Heterogeneous institutional investors and CEO compensation

This paper examines the relationship between institutional ownership and executive compensation by taking into account the heterogeneity of institutional investors. The paper finds that ownership by transient institutional investors, who have short investment horizons and active trading, is positively related to the performance sensitivity of option grants for CEOs. However, no significant relationship holds for other types of institutions, including those dedicated institutional investors, who have longer horizon and concentrated holdings. Further tests suggest that the positive relationship between transient institutional ownership and the CEO pay-for-performance sensitivity is not driven by the trading behavior of transient institutional investors when stock performance is good. Instead, the paper documents preference of transient institutional investors for greater performance sensitivity of option grants for CEOs. After using an instrument approach to control for preference and endogeneity, transient institutional ownership is no longer significantly related to the CEO pay-for-performance sensitivity. Additionally, the paper does not find dedicated institutional investors serve a monitoring role in correcting overcompensation paid to CEOs. After controlling for preference and endogeneity, neither the level of salary nor the level of total direct compensation for CEOs is significantly related to dedicated institutional ownership. The findings suggest that on average the influence of institutional investors on CEO compensation occurs indirectly through their preference in line with their different investment types.     

Earnings Warnings and CEO Welfare

Some CEOs decide voluntarily to issue a warning when they expect a negative earnings surprise. Prior research suggests that warnings contain incremental information beyond actual earnings; warning firms tend to experience permanent earnings decreases. This paper investigates whether compensation committees take warnings into account in setting CEO compensation. We find that warnings are significantly negatively (positively) associated with CEO bonus (option grants), suggesting that compensation committees adjust CEO compensation towards a more high‐powered structure after warnings. However, the sensitivity of bonus or option grants to earnings and stock returns is not affected except for bonus sensitivity to stock returns. We also find weak evidence of an increase in forced CEO turnover after warnings, accompanied by a significant increase in its sensitivity to stock returns. This benefits CEOs with higher ability but imposes more risk on other CEOs. These findings provide a partial explanation of why not every CEO facing a negative surprise decides to issue a warning. Our results are robust to various specifications. In particular, the impact of warnings on compensation appears invariant to the timing or the number of warnings. Overall, these findings suggest that the signal from warnings is used in determining CEO compensation and retention.     

Compensation committee governance quality,chief executive officer stock option grants,and future firm performance

This paper examines whether the relationship between future firm performance and chief executive officer (CEO) stock option grants is affected by the quality of the compensation committee. Compensation committee quality is measured using six committee characteristics – the proportion of directors appointed during the tenure of the incumbent CEO, the proportion of directors with at least ten years’ board service, the proportion of directors who are CEOs at other companies, the aggregate shareholding of directors on the compensation committee, the proportion of directors with three or more additional board seats, and compensation committee size. We find that future firm performance is more positively associated with stock option grants as compensation committee quality increases.     

CEO Inside Debt Incentives and Corporate Tax Sheltering

This paper examines the relation between CEO inside debt holdings (pension benefits and deferred compensation) and corporate tax sheltering. Because inside debt holdings are generally unsecured and unfunded liabilities of the firm, CEOs are exposed to risk similar to that faced by outside creditors. As such, theory (Jensen and Meckling [1976]) suggests that inside debt holdings negatively impact CEO risk‐appetite. To the extent that corporate tax shelters are likely to result in high cash flow volatility in the future, we expect that inside debt holdings will curb CEOs from engaging in tax shelter transactions. Consistent with the prediction, we document a negative association between CEO inside debt holdings and tax sheltering. Additional analyses suggest that the effect of inside debt on tax sheltering is more (less) pronounced in the presence of high default risk and liquidity threats (cash‐out options in pension packages). Overall, our results highlight the importance of investigating the implication of CEO debt‐like compensation for corporate tax policies.     

Bidder CEO and Other Executive Compensation in UK M&As

This paper investigates the impact of M&As on bidder (CEO and other) executive compensation employing a unique sample of 100 completed bids in the UK over the 1998–2001 period. Our findings indicate that less independent and larger boards award CEOs significantly higher bonuses and salary following M&A completion both for the full sample and for the UK and US sub‐samples. UK CEOs and executives are rewarded more for the effort exerted in accomplishing intra ‐ industry or large mergers than for diversifying or small mergers and their cash pay is unaffected by other measures of their managerial skill or performance. US bidders are rewarded at higher levels than their UK counterparts and their remuneration is related only to measures of CEO dominance over the board of directors. Overall our findings offer support for the managerial power rather than the agency theory perspective on managerial compensation.     

