CEO Pay Ratio Rule Rankles Both Sides of Heated Debate

The final rule for the Dodd-Frank-mandated disclosure disappoints its opponents and some proponents alike.
David McCannAugust 5, 2015

Two years after issuing a proposed rule for the controversial “CEO pay ratio” provision of the Dodd-Frank Act, the Securities and Exchange Commission today released a final rulemaking that left many interested parties unsatisfied.

Rich guyThe new rule will force most publicly held companies to disclose, starting with their 2017 proxy statements, how their chief executive’s compensation compares with that of the median pay among all other employees. As required by the JOBS Act, the rule does not apply to emerging growth companies.

How Startup CFO Grew Food Company 50% YoY

How Startup CFO Grew Food Company 50% YoY

This case study of JonnyPops’ success highlights the unusual financial and operational strategies that enabled rapid expansion into a crowded and highly competitive frozen treat market. 

In comment letters filed with the SEC, companies — mostly large, multinational ones — had raised strong objections to the proposed rule. Most were variations on two themes. For one, they said determining median pay within their work forces would be a difficult, costly process.

The rationale for that stance was generally two-fold: that most global companies use a patchwork of often incompatible payroll systems in the countries where they operate; and that definitions of “compensation” are significantly different from country to country, given variability in the treatment of social benefits, health care, and taxes. There were also claims that further burdens would be imposed by the proposed (and now final) requirement to include part-time workers in the calculation of median pay.

The other objection theme was that the existing required CEO compensation disclosures were sufficient to allow investors to make informed decisions on buying stocks and voting their shares.

There is also a cost component to multinationals’ discontent. For large companies doing business in dozens of countries, the cost of calculating the pay ratio could run into the hundreds of thousands of dollars, says Alan Johnson, managing director of compensation consulting firm Johnson Associates. Altogether, the SEC estimates, the aggregate cost in the first year for all companies subject to the rule will be $1.2 billion.

In a July 21 comment letter to the SEC, John Hayes, chief executive of Ball Corp. and chairman of the Business Roundtable, an association of CEOs, argued that the ratio should include full-time, domestic U.S. workers only. “Unless all non-U.S., part-time and seasonal employees are excluded from the pay ratio calculation, the costs and burdens on companies imposed by the SEC’s final rule will likely be exponentially higher than if the calculation were limited to full-time U.S. employees only,” Ball wrote.

Companies had lobbied heavily for the SEC to let them exclude some worldwide employees from the calculation. Because wages are higher in the United States than in almost every other country in the world, the fewer foreign workers that are included, the lower a multinational’s pay ratio will be.

Still, the commission had found in two studies that pay ratios would not be significantly affected if a minority of employees were excluded. Even excluding 40% of employees would reduce the average pay ratio by only 11%, the SEC found.

But the final rule allows companies to exclude only 5% of their overseas workers. Not only did that not satisfy companies, as such exclusion will scarcely reduce their burden and compliance costs at all, it also didn’t satisfy the AFL-CIO, the trade union federation, which has been among the most vocal, high-profile supporters of increased CEO compensation disclosure.

The AFL-CIO’s objection was based on the wording in Dodd-Frank directing the SEC to issue rules for implementing the pay ratio provision. The statute says the commission must “require disclosure of the median of the annual total compensation of all employees of an issuer” (emphasis added).

The final rule’s departure from the requirement as stated in the statute seems almost certain to set the stage for protracted court battles similar to the one decided in June by the Supreme Court that examined the implications of precise wording in the Affordable Care Act.

“The statute is clear: ‘all employees’ means all employees,” said Heather Slavkin Corzo, director of the AFL-CIO’s Office of Investment, at a Tuesday news conference. Further, she noted that since the rule allows companies to employ statistical sampling methods and estimates in calculating median employee compensation, which she called a reasonable compromise, “it’s hard to understand the rationale for allowing companies to omit other segments of the work force from the calculation.”

