They say every cloud has a silver lining and so it seems with recent developments related to the CEO pay ratio rule. By releasing new guidance on the rule last week, the SEC has dashed hopes that it would delay the effectiveness of the rule. However, at the same time, it has taken important steps to reduce the compliance burden.

The guidance, which consists of an Interpretive Release, revised pay ratio Compliance and Disclosure Interpretations, and a Division of Corporation Finance paper on the use of statistical sampling and other methods, introduces the following noteworthy changes or clarifications:

  • Permits Use of Recognized Tests to Identify and Exclude Independent Contractors

The Interpretive Release (and updated Compliance and Disclosure Interpretations (CDIs)) permits companies to determine whether an individual is excludible from the employee pool as an independent contractor by applying “widely recognized tests” used in other contexts, such as for tax and employment law purposes, rather than exclusively by reference to whether a non-employee worker’s compensation is determined by an unaffiliated third party.

Permitting reliance on existing tax or other determinations as to the status of a contractor strikes a time-consuming exercise off the pay ratio to-do list for most companies.

  • Clarifies Requirements for Selecting a “Consistently Applied Compensation Measure”

SEC CDI 128C.01 released in October 2016 suggested, by way of example, that it would not be appropriate to use total cash compensation as the compensation measure to identify the employee with median annual compensation if a company “also distributed annual equity awards widely among its employees.” The apparent requirement to evaluate various elements of global employee compensation to capture “widely distributed” items increased complexity, both in identifying and considering such pay elements and in collecting data from a variety of internal and external sources. In updating its pay ratio CDIs, the SEC has revised CDI 128C.01, to permit companies to “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 that are widely distributed to employees.”

Although companies must ensure that the compensation measure they select reasonably reflects the annual compensation of employees, the ability to make this assessment using internal records, such as from tax or payroll, without running a parallel analysis of whether compensation items are widely distributed, streamlines the process of finding the median employee.

  • Requires Reasonableness but Reduces the Risk of SEC Enforcement Action

In its Interpretive Release, the SEC outlines the various ways in which the pay ratio rule affords companies flexibility in determining the median employee and calculating employee compensation, including its permitted use of reasonable estimates, assumptions, adjustments and statistical sampling. In doing so, the SEC recognizes that the pay ratio disclosure may involve imprecision and confirms that such disclosure will not provide the basis for SEC enforcement action unless it was made without a reasonable basis or other than in good faith. Along with this, the SEC has released new CDI 128C.06, in which it allows companies to characterize their pay ratio disclosure as a “reasonable estimate calculated in accordance with Item 402(u).”

This enforcement guidance provides reassurance to companies concerned about potential liability for their pay ratio disclosures and may, to some extent, make it more difficult for plaintiff shareholders to found claims for deficient disclosures (although there are obviously no guarantees in this regard, given how creative plaintiffs can be).

  • Provides Examples of Permitted Sampling Methods and “Other Reasonable Methods”

In its pay ratio adopting release, the SEC provided limited guidance on the use of statistical sampling to determine the employees from which the median employee is identified and no guidance on what “other reasonable methods” may be used under Instruction 4.2 to Item 402(u). The lack of prescriptive guidance around these methods was intended to promote flexibility, but left uncertainty and concern as to what is appropriate in this context.

In its paper on the calculation of the pay ratio disclosure, the Division of Corporation Finance has squarely addressed these concerns by:

i. confirming that companies may combine the use of sampling methods with estimates and other methods, such as through using different methods for different geographic or business units;

ii. providing a non-exhaustive list of permitted sampling methods, including random, stratified, cluster and systematic sampling, and a description of each method;

iii. outlining specific situations where the use of estimates may be appropriate, including in characterizing the statistical distribution of employee compensation and calculating a consistent measure of compensation;

iv. identifying examples of other permitted reasonable methods to determine the employee pool, including making assumptions about the distribution of compensation and adopting reasonable methods to impute or correct missing values or address extreme/outlier observations; and

v. perhaps most helpfully, setting out three hypothetical company scenarios to demonstrate the practical application of the above guidance.

No Relief Allowing Exclusion of Non-US Employees

The SEC guidance fell short for any companies hoping for more drastic change, such as relief from the requirement to include their non-US employees in the employee pool when determining the median employee. However, the Interpretive Release clarifies that companies may use appropriate existing internal records in determining whether the “de minimis exemption” is available to permit exclusion of employees who are outside the United States in an amount up to 5% of total employees. Further, the new guidance on sampling and other methods may alleviate the burden of collecting and processing information related to non-US employees.

Back to the Grindstone…

Although the new SEC guidance is welcome and helpful, it has not come a minute too soon as the clock ticks down to the beginning of the 2018 proxy season. And companies optimistic that the pay ratio would be mostly disregarded should take note of the results of Institutional Shareholder Services’ 2017-2018 Policy Survey, released on September 25th. Only 16% of survey respondents indicated that they were not planning to use the pay ratio disclosure information.

Further, a majority of investor respondents indicated that they intend to compare pay ratios across companies or industry sectors, use them to assess year-on-year changes at individual companies, and/or use them as a data point in determining votes on compensation-related resolutions and as background material for engagement with the company. Perhaps unsurprisingly, non-investor respondents – on the front lines of calculating the ratio – most frequently indicated that the information would not be meaningful to shareholders.


Victor Flores is a partner in Baker McKenzie’s Employment & Compensation Practice, with a focus on Executive Compensation and Employee Benefits. Victor advises global US and non-US companies – both public and private – on all aspects of executive compensation and benefits matters, including the corporate, securities and tax law, and ERISA issues arising in the implementation and administration of compensation programs. He regularly helps clients with the design and implementation of equity and non-equity based incentive compensation programs and nonqualified deferred compensation programs. Victor also has extensive experience advising on compensations and benefits issues in mergers and acquisitions, corporate reorganizations, private equity and other corporate transactions.


Sinead Kelly is a partner in Baker McKenzie’s Compensation practice in San Francisco. She advises on U.S. executive compensation and global equity and has practiced in the compensation field since 2005. In her practice, Sinead counsels U.S. and non-U.S. public and private companies on all aspects of equity and executive compensation plans and arrangements, including plan design, drafting, administration and governance. In this regard, Sinead advises on and assists companies with compliance with U.S. federal and state securities and tax laws relating to compensation arrangements, as well as with preparing SEC disclosures, complying with stock exchange rules and addressing non-U.S. tax and regulatory requirements. She has been repeatedly recognized by Legal 500 as a leading lawyer for Executive Compensation and Employee Benefits.