by Cydney Posner
One of the arguments that has often been used to oppose the Dodd-Frank pay-ratio provision is that the rule does not really provide information that benefits investors; instead, the argument goes, the real animus for the rule is a political effort to focus attention on inequality. Now, an analysis of governance ratings from Bank of America Merrill Lynch, reported in the WSJ, suggests that pay-ratio information just could provide some warning signs that investors may find valuable.
As you probably recall, the Dodd-Frank pay-ratio provision and related SEC rule requires disclosure, in a wide range of SEC filings, of the ratio of the median of the annual total compensation of all employees of the company to the annual total compensation of the CEO. Adoption by the SEC of final rules to implement the provision took more than five years from the date of enactment of Dodd-Frank in 2010. In part, the delays could be ascribed to the interest-group politics surrounding the provision, as well as the SEC’s efforts to address cost and complexity concerns by devising a relatively flexible approach. (See this Cooley Alert.) Throughout the long process, business, organized labor and consumer advocacy groups lobbied intensively both for and against the rule. Republicans in Congress sought numerous times to repeal the provision and pressured the SEC to delay adoption of final rules, while Democrats pressured the SEC to accelerate its implementation. Proponents of the provision, focusing on reports of the mounting disparity between executive and worker pay (and income inequality in general), argued that pay-ratio information was essential to allow investors to determine if executive pay was excessive and needed to be reined in. The WSJ reports that the “ratio has ballooned since the 1970s: The bosses of America’s 350 largest companies made on average 276 times the money of their rank-and-file subordinates in 2015, up from 30 times in 1978, according to the left-leaning Economic Policy Institute.” Opponents of the provision argued that, for almost all companies, calculating the ratio would be of little value to investors, but tremendously complicated, expensive and potentially inaccurate. As the WSJ points out, opponents argued that the pay ratio “isn’t instructive” because a high ratio may indicate only that some companies—retail chains, for example—employ more unskilled workers than, say, investment banks. In addition, “[c]omparisons within the same sector are likely to get bogged down in discussions of how one company’s business model or geographic scope is different from another’s.”
SideBar: See also this PubCo post, which discusses the views of several institutional shareholders on pay-ratio disclosure and this PubCo post, which discusses the potential impact of disclosure of a firm’s pay ratio on consumer behavior.
In February, based on his “understanding that some issuers have begun to encounter unanticipated compliance difficulties that may hinder them in meeting the reporting deadline,” Acting SEC Chair Michael Piwowar issued a statement directing the Corp Fin staff to revisit the pay-ratio disclosure rules. This statement sought public input on any unexpected challenges that issuers experienced as they prepared for compliance with the rule and whether relief was needed. He also directed the staff to reconsider the implementation of the rule based on any comments submitted and to determine whether additional guidance or relief was appropriate. (See this PubCo post.) With the new SEC Chair now installed, however, we have yet to hear of any action to be taken or proposed with regard to the current pay-ratio rule.
In addition, in June, the House passed the Financial CHOICE Act of 2017, which seeks to repeal the pay-ratio provision. However, commentators believe that the bill is unlikely to become law as it currently stands. According to the WSJ, the bill “isn’t expected to earn sufficient support to advance in the Senate…. Senators are working on their own regulatory rollback, which they hope to pass with support from at least some Democrats.” Reportedly, the Democrats decided against offering any amendments to the bill because they viewed it as “fatally flawed.” Apparently, the approach of the Senate Banking Committee is to advance separate legislation that addresses Dodd-Frank in a more piecemeal fashion that might garner some Democratic support, with the result, presumably, that some of the more controversial provisions of the Financial Choice Act would be less likely to advance. However, according to the article, “Republicans and Democrats in the Senate so far have only been able to agree on relatively minor changes to Dodd-Frank. Mr. Hensarling [Chair of the House Financial Services Committee and sponsor of the bill] said he is looking for ways to push pieces of the plan through the Senate without Democratic support by attaching some measure to the annual budget bill, which passes on a majority vote.” Whether pay-ratio might be one of those pieces remains to be seen. (See this PubCo post and this PubCo post. )
SideBar: All of these hiccups notwithstanding, the 2018 proxy season will soon be upon us, and companies may want to start thinking about how they will implement the new pay-ratio rule, assuming it is not repealed or further modified or delayed. Cooley’s Comp Talks webcast on July 19 will address pay-ratio calculations and disclosure, including strategies for navigating through decision points and practical advice on managing the process. You can register for the webcast here.
The WSJ article argues that, assuming pay-ratio disclosure does become a feature of 2018 proxy statements, it will at least provide shareholders with “a sliver of insight into the companies they own….The key insights will come from seeing how it evolves for a specific company over time. A widening ratio could be a warning flag that a management team is getting greedy. Executive pay ballooned in the financial sector before the 2008 banking crisis. Those companies that went bankrupt were particularly guilty of deteriorating pay practices, according to an analysis of governance ratings by analysts at Bank of America Merrill Lynch. Pay ratios could have made this more obvious at the time—and may help bring subsequent lapses to wider attention.” In addition, the article suggests that knowledge about median employee pay “would also fill gaps in investors’ understanding, such as how the wage bill compares with other costs,” although, because that calculation is required to be updated only once every three years, “useful insights into how the median wage changes relative to profit, say, would take years to emerge.”
SideBar: Companies that are starting to fret about how their pay ratios will compare with their peers and whether an unseemly gap might be detrimental to their reputations and unsettle their work forces might want to take a look at this PubCo post. The post discusses an article from the WSJ with recommendations from several “reputation management experts” on how to navigate this minefield.
The article cautions, however, that investors should “wield their new analytical tool with caution,” and should not “assume more thriftily paid bosses offer value for money.” Indeed, a study cited in the article showed a strong positive correlation between executive pay and three-year TSR (perhaps reflecting in part the prevalence of pay-for-performance measures based on TSR).
SideBar: Compare this study, also reported in the WSJ, from corporate-governance research firm MSCI, which showed that, over the long term, there was a significant misalignment between CEO pay and stock-price performance. The study looked at CEO pay relative to total shareholder return for around 800 CEOs at more than 400 large- and mid-sized U.S. companies over a decade (2006 to 2015). For the companies surveyed, the study found, on average, that CEO pay and performance had an inverse relationship; according to the WSJ,“MSCI found that $100 invested in the 20% of companies with the highest-paid CEOs would have grown to $265 over 10 years. The same amount invested in the companies with the lowest-paid CEOs would have grown to $367.” What accounts for these stunning results? The WSJ concluded that the study “results call into question a fundamental tenet of modern CEO pay: the idea that significant slugs of stock options or restricted stock, especially when the size of the award is also tied to company performance in other ways, helps drive better company performance, which in turn will improve results for shareholders. Equity incentive awards now make up 70% of CEO pay in the U.S.” Fortune, reporting on the same study, quotes MSCI to similar effect: “‘[W]e found little evidence to show a link between the large proportion of pay that such awards represent and long-term company stock performance. In fact, even after adjusting for company size and sector, companies with lower total summary CEO pay levels more consistently displayed higher long-term investment returns.’” (See this PubCo post.)