Pay ratio clarifications: SEC adopts new guidance



September 26, 2017

Securities Law Alert

Author(s): Kelly D. Babson, Lloyd H. Spencer

On September 21, 2017, the Securities and Exchange Commission (“Commission”) released interpretive guidance to assist companies in their efforts to comply with the pay ratio disclosure rule adopted by the Commission in 2015, as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The disclosures regarding the compensation of the company’s principal executive officer relative to the compensation of the company’s median employee, which are set forth in Item 402(u) of Regulation S-K, will be required in various filings with the Commission beginning in early 2018.  Nixon Peabody’s alert describing the pay ratio disclosure rule is available here.  Additionally, on September 21, 2017, the Commission’s Division of Corporation Finance staff (“Staff”) separately provided its own guidance about the pay ratio disclosure rule and updated various Compliance and Disclosure Interpretations (“C&DIs”) consistent with the newly- released guidance. The Staff guidance addresses the use of estimates, statistical sampling and other reasonable methodologies in determining the pay ratio and includes examples illustrating possible applications of the Commission’s guidance under several scenarios.

In the Commission’s press release announcing the guidance, both Commission Chairman Jay Clayton and Director of the Division of Corporation Finance William Hinman indicated that the guidance is intended to assist companies with their compliance efforts and reduce the costs of complying with the rule’s disclosure requirements. The interpretive guidance released by the Commission and the Staff is summarized below.

Commission guidance: clarifications on the use of estimates, assumptions and statistical sampling measures.

Companies may use reasonable estimates, assumptions and methodologies, and statistical sampling.

The pay ratio disclosure rule allows companies significant flexibility in determining the appropriate methods to identify the median employee and calculate the median employee’s annual total compensation.  To identify the median employee, companies may use statistical sampling and a consistently applied compensation measure (such as payroll or tax records). To identify the median employee’s compensation or any elements of annual total compensation, companies may use reasonable estimates.

The rule will allow, and practicality will likely require, companies to make substantial estimations to comply, which the Commission acknowledges may involve some degree of imprecision and therefore increase liability concerns with regard to these disclosures. The Commission’s guidance clarifies that so long as a company uses reasonable estimates, assumptions or methodologies, the pay ratio and related disclosure “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.”

In a similar vein, new Staff guidance under C&DI 128C.06 provides that the Staff would not object if a company states in its disclosures that the pay ratio disclosed is a “reasonable estimate calculated in a manner consistent with Item 402(u).”

Companies may use appropriate existing internal records in making certain determinations.

The identification of the median employee’s compensation requires companies to determine the median of the annual total compensation of all employees, excluding the principal executive officer.  The Commission’s guidance clarifies that companies may use existing internal records, such as tax or payroll records, to make this determination.

First, internal records may be used in evaluating whether the 5% de minimis exemption is available. The rule defines the term “employee” to include U.S. employees and employees located in a jurisdiction outside of the United States (“non-U.S. employees”). The inclusion of non-U.S. employees will likely raise compliance costs for multinational companies due to the lack of uniformity across payroll structures. To address this concern, the rule allows for the exemption of non-U.S. employees where non-U.S. employees account for 5% or less of the company’s total combined U.S. and non-U.S. employees, with certain limitations.

Second, the Commission indicates that “in many circumstances” a company’s existing internal records may be appropriate in identifying the median employee.  Companies are allowed to use a “consistently applied compensation measure,” or CACM, such as information derived from tax or payroll records. The Commission’s guidance (and revised C&DI 128C.01) clarifies that internal records that reasonably reflect annual compensation may be used to identify the median employee, even if those records do not include every element of compensation, such as equity awards widely distributed to employees.  The realities of using a CACM may mean that there are atypical characteristics of the identified median employee’s compensation that significantly impact the resulting pay ratio.  In this case, the Commission guidance reiterates, as provided in the Commission’s 2015 adopting release for the pay ratio disclosure rule, that the company may substitute another employee with compensation that is substantially similar to that of the originally identified median employee based on the compensation measure the company used to select the originally identified median employee.

Companies may use widely recognized tests to determine whether workers are employees.

The pay ratio disclosure rule further defines the term “employee” to mean an individual employed by the company or any of its consolidated subsidiaries. Excluded from the definition are those workers who provide services to the company or its consolidated subsidiaries, but who are employed, and whose compensation is determined, by an unaffiliated third party. These workers are considered independent contractors or “leased” workers, as companies generally do not control the level of compensation that these workers are paid.  Most companies already make determinations as to whether workers are employees or independent contractors in other contexts of their business. The Commission guidance confirms that the standard provided in the rule, as noted above, is non-exclusive and a company may apply a widely recognized test under another area of the law, such as one derived from guidance published by the Internal Revenue Service, with respect to independent contractors, to make this determination for the purposes of the pay ratio disclosure.

Staff guidance: permissible uses of reasonable estimates, assumptions and statistical sampling measures.

Combining reasonable estimates with other methodologies.

The pay ratio disclosure rule does not specify the “other reasonable methods” that may be appropriately used so that each company has the flexibility to determine the combinations of methods that best suit its own facts and circumstances. For example, a company with multinational operations or multiple business lines is allowed to use sampling for some geographic/business units and a combination of other methodologies and reasonable estimates for other geographic/business units.

Examples of sampling methods.

