At an open meeting this morning, SEC Commissioner Daniel Gallagher contended that, in its efforts to adopt pay-ratio rules that conform to the Dodd-Frank mandate, the SEC was just putting itself in a box – viewing the Dodd-Frank mandate as so prescriptive that the SEC could only push on the sides of the box without fundamentally altering it. But, he said, the SEC is really just a mime and the box is imaginary. Whether or not this evocative image is an accurate one, it surely reflects the fervent clash of views that suffused this morning’s long-anticipated meeting.
Not surprisingly, at the meeting, the SEC adopted, by a vote of three to two,final rules to implement Section 953(b) of Dodd-Frank, the pay-ratio provision. The pay-ratio provision mandates that the SEC require most public companies to disclose, in a wide range of their SEC filings:
- the median of the annual total compensation of all employees of the company, except the CEO (that is, the point at which half the employees earn more and half earn less);
- the annual total compensation of the CEO; and
- the ratio of the two amounts above.
It has taken more than five years since enactment of Dodd-Frank in 2010 to finally bring the pay-ratio rule to fruition. In part, the delays can be ascribed to the interest-group politics surrounding the provision. Throughout the long process, business groups, organized labor and consumer advocacy groups lobbied intensively both for and against the rule. The Commissioners indicated at the open meeting that the SEC had received 287,000 comment letters on the proposal, including 1,500 unique letters. Just last month, a petition with 165,000 signatures, gathered by the AFL-CIO and others, was delivered to the SEC demanding implementation of the pay-ratio rule. Republicans in Congress have sought numerous times to repeal the provision or pressured the SEC to delay adoption of final rules, while, more recently, Democrats have pressured the SEC to accelerate its implementation. (See this PubCo post and these news briefs of 6/24/11, 7/13/11 and 6/20/13.)
Pay-ratio disclosure proponents, focusing on reports of the mounting disparity between executive and worker pay (and income inequality in general), have argued that pay-ratio information is essential to allow investors to determine if executive pay is excessive and needs to be reined in. According to a recent study from the Economic Policy Institute, for the largest U.S. public companies, CEO pay in 2014 was 303 times an average worker’s pay, compared to just 20 times in 1965. Providing pay-ratio data, they contended, may encourage boards, in setting executive compensation, to consider internal pay equity, not just external peer-to-peer comparisons, which, many argue, tend to inflate executive pay. In addition, shareholders may use that data to inform their say-on-pay votes.
Opponents of the provision have argued that, for almost all companies, calculating the ratio would be of little value to investors, but tremendously complicated, expensive and potentially inaccurate. In the proposal released in 2013, the SEC sought to address these cost and complexity issues by offering a relatively flexible approach that allowed each company to choose from several options for identifying the median in the way that best suits the size, structure and compensation practices of that company. In particular, the proposal allowed companies to use estimates and statistical sampling, as well as any “compensation measure,” such as W-2 wages or payroll, to identify the median in the employee population.
While that flexibility was welcomed, criticism has not abated. Most of the angst, however, has been reserved for the proposal’s requirement to include in the calculation of median compensation both foreign and part-time employees. Companies with a global workforce, they contended, could face a variety of different complex payroll and pension systems, different compensation practices and different income tax reporting regimes in each country (i.e., no W-2s), and may not have a centralized network for capturing and analyzing all these types of data. The complications arising out of these variables could be compounded by foreign currency fluctuations as well as foreign privacy rules. Moreover, with regard to part-time, seasonal and temporary employees as well as employees located in less developed countries where per-capita income and cost of living are substantially lower, companies and business organizations raised the concern that including these employees in the median calculation would substantially (and inappropriately) skew the results to widen the gap.
In its efforts to respond effectively to these objections, the SEC majority has clearly felt constrained by the provision’s mandate to include “all employees” in the calculation. Organized labor and consumer advocacy groups contended that the Dodd-Frank mandate is “unambiguous” and that the SEC simply does not have “regulatory flexibility” under the statute to permit the exclusion of any employees from pay-ratio calculations. Nevertheless, the SEC attempted to thread the needle to provide some additional relief to companies on this issue, while still hewing closely – or closely enough – to the text of Dodd-Frank.
