SEC Approves Final Rules for Pay Ratio Disclosure

by Holland & Knight LLP
Contact

HIGHLIGHTS:

  • SEC commissioners voted to approve the final "pay ratio" disclosure rules intended to help shareholders evaluate executive compensation practices.
  • Companies must comply with the final pay ratio rules commencing with their first fiscal year beginning on or after January 1, 2017.
  • The final rules contain specific disclosure obligations that include disclosing the median of the annual total compensation of all employees, excluding the CEO; the annual total compensation of the CEO; and the ratio of the median to the annual total compensation of the CEO.

The Securities and Exchange Commission (SEC) adopted the final "pay ratio" disclosure rules to implement Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) at an open meeting on August 5, 2015. Following its release of the proposed pay ratio disclosure rules in September 2013, the SEC received over 287,400 comment letters. Out of these, over 1,500 were individual letters reflecting a wide range of views concerning the proposed rule, and nearly 286,000 were one of 12 types of form letters either supporting the proposed rule or supporting the idea of adopting a rule based on Section 953(b) of the Dodd-Frank Act.

The SEC commissioners voted three to two to approve the controversial rules, with commissioners Daniel M. Gallagher and Michael Piwowar voting against approval. Highlighting the controversy, Commissioner Gallagher noted in remarks prior to the vote that the SEC was "on the cusp of adopting a nakedly political rule that hijacks the SEC's disclosure regime to once again effect social change desired by ideologues and special interest groups." In adopting the final rules, the SEC noted its belief that, notwithstanding the lack of available legislative history, Section 935(b) "was intended to provide shareholders with a company-specific metric that can assist in their evaluation of a company's executive compensation practices." To that end, the final rules differed from the proposed rules in various circumstances as a result of the SEC's attempt "to tailor the final rule to meet that [legislative] purpose while avoiding unnecessary costs."

Effective Date of the New Pay Ratio Rules

Companies must comply with the final pay ratio rules commencing with their first fiscal year beginning on or after January 1, 2017. As such, for companies that have a calendar fiscal year, pay ratio disclosure will cover fiscal year 2017 and be included in the 2018 Annual Meeting proxy statements. 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, as the case may be. The final rules also include specific transition rules applicable to new registrants as well as to companies that engage in business combinations and acquisitions.

Summary of the Final Rules

The final pay ratio disclosure rules implement Section 953(b) of the Dodd-Frank Act by amending Item 402 of Regulation S-K to include a new Paragraph (u) that requires companies other than emerging growth companies, smaller reporting companies or foreign private issuers to disclose all of the following:

  • the median of the annual total compensation of all employees, excluding the principal executive officer (i.e., the CEO)
  • the annual total compensation of the CEO
  • the ratio of the median to the annual total compensation of the CEO

The disclosure must be presented as either a ratio of the median of annual total compensation of all employees to the CEO's annual total compensation, with the median equal to one, or as a multiple. A narrative description may be easier for investors to understand than a numerical ratio.

Companies are required to present the new pay ratio disclosure in any registration statement, proxy statement, information statement and annual report that is required to include the executive compensation disclosure required by Item 402 of Regulation S-K. Although the final rules do not mandate where the pay ratio disclosure should appear, those companies voluntarily including pay ratio disclosure in their SEC filings to date generally have included the disclosure in their Compensation Discussion and Analysis. Similar to the other executive compensation disclosure, the final rules confirm that the pay ratio disclosure will be deemed "filed," not "furnished," under the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, making the disclosure subject to a higher level of potential liability.

"All Employees" Are Covered by the Rules

The final rules apply to "all employees" of a company, which includes all full-time, part-time, temporary and seasonal employees of the company or any of its subsidiaries in the United States and abroad. Independent contractors, "leased" workers or other temporary workers who are employed by a third party are not covered by the final rules. Compensation is permitted, but not required, to be annualized for employees who were not employed for a full fiscal year. However, full-time equivalent adjustments for part-time workers, annualizing adjustments for temporary or seasonal workers and cost-of-living adjustments for non-U.S. workers is not permitted.

