Compensation of public company executives re-emerged back into the public limelight after the recent financial crisis which began in late 2007. The public perception was one of outrage in large part due to the fact that many investors in public companies were experiencing significant losses in their investment portfolios while CEOs and other executives were still being paid record levels of compensation and bonuses.
As a direct result, Congress enacted a number of new laws intended to fix these perceived social injustices, most of which were included in the Dodd-Frank Act. Section 953(b) of Dodd-Frank, for example, was a highly controversial part of Dodd-Frank which directed the SEC to adopt rules requiring public companies to disclose the ratio of the CEO’s total compensation to that of its median employee. The crux of the controversy surrounding this rule related to how companies should determine median employee salary. Should part-time employees be included or just full-time employees? How should companies treat international employees in countries that have significantly lower relative wages as compared to the U.S.? Another concern of critics was whether the pay ratio metric was useful for investors.
On September 18, 2013, the SEC promulgated proposed rules regarding CEO pay ratio disclosures. As required by the Dodd-Frank Act, the proposal would amend existing executive compensation disclosure rules to require companies to disclose:
- The median of the annual total compensation of all its employees except the CEO.
- The annual total compensation of its CEO.
- The ratio of the two amounts.
The proposed rule would not specify any required calculation methodologies for identifying the median employee in terms of total compensation for all employees. Instead, it would allow companies to select a methodology that is appropriate to the size and structure of their own businesses and the way they compensate employees.
Like the other SEC disclosure rules mandated by Dodd-Frank, it seems that Congress is attempting to indirectly fix situations it views as problematic for one reason or another by mandating that public companies disclose certain things in their public filings. I presume the thought is that companies will be incentivized to change their practices so as not to be publicly shamed through these disclosures in their public filings. My presumption is supported, to some extent, by Commissioner Gallagher’s recent public comments where he stated his belief that the only purpose of the CEO pay ratio rules were to “name and, presumably in the view of its proponents, shame U.S. issuers and their executives.”
Interestingly, and perhaps unbeknownst to Congress, there is empirical evidence to suggest that mandated disclosure is a poor means to influence behavior. In fact, in many cases, disclosure requirements may have the opposite effect of what was originally intended. For example, in his book Predictably Irrational, Duke University behavioral economist Dan Ariely explains how executive compensation disclosure rules have back fired in the past. According to Ariely, CEOs made approximately 36 times more than the average worker in 1976. By 1993, the year which the SEC adopted executive compensation disclosure rules for public companies, this ratio had increased to approximately 131 to 1. After the executive compensation disclosure rules became effective, they had the effect of actually accelerating the increase in the ratio of CEO pay to the average employee and by 2000, that ratio reached approximately 525 to 1.
One proposed explanation for the increase in CEO compensation that Ariely offers is that once executives knew how other executives were being compensated through disclosures in public filings, executives who were “underpaid,” relatively speaking, wanted their compensation to be increased commensurate with executives of other companies in their peer group. Rather than suppressing executive pay and perks (presumably what Congress had intended), public company executives were comparing their compensation to other similarly situated executives and pursuing pay increases to the extent they felt underpaid relative to their peers. This phenomenon has been referred to as the “keeping up with the Joneses” mentality and the effect of this phenomenon on executive compensation is the subject of an excellent New York Times article which focuses on the problems of benchmarking executive compensation and why the present norms relied upon to set executive compensation are flawed. The gist is that if there is perfect information about executive compensation, everyone except the highest paid executive will feel underpaid.
In summary, there is evidence to suggest that trying to direct behavior of public companies through disclosure requirements is not an effective means to accomplish intended goals. Aside from creating additional complications and expense for public companies which are already over-burdened, these disclosures could have the opposite effect of what was initially envisioned. Moreover, I continue to believe that regulations should be narrowly tailored to correct material market failures. The expansion of disclosure burdens on public companies which do not further this not only serves to disadvantage U.S.-based issuers through increased compliance costs, but also provides little or no benefit to investors.