SEC Proposes Pay-Ratio Rules

By Cydney Posner

This morning, the SEC voted, by a vote of three to two, to propose for public comment the highly anticipated rules requiring companies to provide disclosure regarding internal pay equity, as mandated by Section 953(b) of Dodd-Frank. Neither the press release nor proposal release has yet been posted.

Under Dodd-Frank, the SEC was required to amend Item 402 of Reg S-K to require each company to disclose, in a wide range of its SEC filings, including registration statements, annual reports and proxy statements:

• the median of the annual total compensation of all employees of the company, except the CEO;
• the annual total compensation of the CEO; and 
•  the ratio of the two amounts above.

The statute mandates that "total compensation" be determined in accordance with existing regulations governing the disclosure of "total compensation" in the Summary Compensation Table in the annual proxy statement, as in effect in July 2010 (when Dodd-Frank was enacted). As a result, under the statute, the calculation for all employees must include salary, bonus, stock awards, option awards, non-equity incentive plan compensation, change in pension value and nonqualified deferred compensation earnings and all other compensation, an undertaking likely to intimidate even the bravest HR computer whiz.

The proposal has taken more than three years to surface and, for rules that, prior to this morning, had not even seen the public light of day, these rules have already been the subject of extensive discussion and interest group lobbying. (See my article of 7/8/13.) Chair White noted at the meeting http://www.sec.gov/servlet/Satellite/News/Speech/Detail/Speech/1370539813310 that the SEC had already received more than 20,000 comment letters on the topic. It has been reported that the SEC staff was ready with a "term sheet" for the proposal within six months after adoption of Dodd-Frank. But the highly prescriptive nature of the statute had, until now, largely stymied the SEC's efforts to streamline the required analysis sufficiently to make implementation more practical. Moreover, vigorous lobbying efforts by business interests opposed to the provision (including a couple of efforts in the House of Representatives to repeal the provision altogether), led to long delays. These opponents of the rulemaking have argued that, for almost all companies, calculating the ratio would be tremendously complicated, expensive and of little value to investors, especially for companies that operate in multiple countries where there are different systems for calculating compensation. In addition, even some of those in favor of addressing perceived inequities in pay have contended that compensation disclosure has often failed to achieve its objectives: the SEC's last major effort at revamping compensation disclosure, they argue, had the unintended consequence of continually ratcheting up executive compensation as executives became aware of what others were being paid and insisted on matching or exceeding those amounts when it came to determining their own compensation. These critics have questioned whether the new pay-ratio disclosure would even budge established trends.

Unions and other pay-ratio supporters, focusing on the mounting disparity between executive and worker pay, have argued that the information is essential to allow investors to determine if executive pay is excessive and needs to be reined in. According to data from the AFL-CIO, in 1982, CEOs of large U.S. companies made 42 times the pay of their factory workers; in 2012, the CEO of an S&P 500 company made, on average, 354 times the average wage of a rank-and-file U.S. worker. They also point to academic studies establishing that high pay disparities between CEOs and their employees can hurt employee morale, reduce workplace productivity and lead to increased employee turnover, all consequences that can affect profitability.  With pay-ratio advocates having reportedly mounted their own lobbying effort -- not to mention the increased volume of media discussion regarding income inequality in general -- it comes as no surprise that the SEC would finally propose these rules for public comment.

Fortunately, the SEC sought to address cost and complexity concerns by adopting a relatively flexible approach that would allow companies to calculate the information in the way that best suits the company. There is apparently no prescribed method for doing the calculation, as long as it is a consistently applied compensation measure. For example, it was noted that companies with few employees may be able to do the calculation for the entire employee population without much difficulty. Larger companies may want to employ statistical sampling. In that regard, the economist from the Division of Economic and Risk Analysis observed that the breadth of the statistical sampling would depend on how widely compensation is distributed around the mean. For companies with a low variance, the sample population size might be less than 100; for companies with a high variance, the sample size may be more than 1000. Another possible methodology noted at the meeting was simply to identify the median employee based on an established pay component, such as wages, and then provide the "total compensation" calculation for that employee. Companies will undoubtedly want to assess the results under various types of calculations, but will need to settle on one for "consistent application." The calculation must include all employees, including employees of subsidiaries as well as part-time, temporary and seasonal employees, as of the last day of the fiscal year (although apparently companies could annualize compensation for permanent employees). In their disclosures, companies will need to identify assumptions and estimates, as well as the measure used for the calculation, although the staff emphasized that they were not expecting a "dense" discussion of the statistical methodology. The disclosure would be required in 10-Ks, proxies and registration statements containing compensation disclosure, but would need to be updated only annually in the proxy or 10-K. Emerging growth companies would be exempt, as would smaller reporting companies and certain foreign issuers.

At the open meeting, statements by the various Republican and Democratic commissioners echoed the public debate. Commissioner Gallagher was one of the two dissenters.  In his view, the proposal was expensive but provided no economic benefit; it's sole purpose was to "name and shame." He also viewed the placement of this proposal at the front of the SEC's regulatory queue as a misallocation of resources. With regard to specific criticisms, he took issue with the proposal's broad definition of the employee population to include employees of subsidiaries, as well as seasonal and pert-time employees, without requiring annualization. He argued that including all of these employees, especially on a global scale, ignored the variances of costs of labor and costs of living. The only purpose of the exercise, he contended, must be "to ensure the most eye-poppingly huge ratios possible," a gimmick that doesn't belong in a corporate filing. 

In his statement, new Commissioner Piwowar  not only was "unable to support the pay ratio disclosure proposal, [he objected] to the Commission even considering it." He maintained that it "unambiguously harms investors, negatively affects competition, promotes inefficiencies, and restricts capital formation." For example, investors would be harmed because they would be "distracted from material investment information and at worst misled about the investment itself." He "will choose investor protection over special interests every time." He also contended that the pay-ratio disclosure would "influence how some companies structure their business (e.g., outsourcing jobs versus in-house employees). Some of these business structure changes undoubtedly will lead to inefficiencies, higher costs of capital, and fewer jobs." He specifically requested public comment supporting his views, including a request for "consumer advocates" to submit public comments acknowledging that "the proposed pay ratio disclosure rule unambiguously harms investors." Finally, he hoped that the SEC would "hold itself to higher standards" in the future.

Commissioner Aguilar and new Commissioner Kara Stein both voted in favor of the proposal, with Commissioner Stein generally joining the views of Commissioner Aguilar. In his statement, Commissioner Aguilar contended that shareholders "have the right to know whether CEO pay multiples reflect CEO performance. Shareholders have the right to know how their company's internal pay comparisons may impact employee morale, productivity, hiring, labor relations, succession planning, growth, and incentives for risk-taking." He expressed his views against the backdrop of studies showing that pay multiple have risen substantially over the years, noting that benchmarking to external wage structures to set executive pay, typically at "above average" levels, has contributed to the resulting economically inefficient executive compensation decisions. He hoped that this enhanced compensation disclosure would help company shareholders and independent directors counter this tendency by making "executive compensation more transparent and foster[ing] accountability. Second, pay ratio disclosure can provide a valuable new perspective for executive compensation decisions. 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 [i.e., internal wage structures] may help offset that trend."

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