This practice note focuses on recent market trends covering the Securities and Exchange Commission's (SEC's) pay ratio rulemaking, which was mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (111 P.L. 203, 124 Stat. 1376), and provides recent pay ratio disclosure examples. The SEC originally proposed pay ratio disclosure in 2013, and the proposal generated a great deal of interest and debate. The final rule was adopted in 2015 and required pay ratio disclosure by companies with respect to their first full fiscal year that began on or after January 1, 2017. For calendar year companies, we've now seen three years of pay ratio disclosure.

For additional information on pay ratio disclosure, see Pay Ratio Disclosure and Pay Ratio Rule Presentation. For other market trends articles covering various capital markets and corporate governance topics, see Market Trends.

Disclosure Requirement

The pay ratio disclosure rule is contained in paragraph (u) of Item 402 of Regulation S-K (17 C.F.R. § 229.402(u)). It requires public companies to disclose:

  • The median of the annual total compensation of all employees other than the chief executive officer
  • The annual total compensation of the chief executive officer
  • The ratio of these amounts

Filings Requiring Pay Ratio Disclosure

Generally, the pay ratio disclosure appears in filings that require executive compensation disclosure pursuant to Item 402 of Regulation S-K, such as proxy and information statements, annual reports on Form 10-K, and registration statements under the Securities Act of 1933 and the Securities Exchange Act of 1934.

Location of the Disclosure

The pay ratio disclosure is called for by Item 402(u) of Regulation S-K, which means it is a part of the executive compensation disclosure, but it is not part of the Compensation Discussion and Analysis required by Item 402(b) of Regulation S-K (17 C.F.R. § 229.402(b)). Generally, companies present the pay ratio chronologically in the order that it appears in Item 402, which is following the executive compensation and potential payments upon termination or change in control tables.

Employees Covered

For the purposes of the pay ratio rule, the term "employee" means an individual employed by the company or its consolidated subsidiaries as of any date (determined by the company) within the last three months of the company's last completed fiscal year. In addition to full-time employees and employees based in the United States, the term includes:

  • Employees based outside of the United States
  • Part-time employees
  • Temporary employees
  • Seasonal employees

Independent contractors, leased workers, and any employee employed by, and whose compensation is determined by, an unaffiliated third party are not considered employees for purposes of the pay ratio disclosure rule.

Individuals who become employees as a result of a business combination or the acquisition of a business can be omitted from the calculation of the median of the annual total compensation of all employees other than the chief executive officer for the fiscal year in which the transaction became effective.

Limited Exemption for Foreign Employees

There are two limited exemptions from the definition of employee. These exemptions permit companies to exclude certain employees located in non-U.S. jurisdictions (non-U.S. employees) from the pay ratio calculation.

The first is an exemption for employees in a foreign jurisdiction in which data privacy laws or regulations are such that, despite the company's reasonable efforts to obtain and process the information necessary to comply with the pay ratio disclosure rule, the company is unable to do so without violating those data privacy laws or regulations.

The second is a de minimis exemption for excluding nonU.S. employees who make up 5% or less of the total employee population.

Companies Exempt from Pay Ratio Disclosure Requirement

Smaller reporting companies, emerging growth companies, foreign private issuers, MJDS filers (i.e., registrants filing under the U.S. Canadian Multijurisdictional Disclosure System), and registered investment companies are not subject to the pay ratio disclosure requirement.

Identifying the Median Employee

The pay ratio disclosure rule gives companies flexibility to select a method for identifying a median that is appropriate to the size and structure of their businesses and compensation programs.

Companies may identify the median based on total compensation regarding their full employee population or by using a statistical sample or another reasonable method. Reasonable estimates of the median for companies with multiple business lines or geographical units may be determined using more than one statistical sampling approach.

The median employee must be an actual, individual employee. However, companies are not required to, and should not, identify the median employee by name or other identifiable information. Companies may choose to generally identify the median employee's position to place the compensation in context, but the instructions to the rule specify that they should not do so if providing the information could identify any specific individual.

Companies need only identify a median employee once every three years, unless there has been a change in the employee population or employee compensation arrangements that would significantly change the pay ratio disclosure. In addition, if the median employee is no longer with the company, promoted to a different position, or the makeup of the employee population has significantly changed as a result of a change of control or merger, companies are permitted to substitute a new median employee who has substantially similar compensation as the previous median employee, using the same consistently applied compensation measure as was previously used.

In year three of the pay ratio disclosure, most companies retain the same median employee for their pay ratio disclosure. By comparison, in year two, more companies identified a new median employee than not. As a reminder, calendar year companies that have not reidentified their median employee will need to do so for the upcoming 2021 proxy season.

In 2021, many, if not most, companies may need to reidentify the median employee, even if they're not required to by the every three-year rule. The COVID-19 pandemic has caused companies to implement workforce reductions, furloughs, and changes in pay across many industries. All companies should consider whether these events constituted significant changes in the employee population or in employee and executive compensation arrangements. Additionally, some chief executive officers have agreed to reduce, defer, or otherwise accept changes to elements of their compensation in response to the pandemic, so companies are expected to discuss the impact of the pandemic on compensation and, ultimately, the pay ratio.

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Originally Published by Practical Guidance

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