SEC Eases Pay Ratio Rule

By Steve Quinlivan, Jill Radloff, Cate Heaven Young and David Jenson

Two pieces of guidance emerged from the Securities and Exchange Commission on September 21, 2017, with respect to the pay ratio rule. The guidance was issued by the Commission and the Commission's Division of Corporation Finance. The Division also updated previously issued Compliance and Disclosure Interpretations (CDIs). The emergence and timing of this guidance signals that the rule will be effective for the upcoming proxy season and will not be delayed or modified.

Some highlights of the new guidance include:

  • The Commission will not commence an enforcement action against a registrant that uses reasonable estimates, assumptions or methodologies, unless the disclosure was either not provided in good faith or was made or reaffirmed without a reasonable basis.
  • Registrants may use internal records to identify the median employee, even if those records do not include every element of compensation.
  • Registrants may apply a widely recognized test under another area of law, such as guidance published by the Internal Revenue Service, to determine whether its workers are employees or independent contractors.
  • Registrants may describe the pay ratio as an "estimate."

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. This is consistent with the Commission’s view of the pay ratio rule as a tool to increase investor understanding of pay policies and practices of individual registrants rather than a metric for comparing one registrant against another. 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. As a result, the Commission confirmed it would not bring an enforcement action if a registrant uses reasonable estimates, assumptions or methodologies to calculate the pay ratio and related disclosure, 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-U.S. Employees

The pay ratio rule permits registrants to exempt non-U.S. employees where these employees account for five percent 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 five percent 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. This is good news for registrants that have decentralized information systems tracking various components of compensation.

A registrant may determine that the median employee identified has anomalous characteristics even when the registrant identified the employee using a consistently applied compensation measure based on internal records. As set forth in the adopting release for the final pay ratio rules, 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 (but lacking the anomalous characteristics) based on the compensation measure it used to select the median employee. The registrant must, however, disclose this fact as part of its brief description of the methodology it used to identify the median employee. This means if a registrant gets to the end of the line with an unusual result, the registrant does not have to start over if a meaningful result can be reached by substituting an employee within the parameters of the Commission's guidance.

Independent Contractors

The compensation of workers who are not "employees" of a registrant is irrelevant for purposes of the pay ratio disclosure. The rule itself provides that a worker is excluded from the definition of "employee" for purposes of the rule if the worker is employed, and the worker’s compensation is determined, by an unaffiliated third party. In its guidance, the Commission clarifies that the exclusion set forth in the rule itself is not the exclusive method for determining whether a worker is an employee or not. Rather, 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 commenters 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  
General Division 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 different sampling methods for different business units. The guidance provides examples of permissible sampling methods. Sampling methods that may be appropriate include random sampling, stratified sampling, cluster sampling and systematic sampling.
  • 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 of other reasonable methodologies, 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 Commission’s interpretive guidance. CDI 128C.05 was withdrawn, which provided a registrant should include a worker as an "employee" if the worker’s 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.

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