SEC Adopts Final Rules on CEO Pay Ratio Disclosure
Tuesday, August 18, 2015

On August 5, 2015, the Securities and Exchange Commission (SEC) finalized rules requiring publicly traded companies to disclose the ratio of median compensation of all employees to the compensation of the principal executive officer. The SEC adopted the rules in response to the mandate of Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

When Will Compliance With the Pay Ratio Rules Be Required?

Issuers will be required to comply with the new rules with respect to compensation for full fiscal years beginning on and after January 1, 2017. Disclosure of the pay ratio will first be required in the annual report covering that fiscal year or, if filed later, the proxy or information statement for the next annual meeting following the end of that fiscal year, subject to a requirement that the pay ratio be filed within 120 days after the end of the fiscal year.

This means that, in the normal course for calendar year issuers, the pay ratio will first be required in the proxy or information statement for the 2018 annual meeting, based on 2017 compensation.

Are the Final Rules Similar to the Proposed Rules Issued in 2013?

Several aspects of the final rules are unchanged from the proposed rules:

  • As in the proposed rules, the disclosure will consist of the following three elements:

    • The median of the annual total compensation of all employees (Median Pay) other than the principal executive officer (CEO);

    • The annual total compensation of the CEO (CEO Pay); and

    • The ratio of the Median Pay to the CEO Pay, expressed either as a ratio in which the Median Pay is one (e.g., 1 to 100) or in narrative as a multiple (e.g., “our CEO’s pay for 2015 was 100 times the median of the total compensation of all of our employees (other than our CEO) for 2015”).

  • Consistent with the proposed rules, the ratio is based on the median employee’s annual total compensation rather than that of the average employee. The “median” employee refers to the “middle” employee as measured by compensation level. The SEC declined to follow the suggestion of some commenters on the proposed rules to permit the use of the average employee in calculating the ratio, citing the specific reference in the statute to the median employee.

  • The median employee for purposes of the ratio must be identified from all employees, including all U.S. and non-U.S. full-time, part-time, seasonal, or temporary workers, subject to limited exceptions for certain non-U.S. employees discussed below.

  • In determining the employees from whom the median employee is identified, issuers may elect to use either the entire employee population or statistical sampling or other reasonable methods. Issuers will be required to disclose the method used.

  • In identifying the median employee with reference to compensation, issuers are not required to calculate the “total compensation,” as defined by the SEC for purposes of the Summary Compensation Table, for their entire employee population or the statistical sample. Instead, issuers may use any compensation measure that is consistently applied to all employees included in the calculation, including amounts derived from payroll or tax records. Once the median employee has been identified using such a compensation measure, however, the issuer will need to use the SEC’s Summary Compensation Table definition of “total compensation” to calculate and disclose the compensation of the median employee and the ratio.

  • Smaller reporting companies, emerging growth companies, U.S.-Canadian Multijurisdictional Disclosure System filers and foreign private issuers that file annual reports and registration statements on Form 20-F are exempt from the pay ratio disclosures. In addition, although the pay ratio will generally be required in registration statements that call for disclosure of compensation information under Item 402 of Regulation S-K, it will not be required in a Form S-1 or Form S-11 filed in connection with a company’s initial public offering.

What Are the Most Significant Differences in the Final Rules Compared to the Proposed Rules?

Although the overall framework of the final rules is similar to the proposed rules, the final rules include a number of changes, most of which provide additional flexibility to issuers:

  • Issuers will need to identify the median employee only once every three years (rather than every year, as under the proposed rules) unless there is a change in the issuer’s employee population or compensation arrangements that the issuer reasonably believes would significantly impact the pay ratio disclosure.

  • Issuers may choose any date within the last three months of the most recently completed fiscal year (rather than the last day, as under the proposed rules) as the date on which the issuer determines the median employee from among all employees.

  • In identifying the median employee and calculating the pay ratio, issuers may make cost-of-living adjustments for 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. If a cost of living adjustment is made, however, disclosure of unadjusted amounts will still be required in addition to the adjusted amounts.

  • Issuers will not need to consider compensation information for employees of joint ventures or subsidiaries that are not consolidated for financial reporting purposes (rather than, as under the proposed rules, considering compensation information for employees of all commonly controlled subsidiaries).

  • Issuers may exclude certain non-U.S. employees in two limited circumstances:

    • Non-U.S. employees for whom the issuer cannot, despite reasonable efforts, obtain or process the compensation information required for the ratio without violating data privacy laws or regulations.

