On August 5, 2015, the Securities and Exchange Commission (the “SEC”) approved its final rule subjecting most public companies to the so-called “Pay Ratio Disclosure” mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The final pay ratio rule requires annual disclosure of the ratio of a reporting company’s principal executive officer’s total annual compensation to the median of the total annual compensation of all its employees. The final rule can be found here.

Most public companies will be required to make the pay ratio disclosure following their first full fiscal year beginning on or after January 1, 2017. For a typical, calendar-year reporting company, the first pay ratio disclosure would be made in its proxy statement for its 2018 annual meeting. Smaller reporting companies, emerging growth companies and foreign private issuers are exempt from the disclosure requirements and are given a one-year transition period to comply with the disclosure requirements if they lose their exempt status.

The final rule addresses several concerns raised by the SEC’s September 18, 2013 proposed pay ratio rule. Nevertheless, compliance with the pay ratio disclosure requirement will be a significant additional burden on reporting companies.

Changes from the Proposed Rule

The following differences between the final rule and the proposed rule should provide some relief to the compliance burden on reporting companies:

      • As mentioned above, the final rule pushes out the initial compliance date by a year, to follow the reporting company’s first full fiscal year beginning on or after January 1, 2017.
      • The final rule permits a reporting company to determine its median employee 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 its pay ratio disclosure.
      • The final rule permits a reporting company to exclude non-U.S. employees under two limited circumstances: (i) non-U.S. employees may be excluded if compliance with the rules for determination of the median employee would violate the data privacy laws of the foreign jurisdiction in which the non-U.S. employee is located; and (ii) non-U.S. employees consisting of up to 5% of the reporting company’s total employees may be excluded pursuant to a de minimis exemption.
      • The final rule requires a reporting company to include employees of a subsidiary only if the subsidiary is consolidated with the reporting company in preparing its financial statements.
      • The final rule permits a reporting company to select any date within three months prior to the last day of its last completed fiscal year to determine who is an employee for purposes of determining the median employee of the reporting company.
      • The final rule grants new reporting companies, smaller reporting companies, emerging growth companies, and foreign private issuers a transition period following registration or loss of exempt status before they will be required to comply with the pay ratio disclosure requirements.

Summary of the New Pay Ratio Disclosure Requirements

General

The final rule adds a new paragraph (u) to Item 402 of Regulation S-K, which requires disclosure of:

(A) the median of the annual total compensation of all employees of the reporting company, except the reporting company’s principal executive officer (as defined in Item 402, the “PEO”);

(B) the annual total compensation of the reporting company’s PEO; and

(C) the ratio of the amount in (B) to the amount in (A), presented as a ratio in which the amount in (A) equals one, or, alternatively, expressed narratively in terms of the multiple that the amount in (B) bears to the amount in (A).

Companies subject to the final rule will be required to include the pay ratio disclosure in registration statements, proxy and information statements, and annual reports that are currently required to include executive compensation information pursuant to Item 402 of Regulation S-K and the requirements of the relevant form. The pay ratio disclosure is not required in reports that do not require executive compensation information under Item 402 of Regulation S-K, such as current reports on Form 8-K and quarterly reports on Form 10-Q. As a result, the pay ratio disclosure will be included with a reporting company’s annual executive compensation disclosure—typically in its the annual proxy statement but, in any event, not later than 120 days after the end of each fiscal year.

Determination of Employees

“Employee” is defined as an individual employed on any date of the reporting company’s choosing within the last three months of its last completed fiscal year. Subject to limited exceptions, all U.S. and non-U.S. full-time, part-time, temporary and seasonal employees of the reporting company or any of its consolidated subsidiaries are to be included in the pay ratio calculation. Employees of unaffiliated third parties or independent contractors are not considered employees. Employees acquired in a business combination or acquisition transaction may be omitted in the fiscal year the transaction occurred, but the reporting company must disclose the transaction and the approximate number of employees omitted.

