Last call! SEC’s pay ratio rule effective for 2018 proxy statements

Eversheds Sutherland (US) LLP

Eversheds Sutherland (US) LLP

The long-awaited pay ratio rule (the Rule), adopted by the Securities and Exchange Commission (the SEC) on August 5, 2015, finally takes effect in 2018.1  The Rule, which is intended to provide shareholders with a metric to assist them in their assessment of a company’s executive compensation practices, is codified in Item 402(u) of Regulation S-K and requires pay ratio disclosure in any annual report, proxy or information statement, or registration statement that requires disclosure under Item 402 of Regulation S-K.

Registrants Covered by the Rule 

The Rule does not cover emerging growth companies, smaller reporting companies, foreign private issuers and US-Canadian Multijurisdictional Disclosure System (MJDS) filers. The Rule also explicitly does not apply to registered investment companies; however, business development companies are subject to the pay ratio disclosure requirement. A registrant that ceases to be an emerging growth company or a smaller reporting company is not required to provide pay ratio disclosure until after the first full fiscal year after exiting such status. 

In addition, although registrants will not be required to provide pay ratio disclosure in registration statements for an initial public offering or a registration statement on Form 10, any such registrant will be required to disclose its pay ratio with respect to compensation for the first fiscal year commencing after the year in which it becomes subject to the requirements of Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934, but no earlier than the year commencing January 1, 2017.

Disclosure Required Under the Rule

The Rule requires registrants subject to the Rule to disclose: 

  • the median of the annual total compensation of all employees of the registrant, except the chief executive officer (CEO) (or any equivalent position), 
  • the annual total compensation of the CEO, and 
  • the ratio of these two amounts.

The ratio must be expressed in one of two ways: (a) disclosed so that the median of the annual total compensation of all employees equals one (e.g., 100 to 1 or 100:1), or (b) expressed narratively by stating the CEO’s annual total compensation as a multiple of the median (e.g., 100 times that of the median employee). Therefore, under the Rule, a registrant must (1) identify its employees, (2) identify the median employee, and (3) then determine the annual total compensation of that median employee (with certain estimates permitted).

“Employees” Covered Under the Rule

The Rule defines “employee” to include a registrant’s US and non-US employees (other than the CEO) as of a date selected by the registrant within the last three months of the last completed fiscal year.2  This includes any part-time, seasonal, and temporary employees employed by the registrant or any of its consolidated subsidiaries. Because the definition refers to workers “employed by the registrant,” workers who provide services to the registrant or consolidated subsidiaries as independent contractors or “leased” employees are generally excluded from the definition of “employee.”

Non-US employees are generally included in the definition of employee, subject to two exemptions: (1) the data privacy exemption and (2) the de minimis exemption. 

Data Privacy Exemption

Registrants may exclude from their determination of the median employee an employee who is employed in a non-US jurisdiction in which the data privacy laws or regulations prohibit the registrant from obtaining the information necessary to comply with the Rule (the Data Privacy Exemption). The registrant must make “reasonable efforts” to comply with the data privacy laws before relying on the exemption, including using or seeking relief under, or an exemption from, any governing data privacy laws. In addition, a registrant relying on the Data Privacy Exemption must obtain a legal opinion from counsel regarding the inability to obtain or process the required information, file such legal opinion as an exhibit to the relevant filing, and comply with additional disclosure requirements. If any employee is excluded under the Data Privacy Exemption, all employees in the relevant jurisdiction must be excluded. 

De Minimis Exemption

In addition, registrants may exclude non-US employees from their pay ratio calculations if such employees account for 5% or less of their total employees (or, if a registrant’s non-US employee population is in excess of 5%, it can exclude up to 5%) (the De Minimis Exemption). If a registrant excludes any non-US employees under the De Minimis Exemption because such employees account for 5% or less of its total employees, then the registrant must exclude all non-US employees. Further, if a registrant chooses to exclude any non-US employees in a particular foreign jurisdiction under the De Minimis Exemption, it must exclude all employees in that jurisdiction and provide certain additional required disclosure. If more than 5% of a registrant’s employees are located in a particular non-US jurisdiction, then no employees from such jurisdiction may be excluded under the De Minimis Exemption. It should be noted that any employee excluded under the Data Privacy Exemption counts toward the 5% de minimis limit. 

