On August 5, 2015, nearly two years after the SEC’s initial proposal, the SEC adopted, by a three-to-two vote split along party lines, the pay ratio disclosure rules1 mandated by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 953(b) and the new rules require public companies to disclose (i) their CEO’s total annual compensation as reported in the Summary Compensation Table, (ii) the median total annual compensation of all of their employees, other than the CEO, and (iii) a ratio comparing the two values. According to the Adopting Release, the intent behind Section 953(b) and the final pay ratio rules is to provide shareholders with additional information when considering say on pay proposals.
The new rules, implemented as a new paragraph (u) to Item 402 of Regulation S-K, reflect the SEC’s consideration of feedback and comments received on the initial proposal as well as feedback on the statutory requirement received prior to the initial proposal in 2013. In particular, the new rules include the following modifications:
- adding a data privacy exemption permitting registrants to exclude from the pay ratio computation the compensation of non-U.S. employees in countries with data privacy laws that hinder compliance with the new rules;
- adding a de minimis exemption that permits registrants to exclude from the pay ratio computation up to 5% of their total workforce who are non-U.S. employees (however, this exemption is not available if non-U.S. employees excluded under the data privacy exemption described above represent 5% or more of the registrant’s total workforce);
- allowing registrants to identify the median employee every three years, instead of every year, for purposes of computing the pay ratio;
- allowing registrants to choose a date within three months of fiscal year end, rather than the fiscal year end date, to determine its employee population; and
- deferring the initial compliance date from the first fiscal year following the effective date of the new rules, which would have been the 2016 fiscal year, to the fiscal year beginning on or after January 1, 2017, with a corollary deferral for new registrants and existing registrants exiting smaller reporting or emerging growth company status to prevent them from becoming subject to the new rules before existing registrants.
Effective and Compliance Dates
The new rules will become effective 60 days after publication in the Federal Register, which is pending as of the date of this update.
Existing registrants will need to report pay ratios with respect to compensation for fiscal years beginning on or after January 1, 2017, with the first such disclosure to be included in registrants’ Annual Reports on Form 10-K or proxy statements filed in 2018.
New registrants, and existing registrants exiting smaller reporting or emerging growth company status, will have additional time to comply with the rules as described below.
Pay Ratio Disclosure
Under the new rules, a registrant will have to provide annual pay ratio disclosure in Annual Reports on Form 10-K, proxy and information statements and registration statements required to include compensation information under Item 402 of Regulation S-K.
The pay ratio may be expressed either in numerical form with the median total annual compensation of all employees being equal to one or in narrative form with the CEO’s total annual compensation expressed as a multiple of median total annual compensation for all employees. For example, a registrant could state that the pay ratio is “1 to 5” or that the CEO’s compensation is “five times the median of the annual total compensation of all employees.”
If more than one person served as CEO of the registrant in the applicable reporting period, a registrant may base the pay ratio on the annualized compensation of the CEO on the employee determination date discussed below or the aggregate compensation of the CEOs who served in that position during the applicable reporting period.
Registrants may also include additional ratios or narrative descriptions to supplement the required pay ratio disclosure, so long as any additional ratios or descriptions are clearly identified, not misleading and not given greater prominence than the required disclosure.
Scope of "All Employees"
The first step in computing a registrant’s pay ratio is determining the scope of its total employee population. Despite some criticism of the proposed rules, the final rules broadly define “all employees” as all U.S. and non-U.S. employees, including part-time, seasonal and temporary workers. The SEC felt that inclusion of U.S. and non-U.S. employees was consistent with congressional intent and would provide disclosure that reflects the actual composition of a registrant’s workforce. The final rules also clarify that “all employees” include the employees of the registrant’s consolidated subsidiaries, but exclude other workers supplied by third parties, such as leased employees and independent contractors. While the proposed rules would have required registrants to determine its total employee population as of fiscal year end, the new rules permit registrants to choose a date within three months prior to their fiscal year end. Registrants must then include the determination date in the pay ratio disclosure.
Exemptions for Non-U.S. Employees
As discussed above, the new rules provide a data privacy exemption and a de minimis exemption that are designed to simplify compliance and minimize costs.
Data Privacy Exemption. The data privacy exemption permits a registrant to exclude non-U.S. employees located in countries with data privacy laws or regulations that make it impossible for the registrant to obtain or process the information necessary for compliance with the pay ratio rules in spite of the registrant’s reasonable efforts. Reasonable efforts include using or seeking an exemption from the applicable data privacy laws and procuring a legal opinion from counsel opining as to the registrant’s inability to obtain the necessary information, including an inability to obtain an exemption or other relief from the data privacy law. Registrants will be required to file the legal opinion as an exhibit with the filing where the pay ratio disclosure appears. The final rules do not allow cherry-picking, so a registrant relying on the data privacy exemption must exclude all non-U.S. employees located in the affected country.
Registrants relying on the data privacy exemption must disclose the country where the excluded non-U.S. employees are located, the approximate number excluded under the exemption, the applicable data privacy law and how compliance with the pay ratio rules would violate such law.
