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What You Need to Know About the September 2017 SEC Pay Ratio Guidance

On September 21, 2017, the Securities and Exchange Commission (SEC) released additional pay ratio guidance in the forms of an interpretive release, guidance from the Department of Corporate Finance (Corp Fin), and updates to the Compliance and Disclosure Interpretations (CDIs). This is the second time that the SEC has provided clarifications following the release of the final rule in August 2015. (The first time was a volley of CDIs released in October 2016, which we covered in a prior issue brief.)

The new batch of guidance primarily reiterates and clarifies flexibility that the rule already allowed. However, there is one substantial update: the ability to use the standard IRS definition of an employee. Previous guidance pointed employers toward a more inclusive definition that would incorporate people who are otherwise classified as contractors under tax law.

Below we’ll go over the highlights of the interpretive guidance and updates to the CDIs and we’ll discuss the ideas posed in the Corp Fin guidance regarding statistical sampling.

Contractors and Employees

The provision [directing companies to test whether contractors’ pay is set by the company] was not intended to serve as an exclusive basis for determining whether a worker is an employee of the registrant. Accordingly, we believe it would be consistent with Item 402(u) for 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 SEC’s original definition of employee for pay ratio purposes was very broad. It included workers who were full-time as well as part-time; permanent, temporary, and seasonal; domestic and international. It even included certain contractors. This last was certainly the most ambiguous area of the employee definition since it involved a potentially complicated analysis into whether the company or an unaffiliated party set the contractors’ pay.

The new interpretive guidance clears up this ambiguity by allowing companies to define an employee the same way as for other common areas of law or tax. To this end, the SEC specifically mentions “guidance published by the Internal Revenue Service with respect to independent contractors.” The new guidance also withdraws a prior CDI (released in October 2016) that focused on testing whether the registrant sets the pay.

The takeaway:

To determine who is included in the pay ratio analysis, companies with contractors are now free to use the IRS definition of an employee. Companies with a significant contractor population should carefully consider the costs and benefits of different employee definitions for these purposes. All in all, this new guidance brings clarity to an area that was perplexing to many organizations.

Statistical Sampling

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…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.
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.

In the Corp Fin guidance, the SEC discusses statistical sampling along with various issues that companies have encountered with the use of sampling and “reasonable estimates” in practice. The SEC also provides three examples of how a company may address a complicated population. Consistent with our prior interpretations of the topic, the SEC suggests various possible approaches using analysis from the full population, a sample from available employees in a group, or distributional analysis.

Distributional analysis is useful where data for a subset of employees is unavailable. This technique makes it possible to draw inferences from known segments that have similar compensation properties. But for distributional analysis to work, you must do the sampling correctly and in a manner consistent with the economic principles spelled out in the pay ratio rule.

The new guidance also reiterates a key point of statistical sampling: You cannot use sampling, or any other approach, to disregard any core employee demographic category. Put differently, sampling does not allow you to exclude certain employee groups, divisions, or locations.

The takeaway:

The new guidance is a helpful confirmation, but it doesn’t change the way most companies can or should approach their analysis. We’re happy to continue helping clients with both data-rich population analyses and robust statistical sampling. But for most companies, it’s still probably faster and easier to analyze the full population.

CACM and Median Employee Selection

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 consistently applied compensation measure (CACM) describes the measure of compensation that companies use to identify the median employee. The pay ratio ultimately must be calculated using Summary Compensation Table (SCT) conventions for annual total compensation. But to identify the median employee, the rule allows companies to select a CACM based on their facts and circumstances.

In one of the October 2016 CDIs, the SEC stated that the CACM needed to be representative of the employee population and overall pay practices. They cited an example of needing to include equity in the CACM if equity is granted broadly. This suggested that companies were more or less required to incorporate major components of pay, regardless of the cost/benefit of gathering and using that data.

In the new interpretive guidance and a corresponding update to that CDI, the SEC eases the CACM requirements. Companies may use existing internal records to calculate the CACM, as long as the CACM still reasonably reflects compensation. For example, a company may use total cash compensation as its CACM—excluding equity—as long as the exclusion of equity would not substantially change their median pay.

The takeaway:

Companies with large populations receiving equity grants or substantial, nontraditional compensation should continue to include this data in some fashion. Simply ignoring it runs the risk of choosing a nonrepresentative or volatile median employee. If collecting such data for the whole population is not feasible, we recommend selecting 5 to 10 employees around the median to test for consistency after including all SCT elements for those individuals.

Reasonable Estimates

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.

In its final ruling from 2015, the SEC stated that reasonable estimates could be applied in the analysis. This could include (for example) the use of statistical sampling in place of the full population, the use of a consistently applied compensation measure (CACM) instead of each employee’s annual total compensation, and more. However, this left some companies confused about where the boundaries lay, or how heavily estimation methods could be relied upon.

In the interpretive release, the SEC reiterates that the concept of reasonability can be applied throughout the entire analysis, which naturally leads to a degree of imprecision. They emphasize that the standard of care is performing the analysis and calculations in good faith and in accordance with reasonable economic principles, which are spelled out in the rule. In addition, the SEC confirms via a new CDI that companies can refer to their pay ratio as an estimate, given that various reasonable assumptions are baked into the analysis giving rise to that ratio.

The takeaway:

The guidance in this area doesn’t change the application of the rule. Neither should it affect any company’s ideal methodology for computing their pay ratio. We view this as a validation of existing best practices, not a new standard of care. The clarification is largely one of semantics, as any calculation that relies on any assumptions or statistical techniques is inherently an estimate.