Advanced topics in financial reporting including accounting for multi-corporate business entities, international operations, and other topics. Prereq: Honors ...
!"#$"#%&'()"*'#+%+,'-(.%/'"*'#0-(%+1(."$23%+%4'5'+&(!"5$'+0%&6"+7(.8'"#9(%+1(:*61'+,' ; 1, Y < 1, and I is a given positive constant. 62 is a profit shock that is realized after investment is made, such that E(E2)= 0. It is assumed that the firm (initially) cannot exploit this investment opportunity without M. Following the realization of X2, the firm is liquidated, with the shareholders receiving the residual profits after the payment of D and any (junior) debt B1 issued to a risk-neutral bond market in Period 1. For simplicity, the interest rate is normalized to be zero. It will be assumed that Z > [1 + (D - rT)/I], so that the first-best investment is I. M's objectives are different from maximizing V1, however. Apart from being risk averse, M also enjoys private benefits from the firm's investments: In Period 1, M maximizes a utility function UM = E[u(w2M)]+ )I1,where wM is M's (possibly risky) monetary wealth in Period 2, and 4 > 0 is a given constant. It is convenient to normalize u(0) = 0, and assume that M's reservation utility in Period 1 is TI.Ex-ante shareholder value is then maximized by investing I, = I financed through a borrowing of B* = max{0, - 7r}, and paying zero salary to M. We will assume that the investment level chosen by M is nonverifiable. Also, M's borrowings in Period 1 (through the issue of junior debt) cannot be ex-ante 455
CYERT,KANG, AND KUMAR and Top-ManagementCompensation Governance Corporate
restricted by the outside shareholders either directly or indirectly by tying M's compensation to the new borrowing.4 Under these assumptions, the first-best arrangement is not self-enforceable. In case of a zero salary, with a risk-neutral bond market and zero interest rate, the manager will issue junior debt of the amount Bm1a= [(Z - Y)I + YrT- D]/(1 - Y) (since any further junior debt is nonrepayable in expectation), and his optimal investment will be equal to jax = Bmax for the manager. However, we allow incentive provision through the award of equity-based compensation to the CEO.5 A typical compensation for M will be represented by the pair C = (Al, nl), where A1 is a fixed cash compensation paid to the manager in Period 1, and n, is the number of newly issued shares provided to him. We explicitly model the corporate governance process that results in the determination of C1.Consistent with practice, the BOD proposes top-management compensation for shareholder approval, after consultations with the CEO. The corporate governance literature strongly suggests in fact that the CEO is very influential with the BOD in setting top-management compensation levels (Mace 1986, Patton and Baker 1987, Crystal 1991). Therefore, M initially suggests a compensation C1 to J. If J accepts, then C1 is made public knowledge. Individual shareholders can either (implicitly) accept C1 or disapprove by taking control of the firm and renegotiating with M (see below). As pointed out by Black (1998), there is little evidence that CEO compensation arrangements can be overturned by shareholders through alternative means, such as proxy votes. Meanwhile, if J rejects M's proposed Cl, then 4We do not generally observe shareholder contracts with managers that restrict borrowing directly or indirectly. There are at least two reasons for this. First, if all contingencies can not be ex-ante spelled out (which is the plausible assumption), then such restrictions can inappropriately take away managerial discretion. Second, such restrictions introduce another moral hazard problem since management can attempt to evade financial leverage limits by increasing the firm's operational leverage (for example, by aggressively courting credit from suppliers). 5Note that nonlinear contracting will not eliminate the agency problem: M's optimal investment always exceeds the efficient investment level I with any sharing rule (for M).
456
either the impasse is resolved through a change of ownership by a takeover, or the firm is liquidated with the shareholders receiving S1 = max{0, Tr- D}.6 J receives a personal benefit of K+ in Period 2 if the firm does not default, but suffers a loss of Kif the firm defaults.7 Finally, J's opportunity costs of performing his corporate governance function are assumed to be zero. Formally, let O E {Cj, 0} denote the outcome in the negotiation game between J and M, where Cj = (At, n{) is the mutually agreed upon compensation, and 0 represents the alternative event. When O0 becomes known, L can either (implicitly) accept the compensation arrangement or attempt to overturn it by gaining control of the firm by making a cash tender offer for a proportion a' - aL of the firm's shares (where at > 0.5). In the event of a successful tender offer, L displaces J. There are fixed costs of 6 of making the offer (Shleifer and Vishny 1986). Majority ownership allows L to change the status quo compensation policy, if CJ provides excessively large rents to M, for example. But, following the takeover, L can even attempt to replace the rent-seeking M by an equivalently skilled management that imposes lower agency costs on the firm. We assume that with probability 0 < 0 < 1, L can successfully replace M and implement the first-best arrangement. With the probability (1- 0), M continues managing the firm, and his compensation is determined 6
Here, M receives zero compensation in liquidation, since this is M's compensation in the absence of quasi monopoly rents from operating the firm. Also, liquidation is a threat-point in the negotiation game that is triggered when there is an impasse between M and J, and no shareholder is willing to takeover the control of the firm. Thus, liquidation serves as a useful "off-equilibrium-path" threat to restrict the equilibrium behavior of M, J, and L. From an empirical standpoint, corporate governance and survival outcomes are extremely uncertain in such situations. However, there is evidence that such situations often end in liquidations or bust-ups, especially following takeovers by large shareholders (Berger and Ofek 1996). 7This formulation parsimoniously captures two realistic features of serving on the BOD: (1) a major benefit of directorships of solvent firms is the "prestige" or "self-esteem" derived from service, and the increased likelihood of service on other boards (Aghion and Bolton 1992, Shivdasani and Yermack 1998), and (2) there is a nontrivial threat of personal liability lawsuits being brought by shareholders in the event of a default.
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as an outcome of a negotiation game with L. This game is assumed to be set up similar to that between J and M. The post-takeover game set-up follows a large literature that emphasizes, both theoretically and empirically, the management disciplining role of takeovers (e.g., Long and Walkling 1984, Jensen and Ruback 1983, Jensen 1986, 1993). Large shareholders have the greatest incentive to reduce managerial agency costs through changes in incentive compensation arrangements, and even outright replacement of rent-seeking managers, since they gain the most from such value improvements. Following the outcome of the takeover game, if the firm is still operational, 62 is realized. This determines X2, and the liquidating cash assets of the firm are (X2+ ir + B1- I1- A1). The firm is then liquidated according to the terms specified above. 2.2.
