Effect of the Sarbanes-Oxley Act on CEOs' stock ... - SSRN papers

Effect of the Sarbanes-Oxley Act on CEOs’ stock ownership and payperformance sensitivity* Hsihui Chang Drexel University Email: [email protected] Hiu Lam Choy Drexel University Email: [email protected] and Kam-Ming Wan University of Hong Kong Email: [email protected] Forthcoming at the Review of Quantitative Finance and Accounting First Draft: November 2005 Last Revised: December 2010

Abstract The main purpose of this paper is to provide evidence on the effect of the Sarbanes−Oxley Act on stock ownership and the various measures of pay-performance sensitivity of CEOs’ wealth. The Sarbanes−Oxley Act (SOX) provides a natural experiment for examining how stock ownership and executive pay structure adapt to a change in regulatory environment. Using annual compensation data of S&P 1500 firms in 1994−2005, we examine the impact of SOX on stock ownership and pay-performance sensitivity of CEOs. Consistent with our expectations, we find that in light of SOX: (i) stock ownership and (ii) the total pay-performance sensitivity of CEOs have decreased substantially, indicating that SOX induces a weaker incentive alignment between shareholders and CEOs. In contrast, we find that after SOX stock ownership and the total pay-performance sensitivity of CEOs have remained unchanged in the regulated industries. Keywords: SOX, CEO, stock ownership, pay-performance sensitivity JEL Classifications: G38, J33 * We gratefully acknowledge the comments and suggestions of Armen Alchian, Harold Demsetz, Michael Firth, Y. K. Fu, Kevin C. K. Lam, T. J. Wong, Danging Young, and the workshop participants at Drexel University, Syracuse University, the Hong Kong Polytechnic University, National Taiwan University, National Chung Hsin University, University of Hong Kong, and the Chinese University of Hong Kong. The paper is previously titled “Effect of the Sarbanes−Oxley Act on CEOs’ Stock Ownership and Pay-for-Performance Sensitivity: Early Evidence.

Electronic copy available at: http://ssrn.com/abstract=1268591

1 Introduction This paper examines the impact of Sarbanes-Oxley Act (hereafter referred to as SOX) on CEOs’ stock ownership and the pay-performance sensitivity. In the wake of the accounting scandals and ensuing crashes of Enron, WorldCom, and other U.S. companies, the U.S. Congress enacted the Sarbanes−Oxley Act on June 24, 2002, and President Bush signed it into law on July 30 of the same year. The objective of SOX is to restore integrity in the financial market by reinforcing corporate accountability and improving the accuracy and reliability of corporate disclosures. SOX requires management to certify the financial reports and forfeit any incentive pay the management receives if the firm has to restate the financial reports the management certified. We investigate how this regulation of SOX affects management’s ownership in the firm and pay-performance sensitivity. SOX represents one of the largest reforms in corporate regulation.

Its impact is

controversial. The general public and market operators have widely applauded SOX. The disclosure of internal control weakness per Section 404 is helpful in identifying firms with lower accruals and earnings quality (Doyle et al. 2007; Nagy 2010). Hence, SOX can be beneficial for investors in evaluating the weight they can place on the reported earnings numbers. On the other hand, Mulherin (2007) reviews the current studies on SOX and concludes that the overall impact of SOX is negative, particularly on shareholder wealth. In addition, Linck et al. (2009) examine SOX’s effect on the supply and demand of directors. They find that governance costs have increased significantly, particularly among smaller firms, after SOX. Thus, the evidence on the impact of SOX is mixed. We find that SOX induces a weaker incentive alignment between shareholders and CEOs, an unintended consequence of SOX. Specifically, several SOX provisions have raised

2 Electronic copy available at: http://ssrn.com/abstract=1268591

penalties and legal responsibilities facing CEOs. Consequently, these provisions lower the risktaking incentives facing CEOs and their incentive alignments with the shareholders. Consistent with the former claim, Bargeron et al. (2010) find that companies reduce expenditures on risky investment projects (i.e. capital expenditures as well as research and development expenses) and increase their cash holdings in the post-SOX period. Our study empirically evaluates the latter claim.

