SEC (Limited) Guidance on Pay-Ratio Disclosure

[September 21, 2017], the SEC announced that it had adopted interpretive guidance in connection with the pay-ratio disclosure requirement, which mandates public company disclosure of specified pay-ratio information, beginning with the upcoming 2018 proxy season. Generally, the guidance provides a more expansive reading of three topics: company reliance on reasonable estimates, the use of existing internal records to determine the median employee and non-U.S. employees, and the use of other recognized tests and criteria (such as published IRS guidance) to determine employee/independent contractor status. At the same time, Corp Fin issued separate guidance regarding the use of statistical sampling (to be addressed in a subsequent post) and updated CDIs on topics related to the new SEC guidance. For a more complete discussion of the pay-ratio rule, see our Cooley Alert, SEC Adopts Final Pay-Ratio Rule.

As you probably recall, the Dodd-Frank pay-ratio provision and related SEC rule require disclosure, in a wide range of SEC filings, of the ratio of the median of the annual total compensation of all employees of the company to the annual total compensation of the CEO. Adoption by the SEC of final rules to implement the provision took more than five years from the date of enactment of Dodd-Frank in 2010, as the SEC sought to address public comment about the difficulties of implementing the rule. To that end, the SEC attempted to provide flexibility to “reduce costs and burdens” while maintaining the intended benefits. The new guidance observes that the disclosures to be provided under the rule were intended to benefit investors by allowing “shareholders to better understand and assess a particular registrant’s compensation practices and pay ratio disclosures rather than to facilitate a comparison of this information from one registrant to another.”

Use of Reasonable Estimates, Assumptions, and Methodologies and Statistical Sampling

The final pay-ratio rule provided significant flexibility in how companies could identify the median employee and in calculating his or her total annual compensation. As the guidance notes, the “disclosure may be based on a registrant’s reasonable belief; use of reasonable estimates, assumptions, and methodologies; and reasonable efforts to prepare the disclosures.” For example, registrants may use reasonable estimates to identify the median employee, including by using statistical sampling, and calculate the annual total compensation (or any elements of it) by using reasonable estimates. As a result, the SEC—note that this isn’t just guidance from the staff of Corp Fin—acknowledged that the “pay ratio disclosures may involve a degree of imprecision,” which raised “concerns about compliance uncertainty and potential liability. In our view, 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 Commission enforcement action unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith.” [Emphasis added.] (Presumably, however, that doesn’t eliminate the possibility that the SEC won’t question the reasonableness of the estimates or the basis or the company’s good faith.)

Note also that the staff of Corp Fin has added new CDI 128C.06, which advises that, in light of the degree of imprecision involved in the calculation, the staff would not object if a company describes the pay ratio as a “reasonable estimate calculated in a manner consistent with Item 402(u).”

Use of Internal Records

Non-U.S. Employees. Under the rules, the company must disclose the median of the annual total compensation of all employees of the company, except the CEO (that is, the point at which half the employees earn more and half earn less). “All employees” includes non-U.S. employees, except that companies are permitted to exclude non-U.S. employees where these employees account for 5% or less of the company’s total U.S. and non-U.S. employees, with certain limitations. The guidance clarifies “that a registrant may use appropriate existing internal records, such as tax or payroll records, in determining whether the 5% de minimis exemption is available.” [Emphasis added.]

Median Employee. In addition, under the rule, to identify the median employee in the population or sample, a company may use annual total compensation or any other consistently applied compensation measure, such as compensation amounts reported in its payroll or tax records (e.g., W-2 wages). The guidance confirms that “the use of existing internal records may, in many circumstances, be appropriate in identifying a registrant’s median employee.” The guidance, in what appears to be a change from the previous position of the Corp Fin staff, clarifies that “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.” The SEC acknowledges that in “using a consistently applied compensation measure based on internal records, the registrant may determine that there are anomalous characteristics of the identified median employee’s compensation that have a significant higher or lower impact on the pay ratio. The Commission discussed this issue in the adopting release specifically and noted that, in such a circumstance, instead of concluding that the consistently applied compensation measure the registrant used was unsuitable to identify its median employee, the registrant may substitute another employee with substantially similar compensation to the original identified median employee based on the compensation measure it used to select the median employee.”

In this context also the staff of Corp Fin has updated a CDI consistent with the SEC’s less prescriptive position on use of a consistently applied compensation measure, including the apparent shift in position on the use of internal records, such as cash compensation, even where employee equity awards are widely distributed. Revised CDI 128C.01 now provides that “any measure that reasonably reflects the annual compensation of employees could serve as a CACM. The appropriateness of any measure will depend on the registrant’s particular facts and circumstances. As the Commission stated in the interpretive release, ‘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.’”

Previously, the CDI provided examples of Corp Fin’s view as to whether a measure might be appropriate under particular facts and circumstances. In one of the examples provided in the prior CDI, now apparently reversed, the staff indicated that total cash compensation could be an appropriate CACM unless annual equity awards were widely used to compensate employees. The prior version of the CDI also provided that Social Security taxes withheld would likely not be an appropriate CACM unless all employees earned less than the Social Security wage base. However, the requirement that a CACM “reasonably reflect” annual compensation does not mean that the same median employee must be identified under the CACM as would be identified using the S-K definition of annual total compensation. Any compensation measure used to identify the median employee must be briefly disclosed. The significance, if any, of the elimination of these latter concepts in the newly revised CDI is not entirely clear.

Independent Contractors

In perhaps the most interesting aspect of the guidance, the SEC permits an expansion of the exclusion from the definition in the rule of the term “employee.” The rule defines an employee as “an individual employed by the registrant or any of its consolidated subsidiaries,” but excludes from the definition of employee “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 or ‘leased’ workers.” The SEC viewed this exclusion as appropriate “because registrants generally do not control the level of compensation that these workers are paid.” However, the application of this exception in today’s “gig” economy, in which many workers who provide services directly to or for companies are identified as “independent contractors,” was not really clear. Under the new guidance, the SEC concluded that the exclusion in the rule for workers who are employed by unaffiliated third parties is not the exclusive basis for determining whether a worker is an employee of the registrant.” Given that “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,” the SEC will allow companies “to use widely recognized tests to determine who is an ‘employee’ for purposes of the rule.” The “test might, for example, be drawn from guidance published by the Internal Revenue Service with respect to independent contractors.”[Emphsis added.] Note also in this regard that the SEC has withdrawn CDI 128C.05, which had addressed the issue of employee/independent contractor status.