On August 5th 2015, the Securities Exchange Commission (SEC) adopted a pay ratio disclosure rule for public companies in the United States. This new rule requires companies to disclose the ratio of the annual compensation of the Chief Executive Officer (CEO) in relation to the median of the annual total compensation of the entire company’s employees. Although the rule excludes small companies, foreign private issuers and emerging growth companies, nearly 3,600 firms will have to publish their ratio from 2018 onwards.
The CEO pay ratio has been approved by the SEC to increase transparency within companies to help investors and shareholders make decisions, especially regarding their say on pay votes to judge the pay equity of a firm. Thus shareholders get more information about a firm as well as about the firm’s pay ratio, which could influence their decisions regarding their say on pay votes. Another reason the SEC introduced the new disclosure rule is to limit the increase of CEO compensation. It is noticeable that from the late 1970s until 2013 CEO compensations rose by about 937%.
As a consequence of this new rule, companies have two options to influence the pay ratio. If it is considered to be too high, they can lower the CEO compensation or increase the wages of the employees to raise the median. These two choices can have a considerable impact on the firm’s profit. Furthermore, a high pay gap can negatively affect employee morale and the work climate of the whole company due to the pay inequity. Moreover, high pay ratios can have an adverse impact on a firm’s sales and reputation.
This new ratio is supposed to help shareholders, which is why it is important to analyse how the stock market reacted to this disclosure rule and how it has changed the shareholder’s wealth. Nevertheless, the new rule can have a few negative impacts, for example implementation costs, negative press coverage and unfavourable influence on the working morale, only to name a few of the possible
consequences. However, transparency will increase and there will be less information asymmetries, which may lead to a decrease of the cost of capital and an increase in the firms’ stock liquidity. An analysis of market reactions will reveal, if and how shareholders reacted to this new disclosure rule. With the help of market reactions data and prior literature, it is possible to find explanations for the shareholders’ reactions.
The impact the adoption of the pay ratio disclosure rule has had on stock markets can be measured by an event study. This study tries to find out, if there were any market reactions to the SEC proposal and approval. The finding of abnormal returns at the event day can be explained by different hypotheses. In this research, I am going to analyse the companies of the S&P 500 since all these firms are affected by the new disclosure rule.
The SEC received over 287,000 comment letters, which shows that many companies, investors and shareholders were involved in and concerned about the new rule. As there were that many stake- and shareholders who tried to lobby the SEC aggressively, there is a need to analyse the new rule and to evaluate the related market reactions.
To gain insight into investors’ expectations regarding the pay ratio disclosure rule, I am going to analyse the abnormal returns by using an event study covering two different events. Considering the publication dates of the pay ratio disclosure rule, I determined the first event based on the day the SEC proposed the new rule in 2013. The second event to observe is in 2015, when the SEC eventually approved the rule. I am going to analyse the abnormal returns to find out if there were any market reactions to the announcement and approval of the pay ratio disclosure rule. In addition, cross-sectional tests allow us to determine if CEO compensation, (estimated) pay ratio or firm value have an influence on stock prices.
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