David Marshall Block, Marty Dunn, Rose A. Zukin, and Scott Lesmes
Public Companies Counseling + Compliance and Capital Markets
On September 21, 2017, the Securities and Exchange Commission (the “SEC”) published interpretive guidance (the “SEC Guidance”) to assist public companies in their preparation of the pay ratio disclosure required by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Act”). The staff of the SEC’s Division of Corporation Finance (the “Staff”) separately published interpretive guidance (the “Staff Guidance) relating to the use of sampling and other reasonable methodologies. This Staff guidance is intended to assist registrants in determining how to use statistical sampling methodologies and other reasonable methods in complying with the pay ratio disclosure obligation. The Staff has further supplemented its guidance with new and revised Compliance and Disclosure Interpretations.
Public companies subject to the requirements under Section 953(b) of the Act must provide pay ratio disclosure for their first fiscal year beginning on or after January 1, 2017; as a result, these subject companies will begin providing pay ratio disclosures in early 2018. The following public companies are not subject to the pay ratio disclosure obligation: emerging growth companies, smaller reporting companies, foreign private issuers, filers under the U.S.-Canadian Multijurisdictional Disclosure System, and registered investment companies.
For a detailed discussion of the rule and previous Staff guidance, click here.
DISCLOSURE REQUIRED BY ITEM 402(U) OF REGULATION S-K
The SEC adopted the rules implementing Section 953(b) of the Act in 2015. These final rules added new paragraph (u) to Item 402 of Regulation S-K. New Item 402(u) requires disclosure of (i) the median of the annual total compensation of all employees of the company, except the CEO of the company; (ii) the annual total compensation of the CEO of the company; and (iii) the ratio of the amount in (ii) to the amount in (i), presented as a ratio in which the amount in (i) equals one, or, alternatively, expressed narratively in terms of the multiple that the amount in (ii) bears to the amount in (i).
Section 953(b) of the Act did not prescribe a methodology that must be used to identify the median employee. Accordingly, in the adopting release, the SEC expressly sought to provide flexibility to subject companies to choose their own individual methods to identify the median employee based on their own facts and circumstances, noting that companies may use statistical sampling and/or “other reasonable methods.” The SEC’s final rule in this regard provided for flexibility in setting the parameters of the statistical sampling method and further did not specify the “other reasonable methods” that may be appropriate.
THE STAFF GUIDANCE
In identifying the “median employee” as the point of comparison, the SEC’s rule states that subject companies may use a methodology that uses reasonable estimates. The median employee may be identified using annual total compensation, or any other compensation measure that is consistently applied to all employees included in the calculation, such as information derived from tax and/or payroll records. In addition, in determining the employees from which the median is derived, a company is permitted to use its employee population or statistical sampling and/or other reasonable methods. The Staff Guidance addresses various aspects of the use of sampling methodologies and reasonable methods, as follows.
Combination of Methods to Determine the “Median Employee”
The Staff Guidance clarified that registrants may combine the use of reasonable estimates with the use of statistical sampling or other reasonable methodologies. For example, a registrant with multinational operations or multiple business lines is permitted to use sampling for some geographic/business units and a combination of other methodologies and reasonable estimates for other geographic/business units. The Staff points registrants to Instruction 4.2 to Item 402(u), which provides that “[i]n determining the employees from which the median employee is identified, a registrant may use its employee population or statistical sampling and/or other reasonable methods.” The Staff stated that the use of “and/or” in the instruction indicates that a registrant is permitted to use a combination of statistical sampling and other reasonable methods.
Examples of Other Reasonable Methodologies
Instruction 4.2 to Item 402(u) permits registrants to use other reasonable methods in determining the employees from which the median employee is identified. As addressed in the adopting release, Item 402(u) does not specify any required methodology and permits registrants flexibility to choose a method or combination of methods based on their facts and circumstances. Any method or combination of methods used would need to be reasonable.
The Staff Guidance provides the following examples of common statistical techniques and methodologies registrants may consider:
Examples of Situations Where Registrants May Use Reasonable Estimates
Instruction 4.1 to Item 402(u) provides that “registrants may use reasonable estimates both in the methodology used to identify the median employee and in calculating the annual total compensation or any elements of total compensation for employees other than the [CEO].”
The Staff Guidance includes the following examples of situations where registrants may use reasonable estimates under the appropriate facts and circumstances:
Examples of Sampling Methods
The adopting release emphasized that registrants have flexibility as to the sampling methods they may use under the rule. Item 402(u) does not set forth specific limitations regarding the methods of sampling that are permissible.
The Staff guidance provides the following examples of the sampling methods that could be appropriate to use (alone or in combination), depending on a registrant’s particular facts and circumstances:
Hypothetical Examples of the Use of Reasonable Estimates, Statistical Sampling and Other Reasonable Methods
In the Staff Guidance, the Staff provided helpful illustrations of the principles that a registrant may consider when using reasonable estimates, statistical sampling and other reasonable methods to identify its median employee, noting that the application of principles should be tailored to a specific registrant’s facts and circumstances. The hypotheticals are available at the link to the Staff Guidance provided above.
THE SEC GUIDANCE
Compliance Uncertainty and Potential Liability
In light of the use of estimates, assumptions, adjustments and statistical sampling permitted by the rule, commenters to the SEC rule expressed concern that the imprecision in pay ratio disclosures may result in compliance uncertainty and potential liability.
In the SEC Guidance, the SEC expressed its view that if a registrant uses 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.
Use of Internal Records
The final rule allows a registrant to use existing internal records, such as tax or payroll records, to determine the median of the annual total compensation of all its employees excluding its CEO.
In the SEC Guidance, the SEC provided the following guidance as to the use of existing internal records to make this determination.
Item 402(u)(3) excludes from the definition of “employee” those workers who are employed, and whose compensation is determined, by an unaffiliated third party but who provide services to the registrant or its consolidated subsidiaries as independent contractors.
Commenters expressed concerns about the application of the final rule’s definition of “employee.” Because registrants already make determinations as to whether a worker is an employee or independent contractor in other legal and regulatory contexts, such as for employment law or tax purposes, some commenters suggested that the SEC should allow registrants to use widely recognized tests to determine who is an “employee” for purposes of the rule.
In the SEC Guidance, the SEC stated that it would be consistent with Item 402(u) for a registrant to apply a widely recognized test under another area of law – such as guidance published by the Internal Revenue Service with respect to independent contractors – that the registrant otherwise uses to determine whether its workers are employees, noting that the provision was not intended to serve as an exclusive basis for determining whether a worker is an employee of the registrant.
IMPLICATIONS OF THE GUIDANCE
The new guidance reinforces the flexibility given to registrants in implementing the pay ratio disclosure rules. The broad discretion granted to registrants will ease the burden of compliance and allow registrants to tailor their selected methodologies to the specific demands of their businesses. However, registrants should still take care to properly disclose their selected methodologies and consider how such information is presented to shareholders.
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