    • Non-U.S. employees to the extent either (1) the issuer’s and its consolidated subsidiaries’ non-U.S. employees as a whole account for 5 percent or less of the issuer’s and its consolidated subsidiaries’ total worldwide employees or (2) the non-U.S. employees being excluded account for less than 5 percent of the issuer’s and its consolidated subsidiaries’ total non-U.S. employees. If an issuer excludes any employees in a non-U.S. jurisdiction because they account for less than 5 percent of the issuer’s and its consolidated subsidiaries’ total non-U.S. employees, however, it must exclude all non-U.S. employees in the jurisdiction.

  • Supplemental disclosures are expressly authorized, including additional ratios, so long as the supplemental disclosures are clearly identified, not misleading and not presented with greater prominence than the required ratio.

  • Issuers with multiple CEOs during a year may calculate the ratio either by (1) annualizing the partial year compensation of the CEO serving on the date used to calculate the ratio or (2) combining the compensation of the CEOs.

  • Newly public issuers and issuers leaving exempt status will have special transition periods for complying with the rules.

What Should Companies Do to Prepare for the Pay Ratio Disclosures?

  • Assess which method of determining the median employee will be most appropriate in the context of existing systems, whether statistical sampling is a desirable alternative and whether any modifications to existing systems are needed to permit this determination.

  • Determine the extent to which the compensation of part-time, seasonal and temporary workers, as well as international workers, is captured by existing systems.

  • Consider which determination date within the last three months of a fiscal year will be most appropriate for the calculation of the ratio. Individuals not employed on the determination date will not be included in the calculation of the ratio.

  • Evaluate whether any non-U.S. data privacy laws or regulations will apply to non-U.S. employees’ compensation information and, if so, whether obtaining or processing the compensation information will violate such laws or regulations, whether reasonable efforts would permit compliance and whether an exemption or other relief is available.

  • Determine whether any non-U.S. employees may be excluded under the 5 percent de minimis rule and, if so, identify which employees will be excluded.

  • Consider whether to include any supplemental pay ratios or other supplemental disclosures.

Detailed Summary of the Final Rules

A detailed summary of the final pay ratio rules follows below.

Components and Scope of the Required Disclosure. The rules will require U.S. issuers subject to the reporting requirements of the Securities Exchange Act of 1934, other than smaller reporting companies, emerging growth companies, foreign private issuers and U.S.-Canadian Multijurisdictional Disclosure System filers to disclose the following items:

  • The median of the annual total compensation of all employees of the company and its consolidated subsidiaries (Median Pay) other than the principal executive officer (CEO);

  • The annual total compensation of the CEO (CEO Pay); and

  • The ratio of the Median Pay to the CEO Pay, expressed either as a ratio in which the Median Pay is one (e.g., 1 to 100) or in narrative as a multiple (e.g., “our CEO’s pay for 2015 was 100 times the median of the total compensation of all of our employees (other than our CEO) for 2015”).

This disclosure will generally be required in proxy statements, information statements, annual reports and registration statements that require disclosure of executive compensation under Item 402 of Regulation S-K.

Calculation of Pay for Purposes of the Ratio. Both the Median Pay and the CEO Pay will be calculated on the same basis as total compensation for purposes of the Summary Compensation Table under Item 402(c)(2)(x) of Regulation S-K. Under these rules, total compensation is the sum of (1) base salary, (2) bonuses (both discretionary bonuses and those paid under a pre-established incentive plan), (3) grant date fair value of equity awards, (4) change in pension value and above-market or preferential nonqualified deferred compensation earnings, and (5) all other compensation, including such items as perquisites, tax gross-ups, and severance.

Under the final rules, companies may, but are not required to, annualize the total compensation for all permanent full-time and part-time employees who were employed for less than the full fiscal year. However, the rules will not permit full-time adjustments for part-time workers or annualization for temporary or seasonal employees. A company may use reasonable estimates to determine the Median Pay, but not the CEO Pay.

Personal benefits aggregating less than $10,000 and compensation under non-discriminatory benefit plans may be included in the median employee’s annual compensation so long as the items are also included in the CEO’s annual compensation. Any material difference between the CEO’s annual compensation used in the pay ratio disclosure and the compensation shown in the Summary Compensation Table will need to be explained.

Identifying the Median Employee. In identifying the median employee whose pay will be the basis for the Median Pay, the potential pool of employees will include all individuals employed by the listed company or any of its consolidated subsidiaries on a single date during the last three months of the most recently completed fiscal year. The listed company may identify any date during the three month period for purposes of identifying the median employee. If the date selected by the company changes from year to year, the company must explain the reason for the change.

