executive compensation - universität ulm

Executive Compensation

Nino PapiashviliInstitute of Finance

Ulm University

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Introduction

Corporation is a structure established to allow different parties to contribute capital, expertise and labor for the maximum benefit for all of them:The investors get the chance to participate in the profits of the enterprise without

taking responsibility for the operations

The managers get the chance to run the company without taking the responsibility of personally providing the funds

The separation of ownership and control gives rise to the principal-agent problem between managers and shareholders - shareholders want to increase the value of the firm, managers want to pursue their own interests

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What do Managers Want?

Tempting Alternatives instead of looking for positive NPV projects:

Reduced Effort: slack off instead of doing a high-effort high-pressure activity

Perks: private benefits – non-pecuniary rewards like corporate jets, sports tickets, luxury resorts, lavish office accommodation etc.

Empire Building: prefer large companies rather than small ones which leads to acquisitions that may not always be value creating undertakings

Entrenchment: prefer to invest in projects that require special skills the manager possesses

Avoiding Risk: if the manager cannot share in the upside of the risky projects, safer projects will be preferred => some risky projects create value for shareholders

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What Do Shareholders Want?

Maximize the value of their wealth

How can shareholders ensure that managers do not act solely in their interests and try hard to increase the value of the firm?

Monitoringrequires time and moneysome agency costs cannot be prevented with monitoringdispersed shareholders depend on delegated monitoring (boards of directors)

Give CEOs the right incentives provided by compensation plans. Can be based on: Input: manager’s effort - it is unobservable and difficult to measure Output: value added as a result of manager’s decision

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Composition of CEO Compensation

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Salary

Bonuses

Options

Stocks

Other

Median CEO compensation of large companies in 2008 CEO Compensation Components

CEO Compensation – Bonuses

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Bonuses depend on increases in accounting measures of performance (e.g. earnings)

Potential Problems:

• Managerial Myopia - pump up short-term profits and/or cut expenses, leaving longer-term problems to successors

• Growth in earnings does not necessarily mean that shareholders are better off. Shareholders want onlypositive NPV investments.

In judging executive performance the focus should be on value added – the addition to shareholder wealth due to management’s hard work - returns over the cost of capital

A growing number of firms now calculate EVA (Economic value added) and tie management compensation to it

Residual Income Pros: Better measure than gross earnings = invest if the increase in earnings is enough to cover the cost of capital. Works as substitute for explicit monitoring for top management

Residual Income Cons: Accounting numbers are often not accurate but biased – calls for major adjustments to the income statements and balance sheets, difficult to evaluate growth opportunities

Equity Based Compensation

The optimal principal-agent contract should compensate the agent based on the achievement of objectives within the scope of his control

Since managerial effort essentially is unobservable and accounting results are not accurate the share price of a firm provides a useful tool for evaluating executive performance

Stock options are supposed to be the ultimate example of compensation for performance The company gives the option recipient the right to purchase a block of company’s stock at some specified point in the

future at a strike price set at the time of award By tying managerial compensation to firm’s stock – managers focus attention on stock values and company ownership that

promotes loyalty, rewards long-term business success and develops common interests between managers and shareholders

The popularity of stock options in the past couple of decades can be explained by: Beneficial accounting treatment – no need to record on income statement => reduced recognition of expense Options are tax deductible – when exercised the expense (difference between market price and strike price) will be recorded

Awards of restricted stock instead of (or in addition to) stock options continue to rise as market pressure (bear markets) or changes in accounting rules force option grants to be expensed (removing the balance sheet advantage of options over stocks)

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CEO Compensation – Stock OptionsA badly designed option plan might produce significantly less value for shareholders:

Compensation based on absolute share price performance does not fully reflect the success or failure of the manager rewards managers even when their efforts have not contributed to the share price increase => might be driven solely by

factors such as changes in the economy that benefit the firm’s industry or the market as a whole according to studies market and industry factors account for about two-thirds of the stock price movements even managers who perform poorly can profit when their compensation is linked to changes in the absolute share price

options have no downside risk at worst, negative shocks make options worthless Positive shocks can increase the value of the options by an unlimited amount => the value of the options is always positive lead to excessive risk taking by managers

Resetting of Option Exercise Prices - lowering of the options’ strike price when the stock price falls below the original exercise price

The possibility that the exercise price will be lowered ex post if the stock price declines dilutes ex ante incentives

Companies claim that these adjustments are necessary to retain and motivate executives when prices fall to levels that make existing options far out-of-the-money = > these ex post retention and incentive benefits outweigh the ex ante costs

Price resetting might be appropriate after a general market downturn, because such an event is outside of the executives’ control and executives will demand a large risk premium if there is no adjustment for general market corrections

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CEO Compensation – Stock Options

Alternative ways of designing options

Indexing the exercise price of options - compensation dollars could be much better targeted if executives received these dollars only to the extent that the increase in their firm’s share price was due to firm-specific performance, rather than sector or general market performance. Indexing could be done relative to market index; the average performance of peer firms; to the performance of the companies in the bottom quartile of the industry etc.

