As we have noted in previous Legal Updates, most public companies will be required, for the first time, to include pay ratio disclosure in their 2018 proxy statements. The pay ratio rule, which is contained in paragraph (u) of Item 402 of Regulation S-K, will require public companies to disclose:

  • the median of the annual total compensation of all employees other than the chief executive officer;
  • the annual total compensation of the chief executive officer; and
  • the ratio of these amounts.

The pay ratio rule, as well as previously issued guidance from the staff (Staff) of the Division of Corporation Finance of the US Securities and Exchange Commission (SEC), contains many details regarding how this calculation should be made and disclosed. For more information on the rule itself and previously issued guidance, see our Legal Updates “Understanding the SEC’s Pay Ratio Disclosure Rule and Its Implications,” dated August 20, 2015;1 “SEC Provides Pay Ratio Disclosure Guidance,” dated October 25, 2016;2 and“Get Ready for Pay Ratio,” dated September 6, 2017.3

On September 21, 2017, the SEC issued an interpretive release (Release) providing guidance to assist companies in their efforts to comply with the new pay ratio disclosure requirements.4 At the same time, the Staff provided additional guidance (Guidance) to assist companies in determining how to use statistical sampling and other reasonable methods to identify the median employee’s compensation.5 Finally, the Staff revised one previously issued compliance and disclosure interpretation (CDI), added a new CDI and withdrew one previously issued CDI relating to guidance on the methodology for applying compensation measures and determining the employee population to identify the median employee.6

The Release

In the Release, to assist companies in their compliance efforts, the SEC provided guidance on using:

  • reasonable estimates, assumptions and methodologies and statistical sampling in identifying the median employee and calculating the median employee’s annual total compensation;
  • internal records in determining the annual total compensation of all employees other than the chief executive officer; and
  • widely recognized tests to determine whether its workers are employees.

Use of Reasonable Estimates, Assumptions and Methodologies and Statistical Sampling

The pay ratio disclosure rule gives companies flexibility to select a method for identifying the median employee and calculating an annual compensation for that person that is appropriate to the size and structure of their businesses and compensation programs. Companies may identify the median employee based on any consistently applied compensation measure (CACM), such as compensation amounts reported in their tax and/or payroll records. 

In the Release, the SEC makes clear that the required disclosure may be based on: 

  • a company’s reasonable belief; 
  • use of reasonable estimates, assumptions and methodologies; and 
  • reasonable efforts to prepare the disclosures.  

Further, the SEC stated that, in its view, 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 [SEC] enforcement action unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith.”

Use of Internal Records

As noted earlier, the pay ratio disclosure rules require companies to disclose “the median of the annual total compensation of all employees other than the chief executive officer.” In the Release, the SEC provided guidance as to how existing internal records can be used to make this determination. First, in determining whether to take advantage of the de minimis exemption that applies if non-US employees account for 5 percent or less of a company’s total employees, the SEC clarified that a company may make use of appropriate existing internal records, such as tax or payroll records. Second, the SEC clarified that in many circumstances existing internal records may be used to identify a company’s median employee. In particular, a company “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.”  

Independent Contractors

The pay ratio rules define “employee” as an individual employed by the company or any of its consolidated subsidiaries, and exclude from the definition those workers who are employed, and whose compensation is determined, by an unaffiliated third party but who provide services to the company or its consolidated subsidiaries as independent contractors or “leased workers.” In the Release, the SEC makes clear that this exception was not intended to serve as an exclusive basis for determining whether a worker is an employee. The SEC said that a company could apply a widely recognized test under another area of law that it otherwise uses, such as employment or tax, to determine whether its workers are employees for purposes of the pay ratio rules.

The Guidance

In the Guidance, the Staff provided examples of sampling and other reasonable methodologies that may be used to identify the median employee and to calculate the total compensation or any elements of total compensation for employees.

Combining Estimates and Sampling

Companies may combine the use of reasonable estimates with the use of statistical sampling or other reasonable methodologies. As an example, the Staff said that a company with multinational operations or multiple business lines could use a sampling for some geographic/business units and a combination of other methodologies and reasonable estimates for the other units.

