Firms’ Inattention in the Compensation Design Process: Evidence from the SEC Enforcement Releases

Abstract

I show that firms exhibit limited attention when designing their CEO compensation. Using Fortune 500 firms subject to SEC Accounting and Auditing Enforcement Releases (AAERs) between 1999 and 2013, I find that explicit mention of compensation issues (compensation-mentioning releases or CMRs) only affects subsequent compensation design at peer firms. CMRs lead to significant declines in CEO pay-for-performance sensitivity (i.e., delta), risk-taking incentives (i.e., vega), and excessive portfolio incentives in peer firms compared to non-peer firms. Such declines are more pronounced in peer firms with a more similar compensation design to those of the accused firms. I document that peer firms adjust their compensation design to avoid the SEC's attention and to reduce misreporting risk. My results further suggest that the AAERs, although focusing on financial reporting violations, can influence corporate compensation policy.

Keywords: SEC enforcement actions; compensation design; limited attention; peer effects

JEL Classification: J33, M41, M52, G38