Akerlof (1980) defines social norms or customs as acts whose utility to the agent performing them depends in some way on the beliefs and actions of others. Social norms are thought to be important determinants of economic behavior (Elster, 1989; Kubler, 2001). In the setting of capital markets, social norms manifest themselves in the form of "socially responsible investing" where investors do not invest in corporations which operate in specific industries perceived to be exploiting human vice (Haigh and Hazelton, 2004; Statman, 2000; Statman, 2006). However, others have argued that investing in stocks that exploit human vice or "sin" stocks provide superior returns when compared to other investment strategies (Ahrens, 2004; Fabozzi, Ma, and Oliphant, 2008; Krantz, 2011; Nelson, 2009; Statman and Glushkov, 2008; Waxler, 2004). Sin stocks are defined as the stocks of publicly traded corporations that are engaged in morally reprehensible productive activities--typically those engaged in the production of alcohol and tobacco products as well those companies operating in the gaming industry.
Hong and Kacperczyk (2009) document that social norms can have important effects in capital markets. Specifically, they provide empirical evidence showing that sin stocks are ignored by investors even though they provide superior returns due to a "neglect effect." This is due to investors following social norms for not investing in such stocks. Kim and Venkatachalam (2011) reinforce this result by documenting that this "neglect effect" holds true even though sin firms possess higher financial reporting quality. We investigate how this "neglect effect" influences CEO pay arrangements at sin firms. Specifically, we examine the association between CEO pay and firm performance for a sample of sin stocks as compared to the general population of Standard & Poor's (S&P) 1500 stocks whose CEO pay data is available on the S&P ExecuComp database for the years 1992-2010.
To the best of our knowledge, this is the first paper to examine the influence of social norms on CEO pay. We add to the small but growing literature on social norms by documenting that CEOs of sin firms earn higher pay than CEOs of non-sin firms, and that the association between CEO pay and firm performance is higher for CEO bonuses and cash pay. The results of this study show how social norms influence the behavior of corporate boards in terms of how they reward their CEOs in addition to their effect on investor behavior and capital markets. This study may also prove to be useful to compensation committees of corporate boards as they determine CEO pay arrangements in the future.
The rest of the paper is organized as follows. Section 2 reviews the current research on the effects of social norms in financial markets. Section 3 examines CEO pay arrangements in sin firms versus non-sin firms. Section 4 summarizes and offers some concluding comments.
SOCIAL NORMS IN FINANCIAL MARKETS
Becker's (1957) theory of discrimination is perhaps the earliest work on the influence of social norms on markets. Becker (1957) explains that, in labor markets, agents (employers) may discriminate against hiring individuals possessing certain characteristics (e.g., gender or race), even if this discrimination results in harm (financial costs) to the agents. Akerlof (1980) formally defines social norms or customs as acts whose utility to the agent performing them depends in some way on the beliefs and actions of others.
In the setting of capital markets, social norms manifest themselves in the form of "socially responsible investing." Socially responsible investing "refers to the practice of directing investment funds in ways that combine investors' financial objectives with their commitment to social concerns such as social justice, economic development, peace or a healthy environment" (Haigh and Hazelton, 2004, 59). …