United States: SEC Adopts Pay Ratio Rule

The US Securities and Exchange Commission (SEC) has adopted a final rule to implement the requirement of Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) that public companies disclose the ratio of the median of the annual total compensation of all employees to the total compensation of the company's CEO (or principal executive officer).

The final adopted rule is generally consistent with the SEC's original proposal, but contains some modifications which the SEC intended to mitigate compliance costs and practical difficulties associated with the proposed rule.

Overview

The rule requires companies to disclose:

  1. the median of the annual total compensation of all the company's employees (except the CEO),
  2. the annual total compensation of the CEO, and
  3. the ratio of (a) to (b) in a ratio in which (a) equals one or, alternatively, expressed narratively, in terms of the multiple (b) bears to (a).

For example, the pay ratio could be expressed as "1 to 268" or expressed narratively as "the CEO's annual total compensation is 268 times that of the median total compensation of all employees".

The rule requires pay-ratio disclosure in any annual report, proxy or other registration or information statement that requires executive compensation disclosure.  Companies are required to provide disclosure of their pay ratios for their first fiscal year beginning on or after January 1, 2017.  For a calendar-year company, the disclosure therefore would be required in the company's proxy statement for its 2018 annual meeting.  This time table allows one full reporting cycle to implement any necessary system changes.

The pay ratio would have to be updated annually, although, as discussed below, the median employee would only need to be identified every three years.  The pay ratio disclosure need not be updated until the company files its proxy statement for its annual shareholder meeting, provided that updated pay ratio information must, in any event, be filed not later than 120 days after the end of the fiscal year (i.e. with the Form 10-K annual report).

The most important details of the new rule are summarized below.

Subject to certain exclusions, the company must consider all employees to determine the median employee.

To determine the median employee, the company must select a date within the last three months of the fiscal year (and disclose such date) and consider all employees employed on such date.  In so doing, it must consider:

  • US and non-US employees (subject to potential exclusions discussed below),
  • employees of the company and its consolidated subsidiaries,
  • full-time and part-time employees and
  • seasonal and temporary employees employed on the selected calculation date.

However, consultants and independent contractors are not deemed employees and need not be considered for this purpose, and leased employees need not be considered for this purpose, in each case, as long as they are employed, and their compensation is determined by, an unaffiliated third party.  A company may exclude non-US employees when determining its median employee in the following two limited circumstances:

  1. Data privacy exemption - A company may exclude non-US employees who are employed in jurisdictions with data privacy laws that make the company unable to comply with the pay ratio disclosure requirement without violating such laws, provided that the company take reasonable efforts to apply for an exemption or other relief under the applicable jurisdictions' data privacy laws and obtain a legal opinion that supports the company's claims for this exemption. Also, the company seeking such exemption must list the excluded jurisdictions, identify the specific data privacy law or regulation, explain how complying with the final rule violates the law or regulation, and provide the approximate number of employees exempted from each jurisdiction based on this exemption; and
  2. De minimis exemption - If non-US employees make up 5% or less of a company's total US and non-US employees, the company may exclude all of them when identifying its median employee; provided that, if the company excludes any non-US employees under this exemption, it must exclude all of them.  If a company has more than 5% non-US employees, it may exclude non-US employees up to the 5% threshold; provided that, if such company excludes any non-US employees in a particular foreign jurisdiction, it must exclude all the employees in that jurisdiction.  If a company uses this exemption, it would have to make certain disclosures with respect to the exclusions.  In calculating the number of non-US employees that may be excluded under the de minimis exemption, a company must count any non-US employee exempted under the data privacy exemption against the availability.  A company may exclude any non-US employee that meets the data privacy exemption, even if the number of excluded employees exceeds 5% of the company's total employees.  If, however, the number of employees excluded under the data privacy exemption equals or exceeds 5% of the company's total employees, the company may not use the de minimis exemption to exclude additional non-US employees.

A company may also exclude any employees of an entity that the company acquired for the fiscal year in which the acquisition occurred (but not future years).  A company would be required to identify the acquired business and disclose the approximate number of employees it omitted in order to rely on this exemption.

Median employee may be calculated once every three years.

Although, as discussed above, a company must disclose the pay ratio annually, the final rule allows a company to identify the median employee whose compensation will be used for the annual total compensation calculation 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.  If there have been no changes that the company reasonably believes would significantly affect its pay ratio disclosure, the company must disclose that it is using the same median employee in its pay ratio calculation and describe briefly the basis for its reasonable belief. For example, the company could disclose that there has been no change in its employee population or employee compensation arrangements that it believes would significantly affect the pay ratio disclosure.  However, the company still must update its calculation of that median employee's annual total compensation each year and use that new figure to update its pay ratio disclosure each year.

Cost-of-living adjustment permitted.

