SEC Rules to Expose Highest Executive Pay Can Be Easily Gamed

Breaking Down the Executive Pay-Ratio Rule

When the U.S. adopted a new rule last week forcing companies to show how much more top executives earn than workers, regulators noted there’s leeway. Academics and activists have spent the time since then figuring out how boards might game the system.

The 294-page pay ratio rule “provides companies with substantial flexibility,” while remaining true to the 2010 Dodd-Frank Act that mandated its creation, Securities and Exchange Commission Chairman Mary Jo White said Aug 5.

The rule requires public U.S. companies to compare their workers’ median pay with their CEO’s total compensation -- including salary, bonus and equity awards -- starting with 2017.

But getting to that figure can be complicated. So, to ease the burden, the rule lets businesses use statistical sampling to estimate the median, rather than calculating it by tallying their entire payroll. And they only have to do that math at least once every three years.

For boards worried about reporting a big gap in pay, there are also several ways the rule’s flexibility can work to their advantage (an SEC spokeswoman declined to comment):

*Boards can pick the date for their data.

Employers can survey their workforce on any day within the last three months of their most recent fiscal year to define median pay. That may enable companies to exclude many seasonal workers, said Heather Slavkin Corzo, director of the office of investment at AFL-CIO, the largest federation of unions in the U.S.

“For a retail company with a Dec. 31 fiscal year-end, the workforce is going to look very different on Oct. 1 than it would on Dec. 23,” she said.

United Parcel Service Inc. said last year it expected to hire at least 90,000 seasonal employees to handle a surge in package deliveries around Christmas. Excluding such workers, it employed 435,000 at the end of 2014.

*Companies can omit contractors.

The law lets companies exclude people employed by contractors or other independent entities. That will probably affect the pay ratio for U.S.-based retailers such as Nike Inc. and L Brands Inc. that outsource manufacturing.

“If their business model relies on a high concentration of low-wage workers that aren’t part of their formal workforce, the number may appear to be much better than if you actually included the people who are responsible for producing the goods,” AFL-CIO’s Slavkin Corzo said.

Financial firms and technology companies also outsource a significant amount of computer and back-office work, said Ron Hira, an associate professor of political science at Howard University.

*Companies can omit some workers abroad.

The rule lets companies exclude up to 5 percent of their staff if they’re outside the U.S. That may narrow ratios for businesses with a share of workers earning significantly less abroad. In addition to outsourcing, many big banks have shifted part of their technology, back-office and legal operations to low-wage locations such as India and the Philippines, Hira said.

“The term of art they use is that they’ve ‘rebalanced their workforce,’” Hira said. “We’re talking about hundreds of thousands of people that are overseas.”

*Sign-on packages for new CEOs may be ignored.

When a company hires a new CEO, the law presents two options. The business can combine pay for both the new and the former leader for that year. Or, it can annualize pay for the person in charge on the date that median pay is defined.

The latter method means a company could time their calculation or the CEO transition to use figures for the lower-paid executive. Incoming chiefs often get packages laden with equity, which could skew that side of the ratio upward.

Microsoft Corp.’s Satya Nadella received a reported pay package valued at $84.3 million after being named CEO of the software company in 2014. Nadella’s predecessor, Steven Ballmer, had reported pay of $483,584 that year.

*Companies can exclude data subject to privacy laws.

Companies can exclude workers located in countries with privacy laws that prohibit sharing of information such as payroll data, according to the ruling. The SEC notes that jurisdictions including China and Mexico, which are vital manufacturing hubs for many U.S. companies, have adopted or are considering laws that limit access to local compensation data.

“How can a company possibly file financial statements if they can’t get information about what they’re paying their workers?” AFL-CIO’s Slavkin Corzo said. “It’s hard to imagine that this would prevent the transfer of anonymized data, which would be perfectly fine to use in determining the median.”

*Companies can bolster awards before the rule.

A board concerned with displaying a big gap in pay for its 2017 fiscal year could load up the CEO’s package for 2016, then cut it the following year. When companies front-load awards for executives, reported pay, as listed in their summary compensation table, typically drops the next year. Often, the initial grant is intended to reward several years of work.

Apple Inc. CEO Tim Cook’s reported pay last year was $9.2 million. That figure doesn’t include 80,000 restricted stock units granted to him in August 2011 that were also meant to compensate him for 2014. After annualizing his initial grant, he was awarded $64.9 million in 2014, according to the Bloomberg Pay Index, a daily ranking of the highest-paid U.S. executives that values compensation as of a company’s fiscal year-end.

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