The SEC’s Dodd-Frank pay-ratio rules are central to a flurry of Democratic legislation designed to expand executive compensation disclosures or punish outsized pay gaps between the C-suite and corporate rank-and-file. But doubts persist over whether the Dodd-Frank Act rules can provide a reliable foundation for the progressive policy reforms. Sec. 953(b) of PL111-203
The proposals come as public companies have largely adjusted to the disclosures, following their fourth proxy season since the requirements of Release No. 33-9877, Pay Ratio Disclosure, kicked in. The rules, finalized in 2015 and first included in the 2018 proxy season, require issuers to disclose a ratio comparing the total compensation of the CEO to that of the median employee.
Since then, Democratic lawmakers, unions, and financial reform groups have seized on the compensation disparities highlighted by the disclosures, such as Walmart Inc.’s 1078:1 ratio from President and CEO Doug McMillon’s $22.5 million in compensation compared to the median associate’s compensation of $20,942. The 500 largest companies by revenue traded on U.S. stock exchanges produced a median 2020 ratio of 227:1, compared to 191:1 for the prior year, according to corporate data firm Equilar Inc.
That progressive outrage is increasingly translating into Democratic legislation using pay ratio as its base. In June, the House passed a legislative package that included the language of Rep. Nydia Velázquez’s Greater Accountability in Pay Act, which would build upon the Dodd-Frank requirements by mandating public companies disclose an additional ratio, this one comparing executive pay raise percentages to those of the median employee. At the same time, the pay ratios are increasingly forming the foundation of legislation imposing taxes or fees on businesses that hit a certain CEO-to-worker pay gap.
The problem, however, is that the considerations behind each pay ratio can and do vary wildly from company to company, raising reliability and comparability questions that undercut efforts to build new policy off the rules.
“There are just so many different variables,” said George Georgiev, an assistant professor at Emory University School of Law whose research includes SEC disclosures and other areas of securities regulation and corporate governance. “So you are not really comparing apples and oranges, it’s almost like you are comparing apples and avocados. It’s really very difficult to compare.”
‘Not too meaningful’
The pay ratio rules under former SEC Chair Mary Jo White were marked by a long, slow, rancorous rulemaking process, with Republican lawmakers making repeated attempts to scrap the rules and Democrats urging the SEC on and reminding the commission of its mandate from Congress, framing the disclosure as critical for investors.
But large investors have never really embraced the disclosure nearly as much as unions, activists, and other income inequality critics have. The Council of Institutional Investors (CII), which represents some $4 trillion in assets under management, never took a position on the rules; its members have been divided on the issue, according to Executive Director Amy Borrus.
That debate has largely faded into the background as companies adjusted to the new disclosure. Now, “to a certain extent it’s become almost boilerplate,” said Deborah Lifshey, managing director in the New York office of compensation consultancy Pearl Meyer & Partners, LLC.
Year one of the disclosures did have big costs associated with it, Lifshey said. But those fell off in year two and year three, she said. The pay ratio rules allow companies to use the same median employee compensation figure for three straight years, barring some major changes in compensation or headcount. In this past year, the costs “picked up slightly because everybody had to redo their median.” But for the most part, Lifshey said companies followed the same methodology they used in the first year.
“What we’ve been saying for four years is, it’s not too meaningful,” Lifshey said, with so much leeway and flexibility that cause fluctuations in the pay ratios.
“Data is always good to have when you are benchmarking compensation,” she said. “It’s one data point, and it’s somewhat interesting, but we have never viewed it as something that would drive how a compensation committees determine compensation.”
Some companies, especially those with high pay ratios, choose to include narrative spin explaining the figure, although such an explanation is not required under the rules. Walmart, in its 2021 proxy statement, argued that its case is unique “because we are significantly larger than most of our peer group companies in terms of revenue, market capitalization, and the size and scope of our worldwide employee population.”
“Therefore, our reported pay ratio may not be comparable to that reported by other companies due to differences in industries, scope of international operations, business models, and scale, as well as the different estimates, assumptions, and methodologies applied by other companies in calculating their respective pay ratios.”
And that explanation echoes the language used by the SEC itself, which in Release No. 33-9877 warned “we do not believe that precise conformity or comparability of the pay ratio across companies is necessarily achievable given the variety of factors that could cause the ratio to differ.”
The SEC intentionally built flexibility into the way companies can calculate their median employee compensation, resulting in core differences in methodology from one company to the next. Companies are allowed to use reasonable estimates to identify the median worker, such as statistical sampling and a “consistently applied compensation measure” that can include payroll or tax records. In identifying the median employee, cost-of-living adjustments are allowed for employees in jurisdictions other than where the CEO resides.
The differing profile of companies, especially large, multinational ones, have also stood in the way of any easy comparison of one pay ratio to another. How overseas workers would skew the median employee compensation figure was a particularly vexing question during the rulemaking process – with critics fretting that large populations of lower-paid foreign workers would result in outsized pay ratio disparities.
The rule’s definition of an employee encompasses both U.S. and non-U.S. workers, including part-time, seasonal, or temporary workers employed by the company. Independent contractors and “leased” workers employed by a third party are not included in that definition. In a nod to those concerns over oversee employees, the final rules included two exemptions that allow a company to exclude all foreign workers if those workers made up 5 percent or less of its total employees, and exclude employees from companies whose data privacy laws obstruct the sharing of compensation data.
