SEC Issues C&DIs on CEO Pay Ratio Disclosure, Exempt Offerings Under Rule 701 and Sales of Securities Under Rule 144(d)

Highlights 

CEO Pay Ratio Disclosure C&DIs 

• The appropriateness of a compensation measure to identify the median employee depends on a company’s particular facts and circumstances, and any measure that reasonably reflects the annual compensation of employees may serve as a compensation measure. 
• Workers whose compensation is determined by a company should be included in the determination of the company’s employee population regardless of whether such workers would be considered “employees” for tax or employment law purposes. 

Rule 701 and Rule 144(d) C&DIs 

• Issuers reporting under the Securities Exchange Act of 1934 are not required to register the offer and sale of shares issuable upon the exercise of options where the issuance of such shares became the obligation of the reporting issuer as the result of the acquisition of a private company. 
• The holding period under Rule 144(d) for restricted securities received by an employee pursuant to an individually negotiated employment agreement begins when the employee is deemed to have paid for such securities. 

The U.S. Securities and Exchange Commission (the “Commission”) issued five Compliance and Disclosure Interpretations (“C&DIs”) on October 18, 2016, addressing certain aspects regarding the CEO pay ratio disclosure rules, as set forth in Item 402(u) of Regulation S-K. The C&DIs covered two main topics: (i) the use of a consistently applied compensation measure in identifying a company’s median employee; and (ii) the application of the term “employee” to furloughed employees and independent contractors or “leased” workers. The new pay ratio disclosure C&DIs are discussed in detail below under the heading “Guidance on CEO Pay Ratio Disclosure.” 

On October 19, 2016, the Commission issued one new C&DI and two revised C&DIs relating to the Securities Act of 1933, as amended (the “Securities Act”). The new C&DI and one of the revised C&DIs relate to exempt offerings and sales of securities pursuant to Rule 701 and the other revised C&DI relates to the holding period for restricted securities under Rule 144(d). These C&DIs are discussed in detail below under the heading “Guidance on Exempt Offerings under Rule 701 and Sales of Securities under Rule 144(d).” 

Guidance on CEO Pay Ratio Disclosure 

Consistently Applied Compensation Measures (C&DIs 128C.01 - 03) 

Item 402(u) of Regulation S-K allows a company to identify its median employee by using annual total compensation or any other compensation measure that is consistently applied (a “CACM”) to all employees included in the calculation. The Commission allows a company to use a CACM other than annual total compensation in identifying its median employee because of concerns about the expected compliance costs of calculating annual total compensation for all employees. 

Under the CEO pay ratio rule, a company may use any CACM that reasonably reflects annual compensation of employees in determining its median employee. According to the C&DIs, the appropriateness of a measure depends on the company’s particular facts and circumstances. For example, total cash compensation may be an appropriate CACM unless the company widely distributes equity awards to its employees. In contrast, Social Security taxes withheld would likely not be an appropriate CACM unless all employees earned less than the Social Security wage base. In addition, the Commission accepts that the CACM will not necessarily identify the same median employee as would be identified using annual total compensation. Also, the C&DIs indicate that using hourly or annual pay rates to identify the median employee is not, by itself, appropriate. Companies must also take into account hours actually worked or amounts actually paid. 

The C&DIs also address the time period to use when a company uses a CACM to identify the median employee. According to the C&DIs, there are two important times in the calculation of the CEO pay ratio: 

1. the time at which the employee population is determined (the “Population Date”), which must be within three months of the end of the company’s fiscal year; and
2. the time period during which the annual total compensation or other CACM is determined for the population of employees and used to identify the median employee within such population (the “Compensation Period”). 

The C&DIs clarify that the Population Date need not fall within the Compensation Period. In addition, the Compensation Period is not required to be a full annual period. Moreover, a CACM may consist of annual total compensation from the company’s prior fiscal year so long as there has not been a change in the employee population or employee compensation arrangements that would result in a significant change of the company’s pay distribution. 

Employees (C&DIs 128C.04 - 05) 

Furloughed Employees 

The C&DIs discuss whether the employee population used in identifying a company’s median employee should include furloughed employees and, if so, how the furloughed employee’s compensation should be calculated. Noting that Item 402(u) does not define or even address furloughed employees, the Commission determined that, assuming the furloughed worker meets the definition of “employee” for purposes of the CEO pay ratio rule, he or she should be included in the employee population and his or her compensation should be determined by the same means as for a non-furloughed employee. Consistent with these rules, if the furloughed employee is a permanent employee (full-time or part-time), the company is permitted to annualize his or her compensation for purposes of identifying the median employee. 

