SEC Issues Significant Guidance on Pay Ratio Rules

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."[1] 

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:

  • Employees Covered by the Rule and the Treatment of Independent Contractors:  Item 402(u) defines an "employee" for purposes of the rule as "an individual employed by the registrant or any of its consolidated subsidiaries, whether as a full-time, part-time, seasonal, or temporary worker" and expressly excludes individuals "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’s new guidance affirmatively states that this exclusion is not the exclusive basis for determining whether a worker is an "employee" for purposes of the rule, and confirms that companies may use tests from other areas of law (e.g., tests under employment or tax law) to determine who is an employee.  Accordingly, companies generally will not be required to count independent contractors or workers employed by unaffiliated third parties as company "employees" for purposes of the pay ratio rule. 

    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.

  • Using a Consistently Applied Compensation Measure to Identify the Median Employee:  The SEC confirmed that companies can rely on existing internal records (such as tax and payroll records) that reasonably reflect annual compensation when utilizing a consistently applied compensation measure to identify the median employee, even if those records do not include every element of compensation such as equity awards.  This guidance is helpful because many companies administer their equity compensation through a separate reporting system and valuing equity compensation can be problematic.  In particular, this guidance will reduce compliance costs for companies seeking to rely on salary and cash bonus information or similar "base pay" information as the basis for identifying their median employee when the companies are able to conclude that such measures provide a reasonable alternative to annual total compensation for identifying their median employee.   

    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. 

  • Reliance upon Internal Records, Reasonable Estimates, Assumptions, and Methodologies: The new guidance reaffirms concepts from the Adopting Release allowing companies to rely upon reasonable estimates, assumptions, and methodologies, including statistical sampling, to comply with the rule.  For example, in its interpretive release, the Division identified a variety of situations where reasonable estimates may be used under the rule, including to:
    • analyze the composition of the workforce;
    • characterize the statistical distribution of compensation of employees;
    • calculate annual total compensation or another consistently applied compensation measure;
    • evaluate the likelihood of significant changes in employee compensation from year to year;
    • identify the median employee;
    • identify other employees around the middle of the compensation spectrum; and
    • use the mid-point of a compensation range to estimate compensation

    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: 

    • making one or more distributional assumptions, such as assuming a lognormal or another distribution provided that the company has determined that the use of the assumption is appropriate given its own compensation distributions;
    • reasonable methods of imputing or correcting missing values; and
    • reasonable methods of addressing extreme observations, such as outliers.

    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. 

  • Important Implications and the Role of Disclosure: Importantly, the SEC acknowledges that, in light of the use of estimates, assumptions, adjustments, and reasonable methodologies allowed under the rule, "pay ratio disclosures may involve a degree of imprecision."  The new guidance addresses a number of implications of this aspect of the rule. 
    • Good Faith Standard: Acknowledging the inherent imprecision in these estimates, assumptions, and methodologies, the SEC stated 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 Commission enforcement action unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith."
    • Anomalous Results: The SEC acknowledges that the use of a consistently applied compensation measure based on internal records may identify a median employee whose annual total compensation has anomalous characteristics.  The SEC’s guidance reaffirms that in such a situation, a company may substitute another employee with substantially similar compensation to the originally identified median employee.  We believe this same approach is generally appropriate when a company identifies more than one employee with the same median compensation based on its consistently applied compensation measure and that it would be consistent with this guidance for such a company to assess the annual total compensation of those employees and select the most representative case as its median employee. 
    • Disclosure as Reasonable Estimate:  Consistent with the SEC’s new guidance, the Division issued a new interpretation (C&DI 128C.06, issued Sept. 21, 2017) stating that the Division would not object if a company states that its disclosed pay ratio is a reasonable estimate calculated in a manner consistent with Item 402(u)

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.

   [1]   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.

Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have about these developments. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work, or any of the following lawyers in the firm’s Securities Regulation and Corporate Governance practice group:

Brian J. Lane - Washington, D.C. (+1 202-887-3646,
Ronald O. Mueller – Washington, D.C. (+1 202-955-8671,
James J. Moloney - Orange County (+1 949-451-4343,
Elizabeth Ising – Washington, D.C. (+1 202-955-8287,
Sean C. Feller – Los Angeles (+1 310-551-8746,
Lori Zyskowski – New York (+1 212-351-2309,
Gillian McPhee – Washington, D.C. (+1 202-955-8201,
Maia Gez – New York (+1 212-351-2612,
Krista Hanvey – Dallas (+1 214-698-3425,
Julia Lapitskaya – New York (+1 212-351-2354,

© 2017 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.