Big News! As many readers may already be aware, the SEC released an interpretive release, a press release, and new C&DIs related to the CEO pay ratio yesterday at the COB in Washington. I was just plugging in my flash drive to give a presentation on the CEO Pay Ratio Rules to the Minneapolis Chapter of NASPP when fellow blogger Liz Dunshee came to the podium with the announcement from SEC, which she read aloud for the assembled group (I am still recovering from eye surgery and cannot read well).

The various releases provide some very useful and welcome clarification. Three cheers for the SEC staff. Since I am out of town (and unable to read anyway), my colleagues Tom Moore, Nyron Persaud, and Ariane Andrade put together the following highlights regarding this new guidance:

  • Enforcement Guidance: The SEC acknowledges in the interpretive release that some imprecision is inherent in the preparation of pay ratio disclosures given that the data-gathering process and calculations involve several layers of estimation, adjustments, and statistical sampling. Accordingly, so long as companies use reasonable estimates, assumptions, or methodologies, the pay ratio itself and the corresponding disclosure will not provide the basis for a SEC enforcement action, unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith. In fact, newly issued C&DI Q/A 128C.06 seems to suggest that all companies should specifically describe their pay ratios as an estimate in their disclosures (assuming that such a statement could be made in good faith). It is not clear how this new guidance would impact any potential private litigation.
  • Employee Determinations: Previously, Item 402(u)(3) of Regulation S-K indicated that the definition of “employee” did not include workers who are employed, and whose compensation is determined by an unaffiliated third party. Based on this new guidance, however, issuers may, in the process of determining who is an “employee” for purposes of the pay ratio calculation, apply a widely recognized test under another area of law (e.g., tax or employment laws) that they would otherwise use to determine whether their workers are employees. For example, for a U.S. workforce, an issuer could now determine who is an employee for pay ratio purposes by whether or not an individual receives a Form W-2 or a Form 1099. The previous guidance provided by C&DI Q/A 128C.05 (now withdrawn) stated that a company had to include workers whose compensation it determined, regardless of any classification made under tax or employment laws.
  • Median Employee Determinations: Companies may use internal records that reasonably reflect annual compensation to identify the median employee, even if those records do not include every element of compensation, such as equity awards widely distributed to employees. Previously, C&DI Q/A 128C.01 said that total cash compensation could be a consistently applied compensation measure, unless the company widely distributed equity awards. Companies may want to consider updating or reassessing their CACM determinations based on this more flexible guidance.
  • Combining Methods. The Division of Corporate Finance clarified that companies may use a combination of statistical sampling and other reasonable methods in order to identify the median employee.
  • The Division of Corporate Finance provided examples of the types of statistical sampling methods that be may appropriate:
    • simple random sampling (drawing at random a certain number or proportion of employees from the entire employee population);
    • stratified sampling (dividing the employee population into strata, e.g., based on location, business unit, type of employee, collective bargaining agreement, or functional role and sampling within each strata);
    • cluster sampling (dividing the employee population into clusters based on some criterion, drawing a subset of clusters, and sampling observations within appropriately selected clusters;
    • cluster sampling may be conducted in one stage or multiple stages; and
    • systematic sampling (the sample is drawn according to a random starting point and a fixed sampling interval, every employee is drawn from a listing of employees sorted on the basis of some criterion).
  • In addition, the Division of Corporate Finance provided examples of situations where other reasonable methods may be appropriate:
    • analyzing the composition of the company’s workforce (by geographic unit, business unit, employee type);
    • characterizing the statistical distribution of compensation of the company’s employees and its parameters (e.g., a lognormal, beta, gamma, or another distribution, or a mixture of distributions—for example a mixture of two normal or lognormal distributions yielding a bimodal distribution);
    • calculating a consistent measure of compensation and annual total compensation or elements of the annual total compensation of the median employee;
    • evaluating the likelihood of significant changes in employee compensation from year to year;
    • identifying the median employee;
    • identifying multiple employees around the middle of the compensation spectrum; and
    • using the mid-point of a compensation range to estimate compensation.
  • The Division of Corporate Finance also provided examples of other reasonable methods:
    • making one or more distributional assumptions, such as assuming a lognormal or another distribution provided that the company has determined that the use of the assumption is appropriate given its own compensation distributions;
    • reasonable methods of imputing or correcting missing values; and
    • reasonable methods of addressing extreme observations, such as outliers.
  • Lastly, the Division of Corporate Finance provided a few illustrative examples of how statistical sampling and/or other reasonable methods may be applied in particular fact patterns.