The efficiency of compensation contracting in China: Do better CEOs get better paid?

Over recent years, China adopted a number of ‘western-style’ reforms of corporate governance and executive compensation. We investigate whether boards of Chinese firms evaluate CEO ability and remunerate their CEOs accordingly, an essential tenet of efficient compensation contracting. Using Data Envelopment Analysis to measure CEO ability, we do not find any evidence that CEO ability matters in compensation contracting decisions—it does not lead to either higher pay, stronger pay-for-performance sensitivity, or a higher likelihood of equity grants. This is surprising, since we find evidence that higher ability CEOs achieve superior firm performance. In contrast, we find that powerful CEOs do not overperform, while they enjoy large abnormal pay. Overall, our results suggest that Chinese firms fail to embrace new corporate governance reforms and are unable to fully utilize the reforms’ benefits.

     

Underwater Options and the Dynamics of Executive Pay-to-Performance Sensitivities

We empirically analyze the dynamics of executives' pay‐to‐performance sensitivities. Option pay‐to‐performance sensitivities become weaker as options fall underwater, often leading to pressures to reprice options or restore pay‐to‐performance sensitivity in other ways. Building a detailed data set on executives' portfolios of stock and options, we find that the responsiveness of pay‐to‐performance sensitivities (created by all executive holdings of stock and options) to changes in stock price is large. The elasticity of pay‐to‐performance sensitivities with respect to stock price decreases is about 0.7 and is larger for high‐option executives and for executives with high percentages of options already underwater. The dominant mechanism through which companies offset declines in option pay‐to‐performance sensitivities is larger option grants following stock price declines; on average, these larger grants restore approximately 40% of the stock‐price‐induced pay‐to‐performance sensitivity declines. Option repricings are inconsequential in this regard, despite the attention they have attracted. In looking at positive returns, we find the reverse: higher returns both directly increase pay‐to‐performance sensitivities and lead to larger option grants, which raise pay‐to‐performance sensitivities further. Thus, option grants to executives tend to be largest following large stock price increases or large stock price decreases.     

The Relationship between Shareholder Return and CEO Pay over a CEO's Full Period of Service

The author reports the findings of his examination of the relationship between CEO pay and performance, as measured by shareholder returns, using measures of compensation and returns that span a CEO's full period of service. Unlike studies that look at annual measures of CEO pay and stock returns—which are distorted by the widespread use of options and the arbitrary effects of when CEOs choose to exercise their options—the author finds a statistically significant connection between total compensation and shareholder return measured over full periods of service for 521 S&P 500 CEOs. Indeed, after one adjusts for differences in the length of a CEO's service, shareholder return is arguably the most important determinant of variation in the amount paid CEOs over their complete tenures. Besides answering the legion of critics of CEO pay, the author's analysis refutes the claim that bull markets are the main force driving executive pay by demonstrating that the increases in career pay attributable to increases in shareholder returns are almost exactly offset by reductions in pay when the Value‐Weighted (S&P 500) Index increases by the same amount. In other words, CEOs’ cumulative career pay is effectively driven by the extent to which their stock returns outperform the broad market. The analysis also casts doubt on the popular claim that the link between CEO pay and corporate size provides incentives to undertake even value‐reducing acquisitions to boost size. As the author's analysis shows, the estimated losses in career CEO pay associated with even small declines in shareholder returns are likely to be offset by the pay increases attributable to size.     

CEO Incentives—It's Not How Much You Pay,But How*

In this 1990 Harvard Business Review classic, the authors begin by correcting a number of widespread misconceptions:

• • Contrary to headlines at the time, top executives at the end of the 1980s were not receiving record salaries and bonuses. Instead they were catching up to real levels of pay that prevailed during the 1930s and had dropped sharply since then.
• • Annual changes in executive compensation during the 1970s and 1980s were largely unrelated to changes in corporate performance, with CEO total compensation varying by only about $3 with every $1,000 change in shareholder wealth. (And the variability of total CEO pay was no higher than that of the compensation of hourly and salaried employees.)
• • With respect to pay for performance, U.S. compensation practices in the '70s and '80s were getting worse rather than better over time. The percentage of stock ownership by CEOs in large public companies was ten times greater in the 1930s than in the 1980s. And during the previous 15 years (1975-1989), CEO holdings as a fraction of value had actually fallen.