Equilibrium Compensation and Comparative Statics We denote M's optimal investment for a given (C1, y) by I (Cl, y). Consider the compensation negotiations between L and M, conditional on L gaining control, with some ownership fraction, aT > 0.5. If M is not replaced, then M suggests some C1 to L, whose expected payoffs as a function of C1 are, UL(CI, ac, y) = (acN/(N + n1))V,(C1, y) (where V (Cl, y) is the expected shareholder liquidation value for a given (C1, y)). Let UM(C1,y) denote M's expected utility. Any equilibrium compensation CL = (AL,nL) then maximizes UM(C1,y) subject to the constraints that (i) UL(C1,aL, y) > aLS1 and (ii) UM(CL, y) > u(aMS,).
It is straightforwardly shown that any CL will generically have equity-based compensation; i.e., n > 0, as long as the exogenous parameters S1 and E[e2 I 62 > 0] E+[E2] are such that S1 : E+[2]. The reason is that if nL = 0, then M chooses the maximum feasible investment by utilizing the firm's borrowing capacity completely. In this situation, V1= E+[e2], which cannot generically be an equilibrium: It will either be in L's best interest to reject M's proposal (if S1 > E+[e2]) or be in M's own best interest to suggest a compensation with a positive equity award. Finally, AL > 0 if M values some minimal certain MANAGEMENT SCIENCE/Vol.48, No. 4, April 2002
wealth sufficiently highly at the margin, i.e., if the Inada condition, limw,0 u'(w) = oo, is satisfied. In this case, an all-equity compensation package will be prohibitively expensive in terms of meeting M's reservation utility for continued employment with the firm. It also turns out that M's optimal offer does not depend on the fraction of the firm held by L (as long as a' > 0.5). Thus L's expected payoffs in the post-takeover (subgame) equilibrium are linear T: UL(, y) = LV, with VL OV + (1in the shareholder + nl))Vl(CL, y), S}, )max{(N/(N value of the firm following a takeover by L. Here, V* is the expected liquidating value of the firm under the first-best investment and borrowing levels (I, B*). Meanwhile, L's expected payoffs given some outcome O of the negotiation game between J and M are UL((O, y), where UL]= (aLN/(N + n1))V (CJ, y) if Oj = Cj, and UjL= aLS1, if Oj = 0. If ULLexceeds U]Lby a sufficient amount, then L will have incentive to take control if he can purchase aL - aL fraction of N from the small shareholders (where 0.5 < a- < (1 - aJ + aM)) at a price P for the firm such that, UL (a L, ') - UJL(OJ,y)-
((L-
aL)P-
> 0. But, view-
ing the success of the takeover attempt as independent of his own decision, a rational small shareholder will tender if and only if P > V1L(Grossman and Hart 1980). In equilibrium, therefore, P = V1L.Substituting this above, and using the definitions of ULLand UL, we conclude that L will not make a bid for control only if aLVL - UL-
< 0.
We now analyze the negotiation game between J and M, taking as given some 0.5 < a(L< (1- (aJ + aM)). For any given C1, J's expected payoffs are U'(C,
ns+ ) =( N
)V1(C1, Y)
+ (1- Q(C1, y))K+ - Q(C1, y))K-. Here, Q(C1, y) is the probability of default. M's optimal strategy can then be derived in the following manner. Let, UM(0) and UJ(0) respectively denote M and J's expected utility (in the continuation game) if they are unable to agree on a compensation.8 8 UM(O)= + (1 - )max{UM(Cl,y), u(aMS1)},if a I(V1Ou(aMV*) S1)> 4, and u(aMS1)else. UJ(0) is calculatedanalogously.
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CYERT, KANG, AND KUMAR CorporateGovernanceand Top-ManagementCompensation
Next, let, Cj = (Aj,n{) be a solution, if it exists, to the following optimization problem: Maximize UM(C1,y), subject to UJ(C, y)) > U(0z)
aLV -V?-(N
)V(C
)
(1)
(2)
If a solution to this constrained maximization problem exists, and if Uf > UM(0), then Cj is the equilibrium compensation contract when the firm is operational and there is no takeover. Analysis of this problem shows that the equilibrium will typically involve positive equity compensation for the CEO: Under the most plausible parameterizations, either L or J will not accept the managerial investment behavior that is implied by giving zero equitybased compensation to M. Moreover, the equilibrium equity-compensation will typically exceed the level that maximizes shareholder value. Since the J's objectives deviate from those of the shareholders, and takeovers involve deadweight costs on L, the CEO is emboldened to ask for large equity-based awards. In fact, the size of the equity-based compensation award depends on factors that determine J's incentive alignment with the shareholders, and L's takeover incentives. This point is now made precise through comparative statics. To aid readability, we report the comparative statics separately for salary and equity compensation.9 PROPOSITION1. The equilibriumequity-basedcompen-
sation nJ is (i) decreasing in aL, (ii) decreasing in aJ if the default probabilityis not too large, (iii) increasing in e, (iv) increasing in N, and (v) decreasing in the default probabilityQ. But the relationof nJ to Z (the "magnitude" of the growth-opportunity), rr,D, and aM is ambiguous. PROPOSITION2. The relation of the equilibriumfixed
salary AJ to the variablesspecifiedin Proposition1 is generally ambiguous.However, the relationof Aj to these variables is opposite in sign to that of nJ if M borrowsup to the debt capacity of thefirm. 9 Proofs of these comparative statics are available from the authors.
