On August 5, 2015, the SEC adopted long-awaited and controversial rules requiring annual disclosure of the ratio of the compensation of a registrant’s principal executive officer (PEO) to the median compensation of all other employees. The new rules, found in new paragraph (u) of Item 402 of Regulation S-K, implement Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The new requirements do not apply to emerging growth companies, smaller reporting companies, foreign private issuers that file annual reports on Form 20-F, or Canadian issuers utilizing the multi-jurisdictional disclosure system.
The new rules become effective with respect to a registrant’s first full fiscal year beginning on or after January 1, 2017. Thus, a registrant reporting on a calendar year basis will first need to include the new disclosure in its 2018 proxy statement.
The new disclosure (Pay Ratio Disclosure) will consist of: (A) the median of the annual total compensation of all employees of a registrant (except its PEO); (B) the annual total compensation of the registrant’s PEO; and (C) the ratio of the amount in (B) to the amount in (A) either presented as a ratio in which the amount in (A) equals one, or expressed narratively as the multiple that the amount in (B) bears to the amount in (A). The ratio must be disclosed such that the PEO’s annual total compensation is always compared to the median employee’s annual total compensation. Registrants may provide additional information, including additional pay ratios, to supplement the required ratio, as long as such information is clearly identified, not misleading, and is not presented with greater prominence than the required ratio. Pay Ratio Disclosure will be required in annual reports on Form 10-K, Securities Act and Exchange Act registration statements, and proxy or information statements (to the same extent these forms require compliance with Item 402), and will not be required for a registrant’s most recently completed fiscal year until it files its annual report on Form 10-K for such year, or, if later, its proxy or information statement for its next annual meeting of shareholders (or written consents in lieu of such a meeting), but, in any event, not later than 120 days after the end of such fiscal year.
Identification of the Median Employee
Although the rule speaks in terms of the median of the annual total compensation (calculated in accordance with Item 402(c)(2)(x)) of all of the registrant’s employees other than the PEO, the SEC recognized that such a calculation would be impractical for most registrants since they typically do not compile annual total compensation on that basis for anyone other than their PEO and their other most highly compensated executive officers. Instead, the rule requires the registrant to identify the median employee using annual total compensation or any other compensation measure that is consistently applied to all employees, such as information derived from tax and/or payroll records, and then determine the annual total compensation of that employee in accordance with Item 402(c)(2)(x) (as described in “Calculation of Annual Total Compensation” below). If a registrant identifies the median employee using a compensation measure other than annual total compensation, it must disclose the measure used. Registrants may also use reasonable estimates in the methodology used to identify the median employee. In determining the employees from which the median employee is identified, a registrant may use its employee population, statistical sampling and/or other reasonable methods (which are not defined in the rule).
If the registrant reasonably determines that there are anomalous characteristics of the compensation of the individual identified as the median employee that would have a significant impact on the pay ratio, the registrant may substitute another employee with substantially similar compensation to the original median employee based on the compensation measure used to select the original median employee. The registrant must disclose a substitution on this basis as part of its brief description of the methodology used to identify the median employee.
Once a median employee has been identified, he or she may be used for purposes of Pay Ratio Disclosure for three years, unless there is a change in the registrant’s employee population or employee compensation arrangements that the registrant reasonably believes would result in a significant change in the Pay Ratio Disclosure. If the registrant determines to use the same median employee in years two and three, it must disclose that it is doing so and describe briefly the basis for its reasonable belief that there has been no such change in employee population or employee compensation arrangements. If there has been a change in the median employee’s circumstances in years two or three that the registrant reasonably believes would result in a significant change to its Pay Ratio Disclosure, it may identify as the median employee another employee whose compensation is substantially similar to the original median employee based on the compensation measure used to select the median employee in year one. If there has been a change in employee population or employee compensation arrangements that the registrant reasonably believes would result in a significant change in the Pay Ratio Disclosure, the registrant must identify a new median employee. Regardless of the method used to identify the median employee in a year, the registrant must still calculate his or her annual total compensation in that year for purposes of its Pay Ratio Disclosure.