Majority of the options are granted at-the-money - with an exercise price equal to the company’s stock price on the date of the grant. Options could be designed with an exercise price that rises or falls with either sector or broader market movements

Performance-conditioned vesting of options. The vesting of options could be made dependent on the share price exceeding a certain benchmark - the options do not vest (become exercisable) unless certain performance targets are met. These performance targets might involve an index

Each of the possible alternative mechanisms would tie an executive’s reward more closely to firm-specific performance over which he has considerable control

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CEO Compensation – Stock Options

Why do we not observe more “optimal” type of options?

The optimal contracting approach – arm’s-length bargaining contracting:

executive compensation is viewed as designed to minimize the agency costs that exist between executives (the agents) and shareholders (the principals)

The board is viewed as seeking to maximize shareholder value, with the compensation scheme being designed to serve this objective

The managerial power approach

the ability of executives to influence their own compensation schemes

compensation arrangements approved by boards often deviate from optimal contracting because directors are captured or subject to influence by management => executives can receive pay (rents) in excess of the level that would be optimal for shareholders

Rent extraction practices lead to the use of inefficient pay structures that weaken incentives

many of the most prominent features of option grants— the use of non-indexed options, at-the-money strike prices—are better explained by the managerial power approach => plays a significant role in the design of option plans and practices 10

THE GROWTH OF EXECUTIVE PAY

Together, these firms (S&P 1500) constitute more than 80 % of the total market capitalization of US public firms

executive’s total compensation = salary, bonuses, long-term incentive plans, restricted stock awards and options

Among S&P 500 firms, average CEO compensation increased by 146 % from 1993 to 2003

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Between 1993-2003 firm size increased considerably The average size of the S&P 500 firms, as measured by sales, increased by 40 %

Can the growth in pay be explained by the change in firm size, performance and industry mix during this period?

Year dummies indicate how much, holding firm attributes fixed, log compensation went up over years relative to 1993

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Compensation increased far beyond what can be attributed to changes in size and performance

The year dummy variables increase monotonically

the levels of the CEO compensation increased by 96 % b/w 1993 & 2003

Source of the increase in compensation

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Equity-based compensation of the executives of the S&P 500 firms increased from 41% of the total compensation in 1993 to 59 % by 2003

The fraction of equity-based compensation ‘peaked’ in 2000 and declined considerably afterwards

Did equity-based compensation increase at the expense of cash compensation?

Cash compensation also increased by almost 40 % between 1993 and 2003 (not reported here)

No clear substitution effect of reductions in cash compensation accompanying the increase in equity-based compensation

THE INCREASE IN THE ECONOMIC SIGNIFICANCE OF EXECUTIVE PAY

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Examine CEO compensation growth relative to earnings growth

aggregate top-five exec. compensation in 1993–2003 comprised about 6.6 % of the aggregate earnings of these firms

the ratio has been trending upwards, increasing from 5% in 1993 to 9.8 % in 2001

EXPLAINING THE GROWTH OF PAYThe arm’s-length bargaining (contracting View/Agency-Theory) perspective:

The effect of the bull (boom) market on the supply and demand of executives the demand for executives goes up and firms need to pay more in order to retain and hire executives the wealth of executives increased => increase in reservation wage by increasing the monetary amount needed to induce

executives to work executives need to exert more effort => increased pay levels are needed to compensate them for the disutility involved in

higher effort levels

Changes in executive mobility, turnover and Liability: hiring of CEOs from outside the firm has increased => with more outside options, executives’ bargaining positions have

strengthened the incidence of executive firing has increased => compensation levels had to go up to compensate executives for the higher

risk of being fired

Increases in value of outside options the rewards in other types of positions to which executives could have switched might have increased => public companies

had to increase executive pay to retain their executives

The Managerial-power Perspective

Directors are willing to go along with compensations that are favourable for managers. How far they will go from shareholder interests depend on the market penalties and social costs they will bear for adopting these arrangements: The stock-market boom has increased the pay levels that are defensible and acceptable to outsiders without triggering

significant outrage => give managers and directors more latitude to boost pay 16

ARE CEOs REWARDED FOR LUCK?

