SEC Adopts Final Rule Requiring Pay Ratio Disclosure

 

August 7, 2015

 

On August 5, 2015, the Securities and Exchange Commission (“SEC”) adopted final rules and certain form amendments requiring a registrant to disclose the ratio (“pay ratio disclosure”) of the median of the annual total compensation of all of its employees to the annual total compensation of its chief executive officer or principal executive officer (“PEO”).

 

Pay ratio disclosure will be required in an issuer’s annual report, proxy or information statement, or registration statement that requires executive compensation disclosure. 

Pay ratio disclosure will not be required in the registration statement for a company’s initial public offering.

 

The new disclosure requirements do not apply to emerging growth companies, smaller reporting companies or foreign private issuers.

 

A company will be required to comply with the new rules in the first fiscal year beginning on or after January 1, 2017.

The new disclosure requirements implement Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.  In adopting the new rules, the SEC stated that it believed that Section 953(b) was intended to provide shareholders with a company-specific metric that can assist in their evaluation of companies’ executive compensation practices.

 

Pay Ratio Disclosure Requirements

 

The final rule adopts a new paragraph (u) to Item 402 of Regulation S-K.  The final rule and form amendments require disclosure of:

  • the median of the annual total compensation of all employees of a registrant (except the PEO of a registrant)

  • the annual total compensation of a registrant’s PEO

  • the ratio of the median of the annual total compensation of all employees of a registrant to the annual total compensation of the registrant’s PEO or, alternatively, expressed narratively in terms of a multiple

 

The ratio is required to be disclosed as a factor rather than as a fraction.

 

A registrant has one of two options to express the ratio, as follows:

  • disclose the pay ratio with the median of the annual total compensation of all employees equal to one and the PEO’s compensation as the number compared to one, e.g., 50:1, or

  • disclose the pay ratio narratively by stating how many times higher (or lower) the PEO’s annual total compensation is than that of the median employee, e.g., “50 times that of the median of the annual total compensation of all employees”

 

Filings Requiring Pay Ratio Disclosure

 

Pay ratio disclosure is required in all filings that call for executive compensation disclosure under Item 402, including:

  • annual reports on Form 10-K

  • registration statements (under the Securities Act and the Exchange Act)

  • proxy and information statements

 

The final rule does not require pay ratio disclosure in other filings.

 

Companies Not Required to Comply with New Disclosure Requirements

 

The final rule does not require pay ratio disclosure by:

  • smaller reporting companies

  • foreign private issuers

  • US-Canadian Multijurisdictional Disclosure System filers

  • emerging growth companies

 

Covered “Employees”

 

For purposes of the pay ratio disclosure, the term “employee” includes a registrant’s U.S. and non-U.S. employees as well as part-time, seasonal and temporary employees of the registrant and its consolidated subsidiaries.

 

Workers who provide services as independent contractors or “leased” workers are excluded provided they are employed, and their compensation is determined, by an unaffiliated third party. 

 

The term “employee” includes a company’s officers other than the PEO.  However, a company may supplement its pay ratio disclosure or provide additional pay ratios if it wants to explain the effect of including part-time, seasonal and temporary employees in its pay ratio disclosure.

 

Employed Date

 

The term “employee” means an individual employed on any date of the company’s choosing within the last three months of the registrant’s last completed fiscal year. 

 

A registrant is required to disclose any such date used to identify the median employee.

 

Employees Located Outside the U.S. are Included

 

The term “employee” includes a company’s U.S. and non-U.S. employees.   

 

There are two exemptions from the definition of “employee” for purposes of this requirement, as follows:

  • if a foreign jurisdiction’s data privacy laws or regulations prohibit the company from complying with the rule, the company may exclude from its determination of the median employee an employee who is employed in such foreign jurisdiction; although the company must use reasonable efforts to include using or seek an exemption from such requirements and provide certain related disclosures

  • if a de minimis number of a registrant’s employees work outside the U.S. (i.e., if non-U.S. employees make up 5% or less of its total U.S. and non-U.S. employees), it may exclude all of them when identifying its median employee provided it discloses the jurisdiction or jurisdictions from which employees are being excluded, the approximate number of employees excluded, the total number of its U.S. and non-U.S. employees, and the total number of its U.S. and non-U.S. employees used for purposes of its de minimis calculation

 

COLA Adjustment

 

Under the new rule, a registrant has the option to make cost-of-living adjustments to the compensation of its employees in jurisdictions other than the jurisdiction in which the PEO resides when identifying the median employee, provided the adjustment is applied to all employees included in the calculation.  If a registrant chooses this option, the compensation of such employees will need to be adjusted to the cost of living in the jurisdiction in which the PEO resides.

