On October 18, 2016, the Staff of the Division of Corporation Finance (Division) of the Securities and Exchange Commission (SEC) released new Compliance & Disclosure Interpretations (C&DIs) for the controversial pay ratio rules, which were approved by the SEC on August 5, 2015. The pay ratio rules, which are found under Item 402(u) of Regulation S-K, require U.S. public companies to disclose (i) the median of the annual total compensation of all employees of the registrant (except the chief executive officer (CEO)), (ii) the annual total compensation of the CEO and (iii) the ratio of these two amounts. Companies will be required to disclose this pay ratio information for their first full fiscal years beginning on or after January 1, 2017. Accordingly, companies with a December 31 fiscal year-end must present the pay ratio disclosures beginning with their Form 10-Ks or proxy statements filed in 2018.
The pay ratio rules give companies reasonable latitude to determine a particular methodology for identifying the median employee and, in limited cases, permit the exclusion of certain non-U.S. employees. However, it is expected that compliance with the pay ratio rules will be burdensome and costly, particularly for large or multinational companies. The new C&DIs, which are summarized below, attempt to clarify and resolve some of the questions that companies have raised as they prepare to comply with the pay ratio disclosure rules.
Selecting a Consistently Applied Compensation Measure (C&DI 128C.01)
Item 402(u) does not specify a particular methodology for identifying the median employee, but instead allows companies to choose the appropriate methodology based on their own facts and circumstances. A registrant may identify the median employee using annual total compensation (as calculated using Item 402(c)(2)(x) of Regulation S-K (Annual Total Compensation)) or any other consistently applied compensation measure (CACM).
According to C&DI 128C.01, the appropriateness of any measure will depend on the registrant’s particular facts and circumstances. For registrants not using Annual Total Compensation to identify the median employee, any measure that reasonably reflects the annual compensation of employees could serve as a CACM. While the Division did not provide an exhaustive list of what it would consider a reasonable reflection of annual compensation, it did provide some parameters regarding what it believes may constitute a CACM:
- Total Cash Compensation: According to the Division, total cash compensation could be a CACM so long as the registrant did not also distribute annual equity awards widely among its employee base.
- Social Security Taxes: Calculating annual compensation of employees on the basis of withheld social security taxes would likely not be a CACM, according to the Division, unless all employees earned less than the Social Security wage base.
The Division did acknowledge that it would not necessarily expect the CACM to identify the same median employee as would be identified using Annual Total Compensation.
Using Hourly or Annual Rates of Pay as a CACM (C&DI 128C.02)
According to C&DI 128C.02, the Division does not believe that the use of an hourly or annual pay rate alone is an appropriate CACM to identify the median employee. Item 402(u) does not permit making a full-time equivalent adjustment for part-time employees, and, according to the Division, using an hourly rate without taking into account the number of hours actually worked would be an attempt to do just that. Also, Item 402(u) does not permit a registrant to annualize pay except in limited circumstances; using only an annual rate, without regard to whether employees worked the entire year and were actually paid that amount during the year, would essentially be annualizing pay.
Determining Employee Population Versus Identifying Median Employee (C&DI 128C.03)
Item 402(u) requires a registrant to select a date within three months following 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, the registrant identifies the median employee from that population using either Annual Total Compensation or another CACM. According to C&DI 128C.03, a registrant is not required to use a period that includes the date on which the employee population is determined. Furthermore, according to the Division, the registrant is not required to use a full annual period. Annual Total Compensation from the registrant’s prior fiscal year may be considered a CACM, 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 the registrant’s pay distribution to its workforce.
Furloughed Employees (C&DI 128C.04)
Item 402(u) identifies only four classes of employees: full-time, part-time, temporary and seasonal. The rule does not specifically address furloughed employees. According to the Division, because “furlough” could have different meanings for different employers, registrants should, based on facts and circumstances, first determine whether the furloughed worker is, in fact, an employee. If the furloughed worker is determined to be an employee of the registrant on the date that the employee population is determined, then the registrant must determine the furloughed worker’s compensation using the same method as for a non furloughed employee. Because Item 402(u)(3) of Regulation S-K identifies four classes of employees—full-time, part-time, temporary and seasonal - the registrant must determine in which class the furloughed employee belongs on that date and determine the individual’s compensation using Annual Total Compensation or another CACM.
Reiterating Instruction 5 of Item 402(u), C&DI 128C.04 points out that a registrant may annualize the total compensation for all permanent employees (full-time or part-time) who were employed by the registrant for less than the full fiscal year or who were on an unpaid leave of absence during that period. However, a registrant may not annualize the total compensation for employees in temporary or seasonal positions. Additionally, a registrant may not make a full-time equivalent adjustment for any employee.
Independent Contractors and Leased Workers (C&DI 128C.05)
According to the Division, a registrant should include a worker as an “employee” for the purposes of Item 402(u) if the worker compensation is determined by the registrant or one of its consolidated subsidiaries. This is true, according to the Division, regardless of whether such worker would be considered an “employee” for tax or employment law purposes. When a registrant obtains services of workers by contracting with an unaffiliated third party that employs the workers, the Division does not believe that the registrant is determining the workers’ compensation for purposes of Item 402(u) if the registrant specifies only that those workers receive a minimum level of compensation. Furthermore, the Division believes that an individual who is an independent contractor may be the “unaffiliated third party” who determines his or her own compensation.