The economic consequences of executive compensation disclosure: evidence from Germany

Abstract

PURPOSE OF THE STUDY Executive compensation frequently makes headlines in both academic journals and the yellow press. From the academic point of view, executive compensation has its grounds in agency theory. Effective compensation schemes align the interests of managers and owners and motivate managers to maximize shareholder value. Disclosure of compensation schemes enables shareholders to evaluate the remuneration contracts’ adequacy. In 2005, the German legislator created a natural experiment to study the economic consequences of executive compensation disclosure. From 2006 on, firms were obliged to disclose individual compensation details for their executive board members. Prior to that, disclosure of individual figures was recommended but voluntary, disclosure was mandatory only for the board as a whole. The setting allows examining whether voluntary individual disclosure reveals information about the underlying firms, whether the capital markets appreciated the increased disclosure requirements and how firms reacted to the amendment.

DATA AND METHODOLOGY The sample is collected from a repeated cross-section of the constituents of the German stock indexes DAX, MDAX, SDAX and TecDAX for the years 2005-2007. After exclusion of missing data, 428 out of 480 firm years (160 firms for three years) remain which represents a considerable portion of the total German market capitalization. Compensation data is hand collected from annual reports, other financial data is taken from the Thomson One Banker database. Hypotheses are tested by comparisons of means, random effects regressions, difference-in-differences analysis and an event study that uses constant mean return and mean adjusted return models.

RESULTS The results show structural differences between voluntary disclosing and non-disclosing firms. Disclosing firms use performance-based compensation to a greater extent but pay comparatively more than their non-disclosing peers. Event study results indicate positive capital market reactions around the dates the amendment was introduced. The findings support the governance improvement hypothesis which predicts improvements of compensation schemes when disclosure is more detailed. Examination of the real firm reactions shows increases in absolute pay levels and the performance-based portions. Especially, firms increase compensation when they switch to individual disclosure. Possible reasons are higher competition for labor or compensation for the higher risk of variable payments.