The SEC has adopted rules requiring all US publicly reporting companies to disclose the ratio of the annual total compensation of the company’s chief executive officer to the median of the annual total compensation of all other employees of the company.
The SEC has adopted rules requiring all US publicly reporting companies to disclose the ratio of the annual total compensation of the company’s chief executive officer to the median of the annual total compensation of all other employees of the company. The disclosure is required in any annual report, proxy statement, information statement or registration statement that otherwise is required to include other executive compensation information. The requirement does not apply to emerging growth companies, foreign private issuers, smaller reporting companies, MJDS filers and registered investment companies. Companies must comply with the new requirement for the first fiscal year beginning on or after January 1, 2017, meaning that the pay ratio disclosures will likely first be required in calendar-year companies’ annual reports or proxy statements filed in 2018.
Overview of the pay ratio disclosure requirements
The general requirement calls for disclosure of (A) the median of the annual total compensation of all employees (other than the CEO), (B) the annual total compensation of the CEO, and (C) the ratio of the amount in (B) to the amount in (A). The information can be presented as a ratio or expressed narratively in terms of a multiple. The total compensation of the CEO and median employee is calculated in accordance with Item 402(c)(2)(x) of Regulation S-K, which generally includes salary (or wages plus overtime), bonus, stock awards, option awards, non-equity incentive plan compensation, changes in pension value and nonqualified deferred compensation earnings, and all other compensation.
The disclosure is required in any filing that calls for executive compensation disclosure generally, including annual reports on Form 10-K, registration statements under the Securities Act of 1933 and the Securities Exchange Act of 1934, and proxy and information statements. Companies do not need to update their pay ratio disclosure for their most recently completed fiscal year until they file their annual report on Form 10-K or, if later, their proxy or information statement for their next annual meeting of shareholders but, in any event, not later than 120 days after the end of such fiscal year.
Companies may present additional information, including additional ratios, to supplement the required ratio, but are not required to do so. Any such additional information must be clearly identified, not misleading, and not presented with greater prominence than the required ratio.
The employees covered include all employees, whether or not located in the United States (subject to two exceptions described below), employed by the company or any of its consolidated subsidiaries whether as full time, part-time, seasonal or temporary workers. Officers other than the CEO are included.1 Employees of non-consolidated subsidiaries are excluded (companies typically consolidate subsidiaries where they own over 50 percent of the outstanding voting shares). The employees used to identify the median employee for a fiscal year must be chosen as of any date within the last three months of such year.
The SEC requires part-time, seasonal and temporary workers to be counted as employees, notwithstanding comments that their inclusion would make the ratio misleading. However, the SEC stated in the adopting release that a company can supplement its pay ratio disclosure or provide additional pay ratios for its shareholders to consider if it wants to explain the effect of including part-time, seasonal and temporary employees on its pay ratio disclosure. Similarly, with respect to the exclusion of “leased” employees, companies can discuss their reliance on “leased” workers in their narrative disclosure, and may provide additional ratios that factor in these workers.
Excluding non-US employees
Employees located in a jurisdiction outside the United States can be excluded from the calculation in two circumstances.
First, non-US employees can be omitted if they are employed in a foreign jurisdiction in which the laws or regulations governing data privacy are such that, despite the company’s reasonable efforts to obtain or process the information necessary, the company is unable to do so without violating such data privacy laws or regulations. The reasonable efforts must include, at a minimum, using or seeking an exemption or other relief under any governing data privacy laws or regulations.
If a company uses this exemption, it must list the excluded jurisdictions, identify the specific data privacy law or regulation, explain how complying with the disclosure requirement would violate the data privacy law or regulation, and provide the approximate number of employees exempt from each jurisdiction. If a company excludes any employees in a jurisdiction, it must exclude all employees in such jurisdiction. The company also must obtain a legal opinion that opines on the inability of the company to obtain or process the information necessary for compliance without violating the jurisdiction’s laws or regulations governing data privacy, including the company’s inability to obtain an exemption or other relief. The opinion must be filed as an exhibit to the filing in which the pay ratio disclosure is included.
Second, non-US employees can be omitted if they account for 5 percent or less of the company’s total employees. If the company excludes any non-US employees based on this provision, it must exclude all non-US employees. In addition, if non-US employees exceed 5 percent of the company’s total employees, the company can exclude up to 5 percent of its employees who are not US employees, so long as, if the company excludes any non-US employees in a particular jurisdiction, it must exclude all non-US employees in that jurisdiction. If more than 5 percent of a company’s employees are located in any one non-US jurisdiction, the company may not exclude any employees in that jurisdiction.