The pay ratio disclosure rule does not proscribe the use of any specific sampling techniques or set forth specific limitations regarding sampling methods. Instead, the instructions to the rule indicate that companies must use reasonable methods and make reasonable estimates.  The Commission stated in the rule’s adopting release that all statistical sampling approaches should draw observations from each business or geographical unit with a reasonable assumption on each unit’s compensation distribution and infer the company’s overall median based on the observations drawn.

The Staff provided the following non-exclusive examples of sampling methods that could be appropriate to use (alone or in combination), depending on the company’s particular facts and circumstances:

  • simple random sampling (drawing at random a certain number or proportion of employees from the entire employee population);
  • stratified sampling (dividing the employee population into strata, e.g., based on location, business unit, type of employee, collective bargaining agreement or functional role and sampling within each strata);
  • cluster sampling (dividing the employee population into clusters based on some criterion, drawing a subset of clusters and sampling observations within appropriately selected clusters; cluster sampling may be conducted in one stage or multiple stages); and
  • systemic sampling (the sample is drawn according to a random starting point and a fixed sampling interval, every nth employee is drawn from a listing of employees sorted on the basis of some criterion).

Situations in which reasonable estimates may be appropriate.

The Staff provided the following examples of situations in which companies may use reasonable estimates under the appropriate facts and circumstances:

  • analyzing the composition of the company’s workforce (by geographic unit, business unit, employee type);
  • characterizing the statistical distribution of compensation of the company’s employees and its parameters (e.g., a lognormal, beta, gamma or another distribution, or a mixture of distributions — for example a mixture of two normal or lognormal distributions yielding a bimodal distribution);
  • calculating a consistent measure of compensation and annual total compensation or elements of the annual total compensation of the median employee;
  • evaluating the likelihood of significant changes in employee compensation from year to year;
  • identifying the median employee;
  • identifying multiple employees around the middle of the compensation spectrum; and
  • using the mid-point of a compensation range to estimate compensation.

Examples of other reasonable methodologies.

Companies may use other reasonable methods to determine the set of employees from which the median employee is identified. The Staff provided the following examples of common statistical techniques and methodologies companies may consider:

  • making one or more distributional assumptions, such as assuming a lognormal or another distribution provided that the company has determined that the use of the assumption is appropriate given its own compensation distributions;
  • reasonable methods of imputing or correcting missing values; and
  • reasonable methods of addressing extreme observations, such as outliers.

Hypotheticals.

The Staff provided three hypotheticals, which are summarized in the table below, to assist companies with their compliance efforts and reduce the costs associated with preparing their pay ratio disclosures. Additional details provided in the hypotheticals are available through the link below. The Staff noted that some of the techniques referenced in the hypotheticals below might be more suitable for larger companies with more complex workforces, and that the hypotheticals are not meant to suggest that companies should follow any particular approach. As further noted in the Staff guidance, simpler approaches to determining the pay ratio may be appropriate in many cases.

Facts  Guidance 
Company A has employees in the U.S. and outside the U.S. within three business units and 21 geographic units, covered by multiple payroll systems. Where a company has multiple business units, the company may perform sampling from each of the business units. From each business unit, the company would obtain samples of compensation data on what it believes to be a representative basis of employee pay within that business unit.
Company B has a global workforce with employees concentrated in
the following geographic units: North America, China, Europe and Latin America.
Where a company has employees in several geographic units with different compositions of employees at each unit, the company may choose the most appropriate methodology for each respective unit, including a combination of statistical sampling and other methods, to identify the median. The company may determine the specific sampling methods to be used “based on the company’s knowledge of the workforce distribution across jurisdictions, composition of full-time and part-time employees, distribution of employees among typical occupations, and the company’s pay structures for typical occupations.” The company would follow the approach that works best for each individual unit and then combine the information collected to identify the median employee. The hypothetical provides specific examples of methods that may be used within each of the geographic units under various conditions to obtain information that would then be combined to identify the median employee.
Company C has employees in the U.S. and Asia. Where a company reasonably believes, based on its composition and compensation policies, that there are different statistical distributions of employee compensation across its workforce, the company may group workers with similar distributions and identify the median compensation based on the resulting distribution mixture. For example, the company may identify the following four main groups of workers: full-time employees in the U.S.; part-time employees in the U.S.; full-time employees in Asia; and part time employees in Asia. The company may then use different sets of assumptions and estimates for the different groups.  For the U.S. employees, the company could use distribution assumptions based on data regarding pay levels and hours of a typical full-time and part-time employee at the company. For the employees in Asia, the company could use distribution parameters based on reasonable estimates of typical full-time and part-time employee pay provided by regional managers. The combination of the data collected would yield the median.

What should companies be doing now?

Taken as a whole, the newly issued Commission and Staff guidance reinforces and encourages use of the flexibility afforded under the pay ratio disclosure rule with regard to calculation methodologies and median employee determinations. This guidance may be particularly welcome to issuers grappling with the challenging task of aggregating and analyzing data from diversified global operations and multiple payroll platforms.

Companies subject to the pay ratio disclosure requirements are encouraged to continue their data gathering and disclosure compliance preparations, consistent with the flexible approach as described in the rule and this guidance and as appropriate for their specific organizational structure. Additionally, in applying this guidance, companies should continue to be mindful of how this information will be communicated to and received by shareholders, employees and other interested parties.

The Commission’s guidance on pay ratio disclosure is available here.

The Staff’s guidance on pay ratio disclosure is available here.

The revised pay ratio C&DIs are available here.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

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