CEO Compensation and Firm Performance: an Empirical Investigation of UK Panel Data

This paper examines the link between CEO pay and performance employing a unique, hand‐collected panel data set of 390 UK non‐financial firms from the FTSE All Share Index for the period 1999–2005. We include both cash (salary and bonus) and equity‐based (stock options and long‐term incentive plans) components of CEO compensation, and CEO wealth based on share holdings, stock option and stock awards holdings in our analysis. In addition, we control for a comprehensive set of corporate governance variables. The empirical results show that in comparison to the previous findings for US CEOs, pay‐performance elasticity for UK CEOs seems to be lower; pay‐performance elasticity for UK CEOs is 0.075 (0.095) for cash compensation (total direct compensation), indicating that a ten percentage increase in shareholder return corresponds to an increase of 0.75% (0.95%) in cash (total direct) compensation. We also find that both the median share holdings and stock‐based pay‐performance sensitivity are lower for UK CEOs when we compare our findings with the previous findings for US CEOs. Thus, our results suggest that corporate governance reports in the UK, such as the Greenbury Report (1995) that proposed CEO compensation be more closely linked to performance, have not been totally effective. Our findings also indicate that institutional ownership has a positive and significant influence on CEO pay‐performance sensitivity of option grants. Finally, we find that longer CEO tenure is associated with lower pay‐performance sensitivity of option grants suggesting the entrenchment effect of CEO tenure.     

Corporate governance when founders are directors

We examine chief executive officer (CEO) compensation, CEO retention policies, and mergers and acquisition (M&A) decisions in firms in which founders serve as a director with a nonfounder CEO (founder-director firms). We find that founder-director firms offer a different mix of incentives to their CEOs than other firms. Pay-for-performance sensitivity for nonfounder CEOs in founder-director firms is higher and the level of pay is lower than that of other CEOs. CEO turnover sensitivity to firm performance is also significantly higher in founder-director firms compared with nonfounder firms. Overall, the evidence suggests that boards with founder-directors provide more high-powered incentives in the form of pay and retention policies than the average US board. Stock returns around M&A announcements and board attendance are also higher in founder-director firms compared with nonfounder firms.     

Can CEO dismissals be proactive?

We find significant variation in the prior stock returns of firms that dismiss their CEOs between 1996 and 2008. 49% of firms that dismiss their CEOs do so in the absence of negative industry-adjusted stock returns prior to dismissal (37% dismiss in the absence of negative raw returns). We find evidence for two reasons why boards may dismiss CEOs early, i.e., in the absence of significant poor prior stock performance. First, we find that early dismissals are more likely to be associated with corporate scandals, suggesting that CEOs that are found to engage in unethical or illegal activities are dismissed although their actions may not have a significant adverse impact on firm value. Second, we find support for the argument that early dismissals are proactive actions by boards to dismiss low ability CEOs. We find that firms with more equity-based compensation for directors and higher independent director ownership are more likely to dismiss their CEOs early. Boards with strong incentives are more likely to be proactive and act on their private information about the CEO than boards with poor incentives. Early dismissal firms experience a short-lived decline in operating performance around the date of CEO dismissal, and their operating performance recovers immediately after the CEO is replaced. On the other hand, the operating performance of late dismissal firms declines significantly prior to dismissal and improves substantially after dismissal. We also find that CEOs that are dismissed early are not more likely to find new CEO positions than CEOs that are dismissed late, supporting the idea that early dismissal CEOs may not have different ability than late dismissal CEOs.     

Hedge fund activism,CEO turnover and compensation

This paper examines the governance role of hedge fund activists by analyzing the impact of these activists on CEO turnover, CEO pay, and CEO pay-performance link in targeted companies. Using the difference-in-difference approach, we first find significantly higher CEO turnover following hedge fund activism. After we split target companies into the CEO-turnover and non-CEO-turnover sub-samples, we find that only new CEOs in targeted companies get more compensation following hedge fund activism while incumbent CEO pay does not significantly change. The relationship between CEO bonuses and return on assets following hedge fund activism also differs across the subsamples split by CEO turnover. Pay-performance relationship is enhanced by hedge fund activism for new CEOs, but not for incumbent CEOs. In additional analyses, we document that CEO turnover is positively associated with Tobin’s Q and shareholder votes on Say on Pay in target companies after hedge fund activism.     

Peer choice in CEO compensation

Current research shows that firms are more likely to benchmark against peers that pay their Chief Executive Officers (CEOs) higher compensation, reflecting self serving behavior. We propose an alternative explanation: the choice of highly paid peers represents a reward for unobserved CEO talent. We test this hypothesis by decomposing the effect of peer selection into talent and self serving components. Consistent with our prediction, we find that the association between a firm's selection of highly paid peers and CEO pay mostly represents compensation for CEO talent.     

