The Seemingly Unavoidable Pay Ratio Rule


Will the Median Employee Please Stand Up?

In a surprise move, the United States Securities and Exchange Commission (“SEC”) announced that the so-called “Pay Ratio Rule” will remain in effect for the 2018 proxy season. These regulations were adopted by the SEC in August 2015 under the Dodd–Frank Wall Street Reform and Consumer Protection Act and became effective for fiscal years commencing on or after January 1, 2017, but many expected that the current administration would delay their implementation or withdraw them completely. The Pay Ratio Rule amends Item 402 of Regulation S-K and requires public companies to disclose the median of the annual total compensation of all employees (excluding the CEO), the annual total compensation of the CEO, and the ratio of those two amounts. The adopting release for the Pay Ratio Rule and the rule itself can be found here.

The SEC has offered interpretive guidance that is intended to ease some of the uncertainty and assist in the calculations required under the Pay Ratio Rule. The contents of this guidance is discussed and linked below.

When Must Companies Comply with the Pay Ratio Rule?

It depends. The Pay Ratio Rule requires annual disclosure for fiscal years beginning on or after January 1, 2017. For many companies, the pay ratio disclosures will be first required for proxy statements delivered in 2018. By comparison, a company with a December 1—November 30 fiscal year end will be required to first provide the pay ratio disclosure in 2019. A newly reporting company would be required to report its pay ratio for the first fiscal year following the year in which it becomes subject to the SEC’s reporting requirements. Foreign private issuers, Canadian MJDS filers, registered investment companies, emerging growth companies and smaller reporting companies are exempt from the disclosure requirements of the Pay Ratio Rule. Companies that cease to be smaller reporting companies or emerging growth companies do not need to provide pay ratio disclosure until after the first full fiscal year after exiting that status.

When is Pay Ratio Disclosure Required?

The pay ratio disclosure is required in any annual report, proxy or information statement or registration statement that requires executive compensation disclosure pursuant to Item 402 of Regulation S-K. We expect that most companies will include pay ratio disclosure in their proxy statements, along with other compensation discussion and analysis. In doing so, particular attention to filing timelines is encouraged to ensure that the disclosure is properly incorporated by reference in Form 10-K. As noted above, pay ratio disclosure is not required to be disclosed in a registration statement for an initial public offering of securities; i.e., (on Forms S-1, S-11 or 10). For other registration statements, a company typically may incorporate pay ratio disclosures by reference.

Have There Been Recent Developments Impacting the Implementation of the Pay Ratio Rule?

Yes. In June 2017, the United States House of Representatives passed the Financial CHOICE Act (H.R. 10). One of the provisions of the legislation proposes to repeal Section 953(b) of the Dodd-Frank Act, which directed the SEC to adopt the Pay Ratio Rule. Although the Financial CHOICE Act briefly gave observers hope that the Pay Ratio Rule would be retracted before becoming effective, it now seems unlikely that the United States Senate will approve the Financial CHOICE Act in its current form, if at all, before the 2018 proxy season.

Further dashing the hopes of Pay Ratio detractors Rule, on September 15, 2017, while speaking at an American Bar Association business law conference, William Hinman, Director of the SEC’s Division of Corporate Finance, stated that the SEC did not intend to delay its implementation of the Pay Ratio Rule. Less than a week later, on September 21, 2017, the SEC issued a press release relating to a number of pieces of guidance being issued on the same day relating to the Pay Ratio Rule. In addition to the press release, the SEC issued interpretative guidance (“Interpretative Guidance”), a long-form FAQ and revised compliance and disclosure interpretations ("C&DIs") A redlined version of the relevant C&DI’s is included as an addendum to this Client Alert.

In its press release, the SEC’s staff makes clear that the guidance related to the Pay Ratio Rule is intended to: (i) state the SEC’s views on the use of reasonable estimates, assumptions and methodologies, and statistical sampling permitted by the rule; (ii) clarify that a company may use appropriate existing internal records, such as tax or payroll records, in determinations about the inclusion of non-U.S. employees and in identifying the median employee; and (iii) provide guidance as to when a company may use widely recognized tests to determine whether its workers are employees for purposes of the rule. In addition, the SEC staff’s guidance allows for relaxed enforcement priorities relating to the Pay Ratio Rule.

