SEC Adopts Final Pay Ratio Rule

By Heyward Armstrong, Amy Batten and Gerald Roach

The U.S. Securities and Exchange Commission (SEC) has adopted a final pay ratio rule that implements Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) nearly two years after its initial proposal. The final rule requires U.S. public companies (other than emerging growth companies, smaller reporting companies, foreign private issuers, multijurisdictional disclosure system (MJDS) filers and registered investment companies) to disclose a ratio that demonstrates how much greater the annual compensation of their principal executive officer (PEO) is than that of the median of their other employees. Public companies subject to the rule must calculate the pay ratio with respect to compensation for their first full fiscal year beginning on or after January 1, 2017. Accordingly, the first pay ratios will first appear in public company filings in 2018, and there is transition relief for newly public companies. 

Calculating the required pay ratio requires companies to undertake three seemingly simple steps: (i) determine the company’s universe of employees, (ii) identify the median employee, and (iii) calculate annual compensation for the PEO and the median employee. Public companies must calculate the pay ratio every year, but under the final rule are only required to identify the median employee once every three years, so long as they reasonably believe that there has been no change in their universe of employees or compensatory arrangements that would cause a significant change in their pay ratios.  

The data collection and analysis necessary to calculate the pay ratio will represent a significant undertaking, which for multinational companies will be complicated by cross-border legal, economic and cultural issues that affect how employees are compensated. In response to these and other concerns, the final rule provides public companies with some flexibility in determining and presenting the pay ratio disclosures. Some of this flexibility, however, merely allows companies to make additional calculations to present what may be a more meaningful ratio in addition to (and not in lieu of) the standard pay ratio. Particularly given the speculative nature of the pay ratio’s utility to investors, public companies will need to evaluate whether the additional efforts necessary to provide more robust pay ratio disclosure are worthwhile or whether they should instead devote their efforts to focusing investors on the true drivers of their executive compensation programs.

Determining the Universe of Employees

Since the prescribed pay ratio requires calculation of compensation for the median company employee, public companies must first determine which employees make up the universe of employees from which the company will identify the median. A company may take the required snapshot of its employee base on any date within the last three months of its fiscal year. Once the company selects the date, however, it must use the same date for subsequent calculations or disclose the change and provide a brief description of the reason for the change. 

All employees of the company and its consolidated subsidiaries count for purposes of the pay ratios: U.S. and non-U.S., full-time and part-time, and permanent, temporary and seasonal. Independent contractors, consultants and persons employed by a third party (also known as “leased” employees) do not count as employees. Thus, in general, the universe of employees for purposes of identifying the median employee is the company’s entire employee population, with the following two exceptions created by the SEC in response to particular concerns raised by comment letter submitters:

• Non-U.S. Employees Whose Compensation Data is Legally Inaccessible. If after exercising reasonable efforts (including using or seeking an exemption or other relief under any governing data privacy laws or regulations), a company is unable to obtain the compensation data of employees in foreign jurisdictions, then it may exclude those employees from the universe of employees used to calculate the pay ratio provided that the company makes certain disclosures about the exclusion and obtains and files a legal opinion from counsel that opines on the inability to obtain or process the data.  
• De Minimis Numbers of Non-U.S. Employees. A company may exclude non-U.S. employees that account for less than five percent of its total employee population, with two principal caveats as follows: (i) if it excludes any non-U.S. employee in a particular jurisdiction, it must exclude all other non-U.S. employees in that jurisdiction, and (ii) any employees excluded because their compensation data is legally inaccessible count towards the five percent. 

