Guidance Reinforces Flexibility in Identifying the Median Employee While Maintaining Limits on Annualizing Compensation

SUMMARY

The Securities and Exchange Commission's Division of Corporation Finance has posted on its website five new Compliance and Disclosure Interpretations regarding the CEO pay ratio disclosure, which will be required for most U.S. public companies beginning with the 2018 proxy season. All of the new interpretations (which are set out in Annex A of this publication) relate to determining the median employee for purposes of the ratio.

  • The guidance makes clear that a consistently applied compensation measure, or CACM, that is used to identify the median employee may cover less than an annual period, may cover a time period that does not include the date on which the employee population was determined, and may generally consist of annual total compensation from the registrant's prior fiscal year.
  • While reinforcing flexibility, the guidance notes examples of measures that would generally not be permissible CACMs because they do not reasonably reflect the annual compensation of employees, including the use of:
    • cash compensation when employees widely receive equity awards;
    • hourly or other rates of pay without factoring in time worked; and
    • Social Security taxes unless all employees earn less than the Social Security wage base.

Even though the new disclosure will not be required until the 2018 proxy season, companies may find it helpful to conduct dry-runs of the calculation based on past compensation data in order to develop an appropriate methodology, identify and resolve interpretive, practical or disclosure issues, and ensure that systems are in place to capture information necessary to support the chosen methodology.

BACKGROUND

As directed by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, on August 5, 2015, the SEC adopted the final pay ratio disclosure rule as Item 402(u) of Regulation S-K.1 The rule requires that U.S. public companies disclose:

  • the median of the annual total compensation of all employees of the registrant, except the registrant's CEO;
  • the annual compensation of the registrant's CEO; and
  • the ratio of those two amounts.

Disclosure is required with respect to the first fiscal year beginning on or after January 1, 2017; accordingly, the rule becomes effective beginning with the 2018 proxy season. The pay ratio disclosure rule does not apply to emerging growth companies, smaller reporting companies, foreign private issuers, filers under the U.S.-Canadian Multijurisdictional Disclosure System and registered investment companies.

HIGHLIGHTS FROM THE PAY RATIO GUIDANCE

Using CACMs to Identify the Median Employee

Permissible CACMs. The rule permits a registrant to use annual total compensation as determined under existing executive compensation rules, referred to as annual total compensation, or any other CACM, including from compensation amounts reported in its payroll or tax records, to identify the median employee. The new guidance provides that the CACM need not necessarily identify the same median employee as would annual total compensation and may be any measure that reasonably reflects the annual compensation of employees depending on the facts and circumstances. Under the rule, the registrant must briefly disclose the compensation measure used to identify the median employee.

The guidance provides two examples of measures that would generally not be permissible CACMs for a registrant because they do not reasonably reflect the annual compensation of employees:

  • cash compensation when employees widely receive equity awards; and
  • Social Security taxes unless all employees earn less than the Social Security wage base.

Rates of Pay that Act as Full-Time Equivalent Adjustments or that Annualize Pay Are Not Permissible CACMs. The rule does not permit full-time equivalent adjustments for part-time employees and permits annualizing adjustments only for permanent employees who did not work the entire year. Consistent withthe prohibition on full-time equivalent adjustments, the guidance provides that an hourly rate of pay may not be a CACM without taking into account the number of hours actually worked. Similarly, consistent with the limits on permitted annualizing adjustments, an annual rate may not be a CACM without taking into account whether the employees worked the entire year and the amount actually paid during the year.

Applying the CACM. The guidance makes clear that a CACM used to identify the median employee may cover a time period that is not a full annual period and that does not include the date on which the employee population was determined. In addition, the CACM may consist of annual total compensation from the registrant's prior fiscal year so long as there has not been a change in the registrant's employee population or employee compensation arrangements that would result in a significant change of its pay distribution to its workforce. For example, the registrant may use the trailing 12 months in applying the CACM.

Determining the Relevant Employee Population

Employees Are Either Full-Time, Part-Time, Temporary or Seasonal. The guidance makes clear that there are only these four classes of employees. Registrants with other classes of workers, for example "furloughed employees," that the registrant determines are employees on the date it sets the employee population, must decide under which of these four classes such employees fit given its facts and circumstances. The registrant then must calculate the total annual compensation or CACM in accordance with the instructions and guidance for that class of employee. This guidance does not provide specifics as to what the registrant should consider when deciding under which class of employee such workers may fit. As noted above, the registrant may not make a full-time equivalent adjustment for any employee, and the guidance cautions against other adjustments that implicitly annualize compensation.

Determining Independent Contractors and Leased Employees. The rule permits a registrant to exclude workers who provide services to the registrant as independent contractors and "leased" workers as long as they are employed, and their compensation is determined, by an unaffiliated third party. The guidance emphasizes that the determining factor in determining independent contractor status is whether the registrant or one of its consolidated subsidiaries determines the compensation of the worker. The determination of whether a worker is an independent contractor is not whether or not he or she would be considered an "employee" for tax or employment law purposes or under other definitions of "employee." In evaluating whether the registrant determines the compensation of workers, the guidance clarifies that certain compensation-related terms, such as a minimum level of compensation, in a registrant's contract for workers with an unaffiliated third party are not compensation decisions by the registrant. Accordingly, such workers may be independent contractors. In addition, individuals may be independent contractors if the individual determines his or her own compensation and therefore acts as the unaffiliated third party.

IMPLICATIONS

Since the disclosure will generally be required in 2018 proxy statements based on 2017 compensation data, U.S. public companies should consider the rule requirements and this guidance when making 2017 compensation decisions that may impact this disclosure. Companies may find it helpful to conduct dry-runs of the calculation based on past compensation data in order to develop an appropriate methodology, identify and resolve interpretive, practical or disclosure issues, and ensure that systems are in place to capture information necessary to support the chosen methodology.

Companies should also be mindful that the pay ratio rule requires disclosure of the methodology used to determine the median employee and any material assumptions, adjustments or estimates used to identify the median employee or to determine total compensation. Given the facts-and-circumstances nature of pay ratio disclosure, there will necessarily be a wide range of methodologies and assumptions. As a result, required disclosure of the methodology and assumptions used, along with any supplemental narrative disclosure (which is permissible if clearly identified, not misleading, and not presented with greater prominence than the required disclosure), will be a key method for companies to communicate to their shareholders about their pay ratio and the facts and circumstances that impact the ratio.