The pay ratio rule: Get ready, get going: it's time to make lemonade--boards should be thinking strategically today about how they will change their compensation programs and disclosures to mitigate the coming controversy.

• Author: Elson, Charles M.

The CEO to median-worker pay ratio rule, recently proposed by the SEC, has become perhaps the most controversial requirement of the new Dodd-Frank corporate governance reforms. Until very nearly the time it became required by law, this little noted concept was absent from most progressive governance reform agendas. Nonetheless, in the crucial moments prior to the passage of Dodd-Frank, the idea gained a champion in Senator Robert Menendez, became part of the legislation, and soon after its passage found an advocate in the AFL-CIO. Despite an ongoing repeal movement, it is most likely here to stay.

It has been argued that the primary intention of this disclosure mandate is to embarrass companies and disrupt their work cultures so that they might change their executive compensation behavior (which, frankly, to most that support this provision, means paying CEOs less and other workers more). This "shock and awe" campaign against corporate America will undoubtedly succeed on both counts. Bloomberg News has estimated that the average ratio will be 204-to-1, with some outliers, such as J.C. Penney Co., having ratios in excess of 1,000-to-1. Many boards and CEOs will be embarrassed and most companies will be disrupted to some extent by the publication of these figures. Boards should be thinking strategically today about how they will change their compensation programs and disclosure to mitigate the coming controversy.

The centrally relevant criterion

While the issue of pay disparity obviously invites the use of many frameworks for evaluation, the dialogue surrounding the new rule has focused mostly on the costs and its benefits. As an element of the SEC's disclosure regime, the centrally relevant criterion, identified by both the rule's proponents and its critics alike, has been the "materiality" of the soon-to-be public information. With respect to the securities laws, the SEC and the courts have customarily defined a material disclosure to be one which a reasonable person would likely find to be important to an investment or portfolio decision.

It is important to consider the merits and, hence, the materiality of the ratio disclosure because, by the SEC's estimates, this will be an expensive requirement to implement. Most companies do not have centralized payroll systems, as the Center for Executive Compensation noted in a letter to the SEC. Aggregating and compiling data from these multiple systems for the computation of the median worker's pay will be a complicated matter. Even the form in which the bill mandates that total median worker pay be disclosed, and therefore also be identified with reference to, is a form which was developed for executive compensation purposes and will thus prove foreign to the methods of calculation already in use.

An additional complication, which will impact implementation to great effect, is that the median worker must be identified from all of a company's...