Say on Pay Laws, Executive Compensation, CEO Pay Slice, and Firm Value around the World

Ricardo Correa is Chief of the International Financial Stability Section, Division of International Finance, U.S. Federal Reserve Board; Ugur Lel is Nalley Distinguished Chair in Finance and Associate Professor of Finance at University of Georgia Terry College of Business. This post is based on their recent article. Related research from the Program on Corporate Governance includes The CEO Pay Slice by Lucian Bebchuk, Martijn Cremers and Urs Peyer (discussed on the Forum here).

In our study Say on Pay Laws, Executive Compensation, Pay Slice, and Firm Valuation around the World, which was recently published in the Journal of Financial Economics, we examine changes in CEO compensation and in firm valuation around the adoption of say on pay (SoP) laws in a large cross-country sample of firms. SoP laws aim to more closely align the interests of executives with those of shareholders—a key tenet of corporate governance—by providing shareholders with the ability to vote on their firms’ compensation policies on a periodic basis. The main purposes of these laws are to limit the seemingly excessive levels of CEO pay, tighten the link between firm performance and CEO pay, and improve disclosure on executive compensation. Between 2003 and 2012, 11 developed countries passed SoP laws, and several countries are either contemplating or have recently adopted such laws, notably Switzerland and France.

Existing empirical studies, which have mainly focused on SoP laws in either the United States or the United Kingdom, have found little evidence of a decrease in CEO compensation, some evidence of an increase in the sensitivity of CEO compensation to firm performance, and mixed evidence of an effect on firm valuation (Ferri and Maber, 2013; Iliev and Vitanova, 2015). However, single-country studies do not always use an adequate counterfactual of firms not subject to new legislation. To address this issue, we construct a data set of more than 17,000 firms in 38 countries from 2000 to 2012, and we also add a number of controls to proxy for the strength of corporate governance and differences in firm characteristics across countries.

In our results, CEO pay declines approximately 7% following the passage of SoP laws, and the sensitivity of CEO pay to firm performance increases 5%, on average, compared with observations in the control group (i.e., firms in countries that did not pass an SoP law or that had not passed such a law at a particular point in time). The decline in CEO compensation is more severe in firms with poor performance. For example, following the passage of SoP laws for firms in the bottom quartile of firm performance as measured by industry-adjusted stock returns, total CEO pay decreases 9.1%, or an average of $99,576 (in the sample, average total CEO pay is $1.1 million). Thus, in contrast to existing single-country studies of SoP laws, we are able to show that SoP laws are associated with a decrease in CEO pay growth once a large counterfactual sample is constructed.

More importantly, these changes in CEO pay around SoP laws are more pronounced for firms with problematic pay practices and weak governance environments prior to the SoP laws. For example, we find a relative decrease of 18.5% in CEO pay following SoP laws for firms with excess pay, which translates to a $201,991 decline in CEO compensation. In addition, the sensitivity of CEO pay to firm performance improves 7% for firms with excess pay and “busy boards” in the pre-SoP period. These results are consistent with increased shareholder influence following the adoption of SoP laws, which are directed at firms with weak pay and governance policies. Results remain robust when we implement a neighbor-matching strategy to directly compare firms similar in all aspects except SoP regulation. CEO compensation results are also robust when we instrument for SoP legislation with political environment variables.

We also analyze changes in the CEO pay gap, which is the difference between CEO compensation and the median value of compensation of the next top four managers. Like high absolute pay, a high CEO pay gap may reflect either excessive CEO influence or an optimal pay practice; Lazear and Rosen (1981) hypothesize that boards may wish to create “tournament incentives” to incentivize greater effort by top management. Looking at CEO pay gap instead of absolute pay also allows us to use non-CEO managerial pay as an additional, internal control for firm characteristics. We find that the CEO pay gap for firms subject to SoP laws is 11% lower than for control firms—an unintended consequence of SoP laws.

A natural question that follows is whether this decrease in pay inequality around SoP laws is for good reasons—i.e., reducing entrenched managers’ ability to expropriate wealth from shareholders as higher compensation, as in Bebchuk, Cremers, and Peyer (2011)—or for bad reasons—i.e., denying a premium for highly talented CEOs, and therefore a disincentive. We test these competing hypotheses by analyzing the effect of SoP laws on firm values, particularly for firms that allocate a large share of compensation to their CEO relative to other top executives. We find that firms with higher levels of pay inequality prior to the SoP laws experience a larger increase in firm value following the enactment of the laws. This result suggests that pay inequality decreases after the adoption of SoP laws for good reasons.

In sum, our findings support the stated objective of SoP laws—to better align executive and shareholder interests and to more closely tie compensation to firm performance, with the goal of achieving an overall positive effect on firm valuation. Our findings also suggest that managerial entrenchment and excessive CEO influence have been at least partly responsible for rising CEO pay.

The complete article is available for download here.

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