November 12, 2013
In promulgating rules to enact the Pay Ratio Disclosure requirement of the Dodd-Frank Act, this Agency has asked whether a registering company should be required to disclose the methodology they use to calculate median employee compensation. Question 38; 78 Fed. Reg. 60,576. The calculation methodology used by companies should indeed be disclosed, in order to ensure the appropriate scope of delegated authority and ease of cross-industry comparison by investors.
1. Allowing companies to craft median compensation numbers without agency review of their methodology is a bridge too far. The SEC has broad deference, as a matter of law, to determine the statistical procedures to be used to determine statutory metrics. See Zuni Pub. Sch. Dist. No. 89 v. Dep’t of Educ., 550 U.S. 81, 94 (2007) (determining that calculation methods are “the kind of high technical, specialized interstitial matter that Congress often . . . delegates to specialized agencies to decide”). While companies should be granted some flexibility to determine which methodology is the most appropriate and least cumbersome given their unique circumstances, the ultimate authority to check those calculations belongs in the specialized hands of the agency.
If the companies did not have to report their methodology, it would leave the SEC powerless to do anything except (a) check a company’s math in calculating their ratio and (b) require publication of that number. This is especially worrying in light of the SEC’s propensity to agency capture in the Dodd-Frank context. See Paul Rose & Christopher J. Walker, Dodd-Frank Regulators, Cost-Benefit Analysis, and Agency Capture, 66 Stan. L. Rev. Online 9 (2013).
2. Investors should have access to the median calculation methodology in order place pressure on companies to select sensible methodologies and grant investors sufficient information.
If disclosure upon material change is not required, companies have an incentive to select methodologies that are based upon questionable assumptions (insufficiently small sample sizes, for instance). See Hogan Lovells, SEC Issues Proposal to Implement Dodd-Frank CEO Pay Ratio Disclosure Requirement, Lexology (Oct. 1 2013), http://www.lexology.com/library/ detail.aspx?g=d875deb4-d484-42dd-9e0f-dd166f966f24 (noting that sampling and other estimates are permissible with little guidance on specifics). Moreover, multiple companies within an industry could use entirely different methodologies, making it impossible for investors and regulators to compare or glean any information from the Pay Ratios. Cf. Gary Shorter, The “Pay Ratio Provision” in the Dodd-Frank Act, Congressional Research Service, 19 (Oct. 28, 2013).
Instead, when companies are required to disclose their methodologies, it creates pressure across the industry for companies to use the same ratio calculation. See generally James A. Cotton, Toward Fairness in Compensation of Management and Labor, 18 N. Ill. U.L. Rev. 157 (1997). Accordingly, the public disclosure of calculations will create market-based pressures on companies to select sensible methodologies. Moreover, industries will therefore naturally drift toward a unified system of calculation, making comparison for investors a far easier task.
For the aforementioned reasons, registrants should indeed be required to disclose their methodology for identifying their median employee.