KMK Law Corporate & Securities Blog

On September 21, 2017, the Securities and Exchange Commission (SEC) issued interpretive guidance on the CEO pay ratio rule. Simultaneously, the SEC’s Division of Corporation Finance issued guidance on calculation of the pay ratio and updated C&DIs related to the new guidance. Together, these issuances strongly suggest that the SEC is not modifying or deferring the effectiveness of the rule and that it will be in place for the upcoming 2018 proxy season.

SEC Guidance:
The SEC guidance generally provides more expansive interpretations of three topics: an issuer’s reliance on reasonable assumptions and estimates; an issuer’s use of internal records to determine the median employee and use of non-U.S. employees; and an issuer’s use of other commonly recognized tests to determine employee status (e.g., IRS guidance). 

Use of Reasonable Assumptions and Estimates
The SEC noted that the pay ratio rule provides companies with significant flexibility to determine the appropriate methodologies to both identify the median employee as well as calculating the median employee’s annual total compensation. Required disclosure may be based on an issuer’s reasonable belief; use of reasonable estimates, assumptions and methodologies; and reasonable efforts to prepare the disclosures. The Commission acknowledges that perfection is not required given that the data-gathering process and related calculations involve the use of estimates, adjustments and statistical sampling. As such, so long as issuers use reasonable estimates, assumptions, or methodologies, the pay ratio itself and the related disclosure will not provide the basis for an SEC enforcement action, unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith. The separate C&DI issued permits companies to call the pay ratio disclosure an estimate in any required disclosure.

Use of Internal Records; De Minimis Exemption
The pay ratio rule permits issuers to exempt non-U.S. employees when those employees account for 5% or less of the issuer’s total U.S. and non-U.S. employees. The new SEC guidance provides that issuers may use their internal records, such as tax or payroll records, to determine if the de minimis exemption for foreign employees is available. Issuers may also use internal records for the consistently applied compensation measure (CACM) used to identify the median employee, even if those records do not include every element of compensation, such as equity awards widely distributed to employees. When calculating total compensation for the median employee that the issuer identified using a CACM, the issuer may determine that there are anomalous characteristics of the median employee’s compensation that have a significantly higher or lower impact on the pay ratio. The SEC noted that the issuer may substitute another employee with substantially similar compensation based on the compensation measure used, rather than using a new measure. 

Employee Status
In determining whether independent contractors are “employees” for purposes of calculating the pay ratio disclosure, a company is permitted to use widely recognized tests under other areas of law, such as IRS determinations, etc., to determine whether an individual is an independent contractor or an employee.

Division of Corporation Finance Guidance:
In addition to the SEC guidance, the Division of Corporation Finance’s guidance provided issuers with examples of how companies can use both statistical sampling and estimates to identify the median employee and to determine his or her annual total compensation. In particular, the guidance notes that issuers may combine the use of reasonable estimates with the use of statistical sampling or other reasonable methodologies. As an example, the SEC noted that an issuer with multinational operations or business units would be permitted to use sampling for some geographic/business units and a combination of other methodologies and estimates for other geographic/business units. Although technical, the guidance is helpful for issuers in their selection of the appropriate sampling method, and includes some of the statistical and other reasonable methodologies below:

• Simple random sampling (drawing at random a certain number of employees);
• Stratified sampling (dividing the employees into groups (‘strata’) based on location, unit, function, etc.);
• Reasonable methods of imputing or correcting missing values;
• Reasonable methods of addressing extreme observations (i.e., outliers);
• Analyzing the composition of the company’s workforce;
• Calculating a CACM and annual total compensation or elements of the annual total compensation of the median employee; and
• Using the mid-point of a compensation range to estimate compensation.

Issuers should consider updating or reassessing their CACM determinations based on this new guidance and should evaluate the methods used and determine whether a combination of methods would be reasonable and appropriate given their facts and circumstances.

The new SEC release can be found here. The Division of Corporation Finance guidance can be found here. The new C&DIs can be found here.