With the aim of reversing these trends, the authors offered three recommendations:

• • Substantial equity ownership by CEOs.
• • Structuring of cash compensation to provide big rewards for outstanding performance and meaningful penalties for poor performance.
• • Increased threat of dismissal for poor performance.

Since publication of this article in 1990, the first and third of these goals have largely been accomplished (while the second has proved more elusive).     

CEO EQUITY PORTFOLIO INCENTIVES AND LAYOFF DECISIONS

CEOs with higher equity‐based compensation are widely believed to be more likely to act in shareholders' interests. Unlike less common acquisitions, voluntary liquidations, or seasoned equity offerings, layoffs are comparatively common elements of firms' operating strategies. We find that CEOs with at least one year of tenure who possess greater incentives from portfolios of restricted stock and stock option grants are more likely to announce layoffs, and that these layoffs create shareholder value. We conclude that accumulated portfolios of restricted stock and stock option grants encourage CEOs to adopt operating strategies that improve operating profits and stock performance.     

SIX CHALLENGES IN DESIGNING EQUITY-BASED PAY

The past two decades have seen a dramatic increase in the equitybased pay of U.S. corporate executives, an increase that has been driven almost entirely by the explosion of stock option grants. When properly designed, equity‐based pay can raise corporate productivity and shareholder value by helping companies attract, motivate, and retain talented managers. But there are good reasons to question whether the current forms of U.S. equity pay are optimal. In many cases, substantial stock and option payoffs to top executives–particularly those who cashed out much of their holdings near the top of the market–appear to have come at the expense of their shareholders, generating considerable skepticism about not just executive pay practices, but the overall quality of U.S. corporate governance. At the same time, many companies that have experienced sharp stock price declines are now struggling with the problem of retaining employees holding lots of deep‐underwater options. This article discusses the design of equity‐based pay plans that aim to motivate sustainable, or long‐run, value creation. As a first step, the author recommends the use of longer vesting periods and other requirements on executive stock and option holdings, both to limit managers' ability to “time” the market and to reduce their incentives to take shortsighted actions that increase near‐term earnings at the expense of longer‐term cash flow. Besides requiring “more permanent” holdings, the author also proposes a change in how stock options are issued. In place of popular “fixed value” plans that adjust the number of options awarded each year to reflect changes in the share price (and that effectively reward management for poor performance by granting more options when the price falls, and fewer when it rises), the author recommends the use of “fixed number” plans that avoid this unintended distortion of incentives. As the author also notes, there is considerable confusion about the real economic cost of options relative to stock. Part of the confusion stems, of course, from current GAAP accounting, which allows companies to report the issuance of at‐the‐money options as costless and so creates a bias against stock and other forms of compensation. But, coming on top of the “opportunity cost” of executive stock options to the company's shareholders, there is another, potentially significant cost of options (and, to a lesser extent, stock) that arises from the propensity of executives and employees to place a lower value on company stock and options than well‐diversified outside investors. The author's conclusion is that grants of (slow‐vesting) stock are likely to have at least three significant advantages over employee stock options:

• ? they are more highly valued by executives and employees (per dollar of cost to shareholders);
• ? they continue to provide reasonably strong ownership incentives and retention power, regardless of whether the stock price rises or falls, because they don't go underwater; and
• ? the value of such grants is much more transparent to stockholders, employees, and the press.

     

Is U.S. CEO Compensation Broken?

This article addresses four major concerns about the pay of U.S. CEOs: (1) failure to pay for performance; (2) excessive levels of pay; (3) failure to index options and other equity-based pay, resulting in windfalls; and (4) too much unwinding of incentives. The authors' main message is that most if not all of these concerns are exaggerated by the popular tendency to focus on the annual income of CEOs (consisting of salary, bonus, and stock and option grants) while ignoring their existing holdings of company equity.
Taking into account the effect of stock price changes on CEO wealth leads the authors to a number of interesting conclusions. First, the pay-for-performance relationship is strong and has grown significantly in recent years. Second, what may appear as above-normal growth in annual pay levels may be necessary to compensate CEOs for the increased risk associated with their growing level of equity-based incentives. Third, conventional (that is, unindexed) stock and options, when viewed as a combination of market risk and firm-specific risk, may provide an optimal solution to two conflicting demands: shareholders' demand for executive rewards tied to company performance and executives' preference to diversify their wealth. Finally, there is little evidence of widespread CEO unwinding of incentives, and levels of CEO equity ownership in the U.S. remain impressively high.     

