Governance reforms gain momentum with SEC pay-ratio disclosure proposal

October 9, 2013

By Bora Yagiz, Compliance Complete

NEW YORK, Oct. 9 (Thomson Reuters Accelus) – The U.S. Securities and Exchange Commission has proposed a rule that would make public companies disclose the pay gap between their top executive and the rest of the staff. But the divided 3-2 vote by which the proposal was advanced reflects the fierce debate between opponents to call it difficult and unnecessary, and advocates who say it provides a useful measurement for shareholders who want to rein in excessive compensation.

The proposed rule represents an attempt to alleviate the classical principal-agency problem, where the interest of the senior management may front-run that of the shareholders’ through overcompensation. It may also help regulators in furthering a growing effort to improve corporate risk-management practices. But the challenges of compiling useful figures may be daunting.

The requirement is part of the 2010 Dodd-Frank Act’s response to a public uproar over executive compensation levels seen as misaligned. This was most visible in the skewed compensation structures tied to the origination of mortgages in the build-up before the crisis and in the aftermath. A well-publicized example was AIG’s awarding of $165 million in bonuses at a time the firm was receiving a government bailout.

report by the Financial Crisis Inquiry Commission in 2011 squarely put the blame on executive pay as a cause of the financial crisis.

Commenters on the SEC’s initial consultation on pay-ratio disclosure flooded the agency with 20,000 letters.

The rule, if adopted, will require firms to disclose:

  • the median of the annual total compensation of all employees of the registrant, except the principal executive officer of the registrant;
  • the annual total compensation of the principal executive officer of the registrant; and
  • the ratio of the median of the registrant’s employee compensation to its principal executive officer compensation.

A package of compensation rules

The pay ratio rule is part of a package of Dodd-Frank provisions that are designed to regulate behavior encouraged by compensation structures.

Other components (DFA 951, 952, 954, 955, and 956) require companies to incorporate independent compensation committees, to introduce “clawback” provisions to recover executive compensation made on the basis of erroneous and noncompliant financial statements, and to prohibit any incentive-based compensation arrangements that may create systemic risk causing financial institutions to suffer material loss.

So far, SEC has adopted final rules on shareholder approval of executive compensation and “golden parachutes” (DFA 951), and on independence of compensation committees (DFA 952).

Fed led the charge

The Federal Reserve Bank has led the charge on executive pay by issuing a general guidance on incentive compensation as early as 2009 . The guidance, adopted jointly with other banking regulators, calls for giving shareholders a nonbinding vote on compensation arrangements.

The Fed also conducted a horizontal review, a peer analysis of large, complex banking organizations, to understand various compensation arrangements and to provide relevant guidance.

These initiatives have made an impact, as banks have started to align executive pay more closely with risk, deferring in the process more of the incentive compensation than they did before. This helped rectify the problem of “fake alpha,” which rewards short-term profit spikes with no regard to returns or losses in subsequent accounting prriods.

Currently, financial firms are required to disclose the “named executive officers” — the five highest-paid employees, including the chief executive – in summary compensation table.

Widening gap

Proponents of the pay-ratio rule, which include consumer, labor and shareholder-advocacy groups, say executive compensation levels have gotten out of hand and senior executives should not be able to take large severance packages even as the companies they lead go bust. A study by the Institute for Policy Studies shows that the pay gap between CEOs and the average American worker has widened, from 195-to-1 in 1993, to 354-1-1 in 2012.

Proponents say the rule would offer another metric that may help investors making comparisons across companies, and it would also, by bringing this information into the light, help improve the productivity and morale of the rank-and-file employees. As such, the rule may be expected to encourage companies to rethink and potentially narrow the gap in their pay structures, advocates say.

Companies, banks among them, and business organizations such as The Financial Services Roundtable, The Center on Executive Compensation, U.S. Chamber of Commerce, and the Securities Industry and Financial Markets Association, oppose the rule conceptually. They call the rule the product of excessive congressional zeal and reactionary in nature, attempting to appease the public discontent.

They add that legislation on pay-ratio disclosure is merely a vague paragraph within Dodd-Frank, and with no set deadline. They say such disclosure provides little added value for the investor.

Indeed, during the SEC vote last week, Commissioner Michael Piwowar deplored the proposal and said the commission “should not even be spending any of its limited resources,” on it.

Vineeta Anand, the chief research analyst of the AFL-CIO trade-union confederation, differs. “When you think about how many thousands of pages the DF law is compared to this tiny provision and the amount of outcry and noise, this tells you just how important this provision is to investors and how desperately companies want to do anything to not disclose it.”

Calculating pay

Opponents of the pay-ratio rule contend that computation and calculation of an organization’s employees would be exorbitantly time-consuming and costly, as most of the companies would have to develop centralized administrative systems and controls.

“There is a widespread misconception that this information is readily available at the touch of a button,” a group of 23 trade associations said in a comment letter on the plan.

Estimating certain components of the chief executive’s pay package, namely the accumulated benefits in an executive pension plan and the value of the stock options can indeed be difficult. Short of having regulators offering a prescribed discount rate to every company, each company’s present value calculation of future benefits could differ significantly from one another.

Similarly, valuing stock options may present difficulties due to their fluctuations over the course of a given year. A snapshot (such as at year end) may likewise prove to be arbitrary.

comment letter by the Center on Executive Compensation whose members include chief human-resource officers, cited a survey it conducted saying that nearly half of the respondents would require about three months to compile the median employee pay, due to a lack of central recordkeeping systems. It said calculation costs would be excessive.

Anand disputed this assertion “Financial companies already possess this information. They do tell their employees their total compensation for each year,” she said.

If they have to disclose the total number of compensation for all employees for accounting and funding purposes in their 10-K reports, and calculate their top 5 highest paid employees, why not calculate the median as the 6th number?” she said.

Other issues such as the inclusion of part-time employees, the currency conversions used in compensation calculations for non-US employees for companies with global presence, and a high staff turnover are indicated by opponents of the rule to potentially complicate matters further.

The proposal would require the inclusion of total compensation for non-U.S. employees, some of whom have different standards of living. The SEC is unlikely to change its stance here, however, because the Dodd-Frank language reads “all” employees, regardless of their location, and whether they are full or part-time employees.

The proposed rule strives to allay concerns over the regulatory burden. The SEC has refrained from prescribing complex formulas for calculating the figures, limiting itself to more general guidelines.

Companies would be able to use statistical sampling if desired in calculating the median pay, and using either the annual total compensation as determined under Regulation S-K or another comparable measure such as payroll or tax records for estimates. As such, companies have a great deal of latitude in defining their total compensation and in calculating various variable components thereof.

This flexible approach may undermine the rule’s usefulness, experts say. Different companies may come up with different definitions of total compensation and apply different statistical sampling techniques, depending on their particular circumstances and purposes. The discrepancy may well yield misleading comparisons across companies.

“This point may be overlooked by the media, and the critics, attracting unwarranted public ire on the topic,” said Steven Seelig, Senior Executive Compensation Consultant at Towers Watson.

A monitoring tool

Despite the challenges, just as the drafting of the “living will” resolution plans has allowed regulators to better grasp the structure of banking organizations, the pay ratio exercise could similarly be used by regulators in monitoring compensation practices.

A drastic deviation from the peer group, or an increase in a risk-encouraging bonus practices that would raise the disclosed ratio, could provide useful red flags for investors, and regulators alike.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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