SEC Adopts Final Dodd-Frank Pay Ratio Disclosure Rules

Practical Law Legal Update w-000-4999 (Approx. 11 pages)

SEC Adopts Final Dodd-Frank Pay Ratio Disclosure Rules

by Practical Law Corporate & Securities

Pay Ratio Disclosure

New Item 402(u) of Regulation S-K will require companies to disclose:

The median of annual total compensation of all employees of the company, excluding the principal executive officer (PEO). Essentially, this is the annual total compensation of the company's median employee (see Identifying the Median Employee).
The annual total compensation of the PEO.
The ratio of these two amounts. This ratio can be expressed in one of two ways:
- a numeric ratio where the median employee's annual total compensation is represented as one and the PEO's compensation is represented as a number compared to one. For example, if a company's median annual total compensation for employees is $50,000 and the PEO's annual total compensation is $2,500,000, the PEO's compensation is 50 times larger than the median employee's compensation, so the company could describe the pay ratio as 50 to 1 or 50:1; or
- a narrative description of the pay ratio stating how many times higher (or lower) the PEO's annual total compensation is than that of the median employee. Using the above example, the company could disclose that "the PEO's annual total compensation is 50 times that of the median of the annual total compensation of all employees."

Meaning of "All Employees"

Under Item 402(u), "employees" of the company means all individuals employed by the company or any of its consolidated subsidiaries, whether as a full-time, part-time, seasonal, or temporary worker, as of a date chosen by the company within the last three months of its last completed fiscal year.

Independent contractors or "leased" or other temporary workers employed by a third party are not included in this definition.

Non-US employees are included in the definition of employees but may be excluded in the following circumstances:

Non-US employees that are employed in a foreign jurisdiction with data privacy laws that make the company unable to comply with Item 402(u) without violating those laws (see Using the Foreign Data Privacy Laws Exemption).
Up to 5% of the company's total employees that are non-US employees, including any non-US employees excluded using the data privacy exemption (see Calculating the De Minimis Exemption).

Using the Foreign Data Privacy Laws Exemption

A company that intends to exclude non-US employees from consideration because of potential violations of foreign data privacy laws must:

Use reasonable efforts to obtain information for the pay ratio calculation, including using or seeking an exemption or other relief under any governing data privacy laws or regulations.
Obtain a legal opinion from counsel on the company's inability to obtain or process the information necessary for compliance with the rule without violating a particular jurisdiction's data privacy laws or regulations. This opinion must be filed as an exhibit to the company's filing that includes the pay ratio disclosure.

If a company excludes any non-US employees in a particular jurisdiction because of its data privacy laws, the company must exclude all non-US employees in that jurisdiction.

A company may exclude the non-US employees that meet this data privacy exemption, regardless of the percentage of the company's total employees they represent.

A company using the data privacy exemption must provide additional disclosure about it (see Non-US Employees).

Calculating the De Minimis Exemption

If a company's non-US employees account for 5% or less of its total employees, the company can exclude its non-US employees from consideration when determining its employee population. However, if the company chooses to exclude some of those non-US employees, it must exclude all of them.

If a company's non-US employees exceed 5% of its total employees, it may exclude up to 5% of those employees who are non-US employees. However, if a company excludes any non-US employees in a particular jurisdiction, it must exclude all non-US employees in that jurisdiction. If more than 5% of a company's employees are located in any one non-US jurisdiction, the company may not exclude any employees in that jurisdiction under the de minimis exemption.

A company using the de minimis exemption must provide additional disclosure about it (see Non-US Employees).

A company can use both non-US employee exemptions together. If the number of employees excluded under the data privacy exemption is less than 5% of the company’s total employees, the company may also use the de minimis exemption to exclude no more than the number of non-US employees that, when combined with those excluded under the data privacy exemption, does not exceed 5% of its total employees.

A company cannot use the de minimis exemption if it uses the data privacy exemption to exclude certain non-US employees and the number of employees excluded under the data privacy exemption equals or exceeds 5% of the company's total employees.

