It's OK to pay well, if you write well: The effects of remuneration disclosure readability

• Author: Lynn Hodgkinson,Danial Hemmings,Gwion Williams
• Date: 01 May 2020
• DOI: http://doi.org/10.1111/jbfa.12431
• Published date: 01 May 2020

DOI: 10.1111/jbfa.12431

It’s OK to pay well, if you write well: The effects

of remuneration disclosure readability

Danial Hemmings Lynn Hodgkinson Gwion Williams

Bangor Business School, Bangor University,

Bangor, United Kingdom

Correspondence

DanialHemmings, Bangor Business School,

BangorUniversity, Hen Goleg, College Road,

Bangor,Gwynedd LL57 2DG, United Kingdom.

Email:d.hemmings@bangor.ac.uk

Abstract

We examine whether, and how, shareholders’ votes in the Say-

on-Pay (SOP) are affected by the readability of the Compensation

Discussion and Analysis (CD&A). Despite the SEC’s Plain English

requirement, qualitative disclosures on executive remunerationare

generally long and complex. Extant evidence on whether low read-

ability results in higher or lower shareholder dissent in the SOP,how-

ever,is ambiguous. We resolve this debate by demonstrating that the

effects of readability on SOP voting are heterogeneous; while obfus-

cation may reduce dissent when CEO compensation is close to “nor-

mal” levels, diminished readability results in increased scepticism

when pay levels are clearly excessive. The moderatingrole of read-

ability is most pronounced for firms with less sophisticated share-

holders, consistent with readability acting as a heuristic cue. Our

results are robust to propensity score matching, and are less pro-

nounced (1) when shareholders have less time to review the CD&A,

and (2) when shareholders are distracted by competing AGMs, sug-

gesting they are driven by readability, directly. Overall, our results

highlight that greater use of Plain English in remuneration disclo-

sures can have a substantial persuasiveimpact on shareholders.

KEYWORDS

Compensation Discussion and Analysis, Executive compensation,

Plain English, Readability,Say-on-Pay

JEL CLASSIFICATION

G34, G38, J33, M41, M48

1INTRODUCTION

Despite the SEC’s requirement that firms produce a Plain English report on executive remuneration, the typical

Compensation Discussion and Analysis (CD&A) remains complex and unengaging (Larcker,Schneider, Tayan,& Boyd,

2015). Accessible and informative disclosure in the CD&A is important as it serves as a basis for the Say-on-Pay(SOP)

shareholder vote on executive remuneration. The SOP provides shareholders a voice on whether theyapprove the

J Bus Fin Acc. 2020;47:547–586. wileyonlinelibrary.com/journal/jbfa c

2020 John Wiley & Sons Ltd 547

548 HEMMINGS ET AL.

compensation of Named Executive Officers.1With the aim of fostering shareholder engagement, the SEC encourages

firms to produce a CD&A that clearly communicates the firm’s compensation story, and which “put[s] into perspective

the numbers and narrative that follow it” (SEC, 2006, p. 29). Counter to this idea, however,the survey by Larcker et al.

(2015) of institutional investors finds that only 38% consider the typical compensation disclosure to be clear and easy

to understand.

While very few prior studies in Accounting and Finance have examined the text of remuneration disclosures

(El-Haj, Rayson, Walker,Young, & Simaki, 2019), extantevidence suggests that poor readability has ambiguous effects

on shareholder voting patterns in the SOP.For example, Hooghiemstra, Kuang, and Qin (2017) find that diminished

readability of the Directors Remuneration Report (DRR) can successfully obfuscate problematic CEO pay in the UK,

thereby leading to lower SOP dissent, on average, in the face of excessiveCEO pay. On the other hand, they find that

low readability leads to increased dissent at firms with high institutional ownership, suggesting that low readability

may,alternatively, increase scepticism regarding the appropriateness of pay arrangementsin some cases. Lo, Yang, and

Zhang (2014) report evidence of a negative relationship between CD&A readability and SOP dissent, on average, for

S&P 1500 firms, suggesting higher overall levels of scepticism accompany low readability in the US. Conversely, Bal-

sam, Boone, Liu, and Yin (2016), also using US data, do not find a significant relationship between CD&A readability

and SOP dissent, overall.

Our study contributes to this debate by demonstrating that the effect of readability on SOP dissent is contingent

on the perceived degree of excessivenessin CEO pay. Intuitively, our results indicate that low readability leads share-

holders to become increasingly sceptical of apparent CEO pay excesses,as the latter increases. The obfuscation effect

of diminished readability in reducing SOP dissent, identified by Hooghiemstra et al. (2017), appears limited to cases

where pay excesses are moderate, but gives way to increased scepticism and higher SOP dissent when CEO pay is

prima facie more clearly excessive.

The manner by which disclosure readability affects investors’ decision making has received increased attention in

recent years.For example, it has been shown that readability affects the valuation judgements of equity holders (Hsieh,

Hui, & Zhang, 2016; Hwang & Kim, 2017; Rennekamp, 2012), as well as the risk perceptions of debt holders (Bonsall

& Miller, 2017). The potential impact of corporate disclosure readability on shareholder monitoring and voting deci-

sions(i.e., shareholder “voice”), however, remains largely unexplored. Arrangementsfor executive pay is a setting where

there are incentives for managers to foster support from shareholders through strategic communication or symbolic

action. For example, evidence from “just voteno” campaigns that preceded SOP suggests that mere public displays of

shareholder dissatisfaction with pay arrangements can incentivise directors to take swift action to avoid embarrass-

ment (Del Guercio, Seery, & Woidtke, 2008), in some cases even ousting the reigning CEO (Ertimur, Ferri, & Muslu,

2011). While the SOP in the US is currently non-binding, high SOP dissent can lead to public shaming (Cai & Walkling,

2011) and enhanced external scrutiny (Ertimur,Ferri, & Oesch, 2013). The SOP can therefore provide a catalyst for

enhanced shareholder outreach and engagement.

