The staff of the SEC’s Division of Corporation Finance (Staff) recently issued guidance on the SEC’s pay ratio disclosure rule (Rule)1 in the form of new compliance and disclosure interpretations.2 The Staff’s guidance can be found here.

Under the Rule, most companies required to provide compensation disclosure pursuant to Item 402 of Regulation S-K in filings with the SEC3 must disclose in their annual reports, proxy or information statements, and registration statements in which executive compensation disclosure under Item 402 of Regulation S-K is required, (1) the median annual total compensation of all employees, except their principal executive officer (PEO), (2) the PEO’s annual total compensation, and (3) the ratio of these two compensation amounts.4 Disclosure under the Rule must be made with respect to compensation for fiscal years beginning on or after January 1, 2017. Thus, an issuer with a December 31 fiscal year must first make pay ratio disclosure under the Rule as to the compensation deemed paid by it for the year ending December 31, 2017, and most issuers subject to the Rule are likely to make their first pay ratio disclosure in their proxy statements used in the 2018 proxy season.

Issuers subject to the Rule should review the Staff’s guidance in connection with determining the issuers’ employee population and identifying their employee earning the median annual total compensation of all of their employees other than their PEO (Median Employee) to ensure their determination of their Median Employee is in compliance with both the Rule and the Staff’s guidance. Those issuers intending to take advantage of the flexibility that the Rule affords regarding the compensation measure used to determine an issuer’s Median Employee should pay particular attention to the Staff’s guidance regarding the acceptability and mechanics of such a measure.

Staff Guidance

Compliance challenges. The Rule poses two principal compliance challenges for an issuer:

  • determining who the issuer's “employees” are for purposes of the Rule; and
  • identifying the issuer's Median Employee in a manner permitted by the Rule.

For many, if not most, issuers and especially for issuers with large workforces, identifying the Median Employee will be by far the more daunting of those challenges. Recognizing the difficulty that many issuers were likely to encounter in identifying the Median Employee by using the total compensation of their employees for a fiscal year calculated in the manner prescribed by Item 402(c)(2)(x) of Regulation S-K (Total Compensation), the Rule allows issuers to use a consistently applied compensation measure (CACM) other than Total Compensation to determine their Median Employee. The fluidity of workforces and the different types of relationships that may exist between an issuer and its workers may raise questions for issuers about exactly who are their “employees” for purposes of the Rule.

The Staff’s guidance addresses the use of a CACM to identify an issuer’s Median Employee and whether certain workers are “employees” for purposes of the Rule.

Acceptable CACMs (Questions 128C.01 and 128C.02). When selecting a CACM, the Staff notes that:

  • any measure reasonably reflecting the annual total compensation of employees can serve as an acceptable CACM;
  • the appropriateness of a CACM will depend on the issuer’s particular facts and circumstances;
  • although a CACM must reasonably reflect annual compensation, the CACM is not expected to identify the same Median Employee as would be identified if the issuer used Total Compensation to determine its Median Employee; and
  • any compensation measure used in a CACM must be briefly disclosed.

In this regard, the guidance indicates that a CACM can include information such as an issuer’s tax or payroll records, and that total cash compensation can be a CACM unless the issuer also distributes annual equity awards widely among its employees.

An appropriate CACM cannot be based on either (1) Social Security taxes withheld unless all employees of the issuer earned less than the Social Security wage base or (2) as a general matter, the exclusive use of an hourly or annual rate of pay. An hourly or annual pay rate may be a component used to determine an employee’s overall compensation. However, the Staff considers the use of an hourly pay rate in a CACM without taking into account the hours actually worked by each employee to be similar to making a full-time equivalent adjustment for part-time employees, which the Rule prohibits for any employee, including part-time employees. Likewise, the Staff deems the use of an annual pay rate without regard to whether employees worked the full year and were actually paid the amount of the annual pay rate to be similar to annualizing pay, which the Rule permits only in limited situations, such as when a permanent employee is hired during the course of the fiscal year for which compensation is being determined or is on an unpaid leave of absence during such fiscal year.

