Item 402(u) of Regulation S-K was adopted in 2015 to implement the pay ratio disclosure provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and will require pay ratio disclosure with respect to the first fiscal year beginning on or after January 1, 2017 (i.e., such disclosure will be required during the 2018 proxy season)[1]. The required disclosures consist of the total compensation of the registrant’s principal executive officer, the median total compensation of the registrant’s employees other than its principal executive officer, and the ratio of the first of these amounts to the second.

One major concern expressed by larger registrants, particularly those with extensive foreign operations, has been the difficulty of identifying the median employee whose total compensation needs to be disclosed. The SEC attempted to address some of those concerns when it adopted Item 402(u), and on September 21, 2017, published interpretive guidance concerning that issue. The Division of Corporation Finance issued additional guidance on the same day.

SEC Guidance on Pay Ratio Disclosure

Under the rule, a registrant must identify the median employee using annual total compensation or any other compensation measure that is consistently applied to all employees, and then determine the annual total compensation of that employee in accordance with S-K Item 402(c)(2)(x). The pay ratio rule provides flexibility in determining appropriate methodologies to identify the median employee and calculating the median employee’s annual total compensation, as required disclosure may be based on use of reasonable estimates, assumptions, and methodologies. For example, the rule permits registrants: (i) to use reasonable estimates to identify the median employee, including by using statistical sampling (discussed below) and a consistently applied compensation measure (such as payroll or tax records); and (ii) to use reasonable estimates in calculating the annual total compensation or any elements of annual total compensation for employees. In response to concerns over the imprecise nature of these calculations, the SEC has 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 an SEC enforcement action unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith.

In making the determinations required by the rule, the term “employee” is defined to include both US and non-US employees. To address concerns about compliance costs, however, the rule permits registrants to exclude non-US employees where they account for five percent or less of the registrant’s total US and non-US 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 this 5 percent de minimis exemption is available.

In addition, the term “employee” is defined to exclude workers who are employed, and whose compensation is determined, by an unaffiliated third party and who provide services to the registrant or its consolidated subsidiaries as independent contractors or “leased” workers. The guidance notes, however, that this provision was not intended to serve as the exclusive basis for determining that a worker is not an employee of the registrant. Accordingly, the guidance permits a registrant to apply a widely recognized test under another area of law that the registrant otherwise uses to determine whether its workers are employees.

The guidance also 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.

In calculating total compensation in accordance with S-K Item 402(c)(2)(x) for the identified median employee, the registrant may determine that there are anomalous characteristics of the identified median employee’s compensation that have a significant impact on the pay ratio. In such case, the registrant may substitute another employee with substantially similar compensation (based on the measure used to select the median employee) to the original identified median employee.

Division of Corporation Finance Guidance

The pay ratio rule permits a registrant to use its employee population or statistical sampling and/or other reasonable methods in determining the median employee. On September 21, 2017, the Division of Corporation Finance issued guidance on the foregoing, clarifying 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.

Some examples of the sampling methods that could be appropriate to use (alone or in combination), depending on the registrant’s particular facts and circumstances include, but are not limited to: (i) simple random sampling (drawing at random a certain number or proportion of employees from the entire employee population); (ii) 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); (iii) 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); and (iv) systematic sampling (the 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 where registrants may use reasonable estimates under the appropriate facts and circumstances, include, but are not limited to: (i) analyzing the composition of the company’s workforce (by geographic unit, business unit, employee type); (ii) 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—for example a mixture of two normal or lognormal distributions yielding a bimodal distribution); (iii) calculating a consistent measure of compensation and annual total compensation or elements of the annual total compensation of the median employee; (iv) evaluating the likelihood of significant changes in employee compensation from year to year; (v) identifying the median employee; (vi) identifying multiple employees around the middle of the compensation spectrum; and (vii) using the mid-point of a compensation range to estimate compensation.

Examples of common statistical techniques and methodologies registrants may consider, include, but are not limited to: (i) 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; (ii) reasonable methods of imputing or correcting missing values; and (iii) reasonable methods of addressing extreme observations, such as outliers.

The guidance also provides illustrative examples of the principles that a registrant may consider when using reasonable estimates, statistical sampling, and other reasonable methods to identify its median employee, stressing that application of the principles should be tailored to a specific registrant’s facts and circumstances, and that the use of estimates, statistical sampling, and other methods must be reasonable.

C+DIs

In connection with the foregoing guidance, a new pay ratio C+DI was issued (Question 128C.06) stating that the staff would not object if a registrant states in any required disclosure that the pay ratio is a reasonable estimate calculated in a manner consistent with S-K Item 402(u). In addition, Question 128C.01 was updated to refer to the interpretive release, noting, among other things, that if a registrant does not use annual total compensation using S-K Item 402(c)(2)(x) of Regulation S-K to identify the median employee, it may use another consistently applied compensation measure, including “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.”

Question 128C.05 (relating to the determination of employees) was withdrawn.

ENDNOTE

[1] The new requirements do not apply to emerging growth companies, smaller reporting companies, foreign private issuers that file annual reports on Form 20-F, or Canadian issuers utilizing the multi-jurisdictional disclosure system.

This post comes to us from Arnold & Porter Kaye Scholer LLP. It is based on the firm’s client alert, “SEC Issues Pay Ratio Guidance,” dated September 29, 2017, and available here.