Contracting view predicts that shareholders will not reward CEOs for observable luck - changes in firm performance that are beyond the CEO's control paying for luck cannot provide better incentives

The study of CEO pay sensitivities to luck

Within the agency framework CEO pay is estimated by the equation:

Estimate the sensitivity of pay to luck by using a two-stage procedure:

1. predict performance using luck and other controls => isolate changes in performance that are caused by luck

2. see how sensitive pay is to these predictable changes in performance => agency theory predicts that β-Luck = 0

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Firm fixed effects

Time fixed effects

Other Controlspay-for-performance sensitivity

ARE CEOs REWARDED FOR LUCK?1. Oil Industry Study:

the price of crude oil •fluctuated dramatically between 1977 & 1994

these fluctuations have caused large movements in industry profits

they are likely to have been beyond the control of a single CEO Oil price movements provide an ideal place to test for pay for luck

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CEO pay changes and oil price changes correlate quite well in 12 of the 17 years:

suggestive of pay for luck

When CEO pay and oil prices move in opposite directions are all years in which the oil price drops:

asymmetry: while CEOs are always rewarded for good luck, they may not always be punished for bad luck

ARE CEOs REWARDED FOR LUCK?Multivariate Analysis

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Increases in performance (accounting & market) is correlated with the increase in total CEO compensation

The sensitivity of pay to luck rises to 2.15 rise in accounting returns by 1% due to luck raises pay by 2.15 %

Oil CEOs are paid for luck that comes from oil price movements


2. More General Tests

examine luck shocks that affect a broader set of firms: 792 large corporations in 1984 –1991

Focus on two measures of luck:

movements in exchange rates are beyond a specific CEO’s control since they are primarily determined by macroeconomic variables different industries are affected by different countries’ exchange rates construct industry-specific exchange rate movements – the weighted average of real exchange rates by

industry. The weights are the share of each foreign country’s import in total industry imports

Mean industry performance To capture external shocks that are experienced by all firms in the industry

Repeat the two stage estimation analysis instrumenting for performance using the two measures of luck

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The sensitivity of pay to luck is about the same (or more) as the sensitivity of pay to general performance

The results so far clearly establish pay for luckevidence of skimming (The managerial power approach) – when CEOs capture the pay process

Good performance provides the CEO with extra slack without outrage from investors (shareholders may scrutinize a firm more closely during bad times)

This allows higher pay when performance is good and produces a positive link between pay and performance


The Effect of GovernanceTesting the skimming view - it is exactly in the poorly governed firms where

CEOs are expected to most easily gain control of the pay processexpect more pay for luck in the poorly governed firms

How does pay for general performance (not luck) differ between well-governed and poorly governed firms?

Does the effect of governance on pay for general performance and for luck differ in well-governed and poorly governed firms?To get at pay for luck, we re-estimate the previously used equation using two-stage

instrumental variables procedure (instrument used is mean industry performance)

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Adding a large shareholder has no significant effect on the sensitivity of pay to general performance

But the sensitivity of pay for luck significantly diminishes in the presence of a large shareholdera 1 % increase in accounting returns due to luck leads to 0.42% decrease in pay when there is a large shareholder

The Effect of Governance – the presence of large shareholderslarge shareholders improve governance in a firm => less pay for luck


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The Effect of Governance – CEO entrenchmentexpect a rise in pay for luck with CEO tenure in the absence of a large shareholder But less or no rise in the presence of a large shareholder

while tenure does not affect pay for performance, it greatly increases pay for luck with no large shareholder present

with a large shareholder present tenure does not affect pay for luck at all

Consistent with skimming hypothesis

Summary

We have found that:

CEOs are rewarded for luck

pay for luck is strongest among poorly governed firms Adding a large shareholder on the board decreases the pay for luck

Poorly governed firms fit the predictions of the managerial power (skimming) view

Well-governed firms fit the predictions of the contracting view better=> they are to remove the effect of luck in setting pay

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Opportunistic Timing of CEO Pay Awards

• Equity based compensation might motivate managers to make superior decisions. Alternatively, managers might have influence over the terms of their own compensation and use this power to significantly increase their wealth for reasons unrelated to the options' purported incentive purpose like managerial skill, effort, or performance (e.g. to obtain more equity awards in advance of anticipated stock price increases)

