On August 5, 2015, the Securities and Exchange Commission (SEC) adopted a final rule to implement the “CEO pay ratio” disclosure mandated by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. New Item 402(u) of Regulation S-K requires public companies to disclose the ratio of the annual total compensation of its principal executive officer (PEO) to the median annual total compensation of the company’s other employees.

Item 402(u) requires registrants to disclose:

• The median of the annual total compensation of all employees of the company other than the PEO;
• The annual total compensation of the company’s PEO; and
• The ratio between these two amounts.

The ratio must be expressed either as a ratio in which the median employee’s annual total compensation is equal to one, or narratively by stating how many times higher or lower the PEO’s annual total compensation is than that of the median employee. For example, if a registrant’s median annual total compensation for employees is $50,000 and its PEO’s annual total compensation is $2,500,000, the registrant may describe the pay ratio as 50 to 1 or 50:1, or by stating, “The PEO’s annual total compensation is 50 times that of the median of the annual total compensation of all employees.” A registrant is not permitted to present the median employee’s annual total compensation as a percentage of the PEO’s compensation (e.g., “The median employee’s annual total compensation is 2% of the PEO’s annual total compensation”).

Employees Covered by the Rule

Item 402(u) defines “employee” as including a registrant’s and any of its consolidated subsidiaries’
domestic, foreign, part-time, seasonal, and temporary employees (other than the PEO). It also encompasses both hourly and salaried employees. There are a few exclusions to this definition:

• Independent contractors or “leased” workers so long as they are employed by, and their compensation is determined by, an unaffiliated third party; Where a jurisdiction’s
  data privacy laws or regulations are such that, despite a registrant’s reasonable efforts to obtain or process the payroll information required for the disclosure, it is unable to do so without violating those laws or regulations;[1] and
• Where a de minimus number of a registrant’s employees work outside the United States.[2]

[1] In order to obtain the benefit of this exclusion, the registrant must (i) seek an exemption or other relief under the jurisdiction’s governing data privacy laws or regulations; (ii) list the excluded jurisdictions, identify the data privacy law(s) or regulation(s), explain how complying with Item 402(u) would violate such law(s) or regulation(s), and provide the approximate number of employees exempted from each jurisdiction based on this exclusion; and (iii) obtain and file with the SEC a legal opinion opining on the inability of the registrant to obtain or process the payroll information necessary for compliance.

[2] The SEC has provided guidance that a registrant whose non-U.S. employees make up 5% or less of their total U.S. and non-U.S. employees may exclude them, provided that the registrant excludes all non-U.S. employees from the calculation. A registrant with more than 5% non-U.S. employees may exclude those employees up to the 5% threshold only if it excludes all employees in that jurisdiction.

The “Median” Employee

Preparation of the pay ratio disclosure requires identification of the median employee from the employee pool. A registrant must identify the “median employee” once every three years and must disclose the date used to identify the median employee. The SEC provided flexibility in the rule with respect to the median employee determination date and has permitted registrants to choose a date within the last three months of the registrant’s last-completed fiscal year. If that determination date changes after “year one,” the registrant must disclose the reason for that change in “year two” or “year three,” as applicable.

If the registrant uses the same median employee for each of the three years, it must disclose that fact. The registrant must also briefly describe the basis for its belief that there have been no changes in its employee population or employee compensation arrangements that would result in significant changes to its disclosure. If there has been a change in its employee population or employee compensation
arrangements during the three-year period that the registrant reasonably believes would result in a significant change to its pay ratio disclosure, the registrant must disclose the change, re-identify the median employee, and provide an explanation about the reason for the change.

Additionally, if the median employee’s compensation changes within those three years (for example, if the median employee is no longer in the same position or employed by the registrant), the registrant may use another employee with substantially similar compensation as its median employee.

In identifying the median employee, registrants need not calculate each employee’s compensation using the Item 402(c)(2)(x) standard used for disclosure of total annual compensation (referenced below). Instead, the SEC has permitted registrants to select from a range of suitable methodologies based on the registrant’s facts and circumstances. Registrants may identify their median employees by using annual
total compensation or any other compensation measure that is consistently applied to all employees in the calculation, such as tax and/or payroll records. In determining the employees from which the median employee is identified, registrants may use their total employee population, a statistical sampling of their total employee population, or other or additional reasonable methods.

Registrants are permitted to make cost-of-living adjustments to the compensation of their employees living in jurisdictions other than where the PEO resides. Registrants must, however, apply the adjustment to all employees in the jurisdictions who are included in the calculation. If a cost-of-living adjustment is used to identify the median employee, a registrant must use the same adjustment in calculating the employee’s annual total compensation and briefly describe the cost-of-living adjustments it used to calculate the median employee’s annual compensation (including the measure used as the basis for the cost-of-living adjustment). A registrant electing to present the pay ratio in this manner must also disclose the median employee’s annual total compensation and pay ratio without the cost-of-living adjustments.

Calculation of Annual Total Compensation

For purposes of calculating the annual total compensation for its median employee, reference is made to the definition of “total compensation” in Item 402(c)(2)(x) of Regulation S-K. As such, the registrant must determine the total compensation for the registrant’s last-completed fiscal year. Registrants may use reasonable estimates when calculating the elements of the annual total compensation, so long as those estimates are clearly identified.

Additionally, although registrants are permitted to identify the median employee only once every three years, annual total compensation for that employee must be calculated each year.

PEO Replacements

In the event that a registrant replaces its PEO with another PEO during its fiscal year, the registrant has two options: (i) take the total compensation calculated pursuant to Item 402(c)(2)(x) (and reflected in the Summary Compensation Table) to each person who served as PEO during the year and combine those figures; or (ii) look to the PEO serving in that position on the median employee determination
date and annualize that PEO’s compensation.

Filings and Excluded Filers

The pay ratio disclosure must be made in any filing described in Item 10(a) that calls for executive compensation disclosure under Item 402, including annual reports on Form 10-K; registration
statements under the Securities Act of 1933, as amended (the “Securities Act”) and the Securities Exchange Act of 1934, as amended (the “Exchange Act”); and proxy and information statements requiring compliance with Item 402. Such information is deemed “filed,” and not “furnished,” for purposes of the Securities Act and the Exchange Act, including for purposes of Section 18 liability under the Exchange Act.

Smaller reporting companies, emerging growth companies, foreign private issuers, and registered investment companies, among others, will not be required to comply with the pay ratio rules.

Compliance Date and Grace Period

The new rules require registrants to include the pay ratio disclosure for their first fiscal year beginning on or after January 1, 2017, and will therefore become effective for the 2018 10-K and proxy season.

Newly registered companies will not have to disclose pay ratios in their initial registration statements,
but will be required to do so in their first 10-K or proxy statement filed with the SEC after their second fiscal year following the date they became subject to the Exchange Act.

For any questions or greater clarity on the new rules, please contact the Hinckley Allen attorney with whom you regularly work with.