It is generally accepted that low readability increases the costs to shareholders of collecting and processing

information (Bloomfield, 2002). Since investors’ attention is a scarce resource (Hirshleifer & Teoh, 2003), allocation

of time and effort to processing information from corporate documents may be limited when these costs outweigh

the benefits of being better informed. In the context of the SOP, retail investors,2in particular, may consider that

their vote is unlikely to be pivotal,and thus view only slight potential benefit from a thorough review of compensation

arrangements. Accordingly, small shareholders appear disinclined to engage meaningfully with the SOP unless pay

arrangements are clearly inappropriate, and tend not to vote “against” in the SOP unless executive pay is highly

excessive (Stathopoulos & Voulgaris,2016). It is reasonable, therefore, to expect that more complex CD&A may “put

1NamedExecutive Officers comprise the Chief Executive Officer, Chief Financial Officer and the next three most highly paid executives.

2Retail investors(i.e., non-institutional investors) are likely to own only a small portion of the firm, which renders many monitoring activities cost-ineffective

(see Grossman & Hart, 1980; Strickland, Wiles, & Zenner,1996). They are also likely to be less sophisticated compared with institutional (i.e., professional)

investors.

HEMMINGS ET AL.549

off” shareholders from challenging executivepay arrangements, unless they prima facie have a strong reason to believe

that pay arrangements are problematic.

Dissuading investors from extracting information may be desirable to managers when there is information that

they would prefer to keep hidden (Courtis, 1998). From the preparers’ perspective, managers maytherefore engage

in obfuscation, for example by lowering disclosure readability,when there are incentives to conceal information from

shareholders or other stakeholders, such as labour unions (Frantz, Instefjord, & Walker, 2013). Managers’ intent may

evenbe “to leave readers confused and to put them off probing further” (Merkl-Davies & Brennan, 2007, p. 127). Laksmana,

Tietz, and Yang (2012) find evidence of obfuscation when CD&A were first introduced; however, they argue further

that “heightened public scrutiny and regulatory oversight” (Laksmana et al., 2012, p. 201) resulted in the disappearance

of this effect from as early as the second year of the CD&A, suggesting deliberate obfuscation of the CD&A to be

unsuccessful.

In contrast to the obfuscation hypothesis, it is well documented in the Psychology literature that processing flu-

ency (the ease with which information is gathered and processed) tends to positively affect perceptions of authors’

credibility (Rennekamp, 2012). A difficult to read CD&A may thus intensify shareholders’ suspicions that compen-

sation arrangements are inappropriate, and that they cannot rely on the firm to act in their interest (Hwang &

Kim, 2017). The processing fluency heuristic has been shown to affect investors’ valuation decisions. For exam-

ple, Rennekamp (2012) provides experimental evidence that investors weigh information more heavily within val-

uation judgements when presented in plainer English. Consistently, Hwang and Kim (2017) find that closed-end

funds trade at a greater discount to their fundamental value when they produce less readable reports, and argue

that the perceived value of delegated management is lower when they make disclosures that are difficult to

read.

The obfuscation and processing fluency effects of low disclosure readability are related, yet contradictory effects.

Both obfuscation and processing fluency effects derive from the notion that low readability makes it more difficult

for readers to extract the information content from disclosures. Yet,while the obfuscation hypothesis predicts that

low readability makes shareholders less likely to challenge management, the processing fluency hypothesis suggests

that low readability increases suspicion, and therefore shareholders will be more likely to challenge management as

a result. We attempt to disentangle these effects by arguing that readability effects are likely to be heterogeneous,

and depend on whether shareholders prima facie consider executivepay levels to be problematic, and have therefore a

more pressing need for adequate justification. Specifically,we expect the obfuscation effect of low readability in reduc-

ing SOP dissent is more likely to dominate when CEO pay otherwise appears in line with benchmarks. When CEO pay

is clearly excessive (e.g., well above the sector average), shareholders’ default position is to challenge management,

unless the CD&A tells a convincing “compensation story”—i.e., low readability hinders shareholders’ discovery of an

adequate justification.

We isolate CD&A text from 2,686 proxy statements of S&P 1500 firms holding a SOP vote on compensation

awarded between fiscal years 2010 and 2014, and measure readability using the Bog Index(following Bonsall, Leone,

Miller,& Rennekamp, 2017), as well as the Gunning-Fog Index. We observe that the readability of the typical CD&A is

verylow; on average, Bog is estimated at 96.5, which indicates “poor” readability according to the index; we estimate Fog

to be 23.6 on average, which suggests that 23.6 yearsof formal education are required in order to be able to compre-

hend the typical CD&A on first reading. Our main results indicate that CD&A readability plays a significant moderating

role on the link between CEO excesscompensation (Excess comp) and SOP dissent, consistent with the processing flu-

ency effect of low readability dominating over the obfuscation effect at high levelsof Excess comp. Specifically, we find

that the conditional incremental probability of receiving a high levelof dissent (>30% votes cast “against”) given Excess

comp, is significantly higher for firms with a High Bog or High Fog CD&A (greater than median Bog or Fog). The economic

significance of this result appears substantial. We estimate the probabilityof high dissent for a firm with Excess comp of

two standard deviationsabove the mean to be 27.5% when CD&A Bog is high, compared to 17.8% when low; and 33.9%

(13.8%) when Fog is high (low). We also find the results are more pronounced for firms with low institutional ownership

which is consistent with heuristic processing.