On August 5, 2015, the Securities and Exchange Commission (“SEC”) adopted its long-awaited CEO pay ratio rule applicable to most SEC reporting companies. Specifically, the final rule requires annual disclosure of:
- the median of the annual total compensation of all employees of the registrant, except its chief executive officer;
- the annual total compensation of its chief executive officer; and
- the ratio of the two amounts.
Companies subject to the rule will be required to comply with it for the fiscal year beginning on or after January 1, 2017. Thus, for calendar year companies, the 2018 proxy season will be the first time when the disclosure mandated by the final rule will be required.
To review the SEC’s adopting release, click here.
Applicability to Filings and Registrants
Pay ratio disclosure must be included in any filing that requires executive compensation disclosure under Item 402 of Regulation S-K, including annual reports on Form 10-K, proxy or information statements and registration statements under the Securities Act of 1933 and Securities Exchange Act of 1934.
Pay ratio disclosure is not required for emerging growth companies, smaller reporting companies, foreign private issuers and U.S.-Canadian Multijurisdictional Disclosure System filers.
The Definition of “Employee”
The final rule defines “employee” as an individual employed on any date of the registrant’s choosing within the last three months of the registrant’s last completed fiscal year. The date so chosen by a registrant must be disclosed, but the final rule does not require the registrant to state its reasons for choosing that date. However, if the determination date changes from the prior year, reasons for that change must be disclosed.
Under the final rule, in order to determine the “median of the annual total compensation of all employees,” full-time, part-time, seasonal and temporary employees of registrants and of their consolidated subsidiaries must be taken into account. Independent contractors and “leased” workers are excluded from the determination if they are employed by an unaffiliated third party who determines their compensation.
Non-U.S. employees must be part of the analysis, just like U.S. employees, with two limited exceptions. First, non-U.S. employees from countries in which companies cannot, despite reasonable efforts, obtain or process information necessary to comply with the final rule without violating data privacy laws or regulations of those countries, can be excluded from the determination. The final rule sets forth additional disclosure requirements for registrants using this exemption, including filing with the SEC a legal opinion that opines on the inability of the registrant to obtain or process the necessary information.
Second, if non-U.S. employees of a registrant represent 5% or less of their total U.S. and non-U.S. employees, the non-U.S. employees may be excluded from the determination. If a registrant’s non-U.S. employees exceed 5% of the registrant’s total U.S. and non-U.S. employees, it may exclude up to 5% of its total employees who are non-U.S. employees. If a registrant excludes any non-U.S. employees in a particular jurisdiction, it must exclude all non-U.S. employees in that jurisdiction. Additional disclosures will be required if this exemption is used, including the disclosure of the jurisdiction or jurisdictions employees from which are excluded and the approximate number of employees excluded from each jurisdiction.
A registrant may omit any employees that became its employees as a result of a business combination or acquisition of a business for the fiscal year in which the transaction becomes effective, but the registrant must disclose the approximate number of employees it is omitting.
Identifying the Median Employee
The final rule provides registrants with a significant amount of flexibility in determining the employees from which the median employee is identified. Registrants may use their entire employee populations, statistical sampling or any other reasonable method. A registrant 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, such as information derived from the registrant’s tax and/or payroll records.
In identifying the median employee, registrants may make cost-of-living adjustments to the compensation of their employees in jurisdictions other than the jurisdiction in which the chief executive officer resides so that the compensation is adjusted to the cost of living in the jurisdiction in which the chief executive officer resides. If a registrant opts to use a cost-of-living adjustment to identify the median employee, it must also disclose the median employee’s annual total compensation and pay ratio without the cost-of-living adjustment.
Registrants may annualize compensation for their full-time and part-time permanent employees who did not work for the entire year, but they cannot adjust a part-time schedule to a full-time equivalent schedule. Annualizing adjustments for temporary or seasonal workers are not permitted, either.
Registrants must identify a median employee and determine that employee’s annual total compensation in accordance with Item 402 of Regulation S-K so that it can be used in the disclosure of the pay ratio. Personally identifiable information about the median employee should not be disclosed.
In a departure from the proposed rule and as suggested by the American Bar Association in its comment letter, once a registrant has identified its median employee, the same median employee may be used for three years for purposes of the pay ratio disclosure, as long as there have been no changes in the registrant’s employee population or employee compensation arrangements that the registrant reasonably believes would significantly affect the pay ratio disclosure.
Calculation of Annual Total Compensation
Once a median employee has been identified, the calculation of annual total compensation of the median employee and the chief executive officer must be made in accordance with the requirements of Item 402 of Regulation S-K. The final rule specifies that references to “named executive officer” in Item 402 are deemed to refer instead to “employee.” Additionally, if the median employee is a non-salaried employee, references to “base salary” and “salary” in Item 402 are deemed to refer to “wages plus overtime,” as applicable.
Registrants may use reasonable estimates in calculating the annual total compensation of their median employee (or any elements thereof), but if they do so, they must clearly identify any estimates used. Even though, as discussed above, the final rule permits the identification of the median employee every three years, annual total compensation of such employee must calculated each year.
Pay Ratio Disclosure
The ratio of the annual total compensation of the median employee to that of the chief executive officer may be expressed either (i) as a ratio in which the median employee’s compensation equals one (e.g., 1 to 200) or (ii) narratively as the multiple that the amount of the CEO’s compensation bears to the amount of the median employee’s compensation (i.e., the CEO’s total compensation is 200 times that of the annual total compensation of the median employee).
In addition to disclosing the ratio, the final rule requires a brief disclosure of the methodology and any material assumptions, adjustments (including cost of living adjustments) or estimates used to identify the median employee or to determine annual total compensation or any elements of total compensation, which must be consistently applied. If statistical sampling is used, registrants must describe the size of both the sample and the estimated whole population, any material assumptions used in determining the sample size and the sampling method (or methods) used. If such methodology, assumptions, adjustments or estimates change from the prior year and the effects of any such change are significant, registrants must briefly describe the change and the reasons for the change. Registrants are generally not required to include any technical analyses or formulas.
Registrants may present additional information, including additional ratios, to supplement the required ratio, but are not required to do so. Any additional information must be clearly identified, not misleading, and not presented with greater prominence than the required ratio.
The final rule treats the pay ratio disclosure, as with other Item 402 information, as “filed” for purposes of the Securities Act of 1933 and Securities Exchange Act of 1934, and, therefore, subject to potential liabilities under those statutes.
Takeaway
As Chair White said in her opening statement at the SEC’s meeting, “To say that the views on the pay ratio disclosure requirement are divided is an obvious understatement.” The SEC received more than 287,400 comment letters, including over 1,500 unique letters, with some asserting the importance of the rule to shareholders as they consider the issue of appropriate CEO compensation and investment decisions, and others asserting that the rule has no benefits and will needlessly cause registrants to incur significant costs. While the SEC’s discretion on the rule was somewhat limited by the Dodd-Frank Act mandate, the final rule recommended by the SEC staff and adopted by the SEC Commissioners provides registrants with significant flexibility in determining the pay ratio and in explaining it to investors.
For additional information about the final rule, please contact any of the authors.