On August 5, 2015, the SEC adopted new rules implementing the pay ratio disclosure requirement of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). Section 953(b) of the Dodd-Frank Act required the SEC to adopt rules requiring reporting companies to disclose the ratio of the annual compensation of the company’s median employee to the annual compensation of its principal executive officer. These rules will become effective generally for companies in their Form 10-K for the 2017 fiscal year or in their proxy statement for the 2018 annual meeting. Below are some frequently asked questions that companies should be considering now in preparing for this new disclosure.
1. What are the new rules on pay ratio generally?
The new rules are contained in a new Item 402(u) of Regulation S-K added by the SEC. Item 402(u) generally requires companies to disclose
- the median of the annual total compensation of all company employees other than the company principal executive officer (PEO),
- the PEO’s annual total compensation, and
- the ratio between the two numbers.
2. What companies are required to provide the new pay ratio?
All reporting companies must provide the pay ratio disclosure, except for
- smaller reporting companies,
- emerging growth companies,
- foreign private issuers, and
- registered investment companies.
3. When and where is the new pay ratio disclosure required?
Companies must include pay ratio disclosure in filings that are required to include executive compensation information under Item 402 of Regulation S-K. This will generally include proxy statements, annual reports on Form 10-K and registration statements. The pay ratio disclosure must be included by covered companies for the first full fiscal year beginning on or after January 1, 2017. Thus for calendar year companies, the pay ratio disclosure will generally be required in the Form 10-K for the year ended December 31, 2017, or in the proxy statement for the 2018 annual meeting. The pay ratio information with respect to the company’s last completed fiscal year is not required to be disclosed until the filing of its annual report on Form 10-K for that last completed fiscal year or, if later, the filing of a definitive proxy or information statement relating to its next annual meeting of shareholders provide that the pay ratio disclosure must be made no later than 120 days after the end of the previous fiscal year.
On September 21, 2017, the SEC issued a press release which confirmed that it was not going to delay the implementation of the pay ratio rule and provided additional guidance to companies through interpretive guidance and staff guidance that clarified that companies are given broad flexibility in determining the appropriate methodologies to identify the median employee and are permitted to use reasonable estimates and assumptions in complying with the pay ratio disclosure.
4. How do you determine the median employee?
The pay ratio disclosure requires that companies identify an actual median employee and disclose that employee’s annual total compensation for the company’s last completed fiscal year. A company is not required to (and should not) disclose any personally identifiable information about the median employee other than that individual’s annual total compensation. A company may disclose the median employee’s position but should not do so if it could identify the individual.
To identify the median employee, companies can use:
- Annual total compensation, as that term is defined in Item 402(c)(2)(x) of Regulation S-K. This is the measure of compensation that reporting companies use to report their named executive officers compensation in the summary compensation tables; or
- Any other consistently applied compensation measure (CACM), such as information derived from the company’s tax and/or payroll records.
Any measure that reasonably reflects the annual compensation of employees can serve as a CACM. The appropriateness of the measure will depend on the company’s particular facts and circumstances. For example, total cash compensation could be a CACM unless the company also distributed annual equity awards widely among its employees. The company will be required to briefly disclose the compensation measure used to determine the median employee.
The median employee must be selected based on a company’s employee population on a specific date within three months of the end of its fiscal year, which date must be disclosed. If the company changes the date used to identify its median employee from the date used for the previous year, it must disclose the change and give a brief explanation of the reason for the change.
In applying the CACM to identify the median employee, a company is not required to use a period that includes the date on which the employee population is determined nor is it required to use a full annual period. For example, if the company chooses November 30 as the date for the company’s employee population determination, it can apply a CACM for the nine months ended September 30 for all employees as of November 30 to determine the median employee. A CACM may also consist of annual total compensation from the company’s prior fiscal year so long as there has not been a change in the company’s employee population or employee compensation arrangements that would result in a significant change of its pay distribution to its workforce.
5. Once the median employee is identified, how do you calculate that employee’s annual total compensation?
Annual total compensation for the median employee, as well the annual total compensation for the PEO, is determined in the same way that total compensation for the named executive officers is determined under Item 402(c)(2)(x) of Regulation S-K. The annual total compensation for both the median employee and the PEO must be calculated for the company’s last completed fiscal year, even if the company uses a different period to determine the identity of the median employee. For non-salaried employees, references to base salary and salary may be deemed to refer instead to wages plus overtime. If the same median employee is used for more than one year as described below, that median employee’s annual total compensation must be recalculated for each year.
