Conflict Minerals and Pay Ratio: SEC Rules of Unintended Consequences

U_S_SEC_logoIn a highly influential 1936 essay, “The Unanticipated Consequences of Purposive Social Action,” sociologist Robert K. Merton explained that there were five sources of unintended consequences. One is the “imperious immediacy of interest:” someone wants the intended consequences of an action so badly that they consciously ignore any unintended effects. One can find many examples of this in government regulation. In fact, the Securities and Exchange Commission (SEC) provided an ideal illustration recently with its final rule that requires each listed company to express, in a ratio, how its workforce’s median pay compares with its CEO’s compensation.

The rule is one of 300 regulations SEC must promulgate pursuant to the Dodd-Frank Act. Dodd-Frank imposed no statutory deadline within which SEC had to act on this highly contentious provision of the law. Pressure from imperious politicians and Occupy Wall Street-type special interests created an artificial immediacy, and the Commission was happy to oblige. Several SEC Commissioners, as well as many public commenters, informed Commission staff and leadership about this name-and-shame device’s likely unintended effects. But the final rule paints only a rosy picture of how employees and shareholders will benefit.

SEC, it seems, has learned nothing from the disastrous results wrought by another Dodd-Frank-mandated regulation: the so-called Conflict Minerals Rule. That rule implemented a Dodd-Frank provision requiring that businesses whose products contain minerals such as tin, tantalum, and tungsten disclose whether they had obtained these materials from areas of armed conflict in Africa. Congress and SEC ignored warnings that this de facto embargo could foment, not alleviate, violence in places like the Congo.

The unintended consequences have occurred exactly as some predicted. Freelance journalist David Aronson detailed its devastating impact on the Congo in an August 2011 New York Times op-ed. Reduced mineral purchases deprived many Congolese of their only source of income. Though the rule was meant to reduce the influence of the area’s warlords, Aronson wrote, “The [rule’s] chief beneficiary is Gen. Bosco Ntaganda, who is nicknamed The Terminator and is sought by the International Criminal Court.”

A study published on June 2, 2015 adds empirical support to Mr. Aronson’s first-person account of the rule’s impact. Independent researchers from the University of Wisconsin and the London School of Economics concluded that violence in the Congo has increased 143% since Congress passed the Dodd-Frank Act. Militias that previously derived income from shaking down miners turned to looting local villages instead, “taking civilian assets in unpredictable ways and at unpredictable times.” The authors cite data revealing that the law has also led to widespread unemployment, which in turn increased poverty and reduced literacy.

Despite this cautionary tale, SEC moved hastily forward with its pay-ratio rule, which it claims will advance “pay equity” within companies, improve “employee morale,” and empower shareholders. One can easily envisage reactions to the rule that would undermine each of those contrived benefits. In addition to or instead of lowering their CEO’s compensation, image-conscious companies may shed lower-paid workers and increase the responsibilities (but not the salaries) of other employees. The rule also creates a perverse disincentive against hiring lower-skilled individuals willing to trade higher wages for employment opportunities. Businesses with many overseas employees, whose wages must be factored in under the rule, could choose to outsource that work instead to foreign contractors. Such businesses would thus have less control over those workers’ labor conditions. How do these consequences financially benefit employees or improve worker morale?

Shareholders don’t win when companies are unable or unwilling to hire a high-profile executive whose fair-market salary demands would skew pay-ratio numbers. Nor do they benefit when a CEO’s resignation over his or her pay sends the company’s stock value plummeting. And perhaps SEC Commissioner Daniel Gallagher was only half-joking when, in his dissenting statement to the rule, he wondered whether “demand[s] [for] additional pay to compensate for risk of character assassination” would actually drive up CEOs’ salaries.

In addition to being prone to unintended consequences, government regulations drafted by bureaucrats under the influence of the “imperious immediacy of interest” will be especially vulnerable to legal challenge. The last thing regulators driven by a “just cause” will worry about, for instance, is the constitutional rights of their targets. Last August, around the same time SEC finalized the pay-ratio rule, a U.S. Court of Appeals for the D.C. Circuit three-judge panel found in NAM v. SEC that the Conflict Minerals Rule’s disclosure mandate unconstitutionally compels speech. This week, the D.C. Circuit rejected SEC’s request for rehearing en banc.

The pay-ratio rule is vulnerable to a similar First Amendment challenge, as Andrew Morris of the law firm Morvillo LLP explains in an October 23 WLF Legal Backgrounder. Mr. Morris argues that the mandate would not even survive a court’s application of the lowest level of scrutiny for compelled speech from the Supreme Court’s Zauderer decision. The pay-ratio rule, like the Conflict Minerals Rule’s mandate, would not be reasonably effective at advancing SEC’s stated goal. A rule that encourages companies to dismiss lower-paid workers or pursue overseas outsourcing doesn’t, as we’ve explained, directly advance pay equity or boost employee morale. It does the opposite. Shareholders don’t materially benefit when successful CEOs quit or highly-qualified candidates pass up executive opportunities due to the pay-ratio rule.

Mr. Morris explains that a successful legal challenge to the pay-ratio rule would not only do away with a counterproductive disclosure mandate, it could quash SEC’s quest to impose “corporate social responsibility” and refocus the agency on its actual mission: investor protection.

That’s the type of unintended consequence SEC and the public should welcome.

Also published by Forbes.com on WLF’s contributor page

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