Compensation

SEC Reforms and Executive Pay

WITH AN ECONOMIC SLOWDOWN under way this year, fat executive pay packages are once again coming under tough scrutiny. Of course, the hue and cry about overpaid chief executives really started a decade ago. The protestations triggered Securities and Exchange Commission reforms that required companies to prominently disclose executive compensation details that previously had been buried in the fine print of shareholder proxy statements. As a result, the particulars on how much top executives make are now readily available for all to see. The new regulations, adopted in 1992, also permitted shareholders to put executive pay to a vote for the first time.

The SEC’s aim was to empower stockholders and bring CEO salaries in line with company performance. But did it? Recent research conducted by Karen Nelson, an assistant professor of accounting at the Business School, reveals that investors viewed the change in proxy laws as more a hindrance to business than a tool to keep salaries in line.

Nelson’s study looks at the effects of the proxy reforms in two ways. First, it examines the stock market’s reaction to the regulatory changes as they were announced and implemented. Second, it looks at compensation proxy proposals and votes between 1992 and 1995 at 64 corporations. Through this two-part study, Nelson and her coauthors, Marilyn F. Johnson, associate professor of accounting at Michigan State University’s Eli Broad College of Business, and Margaret B. Shackell, assistant professor of accountancy at the University of Notre Dame’s Mendoza College of Business, determined that the stock market had a negative reaction to the SEC changes. They also found that the proxy reforms increased political pressure on firms regarding executive compensation—but not necessarily at the firms where executive pay was most at odds with company performance. “The idea was that investors would be able to take the proxy, see how executive performance was stacking up and look at their compensation, and say, ‘OK, is this in line?’” says Nelson.

To achieve this goal, the SEC made two main changes to its regulations. First, the SEC required companies to more prominently disclose in corporate financial statements the compensation, including a dollar value on stock options, of their five highest-paid employees. The second change transformed proxy bylaws so that any shareholder with either $2,000 worth of shares or 1 percent of a company’s stock could submit a proxy on executive compensation packages. Prior to this regulatory change, determining executive compensation was considered “ordinary business” and not subject to shareholder voting.

One probable reason for the market’s negative reaction to the proxy reform, Nelson says, was the likelihood of small, unsophisticated shareholders putting forth proposals that made poor business and strategic sense. For example, a proxy at BellSouth by a small shareholder proposed that the CEO’s compensation be limited to no more than two times what the president of the United States makes on the grounds that no corporation is more complex than the United States. While BellSouth responded that it was not practical to set an arbitrary salary level well below that of market level, the proxy still received 15 percent of the vote. “The downside is that it brings out of the woodwork all of these investors who have a political agenda, who have a personal agenda, and who don’t understand how compensation should be set,” says Nelson. “In particular, it brings out people who are focusing solely on pay levels or levels of pay for performance.”

While the SEC reforms did increase political pressure on firms regarding executive compensation, the companies that received the most shareholder proposals on the matter were not the ones where executive pay was most out of whack with company performance, but those that were politically visible, says Nelson.

However, Nelson also found that the actual votes on compensation proxies did reflect whether executive compensation was in line with the company’s performance. Nelson notes that while small, unsophisticated stockholders can put forth proxies, it is the large institutional stockholders who tend to decide the vote.

—Margaret Young

An Empirical Analysis of the SEC’s 1992 Proxy Reforms on Executive Compensation, Karen Nelson, Marilyn F. Johnson, and Margaret B. Shackell, GSB Research Paper #1679, February 2001