Howard Berkenblit

Investors looking for better ways to judge the merits of executive compensation packages were given a new tool by the Securities Exchange Commission in September, but it may not be as useful as it seems.

The SEC adopted the “pay ratio” rule, which requires publicly traded companies to disclose the compensation gap between what the company pays its chief executive officer and the pay and benefits of its “median worker.” Investor advocates, shareholder groups and union pension funds have pushed for the rule, saying that CEO compensation overall has grown to nearly 300 times what typical employees earn.

Business groups such as the Business Roundtable say producing a pay ratio is difficult in a global economy. International corporations that operate multiple businesses in a host of countries with their own rules and regulations must compare different compensation systems from varying environments. Implementing the new rule, they say, will cost U.S. companies more than $700 million a year – nearly 10 times the $73 million the SEC has estimated.

Federal securities laws compel firms to disclose material information to investors so that they can make informed investment and voting decisions. But the pay ratio rule could lead investors to make “arbitrary and distorted conclusions” regarding corporate compensation practices if industry groups are correct about the challenge of blending multiple payroll systems.

The SEC has tried to address many of the concerns of business leaders by providing companies greater flexibility in meeting the rule’s requirements. The rule does not apply to smaller reporting companies, emerging growth companies, foreign private issuers, MJDS filers and registered investment companies.

In addition, companies operating in multiple countries are allowed to apply cost-of-living adjustments when computing differences to identify the median employee. However, companies must still disclose the median employee’s actual annual compensation and pay ratio before any cost-of-living adjustments can be applied. The rule also allows international companies to exclude certain non-U.S. employees from its calculations. A company can also apply a methodology that is suited to its own facts and circumstances.

And to further reduce the burden of compliance, the SEC will allow a company to use one particular median employee to represent the entire workforce for up to three fiscal years – unless there has been a substantial change in the size of a company’s workforce or in the benefits package a company pays.

What this means is that the SEC seemed to envision the “median worker” to be more than just a statistic but a real person, with a name and face – someone, in short, who might find their picture on the wall as the Company X “Median Worker” someday instead of its “Employee of the Month!”

Complying With Dodd-Frank 

With the 2010 passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act shareholders were granted a “say on pay” right regarding executive compensation. More than 70 percent of company managers have had their say-on-pay resolutions approved by shareholders by margins of 90 percent or more. Fewer than 50 out of 3,800 shareholder groups rejected the compensation packages managers put before them.

If these early returns are any indication, the new rules under Dodd-Frank are having their intended effect as shareholders now feel themselves empowered to hold chief executives more accountable by tying their benefit packages more closely to company performance.

And it is precisely this success which makes the SEC’s new pay ratio requirements all the more puzzling. Sure it still pays to be a CEO. Median compensation for the heads of Standard & Poor’s 500 companies rose to a record $10.6 million. That is up from $10.5 million the year before, according to the compensation data firm Equilar and the Associated Press.

But CEO pay is already fully described in the SEC filings of the very firms which must now also comply with this additional pay ratio mandate. It’s unclear how the pay ratio will further inform investors when considering buying a company’s stock. It’s hard to calculate and arbitrary. It also probably won’t be comparable from one company to the next if it is based on methods of calculation rather than underlying issues of compensation.

The SEC has tried its best to strike a balance between the Congressional mandates of Dodd-Frank and industry complaints about how implementation of the new rules was onerous. In the end the pay ratio rule might undermine its stated mission of protecting investors and the public interest by perversely leading investors astray. It requires companies to produce information that, by its very nature is not just redundant and expensive to obtain, but arbitrary, immaterial and misleading as well.

Howard E. Berkenblit is a partner and leader of the Capital Markets Group of the law firm of Sullivan & Worcester, based in Boston.