As our clients and friends know, each year Mintz Levin provides an analysis of the regulatory developments that impact public companies as they prepare for their fiscal year-end filings with the Securities and Exchange Commission (the "SEC") and their annual shareholder meetings. This memorandum discusses key considerations to keep in mind as you embark upon the year-end reporting process in 2016.1
As was the case last year, there are no SEC rule changes that will directly affect the year-end reporting process. There are, however, a few key changes pending, for which companies should take steps now to prepare for compliance.
First among these is the "pay ratio" disclosure rule issued under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), that was finalized by the SEC in August. This new rule requires companies to disclose the ratio of median employee compensation to principal executive officer compensation and is set forth as Item 402(u) of Regulation S-K. The rule requires companies to begin providing this pay ratio information in their executive compensation disclosure with respect to the fiscal year beginning on or after January 1, 2017 in time for the 2018 proxy season. All public companies will be subject to this new disclosure requirement, with the exception of emerging growth companies, smaller reporting companies and foreign private issuers. The SEC proposed the remainder of the Dodd-Frank Act executive compensation rules in 2015. It proposed rules regarding hedging of shares by employees and directors in February, measuring pay for performance in April, and clawback of "erroneously awarded compensation" in July, but no time frame has yet been set for the finalization of these rules and they will not be in place this proxy season. Shareholder activism remains strong, and institutional shareholders are continuing to put pressure on companies to conduct their affairs in a more transparent manner, encouraging the adoption of governance policies that benefit shareholders, such as executive compensation clawbacks, stock ownership guidelines, and majority voting, and discouraging policies such as plurality voting, staggered boards and "poison pill" plans. As the largest public companies have adopted many of these corporate governance initiatives already, institutional investors are moving their attention to smaller companies that may historically have lagged in the adoption of shareholder-friendly governance features.
We will continue to update you on important changes in these areas. Our blog, "Securities Matters," provides comprehensive coverage of all aspects of the federal and state securities laws and regulation, capital market trends and best practices, corporate governance matters, Delaware corporate law, developments in securities and shareholder litigation, SEC enforcement, and related topics. Please subscribe to our blog at http://www.securitiesmatters.com/ to stay current on new developments.
We have addressed topics that we believe will be of interest to this year's reporting season in further detail below.
"Pay Ratio" Disclosure Rules Finalized; First Disclosure Required in 2018 for 2017 Fiscal Year. On August 5, 2015, the SEC adopted a final rule2 implementing Section 953(b) of the Dodd-Frank Act, requiring most reporting companies to disclose the ratio of median employee compensation to principal executive officer compensation. The final rule, which adds Item 402(u) to Regulation S-K with a conforming amendment to Item 5.02(f) of Form 8-K for companies whose salary and/or bonus information is not available at the time of filing the proxy statement, requires companies to begin providing pay ratio disclosure in filings that otherwise require executive compensation disclosure for the first full fiscal year beginning on or after January 1, 2017 in time for the 2018 proxy season. All public companies will be subject to this new disclosure requirement, with the exception of emerging growth companies, smaller reporting companies and foreign private issuers.
The pay ratio rule requires disclosure of:
Median Employee Compensation. The median of the annual total compensation of a company's employees, excluding its principal executive officer; CEO Compensation. The annual total compensation of the company's principal executive officer; and Pay Ratio. The ratio of the company's median employee compensation to the compensation of its principal executive officer. In addition to the ratio itself, disclosure describing the methodology used to identify the median employee, determine total compensation and any material assumptions, adjustments (including allowable cost-of-living adjustments) or estimates used to identify the median employee or to determine annual total compensation will also be required. Consistent with the proposed rule, when identifying the median employee, the final rule requires companies to include all employees, including full-time, part-time, temporary, seasonal, and foreign employees employed by the company or any of its subsidiaries and to annualize the compensation of permanent employees who were not employed for the entire year, such as new hires. Companies may not, however, annualize the compensation of part-time, temporary, or seasonal employees. Consultants and other advisors who are not employees and individuals who are employed by unaffiliated third parties are not to be included in the calculation.
The SEC made changes from the proposed rule to address concerns regarding the cost of compliance with the rule and to make the rule a bit easier for companies to implement. For example, the SEC changed the timing of the date of the ratio calculation. Instead of the determination being made based solely on the number of employees employed as of the last day of a company's prior fiscal year, the final rule allows a company to choose a date within the last three months of its last completed fiscal year on which to determine the employee population. In addition, companies may identify its median employee once every three years unless there has been a change in its employee population or compensation arrangements that the company reasonably believes would result in a significant change to its pay ratio and, if within those three years, the median employee's compensation changes, the company may use another employee with substantially similar compensation as its median employee.
To address the criticism regarding the inclusion of foreign employees, the final rule allows companies to exclude foreign employees from the calculation under two circumstances:
Foreign Data Privacy Law Exemption If the foreign employees are employed in a jurisdiction with data privacy laws that make the company unable to comply with the rule without violating those laws, provided that the company obtains a legal opinion from counsel to that effect and files the legal opinion with the SEC with its disclosure filing. De Minimis Exemption If a company's foreign employees account for 5% or less of its total employees, it may exclude all foreign employees when making its pay ratio calculation. However if it chooses to exclude foreign employees, it must exclude all of them. If more than 5% of a company's employees are foreign employees, it may also exclude up to 5% of its total employees who are foreign employees. However, if a company excludes any...