United States: SEC Finalises Pay Ratio Disclosure Requirements

On 5 August 2015, in a 3-2 vote of commissioners cast along party lines, the SEC released final rules implementing the pay ratio disclosure requirements of Section 953(b) of the Dodd-Frank Act. The final rules are largely consistent with the proposed rules issued by the SEC in September 2013, and will be codified as paragraph (u) to Item 402 of Regulation S-K. Foreign private issuers are exempt from these rules.

  • Summary of Proposed Pay Ratio Disclosure Requirements
    • The final rules establish a prescribed format for comparing the total compensation of the registrant's principal executive officer ("PEO") to the median compensation paid to the registrant's covered employees. New Item 402(u) of Regulation S K requires issuers to disclose:
      • the median of the annual total compensation of all employees of the registrant (except the registrant's PEO) (the "Median Compensation");
      • the annual total compensation of the registrant's PEO (the "PEO Compensation"); and
      • the ratio of the Median Compensation to the PEO Compensation (the "Ratio").
    • The SEC refers to the disclosure of the above three items as the "pay ratio" disclosure. The Ratio must be presented as either:
      • a ratio in which the Median Compensation equals one; or
      • a narrative in terms of the multiple that the PEO Compensation bears to the Median Compensation.
    • For example, if the Median Compensation is $100 and the PEO Compensation is $1,000, the Ratio can be presented as: (1) 10 to 1, (2) 10:1 or (3) "The PEO Compensation is ten times the Median Compensation."
  • When and Where the Pay Ratio Disclosure is Required
    • The first reporting period is the first full fiscal year beginning on or after 1 January 2017.
    • The final rules require the pay ratio disclosure in any SEC filing that calls for executive compensation disclosure under Item 402 of Regulation S K. Therefore, for calendar year registrants, the first pay ratio disclosure will be made in early 2018, as part of the proxy statement or information statement for the 2018 annual meeting. For some fiscal year companies, the disclosure may not be made until 2019. For example, if a registrant's fiscal year starts on 1 November 2017 and ends on 31 October 2018, the first pay ratio disclosure will be made in the next proxy statement or information statement, which may not be distributed until January 2019.
  • New Registrants
    • The first pay ratio disclosure for a new registrant will follow the first full fiscal year beginning after the registrant has (1) been subject to the requirements of Sections 13(a) or 15(d) of the Exchange Act for a period of at least 12 months beginning on or after 1 January 2017 and (2) filed at least one annual report pursuant to those same sections of the Exchange Act that does not contain the pay ratio disclosure.
    • By way of example, if a calendar year company completes its initial public offering on 1 March 2017; its pay ratio disclosure must be included in its proxy or information statement for its 2019 annual meeting of shareholders (but no later than 120 days following the end of the 2018 fiscal year).
    • No pay ratio disclosure is required on a registration statement on Form S 1 or Form S 11 for an initial public offering, or a registration statement on Form 10.
  • Identifying the Median Employee
    • The final rules allow a registrant to identify its median employee once every three years, unless there has been a change in its employee population or compensation arrangements that it reasonably believes would result in a significant change in the pay ratio disclosure.
    • If there has been no change to a registrant's employee population or compensation arrangements, but the median employee is no longer employed with the registrant (or has had a change in circumstances), the registrant may use another employee whose compensation is substantially similar to the original median employee based on the compensation measure used to identify the original median employee.
    • Registrants may choose any date within the last three months of the relevant fiscal year to determine its median employee. Only employees that are employed on the chosen date will be taken into account for purposes of determining the median employee.
    • Each registrant is provided flexibility to choose a method to identify the median employee based on the registrant's facts and circumstances. The chosen methodology may use reasonable estimates. Further, because of the complexity of applying the Item 402(c)(2)(x) of Regulation S-K ("Item 402(c)(2)(x)") calculation to all employees of a registrant, the final rules permit registrants to use any other consistently applied compensation measure, such as information derived from tax and/or payroll records. If the measure used is recorded on a basis other than the registrant's fiscal year, such as might be the case with tax and/or payroll records, the registrant may use the same annual period used in those records.
