The COVID-19 pandemic created unprecedented challenges for corporations, leading them to reassess crucial practices including executive compensation, a key component of corporate governance. In our recent article titled, “COVID-19 Motivated Changes to Executive Compensation,” we examine the conditions under which corporations chose to reduce CEO salaries during the pandemic and offer new insights into shareholder reactions and implications for CEO compensation.

Theoretical Frameworks Underpinning Compensation Adjustments

Our study is framed through three theoretical lenses: efficient contracting, signaling, and rent extraction. Efficient contracting theory posits that the salary cuts are necessary adjustments,  in shareholders’ best interests, given the challenging economic environment. This theory highlights the proactive governance measures that firms take, recognizing the need to adapt quickly to safeguard the firm’s financial health and align with shareholder expectations.

Signaling theory suggests that CEO salary cuts are a signal to the market that the firm is actively managing the crisis, helping maintain legitimacy and manage external perceptions during a period when other unpopular decisions—such as layoffs and furloughs—were necessary. By implementing pay cuts, companies could demonstrate responsibility and accountability, which were crucial in maintaining investor confidence and employee morale during turbulent times.

On the other hand, rent extraction theory posits that powerful executives are more likely to extract rent from the firm and thus might resist pay cuts to preserve their compensation, offering a contrasting perspective to the other two frameworks.

Impact of the Pandemic on Compensation Decisions

We manually collect a sample of 482 firms that implemented salary cuts from searches of 8-K and 10-Q filings. We then compare these firms to a larger group of 3,059 publicly traded firms that do not cut CEO salary. We find that firms cutting CEO salary typically exhibited poorer performance prior to the pandemic, had lower cash reserves, and were more exposed to the pandemic’s direct impacts. We also find that firms with robust governance structures—characterized by significant board independence, diverse representation on the board, and separate positions of CEO and the board chairman—were more likely to implement salary cuts. This suggests that strong corporate governance can mitigate self-serving behaviors and facilitate compensation decisions that reflect broader corporate interests. Combined, these findings suggest that salary cuts were used as strategic adjustments to better align executive pay with the drastically changed economic landscape and the firm’s deteriorating financial health.

Market Response to Pay Cuts

Notably, we find that the salary cuts were often well-received by shareholders, particularly when there was a large disparity between CEO compensation and that of average employees, highlighting the importance of perceived fairness in executive pay practices. We also observe a significantly higher reaction in firms that are first movers among their peers in cutting pay. The positive market reactions to announcements of CEO pay cuts, particularly in firms that were first movers among their peers, underscore the importance of transparency and proactive management in times of crisis. These reactions highlight how timely and decisive actions can enhance investor confidence.

Shift in Performance Metrics and Strategic Equity Grants

We also explore other aspects of CEO compensation changes. First, we compare the magnitude of other annual pay changes relative to the year prior to the pandemic between firms cutting CEO pay and other firms to shed light on whether firms substitute other forms of pay for salary cuts. We find that the total annual compensation in cutting firms declines significantly more than in non-cutting firms. However, this decline in total compensation appears to be partially offset by well-timed equity grants. While firms may have provided these equity grants to restore CEOs’ incentives lost due to declining equity prices in pay-cutting firms, the subsequent increase in value overshadows the salary cuts.

Lastly, we find a significant shift in the performance metrics used in performance-based incentives, as firms that implemented CEO pay cuts were more likely to shift away from the use of earnings-based measures. This is consistent with the controllability principle, which suggests that the board should put less weight on performance metrics that the CEO has less control over.

Conclusion and Implications for Future Governance

Our study underscores the complex dynamics influencing executive compensation decisions during a global crisis. Our findings suggest that firms’ decisions reflect attempts to efficiently adjust pay contracts in response to pandemic-induced changes in contracting environments, attempts to lend legitimacy to difficult and potentially controversial decisions firms make in managing the pandemic, and firm governance characteristics. We document a significantly more positive market reaction to the announcement of CEO pay cuts in firms with higher pay ratios, suggesting those cuts add legitimacy to other decisions made by those firms in managing the pandemic, and in firms that are first movers among their peers in cutting pay.

By providing evidence on the conditions under which firms adjust CEO pay and how these decisions are received by the market, the study offers insights for corporate boards and executives. Lessons drawn from this pandemic can inform broader discussions on executive compensation and corporate governance, guiding future reforms that ensure alignment between executive incentives and the long-term interests of stakeholders, thereby enhancing overall corporate governance practices.

The complete article, forthcoming in Journal of Management Accounting Research, is available for download here.