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E-MailDiane K. Denis is Terrence Laughlin Chair in Finance and Professor of Business Administration at the University of Pittsburgh Katz School of Business; Torsten Jochem is Assistant Professor in Finance at the University of Amsterdam Business School; and Anjana Rajamani is Assistant Professor of Finance at Erasmus University Rotterdam School of Management. This post is based on their recent article, forthcoming in the Review of Financial Studies. Related research from the Program on Corporate Governance includes the book Pay without Performance: The Unfulfilled Promise of Executive Compensation, by Lucian Bebchuk and Jesse Fried.
Growth in institutional ownership and activism combined with regulatory changes have led shareholders to play an increasingly important role in the governance of U.S. public firms. While a well-developed literature provides evidence on the direct effects of shareholder governance actions on the firms that are subject to them, there is scant evidence to date on the indirect effects for firms that are peers of the subject firms.
In our article, Shareholder Governance and CEO Compensation: The Peer Effects of Say on Pay, forthcoming in the Review of Financial Studies, we provide evidence on the spillover effects of say on pay voting. We document that firms undertake relative reductions in CEO compensation following their compensation peers’ weak say on pay votes. We define a weak say on pay vote as shareholder support in the bottom decile of Russell 3000 firms (less than 72.5%). We label firms that have weak-vote peers but do not themselves experience a weak vote as primary firms; they are the focus of our analysis. Firms that have neither a weak say on pay vote nor compensation peers that experience weak votes are our control firms. Changes in the CEO compensation of control firms serve as the counterfactual compensation change to which we compare the primary firm compensation changes.
Our 2009-2014 sample period includes the first two years of mandatory say on pay voting (2011 and 2012), as well as two pre- and two post-event years. We use a difference-in-differences setup to analyze how primary firms change CEO pay relative to control firms in the aftermath of their peers’ weak votes. We find that primary firms pay their CEOs significantly more than control firms do in the two years prior to their compensation peers’ weak say on pay votes, and significantly reduce relative CEO compensation in the two years after those votes. In particular, primary firm CEO pay declines by 10.1% (or $476,300 for the average sample firm) relative to the pay of control firms, thereby eliminating the pre-vote compensation difference between them.
We find evidence consistent with two channels through which these relative pay changes occur. The first is a learning channel, in which peers’ weak votes provide primary firm boards with information that is relevant to the pay design for their own CEOs. We find that primary firm pay changes reflect proxy advisers’ concerns about their peers’ compensation contracts. In addition, pay changes are greater when their weak-vote peers exhibit above-median performance. This suggests that primary firms reduce CEO pay when peers’ weak say on pay votes are more likely to reflect shareholder concerns regarding pay design rather than discontent with peers’ general firm performance. Pay spillovers are also larger when primary firms compete more closely in the executive labor market with their weak-vote peers; i.e. when peer pay is most likely to be a relevant benchmark. Labor market considerations also play a moderating role as primary firms’ boards make fewer pay reductions when their CEOs have more outside options. This suggests that compensation committees are not only assessing the information content of their peers’ votes but also deliberating the potential consequences of their pay decisions. Collectively, these findings suggest that relative reductions in the pay of primary firm CEOs are a response to the information contained in their peers’ weak say on pay votes.
The second channel is a compensation targeting channel. Many firms target a specific range or percentile of their peers’ pay levels when setting their own CEO compensation. Hence, when peers reduce compensation following their own weak votes, this affects the primary firms’ relative positions in the pay distribution of their compensation peers. We find that primary firms’ compensation changes are proportional to those needed to retain their relative positions in their respective peer groups. Further, using the differences in primary and weak-vote firms’ fiscal year ends, we find that primary firm reductions are more likely to occur after peers’ staggered disclosures of revised pay. This suggests that primary firm compensation changes are responses to peers’ revised pay, as well as to the information contained in peers’ weak votes.
Our evidence suggests that compensation consultants play a role in transmitting information about peers’ weak votes and compensation changes to primary firms. We explore the types of information that consultants provide to their client firms by reading the CD&A sections of primary firms’ proxy statements and by conducting a survey of the compensation consultants employed by the primary firms. The information we collect suggests that compensation consultants frequently provide their clients with information about peers’ compensation and the results of peers’ say on pay votes. We also explore the possibility that primary firm boards reduce relative compensation because their shareholders pressure them to do so but find no such evidence using various measures that are likely to relate to potential shareholder pressure.
Our findings have three implications:
- The peer effects of shareholder governance are more nuanced and widespread than previously thought. Prior evidence indicates that firms respond to such large-scale governance actions as hedge fund targeting and mergers. Our evidence indicates that firms also respond to dissatisfaction expressed by peers’ shareholders through votes that occur regularly in the normal course of firm activities.
- Weak say on pay votes affect compensation in a much broader set of firms than previously thought. Shareholder support in say on pay votes overall is usually quite strong, with median support rates of 95% during our sample period. Thus, if weak say on pay votes affect compensation only for the relatively small set of firms that experience such votes, the overall effects of say on pay would arguably be limited. Proactive pay changes among peer firms may help explain the relatively low frequency of weak say on pay votes.
- Compensation benchmarking reflects labor market competition. Boards respond to negative information about the compensation of highly paid peer CEOs by reducing relative CEO compensation. It is unlikely that agency-related compensation benchmarking would lead primary firms to decrease relative CEO pay.
The complete article is available for download here.