CEO overconfidence and corporate cash holdings

This study proposes chief executive officer (CEO) overconfidence to be an alternative explanation to corporate cash holdings. We find positive effects of CEO overconfidence on the level of cash holdings and the value of cash, which are mainly due to the investment environments faced by firms. The positive effects of CEO overconfidence on cash holdings level and cash value are barely affected by the traditional motives of cash holdings based on trade-off and agency theories. The analysis of cash sources further explains why firms with overconfident CEOs can aggressively pursue risky investments and maintain large cash holdings at the same time. Although the prior literature indicates that overconfident CEOs tend to avoid equity issues for their capital investments, the contribution to cash savings from equity is higher than that from debt. Additional robustness tests also support our empirical findings.     

Changes in CEO compensation structure and the impact on firm performance following CEO turnover

We document changes in compensation structure following CEO turnover and relate them to future performance. Compared to outgoing CEOs, incoming CEOs derive a significantly greater percentage of their compensation from option grants and new stock grants. The voluntary turnover sample shows similar changes in compensation structure while the forced turnover sample results suggest that new stock grants drive the significant increase in incentive compensation following turnover. Post-turnover performance is positively associated with new stock grants as a percentage of total compensation in the full sample and when analyzing forced and voluntary turnovers separately. We find limited evidence that future operating income is positively associated with option grants following forced turnover. Post-turnover improvement in operating income is positively associated with an increase in new stock grants for the incoming relative to the outgoing CEO.

The Young and the Restless: A Study of Age and Acquisition Propensity of CEOs of UK Firms

Using a large sample of CEOs of UK firms, we show that CEO age is a key determinant of acquisition activity. We find that younger CEOs are more likely to acquire another firm and spend more on large capital expenditures. We argue that while younger CEOs of both UK and US firms undertake more acquisitions than their older peers, their motivations for acquisitions might differ. We find that the stock market perceives acquisitions by younger CEOs to be of a higher quality. Following previous studies, we use CEO tenure as a proxy for reputation, and find that large acquisitions enhance CEO reputation, especially for younger CEOs. In contrast to the previous findings for CEOs of US firms, we determine that the compensation of CEOs in the UK does not increase after acquisitions. This absence of a compensation incentive for CEOs of UK firms is consistent with the idea that the UK compensation structure is more restrictive and has a smaller equity‐based component. Our evidence is also inconsistent with an overconfidence effect. Overall, our results provide consistent evidence of executive signaling by younger CEOs of UK firms eager to distinguish themselves.     

CEO compensation, option incentives, and information disclosure

This paper examines the impact of information disclosure on the valuation of CEO options and the incentives created by those options. Prior executive compensation research in the US has made assumptions about key input variables that can affect the calculation of option values and financial incentives. Accordingly, biases may have ensued due to incomplete information disclosure about noncurrent option grants. Using new data on a sample of UK CEOs, we value executive option holdings and incentives for the first time and estimate the levels of distortion created by the less than complete US-style disclosure requirements. We also investigate the levels of distortion in the UK for the minority of companies that choose to reveal only partial information. Our results suggest that there have to date been few economic biases arising from less than complete information disclosure. Furthermore, we demonstrate that researchers using US data, who made reasonable assumptions about the inputs of noncurrent option grants, are unlikely to have made significant errors when calculating CEO financial incentives or option wealth. However, the recent downturn in the US stock market could result in the same assumptions, producing exaggerated incentive estimates in the future.     