A company may use reasonable estimates both in the methodology used to identify the median employee and in calculating the annual total compensation or any elements of total compensation for employees other than the PEO.
6. How often must the company identify the median employee?
The company may identify its median employee once every three years unless there has been a change in its employee population or employee compensation arrangements that it reasonably believes would result in a significant change to its pay ratio disclosure. If there have been no changes, the company must disclose that it is using the same median employee in its pay ratio calculation and describe briefly the basis for its reasonable belief. If there has been a change in the company’s employee population or employee compensation arrangements that the company reasonably believes would result in a significant change in its pay ratio disclosure, the company must re-identify the median employee for that fiscal year. If the median employee identified in year one is no longer appropriate as the median employee in years two or three because of a change in the original median employee’s circumstances, the company may use another employee whose compensation is substantially similar to the original median employee based on the compensation measure used to select the original median employee.
7. Who is required to be included in the employee population used to determine the median employee?
The employee population includes any individual employed by the company or any of its consolidated subsidiaries, whether as a full-time, part-time, seasonal or temporary worker. The definition of an employee does not include those workers who are employed, and whose compensation is determined, by an unaffiliated third party but who provide services to the company or its consolidated subsidiaries as independent contractors or “leased” workers. The employee population must also include employees located in a jurisdiction outside the United States unless one of two exemptions is met (see below).
A company may annualize the total compensation for all permanent employees (full-time or part-time) that were employed by the company for less than the full fiscal year (such as newly hired employees or permanent employees on an unpaid leave of absence during the period); however, a company may not annualize the total compensation for employees in temporary or seasonal positions nor may it make a full-time equivalent adjustment for any employee.
8. What are the two exemptions for non-U.S. employees?
Companies may exclude non-U.S. employees from its employee population if:
- the employee is employed in a foreign jurisdiction in which the laws or regulations governing data privacy are such that, despite its reasonable efforts to obtain or process the information necessary for compliance with the pay ratio rule, the company is unable to do so without violating such data privacy laws or regulations (data privacy exemption); or
- the company’s non-U.S. employees account for 5% or less of the company’s total employees (de minimis exemption).
The company’s reasonable efforts with respect to the data privacy exemption shall include, at a minimum, using or seeking an exemption or other relief under any governing data privacy laws or regulations. If the company chooses to exclude any employees using the data privacy exemption, it shall list the excluded jurisdictions, identify the specific data privacy law or regulation, explain how including such employees violates such data privacy law or regulation (including the efforts made by the company to use or seek an exemption or other relief under such law or regulation), and provide the approximate number of employees exempted from each jurisdiction based on this exemption.
In the de minimis exemption, if the company chooses to exclude any non-U.S. employees, it must exclude all non-U.S. employees. Additionally, if the company’s non-U.S. employees exceed 5% of the company’s total U.S. and non-U.S. employees, it may exclude up to 5% of its total employees who are non-U.S. employees; provided, however, if the company excludes any non-U.S. employees in a particular jurisdiction, it must exclude all non-U.S. employees in that jurisdiction. If more than 5% of the company’s employees are located in any one non-U.S. jurisdiction, the company may not exclude any employees in that jurisdiction.
In calculating the number of non-U.S. employees that may be excluded under the de minimis exemption, the company must count against the total any non-U.S. employee exempted under the data privacy exemption. The company may exclude any non-U.S. employee from a jurisdiction that meets the data privacy exemption, even if the number of excluded employees exceeds 5% of the company’s total employees. If, however, the number of employees excluded under the data privacy exemption equals or exceeds 5% of the company’s total employees, the company may not use the de minimis exemption. Additionally, if the number of employees excluded under the data privacy exemption is less than 5% of the company’s total employees, the company may use the de minimis exemption to exclude no more than the number of non-U.S. employees that, combined with the data privacy exemption, does not exceed 5% of the company’s total employees.
