The SEC’s Division of Corporation Finance posted five new Compliance and Disclosure Interpretations (C&DIs) regarding the pay ratio disclosure requirements in Item 402(u) of Regulation S-K on October 18, 2016. The “pay ratio” rule, which is mandated by the Dodd-Frank Act, requires public companies to disclose the median annual total compensation of its employees, the annual total compensation of its CEO, and the “pay ratio” of those two amounts. Disclosure of the pay ratio is required with respect to the first fiscal year beginning on or after January 1, 2017, so for calendar-year companies, the first disclosure will be required in their 2018 proxy statements and will be based on 2017 compensation.

Below is a brief summary of the five new C&DIs, which all relate to determining the median employee for purposes of calculating the ratio:

1. Use of a consistently applied compensation measure (CACM) to identify the median employee: The rules allow a company to use a CACM instead of annual total compensation calculated in accordance with Item 402(c)(2)(x) of Regulation S-K, so long as the CACM reasonably reflects its employees’ annual compensation. The C&DI provides two examples of measures that would likely not be a CACM:

• Total cash compensation when the company widely distributes annual equity awards
• Social Security taxes withheld, unless all employees earned less than the Social Security wage base

The company should briefly describe the CACM that is used, and the C&DI confirmed that the use of the CACM does not have to result in the selection of the same median employee who would have been identified using annual total compensation.

2. Use of hourly or annual pay rates as a CACM: A company may not use hourly or annual pay rates as its CACM, as using a pay rate without taking into account the number of hours actually worked is similar to annualizing the pay of part-time employees, which is expressly prohibited.

3. Time period used to identify the median employee: The rules require a company to identify its employee population as of a date within the last three months of its fiscal year, and then use a CACM in order to identify its median employee as of that date. When a company applies the CACM to identify the median employee, the company does not have to use a time period that includes the date on which the employee population is determined and it does not have to use a full annual period.

4. Determining whether a furloughed employee should be included in the employee population: The rules do not address furloughed employees and only recognize four classes of employees: full-time, part-time, temporary and seasonal. It is up to a company to determine in which of these classes an employee fits, and then calculate the compensation of the employees in that class in accordance with the rules. A company may annualize the compensation for full-time and part-time employees who were not employed during the entire fiscal year, but may not annualize the compensation of temporary or seasonal employees.

5. Determining whether a worker is an “employee”: Independent contractors or leased workers may be excluded from a company’s employee population if an unaffiliated third party determines their compensation. The C&DI emphasizes that whether a company determines an individual’s compensation does not coincide with whether the individual is considered an “employee” for tax or employment law purposes.

Since the pay ratio disclosure will be required in 2018 proxy statements based on 2017 compensation, public companies should begin developing an appropriate methodology for determining the median employee and calculating his or her compensation at this time. Here is a link to the five new C&DIs available on the SEC’s website.