Background

In August 2015, the SEC adopted its final rule implementing Section 953(b) of Dodd-Frank, which requires public companies to disclose the “pay ratio” between their chief executive officer’s annual total compensation and the annual total compensation of their “median” employee.

Although the Pay Ratio Rule incorporates several changes to the previously proposed iteration in an effort to lessen some of the administrative burden placed on companies, compliance is still likely to prove onerous. Companies should not wait to start assessing what compliance with the Pay Ratio Rule will require and formulate a strategy for moving forward.

The Final Rule

As required by Section 953(b) of the Dodd-Frank Act, the SEC’s final Pay Ratio Rule amends Item 402 of Regulation S-K to require disclosure of:

• the median of the annual total compensation of all employees of the company, excluding the CEO;

• the annual total compensation of the company’s CEO; and

• the ratio of the median of the annual total compensation of all employees, excluding the CEO, to the annual total compensation of the CEO (CEO Pay Ratio).

Companies must begin disclosing CEO Pay Ratios with their first full fiscal year starting on or after January 1, 2017. This disclosure requirement applies to all U.S. public companies required to provide a summary compensation table disclosure under Item 402(c) of Regulation S-K (in annual reports on Form 10-K, registration statements, and proxy statements). It does not apply to emerging growth companies, smaller reporting companies, foreign private issuers, Multijurisdictional Disclosure System filers, or registered investment companies.

In general, the Pay Ratio Rule requires a company to identify its median employee only once every three years. If, however, there has been a change to the median employee’s circumstances or to a company’s employee population or employee compensation levels that the company reasonably believes would result in a “significant” change to the CEO Pay Ratio, the company must reassess and re-identify its median employee. If not, and the median employee is carried over from the prior year, a company must disclose its use of the same median employee for the CEO Pay Ratio and briefly describe its reasonable basis for believing that a significant change has not occurred.

A company may select any date within the last three months of the last completed fiscal year to identify its median employee. The Pay Ratio Rule defines “employees” to include all full‑time, part-time, seasonal, and temporary employees of a company and its consolidated subsidiaries, whether or not the employee is located within or outside the United States. The employees of joint ventures and unconsolidated subsidiaries are excluded. Independent contractors and “leased” workers serving a company are also excluded, but only if those individuals are employed by an unaffiliated third party and their compensation is determined by that third party. A company may annualize compensation for its permanent employees (both full‑ and part-time) who were not employed during the entire fiscal year, but may not make full‑time equivalent adjustments for part-time employees and may not annualize the compensation of its seasonal or temporary employees.

Non-U.S. employees are generally included in the definition of “employee,” but the Pay Ratio Rule does provide two exemptions under which companies may exclude them. First, it permits a company to exclude non-U.S. employees employed in jurisdictions with data privacy laws or regulations that, despite reasonable efforts, prevent the company from obtaining the necessary information without violating those data privacy laws or regulations. Second, the Pay Ratio Rule has a de minimisexemption that allows a company to exclude (i) all non-U.S. employees, if they account for 5% or less of the company’s total employees; or (ii) up to 5% of its total employees who are non-U.S. employees, if the company’s non-U.S. employees exceed 5% of its total employees. These exemptions are accompanied by a number of restrictions and disclosure requirements, so companies should take care when determining whether to invoke them.

Once the employee universe has been established, the Pay Ratio Rule affords a company some flexibility in selecting its method for identifying the median employee. A company may identify the median employee using (i) the company’s entire employee population, (ii) a statistical sampling, or (iii) other reasonable methods. Further, when determining the median employee, a company does not have to calculate each employee’s compensation under Item 402(c)(2)(x) of Regulation S-K, as is required for named executive officers. Rather, a company may identify the median employee using annual total compensation or any other compensation measure (such as compensation amounts reported in payroll or tax records), as long as the method is consistently applied to all employees included in the calculation. Once the median employee is identified, however, for purposes of determining the ratio, that person’s annual total compensation must be calculated using the Item 402(c)(2)(x) standard.

The Pay Ratio Rule requires disclosure of the CEO Pay Ratio in any annual report, proxy or information statement, or registration statement that already requires executive compensation disclosure under Item 402. In addition to the CEO Pay Ratio, companies must disclose the methodologies, material assumptions, estimates, and adjustments used in identifying the median employee and the calculation of that employee’s annual total compensation. Companies are not required, but are granted discretion to further supplement their CEO Pay Ratio disclosure with a narrative discussion or additional ratios that may, for example, provide greater context. This additional information must be clearly identified, not misleading, and not presented with greater prominence than the CEO Pay Ratio.

Moving Forward

While many speculate that the Pay Ratio Rule will be challenged in court or that Congress will amend the underlying statute before companies must comply, companies adopting a wait and see approach do so at their own peril. Companies subject to the Pay Ratio Rule should be proactive in assessing what compliance will require and formulating a plan for meeting these potentially onerous requirements. In doing so, companies should consider doing the following in the coming months and years:

• Engage counsel early to help navigate compliance. To the extent that the company has non-U.S. employees working in jurisdictions that are potentially subject to the data privacy exemption, this engagement should also include foreign counsel.

• Carefully weigh the potential risks and benefits of identifying the median employee by surveying the entire employee population versus using “other reasonable methods.” While other seemingly reasonable methods may be cheaper and less burdensome to carry out than assessing the entire employee population, a company will have to be prepared to defend its chosen method to the SEC (and potentially in court), at least until better guidance is given regarding what methods the SEC deems “reasonable.”

• Evaluate potential testing dates given that the Pay Ratio Rule allows companies to select a date within the last three months of its fiscal year.  This will be of particular interest for companies with large seasonal work forces, but may be worth considering for other companies as well.

• Prepare a plan for engaging with shareholders regarding the CEO Pay Ratio disclosure. This may include, but should not be limited to, taking advantage of the Pay Ratio Rule’s provision allowing companies to provide context for the ratio in their disclosures.

• Engage the company’s Human Resources personnel in the process. Upon public disclosure of the CEO Pay Ratio, half of the company’s employees will discover that they make less than a majority of their colleagues. The company should involve Human Resources to help address potential morale issues that may result.

• Review and assess any CEO Pay Ratio disclosures made by peer companies as well as the SEC’s, investors’, and the public’s reactions to those disclosures.