Insights

SEC Adopts Final CEO Pay Ratio Disclosure

What you need to know:

On August 5, 2015, the SEC adopted a final rule pursuant to the Dodd-Frank Act requiring SEC reporting companies (other than emerging growth companies, smaller reporting companies, foreign private issuers, multijurisdictional filers and registered investment companies) to disclose annually:

  • the median of the annual total compensation of all of their employees, excluding  the CEO;
  • the annual total compensation of the CEO; and
  • the ratio of the annual total compensation of the median employee to the CEO’s annual total compensation.

The disclosure will first be required in the annual report for a company’s fiscal year beginning on or after January 1, 2017, meaning that issuers with calendar fiscal year ends must include the CEO pay ratio information in their Form 10-K or annual meeting proxy statement filed in 2018. The disclosure requirements are set forth in new Item 402(u) to Regulation S-K.

What you need to do:

Preparation of pay ratio disclosure and the underlying calculations will require the collection and analysis of significant amounts of data as well as a number of strategic decisions on the part of company management. Companies will also want to consider the optics of their disclosure well in advance. The following steps should be taken in the near term:

  • Gain an understanding of the disclosure requirements and how to comply;
  • Determine whether the company employs persons in foreign jurisdictions with data privacy laws that might apply to obtaining and processing information required to comply with the final rule;
  • Determine the method by which the company will identify its median employee and calculate such employee’s annual total compensation, including whether any cost-of-living adjustments are appropriate; and
  • Start thinking about how to put pay ratio disclosure in context through narrative descriptions, with the goal of assisting the consideration by shareholders of such disclosure when deciding how to vote on “say on pay” proposals.

Companies Covered

The CEO pay ratio disclosure rule applies to all US public reporting companies other than emerging growth companies, smaller reporting companies, foreign private issuers, US-Canadian Multijurisdictional Disclosure System filers and registered investment companies. Companies that lose exempt status will have a one year grace period before compliance with the pay ratio disclosure rule is required.

Newly public, non-exempt companies are required to comply with the rule with respect to compensation for the first full fiscal year commencing after the year in which the company becomes subject to the periodic reporting requirements of the Securities Exchange Act of 1934, but no earlier than January 1, 2017.

Mandatory Pay Ratio Disclosure

The final rules require annual disclosure of:

  • the median of the annual total compensation of all of their employees, excluding the CEO;
  • the annual total compensation of the CEO; and
  • the ratio of the annual total compensation of the median employee to the CEO’s annual total compensation.

The pay ratio may be expressed as a ratio in which the median employee’s compensation equals one, or it may be expressed in a narrative statement indicating the multiple of the median employee’s compensation that represents CEO compensation.

In addition to the basic numbers, companies must also disclose the methodology, material assumptions, adjustments (including any cost-of-living adjustments) and estimates used in the calculations. If a company changes the methodology or material assumptions, adjustments or estimates from those used in the previous period, and if the effects of any such change are significant, the company must describe the changes and the reasons behind them.

A company may choose to include additional ratios or other information to supplement and provide further context for the required ratio. For instance, a company may present supplemental ratios showing the effect of part-time or temporary employees or of non-U.S. personnel on the required pay ratio disclosure. Any additional ratios must be clearly identified and explained, cannot be misleading and cannot be presented with greater prominence than the required ratio.

Employees Included in Identifying the Median Employee

While the proposed rules provided that “employee” status was determined as of the last day of a company’s fiscal year, the final rules provide for greater flexibility with the determination to be made as of a date that falls within the last three months of the company’s fiscal year. Companies are to disclose the measurement date and, if a change is made to the measurement date, the reason for any such change.

An employee for purposes of the rule is any individual employed by the company or a consolidated subsidiary as of the measurement date, including any part-time, seasonal or temporary employee, and any non-US employees. Not included within the definition of employees are independent contractors and leased employees. Persons who become employees as a result of an acquisition may be excluded with respect to the fiscal year in which the acquisition occurs, provided the company discloses the approximate number of employees being excluded.

The final rules provide two limited exemptions with respect to non-US employees:

  •  A company may exclude from the determination of the median employee all persons employed outside the US in a jurisdiction with data privacy laws that prohibit the collection of information necessary for compliance with the rule, provided that legal counsel provides an opinion regarding the inability to obtain or process such information; and
  • A company may exclude from the determination of the median employee non-US employees representing 5% or less of the company’s total employees (including any excluded under the data privacy exemption).

If a company excludes an employee in a particular foreign jurisdiction, the company must exclude all employees in that foreign jurisdiction. As a result, no company may, on the basis of the de minimus exception, exclude an employee in a country in which more than 5% of the company’s total employees are employed.

Identifying the Median Employee

Companies have flexibility under the final rule in selecting the method by which it will identify the median employee:

  • A company may narrow the employees to be included in the determination of the median by using statistical sampling or other reasonable methods, provided such methods are adequately described;
  • In identifying the median of the employees included in the calculation, a company may use either annual total compensation (on the same basis as for the proxy statement summary compensation table) or any other compensation measurement that is consistently applied to all employees included in the calculation, such as W-2 reportable wages;
  • A company may make reasonable cost-of-living (for employees in jurisdictions other than where the CEO resides) and annualizing adjustments in identifying the median employee and calculating annual total compensation; and
  • A company may use the same median employee for three consecutive years (rather than requiring an annual calculation, as contemplated by the proposed rules), absent a change in employee population or compensation arrangements generally that the company reasonably believes would result in a significant change in the pay ratio disclosure. If the median employee changes his or her position or leaves the company during that three-year period, the company may select another employee with substantially similar compensation to the original median employee to serve as the median employee.

Companies may annualize compensation for employees that worked only a portion of the fiscal year. However, companies may not annualize compensation for part-time or temporary employees.

A cost-of-living adjustment used to identify the median employee must also be used in calculating the median employee’s annual total compensation for purposes of determining the pay ratio. In addition, the company must disclose the country in which the median employee is located, the median employee’s actual annual total compensation and the pay ratio calculated without applying the cost-of-living adjustment.

Calculating “Total Compensation” of Median Employee

Annual total compensation on which the pay ratio is based is determined in the same manner as used for the company’s named executive officers in the summary compensation table, although the rule permits companies to use reasonable estimates where appropriate given that the elements of compensation of the median employee may differ from those of named executive officers. The rule also allows a company to include certain types of compensation and benefits available to employees generally that may be omitted from the summary compensation table for named executive officers, such as health benefits or employee discounts, provided that if such an item of compensation is included for the median employee it must also be included for the CEO (to the extent applicable) in determining the pay ratio.

Guarding Against Disclosure of Personally Identifiable Information

The rule prohibits disclosure of personally identifiable information about an employee other than his or her compensation. While a company may generally identify an employee’s position in order to place compensation in context, this information is not required and should not be included if it could lead to the identification of a specific individual.