In a new paper, we examine whether SEC comment letters on deficiencies in compensation disclosure have an impact on executive-compensation “contract efficiency,” meaning the extent to which such contracts align with shareholder interest. The goal of comment letters is not to change firms’ compensation contract design but to make sure that compensation details are disclosed in compliance with securities regulations so that shareholders are informed. We posit, however, that these letters indirectly influence compensation contract design by improving disclosure.

Improved disclosure can lead to changes in compensation contracts because better-informed market participants strengthen market discipline. In fact, one of the SEC’s stated goals for executive compensation disclosure regulations is to enhance market discipline, as former SEC Chair Christopher Cox stated in discussing changes to disclosure regulations in 2006.

In our paper, the particular aspect of contract design we focus on is pay-for-performance sensitivity, i.e., the extent to which pay is tied to performance. We consider contracts with higher pay-for-performance sensitivity more efficient because they are better aligned with shareholder interests. For that reason, there is a regulatory emphasis on it. Regulation S-K Item 402(v), the most recent disclosure requirement set forth in August 2022, requires the tabulation of more granular compensation details, stock returns, peer returns, and other performance measures. These changes are designed to promote transparency regarding pay for performance.

We use a large sample of 27,164 SEC comment letters about executive compensation disclosure from 2005 to 2020. First, we find that receiving a comment letter is associated with a lower level of future plan-based compensation for CEOs (i.e., stocks, options, and non-equity incentive awards), but it does not affect the other components of total compensation. We also find that comment letters lower excessive plan-based compensation.

Motivated by these initial results, we examine how the receipt of an SEC comment letter affects pay-for-performance sensitivity of plan-based compensation, adopting the relative performance evaluation (RPE) framework. Within this framework, we capture the extent to which the firm ties its CEO’s pay to the firm’s performance, with annual stock returns serving as a proxy for performance, and whether the compensation contract filters out industry peers’ returns, which are meant to capture exogenous shocks outside of the CEO’s control. This approach captures the extent to which CEO compensation is (i) positively associated with firm performance and (ii) negatively associated with peer performance.

Our main results suggest that the receipt of a comment letter leads to higher pay-for-performance sensitivity. Firms also increase the use of RPE when compensating CEOs by better filtering out peers’ performance in compensation. In our subsequent tests, we examine cross-sectional variation in stakeholder attention using four proxies: the number of negative press articles written about the firm, the number of comment letter downloads on EDGAR, the number of ISS recommendations on proxy voting that are counter to management’s recommendations, and whether the firm’s existing contract efficiency is low. Our findings suggest that firms improve their contract design in anticipation of negative stakeholder attention following comment letter receipt. We also examine variation in comment letter characteristics based on (i) whether the firm changes its disclosure about its existing compensation by restating its 10-K after receiving a comment letter and (ii) whether the stock market reacts more negatively to the comment letter. We find that comment letters that are more likely to improve the firm’s disclosures about executive compensation are more likely to increase the sensitivity of the CEO’s pay to the firm’s performance.

Consistent with this finding of an improvement in contract efficiency, we also document higher average investment efficiency, in particular mitigation of underinvestment, and a higher return on assets in years after the receipt of a comment letter. These findings provide further support for the receipt of a comment letter being associated with better future contract design.

Analyses of awards under compensation plans show more awards based on performance rather than the passage of time following the receipt of a comment letter, consistent with an increase in pay-for-performance sensitivity. The peers serving as benchmarks for the firm’s performance are also more likely to be in the same two-digit SIC industry and of similar size after receiving a comment letter. These results reinforce our main findings that receiving a comment letter about executive compensation is associated with improved contract design.

We do not find evidence that the quality of the compensation committee or the full board changes comment letters’ effect on contract design. Instead, higher-quality compensation committees and boards are associated with higher pay-for-performance sensitivity, irrespective of whether the firm receives a comment letter. Overall, our findings suggest that the main factor in comment letters’ effect on compensation is enhanced market discipline through improved disclosure rather than board characteristics.

We find that, when a firm receives a comment letter, its CEO’s compensation from stock, option, and non-equity incentive awards becomes more sensitive to the firm’s own performance and to its performance relative to industry peers. Grants of those incentive awards become more contingent on achieving performance-based goals and more similar firms are chosen as performance-benchmarking peers. Those CEOs subsequently make more efficient investments in an effort to enhance firm performance, and the firms’ future profitability improves. Overall, comment letters on compensation disclosure lead to more efficient CEO compensation contracts that are better aligned with shareholder interests. Our study sheds light on the regulatory efficacy of comment letters in the context of executive compensation.

This post comes to us from Rachel Geoffroy at Ohio State University’s Fisher College of Business, Sophia Hamm at Tulane University’s A.B. Freeman School of Business, and Brent Schmidt at Pennsylvania State University’s Smeal College of Business. It is based on their recent article, “The Effects of SEC Comment Letters on Compensation Contract Efficiency,” available here.