On September 21, the SEC and the staff of the Division of Corporation Finance issued new and updated interpretive guidance regarding the CEO pay ratio disclosure required by Item 402(u) of Regulation S-K. The guidance consists of three parts: an SEC interpretive release; staff guidance concerning the use of statistical sampling and other methods for identifying the median employee; and new and revised staff Compliance and Disclosure Interpretations (CDIs). The CDIs are posted on the SEC’s website under the CDI category “Regulation S-K” and are identified by their September 21, 2017 issue date or update date.

The guidance responds to concerns raised to the SEC and the staff regarding uncertainties in the process by which companies must (or may) identify the median employee, as well as the potential liability associated with that process and the related disclosure. The guidance affords companies significant flexibility in developing and applying methodologies to arrive at the required ratio, and provides a measure of comfort concerning the circumstances in which the SEC might authorize an enforcement action for deficient pay ratio disclosure.

Background

Pay ratio disclosure will be required for most U.S. public companies beginning with the 2018 proxy season.

The pay ratio rule requires that companies disclose the following three values:

Median of the annual total compensation of all employees of the company other than the CEO
Annual compensation of the CEO
Ratio of those two amounts

The new guidance supplements and expands upon the staff guidance provided in October 2016. At that time, the staff issued CDIs that addressed common concerns regarding identification of the median employee, including (1) when to include independent contractors and leased workers in the employee population, (2) how to address furloughed workers as part of the employee population, (3) what types of compensation are appropriate to use as a consistently applied compensation measure and (4) what time period to use for applying the CACM to the employee population. The new guidance clarifies the prior guidance in some respects and addresses additional questions that have arisen as companies continue to work on compliance with the disclosure requirement.

Interpretive guidance by SEC

Reasonableness. As the instructions to Item 402(u) make clear, reasonableness is a key element of the estimates and judgments companies must make in preparing pay ratio disclosure. The instructions state that companies may use reasonable estimates to identify the median employee and to calculate the annual total compensation or any elements of the annual total compensation of employees. The instructions also state that companies may use reasonable methods to identify the employee pool from which they select the median employee.

In its interpretive release, the SEC acknowledges that the use of estimates and assumptions could create a “degree of imprecision” in a company’s pay ratio disclosure. Recognizing that this imprecision is inherent in the rule’s approach, the SEC reassures companies 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.”

Independent contractors. The interpretive release provides guidance on the circumstances under which independent contractors may (or may not) be considered “employees” for purposes of the rule.

Item 402 excludes from the definition of “employee” 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. This exclusion has caused widespread uncertainty among companies that use independent contractors who provide short-term or long-term workforce support, particularly where the companies may be considered co-employers of such workers under state or other laws.

The staff previously had taken the position in a CDI, now withdrawn, that in considering whether contractors or leased workers are “employees,” a company should consider the composition of its workforce and its overall employment and compensation practices. In addition, the superseded CDI had indicated that the company should count workers as employees if they are employees of an unaffiliated third party but their compensation is determined by the company.

The SEC clarifies in the new release that the language in Item 402(u)(3) concerning workers who are employed, and whose compensation is determined, by an unaffiliated third party is not the only basis for determining whether a worker is an employee under the rule. The SEC acknowledges that companies already may classify workers as employees in other legal or regulatory contexts, such as under employment or tax laws. Accordingly, companies may apply a “widely recognized test under another area of law” that they otherwise use to determine whether workers are employees. This part of the new guidance could have a significant impact on the way that companies assess independent contractors and leased workers for purposes of the pay ratio disclosure.

Internal records. The interpretive release clarifies the SEC’s views on the use of internal records to determine the median employee. The updated views illustrate the SEC’s flexible approach to compliance.

The SEC explains that companies may use internal records, such as tax or payroll records, in determining whether the “de minimis” exception is available for a company’s non-U.S. employees. This exception generally permits a company to exclude for any reason up to 5% of its non-U.S. employees from the median employee determination.

The SEC also updates its views on the use of internal records as a consistently applied compensation measure (CACM). The staff previously had taken the position in a CDI, now modified, that a measure such as total cash compensation would be an appropriate CACM unless the company distributes equity awards widely among its employee population. The SEC clarifies in the new release that companies may use as a CACM internal records that reasonably reflect annual compensation even if the records do not include every element of compensation, such as equity awards widely distributed to employees.

