SEC Staff Issues Guidance on CEO Pay Ratio Disclosure Rules

October 28, 2016

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On October 18, 2016, the Staff of the Securities and Exchange Commission’s Division of Corporation Finance published guidance on Item 402(u) of Regulation S-K, the rule it adopted in 2015 to implement Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 953(b) requires public companies to disclose the relationship between the annual total compensation of their Chief Executive Officer and the median of the annual total compensation of all their employees.

As companies have begun to delve into the compliance requirements of the CEO pay ratio rule, including developing a “sample” pay ratio calculation, numerous questions have arisen as to how to apply the rule to their specific facts. Unsurprisingly, the majority of these questions involve the process for identifying the “median employee.” To assist companies, the SEC Staff has issued five Compliance and Disclosure Interpretations that address the most common questions that have been received to date on how to identify the “median employee,” including:

  • How to determine when independent contractors and “leased” workers should be included in your employee population;
  • What time period may be used in applying a “consistently applied compensation measure” to identify the “median employee;” and
  • What type of compensation may be used as the “consistently applied compensation measure.”

This Thoughtful Disclosure Alert summarizes the key aspects of the SEC Staff guidance. Download the Compliance and Disclosure Interpretations »

Treatment of Independent Contractors

The fundamental requirement of the CEO pay ratio rule is that companies disclose the ratio of the median of the annual total compensation of all employees with the annual total compensation of their Chief Executive Officer. For this purpose, the “median employee” is to be identified from the overall population of the company (and its consolidated subsidiaries). Item 402(u) provides that, for purposes of determining a company’s employees, workers who provide services to the company as independent contractors or “leased” workers” and who are employed, and whose compensation is determined, by an unaffiliated third party do not need to be included in the employee population. This statement has resulted in numerous questions as to whether, by negative implication, workers who provide services as independent contractors and whose compensation is not determined by an unaffiliated third party must be treated as employees.

The SEC Staff guidance (C&DI 128C.05) addresses this question by noting that, regardless of whether a worker who is providing services to a company would be considered an “employee” for tax or employment law purposes, whether a worker is an employee for purposes of the CEO pay ratio rule is to be determined by considering the composition of a company’s workforce and its overall employment and compensation practices. Where the company obtains the services of workers by contracting with an unaffiliated third party that employs the workers, the company would not be considered to be determining the workers’ compensation for purposes of the rule. Further, this would be true even where, for example, the company only specifies that these workers receive a minimum level of compensation. Also, the Staff notes that an individual who is an independent contractor may be the “unaffiliated third party” who determines his or her own compensation.

Initial Observations. While the SEC Staff guidance resolves any lingering uncertainty as to whether independent contractors who do not qualify for the stated exemption must be evaluated for possible inclusion in a company’s employee population, it does not offer a dispositive framework for making this evaluation. Nonetheless, its reference to considering the composition of a company’s workforce and its overall employment and compensation practices when classifying workers should be helpful to most companies with a significant number of non-employee workers. Further, where a company retains one or more independent contractors who are truly self-employed (such as a professional advisor), it should be able to exclude such individuals even though they are not actually employed by a third party.

Selection of Determination Date

To identify the specific members of its employee population that will be used to identify the “median employee,” a company may select any date within the last three months of its last completed fiscal year. The obvious advantage of selecting a date earlier than the last day of the fiscal year is that it gives the company additional time within which to collect the needed compensation data to identify the “median employee.” Of course, this advantage is somewhat limited if the company must wait until fiscal year-end to obtain this data.

The SEC Staff guidance (C&DI 128C.03) provides that for purposes of applying a “consistently applied compensation measure” 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 a full annual period. Further, a “consistently applied compensation measure” 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.

The SEC Staff guidance (C&DI 128C.04) further provides that, in the case of “furloughed” workers, companies will need to determine whether they should be included in their employee population based on their particular facts and circumstances. Where a 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.

Initial Observations. This SEC Staff guidance should make it much easier for companies to integrate the collection and analysis of the compensation data necessary to identify the “median employee” into their proxy statement preparation process. Prior to the Staff's guidance, it was unclear whether selecting a determination date that preceded the last day of the last completed fiscal year served any useful purpose if a company had to wait until fiscal year end to gather the pay data needed to identify its “median employee.” As long as the selected compensation measure is consistently applied, a company is permitted to use partial year information – or, under certain circumstances, even information from the prior fiscal year – to evaluate its employees as of the determination date.

Selection of Compensation Measure

Once a company has determined and identified its employee population, it may identify the “median employee” from this population using either annual total compensation or another compensation measure that is consistently applied to all employees, such as data derived from its tax and/or payroll records. In applying this principle, questions have arisen as to what constitutes a permissible compensation measure.

The SEC Staff guidance (C&DI 128C.01) provides that any measure that reasonably reflects the annual compensation of a company’s employees may serve as a “consistently applied compensation measure.” Further, the appropriateness of any measure will depend on the company’s particular facts and circumstances.

For example, total cash compensation may qualify as a consistently applied compensation measure unless the company also distributes annual equity awards widely among its employees. In contrast, Social Security taxes withheld would likely not be a consistently applied compensation measure unless all employees earned less than the Social Security wage base. The Staff guidance (C&DI 128C.02) also provides that a company may not exclusively use hourly or annual rates of pay as its consistently applied compensation measure. While 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 will not be an appropriate compensation measure for this purpose.

Initial Observations. The SEC Staff guidance makes clear that any “consistently applied compensation measure” must reflect the overall compensation paid or earned during the selected pay period, rather than just the rate of pay. While we expect that most companies will use some measure of cash compensation, such as Form W-2 wages or total cash compensation, as its compensation measure, the Staff’s observation that cash compensation would not be appropriate where a company also grants equity awards “widely” within the organization confirms that the selected measure must reflect the company’s compensation structure to be an acceptable alternative to using annual total compensation. This interpretation may prove problematic for technology companies that grant equity awards to substantially all of their employees, as it may limit their ability to select a wholly cash-based compensation measure.

Disclosure Not Required Until 2018

As reflected in the final rule, the CEO pay ratio rule applies to compensation provided for the first full fiscal year beginning on or after January 1, 2017. Thus, companies with calendar year fiscal year-ends will first provide the disclosure during the 2018 proxy season with respect to their 2017 compensation.

As more companies begin to focus on the application of the CEO pay ratio disclosure requirement – and the intricacies of Item 402(u) – to their specific situations, it is possible that additional guidance may be forthcoming in the months ahead.

Need Assistance?

Compensia can assist companies in preparing their CEO pay ratio disclosure, including developing a process for identifying their “median employee.” If you would like assistance in understanding how the CEO pay ratio disclosure requirement will affect your company, preparing your initial CEO pay ratio disclosure, or if you have any questions on the subjects addressed in this Thoughtful Disclosure Alert, please contact Mark A. Borges.