Tuesday, March 22, 2011

IMHO: The Stupidest Rule

NOTE: This post, in particular, is my opinion. It may not be the opinion of my employer, and advertisers, or anyone else, for that matter.

There has to be a stupidest rule. I think I know what it is. You probably disagree, and if you do, you are free to ignore me, comment, or blog about your own choice. But, with apologies to Leslie Gore, it's my blog and I'll give my opinion if I want to.

So, what is it? It's Section 953(b) of the Dodd-Frank Act, sometimes known as the pay ratio rule. Before we talk about what's in this dreaded, or should I say dreadful, subsection, let's understand how it got there. It wasn't in the original language developed by Rep. Barney Frank (D-MA), but Sen. Robert Menendez (D-NJ) insisted that this was an important provision of financial reform. We'll return to this later.

What does this subsection require SEC registrants to do? It requires them to disclose the total annual compensation of the Chief Executive Officer (CEO) and that of the median employee of the employer when ranked by compensation, and then to disclose the ratio of the pay of the median employee to that of the CEO. Now, understand, total annual compensation isn't just cash. It's also the value of equity compensation, the value of pension accruals, the value of perquisites, and pretty much everything else that has value. Calculating this for the CEO is not an easy task, but companies have to do it anyway as part of their proxy reporting for the CEO and four other generally very well-paid employees. So, that part is done.

Now let's return to Senator Menendez. Many people upon reading the law said that Senator Menendez must have meant that this exercise was only to include full-time US employees. According to the senator, they were wrong. He said that when he wrote every employee of the employer, he meant every employee of the employer.

Now, I'm sure that Senator Menendez is a smart man. Like many of his brethren in the US Senate, he graduated from law school. And, in the House of Representatives (before being appointed to the US Senate by then Governor Corzine), he rose quickly through the ranks of Democratic Congressman to assume a key leadership role. But, I wonder if he understands what he hath wrought.

For the mathematically challenged among us, let me digress. What exactly is a median, other than the center of a highway where some governing entities let pretty things like wildflowers grow? You find the median of a set of data by ranking all the data points from top to bottom and picking the one exactly in the middle. So, if you have 101 employees, this would be the 51st when ranked, because 50 would be higher-paid and 50 would be lower-paid. If you have 100,001 employees, this would be the 50,001st when ranked, and so forth. OK, that sounds easy enough, but first you have to rank them. And, in order to rank them, you need to, at least in theory, determine the total annual compensation of each person who works for your company.

Let's consider some of the challenges. If your company has a defined benefit pension plan, then you need to determine the increase during the year in the actuarial present value of accumulated plan benefits for each individual from one year to the next using a set of pretty much prescribed actuarial assumptions. With apologies to Ringo Starr, this don't come easy, you know it don't come easy. Maybe you grant broad-based stock options. If so, have you calculated the grant date value of all the options that vested in that year? That don't come easy either. And, then, let's assume that you are a multinational corporation -- not one of those that many think are evil because they ship jobs oversees -- that has employees in various countries around the world both for distribution purposes and for purposes of harvesting the raw materials that you use to make your products. You have to determine the compensation of each of those non-resident aliens as they are known in the Internal Revenue Code. Hmm, how do you do that? Suppose you pay some of your people in Slovakian Koruny (how else would you pay your Slovakian employees). Do you convert all of their Koruny to US dollars on one date, and if so, at which exchange rate? Or, do you do it separately using a then current exchange rate for each pay period? Perhaps if I asked Senator Menendez, he would know which method he intended. On the other hand, could it be that he didn't consider this complication?

So, now we have calculated this obviously very useful number for all of our employees who worked for us during the year. We rank them and count them. And we find the monkey in the middle (that was a childhood game where I grew up and we all took turns at being the monkey), so to speak. Finally, we take the total annual compensation for that person and divide it by the total annual compensation for the CEO.

Let's consider some possible numbers that might not be unusual for a Fortune 100 company. The CEO was rewarded with $7,685,249 in total compensation for the year while Ms. Median earned 54,992. I punch these numbers into my handy-dandy HP-12C calculator (as my brain has gotten too rusty to do the math in my head) and I get .007156, at least that's what I get when I round to 6 decimal places. Hmm, is that the correct number of decimal places? I don't know. If I round it to 2 decimal places, I get .01 (that's the same result that I would get for every ratio from .005000 up to .014999, so I don't think that is what was intended). Maybe Senator Menendez wanted 4 decimal places. If so, I'll report .0072.

I wonder if that's right. Perhaps I'll ask Senator Menendez. Well, unfortunately, I don't have ready access to him, and in any event, the law gives the wonderful mathematicians (oops, they're not mathematicians) at the Securities and Exchange Commission (SEC) the obligation to regulate this oh so important provision.

So now that I have decided to report my result as 0.0072, what gets done with this? Is that a good result? Will our shareholders be impressed? Will they think this is horrible? Will they wonder how much money it cost us to determine this number (probably not)? How about the shareholder advisory service firms? Will this number be important to them (I certainly hope not)? Perhaps instead of reporting this silly number, I should report its reciprocal (approximately 140, meaning that on this basis, the CEO made 140 times as much as the median employee). Nope, that's not what the rule says, even though this number would mean more to most observers.

Before concluding, I need to note that I do think that lots of CEOs are paid far more than they are worth. Yes, executive compensation has gotten out of hand, but this is not the answer. I consider myself far more informed than the typical shareholder on this issue, and I can assure you that the first time that I see a proxy statement including this ratio, I won't know if it's too high or too low, and frankly, I won't care. But, I do fear that some person with too much time on their hands is going to get this number for each company in, for example, the Fortune 500, and rank the Fortune 500 companies by this number. Surely, some reporter who is looking for an inflammatory story will take those rankings and tell us how some executives and compensation committees are evil. Frankly, they might be, but this isn't the way to determine.

And, finally, Senator Menendez, do you know what I would like to be able to do with those numbers. I'd like to find out what each Fortune 500 company's compliance burden is to do the work necessary to comply with Dodd-Frank Section 953(b). And, I'd like to compare that to CEO pay, and tell you how many companies in the Fortune 500 I have found whose cost of complying with your pet provision exceeds the total annual compensation for their CEO.

Perhaps that is what was really intended for this, the stupidest rule ...

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