Section II.B.1.c. of the adopting release includes many examples of how these exemptions work together.

Business Combinations

A company can exclude any employees that joined the company as a result of a business combination or acquisition from its pay ratio calculations for the fiscal year in which the transaction was completed. However, the company must:

Disclose this information (see Exclusion of Other Employees).
Include those employees in the total count of employees for pay ratio calculations starting in the following fiscal year and evaluate whether their inclusion as company employees represents a "significant change" (see Identifying the Median Employee).

Identifying the Median Employee

The company may identify its "median employee", used in calculating the pay ratio, only once every three years (instead of annually) as long as during the last completed fiscal year, there has been no change in its employee population or employee compensation arrangements that the company reasonably believes would result in a significant change to its pay ratio disclosure. For example, the company must include any employees excluded because of an acquisition in its calculation of total employees for the next fiscal year and evaluate whether the inclusion of these employees and their compensation would significantly affect the company's pay ratio disclosure. However, the company must calculate total compensation for that median employee and determine the pay ratio every year.

If the company determines that there has been no change in its total employees or employee compensation, it can use the same median employee for its pay ratio calculation but must make additional disclosure (see Identifying the Median Employee). If the company uses the same median employee, it must calculate that employee's annual total compensation each year and use that amount to update its pay ratio disclosure each year, until the company must undertake the process of identifying the median employee again (every three years).

If the company determines that there has been a change in a fiscal year, it must go through the process of identifying a new median employee for that fiscal year.

If there has been a change in the median employee's specific circumstances that the company believes would result in a significant change to its pay ratio disclosure, the company can use another employee whose compensation is substantially similar to the original median employee's compensation based on the compensation used to select the original median employee.

The company can use reasonable estimates in the methodology used to identify the median employee, including that:

The median employee can be identified using annual total compensation (see Calculating Annual Total Compensation) or any other compensation measure that is consistently applied to all employees included in the calculation. The company can use a measure that may be defined differently across jurisdictions (such as taxable wages or cash compensation) and may include different annual periods as long as within each jurisdiction the measure is consistently applied.
In determining the universe of employees from which it will identify the median employee, the company can use:
- its employee population;
- statistical sampling. While the final rule does not provide specific parameters for statistical sampling, the SEC staff stated their belief that a relatively small sample size may be appropriate in certain situations. For example, in an earlier analysis in the proposing release, the SEC staff determined that the appropriate sample size for companies with a single business or geographical unit varied between 81 and 1,065 employees across industries, with the average estimated sample size close to 560. The SEC staff also indicated that reasonable estimates of the median for companies with multiple business lines or geographical units may be determined using more than one statistical sampling approach; or
- any other reasonable method.

For example, a company could identify the median employee by calculating annual total compensation of each employee using either its full employee population or a statistical sample of that population. Alternatively, the company could first identify a median employee based on any consistently applied compensation measure, such as amounts reported in payroll or tax records, and then calculate that median employee's annual total compensation.

In addition, in identifying the median employee, regardless of what compensation measure is used, the company can make cost of living adjustments (COLAs) to the compensation of employees in jurisdictions other than the jurisdiction in which the PEO resides so that their compensation is adjusted to the cost of living in the PEO's jurisdiction.

Whatever approach a company takes, it must disclose additional information about its methodologies and estimates (see Methodologies, Assumptions and Estimates).

Calculating Annual Total Compensation

A company must calculate total compensation for any or all employees in accordance with Item 402(c)(2)(x) of Regulation S-K. For non-salaried employees, the references to base salary or salary in Item 402 would be deemed to refer, if applicable, to wages plus overtime.

Annual total compensation means total compensation for the company's last completed fiscal year. However, the company is not required to use total compensation as calculated in accordance with Item 402 to identify the median employee (see Identifying the Median Employee).

Companies are permitted, but not required, to annualize total compensation for permanent employees who did not work during the entire year, such as new hires or those employees who took an unpaid leave of absence. However, companies are not permitted to:

Make full-time equivalent adjustments for part-time workers.
Annualize compensation for temporary and seasonal workers.