Specifically, we use annual

compensation data of S&P 1500 firms in 1994−2005 and investigate the impact of SOX on stock ownership and pay-performance sensitivity of CEOs. Consistent with our expectations, we find that: (i) equity ownership and (ii) the total pay-performance sensitivity of CEOs have decreased substantially after SOX, indicating that the incentive alignment between shareholders and CEOs has weakened significantly. This paper contributes to the extant literature in three ways. First, our study provides evidence on the change in the total pay-performance sensitivity of CEOs in the post-SOX period. Our results imply that both shareholders and CEOs take actions to minimize the impact of SOX on their wealth. Specifically, shareholders pay CEOs less in incentive pay; while CEOs sell personal holdings of their companies’ stocks after SOX. These actions altogether reduce the total pay-performance sensitivity of CEOs. Our findings are consistent with those of Banerjee et al. (2005). They find that CEOs are awarded fewer stock options in the post-Enron period, a period starting shortly before the adoption of SOX. Nevertheless, our study differs from their study in that we examine the impact of SOX on the change in all sources of incentives facing CEOs; while they look at the change in a single source of incentive provided to CEOs (that is, stock option grant) in a period before SOX. That is, this study complements Banerjee et al. (2005) in two perspectives. First, we

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examine the impact of SOX while they examine the impact of accounting scandal. Second, we measure changes in all sources of incentives whereas they examine a single source. This difference is important because CEOs could take personal actions to nullify incentives embedded in their compensation contracts. For example, Ofek and Yermack (2000) find that CEOs sell personal holdings of their companies’ stocks when they are awarded new stock option grants. The sales neutralize the additional firm-specific risk borne by the CEOs arising from the new option grants.

Ultimately, the incentive alignment between shareholders and CEOs is

determined by how closely the wealth of CEOs varies with that of shareholders. Thus, an examination of the total pay-performance sensitivity of CEOs is warranted and gives us a complete picture of SOX’s effect on the incentive alignment between shareholders and CEOs. In addition, stock option grants are only a part of the total incentives provided to CEOs. According to Aggarwal and Samwick (1999), CEOs’ pay, including salary and other incentive pay, averaged about $2.3 million in 1995, while the change in their wealth resulting from holdings of their firms’ stocks and options averaged about $24.2 million. This implies that the effect of a change in the value of existing stock and option holdings on a CEO’s total firmspecific wealth is approximately ten times larger than that of a CEO’s total pay in any single year. Second, this paper is the first to examine the impact of SOX on stock ownership and payperformance sensitivity of CEOs in regulated industries. Our results indicate that after SOX the incentive alignment between shareholders and CEOs has increased significantly in the regulated industries.

In contrast, such alignment has substantially weakened in the non-regulated

industries after SOX.

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Third, our study sheds light on the debate over whether ownership structure is endogenously determined (Demsetz and Lehn, 1985; Morck et al. 1988; McConnell and Servaes, 1990; Kole and Lehn, 1997 & 1999). Our empirical evidence supports the claim that ownership structure is endogenously determined. Specifically, stock ownership of CEOs has decreased significantly to adapt to the more stringent regulatory environment in the post-SOX regime. It is worth noting that our research setting is especially suitable for examining the aforementioned debate because it is less susceptible to the endogeneity bias as SOX is enacted by politicians rather than by corporate executives. Second, SOX was enacted swiftly, giving little time for corporate executives to lobby the government. Previous studies examining the aforementioned debate can produce unreliable findings because they are vulnerable to the endogeneity bias. Coles et al. (2007) find that the customary remedies of endogeneity and causation, which are commonly used in the study of ownership structure and firm performance, are ineffective in correcting the endogeneity bias. The rest of the paper is organized as follows: Section 2 provides the theoretical background to develop our research hypotheses; it includes a description of the major provisions in SOX that are relevant to the structure of executive compensation and research hypotheses regarding SOX’s effect on CEOs’ stockholdings and their pay-performance sensitivities. Section 3 describes the data and sample used in this study. Section 4 describes research method and Section 5 presents and discusses our empirical results, while Section 6 offers conclusions of our paper.

