Critics of Pay Ratio Rule Urge Changes in Comments to SEC

Be careful what you wish for.

Those who demanded more flexibility in how the Securities and Exchange Commission wants companies to comply with the controversial pay ratio rule got what they wanted. Now, some are bemoaning that apparent victory in comment letters to the SEC.

In September, the SEC approved a proposed rule that requires companies to disclose a comparison of their CEO's pay to that of the median employee. Companies will need to produce a median compensation figure for all workers, domestic and overseas. In a concession to opponents of the rule, the SEC plans to allow the use of statistical sampling, based on payroll data, to derive that figure.

While few public companies that will be required to implement the rule submitted comments, trade and industry associations and other representative organizations had plenty to say. The National Investor Relations Institute, an association of corporate IR officers, is among those fretting over the alternative way to compare pay.  The absence of SEC-endorsed methodologies to define statistical sampling could open the door for proxy advisory firms or activist investors to apply their own and “further confuse other investors, or propose more onerous methodologies that may become the default standard, and undercut the flexibility for issuers,” it wrote in a letter to the SEC.

The pay ratio rule, mandated by the Dodd-Frank Act, has been endorsed by many consumer and shareholder advocacy groups, as well as labor unions. Opposition has been plentiful, however, with critics that include many executive compensation consultants and the U.S. Chamber of Commerce. As the SEC prepares to finalize the rule, it has received more than 32,000 comment letters ahead of a Dec. 2 deadline for submissions. Many of those comments, as is typically the case, are duplicative form letters voicing support and urging the Commission to move quickly and without concession.

While the SEC offered flexibility for pay calculations, NIRI still “expects that compliance costs will be exorbitant, especially for those firms with overseas employees,” unless the scope is limited to domestic workforces, wrote CEO Jeffrey Morgan.

The disclosures may further confuse investors because companies likely will use different methodologies and statistical sampling techniques to calculate median employee compensation. “While NIRI appreciates the SEC's intent to provide more flexibility to issuers, this approach—and the lack of established private sector standards to make such calculations—may encourage some issuers to take statistical shortcuts to save money,” Morgan wrote. “At the same time, more cautious companies would incur greater expenses to ensure that they produce a more accurate (and presumably higher) ratio number, a fact that won't be considered by most investors when the company is compared to its peers.”

The Center on Executive Compensation argued in one of its letters that “statistical sampling would not ease the core burdens associated with calculating the pay ratio for most global companies.” Most companies, especially larger multinational companies, do not maintain a centralized list of employees that is linked to their compensation information, it explained. Information about each individual employee, including payroll data, is typically maintained in each country, business unit or individual location.

Raymond Link, CFO of FEI Company, a Nasdaq listed supplier of scientific instruments with an international workforce, wrote in his concerns about the complexity of the calculation. He estimates it will take over 1,000 hours, at a cost of $250,000, to develop the database and methodology the SEC's proposed rule requires. On an annual basis, 500 man-hours would be needed to support the ongoing effort, at a cost of more than $100,000.

His suggestions for alleviating that burden include defining “employees” as only those employed by the U.S. parent organization and domestic subsidiaries. In effect, this would be all employee compensation reported to the Internal Revenue Service. He also urged the SEC to exclude individuals no longer employed at year-end as annualizing salary data would add to the cost for companies. These suggestions could decrease his costs by nearly 90 percent, Link said.

Karl Muth, a lecturer in economics and public policy at Northwestern University, took aim at the entirety of the rule. “There is no empirical evidence that CEO pay relative to median worker pay is an indicator of CEO effectiveness (or, for that matter, a median worker's effectiveness), nor that CEOs that are highly paid relative to median workers are uniformly more able, or less able, to defend and assert the interests of shareholders,” he wrote in a comment letter to the SEC.

“While NIRI appreciates the SEC's intent to provide more flexibility to issuers, this approach—and the lack of established private sector standards to make such calculations—may encourage some issuers to take statistical shortcuts to save money.”

—Jeffrey Morgan,

CEO,

National Investor Relations Institute

“A CEO's choice to take a very low salary due to windfalls in prior years or as a gesture to disappointed shareholders or in the wake of marrying a wealthy spouse does not make her leadership more effective or her service to shareholders more valuable,” Muth added. “If anything, an underpaid CEO may be more difficult for a board from a governance perspective, as one of the key levers for CEO control, compensation, is removed.”

Proponents of changes to the proposed rule had other suggestions as well:

The rule's pay ratio calculation should be limited to full-time, U.S.-based employees.

Given the difficulty of gathering worldwide employee data and the reality that many companies will have to rely on estimates, the SEC should treat pay ratio disclosures as “furnished,” rather than “filed.”

If the SEC extends the mandate to non-U.S. employees, companies should receive at least two years to prepare before they have to include those overseas employees in their calculations.

If part-time and seasonal employees are included, the SEC should permit companies to annualize the pay data of those employees to provide more meaningful comparisons.

The SEC should extend the comment period for another 60 days to allow issuers more time to prepare estimates of their potential compliance costs.

Many of those offering comments also urged the SEC to undertake an education effort to help retail investors “understand the limits of pay ratio disclosure” and remind them where to find other information, such as in the Compensation Discussion and Analysis section of a company's proxy statement, that provide a more complete understanding of corporate pay practices.