Definition of “Employees” and Related Exemptions
The population from which the median employee is to be identified consists of the full-time, part-time, seasonal and temporary employees of the registrant or any of its consolidated subsidiaries (including officers other than the PEO) as of a date chosen by the registrant within the last three months of its last completed fiscal year (the Chosen Date), and includes employees located in the United States, as well as employees located in jurisdictions outside the United States (non-US employees), subject to the exemptions described below. Independent contractors, or “leased” workers employed (and whose compensation is determined) by an unaffiliated third party, are excluded from the definition of “employee”. The Chosen Date must be disclosed and if it has been changed from the prior year, both the change and the reasons for the change must be disclosed.
Data Privacy Exemption
In determining the median employee, registrants are permitted to exclude employees located in a foreign jurisdiction in which the law or regulations governing data privacy (Data Privacy Laws) are such that the registrant cannot obtain or process the necessary information despite using its reasonable efforts to do so (which must include seeking an exemption or other relief from such Data Privacy Laws) without violating such Data Privacy Laws. If any employees in a particular jurisdiction outside the United States are excluded under this exemption, all employees in that jurisdiction must be excluded, and the registrant must identify the excluded jurisdictions and the relevant Data Privacy Laws, explain how compliance with Item 402(u) would violate such Data Privacy Laws (including its efforts to seek an applicable exemption or other relief), and provide the approximate number of employees from each jurisdiction who were excluded. The registrant must also obtain a legal opinion as to its inability to obtain or process the information necessary for compliance with Item 402(u) without violating that jurisdiction’s Data Privacy Laws, including its inability to obtain an applicable exemption or other relief (and file such opinion as an exhibit to the filing containing the Pay Ratio Disclosure).
De Minimis Exemption
The rule also includes a de minimis exemption, which permits registrants to exclude all non-US employees in identifying the median employee if these employees account for five percent or less of the registrant’s total employees. If any non-US employees are excluded under this exemption, all non-US employees must be excluded, subject to the following. If a registrant’s non-US employees exceed five percent of the registrant’s total employees, it may exclude up to five percent of its total employees who are non-US employees, provided that if a registrant excludes any employees in a particular jurisdiction, it must exclude all employees in that jurisdiction. If more than five percent of a registrant’s employees are located in any one jurisdiction, the registrant may not exclude any employees in that jurisdiction under this exemption. The registrant must also disclose the jurisdictions from which its non-US employees are being excluded, the approximate number of employees excluded from each jurisdiction under the de minimis exemption, the total number of its US and non-US employees irrespective of any exemption (de minimis or data privacy), and the total number of its US and non-US employees used for its de minimis calculation.
Cost of Living Adjustments
In identifying the median employee, whether using annual total compensation or any other compensation measure, the registrant may make cost of living (COL) adjustments for the compensation of employees residing in different jurisdictions from the PEO to adjust the compensation to the COL in the jurisdiction in which the PEO resides, provided such adjustment is applied to all such employees included in the calculation. If the registrant uses this COL adjustment to identify the median employee, and the median employee identified does not reside in the same jurisdiction as the PEO, the registrant must use the same COL adjustment in calculating the median employee’s annual total compensation for Pay Ratio Disclosure. The registrant must also disclose the country in which the median employee is located, and describe the COL adjustments it used, including the measure used and the basis for the COL adjustment. If a registrant does not make COL adjustments when identifying the median employee, it may not make COL adjustments to the median employee’s annual total compensation. If COL adjustments are used, the registrant must also include Pay Ratio Disclosure without the COL adjustments (to calculate this pay ratio, the registrant will need to identify a different median employee without using any COL adjustments).
Calculation of Annual Total Compensation
Once the registrant identifies the median employee, the registrant must calculate that employee’s annual total compensation for the registrant’s last completed fiscal year in accordance with Item 402(c)(2)(x), and disclose that amount as part of the Pay Ratio Disclosure. The annual total compensation for the registrant’s PEO will also be determined in accordance with Item 402(c)(2)(x). Registrants may use reasonable estimates in calculating the annual total compensation or any elements of compensation for the median employee, as long as the registrant has a reasonable basis to conclude that its estimate approximates the actual amount of Item 402(c)(2)(x) compensation, or particular elements under Item 402(c)(2)(iv-ix).