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Theoretical background and hypotheses development

2.1

SOX pertaining to stock ownership and executive compensation

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The objective of SOX is to deter corporate frauds by making CEOs and CFOs accountable for their managerial decisions. Specifically, Section 302 of SOX requires them to certify each periodic (annual and quarterly) financial report of their firms. To the best of these executives’ knowledge, financial reporting must be “accurate” and contain all “material” information. That is to say, these reports have to fairly reflect the operations and financial conditions of the firms in all material respects. In addition, CEOs and CFOs will be penalized if financial reports of their firms fail to meet the requirements specified in SOX. Section 304 of SOX requires that any incentive pay (for example, bonuses, stock options and restricted stocks) that CEOs and CFOs received and any profit realized from the sale of their firms’ securities, during the 12-month period following the first public issuance of the financial report, be subject to forfeiture. The forfeiture is triggered when a firm is required to restate its financial report(s) due to material noncompliance, as a result of misconduct, with any financial reporting requirement under the securities laws. Section 1106 of SOX substantially raises the maximum criminal penalties for each violation of the 1934 Act by executives to $5 million (from $1 million) and 20 years (from 10 years) of imprisonment.

2.2

Research hypotheses As CEOs are the main target of many SOX provisions, we focus our analyses on the

change in CEOs’ stock ownership and pay-performance sensitivity. CEO Stock Ownership We expect that equity ownership of CEOs decreases in the post-SOX period for the following three reasons. First, prior studies (Demsetz and Lehn 1985; Kole and Lehn 1997; Kole and Lehn 1999; Booth et al. 2002) find that regulation provides subsidized monitoring and

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decreases costs of monitoring managerial performance. Some firms implement mandatory target ownership plan to improve corporate governance (Core and Larcker 2002) because studies document that firms with low insider ownership tend to have higher agency costs (Pantzalis et al. 1998). With the monitoring provided by the SOX regulation, firms no longer need to depend, or at least to a lesser extent, on management ownership to improve their corporate governance. In other words, the potential benefit from management ownership is likely to be smaller in the postSOX than in the pre-SOX period. Demsetz and Lehn (1985) also suggest that regulation can reduce benefits from management ownership (denoted as control potential in their paper) because of the subsidized monitoring and disciplining. Hence, management ownership can decrease in the post-SOX period. Second, regulation restricts managers’ investment discretions (Smith and Watts 1992) and such a restriction reduces the marginal product of managers’ decisions. The aforementioned factors suggest that following SOX managers face enhanced risk of owning their firms’ equity because they are less capable in influencing the success of their firms in the post-SOX period. In other words, performance of firms is determined more by exogenous factors (e.g. regulation) that are out of the managers’ control in the post-SOX period. To reduce such risk exposure, managers voluntarily reduce personal holdings of their firm’s equity in the post-SOX period. Third, profits from trading their companies’ equities could be taken away after SOX. Specifically, profits CEOs realized from trading their own companies’ securities (such as common stock, preferred stock, and debt) are subject to forfeiture in the post-SOX period if CEOs are charged with violating SOX rules. Therefore, CEOs are less certain (in an ex-ante sense) if they could profit from trading their own companies’ securities. This uncertainty arises because the interpretation of “accuracy” and “materiality” involves subjective judgment that

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could vary between individuals and change from one situation to another. This variation in interpretation could be driven by factors such as information asymmetry and difference in the timing of decisions.

As financial reporting requires the management to make certain

assumptions or estimates regarding the operation of the business (e.g. estimation of bad debt or obsolescence of inventory), this calls for subjective judgment based on the management’s knowledge and information available.

Management can form their judgment based on

proprietary information that is not available to the regulators or the public. This proprietary information can arise from the management’s position in the firm, industry and its own knowledge and experience about the firm.

On the other hand, regulators have access to

information regarding potential problematic areas in accounting based on their past experience with other violators. This information asymmetry between the two parties can cause one error to be judged as immaterial by one party but material by the other. Further, there is a difference in the timing of the decisions made by the management and regulators. The information set on which decisions are based can differ due to this timing difference.