In calculating the number of non-US employees that may be excluded under this de minimis exemption, a company must count against the total any non-US employee exempted under the data privacy law exemption. A company can exclude any non-US employee from a jurisdiction that meets the data privacy exemption, even if the number of excluded employees exceeds 5 percent of the total employees. However, if the number of employees excluded using the data privacy exemption equals or exceeds 5 percent of the company’s total employees, the company may not use the de minimis exemption. Also, if the number of employees excluded under the data privacy exemption is less than 5 percent of the total employees, the company can use the de minimis exemption to exclude no more than the number of non-US employees that, combined with the number of employees excluded under the data privacy exemption, does not exceed 5 percent of the company’s total employees.
If a company excludes non-US employees under the de minimis exemption, it must disclose the jurisdiction or jurisdictions from which those employees are being excluded, the approximate number of employees excluded from each jurisdiction, the total number of US and non-US employees (before any exclusion), and the total number of employees used for the de minimis calculation.
Choosing a date within the last three months of the fiscal year
A company must determine its employees on any date within the last three months of its last completed fiscal year. This is a change from the proposed rule, which would have required the calculation to be made on the last day of the company’s fiscal year (which is the date used for selecting the named executive officers included in the summary compensation table). The company must disclose the date used, and if the company changes the date from the prior year, the company must disclose this change and provide a brief explanation about the reason for the change.
Identifying the median employee: once every three years
A company must identify its median employee whose compensation will be used for the annual total compensation calculation only once every three years and calculate total compensation for that employee each year, provided that during the last completed fiscal year there was no change in its employee population or employee compensation arrangements that it reasonably believes would result in a significant change to its pay ratio disclosure. If there is no such change, the company must disclose that it is using the same median employee in its pay ratio calculation and describe briefly the basis for this reasonable belief. If the company is using the same median employee, it must calculate that median employee’s annual total compensation each year and use that figure to update its pay ratio disclosure each year. The proposed rule would have required the median employee to be chosen every year, rather than once every three years.
If there has been a change in the company’s employee population or employee compensation arrangements that the company reasonably believes would result in a significant change in its pay ratio disclosure, the company must re-identify the median employee for that fiscal year. If it is no longer appropriate to use the median employee identified in year one as the median employee in years two or three because of a change in the original median employee’s circumstances that the company reasonably believes would result in a significant change in its pay ratio disclosure, the company may use another employee whose compensation is substantially similar to the original median employee based on the compensation measure used to select the original median employee.
Identifying the median employee: flexibility
Companies must identify a median employee for purposes of calculating the pay ratio, but the rules do not specify any required methodology for companies to use in identifying this median employee. Instead, companies are given flexibility in choosing a method based on their own facts and circumstances. The median employee can be determined using annual total compensation, or another compensation measure consistently applied to all employees. Companies can use reasonable estimates. In determining the employees from which the median is identified, companies can use their employee population, statistical sampling or other reasonable methods. In any event, the company must briefly describe the methodology it used to identify the median employee and any material assumptions, adjustments or estimates it used to identify the median employee or to determine total compensation or any elements of total compensation, which must be consistently applied.
The SEC’s adopting release states that “in determining their methodology [for choosing the median employee], registrants may consider, among other factors, such variables as: the size and nature of the workforce; the complexity of the organization; the stratification of pay levels across the workforce; the types of compensation the employees receive; the extent that different currencies are involved; the number of tax and accounting regimes involved; and the number of payroll systems the registrant has and the degree of difficulty involved in integrating payroll systems to readily compile total compensation information for all employees.”
No matter what method a company chooses to identify its median employee, the company must identify an actual employee and determine that employee’s annual total compensation to use in the pay ratio disclosure. The company cannot calculate average compensation of an average employee, or prepare calculations using a range of employees. However, the rule does not require a company to disclose any personally identifiable information about that employee other than his or her compensation. A company may choose to generally identify the employee’s position to put the employee’s compensation in context, but the company is not required to do so and should not do so if providing the information could identify any specific individual.
Identifying the median employee: annual total compensation or another compensation measure
A company may identify the median employee using annual total compensation or any other compensation measure that is consistently applied to all employees included in the calculation. In using a compensation measure other than annual total compensation, if that measure is recorded on a basis other than the company’s fiscal year (such as information derived from tax and/or payroll records), the company may use the same annual period that is used to derive those amounts. If the company uses a compensation measure other than annual total compensation to identify the median employee, the compensation measure used must be disclosed.
