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On August 5, 2015, the Securities and Exchange Commission adopted final regulations that will require many public companies to calculate and disclose the ratio between the annual total compensation of their chief executive and the median of the annual total compensation of all other employees.1 Once effective, this new pay ratio disclosure will need to be included in any filing that requires executive compensation disclosure under Item 402 of Regulation S-K, including registration statements, proxy and information statements and Annual Reports on Form 10-K. The new disclosure requirements will not apply to smaller reporting companies, emerging growth companies, foreign private issuers or registered investment companies.

When Disclosure is Required

The good news is that companies will not be required to provide disclosure of their pay ratios until their first fiscal year beginning on or after January 1, 2017- so the 2018 proxy season for calendar year filers. Even though the disclosure has been delayed until the 2018 proxy season, companies are nevertheless advised to become familiar with the intricacies of the required calculations sooner rather than later, so as to be in a position to comply with the new disclosure in a timely fashion, as well as consider what supplemental information a company might want to provide in its disclosures to put this ratio into a proper context.

Overview of Rule

The new pay ratio disclosure requirement has been added to Item 402 of Regulation S-K. It requires companies to disclose: (i) the median of the total compensation of all of its employees, except the CEO; (ii) the annual total compensation of its CEO; and (iii) the ratio of those two amounts. Companies must determine and select an employee whose compensation represents the median compensation of all employees other than the CEO by analyzing their full employee population or by using statistical sampling or another reasonable method.

Which Employees to Include

The employee population for this calculation includes all full-time, part-time, seasonal or temporary employees (but not independent contractors) of the reporting company and its subsidiaries, other than the CEO, as of a date within the last three months of the most recently completed fiscal year. The rules prohibit companies from making full-time equivalent adjustments for part-time workers or annualizing temporary or seasonal workers. Subject to limited exceptions, the employee population includes all non-U.S. employees. Once the company has selected the median employee, the total compensation for that median employee must be calculated, using the same principles employed to calculate the total compensation for the CEO.

There are two limited exceptions which permit non-U.S. employees to be excluded from the employee population for purposes of calculating the pay ratio. A company can exclude an employee in a foreign jurisdiction having data privacy restrictions that have prevented it from obtaining or processing the information despite reasonable efforts to do so (which will require, at a minimum, seeking an exemption from the restrictions). The second exception permits non-U.S. employees to be excluded if they constitute five percent or less of a company’s employees. The rule includes a variety of requirements that must be satisfied and disclosures that must be made if a company uses either of these two exceptions.

The rule also allows a company to omit any employees obtained in a merger or acquisition for the fiscal year in which the business combination occurred, though the company must include disclosure regarding the transaction and the number of employees omitted.

Frequency of the Calculation

The median employee only needs to be identified once every three (3) years so long as there has been no change in a company’s employee population or employee compensation arrangements that it reasonably believes would result in a significant change to its pay ratio disclosure. However, the annual total compensation for the selected median employee must be recalculated each year for purposes of the ratio. If there has been a change in circumstances of the median employee that would result in a significant change to the ratio, another employee whose compensation is substantially similar to the median employee may be used.

Other Considerations

In disclosing the ratio, the annual total compensation of all employees other than the CEO must be one. Alternatively, the annual total compensation of the CEO can be expressed as a multiple of the annual total compensation of all other employees.

Companies may present additional information, including additional ratios, to supplement the required ratio, but are not required to do so. However, any additional information must be clearly identified, not misleading, and not presented with greater prominence than the required ratio. Undoubtedly, we will see a wide variance in the amount of accompanying disclosure in the first few years that the ratio disclosure is presented, until companies are able to assess what, if any, impact the disclosure has with their investor base.