For example, the

management’s assumption regarding the recoverability of accounts receivable can ex-post proved to be too low.

However, that can be the best estimate given the information the

management had when the decision was made. In other words, the regulators make their judgment based on information available after the realization of CEOs’ actions whereas CEOs make their decisions based on ex-ante information. Given the complex and fast-evolving nature of the business environment, these two sets of information can be different and hence lead to different decisions on whether an error is material.

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Due to this potential difference in interpreting “accuracy” and “materiality”, CEOs could be wrongfully indicted and penalized even if they are innocent.1 Since costs of litigation are prohibitive and the outcome of the trial is uncertain, corporate executives prefer to settle with regulators even if they are guiltless.2 The increased penalties and legal liabilities following SOX have raised the potential losses borne by CEOs even if the likelihood of wrongful indictment is small. To reduce these potential losses, CEOs reduce stockholdings in their firms. Thus, we state our first hypothesis (in alternate form) as follows: Hypothesis 1: CEOs’ stock ownership in their own firms drops in the post-SOX period.

CEO Compensation In addition to stockholdings, we expect that SOX can have a significant impact on CEOs’ pay structure. Prior literature has examined how various firm characteristics affect CEOs’ compensation. For example, a few studies examine the relationship between ownership structure and executive compensation.

Chen (2002) documents a negative relation between outside

director ownership and CEO incentive compensation. Cyert, Kang and Kumar (2002) find a negative correlation between ownership of the largest shareholder and CEO compensation. Hartzell and Starks (2003) observe that firms with concentrated institutional ownership tend to have lower executive compensation. Zheng (2010) extends the investigation on the impact of institutional ownership to examine the impact of different type of institutional investors on CEO compensation. Studies have also examined the impact of other firm characteristics. Johnson, 1

Examples of wrongful indictments of corporate officers are available on the website of The National Association of Criminal Defense Lawyers at http://www.nacdl.org/public.nsf/legislation/CI_01_015?opendocument. 2 In reality, most enforcement actions will result in some forms of settlement – rather than a full blown trial. The indicted executives usually settle with the Securities and Exchange Commission (SEC) by paying fines and damages, and accepting SEC-imposed penalties. Nonetheless, the indicted executives seldom admit any wrongdoings which relieve them from legal liabilities in private lawsuits.

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Porter and Shackell (1997) and Thomas and Martin (1999) find that when CEOs’ compensation is under public scrutiny, it tends to decrease in subsequent periods. A few studies have also examined the effect of changes in law and regulations on executive compensation. Vafeas et al. (2003) look at how commercial banks change their executive compensation structure after the expanded compensation disclosure requirement and the deductibility of compensation expense restriction imposed by Internal Revenue Service. Our study expands the literature on executive compensation, specifically the impact of regulation on executive compensation structure, by studying the effect of SOX on CEO compensation. We expect that CEOs are paid less in the incentive portion of their total pay3 and the total pay-performance sensitivity of CEOs is smaller in the post-Sox period. 4 First, regulation restricts managers’ investment discretion, thus reducing the importance of managerial functions (Smith and Watts 1992). This, in turn, lowers the marginal product of managers and weakens the association between managerial effort and firm performance. Hence, we expect the total pay, the incentive portion of the total pay, and pay-performance sensitivity of top executives to be smaller following SOX. Second, CEOs’ pay structure is altered to adapt to the increased penalties facing them in the post-SOX period. Section 304 of SOX states that any incentive pay awarded to CEOs could be taken away if “material” restatements of their companies’ financial reports are required. As such, CEOs bear additional risk (namely, the forfeiture risk) for taking compensation in the form of incentive pay in the post- SOX period. To lower this additional risk, CEOs demand less in incentive pay but more in fixed pay, resulting in a smaller sensitivity of a CEO’s incentive pay to 3

Cohen, Dey and Lys (2004) find that the ratio of a CEO’s pay in bonus and option grants to his/her salary has dropped after SOX. 4 We define pay-performance sensitivity as in Jensen and Murphy (1990): The change in an executive’s wealth associated with a change in shareholder wealth.

