Understanding The SEC's Pay Ratio Disclosure Rule And Its Implications

Keywords: pay ratio, disclosure rule, public companies

The US Securities and Exchange Commission (SEC), by a 3 to 2 vote, adopted a pay ratio disclosure rule, requiring public companies to compare the compensation of their chief executive officer to the median compensation of their other employees.1

The SEC has provided a transition period so that the initial pay ratio disclosure will be required with respect to compensation for a company's first full fiscal year that begins on or after January 1, 2017. Therefore, calendar year-end companies will first be required to include pay ratio disclosure in 2018. However, there is a lot that companies should begin doing in the meantime to prepare.

Summary of the Final Rule

Background. The SEC's pay ratio rulemaking was mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The SEC originally proposed pay ratio disclosure in 2013, and the proposal generated a great deal of interest and debate. The SEC received more than 287,000 comment letters. Of these, more than 1,500 were distinct individual letters and the remainder represented form letters submitted by interested persons.

Disclosure Requirement. The new pay ratio disclosure rule is contained in new paragraph (u) of Item 402 of Regulation S-K. It requires public companies to disclose:

The median of the annual total compensation of all employees other than the chief executive officer; The annual total compensation of the chief executive officer; and The ratio of these amounts. Filings Requiring Pay Ratio Disclosure. Generally, the pay ratio disclosure will be needed in filings that require executive compensation disclosure pursuant to Item 402 of Regulation S-K, such as proxy and information statements, annual reports on Form 10-K and registration statements under the Securities Act of 1933 and the Securities Exchange Act of 1934.

Employees Covered. For the purposes of the pay ratio rule, the term "employee" means an individual employed by the company or its consolidated subsidiaries as of any date (determined by the company) within the last three months of the company's last completed fiscal year. In addition to full-time employees and employees based in the United States, the term includes:

Employees based outside of the United States; Part-time employees; Temporary employees; and Seasonal employees. However, a worker employed by, and whose compensation is determined by, an unaffiliated third party, such as independent contractors or leased workers, are not considered employees for purposes of the pay ratio disclosure rule.

For individuals who become employees as a result of a business combination or acquisition, the SEC has created a transition period before those employees must be included in determining the median of the annual total compensation of all employees. For more information, see "Compliance Date and Transition Rules" below.

Limited Exemption for Foreign Employees. In a change from the proposed rule, the SEC has provided two limited exemptions from the definition of employee. These exemptions permit companies to exclude certain employees located in non-US jurisdictions (non-US employees) from the pay ratio calculation. First, the final rule provides an exemption for employees in a foreign jurisdiction in which data privacy laws or regulations are such that, despite the company's reasonable efforts to obtain and process the information necessary to comply with the pay ratio disclosure rule, the company is unable to do so without violating those data privacy laws or regulations. The rule makes clear that in order to satisfy the reasonable efforts requirement of this privacy exemption, the company, at a minimum, must use or seek an exemption or other relief under the applicable foreign law or regulation. In addition, the proxy statement (or other disclosure document) would need to list the excluded jurisdictions, provide the approximate number of employees from each such jurisdiction so excluded and explain how compliance with the pay ratio rule would violate the foreign data privacy law or regulation, describing the company's efforts to obtain an exemption or other relief. The company would also need to obtain an opinion of counsel opining that the company cannot obtain or process the necessary information without violating the applicable privacy laws or regulations and file that opinion as an exhibit to the filing containing the pay ratio disclosure. If a company relies on this privacy exemption for any foreign jurisdiction, it must exclude all employees from that jurisdiction from its pay ratio calculation.

Second, the SEC also provided a de minimis exemption for non-US employees. If non-US employees account for 5% or less of a company's total employees, the company may choose to exclude all, but not less than all, of its non-US employees when identifying its median employee. Where a company's non-US employees exceed 5% of the company's total US and non-US employees, it may exclude up to 5% of its total employees who are non-US employees from this determination. However, if the company excludes any employees in a particular non-US jurisdiction it must exclude all employees in that jurisdiction. Therefore, a company cannot use the de minimis exemption to exclude any employees from a non-US jurisdiction in which more than 5% of its total employees are located. In addition, employees excluded pursuant to the privacy exemption discussed above will count toward the 5% limit for the de minimis exemption. Use of the de minimis exemption also requires an accompanying explanation of the details of how the company applied the exemption.

Companies Covered by Pay Ratio Disclosure Requirement. The pay ratio disclosure will only be required for companies that provide a summary compensation table pursuant to Item 402(c) of Regulation S-K. Smaller reporting companies, emerging growth companies, foreign private issuers, MJDS filers (i.e., registrants filing under the US Canadian Multijurisdictional Disclosure System) and registered investment companies will not be subject to the pay ratio disclosure requirement.

Identifying the Median Employee. The pay ratio disclosure rule gives companies flexibility to select a method for identifying a median that is appropriate to the size and structure of their businesses and compensation programs.

Companies may identify the median employee based on any consistently used compensation measure, such...

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