• New Disclosures Not Required Until 2018 Proxy Season
  • Issuers May Use Estimates and Statistical Sampling

Summary

On August 5, 2015, in a 3-2 vote, the SEC adopted the rule implementing the controversial pay ratio requirement pursuant to Section 953(b) of the Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). The adopting release, which includes the final rule, is available here.

The rule requires companies to disclose:

  • the median of the annual total compensation of all employees, excluding the principal executive officer, or CEO;
  • the annual total compensation of the CEO (which is already required to be disclosed); and
  • the ratio of these two amounts.

Total compensation continues to be defined in the same way as it is for executive officers pursuant to Item 402 of Reg. S-K even though companies do not collect such information for all employees.

The SEC stated its belief that Congress’ reason for mandating the ratio is to "provide a company-specific metric that is relevant and useful to [shareholders’] say-on-pay voting," but acknowledged the absence of any clear statutory purpose.

Many commenters objected to the rule arguing that it provides no economic benefit to investors and would be difficult and costly to calculate. In their dissents, two of the Commissioners noted the substantial costs of the rule, estimated by the SEC as $1.3 billion in initial compliance costs and $526 million in ongoing annual costs, and the absence of any clear statement of purpose or benefits in Dodd-Frank or the SEC adopting release. One Commissioner observed that excluding non-U.S. and non-full time employees would have resulted in savings of $788 million, and criticized the SEC’s failure to analyze whether its decision to include all worldwide employees resulted in corresponding benefits.

The new rule applies to companies required to provide executive compensation disclosure under Item 402(c)(2)(x) of Regulation S-K in proxy statements or annual reports on Form 10-K, as well as registration statements or other filings. Smaller reporting companies, foreign private issuers, MJDS filers, emerging growth companies, and registered investment companies are excluded.

Compliance Date; Transition Periods

Companies are required to report the pay ratio disclosure for their first fiscal year beginning on or after January 1, 2017.

Acquired Businesses. A company would be permitted to omit from its calculation any employees obtained in a business combination or acquisition for the fiscal year in which the transaction becomes effective. The company would be required to identify the acquired business and disclose the approximate number of employees it is omitting.

New Registrants. The first pay ratio disclosure must follow a new registrant’s first full fiscal year beginning after the company (i) has been subject to the reporting requirements of the Securities Exchange Act of 1934 for at least twelve calendar months beginning on or after January 1, 2017 and (ii) has filed at least one annual report under the Exchange Act that does not contain the pay ratio disclosures.

Former Smaller Reporting or Emerging Growth Company. A company that ceases to be a smaller reporting company or an emerging growth company will not be required to provide pay ratio disclosure until after the first full fiscal year after exiting such status and not for any fiscal year commencing before January 1, 2017.

Discussion

The SEC amended Item 402 of Reg. S-K by adding new Rule 402(u). Under the rule, as part of the pay ratio disclosure, companies must first:

  • identify the median employee and
  • calculate that employee's annual total compensation.

The rule allows use of the total employee population or a statistical sampling of that population or other reasonable methods. For example, a company could identify the median of its population or sample using: (1) annual total compensation as determined under existing SEC rules or (2) any consistently-applied compensation measure from compensation amounts reported in its payroll or tax records.

Median Employee

"Employee" Defined

The term "employee" refers to all employees employed as of the last day of the last completed fiscal year and includes full-time, part-time, seasonal and temporary workers, as well as any foreign employees, employed by the company or its consolidated subsidiaries. Directors, independent contractors, "leased employees" and workers employed by, and whose compensation is determined by, a third-party are not covered.

Identifying the Median Employee

The rule does not prescribe a specific methodology for identifying the median employee. Companies may use:

  • their full employee population, or
  • a statistical sampling, or
  • another reasonable method.

When using a statistical method, companies may compute annual total compensation for each employee included in the calculation (with the entire population or statistical sample) to identify the median employee. Alternatively, companies may identify the median employee based on any consistently applied compensation measure (which could include amounts reported in payroll or tax records or other information already tracked and compiled for such purposes) and then calculate annual total compensation for that employee. Companies must disclose the compensation measure used. A company using this method may use the same annual period utilized by these records even if the records are kept on a basis other than its fiscal year.

