The Staff of the Division of Corporation Finance of the Securities and Exchange Commission issued initial interpretative guidance on the pay ratio disclosure rules. The pay ratio rules were mandated by the Dodd Frank Wall Street Reform and Consumer Protection Act and require public companies to determine and disclose the ratio of the compensation of its principle executive officer to the median compensation of its employees. The pay ratio rules are intended to help inform shareholders when voting on “say on pay.”

The pay ratio rules, which were adopted in 2015, require reporting companies to begin including disclosure of a pay ratio in filings made in 2018 for fiscal years beginning on or after January 1, 2017. Smaller reporting companies, emerging growth companies, foreign private issuers, MJDS filers and registered investment companies are exempt from the pay ratio rules.

The Staff guidance addresses three issues: the consistently applied compensation measure used to identify the median employee; the treatment of furloughed employees; and the treatment of independent contractors. The full text of the Compliance and Disclosure Interpretations (C&DIs) are here.

Consistently Applied Compensation Measure Clarifications

How to select a CACM. Instruction 4 to new Item 402(u) of Regulation S-K provides that a company may identify the median employee using annual total compensation or any other compensation method that is consistently applied to all employees included in the calculation, such as information derived from the company’s tax and/or payroll records (referred to as a Consistently Applied Compensation Measure, or CACM). The use of a CACM was meant to provide flexibility in selecting a methodology to identify the median employee. The Staff guidance provides that any measure that reasonably reflects the annual compensation of employees could serve as a CACM and that the appropriateness of any measure will depend on the company’s particular facts and circumstances. For example, total cash compensation could be a CACM unless the company also distributes annual equity awards widely among its employees. Social Security taxes withheld would likely not be a CACM unless all employees earned less than the Social Security wage base. The guidance also clarifies that although the CACM must reasonably reflect annual compensation, it is not expected that the CACM would necessarily identify the same median employee as if the company were to use annual total compensation. Question 128C.01

Use of hourly or annual rates of pay. The guidance clarifies that a company may not exclusively use hourly or annual rates of pay as its CACM. Although an hourly or annual pay rate may be a component used to determine an employee’s overall compensation, the use of the pay rate alone generally is not an appropriate CACM to identify the median employee. Similarly, using an annual rate only, without regard to whether the employees worked the entire year and were actually paid that amount during the year, would be similar to annualizing pay, which the rule only permits in limited circumstances. Question 128C.02

Time periods when using a CACM to identify the median employee. For purposes of calculating a pay ratio, a company must first select a date, which must be within three months of the end of its fiscal year, to determine the population of its employees from which to identify the median. Once the employee population is determined, a company must then identify the median employee from that population using either annual total compensation or another CACM. The C&DI provides that in applying the CACM to identify the median employee, a company is not required to use a period that includes the date on which the employee population is determined, nor is it required to use a full annual period. A CACM may also consist of annual total compensation from the company’s prior fiscal year so long as there has not been a change in the company’s employee population or employee compensation arrangements that would result in a significant change of its pay distribution to its workforce. Question 128C.03

Furloughed Employees

The pay ratio rules do not address furloughed employees. The guidance makes clear that because a furlough can have different meanings for different employers, a company will need to determine whether furloughed workers should be included as employees based on the facts and circumstances. If the furloughed worker is determined to be an employee of the company on the date the employee population is determined, his or her compensation should be determined by the same method as for a non-furloughed employee. A company must determine which of the four classes of employees – full-time, part-time, temporary and seasonal identified by the rule – the furloughed employee falls into and determine that individual’s compensation using annual total compensation or another CACM in accordance with Instruction 5 of Item 402(u). That instruction provides that a company may annualize the total compensation for all permanent employees (full-time or part-time) that were employed by the company for less than the full fiscal year or who were on an unpaid leave of absence during the period. In contrast, a company may not annualize the total compensation for employees in temporary or seasonal positions. A company may not make a full-time equivalent adjustment for any employee. Question 128C.04

Independent Contractors

The pay ratio rules exclude from the definition of an employee, workers who are employed, and whose compensation is determined, by an unaffiliated third party but who provides services to the company as an independent contractor or “leased” worker. The C&DI provides guidance on the circumstances under which a worker would be considered an independent contractor or leased worker and when a company is considered to be determining the compensation of a worker. The C&DI explains that the pay ratio is meant to be a company specific metric. Therefore, in determining when a worker is an “employee” under the rule, the company must consider the composition of its workforce and its overall employment and compensation practices. The C&DI then states that a company should include those workers whose compensation it or one of its consolidated subsidiaries determines regardless of whether these workers would be considered “employees” for tax or employment law purposes or under other definitions of that term. Frequently, a company will obtain the services of workers by contracting with an unaffiliated third party that employs the workers. When a company obtains services in this way, the Staff does not believe that the company is determining the workers’ compensation for purposes of the rule if, for example, the company only specifies that those workers receive a minimum level of compensation. Further, an individual who is an independent contractor may be the “unaffiliated third party” who determines his or her own compensation. Question 128C.05