Pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the Security Exchange Commission’s (Commission’s) 2015 pay ratio rule (Final Rule) required public companies to disclose the annual total compensation of the median employee (excluding the CEO), the annual CEO compensation and the ratio of those amounts. The Final Rule, which amended the executive compensation disclosure regulations under Item 402 of Regulation S-K, mandates pay ratio disclosure for the fiscal year beginning January 1, 2017. As a result, most public companies must provide pay ratio disclosures in their 2018 proxy statements. Exempt from the disclosure requirements are foreign private issuers, smaller reporting companies, Multijurisdictional Disclosure System filers, registered investment companies and emerging growth companies under the Jumpstart Our Business Startups Act.

The Final Rule requires companies to identify the median employee at least once every three years, unless there has been a change in the employee population or compensation significantly affecting the pay ratio, in which case a company would have to disclose the change and re-identify the median employee. The employee pool from which the median employee is determined must include all full-time, part-time, temporary and seasonal employees (other than the CEO) of the company and its consolidated subsidiaries in the U.S. and abroad. Non-U.S. employees may be excluded from the calculation if (1) they make up 5 percent or less of the total workforce, so long as the company excludes all non-U.S. employees, or (2) the company has obtained a legal opinion that the company is unable to obtain the data necessary to comply with the Final Rule without violating the foreign jurisdiction’s privacy laws.

In anticipation of the impending disclosure date and amidst concerns about compliance costs, the Commission and the Division of Corporation Finance (Staff) recently released additional guidance to assist public companies’ compliance efforts.

RECENT GUIDANCE FROM THE COMMISSION AND STAFF

On September 21, 2017, the Commission issued interpretive guidance (Interpretive Guidance) and the Staff separately issued guidance (Staff Guidance) and updated Regulation S-K Compliance & Disclosure Interpretations. The Interpretive Guidance clarifies three topics related to a company’s identification of the median employee: (1) use of reasonable estimates, assumptions, methodologies and statistical sampling; (2) use of existing internal records; and (3) use of widely recognized legal tests to determine whether someone is an employee as opposed to an independent contractor. The Staff Guidance concerns statistical sampling methodologies and other acceptable methods for determining a company’s median employee, and includes several helpful examples illustrating such methods in practice.

Interpretive Guidance

Reasonableness standard signals high bar for potential liability. The Commission made clear that if a company uses reasonable estimates, assumptions or methodologies in calculating the pay ratio, then the resultant disclosures would not provide a basis for an enforcement action unless the disclosures were made without a reasonable basis or were not provided in good faith.

Use of internal records. The guidance clarified a company may use existing internal records, such as tax or payroll records, that reasonably reflect annual compensation to determine total compensation of the median employee, even if those records do not include every element of compensation, such as equity awards. This marks a divergence from previous guidance, which indicated total cash compensation would not be an acceptable compensation measure if annual equity awards were widely distributed among employees.^[1]

Widely recognized tests to determine employee status. In a departure from previous guidance, the Commission provided that for purposes of the Final Rule, a company may apply a widely recognized test that it uses in other areas of law to determine whether workers are employees or independent contractors. The test might be taken from Internal Revenue Service guidance with respect to the employee-independent contractor distinction. In light of this new guidance, the Commission withdrew a prior interpretation which had indicated a company should count as employees “those workers whose compensation it or one of its consolidated subsidiaries determines regardless of whether these workers would be considered ‘employees’ for tax or employment law purposes.”^[2]

Staff Guidance

Companies may combine statistical sampling and other reasonable methods. In determining the employee pool from which the median employee is identified, a company may use its employee population, a statistical sampling, other reasonable methods or a combination of statistical sampling and other reasonable methods. Furthermore, in an effort to afford companies the flexibility to determine which approach best suits their circumstances, the Division Staff clarified that it is not specifying which “other reasonable methods” are appropriate.

A combination of sampling methods is permitted. Companies may use a combination of statistical sampling methods to determine the median employee. For example, potential sampling methods, either alone or in combination, include simple random sampling, stratified sampling, cluster sampling and/or systematic sampling.

Use of reasonable estimates. The Staff provided examples of circumstances that could warrant the use of reasonable estimates, including, among other examples: analyzing the composition of the company’s workforce (e.g., by geographic unit, business unit or employee type); characterizing the statistical distribution of compensation of employees and its parameters; and calculating a consistent measure of compensation and annual total compensation or elements of the annual total compensation of the median employee.

Use of other reasonable methods. The Staff provided examples of other reasonable methods for determining the pool of employees from which the median employee is identified, including, among other examples: making one or more distributional assumptions; reasonable methods of imputing or correcting missing values; and reasonable methods of addressing extreme observations, such as outliers.

The Staff Guidance also includes three hypothetical examples illustrating how a company with employees outside the U.S. and/or multiple business units might use reasonable estimates, statistical sampling and/or other reasonable methods to identify the median employee.

KEY TAKEAWAYS

The new guidance shows that the Commission and Staff are cognizant of the challenges faced by public companies working to comply with the disclosure requirements. The Interpretive Guidance removes some uncertainty concerning companies’ determination of the median employee and suggests that their disclosures will not be second-guessed so long as they use reasonable methods. Moreover, the Staff’s provision of hypothetical examples should be welcome by public companies currently compiling their disclosures, particularly those with a global workforce or different payroll systems across divisions or subsidiaries, for which the pay ratio disclosures are likely to be especially onerous.

Companies preparing for the impending pay ratio disclosure should do the following if they have not already done so:

• Assemble a compliance team internally;

• Prepare a methodology for determining the pay ratio disclosure, including determining which compensation measure is to be used and whether/which statistical sampling methodology will be used;

• Determine whether outside advisors, such as statisticians or other outside consultants, will be engaged; and

• Engage experienced disclosure counsel to ensure that disclosure is properly undertaken.

_{[1] SEC, Compliance and Disclosure Interpretations 128C.01 (Oct. 18, 2016; updated Sept. 21, 2017).}

_{[2] SEC, Compliance and Disclosure Interpretations 128C.05 (withdrawn Sept. 21, 2017).}