Market Reactions to the Regulation of Executive Compensation

Abstract

This paper investigates equity market reactions to the regulation of executive compensation. We exploit a natural experimental setting in Germany, where recent legislation introduces restrictions on the relative amount and on the components of board executive compensation packages, and invokes liability for the supervisory board in case of inappropriate remuneration arrangements. We use this exogenous shock to the contracting environment to infer market perceptions of the usefulness of the regulation. Using event study methodology, we investigate market reactions for the first-time announcement of regulatory intent and for a pooled sample of seven events leading to the adoption of the law act. We find weak evidence of an average negative market reaction to the proposed regulation. Multivariate analyses reveal that firms which were particularly affected by the regulation because board members received high abnormal remuneration on average experienced larger stock price discounts. Consistent with this, we find a positive relation between pay-performance sensitivity and the equity market reaction. Taken together, these findings indicate that the regulation was not considered beneficial from a shareholder perspective. This result is consistent with the market perceiving the regulation of executive compensation to impose potentially inefficient contractual arrangements for some firms.