On September 21, 2017, the Securities and Exchange Commission (“SEC”) released detailed guidance, an interpretive release, and several new or modified Compliance and Disclosure Interpretations regarding the rule that will require most public companies to disclose the ratio of their CEO’s annual pay as compared with the annual compensation of their “median employee” (commonly known as the “CEO Pay Ratio”).
While there was some speculation that this controversial rule would be withdrawn or delayed, it is now clear that the CEO Pay Ratio disclosure rule will go into effect as scheduled. Companies should already be preparing to identify their “median employee” in order to be able to provide the required disclosures in 2018. The SEC’s recent guidance provides additional details regarding how the median employee may be determined, and clarifies that companies have some flexibility with the use of statistical sampling and reasonable estimates in the identification of the median employee.
Disclosure regarding the CEO Pay Ratio is required under section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and final regulations were adopted in 2015. The majority of public companies must include the required disclosure in SEC filings that include executive compensation disclosure for the first fiscal year beginning on or after January 1, 2017, which, for most companies, means including the required disclosure in their 2018 proxy statement based on 2017 compensation data. However, smaller reporting companies, foreign private issuers, Multijurisdictional Disclosure System filers, “emerging growth companies” under the Jumpstart Our Business Startups Act, and registered investment companies, are exempt from the CEO Pay Ratio rule.
No Enforcement Actions for Use of Reasonable Estimates or Assumptions
The SEC guidance acknowledges that the CEO Pay Ratio disclosure may “involve a degree of imprecision.” In order to account for this imprecision, the SEC has stated that if a company uses reasonable estimates, assumptions, or methodologies in its preparation of the CEO Pay Ratio disclosure, the disclosure that results from such use will not form the basis of an SEC enforcement action. The SEC may decide to pursue an enforcement action if the disclosure was made or reaffirmed without a reasonable basis, or was provided in bad faith.
Flexibility on the Use of Statistical Sampling and Reasonable Estimates
The SEC noted that the final rules regarding the CEO Pay Ratio disclosure were intended to provide companies with some degree of flexibility in the determination of the median employee, so that companies could make determinations based on their particular facts and circumstances, including through the use of statistical sampling and reasonable estimates. The SEC guidance further stresses that the rules are intended to be flexible, and provides examples of the types of statistical sampling and reasonable estimates that would be acceptable.
- Combination of Sampling and Reasonable Estimates. A company may use a combination of statistical sampling and other methodologies and reasonable estimates, and may use multiple sampling methodologies, depending on the company’s particular facts and circumstances.
- Sampling Methodologies. The SEC outlined some examples of sampling methods, including a simple random sampling, a stratified sampling (based on location, business unit, etc.), cluster sampling based on some criterion, and systematic sampling.
- Reasonable Estimates. The SEC provided some examples of when reasonable estimates may be appropriate, including calculating a consistent measure of compensation and annual total compensation of the median employee, identifying the median employee, identifying several employees around the median of the compensation spectrum, and using a mid-point of a compensation range to estimate compensation.
Use of Internal Records to Identify Median Employee
The SEC guidance clarifies that companies may identify the median employee using internal records, even if those records do not include every element of compensation. For example, the median employee may be identified using the company’s tax or payroll records, even if those records do not include equity awards that are widely granted to employees. However, when determining the pay ratio of the CEO to the median employee, the total compensation of the median employee must be used.
Generally, independent contractors who are employed by and whose compensation is determined by an unaffiliated third party are not to be included in the population of employees for purposes of determining the median employee. The SEC guidance states that companies may use a widely recognized test under another law, such as IRS guidance regarding independent contractors, to determine whether an individual should be considered an employee or an independent contractor for purposes of determining the median employee.
Client Alert 2017-223