Further, the SEC reminds companies that if the use of internal records as a CACM results in the identification of a median employee who is determined to have anomalous compensation characteristics that have a significant impact on the pay ratio, companies may substitute for that median employee another employee with substantially similar compensation based on the CACM which the company originally used. If a company does substitute another employee, it must disclose the substitution as part of its brief description of the methodology it used to identify the median employee.

Staff guidance on statistical sampling and reasonable methods

The staff separately issued guidance to assist companies in determining how to use statistical sampling methodologies and other reasonable methods to analyze the employee population for purposes of the pay ratio disclosure. The instructions to Item 402(u) state that when identifying the median employee, companies may use the entire employee population “or statistical sampling and/or other reasonable methods.” The staff clarifies in the new guidance that companies are permitted to use a combination of methods, including:

Combining different statistical sampling methods
Combining statistical sampling with other reasonable methods
Combining different reasonable methods with one another

The guidance presents examples, summarized below, of the application of these methods. The staff emphasizes that the specified methods are not exclusive and do not preclude the use of other reasonable methods.

Statistical sampling methods. The staff identifies the following examples of permissible sampling methods:

Simple random sampling (drawing at random a certain number or proportion of employees from the entire employee population)
Stratified sampling (dividing the employee population into strata, e.g., based on location, business unit, type of employee, collective bargaining agreement or functional role, and sampling within each stratum)
Cluster sampling (dividing the employee population into clusters based on some criterion, drawing a subset of clusters, and sampling observations within appropriately selected clusters, with such cluster sampling being conducted in one stage or multiple stages)
Systematic sampling (drawing the sample according to a random starting point and a fixed sampling interval, e.g., every nth employee from a listing of employees sorted on the basis of a particular criterion)

Other reasonable methods. The staff enumerates the following as “other reasonable methodologies”:

Making one or more distributional assumptions, such as assuming a lognormal or another distribution, so long as the company has determined that the use of the assumption is appropriate given its own compensation distributions
Employing reasonable methods of imputing or correcting missing values
Employing reasonable methods of addressing extreme observations, such as outliers

Reasonable estimates. The staff indicates, by way of example, that companies may use reasonable estimates in:

Analyzing the composition of the company's workforce (e.g., by geographic unit, business unit or employee type)
Characterizing the statistical distribution of compensation of the company’s employees and its parameters (e.g., a lognormal, beta, gamma or another distribution, or a mixture of distributions, such as a mixture of two normal or lognormal distributions yielding a bimodal distribution)
Calculating a consistent measure of compensation and annual total compensation or elements of the annual total compensation of the median employee
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
Using the mid-point of a compensation range to estimate compensation

Combinations of methods. The staff applies some of the types of methods and estimates outlined above to several fact patterns to illustrate how companies may use combinations of methods in identifying the median employee.

The lesson of the interpretive release and the Division’s guidance is that the SEC and its staff are willing to extend significant latitude to companies in preparing pay ratio disclosure.

New and revised CDIs

In conjunction with the SEC’s interpretive release and the staff’s guidance discussed above, the Division also updated and supplemented the pay ratio CDIs it initially posted in October 2016.

Notably, the staff issued new CDI 128C.06, which clarifies that companies are permitted to state that the pay ratio disclosed is a “reasonable estimate” that was prepared in accordance with Item 402(u). This CDI responds to requests that the staff permit companies to disclose that the reported pay ratio is an estimate as a result of the possible use of assumptions, adjustments and statistical sampling.

The staff also withdrew former CDI 128C.05, which had addressed when independent contractors and leased workers might be considered employees for purposes of identifying the median employee. This withdrawal is consistent with the SEC’s updated position concerning independent contractors in the interpretive release, as discussed above.

Finally, the staff revised CDI 128C.01, which addresses the appropriateness of a company’s CACM selection for purposes of identifying the median employee. The staff modified the CDI to account for the SEC’s statement in the interpretive release that internal records may be used as the CACM even if certain components of compensation, such as equity awards, are not included.

Looking ahead

The additional guidance from the SEC and the staff has been much anticipated. As the deadline for complying with the pay ratio disclosure requirement quickly approaches, SEC or Congressional action to delay the implementation of the rule becomes less likely. Companies therefore should proceed under the assumption that the pay ratio rule will be implemented in accordance with the original regulatory timeline.

Although the recent guidance provides a number of helpful examples and clarifies the flexibility that the SEC and the staff believe the rule provides, companies must ensure that their process and the resulting disclosure are grounded in reasonableness and good faith. Companies also should continue to assess the impact of their pay ratio disclosure on all of their constituencies, including their internal workforce, and prepare to respond to the attention the disclosure may receive.