, the SEC - voting along party lines - adopted Rules that are consistent with its initial proposal, leaving largely intact many of the most debated and controversial issues.

The Rules require public companies to disclose:

  1. The median of the annual total compensation of all employees, other than the principal executive officer (“PEO”);
  2. The annual total compensation of the PEO (which is already required to be disclosed); and
  3. The ratio of these two amounts.

The Rules require the pay ratio to be disclosed either as a ratio (e.g., 50:1 or 50 to 1) or in narrative form in terms of the multiple (for example, “the CEO’s total compensation amount is 50 times that of the median of the annual total compensation of all employees”).

Disclosure must be included in all filings that requires executive compensation disclosure, including annual reports, proxy and information statements, and registration statements that otherwise require such disclosure.

TIMING

Pay ratio disclosure is required annually, but the median employee calculation must only be performed once every three years, unless there is a change in employee population or employee compensation arrangements that could significantly skew the pay ratio. A company may also choose any date within the last three months of their last completed fiscal year to determine their employee population for purposes of identifying the median employee.

EXCLUSIONS

In determining employee populations, companies may exclude certain non-U.S. employees in jurisdictions where foreign data privacy laws prevent including the employees. If non-U.S. employees make up 5 percent or less of a company’s workforce, they may also be excluded. 

If non-U.S. employees make up greater than 5 percent of a company’s worldwide employees, the company may exclude up to 5 percent of its total employees who are non-U.S. employees. If any employee is excluded in a jurisdiction, all must be excluded. However, in calculating the number of non-U.S. employees that may be excluded, a company must take into account any non-U.S. employees exempted under a foreign data privacy law. Therefore, if the number of employees excluded under the data privacy exemption equals or exceeds 5 percent of the company’s total employees, this de minimis exemption cannot be used.

Finally, companies may exclude employees that became employees as a result of a business transaction for the fiscal year in which the transaction occurred.

IDENTIFYING THE “MEDIAN EMPLOYEE”

The Rules offer companies some flexibility in identifying the “median employee” for purposes of establishing the pay ratio. A company may use a method that is appropriate considering the size and structure of its business, as well as the manner in which it compensates its employees.

Total annual compensation, or any other compensation measure consistently applied (such as information from tax or payroll records), may be used to identify the median employee. If a statistical sample of the entire employee population is used in identifying the median employee, it must be a reasonable representation of the company’s total employee population.

As part of its pay ratio disclosure, a company must describe its methodology for identifying its median employee and the median employee’s annual total compensation.

MORE THAN ONE PEO?

If a company has more than one non-concurrent PEO during a fiscal year, it may calculate the annual total compensation for its PEO by either (i) calculating and combining the compensation for each PEO during the fiscal year, or (ii) annualizing the PEO’s compensation on the date it selects to identify the median employee. The company must disclose what method it chose to use.

WHAT SHOULD COMPANIES DO?

There is more detail in the Rules that should be reviewed by affected companies, and companies should consult with experienced counsel to ensure compliance. Given the extent of the Rules, we expect that compliance will be cumbersome.

While the duty to disclose does not begin until 2017, it’s important that companies begin gathering data and establishing systems now, so that they are ready when the time comes to comply with the Rules.