In identifying the median employee, the company may make cost-of-living adjustments to the compensation of employees in jurisdictions other than the jurisdiction in which the CEO resides so that the compensation is adjusted to the cost of living in the jurisdiction in which the CEO resides. The company also must briefly describe the cost-of-living adjustments it used to identify the median employee and to calculate the median employee’s annual total compensation. A company electing to present the pay ratio in this manner must also disclose the median employee’s annual total compensation and pay ratio without the cost-of-living adjustment.
In determining the median employee, the company can annualize the total compensation for all permanent employees (full-time or part-time) that were employed by the company for less than the full fiscal year. However, a company cannot annualize the total compensation for employees in temporary or seasonal positions, but may make additional narrative disclosures to describe the impact of not making full-time equivalent adjustments for such employees.
Calculating the median employee’s annual total compensation
The median employee’s total compensation is calculated in accordance with Item 402(c)(2)(x) of Regulation S-K using the same “total compensation” calculation necessary for the company’s named executive officers for purposes of the summary compensation table.
Companies are permitted to use reasonable estimates in calculating the annual total compensation of the median employee, including any element of total compensation. Companies must clearly identify any estimates used, and must have a reasonable basis to conclude that their estimates approximate the actual amounts of compensation that are awarded to, earned by or paid to the median employee.
The definition of total compensation generally excludes certain items like benefits under non-discriminatory plans, perquisites and personal benefits that aggregate less than $10,00, but companies may include such items if, in calculating the median employee’s total compensation, the CEO’s total compensation used in the related pay ratio disclosure is also adjusted to reflect the same approach on these items. If this results in a different amount of compensation for the CEO, then the company must explain any difference between the CEO’s total compensation used in the pay ratio disclosure and the total compensation amounts reflected for the CEO in the summary compensation table.
The median employee’s compensation is calculated for the company’s last completed fiscal year, which is the same period during which the CEO’s and other named executive officers' compensation is determined. However, solely for purposes of selecting the median employee, companies can look at compensation amounts derived from the information in their tax and/or payroll records for the same annual period used in those records, which may be different than the company’s last completed fiscal year.
Calculating the annual total compensation with multiple CEO’s
If a company has more than one non-concurrent CEO serving during its fiscal year, the company can calculate the annual total compensation for the CEO in one of two ways. First, the company can calculate the compensation provided to each person who served as CEO during the year for the time he or she served as CEO and combine those figures. Second, the company can look to the CEO serving in that position on the date it selects to identify the median employee and annualize that CEO’s compensation. The company must disclose which option it chose and how it calculated the CEO’s annual total compensation.
Updating for the last completed fiscal year
Pay ratio information with respect to the company’s last completed fiscal year is not required to be disclosed until the filing of the annual report on Form 10-K for that last completed fiscal year or, if later, the filing of a definitive proxy or information statement relating to its next annual meeting of shareholders following the end of such fiscal year. However, the required pay ratio information for a fiscal year must, in any event, be filed not later than 120 days after the end of such fiscal year.
In addition, if a company files a proxy statement (other than a definitive proxy statement for its annual meeting) that requires Item 402 compensation information, the company would be required to include or incorporate by reference pay ratio disclosure for the most recent period that had been filed in its Form 10-K or proxy statement for its annual meeting.
Transition period for initial compliance
A company must comply with the pay ratio disclosure requirement with respect to compensation for the first fiscal year following the year in which it becomes subject to the requirement, but not for any fiscal year commencing before January 1, 2017. The company may omit the pay ratio disclosure from any filing until the filing of the annual report on Form 10-K for the first fiscal year following the year in which it becomes subject to the requirement or, if later, the filing of a proxy or information statement relating to its next annual meeting of shareholders following the end of such year, provided that such disclosure must, in any event, be filed not later than 120 days after the end of such fiscal year. This permits newly public companies to delay compliance so that the pay ratio disclosure is not required in a registration statement on Form S-1 or Form S-11 for an initial public offering or registration statement on Form 10.
Transition period for employees of acquired companies
A company can omit any employees that became employees as the result of a business combination or acquisition of a business for the fiscal year in which the transaction becomes effective, but the company must disclose the approximate number of employees it is omitting. Those employees must be included in the total employee count for the triennial calculations of the median employee in the year following the transaction for purposes of evaluating whether a significant change has occurred. The company must identify the acquired business excluded for the fiscal year in which the business combination or acquisition becomes effective.
Transition period for emerging growth companies and smaller reporting companies
Emerging growth companies and smaller reporting companies are not subject to the pay ratio disclosure requirement. Companies that cease to be emerging growth companies or smaller reporting companies are not required to provide pay ratio disclosure until they file an annual report for the first fiscal year commencing on or after they cease to be a smaller reporting company or emerging growth company.
The authors would like to thank Alec Nealon for his assistance in the preparation of this alert.