The Paradox of Executive Compensation Regulation.

• Author: Myers, Minor

1. Introduction 756 II. The Pay Ratio Discloure and Academic Debates Over Executive Compensation 758 A. The Academic Debate Over Executive Compensation 758 B. The Pay Ratio Disclosure 760 C. The Critique of the Pay Ratio Disclosure 762 D. The Demand for the Pay Ratio Disclosure 763 III. An Experimental Examination of the Pay Ratio Disclosure 764 A. Experiment 1: Pay & Performance 764 1. Methods and Rationale 764 a. Hypotheses 768 2. Results and Discussion 769 a. Preliminary Analyses 769 b. Main Analysis I: Pay vs. Performance 770 c. Main Analysis II: Robustness Tests 773 3. Summation and Follow-Up Experiment: Public v. Private 776 B. Experiment 2: The Median Pay Ratio 778 1. Methods 779 2. Results & Summation 780 a. Preliminary Analyses 780 b. Main Analysis I: Pay, Performance, & the Median Ratio 780 c. Main Analysis II: Robustness Tests 781 d. Secondary Analysis: Demographic Interaction Models 784 IV. Implications of the Results 785 A. The Mixed Effect of Dodd-Frank 785 B. The Paradox of Executive Compensation Regulation 786 C. Debating the Normative Goals of Regulating Executive Compensation 787 V. Conclusion 788 I. INTRODUCTION

   Executive compensation stands apart from the dreary other topics in corporate law. It is a perennial flashpoint in American politics and a constant--and elusive--target of public regulation. Two broad normative critiques fuel this dogged focus on executive pay, one focused on financial incentives, and the other on progressive morality. These two camps make common cause in regulating executive compensation because they share the belief that the status quo is defective. Their regulatory ambitions have been regarded as compatible, if not complementary. But in this Article we demonstrate that the policies that flow from these two critiques work at cross-purposes, revealing a paradox in the regulation of executive compensation.

   The two schools of thought on executive compensation reform are starkly different. The first takes as its touchstone that executive pay should be aligned with performance. Pay practices can and should be used to promote the interests of stockholders in controlling the agency costs at public firms. CEOs whose companies perform well should be paid handsomely, and those whose companies falter should earn less. The absolute level of pay is not relevant. The second critique of executive compensation is rooted in economic justice: absolute levels of CEO pay are obscenely high and should be curbed through regulation.

   The fingerprints of both approaches are evident in the regulatory mandates of Dodd-Frank. Two of its corporate governance provisions require that firms disclose information on the linkage between pay and performance and, also, that firms hold stockholder votes on executive compensation. (1) These policies are products of the agency costs tradition.

   A different part of Dodd-Frank--section 953(b)--requires a disclosure that has attracted an enormous amount of attention. This is the so-called median pay ratio disclosure requirement, forcing companies to compute and disclose the ratio of the CEO's total compensation to the compensation of the firm's median employee. This disclosure requirement has provoked the ire of business groups, (2) and the House of Representatives has introduced legislation to repeal it three times. (3) After years of turmoil at the SEC, the rules went into effect only in the 2018 proxy season--eight years after the passage of Dodd-Frank. The criticism of section 953(b) has focused on its high costs--the SEC estimated issuers would spend $1.3 billion to collect and analyze the data necessary to compute the ratio--while the information disclosed is not obviously useful to investors. The SEC itself had trouble identifying intended benefits from the provision. (4)

   The objective behind section 953(b) is not difficult to discern, however. It has nothing to do with aiding investors, and this is perhaps why it provokes so much controversy. As its supporters have acknowledged, section 953(b) is designed to shame companies that pay their CEOs "too much" and their line employees "too little." (5) The resulting ratio is sensational, and the intended effect is to constrain absolute levels of compensation.

   Section 953(b) is a product of the social justice critique and has no connection to the extensive literature on executive compensation in law and finance. Among scholars of law and finance, the debate is principally over how best to promote stockholder welfare through executive compensation and which among competing proposals best fulfills that goal. The arguments behind section 953(b) are the kind that come chiefly from progressive policy reformers and labor activists, and financial economists and corporate law scholars have little to say on the topic.

