On September 18 the Securities and Exchange Commission proposed rules to implement the "pay ratio disclosure" called for by the Dodd-Frank Act. The rules require publicly traded companies to identify (1) the median annual total compensation of all employees and (2) the median annual total compensation of Chief Executive Officer, and (3) for the benefit of those who haven't mastered the arcane art of division, the ratio of the two numbers. The rules, which are pursuant to Section 953(b) of the Dodd-Frank Act of 2010, are implemented through an amendment to Item 402 of Regulation S-K.
The pay ratio disclosure rule is controversial. Prior to even proposing the rule, the SEC apparently had received over 22,000 comment letters plus a huge number of form letters. The proposed rule itself passed by only a 3-2 vote at the Commission level and totaled 162 pages of text. Yes, it took the Commission staff 162 pages to describe a ratio of two numbers.
Part of the reason the proposal is so lengthy is that the Commission staff is trying to be flexible on how companies implement it. The proposal would exempt "emerging growth companies," "smaller reporting companies," and foreign private issuers, and would allow statistical sampling and other methodological flexibility in making the median employee determination.
The likely reason the staff is trying to be flexible is that they themselves realize that the pay ratio disclosure wIll be costly for businesses and has little to do with investor protection. As Commissioner Michael Piwowar correctly noted, the proposal "unambiguously harms investors" and has no benefits that are within the SEC's mission. And Commissioner Daniel Gallagher pointed out that the SEC staff themselves were unable to identify any benefits from the proposed rule.
So who is in favor of the proposal? Commissioner Luis Aguilar argued that the disclosure of the pay ratio is necessary because "investors are asking if such a high level of CEO-pay multiples is in the interest of corporations and their shareholders." But of course investors as investors are asking no such question. Investors may well believe executive compensation is too high, but that information is already disclosed in excruciating detail under existing rules. The only new piece of information is the determination of the "median" employee, and this is the most costly and irrelevant aspect of the rule. Imagine a large corporation with many subisidiaries, each with its own mix of part-time, seasonal, offshore, and other employees making such a calculation. How is a large company supposed to make that calculation at reasonable cost, and who cares? The most likely scenario is that companies will waste large sums of money attempting to comply with the requirement and investors will pay no attention to the disclosure.
Aguilar cites only three agenda-driven social activist funds who are purportedly "asking" for the disclosure, along with the AFL-CIO (see footnote 3). Indeed, the most vocal supporter of the rules seems to be Richard Trumka, the head of the AFL-CIO. I think it's beyond question that the AFL-CIO may have overriding objectives other than investor protection.
The pay ratio disclosure may, somewhat ironically, work against the labor interests that pressed it so strongly. The disclosure will not reveal anything about overpaid executives (as that is already disclosed), but it may reveal something about overpaid rank-and-file employees. If employees are being overcompensated, one might actually see hostile bidders and activist hedge funds using this information to agitate for a takeover and mass layoffs. So the labor push to calculate this information could actually work against employee interests.
In a sense, the SEC had little choice but to issue pay-ratio rules because Dodd-Frank required this disclosure. However, the SEC has authority to create safe harbors from disclosure rules, and the SEC should do everything possible to minimize the impact on the economy. In particular, the best solution would be for the SEC to create a safe harbor for companies that estimate the pay gap between CEO and median employee on the high side or within a range. That would serve the objectives of the Dodd-Frank Act that assume is that a large gap is a bad thing, while not requiring companies to calculate the exact numbers. Or, alternatively, the Commission could only require disclosure of the ratio only if material to investors, but I won't hold my breath for that.