Say on Pay Design , Executive Pay , and Board Dependence ∗ July 2011 , this version October 2011

Motivated by important international differences in the design of ”say on pay” (SoP), this paper studies how its enforceability and its timing affects compensation decisions of the board of directors (BoD) and the level of board dependence. The analysis suggests that SoP design can have significant economic consequences that should be considered by regulatory authorities. In the context of a three-layer agency model I find that an advisory SoP increases the level of board dependence, the agent’s compensation and her equilibrium effort. I also demonstrate that advisory SoP can only affect CEO compensation if the BoD and some of the firms’ shareholders exhibit social preferences. By contrast, a binding SoP provides shareholders with an effective control over the BoD’s compensation decision. This threat works without any behavioral preconditions but its economic consequences crucially depend on the timing of the vote. A pre-contractual and binding vote effectively reduces the level of board dependence and the agent’s compensation and thereby increases the residual claim of shareholders. A post-contractual and binding vote is an even more effective instrument to control the level of board dependence and the agent’s compensation but it is costly for shareholders because it destroys the agent’s effort incentives. The most appropriate SoP design depends on the objectives of the regulatory authority. A shareholder-oriented regulator does best with a pre-contractual and binding SOP, whereas a welfare-oriented regulator prefers an advisory SoP. Both types of regulators would never adopt a post-contractual and binding SoP because it is associated with the lowest welfare and the lowest shareholder value. A post-contractual and binding SoP can only be attractive for a regulator who aims to accommodate the concerns of compensation critics and therefore prefers the SoP method that provides the most effective measure against seemingly excessive compensation levels.