SEC Adopts Pay Ratio Disclosure Rules Mandated by Dodd-Frank

SEC Adopts Final Pay Ratio Disclosure Rules Mandated Under Dodd-Frank Act

August 11 2015

PDFExecutive Summary

On August 5, 2015, the Commissioners of the SEC voted three-to-two, along party lines, to adopt final rules implementing the pay ratio disclosure mandated under Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Final Rule”).  The Final Rule amends existing executive compensation disclosure rules to require companies to disclose:

  • The median of the annual total compensation of all its employees, except the CEO;
  • The annual total compensation of its CEO; and
  • The ratio of those two amounts.

The Final Rule preserves the substantial flexibility provided under the rule as proposed in 2013 for companies to identify the median employee and calculate total pay.  However, the SEC made several changes and clarifications to the rule in response to comment letters received which provide additional flexibility for companies.  These include:

  • Ability to determine the median employee once every three years
  • Ability to select any date in the last three months of the fiscal year as the determination date
  • Permission to make cost of living adjustments to compensation for employees not living in the same country as the CEO; importantly, companies must also present the ratio on an unadjusted basis
  • Ability to exclude certain non-US employees in instances where (a) foreign data privacy laws would prevent the company from complying with the final rule, or (b) the non-US workforce represents less than 5% of the total workforce

The Final Rule clarifies that the disclosure of additional ratios is permitted so long as it is not misleading or given more prominence than the required ratio.

The SEC extended the initial compliance date to the first fiscal year beginning on or after January 1, 2017 meaning that companies are not required to disclose the CEO pay ratio until the 2018 proxy statement.

As always, we stand ready to assist with any questions that may arise in the implementation of this rule or the crafting of the required disclosure.

The Final Rule

Pay Ratio Disclosure Requirement
As required by Section 953(b) of the Dodd-Frank Act, the rule amends existing executive compensation disclosure rules to require companies to disclose:

  • The median of the annual total compensation of all its employees, except the CEO;
  • The annual total compensation of its CEO; and
  • The ratio of those two amounts.

Companies are required to briefly describe the methodology used to identify the median employee, and any assumptions, adjustments (including cost-of-living adjustments), or estimates used to identify the median employee or to determine annual total compensation of that median employee.

The SEC clarified in the narrative accompanying the Final Rule that companies are permitted, but not required, to supplement the required disclosure with a narrative discussion or additional ratios. Any additional discussion and/or ratios need to be clearly identified, can not be misleading, and may not be presented with greater prominence than the required pay ratio.

Which employees must be included in this calculation?
The Final Rule states that companies may select any date within the last three months of the fiscal year to determine the employee population for purposes of identifying the median employee.  While companies need not provide any details about the rationale behind the choice of determination date, if the date changes on a year-over-year basis, the reason for the change must be disclosed.

Subject to two exceptions detailed below, a company is required to include all employees – U.S. and non-U.S., full-time, part-time, temporary and seasonal – employed by the company or any of its consolidated subsidiaries in performing its pay ratio calculation.

Individuals employed by unaffiliated third parties or independent contractors are not considered to be employees of the company.

When can non-U.S. employees be excluded from this calculation?
Companies can exclude non-U.S. employees from the determination of its median employee in two circumstances:

  • Non-U.S. employees that are employed in a jurisdiction with data privacy laws that make the company unable to comply with the rule without violating those laws.
    • The company must first seek an exemption from the applicable data privacy regulations, and is required to obtain a legal opinion from counsel on the inability of the company to obtain or process the information necessary for compliance with the rule without violating the jurisdiction’s laws or regulations governing data privacy.
    • Companies must list excluded jurisdictions, identify the specific data privacy law or regulation which prevents compliance, explain how complying with the Final Rule violates these laws (including efforts made by the company to use or seek an exemption to the applicable law) and the approximate number of employees exempted.
  • Up to 5 percent of its non-U.S. employees, including any non-U.S. employees excluded using the data privacy exemption.

If a company excludes any non-U.S. employee in a particular jurisdiction, it must exclude all employees in that jurisdiction. The number of employees excluded and the jurisdictions in which they are employed must be disclosed.

How is the median employee selected?
Companies may select a methodology for determining the median employee based on their own facts and circumstances. Companies are permitted to use their total employee population or a statistical sampling of that population and/or other reasonable methods. Examples of reasonable calculation methods include using:

  • Annual total compensation as determined under existing executive compensation rules; or
  • Any consistently-applied compensation measure from compensation amounts reported in its payroll or tax records.

Can compensation be annualized?
Companies are permitted, but not required, to annualize the total compensation for a permanent employee who did not work for the entire year, such as a new hire. However, compares are not permitted to make full-time equivalent adjustments for part-time, temporary and seasonal workers.

Can compensation be adjusted to reflect cost of living differences?
In a change from the proposed rule, the Final Rule allows companies to apply a cost-of-living adjustment to the compensation measure used to identify the median employee. If a company applies this adjustment, it is required to use the same adjustment in calculating the median employee’s annual total compensation.

Companies electing to use this adjustment will also need to disclose a separate, unadjusted ratio in which the median employee is selected and CEO pay ratio is calculated using unadjusted data.

How frequently is the median employee selected?
Companies are permitted to identify the median employee 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. If the median employee identified in year one is no longer in the same position or no longer employed in year two or three, a company is permitted to replace the median employee with an employee in a similarly compensated position.

How is annual total compensation calculated for the median employee?
The annual total compensation is to be calculated in accordance with the total compensation calculation used for named executive officers in the Summary Compensation Table. This compensation will need to be calculated on a fiscal year end basis.

Unlike the calculations for the named executive officers, when calculating the median employee’s total compensation or elements of his/her total compensation, the company may use reasonable estimates. A company will need to identify estimated amounts and the methods used in reaching these amounts.

Where do companies have to disclose the pay ratio?
As a general rule of thumb, a company will need to include the pay ratio disclosure whenever it discloses the summary compensation tables; provided, however, updated pay ratio information must be filed no later than 120 days after the end of such fiscal year.

When does the rule become effective?
Companies are required to report the pay ratio disclosure for their first fiscal year beginning on or after January 1, 2017, generally in the 2018 proxy.

A company that had not previously been a reporting company will be required to report the pay ratio disclosure for the first fiscal year following the year in which it becomes subject to the Commission’s reporting requirements, but not for any fiscal year commencing before January 1, 2017.

Are there any transition periods?
Companies that engage in mergers and/or acquisitions may 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. These new employees will need to be included in following full fiscal year’s calculation.

Companies that cease to be smaller reporting companies or emerging growth companies are not required to provide pay ratio disclosure until they file a report for the first fiscal year commencing on or after they cease to be a smaller reporting company or emerging growth company.

Are any companies exempt from this disclosure?
Consistent with the proposing release, pay ratio disclosure will not be required by smaller reporting companies, foreign private issuers, U.S.-Canadian Multijurisdictional Disclosure System filers and emerging growth companies.

Our View

We continue to believe that there is limited utility, if any, in the disclosure required by the Final Rule. We recommend that companies begin considering how they will comply with the disclosure mandate, including how to word the narrative for the required disclosure to ensure investors, employees and other stakeholders are provided with the proper context for reviewing the ratio.


 

About Steven Hall & Partners
Steven Hall & Partners is an independent executive compensation consulting firm, specializing exclusively in the areas of executive compensation, board remuneration, non-profit compensation and related governance issues. By focusing solely on this critical and complex segment of the human resources arena, we are able to provide our clients with the highest quality expertise and best counsel available on a practical basis. For more information, please visit www.shallpartners.com and follow us on Twitter @SHallPartners.

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