The CEO pay ratio disclosure mandated by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") will become effective for most public companies in 2018. Under the final rules adopted by the SEC:
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Issuers must disclose the ratio of the annual total compensation of their CEO to the median of the annual total compensation of their other employees (the "Pay Ratio Rule").
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The pay ratio disclosure is required in compensation disclosures for fiscal years beginning on or after January 1, 2017, and therefore will be included in an issuer's proxy or information statements, or, alternatively, in its annual reports on Form 10-K, beginning in 2018.
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Although the pay ratio must be calculated annually based on the prior year's compensation, an issuer is only required to identify its median employee once every three years, subject to certain limitations.
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Smaller reporting companies, emerging growth companies, and foreign private issuers are exempt from this disclosure requirement.
Repeal Uncertain/Implementation Delay Unlikely
The Pay Ratio Rule has been a particularly controversial provision of the Dodd-Frank Act, and earlier this year its viability was uncertain due to both congressional and regulatory actions. Specifically, the Financial CHOICE Act of 2017 contains a provision that would repeal section 953(b) of the Dodd-Frank Act. Although the bill was passed by the House of Representatives in June 2017, most observers do not expect it to be passed by the Senate in its current form. In addition, in early 2017, Michael Piwowar, the then-Acting Chair of the SEC, requested comments on the Pay Ratio Rule and directed the SEC staff to reconsider implementation of the rule based on the comments received. Due to these indications of a possible repeal or implementation delay, many issuers have delayed preparing for this new disclosure requirement. However, at an ABA meeting earlier today, William Hinman, Director of the SEC's Division of Corporation Finance, indicated that the rule will go into effect on time, although he noted that additional guidance may be forthcoming. Thus, considering the amount of work involved in preparing the disclosure, we encourage issuers to begin preparations to comply with the Pay Ratio Rule if they have not already done so.
Preparing the Disclosure
While the pay ratio calculation itself is fairly straightforward, the process of gathering and assessing the underlying data is complex and will likely be time consuming for most issuers, especially issuers that have international operations, multiple payroll systems, or a significant number of independent contractors. Further, the Pay Ratio Rule provides issuers with some flexibility in preparing the disclosure, thus there are decisions to be made prior to calculating the ratio that will be driven by each issuer's particular facts and circumstances.
The following is a brief summary of the steps that an issuer must take in order to prepare the disclosure, and the more significant decision points that arise during the process:
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Assess Workforce in Order to Identify the "Employee" Population. Under the Pay Ratio Rule, an issuer must identify the median of all employees of the issuer and its consolidated subsidiaries as of a date selected by the issuer. This "determination date" may be any date within the last three months of the most recently completed fiscal year. In identifying the relevant employee population, the term "employees" is broadly defined and includes workers who may not be classified as employees under traditional tax and labor law standards, including:
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All full-time, part-time, temporary, and seasonal employees of the issuer and its consolidated subsidiaries, whether employed in the U.S. or foreign jurisdictions.
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Independent contractors and leased employees, unless they are employed by and their compensation is determined by an unaffiliated third party.
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In identifying the median employee, an issuer may look at its entire population or may use statistical sampling or other reasonable methods.
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Determine if Any Exemptions Apply. The Pay Ratio Rule provides the following exemptions, which allow an issuer to exclude certain employees from its determination of the "median" employee:
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Certain non-U.S. employees may be excluded if they represent 5% or less of the issuer's employees or if gathering data relating to employees in a non-U.S. jurisdiction would violate the data privacy laws of that jurisdiction, with certain limitations.
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An issuer may omit employees of a newly-acquired entity for the fiscal year in which the business combination or acquisition becomes effective.
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Select a Compensation Measure to Determine the Median Employee. To identify the median employee, the issuer can use either annual "total compensation" as determined under Item 402(c)(2)(x) of Regulation S-K (the SEC rules governing disclosures in the Summary Compensation Table), or any other compensation measure that is consistently applied to all employees. When calculating compensation, note that:
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Using annual "total compensation" as determined under Item 402(c)(2)(x) of Regulation S-K for each employee will not be practical for most issuers.
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Other compensation measures should "reasonably reflect() the annual compensation of employees," which will depend on the issuer's particular facts and circumstances. Common measures that may be used are variants of cash compensation, such as base salary, W-2 (or its equivalent) wages, or total cash compensation, although if an issuer distributes equity broadly to its workforce, that component may have to be factored in as well.
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Cost of living adjustments are permitted for employees in jurisdictions other than the CEO's jurisdiction, although use of such adjustments is subject to limitations and requires additional disclosure.
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Issuers may annualize compensation for permanent full-time or part-time employees who worked only a portion of the year (for example, recent hires or employees who took unpaid leaves of absence), but may not annualize compensation for temporary or seasonal workers or make full-time equivalent adjustments for part-time employees.
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In determining employee compensation, the issuer need not use a time period that includes its "determination date" or even a full annual period.
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Calculate Annual "Total Compensation" for the CEO and the Median Employee and Resulting Ratio. Once the issuer has identified its median employee, the issuer must calculate the annual "total compensation" of both the median employee and the issuer's CEO for the most recently completed fiscal year, as defined under Item 402(c)(2)(x) of Regulation S-K. An issuer is permitted to include other types of compensation that are typically not disclosed under Item 402(c)(2)(x), such as health insurance premiums, but, for purposes of this ratio, the issuer would need to include (and disclose the existence of) those additional items for both the median employee and the CEO to ensure a fair comparison.
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Draft Disclosure. The Pay Ratio Rule requires an issuer to disclose the methodology used to identify the median and clearly identify any material assumptions, adjustments, or estimates used in identifying the median or determining total compensation. In addition, to the extent the issuer relies on any of the available exemptions, additional disclosure is required. Finally, an issuer is permitted, but not required, to supplement its disclosure with a narrative discussion or additional ratios, which may include an alternative pay ratio including only U.S. employees.
Additional Thoughts
Given that this disclosure will be new for 2018, issuers should expect that it will be highly publicized and scrutinized by many constituencies, including the SEC, investors, proxy advisory firms, employees, labor groups, and the media. As such, it is critical that the issuer's compensation committee and senior management be fully informed of the process and the possible magnitude of the disclosure as early as possible. Further, issuers will want to evaluate whether additional communication efforts are necessary or advisable for their investors and employees to ensure that any key messages, such as how an issuer's staffing model supports its business model, are effectively conveyed.
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