The CEO pay ratio disclosure requirement of Regulation S-K, Item 402(u) mandated by section 953(b) of the Dodd-Frank Act requires most publicly held companies to disclose, among other matters, the ratio of the compensation of the CEO to the compensation of the company’s median employee, excluding the CEO, beginning in the 2018 proxy season. For more detail, see our White Paper SEC Adopts Pay Ratio Disclosure Rule, The Securities and Exchange Commission (SEC) has confirmed that it does not plan to postpone the effective date of the CEO pay ratio rule.

Companies are in the midst of establishing the processes to gather the data and determining the methodologies to use to identify the median employee for the pay ratio disclosure. Many companies are also thinking about whether to issue internal communications to put the pay ratio, once disclosed, into context for their employees. The process of gathering the data for the pay ratio can be daunting. Fortunately, recent guidance from the SEC (in the form of interpretive guidance and Division of Corporation Finance guidance) provides companies with helpful suggestions on how to approach this task to ultimately develop their pay ratio disclosure.

The key points of the new guidance are as follows:

  1. Reasonable Estimates, Assumptions, and Methodologies: Companies may use reasonable estimates, assumptions, and methodologies for identifying the median employee and calculating total compensation for employees other than the CEO. The proxy must disclose the estimates, assumptions, and methodologies used. The SEC’s recent guidance clarified that, if reasonable estimates, assumptions, and methodologies are used, there will be no basis for an SEC enforcement action if the resulting pay ratio and related disclosures are made on a reasonable basis and in good faith.
  2. Employee Determinations: Companies may use a widely recognized test under another area of law, such as tax or employment law, to determine who is an employee for purposes of the CEO pay ratio (e.g., whether an individual receives a Form W-2 or Form 1099). There is no need to conduct a separate employee/independent contractor analysis for purposes of the CEO pay ratio, and the SEC Compliance and Disclosure Interpretation that created confusion on this point has been removed.
  3. Median Employee Determinations: To identify the median employee, companies may use existing internal records, such as tax or payroll records, which reasonably reflect annual compensation, even if those records do not include every element of compensation, such as equity awards widely distributed to employees. Where use of a consistently applied compensation measure identifies a median employee whose compensation package contains anomalies that significantly impact the pay ratio, companies may substitute another employee with substantially similar compensation (and must disclose this substitution when describing the methodology used).
  4. Combining Methods and Useful Guidance Regarding Statistical Sampling: Previous guidance indicated that companies may apply statistical sampling and other methods to identify the median employee. The SEC has clarified that companies are permitted to combine methods, applying the ones that best suit the facts and circumstances. For instance, a company may choose a statistical sampling method to identify the median employee for its overseas operations while relying on more exact calculations based on Forms W-2 for its domestic employees. The guidance provides examples of various kinds of sampling (which is particularly helpful for companies with multinational operations), identifies situations where other reasonable methods may be appropriate, and provides fact patterns on how one or more methods may be applied.