United States: SEC Approves Final Rules For Pay Ratio Disclosure

Shawn Turner, Partner, is based in our Denver office, Lawrie Green, Partner, is based in our Ft Lauderdale office and Christopher Cwalina, Partner is based in our Washington, D.C. office


  • SEC commissioners voted to approve the final "pay ratio" disclosure rules intended to help shareholders evaluate executive compensation practices.
  • Companies must comply with the final pay ratio rules commencing with their first fiscal year beginning on or after January 1, 2017.
  • The final rules contain specific disclosure obligations that include disclosing the median of the annual total compensation of all employees, excluding the CEO; the annual total compensation of the CEO; and the ratio of the median to the annual total compensation of the CEO.

The Securities and Exchange Commission (SEC) adopted the final "pay ratio" disclosure rules to implement Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) at an open meeting on August 5, 2015. Following its release of the proposed pay ratio disclosure rules in September 2013, the SEC received over 287,400 comment letters. Out of these, over 1,500 were individual letters reflecting a wide range of views concerning the proposed rule, and nearly 286,000 were one of 12 types of form letters either supporting the proposed rule or supporting the idea of adopting a rule based on Section 953(b) of the Dodd-Frank Act.

The SEC commissioners voted three to two to approve the controversial rules, with commissioners Daniel M. Gallagher and Michael Piwowar voting against approval. Highlighting the controversy, Commissioner Gallagher noted in remarks prior to the vote that the SEC was "on the cusp of adopting a nakedly political rule that hijacks the SEC's disclosure regime to once again effect social change desired by ideologues and special interest groups." In adopting the final rules, the SEC noted its belief that, notwithstanding the lack of available legislative history, Section 935(b) "was intended to provide shareholders with a company-specific metric that can assist in their evaluation of a company's executive compensation practices." To that end, the final rules differed from the proposed rules in various circumstances as a result of the SEC's attempt "to tailor the final rule to meet that [legislative] purpose while avoiding unnecessary costs."

Effective Date of the New Pay Ratio Rules

Companies must comply with the final pay ratio rules commencing with their first fiscal year beginning on or after January 1, 2017. As such, for companies that have a calendar fiscal year, pay ratio disclosure will cover fiscal year 2017 and be included in the 2018 Annual Meeting proxy statements. Companies that cease to be smaller reporting companies or emerging growth companies are not required to provide pay ratio disclosure until they file a report for the first fiscal year commencing on or after they cease to be a smaller reporting company or emerging growth company, as the case may be. The final rules also include specific transition rules applicable to new registrants as well as to companies that engage in business combinations and acquisitions.

Summary of the Final Rules

The final pay ratio disclosure rules implement Section 953(b) of the Dodd-Frank Act by amending Item 402 of Regulation S-K to include a new Paragraph (u) that requires companies other than emerging growth companies, smaller reporting companies or foreign private issuers to disclose all of the following:

  • the median of the annual total compensation of all employees, excluding the principal executive officer (i.e., the CEO)
  • the annual total compensation of the CEO
  • the ratio of the median to the annual total compensation of the CEO

The disclosure must be presented as either a ratio of the median of annual total compensation of all employees to the CEO's annual total compensation, with the median equal to one, or as a multiple. A narrative description may be easier for investors to understand than a numerical ratio.

Companies are required to present the new pay ratio disclosure in any registration statement, proxy statement, information statement and annual report that is required to include the executive compensation disclosure required by Item 402 of Regulation S-K. Although the final rules do not mandate where the pay ratio disclosure should appear, those companies voluntarily including pay ratio disclosure in their SEC filings to date generally have included the disclosure in their Compensation Discussion and Analysis. Similar to the other executive compensation disclosure, the final rules confirm that the pay ratio disclosure will be deemed "filed," not "furnished," under the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, making the disclosure subject to a higher level of potential liability.

"All Employees" Are Covered by the Rules

The final rules apply to "all employees" of a company, which includes all full-time, part-time, temporary and seasonal employees of the company or any of its subsidiaries in the United States and abroad. Independent contractors, "leased" workers or other temporary workers who are employed by a third party are not covered by the final rules. Compensation is permitted, but not required, to be annualized for employees who were not employed for a full fiscal year. However, full-time equivalent adjustments for part-time workers, annualizing adjustments for temporary or seasonal workers and cost-of-living adjustments for non-U.S. workers is not permitted.

