September 26, 2017
On September 21, 2017, the U.S. Securities and Exchange Commission (the "SEC") and the Division of Corporation Finance (the "Division") issued new interpretive guidance addressing significant issues under the pay ratio disclosure rule mandated by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). The guidance provides a number of helpful clarifications and examples that will assist companies in their efforts to comply with the disclosure rules and, as stated by SEC Chairman Clayton, "encourages companies to use the flexibility incorporated in [the SEC’s] prior rulemaking to reduce costs of compliance."
The guidance consists of an interpretive release by the SEC available here, guidance by the Division available here, and new and revised Compliance & Disclosure Interpretations ("C&DIs") available here. As discussed below, the Division also withdrew an earlier C&DI that had created uncertainty over when independent contractors and other workers would be viewed as company employees for purposes of the rule.
As we previously discussed in this alert, Item 402(u) of Regulation S-K implements the pay ratio disclosure mandate of the Dodd-Frank Act. The rule requires disclosure of: (i) the median of the annual total compensation of all employees of the registrant other than the CEO; (ii) the annual total compensation of the CEO; and (iii) the ratio of these two amounts. Under Item 402(u), companies are generally required to report the pay ratio disclosure based on compensation for their first fiscal year beginning on or after January 1, 2017. For a calendar-year company, the disclosure generally will be required in the company’s 2018 proxy statement, filed next year.
This new guidance reiterates and clarifies important statements and concepts from the SEC’s release adopting Item 402(u) (the "Adopting Release"). In particular, the new guidance emphasizes that the SEC provided companies significant flexibility when it designed the pay ratio rule "to allow shareholders to better understand and assess a particular registrant’s compensation practices … rather than to facilitate a comparison of this information from one registrant to another." Consistent with this approach, the guidance addresses a number of contexts in which, to mitigate the costs of compliance, the pay ratio rule generally allows companies to rely on existing internal records and use reasonable estimates, assumptions, and methodologies to identify the median-compensated employee and calculate that employee’s annual total compensation:
Consistent with the SEC’s new guidance, the Division withdrew one of its prior interpretations (C&DI 128C.05, originally issued in October 2016). The withdrawn C&DI had suggested that companies had to count workers who were employed by unaffiliated third parties as company employees under the rule if the company determined their compensation, regardless of whether the worker was considered an "employee" for tax or employment law purposes. The withdrawn C&DI, by going beyond the language of the rule itself and addressing "workers" generally, had significantly increased compliance costs and concerns as companies tried to determine whether workers employed by third parties might be deemed their "employees" for purposes of the pay ratio rule and, if so, how to obtain compensation information on such workers. By reiterating that Item 402(u)’s definition of "’employee’ is an individual employed by the registrant," and confirming that companies generally can apply a "widely recognized test under another area of law to determine whether its workers are employees" for purposes of Item 402(u), the SEC’s guidance will greatly simplify compliance for many companies.
Consistent with the SEC’s new guidance, the Division modified one of its prior interpretations (C&DI 128C.01, originally issued in October 2016) to omit language indicating that total cash compensation would not be an acceptable consistently applied compensation measure if annual equity awards were widely distributed among employees and that social security taxes withheld would not be an appropriate consistently applied compensation measure unless all employees earned less than the social security wage base. The omitted language had drawn criticism as it failed to take into account the wide variety of equity compensation practices across companies, and (in contrast to the Adopting Release) seemed to focus on the pay structure of a company’s entire workforce, instead of addressing the relative impact of compensation elements paid to employees whose compensation is likely to be at or near the median.
The Division confirms that the pay ratio rule allows companies to use a combination of reasonable estimates, statistical sampling, and other reasonable methodologies. In addition, by citing a variety of different statistical sampling approaches that can be applied under the rule, the Division has reaffirmed its flexibility and deference to companies to determine which reasonable and appropriate sampling methods may work best for their organization. Other examples of reasonable methodologies identified by the Division include:
As noted above, the guidance also confirms that companies may use existing internal records, such as tax or payroll records, in determining and disclosing the median employee’s compensation. For example, Item 402(u) allows companies to exclude non-U.S. employees who constitute up to five percent of the company’s total workforce when identifying the median compensated employee. In the new guidance, the SEC expressly affirms that a company can rely on internal records such as tax or payroll records in applying this five percent test.
Finally, consistent with the SEC’s traditional focus on disclosure, the new guidance notes in a number of contexts the disclosure requirements under the pay ratio rule. For example, the SEC’s guidance notes that if a company substitutes a different median employee to address anomalous results, the company should disclose the substitution as part of its brief description of the methodology it used to identify the median employee. Similarly, the SEC notes that factors relevant to identifying a company’s employees who are covered by the rule may involve material assumptions that should be described as part of the company’s methodology for calculating and disclosing its pay ratio.
Overall, the new guidance reiterates the company-specific facts-and-circumstances nature of pay ratio determinations and further outlines the variety of estimates, methods, and options that a company has at its disposal in determining its employee population, identifying its median employee, and calculating its pay ratio. What is appropriate for one company may not work for another, and companies will need to determine how best to comply with Item 402(u) in light of their size, geographic scope, and business operations. Companies also should carefully evaluate how to briefly describe material estimates, assumptions, and methodologies they employ, to place their pay ratio disclosure in context and reflect the unique nature of the disclosure.
 See SEC, Press Release, SEC Adopts Interpretive Guidance on Pay Ratio Rule, Sept. 21, 2017, available here.
The following Gibson Dunn lawyers assisted in the preparation of this client update: Ronald O. Mueller, Elizabeth Ising, Maia Gez and Krista Hanvey.
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