SEC adopts final pay ratio disclosure rule

What Rule Did the SEC Adopt?

The SEC adopted the final pay ratio rule required by Dodd-Frank.

On August 5, 2015, the SEC adopted a final rule implementing Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This new rule is reflected in Item 402(u) of Regulation S-K. Dodd-Frank Section 953(b) and Item 402(u) require companies to disclose for the prior fiscal year:

• the median annual total compensation of all of the company's and its consolidated subsidiaries' employees (excluding the principal executive officer (the "PEO")), which requires that the company identify the median employee1 and the employee's total compensation;
• (ii) the PEO's annual total compensation; and
• (iii) the ratio between the median employee's compensation and the PEO's compensation.2 

The SEC intends this information to assist shareholders in exercising their say-on-pay voting rights under Section 951 of Dodd-Frank and to provide shareholders with further insight into the pay practices of the company.   

The rule contains many specific requirements and possible exemptions that the company is required or permitted to consider in performing the calculations above.  Some highlights are:

• Three Month Determination Window - The company may measure the median annual total compensation to determine the median employee as of any date within the last three months of its fiscal year;
• Measurement Required Every Three Years – While the company must calculate the total annual compensation for the median employee every year, it may determine the median employee once every three years.  The company may continue to use its prior designated median employee (or a similarly situated employee) for the pay ratio calculations for the three year period, unless certain changes in compensation or employee population have occurred that the company reasonably believes would significantly impact pay ratio disclosures;
• Flexible Methodology for Identifying Median Employee – The rules permit a company to disclose and use its own methodology to calculate the median employee using compensation measures that are consistently applied to all employees and reasonable estimates based on the company's facts and circumstances;
• Calculating Total Compensation of the Median Employee and PEO Based on Existing Measure - The calculation of the median employee's total annual compensation must be completed in the same manner as executive compensation for the PEO under Item 402(c)(2)(x), subject to certain reasonable estimates; and
• All Employees Are Covered With Few Exceptions – "Employees" as defined in Item 402(u) covers all individuals employed by the company or its consolidated subsidiaries, whether full-time, part-time, seasonal, or temporary workers and whether or not they are U.S. employees or non-U.S. employees, subject to certain exclusions for non-U.S. employees that are discussed below.

When Does Compliance Start?

Compliance starts with the executive compensation disclosures for the fiscal year beginning on or after January 1, 2017.

For non-exempt companies that use calendar fiscal years and report their executive compensation in their annual meeting proxy statement within 120 days of fiscal year end, the first filing that will require the pay ratio disclosures will be the proxy statement for their 2018 annual meeting of shareholders.  For calendar fiscal year companies that disclose executive compensation information in their Annual Report on Form 10-K, their annual report for fiscal year 2017, filed in early 2018, will be their first pay ratio disclosure filing.

What Companies Must Comply?

All SEC reporting companies except certain companies that generally have reduced disclosure requirements

All SEC reporting companies will be required to comply with the pay ratio disclosures, except certain companies that often have reduced disclosure requirements.  These include:

• Smaller Reporting Companies;
• Emerging Growth Companies;
• Foreign Private Issuers;
• U.S.- Canadian Multijurisdictional Disclosure System filers; and
• Registered Investment Companies.

The rules also include transition periods that do not require compliance for companies that are: (i) new registrants, (ii) companies engaging in business combinations or acquisitions, and (iii) companies that cease to be smaller reporting companies or emerging growth companies.

Which Filings Will Require Additional Disclosure?

All filings that require executive compensation disclosure under Item 402 of Regulation S-K.

Any filing described in Item 10(a) of Regulation S-K that contains executive compensation disclosure under Item 402 of Regulation S-K must include the pay ratio disclosures.  Generally, these will include certain:

• Registration Statements;
• Proxy Statements and Information Statement; and
• Annual Reports.3

What Next?

• Develop Methodology and Cost Reduction Strategy
  The pay ratio rules allows companies to develop a company-specific calculation methodology that may, in some cases, help defray some compliance costs, but will also require additional disclosure.  Permitted, flexible components of potential methodologies include:
  • using statistical sampling to identify the median employee;
  • finding an already available, consistent compensation measure to calculate total compensation for median identification purposes;
  • utilizing reasonable estimates when calculating total compensation for the median employee;
  • applying employee reporting exemptions, such as: (i) excluding a limited number of non-U.S. employees (no more than 5% of the total), and (ii) excluding non-U.S. employees whose compensation data the company cannot obtain or process due to foreign privacy restrictions (the company must secure a legal opinion);
  • excluding independent contractors, leased workers, and workers employed by third parties;
  • utilizing exceptions for recent business combinations and acquisitions;
  • applying cost-of-living adjustments for certain employees;
  • annualizing income for permanent employees that were not employed for a full year, such as new hires and employees taking unpaid leave4; and
  • maintaining a consistent median employee over three years, if there are no significant changes to total compensation.
  The rules allow that a company may use consistently applied tax or payroll numbers as possible consistent compensation measures.  Finding and employing these measures may allow companies to adopt a methodology that permits easier calculation and simplified year-on-year tracking.
• Develop Clarifying Metrics
  The adopted rules allow companies to present additional narrative and ratios to clarify and supplement the required pay ratio disclosure.  This supplemental information must be clearly identified, cannot be more prominent than the required disclosure, or be misleading.  However, the supplemental disclosure can be used to explain a company's pay ratio, remedy possible misinterpretation of the required data by shareholders, and explain unfavorable comparisons between the company and its peer companies.5
• Test Run 2015 and 2016 Fiscal Year Numbers
  Companies that do not meet one of the exemptions discussed above or that may cease to meet the requirements by 2017 should consider preparing test calculations using the company's 2015 and 2016 data to ease the disclosure burden when first reporting in early 2018.