The pool of employees will include all full-time, part-time, seasonal, or temporary workers employed on the day selected by the company, whether located in the U.S. or outside the U.S. (subject to limited exceptions for certain non-U.S. employees described below). There is no exclusion for employees who are subject to a collective bargaining agreement. However, the definition of employee would not include those workers who are employed, and whose compensation is determined, by an unaffiliated third party but who provide services to the company or its consolidated subsidiaries as independent contractors or leased workers.

Non-U.S. employees may be excluded in two limited circumstances:

  • Non-U.S. employees for whom the company cannot, despite reasonable efforts, obtain or process the compensation information required for the ratio without violating data privacy laws or regulations. Reasonable efforts must include, at a minimum, using or seeking an exemption or other relief under any governing data privacy laws or regulations. If employees are excluded under this exemption, the company must list the excluded jurisdictions and the specific data privacy laws at issue, explain how complying with the pay ratio rule would violate the law, describe the efforts made to seek relief, disclose the approximate number of employees exempted by jurisdiction and file a supporting legal opinion as an exhibit.

  • Non-U.S. employees to the extent either (1) the issuer’s and its consolidated subsidiaries’ non-U.S. employees as a whole account for 5 percent or less of the issuer’s and its consolidated subsidiaries’ total worldwide employees or (2) the non-U.S. employees being excluded account for less than 5 percent of the issuer’s and its consolidated subsidiaries’ total non-U.S. employees. If an issuer excludes any employees in a non-U.S. jurisdiction because they account for less than 5 percent of total non-U.S. employees, however, it must exclude all non-U.S. employees in the jurisdiction. It must also disclose the jurisdictions from which employees are being excluded, the approximate number of employees excluded from each jurisdiction, the total number of U.S. and non-U.S. employees and the total number of U.S. and non-U.S. employees used in calculating the 5 percent limit. In addition, to the extent employees are excluded under the data privacy exemption described above, those employees apply against the 5 percent cap on the number of employees who may be excluded under this de minimis exemption.

Employees of an acquired business may be excluded from the determination of the median employee for the year in which the acquisition occurs, but the approximate number of employees omitted must be disclosed and the employees should 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 any acquired business the employees of which are excluded under this rule.

In determining the employees from whom the median employee is identified, companies will be permitted to use either their entire employee population or statistical sampling or other reasonable methods.

In identifying the median employee from the relevant group, companies will be permitted to use either (1) actual annual total compensation, calculated using the Summary Compensation Table rules, or (2) any other annual compensation measure that is consistently applied to all employees included in the calculation. The regulations provide as examples of alternative compensation measures amounts derived from the company’s payroll or tax records. Such records may be used to identify the median employee even if they are kept on an annual basis other than the fiscal year of the registrant.

In identifying the median employee, companies may (but are not required to) 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. If a cost-of-living adjustment is made to identify the median employee, and the median employee resides in a jurisdiction different from the CEO, then the same cost-of-living adjustment must be used in calculating the median employee’s annual total compensation. In this situation, the jurisdiction of the employee must be disclosed, along with a brief description of the cost-of-living adjustments used and the median employee’s annual total compensation and pay ratio without the adjustments.

Companies will be required to disclose the methodology used to identify the median employee and disclose any material assumptions, adjustments or estimates that are used to identify the median or to determine any elements of total compensation. Estimated amounts will need to be clearly identified. A company will need to explain any change in methodology from year to year, including the reason for the change and an estimate of its impact on the median and the ratio.

The median employee will need to be identified only once every three years, unless there was a change in the employee population or employee compensation arrangements during the company’s last completed fiscal year that the company reasonably believes would significantly affect the pay ratio disclosure. The median employee’s Median Pay, however, must be recalculated each year.

If the company uses the same median employee for multiple years, it must disclose that fact and describe the basis for its reasonable belief that no changes have occurred that would significantly affect the pay ratio disclosure. If there is a change in the 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.

Transition Periods. The rules include a one-year transition period for newly public companies and companies that cease to be smaller reporting companies or emerging growth companies.

Status of Pay Ratio as Filed Rather Than Furnished. Under the final rules, the pay ratio disclosure will be considered “filed,” and not merely “furnished,” for purposes of liability under the Securities Act of 1933 (Securities Act) and the Securities and Exchange Act of 1934 (Exchange Act). Filed information is subject to liability under Section 18 of the Exchange Act, which imposes liability for misleading statements in reports or documents filed with the SEC, and is subject to automatic incorporation by reference into the company’s Securities Act registration statements, which could give rise to liability under Section 11 of the Securities Act. 

 

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