De Minimis Exemption. A registrant may also exclude some or all of its non-U.S. employees under the de minimis exemption. If the registrant’s total non-U.S. employees represent 5% or less of the registrant’s total workforce, all (but not just some) of the non-U.S. employees may be excluded. Cherry-picking by the registrant is prohibited. If more than 5% of the registrant’s total workforce are non-U.S. employees, the registrant may exclude up to 5% of its total employees who are non-U.S. employees, as long as the registrant does not pick and choose which employees to exclude in a particular country. However, if more than 5% of the registrant’s employees are located in any one non-U.S. country, then the employees in that country may not be excluded. In addition, non-U.S. employees excluded under the data privacy exemption will count against the 5% cap.
Registrants relying on the de minimis exemption must disclose the country where the excluded non-U.S. employees are located, the approximate number excluded under the exemption, the size of the registrant’s total workforce including such excluded employees and the total number of U.S. and non-U.S. employees used for the de minimis calculation.
Exclusion of Employees from Business Combinations
The final rules permit a registrant that underwent a business combination to exclude employees from the recently-acquired entity from the pay ratio computation until the first full fiscal year following the business combination. If employees are excluded because of a business combination, registrants must identify the acquired business and the approximate number of employees excluded.
Identifying the Median Employee
The next step in preparing the pay ratio disclosure involves identifying the registrant’s median employee. There are several ways to do this under the new rules. A registrant may examine the entire employee population or may use reasonable methods to identify the median employee, including the use of statistical sampling. The median employee may then be identified using (i) annual total compensation as determined under Item 402(c) of Regulation S-K or (ii) a consistently-applied compensation measure, such as amounts reported in payroll or tax records. Compensation for new, permanent employees may be annualized, but not for part-time, temporary or seasonal employees. In addition, the new rules permit a registrant to adjust the compensation of employees that live outside the CEO’s country of residence to account for the cost of living in the CEO’s country of residence, which the proposed rules would not have allowed. The cost-of-living adjustment is intended to increase comparability between CEO and employee compensation where such compensation may be affected by the varying economic conditions of the countries in which a registrant operates.
Rather than identifying the median employee every year as the proposed rules would have required, the new rules permit the registrant to identify the median employee once every three years, unless there has been a significant change in the employee population or employee compensation arrangements that would lead to a significant change in the pay ratio. If the median employee identified in year one is no longer appropriate, perhaps because of the employee’s promotion or departure from the company, then the registrant may use an employee whose compensation is substantially similar to the original median employee as it was determined in year one. However, while the median employee may be selected every three years, the registrant is required to calculate that employee’s total annual compensation and report the pay ratio annually.
The registrant must briefly describe the methodology used to identify the median employee, including whether or not the median employee has changed since the prior year and the reasons for using the same or a different median employee, and any material assumptions, adjustments or estimates used, including cost-of-living adjustments. Any such methodology must be consistently applied by the registrant. While registrants are not required to name the median employee in their pay ratio disclosure, registrants may wish to supplement their disclosure with the median employee’s title, responsibilities or country of employment.
Calculation of the Median Employee's Compensation
Once the median employee has been identified, the new rules require that the registrant calculate that employee’s total annual compensation under the rules currently in Item 402(c)(2)(x) of Regulation S-K. The registrant is allowed to use reasonable estimates to determine the annual total compensation or any elements of the total compensation for the median employee, such as perquisites or changes in defined benefit pension plan amounts. If the registrant has applied a cost-of-living adjustment in determining the median employee, and the median employee lives outside the CEO’s country of residence, the registrant must calculate such employee’s total compensation on an unadjusted basis and an adjusted basis taking cost-of-living into account and disclose these calculations in its disclosure. Disclosure related to the total compensation of the median employee must briefly describe the methodology used and any material assumptions, adjustments or estimates.
Smaller reporting companies, emerging growth companies, U.S.-Canadian Multijurisdictional Disclosure System registrants, foreign private issuers and registered investment companies are not required to provide pay ratio disclosures under the final rules.
Additional Transition Periods
Newly registered companies will not have to disclose pay ratios in in their initial registration statements on Form S-1, Form S-11 or Form 10. Rather, these new registrants must provide their first pay ratio disclosure in the Annual Report on Form 10-K or the proxy statement filed with the SEC in their second fiscal year following the date that they became subject to the Securities Exchange Act of 1934, as amended. Accordingly, a new registrant that completes its initial public offering during 2017 will be required to provide its first pay ratio disclosure in either its Annual Report on Form 10-K for the 2018 fiscal year to be filed in 2019 or its proxy statement for the 2019 annual shareholder meeting.
Similarly, existing registrants exiting smaller reporting or emerging growth company status do not need to disclose their pay ratio until the first fiscal year after they cease being an excluded registrant. Accordingly, an existing registrant that ceases to be a smaller reporting or emerging growth company as of January 1, 2018 (because of events that occurred during 2017) must first include pay ratio disclosure in either its Annual Report on Form 10-K for the 2018 fiscal year to be filed in 2019 or its proxy statement for the 2019 annual shareholder meeting.
Since the Dodd-Frank Act’s enactment in 2010, pay ratio disclosure has come under fire in Congress with legislation introduced to repeal the relevant Dodd-Frank Act provision, in SEC meetings where Commissioners Gallagher and Piwowar challenged the propriety of considering, much less adopting, these rules, and in statements issued by the U.S. Chamber of Commerce and other corporate advocates challenging the intent behind, and the merits of, such disclosure. At this time, there is strong speculation that the rules will be challenged in court, a process which may take years to resolve. In the meantime, companies should start preparing for these new rules and consider any disclosure systems or processes they will need to implement to comply with the new pay ratio rules.