Does Pay Activism Pay Off for Shareholders? Shareholder Democracy and its Discontents

Abstract

We examine the consequences of pay activism (shareholder democracy) in a model where some forms of compensation (discretionary pay) are unrelated to performance, yet maximize shareholder welfare. Pay is set by a board that can either be aligned with shareholders or with management. This board is armed with multi-dimensional precise information regarding both managerial preferences and the firm’s investment opportunity set while shareholders only receive imprecise signals regarding the firm’s prospects. A shareholder oriented board sets corporate investment policy and discretionary pay to maximize shareholder payoff. A manager oriented board can uses pay and investment policy to enrich management. This causes shareholders, who are uninformed about board type, to view the use of discretionary pay with a degree of “suspicion.” Relative to a charter-based pay policy that either insulates boards from shareholder scrutiny, or imposes ex ante restrictions on discretionary pay, democracy has the advantage that shareholder suspicion, which incorporates their information from a non-verifiable and non-contractible signals, imposes signal-contingent restrictions on compensation policy. However, shareholder suspicion and the threat of sanctions also cause boards to further distort pay and investment policy to reduce suspicion. Simulations over our parameter space suggest that ex ante shareholder welfare is higher under democracy relative to charter-based policy for only 2.29% of the parameter draws.