Behavioral Implications of the CEO-Employee Pay Ratio

Lynne L. Dallas is Professor of Law at University of San Diego School of Law. This post is based on Professor Dallas’ recent comment letter submitted to the SEC, available here.

On February 6, 2017 the Securities and Exchange Commission requested comments on further delay in implementing Section 953(b) of the Dodd-Frank Act that requires disclosure of CEO-employee pay ratios by public companies. This request should be analyzed in the context of a law that has been on the books almost seven years and has already been the subject of extensive public comments and SEC releases. Moreover, the SEC has granted to public companies considerable flexibility in calculating their ratios. These companies have substantial capabilities with today’s technology to collect and analyze data.

The request for further delay in this context seems symptomatic of a perception by some that the disclosure of CEO-employee pay ratios is not material to investors. For example, the SEC’s main reason for the considerable flexibility granted to public companies in calculating their ratios is the belief that such ratios are not meaningfully comparable across companies because companies are in different industries and have different business models. [1] This argument, however, would justify the non-disclosure of all financial information that companies are currently required to disclose, including profits. Information made available in SEC filings is often made more meaningful to investors when analyzed by analysts who control for various differences among companies. In the context of CEO-employee pay ratio studies, researchers control for such factors as industry sector, firm size, job mix, location and other factors to arrive at excess pay ratios, called the residual, that provide a basis for analysis.

Even from an intra-corporate perspective, however, the CEO-employee pay ratio is material to investors. To assist in the assessment of whether there should be further delays in implementing Section 953(b), I briefly delineate below reasons why the CEO employee pay ratio is meaningful to investors, with emphasis on behavioral implications. [2]

  • The CEO-employee pay ratio provides an internal benchmark for boards of directors in setting CEO compensation. Shareholders view this internal benchmark to be important, as demonstrated by a recent study showing a positive relationship between shareholders’ dissent on “say on pay” proposals and higher ratios. [3]
  • The CEO-employee pay ratio may indicate the degree of influence CEOs have over their boards of directors. The public disclosure of high ratios has the potential to constrain boards from deferring to their CEOs on compensation matters and encourages boards to limit excessive CEO compensation
  • High CEO-employee pay ratios also send a message to company employees that a main purpose of the company is to serve individual self-interest. As social science studies reveal, this focus on self-interest gives rise to unethical cultures within companies. Such cultures contributed to the financial scandals in the early 2000s and the financial crisis of 2008-2009. [4]
  • High CEO-employee pay ratios may also increase the likelihood of overconfidence on the part of CEOs due to the positive feedback they provide. One study explored the impact of CEO hubris on the size of acquisition premiums, using as one measure of hubris the ratio of the CEO’s pay relative to that of the second-highest paid executive in the company. This measure was viewed to be a “telling indicator of the CEO’s own sense of potency and self-esteem.” [5] The study found a positive relationship between pay ratios and the size of acquisition premiums, and a negative relationship between hubris and shareholder returns.
  • High pay disparities may activate CEOs’ economic self-conception, increasing the likelihood that they will view employees as merely short-term means to an end. Large pay disparities symbolize CEOs’ status and power, creating greater psychological distance between CEOs and lower-level employees. One study found a relationship between high CEO compensation and the callous treatment of lower-level employees, including significant employee downsizing, safety violations, poor union relations, and underfunded retirement plans. [6]
  • The relevance of pay disparities to employee motivation and behavior has been the subject of research for many years. One study addressed the issue of whether employees lower in the hierarchy care about CEO pay. This study considered pay disparities between the CEO and the top five levels of managerial employees. It found that the managerial employees were more likely to leave the firm when they were underpaid relative to the CEO and more importantly, that this effect was more pronounce for the two lowest levels of managers. The researchers gave the following explanation for this latter finding: “Perhaps overpayment of the CEO is particularly salient to those at lower levels in the organization because of the fact that their financial situation contrasts most sharply with that of the CEO. In this instance, inequity relative to the CEO may create more intense feeling of injustice.” [7]
  • Pay disparities contribute to inequality in the United States. [8] Increasing inequality is a concern for corporations and investors. It impacts consumer demand for products. While declining wages have been offset to some degree by consumer debt and workers (and their family members) working longer hours, there are limits to these strategies for creating consumer demand. Rising inequality also raises the specter of political instability that increases business risk. The polarization, anger and dissatisfaction of workers, as exhibited in the popularity of Bernie Sanders and Donald Trump in the most recent national election, are signs of significant political dissatisfaction.
  • Shareholders do not have access to pay ratios required by Section 953(b), limiting their ability to evaluate their companies. Information on lower-level employee compensation is limited. Existing databases are subject to one or more of the following problems: They provide only industry-specific information, higher-level employee compensation information, voluntarily disclosed information subject to the self-selection bias, or information on companies with lower ratios than typically found among public companies.

In summary CEO-employee pay ratios are material to investors. They provide boards of directors an internal benchmark in setting CEO pay and information relevant to shareholders in evaluating CEO pay. Their disclosure may encourage corporate boards to defer less to CEOs on compensation matters and limit excessive CEO compensation. High CEO-employee pay ratios foster unethical and problematic work cultures within companies. They lead to CEO overconfidence resulting in inappropriate risk assessments and unfortunate internal corporate dynamics. Additionally, CEO-employee pay ratios provide information on income inequality of interest to investors and corporations generally and information not heretofore available to investors.


1SEC Release No. 33-9877, No. 34-75610, Pay Ratio Disclosure, Final Rule, Aug. 5, 2015, at 12, 102-03, 209-10, In addition, it is argued that the potential for earnings manipulation is a reason for nondisclosure of the CEO-employee pay ratio. This kind of argument, however, would foreclose nearly all financial disclosures required by public companies.(go back)

2For additional information, see Lynne L. Dallas, Comment Letter, Mar. 21, 2017, .(go back)

3Steven S. Crawford, Karen K. Nelson & Brian R. Rountree, Mind the Gap: CEO‐Employee Pay Ratios and the Shareholder Say on Pay Votes, January 2016, back)

4Lynne L. Dallas, Short-Termism, the Financial Crisis, and Corporate Governance, 37 J. Corp. L. 265, 316-23, 355-61 (2012): Lynne L. Dallas, A Preliminary Inquiry into the Responsibility of Corporate Officers and Directors for Corporate Climate: The Psychology of Enron’s Demise, 35 Rutgers L. J. 1, 34-40, 45-55 (2003).(go back)

5Mathew L.A. Hayward & Donald C. Hambrick, Explaining the Premiums Paid for Large Acquisitions: Evidence of CEO Hubris, 42 Admin. Sci .Q. 103, 121 (1997).(go back)

6Sreedhari D. Desai et al., When Executives Rake in Millions: the Callous Treatment of Lower Level Employees: Meanness in Organizations (2011), at 3-4, 6-9, 11-12, back)

7James B. Wade, Charles A. Reilly III & Timothy G. Pollock, Overpaid CEOs and Underpaid Managers: Fairness and Executive Compensation, 17 Org. Sci. 527, 540 (2006).(go back)

8E.g., Jonathan L. Willis & Julie Wroblewski, What Happened to the Gain from Strong Productivity Growth, Fed. Reserve Econ. Rev. 1, 20 (2007).(go back)

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