Georgiev and Steven Bank of UCLA School of Law in 2019 released an 80-page paper on the rule – which examined the history, design, and effectiveness of the rules – and concluded that the disclosures are characterized by “low informational integrity,” while the numbers resonate with the public far more than other corporate disclosures.
“We conclude that it’s really impossible to actually come up with a reliable pay ratio that really, in a single number, tells you something meaningful and comparable across different companies, different industries, different company structures as well,” Georgiev said.
Pay Raise Disclosure
Those warnings about the limitations of pay ratio have not deterred those who want to use the rules as a foundation for progressive reforms.
Velázquez, in an October 5 House Financial Services Committee hearing in which SEC Chair Gary Gensler was the lone witness, asked the SEC chief how her pay-raise disclosure bill “will help increase the accuracy of equity prices, allow investors to make more informed decisions, and allow the SEC to provide better oversight over our capital markets.” She described her bill as built off the Dodd-Frank pay ratio.
Gensler replied that “I think that investors benefit by understanding and having transparency about executive compensation, and there are a number of features, including your bill, to do that.” He pointed to the SEC remaining work on unfinished Dodd-Frank executive compensation mandates: the clawback rules, pay versus performance, and institutional investment manager disclosure of say-on-pay votes.
“All in all it helps the efficiency of markets where investors get to decide when they have full and fair disclosure on executive compensation,” Gensler said.
Under the language of the Greater Accountability in Pay Act, public companies would be required to include a ratio comparing “the percentage increase in the median of the annual total compensation of all executive officers” over the past year to “the percentage increase in the median of the annual total compensation of all employees of the issuer, excluding executive officers.”
The bill passed the House as part of a broader package of environmental, social, and governance (ESG) reforms in H.R. 1187, the Corporate Governance Improvement and Investor Protection Act. That package, however, only narrowly cleared the House on a razor-thin 215-214 vote, with four Democrats breaking ranks to oppose the bill, and no Republican support. The Senate has shown no sign up picking up the ESG package, dimming hopes for pay raise disclosure in the near future.
The bill’s “prospects seem dim,” Ani Huang, president and CEO of the Center On Executive Compensation, wrote in an email. Huang said it is not clear the measure could clear a filibuster hurdle in the Senate, and noted opposition to the enhanced reporting requirements in the bill by Sen. Pat Toomey, the ranking Republican on the Senate Banking Committee.
Executive pay is primarily market-based, and most companies target the median of the market for all levels within the company, according to Huang, who added that the pay ratio for a company then depends on a number of factors, such as industry location, employee base, business structure, and the competitive market.
“Because of this basic premise, which most investors understand, disclosure of the pay ratio did not significantly alter the way in which companies compensate employees and did not change executive pay,” Huang wrote. “When investors failed to latch on to pay ratio, proponents developed a new disclosure idea, which was ‘pay raise ratio.’ This is intended to show the increase in CEO pay compared to the median worker rather than just the absolute numbers.”
“However, our view is that the same mechanics will apply – it will not be used by investors because it is not an appropriate proxy for sustainability or performance,” Huang wrote.
Taxes and Fees
First came Portland. In 2016, the City Council approved a surtax, based directly on the SEC rules, on publicly traded companies in the city with a 100:1 or greater CEO pay ratio. That surtax is 10 percent for companies with a ratio between 100:1 and 250:1, and 25 percent for 250:1 or higher.
In 2020, San Francisco voters passed Proposition L, which created a more local variant of the pay ratio rules. The measure is expected to raise between $60 million to $140 million each year by taxing companies in which the highest paid managerial employees is paid more than 100 times the median employee in the city.
And in March, Sen. Bernie Sanders of Vermont, the Chair of the Senate Budget Committee, rolled out S. 794, the Tax Excessive CEO Pay Act, which – like Portland’s measure – is couched directly in the Dodd-Frank pay ratio language. Under the bill, companies with a 50:1 or higher ratio would face escalating increases to their corporate tax rate, up to five additional percentage points for those higher than 500:1. The bill makes one notable departure to account for companies where the chief executive isn’t the highest paid employee, by stipulating that, in those cases, the highest paid employee would determine the ratio.
Democrats on Capitol Hill have also explored the idea of imposing fees on banks that post an excessive pay ratio. In a late September House Financial Services subcommittee hearing, the panel floated a discussion draft of the Financial Services Worker Bill of Rights Act, which would establish a series of annual supplementary fees on banks with a greater than 100:1 ratio.
All of those measures reflect a core tension at the heart of pay ratio disclosure: whether the rules were intended to inform investors – as argued by the SEC in Release No. 33-9877 – or whether it is designed to exert social pressure on corporate compensation practices, or some combination of both.
“What is the goal here?” Lifshey said. “Is it your goal to lower CEO pay or to pay more across the board so your median is higher? You enact legislation and you hope that it has a purpose, besides revenue raising. But the point is I don’t think that any compensation committee really looks at this with the intent to use it to draw up policy.”
Georgiev, as well, expressed skepticism over the revenue-raising measures.
“There are just so many other more obvious and more objective ways to improve corporate taxes,” Georgiev said. “Putting in a pay ratio tax will undermine the objectivity and I think the legitimacy of the tax system, just because it’s so subjective. I’m not saying that we shouldn’t tax corporations more, or that the tax regime couldn’t stand to be improved. All I’m saying is that the pay ratio is just a very very bad way of doing it.”
This article originally appeared in the October 18, 2021 edition of Accounting & Compliance Alert, available on Checkpoint.
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