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SEC Issues Guidance on Pay Ratio Rule

by   |   September 21, 2017

Two major pieces of guidance emerged from the SEC on September 21, 2017, with respect to the pay ratio rule. First, the Commission issued interpretive guidance on the rule.  Second, the Division of Corporation Finance also issued its own guidance.  The Division also updated previously issued Compliance and Disclosure Interpretations, which are referred to as CDIs.  The emergence of this guidance clearly signals the rule will be effective for the upcoming proxy season and will not be delayed or modified.

Commission Interpretive Guidance

Use of Reasonable Estimates, Assumptions, and Methodologies and Statistical Sampling

The Commission noted the pay ratio rule affords significant flexibility to registrants in determining appropriate methodologies to identify the median employee and calculating the median employee’s annual total compensation. Required disclosure may be based on a registrant’s reasonable belief; use of reasonable estimates, assumptions, and methodologies; and reasonable efforts to prepare the disclosures.

In light of the use of estimates, assumptions, adjustments, and statistical sampling permitted by the rule, the Commission noted the pay ratio disclosures may involve a degree of imprecision. This has led some commenters to express concerns about compliance uncertainty and potential liability. In the Commissions view, if a registrant 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.

As always, a no-action position of the Commission is not binding on any court.

Use of Internal Records

Non-US Employees

The pay ratio rule permits registrants to exempt non-U.S. employees where these employees account for 5% or less of the registrant’s total U.S. and non-U.S. employees, with certain limitations. In the interpretive guidance the Commission clarifies that a registrant may use appropriate existing internal records, such as tax or payroll records, in determining whether the 5% de minimis exemption is available.

Median Employee

In the interpretive guidance the Commission clarifies that a registrant may use internal records that reasonably reflect annual compensation 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 identified median employee that the registrant identified using a consistently applied compensation measure based on internal records, the registrant may determine that there are anomalous characteristics of the identified median employee’s compensation that have a significant higher or lower impact on the pay ratio. The Commission observed the registrant need not conclude its methodology was unsuitable to identify its median employee. Instead, the registrant may substitute another employee with substantially similar compensation to the originally identified median employee based on the compensation measure it used to select the median employee.

Independent Contractors

In determining who is an “employee” for purposes of the rule, registrants may apply a widely recognized test under another area of law that the registrant otherwise uses to determine whether its workers are employees. The Commission appears to agree with commentators that such a test might, for example, be drawn from guidance published by the Internal Revenue Service with respect to independent contractors.

Division of Corporation Finance Guidance

The Division’s guidance is meant to assist registrants in determining how to use statistical sampling methodologies and other reasonable methodologies. The Division’s guidance:

  • Notes registrants may combine the use of reasonable estimates with the use of statistical sampling or other reasonable methodologies. For instance, a registrant with multinational operations or multiple business lines is permitted to use sampling for some geographic/business units and a combination of other methodologies and reasonable estimates for other geographic/business units.
  • Notes registrants are permitted to use a combination of sampling methods and examples are provided.
  • Provides examples of situations where registrants may use reasonable estimates such as identifying the median employee and using the mid-point of a compensation range to estimate compensation.
  • Notes that registrants may use a combination of reasonable methodologies and provides examples, including using reasonable methods of addressing extreme observations, such as outliers.
  • Provides hypothetical examples of the use of reasonable estimates, statistical sampling and other reasonable methods. The hypotheticals involve three companies with complex international operations and work forces.

Updated CDIs

New CDI 128C.06 provides that the pay ratio may be referred to as an “estimate.” CDI 128C.01 was revised to refer to the Commissions interpretive guidance.  CDI 128C.05 was withdrawn, which provided  a registrant should include a worker as an “employee” for the purposes of Item 402(u) if the worker compensation is determined by the registrant or one of its consolidated subsidiaries. According to the withdrawn CDI, this was true regardless of whether such worker would be considered an “employee” for tax or employment law purposes.