• Work in financial economics has contributed substantially to identifying the existence of opportunistic timing of executive option awards:

Yermack (1997) shows that stock prices exhibit negative abnormal returns prior to a grant date and positive abnormal returns afterward

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Mean cumulative abnormal stock returns (CARs) for 620 stock option awards to Fortune 500 CEOs between 1992 and 1994

Companies making stock option awards outperform the market by 2% during approximately ten weeks (50 trading days) following the award date

The average abnormal increase in option award value is $30,000 after 20 trading days and $48,900 after 50 trading days

Yermack, D. (1997). Good timing: CEO stock option awards and company news announcements. The Journal of Finance, 52(2), 449-476.


Alternative explanation for the patterns observed in the data:

News of option awards reaches the investing public around the time of the grant date => investors might then buy shares, either because of the expected value of greater managerial incentives or in response to the optimistic signal conveyed by the CEO‘s receipt of an option award News of CEO stock option awards remains undisclosed until proxy statements are published approximately

three months after the end of company fiscal years—three to fifteen months after the awards The study of quarterly earnings announcements which are known in advance by CEOs shows that favorable

earnings announcements occur after stock option awards => sign of opportunistically timing stock option awards around news disclosures

Insider trading by CEOs or others accounts for the rise in stock prices just after CEO option awards Abnormal stock returns do not begin to cumulate until after the award dates of CEO stock The abnormal volume surrounding CEO option awards never begins to approach the levels needed to explain

the abnormal stock returns of more than 2 % => volume evidence does not support the CARs observed during award periods

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Lucky CEOs and Lucky Directors

Examine the determinants and implications of opportunistic option timing practices

Study the universe of all at-the-money, unscheduled option grants awarded to the CEOs and independent directors of public companies during 1996 to 2005

Focus is on “lucky” grants - given at the lowest price of the month

Opportunistic timing results in an abnormally high fraction of grants being “lucky grants”

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Data

The sample contains:

19,036 CEO grant events in 5,819 firms

25,888 independent director grant events in 6,441 different firms.

the strategy is to examine at-the-money grants on days in which the stock prices were at the bottom of the price distribution

call these grants “lucky” grants and compare the incidence of lucky grants to cases in which the grant date is chosen without regard to the price distribution

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Lucky Grants

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12% vs. 4% of the CEO grants were given at the lowest and highest prices of the month9.5% vs. 6% of director grants were given at the lowest and highest prices of the month

asymmetry between the incidence of grants at the lowest and highest prices of the month

Lucky GrantsEstimate the number of opportunistically timed grants:

compare the actual number of lucky grant events to the expected number of grant events that would have been lucky if grant events were allocated randomly during the month

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50% of lucky CEO and 33% of lucky director grants were due to opportunistic timing

Lucky CEO (Director) grant price is 12% (11%) lower than the median price of the month

The Role of Independent Directors

One probable cause of opportunistic timing of grant awards is agency problems:

why directors failed to prevent it? directors did not know about opportunistic timing Directors had incentives to allow such practices to continue

Check the grant award dates of independent directors:

29% of all sample director grant events coincided with awards to one or more executives

Some director grant events could have coincided with grants awarded to executives (for various reasons)Then the likelihood of a CEO grant event being lucky should not be correlated with whether

independent directors received an option grant on the same day

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Lucky Directors

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Lucky = 1 if the price on a given day is the lowestthe incidence of luck among director grant events not coinciding with executive awards issignificantly higher than random

examine how the likelihood of a lucky director grants depend on the existence of a simultaneous award to executivesthe odds that a director grant event is lucky increases when an executive also receives a grant on the same dayGrant choices were made with an aim to benefit independent directors in connection with the provision of benefits to the CEO

Is Director Luck Due to Routine Timing?

The higher-than-normal incidence of director luck could have been a mere byproduct of firms “routinely” timing all grants to everyone

• The sample shows that the incidence of firms that provided lucky grants to all recipients was very low: Firms that commonly awarded lucky grants did not uniformly provide such

grants to all recipients, but rather provided grants that were not lucky to some recipients – only 5% of the firms had grants that were always lucky (292 firm-year observations)

The results concerning director luck were not due to routine timing

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The Gains from Opportunistic Timing

Compute the grant’s actual value under truthful reporting i.e. if it was granted: • (i) when the price was equal to the month’s median price • (ii) on a randomly selected day during the grant month • (iii) at the end of the grant month

