Last week, the Securities and Exchange Commission (SEC) provided additional guidance for complying with the pay ratio disclosure requirements adopted under the Dodd-Frank Act that take effect in 2018. According to SEC Chairman Jay Clayton, " the guidance reflects the feedback the SEC has received and encourages companies to use the flexibility incorporated in our prior rulemaking to reduce costs of compliance.”
In 2015, the SEC adopted new Item 402(u) of Regulation S-K to add the following disclosure requirements:
- The median of the annual total compensation of all its employees, except the CEO.
- The annual total compensation of its CEO.
- The ratio of those two amounts.
These new disclosures initially appeared innocuous, but a closer look revealed that they are rife with details, and could require registrants to implement costly administrative measures to ensure compliance. While some initial guidance was provided through Compliance and Disclosure Interpretations (C&DIs) released in October 2016, numerous questions remained as to how to approach these calculations and the related disclosures.
Flexibility as a Key Component
The guidance is set forth in three sources – an interpretive release (Securities Act Release No. 33-10415; Securities Exchange Act Release No. 34-81673; the Interpretive Release); a statement from the SEC’s Division of Corporate Finance (Corp Fin Guidance) and updated C&DIs.
When adopting the pay ratio rules, the SEC stated that, in order for the data points provided by the rules to be of use to investors, the rules “should be designed to allow shareholders to better understand and assess a particular registrant’s compensation practices and pay ratio disclosures rather than to facilitate a comparison of this information from one registrant to another.” As such, the SEC emphasized that the rules provide flexibility for each registrant to determine how to comply in a manner that would “reduce costs and burdens for registrants while preserving what [the SEC perceives] to be the purpose and intended benefits” of the statutorily mandated disclosure.
This flexible approach allows registrants to use reasonable estimates, assumptions, and methodologies, as well as reasonable efforts to prepare the disclosures. However, the SEC notes in the Interpretive Release that this approach can also result in a degree of imprecision, and acknowledged the need to address concerns as to whether uncertainty would lead to challenges to the accuracy of the disclosure. Accordingly, the Interpretive Release provides that if a registrant uses reasonable estimates, assumptions or methodologies, the pay ratio and related disclosure that result 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 not provided in good faith. A newly issued C&DI specifies that registrants are permitted to call such pay ratio disclosures “a reasonable estimate, calculated in a manner consistent with Item 402(u).”
Using Existing Internal Records
As previously noted, Item 402(u) requires a registrant to disclose the median of the annual total compensation of all its employees, excluding its principal executive officer. “Employees” include U.S. employees and employees located in any jurisdiction outside the U.S. In an effort to address concerns about compliance costs for multinational companies, registrants may generally exclude non-U.S. employees from its calculations where such employees account for 5 percent or less of the registrant’s total U.S. and non-U.S. employees.
The Interpretive Release clarifies that a registrant may use appropriate existing internal records, such as tax or payroll records, in determining whether the 5 percent de minimis exemption from the rule is available.
In addition, a registrant may use existing internal records that reasonably reflect annual compensation as the “consistently applied compensation measure” required by the rules to identify the median employee. The Interpretive Release clarified this approach may be acceptable even if those records exclude certain compensation elements, such as equity awards widely distributed to employees.
The SEC noted that if a registrant determines that there are unusual characteristics of the identified median employee’s compensation that have a significant impact on pay ratio, “the registrant may substitute another employee with substantially similar compensation to the original identified median employee based on the compensation measure it used to select the median employee.”
Defining an "Employee"
The SEC has reversed its position that it had taken in an earlier C&DI regarding the definition of “employee.” For purposes of Item 402(u), “employee” is defined as “an individual employed by the registrant or any of its consolidated subsidiaries.” Excluded from this definition are workers who are employed, and whose compensation is determined, by an unaffiliated third party, but who provide services as independent contractors to the registrant. In the Pay Ratio Release, the SEC indicated that excluding independent contractors is appropriate, because registrants generally do not control the level of compensation paid to such workers. However, because some registrants already make determinations as to whether a worker is an employee or independent contractor in other legal or regulatory contexts, the SEC has clarified that a registrant may apply a widely recognized test under another area of law that the registrant otherwise uses to determine whether its workers are employees.
What constitutes using “reasonable methodologies” or appropriate statistical sampling will depend on the facts and circumstances of the registrant. The Corp Fin Guidance provided detailed guidance and hypothetical examples regarding some common statistical techniques and methodologies registrants may consider, but it did not specify any requirements for statistical sampling.
The staff challenged registrants to expand their statistical analysis vocabulary (or perhaps will cause a ramp-up of demand for consulting work by statisticians) by citing terms such as “lognormal” and “multimodal” distributions, but emphasized that the key to using any analytical tool is to apply reasonableness, as evidenced by some examples set forth in the Corp Fin Guidance:
- Registrants may use a combination of reasonable estimates, statistical sampling and other reasonable methodologies, for example, in businesses with multiple business lines or geographic units.
- One or more statistical sampling methods can be used, including, but not limited to, simple random sampling, stratified sampling, cluster sampling, and systematic sampling, and the release advises that “all statistical sampling approaches should draw observations from each business or geographical unit with a reasonable assumption on each unit’s compensation distribution and infer the registrant’s overall median based on the observations drawn."
- Other reasonable methods may be used in combination with other approaches, including, but not limited to, making distributional assumptions, imputing or correcting missing values, and addressing outliers and other extreme observations.
- The Corp Fin Guidance also included several hypothetical examples illustrating the application of these principles across multiple business units and geographical locations.
Although challenges have brought uncertainty to the long-term future of the pay ratio rules, they remain in effect. Registrants must therefore continue their efforts to comply with the rules in the upcoming year. The guidance should provide comfort to registrants – so long as actions to report the pay ratio are reasonable, the SEC will not second guess the disclosure.