SEC Releases Interpretative Guidance on Pay Ratio Rule

Chris Gaetano
Published Date:
Sep 22, 2017

The Securities and Exchange Commission has released interpretative guidance on the controversial pay ratio rule which mandates that companies to disclose the ratio of compensation between the CEO and rank-and-file employees. The rule, approved in 2015 as part of the Dodd-Frank Act, requires companies to disclose the median of the annual total compensation of all its employees save the CEO, the annual total compensation of its CEO, and the ratio of those two amounts. However SEC Commissioner Michael Piwowar, when he was acting chair, said in February that there were plans to revisit the rule in light of unanticipated compliance difficulties. 

The interpretative guidance said that the rule was already built with a large degree of flexibility for registrants "in determining appropriate methodologies to identify the median employee and calculating the median employee’s annual total compensation." The rule permits registrants to use reasonable estimates to identify the median employee, including by using statistical sampling and a consistently applied compensation measure (such as payroll or tax records). It also allows registrants to use reasonable estimates in calculating the annual total compensation or any elements of annual total compensation for employees, and further provides that if a registrant changes its methodology or its material assumptions, adjustments, or estimates, and the effects are significant, the registrant can do so, provided it briefly describes the change and the reasons behind it. 

However, said the interpretative guidance, stakeholders still expressed concerns about "compliance uncertainty and potential liability." In answer to these concerns, the guidance said that, in the view of the SEC, so long as 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.

It also clarified that registrants may use appropriate existing internal records, such as tax or payroll records, in determining whether the rule's 5 percent de minimus exemption  for non-U.S. employees applies. Similarly, the commission also feels that internal records that reasonably reflect annual compensation can be used to identify the median employee, even if those records do not include every element of compensation, such as equity awards widely distributed to employees. If there's anomalous characteristics of the identified median employee compensation that could significantly impact the ratio, the registrant can substitute another employee with substantially similar compensation, based on the compensation measure used to select the median employee. 

Finally, in determining whether or not someone even counts as an employee for the purposes of determining the ratio, the SEC said that registrants can apply "a widely recognized test under another area of law that the registrant otherwise uses to determine whether its workers are employees" such as employment law or tax law. 

Beyond the interpretative guidance, the SEC also released staff guidance on the use of statistical sampling methodologies and other reasonable methods of determining the pay ratio. The staff guidance clarifies that registrants may combine the use of reasonable estimates with the use of a statistical sampling or other reasonable methodology. So, for example, a registrant can use sampling for some geographic or business lines, and a combination of other methodologies and reasonable estimates for other units.

It also provides some examples of what would be considered a reasonable sampling method, which includes: 

* simple random sampling (drawing at random a certain number or proportion of employees from the entire employee population);

* 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);

* 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

* 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).

The guidance provides similar lists of examples for what counts as a reasonable estimate (for instance, calculating a consistent measure of compensation and annual total compensation or elements of the annual total compensation of the median employee), reasonable methodologies (like 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), and some hypothetical examples of the use of these reasonable sampling, methodologies and estimates. 

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