The final rules require (with some exceptions described below) that all employees of the company and its consolidated subsidiaries be included in the calculations, including foreign, part-time and seasonal employees. However, the flexibility already incorporated into the proposal — the ability to use statistical sampling, estimates and any consistently applied compensation measure (such as information derived from payroll or tax records) to calculate compensation and to identify the median employee — survived generally unscathed into the final rules. The final rules also continue to require that companies describe the methodology selected, estimates used and assumptions made. As in the proposal, companies may supplement with additional narrative or ratios. The required ratio information will need to be updated only for the 10-K or, if later, in proxy statements requiring executive compensation disclosure. Emerging growth companies, smaller reporting companies, foreign private issuers, MJDS filers and registered investment companies are exempt from the rules. The rules require that companies report pay ratio information for their first fiscal years beginning on or after January 1, 2017, although there are some extensions and exceptions in connection with IPOs, business combinations ad companies that cease to be EGCs or SRCs.
The final rules create several new accommodations designed to address some of the cost and complexity objections. In particular, the final rules provide for the following:
- An exclusion for non-U.S. employees if compliance would cause a violation of foreign privacy laws, provided the company files with the SEC a legal opinion supporting that position;
- A de minimis exclusion, in identifying the median, for non-U.S. employees that account for 5% or less of the company’s employees, including any non-U.S. employees that are being excluded under the data privacy exemption;
- Companies may apply a cost-of-living adjustment to the compensation measure used to identify the median employee and the same adjustment to the calculation of the total compensation paid to the median employee to reflect the cost of living applicable in the jurisdiction where the CEO resides, provided that unadjusted median compensation and unadjusted ratio must are also disclosed;
- Companies are permitted to identify the median employee only once every three years, instead of every year, provided there have not been changes in employee compensation or in the employee population that the company reasonably believes would significantly affect the pay ratio (and, in the event the median employee departs from the company or his or her position changes, the company may use another employee with substantially similar compensation as its median employee); and
- Companies may determine the employee population for purposes of identifying the median employee at any point within the last three months of the fiscal year (instead of just on the last day of the fiscal year).
In her statement, Chair Mary Jo White observed that to “say that the views on the pay ratio disclosure requirement are divided is an obvious understatement.” From her perspective, one of the SEC’s jobs “is to implement the mandates of Congress – and to do so in a way that is as cost-effective as feasible and that best advances our mission. [This provision of Dodd-Frank] is the law, and we are required to carry it out….”
Commissioner Luis Aguilar cited as potential benefits of the new disclosures that they would better equip shareholders to promote accountability for compensation policies and practices, better inform investors in connection with “say-on-pay” advisory votes and “promote better shareholder engagement on executive compensation issues.“ He also observed that some commenters had argued that the new disclosures “could provide visibility into other hard-to-measure indicators of a company’s long-term health, such as the effectiveness of its corporate governance.” While he recognized that many were also skeptical of the rules in light of the costs and complexities associated with compliance, he asserted that Dodd-Frank “did not expressly carve out any categories of employees, whether they are part-time, temporary or seasonal, or employees situated in the U.S. or abroad.” Commissioner Kara Stein also recited some expected benefits of the disclosure, such as allowing shareholders to monitor changes in the ratio from year to year and to see how the company manages its human capital.
As expected, both Commissioners Gallagher and Michael Piwowar dissented on the vote, both contending that, in effect, the SEC had not adequately performed the required cost-benefit analysis. Borrowing from Justice Scalia, Commissioner Gallagher characterized the rationale for the rules as “pure applesauce.” Commissioner Piwowar viewed the suggested benefits as just “conjecture.” Instead, Commissioner Gallagher maintained, citing as evidence various statements from the AFL-CIO, the real purpose of the rules was to shame and embarrass companies into lowering CEO pay. But, he contended, addressing income inequality is not within the province of the SEC, and there was nothing in the record to show that the SEC had performed the work necessary to consider what, if any, the benefits of the rules are. He viewed the information gained as of such low quality that it actually obscured the material information already available to shareholders. To determine whether there were benefits to shareholders, Commissioner Piwowar argued, the SEC should have performed “investor testing” as authorized under Section 912 of Dodd-Frank. Commissioner Gallagher concluded that there was “no reasoned basis” for the rules. Rather, he opined, the pay-ratio rules may well be the “most useless” of the Dodd-Frank requirements. Moreover, Commissioner Gallagher contended, whatever the benefits may be, they don’t justify the enormous costs: the initial costs of compliance were expected to be $1.3 billion, with ongoing costs of $526 million.