Identifying the Median Employee

After a company determines its universe of employees, it must then evaluate how to identify the median employee within that universe. To do so, it must first determine the employees within that universe from which it will identify its median employee. The SEC’s final rule permits companies to use any of the following methodologies the company believes is most appropriate to make that determination:

• Sorting the Entire Employee Population. In the truest calculation of “median,” a company may sort each person in its identified universe of employees in order to identify the median employee. 
• Utilizing Statistical Sampling. Utilizing statistical sampling to identify the subset of employees from which the company will identify its median employee may reduce compliance costs for some companies by limiting the number of employees that must be sorted by a consistent compensation measure. The SEC has declined to prescribe specific methodologies for statistical sampling, but has provided some general guidance for registrants that may utilize it.
• The appropriate sample size for the universe of employees will depend upon reasonable assumptions about the concentration of the underlying compensation distribution. Populations with more broadly distributed compensation will require larger samples to identify the median employee.
• Companies with multiple business lines or geographical units may make reasonable estimates by using more than one statistical sampling approach.
• It may not be necessary to sort the entire statistical sample. A company may further reduce the number of employees whose compensation must be analyzed to determine the median employee by excluding employees whose compensation clearly falls on the high or low end of the sample. 
• Utilizing Other Reasonable Methods. The final rule allows companies to use “other reasonable methods” to identify the subset of employees from which the company would identify its median employee. In its adopting release, the SEC declined to specify what specific “other reasonable methods” may be permissible, noting that it sought “to allow each registrant the flexibility to determine the method that best suits its own facts and circumstances.” Although the SEC did not specifically authorize the use of any particular alternative, it noted that some of the suggestions submitted by authors of comment letters may be among permissible ones. Such suggestions included, among others, (i) employing a methodology using salary grades or levels, as appropriate, and (ii) sorting employees based on rates of pay instead of pay earned over the course of a year.

Once the company identifies the employees from which it will identify its median employee, it is permitted to use any compensation measure that is consistently applied to all employees included in the analysis, such as taxable wages, cash compensation and information derived from tax and/or payroll records, for purposes of identifying the median employee. Companies may use different compensation measures for each jurisdiction, so long as, within each jurisdiction, the measure is consistently applied. Companies may not annualize compensation data for temporary or seasonal workers, but may annualize the compensation of permanent employees who do not work the whole year. Although the final rule permits companies to make cost-of-living adjustments for employees in jurisdictions other than the jurisdiction in which the PEO resides, companies that employ cost-of-living adjustments in identifying the median employee or such employee’s compensation must disclose the adjustments made and still present the compensation and pay ratio without the cost-of-living adjustments. To calculate this pay ratio, the company would need to identify the median employee without using any cost-of-living adjustments.

Calculating Compensation

The pay ratio rule requires presentation of the total annual compensation of the PEO, the total annual compensation of the median employee and the ratio between the two. Unlike the requirements with respect to identifying the median employee, for purposes of determining the pay ratio, “total compensation” for the company’s last completed fiscal year must be calculated pursuant to Item 402(c)(2)(x) of Regulation S-K for both the PEO and the median employee, consistent with the presentation of “total annual compensation” presented in its Summary Compensation Table.

The final rule allows companies to make reasonable estimates in determining the total annual compensation of its median employee, including using reasonable estimates to calculate any particular element of total annual compensation under Item 402(c)(2)(x). The SEC has noted that in some instances, such as trying to calculate the aggregate change in actuarial present value of an employee’s defined pension benefit plan, the employers typically do not have access to the information that would be needed to calculate the required information. The rule also notes certain logical extensions of the language – “salary” equates to “wages plus overtime” and government-related pension benefits for non-U.S. employees may be excluded just as Social Security benefits are excluded for U.S. employees. 

The SEC has acknowledged that “the application of the definition of total compensation under Item 402(c)(2)(x) to employees who are not executive officers could understate the overall compensation paid to such employees” and, accordingly, that companies may include personal benefits that are less than $10,000 in the aggregate and compensation under non-discriminatory benefit plans, so long as such compensation is also included for the PEO. The disclosure must explain any differences in “total annual compensation” for the PEO from that presented in the summary compensation table. Companies are also permitted to present additional pay ratios and other information that they believe more accurately reflect the compensation situations of their organizations, provided that they are clearly identified, not misleading and are not presented with greater prominence than the required ratio.