Can a Company Use Reasonable Estimates, Sampling Methods and “Other Reasonable Methods” in Combination?

Yes. As part of its efforts to provide more flexibility to companies in selecting a consistently applied compensation methodology, in the FAQ, the SEC provides a number of technical clarifications as to reasonable estimates and valid statistical sampling methodologies, including that companies may use a combination of statistical sampling and other reasonable methods in order to identify the median employee. Throughout the FAQ, the SEC reiterated that, when adopting the Pay Ratio Rule, it expressly sought to provide flexibility to companies in the use of reasonable estimates, sampling methods and “other reasonable methods.” The SEC did caution, however, that a company’s usage of estimates and methods must be reasonable and must be tailored to the company’s specific facts and circumstances. In the FAQ, the SEC provided scenarios in which it would be appropriate to use reasonable estimates, examples of appropriate statistical sampling and three illustrative fact patterns involving the use of reasonable estimates, statistical sampling and/or "other reasonable methods" alone or in combination.

Can a Company Use Existing Internal Records When Calculating Pay Ratio Disclosure?

Yes. The Interpretive Guidance provides that public companies can use “existing internal records” both with respect to figuring out the 5% carve-out for non-U.S. employees and also for determining the median employee. Although the SEC did not define “existing internal record,” the SEC did state in the Interpretive Guidance 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.” In addition, the Interpretive Guidance confirms that, if a company identifies a median employee as a result of using a consistently applied compensation measure based on internal records and determines that the identified median employee’s compensation includes anomalous characteristics, such that the compensation may have a significant impact on the pay ratio, the registrant may substitute another employee with substantially similar compensation.

Can a Company Use Widely Recognized Tests to Determine Whether Its Workers Are Employees?

Yes. The C&DIs retract prior SEC guidance on the definition of an employee that provided that the entity that determines an individual’s compensation is the exclusive basis on which to make the determination of inclusion in a company’s pay ratio calculation. In addition, the Interpretive Guidance confirms that the definition of whether an individual is an employee may be determined under any “widely recognized test under another area of law that the company uses to determine whether its workers are employees.” In particular, the Interpretive Guidance states that “guidance published by the Internal Revenue Service with respect to independent contractors” may be used as a source to determine whether a particular individual is an employee for pay ratio purposes. In other words, the SEC is not creating an independent contractor test that is going to be different than the IRS test already implemented by many companies.

Can Pay Ratio Disclosure Be the Basis for an SEC Enforcement Action?

Yes, under limited circumstances described below. In addition to relaxing certain aspects of pay ratio disclosure, the Interpretive Guidance provides assurances that the SEC understands that pay ratio disclosures may involve a certain degree of imprecision, such that if a public company “uses reasonable estimates, assumptions or methodologies, 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.” Also, one of the new C&DIs on the topic (128C.06) suggests that companies may want to specifically state that the pay ratio is a reasonable estimate calculated in a manner consistent with the SEC’s rules.


It is highly unlikely that the U.S. Senate will pass the Financial CHOICE Act before the 2018 proxy season. In combination with Director Hinman’s comments and the SEC’s new guidance on the Pay Ratio Rule, it seems only prudent that public companies that have not already begun preparing their pay ratio disclosure should begin to do so now. A sample action item list to be considered in connection with preparation of pay ratio disclosure is included as an addendum to this Client Alert.

For additional informationor updated developments on the Pay Ratio Rule, please contact Marc Adesso, Wes Scott or any member of Waller’s Capital Markets and Securities team, or James Bristol or any member of Waller’s Executive Compensation team.

The opinions expressed in this bulletin are intended for general guidance only. They are not intended as recommendations for specific situations. As always, readers should consult a qualified attorney for specific legal guidance.