Securities Regulation: The Flaws and Misuse of the SEC's Pay Ratio Disclosure Rule
George S. Georgiev
BA, Colgate University, 2002
MA, University of Munich, 2008
JD, Yale Law School, 2007
Scholarly interests: business law, corporate governance, securities regulation, mergers & acquisitions, corporate finance, executive compensation
Full profile: bit.ly/GSGeorgiev
Professor Georgiev teaches and writes about business law. His current research examines the intersection of corporate governance and securities regulation, including questions about the design and performance of the SEC disclosure regime. His courses include Business Associations, Contracts, and Corporate Governance. Georgiev joined Emory Law in 2016 after serving as a visiting assistant professor at UCLA School of Law. Prior to that, he was a corporate lawyer with Sullivan & Cromwell llp and Clifford Chance llp. While in practice, he advised on large cross-border M&A deals and financing transactions for corporations and sovereigns, including landmark transactions such as the recapitalizations of several large banks during and after the 2008 global financial crisis. Georgiev is a member of the New York bar. His research has been published in journals including Boston College Law Review, UCLA Law Review, Utah Law Review, and Minnesota Law Review, and he has been quoted by the New York Times, Los Angeles Times, Financial Times, BBC, and Bloomberg. The excerpted article that follows was discussed at a recent congressional hearing, and has been featured in the Los Angeles Times, Bloomberg, CFO Magazine, Agenda (Financial Times), NPR’s AirTalk, the Columbia Law School Blue Sky Blog, and the Oxford Business Law Blog.
Selected Publications
Securities Disclosure As Soundbite: The Case of CEO Pay Ratios, 60 Boston College Law Review 1123 (2019) (with Steven A. Bank)
Too Big to Disclose: Firm Size and Materiality Blindspots in Securities Regulation, 64 UCLA Law Review 604 (2017)
Paying High for Low Performance, 100 Minnesota Law Review Headnotes 14 (2016) (with Steven A. Bank)
Shareholder vs. Investor Primacy in Federal Corporate Governance, 62 UCLA Law Review Discourse 71 (2014)
The Reformed CFIUS Regulatory Framework: Mediating Between Continued Openness to Foreign Investment and National Security, 25 Yale Journal on Regulation 125 (2008)
Contagious Efficiency: The Growing Reliance on US-Style Antitrust Settlements in EU Law, 2007 Utah Law Review 971 (2007)
Securities Disclosure as Soundbite: The Case of CEO Pay Ratios
by George S. Georgiev (excerpt)
Since 2018, US public companies have had to calculate and report a new, unconventional statistic - a CEO pay ratio - which links CEO pay to the pay of rank-and-file workers. Based on a last-minute addition to the Dodd-Frank Act of 2010, the disclosure requirement generated significant controversy during the lengthy SEC rulemaking process. Companies and their executive compensation consultants spent years and considerable resources preparing to comply with the rule. Once the pay ratio figures started arriving in 2018, they captured public imagination in ways that the typically long and technical corporate disclosure documents never do. The sizeable pay gaps highlighted by the data have led to extensive media coverage, fueling public outrage and reinforcing concerns over pay inequity and economic inequality. Progressive politicians have cited the pay ratio data when proposing new business regulation bills. The city of Portland, Oregon, has imposed a penalty business tax on firms whose pay ratio exceeds 100:1. Similar measures have been proposed in states from California to Illinois to Massachusetts, and at the federal level.
In a recent article, co-authored with Professor Steven Bank of UCLA School of Law, we analyze the history, design, and effectiveness of the pay ratio disclosure rule. We suggest that the rule reflects a unique approach to securities disclosure, which we term disclosure-as-soundbite. This approach is characterized by high public salience - the pay ratio is superficially intuitive and resonates with the public to an extent much greater than other disclosure does; and by low informational integrity - the pay ratio is a relative outlier in terms of certain baseline characteristics of disclosure, meaning that the information is lacking in accuracy, difficult to interpret, and incomplete. We find that in its current formulation the rule is ineffectual and potentially counterproductive when viewed as a means of generating useful and reliable information for investors, or influencing firm behavior on matters of worker and executive compensation. The pay ratio is more successful in fomenting or contributing to public discourse on broader societal matters relating to pay inequity and economic inequality, though the quality of the underlying information likely limits the quality of the discourse.
High public salience is a deliberate design feature of the rule. By linking the earnings of workers to those of corporate executives, the pay ratio takes on a personal dimension absent in other disclosure. Expressed as a single, seemingly straightforward number, it can appear to carry a great deal more information than it actually does. This allows for powerful rhetorical points, as highlighted by the following news story headlines from 2018: “Want to Make Money Like a CEO? Work for 275 Years;” “CEOs Paid 1,000 Times More Than Average Workers;” “At Walmart, the CEO Makes 1,188 Times as Much as the Median Worker;” and “Fortune 500 CEOs Are Paid from Double to 5,000 Times More Than Their Employees.” This explains the pay ratio’s success in attracting the attention of a broad set of audiences, including the news media, national politicians, state and local governments, labor unions, think tanks, and firms’ employees and customers (in addition to corporate decision-makers and advisers).
The flipside of the pay ratio’s high public salience is its low informational integrity relative to the rest of the securities disclosure regime. Though not perfect, disclosure rules generally share certain baseline characteristics - accuracy, comprehensibility, and completeness. The pay ratio is an outlier on each of these counts. The accuracy of the information is questionable because of the broad ways in which the SEC defined the underlying inputs - median worker pay and CEO pay - along with the methodological flexibility it granted firms in making the relevant calculations. Each firm’s pay ratio also presents a challenge of interpretation, and hence comprehensibility, because of the absence of objective pay ratio benchmarks and the lack of comparability among different firms’ ratios. Finally, the SEC rule requires firms to disclose only numbers, without explanation or context, which renders the information incomplete in what we believe are important ways.