Independent Contractors and “Leased” Workers 

For purposes of the CEO pay ratio disclosure rule, the definition of employee does not include workers who are employed, and whose compensation is determined, by an unaffiliated third party but who provide services to the company as independent contractors or “leased” workers. The C&DIs address the circumstances under which workers are considered to be independent contractors or leased workers for purposes of the rule, as well as when a company is considered to be determining the compensation of a worker. The Commission observed that in order to determine whether a worker is an “employee” of the company, the company should consider the composition of its workforce and its overall compensation practices. Workers whose compensation the company determines should be included regardless of whether these workers would be considered “employees” for tax or employment law purposes. 

In a situation where a company obtains services of workers through an unaffiliated third party that employs those workers, the Commission does not believe that the company determines the workers’ compensation even if, for example, the company specifies that those workers receive a minimum level of compensation. The Commission also observed that an individual who is an independent contractor may be an “unaffiliated third party” who determines his or her own compensation. 

Guidance on Exempt Offerings under Rule 701 and Sales of Securities under Rule 144(d) 

Exempt Offerings (C&DIs 271.04 and 271.24) 

In a revised C&DI the Commission states that issuers reporting under the Securities Exchange Act of 1934 (the “Exchange Act”) are not required to register the offer and sale of shares issuable upon the exercise of options where the issuance of such shares became the obligation of the reporting issuer following its acquisition of a private company not previously subject to the reporting requirements pursuant to the Exchange Act (a “non-reporting company”). In the original version of the C&DI, which was issued in January 2009, the Commission indicated that when a non-reporting company is acquired by a reporting company, and options issued by the non-reporting company in reliance on Rule 701 are assumed by the reporting company and converted into options to acquire shares of the reporting company, the reporting company may not rely on Rule 701 to exempt the exercise of such options. The revised C&DI reverses the Commission’s prior interpretation with respect to Rule 701 and extends the exemption for sales of securities by non-reporting companies under Rule 701(b)(2) to a reporting company’s issuance of securities upon exercise of options assumed from an acquired non-reporting company. The revised C&DI also clarifies that the reporting company’s disclosures under the Exchange Act will satisfy the disclosure requirements called for under Rule 701(e). 

A new C&DI addresses exempt offers and sales of restricted stock unit (“RSU”) awards under Rule 701 to employees and the timing requirements for delivery of the additional information specified in paragraphs (1) through (4) of Rule 701(e), if, over a 12-month period, the issuer sells an aggregate amount of securities (including the RSUs) in excess of US$5 million. The new C&DI provides that, under such circumstances, the issuer must deliver the required additional information to investors within “a reasonable period of time before the date of the sale” of the securities. For purposes of the sale of RSUs that relies on Rule 701for exemption, the date of sale is the date the RSU award is made. The additional information required under Rule 701(e) must, therefore, be provided to investors within a reasonable time before the date the RSU award is granted. Though RSUs are typically considered derivative securities, the Commission noted in the C&DI that Item 701(e)(6), which relates to the exercise or conversion of derivative securities, does not apply because the RSUs do not need to be exercised or converted. 

Sales of Securities (C&DI 532.06) 

A revised C&DI clarifies the Commission’s prior interpretive response with respect to the holding period for restricted securities issued pursuant to a written agreement under Rule 144(d), particularly the time when such holding period begins to run. In the original C&DI, which was issued in January 2009, the Commission stated that, “where restricted securities are issued to an employee in connection with an individually negotiated employment agreement,” the holding period under Rule 144(d) with respect to such restricted securities begins to run at the time such employee’s securities vest, subject to the fulfillment of any applicable conditions. The revised C&DI clarifies that the holding period under Rule 144(d) for restricted securities received by an employee pursuant to an individually negotiated employment agreement begins when the recipient of such restricted securities is deemed to have paid for the securities and thereby assumed the full risk of economic loss with respect thereto. For full-value awards, if the vesting of the securities is conditioned solely on continued employment and/or satisfaction of performance conditions that are not tied to the employee’s individual performance and the employee pays no further consideration for the securities, the date investment risk passes to the employee would be the date of the employment agreement. For awards that require additional payment upon exercise, conversion or settlement, the date investment risk passes to the employee would be the date when such additional payment is made.