Does Sensationalism Affect Executive Compensation? Evidence from Pay Ratio Disclosure Reform

Beginning in 2018, U.S. public firms were required to report the ratio of the chief executive officer's (CEO) compensation to their median employee's compensation in the annual proxy statement. Exploiting the staggered reporting of pay ratios, we find little evidence that total CEO compensation changes in response to pay ratio disclosure reform. However, we do find that boards significantly adjust the mix of compensation awarded by reducing the sensitivity of CEO pay to equity price changes, particularly when the CEO is likely to garner media scrutiny, and by reducing reliance on stock-based and other compensation components that are most susceptible to media coverage surrounding the pay ratio disclosure. Firms ultimately disclosing higher pay ratios garner more media coverage around the filing of their proxy statement, and more negative-toned coverage in the subsequent month. Finally, we find evidence that greater pay disparity is associated with greater selling activity by retail investors and more negative say-on-pay votes following pay ratio reform, consistent with a broad set of investors responding to public scrutiny resulting from pay ratio disclosures.     

Generalists versus specialists: Lifetime work experience and chief executive officer pay

We show that pay is higher for chief executive officers (CEOs) with general managerial skills gathered during lifetime work experience. We use CEOs' résumés of Standard and Poor's 1,500 firms from 1993 through 2007 to construct an index of general skills that are transferable across firms and industries. We estimate an annual pay premium for generalist CEOs (those with an index value above the median) of 19% relative to specialist CEOs, which represents nearly a million dollars per year. This relation is robust to the inclusion of firm- and CEO-level controls, including fixed effects. CEO pay increases the most when firms externally hire a new CEO and switch from a specialist to a generalist CEO. Furthermore, the pay premium is higher when CEOs are hired to perform complex tasks such as restructurings and acquisitions. Our findings provide direct evidence of the increased importance of general managerial skills over firm-specific human capital in the market for CEOs in the last decades.     

Blockholder monitoring and the efficiency of pay-performance benchmarking

In this article I examine how the performance sensitivity of CEO compensation is related to the level and turnover of outside block ownership. Separating firm performance into firm-specific (Skill) and exogenous (Luck) components, I find that pay sensitivity to Luck increases with blockholder turnover, whereas pay sensitivity to Skill increases with blockholding size. Furthermore, when blockholder turnover is higher, CEO pay increases more with positive Luck but does not decrease as much with negative Luck; also, excess CEO compensation is larger. Thus, the rent accruing to CEOs via asymmetric pay sensitivity to Luck is partly explained by short investment horizons of large shareholders.     

Does Say‐on‐Pay Matter? Evidence from Say‐on‐Pay Proposals in the United States

We investigate the effect of say‐on‐pay (SOP) proposals on changes in executive and director compensation. Relative to non‐SOP firms, SOP firms’ total compensation to CEOs does not significantly change after the proposal. However, the mix of compensation does change—companies move away from using cash compensation toward more incentive compensation, offsetting the reduction in bonus. Further, the mix of compensation of non‐CEO executives changes similarly to that of CEOs. Compensation to directors of SOP firms increases less than non‐SOP firms. Firms whose CEOs are well compensated, especially with cash‐based compensation, are most likely to receive a proposal.     

Are long-tenured CEOs rent seekers? Analysis of cash compensation and post disposal performance

Are typical long-tenured CEOs rent-seekers? Do compensation committees consider undiversified risk for veteran executives and design their cash pay to limit their risk exposure? Because an exit decision requires board approval, discontinued operations provide a unique setting to analyze intervention by compensation committees. Seasoned managers should require less oversight because their ability has been revealed over time. However, as CEOs advance in their careers, they are more likely to acquire power to influence board decisions. They are also more risk averse and potentially more myopic than younger CEOs because they hold a large undiversified portfolio. Lucrative labor markets for talented retired executives can incentivize long-tenured CEOs to maintain a solid reputation. I reexamine the previously reported differential sensitivity of CEO cash compensation to positive or negative-valued disposal decisions, which can be viewed as rent-seeking. I show that cash pay for veteran CEOs are shielded from the effect of both negative and positive-valued discontinued operations, suggesting that compensation committees alter their cash pay. This evidence does not support rent-seeking. I also find strong evidence that long-tenured CEOs make better exit decisions to improve future firm performance than less experienced executives.     

