Executive compensation took a brief dip in the wake of the recession from 2008-2009, but CEO pay may already be on the rebound. A recent New York Times study showed the median salary for top executives at 200 of the largest U.S. firms rose to $10.8 million in 2010, a 23 percent gain from the previous year. But the fact that executives’ pay is on the rise doesn’t mean that shareholders are necessarily satisfied with their performance.
There are rules that govern how companies report compensation packages for their top executives. New research suggests that when firms fail to comply with these disclosure requirements, there is a good chance that they are deliberately attempting to conceal damaging information.
The public can access information about executive pay through corporate filings, and regulators have taken steps in recent years to make these data more transparent and accessible. But McCombs School of Business Assistant Professor Yong Yu says that despite stricter regulations, shareholders still are not getting the information they need to call for changes to compensation packages.
Deciding to Break the Rules
Companies in the U.S. are required to report their executives’ compensation and other information in their annual proxy statements. In 2006, the Securities and Exchange Commission overhauled its executive compensation disclosure rules to require much more detailed disclosures in an effort to help investors better understand and monitor compensation practices.
The SEC’s goal in the 2006 rule change, Yu says, was to make shareholders more aware of how their investments are being managed. If they feel the CEO is overpaid, they can put pressure on the firm to reduce the compensation; at least, that’s how it’s supposed to work.
However, shortly after the new rules took effect, an SEC focused study revealed that many firms were not providing all of the required information about their CEOs’ compensation packages. SEC experts examined the filings of about 350 large companies and found that few of them fully complied with all the new rules. Yu and his co-authors randomly selected 50 firms not included in the SEC study and observed very similar results.
Yu says that while the new regulations are complex and firms claim the reporting defects were honest mistakes, his research suggests it is more likely that the companies made strategic choices in deciding to not to reveal certain information about CEO compensation.
“Both our findings and the SEC's reviews suggest that it’s not because the companies don’t understand the rules,” Yu says. ”They understand the rules pretty well, but they refuse to comply.”
The researchers — Yu, McCombs Professor John Robinson, and Yanfeng Xue of George Washington University — also discovered evidence that firms that had previously been criticized in the press for overpaying their CEOs were more likely to have defects in their disclosures.
The study reports, “Although this result must be interpreted cautiously, it suggests that managers respond to public criticism of CEO compensation by withholding mandated compensation information.”
What’s more, Yu and his co-authors observed that firms continued to overpay their CEOs even after being exposed by the SEC for defective disclosures — and even after the executives’ real compensation figures were made public.
“We find no evidence whatsoever of a decrease in compensation,” Yu says. “Even when it’s made public, and people figure out they got paid too much, they do not appear to be afraid or ashamed to keep receiving that kind of compensation.”
How Much Compensation is Too Much?
While it might seem subjective to determine the point at which a CEO is given “too much” compensation, Yu’s team defined fair compensation in terms of how well the company performed under the executive’s leadership and how difficult it was to manage the company. More specifically, the excessive compensation is the part of a CEO's compensation that cannot be justified by performance, firm size, tenure, operating complexity, or industry.
“It’s performance-adjusted,” he says. “For a CEO, the pay has to be justified by performance. So we look at how much money you make for your shareholders — both the return performance and accounting performance. If you compare two peer companies — let’s say Pepsi and Coke — if they pretty much have a similar performance, the CEOs should be paid similarly. But if one CEO, given the performance, was paid too much relative to the other, that part of the pay is not justified.”
Paying a Price for Transparency?
The firms identified by the SEC often justified their nondisclosure by contending that disclosing certain compensation information, such as performance targets, would put them at risk of revealing trade secrets to competitors, potentially resulting in financial losses in the form of proprietary costs.
“The companies come back saying, ‘We can’t make those disclosures, because if we tell you our performance benchmarks, our competitors will use that information to figure out our strategic moves and attack us,’” Yu says.
But the researchers found that the argument that the firms avoided proprietary costs by omitting information from the reports did not hold up.
“We find no evidence to suggest that there is a link between the noncompliance and the trade secrets or proprietary costs,” Yu says. “We find no support for the managers’ justifications, and we confirm the concerns of the regulators.”
Yu describes his study as an attempt to explore whether the firms that broke the rules were acting on a legitimate concern that disclosure would put their trade secrets at risk, or whether they were primarily trying to conceal CEO overcompensation.
“We find robust evidence that, at the companies that refuse to comply with the rules, the CEOs are likely to be overpaid,” he says. “They get sweet deals, and those kinds of firms are most likely to not comply.”
Yu believes his study will validate shareholders’ frustrations and demonstrate a need for better tools to make their voices heard when they believe CEOs are over-compensated.
“The key is that you have to give the shareholders the power to monitor executive compensation, like the right to vote on the CEO’s compensation or on the board of directors,” he says.
Congress has made efforts to do just that: Passed in July 2010, the Dodd–Frank Wall Street Reform and Consumer Protection Act grants shareholders the right to call for a vote when they believe executives are being compensated too generously. But there is some evidence that the so-called “say-on-pay” policy does not have enough teeth to make a significant impact. Out of 1,998 companies that have conducted their annual meetings this year, shareholders have only passed successful dissenting votes at 32 firms.
“If they know the information but they can do nothing about it, then you’ll find what we find — that there’s no change,” Yu says.