Study Critiques SEC Pay Ratio Rule, Calls It Disclosure By Soundbite

Chris Gaetano
Published Date:
Feb 12, 2019
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The CEO pay ratio rule that was implemented as part of the Dodd-Frank Act mandates that companies disclose the ratio between CEO pay and median employee pay, and while the ostensible purpose was to shine light on compensation-related governance issues,  two law professors have concluded that, given the vagueness of the rule's requirements, it serves as little more than "click bait" to incite emotions, according to

"The pay ratio is a relative outlier in terms of certain baseline characteristics of disclosure, meaning that the information is lacking in accuracy, difficult to interpret, and incomplete," said the study's authors in their abstract. "We find that in its current formulation the rule is ineffectual and potentially counterproductive when viewed as a means of generating useful and reliable information for investors, or influencing firm behavior on matters of worker and executive compensation."

A major part of this difficulty is that the Securities and Exchange Commission (SEC) gave firms extremely broad discretion on how exactly they would calculate their ratios. When the rule was first proposed, many firms objected based on the estimated compliance costs, particularly when it comes to data gathering. Since the statute requires firms to take the total compensation of all employees into account, this could theoretically include part-time, seasonal and overseas workers, as well as leased workers and independent contractors.

"Including all of them in the definition of 'employees' would reflect the most literal reading of the congressional mandate, but could require the most data-gathering and result in a median worker figure that may not contain much useful information," said the study. 

In response, the SEC explicitly set out to provide firms with maximum flexibility in reporting their own pay ratios. Firms were given a great deal of discretion in determining for themselves who counts as the median employee, as well as what counts as compensation for that employee. On the latter point, for instance, so long as firms are consistent in their methodology, they may use literally any compensation applied to all employees, such as payroll or tax records, even if those records do not include every element of compensation like equity awards. This ambiguity means that it's not just possible but easy to manipulate the information and skew the figures. 

"A firm with a founder-CEO who draws a modest annual salary while holding a large block of stock would report a low pay ratio, hiding the fact that the founder-CEO may have profited greatly from the annual appreciation of his stock holdings," said the study. "Firms organized as limited partnerships, a common model in the private equity industry, compensate their CEOs primarily through partnership distributions. Because those are not included in the calculation of annual total compensation, such firms may also report pay ratios that are artificially low. Finally, if two firms in the same industry differ only in the way their labor force is organized, with one of them outsourcing its low-paid jobs, the firms would report widely different pay ratios, which would obscure internal pay equity rather than illuminate it."

With this in mind, the paper said that companies can easily choose the pay ratio that places them in the best light. For instance, it noted that Amazon reported a relatively low ration of 59:1 despite the fact that its CEO is one of the richest men in the world. Amazon was able to get its ratio lower because his investment returns, which compose the bulk of his earnings, are not part of his reported compensation, "which was a relatively modest $1.68 million."  

Even if that were not the case, though, the study said the information is not very useful because companies can have vastly different compensation structures even if they're in the same industry, making it almost impossible to set a baseline for comparability between companies. For instance, both Hasbro and Mattel, public companies specializing in toys, had extremely different ratios of 160:1 and 4,987:1 respectively. While this is a huge disparity, the paper said it mainly came down to "idiosyncratic" factors. Mattel relies heavily on seasonal and temporary employees, and 78 percent of its workforce is located in lower wage regions of Asia. Hasbro, on the other hand, relies mostly on full-time employees located in the United States. Yet, Hasbro also said in its annual report that most of its toy production is outsourced to lower-wage Asian regions. The difference is that Hasbro did not count these outsourced workers as employees, and so they do not factor into its pay ratio. 

"Despite these similarities, the two companies report radically different median worker pay figures because one company employs those workers directly and the other only does so indirectly," said the study. 

The study said that, because of these factors, any data produced is not very useful for making comparisons between companies. It observed that corporate decision-makers have had a hard time working with this ratio, and "the evidence thus far suggests that boards and investors are not ignoring the pay ratio, though it is unclear precisely how it figures into their decisionmaking." Boards of directors, for example, generally "did not formally consider the pay ratio when making decisions about CEO pay," as only 5 percent of companies even mentioned the rule in their required Compensation Discussion & Analysis filings. Meanwhile, proxy advisers, while not explicitly rejecting the ratios' use, "refused to link the pay ratio disclosures to their voting recommendations for the 2018 proxy season." Investors themselves, while interested in the ratios (63 percent said they planned to compare ratios between companies), do not consider them very important. According to the study, "[t]hree of the largest institutional investors have indicated that the pay ratio would not be a significant factor in their compensation analysis for proxy voting purposes." 

One area where the rule did have an impact, however, was on customers. The study said that when informed of the ratios of various retailers, consumers tended to prefer those with lower ratios, which they perceived as being more competent. For a consumer to favor a higher-ratio company, the study said, it would need to offer the consumer a significant price discount. The study also said that when the 2018 ratios came out, firms that were featured in the media for having particularly high ratios experienced a decreases in sales, on average. It also cited another study, which found that, "When presented with pay ratio data, laypersons zero in on it and become indifferent to information about firm performance." 

In this respect, the researchers said that the regulation had a high degree of "public salience," but low "information integrity." 

"It is simply not possible for a ratio that is the product of methodologically complex concepts such as median worker pay and CEO pay to exhibit a degree of accuracy, comprehensibility, and completeness in line with disclosure rules that require a detailed and nuanced presentation of mainstream corporate information," said the study.

To this end, given that the researchers believe the rule is unlikely to be repealed, the regulation could be improved by moving away from a pure numbers approach and into a more narrative format that can provide context, nuance and explanation, similar to the way executive compensation information is currently disclosed. This would not only make the information more useful to investors, it would also make the ratio itself more difficult to manipulate, at least surreptitiously, because the firm would need to explain its reasoning. 

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