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2.3. Discussion An important result is that CEO equity compensation will be inversely related to L's (initial) shareholding, aL. Increasing n{ has two effects: There is a dilution cost on the existing shareholders, and this cost is increasing in the (initial) stake of the shareholder, at the margin. But there may also be an offsetting incentive effect on the investment behavior of M.10 In equilibrium, however, the former effect dominates at the margin, and there is an unambiguous negative effect on nJ if raLincreases exogenously. The argument in the previous paragraph (also (1)) explains the positive relation of nJ to firm size (which is proportional to N): A higher N reduces the marginal dilution costs equity awards to M, and (2) applies (with the opposite sign) for the transactions costs in the takeover market 5. By the same token, however, the relation of the equilibrium fixed salary to aL is ambiguous: There is a direct negative effect (on AJ) of increasing aL, but there is an opposing and indirect "'wealth" effect because a lower equity award increases the outside shareholders' value ceteris paribus. The relation of n{ to J's initial holdings is also negative as long as the firm is not almost sure to default.11 Meanwhile, a higher default probability unambiguously tightens the internal governance constraint (1) and has a negative impact on nJ. The relation of equilibrium managerial compensation to (1) growth opportunities Z, (2) the (initial) profits r, and (3) debt D, is also of interest. Take the 10M's optimal investment I, on the interior of [0, IJnx]is an increasing function of the cash salary A1: A higher salary reduces the marginal expected utility of wealth (because of the strict concavity of u), and thereby reduces the expected utility cost of inefficient investment for M. The relation of I, with respect to n, is ambiguous:A higher equity award induces an incentive effect that argues for more efficient (lower) investment, but there is also an opposing wealth effect, similar to the one that comes into play with a higher salary. However, I1 is decreasing in n, whenever M's constant relative risk aversion coefficient is less than one, i.e., [-u"(w)w/u'(w)] < 1. 11If the firm will almost surely default, then J's individual rationality constraint (1) can be binding only if V1 (i.e., the equity value under the existing management) exceeds J's reservation utility (for example, if e is large and S1 is low). In this case, a higher ac actually makes J more anxious to accept M's proposal.
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case of a ceteris paribus increase in Z. It is easy to show that in this case M prefers to increasehis investment because of an unambiguous "wealth" effect. This fact may suggest higher equity awards for incentive purposes. But a higher Z also makes the firm more valuable (other things being fixed), and therefore tightens the corporate governance constraintsarguing for lower equity awards. The net effect is ambiguous, and the reasoning with respect to (initial) profits and debt is analogous. Finally, an increase in aM has conflicting effects on M's optimal investment since there is an incentive effect which argues for more efficient (lower) investment and an opposing wealth effect that motivates larger (and less efficient) investment.
3. Empirical Tests 3.1. Empirical Implications and Implementation The principal empirical implications of the model are: Equity-based compensation will be negatively related to (1) the ownership of the largest outside shareholder (aL), (2) the ownership of the BOD (aj), and (3) default risk (Q). But equity-based compensation will be positively related to (4) the number of shares outstanding (N), and (5) factors that increase the costs of displacing the CEO, such as takeoverrelated transactions costs, and factors that increase CEO entrenchment. Furthermore, equity compensation will have an ambiguous relation to the magnitude of the growth opportunities (Z), the current and past economic performance of the firm (r), and to the CEO's (initial) stockholdings (aM). Finally, the governance and takeover-related variables will generally have a weaker (relative to equity compensation) impact on fixed salary. Most of the ownership related variables have a straightforward implementation: for example, the shareholdings of the largest outside shareholder (caL) and the CEO (aM). The director's ownership (aJ) is approximated by the ownership of the compensation committee since this committee is composed of outside directors and is usually given the primary discretion in setting CEO compensation.12 As elsewhere 12
Our results are sustained when we use the shareholdings of the entire board or the independent outside directors.
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in the literature, both stock and accounting returns can be jointly used as a proxy for the firm's profits (7r), and the firm's debt-equity ratio represents the debt obligations (D). We use the factor score measure developed by Baber et al. (1996) as a proxy for future growth opportunities (Z). For estimates of the default risk (Q), we rely on recent evidence by Shumway (1996) that the ex-ante probability of financial distress is best captured by the following three variables: (1) ratio of interest expense to pretax operating profit, (2) whether or not the firm was a "loser" during the last three years,13 and (3) log market value of the firm. Rather than introducing all three variables in the regression equation, we collapse them into a single factor using the principal component analysis. Finally, since the number of shares outstanding (N) is a normalized measure of firm size, we use size (total assets) to measure the predicted impact of N. 3.2. Empirical Specification The foregoing discussion motivates the following empirical specification of CEO compensation. ln(COMP)i, = Po + Jiln(SIZE)i, + /321n(STCK.RTN)i, + ,831n(ACCTG.RTN)i,t +
4
ln(aL)i,t
+ 3i5 ln(raL M)i, + ,6 ln(aM)i,t
+ 7n(a')i,
+ 38ln(Q)i, t + 9 ln(D)i,t
+ ,0oln(Z)i, t + Control Variablesi,t + i, t, (3) where i and t denote the firm and the time subscripts, and the precise definitions of the variables are provided in Exhibit 1. We elaborate on some key features of the empirical specification (3). First, for the sake of parsimony, the theoretical model distinguishes only between fixed compensation (A1) and equity-based compensation (nl), whereas actual CEO's pay packages often include performance-contingent bonuses and other discretionary awards such as special bonuses or 13A firm is operationally defined as a "loser" if its three-year cumulative equity rate of return belonged to the bottom 5% of all NYSE/AMEX stocks during any of prior three calendar years.
