Last week, the SEC issued additional guidance on Item 402(u) of Regulation S-K, the CEO pay ratio disclosure requirement. The Commission has issued an interpretive release on the new rule, while the Staff of the Division of Corporation Finance has published separate guidance on the use of statistical sampling to identify the median employee. We expect that we are going to see an onslaught of law firm memoranda and other articles dissecting this guidance over the next few days (including our own take on what it all means). For now, here are our initial impressions on what just happened.
Starting with the interpretive release, we see at least three fairly significant items:
1. The Commission indicates that as long as a company uses reasonable estimates, assumptions, or methodologies the pay ratio itself and related disclosure that results from such use would not provide the basis for an enforcement action unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith. This is good news, as we were starting to see some concerns that the flexibility contained in the rule could expose a company (and, perhaps, even its senior executives) to the risk of liability given the inherent imprecision in the ratio.
2. The Commission states that a company may use internal records that reasonably reflect annual compensation to identify its median employee, even if those records don’t include every element of compensation, such as equity awards widely distributed to employees. This will be welcome by many companies that have discovered that their compensation information is dispersed among several databases, including some located in foreign countries where accessibility is problematic.
3. The Commission clarifies that the exemption contained in Item 402(u)(3) concerning the exclusion of workers who are employed, and whose compensation is determined, by an unaffiliated third party does not represent the exclusive basis for determining whether a worker should be considered an “employee” of a company. Further, it goes on to state that it is consistent with the rule to apply a “widely recognized test under another area of law” that the company otherwise uses to determine whether its workers are employees. This is very significant – in our view it will make the analysis of whether independent contractors should be considered employees much more straightforward. To reinforce this point, the Division of Corporation Finance has withdrawn Compliance and Disclosure Interpretation No. 128C.05, the question that addressed the treatment of independent contractors and “leased workers.”
In addition to the foregoing, the Division of Corporation Finance’s new guidance on the use of reasonable estimates, statistical sampling and other reasonable methodologies should be very useful in helping companies to construct a sampling approach which fits their specific facts and circumstances.
Some examples of the sampling methods include, but are not limited to: - Random sampling – random draw of certain employees from total population.
- Stratified sampling – dividing employees into strata (based on location, business unit, etc.) and sampling within each strata.
- Cluster sampling – dividing employees into clusters (based on various criteria), sampling within appropriately selected clusters.
- Systematic sampling – sample based on random starting point and fixed sampling interval (e.g., every nth employee taken from list).
While some of the guidance was implicit in the Adopting Release and the Staff’s Compliance and Disclosure Interpretations issued last fall, the scope of the discussion, as well as the numerous examples provided, should go a long way in helping companies better understand the degree of flexibility they truly have in developing a process for identifying the median employee that best fits their specific situation.
