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SEC clarifies CEO pay ratio procedures in Dodd-Frank

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Human Capital BulletinOn Sept. 21 the SEC, along with the Division of Corporate Finance, released new guidance for Item 402(u) of Regulation S-K, otherwise known as the “CEO pay ratio” disclosure. The guidance clarified a number of outstanding questions, specifically relating to the use of statistical sampling, the use of internal records for determining compensation, and techniques companies may use for classifying workers as either “employees” or “independent contractors.”

The CEO pay ratio, originally mandated by the Dodd-Frank Wall Street Reform Act of 2010, requires public companies to disclose the ratio of the total annual compensation of their median employee relative to the company’s principal executive officer (generally the CEO). Authors of the legislation hoped the disclosure would provide investors with greater transparency into companies broader pay levels, and how those amounts compared to the pay of their company’s CEO. With the ratio’s remaining questions finalized, companies must now begin preparations to report their ratio for their first full fiscal year beginning in 2017 (first disclosure for most companies with Dec. 31 fiscal year-ends will occur in 2018 proxy filings). Prior to the guidance, it had been unclear whether the SEC under the Trump Administration would enforce and implement the regulation (see “Reconsideration of Pay Ratio Rule Implementation”). The updated guidance affirms that companies should be moving full steam ahead in their preparations for calculating the ratio.

Identifying the median employeeThe first issue addressed in the guidance pertains to the use of statistical sampling in determining a company’s employee population. The SEC clarified that companies may use any number of reasonable “estimates, assumptions, and methodologies” for determining the median employee and the types of compensation used to assess their total annual pay. As it applies to selecting the median employee, companies may elect to use statistical sampling and/or any other reasonable method that best suits their unique business characteristics. The Division of Corporate Finance, expanding upon the SEC’s guidance, elaborated on a number of potential sampling techniques, demonstrating the level and range of flexibility afforded to companies by the SEC. As an example, companies may use statistical sampling to identify their employee population for certain business divisions/geographies, and completely different methodologies/reasonable estimates for other portions of their business.

Perhaps most importantly, the SEC declared that companies using reasonable estimates and methodologies would not be liable for pay ratio-related lawsuits unless “the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith.” A number of companies submitted concerns to the SEC that the ambiguity of ratio calculation may leave companies open to potential liabilities. The updated guidance confirms that companies should feel comfortable in calculating their ratio so long as they demonstrate the use of reasonable estimates and methodologies.

Use of internal recordsThe guidance also expanded upon the types of compensation that may be considered when identifying the median employee. The SEC stated that companies may use internal records, such as tax or payroll filings, that reasonably reflect total annual compensation, even if those records do not include all elements of a company’s total compensation (i.e., equity, benefits and perquisites). While all elements of compensation are not required to be included when identifying the median employee, all elements must be included when calculating the ratio of the employee’s compensation relative to the principal executive. This clarification will help companies with a workforce spread across multiple geographies or payroll systems that otherwise may have difficulty aggregating all of the necessary information.

Possible exclusionsThe final item addressed in the guidance clarified the range of employees that may (or may not) be excluded from the ratio calculation. Previously, the SEC had suggested that companies may exclude independent contractors from their employee population if their compensation was determined by an unaffiliated third party. Similar to the guidance that companies may use existing internal processes to identify the median employee, companies may also use existing tests, such as those used for tax or employment law purposes, to determine whether workers are classified as employees for the ratio calculation.

Pay ratio disclosure is here to stay
In total, the updated guidance provides companies with even more flexibility to tailor their calculation to what makes the most sense for their business. So long as estimates, assumptions and methodologies are reasonable, companies should feel comfortable using a variety of sampling techniques to identify their employee population. Companies may then use internal compensation records or payroll systems to identify a median employee, provided the compensation reasonably reflects total annual compensation. Finally, companies may replicate previously run employment tests to determine whether workers, for the purpose of the ratio, will be included as employees or excluded as independent contractors.

With the CEO pay ratio’s outstanding questions all but answered, companies should be moving towards finalizing processes for their upcoming proxy disclosures in 2018, especially with the requirement that employee populations must be determined within 90 days of a company’s fiscal year-end (which began around Oct. 1 for companies with a Dec. 31 fiscal year-end). As mentioned, companies will have a number of tools and calculation methodologies available to calculate their ratio in a way that minimizes the time and costs. It is now up to companies, along with input from outside advisers, to determine the most effective route.

Contact

Eric Gonzaga
Principal, Compensation Consulting
T +1 612 677 5336

Rob Storrick
Senior Associate, Compensation Consulting
T +1 612 677 5135

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