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Debate Heats Up Over CEO Pay Ratio Disclosure

Arielle Bikard | March 29, 2011

Few elements of the Dodd-Frank Act create as much dread, say compliance officers, as the requirement that companies calculate and disclose the ratio of CEO compensation to median employee pay. The Securities and Exchange Commission has yet to implement the provision, and companies still hope legislators will kill it.

Opponents of the measure say the number-crunching necessary to figure out that ratio would require companies to collect massive amounts of data and create a compliance nightmare. The details, they say, are endless: Would you count part-time employees? How about someone who quit one month into the year? What about foreign exchange rates? What if someone is fibbing on his or her time sheet?

Governance enthusiasts, however, say companies are simply afraid of publishing an embarrassing number that could hurt their image. “This figure will undoubtedly stand as one of the best-read numbers in public company statements,” says Bartlett Naylor, financial policy advocate in Public Citizen's Congress Watch division. “Ideally, it will introduce a small sense of humility into CEO egos.”

The language is admittedly vague. Section 953(b) of Dodd-Frank requires companies to disclose the ratio of “the median of the annual total compensation of all employees of the issuer”—not including its CEO—to “the annual total compensation” of the CEO. 

The SEC expects to propose rules on the pay ratio provision as early as August, according to its Website.

Some Republicans in Congress, meanwhile, want to prevent Section 953 from taking effect. The Burdensome Data Collection Relief Act, a bill introduced in the House Financial Services Committee on March 14, seeks to repeal the provision. U.S. Rep. Nan Hayworth, R-N.Y., presented the bill earlier this month, saying the pay ratio “will be costly and time-consuming for employers and will serve no useful purpose for company shareholders.”

Others argue that the measure will shine a light on exorbitant executive pay and that companies already have the neccessary data and to compute the measure. This bill “helps a CEO hide his pay behind unfathomable figures,” Naylor says. “It's rich that companies can project to the penny the cost of paperwork burdens, but claim they don't know what they pay their own employees.”

In adopting the Dodd-Frank provision, Congress wanted to highlight the gap in the United States between median public company compensation and CEO compensation, which is greater than in most developed countries, says Robert Kohl, partner at the law firm Katten Muchin Rosenman.

“It was thought that by forcing disclosure of the spread between median compensation and CEO compensation, public companies would be embarrassed into lowering CEO compensation—but like many other provisions of the Dodd Frank Act, implementation of what is essentially a public policy position is another matter,” Kohl says.

Business groups say the difficulty of calculating the ratio for large, global companies will far outweigh the figure's benefit. “If this provision were to be adopted as it is currently written, companies with thousands of employees around the world, subject to differing and frequently changing pay scales, would be required to calculate a median company wage—a costly calculation that serves no useful purpose,” says Larry Burton, executive director of the Business Roundtable. 

For companies like IBM or GE, for example, the effort involved in gathering information on hundreds of thousands of employees in hundreds of countries is staggering, Kohl says.

Compliance officers would have to “comply with a statute that is unworkable,” Burton says. Even the SEC has acknowledged the complexity of compiling the data, he notes. Meredith Cross, director of the SEC's Corporation Finance division has remarked that the mandate is “raising concerns for many about how difficult it may be to perform that calculation.”

CEC POLICY BRIEF

The following excerpt is from the Center on Executive Compensation's Policy Brief on the pay ration:

A little-noticed requirement until after passage in the financial reform bill will require employers to disclose in their proxy statements and other securities filings the ratio of median employee pay, excluding the CEO, to CEO pay. The requirement in Section 953 of the Dodd-Frank Wall Street Reform and Consumer Protection Act is perhaps the most burdensome executive compensation requirement in the bill, as few large public companies have the ability to accurately calculate this ratio. The requirement imposes substantial, costly and counterproductive regulatory burdens on employers at a time when encouraging economic and job growth are top priorities. Even then- Chairman of the House Financial Services Committee, Barney Frank, has indicated that this provision should be revisited, stating that it is “worded poorly” and asks for a “disproportionate amount of information” from companies. Based on initial indications, the SEC does not believe the language of the statute gives it much interpretive authority. For this reason, Congress should repeal this provision.

Employers Required to Calculate Pay for All Employees According to the Proxy Disclosure Rules Designed for Senior Executives

Section 953(b) of the Dodd- Frank Act requires the SEC to promulgate rules mandating companies to disclose in their proxies three additional numbers:

  • The median compensation of “all employees” of the company except for the CEO;
  • The total compensation for the CEO, as disclosed in the summary compensation table in the proxy statement; and
  • The ratio of the median employee pay to CEO pay.