Two Exceptions. In response to comments received, the SEC included in the final rules the following two exemptions from the definition of "employee" pertaining to individuals employed outside of the U.S.:

  • Foreign Data Privacy Law Exemption: Individuals employed outside of the U.S. and who otherwise would be included as an "employee" may be excluded in the event that a company, despite its reasonable efforts, is unable to comply with the rules because doing so would violate applicable foreign data privacy laws or regulations. However, in an effort to prevent abuse of this exemption, the SEC has imposed fairly significant hurdles a company must overcome in order to rely upon this exemption. These include using or seeking an exemptive order or other relief under such laws or regulations, and obtaining a legal opinion with respect to the company's inability to comply with the disclosure rules as a result of such laws or regulations—including demonstrating unsuccessful efforts to leverage an exemption or other relief under such foreign laws or regulations. Further, if a company excludes any non-U.S. employees in a particular jurisdiction under the data privacy exemption, it must exclude all non-U.S. employees in that jurisdiction.
  • De Minimus Exemption: Employees in a jurisdiction located outside of the U.S. may be excluded where those employees represent no more than five percent of a company's total U.S. and non-U.S. employees, with certain limitations. If a company's non-U.S. employees exceed five percent of its total employees, the company may exclude up to five percent of its total employees who are non-U.S. employees.

The final rules contain specific additional disclosure obligations in the event a company seeks to avail itself of either of these exemptions.

Cost-of-Living Adjustments. Pursuant to the final rules, companies may make cost-of-living adjustments for compensation of employees in jurisdictions other than the jurisdiction in which the CEO resides so that the median employee compensation is adjusted to the cost of living in the jurisdiction in which the CEO resides. The company must explain the cost-of-living adjustments used, including the measure used as the basis for the cost-of-living adjustment. The company also must disclose the median employee's annual total compensation and pay ratio without using any cost-of-living adjustments.

Only Employees of Consolidated Subsidiaries. Although the proposed rules covered employees of any of a company's subsidiaries, the final rules limit the universe of covered subsidiaries to only those subsidiaries that are consolidated into the company's financial statements.

Measurement Date for Identifying "Employees" and the "Median Employee"

Unlike the proposed rules, which included the last day of the company's last completed fiscal year as the date for determining the median employee, the final rules permit companies to use any date within three months prior to the last day of their last completed fiscal year to identify their median employee. Companies must disclose the date used, and if they elect to change that date in subsequent years, they must disclose the change and provide a brief explanation about the reason or reasons for the change.

Identifying the "Median Employee"

Identification Required Only Once Every Three Years, but Calculation Required Every Year. The final rules allow companies to identify the median employee every three years (rather than every year, as originally proposed), unless there has been a change in employee population or employee compensation arrangements that the company reasonably believes would result in a significant change in the pay ratio disclosure. However, companies must recalculate the identified median employee's total compensation annually and use that figure in calculating the pay ratio.

Alternative Methodologies to Determine the Median Employee. While Section 953(b) requires companies to calculate median employee compensation in the same way that "named executive officer" total compensation is calculated under Item 402(c)(2(x) of Regulation S-K, it did not specify a methodology to identify the median. Consistent with the proposed rules, the SEC has provided in the final rules flexibility in allowing companies to choose from several alternative methods to identify the median, including:

  • Total Compensation for Each Employee: This involves applying the standards of 402(c)(2)(x) to determine "annual total compensation" of all employees, and then identifying the median.
  • Statistical Sampling: Median employee pay may be based upon the full employee population, a statistical sample of all employees or some other reasonable method. Identification of a median employee need not require a determination of exact compensation amounts for every single employee included in the sample. The variance of underlying wage distributions can materially affect the appropriate sample size for statistical sampling.
  • Consistently Applied Compensation Measures: Identification of the median employee may be based on any consistently applied compensation measure, such as compensation amounts reported in a company's payroll or tax records, as long as the company briefly discloses the measure it used. Companies are permitted to choose a method that is workable based upon their particular facts and circumstances.