What Drives CEOs to Take on More Risk? Some Evidence from the Laboratory of REITs

Many have pointed to excessive risk‐taking by the CEOs of financial firms as a contributor to the recent worldwide economic crisis. The same observers often blame questionable corporate governance structures and compensation practices for that risk‐taking. But is this perception correct? And what is the relationship between CEO incentives and risk‐taking outside of the financial industry, where the government guarantees provided by deposit insurance could have distorted incentives? In an attempt to answer these questions, the authors analyze the relationship between CEO incentives and corporate risk‐taking by 101 U.S. REITs during the period 2003 to 2007. Their main finding is that corporate risk‐taking, as measured by the growth rate in corporate debt (the only measure of risk that is completely under the control of the CEO), is inversely related to CEO stock ownership—that is, the larger the CEO's equity ownership stake, the slower the growth in debt financing and financial risk‐taking. At the same time, the authors find that financial risk‐taking is positively related to large cash bonuses for the CEOs and to situations in which the CEO is also chairman of the board of directors. Finally, the authors also report that CEOs who are relatively new to the job grow more slowly and borrow less, suggesting that boards of directors can temporarily contain risky expansion plans by the CEO. These results provide support for those corporate governance reformers who wish to cut cash bonus payments for CEOs in favor of long‐term stock ownership.     

Restricting CEO pay

We analyze several proposals to restrict CEO compensation and calibrate two models of executive compensation that describe how firms would react to different types of restrictions. We find that many restrictions would have unintended consequences. Restrictions on total realized (ex-post) payouts lead to higher average compensation, higher rewards for mediocre performance, lower risk-taking incentives, and the fact that some CEOs would be better off with a restriction than without it. Restrictions on total ex-ante pay lead to a reduction in the firm's demand for CEO talent and effort. Restrictions on particular pay components, and especially on cash payouts, can be easily circumvented. While restrictions on option pay lead to lower risk-taking incentives, restrictions on incentive pay (stock and options) result in higher risk-taking incentives.     

CEO marital status and corporate cash holdings

We examine the effect of CEO marital status on corporate cash holdings. Consistent with the classical agency framework, we find that firms with single CEOs hold more cash compared to otherwise similar firms with married CEOs and that the excess cash held by single CEOs is significantly discounted by shareholders. Our findings survive a battery of tests to ease endogeneity and selection bias, confirming that results are not simply reflecting innate heterogeneity in preferences. Overall, our findings indicate that a variable outside the common firm- and macro-level determinants, CEO marital status, can significantly influence corporate policies.     

CEO Pay and Corporate Governance in the U.S.: Perceptions,Facts, and Challenges

This article brings a broad range of statistical studies and evidence to bear on three common perceptions about the CEO compensation and governance of U.S. public companies: (1) CEOs are overpaid and their pay keeps increasing; (2) CEOs are not paid for their performance; and (3) boards do not penalize CEOs for poor performance. While average CEO pay increased substantially during the 1990s, it has declined since then— by more than 30%—from peak levels that were reached around 2000. Moreover, when viewed relative to corporate net income or profits, CEO pay levels at S&P 500 companies are the lowest they've been in the last 20 years. And the ratio of large‐company CEO pay to firm market value is roughly similar to its level in the late 1970s, and lower than the levels that prevailed before the 1960s. What's more, in studies that begin with the late '70s, private company executives have seen their pay increase by at least as much as public companies. And when set against the compensation of other highly paid groups, today's levels of CEO pay, although somewhat above their long‐term historical average, are about the same as their average levels in the early 1990s. At the same time, the pay of U.S. CEOs appears to be reasonably highly correlated with corporate performance. As evidence, the author cites a 2010 study reporting that, over the period 1992 to 2005, companies with CEOs in the top quintile (top 20%) of realized pay in any given year had generated stock returns that were 60% higher than the average companies in their industries over the previous three years. Conversely, companies with CEOs in the bottom quintile of realized pay underperformed their industries by almost 20% in the previous three years. And along with lower pay, the CEOs of poorly performing companies in the 2000s faced a significant increase in the likelihood of dismissal by their own boards. When viewed together, these findings suggest that corporate boards have done a reasonably good job of overseeing CEO pay, and that factors such as technological advances and increased scale have played meaningful roles in driving the pay of both CEOs and others with top incomes—people who are assumed to have comparable skills, experience, and opportunities. If one wants to use increases in CEO pay as evidence of managerial power or “board capture,” one also has to explain why the other professional groups have experienced similar, or even higher, growth in pay. A more straightforward interpretation of the evidence reviewed in this article is that the market for talent has driven a meaningful portion of the increase in pay at the top. Consistent with this conclusion, top executive pay policies at roughly 97% of S&P 500 and Russell 3000 companies received majority shareholder support in the Dodd‐Frank mandated “Say‐on‐Pay” votes in 2011 and 2012, the first two years the measure was in force.