The pay ratio’s low informational integrity is illustrated by the ease with which individual firms’ characteristics can skew the reported figures. A firm with a founder-CEO who draws a modest annual salary while holding a large block of stock would report a low pay ratio, hiding the fact that the founder-CEO may have profited greatly from the annual appreciation of his stock holdings. Firms organized as limited partnerships, a common model in the private equity industry, compensate their CEOs primarily through partnership distributions. Because those are not included in the calculation of annual total compensation, such firms may also report pay ratios that are artificially low. Finally, if two firms in the same industry differ only in the way their labor force is organized, with one of them outsourcing its low-paid jobs, the firms would report widely different pay ratios, which would obscure internal pay equity rather than illuminate it.
The nature of the pay ratio also makes any aggregate information extremely malleable. Different news stories from 2018 featured different aggregate CEO-to-worker pay ratios, ranging from 361:1 at the high end to 144:1 at the low end, with several other reported ratios occupying spaces in between. These differences reflected different sample sizes, the timing of aggregation, and the aggregation methodology (average vs. median). On a superficial level, however, each of the ratios purported to reflect the economywide CEO-to-worker pay ratio. Even when the precise method of aggregation was flagged in the reports, it likely did not register with the public. Instead, the various aggregate figures became little more than soundbites.
The article also analyzes the rule’s lengthy and, at times, fraught path to adoption. During a multistage rulemaking process, the SEC received over 2,000 unique comment letters and over 320,000 form letters about the rule from a wide range of stakeholders, including many members of Congress. Without any legislative history to go by and under constant pressure from ardent opponents and proponents of pay ratio disclosure, the SEC had to work to fit the highly specific congressional mandate within the existing tapestry of federal securities regulation. To do so, the SEC justified the rule with reference to informing investors’ say-on-pay voting decisions, and sought to minimize the costs of compliance by affording firms broad flexibility in calculating the pay ratio.
A close examination of the political dialogue and rulemaking process reveals that stakeholders have ascribed several different functions to the rule, in addition to or in lieu of, the informational function, which the SEC endorsed. One of these is a behavioral function - the pay ratio as a means of influencing corporate decision-making in substantive ways. For example, the disclosure requirement could in theory induce firms to improve their pay ratio by reducing CEO pay or increasing median worker pay or, more generally, encourage them to devote more attention to employee compensation matters. Another is a public discourse function - the pay ratio as a means of fostering or contributing to a public conversation about economy-wide pay inequities and economic inequality more broadly. The informational, behavioral, and public discourse functions are not exclusive of one another, and this overall ambiguity about the rule’s functions is an important part of understanding the rule itself.
Our analysis of the rule’s effectiveness takes these different functions into account. We find that the pay ratio rule is ineffectual and potentially counterproductive in fulfilling an informational or a behavioral function due to its low informational integrity - the inherent lack of accuracy, difficulty in interpretation, and incompleteness of the information. The pay ratio’s high public salience does nothing to help in this regard. On the other hand, high public salience renders the pay ratio rule more successful in fulfilling a public discourse function: The nature of the subject matter and the superficial simplicity of the information can be very effective in attracting public attention to questions of pay inequity and economic inequality. The quality of the discourse, however, is limited by the rule’s low informational integrity.
Our policy proposal focuses on improving the pay ratio’s informational integrity and moving beyond the disclosure-as-soundbite approach. As currently formulated, the rule does not require firms to provide context or explanation for the disclosed pay ratio numbers. In other words, in an effort to ensure maximum flexibility and minimize compliance costs, the SEC adopted a numbers-only approach to pay ratio disclosure. We suggest that the SEC should revisit this decision and mandate a narrative disclosure approach that provides information about median worker pay and the resulting pay ratio with more context, nuance, and explanation. Doing so would make firms’ disclosures easier to interpret and more complete, which could improve the pay ratio’s ability to fulfill an informational or a behavioral function. It could also improve the quality and increase the quantum of compensation-related information that can be used as part of public discourse. This narrative disclosure approach would be in line with the format of existing disclosure requirements relating to executive compensation.
Looking ahead, pay ratios may be here to stay despite their problematic nature. The Portland, Oregon, ordinance imposing special business taxes on firms that exceed a 100:1 pay ratio is raising revenue as of 2019, and several other states are considering similar legislation. Pay ratios have also gained traction internationally: US-style disclosure rules have been adopted in the United Kingdom (with effect from 2020) and India (with effect from 2013) and have been mooted in Australia and at the EU level. Israel has adopted a law limiting the deductibility of CEO pay for firms in the financial sector to 44 times the pay of their lowest-paid worker. A failed 2013 referendum in Switzerland sought to cap companies’ pay ratios at 12:1. And in the United Kingdom, politicians have proposed using pay ratios to set caps on pay for government workers and contractors. Such developments make understanding the impact and the pitfalls of pay ratios all the more important.
More broadly, there is also a strong push to require firms to provide additional disclosure of their human capital management practices and for boards’ compensation committees to oversee employee compensation alongside executive compensation. These issues are subject to ongoing research.
—from Securities Disclosure As Soundbite: The Case of CEO Pay Ratios, 60 Boston College Law Review 1123 (2019) (with Steven A. Bank)