It has been three proxy seasons since the CEO pay ratio became the mandatory disclosure for most U.S. public companies. The CEO pay ratio rules allow a registrant to use the same median employee for comparison purposes for up to three years, unless there has been a change in the registrant’s employee population or compensation arrangements that the registrant reasonably believes would result in a significant change in the disclosure. Companies that have relied on the same initial median employee determination from year one will need to select a new median employee for this upcoming proxy season. This memorandum provides a refresher on the rules for selecting a median employee and discusses additional related disclosure considerations to keep in mind if your company instituted reductions in force this year due to COVID-19.
Item 402(u) of Regulation S-K requires U.S. public companies to disclose the median annual total compensation of all employees of the registrant (except the principal executive officer, or PEO), the total compensation of the PEO and the ratio or multiple of those two amounts, as well as a narrative disclosure regarding the methodology used to identify the median employee. The narrative must include any material assumptions, adjustments or estimates used to determine the median employee and to calculate annual total compensation.
When registrants, prepared to comply with the CEO, pay ratio rules for the first time, one challenge they faced was identifying the initial median employee. There are two key steps to identifying the median employee: (1) determining the employee population and (2) selecting the median employee from within the employee population using a consistently applied compensation measure, or CACM.
Choosing a Determination Date
Registrants may choose any date within the last three months of the registrant’s fiscal year (e.g., October through December for registrants with fiscal years that align with the calendar year) to determine the median employee. Only employees who are employed on the selected date will be taken into account when determining the median employee. If a different date is used from the prior year, registrants must disclose the new date and a brief explanation of the reason for the change. As noted below in “Selecting the Median Employee,” the date selected to determine the applicable employee population does not necessarily need to align with the period selected for the CACM.
The final rules define “employee” as all worldwide employees of the registrant and any of its consolidated subsidiaries. This includes full-time, part-time, seasonal and temporary employees, but not workers classified other than as employees, such as directors or independent contractors.
Registrants that have furloughed a portion of their employee population, a more common practice this year due to COVID-19, should consider whether to include furloughed employees in the median employee population. Item 402(u) does not define or address the treatment of furloughed employees; however, the SEC has issued guidance with respect to the pay ratio rule that addresses the inclusion of furloughed workers and indicates that registrants will need to determine whether furloughed workers ought to be included based on the registrant’s particular facts and circumstances. If a furloughed worker is determined to be an employee of the registrant on the date the employee population is determined, the furloughed worker’s compensation should be included using the same CACM as used for a non-furloughed employee.
Registrants may exclude certain non-U.S. employees from the employee population used to select the median employee.
Importantly, a registrant may use its full employee population, a statistical sampling or another reasonable method to determine the median employee. Registrants can make their own determinations of an appropriate sample size based upon the underlying distribution of compensation data. The SEC also stated that it would not object to a registrant describing its pay ratio as an estimate, provided it is reasonable and calculated in a manner consistent with Item 402(u).
Once a registrant has set its employee population, it may use any measure that reasonably reflects the annual compensation of employees as a CACM for selecting the median employee. Whether a particular CACM is reasonable depends on the registrant’s particular facts and circumstances. Certain acceptable methods include: (1) taxable W-2 wages, (2) total cash compensation and (3) base salary plus bonus, if that reasonably reflects the registrant’s compensation profile.
In applying the CACM, the registrant may annualize total compensation for any permanent full-time or part-time employees who did not work for the entire fiscal year because, for example, the employee was newly hired or had taken an unpaid leave of absence. If a furloughed employee is a permanent employee (full-time or part-time), the registrant is permitted to annualize a furloughed employee’s compensation. A registrant, however, may not annualize total compensation for temporary or seasonal workers or for purposes of making full-time equivalent adjustments. As noted above, in applying the CACM to identify the median employee, a registrant is not required to use a period that includes the date on which the employee population is determined nor is it required to use a full annual period.
The registrant may make a cost of living adjustment to the compensation of its employees in jurisdictions other than the jurisdiction in which the PEO resides, so long as the adjustment is applied to all employees outside of the PEO’s jurisdiction. If the registrant chooses to do so, it must describe the adjustment and disclose the pay ratio without the adjustment, which may lead to disclosure based on two different median employees.
As noted above, the CEO pay ratio rules allow a registrant to identify its median employee once every three years, unless there has been a change in its employee population or compensation arrangements that it reasonably believes would result in a significant change in the pay ratio disclosure.
During the three-year period, if there has been no significant change, but the median employee is no longer employed with the registrant (or has had a change in circumstances), the registrant may use another employee whose compensation is substantially similar to the original median employee based on the compensation measure used to identify the original median employee. If a registrant is using the same median employee as a prior year, it must disclose that it is doing so and briefly explain its rationale.
The registrant may also omit new employees in the applicable fiscal year who are onboarded as part of a transaction or acquisition, but must factor them in beginning in the first full fiscal year following the transaction. If the additional employees would result in a significant change, the registrant must identify a new median employee.
Registrants should consider whether they have kept the same median employee for the past three years or have otherwise had significant changes in their employee population or compensation arrangements such that a new median employee needs to be selected for the upcoming annual proxy. Registrants should be mindful that significant changes in their employee population during the year due to COVID-19 could necessitate the selection of a new median employee. Registrants that expect to identify a new median employee should begin the process of formulating a strategy and gathering required information to identify their employee population and determine their CACM for identifying their new median employee. Even though this may not be the first time through the process, it may still be time consuming and proxy season is fast approaching.