Client Alert: SEC Issues Further Guidance on CEO Pay Ratio Rules

SEC Issues Further Guidance on CEO Pay Ratio Rules

October 3 2017

The SEC recently released helpful guidance to companies related to the CEO pay ratio requirements in Item 402(u) of Regulation S-K via an Interpretive Release, Division of Corporation Finance memo on use of statistical sampling and other reasonable methods as well as an update to Compliance and Disclosure Interpretations (“CD&Is”).  For further information on CEO pay ratio disclosure, please see our previous client alerts here and here.

In light of the impending 2018 CEO pay ratio disclosures and concerns raised about the calculations, it appears that the SEC issued this guidance to reiterate its view that companies have significant flexibility in making reasonable estimates to comply with the pay ratio disclosures as well as providing clarification on several significant calculation matters.

Use of Reasonable Estimates, Assumptions, Methodologies and Statistical Sampling

  • Risk of Liability Reduced
    • The SEC recognized that the use of estimates, assumptions and statistical sampling may lead to pay ratio disclosures that “may involve a degree of imprecision.” To lessen potential liability concerns, the SEC clarified that there would be no basis for an enforcement action unless the disclosure was made or reaffirmed without a “reasonable basis” or was provided other than in good faith.
    • Note that an updated CD&I explicitly states that the SEC is comfortable with companies disclosing that the pay ratio is a reasonable estimate calculated in a manner that is consistent with the regulations.
  • Use of Internal Records
    • The Interpretive Release allows companies to use existing internal records, such as tax or payroll records, in identifying the median employee and determining whether the 5% de minimis exemption for non-U.S. employees is available. Of importance, the SEC confirmed that internal records could be utilized to establish the median employee even if those records don’t include every element of compensation, e.g. broad-based equity awards.  This is a welcomed effort to provide flexibility for companies that modifies previous CD&I guidance that was viewed as confusing and problematic by many companies.
  • Independent Contractors
    • The SEC significantly eased the burden on companies as it relates to determining whether independent contractors are employees for purposes of the pay ratio rules. The Interpretative Release states that companies may apply a widely recognized test under another area of law, such as employment or tax law, to assess whether independent contractors should be considered employees for pay ratio calculation purposes.  This guidance is in response to a now withdrawn CD&I, which led to confusion and created additional complexity.

Guidance from Division of Corporate Finance

  • Use of Multiple Methods to Determine Median Employee
    • SEC staff confirmed that companies may combine the use of reasonable estimates with statistical sampling or other reasonable methodologies with an overall objective of allowing each company the flexibility to determine the method that best suits its own facts and circumstances
  • Examples of Sampling Methods
    • Guidance lays out the following sampling methods that could be appropriate to use (alone or in combination), but also notes that companies are not limited to these specific sampling techniques:
      • 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
      • Systematic sampling – 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
    • Examples of situations reasonable estimates may be used
      • Some examples of situations where registrants may use reasonable estimates under the appropriate facts and circumstances, include, but are not limited to:
        • 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)
        • 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
        • Using the mid-point of a compensation range to estimate compensation

Our View
With the release of further guidance, as well as recent public comments from a senior SEC staffer, it is clear that barring any Congressional action, any delay or repeal of the CEO pay ratio disclosure is highly unlikely.  Based on the additional flexibility provided in the most recent guidance, companies may decide to reconsider or revise the various methodologies it may use and model out the results under each to help evaluate the most reasonable calculation method.

Once the methodology is settled upon and estimated values are calculated, establishing a thoughtful and comprehensive communication strategy, including drafting of appropriate disclosures and development of significant internal and external talking points will be critical.

As always, we stand ready to assist with any questions that may arise in the implementation of this rule or the crafting of the required disclosure.

About Steven Hall & Partners
Steven Hall & Partners is an independent executive compensation consulting firm, specializing exclusively in the areas of executive compensation, board remuneration, non-profit compensation and related governance issues.  By focusing solely on this critical and complex segment of the human resources arena, we are able to provide our clients with the highest quality expertise and best counsel available on a practical basis.  For more information, please visit www.shallpartners.com and follow us on Twitter @SHallPartners.

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