Permissible time periods for calculating a CACM (Question 128C.03). Regarding the mechanics of a CACM, the guidance indicates that:

  • the Median Employee must be identified from the employee population as of the date chosen by the issuer within the last three months of its fiscal year (Employee Population)5 using the Total Compensation or another CACM;
  • the period for which an issuer uses a CACM to determine its Median Employee need not include the date on which the issuer’s Employee Population is determined and need not be a full annual period; and
  • a CACM may also consist of Total Compensation from the issuer’s “prior fiscal year”6 so long as a change in the issuer’s Employee Population or employee compensation arrangements has not occurred that would result in a significant change in the issuer’s pay distribution to its workforce.

Determining whether furloughed employees are “employees” under the Rule (Question 128C.04). The guidance indicates that whether a worker who is on furlough at the date of the Employee Population determination is considered part of the Employee Population is a facts-and-circumstances test. If an issuer determines that a furloughed worker is an employee on the date of the issuer’s determination of its Employee Population, the compensation of the furloughed worker is to be determined in the same manner as the compensation of the issuer’s non-furloughed employees. Such determination must be based on the rules for the determination of the Total Compensation of the members of the class of employees (i.e., full-time, part-time, temporary or seasonal employees) to which the issuer deems the furloughed worker to belong.

In calculating the compensation of a furloughed worker who is an “employee” for purposes of the Rule, the issuer may annualize the compensation of a furloughed worker who worked for less than all of the pertinent fiscal year if the issuer determines that worker was a permanent full-time or permanent part-time employee, but may not annualize the compensation of a furloughed worker that is determined to be a temporary or seasonal worker. Moreover, an issuer may not make a full-time equivalent adjustment for any furloughed worker.

Determining when a worker is an independent contractor or leased worker under the Rule and when an issuer is considered to be determining the compensation of a worker (Question 128C.05). The guidance indicates that when determining if a worker is an “employee” under the Rule, an issuer must consider the composition of its workforce and its overall employment and compensation practices. An issuer should include in its Employee Population those workers whose compensation the issuer or one of its consolidated subsidiaries “determines,” regardless of whether those workers would be considered to be employees of the issuer for tax or employment law purposes or under other definitions of the term “employee.”

The Staff does not believe an issuer is “determining” the compensation of workers whose services the issuer acquires by contracting with an unaffiliated third party that employs the workers if, for example, the issuer only specifies those workers receive a minimum level of compensation. An individual who is an independent contractor with respect to an issuer may be an “unaffiliated third party” determining his or her own compensation.

Practical Considerations

Planning opportunity. The Staff’s guidance that a CACM may use the compensation of an Employee Population for less than a full annual period to determine a Median Employee may present a planning opportunity for some issuers. Issuers should consider whether using in a CACM the compensation of their employees for a particular period, perhaps a period before or after an adjustment in the compensation of a particular group or significant portion of their employees, will result in the identification of a Median Employee whose annual total compensation will result in a pay ratio disclosure that is more palatable to the issuer. Issuers should also consider whether using an annual period or a particular shorter period, such as a period in which equity awards were made or not made or bonuses were paid or not paid, to determine a Median Employee in a CACM would result in a more or less acceptable pay ratio disclosure. Unfortunately, this planning opportunity is unlikely to be of any significant value to any issuer with a large employee population that includes a significant number of lower paid hourly workers.

Moreover, an issuer considering using employee compensation for a period of less than the full fiscal year in a CACM to determine its Median Employee should be careful that such compensation reasonably reflects annual compensation and does not result in the pay ratio disclosed being so skewed from the pay ratio which would result from the use of a full year’s compensation to determine the Median Employee that the pay ratio disclosure is materially misleading.

Prepare for compliance. Although the first disclosures under the Rule will not be made for over a year, issuers should already be preparing to comply with the Rule. For those issuers with large employee populations and varied compensation arrangements for a large portion of their workforce, compliance with the Rule may well prove to be a time consuming and costly undertaking. As noted in our prior alert on the Rule, the lead time needed to design, test and implement the methodology to be used to comply with the Rule and the systems for capturing the information needed to comply with the Rule could be long.

Issuers who have not already commenced their preparations for compliance with the Rule should start making those preparations soon. Those preparations should include making any necessary changes to disclosure controls and procedures. An issuer should take into account the Staff’s guidance in the issuer’s disclosure controls and procedures and other procedures for compliance with the Rule. When doing so, however, issuers are cautioned to consult the provisions of the Rule as well as the guidance discussed above.