SEC Issues Additional Guidance on CEO Pay Ratio Rule

On September 21, 2017, the U.S. Securities and Exchange Commission (SEC) released several items that provide additional guidance on the CEO Pay Ratio Rule (the “Rule”):

(1)   SEC interpretive guidance;

(2)   Revised pay ratio Compliance and Disclosure Interpretations (C&DIs) reflecting the SEC’s interpretive guidance; and

(3)   A separate guidance released by the staff of the SEC’s Division of Corporation Finance.

The additional guidance confirmed that the SEC does not plan to postpone the effective date of the Rule.  This means that calendar-year public companies must be ready to disclose their pay ratio in their 2018 proxy statements as has been contemplated.  However, the new guidance should simplify a public company’s ability to comply with the Rule in a more cost effective way by permitting the exclusion of independent contractors from such calculation, the use of records already generated by the public company in identifying the median employee and the expanded use of estimates and statistical sampling.  Additionally, the SEC’s guidance makes clear that so long as a public company is in good faith utilizing a reasonable basis to comply with the Rule, this disclosure will not form the basis for a SEC enforcement action. 

SEC Interpretive Guidance and Changes to the C&DIs

Independent Contractors

New guidance regarding independent contractors should make the calculation of the median employee simpler by eliminating the requirement to make a separate worker classification solely for the purpose of calculating the pay ratio. Specifically:

• Contrary to one of the SEC’s C&DIs issued in October 2016, the new interpretive guidance provides that a public company can determine whether a worker is an “employee” for purposes of the Rule by applying a widely recognized test used under another of area of law, such as tax law or employment law; and
• The C&DI issued in October 2016, which suggested that independent contractors could only be excluded if their pay was determined by an unaffiliated third party rather than the registrant itself, has now been withdrawn.

Use of Internal Records

The interpretive guidance provides that registrants can use tax, payroll and other existing internal records as estimates in the following two circumstances:

• De minimis exemption – a public company can use internal records to determine whether the number of employees in a certain foreign jurisdiction is small enough to allow the public company to exclude such employees under the 5 percent de minimis exemption; and
• Median employee – a public company can also use internal pay records as its “consistently applied compensation measure” (CACM) to identify its median employee as long as the internal pay records reasonably reflects annual compensation, “even if those records do not include every element of compensation, such as equity awards widely distributed to employees.”  This provides public companies with more flexibility to use internal pay records than did the previously issued C&DI, which stated that total cash compensation could be a CACM unless the registrant also distributed equity awards widely among its employees.  That C&DI has been amended to reflect the new interpretive guidance.

However, note that internal records cannot be used to calculate the total compensation of the median employee once the median employee is identified.  According to Item 402(u)(2) of Regulation S-K, this calculation should be done using the same process as the public company uses to calculate the total compensation of its principal executive officer (though other reasonable estimates can still be used if exact data is unavailable according to Instruction 4 to Item 402(u) of Regulation S-K).

SEC Enforcement Actions

The interpretive guidance acknowledges that pay ratio disclosures will “involve a degree of imprecision” given that reasonable estimates and statistical sampling are permitted.  As such, the interpretive guidance provides that the ratio and disclosure that results from a public company using reasonable estimates would not provide the basis for an enforcement action unless the disclosure lacked a “reasonable basis or was provided other than in good faith.”   In addition, new C&DI Question 128C.06 provides that “the staff would not object if a registrant states in any required disclosure that the pay ratio is a reasonable estimate calculated in a manner consistent with Item 402(u).”

Division of Corporation Finance Guidance

The guidance published by the staff of the Division of Corporation Finance focuses on the use of reasonable estimates and statistical sampling in determining the median employee. Overall, the staff guidance reiterates that public companies have wide latitude to use statistical sampling and reasonable estimates to arrive at the pay ratio. 

Highlights of the guidance provided by the staff regarding statistical sampling and reasonable estimates are as follows:

• Public companies can use “reasonable estimates” at all stages of calculating the median employee’s compensation, including but not limited to analyzing the composition of the public company’s workforce, calculating a CACM, identifying the median employee, calculating the annual total compensation or elements of total compensation of the median employee, and evaluating the likelihood of significant changes in employee compensation from year to year;
• Statistical sampling methods may include, but are not limited to, simple random sampling, stratified sampling, cluster sampling, and systematic sampling;
• Public companies are not required to use the same statistical sampling method for all geographic locations and/or business units;
• Public companies may use statistical sampling for one location or business unit without having to use statistical sampling for all locations/business units; and
• Public companies may use other statistical techniques in addition to sampling when determining the median employee, such as imputing or correcting missing data points and addressing outliers.

The staff’s guidance also includes a number of hypothetical examples of the application of statistical sampling and other techniques to locate the median employee, with specific attention paid to challenges faced by large public companies with a complex global workforce.  While these examples provide companies with helpful ideas on how to best sample their workforces, the staff notes that the examples “are not meant to suggest that registrants must follow any particular approach” so public companies should not feel constrained to the approaches specifically mentioned in the guidance.