Welcome the CEO Pay Ratio

Posted by Marc Hodak on August 6, 2015 under Executive compensation, Stupid laws | 4 Comments to Read

Hail ants

The CEO Pay Ratio mandated by Dodd-Frank is finally here. The rule sounds simple enough: Companies must disclose the ratio of their CEO’s pay to that of their median worker. Interesting information, perhaps, but the SEC supposedly exists for a more lofty purpose than mandating nice-to-know data. It must, by law, act in the interests of investors. In fact, the Administrative Procedures Act requires the SEC to “base . . . decisions on the best reasonably obtainable scientific, technical, economic, and other information concerning the need for, and consequences of, the intended regulation.”

The CEO Pay Ratio rule is, indeed, of great interest to certain people. Union leaders believe that the rule will give them another crowbar with which to negotiate their members’ wages and benefits. Class warriors believe it will give them more ammo to shame corporations into reducing inequality. Fair enough. But the SEC does not normally allow itself to be used by unions for getting involved in labor relations, or by class warriors in anti-corporate crusading. So, why are they bothering with this rule?

Quite simply, because Dodd-Frank requires them to. The CEO Pay Ratio provision was inserted into the law, without debate, at the last minute by Senator Menendez. His rationale, explained after the fact, was, “This simple benchmark will help investors monitor both how a company treats its average workers and whether its executive pay is reasonable.”

How, exactly, will this “simple benchmark” help investors do those things? What number, or range, for this ratio tells an investor that a company is treating its average workers well or poorly, or that a company is paying its CEO reasonably (given that CEO pay is already thoroughly disclosed)? What economic or financial standards can be created using this or other data to enable investors to figure these things out?

As someone who has been asking this over the five years it has been debated, I can assure you that those questions have never been answered, neither by the rules proponents nor by the investors they claim to want to help. That’s because there is no logical basis for believing that the pay ratio can usefully inform investors either with regards to the company’s treatment of workers or the reasonableness of their executives’ pay. Consequently, there is no scientific or economic evidence that this ratio, alone or in combination with any other data, can be used to judge how well the company is being managed, or otherwise be related to company value—i.e., the nominal concern of investors. The Pay Ratio provides no more useful information than the ratio between the company’s highest cost office space versus its average cost of warehouse space, or between its highest cost commodity inputs versus its average cost of materials.

In other words, the SEC is simply being used in an experiment in social engineering. The expectation is that this ratio will shame boards into changing how they pay their CEOs. That goal might have some redeeming value if this experiment hadn’t already been tried, twice. The “shaming” theory was, in fact, largely behind disclosure rules enacted in 1992 and in 2006. A rational person would have looked at these and similar results, and decided it was time to try another hypothesis. Alas, it appears we are not dealing with rational persons. So today, ideology trumps science.

  • Dan Walter said,

    Well said Marc!

  • Andy Klemm said,


    All public companies and their investors need to read your commentary. It should be called the Menezdez ratio, and the senator needs to live with its Forest Gumpian consequences.

  • Banking and finance roundup - Overlawyered said,

    […] pay shaming theory has been tried and failed twice, but why not one more try? [Marc Hodak, […]

  • Richard Gray said,

    To assess whether there is a problem, one first has to know the facts. So to the general and amorphous left-wing complaint of “wage gap/income disparity,” we must crunch real numbers to determine what we are even talking about. That is the usefulness of the information and nothing more need be said to justify the disclosure rules.

    Therefore the specific questions of “how a company treats its average workers” and “whether its executive pay is reasonable” are cart-before-the-horse. We won’t know whether the numbers speak to these issues until we see what the numbers are.

    To play in the hypothetical world, pay is one aspect of “how a company treats its average workers.” For the easiest example, no pay is bad treatment. Does CEO/worker pay ratio also speak to worker treatment? You assume that it does not. To the contrary, I think a high ratio could be indicative of (relative) poor treatment, and thus the information could be valuable in that regard — depending on what it is.

    “Whether executive pay is reasonable” is a subjective determination. “Reasonable compared to what?” is a natural next question. And, “compared to what the company workers make” could be a reasonable answer, depending on what the numbers are.

    Bottom line, we need to know the numbers as the first step of assessment.

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