What do public companies working to implement the pay ratio rules before next proxy season and Vince Gill circa 1989 have in common? They have both seen a sight for sore eyes, as the guidance released by the SEC on September 21st provides issuers with increased flexibility and relief with respect to the pay ratio rules. This client alert briefly summarizes the SEC’s seven-page interpretive release and the SEC staff’s related published guidance and updated Compliance and Disclosure Interpretations (“C&DIs”), all of which can be accessed easily at the SEC’s new website dedicated to pay ratio disclosure, www.sec.gov/corpfin/pay-ratio-disclosure.
In its interpretive release, the SEC reinforces that the pay ratio rules afford companies significant flexibility in determining appropriate methodologies to identify the median employee and calculate his or her annual total compensation, including through the use of reasonable estimates, assumptions, adjustments and statistical sampling. The SEC goes on to say that a company’s pay ratio disclosure which results from the use of reasonable estimates, assumptions and methodologies will not provide the basis for an enforcement action unless the disclosure was made “without a reasonable basis or was provided other than in good faith.” The SEC also clarifies in the release that companies may use their existing internal records, such as tax or payroll records, in order to (i) determine whether the five percent (5%) “de minimis exemption” for non-U.S. employees is available and (ii) identify the median employee, even if the internal records do not include every element of compensation, such as widely distributed equity awards. Finally, the SEC acquiesced to commenters’ requests that companies be permitted to use “widely recognized tests,” such as those required for employment law or tax purposes, in order to determine if a worker is an employee or an independent contractor under the rule.
The related guidance separately published by the staff of the SEC’s Division of Corporation Finance provides companies with additional, more specific direction on the use of statistical sampling, reasonable estimates and reasonable methodologies. Companies are permitted to combine statistical sampling and “other reasonable methods” in order to determine the median employee, and companies can combine multiple sampling methods so long as the sampling includes employees from each business or geographical unit. The SEC staff provides examples of reasonable sampling methods, including simple random sampling (drawing a certain number of employees at random from the entire population) and systematic sampling (every nth employee is drawn from an employee list sorted on the basis of some criterion). Reasonable estimates may be used to identify the median employee (e.g., by identifying multiple employees around the middle of the compensation spectrum) and calculate his or her annual total compensation (e.g., by using the mid-point of a compensation range to estimate compensation). The staff also clarifies that “reasonable methodologies” include making distributional assumptions appropriate for the company and addressing extreme observations in a reasonable manner. Finally, the guidance statement includes three hypothetical examples of how a company may use statistical sampling, reasonable estimates and reasonable methodologies.
The SEC staff also updated C&DI 128C.01 regarding a company’s use of a “consistently applied compensation measure” instead of annual total compensation in order to identify the median employee to include additional guidance from the interpretive release. This C&DI now clarifies that a company may use its existing internal records that reflect annual compensation to identify the median employee. The SEC staff withdrew C&DI 128C.05, which addressed how to classify a worker as an employee or an independent contractor, and added C&DI 128C.06, which permits companies to state in their disclosures that the pay ratio is a “reasonable estimate calculated in a manner consistent with Item 402(u).” Most companies will likely describe their pay ratio disclosures in this way, as well as take advantage of the increased flexibility reflected in this latest guidance.
SEC Chairman Jay Clayton reassured companies that it is a priority of the SEC to allow “companies to use operational data and otherwise readily available information to produce the disclosures,” and although it remains to be seen how companies will apply this new guidance to their pay ratio calculations and disclosures, companies should be encouraged by the SEC’s attempt to decrease the burden associated with these rules.