Compensation Consultant Selection, Switch and CEO Pay

The following post comes to us from Wei Cen of the Department of Applied Economics and Management at Cornell University and Naqiong Tong of the University of Baltimore.

In the paper, Big or Small: Compensation Consultant Selection, Switch and CEO Pay, we provide new evidence showing that CEOs of firms engaging BIG6 consultants receive lower equity payments and lower total compensations compared to that of firms engaging SMALL consultants. Although most prior studies have examined the compensation consultants’ potential conflicts of interest and its impact on CEO pay, little was known about why a firm retains its compensation consultants between BIG6 and SMALL consultants and what impact of a switch between BIG6 and SMALL consultant have on CEO pay. This study is the first study to investigate the impact of a firm’s selection between BIG6 and SMALL firms on CEO pay and the impact of a switch between BIG6 and SMALL consultant on CEO pay. The expertise, “repeat business” and reputation arguments imply that BIG6 consultants have incentives to design optimal contracts for CEOs to align the shareholder’s interest with the CEOs’ interest. However, the “other service” argument predicts that BIG6 consultants will design less optimal contracts and reward CEO higher pay to win CEO’s favor since the power of approval other service rests on CEOs.

Using a sample of U.S. S& P 1500 firms from 2007-2009, we provide new evidence that CEOs of firms with BIG6 firms receive lower equity payments and lower total compensations. In addition, we also find that a switch in a firm’s compensation consultants does influence its CEO pay via two directions. When a firm switches its consultant from SMALL to BIG6 consultants (SMALL to BIG6), its CEO receives lower bonus, lower equity and lower total compensation. By contrast, when a firm switches its consultant from BIG6 to SMALL consultants (BIG6 to SMALL), its CEO receives higher salary, higher bonus, higher equity and higher total compensation. In particular, our evidence supports the argument that despite criticism of potential conflicts of interest, big consultants tend to design more optimal contract to reduce CEO’s “excess pay”.

Since the detail reasons of consultant switching is not given in the proxy statement, this study is limited in drawing a conclusion of opinion shopping. Nevertheless, our findings do have policy implications, especially when the new SEC regulation has passed in August 2009, which requires firms to disclose their fees paid to their consultants for both compensation-related services and non-compensation-related services. Although the 2009 SEC regulation does not prohibit companies from purchasing other services, to avoid disclosure of service fees charged by consultants, firms can either switch to a new consultant if their previous consulting firms provide other services, or to hire two or more consultants, one working exclusively for the board and the other(s) working for management (while providing other services). Therefore, we should observe more cases of firms that switch their compensation consultants or the popularity of multiple consultants. Future research can examine the switch of compensation consultants under the new regulation and how it influences CEO pay.

The full paper is available for download here.

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