On September 21, 2017, the U.S. Securities and Exchange Commission (SEC) released additional guidance on the pay ratio disclosure rules that require public companies to disclose how the compensation of their chief executive officer compares to the median annual total compensation of their employees overall. As a reminder, these rules are effective for most public companies (other than emerging growth companies and smaller reporting companies) in 2018 with respect to 2017 compensation. For a summary of the key provisions of these rules, please see our previous WSGR Alert. The SEC's additional guidance provides relief on a number of issues that should reduce the overall time burden on companies and provide greater flexibility in how they calculate and disclose their pay ratio. This guidance also resolves any lingering possibility that the SEC will delay or significantly modify any requirements related to the pay ratio disclosure rules.

Reasonableness Standard Affirmed

The SEC confirmed the reasonableness standard set forth in the pay ratio disclosure rules and further clarified that such use of "reasonable estimates, assumptions or methodologies [and] 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." In addition, the SEC released a Compliance and Disclosure Interpretation (C&DI) (available here) stating that the SEC would not object to companies including a statement in their disclosure that the pay ratio is a reasonable estimate calculated in a manner consistent with Item 402(u). Because of this C&DI, we suggest that companies consider including such a statement in their disclosure.

Use of Internal Records Permitted for Identifying Median Employee and Exclusion of Certain Non-U.S. Employees

The SEC clarified that in identifying the median employee, companies may use internal records that reasonably reflect annual compensation, even if those records do not include every element of compensation, such as equity awards widely distributed to employees. The SEC updated a previously issued C&DI to refer to this guidance and remove reference to examples that stated that total cash compensation would not be an appropriate measure if the company distributed equity awards widely among its employees and that withheld Social Security taxes would not be an appropriate measure unless all employees earned less than the Social Security wage base. As revised, this C&DI further supports the ability of companies to use data that is already available internally, which should ease the calculation burden related to identifying the median employee. The SEC also clarified that companies may use internal records to determine whether certain non-U.S. employees may be excluded under the five percent de minimis exception. Companies should note, however, that this guidance applies only to the identification of the median employee. Once the median employee is identified, such employee's annual total compensation as calculated in the same manner as for executives in the summary compensation table (which includes equity awards) will need to be determined and disclosed.

Independent Contractor Exception Clarified

The SEC clarified that it would be acceptable for companies to apply a widely recognized test under another area of law, such as for employment law or tax purposes, that the company otherwise uses to make the determination between employee and independent contractor. Previously, the rules indicated that companies would be required to perform a test based on the language of Item 402(u)(3), which allowed companies to exclude a worker as an independent contractor if the worker's compensation was determined by an unaffiliated third party and not the company. In line with this new guidance, the SEC withdrew a C&DI related to the previous test for whether a worker qualified as an independent contractor. This change provides greater clarity regarding the analysis and should ease the burden of having to analyze different types of service arrangements for purposes of determining the median employee.

Guidance on Statistical Sampling

The SEC provided further guidance on how companies may use statistical sampling and other reasonable methodologies in determining their median employee and median annual total compensation. Sampling methods that the SEC noted would be appropriate 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 groups based on criteria such as location, business unit, type of employee, collective bargaining agreement, or functional role, and sampling within each group);
• 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 (drawing the sample according to a random starting point and a fixed sampling interval, with every nth employee drawn from a listing of employees sorted on the basis of some criterion).

The examples provided by the SEC for where such statistical sampling would be applicable include larger companies with multinational operations, multiple business lines, or multiple payroll systems. However, smaller and larger companies alike are able to benefit from statistical sampling in a number of general areas, such as evaluating the likelihood of significant changes in employee compensation from year to year, imputing or correcting missing values, and addressing extreme outliers. For a full description of how and where statistical sampling may be used, please see the SEC's full guidance here.

The SEC's additional guidance provides companies with greater flexibility on methodology and use of reasonable estimates, but it is important to keep in mind that companies may face increased scrutiny if their methods are unclear. While we are not certain how investors and other stakeholders will use the pay ratio disclosure, companies should be cognizant of potential investor, employee, and media reaction to their individual pay ratio, as well as their pay ratio relative to similarly situated companies. Companies may wish to proactively prepare for potentially challenging feedback from internal and external stakeholders in tandem with their disclosure preparation and have a plan in place to address such concerns should they arise. As noted in a previous WSGR Alert, we recommend that companies aim to complete this analysis well in advance of proxy season given the amount of time and effort that is likely to be required.