The great pay ratio debate

On September 18, the SEC released its much-anticipated proposed rule that would require public companies to disclose how much their chief executives are paid compared with their average employee, as mandated by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Dissenting comments from two of the SEC’s five commissioners make plain the agency’s ambivalence about moving forward with a rule that has drawn growing criticism for what many perceive as a departure from the agency’s investor protection mandate. ‘The lack of a specific market failure identified as motivating the enactment of this provision poses significant challenges in quantifying potential economic benefits, if any, from the pay ratio disclosure,’ the proposal states.

The more than 22,000 comment letters the SEC received during the public comment period attest to the elevated level of interest – if not polarization – among investors and other stakeholders. The proposed rule is subject to another 60-day period for public comment, which started on September 23. Given the time the regulator will need to review the many thousands of comments the proposal is likely to attract, the rule will probably not become effective until 2014, said Jim Barrall, a partner at Latham & Watkins who co-chairs its benefits and compensation practice, during an Equilar webinar on September 23. That would give companies whose fiscal year matches the calendar year all of 2015 to calculate their median employee compensation, with initial disclosure to follow in the 2016 proxy season, he noted.

During the SEC’s open meeting on September 18, newly appointed commissioner Michael Piwowar vehemently opposed the regulator even considering such a rule, citing the harm to investors and disruption of competition it would cause. He pointed out that the rule’s proponents acknowledge that shaming CEOs is the proposed rule’s main purpose.

‘But the shame from this rule should not be put upon CEOs. It should be put upon the five of us who will be voting on this proposal today,’ Piwowar said. ‘Shame on us for putting special interests ahead of investors. Shame on us for letting special interests distract us from our core mission. Shame on us for surrendering our rulemaking agenda to special interests.’

Counting the costs

Some of the commission’s queasiness about the adverse impact the rule could have on competition is based on the ‘potentially significant’ costs it would entail for the 4,000-odd companies that it covers. Smaller reporting companies with net worth below $5 million, foreign private issuers and emerging growth companies protected by the JOBS Act are exempt from the provision.

The proposed rule defines ‘annual total compensation’ as total compensation for the last completed fiscal year, consistent with existing disclosure requirements, and would allow companies to use reasonable estimates when calculating annual total compensation, any element of total compensation and the annual total compensation of the median employee. It further defines ‘all employees of the registrant’ to include full-time, part-time, temporary, seasonal and non-US employees as long as they are employed as of the last day of the company’s prior fiscal year.

At the SEC’s open meeting, commissioner Daniel Gallagher lamented the inflexibility of the proposed rule’s definition of ‘issuer’ under Section 953(b). Rather than restricting the application to the registrant itself (and thereby requiring issuers to include only their own employees in the median pay calculation), the rule adopts the enterprise-wide interpretation of Regulation S-K’s Item 402, which requires compensation for employees of a company’s foreign subsidiaries to also be included in the calculation, making it more costly than it could otherwise have been.

That definition is the most onerous aspect of the proposed rule, Barrall agreed in a recent post on the Conference Board Governance Center blog. ‘Unless these rules are liberalized, they will impose substantial costs and administrative burdens on companies with large numbers of employees, especially if they are employed around the world and in different lines of business with high pay variances,’ he wrote.

Barrall urged firms to take time during the public comment period to determine how they would gather and analyze the information required to comply with the rules, and to file comments with the SEC that discuss the costs and burdens of doing so, using the SEC’s 69 requests for comments as a guide. Topics to address, he said, include databases that would have to be built and analyzed, the impact of data privacy laws in certain jurisdictions, and the technical difficulties of using statistical samplings or other reasonable estimation techniques and consistently applied compensation measures to identify the median compensated employee.

The benchmarking problem

In the SEC’s other camp, commissioner Luis Aguilar, who cited a need for pay ratio disclosure in February, reaffirmed his support for the rule at the SEC’s open meeting, citing concern over excesses created by the practice of benchmarking executive pay to that of industry peers. ‘If comparing CEO compensation solely to the compensation of other CEOs can lead to an inefficient upward spiral, then comparing CEO compensation to the compensation of an average worker may help offset that trend,’ Aguilar said in his prepared remarks at the SEC’s open meeting.

But concerns about the statistical validity of benchmarking a CEO’s compensation against that of industry peers don’t justify a pay ratio disclosure requirement, says Patrick Quick, a partner in Foley & Lardner’s transactional and securities practice in Milwaukee. ‘You’re taking a tool that is otherwise irrelevant and using it on the chance it will at least have a counterbalancing effect,’ he explains. ‘I would rather they try to tailor something to this concern Aguilar has or leave it to shareholders to point out that statistical problem.’

Any notion that pay ratio disclosure might compensate for benchmarking is further undermined by the fact that it would only apply to public companies’ CEOs. These constitute only a portion of the entire market for senior executives, which also includes those from private firms, family-owned enterprises and companies owned by private equity players, Quick adds.

Matt Orsagh, director of capital markets policy at CFA Institute, believes any additional piece of information can be helpful to investors, but says he’s wary of any one number standing in for a larger concept, citing the misplaced fixation on quarterly earnings.

‘Pay ratio shouldn’t be a stand-in for whether pay is good, bad or ugly; it’s much more complicated than that,’ he says. ‘If a company has been rebuilding for five years and the CEO has had pay that vested over those years, and [based on the firm’s renewed growth] in that fifth year he/she gets huge pay because of what he/she helped build over five years, his/her compensation could be doubled or tripled. If all you see is one number in one time frame and you don’t have any context, it could be [harmful].’

Orsagh hopes investors and media will take a more nuanced view of the pay ratio over the years as best practices concerning calculation and reporting emerge. ‘With say on pay, there was much gnashing of teeth and wringing of hands when it first came out, but it has helped companies have more engagement with investors,’ he says. ‘I hope this pay ratio disclosure can do something similar.’