Sampling Methods

The Guidance gives the following examples of sampling methods that companies may use, alone or in combination:

  • simple random (drawing at random a certain number or proportion of employees from the entire population);
  • stratified (dividing the employees into strata and then taking a random sample from each category);
  • cluster (dividing the employees into clusters based on a criterion, drawing a subset of clusters and sampling observations within the selected clusters); and 
  • systematic (sorting the entire population of employees on the basis of a criterion and sampling at a fixed interval, e.g., every 25th name).

Reasonable Estimates

The Guidance gives the following examples of situations where companies may use reasonable estimates:

  • analyzing the composition of the company’s workforce;
  • characterizing the statistical distribution of compensation of the company’s employees and its parameters;
  • calculating a consistent measure of compensation and annual total compensation or elements of annual total compensation;
  • 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.

Reasonable Methodologies

In addition, the Guidance identifies the following examples of common statistical techniques and methodologies that companies may consider reasonable:

  • making one or more distributional assumptions provided that the assumption is appropriate given a company’s own compensation distributions;
  • using reasonable methods of imputing or correcting missing values; and
  • using reasonable methods of addressing extreme observations and outliers.

Hypothetical Examples

Finally, the Guidance provides three hypothetical examples of how it could be applied in situations involving employees located in various geographic regions inside and outside the United States.

The CDIs

The Staff revised one of the CDIs that it issued on October 18, 2016, added a new CDI and deleted a previous CDI – in each case to be consistent with a position contained in the Release.

  • Revised CDI 128C.01 addresses how a company should select a CACM to identify the median employee if it does not use total annual compensation. Previously this CDI stated that total cash compensation could not be a CACM if a company widely distributed annual equity awards among its employees and that Social Security taxes withheld would not likely be a CACM unless all employees earned less than the Social Security wage base. These two items were deleted and the CDI now observes that a company 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.
  • New CDI 128C.06 makes clear that the Staff will not object if a company discloses the pay ratio as a reasonable estimate calculated in a manner consistent with Item 402(u) of Regulation S-K. This position recognizes that the use of estimates, assumptions, adjustments and statistical sampling permitted by the rule may cause a degree of imprecision.
  • Finally, previous CDI 128C.05 dealing with making a determination of whether a worker is an employee or an independent contractor or “leased” employee has been withdrawn. 

Practical Considerations

The Release, the Guidance and the updated CDIs provide important and helpful new guidance on important pay ratio topics that many companies will want to consider, as it could have a significant impact on the process used to comply with the pay ratio disclosure requirements. Companies should review this new information, along with the previously issued interpretations, carefully as they prepare and finalize their required disclosures.

Revisiting Decisions

Companies may want to revisit decisions they have already made with respect to their planned pay ratio disclosures in light of the new interpretations. For example, some companies may have planned to use a CACM other than total cash compensation because the withdrawn CDI did not allow companies to identify their median employee based on cash compensation if they widely distributed equity awards to their employees. Such companies may now want to consider whether total cash compensation would be the appropriate internal record for them to rely on for this determination in light of their particular facts and circumstances.

Timing

Even though the positions in the Release, the Guidance and the updated CDIs may be viewed favorably, preparing for the upcoming disclosure requirement will still take a great deal of time and effort. Companies still need to determine the methodology they will use to comply with the rule and then fine-tune the details. The timing of the release of these documents should serve as a reminder that companies should be working on the mechanics of pay ratio disclosure and implementing corresponding disclosure controls now so that they will be ready to comply with the new disclosure requirement in the upcoming proxy season.

Investor Use

Although Institutional Shareholder Services (ISS) has not yet indicated how it will factor pay ratio disclosures into future voting decisions, on September 25, 2017, ISS released the results of its 2017-2018 Global Policy Survey.7 With respect to the new pay ratio disclosures, ISS reported that “[n]early three-quarters of the investor respondents indicated that they intend to either compare the ratios across companies/industry sectors, or assess year-on-year changes in the ratio at an individual company or use both of these methodologies.” In addition, many of these investor respondents indicated that they intended to use the disclosed data on pay ratios as one data point in determining votes on compensation-related resolutions, as well as using it as background material for engagement with the company. Companies should keep this in mind when drafting their pay ratio disclosures.