SEC Issues New Guidance on Pay Ratio Rule, Emphasizing “Flexibility” of Median Employee Pay Calculation

10.06.2017

By Heyward Armstrong, Amy Batten and Gerald Roach

On September 21, 2017, the U.S. Securities and Exchange Commission (SEC) issued an interpretive release to assist public companies in complying with the SEC’s pay ratio rule. The SEC’s interpretive release emphasized the “significant flexibility” the rule gives public companies in determining their median employee and calculating the compensation of their median employee.

In connection with the SEC’s interpretive release, the Division of Corporation Finance published companion guidance to assist public companies in using statistical sampling and other reasonable methodologies under the pay ratio rule. The staff also published one new and one updated Compliance & Disclosure Interpretation (C&DIs) to reiterate the guidance provided in the interpretive release.

The pay ratio rule, which implements Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, was finalized approximately two years ago. The rule requires many U.S. public companies to calculate the annual compensation of their principal executive officer (PEO) and their so-called “median employee.” Companies must then disclose the ratio illustrating the disparity between the two in their public filings. Public companies covered by the rule were required to start calculating the ratio beginning in 2017, and their ratios must be published in public filings beginning next year. Emerging growth companies, smaller reporting companies, foreign private issuers, multijurisdictional disclosure system (MJDS) filers and registered investment companies are not covered by the rule.

An overview of the final rule, which is Item 402(u) in Regulation S-K, is available in Smith Anderson’s August 27, 2015 Securities Alert “SEC Adopts Final Pay Ratio Rule.”

New SEC Interpretive Release Seeks to Mitigate Compliance Challenges

Large, multinational public companies covered by the rule are likely to face compliance challenges in calculating their ratio, especially in properly identifying their median employee and in determining that employee’s compensation. Companies must identify their median employee once every three years, but they are required to calculate that employee’s compensation every year. Although companies can simply compile a list of all of their employees and identify the median employee from that list, that may be excessively burdensome for large companies. Thus, the pay ratio rule provides that companies “may use reasonable estimates both in the methodology used to identify the median employee and in calculating the annual total compensation or any elements of total compensation for employees other than the PEO.” As an alternative to simply picking the median employee from a comprehensive list, the rule allows companies to use “statistical sampling and/or other reasonable methods.”

The SEC’s interpretive release seeks to provide greater clarity on this part of the rule and further mitigate the compliance burdens associated with determining the median employee and making the pay ratio disclosures required by the rule. Key takeaways from the interpretive release include the following:

Disclosures involve imprecision. The required pay ratio disclosures “may involve a degree of imprecision,” but the SEC confirmed that, so long as a public company makes the disclosures using reasonable estimates, assumptions or methodologies, with a reasonable basis and in good faith, the SEC will not have a basis upon which to bring an enforcement action against the company with respect to the disclosures. As reiterated in C&DI 128C.06, companies may state in their required public disclosures that their pay ratio is “an estimate” without risking any objection from the SEC staff.
Definition of employee. In determining who is an “employee” for purposes of the rule, companies may use “a widely recognized test under another area of law that the [company] otherwise uses to determine whether its workers are employees.”
Identifying the median employee with existing records. Companies may “in many circumstances” be able to use existing records, such as payroll or tax records, to identify their median employee rather than constantly generating comprehensive new lists of all employees.
Calculating total compensation using existing records. Existing records may also be used to calculate median employee annual total compensation, even if they leave out some aspects of total compensation like equity awards. The staff reiterated this guidance in its updated C&DI 128C.01. The records must still provide a reasonable reflection of total compensation.
5% Non-U.S. employees. Companies are already allowed to exclude non-U.S. employees from their survey of total employees if non-U.S. employees make up 5% or less of total employees. The interpretive release clarifies that companies may rely on records they already have to determine whether they meet the 5% threshold for non-U.S. employees.

SEC Staff Guidance Provides Examples of Compliance Approaches

In its new guidance, the SEC staff also provides examples of ways that companies may be able to use sampling methods and reasonable estimates to comply with the pay ratio rule. The SEC staff cautions that compliance is based on a company’s “particular facts and circumstances.” However, the examples are nevertheless illustrative because they add specificity to some of the broad language in the rule. Examples provided in the new guidance include:

Combining statistical sampling and other reasonable methods. In identifying the median employee, companies with many different business divisions may use “statistical sampling” for some divisions and other “reasonable methods” for other divisions. In other words, companies may use varied methodologies to identify the median employee as long as the methodologies they use are reasonable.
Sampling based on groups. Sampling methods that may be appropriate for companies to use in narrowing down employees from which to derive their median employee include simple random sampling of the employee population. However, companies may also potentially conduct sampling by taking samples from particular groups based on categories like location, business unit or job function.
Statistical distribution to measure compensation. Reasonable estimates that may be appropriate include using a statistical distribution of compensation to measure compensation across the company’s employees. Reasonable estimates may also be used to evaluate how much employee compensation has changed year over year.
Mixing methods for estimates and sampling. It may be appropriate for companies to use different kinds of sampling methods and reasonable estimates in combination with each other, especially if they are using different methods and estimates for different segments of their company.

Impact of the SEC Guidance and Next Steps

The SEC interpretive release and related staff guidance and C&DIs clarify and reiterate that public companies have meaningful flexibility in the methods and information they use to determine their median employee, calculate that employee’s total compensation and make the disclosures required by the pay ratio rule. This guidance collectively confirms that the pay ratio rule does not require extreme precision, but instead that compliance will be assessed based on the exercise of reasonableness and good faith.

Although the SEC has confirmed that public companies have substantial flexibility under the pay ratio rule, the rule’s compliance workload will continue to be significant, especially for large, multinational companies with employees in multiple jurisdictions. As we discussed in our previous Alert, public companies subject to the rule should have a multidisciplinary team in place to ensure that they are able to determine the median employee, calculate that employee’s total compensation and make the disclosures required by the rule in their 2018 proxy statements. As part of this process, public companies will need to consider the extent to which they view the pay ratio disclosure as merely a compliance exercise or as conveying meaningful information regarding their compensation programs.

We continue to believe, as discussed in our previous Alert, that companies may be best served by approaching the pay ratio rule with the goal of efficiently providing the specific information required by the rule, together with appropriate disclosure to explain the methodology and estimates they have used to prepare the disclosure consistent with the SEC’s guidance. By doing so, companies can continue to focus their disclosures on their most important executive compensation story -- i.e., how they have designed their executive compensation programs to drive company performance and shareholder returns.

If you have any questions about the SEC's pay ratio rule or if you would like to learn more about the issues covered in this Alert, please contact your Smith Anderson lawyer.

Special thanks to Will Robinson, contributing writer.