The Paradox of Executive Compensation Regulation
44 Journal of Corporation Law (2019 Forthcoming)
41 Pages Posted: 13 Sep 2018 Last revised: 22 Feb 2019
Date Written: September 4, 2018
Two distinct and competing normative objectives lie behind policies aimed at regulating executive compensation. One seeks to align executive pay with company performance, a commitment held widely by specialists in law and financial economics. The second seeks to regulate the magnitude of compensation to ensure that no one is paid “too much.” Both share the goal of altering the status quo, and for that reason they often make uneasy allies in legislative reform efforts. These approaches often result in legislative schizophrenia, with different provisions sitting uncomfortably next to each other.
The Dodd-Frank Act exemplifies this dynamic. On the one hand, the Act includes provisions designed to push pay into greater alignment with performance by requiring firms to clearly disclose the pay-performance relationship and also hold periodic votes on compensation. On the other hand, Dodd-Frank also mandated a so-called pay ratio disclosure, which requires that each public company disclose the ratio of its CEO’s pay to the pay of its median employee.
Through a series of psychological experiments, we demonstrate that the pay ratio disclosure undermines the policy goal of aligning pay with performance. Our study focuses on how non-specialists think about executive compensation. Lay attitudes are of interest for two reasons. First, lay persons may differ dramatically from law and finance specialists in how they analyze executive compensation. We find that lay persons are largely indifferent to firm performance in evaluating executive compensation. Second, the views of lay persons shape policy because politicians will be responsive to public opinion, not specialist opinion, particularly on matters of high salience. Lay attitudes, in other words, affect the substantive governance obligations, at least at the federal level. Whatever attention laypersons devote to performance vanishes when they are presented with the median pay ratio. Their level of anger—the extent to which they desire that someone “do something” about executive compensation—is determined exclusively by absolute levels of pay and by the median pay ratio disclosure, not by firm performance.
This brings into view a paradox of executive compensation regulation: Neither reform movement can succeed legislatively without the other, yet they may work at cross-purposes with each other. We offer a preliminary exploration of some implications of these findings for corporate governance reform.
Keywords: executive compensation, corporate law, Dodd-Frank, empirical study
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