Once the company has identified the median employee, it must calculate annual total compensation for both the median employee and the PEO in accordance with Item 402(c)(2)(x) and then calculate the ratio. No matter what method a company chooses to identify its median employee, it must select an actual employee and determine that employee's annual total compensation to use in the pay ratio disclosure.

The company can use reasonable estimates in calculating annual total compensation of the median employee under Item 402(c)(2)(x). For example, a company will likely need to make estimates to determine aggregate change in actuarial present value of any defined pension benefits for the median employee.

If the company uses a COLA to identify the median employee and the median employee is an employee in a jurisdiction other than the one in which the PEO resides, the company must use the same COLA in determining the median employee's annual total compensation. If the company does not use a COLA to identify the median employee, it cannot use a COLA in determining the median employee's annual total compensation.

In calculating the annual total compensation of the median employee, the company may choose to include personal benefits or perks that aggregate less than $10,000 and compensation under non-discriminatory benefit plans as long as the company also includes these items in calculating the PEO's annual total compensation for purposes of the pay ratio. These items are typically excluded from the Item 402(c)(2)(x) calculation of PEO compensation for the Summary Compensation Table.

Whatever approach a company takes, it must disclose additional information about its assumptions, adjustments and estimates (see Methodologies, Assumptions and Estimates).

PEO Annual Total Compensation

The annual total compensation for the PEO must be the number disclosed in the company's Summary Compensation Table, unless it is modified to conform to the calculation of the median employee's annual total compensation.

If the company changes or replaces its PEO during the fiscal year, the company can choose one of the following options:

It can take the total compensation disclosed in the Summary Compensation Table for that fiscal year for each PEO and combine the two numbers.
It can identify the PEO serving on the measurement date used to identify the median employee and annualize that PEO's compensation.

In either event, the company must make additional disclosure (see PEO Information).

Additional Disclosure

The company must provide additional disclosure to accompany its pay ratio.

Measurement Date

The company must disclose the date used to identify the median employee (see Meaning of "All Employees"). If a company changes the date it uses to identify the median employee, the company must disclose the change and provide a brief explanation about the reason or reasons for the change.

Non-US Employees

If a company excludes any non-US employees under the data privacy exemption, the company must:

List the excluded jurisdictions.
Identify the specific data privacy law or regulation.
Explain how complying with the pay ratio requirement violates the data privacy law or regulation and describe its efforts to use or seek an exemption or other relief under the law or regulation.
Disclose the approximate number of employees exempted from each jurisdiction based on this exemption.

If a company excludes any non-US employees under the de minimis exemption, it must disclose:

The jurisdiction(s) in which those employees are located.
The approximate number of employees excluded from each jurisdiction.
The total number of its US and non-US employees (without taking any exemption or exclusion into account).
The total number of its US and non-US employees used in its de minimis calculation.

Exclusion of Other Employees

If the company is omitting employees from its determination of total employees because of a recently completed business combination or acquisition (see Business Combinations), the company must:

Disclose the number of employees it is omitting from its calculation.
Identify the acquired business that is excluded for the fiscal year in which the transaction was completed.

Identifying the Median Employee

If the company uses the same median employee for more than one completed fiscal year because the company has determined that there have been no changes in its employee population or employee compensation arrangements that it reasonably believes would result in a significant change to its pay ratio disclosure, the company must:

Disclose that it is using the same median employee in its pay ratio calculation that it did for one or more earlier fiscal years.
Describe briefly the basis for its reasonable belief that no change has occurred.

If the company uses a compensation measure other than annual total compensation to identify the median employee, it must disclose the compensation measure used.

Cost of Living Adjustments

If the company uses a COLA to determine the median employee, it must:

Describe briefly the COLAs used for that purpose and any COLAs used to calculate the median employee's annual total compensation, including the measure used as the basis for the COLA.
Also disclose the median employee's annual total compensation and the pay ratio without the COLA. To calculate this pay ratio (without COLA), the company will need to determine which employee would be the median employee without using any COLAs (see Identifying the Median Employee).

