SEC Issues Additional Guidance
In testimony last week before the Senate Committee on Banking, Housing and Urban Affairs, Securities and Exchange Commission (SEC) Chair Jay Clayton advised that the pay ratio disclosure rule “will continue to be implemented on schedule.”1 To that end, the SEC and the Staff of the SEC’s Division of Corporation Finance recently issued new guidance to assist companies in preparing their pay ratio disclosure as the compliance date approaches. Under the final rule adopted by the SEC in 2015 to implement Dodd-Frank’s mandated pay ratio disclosure requirement, public companies must provide pay ratio disclosure for the first fiscal year beginning on or after January 1, 2017. The pay ratio rule requires a public company to disclose (i) the median annual total compensation of its employed workforce (other than its CEO), (ii) the annual total compensation of its CEO, and (iii) the ratio of those two amounts.
The new pay ratio guidance collectively consists of a SEC interpretive release; Staff guidance regarding methods for calculating pay ratio disclosure; and new and revised Staff Compliance and Disclosure Interpretations (C&DIs) that update previously issued C&DIs. In response to feedback received by the SEC and with a view to assisting companies in complying with the disclosure rule while reducing their costs of doing so, the guidance principally focuses on the following:
- Use of reasonable estimates, assumptions and methodologies and statistical samplings;
- Use of internal records to determine the median employee; and
- Independent contractors and determination of who is an “employee”
Use of Reasonable Estimates, Assumptions and Methodologies, and Statistical Sampling
The pay ratio rule affords companies flexibility in determining pay ratio disclosure. For example, the instructions to Item 402(u) of Regulation S-K provide that a company may use reasonable estimates in the methodology used to identify its median employee and also in calculating the annual total compensation or any elements of total compensation for employees (other than the CEO). The instructions also permit a company to use its employee population or statistical sampling and/or other reasonable methods in determining the employees from which the median employee is identified.
The new guidance assuages concerns about the imprecision in disclosure derived from estimates, assumptions and statistical sampling. The SEC’s view is that if a company “uses reasonable estimates, assumptions or methodologies, the pay ratio and related disclosure that results from such use would not provide the basis for Commission enforcement action unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith.”2 Consistent with that view, the Staff of the Division of Corporation Finance confirmed that it would not object to a company’s statement that its pay ratio is a reasonable estimate calculated in a manner consistent with the rule.3 The Staff guidance provides examples of situations where companies may use reasonable estimates, as well as examples of sampling and other reasonable methods that may be used. Hypothetical examples are also presented to better assist companies in determining how they may appropriately use statistical sampling and other reasonable methods and the flexibility available to them.
Use of Internal Records to Determine Median Employee
The pay ratio rule requires a company to disclose the median of the annual total compensation of all of its employees, other than its CEO.4 Under the instructions to the rule, a company may identify its median employee by using a consistently applied compensation measure. The SEC’s interpretive release clarifies that, to identify its median employee, a company may use existing internal records (such as tax or payroll records) that reasonably reflect annual compensation, even if those records do not include every element of compensation, such as widely distributed equity awards. If a median employee has been identified based on internal records but a company determines that there are anomalous characteristics of the employee’s compensation that have a significant impact on the pay ratio, the guidance reiterates that the company may substitute another employee with substantially similar compensation based on the consistently applied compensation measure it used to select the original median employee. In determining the median of the total annual compensation of all its employees, a company is permitted under the pay ratio rule to exempt non-U.S. employees where those employees account for 5% or less of the company’s total U.S. and non-U.S. employees, subject to certain limitations.5 The new guidance clarifies that a company may use appropriate existing internal records (such as tax or payroll records) in determining whether the 5% de minimis exemption is available.
Independent Contractors and Determination of Who Is an “Employee”
In determining whether a worker is an “employee” for purposes of pay ratio disclosure, companies are instructed under the rule that 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 new guidance clarifies that this exclusion was not intended to be the exclusive basis for determining whether a worker is an employee or independent contractor, and recognizes that companies may already make such determinations for other legal or regulatory purposes (such as under employment law or for tax purposes). Accordingly, the guidance acknowledges that a company may apply a widely recognized test under another area of law that the company otherwise uses to determine whether its workers are employees.
It is clear that the SEC and the Staff recognize the challenges that public companies may face in complying with the mandated pay ratio disclosure. The new guidance clarifies some of the ambiguities in the disclosure requirement that became more apparent as companies began implementing their compliance efforts and permits companies to use operational information and certain other available information in an effort to reduce the costs associated with compliance. As Chair Clayton informed the Senate Committee, “the Staff will continue to monitor the rollout of the rule, in particular for whether unanticipated costs or difficulties have arisen.” In the meantime, we suggest that companies begin to collect information and prepare now for upcoming compliance with the pay ratio rule.