Pay Ratio: The Time Has Come

For anyone involved in the preparation of an issuer’s compensation disclosures as part of its annual proxy statement or Form 10-K filing, the time has come to tackle the “pay ratio” calculation and disclosure requirements. After an extended period in development and considerable public speculation in recent months about its fate, it is becoming increasingly clear that the implementation of the final pay ratio rules issued by the Securities and Exchange Commission (SEC) in August 2015 (the “Final Pay Ratio Rules”) will proceed on the currently scheduled timetable, with the first disclosures for calendar year issuers due in their next annual proxy statements (i.e., those to be filed, generally, in spring 2018). In light of the approaching compliance deadline, on September 21, 2017, the SEC and, separately, the SEC’s Division of Corporate Finance issued related guidance designed to aid companies as they work to comply with the Final Pay Ratio Rules. The latest guidance emphasizes the fact that many aspects of the rules are designed to provide flexibility in how issuers approach compliance with the pay ratio calculation and disclosure requirements and that there is the ability to use methods that are tailored to fit an issuer’s facts and circumstances.

Background

The Final Pay Ratio Rules codify the portion of the Dodd-Frank Act requiring an issuer to calculate and disclose three data points in its annual filing: the annual total compensation of the company’s chief executive officer; the median of the annual total compensation of the company’s worldwide employee population (excluding the chief executive officer); and the ratio of the median annual total compensation of the employee group to the annual total compensation of the company’s chief executive officer. While the annual total compensation of the chief executive officer is already detailed in a reporting company’s compensation disclosures, the Final Pay Ratio Rules provide the framework for calculating the so-called median employee compensation, as well as the disclosure of the pay ratio itself. This framework is summarized in our prior client memorandum, SEC Adopts Pay Ratio Disclosure Rule and Provides Companies with Another Year to Plan for Compliance.

Final Pay Ratio Rules

In brief, issuers that are subject to the Final Pay Ratio Rules must calculate and disclose the required information by:

• Establishing the employee pool with respect to which the median employee is determined, taking into account the issuer’s worldwide employee population, including all full-time, part-time, seasonal and temporary employees of the company and any consolidated subsidiaries, with limited exceptions for a de minimis number of non-US employees, and compliance with local data privacy laws;
• Identifying the median employee by utilizing a reasonable, consistently applied compensation measure that reasonably reflects the annual total compensation of employees in the identified employee population or a statistical sampling of that population, or by applying another reasonable method;
• Setting an appropriate measurement date within the last quarter of the issuer’s fiscal year, and the compensatory period to be used in identifying the median employee;
• Calculating the selected median employee’s annual total compensation in the same way that annual total compensation is calculated for the named executive officers under the rules applicable to the summary compensation table, applying reasonable assumptions or estimates as needed;
• Providing information in the issuer’s disclosures regarding the methods and assumptions used to make the determinations and calculations described above; and
• Setting forth in the issuer’s disclosures the required compensation data points and actual ratio of the median employee’s annual total compensation to the chief executive officer’s annual total compensation.

September 21 Guidance

The recent guidance focuses generally on issues related to the process of determining an issuer’s median employee and updates a set of Compliance and Disclosure Interpretations (C&DIs) first published by the SEC in October 2016. Specifically, the guidance:

• Emphasizes that the rules are designed to provide flexibility to issuers in determining the appropriate methodology used to determine the median employee and calculating the median employee’s total compensation, and gives issuers comfort that pay ratio and related disclosures that are based on reasonable estimates, assumptions and methodologies applied in good faith would not provide a basis for an SEC enforcement action;
• Clarifies that issuers may rely on existing internal records, such as payroll or tax records, for purposes of determining whether the de minimis non-US employee exemption applies and as a means to identify the median employee (even if such records do not include every element of compensation, such as equity awards widely distributed to employees).
• Clarifies that issuers do not need to include in the covered employee population those individuals identified by the issuer as “independent contractors” or “leased” workers for other employment law or tax law purposes.
• Acknowledges that due to the nature of using estimates, assumptions and statistical sampling, the pay ratio disclosures may involve a “degree of imprecision”; therefore, an issuer may state in its disclosure that the pay ratio is a reasonable estimate calculated in a manner consistent with the Final Pay Ratio Rules.

In addition, the Division of Corporate Finance guidance provides several (non-exclusive) examples of the types of statistical sampling that an issuer could employ as part of its methodology in determining the median employee. These examples may help issuers determine whether statistical sampling could be an effective tool for their own calculations.

Covered and Exempt Companies

Generally, issuers required to include a summary compensation table in their annual compensation disclosures are subject to the Final Pay Ratio Rules and must include the pay ratio and related disclosures in their proxy statement or Form 10-K filing reporting the first full fiscal year that begins on or after January 1, 2017. Issuers that have public debt (even if they do not have publicly traded equity securities) are not exempt and must also provide the required information in their Form 10-K. Importantly, emerging growth companies, smaller reporting companies, foreign private issuers and MJDS filiers are all exempt from complying with the Final Pay Ratio Rules, while they qualify as such.

To Do

The timing of the latest guidance serves as a wake-up call for issuers. The new guidance makes clear that issuers have a variety of options on how to approach the required determinations and calculations, but, even with the level of flexibility allowed, there is a substantial process that must be undertaken, which needs to start sooner rather than later to ensure that there is enough time to make appropriate decisions and complete the implementation of the chosen methodology. For issuers who have already been thinking about pay ratio implementation, but may have put it on the shelf until the 2018 proxy preparations begin, now is the time to review those previously discussed strategies against the new guidance, test the process and outcomes and begin to develop drafts of the required disclosures. If implementation of pay ratio disclosures has not yet been a priority, it is time to start!