The rules require that the methodology to identify the median employee, and any material assumptions, adjustments (including any COL adjustments) or estimates used to identify the median employee, or to determine total compensation or any elements of total compensation, be briefly described and consistently applied, and any estimated amounts be clearly identified as such. Any change in methodology, significant assumptions, adjustments or estimates from the prior year, and the reasons therefor, must be disclosed if the effects of any such change are significant.
PEO Compensation not Available
A registrant that is relying on Instruction 1 to Items 402(c)(2)(iii) and (iv) (which permits registrants to omit the PEO’s salary or bonus for the last completed fiscal year from the Summary Compensation Table if it is not calculable until a later date), may omit Pay Ratio Disclosure until such amounts are determined. Registrants shall disclose that the Pay Ratio Disclosure is not calculable until the PEO’s salary or bonus, as applicable, has been determined, as well as the date that the PEO’s actual total compensation is expected to be determined. The Pay Ratio Disclosure must be disclosed in the filing under Item 5.02(f) of Form 8-K that discloses the PEO’s salary or bonus in accordance with Instruction 1 to Item 402(c)(2)(iii) and (iv). Although a filing is triggered under Item 5.02(f) when the PEO’s omitted salary or bonus becomes calculable in whole or in part, the pay ratio information is required only when the salary or bonus becomes calculable in whole.
Transition periods are provided for new registrants, entities that cease to be emerging growth companies or smaller reporting companies, and in the context of business combinations and acquisitions.
 The SEC received more than 287,400 comment letters concerning the proposed rule, although more than 99 percent of them were form letters. The House Financial Services Committee has announced that it will consider legislation to repeal §953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act in the fall (prior to the effective date of the new rules).
 The new disclosure will be deemed “filed” and not “furnished.”
 As described below in “Identification of the Median Employee,” the SEC has interpreted clause (A) to require the identification of one “median employee,” whose compensation will then be used to determine the annual total compensation calculation. Personally identifiable information about the median employee other than compensation is not required.
 A registration statement that incorporates by reference a Form 10-K (or amended Form 10-K) containing all Part III information other than updated pay ratio information could be declared effective before the registrant’s definitive proxy or information statement containing updated pay ratio information is filed in accordance with General Instruction G(3) of Form 10-K.
 If a measure is used which is not based on the registrant’s fiscal year (e.g., tax records), the registrant may use the same annual period that is used to derive the applicable amounts. In addition, a consistently applied compensation measure (e.g., taxable wages), may be defined differently across jurisdictions and may include different annual periods, so long as such measure is applied consistently within each jurisdiction. Compensation may be annualized for all permanent employees (full or part-time) who were employed for less than the full fiscal year (but not for seasonal or temporary employees). Full-time equivalent adjustments are not permitted under any circumstances.
 This flexibility, combined with a registrant’s ability to choose an appropriate methodology and compensation measure, can be used to identify the one median employee required by the rules.
 The number of employees who may be excluded using the de minimis exemption is reduced by the number of employees excluded by reason of Data Privacy Laws (but a registrant may exclude any non-US employee that meets the data privacy exemption, even if the number of excluded employees exceeds five percent of the registrant’s total employees).
 References to “named executive officer” will be deemed to refer to “employee,” and for non-salaried employees, references to “base salary” and “salary” will be deemed to refer to “wages and overtime.”
 If a registrant replaces its PEO during its fiscal year, it may either use the total compensation calculated pursuant to Item 402(c)(2)(x), and reflected in the Summary Compensation Table, provided to each person who served as PEO during the year and combine those figures, or it may annualize the compensation of the PEO serving in that position on the date it selects to identify the median employee (and the option chosen must be disclosed).
 Registrants may exclude government-related pension benefits for non-US employees, just as social security benefits are excluded under “total compensation” for US employees. In addition, registrants may include personal benefits that aggregate less than $10,000 and compensation under non-discriminatory benefit plans in calculating the annual total compensation of the median employee, provided that the PEO calculation uses the same approach. Any difference between the PEO’s annual total compensation used in the Pay Ratio Disclosure and total compensation amounts reflected in the Summary Compensation Table must be disclosed if material.
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