The company must also disclose if, from one fiscal year to the next, it changed from using a COLA to not using that adjustment or if it changed from not using the COLA to using it.

Methodologies, Assumptions and Estimates

The company must describe:

The methodology used to identify the median employee.
Any material assumptions, adjustments (including any COLAs (see Cost of Living Adjustments)) or estimates used to:
- identify the median employee; or
- determine total compensation or any elements of total compensation.

The company must also identify any estimated amounts used.

For example, when statistical sampling is used, a company 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(s) used.

If the company changes any methodologies, assumptions, adjustments or estimates from the prior year and the results of the changes are significant, the company must also:

Describe the change.
Describe the reason for the change.
Provide an estimate of the impact of the change on the median and the ratio.

PEO Information

The company must explain the difference, if any (and if material), between the PEO's annual total compensation used in the pay ratio disclosure and the total compensation amount reflected in the Summary Compensation Table.

If the company has more than one PEO serving during the fiscal year, it must disclose which option it chose for calculating PEO annual total compensation and how it made the calculation.

Supplemental Information

A company may disclose additional information, including additional ratios, to supplement the required pay ratio, but is not required to do so (other than the requirement to provide a pay ratio without a COLA if the company is using a COLA to determine the median employee).

Any additional disclosure must be clearly identified and not misleading, and cannot be disclosed with greater prominence than the required ratio.

Companies Subject to Pay Ratio Requirement

The pay ratio disclosure requirement applies to reporting companies that are required to provide summary compensation disclosure under Item 402(c) of Regulation S-K. The following categories of companies are not required to make pay ratio disclosure:

Emerging growth companies (EGCs). EGCs are specifically exempt under Section 102(a)(3) of the JOBS Act. However, once an EGC loses its EGC status, it must start providing pay ratio disclosure for the first full fiscal year after January 1, 2017 (see Timing for Pay Ratio Disclosure).
Smaller reporting companies. However, once a company loses its smaller reporting company status, it must start providing pay ratio disclosure for the first full fiscal year after January 1, 2017 (see Timing for Pay Ratio Disclosure).
Foreign private issuers and multijurisdictional disclosure system (MJDS) filers.
Registered investment companies.

Companies must disclose the pay ratio in any filing that includes Item 402 compensation disclosure, including Securities Act registration statements (but see Timing for Pay Ratio Disclosure). Companies must first disclose the pay ratio for a completed fiscal year in their annual report on Form 10-K for that year or their proxy statement for the annual meeting, as long as the proxy statement was filed within 120 days after the end of the fiscal year. The pay ratio would then need to be included or incorporated by reference in any other registration statement, proxy statement or other report requiring executive compensation disclosure filed afterwards.

Timing for Pay Ratio Disclosure

Public companies must begin making pay ratio disclosure for the first fiscal year that begins on or after January 1, 2017. Therefore, a company with a December 31 fiscal year end would be required to make the disclosure for fiscal year 2017 in its Form 10-K for 2017 due in 2018 or the proxy or information statement for its 2018 annual meeting.

A previously non-reporting company is not required to make pay ratio disclosure in a registration statement on Form S-1 or S-11 for an IPO or in a Form 10. Instead, the company must provide pay ratio disclosure for the first fiscal year beginning on or after the date the company becomes a reporting company, but not for any fiscal year starting before January 1, 2017. Therefore, for example, if a company with a December 31 fiscal year end completes an IPO in 2016, the company will be required to make the first disclosure in its Form 10-K for the year ended December 31, 2017 or its 2018 proxy or information statement.

Filed versus Furnished

Pay ratio disclosure will be considered filed (as opposed to furnished) for purposes of the Securities Act and Exchange Act, meaning it will be subject to applicable liability provisions including:

Section 18 of the Exchange Act.
Section 11 of the Securities Act, when incorporated by reference into a registration statement.

Pay ratio disclosure will also be covered by Sarbanes-Oxley certifications.

SEC Adopts Final Dodd-Frank Pay Ratio Disclosure Rules | Practical Law