On August 5, 2015, the Securities and Exchange Commission (SEC) adopted the final pay ratio disclosure rules to implement Section 953(b) of the Dodd-Frank Act. These rules, which will require proxy disclosure in 2018 for calendar year companies, require public company issuers to disclose how the compensation of their chief executive officer (CEO) compares to the median compensation of its employees overall. The final rules generally follow the rules first proposed in September 2013, with a few notable exceptions.

In general, the rules require disclosure of:

• the annual total compensation of the CEO;
• the annual total compensation of the employee identified as having received the median compensation based on all employees of the issuer other than the CEO; and
• the ratio of these two amounts.

Subject to limited exceptions, issuers must disclose the pay ratio for the fiscal year starting on or after January 1, 2017.

Which issuers are required to make the pay ratio disclosure and in what filings does it need to be disclosed?

Most SEC reporting issuers will be required to include the pay ratio disclosure in annual reports on Form 10-K, registration statements, and proxy and information statements, in each case whenever these forms require executive compensation disclosures under Item 402 of Regulation S-K. Emerging growth companies, smaller reporting companies, foreign private issuers, U.S.-Canadian Multijurisdictional Disclosure System filers, and registered investment companies are not subject to the rules. Issuers that previously were smaller reporting companies or emerging growth companies must disclose their pay ratio for the first full fiscal year beginning after they exit that status, but in no event for any fiscal year prior to January 1, 2017.

How is the "median employee" determined?

The "median employee" is an employee that represents the employee at the 50th percentile, or the "middle employee," calculated by ordering the compensation of all employees (other than the CEO) from highest to lowest, with half of the employees having higher compensation and half having lower compensation.

Issuers have to identify the median employee only once every three years, or sooner if the employee population or compensation arrangements change in a manner that the issuer reasonably believes would significantly affect the pay ratio (e.g., an event occurs that results in a large number of lower-paid workers). If there have been no such changes, the issuer must disclose that it is using the same median employee for its calculation and briefly describe why it reasonably believes the pay ratio would not be significantly changed.

There is no required calculation methodology for identifying the median employee. Issuers are permitted to choose from the following options:

• identifying the median employee using the full employee population;
• identifying the median employee using a statistical sampling; or
• identifying the median employee by using other reasonable methods.

Issuers may identify the median employee using compensation based on annual total compensation or any other compensation measure consistently applied to all employees (e.g., tax or payroll records). Issuers must briefly describe the methodology used; any material assumptions, adjustments, or estimates; the compensation measure used (if annual total compensation was not used); and the date used to determine the median employee. An issuer need not disclose the reason why it chose a particular date, but if the date changes from year to year, the issuer must disclose the change and briefly explain the reason for the change.

To identify the median employee, issuers are permitted to make cost-of-living adjustments for the compensation of employees in jurisdictions other than where the CEO resides. If a cost-of-living adjustment is used to identify the median employee and the median employee does not reside in the same jurisdiction as the CEO, then the issuer must use the same cost-of-living adjustment to calculate the median employee's annual total compensation and disclose the country where the median employee is located. The issuer is also required to briefly describe the cost-of-living adjustments. If the issuer uses cost-of-living adjustments to disclose the pay ratio, it must separately disclose the pay ratio without the cost-of-living adjustments.

Who is an "employee" for purposes of determining the median employee?

An "employee" is any full-time, part-time, seasonal, or temporary worker employed by the issuer and any of its consolidated subsidiaries (including officers other than the CEO) as of any date of the issuer's choosing within the last three months of the prior fiscal year. Employees include all salaried and non-salaried employees throughout the world.

The rules permit the exclusion of: (1) non-U.S. employees when a foreign jurisdiction's data privacy laws or regulations are such that, despite the issuer's reasonable efforts to obtain or process information necessary to comply with the rule, the issuer is unable to do so without violating those laws or regulations (but the issuer must receive an opinion of counsel that this is true); and (2) up to 5 percent of non-U.S. employees generally (including those excluded under the data privacy law exception).

Issuers must exclude all independent contractors, leased workers, and other temporary workers who are employed by an unaffiliated third party.

Issuers may exclude any individuals that became their employees as a result of a business combination or acquisition for the fiscal year in which the transaction occurs. However, these individuals would need to be taken into consideration for subsequent years.

How does an issuer calculate the annual total compensation for the median employee for purposes of the pay ratio?

