alerts & publications

SEC Issues Final Pay-Ratio Rule

On August 5, 2015, the SEC issued final rules requiring disclosure of the ratio between the annual total compensation of the issuer’s principal executive officer (referred to in this alert as the “PEO”) and the median annual total compensation of its employees (the “Final Rule”). This Alert summarizes some of the key features of the Final Rule, and includes our thoughts on some of the implementation challenges issuers may face and a checklist that can be used to help prepare the required disclosures. The full text of the adopting release for the Final Rule is available here.

The Final Rule was adopted in response to Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 953(b) required the SEC to adopt a rule requiring reporting issuers to disclose the median of the annual total compensation of all employees (excluding the PEO), the annual total compensation of the PEO, and the ratio of the two.

The new disclosure requirements will become effective for the issuer’s first fiscal year beginning on or after January 1, 2017. For issuers whose fiscal year is the calendar year, this means that the disclosure will first be required in the company’s proxy statement filed in 2018 covering 2017 compensation.

Pay Ratio Disclosure

The Final Rule adds a new Item 402(u) to the existing executive compensation disclosure rules contained in Item 402 of Regulation S-K. Simply put, Item 402(u) requires the issuer to disclose:

• the annual total compensation of the PEO;
• the median of the annual total compensation of all employees of the issuer (except the PEO);
• the ratio of the annual total compensation of the PEO to the median of the annual total compensation of all employees of the issuer (except the PEO).
  
  For example: If the PEO’s total compensation is $7,500,000, and the median of the annual total compensation of all employees of the issuer (except the PEO) is $50,000, the issuer could describe the pay ratio as being 150 to 1 or 150:1, or the issuer could disclose the pay ratio narratively by stating that that the PEO’s annual total compensation is 150 times that of the median of the annual total compensation of all employees.

For these purposes, the “annual total compensation” of the PEO and the median employee is their compensation for the last completed fiscal year as determined using the rules for determining the compensation for each named executive officer presented in the Summary Compensation Table (including the employee’s cash compensation for the fiscal year, the grant date fair value of equity awards granted to the employee during the fiscal year as determined under applicable accounting rules, and the value of any perquisites or personal benefits or other compensation received by the employee for the fiscal year).

Like other elements of Item 402, information provided in response to Item 402(u) will be “filed” for purposes of the Securities Act of 1933 and the Securities Exchange Act of 1934 and not merely “furnished.”

Procedures for Identifying the Median Employee

The new Item 402(u) requires that issuers analyze the compensation of their workforce and determine the “median employee” (i.e. the individual employee whose compensation is at the median level of all employees, excluding the PEO and certain other employees who may be omitted from the analysis under the rules described below). Item 402(u) includes the following instructions for determining the issuer’s median employee:
 

• All Employees Requirement: In general, all employees of the issuer and its consolidated subsidiaries (including full-time, part-time, seasonal and temporary workers), whether employed in or outside of the United States, must be taken into account in determining the median employee. The determination of the employee group is made as of a particular date chosen by the issuer that falls within the last three months of the issuer’s last completed fiscal year.
  
  
• Exclusion of Certain Employees:
  
  
  • Data Privacy Exception. An issuer may exclude employees in a particular non-US jurisdiction where obtaining the required compensation information would violate local data privacy rules. The issuer must obtain a legal opinion to that effect and must use reasonable efforts, including using or seeking an exemption or other relief, to obtain or process the required information. If an issuer excludes employees in a particular jurisdiction in reliance on this exception, all employees in that jurisdiction must be excluded.
    
    
  • Exclusion of All Non-US Employees if Less than 5% of Total Workforce. Issuers may exclude all of their non-US employees if the issuer’s non-US employees constitute less than 5% of the issuer’s total employees. In these circumstances, the issuer may not selectively include some non-US jurisdictions but exclude others.
    
    
  • De Minimis Exception. For issuers whose non-US employees constitute more than 5% of their total employees, they may exclude a number of their non-US employees not in excess of 5% of their total employees (with the 5% determined after taking into account any employees excluded based on the data privacy exception noted above). If an issuer excludes employees in a particular jurisdiction in reliance on this exception, all employees in that jurisdiction must be excluded. If more than 5% of the issuer’s total employees are located in any one non-US jurisdiction, none of the employees in that jurisdiction may be excluded under this exception.
    
    
  • Merger and Acquisition Activity. Issuers may exclude individuals who become employees as a result of a business combination or acquisition during the fiscal year.
    
    
  • Independent Contractors and Leased Employees. Individuals who provide services as independent contractors or “leased” workers are excluded from the definition of employee so long as they are employed, and their compensation determined, by an unaffiliated third party.
    