The calculations show that the value of the grants are 20% to 21% higher than the value of the grant in the absence of such timing

The estimate of the dollar gain to the CEO ranges from 1.4 to 1.7 million dollars

The gain from an opportunistically timed grant to the total CEO compensation represents 9% to 10%

Opportunistic timing produced significant ex post profits to CEOs exercising opportunistically timed grants:• The profits CEOs made from exercising lucky options were higher by 13% compared with the

scenario in which the grant was awarded at the median price of the grant month

opportunistic timing significantly increased CEOs’ gains from option awards not only ex ante but also ex post

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“lucky CEO” = 1 if the grant was given at the lowest price of the month“relative gain from luck (CEO)” = the gain from lucky grant divided by total reported compensation

The higher is the incidence of lucky grants and CEO’s gain from receiving a lucky grant, the higher is the CEO’s total compensation from other sourcesCEOs’ influence over the pay-setting process, or some other governance problem, resulted both in lucky grants to the CEO and in the CEOs receiving higher compensation from other sources

Directors who received lucky grants were less likely to resist higher CEO pay:when directors received a lucky grant, the CEO’s compensation for the year was higher by about 9% (exp(0.088))

The Gains from Opportunistic Timing

The Determinants of Opportunistic Timing

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Potential gains from opportunistic timing are larger the greater the difference between the lowest and median price

The use of opportunistic timing is not a result of a habitual following of a practice, but rather a consequence of an economic decision that is sensitive to payoffs

The Timing – grants are more likely to be lucky when the payoffs from such luck are higher

The Determinants of Opportunistic Timing

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CEO InfluenceThe longer the CEO tenure, the more influence he is expected to have on directors and internal pay practices

Board IndependenceOpportunistic timing is associated with boards that lack a majority of independent directors

But this link is weakened when directors receive lucky grantsCEO’s are more likely to be lucky when directors receive lucky grants

Outside blockholder needs to be on the compensation committee to make a difference with respect to opportunistic grants

Summary

Opportunistic timing increases the incidence of lucky grants given on days with the lowest price of the month

The grants awarded to independent directors, who are charged with overseeing the company’s executives, are themselves affected by opportunistic timing

CEOs who received lucky grants had higher income from other sources of compensation no evidence for the hypothesis that firms providing opportunistically timed CEO grants reduce

their compensation from other sources

Opportunistic timing is correlated with greater CEO influence on pay-setting. Grants are more likely to be lucky when the company:Has a long-serving CEO lacks a majority of independent directors on the board Does not have an independent compensation committee with an outside blockholder on it

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References:

*Bebchuk, L., & Grinstein, Y. (2005). The growth of executive pay. Oxford review of economic policy, 21(2), 283-303.

*Bertrand, M., & Mullainathan, S. (2001). Are CEOs rewarded for luck? The ones without principals are. Quarterly Journal of Economics, 901-932.

*Bebchuk, L. A., Grinstein, Y., & Peyer, U. (2010). Lucky CEOs and lucky directors. The Journal of Finance, 65(6), 2363-2401.

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Optional Readings/Presentations:

Yermack, D. (1997). Good timing: CEO stock option awards and company news announcements. The Journal of Finance, 52(2), 449-476.

Aboody, D., & Kasznik, R. (2000). CEO stock option awards and the timing of corporate voluntary disclosures. Journal of Accounting and Economics, 29(1), 73-100.

Chauvin, K. W., & Shenoy, C. (2001). Stock price decreases prior to executive stock option grants. Journal of Corporate Finance, 7(1), 53-76.

Bertrand, M., & Mullainathan, S. (2003). Enjoying the quiet life? Corporate governance and managerial preferences. Journal of Political Economy, 111(5), 1043-1075.

Hartzell, J. C., & Starks, L. T. (2003). Institutional investors and executive compensation. The Journal of Finance, 58(6), 2351-2374.

Callaghan, S. R., Saly, P. J., & Subramaniam, C. (2004). The timing of option repricing. The Journal of Finance, 59(4), 1651-1676.

Yermack, D. (2006). Flights of fancy: Corporate jets, CEO perquisites, and inferior shareholder returns. Journal of Financial Economics, 80(1), 211-242.

Cicero, D. C. (2009). The manipulation of executive stock option exercise strategies: Information timing and backdating. The Journal of Finance, 64(6), 2627-2663.

Salas, J. M. (2010). Entrenchment, governance, and the stock price reaction to sudden executive deaths. Journal of banking & finance, 34(3), 656-666.

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executive compensation - universität ulm

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