With respect to the methodology, the SEC indicated that:

  • companies may select a methodology that uses reasonable estimates as a way to mitigate costs, both in identifying the median employee and in calculating total compensation or any elements thereof.
  • companies with multiple business lines or geographical units may utilize more than one statistical sampling approach.
  • companies may not need to determine exact compensation amounts for every employee in a random sample, since identifying the median may not require calculating amounts for those with extremely low or high pay.

Annual Total Compensation

The rule defines annual total compensation in accordance with existing SEC rules (Item 402(c)(2)(x) of Reg. S-K) with respect to the last completed fiscal year. However, companies will have some flexibility in calculating total annual compensation of employees. The rule allows reasonable estimates when:

  • calculating the annual total compensation, or
  • any element of total compensation.

Companies must clearly identify any estimates used, and have a reasonable basis for believing that they approximate actual amounts.

Annualization and Full-Time Equivalent Adjustments Companies

will be permitted to annualize compensation for all permanent full-time or part-time employees (e.g. newly hired employees or unpaid leave of absence) on the last day of the fiscal year. However, annualizing is not permitted for seasonal or temporary workers. The final rule prohibits full-time equivalent adjustments under all circumstances, as the SEC determined such adjustments would distort an issuer’s workforce composition and compensation structure.

Compensation Elements

The rule provides that, for non-salaried employees, "salary" under Reg. S-K means "wages plus overtime" as applicable.

The SEC indicated that companies may use reasonable estimates, as described above, in determining the change in actuarial value of defined benefit obligations, where information may not be available when needed, such as in the case of multi-employer plans.

The SEC noted that, when calculating annual total compensation for the median employee, companies may, if they choose, include personal benefits or perquisites (even if less than $10,000) or compensation under 401(k), health or other non-discriminatory plans - even though such amounts are typically excluded in summary compensation tables. However, for consistency, those compensation elements would need to be included for the CEO's total compensation for purposes of the pay ratio computation, and companies would need to explain any differences from the summary compensation table, if material.

By contrast, the SEC believes that any accrued benefit under a government-mandated pension plan would not be considered compensation, because it is provided by the government and not the employer.

Optional Elections

The final rule provides several elections that companies may make that the SEC intended to provide some flexibility. In each case, additional disclosure would be required and, in one case, a legal opinion.

Cost of Living

Adjustment Companies may make cost-of-living adjustments for the compensation of employees in jurisdictions other than the jurisdiction in which the CEO resides to identify the median and calculate annual total compensation. In that case, the company must apply the adjustment to all employees included in the calculation and use the same adjustment in calculating the median employee’s annual total compensation. Additionally, the company must (i) disclose the country in which the median employee is located, (ii) describe the adjustments and measure used and (iii) to provide context, disclose the median employee’s annual total compensation and pay ratio without the cost-of-living adjustments. In turn, this would require the company to identify the median employee without using any cost-of-living adjustments.

The SEC recognized that companies with sizeable work forces in lower cost countries may be likely to choose to adjust their compensation figures, while companies in higher cost countries may not, but believes the related disclosure requirements address any concerns about the "level of subjectivity" created by the ability to so choose.

Calculation Date for Median Employee

Companies may choose any date during the last three months of its fiscal year to determine the median employee and must disclose that date. If it changes the date used in a subsequent year, the company must disclose the change and briefly explain the reason. The SEC acknowledged that this flexibility may allow companies that employ temporary or seasonal employees only during a limited window at the end of their fiscal year (e.g., retailers) the ability to exclude those employees from the calculation.

Triennial Identification of Median

Employee Companies can choose to use the same median employee for three years unless there has been a change in the employee population or employee compensation arrangements that the company reasonably believes would result in a significant change in the pay ratio disclosure. However, the company must still calculate the individual’s annual total compensation and use that figure in calculating the pay ratio every year. Additionally, the company must disclose that it is using the same individual and briefly describe the basis for its belief that there have been no such changes. As an example, the rule provides that the company could disclose that there has been no change in its employee population or employee compensation arrangements that it believes would significantly impact the pay ratio disclosure.