    
• Methodology to Determine Employee Compensation: For purposes of identifying the median employee, the issuer may use any compensation measure that is consistently applied to all employees in the calculation, such as tax or payroll records. (If an alternative compensation measure is used to determine the median employee, annual total compensation calculated using the rules for determining compensation in the Summary Compensation Table must still be used for purposes of disclosing the actual pay ratio.) The consistently applied measure may be defined differently across jurisdictions and may include different annual periods as long as, within each jurisdiction, the measure is consistently applied. Issuers may also use reasonable estimates and may use statistical sampling (as opposed to determining the compensation for every employee). Compensation for permanent employees (full-time or part-time) who were not employed during the entire fiscal year may be annualized. However, compensation of temporary and seasonal employees may not be annualized, and compensation of part-time employees may not be adjusted to full-time.
  
  
• Cost of Living Adjustments. In determining the median employee, cost-of-living adjustments may also be made to compensation of employees that are not located in the same jurisdiction as the PEO. If an adjustment is made, the adjustment must be applied to all employees included in the calculation. If a cost-of-living adjustment is used to determine the median employee and the median employee is one who is not located in the same jurisdiction as the PEO, the same cost-of-living adjustment must be made in calculating annual total compensation. A cost-of-living adjustment may not be made in calculating annual total compensation if such adjustments were not used when determining the median employee.
  
  
• Median Employee Identification Required Every Three Years: The issuer may identify its median employee once every three years instead of every year. That is, once the median employee has been determined, the use of that same individual’s compensation for purposes of determining the compensation of the median employee is permitted for a period of three years (but, in those circumstances, the employee’s annual total compensation must be re-determined each year for purposes of disclosing the actual pay ratio).
  
  For example: Employee A is identified as the median employee for fiscal 2017 as of the median employee determination date used (the date selected for this purpose that falls within the last three months of fiscal 2017). The issuer must determine Employee A’s annual total compensation for fiscal 2017 to use in the pay ratio disclosure. Except as noted below, Employee A may also be used as the median employee for purposes of the fiscal 2018 and fiscal 2019 pay ratio disclosures without the need to determine another median employee, but Employee A’s annual total compensation must be re-calculated for each of those two years for purposes of presenting the actual pay ratio each year.

However, if there has been a change in the issuer’s employee population or employee compensation arrangements that the issuer reasonably believes would result in a significant change to its pay ratio disclosure (compared with using the same median employee selected for the applicable prior year during that three-year period), the issuer must re-identify the median employee for the new fiscal year. In addition, an issuer may select another employee whose compensation is substantially similar to the compensation of the original median employee if the issuer believes that it is no longer appropriate to use the original median employee during the three-year period because of changes in the original median employee’s circumstances.

PEO Compensation Disclosure

If the issuer had more than one individual who served as PEO during the fiscal year, the issuer may either (1) combine the total compensation of these individuals for the portion of the fiscal year that each served as PEO, or (2) annualize the total compensation as PEO of the individual who was serving as PEO on the date used to identify the issuer’s median employee as described above.

Exempt Companies

JOBS Act emerging growth companies, smaller reporting companies, and foreign private issuers are exempt from the disclosures required under the Final Rule.

Required Disclosures

Item 402(u)’s disclosure requirements go beyond simply disclosing the pay ratio. The issuer’s methodology and any estimates and adjustments made in determining the median employee must be disclosed in the proxy. Disclosure must be made whether the median employee is the same individual used for the prior fiscal year. Additional disclosures are also required with respect to any exclusions of employees from the determination, the use of cost-of-living adjustments, and in circumstances where more than one PEO was in office during the year. In all cases, issuers should not disclose any personally identifiable information about the median employee other than the employee’s total compensation. A disclosure checklist is attached to help issuers navigate and prepare the required disclosures.

OMM Comments

Our thoughts on some of the key features of the Final Rule and implementation challenges issuers may face are highlighted below: 
 

• Methodology for Determining Median Employee: As outlined above, the methodology for determining the median employee can be complex. Issuers will need to consider the alternative procedures provided in the Final Rule in light of their particular workforce and determine whether they should consider the compensation data for all employees or use statistical sampling, whether certain employees can and should be excluded, whether cost-of-living adjustments should be applied, whether compensation of newly-hired employees should be annualized, and so forth. In each case, issuers will need to balance the benefits and costs (including any applicable enhanced disclosure obligations) of using the different approaches permitted under the Final Rule.
  
  
• Median Employee Identification Date. Consider which date (within the last three months of the fiscal year) will be used to determine the median employee, particularly if changes in the workforce (such as temporary or seasonal employees) or administrative concerns (pay cycle end dates and time required to perform the calculations) could have a significant impact.
  
  
• Presentation in the Proxy: Issuers will also need to consider how they want to present the pay-ratio disclosure in the proxy. New Item 402(u) permits issuers to present additional information, including additional ratios, to supplement the required ratio, as long as the supplemental information is not misleading or more prominent than the required ratio. For example, an issuer could consider presenting the ratio of the PEO’s total compensation to the median compensation for a subset of employees (such as all full-time employees, all U.S. employees, or all full-time U.S. employees) in addition to the required ratio.

Click here to view the Pay-Ratio Rule Disclosure Checklist.