In yet another divisive 3-2 vote along party lines, on August 6, 2015, the U.S. Securities and Exchange Commission (SEC) adopted final rules requiring public companies (other than emerging-growth companies, smaller reporting companies and foreign private issuers) to disclose the ratio of the compensation of its chief executive officer to the median compensation of its employees (CEO Pay Ratio). The new rules were mandated under Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Overview of final rules vs. proposed rules: same structure, minor tweaks, delayed effective date. Overall, the final rules retain the basic structure set forth in the proposed rules. A few changes have the potential to somewhat ease compliance burdens. (The SEC issued a fact sheet summarizing changes under the final rules.) 

While the final rules provide some flexibility, it will nevertheless be expensive and time-consuming to select, develop and test an appropriate methodology for identifying the median employee based on a public company’s particular facts and circumstances.  It also will be challenging to briefly describe the selected methodology and any related assumptions or estimates in an understandable and accurate manner.  Given that all employees (subject to limited exceptions noted below) will need to be taken into account when identifying the median employee, public companies should consider providing supplemental disclosure, alternative pay ratios, or both, to place the CEO Pay Ratio in proper context.

Fortunately, there is a delayed effective date that provides for one additional transition year as compared to the proposed rules. Public companies will be required to report the CEO Pay Ratio for their first fiscal year beginning on or after January 1, 2017.  As a result, in many cases, disclosure of the CEO Pay Ratio will not be required until the 2018 proxy statement.

Key points to note: The following are some key points about the final rules:

• Compliance is likely to be time-consuming and expensive.  In recognition of the time it will take to comply with the rules, the SEC provided additional transition time in the final rules to “implement systems to compile the disclosure and verify its accuracy.” The SEC estimates that, in the aggregate, the initial compliance costs will exceed $1.3 billion and that the ongoing annual compliance costs for more than 3,500 public companies will exceed $500 million.  Preparing for this disclosure will likely involve taking statistical samples of employees, selecting appropriate compensation measures for identifying the employee at the median, and preparing disclosure so that a shareholder can assess the CEO Pay Ratio methodology and any related assumptions and estimates.  It also will be important to develop and implement disclosure controls and procedures for calculating the CEO Pay Ratio. 

• The rules allow for the identification of the median employee only once every three years . . . . maybe. A public company will only be required to identify its median employee for the CEO Pay Ratio only once every three years. However, there is an important condition that must be satisfied in order to take advantage of this rule—there must not be “any change in its employee population or employee compensation arrangements that it reasonably believes would result in a significant change to its pay ratio disclosure.” If there is such a change, the company must re-identify the median employee for that year.

• There is some flexibility in selecting a snapshot date to measure the number of employees. The final rules allow a public company to select any date within the last three months of a fiscal year to determine the employees considered in identifying the median employee.  As a result, it may be possible to take into account only employees employed by the public company and its subsidiaries as of the beginning of the last fiscal quarter for purposes of determining the median employee instead of having to wait until year end. Of course, being able to use an earlier testing date will depend upon the sophistication of Human Resources Information Systems (HRIS) and payroll systems.

• No exclusions or adjustments allowed for part-time, temporary and seasonal employees.  Commentators on the proposed rules had requested that employees who were not employed on a full-time basis be disregarded when identifying the median employee. Alternatively, commentators suggested that public companies be allowed to annualize compensation for these employees. Unfortunately, the final rules do not adopt either of these approaches.  Compensation may only be annualized for full-time employees who are employed less than 12 months during a fiscal year. In addition, independent contractors or leased employees are not taken into account in determining the median employee.

• Limited relief for public companies with operations outside of the United States. Commentators on the proposed rules had also requested that employees located outside the United States be disregarded when determining the median employee. The final rules do allow for foreign-employee exclusions, but it remains to be seen how useful they will be, particularly for larger multi-national public companies. A new foreign-data privacy law exception allows a public company to disregard employees from a foreign jurisdiction, but only if it can demonstrate, through a legal opinion that is filed with the SEC, that local laws make it unable to gather the information required for compliance without violating those laws. A new de minimis exception allows for not more than five percent of non-U.S. employees to be disregarded, including employees covered under any data privacy exemption, but subject to stringent rules designed to ensure that there is no cherry picking or partial exclusions of non-U.S. employees from a particular non-U.S. jurisdiction.

• Transition rule for mergers-and-acquisitions (M&A) transactions.  The final rules allow a public company to omit any employees that become its employees due to an M&A transaction that closes during a fiscal year, but only if there is disclosure of the transaction and approximately how many employees are being excluded. These employees would then be included in the total employee count for the triennial calculation of the median employee in the fiscal year following the M&A transaction when determining whether a significant change had occurred.

• Supplemental pay disclosure and alternative ratios are permitted. Consistent with the approach taken by the SEC with respect to the proposed rules for pay for performance, the final rules allow public companies to include supplemental narrative discussion about the mandated calculation of the CEO Pay Ratio, alternative pay ratios or both, so long as they are clearly identified, not misleading and not presented with greater prominence than the mandated CEO Pay Ratio.

What’s next? We expect that there will be challenges to the final rules in both Congress and the courts. Even prior to the issuance of the final rules, bills were introduced in both the U.S. Senate and the House of Representatives to repeal the CEO Pay Ratio requirement. In addition, at the SEC’s open meeting prior to the vote on the final rules, Commissioner Daniel M. Gallagher's statement hinted at a constitutional challenge to the final rules.  Nevertheless, it is not too soon for public companies to begin evaluating what must be done to comply with the final rules, including what types of methodologies and testing date will be most appropriate to identify the median employee given employee demographics and HRIS and payroll systems.  It is also not too early to consider the extent to which the exclusions for non-U.S. employees may be useful depending upon local law and the various locations of these employees.