A Simple Solution That Made a Hard Problem More Difficult

Congressional leaders, in their rage against ever-rising executive compensation and income inequality, have created more murkiness.

The irony is that it all came out of such a simple-sounding idea: requiring that the pay of a company’s chief executive be compared to the median salary of its employees. Carrying out the law may well result in costs that are just as obscene as the pay it is disclosing.

When the Dodd-Frank Wall Street Reform and Consumer Financial Protection Act was being completed, a new section was inserted in the final hours of negotiation. It was two-thirds of the way in, at Section 953(b). The section was also short, at only 140 words, in a bill that would eventually run about 2,300 pages.

What the section required was that all public companies disclose this median number on worker pay, placed side-by-side to the chief executive’s pay.

What could be so hard about making such disclosure, right? It turns out plenty.

The first problem came in how compensation is calculated. We are decades past the time when manager compensation was simply what you received in a paycheck. Now, compensation includes options, pensions, 401(k) matches, health benefits, parking allowances and other various perquisites. Calculating this all as one figure — and in particular valuing average stock options for employees as well as top executives — can be difficult.

The problem is compounded because the rule says that the median is calculated with respect to “all” employees.

Take a multinational conglomerate with 50,000 employees across the globe. That company has the task of not only figuring out the total compensation provided to every employee, but it also has to collect and analyze this information, much of which is in different currencies. And some of this information collection is arguably prohibited by privacy rules in the European Union and other countries like Japan and Canada.

Then there is the issue of when to calculate it. The number will fluctuate from day to day. The end result is that what was thought a simple calculation is turning into an exercise that could cost some companies millions.

There is no Congressional record of why this provision was inserted. It was placed into the bill by Senator Robert Menendez during a 20-minute session of the Senate Banking Committee called to mark up a draft version of the final bill. It certainly never had full hearing.

But it is not hard to figure out the motivations behind it. The idea was to shame companies that had excessively high executive compensation to either pay their chief executives less or their workers more. The provision also comes in light of the increasing income disparity between the two. Pay for chief executives has risen to 277 times the average workers’ pay, from 20 times in 1965, according to the Economic Policy Institute.

This is not the first time that the Dodd-Frank Act’s seemingly innocuous disclosure requirements are costing more than anticipated. The rule on disclosure of conflict minerals — Section 1502 — will cost United States companies $3 billion to $4 billion just for initial compliance, according to Securities and Exchange Commission estimates. Industry estimates are higher, up to $16 billion. Many multinationals have hired one or more employees solely dedicated to compliance with this conflict minerals provision.

These added costs of the pay disclosure would be bearable if there was evidence it would do anything. But, like the disclosure requirement for conflict minerals, the evidence is mixed that the expense is worth it.

First, compensation disclosure has been mandated in some form for decades. But instead of empowering shareholders, it has allowed executives to see what others are paid. This has led to a “Lake Wobegon” effect in executive compensation, pushing each chief executive to demand to be paid “above average,” and the result has been ever-increasing compensation.

It is not clear how the new disclosure required by Dodd-Frank would change established trends. Companies that already disclose executive pay are not going to suddenly change their ways.

And as Daniel M. Gallagher, an S.E.C. commissioner, asked, what is the benefit to investors?

It’s not only that it is likely to have no effect, the information provided might actually be misleading. If global employees are included, the ratio will be exaggerated by relatively low-paid employees in less-developed countries.

The end result is that companies are likely to spend millions for something that is likely to do nothing.

So, what explains this rule?

At first blush, it appears to be cheap regulation, simply requiring disclosure instead of trying to fix the problem. But it also appeals to those politicians who are justifiably trying to address income inequality.

Advocating for this provision, Senator Menendez said that “income inequality is a real, growing concern in our nation, as it should be,” and that “a company’s treatment of their average workers is not just a reflection of their corporate values, but is also material information for investors.”

But if the concern is income inequality, or even executive pay, isn’t it better to meet it head on, rather than through these indirect methods that only seem to cause more trouble?

Now, the whole mess is with the S.E.C. to sort out. The agency is expected to announce rule-making on this provision in the next few months.

The hope of companies is that the S.E.C. cuts back on some of the more irrational components of the rule. Even the A.F.L.-C.I.O., which strongly advocated for this disclosure, recognizes that there are problems. In a release, the union argued that companies should not count all employees as the statute says, but rather use statistical sampling methods.

The statute, however, is strongly worded, saying the median should be calculated for “all employees.” If the S.E.C. tries to water down the provision as the A.F.L.-C.I.O. suggests, it may lead to a lawsuit in court to strike the rule down by companies themselves.

The hope would be to show that in its statutory form, it is so extreme that it should be repealed. Corporate America has a friend with House Republicans. The Burdensome Data Collection Relief Act was recently passed by a House committee to repeal this measure.

Easy-sounding fixes like more disclosure can sometimes have unintended and costly consequences. There are also no easy answers to hard problems. This type of legislation appears to be more about being able to show that you are doing something, anything about a problem without actually fixing it. Last-minute legislating of this type is also bound to cause problems. The S.E.C. has sat on this rule-making because it is so difficult to actually enact.

Unless Congress acts, the S.E.C. will have to sort out trying to balance an inflexible statute against political demands and what will actually work. Executive compensation may be excessively high and income inequality a real problem, but that seems beside the point.