Why the new SEC rule is the wrong way to fix CEO pay

SEC's First Asset-Manager Rules Coming In Q3, White Says
SEC chair Mary Jo White: She has enough on her plate without having to be America's income-inequality cop.
Photograph by Andrew Harrer — Getty Images

Fulfilling a mandate from Congress, the Securities and Exchange Commission has ordered public corporations, beginning for the year 2017, to publish the ratio of each CEO’s compensation to the median pay for their workforce.

The ratios will confirm what we already know—CEOs earn some 300 times the pay of ordinary workers. At some companies, the figure will undoubtedly be much higher. The fact that executives earn more in a day than other people earn in a year is a social scandal, perhaps a social tragedy—but is this rule an appropriate response?

The job of the SEC is to protect investors and to regulate corporate disclosures so that investors can make properly informed decisions. Executive pay is clearly an investor concern, and the SEC has not done an adequate job of preventing abuse. But it’s hard to see how this rule will further the cause. What it does, instead, is blur the line between two seemingly related but actually quite distinct missions: one, investors’ proper concern for ensuring they are getting their money’s worth for the talent hired; and two, the social concern with inequality.

For an investor, the relevant questions about CEO pay include: Is pay in proportion to the value added? Is the executive paid on a scale commensurate with rival executives, public and private, in the same industry? Is the board that determines pay truly acting at arm’s length? Are the managers’ incentives properly aligned with those of shareholders? Is there meaningful downside for poor performance as well as potential upside? Does the CEO have actual capital at risk?

Pay disparities between top and bottom are not germane to the investment process. Indeed, they are a concern with respect to all highly paid workers—athletes, managers at privately held firms, best-selling writers, etc.—not just public-company CEOs. This is another way of saying that the rule imposes on the public disclosure process a burden of tending to inequality that Congress would do better to deal with in the tax code, rather than imposing on the SEC.

Moreover, the rule will create pressures that can be inconsistent with good corporate governance. Since hamburger flippers at McDonald’s earn far less than workers in other industries (say, software), the effect of the SEC rule will be to put downward pressure on Steve Easterbrook, CEO at the Golden Arches, and upward lift for the (already super-endowed) CEOs in Silicon Valley. There is no business reason for this. There cannot be a tougher job in corporate America than trying to revive McDonald’s. And if you are an investor in McDonald’s, the ratio of Easterbrook’s pay to that of the average worker is irrelevant. What’s relevant is whether Easterbrook can get people to buy more hamburgers, and how much he is demanding for his services.

There is a serious compensation problem in corporate America, and one specific to publicly held companies. Public CEOs are paid from shareholder capital, but the decisions are made by friendly or even conflicted boards. In short, there is an agency problem. Someone has to make sure boards properly fulfill their role as the shareholders’ agent.

What could Congress and the SEC do to curb compensation abuses? Since shareholders are the proper constituency, empower shareholders. First, strengthen the weak mechanisms for proxy access so that shareholders are better able to nominate and elect directors, by forcing, or coaxing, companies to grant proxy access to large investors. The subject has been a battleground for years, with groups such as the Business Roundtable opposing shareholder activists who have the temerity to argue that shareholders should choose their own director nominees. Defenders of the status quo won an unfortunate victory in 2011, when an SEC access rule was vacated by the U.S. Court of Appeals for the District of Columbia. That decision was made on procedural grounds; the SEC should try again. And in any case, many corporations have voluntarily accepted SEC guidelines on proxy access. Proxy access proposals have mushroomed this year, with more than 100 such proposals submitted for shareholder vote. Congress should give the SEC explicit authority to compel proxy access to shareholders with meaningful stakes.

Although the procedural details are complicated, the principle is clear: Boards hate dissension. Given the presence of even one activist director who raised a stink about CEO pay, compensation committees, rather than risk a divided vote, would be inclined to moderate the size of awards.

Second, and more radically, Congress should authorize the SEC to revise its voluntary “say on pay” rule to give it mandatory teeth in the case of awards that eclipsed certain thresholds. Notice, the SEC wouldn’t be setting a ceiling on pay, which is rightfully left to markets. It would be empowering owners to act directly.

Shareholder democracy has always been an oxymoron (management nearly always wins). On a subject such as executive pay, in which management is palpably conflicted, governance via board representation is particularly flawed. Decision by shareholder plebiscite is a proper remedy. It would mightily get the attention of directors, and is a better approach than foisting the job of being the nation’s inequality cop on the already challenged SEC.

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