Two Exceptions. In response to comments received, the SEC included in the final rules the following two exemptions from the definition of "employee" pertaining to individuals employed outside of the U.S.:

  • Foreign Data Privacy Law Exemption: Individuals employed outside of the U.S. and who otherwise would be included as an "employee" may be excluded in the event that a company, despite its reasonable efforts, is unable to comply with the rules because doing so would violate applicable foreign data privacy laws or regulations. However, in an effort to prevent abuse of this exemption, the SEC has imposed fairly significant hurdles a company must overcome in order to rely upon this exemption. These include using or seeking an exemptive order or other relief under such laws or regulations, and obtaining a legal opinion with respect to the company's inability to comply with the disclosure rules as a result of such laws or regulations—including demonstrating unsuccessful efforts to leverage an exemption or other relief under such foreign laws or regulations. Further, if a company excludes any non-U.S. employees in a particular jurisdiction under the data privacy exemption, it must exclude all non-U.S. employees in that jurisdiction.
  • De Minimus Exemption: Employees in a jurisdiction located outside of the U.S. may be excluded where those employees represent no more than five percent of a company's total U.S. and non-U.S. employees, with certain limitations. If a company's non-U.S. employees exceed five percent of its total employees, the company may exclude up to five percent of its total employees who are non-U.S. employees.

The final rules contain specific additional disclosure obligations in the event a company seeks to avail itself of either of these exemptions.

Cost-of-Living Adjustments. Pursuant to the final rules, companies may make cost-of-living adjustments for compensation of employees in jurisdictions other than the jurisdiction in which the CEO resides so that the median employee compensation is adjusted to the cost of living in the jurisdiction in which the CEO resides. The company must explain the cost-of-living adjustments used, including the measure used as the basis for the cost-of-living adjustment. The company also must disclose the median employee's annual total compensation and pay ratio without using any cost-of-living adjustments.

Only Employees of Consolidated Subsidiaries. Although the proposed rules covered employees of any of a company's subsidiaries, the final rules limit the universe of covered subsidiaries to only those subsidiaries that are consolidated into the company's financial statements.

Measurement Date for Identifying "Employees" and the "Median Employee"

Unlike the proposed rules, which included the last day of the company's last completed fiscal year as the date for determining the median employee, the final rules permit companies to use any date within three months prior to the last day of their last completed fiscal year to identify their median employee. Companies must disclose the date used, and if they elect to change that date in subsequent years, they must disclose the change and provide a brief explanation about the reason or reasons for the change.

Identifying the "Median Employee"

Identification Required Only Once Every Three Years, but Calculation Required Every Year. The final rules allow companies to identify the median employee every three years (rather than every year, as originally proposed), unless there has been a change in employee population or employee compensation arrangements that the company reasonably believes would result in a significant change in the pay ratio disclosure. However, companies must recalculate the identified median employee's total compensation annually and use that figure in calculating the pay ratio.

Alternative Methodologies to Determine the Median Employee. While Section 953(b) requires companies to calculate median employee compensation in the same way that "named executive officer" total compensation is calculated under Item 402(c)(2(x) of Regulation S-K, it did not specify a methodology to identify the median. Consistent with the proposed rules, the SEC has provided in the final rules flexibility in allowing companies to choose from several alternative methods to identify the median, including:

  • Total Compensation for Each Employee: This involves applying the standards of 402(c)(2)(x) to determine "annual total compensation" of all employees, and then identifying the median.
  • Statistical Sampling: Median employee pay may be based upon the full employee population, a statistical sample of all employees or some other reasonable method. Identification of a median employee need not require a determination of exact compensation amounts for every single employee included in the sample. The variance of underlying wage distributions can materially affect the appropriate sample size for statistical sampling.
  • Consistently Applied Compensation Measures: Identification of the median employee may be based on any consistently applied compensation measure, such as compensation amounts reported in a company's payroll or tax records, as long as the company briefly discloses the measure it used. Companies are permitted to choose a method that is workable based upon their particular facts and circumstances.

Determining Total Compensation; Methodology, Assumptions and Estimates

Once the median employee is determined, the final rules require that the total compensation of the median employee be calculated in accordance with Item 402(c)(2)(x) of Regulation S-K (i.e., consistent with the methodology for calculating total compensation for named executive officers). Consistent with the proposed rules, the final rules permit companies to use reasonable estimates to determine the median salary and value of the various elements of total compensation.

