Five years after the adoption of the Dodd-Frank Act, two years after the proposed rule, and despite periodic rumors that it might never occur, on August 5, 2015, the Securities and Exchange Commission (the “SEC”) adopted the “pay ratio” disclosure rules which require SEC reporting companies to calculate and disclose the annual total compensation of the company’s chief executive officer, the median of the annual total compensation of the company’s worldwide employee population (excluding the chief executive officer) and the ratio of the median total compensation of the employee group to the annual total compensation of the company’s chief executive officer.
Timing and Application of the New Disclosure: The new disclosure requirements (the “Final Pay Ratio Rules”) have been adopted largely as proposed in September 2013, with certain changes that mainly are intended to help companies manage the cost of compliance. Disclosure of the pay ratio information will be required in companies’ executive compensation disclosures in Form 10-K annual reports, registration statements and proxy or information statements. The Final Pay Ratio Rules become effective for a company’s first fiscal year beginning on or after January 1, 2017, with the required disclosures (for calendar year companies) appearing in the Form 10-K or proxy statement filed in 2018. Smaller reporting companies, foreign private issuers, emerging growth companies and registered investment companies are not required to comply with the Final Pay Ratio Rules, though business development companies will be subject to them.
Disclosure Requirements: Generally, the Final Pay Ratio Rules require the disclosure of (1) the chief executive officer’s annual total compensation, (2) the median of the annual total compensation of all employees of the company (excluding the chief executive officer) and (3) the ratio of the two. Certain explanatory information must also be included, which will vary from company to company depending on the methodology used to make the required calculations. Companies may choose to also provide additional information and context around the pay ratio results, including calculating additional ratios, as long as the additional information does not confuse the reader or otherwise overshadow the required information.
Establishing the Employee Pool: A company must determine the median annual total compensation of all its employees (excluding the chief executive officer) based on its world-wide employee population, taking into account full-time, part-time, seasonal and temporary employees of the company and any consolidated subsidiaries. In a departure from the proposed rules, the population must be measured for purposes of determining the median employee as of any date within the last three months of a company’s fiscal year, as opposed to a mandated measurement date of the last day of the company’s fiscal year. As part of the Final Pay Ratio Rules, two exemptions from the includable employee population base were adopted. Under these exemptions, a company may exclude from the employee pool (a) non-U.S. employees where those employees account for 5% or less of the company’s total world-wide employee base; and (b) non-U.S. employees where applicable data privacy laws would prohibit a company from accessing and utilizing the relevant compensation information. Use of either exemption triggers additional requirements to disclose, among other items, that the company is taking advantage of the exemption, how many employees have been excluded and the rationale for applying the exemption. In addition, in the case of the data privacy exemption, a legal opinion stating that the information could not be obtained or processed under the relevant laws must be included as an exhibit to the filing in which the pay ratio information is disclosed. If a company engaged in an acquisition or business combination during the year, employees of the acquired business do not need to be considered in the acquirer’s employee population until the fiscal year following the year of the transaction; however, consistent with the other employee- population exemptions, the acquirer’s disclosure, for the year of the transaction, must provide information about the fact that the acquired business employees are excluded and the approximate number of those employees.
Identification of Median Employee: As was the case under the proposed rules, companies are provided flexibility under the Final Pay Ratio Rules in how to calculate compensation for the purpose of identifying the median employee. Companies may use an analysis of a consistently applied measure of compensation for all of the relevant employees (such as tax or payroll records), a statistical sampling of such employees, or another reasonable method. The calculations may take into account reasonable assumptions and, for non-U.S. employees in countries other than where the chief executive officer resides, cost-of-living adjustments. Whatever method and assumptions are used must be briefly described as part of the disclosure.
Pay Ratio Calculation Requirements: Once the median employee is identified, his or her total compensation must be determined, generally in accordance with the rules that apply to the company’s named executive officers for purposes of the summary compensation table. For the median employee, the company may use reasonable estimates in calculating any of the required elements of total compensation as long as those estimates are clearly identified in the disclosure. It is that total compensation number that is used for purposes of calculating the pay ratio. Importantly, in a change from the proposed rules, the Final Pay Ratio Rules require companies to determine the median employee only once every three years, unless there are changes to the employee population or compensation structure that the company reasonably believes would result in a significant change to the ratio calculations and disclosure. However, even if a new median employee determination is not made for a particular year, the total compensation amount for the relevant median employee must be calculated each year in order to refresh the pay ratio figures.
Year to Plan for Compliance: While the SEC purports to have provided companies with enough flexibility in the Final Pay Ratio Rules to allow each company to consider its own unique circumstances and develop a system of compliance that is both functional and cost-effective, it has also recognized, by not requiring compliance until the first fiscal year that begins on or after January 1, 2017, that companies will face significant challenges in developing, testing and implementing that system. In the meantime, companies should consider how best to indentify their median employees given their structures and circumstances, which of the employee pool exemptions introduced in the Final Pay Ratio Rules may be helpful, and what systems are, or are not, in place that will be needed for ongoing compliance with the pay ratio disclosure requirements.