Determining Total Compensation; Methodology, Assumptions and Estimates

Once the median employee is determined, the final rules require that the total compensation of the median employee be calculated in accordance with Item 402(c)(2)(x) of Regulation S-K (i.e., consistent with the methodology for calculating total compensation for named executive officers). Consistent with the proposed rules, the final rules permit companies to use reasonable estimates to determine the median salary and value of the various elements of total compensation.

In using an estimate for annual total compensation (or for a particular element of total compensation of employees other than the CEO), a company must have a reasonable basis to conclude that the estimate approximates the actual amount of compensation under Item 402(c)(2)(x) awarded to, earned by or paid to those employees. If estimates are used, companies must briefly disclose and consistently apply any methodology used to identify the median and any material assumptions, adjustments or estimates used to identify the median or to determine total compensation or any elements of total compensation. Companies must also clearly identify any estimated amount as such.

The Meaning of "Annual"

Consistent with the proposed rules, the final rules define "annual total compensation" as total compensation for the company's last completed fiscal year, consistent with the time period used for other Item 402 disclosure requirements.

Omission of Salary and Bonus Information for CEO and Conforming Form 8-K Amendments

Where the salary or bonus of a named executive officer is not calculable as of the latest practicable date, Instruction 1 to Items 402(c)(2)(iii) and (iv) of Regulation S-K, permits a company to omit such disclosure from the summary compensation table, if the company includes a footnote disclosing that fact and provides the date the amount is expected to be determined. Once the omitted information is determined, the company must disclose the final amounts under Item 5.02(f) of Form 8-K, as well as a new total compensation figure for the named executive officer. Consistent with the proposed rules, the final rules require a company relying on such instruction to include its pay ratio disclosure in the same filing under Item 5.02(f) of Form 8-K.

What Companies Should Be Doing Now

Institutional and activist investors, as well as aggressive securities litigants, undoubtedly will find fertile fields in pay ratio disclosure practices. There are several measures that companies that currently are subject to the new pay ratio disclosure rules, or that reasonably anticipate becoming subject to the rules prior to or shortly after the rules becoming effective, should be taking now in response to the new rules and this heightened scrutiny, including the following:

  • Most importantly, given the volume of information and analytics that will be required, and the necessary strategic decisions regarding appropriate measurement methodologies, assumptions and estimates, companies should begin having meaningful discussions about their approach to pay ratio disclosure now. The decisions include:
    • considering the best method for identifying the median employee and determining whether the current payroll system permits such identification on a cost-effective basis, or whether changes are necessary
    • considering whether cost of living adjustments are appropriate
    • identifying the scope of employees who will be covered by the rules
  • If a company has operations (either directly or through consolidated subsidiaries) in foreign jurisdictions, the company should:
    • consider whether to elect to exclude eligible foreign employees pursuant to the de minimis exemption
    • if the de minimis exemption is not available, commission an in-depth analysis of that jurisdiction's data privacy laws applicable to obtaining and processing employment and biographical information required to comply with the final rule; analysis should include a determination as to whether such employees can be excluded from the "all employees" pool pursuant to the data privacy exemption
  • As described above, pay ratio disclosure will be deemed "filed" and, therefore, subject to heightened levels of potential liability under federal securities laws. As such, companies should analyze their disclosure controls and procedures and internal controls for generating and producing the pay ratio data.
  • Companies should confirm that data privacy controls currently in place are adequate to protect the privacy of the type of data used and reports generated in connection with the pay ratio analysis. Despite the fact that the SEC set a particularly high bar for the data privacy exemption, it did clarify that the rule does not compel a registrant to disclose any personally identifiable information about an employee other than his or her compensation and, in fact, should not disclose information that could identify any specific individual. Thus, companies are tasked with striking the appropriate balance between both compliance with the rule and protection of the privacy of employees' data.
  • Companies should consider drafting "pay ratio" as early as in connection with the 2016 proxy season disclosure, not necessarily to include the disclosure in their 2016 proxy materials, but to begin to understand the context of the disclosure and to strategically consider whether supplemental ratios or other information will assist with interpreting the pay ratio disclosure in a meaningful way given the company's business circumstances.

See the final rule release for Pay Ratio Disclosure.    

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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