Neither the provision nor the legislative history provides any insight on how this provision is to be interpreted. The scope of the section depends upon the definition of “all employees” and whether any relief is given to the calculation of median employee pay.

Read Literally, “All Employees” Refers to All Employees Globally. The statute does not clarify what is meant by “all employees” whose pay is to be used to calculate the median compensation. Read literally, the phrase means all employees of the issuer globally, and could even be read to include affiliates and subsidiaries. Alternatively, the phrase could be read narrowly to mean all U.S. employees. In addition, there is no indication of whether “all employees” includes part-time or merely full-time employees. A logical interpretation would be that the disclosure requirement applies to all full-time U.S. employees, but so far, the SEC has signaled that it believes a broader interpretation may be required.

Comparing the pay of a U.S. CEO to that of employees in the U.S. and other global geographical labor markets would yield a meaningless ratio, since the CEO pay is calculated based on the U.S. market. During a follow-up hearing on the executive compensation provisions in Dodd-Frank in the fall of 2010, then-Chairman of the House Financial Services Committee, Barney Frank, admitted that this disclosure requirement is poorly thought out, stating, “I agree that the section is worded poorly and am willing to change the section because of the disproportionate amount of information that is asked of companies.” Several Members have had similar reactions when briefed on the language.

Median Calculation Requires Separate Pay Calculation for Each Employee. The provision requires companies to determine the median pay of all employees except for the CEO using the same calculations they use to determine total pay under the SEC's proxy disclosure rules. Because the definition of median is “midpoint,” if interpreted literally, companies will be required to calculate pay as specified by the proxy rules for each individual employee and then determine the median of those values. For large employers, this means they will have to accurately calculate pay for tens of thousands and in some cases, hundreds of thousands of employees to determine the median.

Source: Center on Executive Compensation Policy Brief, March 16, 2010.

Even if the SEC wanted to implement a more practical version of the rule, it may be limited in its options. Section 953 is “so prescriptive that the SEC does not have the discretion to interpret the statute in a way to make it workable for companies to comply,” says Tim Bartl, general counsel for the advocacy organization Center on Executive Compensation, who sent a letter of support to Hayworth for her bill on March 15.

Prepare Now

Since Section 953(b) is already law, companies should worry about the mandate's effect until legislation is passed to repeal it, which could happen by the end of the year, Bartl says.

“Another problem is that pay ratio will not be comparable among companies within or among industries: A retailer will have a wider ratio than a hi-tech firm; a company that decides to maintain manufacturing or service centers in-house may have a less attractive pay ratio than one that outsources that work altogether,” says Bartl.

If companies are required to calculate the median pay of “all employees,” as the provision says, that would imply a global calculation. Comparing the pay of a U.S. chief executive to a labor market that includes non-U.S. employees “would yield a meaningless ratio,” Bartl and Tharp argued in a memo to the House committee filed in March. Exchange-rate fluctuations would make the ratio all the more obscure, they said.

Apparently the ratio will need to be filed in multiple reports throughout the year, although until the SEC issues a proposal, when or how often it would need to be updated isn't clear. Section 953(b) merely says the pay ratio must be included in any filing described in the regulation that sets forth federal proxy disclosures; that could be proxy filings, registration statements, quarterly and annual reports, and others.

Despite these objections, some strongly support the Dodd-Frank mandate and oppose the bill to repeal it. At the hearing where the Burdensome Data Collection Relief Act was presented, Damon Silvers, policy director at the AFL-CIO, suggested it be renamed “The Promote CEO Pay Secrecy Act.”

“For many companies, particularly in the financial, high-tech, and service sectors, employee compensation is frequently the single biggest expense,” Silvers said. “Investors will benefit from greater transparency about this spending because high CEO-to-worker pay disparities hurt employee morale and productivity.”

Further, compared to many existing disclosure requirements, this one is “relatively modest,” Silvers said. For example, he said, Whole Foods disclosed its average employee compensation in its annual proxy statement, as well as the fact that its CEO's annual cash compensation is capped at a maximum ratio of the company's average annual employee wage.

The idea that computing the ratio will be overly burdensome for companies is one that Silvers takes issue with. Collecting the required information to comply with the mandate should be manageable, since U.S. employers already report each employee's annual compensation to the Internal Revenue Service—as is also required by most other national tax authorities—and since payroll processing is integral to the accounting process, he said.