 

Also, if the registrant uses a cost of living adjustment (“COLA”) to identify the median employee and the median employee identified is an employee in a jurisdiction other than the one in which the PEO resides, the registrant must use the same COLA in calculating the median employee’s annual total compensation and disclose the median employee’s jurisdiction.

 

If a registrant does not make a COLA to its employees when identifying the median employee, it is not permitted to make COLA to the median employee’s annual total compensation if the median employee is an employee in a jurisdiction other than the jurisdiction in which the PEO resides.

A registrant is required to briefly describe any COLA used to identify the median employee or to calculate the annual total compensation, including the measure used as the basis for the COLA, and disclose the country in which the median employee is located.  Also, a registrant that elects to present pay ratio using COLA must also disclose the median employee’s annual total compensation and pay ratio with the COLA.  To calculate this ratio, a registrant will need to identify the median employee without using any COLA.

 

Employees of Consolidated Subsidiaries

 

Under the new rule, the term “employee” includes only employees of a registrant and its consolidated subsidiaries, generally, subsidiaries in which it owns a controlling financial interest (typically, over 50% of the outstanding voting shares).

 

The new rule permits a company that engages in a business combination or acquisition to omit the employees of a newly-acquired entity from their pay ratio calculation for the fiscal year in which the business combination or acquisition occurs.

 

PEO Compensation in Last Full Fiscal Year Where PEO Served Only Part of Year

 

A company has a choice of two options in calculating the annual total compensation for its PEO in situations in which a PEO is replaced during a fiscal year with another PEO, as follows:

  • it may take the total compensation reflected in the registrant’s Summary Compensation Table provided to each person who served as PEO during the year and combine these figures, or

  • it may look to the PEO serving on the date it selects to identify the median employee and annualize the PEOs compensation

 

A company must disclose which option it chose and how it calculated its PEO total compensation.

 

Annualizing Permanent Employee Total Compensation

 

Under an instruction to the new rule, a registrant may, but is not required, to annualize the total compensation for permanent employees who did not work for the entire year, including new hires, employees on leave under the FMLA, or on active duty, or who took unpaid leave during the period.  This would be permitted for both full-time and part-time employees but is not permitted for seasonal or temporary employees.

 

Identifying the Median Employee

 

The final rule allows a registrant to identify the median employee whose compensation is to be used for the annual total compensation calculation once every three years unless there has been a change in its employee population or employee compensation arrangements that it reasonably believes would result in a significant change in the pay ratio disclosure.  The registrant must disclose if there have been no such changes, that it is using the same median employee, and describe the basis for its reasonable belief that there has been no significant change.

 

Using Annual Total Compensation

 

Flexibility.  A company may choose the method to identify the median employee based on its own facts and circumstances, and may use a methodology that uses reasonable estimates, such as using annual total compensation or any other compensation measure that is consistently applied to all employees included in the calculation, including from tax or payroll records, or use its employee population or a statistical sampling, and other methods. 

 

A company is required to describe the methodology it used to identify the median employee, material assumptions, adjustments (e.g., COLA), or estimates it used to identify the median employee or to determine total compensation or any elements of total compensation, consistently applied.

Statistical Sampling.  The rule permits registrants to use statistical sampling in determining the employees from which the median employee is identified.  

 

The SEC provided the following guidance regarding the use of statistical sampling:

  • a relatively small sample size may be appropriate in certain circumstances

  • a reasonable determination of sample size ultimately depends on the underlying distribution of compensation data

  • reasonable estimates of the median for companies with multiple business lines or geographical units may be determined using more than one statistical sampling approach

  • all statistical sampling approaches should draw observations from each business or geographical unit with a reasonable assumption on each unit’s compensation distribution and infer the registrant’s overall median based on the observations drawn

  • identification of a median employee does not necessarily require a determination of exact compensation amounts for every employee included in the sample

 

Consistently Applied Compensation Measures.  The new rule permits registrants to identify a median employee based on any consistently applied compensation measure, such as information derived from tax or payroll records, as long as it discloses the measure that is used.

 

Calculating Annual Total Compensation

 

The new rule requires that “total compensation” for the median employee and PEO be calculated using the requirements of Item 402(c)(2)(x) of Regulation S-K, although a registrant has flexibility, as discussed above, in identifying the median employee and does not require a company to identify the median employee by calculating the total compensation for each employee.