9. What if the company completed an acquisition during the year which included adding new employees?
A company that completed a business combination or acquisition may exclude the employees of the acquired entity from its pay ratio calculation for the fiscal year in which the transaction became effective. A company relying on this exemption must identify the acquired business and disclose the approximate number of employees excluded from its calculation. The company must include those employees in the next fiscal year. At that time the company must determine whether the inclusion of those employees results in a significant change to the company’s pay ratio disclosure, and if so, the company would need to identify a new median employee.
10. May the company make any cost-of-living adjustments in the determination of the median employee or in the calculation of the median employee’s annual total compensation?
The company may make cost-of-living adjustments to the compensation of employees in non-U.S. jurisdictions other than the jurisdiction in which the PEO resides so that the compensation is adjusted to the cost of living in the jurisdiction in which the PEO resides. If the company uses a cost-of-living adjustment to identify the median employee, and the median employee identified is an employee in a jurisdiction other than the jurisdiction in which the PEO resides, the company must use the same cost-of-living adjustment in calculating the median employee’s annual total compensation and disclose the median employee’s jurisdiction. A company using a cost-of-living adjustment must apply the cost-of-living adjustment to all non-U.S. employees included in the calculation and adjust their compensation to the cost of living in the PEO’s jurisdiction. The company must also briefly describe the cost-of-living adjustments it used to identify the median employee and briefly describe the cost-of-living adjustments it used to calculate the median employee’s annual total compensation, including the measure used as the basis for the cost-of-living adjustment. A company 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 adjustment. To calculate this pay ratio, the company will need to identify the median employee without using any cost-of-living adjustments.
11. Must companies use their entire employee population to determine the median employee?
While companies may use their entire employee population to determine the median employee, companies may also use statistical sampling and other reasonable methods to identify a subset of its entire employee population and then identify the median employee from that subset. Initially, statistical sampling was suggested by the SEC as an example of how to determine the median employee. However, it appears from a recent third-party survey that not many companies intend to use this method. The breadth of data necessary to construct an appropriate sample makes this option not much different than the amount of data that is necessary without statistical sampling. In addition, most companies would need to hire a consultant to construct the sample, which adds to the cost of compliance.
The pay ratio rule grants companies the latitude to determine the appropriate sample size based on their individual facts and circumstances. Also, companies do not have to calculate the exact pay of every employee in the sample. The staff guidance issued on September 21, 2017, provides several hypothetical examples of sampling usage and other reasonable methodologies.
Some examples of the sampling methods that could be appropriate to use (alone or in combination), depending on the company’s particular facts and circumstances include, but are not limited to:
- simple random sampling (drawing at random a certain number or proportion of employees from the entire employee population);
- stratified sampling (dividing the employee population into strata, e.g., based on location, business unit, type of employee, collective bargaining agreement, or functional role and sampling within each strata);
- cluster sampling (dividing the employee population into clusters based on some criterion, drawing a subset of clusters, and sampling observations within appropriately selected clusters; cluster sampling may be conducted in one stage or multiple stages); and
- systematic sampling (the sample is drawn according to a random starting point and a fixed sampling interval, every nth employee is drawn from a listing of employees sorted on the basis of some criterion).
Some examples of situations where companies may use reasonable estimates under the appropriate facts and circumstances, include, but are not limited to:
- analyzing the composition of the company’s workforce (by geographic unit, business unit, employee type);
- characterizing the statistical distribution of compensation of the company’s employees and its parameters (e.g., a lognormal, beta, gamma or another distribution, or a mixture of distributions—for example, a mixture of two normal or lognormal distributions yielding a bimodal distribution);
- calculating a consistent measure of compensation and annual total compensation or elements of the annual total compensation of the median employee;
- evaluating the likelihood of significant changes in employee compensation from year to year;
- identifying the median employee;
- identifying multiple employees around the middle of the compensation spectrum; and
- using the mid-point of a compensation range to estimate compensation.
Some examples of common statistical techniques and methodologies companies may consider, include, but are not limited to:
- making one or more distributional assumptions, such as assuming a lognormal or another distribution provided that the company has determined that the use of the assumption is appropriate given its own compensation distributions;
- reasonable methods of imputing or correcting missing values; and
- reasonable methods of addressing extreme observations, such as outliers.
Finally, the staff guidance provides illustrative examples of the principles that a company may consider when using reasonable estimates, statistical sampling and other reasonable methods to identify its median employee, which are included below.
