On September 21, 2017, the SEC released new guidance on the pay ratio disclosure in Item 402(u) of Regulation S-K, which requires issuers to compare the total annual compensation of their chief executive officer to the median total annual compensation of their other employees. Following is a discussion of the main aspects of the guidance, including: (a) the SEC’s views on the use of reasonable estimates, methodologies and statistical sampling; (b) appropriate statistical sampling methods, other reasonable methods and reasonable estimates; (c) the use of widely recognized tests to determine who is an “employee”; and (d) the use of internal records to evaluate the inclusion of non-U.S. employees in pay ratio calculations and identify the median employee.
Use of Reasonable Estimates, Methodologies and Statistical Sampling
In its new guidance, the SEC acknowledges that some imprecision is inherent in the preparation of pay ratio disclosure because of the use of estimates, assumptions, adjustments and statistical sampling. To address concerns many issuers have regarding compliance uncertainty and potential liability related to pay ratio disclosure, the SEC states in its guidance that “if [issuers use] reasonable estimates, assumptions or methodologies, the pay ratio and related disclosure that results from such use would not provide the basis for [SEC] enforcement action unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith.” In updated Compliance and Disclosure Interpretations (“C&DIs”), the SEC provides that “the staff would not object if [issuers state] in any required disclosure that the pay ratio is a reasonable estimate calculated in a manner consistent with Item 402(u).”
Appropriate Statistical Sampling Methods, Other Reasonable Methods and Reasonable Estimates
The new guidance identifies appropriate statistical sampling methods, other reasonable methods and reasonable estimates, and provides issuers hypothetical examples of how to use each. Statistical sampling methods that can be used to identify the median employee include simple random sampling, stratified sampling, cluster sampling and systematic sampling. Reasonable methodologies include, among others, imputing missing values and reasonable methods of addressing extreme observations, such as outliers. The new guidance provides that issuers can use reasonable estimates both in the methodology used to identify their median employee and in the calculation of the annual compensation for employees other than their CEO. For example, issuers may use reasonable estimates when analyzing the composition of their workforce and calculating a consistent measure of compensation and annual total compensation or elements thereof for their median employee, and can use the mid-point of a compensation range to estimate median employee compensation.
Use of Widely Recognized Tests
In determining who is an “employee” for purposes of the pay ratio rule, issuers now may apply a widely recognized test under another area of law, like tax or employment law, that they otherwise use to determine whether a worker is an employee. For example, issuers may decide that for a U.S. worker, they will determine employee status based on whether a Form 1099 or Form W-2 was issued. Previously, under Item 402(u)(3) of Regulation S-K and a C&DI that the SEC withdrew as part of its new guidance, the only category of individuals that issuers could exclude as “employees” for the purposes of the pay ratio rule were workers who they employed but whose compensation was determined by an unaffiliated third party.
Use of Internal Records
Item 402(u) of Regulation S-K requires issuers to identify their median employee using annual total compensation or another consistently applied compensation measure. Pursuant to the new guidance, issuers may use existing internal records that reasonably reflect annual compensation, such as tax or payroll records, in determining their pay ratio. For example, issuers can use internal records to determine if they can exclude non-U.S. employees that account for 5% or less of their total U.S. and non-U.S. employees, based on the exemption in Item 402(u)(4)(ii) of Regulation S-K. In addition, the SEC guidance provides that, when determining the median employee, “[issuers] 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.”
In summary, the SEC’s guidance builds additional flexibility into the pay ratio determination for issuers. While this flexibility is good news for issuers, it makes it all the more important that issuers work closely with their compensation consultants and legal counsel to complete their pay ratio analysis and disclosure well in advance of finalizing their 2018 proxy solicitation materials. In addition to impacting proxy statements, pay ratios might well have an important effect on employee relations. Issuers should leave enough time to assess how to properly communicate pay ratio results both externally and within their organizations.
SEC Interpretive Guidance: https://www.sec.gov/rules/interp/2017/33-10415.pdf
Guidance on Calculation of Pay Ratio: https://www.sec.gov/corpfin/announcement/guidance-calculation-pay-ratio-disclosure
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Donald R. Reynolds and S. Halle Vakani are members of the Capital Markets practice group of Wyrick Robbins, which represents clients across a broad range of industries in connection with their significant financing transactions and advises public companies on SEC and stock exchange rules, securities law compliance, disclosure and corporate governance matters. The Capital Markets group publishes Client Alerts periodically as a service to clients and friends. The purpose of this Client Alert is to provide general information, and it is not intended to provide, and should not be relied upon as, legal advice.