In recent public comments, staffers at the Securities and Exchange Commission have made it known that, despite numerous efforts to the contrary, the controversial pay ratio rule remains on track with a fast-approaching compliance date.

Adding to the warnings of imminent effectiveness, the Commission has approved interpretive guidance intended to assist companies in their efforts to comply with the Dodd-Frank Act mandate.

Under the final rule, registrants must provide pay ratio disclosure for the first fiscal year beginning on or after January 1, 2017, which means that registrants will begin making pay ratio disclosures in early 2018. Those disclosures, require a comparison of CEO pay with compensation of a public company’s median employee.

“It’s our priority to make sure that we implement disclosure rules mandated by Congress in a way that is true to the mandate and, to the extent practicable, allows companies to use operational data and otherwise readily available information to produce the disclosures,” Chairman Jay Clayton said in a statement.  “[The] guidance on pay ratio reflects the feedback the SEC has received and encourages companies to use the flexibility incorporated in our prior rulemaking to reduce costs of compliance.”

Allowing flexibility

The guidance states the Commission’s views on the use of reasonable estimates, assumptions and methodologies, and statistical sampling permitted by the rule. It also clarifies that a company may use appropriate existing internal records, such as tax or payroll records, in determinations about the inclusion of non-U.S. employees and in identifying the median employee.

The Commission also provides guidance as to when a company may use widely recognized tests to determine whether its workers are employees for purposes of the rule.

The Commission’s staff also provided additional guidance that illustrates how reasonable estimates and statistical methodologies may be used It is intended to assist companies with their compliance efforts and reduce the costs associated with preparing disclosures.

The interpretive guidance is intended to assist registrants in preparation of their pay ratio disclosures required by Item 402(u) of Regulation S-K. It encourages the use of reasonable estimates, assumptions, and methodologies and statistical sampling.

The pay ratio rule affords significant flexibility to registrants in determining appropriate methodologies to identify the median employee and calculating the median employee’s annual total compensation, the guidance says. Required disclosure may be based on a registrant’s reasonable belief; use of reasonable estimates, assumptions, and methodologies; and reasonable efforts to prepare the disclosures. 

Specifically, 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). The rule also allows registrants to use reasonable estimates in calculating the annual total compensation or any elements of annual total compensation for employees.

The rule further provides that if a registrant changes its methodology or its material assumptions, adjustments, or estimates, and the effects are significant, the registrant must briefly describe the change and the reasons for the change.

In light of the use of estimates, assumptions, adjustments, and statistical sampling  permitted by the rule, pay ratio disclosures “may involve a degree of imprecision,” the guidance says.

“This has led some commenters to express concerns about compliance uncertainty and potential liability,” it adds. “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.”

Use of internal records

The final rule defines the term “employee” to include U.S. employees and employees located in a jurisdiction outside the United States (“non-U.S. employees”). The SEC acknowledges that the inclusion of non-U.S. employees would raise compliance costs for multinational companies.

“To address concerns about compliance costs, the rule permits registrants to exempt non-U.S. employees where these employees account for 5 percent or less of the registrant’s total U.S. and non-U.S. employees, with certain limitations,” the interpretive guidance says. “We are clarifying that a registrant may use appropriate existing internal records, such as tax or payroll records, in determining whether the 5 percent de minimis exemption is available.”

The guidance adds that the use of existing internal records may, in many circumstances, be appropriate in identifying a registrant’s median employee. Instruction 4 to Item 402(u) permits a registrant to identify its median employee using a consistently applied compensation measure, such as information derived from the registrant’s tax or payroll records. 

We are clarifying 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 Commission wrote. It recognizes that, when calculating total compensation in accordance with Item 402(c)(2)(x) for the identified median employee that the registrant identified using 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 says it 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. 

Independent contractors

For purposes of Item 402(u), the term “employee” or “employee of the registrant” is defined as “an individual employed by the registrant or any of its consolidated subsidiaries.” Item 402(u)(3) excludes from the definition those 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. In the Pay Ratio Release, the Commission indicated that excluding these workers is appropriate, because registrants generally do not control the level of compensation that these workers are paid.  

Additional guidance, also released on Sept. 21, comes from the SEC’s Division of Corporation Finance Guidance

While providing broad flexibility, the Commission made clear that registrants must determine their own median and may not use industry estimates, such as the employee earnings estimates provided by the Bureau of Labor Statistics, as a substitute for determining their median.

In order to assist registrants in determining how to use statistical sampling methodologies and other reasonable methods, the Division provided the guidance and hypothetical examples of use of sampling and other reasonable methodologies.

May registrants combine the use of reasonable estimates with the use of statistical sampling or other reasonable methodologies? For instance, is a registrant with multinational operations or multiple business lines permitted to use sampling for some geographic/business units and a combination of other methodologies and reasonable estimates for other geographic/business units?

Yes.  Instruction 4.2 to Item 402(u) expressly provides that:

In determining the employees from which the median employee is identified, a registrant may use its employee population or statistical sampling and/or other reasonable methods.

The use of “and/or” in the Instruction indicates that a registrant is permitted to use statistical sampling, other reasonable methods or a combination of statistical sampling and other reasonable methods.  Further, in adopting the “other reasonable methods” language, the Commission indicated that it did not specify “other reasonable methods” that may be appropriate to allow each registrant the flexibility to determine the method that best suits its own facts and circumstances.