Non-U.S. employees may be excluded in two circumstances:

      • Foreign Data Privacy Laws – A reporting company may exclude its non-U.S. employees who are employed in a jurisdiction where data privacy laws would be violated by compliance with the pay ratio disclosure requirement. To rely on this exclusion, however, the reporting company must: (i) use reasonable efforts to obtain the information necessary for compliance, including seeking an exemption or other relief under the applicable data privacy law or regulation and (ii) obtain a legal opinion from counsel on the inability of the reporting company to obtain or process the information necessary for compliance with the rule without violating the jurisdiction’s data privacy laws or regulations.
      • De Minimis Exemption – Reporting companies may exclude non-U.S. employees consisting of up to 5% of their total employees in the following cases:
          • Reporting companies whose non-U.S. employees make up 5% or less of their total U.S. and non-U.S. employees may exclude all non-U.S. employees when identifying their median employee. A reporting company choosing to exclude any non-U.S. employees under this exemption must exclude all of them.
          • Reporting companies with more than 5% non-U.S. employees may also exclude non-U.S. employees up to the 5% threshold, provided that, if such a company excludes any non-U.S. employees in a specific foreign jurisdiction, it must exclude all employees in that jurisdiction.

Non-U.S. employees excluded under the data privacy law exclusion are included in the de minimis calculations as excluded non-U.S. employees.

Reporting companies may, but are not required to, annualize the total compensation for a permanent, full-time or part-time employee who did not work for the entire year. By contrast, full-time equivalent adjustments for part-time workers and annualizing adjustments for temporary and seasonal workers are not permitted when calculating the required pay ratio.

Identification of Median Employee

To meet the requirement of reporting the median of the annual total compensation of all employees, the final rule establishes a two-step process: (1) use a compensation measure methodology to determine a median employee of the reporting company and (2) once the median employee is selected, use the compensation disclosure requirements of Item 402(c)(2)(x) to determine that median employee’s annual compensation. In identifying the median employee, the final rule permits each reporting company to select any reasonable methodology for compensation measure based on that specific company’s own facts and circumstances. The adopting release mentions using, for example:

      • Annual total compensation as determined under existing executive compensation rules;
      • Any consistently-applied compensation measure from compensation amounts reported in its payroll or tax records; and
      • Use of statistical sampling or reasonable estimates.

A reporting company is permitted to make a cost-of-living adjustment to the compensation measure used to identify the median employee for employees that live in a different jurisdiction than the PEO, provided that the adjustment is applied to all such employees included in the calculation. The adjustment would be to the cost-of-living of the jurisdiction of the PEO. If a reporting company applies this adjustment, it is required to use the same cost-of-living adjustment in calculating the median employee’s annual total compensation under Item 402(c)(2)(x) of Regulation S-K. A reporting company must still disclose the median employee’s annual total compensation and the pay ratio without any cost-of-living adjustment.

As mentioned above, the final rule permits a reporting company to determine the median employee only 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 to its pay ratio disclosure. The final rule also permits that if within those three years the median employee’s compensation changes in a way that the company reasonably believes would result in a significant change in the pay ratio or the median employee is no longer employed, the reporting company may choose a new median employee by selecting another employee with a substantially similar compensation position as held by the previous median employee. In any case, a reporting company must still calculate the identified median employee’s annual total compensation and use that figure in calculating its pay ratio every year.

Determination of Total Annual Compensation of the Median Employee

A reporting company is required to calculate the annual total compensation for its median employee using the same rules for calculating the PEO’s annual total compensation as reported in the Summary Compensation Table of its proxy statement or information circular. The final rule allows reporting companies to use reasonable estimates when calculating any elements of the annual total compensation.

PEO Annual Compensation

Calculation of the annual total compensation of the PEO is made in accordance with existing requirements under Item 402(c)(2)(x) of Regulation S-K and is the number reported for the PEO in the reporting company’s Summary Compensation Table disclosure. In situations where the reporting company has had more than one PEO during the course of the last completed fiscal year, the final rule provides two choices: (i) a reporting company may take the total compensation calculated pursuant to Item 402(c)(2)(x), and reflected in the Summary Compensation Table, provided to each person who served as PEO during the fiscal year and combine those figures, or (ii) a reporting company may look to the PEO serving in that position on the date it selects to identify the median employee and annualize that PEO’s compensation.

Additional Disclosure Permitted But Not Required

Reporting companies are permitted, but not required, to supplement the required disclosure with a narrative discussion or additional ratios. Any additional discussion and/or ratios would need to be clearly identified, not misleading, and not presented with greater prominence than the required pay ratio.

Dorsey & Whitney Compliance Webinar

Dorsey & Whitney will be presenting a one hour program highlighting what has changed from the proposed pay ratio disclosure rules and the potential pitfalls and consequences involved in compliance with the new disclosure requirements. If you did not receive Dorsey’s invitation and would like to attend, please register via one of these links: Attend Live in Minneapolis or Participate by Webinar. Dorsey’s program will be presented from 12 noon to 1:00 pm Central Time on August 20, 2015.