Embracing the S.E.C.’s New Executive Compensation Disclosure Rule

The S.E.C recently provoked a storm of controversy when it voted to amend the executive compensation reporting requirements for public companies under the Dodd Frank Act. Many commentators, corporate leaders, and law firms immediately attacked the proposed rules and have discussed the possibility of challenging any adopted rule in the courts. One firm has even characterized the coming litigation as “inevitable.”  But given the flexibility provided by these new rules and the political and legal climate of the day, it seems highly unlikely that any litigation could successfully eliminate these disclosure requirements altogether. Given that reality, corporations and their lawyers would be wise to instead focus their attention on figuring out how to comply with these requirements while taking full advantage of the broad flexibility provided by the statute. Mounting a bloody litigation offensive against these requirements will only squander resources while at the same time provoking even more heated criticism from the already vocal detractors of the growing compensation disparity in this country. But by instead making a good faith effort to comply with these disclosure rules now, companies can demonstrate a commitment to corporate and social responsibility and can better hope to shift the public spotlight away from this issue.

Under the proposed rule, a company would be required to report not only the amount of compensation that the Chief Executive receives, but also the median compensation that the rest of that company’s employees receive. The company is then required to report the ratio between those two figures as a measure of the gap between executive and employee compensation at that company. The 3-2 vote approving this proposed rule split down party lines, with the three Democrats voting for the rule, and the two Republicans voting against.

While this new requirement is fairly simple and seemingly straightforward on its face, many in the business community are concerned about the potential for any of these statistics to be twisted and misconstrued. The rule’s Republican opponents on the Commission suggested that “the proposal is an attempt to shame corporations into reining in executive pay by forcing companies to calculate compensation in a way that is designed to yield eye-popping results.” And eye-popping they can be. For instance, the compensation ratio for former J.C. Penny CEO Ron Johnson was estimated at 1,795-to-1 for fiscal year 2012. While this number is by no means representative of executive compensation ratios for all public companies, executive compensation ratios across the board have undeniably risen over the past decades as executive compensation has grown disproportionately compared with average employee wages. Some sources estimate that the average ratio has risen from 20-to-1 in the 1950s to 120-to-1 in 2000, and has continued to rise precipitously ever since.

Companies also have another reason to fear the new disclosure rule. Under the current regime provided by Rule 402(a)(3) of Regulation S-K, public companies are only required to disclose the compensation of certain “named executive officers” – specifically the principle executive officer, the principle financial officer, and the three most highly compensated executives besides the PEO and PFO. However, there is no requirement to disclose the compensation of any employee outside of this specified group. Therefore, to calculate executive compensation ratios, third parties currently compare a company’s self-reported CEO compensation against an industry-specific estimate or average for workers’ wages; they are not compared with employee wage data provided by the company itself. Given that the new rule requires that the calculation of the median employee remuneration include all part-time, temporary, seasonal, and non-U.S. employees, some companies may be concerned that their compensation ratios based on this new method of calculation will be less flattering than the already high compensation ratios that are currently based upon less precise data. This problem is particularly salient for companies that outsource certain kinds of work to lower-paid populations abroad, especially since the newly proposed rule would also disallow adjusting for the lower costs of living for those workers.

Indeed, one law firm commented that “the proposed rule does not appear to provide meaningful opportunity for registrants to account and adjust for several key aspects of their workforce structure and business model.” However, under the new rule, “[c]ompanies would be permitted but not required to supplement the required disclosure with a narrative discussion or additional ratios if they choose to do so.” For example, companies could release additional compensation ratios that do adjust for cost of living or that exclude non-U.S. based employees, both of which might be a more meaningful basis of comparison between compensation regimes of different public companies. Furthermore, additional commentary could prove a powerful tool to combat any potential misperceptions that a company is worried might be caused by the disclosure of its high and/or skewed compensation ratio. For instance, an explanation in a company’s compensation disclosure that its executive’s compensation is based in some part on whether he or she meets certain performance metrics would go a long way to establishing the value added by the chosen level of compensation. Other additional disclosures detailing, or at least explaining, a high compensation ratio could further assuage corporate detractors and, at the very least, would allow stockholders to stay better informed about the operation of their company.

In response to the proposed rule, some commentators and legal advisors are urging their clients and other public companies to submit comments and suggestions to the S.E.C. during what is left of the official 60-day comment period before the final vote is cast. However, Davis Polk, anticipating “the inevitable litigation that will challenge any rule that is adopted,” has recognized that some “registrants may prefer to go back to their businesses and wait for the dust to settle.”

While postponing action until the rule takes effect may seem like an attractive option for some companies, given the demand by outspoken members of the public and shareholders for corporate responsibility and transparency, simply waiting might not be the wisest option for a savvy company. Instead, companies might benefit from proactively embracing and complying with this new compensation disclosure model to demonstrate a commitment to those corporate values that their shareholders and the public so crave.

This outcry for increased transparency and responsibility by our nation’s leading companies goes beyond executive compensation, permeating many aspects of corporate governance. One salient example is the issue of gender diversity on corporate boards. In a forthcoming paper by Columbia Law’s Tamara Smallman, Ms. Smallman analyzed the gender diversity disclosures, required by the S.E.C.’s 2009 Proxy Disclosure Enhancements, of the Fortune 50 companies. The paper reports an overwhelming failure by these companies to comply with the reporting requirements and urges, among other things, the S.E.C. to more stringently enforce these requirements and implement a system of “naming and shaming” those non-complying companies. This research has become part of a broader and growing dialogue regarding corporate responsibility by the world’s business leaders.

Whether or not litigation postpones or alters the nature of these new executive compensation disclosures, it seems unlikely, given the current administration and popular sentiment, that this issue will quickly or quietly fade away on its own. And as with the gender diversity disclosures, if companies fail to comply with whatever increased requirements are eventually adopted, they run the risk of igniting a new maelstrom of negative attention brought on by the S.E.C., activist members of the public, shareholders, the press, or even enterprising law students. But by taking steps now to affirmatively comply with these newly proposed requirements, companies can demonstrate a commitment to corporate responsibility and a respect for the demands of both their shareholders and the interested public generally.  While some opponents of high executive compensation will undoubtedly jump at any opportunity provided by these disclosures to lambaste what they perceive as corporate greed, for other interested parties, a good faith disclosure may satisfy and mitigate enough of their concerns to shift the spotlight from this issue and allow those corporate executives to get back to doing what they do best.