J. Robert Brown, Jr.*
Congress, in adopting the Dodd-Frank Act, sought to correct some of the abuses believed to have contributed to the financial crisis of 2008-2009. Executive compensation was one of them. Formulas used to determine compensation were thought to promote a short-term perspective that encouraged excessive risk taking. As a result, financial regulators were given the authority to review compensation practices for risk. Likewise, the Act sought to strengthen the integrity of the compensation approval process and to increase clawbacks of performance-based compensation following certain restatements.
Not all compensation provisions, however, were designed to address risk. Some were inserted in an effort to expand the role of shareholders in the governance process. Addressed primarily under the rubric of fairness, the Act gave shareholders an advisory vote on executive compensation. At the same time, Dodd-Frank expanded the information available to shareholders making the determination. Specifically, Section 953(b) required disclosure of a ratio that compared CEO and employee compensation. Although hardly noticed at the time of adoption, the provision eventually generated considerable controversy and engendered serious calls for repeal within Congress.
This article will do several things. First, it will examine the role of compensation ratios in the debate over executive compensation. Second, the article will discuss Section 953(b), including the broad regulatory authority retained by the Securities and Exchange Commission (“SEC” or “Commission”) in implementing the provision. Finally, the article will analyze the current controversy surrounding the provision.
II. Compensation and Ratios
Ratios have long been part of the debate over executive compensation. They typically rely on average CEO compensation as the numerator and average employee compensation as the denominator. In general, they have been used to show the relative increase of CEO compensation over time.
Ratios, however, have not been a particularly useful metric for shareholders. For one thing, they are not computed on a company-specific basis. For another, they are not determined in a consistent fashion. While average CEO compensation can, for the most part, be computed on a uniform basis, there is considerable variance with respect to employee compensation. Ratios may rely on the amount paid to the “average production worker” or “private sector” employee. Some look to the minimum wage. They can exclude particular sub-categories of employees or resort to medians rather than means.
The lack of consistency and the absence of firm specific data minimize the ability to use the metric to assess CEO compensation within a particular company. Thus, while they can demonstrate broad trends in compensation, they have not been particularly helpful in providing shareholders with a tool for assessing the reasonableness of compensation in their own company.
III. Dodd Frank and Compensation Ratios
Sponsored by Senator Menendez of New Jersey and originally part of separate legislation, the requirement to disclose compensation ratios was inserted into the Senate version of Dodd-Frank during committee deliberations. Apparently a late addition, the provision generated no meaningful legislative history.
The requirement addressed many of the concerns that limited the value of compensation ratios to shareholders. Section 953(b) of Dodd-Frank imposed a mandatory formula for calculating the statistic. Moreover, it provided for the determination of ratios on a company-specific basis and mandated the use of medians rather than averages. Implementation was, however, accomplished in a highly complicated fashion. Rather than simply require disclosure of the ratios, the provision in three instances cross-referenced or incorporated portions of existing regulations. The result was substantial discretion on the part of the SEC in implementing the requirement.
Specifically, Section 953(b) provided that ratio disclosure must appear in Item 402 of Regulation S-K (or its successor), the SEC provision defining executive compensation. In effect, Congress opted to write a portion of Item 402, transforming a regulation into a statute. As a consequence, the Commission could amend or rewrite Item 402 with respect to most compensation matters but, once implemented, could not eliminate ratio disclosure.
Congress also referred to SEC regulations in defining the breadth of the disclosure requirement. Section 953(b) provided that ratio disclosure was to appear “in any filing of the issuer described in section 229.10(a).” Because Item 10(a) referred to periodic reports, the reference suggested that the ratios were to be disclosed on a quarterly if not more frequent basis. Congress, however, left the Commission with the discretion to reduce the frequency through amendments to Item 10. Deletion of the words “or other” after “annual report” in Item 10 would eliminate the ratios from all periodic reports except the Form 10-K, effectively requiring only annual disclosure of the information.
Finally, Section 953(b) prescribed the method for calculating employee compensation by referencing Item 402(c)(2)(x), the subsection that defined the CEO’s total compensation. Congress specifically limited the SEC’s authority to change the formula by requiring application of the standard “in effect on the day before the date of enactment of this Act.” The SEC nonetheless retained considerable discretion over the formula. The reference to Item 402 specified the categories of compensation that were to be considered but did not prescribe the method of calculating the categories. That was left to the administrative discretion of the SEC.
The provision, therefore, provided a broad role for the SEC in developing and applying ratio disclosure. The SEC retained the authority to determine the frequency of ratio disclosure and the method used to calculate employee compensation.
IV. The Ongoing Debate
The imposition of ratio disclosure caused little controversy during the debate over Dodd-Frank. As implementation approached, however, vigorous opposition developed over the merits of the provision. Critics asserted that calculation of median compensation for employees would be costly and logistically difficult.  In addition, they challenged the value of the information, asserting in part that the ratios did not provide a meaningful basis for comparison.
The concerns attracted attention in Congress. The Burdensome Data Collection Relief Act called for the repeal of Section 953(b) in its entirety. On June 22, 2011, the House Financial Services Committee approved the legislation by a vote of 33-21. The accompanying report reiterated the concerns about the immateriality of the information and the burdensome nature of the calculation. Attempts in the committee to rewrite Section 953(b) to simplify the formula and limit the frequency of disclosure were defeated. While the matter has not yet passed the House, opposition in the Senate has surfaced.
V. Compensation Ratios Going Forward
Most of the concerns expressed over ratio disclosure can be fixed in the rulemaking process, something that the SEC has indicated will occur before the end of 2011. As discussed, the SEC has considerable flexibility to limit the frequency of disclosure. Likewise, while Congress prescribed the categories used in determining employee compensation, the SEC retains broad discretion to determine how these categories are calculated. As for the treatment of part-time and overseas workers, there may be little administrative discretion over the issue.
With respect to the materiality of the information, ratios have particular importance in the era of “say on pay.” An advisory vote on compensation gives shareholders an opportunity to comment on the reasonableness of CEO pay. Reasonableness, however, requires context. Metrics that allow for a comparison of pay practices among public companies can assist in providing the requisite context. Moreover, the ratios provide a mechanism for the first time for assessing the reasonableness of the compensation within each particular company.
Variations in the ratio that arise from differences in business models or geographic reach can be addressed through accompanying disclosure. Companies can explain the relevant differences through the use of narrative and additional ratios. Moreover, such information will likely have the benefit of providing shareholders with additional insight into the calculation of CEO compensation and the company’s employment practices.
The most significant impact of the ratio may, however, be on the board of directors. The disclosure requirement effectively increases the information available to boards when setting executive pay. Some boards already take ratios into account when determining compensation. Because a bad ratio may be embarrassing, the board has an incentive to alter compensation in order to avoid adverse disclosure. Disclosure of the ratio may, therefore, impact the amount of compensation paid to employees and the CEO.
Ratio disclosure raises some legitimate logistical concerns over the method of computation and the frequency of disclosure. Most can be addressed and resolved by the SEC during the authority process. The addition of ratio disclosure, when coupled with say on pay, provides shareholders with a more meaningful ability to participate in the compensation process.