Preparing for Pay Ratio Disclosure:
The Path of Least Resistance

The pay ratio rule is among the most controversial of the Dodd-Frank Act mandates, as evidenced by the SEC’s receipt of over 287,400 comment letters on its originally proposed rule. Concerns remain over the utility of pay ratio disclosure and associated compliance costs for companies subject to the rule. The SEC stated in its adopting release that, “[n]otwithstanding the disagreement among commenters on the value of the pay ratio disclosure, in adopting the final rule we have sought to implement Congress’s apparent determination that the pay ratio disclosure would be useful to shareholders.” Therefore, although the social issue of compensation disparity continues to receive attention, it is questionable how much attention investors and other stakeholders will give to pay ratio disclosure and to specific companies’ actual pay ratios and calculation methodologies. Companies may be best served by approaching the pay ratio rule with the goal of most efficiently providing the required information, rather than trying to incorporate the pay ratio as any sort of meaningful part of the company’s executive compensation story. Instead, public companies should continue to design their compensation programs to incentivize executives to increase shareholder value and focus their disclosure on the linkage between executive compensation and performance, not PEO compensation to median employee compensation. 

Regardless of the approach the company takes to the pay ratio disclosure, complying with the final rule will require a significant amount of work and involve a multidisciplinary team from across the organization to develop accurate data to calculate and disclose the pay ratio. One of the team’s first planning steps will be determining how to identify the median employee, which will be driven by, among other things, the size and international scope of the company and the interconnectivity of the company’s payroll and financial systems across various divisions and jurisdictions. Depending on the level of complexity involved, companies may benefit from engaging outside advisers such as compensation consultants and statisticians to assist with complying with the rule, and if IT systems need to be upgraded, technology consultants may also need to be engaged. Companies and their compensation committees should have a plan in place prior to the first fiscal year for which the pay ratio disclosures are applicable (2017 for most calendar year-end companies) to ensure that they are able to timely collect and evaluate the necessary payroll and related information for that year to comply with the final rule. To meet this deadline, companies should begin forming their compliance teams now (and brief their compensation committees), and compensation committees should add the pay ratio disclosure planning process to their 2016 agendas. 

As companies and their compensation committees consider compliance with the final rule, they should keep in mind that, in its efforts to reign in the costs and burdens of complying with pay ratio disclosure, the SEC built in areas of flexibility to allow companies to calculate the pay ratio in a manner that best suits their particular circumstances. Some of these flexible provisions seem likely to reduce the administrative burden of compliance for at least some companies. Companies with employees in jurisdictions that may have privacy or data laws that restrict the transmission of compensation related information to the United States may want to first analyze whether all employees in such jurisdictions constitute less than five percent of the company’s employee population and, if so, simply exclude them from further analysis. Additionally, companies with employees in multiple business lines or geographic areas may begin considering what structure of statistical sampling may be appropriate and most cost effective. Some companies may find that employing one of the “other reasonable methods” suggested by some of the comment letter submissions to the SEC (such as determining the median employee by examining pay grade data) saves significant resources in identifying the median employee.

Other areas of flexibility in the pay ratio rule, however, seem only to give companies a means of providing additional color to a picture that is of questionable interest and utility to investors and other stakeholders. For example, incorporating cost-of-living adjustments may result in a narrower pay ratio that more equivalently compares compensation of a U.S.-based PEO with a non-U.S. employee, but will require additional calculations by the company and may only be presented alongside, rather than instead of, the pay ratio calculated without such adjustments. Similarly, companies that wish to provide pay ratios that they believe are more reflective of their compensation situation, such as ratios that use an average rather than a median, may do so only in addition to (and not in lieu of) providing the pay ratio prescribed by the final SEC rule. Accordingly, while the SEC has given companies the ability to tell a potentially “better” pay ratio story by allowing the use of alternative pay ratio disclosures, companies using these disclosure alternatives would still be required to make disclosures using the standard requirements. Unless the extra work produces meaningfully different or more helpful disclosures, we expect public companies may instead decide to simply provide the required disclosures and focus their efforts on telling their executive compensation stories without unnecessary or artificial references to the pay ratios.  

If you have any questions about the SEC's final pay ratio rule or if you would like to learn more about the issues covered in this alert, please contact your Smith Anderson lawyer.

Special thanks to Amanda Keister, contributing writer.