Corzo brushed aside companies’ claims that it would be difficult to arrive at a true median-pay figure because of differences in payroll systems and compensation policies that exist from country to country. “It raises concerns in terms of their internal controls over financial reporting, if they can’t figure out how much they’re paying their work force,” she said.

But, says Steve Seelig, executive compensation counsel for consulting firm Towers Watson, that viewpoint is in a sense like confusing macroeconomics with microeconomics. “Companies are absolutely in control of and understand what their costs are when it comes to worker pay,” he says. “That’s far different from saying they can press a button and immediately access the pay data for all of their foreign workers.”

SEC chair Mary Jo White said in a statement, “To say that the views on the pay ratio disclosure requirement are divided is an obvious understatement. Since it was mandated by Congress, the pay ratio rule has been controversial, spurring a contentious and, at times, heated dialogue.” The commission received more than 287,000 comment letters on the matter, White noted.

In addition to the 5% foreign-worker exclusion, the SEC made some last-minute amendments to the proposed rule that it says will ease companies’ concerns:

  • Allowing companies to use the same median-compensated employee for three years, “unless there has been a change in the employee population or employee compensation arrangements that the company reasonably believes would result in a significant change in the pay ratio disclosure.”
  • Allowing companies to choose any date during the last three months of their fiscal year in determining the median compensation
  • An exemption for situations when foreign data privacy laws would prevent companies from being able to process or obtain the necessary compensation information to calculate the ratio
  • Allowing companies to use cost-of-living adjustments when calculating median compensation

In addition to emerging growth companies, as defined in the rule, also exempt from the rule are smaller reporting companies, foreign private issuers, registered investment companies, and registrants filing under the U.S.-Canadian Multijurisdictional Disclosure System.

The Impact on CFOs

Although their own compensation is not a facet of the pay ratio rule, there are assorted weighty issues for CFOs.

“It will be hard to calculate, CFOs will be blamed if the calculation is wrong, and no one will believe it was an honest mistake,” says Johnson.

Calling it a “silly calculation” because of the inclusion of part-time workers (and opining that the rule’s “sole purpose” is to “embarrass companies with a lot of low-paid, part-timers”), Johnson stresses that CFOs should nonetheless take it seriously. “If you get caught cheating on this, the SEC will absolutely nail you to the wall,” he says.

Finance chiefs should also try to counteract any internal qualms if the company’s CEO pay ratio is higher than a competitor’s, according to Johnson. “If a board member says, ‘Why are we at 178 and our competitor is 170? Can’t we do something about that?’ the right answer is probably, ‘No, we can’t.’ Since it’s just a political thing, don’t mess around with it. If you are at 178 and your competitor is at 170, no one will really care. It’s different from quarterly earnings, which really do matter, and people push the envelope on that. I would suggest that this is not something to push the envelope on.”

According to Andrew Liazos, a partner and head of the executive compensation practice at law firm McDermott Will & Emery, the permissible use of statistical sampling and estimates could leave companies vulnerable to strike suits claiming that their disclosures are misleading because of the calculation methods used. “I think you’ll find that there will be all kinds of different approaches being used, at least in the first year,” he says.

CFOs should also be aware of some potential “hidden costs” of the rule, says Seelig of Towers Watson.

“For the first time, employees are going to be privy to the median compensation,” he says. “They’re going to have questions about whether they’re paid fairly and whether the CEO’s pay influences theirs. Companies are really going to have to confront these issues in communicating with the work force.”

External communication will also be important. Companies should prepare to respond to media inquiries about their ratios. “In most cases the ratio is going to appear very high, higher than most local newspaper readers had anticipated, regardless of how it compares to peer companies,” Seelig says. That’s important, as some studies have indicated that a company’s pay ratio may influence consumer behavior, he notes.

Also, he says, there is “plenty of opportunity for mischief” in the form of state lawmakings related to the rule, such as imposing taxes on companies with high CEO pay ratios or giving favorable treatment to contractors with low ratios.