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CYERT,KANG, AND KUMAR and Top-Management Governance Corporate Compensation
1 Exhibit
VariableDefinition
RTN)I7 t + (3 ln(ACCTG RTN)i, + P4 In(aL),,t + f5 ln(aLg,M),,t+ 6 ln(aM),,t+ P7ln(aJ),,t In(COMP),t= f0 + 1IIn(SIZE)i,t+ 2 Iln(STK + Ej,t +P8 In(Q) it + P In(D),t + p1oIn(Z),t + ControlVariables
Definition (Indenotesnatural logarithm)
Variable COMP (Compensation) SIZE(Firmsize) STKRTN(Stockreturn) RTN ACCTG return) (Accounting aL (Largest ownership, non-CEO) aLM (Largest ownership, CEO) aM(CEO's ownership) aJ (Compensation committee's ownership) Q(defaultrisk)
D (Financial leverage) Z (Growth opportunity)
Yeart CEOcompensation, specifiedas either(i) basesalary(ii)equitycompensation, (iii)totalcontingent allexpressedin 1993dollars. compensation, nettotalassetsof yeart expressedin 1993dollars. Beginning 1 +year t commonstockreturn, adjustedforinflation. forinflation. valueof equity,adjusted 1 +year t incomebeforeextraordinary items/book of the largeststockholder, shares,In(aL),,t= 0 ifthe Ownership expressedin percentof totaloutstanding largestholderis theCEO. sharesifthe of thelargeststockholder, Ownership expressedin percentof totaloutstanding largestholderis theCEO,In(aLM),t = 0 otherwise. shares. of theCEO,expressedin percentof totaloutstanding 0.01+ stockownership shares. stockholdingsin percentof totaloutstanding 0.01+ compensation committee's Thecommittee's holdingexcludesthatof theCEOiftheCEOis on thecommittee. variable of:(i) interestexpense/pre-tax income,(ii)indicator operating Principal component cumulative firm(ifthefirm'sthree-year equityrateof returnbelongedto thebottom denotinga "loser" stocksduringanyof the priorthreecalendar 5%of allNYSE/AMEX (iii)negativeof years,0 otherwise), of market value equity. laggedlog termdebt+ bookvalueof equity)expressedin percent. 0.01+ long-term debt/(long scaledbythesum of (i)thesumof capitalexpenditures, R&D,andacquisitions component In[Principal of depreciation expenseforthethreeyearst - 2 thought; (ii)thegeometricgrowthrateof yeart - 2 valueof assets;(iii)theyeart ratioof R&Dto the bookvalueof assets; to t changeinthemarket valueto thebookvalueof assets]. and(iv)theendof yeart ratioof themarket
ControlVariables CEOduality Boardsize of Proportion outsidedirectors CEOage tenure CEO blockholder Internal blockholder External industry Regulated Firmrisk
0 otherwise 1 iftheCEOis thechairman, In [number of directorsintheboard] of alldirectors, In [0.01+ numberof outsidedirectors/number expressedin percent] In [ageof CEO] of yearsCEOhasservedas director] In[number andofficersotherthantheCEO)ownsmorethan5%,0 otherwise 1 ifan internal party(directors andofficers)owns theCEO's thantheCEO, other 1 if anexternal family,directors party(parties morethan5%,0 otherwise 1 ifthefirmbelongsto utilities(SIC49) or banking (SIC602),0 otherwise deviation (inpercent)of thefirm'scommonequity,estimatedusingthe monthly In[standard returnovertheprior60 months]
perks. In the simple two-period framework considered above, the equity-award (n1) is, in effect, a cash "bonus" rule for Period 2. Consequently, we interpret n1 more broadly as all contingent compensation, and use three different specifications of the CEO compensation (COMP): (i) base salary, (ii) equity compensation, that includes all equity-based awards such as restricted stocks, stock options, and stock apprecia460
tion rights, and (iii) all discretionary compensation, that includes not only equity-based compensation but also bonuses and other compensation. Second, all variables are expressed in natural logs with the exception of 0-1 indicator variables. We use the log specification because the existing literature (Roberts 1956, Cosh 1975) as well as our own preliminary analysis indicates that firm size is the most MANAGEMENT SCIENCE/Vol.48, No. 4, April 2002
CYERT, KANG, AND KUMAR Governance and Top-ManagementCompensation Corporate
influential determinant of the level of CEO compensation, and that this relation is best described as loglinear. As a result, the regression coefficients in (3) have an elasticity interpretation. Finally, we use Heckman's (1979) two-step procedure to estimate equations for equity compensation and all discretionary compensation. The Heckman estimation is necessary because equity compensation is not awarded for 49.4% of the sample firm-years, and thus, direct applications of ordinary least squares can yield biased estimates. The control variables account for the influence of variables that are not explicitly considered in our theoretical framework, but are often considered in the literature. These include variables that may impact the effectiveness of corporate governance mechanisms and industry- or firm-specific variables. The governance-related variables are: (1) CEO Duality (i.e., the CEO also serves as the chairperson of the BOD): Jensen (1993) and organizational theorists suggest that "CEO duality" diminishes the extent of board control (Finkelstein and Hambrick 1989). In our framework, duality also serves as proxy for high costs of displacing the CEO. (2) Board Size: Lipton and Lorsch (1992) and Jensen (1993) argue that an "overcrowded" board is less likely to function effectively and is easier for the CEO to control.14 (3) Inside Versus Outside Directors: A high proportion of outside directors is often considered to enhance the quality of corporate governance (Fama and Jensen 1983).15As in the existing literature, we define outside directors as those that are neither a direct family member nor a relative of the CEO, and are not a current or former employee of the firm. (4) Age and Tenureof the CEO: Organizational behavior theorists suggest that the CEO-BOD nexus 14Recently Yermack (1996) finds related evidence that firm value is higher if the board size is smaller, and more directly Core et al. (1999) report that CEO compensation is increasing in board size. 15The role of outside directors in firm performance has been actively investigated, although the results appear mixed. For example, while Rosenstein and Wyatt (1990) and Brickley et al. (1994) find that firm value is related to board composition or appointments of outsider directors, Hermalin and Weisbach (1991) and Yermack (1996) find little evidence that firm performance is related to board composition.
