On September 21, 2017, the SEC issued additional guidance to assist companies in their efforts to comply with the pay ratio disclosures required by Item 402(u) of Regulation S-K. This new guidance is aimed directly at easing some of the key concerns that have been raised regarding the implementation of the pay ratio disclosure requirements which will be applicable beginning in early 2018. Given this new guidance and the fact that the SEC has no apparent plans to delay implementation of these requirements, companies should begin to establish their compliance approach if they have not yet done so.
As noted in our “Corporate Update — Mind the (Pay) Gap: SEC Adopts Final Pay Ratio Disclosure Rules (August 10, 2015),” in August 2015, the SEC adopted a rule requiring companies to disclose the ratio of CEO compensation to the total compensation of its median employee. Last week, through an interpretive release, guidance from the SEC Staff (including hypothetical examples) and revisions to the SEC’s C&DIs, the SEC makes clear that companies:
- have significant flexibility in developing procedures to determine the median employee and the amount of compensation paid to such employee, including expressly allowing the use of estimates and statistical sampling;
- may use existing internal records, including payroll or tax records, in making such determinations; and
- may utilize existing tests and recognized legal frameworks for determining what workers constitute “employees” for this purpose.
Use of Reasonable Estimates, Assumptions and Methodologies and Statistical Sampling
First, the SEC reiterated that the pay ratio rule “affords significant flexibility” to companies to determine appropriate methodologies, including reasonable estimates and/or statistical sampling, to identify the median employee and calculate such employee’s annual total compensation. This flexible framework allows each company to determine the method based on its own facts and circumstances. The SEC assured companies that, if they use reasonable estimates, assumptions or methodologies, the pay ratio and related disclosure “would not provide the basis for Commission enforcement action unless the disclosure was provided or reaffirmed without a reasonable basis or was provided other than in good faith.”
The SEC Staff also issued guidance on the application of statistical sampling and reasonable estimates in the pay ratio rule, including several useful hypothetical examples. These examples appear to allow more expansive sampling than what many compensation consultants expected.
Companies should be mindful that while they have broad discretion in determining the estimates, assumptions and methodologies that are used for purposes of the pay ratio rule, any changes to their approach from year to year that result in significant effects must be briefly described with the reason for the change.
Use of Internal Records
The pay ratio rule applies to both U.S. and non-U.S. employees, resulting in significant concerns regarding compliance costs for multinational corporations. However, non-U.S. employees may be excluded from the calculation if they account for 5% or less of the total employees of the company. The SEC’s guidance makes clear that a company may use existing internal records, such as tax or payroll records, to determine whether this de minimis exemption applies.
In addition, the SEC clarified that, as long as the compensation measure is consistently applied, “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.” In connection with this clarification, the SEC Staff removed previously issued C&DI examples that caused confusion about the extent to which companies could rely on internal records if certain elements of compensation were not included. The SEC also reiterated that, if a company determines there are anomalous characteristics of the identified median employee’s compensation that have a significant higher or lower impact on the pay ratio, the company may substitute another employee with substantially similar compensation to the identified median employee based on the applicable compensation measure.
Independent Contractors and MLPs
Finally, the SEC’s new guidance reiterates that independent contractors or “leased” workers are not subject to, and should not be included in, the median employee or annual compensation calculations. The SEC clarified in the interpretive release that companies may utilize “widely recognized tests” used in other regulatory contexts (i.e., employment law or for tax purposes) in determining whether an individual is an “employee” for purposes of the pay ratio rule. This new guidance should give companies comfort that the application of the rule will not conflict with their existing employee/independent contractor determinations, and eliminates confusing and troubling guidance that applied a different result depending on who made the employee/independent contractor determination.
With respect to MLPs and other similar structures, the pay ratio rule and new guidance do not clarify whether employees of the general partner or another affiliate providing management and operating services for the MLP will be deemed to be "employees" of the MLP. However, Item 402(u)(3) refers specifically to the exclusion of workers who are employed, and whose compensation is determined, by an unaffiliated third party. As a result, it is expected that when MLPs are required to provide pay ratio disclosure, MLPs will be expected to include in their determination of the median employee the compensation of employees of their sponsors, general partners or other affiliates who provide services to the MLP.
What Companies Should Do Now
These disclosure requirements are effective for the 2018 proxy season, so companies should utilize this guidance now to begin determining the procedures they will use to calculate the median employee and total compensation. We recommend that companies work with their compensation consultants to establish a timeline to complete the analysis. In addition, after the median employee and compensation has been determined, we believe that companies should be mindful of any employees that may be sensitive to such information and consider whether to address any concerns individually or collectively with employees. Finally, companies should consider how the pay ratio disclosure will be applied by investors. Nearly three-quarters of respondents in the recently published ISS 2017-2018 Benchmark Voting Policy Survey indicated that they intend to compare the pay ratios across companies and industry sectors or assess year-on-year changes in the ratio (or use both of these methodologies).
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