Opponents of the CEO pay ratio rule have a new ally: a comprehensive academic analysis that methodically constructs a case for the rule’s worthlessness.
The rule, which the Dodd-Frank Act authorized in 2010 and the SEC implemented for 2018 fiscal years, requires public companies to publish in their annual reports the ratio between the total compensation of the company’s CEO and that of its median-paid employee.
The 56-page paper, by law school professors Steven Bank of UCLA and George Georgiev of Emory University, is aptly titled “Securities Disclosure as Soundbite.” Unlike every other SEC-required disclosure, the CEO pay ratio may be reported absent any context whatsoever. All that’s required is the ratio itself, such as “300:1.”
“It’s very bizarre,” Georgiev tells CFO. That’s particularly so, he points out, for a couple of reasons.
For one, the SEC’s rigorous enforcement over the past few years of rules governing companies’ use of non-GAAP metrics “shows that the SEC cares about the integrity of information and about not enabling companies to distort information. So why did it take this approach with the CEO pay ratio?”
Two, executive compensation disclosure as required to be reported in the Compensation Discussion & Analysis section of proxy statements includes “numbers, tables and a long-form discussion about what the numbers mean.”
In their conclusion, the professors recommended that the SEC require similar additional context for the CEO pay ratio. Actually, they’d prefer that the rule were repealed — but, Georgiev notes, that’s unlikely to happen, as it enjoys fairly broad bipartisan support in Congress.
According to the paper, examples of material factors necessary for an understanding of the CEO pay ratio may include:
While the SEC’s official position is that the rule’s purpose is to provide investors with information on how companies are run, in reality “it’s click bait,” Georgiev charges. “It’s supposed to incite emotions [over income inequality].”
The paper observes that the SEC’s “disclosure-by-soundbite” approach to implementing the Dodd-Frank mandate “is characterized by (1) high public salience — the pay ratio is superficially intuitive and resonates with the public to a much greater extent than other disclosure; and (2) low informational integrity — the pay ratio … is lacking in accuracy, difficult to interpret, and incomplete.”
Yet, the professors note, politicians have cited pay ratio data when proposing new business regulation bills. Portland, Oregon, actually imposed a penalty tax on businesses operating in the city whose pay ratio exceeds 100:1. Similar measures have been proposed in California, Illinois, and Massachusetts, as well as at the federal level.
“The use of such an imprecise and easy-to-manipulate metric in substantive tax legislation is, quite plainly, poor public policy,” the paper states.
The flaws inherent in the rule are numerous but not difficult to comprehend. For example, two companies in the same industry may differ only in the way their labor forces are organized: one of them outsources its low-paying jobs, and the other doesn’t. “The firms would report widely different pay ratios, which would obscure internal pay equity rather than illuminate it,” the paper says.
Also, in companies with founder CEOs, the CEO may have profited greatly from the appreciation of his or her stock holdings, which isn’t included in the pay ratio. Similarly, at companies organized as limited partnerships, the partners are paid primarily through distributions, which also aren’t included in the ratio.
Such disparities are significantly compounded by the broad methodological flexibility the SEC affords for arriving at the pay ratio. It allows companies “to choose the pay ratio that places them in the best light,” the professors say. “Thus, two similarly situated companies can report quite different numbers simply because they are permitted to use different inputs or methods of calculating those numbers.”
In perhaps the most extreme example of a meaningless pay ratio, Alphabet’s was a scant 0.000005:1 in 2018. Founder and CEO Larry Page, whose net worth was more than $30 billion thanks largely to his ownership of company stock, was paid $1 for the year, while the median employee received $197,274.
For its part, the SEC has said definitively that pay ratios of different companies should not be compared with one another.
“We took care to say about five times in the paper that pay ratios are not supposed to be compared — but why have numbers if you’re not going to compare them?” Georgiev rhetorically asks.
Indeed, there was an unsurprising avalanche of articles, triggered by the trove of pay ratio data reported in the first year for which the rule was effective, in which just such comparisons were made.
Georgiev claims that the paper, the first academic analysis of the pay ratio rule following the first round of reporting, has a decent chance of influencing changes to the rule.
“I think our proposal is fairly reasonable, so that’s what we’re hoping for,” he says. “You can’t stop journalists from looking for a headline, but you can put the numbers in context.”