In using an estimate for annual total compensation (or for a particular element of total compensation of employees other than the CEO), a company must have a reasonable basis to conclude that the estimate approximates the actual amount of compensation under Item 402(c)(2)(x) awarded to, earned by or paid to those employees. If estimates are used, companies must briefly disclose and consistently apply any methodology used to identify the median and any material assumptions, adjustments or estimates used to identify the median or to determine total compensation or any elements of total compensation. Companies must also clearly identify any estimated amount as such.

The Meaning of "Annual"

Consistent with the proposed rules, the final rules define "annual total compensation" as total compensation for the company's last completed fiscal year, consistent with the time period used for other Item 402 disclosure requirements.

Omission of Salary and Bonus Information for CEO and Conforming Form 8-K Amendments

Where the salary or bonus of a named executive officer is not calculable as of the latest practicable date, Instruction 1 to Items 402(c)(2)(iii) and (iv) of Regulation S-K, permits a company to omit such disclosure from the summary compensation table, if the company includes a footnote disclosing that fact and provides the date the amount is expected to be determined. Once the omitted information is determined, the company must disclose the final amounts under Item 5.02(f) of Form 8-K, as well as a new total compensation figure for the named executive officer. Consistent with the proposed rules, the final rules require a company relying on such instruction to include its pay ratio disclosure in the same filing under Item 5.02(f) of Form 8-K.

What Companies Should Be Doing Now

Institutional and activist investors, as well as aggressive securities litigants, undoubtedly will find fertile fields in pay ratio disclosure practices. There are several measures that companies that currently are subject to the new pay ratio disclosure rules, or that reasonably anticipate becoming subject to the rules prior to or shortly after the rules becoming effective, should be taking now in response to the new rules and this heightened scrutiny, including the following:

  • Most importantly, given the volume of information and analytics that will be required, and the necessary strategic decisions regarding appropriate measurement methodologies, assumptions and estimates, companies should begin having meaningful discussions about their approach to pay ratio disclosure now. The decisions include:
  • considering the best method for identifying the median employee and determining whether the current payroll system permits such identification on a cost-effective basis, or whether changes are necessary
  • considering whether cost of living adjustments are appropriate
  • identifying the scope of employees who will be covered by the rules
  • If a company has operations (either directly or through consolidated subsidiaries) in foreign jurisdictions, the company should:
  • consider whether to elect to exclude eligible foreign employees pursuant to the de minimis exemption
  • if the de minimis exemption is not available, commission an in-depth analysis of that jurisdiction's data privacy laws applicable to obtaining and processing employment and biographical information required to comply with the final rule; analysis should include a determination as to whether such employees can be excluded from the "all employees" pool pursuant to the data privacy exemption
  • As described above, pay ratio disclosure will be deemed "filed" and, therefore, subject to heightened levels of potential liability under federal securities laws. As such, companies should analyze their disclosure controls and procedures and internal controls for generating and producing the pay ratio data.
  • Companies should confirm that data privacy controls currently in place are adequate to protect the privacy of the type of data used and reports generated in connection with the pay ratio analysis. Despite the fact that the SEC set a particularly high bar for the data privacy exemption, it did clarify that the rule does not compel a registrant to disclose any personally identifiable information about an employee other than his or her compensation and, in fact, should not disclose information that could identify any specific individual. Thus, companies are tasked with striking the appropriate balance between both compliance with the rule and protection of the privacy of employees' data.
  • Companies should consider drafting "pay ratio" as early as in connection with the 2016 proxy season disclosure, not necessarily to include the disclosure in their 2016 proxy materials, but to begin to understand the context of the disclosure and to strategically consider whether supplemental ratios or other information will assist with interpreting the pay ratio disclosure in a meaningful way given the company's business circumstances.

See the final rule release for Pay Ratio Disclosure.   

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.

© Holland & Knight LLP | Attorney Advertising

Written by:

Holland & Knight LLP
Contact
more
less

Holland & Knight LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.