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becomes stronger with longer CEO tenure,16 resulting in a compensation package that is more preferable to the CEO-relatively larger cash compensation and smaller equity-based compensation. (5) Other Blockholders:For reasons of simplicity, our theoretical model assumes only one blockholder. To control for the effects of other blockholders, we incorporate separate indicator variables for internal blockholders (stock holders who are current or former executive officers owning more than 5% of the firm) and for external blockholders. The industry- and firms-specific control variables are: (1) An indicator variable for regulated industries: Kostiuk (1989) and Smith and Watts (1992) argue that executives of regulated industries (such as utilities and banks) command lower wages because regulation restricts the managers' discretion, and thus reduces the marginal product of the managerial decision maker. (2) Firm Risk: The standard option-theoretic argument is that that firms with greater financial risk will tend to award more equity-based compensation since the value of stock options is increasing in risk. More recently, Aggarwal and Samwick (1999) motivate the role of financial risk in executive compensation from an agency-theoretic perspective. 3.3. Data Executive compensation and ownership data are compiled from proxy statements, obtained through a mail request to all U.S. public firms traded on the NYSE, AMEX, or NASDAQ National Market System, and listed in the DISCLOSURE database and in 1993 COMPUSTAT primary, secondary, tertiary, and fullcoverage files (4,865 firms). Out of a total of 4,193 responses to our request for proxy statements for 1992 and 1993, we compile the data for 2,006 firms that provide proxy statements for both years. We remove 358 firms for various reasons of data availability, leaving the final sample size at 1,648 firms.17 For ease of exposition, we designate these firms as the "sample" 16This is measured as the number of years he or she has served as
director because this information is available more often than the years served as CEO. 17 The primary reason for a deletion from the sample is that the CEO did not serve the full fiscal year because of exits and entries in
461
CYERT,KANG, AND KUMAR
and Top-Management Governance Corporate Compensation
Table1
FirmSizeDistribution
unless some party holds more than 5% of the firm.19 For about 8.8% of the sample (146 firms) no single Assets SizeClassified byTotal party holds more than 5% of the firm, and not surBasedonthe Classification prisingly, these firms tend to be large. of5%Holder Existence Number of Table 2 displays summary statistics. The first 5% With5% Total Assets firms(percentWithout Size panel gives the fiscal 1992-1993 distributions for Blockholders Divisionsa Range ($mil) ofsample) Blockholders compensation components. Since fiscal year 1992, 4 91 0.1 95 1 -18.6 (5.8%) proxy statements contain information that permits the 2 132(8.0%) 130 2 -33.9 decomposition of executive compensation into five 3 143 146(8.8%) -55.8 3 distinctive components: salary, cash bonus, long-term 6 149 155(9.4%) 4 -88.9 incentive payout (LTIP), the value of stock options 174 183 (11.1%) 9 -150.0 5 and restricted stock granted during the year, and 7 161 168 (10.4%) -268.8 6 "other compensation" (e.g., automobile costs). 10 162 172 (10.7%) -464.8 7 Mean base salary is $366,000, almost 36% of 18 159 177 (10.8%) -965.7 8 mean total compensation of $1,011,000. Cash bonuses 35 179 214 (12.9%) 9 -3,013.0 154 52 10 -251,506.0 206 (12.5%) ($190,000), on average, add about 52% to the base Total 1,502 1,648(100%) 146 salary. Cash bonuses are awarded by 69% of the firms are awarded, they add of 4,865U.S.firms in 1992-1993, and when they arebasedonthe1993distribution aThesizedivisions Market National andNASDAQ listedonNYSE, ASE, byDis- about 75% to the base salary. Option values are comSystem complied closure Inc. puted as in Jensen and Murphy (1990)-using the Black and Scholes (1973) approach-except that we adjust for early exercise using the algorithm recomand refer to the original 4,865 firms as the "popumended in Hemmer et al. (1994).20 The data indilation." The financial and stock price data are from cate that the mean value of options granted ($310,000) COMPUSTAT primary, secondary, tertiary, and fullis larger than cash bonuses, and is about 30% of in Research for CRSP and the mean total compensation. And although almost all (Center coverage files files. firms (91.5%)have stock option plans, only about onePrices) Security Table 1 displays the sample profile in terms of half (50.6%) granted stock options during 1992-1993. When options are granted, however, they constitute firm size deciles based on the book value of total about one-half of the total compensation. assets. Since the deciles are delineated by the distriThe remainder of the table shows statistics for the distribution the bution of the population, expected for a random sample is 10% in each decile. We see governance and stock ownership data.21 As shown in Panel B, mean ownership of the largest non-CEO that the sample is somewhat skewed towards large number equity holder is about 17.2%, whereas the ownership firms, but is still composed of a significant when the CEO is the largest shareholder (26.2% of the of small firms. The firm size ranges from $4.2 milcase) is 24.3%. On average, a typical CEO beneficially lion to $184 billion in total assets, and 302 industries holds about 8% of the firm's equity, while the median are represented (based on the two-digit SIC codes).18 stock ownership is about 2.3%. The average CEO is The last two columns classify the sample into two categories based on the existence of a 5% blockholder 19U.S. firms are requiredto reportlarge-shareholdingsonly if they because the largest shareholder cannot be identified the middle of the fiscal year; the second reason is missing financial information such as total assets, stock price, etc. 18The sample distributions in terms of exchange listings and industry membership are also similar to the population distributions.
462
exceed 5% of common shares. 20Details are available on request. 21All share ownership numbers include "beneficially" owned shares (e.g., shares owned by kin and relatives) and options that can be exercised within 60 days, consistent with the treatment in most empirical studies.
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CYERT,KANG, AND KUMAR and Top-Management Governance Corporate Compensation
Table2
Statistics Summary
Variable
Mean
Median
Std.Dev.
Min.
Q1
Q3
Max.
1.011 0.556 0.366 0.190 0.310 0.045 0.098
0.552 0.398 0.302 0.077 0.006 0.000 0.012
1.571 0.541 0.241 0.392 1.119 0.306 0.506
0.027 0.130 0.012 0.000 0.000 0.000 0.000
0.311 0.256 0.205 0.000 0.000 0.000 0.002
1.103 0.679 0.456 0.223 0.219 0.000 0.051
23.875 7.892 2.693 6.892 21.703 10.943 16.843
2,192.7 0.197 0.055
220.8 0.100 0.077
8,941.8 0.589 0.376
4.2 -0.898 -0.982
63.7 -0.103 0.009
1,083.2 0.355 0.124
184.835 8.441 13.968
A. Compensation Totalcompensation ($ million) Salaryandbonus($ million) Salary Bonus Stockoptionsa Restricted stocks Othercompensation B.SizeandPerformance Totalassets ($ mil) STKRTN RTN ACCTG C.Governance and Variables Ownership non-CEO Largestownership, (aL)b,c CEO(aL,M)b.c Largestownership, CEO's ownership (aM)b CEOage CEOtenure CEOduality Boardsize Comp.committee's
17.12% 24.29% 8.07% 55.3 14.29 0.698 8.82 4.60%
12.10% 19.80% 2.32% 55.0 12.0 1.000 8.00 0.48%
13.59% 16.34% 12.82% 8.3 9.70 0.458 3.22 9.97%
5.00% 5.00% 0.00% 33.0 1.00 0.000 3.00 0.00%
8.72% 11.70% 0.46% 50.0 7.0 0.000 6.0 0.07%
20.00% 31.50% 10.13% 61.0 20.0 1.000 11.00 3.82%
67.5%
71.4%
16.5%
0.0%
57.14%
80.00%
0.398 0.742 2.20
0.000 1.000 2.12
0.489 0.437 0.89
0.000 0.000 0.038
0.000 0.000 1.66
1.000 1.000 2.57
1.000 1.000 8.78
0.318 1.243
0.238 0.932
0.245 2.247
0.0 0.001
0.082 0.752
0.508 1.419
0.994 14.139
0.116 0.129
8.00 0.000
0.049 0.335
0.023 0.000
0.080 0.000
0.144 0.000
0.453 1.000
82.29% 93.90% 93.90% 87.0 50.0 1.000 26.00 81.84%
ownership(aJ)bd
of outside Proportion directorse Internal blockholders External blockholders Defaultrisk(Q) (principal component)f Leverage(D) Growth opportunity (Z: principal component)f Firmrisk Regulated industry
100.0%
Notes. aOption valuesarebasedon the Black-Scholes et al. (1994).91.5% (1973)methodadjustedforearlyexerciseusingthealgorithm byHemmer of samplefirmshaveoptionplans. bAllshareownership dataincludesharesbeneficially ownedandoptionsexersizable within60 days. CStatistics areonlyforthepositiveshareholdings. Thelargestshareholder is theCEOin26.2%of thesample,non-CEO insiderin 18.3%,andexternal partiesin 55.4%.