Do corporate governance mechanisms influence CEO compensation? An empirical investigation of UK companies

The aim of this paper is to empirically examine the influence of corporate governance mechanisms, that is, ownership and board structure of companies, on the level of CEO compensation for a sample of 414 large UK companies for the fiscal year 2003/2004. The results show that measures of board and ownership structures explain a significant amount of cross-sectional variation in the total CEO compensation, which is the sum of cash and equity-based compensation, after controlling other firm characteristics. We find that firms with larger board size and a higher proportion of non-executive directors on their boards pay their CEOs higher compensation, suggesting that non-executive directors are not more efficient in monitoring than executive directors. We also find that institutional ownership and block-holder ownership have a significant and negative impact on CEO compensation. Our results are consistent with the existence of active monitoring by block-holders and institutional shareholders. Finally, the results show that CEO compensation is lower when the directors’ ownership is higher.     

CEO power,M&A decisions,and market reactions

In this study we examine the relationship between CEO power, corresponding acquisition activities and market reactions to mergers and acquisitions (M&A) announcements with a Canadian M&A dataset (1997–2005). We use CEO excess pay as a proxy for CEO power. Our empirical results show that the market reactions to M&A announcements are not related to CEO power. It implies that powerful CEOs do not necessarily make value destroying acquisitions. Our results further show that CEO power levels are significantly higher for acquiring firms compared to the CEOs of non-acquiring firms. In other words, CEOs with more relative power make more acquisitions. Such acquisitions will increase the size of the firm and will allow CEOs to demand a higher compensation level for managing larger asset pools and to derive higher performance incentives that are also generally tied to firm size.     

The impact of family-CEOs and their demographic characteristics on dividend payouts: Evidence from Latin America

We investigate the effect of family-CEOs and CEO demographic characteristics on firms’ dividend policy in Latin America. We show that family-CEO firms pay less amount of dividends and invest more in capital expenditures than nonfamily-CEO firms do. Direct family ownership (ownership concentration) negatively (positively) affects dividend payouts. Among the CEO demographic characteristics, CEO tenure has a consistent and significant negative effect on the dividend payout. Firms in a strong corporate governance environment pay more dividends and are less likely to appoint family members as CEOs, suggesting that strong corporate governance forces firms to pay more dividends and restrains firms from appointing CEOs based on family ties.     

Bank Risk Taking at the Onset of the Current Banking Crisis

We analyze bank governance, share ownership, CEO compensation, and bank risk taking in the period leading to the current banking crisis. Using a sample of large U.S. bank holding companies (BHCs), we find that BHCs with greater managerial control, achieved through various corporate governance mechanisms, take less risk. BHCs that pay CEOs high base salaries also take less risk, while BHCs that grant CEOs more in stock options or that pay CEOs higher bonuses take more risk. The evidence is generally consistent with BHC managers exhibiting greater risk aversion than outside shareholders, but with several factors affecting managers’ risk‐taking incentives.     

Do CEOs gain more in foreign acquisitions than domestic acquisitions?

This paper examines the impact of domestic and foreign acquisitions on chief executive officer (CEO) compensation packages using a sample of 147 completed bids by UK companies from 1999 to 2005. We find that foreign acquisitions lead to higher CEO compensation than domestic acquisitions. Overall, our findings suggest that CEOs have strong incentives to do foreign acquisitions rather than domestic acquisitions since they receive larger compensation following a foreign acquisition regardless of how poor firm performance is. Furthermore, we observe a positive and significant relation between CEO compensation and firm size during the pre-acquisition period for firms involved in foreign acquisitions, thus their CEOs would expect to increase their compensation package through foreign acquisitions. However, our results show that there is no significant link between firm size and CEO compensation during the pre-acquisition period for firms involved in domestic acquisitions.     

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.     

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.     

Seeking safety: The relation between CEO inside debt holdings and the riskiness of firm investment and financial policies

CEO inside debt holdings (pension benefits and deferred compensation) are generally unsecured and unfunded liabilities of the firm. Because these characteristics of inside debt expose the CEO to default risk similar to that faced by outside creditors, theory predicts that CEOs with large inside debt holdings will display lower levels of risk-seeking behavior (Jensen and Meckling, 1976). Consistent with the theoretical predictions, we find a negative association between CEO inside debt holdings and the volatility of future firm stock returns, R&D expenditures, and financial leverage, and a positive association between CEO inside debt holdings and the extent of diversification and asset liquidity. Collectively, our results provide empirical evidence suggesting that CEOs with large inside debt holdings prefer investment and financial policies that are less risky.     

The Effect of Overconfidence on the Sensitivity of CEO Wealth to Equity Risk

Recent theory predicts that shareholders provide overconfident managers with weaker risk-taking incentives. We test this prediction using a sample of bank CEOs over the period 1993–2002. We classify a CEO as overconfident if he is more often characterized as confident than as cautious in press. Consistent with theory, we find that the sensitivity of CEO wealth to equity risk is lower for overconfident CEOs. Our finding suggests that shareholders know whether a CEO is overconfident, and take that into account when designing the compensation contract for the CEO.     

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.