What’s more, Commissioner Gallagher contended, there could have been a savings of $788 million if the SEC had excluded from the definition of “employees” all part-time and non-U.S. employees. By viewing the statute’s reference to inclusion of “all employees” as almost immutable, the SEC had put itself into a “box.” That box was imaginary, he argued, because the SEC “has ample definitional authority, interpretive authority, and exemptive authority” to exclude categories of employees:
“The statute does not include any relevant definition of the term ‘employee.’ So the SEC is free to define ‘employee’ in the way that it chooses. The Commission commonly uses its definitional authority to make sense of legislative language that perhaps didn’t quite hit the mark. Similarly, where a statute is ambiguous, the Commission has the authority to interpret the ambiguous language. Here, the term ‘employee’ is ambiguous. The statutory language ‘all employees’ simply specifies thatall members of the class of ‘employees’ must be included; it does not tell us anything about how that class is defined. Thus, the Commission has broad latitude to define or interpret ‘employee’ to mean ‘persons who are employed by the issuer on a full-time basis within the United States.’ The pay ratio would then need to be the ratio of the pay of the median of allof such persons to the pay of the PEO. Or, the Commission could simply have exempted non-U.S., non-full time employees from the scope of the rule; the release concedes that it would be within the scope of the Commission’s Section 36 exemptive authority to do so.”
Had the SEC taken his recommended course of action, he advised, he could have supported the rules. But the rules then up for a vote were substantially as proposed; the revisions only rearranged some of the deck chairs. Eliminating non-U.S. and part-time employees could have “eliminated the noise” and led to data that was “marginally less useless.”
As a finishing touch, Commissioner Gallagher contended that, like the conflict minerals rules, these rules may run afoul of the First Amendment as improperly compelled speech. In his view, where the purpose is only to name and shame companies, “the rule is not intended to, and does not, produce information in furtherance of a legitimate government purpose.”
[Sidebar: The conflict minerals case is currently pending before the D.C. Circuit, where one of the issues is whether the compelled speech is “purely factual and uncontroversial information.” See these PubCo posts of 1/3/15 , 7/16/14, 7/29/14 and 9/14/14.]
Commissioner Piwowar viewed the pay-ratio rules to be harmful to investors and the benefits cited as only speculative and unsupported. In his view, the Dodd-Frank provision was the product of pandering to politically connected special interest groups, and the rules represented “a blatant attempt to limit executive compensation.” Moreover, he argued, the push for the rule represented a page taken “from Big Labor’s Playbook” and reflected “a strategy to re-make the capital markets with a so-called ‘worker-owner’ viewpoint.” In addition, he pointed out that some states have contemplated using the pay-ratio information for purposes such as adjusting corporate tax rates or awarding government contracts. He also faulted the rule for not providing for cost-of-living adjustments to the compensation of the median employee located in states with lower costs of living, as the rules do for foreign countries. Finally, he suggested that the timing of the meeting to adopt pay-ratio rules was “peculiar” and not “coincidental” in light of the most recent effort in Congress to repeal the pay-ratio provision. In conclusion, he contended that adoption of the rules “is nothing more than a sad example of surrendering the Commission’s agenda to politically-connected special interests and acquiescing to the bullying tactics of their political allies.”
[Sidebar: These two dissenters appear to be setting out a case for a court challenge to the rules. In addition to the claim of potential violation of the First Amendment discussed above, they charge that the cost-benefit analysis was inadequate. You might recall that, in 2011, the D.C. Circuit tossed out the SEC’s mandatory proxy access rules. (See these news briefs.) In that case, plaintiffs Chamber of Commerce and Business Roundtable had argued, among other things, that the SEC failed to properly analyze its costs and that it used inconsistent data to justify the rule and calculate its costs. The Court agreed, concluding that the SEC acted “arbitrarily and capriciously” in issuing the rule when it failed to provide an adequate cost/ benefit analysis. At the time, the WSJ characterized the opinion as a “sharp rebuke to the SEC, marking the fourth time in recent years the same court has thrown out an SEC rule based on similar grounds. The judges scolded the SEC for ‘inconsistently and opportunistically’ presenting the economic costs and benefits in its justification for the rule.”]