Get Ready for the Pay Ratio Rule

We know we have a compliance problem when the Securities and Exchange Commission is three years late in promulgating rules to comply with the Dodd-Frank Act provision to disclose a comparison of CEO pay to that of the rank and file. 

This controversial provision requires companies to include in its compensation plan disclosure “the ratio between the CEO's total compensation and the median total compensation for all other employees.” If the SEC holds true to its intentions to have this rule ready for the 2014 proxy season, it is a call to action for investor relations officers and corporate secretaries, in particular, to prepare plans to explain to their shareholders the specific complexities of this ratio of CEO pay to median employee compensation.

Steve Seelig, a senior regulatory adviser for executive compensation at Towers Watson, says the law is a result of labor union lobbying and has been strenuously opposed by several business organizations. He says too, that the SEC's hands are tied on making the disclosure easier for companies. “Prior public comments suggest that SEC officials have noted they do not believe they have the regulatory authority to permit companies to employ a simplified method to calculate the pay ratio.” So, with that startling conclusion, what are companies to do, particularly when some commentators believe the three-year delay is due to the difficulty the SEC staff is having in coming up with ways to calculate such a complex number?

In its simplest form, if you have a company domiciled only in the United States, where most employees are earning a reasonable salary—a technology company, for example—it may not be that complex. A global retail company, however, with thousands of employees around the world in countries with differing exchange rates for differing skill levels that are mostly poorly paid compared with the CEO will have a much more difficult calculation to make.  And companies that outsource jobs face an even more complex challenge, making comparisons and trend analysis very difficult.

In addressing the complexities of compensation, there are not only currency conversions but actuarial present value calculations, Black-Scholes calculations, gathering data from various sources of payrolls, and computing the value of benefits for which there are really no specific price tag.

Critics of the pay ratio rule say Congress was politically motivated when it made it part of Dodd-Frank and wanted to highlight the social injustice going on between executive pay and median worker compensation. Indeed, in 1980, CEOs of large U.S. companies made 42 times the pay of their factory workers. By 2010, pay of CEOs at S&P 500 companies reached 343 times that of the median U.S. worker, according to the AFL-CIO, a strong proponent of the pay ratio rule. Moreover, the Census Bureau has noted that over the past decade, the median family income has fallen for the first time since the Great Depression. Observers of what's going on behind the scenes say that New Jersey Democratic Senator Robert Menendez, motivated by the AFL-CIO, added this provision to the legislation at the last minute. Critics of the social injustice notion say that knowing the disparity between CEO and average worker pay is not likely to help an investor determine whether the company is a good investment or not.

Another criticism aimed at the SEC is that it really hasn't conducted a cost benefit analysis as is required by law. Estimates by various business groups opposing the rule say that the initial compliance costs will go through the roof and continued compliance beyond that will be very costly with no real benefit to shareholders. To that point, investors appear to be more concerned with a company's stock performance and that of the CEO and for the most part approve compensation plans most of the time. A vote against an executive compensation plan exceeding 20 percent is rare, even though it is often considered a top proxy issue and compensation committees are told to justify a CEO's total compensation plan. “Income equality advocates want to know about CEO pay, but I'm not sure it serves any valid corporate purpose because the CEO labor market is very different from the employee labor market,” says Ira Kay, managing partner at compensation consulting firm Pay Governance. Kay says the most compelling argument for the pay ratio is if it's very high, it demoralizes employees who think it's unfair and hurts productivity and profitability.

A Complex Calculation

In addressing the complexities of compensation, there are not only currency conversions but actuarial present value calculations, Black-Scholes calculations, gathering data from various sources of payrolls, and computing the value of benefits for which there are really no specific price tag.

Among the business organizations that oppose the provision are the U.S. Chamber of Commerce, the Securities Industry and Financial Markets Association, the National Association of Real Estate Investment Trusts, and numerous others. The SEC staff has met with many of these groups to hear their complaints about the difficulty of compliance. Unlike issues of this magnitude in the past where the SEC would conduct a roundtable discussion or appoint a group of experts to make recommendations, there appears to have been no such efforts with regard to the pay ratio rule. Sometimes, placing complex issues in the sunlight only shows that regardless of what the original intention of Congress was, making a social issue out of a market issue may not have been the best course of action.

At a July Senate Banking Committee hearing, SEC chairman Mary Jo White said she hopes to complete the rule in the next month or so. Most interpret her comments to mean sometime in September. If she holds to that schedule, that would allow for the typical 90-day comment period in time for the 2014 proxy season. If only it were that simple.

Is there any value for companies to get ahead of the game and implement their own pay ratio numbers in advance of guidance? Paul Hodson, an executive compensation expert and senior research associate with GovernanceMetrics International, believes that public companies have a chance to score a shareholder relations coup by implementing reform ahead of the SEC. “A company that implemented some of these policies by itself would enhance its reputation fairly significantly,” he says.

While I'm not sure many companies will pursue that course of action, there's the other very important shareholder relations issue that I mentioned in the beginning that investor relations officers and corporate secretaries need to be thinking about now!—drawing up plans to warn investors about the complexity of the issues involved in deriving the CEO pay ratio. Companies that communicate their thinking on the pay ratio will be ahead of the game when the executive compensation plans are rolled out for the 2014 proxy season.