On August 5, 2015, the Securities and Exchange Commission (SEC) adopted the final rule requiring public companies to disclose the ratio of the annual total compensation of their chief executive officer (CEO) to the median total compensation of all employees (the new regulation is often referred to as the “CEO pay ratio”). The new rule implements another executive compensation requirement imposed on the SEC by Congress through the Dodd-Frank Wall Street Reform and Consumer Protection Act. Like many of the measures adopted by the SEC in recent years that are mandated by Dodd-Frank, the CEO pay ratio rule is controversial. The rule was adopted in a three-to-two vote, with the two Republican Commissioners voting against adoption. SEC Commissioner Gallagher spoke vocally against the measure, calling it a mechanism to “shame” companies into lowering CEO pay and arguing that the SEC should focus on more pressing matters since there was no statutory deadline to implement the CEO pay ratio rule. SEC Chair White disagreed, stating that the rule would help inform stockholders when voting on “say on pay” advisory proposals, and calling the rule a “carefully calibrated pay ratio disclosure rule that carries out a statutory mandate.” Despite the political squabbles at the SEC, and more than two years after the rule was originally proposed by the SEC, the CEO pay ratio rule became effective on October 19, 2015.
The final CEO pay ratio rule amends Item 402 of Regulation S-K, the executive compensation disclosure rules, to require public companies to disclose (1) the median annual total compensation of all employees of the issuer (other than the CEO), (2) the annual total compensation of the CEO of the issuer, and (3) the ratio of those two amounts. The adopting release for the new rule states the SEC’s view that the purpose of the rule is to permit shareholders to better understand and assess an issuer’s compensation practices, and to evaluate CEO compensation within the context of a specific company, rather than to permit or promote comparability across issuers, noting that there are a variety of factors that may cause the ratio to differ among issuers. The final rule gives issuers some flexibility in calculating and providing the CEO pay ratio disclosure, reflecting an effort by the SEC to respond to concerns raised by commentators about the significant costs of calculating and providing the required disclosures for some public companies.
Prior to calculating the CEO pay ratio, issuers will be required to identify the “median employee.” The final rule does not specify a single calculation method for issuers to use to identify the median employee, but instead permits issuers to select a reasonable methodology (which may include an analysis of the full employee population or a statistical sampling of the employee population) that is appropriate to the size, structure and compensation practices of the issuer, provided the issuer discloses the methodology used, including any material assumptions, adjustments and estimates, and consistently applies that methodology. After identifying the median employee, issuers then must calculate the “total annual compensation” for that employee for the last completed fiscal year in accordance with Item 402(c)(2)(x) of Regulation S-K. The final rule permits issuers to use reasonable estimates to calculate any component of total compensation. The rule also permits issuers to include additional narrative disclosure or ratios, provided that the additional disclosure is clearly identified, not misleading and is not given greater prominence than the required CEO pay ratio disclosure.
Issuers also have flexibility as to the date used to identify the median employee, which may be any date within three months of the last day of the last completed fiscal year. In addition, the final rule gives issuers the option to identify the median employee only once every three years (unless there has been a significant shift in the employee population or employee compensation arrangements). The term employee is defined in the final rules to include any individual employed by the issuer or one of its consolidated subsidiaries as of the last day of the last completed fiscal year, including U.S., foreign, full-time, part-time, seasonal and temporary employees. Issuers may annualize the total compensation for a permanent employee who was employed at year end, but did not work for the entire year. However, issuers may not make full-time equivalent adjustments for part-time, temporary or seasonal employees.
The CEO pay ratio disclosure will be required to be included in registration statements, proxy and information statements, and annual reports that include executive compensation as required by Item 402 of Regulation S-K. The information will be updated annually. All public companies that are required to provide disclosure under Item 402(c)(2) of Regulation S-K are subject to the new disclosure requirement, except emerging growth companies, smaller reporting companies, foreign private issuers and registered investment companies.
Public companies will first be required to report CEO pay ratio disclosure for the first full fiscal year that begins on or after January 1, 2017, with certain transition periods for companies that have not previously been reporting companies. For calendar year issuers that are subject to the rule, this means that the disclosure will first be required in the issuer’s annual report or proxy statement filed with the SEC in 2018 with respect to 2017.
You can read the final text of the new rules here.