Pay ratio proposal targets CEO compensation

Could United States rule impact employers north of the border?

In September, the Securities Exchange Commission (SEC) proposed a new rule that would require public companies in the United States to disclose the ratio of their CEO’s compensation to employees’ median compensation.

Not surprisingly, the proposal is receiving mixed reactions — but it could have implications for Canadian employers down the road.

Low pay ratios recognized

Many organizations with conspicuously lower pay ratios have been successful, resilient businesses that create good long-term wealth, and the SEC proposal in the U.S. is an important signal that this is an issue that deserves to be taken seriously, according to Peter MacLeod, executive director of the Wagemark Foundation in Toronto.

The organization certifies an employer if the ratio between its highest and lowest earners is competitive and sustainable — defined as no more than 8:1. For example, a firm paying a worker $10 per hour would have a CEO earning no more than $166,400 annually.

The SEC regulations, if finalized, would shine some much-needed light on the run-up of executive pay, said MacLeod.

“What is harmful to free market capitalism is the degree of polarization that’s occurred, so from 1980 to today, CEO pay is up from 35 to 1 in 1980, U.S. numbers, to 350 or 400 to 1. That’s a tenfold increase,” he said.

“I don’t think anyone can seriously say that CEOs today are 10 times smarter or 10 times more productive or 10 times more rare than the 1980s.”

Will it affect pay?

But practically speaking, these rules won’t reduce executive compensation, according to Ray Murrill, a senior consultant at compensation consulting firm McDowall Associates in Toronto.

“Conversely, it’s not going to cause companies to increase the compensation of the median employee just to make the ratio look better — though some people might think that’s the outcome — but it’s not likely because that’s just not affordable.”

The SEC has even acknowledged these ratios are not going to be comparable from one company to the next, he said.

“It’s sexy and has curb appeal but… companies are not going to be spending a lot of time thinking about that when they make executive compensation decisions.”

Compensation committees are already factoring in those considerations, according to Tim Bartl, president of the HR Policy Association’s Center on Executive Compensation in Washington, DC.

“We just don’t think it’s going to be material. We don’t think it’s going to have an impact and it won’t have an impact on compensation. And it’s going to be costly for global companies to implement, another cost that shareholders will bear. So, the question is: Is this really useful? And our answer is that it’s not.”

The ratio really doesn’t tell employees anything — they just want their senior executives or CEOs to be paid consistent with how the company is doing overall, he said.

“It doesn’t tell you how the company is performing, it doesn’t tell you necessarily how the market for talent at the various individual levels throughout the company may be changing, or the skill level of company employees may be changing.”

Greater transparency ‘makes sense’

But greater transparency around the issue makes sense, according to Peter Chapman, executive director of the Shareholder Association for Research and Education (SHARE) in Vancouver.

“It’s become a general reputational issue for firms, particularly with a consumer-facing firm. Having… what’s viewed by ordinary people as an egregious pay ratio could cause reputational damage. Having a broad, across-the-board disclosure on that allows investors to manage that risk,” he said.

“This request, in addition to being based on academic research, also reflects a growing debate amongst governments and citizens about how income equality relates to social health as well. So certainly it’s a timely issue to take up within the framework of investor interests in what drives long-term value.”

Complexity involved

One of the major concerns with the new SEC rules is employers would be required to include all employees in the equation, including full-time, part-time, seasonal or temporary workers, and global employees of multinational companies.

While the SEC change — required under that country’s Dodd–Frank Wall Street Reform and Consumer Protection Act — would not prescribe a specific methodology to employers in how they make the calculation, critics have suggested the math would be too onerous for employers.

No company calculates compensation as defined on the summary compensation table for anyone other than the top five mostly highly compensated executives, said Bartl.

And the median employee must be found using a consistently applied measure of compensation.

“For a domestic employer, that may be doable, but most companies affected by this rule are going to be global in some scope… so this means trying to identify if you are in, say, 50 different countries and you’ve got a different payroll provider in each country, you then may end up sampling in each country,” he said.

“There’s a lot of steps, there’s a lot of complexity and we anticipate there will be a lot of costs.”

‘Should be manageable’

But firms know how much they pay people, said Chapman.

“Certainly there are a few companies concerned about the reporting burden but if there’s a good reason for having this information in the marketplace, and if it’s something that companies are already tracking, it’s a matter of them just putting in place measures to move that information from their internal systems into their disclosure regime,” he said.

“It certainly is going to take some effort, particularly the first year, but, in most cases, it should be manageable.”

A lot of it would depend on the makeup of the company and the types of compensation employees receive, according to Leslie McCallum, a lawyer in the corporate and capital markets practice at Torys in Toronto.

“The easiest case scenario would be a very small employer where every employee is compensated in cash and no other forms of compensation,” she said.

“Where people feel that it’s tricky is when it comes to calculating the other elements of compensation that people are paid, so there may be… a significant part of the workforce that receives other benefits and it could be harder to calculate those.”

The question is whether investors would understand that disclosure and easily compare companies if employers are using different methodologies, said McCallum.

“If the executive compensation disclosure that we already have in the rules is doing its job, then investors should have a pretty good picture and a sense of what they think — even without the ratio.”

Will we see it in Canada?

The SEC rules would not apply to foreign private issuers so Canadian companies listed on a U.S. stock exchange generally would not be subject to the rules, said McCallum. But Canada could someday see similar legislation.

“Some Dodd–Frank and Sarbanes-Oxley (Act) and JOBS Act items have been imported — or the regulators are actively considering importing them — and some have not,” she said.

“The Canadian securities regulators tend to look carefully at SEC initiatives to decide whether they should pursue something similar in the Canadian context.”

However, some cross-border Canadian companies like to provide the same disclosure as their U.S. peers, said McCallum.

“They may go ahead and do it voluntarily and that’s what happened with say on pay. Our regulators decided not to pursue it in the Canadian context by making it mandatory, but you do see quite a number of larger companies that do that,” she said.

“The most likely Canadian companies to adopt (the pay ratio rules) and disclose the information voluntarily are the ones that are listed on the U.S. exchange.”

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