   The disjunction between section 953(b) and academic opinion in law and finance on executive compensation offers a unique opportunity to examine how laypeople think about compensation and its regulation. Lay opinion is interesting for two reasons. First, lay opinion may differ substantially from specialist opinion on executive compensation. In particular, we hypothesize that laypeople do not care about performance but instead are sensitive to absolute pay levels. A focus on absolute levels of compensation is a common theme in news coverage and editorials, and decrying the pay of public company CEOs is an issue that commands bipartisan support. (6)

   Second, lay opinion is important because it shapes the preferences of elected officials. Executive compensation is unique among corporate law topics in that it is highly salient. Thus, lay opinion will be especially influential in determining how elected policymakers approach the issue. Lay opinion shapes public regulation, and public regulation-particularly at the federal level--lays an increasingly heavy hand on the governance of public companies.

   In this Article, we report on psychological experiments designed to gauge how laypersons think about executive compensation and how section 953(b) may influence their analysis. We find laypeople are not sensitive to performance in their reactions to compensation information. When presented with the median pay ratio as required by section 953(b), the effect of performance disappears altogether. In other words, the pay ratio disclosure crowds out any effect of performance in the reactions of laypersons.

   We reveal a paradox in the public regulation of executive compensation. The two normative objectives may in fact work at cross-purposes with each other, and yet executive compensation reform (like Dodd-Frank) may only happen when the two join forces. This suggests two direct implications. First, on the particulars of Dodd-Frank, it seems unlikely that there is an easy solution. One approach would be to repeal section 953(b), as businessoriented groups have been attempting to do. That ought to be an attractive option for the law and finance academics, as it would better promote their goal of aligning pay and performance. But that would roll back a legislative victory for the progressive reformers, who may not care about the pay-performance link and would fight to protect section 953(b).

   Another implication is the possibility of a one-way ratchet in the regulation of executive compensation. If support for the agency costs approach is as weak as our results here indicate, the prospect for reform along those lines appears starkly limited unless that reform effort is joined by the forces of progressive reform. That might mean there would only be support for aligning pay and performance on the downside--that is, only when it has the effect of limiting executive pay. Ensuring public company compensation practices are sufficiently responsive in conditions of high performance may require policies that arise in some other way, if they arise at all.

   One final implication we consider is that our findings have indicated a potential oversight by many law professors and financial economists who focus on executive compensation. In debates with each other, they may win a particular skirmish over which compensation practices best align pay with performance. But they may have lost the war over what broad normative framework to apply to executive compensation in the first place. Law professors and financial economists have devoted themselves to what amounts to an internecine debate, focused specifically on what executive compensation structure most effectively ties pay to performance. Those in that debate may be well-advised to devote at least as much attention to the question of why pay should be aligned with performance in the first place. In particular, critics of executive compensation practices from the incentive-alignment tradition should be more forceful in public debate about why politicians and voters should not care about absolute pay levels or the median pay ratio.

2. THE PAY RATIO DISCLOSURE AND ACADEMIC DEBATES OVER EXECUTIVE

   COMPENSATION

   The pay ratio disclosure in Dodd-Frank is one of the bill's most controversial provisions. The main debate in corporate governance is how best to align CEO incentives with those of shareholders, while the policy issue reflected in the pay ratio disclosure is whether to pursue such an alignment at all. Section 953(b) has attracted dedicated repeal efforts, but at the same time it has received consistent support from politicians.

   1. The Academic Debate Over Executive Compensation

      In the law and finance literature, there is an extensive debate about executive compensation at public companies. In that debate, the disagreement is over whether existing pay arrangements tie pay to performance. On one side, for example, Lucian Bebchuk and Jesse Fried argue the system of setting pay at public companies is fundamentally broken because CEOs have too much power over board members with whom they putatively negotiate. (8) CEOs wield their influence to increase their pay packages and to make...