The SEC adopted a new rule mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd Frank Act”) that requires public companies to disclose the ratio of the compensation of its chief executive officer (“CEO”) to the median compensation of its employees. The rule requires disclosure of this pay ratio in registration statements, proxy and information statements, as well as annual reports that ask for executive compensation disclosure.  Public companies will be required to disclose this pay ratio in their first fiscal year beginning on or after January 1, 2017.

Pay ratio disclosure has been a controversial topic, with the SEC receiving more than 287,400 comment letters since the rule was initially proposed.  The SEC stated that Section 953(b) of the Dodd Frank Act, which mandates the rule, was intended to provide shareholders with a company-specific metric that could assist them in the evaluation of the company’s executive compensation practices.  Therefore, the SEC stated in its adopting release that the rule was designed to meet this purpose and avoid unnecessary costs.

As drafted, the rule does not apply to small reporting companies, emerging growth companies, foreign private issuers, Multi-jurisdictional Disclosure System (“MJDS”) filers or registered investment companies.  In addition under the rule, companies that are subject to this ratio disclosure are given flexibility to identify their median employee by selecting their own methodology based on their particular facts and circumstances.  For example, companies can use their total employee population or a statistical sampling of that population.  In addition, companies can apply a cost-of-living adjustment in identifying the median employee.  However, if such adjustment is used, it would also need to be used in calculating the median employee’s annual total compensation.  In addition, the rule allows companies to make the median employee determination once every three years unless there has been a change in its employee population or employee compensation arrangement that it reasonably believes would result in a significant change to its pay ratio.  In determining the pay ratio, the rule also allows companies to exclude non-U.S. employees from countries in which data privacy laws or regulations make such companies unable to comply with the rule.  There is also a de minimis exemption for non-U.S. employees.  If a company’s non-U.S. employees account for 5% or less of its total employees, it may exclude all of those employees when making its pay ratio calculations.  However under this carve-out, if the company chooses to exclude any non-U.S. employees, it must exclude all of them.

The rule requires that companies describe the methodology used to identify the median employee and any material assumptions, adjustments or estimates used to identify this employee or to determine annual total compensation in their filings.  Companies are also permitted to supplement the required information with a narrative or additional ratios  so long as such additional information is not misleading or presented with greater prominence than the required pay ratio.