Yesterday, the Securities and Exchange Commission (SEC) voted 3-2 to issue final regulations that will require companies to disclose the ratio between the pay of their chief executive officer and the median for all other employees. We're still reviewing the final regulations, but based on what we heard at the SEC meeting, the SEC has made some modest changes from the initial proposal. Companies are still required to inventory their global workforce, including part-timers, temporary and seasonal workers in calculating the median, but some data-gathering activities have been simplified:
- Once companies determine their median employee, they can continue to use that person as the median employee for two more years, as long as their circumstances remain the same.
- Companies that have business combinations can exclude newly acquired employees for that fiscal year’s disclosure.
- Two exclusions for non-U.S. workers were provided. Companies may exclude workers in a jurisdiction with data privacy laws that prevent compliance. Companies can also exclude all non-U.S. employees from a jurisdiction if that number does not exceed 5% of their total employees.
- Companies can apply a cost-of-living adjustment when identifying the median employee and in calculating the median employee’s compensation, although the unadjusted ratio would also need to be disclosed to provide context.
It appears that disclosure associated with the final rules will not be required until the 2018 proxy season — i.e., for the proxy that is filed with respect to compensation for the registrant’s first full fiscal year commencing on or after January 1, 2017.
Here are some additional details discussed at the SECs meeting:
WHAT COMPANIES ARE COVERED?
The disclosure requirement applies to all publicly traded companies that must provide executive compensation disclosure under Item 402(c)(2)(x) of Regulation S-K. It does not apply to the following:
- Smaller reporting companies
- Foreign private issuers
- Multi-jurisdictional disclosure system filers
- Emerging growth companies
- Registered investment companies.
Employees obtained in a business combination or acquisition can be omitted for the fiscal year in which the transaction becomes effective, although the company must then identify the acquired business and disclose the approximate number of employees it is omitting.
INITIAL COMPLIANCE DATE
Companies would be required to report the pay ratio disclosure for their first fiscal year beginning on or after January 1, 2017, using prior-year data. In other words, it appears that disclosure associated with the final rules will not be required until the 2018 proxy season, using 2017 pay data. This is helpful for fiscal-year companies, which under the proposed rule were concerned they might have to comply earlier than calendar-year companies if the rule was made effective for their 2017 fiscal year. There is a transition rule that allows new reporting companies to delay compliance until the first fiscal year following the year in which they become reporting companies.
‘FURNISHED’ AS OPPOSED TO ‘FILED’
This legal issue engendered a host of comments, with the commenters agreeing that the pay ratio information should be “furnished” to the Commission, rather than “filed.” However, the SEC commissioners have not changed their view that this information would be considered “filed” for purposes of the Securities Exchange Act and, accordingly, would be subject to potential liabilities under the Act.
REQUIREMENT TO TAKE ALL EMPLOYEES INTO ACCOUNT
The final regulations still require companies to consider the entire global workforce when determining the median employee, including part-timers, temporary and seasonal workers, with some new exceptions.
The SEC clarified that only individuals employed by the company or any of its consolidated subsidiaries (but not those employed by unaffiliated third parties or independent contractors) would be considered in the median employee determination. Once that population is determined, companies would be able to exclude some non-U.S. workers in determining the median employee under two exceptions:
- Where in-country data privacy laws make the company unable to assemble pay data on those non-U.S. employees, but only if the company obtains a legal opinion from counsel on its inability to obtain or process the information necessary for compliance with the rule without violating the jurisdiction’s laws or regulations governing data privacy
- In addition, companies may exclude up to 5% of their total employees who are non-U.S. employees (counting those excluded under the data privacy exemption), but only if the company excludes every non-U.S. employee in a particular jurisdiction.
It remains to be seen how helpful these exclusions might be. As to data privacy, it may be the case that in-country counsel would conclude that pay data can be managed if identifying elements (i.e., name, identification numbers, etc.) are sanitized, so perhaps there would be few countries where this exception would apply. As to the 5% rule, companies cannot pick and choose which workers it would seek to exclude, but rather, would need to exclude the entire workforce from a county. This forces companies to inventory demographic data on worker pay throughout their organization before decisions about exclusions can be made, which might reduce the exception’s usefulness.
FREQUENCY OF THE CALCULATION
To address concerns about the cost of compliance and that median employee pay could vary significantly from year to year, the final regulations will permit companies to identify the median employee only once every three years unless there’s been a change in the employee population or employee compensation arrangements that it reasonably believes would result in a significant change to its pay ratio disclosure. If that employee’s compensation changes during that three-year period, the company may use another employee with substantially similar compensation as the median employee. This will help companies cope with the risk that the ratio may change from year to year due to movements in the pay of the median worker.
COST-OF-LIVING ADJUSTMENTS PERMITTED
A company would be permitted to apply a cost-of-living adjustment (COLA) to the compensation measure used to identify the median employee and for purposes of calculating the median employee’s annual total compensation. This would mean that all compensation for the sample used to determine the median employee would need to be adjusted by jurisdiction (which we believe means country by country) to be made equivalent to the jurisdiction where the CEO resides.
To provide context for this adjustment, a company electing to present the pay ratio in this manner must also disclose the median employee’s annual total compensation and the pay ratio without the cost-of-living adjustment. This means companies seeking to use this COLA rule would be required to perform two separate calculations for the median employee: one with the adjustment and one without it. This helps mitigate the potential for companies in the same industry using overseas workers to have pay ratios far higher than those that employ only domestic workers.
DEFINING COMPENSATION FOR IDENTIFYING THE MEDIAN EMPLOYEE
The final regulations retain flexibility so that companies need not calculate the precise Summary Compensation Table (SCT) total compensation for every employee and can instead choose any consistently applied definition of compensation (e.g., base compensation) to identify the median employee.
Companies would be permitted, but not required, to annualize the total compensation for a permanent employee who did not work for the entire year, such as a new hire. In contrast, full-time equivalent adjustments for part-time workers and annualizing adjustments for temporary and seasonal workers would not be permitted when calculating the required pay ratio.
DATE FOR MEDIAN EMPLOYEE DETERMINATION
The SEC agreed with commenters that companies should have more flexibility to choose the date during the year for determining the employee population for identifying the median employee. The final regulations would permit companies to select a date within the last three months of its last completed fiscal year on which to determine the employee population for this purpose. This falls short of recommendations that companies could choose any reasonably representative date during the year for this calculation, but should ease compliance somewhat.
DISCLOSURE OF METHODOLOGY USED TO IDENTIFY THE MEDIAN EMPLOYEE
Statistical sampling is still permitted under the final rule and will help companies that can inventory their global workforce demographics in reducing data collection burdens. The disclosure requirements as to the methodology used remain the same as in the proposed regulations, but still raise questions for companies as to how much detail is required since the pay ratio disclosures appear to be considered as “filed.”
Companies would be required to briefly describe the methodology used to identify the median employee and any material assumptions, adjustments (including cost-of-living adjustments) or estimates used to identify the median employee or to determine annual total compensation. Where that employee is identified using a consistently applied compensation measure, that measure would also need to be disclosed, although we suspect companies also will describe why that measure was chosen. Any estimates used in calculating the SCT compensation also would need to be disclosed.
We’ll host a complimentary webcast to take a closer look at the final SEC rules in the weeks ahead. Watch for details on how to register.
Steve Seelig and Bill Kalten are senior regulatory advisors for executive compensation in Towers Watson’s Research and Innovation Center in Arlington, Virginia and Stamford, CT. Email email@example.com, firstname.lastname@example.org or email@example.com