    • Regardless of the measure used to determine the median employee, the total compensation for the identified median employee will need to be calculated using the Item 402(c)(2)(x) calculation for the completed fiscal year.
  • Covered Employees
    • The final rules define "employee" as the US and non US employees of the registrant and any of its consolidated subsidiaries. This definition includes part time, seasonal and temporary employees. Only employees that are employed on the date chosen for the determination of the median employee are taken into account. A consolidated subsidiary of a registrant is a subsidiary with financial statements that are consolidated with those of the registrant. Although this will result in a smaller pool of employees than would be the case under the proposed rules (which required inclusion of all employees of the registrant's subsidiaries as such term is defined under Rules 405 of the Securities Act of 1933 and 12b 2 of the Exchange Act), the SEC does not believe it will undermine the usefulness of the pay ratio disclosure.
  • Exemptions for Non-US Employees
    • Registrants are not required to include non US employees in the pay ratio disclosure if obtaining the information required to comply with the rules would cause a violation of a non US jurisdiction's data privacy laws. Before taking advantage of this exception, the registrant must make reasonable efforts to obtain the information, such as seeking an exemption or other relief. In addition, the registrant must obtain an opinion from legal counsel opining on the registrant's inability to comply with the pay ratio disclosure rules without violating the non US jurisdiction's data privacy laws.
    • If a registrant excludes any non US employee in a particular jurisdiction under this exemption, it must exclude all non US employees in that jurisdiction.
  • There is Also a Tailored Exemption for De Minimis Non-US Employees:
    • Registrants whose non US employees make up 5% or less of their total employees. These registrants may exclude all of their non US employees when identifying the median employee. If the registrant chooses to exclude any of these employees, it must exclude all of them.
    • Registrants whose non US employees make up more than 5% of their total employees. These registrants may exclude non US employees up to the 5% threshold. However, if a registrant excludes any non US employees in a particular jurisdiction, it must exclude all employees in that jurisdiction, subject to compliance with the overall 5% limitation. For example, if employees in a single non US jurisdiction constitute 6% of the registrant's covered employees, none of the employees in that jurisdiction could be excluded, unless the data privacy exception applied.
  • Non US employees that are excluded under the data privacy exemption will also be counted as excluded under the 5% de minimis exemption. As a practical matter, together, these exemptions allow registrants to exclude a number of non-US employees equal to the greater of 5% of total employees and the number of employees covered by the data privacy exemption.
  • Defining Total Compensation
    • The final rules requires that "annual total compensation" for both the PEO and the median employee be determined using the Item 402(c)(2)(x) calculation. However, a registrant may use reasonable estimates for any of the elements of total compensation utilised in the Item 402(c)(2)(x) calculation with respect to its median employee, so long as the registrant has a reasonable basis to conclude that the estimates approximate the actual amount of compensation. For example, reasonable estimates can be used for determining an amount that reasonably approximates the aggregate change in actuarial present value of an employee's defined pension benefit and calculating the amount of personal benefits that may be excluded because the total value is less than $10,000.
    • Reasonable estimates may not be used for purposes of calculating the PEO's total compensation. The total compensation of the identified median employee must be recalculated each year.
  • The Pay Ratio Disclosure is "Filed" with the SEC
    • The pay ratio disclosure required by the new rules is "filed" with the SEC. As a result, false or misleading statements can lead to liability under Section 18 of the Exchange Act. Similarly, regardless of whether the pay ratio disclosure is "furnished" or "filed," potential liability exists under Exchange Act Sections 13(a) and 15(d) if the registrant fails to comply with the rule. Finally, misleading statements in the pay ratio disclosure can be interpreted as a manipulative or deceptive device in connection with the purchase or sale of a security leading to potential liability under Section 10(b) of the Exchange Act and Rule 10b 5 promulgated thereunder.

Our related client publication discussing the final rules is available at: http://www.shearman.com/en/newsinsights/publications/2015/08/sec-final-pay-ratio-rules-what-you-need-to-know

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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