Doomsday Device or Mild Disinfectant?
It was a long time coming. After a mere 37 months of pondering, the SEC finally released its proposed rule implementing the Pay Ratio Disclosure Rule, Section 953(b) of the Dodd-Frank Act. No wonder it’s taken the agency three years to release its proposal: For such a small provision, Section 953(b) has generated a lot of heat.
Inserted into Dodd-Frank at the last minute by Senator Robert Menendez, the 140 word section requires companies to disclose their CEO’s pay as a ratio to the median pay of all the company’s employees. The legislative history gives no indication why the Section was added to the bill. But it doesn’t take a Ph. D. in political history to figure out that it was in response to public outrage at the bloated rewards being raked in by America’s corporate titans – especially on Wall Street.
Inflated executive pay is the great white shark circling below the surface of American politics. Populist anger is as potent on the Tea Party right as on the Occupy left. As president Obama recently pointed out, the average American CEO has gotten a nearly 40 percent raise since 2009, while the average American worker earns less than they did in 1999. According to the AFL-CIO’s authoritative annual Executive Paywatch review, the ratio of CEO-to-worker pay at the 500 largest companies was 42 to one in 1980. By 2011 it had swollen to 380 to one. In France, by contrast, the ratio is 104 to one. In Japan it is only 67 to one.
It’s not just activists and policy wonks who believe that out-sized executive compensation is destructive to both companies and society at large. Management guru Peter Drucker once wrote that the ratio of pay between worker and executive can run no higher than 20-to-1 without damaging company morale and productivity. Christine LaGarde, head of the International Monetary Fund, has pointedly warned that “excessive inequality is corrosive to growth; it is corrosive to society.” John Mackey, CEO of Whole Foods, has capped executive compensation at the company at 19 times the average Whole Foods worker. “Because of the yawning gap between the leaders and the led,” he says, “employee morale is suffering, talented performers’ loyalty is evaporating, and strategy and execution is suffering at American companies. Employees really do care about the issue.” Notably, this sentiment comes from a CEO who, despite the company’s touchy-feely vibe, is strongly anti-union.
Section 953(b) was intended to address this metastasizing inequality, although it’s not clear whether that would be achieved by providing shareholders with another means of assessing a CEO’s value, or through public shaming.
Long before the SEC finally released its proposed rule and request for comments, letters began pouring in to the agency.
Proponents of the upcoming rule argued that great disparities in pay pose clear risks for companies, shareholders and the economy at large. As a senior vice president of an asset management firm noted, “high levels of disparity breeds mistrust in the workplace, dampens productivity, and erodes brand reputation and brand value.” That same commenter quoted Alan Greenspan, the high priest of free-market Objectivism, warning that income equality “is where the capitalist system is most vulnerable. You can’t have the capitalist system if an increasing number of people think it is unjust.” CalPERS, the nation’s largest public pension fund with over $257 billion in assets, welcomed the new disclosure rule because it will shed light on an element of pay which has been “shrouded from view” and “opens the window of CEO pay and will help shareholders to keep management accountable.”
Essentially, proponents echoed Justice Brandeis’ dictum that sunlight is the best disinfectant.
To opponents, the as-yet-unwritten rule was less a disinfectant than a Doomsday Device. Inevitably, companies whose ox would be gored were adamant in their opposition, decrying Section 953(b) as a pointless, expensive, and time consuming intrusion into corporate affairs, a ham-fisted rule which would provide investors with no useful information not available elsewhere in company disclosures. Much of the opposition centered on the purportedly overwhelming difficulties companies would face in trying to determine the median employee – all for the sake of information that would have no real value to investors or, for that matter, the general public.
One supporter of the rule, an executive director of an investment group, derided such concerns as specious, pointing out that human resources costs are among the most significant to any company. Indeed, any company that cannot identify a median employee might have more significant troubles sitting outside its doorway. Surely investors would be interested to learn that a company can’t determine its own median labor costs. (Pro tip: Excel has a handy “median” function.)
The SEC seems to have taken the industry’s arguments to heart. The proposed rule gives companies tremendous latitude in how they identify the median employee wage and does not prescribe any particular methodology or specific computational parameters. A company may choose to survey the full employee population, use statistical sampling, or employ any other “reasonable estimates” or “consistently applied compensation measure”. The SEC believes the flexibility it has built into the proposed rule will reduce costs and burdens while preserving the potential benefits of the disclosure requirements of the Dodd-Frank Act.