Cost-of-living adjustments for non-US workers (to reflect purchasing power disparity) are permitted in jurisdictions other than the jurisdiction in which the CEO resides so that compensation is adjusted to the cost of living in the jurisdiction in which the CEO resides.  If such an adjustment is made, the company must also disclose the median employee total compensation and pay ratio determined without using any cost-of-living adjustment.

Compensation of permanent -- as opposed to temporary or seasonal -- workers hired during the fiscal year may be annualized.

  • Annualization is permitted, not required.
  • Annualization is not permitted for seasonal or temporary workers.
  • Compensation of part time employees employed a portion of the year may be adjusted to the full-year part time compensation.  It may not be adjusted to full-time, full-year compensation.

No specific calculation methodology is mandated for determining the median employee.

  • Companies may choose from several different permitted methodologies to identify the median employee, including:
    • statistical sampling,
    • reasonable estimates or
    • any other consistently applied compensation measures (e.g., cash compensation).
  • The company must briefly disclose and consistently apply any methodology and any material assumptions, adjustments, or estimates used to identify the median employee.  The company must identify estimates as such.
  • A company may choose the most appropriate and cost-effective methodology for determining the median employee, based on its own facts and circumstances, such as:
    • size and nature of the workforce,
    • complexity of the organization,stratification of pay levels across the workforce,
    • types of compensation,extent to which different currencies are involved and
    • number of payroll systems involved and the degree of difficulty in readily integrating the systems to readily compile total compensation information.

The company must determine compensation of the median employee the same way as for named executive officers. 

Once the company identifies the median employee, the fiscal year compensation calculation for the median employee is subject to the same rules as applied to the named executive officers.

  • Dodd-Frank requires conformance to the summary compensation table rules in effect and unchanged since 2010.  The SEC said it will consider the effect on pay ratio reporting of any future changes in the summary compensation table disclosure requirements when they occur.
  • For non-salaried employees, "base salary" will be deemed to refer to "wages plus overtime".
  • For multiemployer defined benefit pensions plans, companies should use reasonable estimates to determine an amount that reasonably approximates the aggregate change in actuarial present vale of an employee's defined benefit pension.
  • The company may exclude personal benefits (perks) under $10,000 and may determine the value based on reasonable estimates.
  • If the company chooses to include perks under $10,000 or items such as broad-based health coverage, then it also must include such items in the CEO pay calculation for purposes of the ratio.
  • The value of personal benefits (such as housing) should be based on the incremental cost to the company.
  • Government-mandated pensions would not be considered a "defined benefit plan" for purposes of the required disclosure.  Therefore, any accrued pension benefit under a government-mandated pension would not be considered "compensation", notwithstanding that the company may be required to contribute to the plan through taxes or otherwise.  The rationale is that the government, not the company, bears the actuarial risk on a government-mandated pension.

The company must briefly disclose and consistently apply any methodology it uses to identify median compensation or to determine total compensation or any elements of total compensation and must clearly identify all estimates as such.

  • If it uses statistical sampling, the company should disclose:
    • the size of the sample as well as the total population,
    • any material assumption it used in determining sample size, and which sampling method(s) it used,
    • how the sampling method deals with separate payrolls or other issues involving multiple businesses or geographical segments,
    • any estimates used and
    • if changes in methodology, material assumptions adjustments or estimates are material, the reasons for the change and an estimate of the impact of the change on the median and the ratio.
  • The SEC stresses that the disclosure should be brief and non-technical (not a discussion of statistical formulas, confidence levels or the steps used in data analysis).
  • A narrative discussion of the ratio, the median or any supplemental information is not required.  Supplemental disclosure, including of additional ratios, is permitted, however.

"Annual compensation" means compensation for the last completed fiscal year.

  • Fiscal year companies using calendar year tax records to determine the median employee would be required to calculate the median employee's total compensation for the last fiscal year, rather than using the annual payroll or tax records.
  • The pay ratio disclosure would be "filed", not "furnished", for purposes of the Securities Act of 1933 and the Securities Exchange Act of 1934, and, accordingly, would be subject to corresponding potential liabilities thereafter.

Certain companies are exempt from the rules or subject to transition rules.

  • Non-US companies that qualify as "foreign private issuers", Canadian MJDS filers, companies that qualify as "emerging growth companies", smaller reporting companies and registered investment companies are not subject to the rules.
  • Companies that are new registrants (such as IPO filers) are subject to certain transition rules and, for example, are not subject to the new rules until their first fiscal year after becoming subject to Exchange Act reporting requirements.

Miscellaneous

  • If there are multiple CEOs during a fiscal year, the company can select from two options (which choice would be disclosed):
    • calculate and combine the compensation provided to each CEO during the fiscal year for the period during which such person served as CEO or
    • calculate and annualize compensation for the person who was serving as CEO on the date the company selected to identify the median employee.

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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