Once the median employee is determined, the issuer is required to calculate the median employee's total compensation in accordance with Item 402 of Regulation S-K as though it was being included in the summary compensation table. Reasonable estimates may be used in certain circumstances to determine the median employee's annual total compensation or any elements of annual total compensation, but the issuer must clearly identify any such estimates. The issuer must also have a reasonable basis to conclude that such estimates approximate the actual amounts of compensation.

How should issuers treat employees who worked only part of the year? What about temporary or seasonal workers?

For full-time or part-time employees who were employed for only part of the year (because they were hired mid-year or took a leave of absence for part of the year), the issuer may (but is not required to) annualize compensation. If an issuer chooses to annualize compensation, it must do so for all permanent employees. Issuers may not annualize compensation for seasonal or temporary employees or apply a cost-of-living adjustment. Issuers may not use a full-time-equivalent adjustment for part-time employees.

How is the annual total compensation for the CEO calculated?

The annual total compensation for the CEO is calculated in the same manner as it is calculated for purposes of the summary compensation table.

If a CEO is replaced during the issuer's fiscal year, the issuer can calculate the annual total compensation in one of two ways: by (1) combining the total compensation for each person who served as the CEO during the past fiscal year; or (2) annualizing the total compensation for the CEO serving on the date used to calculate the median employee.

How must the ratio of the median employee's compensation to the compensation of the CEO be expressed?

The ratio must be expressed as either (1) a ratio in which the annual total compensation of the median employee is equal to one (e.g., "50 to 1") or (2) in terms of the multiple that the CEO's annual total compensation bears to the median employee's annual total compensation (e.g., "the CEO's annual total compensation is 50 times that of the median of the annual total compensation of all employees").

Does an issuer have to explain the ratio or provide an explanation of its employee compensation practices?

No. An issuer is only required to disclose the ratio and, as described above, material assumptions, adjustments, or estimates used.

An issuer may choose to provide additional information (including other ratios) to supplement the required pay ratio, but any additional information should be clearly identified, not be misleading, and not be presented with greater prominence than the required pay ratio.

Issuers are permitted, but are not required, to supplement the required disclosure with a narrative discussion if they wish.

Where should the pay ratio disclosure be located in a filing?

The pay ratio disclosure should be placed with other executive compensation disclosures, such as the summary compensation table and the compensation discussion and analysis.

Is the pay ratio disclosure deemed "filed" or "furnished" for SEC purposes? Is the information covered by the certifications filed with Exchange Act filings?

Similar to other Item 402 information, the pay ratio disclosure is considered filed, not furnished. As a result, it is subject to certain liability provisions under the securities laws and covered by the certification requirements.

Do the rules require other disclosures?

Yes. These questions and answers in this alert are intended to highlight the key disclosure requirements under the pay ratio rules. However, the rules require disclosure of additional details relating to the information and calculations used to determine the pay ratio. For example, the rules specify additional disclosure requirements with respect to employees excluded from the pay ratio calculations.

What is the effective date for the pay ratio disclosure?

Issuers must disclose the pay ratio for the fiscal year starting on or after January 1, 2017. An issuer with a fiscal year ending on December 31, 2016, will first disclose the pay ratio in its Form 10-K, registration statements, and proxy and information statements filed in 2018.

The pay ratio disclosure is not required in a registration statement on Form S-1 or Form S-11 for an initial public offering or in a registration statement on Form 10. A new issuer must comply with the pay ratio disclosure following its first full fiscal year beginning after the issuer has: (1) been subject to reporting requirements of Sections 13(a) or 15(d) of the Securities Exchange Act of 1934 for at least 12 months beginning on or after January 1, 2017; and (2) filed at least one annual report pursuant to Sections 13(a) or 15(d) that does not contain the pay ratio disclosure.

What should issuers do now?

Although the first required pay ratio disclosure is more than two years away, it is likely that issuers will encounter difficulties in preparing for the disclosure. Accordingly, issuers should do the following:

• Explain to the compensation committee that these rules are now final and note when they will be effective for the issuer.
• Identify and test possible methodologies for calculating the pay ratio and prepare a preliminary estimate of the pay ratio.
• Determine whether data privacy rules will prevent sharing the employee information necessary to calculate and disclose the pay ratio so that there is sufficient time to get an exemption or other relief or obtain employee consent, if appropriate, or an opinion of counsel, if necessary.
• Update systems and develop processes to collect the required information.