committee stockholdingsexcludethoseof theCEOwhentheCEOis on thecompensation dCompensation committee. eOutside directors aredirectors whoarenetherrelatives orfamilymemberof theCEO,or presentorformeremployeeof thecompany. fTheprincipal arerecentered to be positivea number. components
55 years old, has served as CEO for about 8 years, and has held directorship for about 12 years. These numbers are consistent with the statistics of previous studies summarized in Rosen (1992). Finally, the CEO MANAGEMENTSCIENCE/Vol.
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is also the board chairperson for about 70% of the firms. The statistics for the BOD indicate that more than half of the U.S. public firms' boards have greater than 463
CYERT,KANG, AND KUMAR and Top-Management Governance Compensation Corporate
eight members, the upper bound recommended by Lipton and Lorsch (1992) and Jensen (1993). Compensation committees, typically consisting of three to four directors, have mean (median) share ownership of about 4.6% (0.48%).22The middle half of the compensation committees hold somewhere between 0.07% to 3.80% of the firm. On average, about 67% of the BOD is occupied by outside directors whose mean and median shareholdings are 5.11% and 1.17%, respectively.
4. Results The primary empirical results are reported in Table 3A. Table 3B reports both Pearson and Spearman correlations for the key variables. In Table 3A, the regression coefficients in the first column are for base salary, and those in the last two columns respectively are for equity compensation and all discretionary compensation.23 For each compensation specification, we report results with the control variables, but results are similar if we exclude these variables. We report results for pooled data for fiscal 1992 and 1993, since the results are similar when we estimate separate regressions for each year or allow for industry effects. Also, we report the results for only the firms with a 5% blockholder (90.5% of the full sample) since the largest shareholder (aL and aL'M)cannot be identified for the remaining firms. Nevertheless, there is no evidence of a selection bias for removing the firms without a 5% blockholder. Most of the coefficient estimates support the predictions of Proposition 1 at strong significance levels. First, contingent compensation, regardless of whether it is defined narrowly as equity compensation (Column 2) or broadly as all discretionary compensation (Column 3), is negatively related to the largest shareholder's ownership. The point estimates The compensationcommitteestockholdingsexclude those of the CEO if the CEO is on the committee, because most companies explicitly state that the CEO does not participatewhen the compensationcommitteedeterminesthe CEO'scompensation. 23Although we start with 1,648 firms for 1992 and 1993, the absence of financialdata to calculateall 19 independentvariables reduces the maximumnumber of firm-yearobservationsentering the regressionto 2,387.
22
464
Table3A
and Ownership The RelationBetweenCEOCompensation and GovernanceCharacteristics (CoefficientEstimatesfor Base Salary(Column1), EquityCompensation (Column2), andDiscretionary 3)a) (Column Compensation Discretionary Equity BaseSalary CompensationCompensation (3) (2) (1)
7.4548 (23.62)** 0.2397 SIZE(Firmsize) (26.48)** 0.0098 STKRTN(Stockreturn) (0.47) -0.0551 RTN ACCTG (-1.77)' return) (Accounting -0.0202 aL (Largest stock non-CEO) (-1.43) ownership, -0.0153 stock aL,M(Largest (-1.07) ownership, CEO) aM(CEO's stockownership) 0.0200 (3.32)** -0.0070 aJ (Compensation committee's ownership) (-1.76)* -0.1886 Q(defaultrisk) (-4.82)** -0.0044 D (Financial leverage) (-1.20) Z (Growth opportunities) -0.0248 (-1.42) Intercept
15.0991 (1.29) 0.2123 (0.51) 0.9075 (5.33)** 0.2070 (0.57) -0.1242 (-2.23)** -0.0800 (-1.34) 0.0562 (2.25)** -0.0479 (-2.88)** -0.6667 (-3.75)** -0.0296 (-2.17)** 0.5707 (8.06)**
7.0537 (4.09)** 0.3999 (6.06)** 1.0318 (8.79)** 0.4213 (2.84)** -0.1431 (-2.71)**
-0.3081 (-5.73)** 0.0400 (1.78)* -0.0440 (-2.94)* -0.9263 (-6.24)** 0.0143 (1.05) 0.3154 (4.87)**
ControlVariables Internal blockholder External blockholder CEOduality Firmrisk industry Regulated of Proportion outsidedirectors Boardsize CEO's age CEOtenure
0.0107 (0.59) 0.0328 (1.46) 0.0385 (2.02)* 0.1567 (5.52)* -0.1723 (-4.19)" 0.0544 (3.15)** -0.0349 (-1.03) 0.0152 (0.25) 0.0539 (3.88)**
0.0893 (1.22) 0.3464 (3.62)** 0.3638 (4.95)** 1.1004 (8.94)* -0.1974 (-0.94) 0.0733 (1.03) -0.2851 (-2.21)"* -1.5159 (-6.12)** -0.2764 (-4.85)*
-0.0326 (-0.48) 0.1215 (1.42) 0.2343 (3.29)** 0.7730 (7.18)** -0.9343 (-5.94)" 0.2729 (4.44)** 0.3290 (2.61)**
-1.3229 (-5.86)" -0.1254 (-2.40)" Continued
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CYERT,KANG, AND KUMAR Governance andTop-Management Corporate Compensation
