The Division of Corporation Finance of the Securities and Exchange Commission (“SEC”) issued guidance in the form of five new Compliance & Disclosure Interpretations (“C&DIs”), regarding the “pay ratio” rules, which require public companies to disclose how their principal executive officer’s pay compares to the pay of all company employees.

The pay ratio rules are required by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), and require public companies to disclose (i) the “median of the annual total compensation” of all employees, other than the principal executive officer (the CEO or other equivalent position) (“PEO”); (ii) the “annual total compensation” of the PEO (which is already required to be disclosed under existing rules); and (iii) ratio of these two amounts. The final rules apply generally to a company’s first full fiscal year beginning on or after January 1, 2017 (the 2018 proxy season for calendar fiscal year companies). Our Client Alert dated August 10, 2015, available here, discusses the final pay ratio rules in greater detail.

The new C&DIs relate to new Item 402(u) (Pay Ratio Disclosure) of Regulation S-K and provide additional guidance to companies on how to determine the “median employee” for purposes of pay ratio disclosure. The full text of the new C&DIs, Questions 128C.01 through 128C.05, are available here and discussed in further detail below.

Using a Consistently Applied Compensation Measure to Identify the Median Employee

The pay ratio rules allow a company to use a consistently applied compensation measure (“CACM”) as an alternative to “annual total compensation,” which is the compensation measure used to calculate compensation for the PEO and other named executive officers in Summary Compensation Tables. Any measure that reasonably reflects the annual compensation of employees could serve as a CACM. The reasonableness of a measure will depend on the company’s particular facts and circumstances. For example, total cash compensation could be an acceptable CACM, unless the company widely grants equity awards to its employees. While the CACM must reasonably reflect annual compensation, the CACM used need not identify the same median employee as would have been identified if the company had used annual total compensation as the compensation measure. In addition, while companies are permitted to consider the annual or hourly rate in determining an employee’s overall annual compensation, the use of an hourly or annual pay rate alone is not an appropriate CACM to identify the median employee.

Choosing a Time Period for Identifying the Median Employee

In order to calculate the required pay ratio, a company must first select a date within three months of the end of its fiscal year to determine the population of its employees from which to determine the median employee, using either annual total compensation or another CACM. In applying the CACM, the company is not required to use a period that includes the date on which the employee population was determined or 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 compensation arrangements that would result in a significant change of its pay distribution for its employees.

Treatment of Furloughed Employees

As different companies may have different meanings for the term “furloughed employees,” a company must determine whether a furloughed employee should be included as an employee for purposes of determining the median employee based on the relevant facts and circumstances. Item 402(u)(3) of Regulation S-K identifies four categories of employees: (1) full-time, (2) part-time, (3) temporary and (4) seasonal. If the furloughed employee is to be considered an employee for purposes of determining the median employee, the company must determine which category of employee to consider such employee a member of for purposes of determining such employee’s compensation using a CACM, and may annualize the total compensation for all permanent employees (full-time or part-time) who were employed for less than the full year or were on unpaid leave of absence during the year.

Determining the Employee Population for Purposes of Determining the Median Employee

In determining whether a worker is an “employee” of the company for purposes of determining the median employee, a company should include only 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. When a company obtains services from an independent contractor who determines his or her own compensation, or from an unaffiliated third party that employs workers and sets compensation for such workers, the SEC does not believe that the company is determining compensation for purposes of the rule, even if it sets a minimum level of compensation.