After much foot dragging, I have finished reading the adopting release for the new pay ratio disclosure rules.  Yes, the release is long (300 pages or so), but adopting releases are always long.  The real reason why it took so long is that the whole concept of pay ratio disclosure just seems silly to me (and apparently to Bob Lamm as well) so I just hoped it would go away.

I am not against finding ways to strengthen the middle class.  Just like I am not against ending the sale of certain minerals in Central Africa that end up funding deadly conflict.  The problem I have is that public companies should not have to bear the complete burden of fixing social ills.  Less than 1% of the 27 million companies in the United States are publicly traded.  And there are plenty of private companies that are larger than most publicly traded companies.  Thus, while we may not agree whether the social goals are worth achieving, I think we can all agree that there are better ways to achieve them than selective enforcement (particularly since the SEC itself has said that the pay ratio will not be comparable from one company to another).  The Securities Edge  has been criticizing the social disclosure movement for some time, but we haven’t yet seemed to have stopped Congress from continuing to go down that path.

So, unless Congress acts to reverse its mandate for public companies to disclose their pay ratios before 2018 (the first year of required disclosure), I suppose we should all start learning how to comply.  Leading practices for calculating the ratio and providing narrative disclosure will develop over the next couple of years, but I have summarized the important parts of the rules in this post:

What is the required disclosure?

Registrants must disclose:

• The median of the annual total compensation of all employees of the registrant (excluding the CEO)
• The annual total compensation of the CEO; and
• The ratio of the median to the CEO’s compensation.

The ratio needs to be expressed as X:1 or X to 1 where “X” represents the CEO’s total compensation and “1” represents the median employee’s salary.  The ratio can also be expressed in narrative form such as: “The CEO’s annual total compensation is X times the median employee’s annual total compensation.”  You can’t disclose the ratio as a percentage or a fraction (i.e., the median employee’s total compensation is 7% of the CEO’s total compensation).

What does “annual total compensation” mean?

Total compensation uses the same definition as Item 402(c)(2)(x) of Regulation S-K (i.e., the “total” number in the Summary Compensation Table).  Thus, once you identify the median employee you will need to calculate that employee’s “total compensation” in the same manner as if that employee was a named executive officer.

You can add personal benefits that aggregate less than $10,000 and compensation under non-discriminatory employee benefit plans in calculating the total annual compensation of the median employee (as long as the same items are added to the CEO’s compensation).  By making this election, the ratio may be reduced significantly as any amounts added to the median employee’s and CEO’s annual compensation will be much more significant as a percentage of the median employee’s annual compensation than the CEO’s annual compensation.

All annual compensation calculations must be made on a fiscal year basis.

Who are employees?  Does it include foreign employees?

All of your employees – part-time, full-time, seasonal, temporary, U.S., and non-U.S. – are included in the definition.  Independent contractors and leased employees (as long as they are not leased from an affiliate) are not part of the calculation (could this lead to a boom in business for employee leasing companies?).  Also, only employees from consolidated subsidiaries are included (this should make compliance easier because you can ignore entities you do not control).

You may be able to exclude certain non-U.S. workers who live in a jurisdiction where privacy laws would prohibit disclosure.  There are lots of hoops to jump through on this exemption, however, such as obtaining a legal opinion, citing the specific privacy law in your disclosures, and seeking a waiver under the law.  Also, if non-U.S. workers make up less than 5% of your workforce, then you can exclude the non-U.S. workers altogether. If you have a significant number of overseas workers, you can exclude up to 5% of your workforce, but if you exclude one worker from a specific jurisdiction you must exclude all workers from that jurisdiction.

How do we identify the median employee?

There are no prescribed methods to make the calculation as long as you are reasonable and the calculation is consistently applied to all employees.  Regardless of which methodology you use, you must disclose methodology you used. You are permitted to use the entire employee population (i.e, list the total compensation by employee and find the median annual compensation based on tax or payroll records) or use statistical sampling.  To identify the median employee, you would just need to use their direct compensation (annual salary plus bonus).  Then, once the median employee is identified, you must calculate the median employee’s total compensation as required under Item 402 as if the employee was a named executive officer.

You can annualize compensation for permanent employees (full-time and part-time), but not for temporary or seasonal workers.

If the median employee lives in a different jurisdiction from the CEO, then you can make cost-of-living adjustments.  You will just need to disclose some information such as the country the median employee resides and how you calculated the cost-of-living adjustment.

You can select any date during the last three months of your fiscal year to make the median determination (it just needs to be the same date each year).  Thus, a company with a significant number of low-paid seasonal employees would likely want to attempt to choose a date when the seasonal employees are not on the payroll.  And, here is some good news: you can use that same “median employee” for three years as long as there hasn’t been a change in the employee compensation or compensation arrangements that would significantly impact the pay ratio.

Where do we disclose this information?  What will it look like?

You will need to make the disclosures in your Annual Report on Form 10-K, proxy and information statements, and registration statements (unless it is your IPO).

The rule requires only the disclosure of the three data points: total annual compensation of the CEO, total annual compensation of the median employee, and the ratio of the median to the CEO’s compensation.  In theory, because the ratios  won’t be comparable (as the SEC freely admits) from company to company because of the varying business models, use of foreign labor, and other factors, it should not be necessary to explain the ratio to investors.  In practice, however, we would anticipate that issuers will want to explain, in narrative or graphic form, factors that impacted the ratio.  You are permitted (but not required) to present additional ratios as well.  For example, you can disclose the ratio covering just U.S. employees.

Of course, hopefully this goes without saying, you shouldn’t disclose any personally identifiable information about the median employee other than compensation.

Is anyone exempt from this rule?

Yep.  Emerging growth companies, smaller reporting companies, and foreign private issuers are exempt from the disclosure rule.

When do we have to provide this disclosure?

That’s where we have sort of good news.  Disclosure isn’t required until the first fiscal year beginning after January 1, 2017.  For calendar year companies, this would mean you would make these disclosures in your Form 10-K filed in February/March 2018 or your proxy statement for your 2018 Annual Meeting.  The long implementation period may give Congress enough time to repeal the statute or business groups sufficient time to ask the courts to invalidate the rule.