Should the CEO Pay Ratio be Regulated?

• Author: Anginer, Deniz

1. INTRODUCTION 472 II. CEO COMPENSATION IN THE UNITED STATES 474 III. REGULATIONS IN CONNECTION WITH EXECUTIVE COMPENSATION 477 IN THE UNITED STATES A. SEC Regulations Prior to the 2008 Financial Crisis 477 B. Regulations Post-Financial Crisis 479 IV. CONTROVERSY SURROUNDING DISCLOSURE RULES ON EXECUTIVE 480 COMPENSATION V. DETERMINANTS OF CEO COMPENSATION 482 A. Setting of Executive Wages 482 B. The Human Resource Perspective and CEO Value 484 C. CEO Power and Board Capture Theory 486 D. Tournament Theory 489 E. Optimal Contract Theory 489 F. Costs Incurred by Terminated CEOs 490 VI. INTERNATIONAL PAY GAP COMPARISON AMONG U.S. AND 490 WESTERN EUROPEAN COUNTRIES A. Compensation Structure: Stock Options 490 B. Monitoring and Ownership Concentration 493 C. Market Forces and the International CEO Pay Gap 494 D. Slow Growth in Worker Compensation 497 E. Cultural Differences and Distributive Fairness 498 VII. OUR EMPIRICAL STUDY: NEW EVIDENCE REGARDING THE COSTS 499 IMPOSED BY THE CEO PAY RATIO A. Data 499 B. Empirical Results 503 VIII. POLICY IMPLICATIONS AND CONCLUSIONS 514 I. INTRODUCTION

   In an apparent effort to limit the escalation of executive compensation through tax policy, the federal government limits the deductibility of nonperformance compensation of the CEO, CFO, and the other three most highly paid executives. Section 162(m) of the Internal Revenue Code prohibits the deduction of more than one million dollars in nonperformance compensation per year for each of these executives. (1) In a further effort to seemingly discourage wide compensation gaps among executives and other employees, recent legislation requires the disclosure of a detailed relative executive compensation measure. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), (2) enacted after the 2008 financial crisis, requires all publicly listed firms to disclose a pay ratio of annual CEO compensation to the median employee compensation (Pay Ratio). (3) Does the federal government have a legitimate interest in attempting to rein in the gap between CEO compensation and that of the median employee through disclosures? One question that should be answered is whether high levels of relative CEO pay harm shareholder interests. This is the question we address in this Article.

   Prior to the Dodd-Frank Act, public corporations were required to disclose only CEO compensation and the compensation of the four other most highly compensated officers. (4) To compute relative CEO compensation, researchers computed the CEO Pay Slice (CPS or Pay Slice), which is the ratio of the CEO's pay to the top five officers' compensation. (5) Opponents of the Dodd-Frank legislation have argued that also requiring disclosure of the Pay Ratio would simply add to the costs of compliance without providing any new information to the market over and above the CPS. (6)

   Growing CEo power is an important corporate governance and public policy question. What is less clear is whether increasing CEo power benefits or harms shareholder interests. in this Article, we investigate the information content of the CEo Pay Ratio in revealing the degree and costs of CEo power. We also compare and contrast our results with the CPS to determine whether the Pay Ratio provides any further information to shareholders than is already available in the CPS.

   The logic of the Dodd-Frank Act suggests that it is more difficult to manipulate the level and variability of the Pay Ratio than the Pay Slice. That is, manipulating the Pay Ratio would require changing the median worker compensation, which is presumably more difficult than simply making adjustments to the salaries of the top four most highly compensated officers. Nevertheless, whether the newly mandated Pay Ratio disclosure provides any new information to the market regarding the level and consequences of CEO power is an empirical question, and the one we analyze in this study.

   Using a sample of hand collected data, we analyze the relation among the Pay Ratio, the Pay Slice, and the determinants and consequences of CEO power. We find that both the Pay Ratio and the Pay Slice are related to measures of CEO power. Importantly, they both remain significant when examined jointly. Hence, contrary to the claims of the opponents of the Dodd-Frank Act, the marginal explanatory power of the Pay Ratio is not subsumed by the CPS. This finding tells us that Pay Ratio provides new and additional information over and above the CPS.