Company A has employees in the U.S. and outside the U.S. within three business units and 21 geographic units, covered by multiple payroll systems.
- One approach would be for the company to perform sampling from each of the three business units. In obtaining samples of compensation data from each of the three business units, the company selects samples from the geographic locations whose employee pay is generally representative of employee pay within the entire business unit.
Company B has a global workforce with employees concentrated in the following geographic units: North America, China, Europe, and Latin America units.The company may use a combination of statistical sampling and other methods to identify the median.
- The company may use a combination of statistical sampling and other methods to identify the median.
- Where statistical sampling is used, the sampling method may be chosen so as to be reasonably representative of the employee population, based on the company’s knowledge of the workforce distribution across jurisdictions, a composition of full-time and part-time employees, distribution of employees among typical occupations, and the company’s pay structures for typical occupations.
- Within the North America geographic unit, the company employs mostly management and administrative employees at headquarters and a workforce consisting mostly of sales employees in 25 other cities. The company identifies the most common occupations of employees working at headquarters and draws a stratified random sample of headquarters employees other than the PEO in those occupations. Almost all employees outside headquarters are sales employees. Based on its understanding of employee pay outside headquarters, the company identifies three cities in which the distribution of employee pay and full-time and part-time employees is reasonably representative of the distribution of pay of employees outside headquarters. In those cities, the company randomly selects stores, from which a random sample of sales employees is drawn.
- For employees in the Europe geographic unit, the company draws a stratified random sample of employees in typical occupations identified based on the company’s knowledge of its workforce and pay structure. Employees in the sample include managers, administrative personnel, service employees, and sales staff.
- For the China geographic unit, the company uses a sample of full-time and part-time employees reasonably believed to be around the middle of the pay scale.
- For the Latin America geographic unit, the information is drawn under a distribution assumption.
- Based on the understanding of pay practices and workforce composition, employee pay in the Latin America unit is estimated to follow a lognormal distribution.
- For example, the company may use reasonable estimates provided by regional managers to determine distribution parameters. Where pay ranges were considered, the mid-point of the pay range is used.
- To identify the median employee, the company combines information from the North America, China, Europe, and Latin America geographic units, obtained as described above.
Company C has employees in the U.S. and Asia.
- Based on the company’s information about its workforce composition and compensation policies, the company reasonably believes the distribution of employee compensation to be multimodal and approximately characterized as a mixture of lognormal distributions, weighted based on estimated workforce composition. The median may be identified based on the resulting distribution mixture.
- As an example, the company may identify four main cohorts of workers: full-time employees in the U.S.; part-time employees in the U.S.; full-time employees in Asia; and part-time employees in Asia.
- For the U.S. employees, distribution assumptions are based on data regarding pay levels and hours of a typical full-time and part-time employee at the company.
- For international workers, distribution parameters are based on reasonable estimates of a typical full-time and part-time employee’s pay provided by regional managers.
12. What information other than the pay ratio between the median employee and the PEO must the company disclose and may the company disclose additional information regarding the calculation of the pay ratio?
Companies must briefly describe the methodology it used to identify the median employee and any material assumptions, adjustment (including cost of living adjustments) or consistently applied estimates used to identify the median employee or to determine the annual total compensation or any elements of the compensation. In addition, a company must clearly identify the estimates used such as the sample size, sampling method or methods used and assumption used in determining the sample size. If a company changes its methodology or a significant assumption, adjustment or estimate from a previous year, it must describe the change if the change has a material impact. Given the flexibility in the use of estimates, assumptions and adjustment permitted under the rule, the company is permitted to state that the pay ratio disclosure is a reasonable estimate calculated in a manner consistent with Item 402(u) of Regulation S-K.
Companies may supplement the required pay ratio disclosure with additional ratios or other information that it believes will help shareholders understand the company’s pay ratio disclosure. However, any additional ratios or other information must be clearly identified, not misleading, and not presented with greater prominence than the required pay ratio disclosure.
As you can see, these rules will require detailed analysis and decisions on how to approach the calculations and disclosures. Companies should begin considering these disclosures now. For more information about this topic, please don’t hesitate to reach out to us or any other member of our Corporate & Securities Practice Group.