In a narrow 3-2 vote, and after years of criticism and complaints from both supporters and opponents, on August 5, 2015, the Securities and Exchange Commission (SEC) adopted a new final rule requiring most registrants to annually disclose the pay ratio between its principal executive officer's (PEO) total compensation and the median compensation of its employees.  Reporting companies must begin complying with the new rule for the first fiscal year beginning on or after January 1, 2017, meaning that for calendar year reporting companies, the new disclosure must appear in their 2018 proxy statement with respect to the 2017 reporting period.

Background

Section 953(b) of the Dodd-Frank Act of 2010 added Section 14(i) to the Securities Exchange Act of 1934 and directed the SEC to adopt rules requiring disclosure of the ratio of total compensation of the PEO to the median compensation of the company's employees. In its initial rule proposal, published in 2013, the SEC sought public comment on the various alternatives for determining the employee population, median employee and types of compensation to be included in determination of the ratio and sought public comment. The SEC received over 280,000 comments on the proposed rule.

As discussed in a prior advisory we issued May 2015, this rulemaking process has happened in parallel with rulemaking pursuant to Section 953(a) of Dodd-Frank, which requires that the SEC institute disclosure requirements linking executive compensation with total shareholder return. Rulemaking for those proposed rules, which would be new Item 402(v) of Regulation S-K, is ongoing. One notable difference between the two new disclosures is that the proposed Item 402(v) is intended to allow for comparability between registrants by prescribing consistency in the manner the disclosures are calculated. In contrast, the SEC acknowledged in the August 5th release of new Item 402(u) that because of the flexibility and discretion given to registrants in determining the pay ratio, it is unlikely that such pay ratios will be easily comparable between registrants.

Required Pay Ratio Disclosure

The new disclosure, included in a newly added paragraph "u" of Item 402 of Regulation S-K, is required in any filing that calls for executive compensation disclosure under Item 402, including proxy and registration statements. The new disclosure is not required for smaller reporting companies, emerging growth companies or foreign private issuers.

In general, Item 402(u) requires disclosure of (1) the median of the annual total compensation of all  employees, except the PEO, (2) the annual total compensation of the PEO, and (3) the ratio of those two amounts.

Determination of "Median Employee"

The final rule does not specify any required methodology for registrants to use in identifying the median employee. Instead, the final rule permits registrants the flexibility to choose a method to identify the median employee based on their own facts and circumstances, including reasonable estimates, information derived from tax or payroll records, or statistical sampling. In any event, the registrant must disclose the methodology used, and any estimates or assumptions made.

The definition of "employee" in the final rule, for purposes of determining the employee population from which to identify the median employee, includes some notable departures from the initial rule proposal, including:

  • inclusion of all of a registrant's US and non-US employees, full-time and part-time, with exceptions for compliance with foreign data privacy laws and where non-US employees account for 5% or less of the registrant's total employees (the de minimus exception);
  • inclusion of employees only of consolidated subsidiaries, as opposed to employees of all subsidiaries, as was suggested in the proposed rule;
  • allowance for cost-of-living adjustments where employees live in jurisdictions different from the PEO, provided that the registrant discloses the adjustments made, and separately discloses the pay ratio and related disclosures on a non-adjusted basis; and
  • inclusion of all full-time, part-time, seasonal and temporary employees, but exclusion of independent contractors and leased workers that are paid by a third party.

The date of determination of the pay ratio and the frequency with which the registrant must identify the median employee were also changed from those originally proposed. The original proposed rule suggested that the pay ratio be determined as of the last day of the registrant's fiscal year. However, to allow more flexibility, the final rule permits the determination date to be any date within three months prior to the last day of the registrant's fiscal year. The determination date used must be disclosed and, if a different date is used in subsequent years, the reason for the change must be explained.