What are some examples of sampling methods that registrants may use?  Are registrants permitted to use a combination of sampling methods?

Yes. When adopting the pay ratio disclosure rule, the Commission expressly sought to provide flexibility to registrants in determining their sampling methods. Instruction 4 to Item 402(u) does not set forth specific limitations regarding the methods of sampling that are permissible.  Rather, the instruction provides that registrants must use reasonable methods and make reasonable estimates.  For example, the Commission expressly stated in the adopting release “that reasonable estimates of the median for registrants with multiple business lines or geographical units may be determined using more than one statistical sampling approach. Additionally, all statistical sampling approaches should draw observations from each business or geographical unit with a reasonable assumption on each unit's compensation distribution and infer the registrant's overall median based on the observations drawn."”

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:

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).

What are some examples of situations where registrants may use reasonable estimates?

Instruction 4.1 to Item 402(u) provides that: registrants may use reasonable estimates both in the methodology used to identify the median employee and in calculating the annual total compensation or any elements of total compensation for employees other than the PEO.

Some examples of situations where registrants may use reasonable estimates under the appropriate facts and circumstances, include, but are not limited to:

analyzing the composition of the company's workforce (by geographic unit, business unit, employee type);

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);

calculating a consistent measure of compensation and annual total compensation or elements of the annual total compensation of the median employee;

evaluating the likelihood of significant changes in employee compensation from year to year;

identifying the median employee;

identifying multiple employees around the middle of the compensation spectrum; and

using the mid-point of a compensation range to estimate compensation.

What are some examples of other reasonable methodologies a registrant may use? May registrants use a combination of reasonable methodologies?

Instruction 4.2 to Item 402(u) permits registrants to use other reasonable methods in determining the employees from which the median employee is identified. As addressed in the adopting release and noted above, Item 402(u) does not specify any required methodology and permits registrants flexibility to choose a method or combination of methods based on their facts and circumstances. Any method or combination of methods used would need to be reasonable. Some examples of common statistical techniques and methodologies registrants may consider, include, but are not limited to:

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.

Examples are provided to illustrate the principles a registrant may consider when using reasonable estimates, statistical sampling and other reasonable methods to identify its median employee. 

Application of the principles should be tailored to a specific registrant's facts and circumstances. In addition, the use of estimates, statistical sampling, and other methods must be reasonable. 

Company A has employees in the U.S. and outside the U.S. within three business units and 21 geographic units, covered by multiple payroll systems.

One approach would be for the company to perform sampling from each of the three business units.  In obtaining samples of compensation data from each of the three business units, the company selects samples from the geographic locations whose employee pay is generally representative of employee pay within the entire business unit.

Company B has a global workforce with employees concentrated in the following geographic units: North America, China, Europe, and Latin America units.

The company may use a combination of statistical sampling and other methods to identify the median.

Where statistical sampling is used, the sampling method may be chosen to be reasonably representative of the employee population, based on the company's knowledge of the workforce distribution across jurisdictions, composition of full-time and part-time employees, distribution of employees among typical occupations, and the company's pay structures for typical occupations.

Within the North America geographic unit, the company employs mostly management and administrative employees at headquarters and a workforce consisting mostly of sales employees in 25 other cities. The company identifies the most common occupations of employees working at headquarters and draws a stratified random sample of headquarters employees other than the PEO in those occupations. Almost all employees outside headquarters are sales employees.

Based on its understanding of employee pay outside headquarters, the company identifies three cities in which the distribution of employee pay and full-time and part-time employees is reasonably representative of the distribution of pay of employees outside headquarters. In those cities, the company randomly selects stores, from which a random sample of sales employees is drawn.

For employees in the Europe geographic unit, the company draws a stratified random sample of employees in typical occupations identified based on the company's knowledge of its workforce and pay structure.  Employees in the sample include managers, administrative personnel, service employees, and sales staff.

For the China geographic unit, the company uses a sample of full-time and part-time employees reasonably believed to be around the middle of the pay scale.

For the Latin America geographic unit, the information is drawn under a distribution assumption.

Based on the understanding of pay practices and workforce composition, employee pay in the Latin America unit is estimated to follow a lognormal distribution.

For example, the company may use reasonable estimates provided by regional managers to determine distribution parameters. Where pay ranges were considered, the mid-point of the pay range is used.

To identify the median employee, the company combines information from the North America, China, Europe, and Latin America geographic units, obtained as described above.

Company C has employees in the U.S. and Asia.

Based on the company's information about its workforce composition and compensation policies, the company reasonably believes the distribution of employee compensation to be multimodal and approximately characterized as a mixture of lognormal distributions, weighted based on estimated workforce composition. The median may be identified based on the resulting distribution mixture.

As an example, the company may identify four main cohorts of workers: full-time employees in the U.S.; part-time employees in the U.S.; full-time employees in Asia; and part-time employees in Asia.

For the U.S. employees, distribution assumptions are based on data regarding pay levels and hours of a typical full-time and part-time employee at the company.

For international workers, distribution parameters are based on reasonable estimates of a typical full-time and part-time employee's pay provided by regional managers.