   Most interestingly however, we also examine the consequences of CEO power using both variables. Here we find that the Pay Ratio is more informative about the agency costs excessive CEO power imposes on shareholders. Specifically, we find that the cost of capital increases significantly as CEO power, as measured by the Pay Ratio, increases. Furthermore, the Pay Ratio dominates and eliminates the information content of the CPS as an explanatory variable for the cost of capital. Our finding indicates that to understand the costs imposed upon shareholders by excessive CEO power, we also need to pay attention to the Pay Ratio. This finding further undermines the assertions of the Dodd-Frank opponents that the Pay Ratio disclosure is simply unnecessary and onerous for public corporations.

   The remainder of this Article is organized as follows. in Part ii, we discuss the evolution of CEO compensation. Part III analyzes various regulations regarding promoting disclosure of executive compensation in the United States followed in Part IV with a discussion of the debates surrounding whether disclosure of CEO pay should be mandated. Part V then addresses potential determinants of CEO compensation, while Part VI describes various theories for the contrasting difference in the Pay Ratio between the U.S. and Western Europe. We then provide, in Part Vii, empirical evidence that the Pay Ratio correlates with increases in the cost of capital for firms and dominates the CPS. Finally, in Part VIII we discuss policy implications and conclude.

2. CEO COMPENSATION IN THE UNITED STATES

   There is no denying the discrepancy between the pay of the CEO and the average worker in the United States. In 2017, "the average CEO of the 350 largest firms in the U.S. received $18.9 million in compensation" representing a "CEO-to-worker compensation ratio of 312-to-1." (7) That ratio was "far greater than the 20-to-1 ratio in 1965 and more than five times greater than the 58-to-1 ratio in 1989 (although it was lower than the peak ratio of 344-to-1, reached in 2000)." (8) To compare, in Europe the CEO-to-worker ratio is about 25-to-1. (9)

   The pay discrepancy is especially prevalent for larger companies. (10) In 2018, the ratio for companies with a market capitalization (cap) above $25 billion was 213-to-1, but it dropped to only 32-to-1 for companies with a market cap below one billion dollars. (11) Similarly, companies with more employees tend to have lower average pay and a higher pay ratio. (12) The highest discrepancy of the Russell 3000 companies was Weight Watchers International Inc., which had a ratio of 5908-to-1 with the CEO'S compensation in 2017 at "$35,524,002 while Weight Watchers' median employee received $6,013." (13)

   These numbers may be even higher than those ratios suggest. In many cases, such as with the Weight Watchers example above, a large portion of the compensation CEOS receive comes in the form of stock options. (14) These stock options, when computing compensation, are valued at the time they were granted. (15) If the stock price increases before the CEO exercises the options, that value is not included in the compensation calculation. (16) Furthermore, in addition to their base pay and stock options, CEOS and executives often receive golden parachutes, which can pay departing executives millions of dollars, regardless of the reason for their departure. (17) In 2013, the average golden parachute for a CEO who was forced out of the job was $48 million. (18)

   While CEO compensation has been increasingly connected to stock options, the growth in CEO compensation is not simply a result of increases in stock prices. Rather, "[t]he growth in CEO compensation also outstripped the returns of shareholders: CEO pay growth has doubled the rise of the S&P Index over the past thirty years." (19) Furthermore, CEOs and other executives now retain more of the largest companies' profits. (20)

   Unsurprisingly, the public response to high CEO pay has been harsh. (21) In 2011, the Occupy Wall Street movement began with a single blog post and ballooned into an international movement with protests in "951 cities in some 82 countries." (22) Although the movement ultimately faded, terms like the " 1%" and the "99%" are engrained in American culture, and the public opinion of CEO pay remains low. According to a Stanford University nationwide survey, "[t]he vast majority (74 percent) of Americans believe that CEOs are not paid the correct amount relative to the average worker." (25) This is true, despite the respondents in the survey "grossly underestimating] how much CEOs make." (26) Although "[t]he typical American believes a CEO earns $1.0 million in pay," the "median reported compensation for the CEOs of these companies is approximately $10.3 million." (27) The distaste with high CEO pay does not mean that Americans would support regulation curtailing CEO pay, however. A study by the Cato Institute found that 73% of Americans believe that CEOs are paid "too much," with 56% of Democrats and 40% of Republicans believing that CEOs are not just overpaid, but that they are paid "far too much." (28) Despite this, the same study found that Americans are hesitant to support regulation of CEO pay. (29) Only 43% of respondents supported regulating the salaries of CEOs and nearly three-fourths of Americans "believe regulations often fail to have their intended effect." (30) More telling, 62% of respondents believed that regulations...