 

A registrant must disclose any such estimates used and must have a reasonable basis to conclude that their estimates approximate the actual amounts of compensation or particular element of compensation awarded or earned or paid to the median employee. 

 

The SEC clarified the use of certain definitions used in Item 402(c)(2)(x) as they apply to “employees,” for purposes of the rule, including that:

  • all references to “named executive officer” are deemed to refer to “employee”

  • for non-salaried employees, references to “base salary” and “salary” are deemed to refer to “wages plus overtime”

 

The SEC stated that a company may use reasonable estimates in determining an amount that reasonably approximates the aggregate change in actuarial present value of an employee’s defined pension benefit.

 

Personal benefits of less than $10,000 and compensation under non-discriminatory benefit plans may be included in the annual total compensation of the median employee provided the PEO’s total compensation also reflects the same approach. 

 

Also, the registrant must explain any differences between the PEO total compensation used in the pay ratio disclosure and the total compensation amounts reflected in the Summary Compensation Table.

 

Even though the median employee may be identified every three years, the total compensation for that employee is required to be calculated every year.

 

Disclosure of Methodology

 

The new rule requires a registrant to provide a brief overview of, and consistently apply, any methodology used to identify the median employee and any material assumptions, adjustments, or estimates used to identify the median or to determine total compensation or any elements of total compensation of the median employee.

 

When statistical sampling is used, a registrant must describe the size of both the sample and the estimated whole population, any material assumptions used in determining the sample size and the sampling method used.  Technical analyses, formulas, confidence levels, or the steps used in data analysis are not required to be disclosed.  Also, a company must disclose any change in methodology, significant assumption, adjustment, or estimate from the prior year if significant, or if it commences or ceases using COLA.

 

Meaning of “Annual”

 

Under the new rule, “annual total compensation” means total compensation for the company’s last completed fiscal year.

 

Timing of Disclosure

 

Pay ratio disclosure information for a company’s last completed fiscal year is not required until it files its annual report on Form 10-K for that year or it files a definitive proxy or information statement for its next annual meeting of shareholders (or written consents), but no later than 120 days after the end of the company’s last fiscal year. 

 

Omitting Salary or Bonus Information for PEO

 

A company may omit pay ratio disclosure until the salary or bonus of its PEO’s total compensation is determined if it omits the salary or bonus of the PEO because it is not calculable until a later date, in reliance upon the instructions to Item 402. 

 

Once the PEO’s salary and bonus become calculable, a company will be required to file the pay ratio disclosure under cover of a Form 8-K, pursuant to amendments to Item 5.02(f) of the Form 8-K.  However, such disclosure is only required once both salary and bonus become calculable.

 

Compliance Dates

 

A company will be required to comply with the new rule requirements in its first full fiscal year beginning on or after January 1, 2017.

 

New registrants must comply with the new rule in its first full fiscal year beginning after the registrant has:

  • been subject to the requirements of Section 13(a) or 15(d) of the Exchange Act for a period of at least twelve calendar months beginning on or  after January 1, 2017, and

  • filed at least one annual report pursuant to Section 13(a) or 15(d) that does not contain pay ratio disclosure

 

Pay ratio disclosure is not required in a registration statement on Form S-1 or Form S-11 for an initial public offering or an initial registration statement on Form 10.

 

Transition Periods for Smaller Reporting and Emerging Growth Companies

 

A company that ceases to be a smaller reporting company or an emerging growth company will not be required to provide pay ratio disclosure until after the first full fiscal year after exiting such status and not for any fiscal year commencing before January 1, 2017.

 

What Action Should a Company be Taking Now? 

 

For most companies, disclosure will be required for the first time in their annual reports on Form 10-K for the year ended December 31, 2017, or proxy statements for their 2018 annual meeting. Accordingly, companies should begin to:

  • identify where employee compensation data is currently held

  • consider the appropriate methodology for identifying the median employee, such as by statistical sampling

  • document methodology used and related assumptions

  • identify covered “employees” and compensation

  • consider any data privacy issues under foreign law that may prohibit disclosure and/or consider the availability of exemptions, including the de minimis exemption

 

For more information, please contact: 
 

Neil R.E. Carr                                                               
Direct Dial: +1 202 587 2983                                       
neil.carr@somertons.com                                             

 

Kathleen L. Cerveny

Direct Dial: +1 202 779 9507

kathleen.cerveny@somertons.com

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