Now that the Commission has finally released the proposed rule, the official comment period is ticking away, and comments continue to pour in – 32,460 and counting. In fact, my inbox is filling with comments even as I write this.
The comments are overwhelmingly in favor of a strong rule. Unsurprisingly, there is more heat than light. Many of the comments from individuals devolve into rants and those from the industry are rants dressed up in legalese. The bulk of the comments in favor of the rule are conclusory arguments that pay disparities are damaging to company moral, socially disruptive, and a bad deal for shareholders. The industry comments, while more measured, tend to be a parade of horribles about expense, intrusiveness, and futility. The National Investor Relations Institute insists the rule “would provide no material benefit to most investors”, a claim which drew withering fire from the Institute for Policy Studies, which denounced the NIRI’s comments as an attempt to trivialize the importance of pay ratio disclosure.
Not all the industry responses are in opposition to the rule. One investment adviser in London, with £1.5 trillion in assets, wrote in strong support of the rule, expressing a desire that a similar rule be implemented in the U.K.
One of the most trenchant comments comes from a retired Xerox employee who drew on her experiences at that company in the aftermath of ex-CEO Paul Allaire’s unfortunate run-in with the SEC. “It is important to figure out how to flag when a CEO goes off the rails out of personal greed and when the Board lets him get away with it.” she writes. “Both employees and investors suffer when things go south.”
Then she gets down to the nitty-gritty.
“CEO pay ratios can raise a warning flag to investors that (a) the corporate Board of Directors may possibly be insufficiently independent or insufficiently diligent regarding investor interests, (b) that the leaders of the company may be short-changing long-term planning and investment over short-term gain, and (c) that the CEO conflict of interest regarding short-term gain may extend to distorting other aspects of reporting, i.e. that the ‘greed’ element may translate into Enron-like stock manipulations and Xerox-like income-cooking.” She then notes that “Even if there’s no fraud, excessive CEO income should be viewed as lost opportunity in corporate investment: in R and D, and in recruiting, training and retaining competent and innovative employees that actually produce corporate profit.”
You won’t find a clearer, more concise argument in favor of the rule than that.
Of course, opposition is likely to remain fierce despite the flexibility the SEC has built into the rule. Lawsuits are sure to follow. The question, then, is what effect the rule will ultimately have.
Who will use the information once it is released? Who will be able to use it. Do big institutional investors even care about the pay ratio? Executive compensation has been the target of criticism for years with no appreciable moderation in CEO pay. Corporate boards, where one hand washes the other, are often composed of fellow executives who are naturally reluctant to undercut one of their own. The Section 951 say-on-pay rule hasn’t exactly broken the corporate pay fever. Most say-on-pay votes go the way management wants them to. It’s true that shareholders rejected a $15 million pay plan for Citigroup’s Vikram Pandit, but Jamie Dimon is still comfortably ensconced as head of JP Morgan Chase, despite the London Whale and all those enormous fines. As Steven Davidoff recently wrote, “Big institutional shareholders…either at best don’t care about changing executive compensation or at worst are being hypocritical, acting only when they have to. This is important because it is these institutional investors that own most of the country’s corporate stock.” And this, in an article about Oracle shareholders rejecting Larry Ellison’s $78.4 million pay package. It may well be that the disclosures required by Section 953(b) will have little appreciable effect on institutional investors.
Which leaves the prospect of shaming salaries down. The country’s highest paid executives don’t seem particularly responsive to shame. Witness how AIG CEO Robert Benmosche recently compared criticism of the millions the company awarded its executives after receiving an $85 billion dollar loan from the feds to actual lynch mobs.
It may be that the SEC and the pay ratio rule are not up to the task of reining in CEO salaries. The cult of the CEO and the vast sums lavished on top executives are the result of changes in the political and social landscape over the past three decades. In the end, investors may not care much either way about what they learn of the pay ratio between CEOs and employees. As long as the market’s up, why rock the boat? It’s just a cost of doing business.
If you want to chime in on the subject, you have until December 2, 2013.