similar firm. The results also show that CEO compensation is generally unaffected by the presence of other Equity Discretionary BaseSalary CompensationCompensation internal blockholders after controlling for the owner(1) (2) (3) ship of the CEO, the BOD, and the largest stockholder. However, the presence of external blockholders (other A(Inverse MillsRatio) -3.3924 1.4298 than L) increase CEO's equity compensation. One n.a. (-0.66) (0.83) explanation for this is that the presence of such blockR2 0.52 0.40 0.34 Adjusted holders reducesL's incentives for a takeover since the Notes. **Significant atthe5%level,two-tailed. chances of a rival bid emerging are higher. atthe10%level,two-tailed. *Significant Second, contingent compensation has a strong negaThetotalsamplesizeis 2,386firm-years for1992and1993.Equity ative association with the size of the compensation includes stock and restricted stocks. compensation options Discretionary includes stockoptions, restricted LTIP, committee's ownership (aI). A doubling of compensacompensation stocks,cashbonuses, and"other" miscellaneous Theregression under tion committee ownership, for example, reduces concompensation. equations Columns 2 and3 areestimated usingHeckman's proce- tingent compensation by about 4% and equity com(1976)two-step dure(withcorrections forconsistent covariance matrix to Greene according pensation by about 5%. The negative relationship is (1981)). robust under different definitions of board ownership, but is the strongest with the compensation committee for aL suggest that a CEO is expected to receive ownership. about 12% less in equity compensation and about 14% Third, and as predicted by theory, the empirical less in total discretionary compensation if the largest relation between all forms of contingent compenshareholder's ownership is twice that of an otherwise sation and default risk (Q) is negative and robust. Table3A
Continued
Table3B TheRelation Between CEO andOwnership andGovernance Characteristics andSpearman Compensation (Pearson Correlations) Pearson Correlations** STK SIZE
ACCTG L,M
RTN
RTN
0.007
0.118
0.132
0.283
-0.048
0.035
-0.023
0.024 -0.880
STK RTN ACCTG RTN
aL
aL
-0.226
aL,M
aM
-0.442
0.035 -0.004 -0.524 0.622
aM
aJ
-0.419
Q
D
Z
-0.689
0.362
0.010
-0.010
0.036
-0.182
-0.036 -0.028 0.096 0.248
-0.309 -0.069 0.166 0.346
-0.009 0.035 -0.064 -0.137
-0.104 -0.028 -0.010 0.057
aBOD
0.345
Q
-0.110
-0.004
D
-0.261
0.080
-0.084 -0.342
Correlations** Spearman STK SIZE STKRTN RTN ACCTG
ACCTG
RTN
RTN
aL
aL M
aM
aJ
Q
D
Z
0.031
0.145 0.341
0.061 -0.056 -0.073
-0.233 0.036 0.019 -0.764
-0.441 0.038 -0.014 -0.446 0.684
-0.415 0.005 -0.057 -0.011 0.106 0.257
-0.723 -0.012 -0.415 -0.005 0.195 0.367 0.375
0.416 0.042 -0.033 0.006 -0.047 -0.149 -0.107 -0.048
-0.242 -0.134 -0.090 -0.023 -0.012 0.063 0.057 -0.091 -0.356
aL aL,M
aM aJ
o D
Note. **The italicized numbers indicate atthe5%level. significance MANAGEMENT SCIENCE/Vol.
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CYERT,KANG, AND KUMAR Governance and Top-Management Corporate Compensation
Interestingly, however, leverage has a negative relation with equity compensation, but not with other forms of contingent compensation. Fourth, consistent with existing studies, and as also predicted by the theoretical model, contingent compensation is strongly positively related to firm size. We also find that CEO duality, which is also a proxy for the costs of CEO displacement (:), is positively related with CEO-contingent compensation: a CEO chairman receives about 36% greater equity compensation than a nonchairman CEO. Fifth, the relation of equity and total contingent compensation to the magnitude of the firm's growth opportunities (Z) is strongly positive, and similar results obtain for recent economic performance. Based on the discussion in ?2.3, these results suggest that the incentive motive for equity awards overrides the opposing tendency due to tighter external governance constraints. A basic empirical prediction of the model is that the corporate-governance-related variables will have an asymmetric and sometimes opposing impact on equity versus fixed compensation. This prediction is supported in Table 3A and B. We find that the largest shareholder's ownership has no significant influence of base salary (independent of whether the largest shareholder is the CEO or not). Similarly, the compensation committee's ownership has a relatively insignificant impact on the base salary. The positive coefficient on CEO's ownership suggests that the CEO's fixed remuneration is increasing in his or her ownership, controlling for the case when the CEO is the largest shareholder. Finally, the pay-performance link between shareholder return and discretionary compensation is sizeable and significant: An increase in the firm's equity value by one percent leads to a roughly equal percentage increase in the CEO's contingent compensation. However, it is striking that the pay-performance link between shareholder return and fixed salary is not significantly different from zero. While the stronger pay-performance sensitivity for incentive compensation is also reported in Cyert et al. (1995) and Hall and Liebman (1998), our analysis shows that this result is robust even when controlling for internal governancerelated and external takeover-related variables.
