The Advisors' Blog

– Broc Romanek, CompensationStandards.com

This op-ed from Simpson Thacher’s Avrohom Kess & Yafit Cohn ran in yesterday’s WSJ:

In 2015 the Securities and Exchange Commission is expected to finalize a new rule that imposes excessive compliance costs on public companies with no discernible benefits to investors. The rule requires that public companies calculate and disclose the ratio of the CEO’s pay to the median annual total compensation of all company employees. Part of the 2010 Dodd-Frank law, this ill-advised rule clearly advances the agenda of interest groups worried about income inequality, politicizes the SEC’s disclosure regime and is inconsistent with the purpose of federal securities laws.

The Securities Exchange Act of 1934, which established the SEC, was intended to protect investors by mandating increased—and truthful—disclosure. After the 1929 stock-market crash, it was thought that enhanced disclosure would restore investor confidence in U.S. capital markets and protect investors against stock manipulation and other deceitful practices.

The law’s stated purpose is “bringing safety to the general public in the field of investment and finance” and regulating the operation of securities and commodities exchanges “for the protection of investors.” The extensive disclosure requirements at the heart of the Exchange Act were predicated on Congress’s philosophy that “[t]here cannot be honest markets without honest publicity.” To this day, the SEC’s mission is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

The pay-ratio requirement is at odds with the SEC’s mission and the objectives of its disclosure framework. Companies are already required by law to disclose the compensation of their most highly paid executive officers, along with the reasons for both the level and type of pay accorded to them. How exactly will investors benefit from a comparison between the compensation of a U.S. CEO and the entirety of the company’s workforce—including part-time and seasonal workers, as well as those based in other parts of the world?

The legislative history of the provision in Dodd-Frank compelling pay-ratio disclosure is strangely silent on that question. The SEC has also struggled to pinpoint the rule’s value, noting in its September 2013 proposed rule that “the lack of a specific market failure identified as motivating the enactment of this provision poses significant challenges in quantifying potential economic benefits, if any, from the pay ratio disclosure.”

The SEC acknowledged that “precise comparability across companies may not be relevant and could generate potentially misleading interpretations or conclusions.”

Left unsaid is the obvious truth: The pay-ratio rule is an attempt to shame companies and their boards to advance the “social justice” goal of more equitable income distribution. It comes with a high price tag: Complying with the pay-ratio rule will require the private sector to spend $710.9 million and 3.6 million hours a year, according to a recent report by the Center for Capital Markets Competitiveness.

This is not the only instance of Congress abusing securities laws to advance social and political goals. Dodd-Frank also required the SEC to promulgate regulations requiring certain companies to investigate and disclose annually whether particular minerals in their products originated in the Democratic Republic of the Congo or an adjoining country. The disclosure is intended to target “the exploitation and trade of conflict minerals” that are “helping to finance conflict characterized by extreme levels of violence” and “contributing to an emergency humanitarian situation therein.”

Presumably, Congress expected that the disclosures would damage the reputations of “offending” companies and pressure them to stop using conflict minerals, whose trade may have funded armed groups in Africa.

But again, using the SEC disclosure framework to push social and political agendas places a significant financial burden on public companies and their shareholders. For example, while the SEC admitted in its 2012 final rule release that the social benefits of the conflict minerals statute “are quite different from the economic or investor protection benefits that the SEC’s rules ordinarily strive to achieve,” the agency estimates that initial compliance would cost between $3 billion and $4 billion.

Annual compliance would cost between $207 million and $609 million. The losses borne by the U.S. economy may be even greater, as these rules will hinder the ability of U.S. issuers to compete with companies that are not subject to the disclosure requirements.

The ostensible political goals advanced by Congress may be important and laudable. Requiring shareholders to bear the costs is not. It obfuscates SEC filings with immaterial and potentially misleading information, to the detriment of investors, and could impair the SEC’s ability to focus its attention and limited resources on fulfilling its intended functions.

Congress must find alternative ways to address social and political ills without upending the SEC’s disclosure regime, taxing American shareholders and further complicating the efforts of the SEC.