Has The SEC Forgotten Its Mission?

There was a moment this week when I had the sinking feeling that I have been wrong about an article of faith: That the Securities and Exchange Commission exists primarily to protect investors.

So I was relieved to find an affirmation on the SEC’s website. The commission’s mission is “to protect investors, to maintain fair, orderly, and efficient markets, and facilitate capital formation.” By the SEC’s own account, protecting investors comes first. Those other goals about maintaining fair and efficient markets and facilitating capital formation (which means creating businesses and other stuff that makes society better off) are good things, too. They do not conflict with investor protection.

There is nothing in the SEC mission statement about advancing the careers of commissioners and staff members, or scoring brownie points with journalists, or placating the political base of whomever happens to occupy the White House. That’s good. I was getting worried about what the SEC is actually trying to accomplish.

Perhaps my concerns can be addressed simply by getting all five commissioners to read their agency’s own website. They may have overlooked it.

How else can we understand the commission’s 3-2, party-line vote requiring public companies to compute and publish a useless ratio that compares CEO compensation to the median earnings of all the company’s employees?

The three Democratic commissioners – newly appointed chairman Mary Jo White, along with Luis Aguilar and Kara M. Stein – say they are merely implementing a mandate Congress imposed in 2010 as part of the Dodd-Frank financial regulation overhaul. To my knowledge, Congress does not have a mission statement. The mission changes according to whoever happens to be in control on Capitol Hill. That was Nancy Pelosi and Harry Reid, together with their fellow Democrats, back in 2010. Investor protection and capital formation were not anywhere near the top of their priority list.

Still, the SEC went out of its way to craft a rule that is of no use to anyone, except to labor unions that claim corporate CEOs are overpaid. That’s sometimes true, but the SEC’s approach won’t be of any help to investors or markets, and it will impede American capital formation by encouraging promising companies to stay private.

The new rule, which is now open to public comment, requires companies to include part-time and seasonal workers in their calculation of median employee pay. The median is the level at which half the employees receive more compensation, and half less.
Let’s consider a hypothetical tax-preparation office. The CEO makes $200,000 a year. Two full-time tax specialists, who work on complex returns and help clients with tax planning and IRS audits, make $100,000 each. Two administrators make $50,000 each. Four seasonal employees, who prepare returns during the April 15 deadline rush, make $19,000 each for four months of intense work, and a fifth seasonal worker who acts as a supervisor makes $24,000 for the same four months.

The average compensation of the four-full time employees other than the CEO is $75,000. Assuming the CEO is also an employee, it seems to me we ought to include his compensation in the all-employee average as well. Doing so means the five full-time workers earn an average of $100,000. The CEO’s ratio to this figure is 2:1.

I don’t know why we would want to consider the five seasonal workers. We have no idea what else they do all year, or how much they earn doing it. If we add them to the all-employee average, they bring it down to $60,000. Excluding the CEO from the employee average drops that figure to $55,556.

But the SEC did not ask for averages; it asked for medians. And, as I understand it, the SEC rule excludes the CEO calculation from the median (though it would have a trivial effect for most public companies anyway). In our example, the median compensation of the nine workers other than the CEO is just $24,000, the amount earned by the seasonal supervisor. Four workers earn more than this figure, four earn less, and one earns the exact amount as the median. The ratio of CEO comp to this median is 8.33:1.

This is why Daniel Gallagher, one of the two Republican commissioners who opposed the rule, said it was crafted to yield “eye-popping” results that are of no practical value.

Investors cannot tell from these ratios whether CEOs are overpaid, or whether they are doing a good job of holding down expenses by hiring (in our example) high-priced workers only for the periods in which they can be kept productive. Generally, shareholders want managers to keep all costs as low as possible, including labor costs. CEOs who are good at this are worth more than those who are not.

The SEC also requires companies to include workers outside the United States in their calculations. That means the median compensation of an American tech firm is affected by the wages paid to call center workers in India, along with the values assigned to fringe benefits provided to those workers (what is the U.S. dollar value of a lunch provided in a company cafeteria in Bangalore?) and the fluctuating value of the Indian currency. The lower cost of living in India is not considered.

Another example of dubious investor protection, and one that cannot be blamed on Congressional mandates, is the new SEC chairman’s insistence that corporations admit fault in most settlements of SEC misconduct charges.

Yesterday morning, several government agencies, including the SEC, imposed a $920 million fine on JPMorgan Chase (JPM) for failing to supervise the traders involved in the “London whale” debacle, which cost shareholders more than $6 billion last year. At the insistence of White, the bank will also admit fault, making it more vulnerable to class-action lawsuits brought in the name of its shareholders. The commission has already gone to court against two bank employees who ostensibly covered up the sinking value of the trades, though the trader who actually placed the bets (and is cooperating with the commission) has not been charged.

So let’s get this straight: the bank’s shareholders, who already lost $6 billion on the errant trades – an amount that was inflated because SEC-mandated disclosures allowed the entire trading world to take advantage of the bank’s desperate position – are now to pony up nearly another $1 billion, plus whatever the bank may lose in suits brought by contingency-fee lawyers in the name of those very same shareholders. The bank being penalized and made to admit fault is the same one that was allegedly victimized by its own employees.

If I don’t imagine JPMorgan shareholders will thank the SEC for its efforts to protect them. It’s as though a fellow walks into a police station, says he has been beaten, and then has to let the cops punch him repeatedly in the face so they can understand what happened. Or as they used to say in Vietnam, “we had to destroy the village in order to save it.”

Sometimes we get so wrapped up in the tasks we set for ourselves that we forget what we were trying to do in the first place. At such times it helps to remember the mission.