In the proposed rule, determination of the median employee, as with the calculation of the pay ratio, was to be done on an annual basis. To lessen compliance costs, the final rule only requires determination of the median employee once every three years, unless there has been a change in employee population or employee compensation that the registrant reasonably believes would result in a significant change to the pay ratio. In any year that the registrant uses the same median employee as the prior year, without re-evaluation, the registrant must expressly disclose that it believes there have been no changes in the employee population or employee compensation that would significantly impact the pay ratio disclosure and require re-evaluation of the median employee. It is important to note that the SEC used the term "significantly impact," as opposed to "materially impact," as the threshold for determining whether the median employee should be re-evaluated. Given the uncertainty of this standard, many registrants may choose to determine the median employee on a more frequent basis.

Determination of Total Compensation

The registrant must determine total annual compensation for the median employee in the same manner it determines total annual compensation for the PEO for purposes of the Summary Compensation Table pursuant to Item 402(c)(2)(x) of Regulation S-K. Because the components of the median employee's compensation may differ from those of the PEO, the registrant is allowed to use reasonable estimates in determining the median employee's total annual compensation, as long as such estimates, and the bases for making them, are disclosed. For example, in determining the PEO's total annual compensation, the instructions to Item 402(c)(2)(ix) permit the exclusion of perquisites and personal benefits as long as the total value is less than $10,000. The SEC noted that registrants may use reasonable estimates for similar benefits received by the median employee and may annualize the total compensation for a permanent employee who did not work for the entire year, such as a new hire, but may not make full-time equivalent adjustments for part-time, temporary and seasonal workers.

The final rule also does not make allowance for the disparate impact of equity awards to the PEO, even if those equity awards are performance weighted.  In calculating total compensation, a registrant is required to use the aggregate grant date fair value calculated in accordance with FASB ASC Topic 718, as in the Summary Compensation Table.  This has the effect of front-loading the compensation to the initial year of the award and disregards how the registrant actually accounts for equity-based compensation in its financial statements.

Notably, although the registrant may identify the median employee once every three years, the total annual compensation for such median employee and the ratio of the median employees compensation to the PEO's total compensation must be calculated and disclosed on an annual basis.

If there is a change in the registrant's PEO in the middle of a fiscal year, the registrant has two alternatives when presenting the Item 402(u) disclosure for that year. First, the registrant can aggregate the total compensation, each as determined pursuant to Item 402(c)(2)(x), actually received by each of the former PEO and new PEO, and use such aggregate total compensation in calculating the pay ratio. Alternatively, the registrant can annualize the compensation of the new PEO. In the event a departing PEO receives severance payments, registrants may find that annualizing the new PEO's total compensation presents a more consistent representation in determining the pay ratio.

Additional Disclosure

The final rule provides that a registrant may supplement its pay ratio disclosure or provide additional pay ratios for its shareholders to consider. A registrant may want to take advantage of the opportunity to provide such disclosure where it feels that the ratio calculated and disclosed pursuant to Item 402(u) is not the best representation of the ratio of total compensation of its PEO to the median compensation of the company's employees. For example, if a registrant wants to explain the effect of including part-time, seasonal and temporary employees on its pay ratio disclosure, the option to include additional disclosure may be useful.

Conclusion

The final rule explains that, as with other Item 402 disclosures, Item 402(u) disclosure will be deemed filed, rather than furnished, meaning that the same level of liability attaches to the new pay ratio disclosures. Additionally, misclassification of independent contractors, as discussed in our recent advisory, may result in improper determination of the employee pool and median employee, and therefore incorrect disclosures under Item 402(u).

The SEC noted that effectiveness of the new Item 402(u) is later than in the originally proposed rule in order to ease compliance. Registrants should begin to consider now the methodology they will use to determine the median employee, so that they can begin to put procedures in place to be ready to make such determination, and the related Item 402(u) disclosures, upon the effective date of the rule. Planning for compliance early can help alleviate some of that cost. Registrants should consider tracking alternative calculation methods for 2015 compensation and reporting the information to the compensation committee in 2016, perhaps with the assistance of legal counsel and the committee's compensation consultant.