THE BLOG
10/21/2013 11:13 am ET | Updated Dec 21, 2013

4 Reasons the SEC's New Ratio Test Will Not Decrease CEO Pay

On September 18, the SEC announced the proposal of a rule intended to increase disclosure of executive compensation as part of its ongoing effort to curb the growth of CEO pay. The new rule, promulgated under Section 953(b) of the Dodd-Frank Act, would require publicly traded companies to disclose (i) the median of the annual total compensation of all employees of the company and (ii) the ratio of that median to its annual total CEO compensation. The rule is ostensibly designed to highlight the pay disparity between top executives, on the one hand, and rank and file employees, on the other hand, at America's biggest and largest companies.

Reasonable minds can differ on the merits of limiting executive pay as a public policy goal and whether such efforts fall within the purview of the federal government. All should agree, however, that there should be a link between goals and tactics and that if this is something our government officials are going to spend time on, they should do so in a manner that actually accomplishes their goal. Not surprisingly, this proposal -- like some of the other rules implemented under Dodd-Frank -- will do little to accomplish the desired effect of narrowing the gap between employee compensation and executive compensation. If anything, it may have the opposite effect.

Here are some reasons why:

1. Disclosure, Not Enforcement: This rule, similar to the Say on Pay rules previously enacted under Dodd-Frank, doesn't actually require companies to change anything about the compensation structure of their CEO and other executives. It doesn't provide for a cut in CEO pay or a raise in employee pay. All it requires is disclosure. The disclosure requirement may cause some bad optics that result in longer hours for a company's P.R. department or a few uncomfortable moments for the CEO when he passes his employees in the hallway. But at the end of the day, they don't require companies to make any changes to their compensation policies.

2. "Flexible" Methodology: The rule does not provide a specific methodology for companies to use in calculating a "pay ratio," but rather companies would have the flexibility to determine the median annual total compensation of its employees in a way that best suits its particular circumstances. "This proposal would provide companies significant flexibility in complying with the disclosure requirement while still fulfilling the statutory mandate," said SEC Chair Mary Jo White. Providing maximum flexibility in the way companies calculate these figures seems to confirm the suspicion that this rule is designed more to give the appearance of enforcement than actual enforcement. Moreover, since there won't be a standardized methodology used across different companies and industries, we will have no way to accurately compare the ratios of different companies and the numbers will be rendered basically meaningless.

3. Lake Wobegon Effect: Lake Wobegon is a fictional Minnesota town whose name has been appropriated to explain a phenomenon in executive pay. Simply put, the belief of every person (and especially corporate executives) that they are at least average, has manifested itself in this arena such that additional disclosure has actually led to greater executive pay, not less. When boards of directors use peer companies' disclosures to assess their own executive compensation policy, they will almost always decide on a package that is above the average of what executives at similar companies are receiving. After all, what CEO is going to tolerate her board alleging that she is below average? As a result, the average level of executive compensation will rise over time, by definition. It's not hard to see how this disclosure can have a similar effect, as it will provide CEOs with lower "pay ratios" an additional piece of evidence to use to argue that they are underpaid relative to their peers.

4. Administrative Costs: Executing these calculations, running these ratios, and putting together these disclosure reports will require a coordinated administrative effort. For many companies, this will be an effort that will require lawyers, accountants, compensation consultants, marketing professionals and others to weigh in. All of that will cost money and it will be a cost that will most likely be passed along to shareholders. One place you can be sure it won't come out of is the CEO pay check.

While this latest proposal, as explained, is not likely to have its desired impact, it will impose a new set of disclosure requirements that companies will have to comply with. It is therefore important that public companies be aware of these expanded requirements during upcoming proxy seasons. Additionally, while this particular proposal does not have the teeth to enforce its supposed purpose, it is clear that dealing with the rise of executive pay is something Congress and the SEC have their sights on as a policy goal. Therefore, companies should continue to monitor any upcoming proposals and discussions out of Washington that may impact executive compensation.

Avi Sinensky is an executive compensation attorney. He lives with his wife and daughter in New York City