Plenty of Support, Too

Those who are in favor of the rule and worry that the SEC will water it down to placate critics of the plan also offered plenty of supporting comments on the rule.  The Institute for Policy Studies, which monitors executive pay, addressed, for example, what it called “attempts to trivialize the importance of pay ratio disclosure” and took issue with NIRI's comment letter.

SO MANY QUESTIONS …

In its proposed rulemaking for a Pay Ratio Rule, the Securities and Exchange Commission suggests dozens of questions that commenter's might wish to address. A sampling of those questions:

Should we revise the proposal so that smaller reporting companies would be subject to the proposed pay ratio disclosure requirements?

Are there alternative ways to fulfill the statutory mandate of covering “all employees” that could reduce the compliance costs and cross-border issues raised by commenters? Would it be consistent with the statute to permit registrants to exclude non-U.S. employees from the calculation of the median?

Should registrants be allowed to disclose two separate pay ratios covering U.S. employees and non-U.S. employees in lieu of the pay ratio covering all U.S. and non-U.S. employees? Should we require registrants to provide two separate pay ratios?

What are the applicable data privacy laws or regulations that could impact the collection or transfer of the data needed to comply with the proposed pay ratio requirement?

How would the proposed flexibility afforded to all registrants ( selecting a method to identify the median, the use of statistical sampling or other reasonable estimation techniques and the use of consistently applied compensation measures to identify the median employee) impact any potential costs and burdens arising from local data privacy laws?

Should the rule cover employees of a registrant's subsidiaries? Should it be limited to subsidiaries that consolidate their financial statements with those of the registrant?

Is it likely that registrants would alter their corporate structure or employment arrangements to reduce the number of employees covered by the proposed requirements? How should we tailor the proposed requirements to address such an impact?

Does the proposed inclusion of all employees raise competition concerns? If so, are there some industries or types of registrants that would be more affected than others?

Should registrants be required to include any individual who was employed at any time during the year, or for some minimum amount of time (and if so, what amount of time) during the year?

Are registrants likely to use statistical sampling to identify the median? How would registrants conduct the sampling? Would it be outsourced or conducted by internal personnel? How much would statistical sampling cost?

Could the flexibility of the proposed requirements allow a registrant to distort its pay ratio in material respects?

Should we require registrants to disclose additional narrative information about the pay ratio or its components, or factors that give context for the median, such as employment policies, use of part-time workers, use of seasonal workers, outsourcing and off-shoring strategies? If so, what additional information should be required?

Source: SEC.

“Pay ratio disclosure would add a new number into the mix, not erase any numbers that already go before the investing public,” wrote Director John Cavanagh on NIRI concerns that the new “headline number” would be a distraction and “the proposed SEC rule will result in garbage data, as some companies take statistical shortcuts to save money.”

“This objection reminds us of the old quip about the kid who kills his parents and then asks the court for mercy—because he's an orphan,” he wrote. “Now, corporate leaders, no longer required to tally up all their paychecks, are decrying their newly won flexibility.”

Sue Ravenscroft, professor of accounting at Iowa State University, proclaim her support for the rule and lash out against the rule's many critics in a comment letter to the SEC. “I have seen similar alarmist rhetoric many times when, for example, the Financial Accounting Standards Board required additional information on capital leases, research and development costs, or unrecorded liabilities,” she wrote. “We always heard that the capitalist system would be brought to its knees if listed companies have to provide additional information, but somehow the dreaded consequences never materialize.”

“As for the requirement being time-consuming and onerous, I have to keep from rolling my eyes,” Ravenscroft added. “Figuring out how much to deduct currently for the expansive stock options executives get is much more complicated, but somehow corporations are able to figure that out. So I have faith that they can figure out median employee pay, especially given the SEC's willingness to allow sampling.”

Others offered a more mixed response. Speaking last week at the 45th Annual Institute on Securities Regulation, an event sponsored by the Practicing Law Institute, Ann Yerger, executive director of the Council of Institutional Investors , admitted her membership has “really mixed views” about the pay ratio rule and sympathized with concerns about the cost of the requirement versus value for investors.  “Companies are going to have to put that number into some kind of context, which is going to be extremely difficult in the first year,” she said.

CII was also among the groups weighing in on the proposal. To do so, it convened a three-person panel comprised of representatives of public, corporate, and union employee benefit plans. “The members generally agreed that the Commission has done an admirable job in proposing to implement the rule in a flexible manner that attempts to strike an appropriate balance between providing potentially useful information to investors and limiting company compliance costs,” CII wrote.

CII agrees that the disclosure should only be required for SEC filings in which other executive compensation disclosures are also required. It will be most meaningful to investors when placed in context with the summary compensation table and Compensation Discussion and Analysis report, it surmised.

Robin Ferracone, CEO of Farient Advisors, also speaking at the PLI conference, urged more companies to directly comment on the rule prior to the Dec. 2 deadline. “Do you run into data privacy laws? Do you include joint ventures? Is it fair to include the global workforce as opposed to a domestic workforce? These are all questions that the SEC would like to hear about,” she said.