Despite some speculation that the new leadership within the Securities and Exchange Commission (SEC) would seek to delay the effectiveness of the CEO pay ratio disclosure rules mandated by the Dodd-Frank Act, the SEC recently confirmed that the new disclosure will go into effect, as scheduled, in the 2018 proxy season. To assist companies in preparing for the new disclosure, the SEC published interpretive guidance (Commission Guidance) on September 21, 2017. The Staff of the Division of Corporation Finance published its own interpretive guidance and updated its Compliance and Disclosure Interpretations (Staff Guidance) on the same date.
The CEO pay ratio disclosure rules codified in Item 402(u) of Regulation S-K implement Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) require disclosure of (i) the median of the annual total compensation of all employees of the company, except the CEO of the company; (ii) the annual total compensation of the CEO of the company; and (iii) the ratio of the amount in (ii) to the amount in (i). Neither Dodd-Frank nor the final SEC rules mandate the exact methodology that companies must use to prepare the required disclosure, and companies have been struggling with establishing the appropriate processes to gather the underlying data, including identifying the “median employee.”
Collectively, the SEC Guidance and the Staff Guidance clarify that the SEC understands the practical challenges imposed by this new disclosure requirement and the different approaches companies may take to provide such disclosure. Key highlights from this new guidance are as follows:
- Employee Determinations. Companies may use any widely recognized tests for determining who its “employees” are, including those tests used today under applicable employment or tax law. In particular, the SEC guidance specifically mentions the employee classification test under tax laws. This interpretation eases concerns that many service providers who are treated as independent contractors for tax and other purposes would have to be treated as employees for purposes of the pay ratio rules.
- Median Employee Determinations. Likewise, to identify the “median employee,” companies may use existing corporate records, such as payroll or tax records, which reasonably reflect annual compensation, notwithstanding the fact that such records may not reflect every element of employee compensation, such as employee equity incentives. Where one employee’s annual compensation is determined to be anomalous, a company is permitted to substitute another employee with substantially similar compensation, but the company must disclose any such modifications when providing the required disclosure relating to the methodologies used by the company.
- Any Reasonable Estimates, Assumptions and Methodologies May Be Used – As Long As They Are Disclosed. Perhaps the most helpful aspect of the SEC’s new guidance was the clarification that companies are permitted to use reasonable estimates, assumptions and methodologies to identify the median employee and calculate the total compensation for employees other than the CEO, but the company must disclose in the proxy statement the estimates, assumptions and methodologies used. The SEC specifically stated that it would not bring an enforcement action against a company under the pay ratio disclosure rules as long as the disclosure was made in good faith and on a reasonable basis. Calculating the CEO pay ratio involves a degree of imprecision, and this statement may be helpful to avoid potential liability due to actual or perceived calculation errors.
- Statistical Sampling. Despite the fact that prior SEC guidance had made it clear that companies may use statistical sampling (as well as other methods) to identify the median employee, the SEC offered further clarification that companies have the ability to combine different sampling or determination methods depending on their own unique facts and circumstances. For example, companies with significant overseas employees operating in multiple jurisdictions may use statistical sampling for such employees but more straightforward methods (such as W-2s) for its US employees. The SEC provides suggestions on many approaches companies can consider in this regard.