United States: SEC Pay Ratio Rules: A Recipe For Compliance And Model Disclosure

The SEC recently adopted its final pay ratio disclosure rules.  Commencing in early 2018, public companies  will have to disclose (i) their CEO's total annual compensation, (ii) the median total annual compensation of all of their employees (other than the CEO), and (iii) a ratio comparing the two values.  This alert explains step-by-step how to comply with the final rules and concludes with a model disclosure.

Step 1:  Determine the CEO's Total Annual Compensation

The CEO's total compensation will be as reported in the Summary Compensation Table.  If the company had more than one CEO during the year, it must either: (i) aggregate the total compensation that was paid to each individual who served as CEO during the year, or (ii) annualize the compensation paid to the individual serving as CEO on the determination date the company selects to identify the median employee.  The company must disclose which method it chose and how it calculated the annual total compensation. 

If a CEO's salary or bonus is not yet calculable, the company may omit its disclosure until such amounts are determinable and disclose when this is expected.  Once the information is available, the company's disclosure would then be filed under Item 5.02(f) of Form 8-K.  Although an Item 5.02(f) filing would be triggered when the CEO's omitted salary or bonus becomes calculable in whole or in part, the pay ratio disclosure is only required when the CEO's salary or bonus becomes calculable in whole. 

Step 2:  Determine the Median Total Annual Compensation for All Other Employees

The final rules define "employee" to include all worldwide full-time, part-time, seasonal, and temporary employees employed by the company or any of its consolidated subsidiaries.  This does not include independent contractors or "leased" employees as long as they are employed, and their compensation is determined, by an unaffiliated third party.  Given recent controversy surrounding this part of the final rules, companies may want to consult their legal expert on whether independent contractors that are self-employed are required to be counted.  Fortunately, the final rules afford some flexibility with respect to identifying the median employee as explained below.

International Employees.

The company may exclude non-U.S. employees from its determination of median employee in two limited instances. 

Foreign Law Exemption:  If compliance with the final rules would cause the company to violate foreign data privacy laws or regulations, the employees of that foreign jurisdiction may be excluded.  Reasonable efforts must first be made to seek an exemption or other relief under the foreign data privacy laws before relying on this exemption.  The company also must obtain a legal opinion from counsel opining on the inability to comply with the final rules without violating foreign laws and file such opinion as an exhibit to the filing in which the pay ratio disclosure is included.

De Minimis Exemption:  If the company's non-U.S. employees account for 5% or less of its global workforce, all of the non-U.S. employees may be excluded.  If the non-U.S. employees exceed the 5% threshold, the company may exclude up to 5% of its global workforce who are non-U.S. employees.  However, non-U.S. employees excluded under the foreign law exemption will count against this 5% cap.

If any non-U.S. employees in a particular jurisdiction are excluded, all non-U.S. employees in that jurisdiction must be excluded.  Cherry-picking within jurisdictions is prohibited. 

Identifying Median Employee Once Every Three Years. 

The company may identify its median employee once every three years unless there has been a change in its employee population or employee compensation arrangements that it reasonably believes would result in a significant change in the pay ratio disclosure.  Also, if the identified median employee's compensation changes, the company can use another employee who previously had substantially similar compensation.  The company must disclose whether it uses the same median employee for three years or a different median employee.

Three-Month Determination Date Window. 

The company may use any date within three months prior to the last day of the year to determine the employee population for purposes of identifying the median employee.  For example, choosing a date before the holidays could avoid the inclusion of seasonal employees.  The chosen date (or a change in the date from a prior year) must be disclosed.

M&A Employees.

The company may exclude any employees of an entity that was acquired by the company during the covered fiscal year (but not future years).  The company would have to disclose the identity of the acquired company and the approximate number of employees excluded.

The final rules also provide additional flexibility in calculating the median employee's total annual compensation:

Reasonable Estimates.  Reasonable estimates such as statistical sampling are permitted, but the company must disclose any material assumptions, adjustments or estimates used to identify the median employee and determine the total annual compensation.

Annualizing Adjustments.  The company may annualize the compensation of a permanent employee (full- and part-time) who did not work for the entire year but not the compensation of temporary or seasonal employees.  Full-time adjustments for part-time employees is also prohibited.

Cost-of-Living Adjustments.  The company may make cost-of-living adjustments to the compensation paid to employees in jurisdictions other than the jurisdiction where the CEO resides.  If the company uses this adjustment, it must use the same cost-of-living adjustment in calculating the median employee's annual total compensation and disclose (i) the median employee's jurisdiction, (ii) the median employee's annual total compensation and the pay ratio, both with and without the cost-of-living adjustment, and (iii) a description of the cost-of-living adjustments used.

Step 3:  Formulate the Pay Ratio

The pay ratio must be expressed either (i) as a ratio in which the annual total compensation of the median employee is equal to one (e.g., 100 to 1 or 100:1), or (ii) narratively in terms of the multiple that the CEO's total annual compensation bears to the annual total compensation of the median employee.

Step 4:  Prepare the Disclosure

The pay ratio disclosure will have to be provided in all filings in which executive compensation disclosure is required by Item 402 of Regulation S-K (e.g., Form 10-Ks, proxy and information statements and registration statements) but not in periodic filings such as Form 8-Ks or 10-Qs.  As with other executive compensation information, the Form 10-K can incorporate this disclosure from a proxy statement that is filed within 120 days after the end of the fiscal year covered by the Form 10-K.  After the initial pay ratio disclosure, the company will be able to benchmark how its pay ratio compares to peer group members.  We expect there will be more commentary on how companies rank and why the pay ratios are what they are by the 2019 proxy season.

Supplemental Disclosure.  The company may supplement its pay ratio disclosure by providing additional pay ratios or a narrative discussion to address any unwarranted conclusions that may be drawn from its disclosure.  Any additional ratios must be clearly identified, not misleading and not presented with greater prominence than the required ratio.

Model Disclosure

Our Compensation Committee reviews the internal pay ratio between the CEO's total compensation and other named executive officers and the median annual total compensation of all employees (excluding the CEO).  We identified the "Median Employee" by taking a statistical sampling of the annual total compensation of all full-time, part-time, seasonal, and temporary employees employed by us on [Date].  In making this determination, we used a sample size of [x] from a population size of [y].   Our CEO had annual total compensation of $10,000,000, and our Median Employee had annual total compensation of $100,000.  Therefore, our CEO's annual total compensation is 100 times that of the median of the annual total compensation of all of our employees.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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