As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act enacted in July 2010, Congress directed the Securities and Exchange Commission (SEC) to adopt pay ratio disclosure requiring public companies to disclose the ratio between the annual total compensation of the median employee and the company’s principal executive officer (PEO), generally the company’s chief executive officer (CEO). The Pay Ratio rules required the SEC to amend Item 402 of Regulations S-K, related to company compensation disclosures. Item 402(u) requires companies to disclose:

1. the median of the annual total compensation of all employees of the company (excluding the company’s PEO);

2. the annual total compensation of the company’s PEO; and

3. the ratio of the two amounts.

The SEC adopted final Pay Ratio rules in August 2015, released additional interpretive guidance in October 2016, and solicited additional comments for consideration in February 2017. All public companies except smaller reporting companies, foreign private issuers, US-Canadian Multijurisdictional Disclosure System filers, emerging growth companies and registered investment companies will be subject to the Pay Ratio rules. The Pay Ratio rules are effective for fiscal years beginning on or after January 1, 2017, and, thus, absent repeal by Congress or delay by the SEC, most public companies will need to comply with the rules beginning with the 2018 proxy season.

Determining the Median Employee

Much of the difficulty of preparing for the Pay Ratio disclosure is the need for companies to identify their median employees. In performing this analysis, a company generally is required to consider all individuals employed by the company or any of its consolidated subsidiaries, including its full-time, part-time, seasonal and temporary workers. However, independent contractors whose compensation is determined by an unaffiliated third party are not required to be included in the overall analysis. In addition, employees acquired through a business combination or acquisition may be omitted for the fiscal year in which the transaction becomes effective, but the approximate number of employees omitted must be disclosed and those employees must be considered in the following year when determining the median employee.

In determining the median employee, companies can also make a cost of living adjustment for employees who do not reside in the same jurisdiction as the PEO. However, if a company chooses to apply a cost of living adjustment, it must separately determine the median employee without applying a cost of living adjustment. Additionally, the ratio without the adjustment must still be disclosed and each jurisdiction in which an adjustment was applied must be disclosed, including the methodology of the adjustment.

Generally, all workers, including those outside of the US, must be included in the median employee analysis, with two limited exceptions. First, the SEC allows companies to exclude employees in foreign jurisdictions where, due to applicable data privacy laws or regulations, companies are unable, after reasonable efforts, to obtain or process the necessary information to conduct the analysis. The data privacy law exclusion requires that companies use or seek exemption or other relief from the applicable laws and regulations, and must obtain a legal opinion from local counsel as to the legal or regulatory limitations (including efforts to obtain relief) that is filed as an exhibit to the applicable disclosure statement. Secondly, the SEC rules also provide for de minimis exceptions that would allow companies to exclude all employees in foreign jurisdictions under certain circumstances, including where the total number of non-US employees is less than 5% of the company’s total employees. This exception also allows companies to exclude all employees in individually selected foreign jurisdictions if the total number of employees excluded – together with employees excluded under the data privacy law exception – is less than 5% of the company’s total employees. Any de minimis exclusion requires disclosure identifying the applicable jurisdiction(s) excluded and quantifying the number of excluded employees relative to the company’s total number of US and non-US employees.

The SEC rules require that a median employee be chosen to represent the employee workforce on a date within the last three months of the most recently completed fiscal year. Once the median employee is determined, the median employee may be used for three years, provided that (i) the company’s employee compensation arrangements or employee population does not change in a way that could significantly impact the Pay Ratio disclosure and (ii) there has not been in a change in the median employee’s circumstances. Any change – or lack of change – from year to year must be described.

Determining the Median Employee’s Annual Total Compensation

In determining the annual total compensation for both the median employee and the PEO, companies are directed to the rules provided for preparing the Summary Compensation Table. However, for employees other than the PEO, companies may use another consistently applied compensation measure (“CACM”), such as information derived from the company’s tax or payroll records. In interpretive guidance added in October 2016, the SEC explained that any measure that “reasonably reflects the annual compensation” would be an acceptable CACM; however, the appropriateness of a measure is dependent on each company’s facts and circumstances.

Certain adjustments may be applied to make the annual total compensation more comparable to that of the PEO’s compensation. First, companies may annualize the annual total compensation of full-time and part-time employees who have not been with the company for the full fiscal year, but this adjustment is not permitted for seasonal or temporary employees. Finally, rather than analyzing all employees, companies may use a statistical sampling of its employee population.

Preparing the Disclosure

There is some flexibility as to where and how the Pay Ratio is disclosed in the proxy statement. The SEC rules do not require that the disclosure be made in the Compensation Discussion & Analysis (“CD&A”) section or under a separately captioned section. However, if the CD&A includes a discussion of internal pay equity, companies may wish to specifically address the Pay Ratio disclosure.

Once the ratio is determined, companies will need to decide how they include the ratio in the proxy – numerically or narratively (or both). Item 402(u)(1)(iii) provides that the Pay Ratio can be expressed as a numerical ratio where the median employee’s compensation is “one,” or as a narrative about how a multiple of the PEO’s compensation relates to the median employee’s compensation. In addition to the ratio, companies must also disclose the methodology they applied in making all the determinations associated with the calculation of the ratio, which would include material assumptions, adjustments, estimates and any changes in the methodology from the prior year’s Pay Ratio disclosure.

In addition to the disclosure of the ratio and the methodology used in determining it, companies may choose to provide some additional contextual or explanatory disclosure related to the ultimate ratio, as long as any such additional disclosure is clearly identified, not materially misleading and not more prominent than the required Pay Ratio.

Next Steps

In preparation for the Pay Ratio disclosure requirements for the 2018 proxy season, companies must assemble the appropriate internal teams and external advisers. Not only will companies need assistance from their accounting firms, compensation consultants and outside counsel, companies will also require support and coordination from their HR, IT, payroll, finance, accounting, legal and communications teams. In preparing the methodologies to be used to identify their median employees and their annual total compensation, companies should consider the implications on the required Pay Ratio disclosure and the potential reactions of their workforces and their shareholders.