Following a business combination or acquisition, consistent with the one year transition, the first time the company would need to evaluate whether the business combination would result in a substantial change to its pay ratio disclosure that would require re-identifying the median employee is in the fiscal year following the transaction.

Replacement of Median Employee

During the three year period described above, companies can replace the median employee if circumstances change, such as in his or her position or employment. In that case, the company can use another employee whose compensation is substantially similar to the original median employee based on their relative compensation in year one. If no others have similar compensation, then the company must re-identify the median employee.

Exclusion of Non-U.S. Employees Due to Foreign Privacy Laws

Companies may exclude from the calculation to determine the median employee those non-U.S. employees when foreign data privacy laws are such that, despite its reasonable efforts to obtain or process the needed information, the company cannot do so without violating such laws. When excluding such employees, the company must (i) exclude all employees in that jurisdiction, (ii) list the excluded jurisdictions, (iii) identify the specific law or regulation, (iv) explain how compliance would have violated such law, including the efforts made to use or seek an exemption or other relief, and (v) provide the approximate number of employees excluded. In addition, the company must file a legal opinion addressing the inability to comply with pay ratio rule without violating such law. The opinion must be filed as an exhibit with the filing in which the pay ratio disclosure is included.

De Minimis Exemption

If non-U.S. employees represent 5% or less of total employees, the company may exclude all of those employees from its calculation. If any are excluded, then all must be excluded. If non-U.S. employees exceed 5% of total employees, the company may exclude up to 5%. If any are excluded in a particular jurisdiction, then all employees in that jurisdiction must be excluded.

The company must disclose (i) the jurisdictions, (ii) the approximate number of employees excluded from each, (iii) the total number of employees without regard to any exemptions, and (iv) the total number of employees used for thede minimis calculation.

In calculating the 5% measure, companies must include any non-U.S. employees excluded under the data privacy exemption. If the number of employees excluded under such exemption exceeds 5%, the de minimisexemption will not be available. If such number is less than 5%, then the balance available under de minimis exemption will be reduced by such amount.

Additional Considerations

Disclosure of Methodology and Assumptions Companies

must briefly describe their methodology and any material assumptions, adjustments or estimates used to identify the median or determine total compensation or any elements of total compensation. For example, if a company identifies a median employee based on a consistently applied compensation measure, it must disclose the measured used. To promote comparability, if assumptions or methodologies are changed in the next year and the effects are significant, companies should briefly describe the change and the reasons for the change. According to the SEC, the purpose of these disclosures is to allow readers to evaluate the appropriateness of the methodologies used.

"Filed" Status

Like other executive compensation information, pay ratio disclosures will be considered "filed" for purposes of federal securities laws and subject to their liability provisions.

Change in CEO

If the CEO changed during the last fiscal year, companies have two options in calculating the annual total compensation. First, the company may use the combined total compensation reflected in the summary compensation table for both CEOs. Alternatively, the company could use the annualized compensation of the CEO in office on the date used to identify the median employee.

Unavailability of CEO Compensation Data

If a company omits CEO salary or bonus because not then calculable in reliance on an existing instruction to S-K Item 402, it may omit the pay ratio too, disclosing that fact and the date expected to be determined. As with salary and bonus, the company must subsequently disclose that omitted information on Form 8-K pursuant to Item 5.02(f) when calculable.

Supplemental Disclosure

Companies are permitted to supplement the required disclosure with a narrative discussion if desired. The SEC believes the rule is not designed to facilitate comparisons among different companies, but recognizes that companies may wish to present additional ratios to address any unwarranted conclusions drawn from such comparisons. Any additional ratios must be clearly identified, not misleading and not presented with greater prominence than the required ratio.

No PII of Median Employee

The rule proscribes the disclosure of any personally identifiable information about the median employee other than his or her compensation. It permits general identification of the employee’s position to put his or compensation in context, but not if that would result in the identification of the specific individual.