A Misbegotten Political Jab at CEO Pay

[T]he new rule ‘hijacks’ the SEC for political purposes.
August 10, 2015 • Commentary
This article appeared in The Wall Street Journal on August 10, 2015.

Should the government require public companies to disclose the ratio of CEO pay to that of the company’s median employee? The Securities and Exchange Commission last week voted 3–2 along party lines for a rule mandating precisely that. In the words of dissenting Commissioner Daniel M. Gallagher, a Republican, the new rule “hijacks” the SEC for political purposes. Commissioner Luis A. Aguilar, a Democrat who voted for the requirement, admitted last week that it is “controversial.” No wonder. The rule is unrelated to the SEC’s mission, imposes significant costs on public companies and will do little to achieve its intended goals.

There are two main arguments in favor of forcing companies to calculate and disclose this pay ratio. The first is that the ratio will help investors evaluate management by providing additional information about whether the CEO’s compensation is appropriate. The second is that the ratio will help address income inequality by telling the public—in the words of a form letter sent to the SEC in favor of the rule—“which corporations are fueling the yawning gap between rich and poor.” Neither argument is convincing.

The SEC, drawing on concepts in its founding 1934 legislation, states on its website that its mission is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” Some disclosure rules—those that provide investors withmaterial information that assists them in making decisions—seem justified under that mission statement.

But a company’s pay ratio is not material information. For one thing, executive pay is already included in companies’ disclosures to the SEC. For another, the ratio has no bearing on whether the CEO’s pay is appropriate. The value of a CEO’s contribution to a company can be measured by several metrics—the extent to which the company’s market share or value has increased, for example—none of which include how much more the CEO makes than the median employee.

Nor does the ratio provide insight into corporate culture and governance. It will be difficult to compare two companies’ ratios, because the calculations will vary widely by industry and business model. A technology company that employs many highly educated, and therefore highly compensated, engineers will tend to have a low number. A retail giant, which employs thousands of part‐​time cashiers, will tend to have a high number. The difference between the two simply reflects the difference in market wages between a software engineer and a cashier.

The argument that the disclosure will pressure companies to narrow the pay gap between executives and workers is irrelevant: Such matters are unrelated to the SEC’s mission, and the agency’s move to stretch its power beyond its intended scope is a dangerous precedent.

Forcing companies to disclose pay ratios is unlikely to have the intended effect. Let’s suppose a company does report a wide gap in pay, which activists then try to use to embarrass it. What are the options? Assuming the company is paying a market rate for the CEO, if it cuts that compensation there is a risk the CEO will go elsewhere.

More likely is that the company will try to goose the ratio from the other direction, by figuring out how to shed its lowest‐​paid employees. It might lay off full‐​time permanent staff, and replace them with a raft of contractors and temps provided by staffing companies, which are explicitly not included in the calculation of the ratio.

In this scenario, the CEO loses no pay, and the wage gap remains untouched. But the most vulnerable workers are shunted into contract positions with no job security. Further, the company suffers because it must pay a middleman to supply the temporary staff, and it loses whatever psychological benefit inures from employees “belonging” to the company instead of being merely contractors.

Then there are the direct costs of implementing the rule: an estimated $1.3 billion up front, according to the SEC’s own calculations, for all listed companies to gather and crunch the relevant data, plus an estimated $526 million a year afterward.

The SEC might have written a slightly less terrible rule—for example, by excluding all temporary and part‐​time employees from the calculation—but the ultimate fault lies with Congress for the provision in Dodd‐​Frank that mandated disclosure of this ratio in the first place. It is difficult to think of another SEC rule with so little redeeming value.

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