Identifying the Median Employee 

Registrants must determine the annual total compensation of the “median employee” in order to determine the pay ratio. Once the median employee has been selected, his or her annual total compensation is calculated in accordance with the rules that apply to determining total compensation of the CEO in the Summary Compensation Table, subject to the ability to use reasonable estimates to value employee benefits, as appropriate, and to include certain non-discriminatory benefits and low-value perquisites.

A registrant is required to identify 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 in the pay ratio disclosure.3  If the median employee’s compensation changes significantly (i.e., as the result of a promotion) or if the median employee is no longer employed by the registrant during the relevant three-year period, the registrant may either re-identify the median employee or select another employee with compensation substantially similar to the original median employee. 

When identifying the median employee, a registrant may make cost-of-living adjustments to the compensation of employees in jurisdictions other than where the registrant’s CEO resides so that the compensation of such employees is adjusted to the cost-of-living in the jurisdiction in which the CEO resides. If such cost-of-living adjustment is utilized to identify the median employee, and the median employee identified does not reside in the CEO’s jurisdiction, the registrant must disclose the median employee’s jurisdiction, use the same cost-of-living adjustment when calculating the median employee’s annual total compensation, and briefly describe the cost-of-living adjustments it used to (i) identify the median employee, and (ii) calculate the median employee’s annual total compensation, including the measure used as the basis for the cost-of-living adjustment. In addition, the registrant must disclose the median employee’s annual total compensation and the pay ratio calculated without applying the cost-of-living adjustment.

The Rule allows for flexibility in methodology depending on a registrant’s particular facts and circumstances. For example, when determining the employees from which the median employee is selected, registrants are permitted to use their employee population, a statistical sampling of that population, and/or other reasonable methods. In addition, a registrant may select a median employee using annual total compensation or any other compensation measure that is consistently applied to all employees included in the calculation (e.g., tax and/or payroll records). If a measure other than annual total compensation is used to identify the median employee, then such measure must be disclosed. In addition, the Rule permits registrants to annualize the compensation of all permanent (full- or part-time) employees who worked for part of the registrant’s fiscal year, but a temporary or seasonal employee’s compensation cannot be annualized.

Narrative Disclosure Required

Registrants are required to summarize the method they use to identify the median employee, along with all material assumptions, estimates and/or adjustments used in such identification and used to calculate annual total compensation. In addition, any estimates used must be clearly identified. Registrants are also permitted to present additional information, including additional ratios, so long as such additional information is clearly identified and is not misleading. In addition, any additional information must not be presented with greater prominence than the required pay ratio.

Regulatory Interpretation and Guidance

On September 21, 2017, the SEC released guidance to advise registrants on how to comply with the Rule.4 Specifically, the SEC interpretive guidance provides the following useful information:

  • The use of reasonable estimates, assumptions, adjustments and statistical sampling to calculate the pay ratio will not result in an SEC enforcement action unless the disclosure is made without a reasonable basis or is not made in good faith.
  • Registrants may use certain existing internal records in order to determine whether the De Minimis Exemption is available. In addition, registrants may use existing internal records to identify the consistently applied compensation measure used to identify the median employee, even if those records do not include every element of compensation, such as widely distributed equity awards. If the annual total compensation calculated in accordance with Item 402 of Regulation S-K for the identified median employee results in anomalous characteristics, registrants can choose another employee with substantially similar compensation based on the compensation measure used, rather than using a new measure.
  • For determining whether independent contractors are “employees” for purposes of calculating the pay ratio disclosure, registrants may use widely recognized tests under other areas of law (e.g., the IRS determination) that the registrant otherwise uses to determine whether its workers are “employees.”

1Registrants subject to the requirement must include the pay ratio disclosure with respect to the first fiscal year commencing on or after January 1, 2017. In other words, registrants with a December 31 fiscal year-end must first include the pay ratio disclosure in their proxy statements or annual reports on Form 10-K filed starting in 2018. The full text of the adopting release for the Rule can be found at

2Registrants must disclose the date selected for the determination of its employee population. A registrant need not disclose the basis for such selection, provided however, that, if a registrant changes the date in a subsequent year, then the registrant must disclose the change along with a brief explanation of the reasons for the change.

3If there are no such changes, a registrant must disclose that it is using the same median employee and describe briefly the basis for its reasonable belief. Registrants should note that, despite the fact that the median employee may remain the same for three years, the median employee’s annual total compensation is an annual determination.

4 SEC, Division of Corporation Finance Guidance on Calculation of Pay Ratio Disclosure (Sept. 21, 2017),; Commission Guidance on Pay Ratio Disclosure, Rel. No. 33-10415 (Sept. 21, 2017), available at

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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