466
4.1. The Role of Other Governance-Related and Control Variables The role of some of the other control variables is noteworthy. First, firm risk is strongly positively related to both the incentive and nonincentive compensation components. The literature has been unable to document such a robust positive relation between firm risk and CEO compensation. The finding that CEOs in regulated industries receive lower compensation is also consistent with the literature (Smith and Watts 1992). Furthermore, unlike the existing literature, our empirical specification allows the role of other internal governance related variables to be examined in conjunction with the ownership- and takeover-related variables. The positive coefficient on the proportion of outside directors for base salary (Column 1) and discretionary compensation equation (Column 3), indicates that CEO cash compensation (in terms of salary and discretionary bonuses) is higher if the board is represented by a greater portion of outside directors. The results also indicate prima facie that board size is a significant force in the determination of equity and discretionary compensation (although the direction of this effect is ambiguous). The significance of this variable vanishes, however, when log total assets, log market value, or all three variables-log total assets, log market value, and log revenues-are used as regressors. This suggests that the significance of the board size is an indirect manifestation of the strong relation between compensation and firm size, and what matters in CEO compensation is directors' stock ownership rather than the mere number of directors. Finally, the coefficients on CEO tenure and age are generally positive for base salary, but are significantly negative for the nonsalary components. The positive coefficient for tenure for base salary appears to be consistent with the managerial power theory that argues for a positive relation of CEO power to her tenure. But the negative relation between tenure and contingent compensation is inconsistent with Gibbons and Murphy's (1992) argument that, as the CEO nears his retirement, the proportion of his performance-contingent pay needs to increase because of diminishing incentives from career concerns.
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Governance and Top-Management Corporate Compensation
Table4
Coefficient Estimates forLarge Versus SmallFirms t-statistics inParentheses)' (Asymptotic BaseSalary Discretionary Compensation Small Small Large Large Firmsb Fmb Firms b Firm Firmsb (1) (2) (3) (4)
Exp.Sign Intercept SIZE (Firm size)
(+)
STKRTN(Stockreturn)
(+)
ACCTG RTN(Accounting return)
(+)
aL (Largest ownership, non-CEO)
(-)
aLM (Largest stockownership, CEO)
(-)
stockownership) aM(CEO's
(?)
aJ (Comp.committee's ownership)
(-)
Q(defaultrisk)
(-)
D (Financial leverage)
(?)
Z (Growth opportunities)
(?)
7.4832 7.8139 (15.28)** (15.76)** 0.2541 0.2015
3.4286 (0.55) 0.5978
9.0654 (4.12)** 0.2770
(14.05)** (13.95)** 0.0257 -0.0185 (0.99) (-0.51) -0.0744 -0.0248
(1.90)* 1.1600 (4.13)** 0.3568
(3.81)** 0.8898 (4.94)** 0.4285
(-1.90)* 0.0274
(-0.47) -0.0560
(1.39)
(1.45)
-0.0898
-0.1765
(1.38) (-2.74)** (-1.13) 0.0261 -0.0455 -0.2094 (1.29) (-2.19)** (-2.53)** 0.0332 0.0093 0.0215 (3.89)** (1.04) -0.0069 -0.0061 (-1.27) (-1.03) -0.0926 -0.2461 (-1.55) (-4.42)** -0.0084 -0.0007 (-1.93)* (-0.11) -0.0092 -0.0550 (-0.42)
(-1.81)*
(-2.49)** -0.3731 (-5.18)** 0.0513
(0.62) -0.0525 (-2.33)** -0.7076 (-3.16)** 0.0038 (0.22) 0.4005
(1.67)* -0.0398 (-1.97) -1.1148 (-5.75)** 0.0309 (1.32) 0.2135
(4.78)**
(2.03)**
Control Variables Included Included Included Included R2 0.22 0.32 Adjusted 0.18 0.33 Size Sample 1,148 1,238 1,238 1,148 Notes. Allequations include control variables inTable indicated arenotreported. 3, butcoefficients atthe5%level,two-tailed, *Significant atthe10%level,two-tailed. **Significant firmsarethosethatbelong tosizedecile6-10inTable 1. aLarge firmsarethosethatbelong bSmall to sizedecile1-5 inTable 1.
4.2. Alternative Estimations and Robustness Checks Consistent with earlier studies, firm size has the greatest explanatory power for variations in all three types of CEO compensation. We therefore estimate separate regressions for "small" versus "large" firms, where "large" firms are those belonging to the top five size deciles (deciles 6 to 10) as delineated in Table 1. Table 4 summarizes results for base salary and discretionary compensation. Although the results are qualitatively similar between small and large firms, the coefficients for largest shareholder (acL)are generally significant MANAGEMENTSCIENCE/Vol.
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for large firms but not for small firms. On the other hand, CEO's ownership (aM) has a positive effect on base salary in small firms, but clearly not for large firms. Sensitivity analyses establish that the empirical relationships shown in Table 3 are robust to alternative specifications, performance measures, and outliers. First, we obtain comparable estimates when we control for outliers using the method suggested by Belsley et al. (1980). Next, we also obtain similar results when we use market model residuals on both equally-weighted and value-weighted CRSP indices, 467
CYERT,KANG, AND KUMAR CorporateGovernanceand Top-ManagementCompensation
instead of raw stock returns; and when we use return on assets (ROA), instead of return on equity (ROE), as the accounting performance measure.
5. Conclusions From the viewpoint of agency theory, various literatures emphasize the role of incentive contracting (e.g., Holmstrom 1979), the implicit discipline imposed on managers by large shareholders and the market for corporate control (ensen and Ruback 1983, Shleifer and Vishny 1986), and the monitoring role of the BOD (Crystal 1991, Byrne 1996, Hermalin and Weisbach 1998). The model developed in this paper provides an integrated framework for considering the interplay of these forces in the equilibrium determination of management compensation. Our empirical analysis contributes to the growing empirical literature on CEO compensation in at least four ways: (1) by demonstrating the importance of factors suggested by the theoretical model, but not verified in the existing literature (e.g., default risk and ownership of the largest shareholder), (2) by documenting the existence of a significant relationship between factors that have been considered by the existing literature without finding a clear relationship (e.g., BOD ownership and the strength of executive pay-performance relationship), (3) by reexamining the role of factors found significant in the literature (e.g., board size) using a more comprehensive empirical specification that takes into account the role of ownership and takeover threats, and (4) by reporting that the efficacy of corporate governance has greater impact on equity-based compensation relative to fixed compensation. Acknowledgments
The authors are grateful to two anonymous referees and Bala Balachandran (the editor) for helpful comments. They also thank Rick Antle, Bill Baber, Morton Kamien, Shyam Sunder, and seminar participants at Carnegie-Mellon University, Humboldt University, University of Maryland, New York University, and Yale University for useful comments.
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Accepted by Bala Balachandran;receivedNovember1994. This paper was with the authors 15 monthsfor 6 revisions.
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