Rough weather at the top- Dolphy D’Souza

Under Companies Act, 2013, every listed company shall disclose, in its Board report, the ratio of the remuneration of each director to that of the median employee, and other prescribed details. Draft rules issued by the Ministry of Corporate Affairs also require disclosure of percentage increases in the remuneration of each director and CEO, and in the median remuneration of employees. The increase in both categories will be compared against the company’s performance.

The disclosures are similar to those required in the US under the Dodd–Frank Act, despite vociferous protests that compliance would be cumbersome and costly. There are two choices in disclosing the pay ratio. For example, if the median employee earned Rs 2.5 lakh and the CEO earned Rs 5 crore, the ratio could be disclosed as 1:200, or that the CEO’s annual total compensation is 200 times that of the median employee.

For many companies, such disclosures will have various consequences. They may negatively impact employee morale, particularly when there is a big gap between the CEO’s salary and that of the median employee. The management could become the target of social activists. Investment analysts might start comparing the disclosures with other companies, and influence remuneration decisions. While it is not legislated that the pay-ratio disclosures will drive compensation decisions, the nomination and remuneration committee will nevertheless have to keep the ratio in mind, ensuring that the disparity is not very wide and is in line with market standards.

An issue that companies are grappling with is the manner in which the median salary is determined. The draft rule states that ‘median’ means the numerical value separating the higher half of a population from the lower half. The median of a list of numbers may be found by arranging all the observations from the lowest to highest value and picking the middle one. For an even number of observations, the median is the average of the two middle values. Thus if there are five employees, the median remuneration is what employee 3 earns. If there are six employees, the median remuneration is the average of the salaries of employees 3 and 4.

This manner of determining the median remuneration has a fundamental flaw. Consider a company with three categories of workers — 550 lowly-paid workers, 250 officers, and 199 middle- and senior-management. The median remuneration would be what worker number 500 gets. Let’s assume that is Rs 2.5 lakh. If the CEO’s salary is Rs 5 crore, the ratio would be 1:200, which appears to be a huge disparity.

The Dodd-Frank Act understands these issues and, therefore, does not prescribe any rigid methodology for determining the median remuneration. An average by category of employees might provide a far more sensible analysis. For example, if a worker’s average salary is Rs 2 lakh, an officer’s average salary is Rs 6 lakh, and management’s average salary is Rs 52 lakh, the average of all three categories would be Rs 20 lakh — the pay ratio between the CEO and the median remuneration is 1:25.

The draft rules should consider this aspect and allow flexibility in determining the median remuneration. As long as the methodology is reasonable, consistently applied and disclosed, it should be acceptable.

The author is Partner in a member firm of Ernst & Young Global.