Congress’s Wrong-Way Approach to CEO Pay

That was one of the questions Congress grappled with when it passed the Dodd-Frank Act in 2010. The public was outraged at the lavish pay of chief executive officers in a period of recession, and legislators responded by requiring more disclosure.

Public companies had long been required to provide extensive detail about their CEOs’ pay packages. Under Dodd-Frank, they also will be required to calculate and disclose the ratio between how much money the median worker earned and the CEO’s pay.

Now, some three years after the bill passed, the Securities and Exchange Commission has finally proposed regulations to implement this new mandate. The commissioners did the best they could with the regulations, but they could not change the basic fact that forcing companies to disclose ratios is fundamentally a bad idea.

Critics, including the SEC’s two Republican commissioners, have lambasted the requirement as overly expensive. Corporations complained it would be difficult to figure out who the median worker was. Large international companies often do not centralize their record-keeping; a subsidiary in India may track its employees using a completely different system than a subsidiary in France. And then there are difficulties with exchange rates, part-time workers and workers who come or go during the course of the year, all of which make the task of figuring out the middle income of tens of thousands of employees worldwide daunting.

The SEC minimized the sting of this requirement by granting broad permission to companies to use different methods to calculate the median compensation package. The proposed rules allow companies to use statistical sampling, for example, rather than having to count every employee. Still, the SEC could not get around the statutory requirement that corporations find some way to determine median worker pay. And no matter what method companies adopt, this will involve time, trouble and expense.

Will the benefit justify the inconvenience? The short answer is no. For starters, the new requirement won’t provide any important information that wasn’t already available. The point of the CEO/worker ratio is simply to emphasize how much more lavishly CEOs are paid than other corporate employees. That point can be easily inferred from current disclosures. If a CEO makes tens of millions of dollars a year, for example, it’s quite clear that the ratio between his pay and that of the average worker will be high.

Newspapers and labor organizations have talked about this ratio for decades. Instead of trying to calculate a particular company’s median compensation, they’ve generally used an average factory worker’s salary or median national income, but the point is almost exactly the same. Whatever extra punch might come from looking at a particular company’s median hardly seems worth the trouble.

What’s more, in its well-intentioned attempt to reduce the compliance burden on companies, the SEC has made it impossible to compare the ratios across companies. The proposed rules permit each company to decide how to determine its median worker’s pay. It seems likely, then, that companies will adopt many different methodologies. “Median” will mean different things to different companies, rendering inter-company comparisons largely worthless.

There’s also a very real possibility that companies will choose their methods based not just on ease of calculation but also on results. To the extent directors and CEOs want to report as low a ratio as they can, their incentive is to choose the highest median possible. With such a wide range of procedures available, the door is wide open to manipulation.

Perhaps more to the point, disclosing the ratio is not going to bring down CEO pay. It’s theorized that the ratio will shame directors and CEOs into cutting executive compensation. But disclosure has never had that effect. In fact, there is a case to be made that increasing disclosure has made things worse by empowering CEOs to argue they deserve at least as much as the chief executives of major competitors.

Corporate directors tend to believe their CEOs are extraordinary and deserve to be paid accordingly. The ratios will just reinforce what they already believe: that a good CEO is worth a factory full of ordinary workers. No doubt corporate lawyers will have to add some boilerplate to companies’ SEC filings, but those filings are already full of justifications for CEOs’ enormous pay packages. Justifying the ratio will just make them a bit longer.

If Congress really wanted to target CEO pay by enhancing disclosure, it should have focused on a ratio that matters much more to directors and the shareholders they represent: CEO compensation to corporate profits.

As CEO pay has risen, it has absorbed a rising share of corporate earnings, earnings that could otherwise have gone to shareholders as dividends or been reinvested to grow the business. Requiring companies to highlight this fact — or even better, the percentage of profits that went to pay the top five executives — could give directors and shareholders some pause before they approve the latest compensation increase. Plus, this is a very simple number to calculate because companies are already required to disclose both earnings and the top five executives’ pay totals.

Still, enhancing disclosure is unlikely to have much lasting impact.

This article appeared in print on page 10 of the October 22nd, 2013 edition of Hamodia.