On September 21, 2017, the Securities and Exchange Commission (“SEC”) issued additional interpretive guidance on the pay ratio disclosure requirement, which requires public companies to disclose the ratio of their CEO’s compensation to that of their “median employee.” This guidance came in the form of (1) an SEC Interpretive Release (“Interpretive Release”), (2) guidance from the Division of Corporate Finance (“Corp. Fin. Guidance”) and (3) modifications to the Compliance and Disclosure Interpretations (“C&DIs”) (see the SEC’s press release here). The new guidance allows for broad discretion in complying with the disclosure requirement and will assist companies as they prepare their disclosures for the 2017 fiscal year.

Specifically:

  • with respect to who is considered an “employee” for the purposes of the rule (as opposed to an independent contractor or leased worker), the new guidance permits reliance on widely recognized tests used in other legal and regulatory contexts, such as for employment law or tax purposes. Practically speaking, this means that any worker who may be treated as an independent contractor under IRS guidance, likely may be excluded from the employee population in determining the median employee;
  • the new guidance clarifies that a company may use appropriate existing internal records, such as tax and payroll records, in evaluating the inclusion of non-U.S. employees and identifying the median employee, even if those internal records do not include every element of compensation (such as equity awards widely distributed to employees); and
  • the new guidance reinforces the flexibility to use reasonable estimates and assumptions and determine reasonable methodologies and statistical sampling to identify the median employee and calculate the median employee’s annual total compensation, and clarifies that companies may use more than one methodology, or any reasonable combination of methodologies or estimates, to identify the median employee.

Classification of Independent Contractors

The Interpretive Release and the associated withdrawal of C&DI 128C.05 provide much more leeway in what was previously thought to be the exclusive means for determining which individuals are employees and which are independent contractors for pay ratio purposes. Item 402(u)(3) of Regulation S-K states that an “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 (or its consolidated subsidiaries) as an independent contractor. C&DI 128C.05 included additional guidance on the determination of an employee, noting that if a workers’ compensation is determined by the company or one of its consolidated subsidiaries, regardless of whether the worker was considered an employee for purposes of tax or employment law purposes, that person would be considered an employee for the pay ratio rules.

The new guidance reverses that C&DI position and indicates that the provision in Item 402(u)(3) “was not intended to serve as an exclusive basis for determining whether a worker is an employee” of the company and that it would be consistent with the rule for a company to “apply a widely recognized test under another area of law” that the company “otherwise uses to determine whether its workers are employees,” e.g., for employment law or tax purposes. This change should make the independent contractor determination less burdensome, although companies are advised to exercise due diligence and maintain proper documentation with respect to the determination that any worker is not an “employee” under Item 402(u)(3).

Use of Internal Records

Non-U.S. Employees

The pay ratio rule generally exempts companies from including non-U.S. employees where they account for 5% or less of the total employees. The Interpretive Release clarifies that a company may use appropriate internal records, including tax records or payroll records, to determine whether this de minimus exemption is available.

Median Employee

The pay ratio disclosure permits a company to use annual total compensation, as determined under existing executive compensation rules, or any other consistently applied compensation measure (“CACM”), such as compensation reported in payroll or tax records, to identify the median employee. The C&DIs posted on October 18, 2016, provided that the CACM may be any measure that reasonably reflects the annual compensation of employees depending on the facts and circumstances, but that, for example, it would not be appropriate to use cash compensation as a measure when employees widely receive equity awards. The new guidance clarifies that the 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.”

In the Interpretive Release, the SEC recognized that the median employee may have anomalous characteristics that have a significant impact on the pay ratio. The Interpretive Release reiterates that in such a case, a company may substitute another employee with substantially similar compensation to the original identified employee based on the compensation measure used to select the median employee, provided that the substitution is disclosed in the company’s methodology.

Use of Reasonable Estimates, Assumptions and Methodologies

Both the Interpretive Release and the Corp. Fin. Guidance make clear that compliance with the pay ratio disclosure will result in a degree of imprecision and that companies have significant flexibility in selecting the appropriate methodologies to identify the median employee and calculate the median employee’s annual total compensation. The guidance clarifies that the use of reasonable belief, reasonable estimates, assumptions, methodologies and reasonable efforts, and the resulting disclosure, will not provide a basis for SEC enforcement action unless these are “made or reaffirmed without a reasonable basis” or “provided other than in good faith.” The SEC’s guidance does not address potential shareholder liability.

The revised C&DIs also clarify that the SEC will not object if a company, in any required disclosure, describes the pay ratio as a “reasonable estimate.”

The Corp. Fin. Guidance provides that companies may combine reasonable estimates with statistical sampling or other reasonable methodologies. For example, companies with multiple business lines or geographical units may use statistical sampling for some business units and may use other methodologies and reasonable estimates for other units. The Corp. Fin. Guidance provides a non-exclusive list of sampling methods that companies may employ, including simple random sampling, stratified sampling, cluster sampling and systematic sampling. The guidance also clarifies that companies have flexibility to use reasonable estimates in the methodology used to identify the median employee and in the calculation of annual total compensation for employees. The guidance also includes hypothetical examples of the use of reasonable estimates, statistical sampling and other methodologies, or a combination thereof, including in the context of companies with global workforces and a mix of full-time and part-time employees.

While the new guidance reinforces the reasonably broad flexibility companies have in their disclosure, the pay ratio rule does require companies to disclose the methodology chosen to determine the median employee and any material assumptions, adjustments or estimates used to identify the median employee or to determine total compensation. We recommend that companies that have not already done so begin immediately to gather the necessary information and adopt the appropriate methodologies for their pay ratio disclosure.