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a change in shareholder wealth in the post-SOX period, ceteris paribus.5 In other words, we expect that the pay-performance sensitivity of CEO incentive pay decreases after SOX. Taking the prediction on changes in CEOs’ stock ownership and compensation structure into consideration, we expect that the total pay-performance sensitivity of CEOs drops in the post-SOX period, ceteris paribus. We state our second hypothesis (in alternate form) as follows: Hypothesis 2: In the post-SOX period, the sensitivity of a CEO’s total wealth to a change in shareholder wealth decreases, ceteris paribus.

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Data and sample We collect compensation and ownership data from the Standard & Poor’s (S&P)

ExecuComp database for the period of 1993−2005.6,7 The ExecuComp database provides data on the annual compensation and ownership of the top five executives for each firm in the S&P 500, S&P MidCap 400, and S&P SmallCap 600 indices. As our analyses involve examining changes in CEOs’ wealth annually, our change analyses begin in 1994.

To maintain

homogeneity of the sample, in our main analysis, we exclude firms in the regulated industries−utilities, financial services, and transportation sectors−because they face different regulatory constraints.

Nevertheless, we examine stock ownership and pay-performance

sensitivity of CEOs in these regulated industries and use their results as a benchmark (to be described in Section 5.2.5). As the main target of SOX is CEOs, we expect that SOX’s effect is the strongest on the 5

Our prediction is consistent with the prediction even if CEOs are more risk-averse after SOX. Although compensation data is available from the ExecuComp as early as 1992, we exclude data in 1992 reasoning that data in this year is not comparable to data from 1993 onwards. This is because the value of stock options granted to top corporate executives was not required to be disclosed in a company’s proxy statement prior to 1993. The SEC approved the 1992 proxy disclosure rules on October 15, 1992 and these rules require U.S. companies to report the value of the stock options granted during the year to the corporate executives. 7 Compensation data for the year 2005 is incomplete because only about half the firms have filed their proxy statements by mid-2006. 6

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stock ownership and compensation structure of CEOs. To prevent contemporaneous events from biasing our results, we use top executives other than CEOs and CFOs (hereafter referred to as Other Executives) as a control group.8 We match the sample of CEOs with Other Executives in the same firm-year. We discard CEO observations without any matching Other Executives observation. As there can be more than one matching Other Executives observation per firmyear, we compute a simple average for each wealth measure for the group of Other Executives in any given firm-year. We then compare the sensitivities of these average wealth measures of Other Executives with those of the corresponding CEO. We also exclude observations in the switching year (that is, the fiscal year when the financial/proxy statements are first affected by SOX) because part of the year can be in the pre-SOX period; while the other part is in the postSOX period. After deleting observations with missing data on executive compensation, our final sample has 4,714 matching executive-year observations (4,714 CEO observations and 4,714 Other Executives observations) for the pay-performance sensitivity analysis.9 The ExecuComp database also provides data on the characteristics of the executives (for example, the number of years they have been with the firm). Data on accounting and stock returns are collected from the Compustat and CRSP databases, respectively. Table 1 presents the sample distribution by year and industry. Our sample is concentrated in the manufacturing sector: 62.5% of our sample is in that sector, followed by 15.0% in the service sector, and 11.2% in the retail trade sector. For each sample firm, we use several proxies to capture different variables of interest in this study: executives’ wealth, ownership, and other contextual variables. The following section 8

We exclude CFOs in our control group because they also face the increased penalties and legal liabilities after SOX. Nonetheless, we perform a robustness test by conducting a separate analysis on CFOs and the results (available upon request) are qualitatively similar to those of CEOs. Due to data limitation, the number of matching executive-year observations for CFOs is substantially smaller than that for CEOs. 9 Due to missing value on ownership and other contextual variables, we have 4,449 observations for the ownership analysis.

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provides a discussion of these variables. Since we use a panel dataset in our analysis, we add subscripts i and/or t in all the variables. The first subscript i is an index of firm. It refers to firm i. The second subscript t is an index of time and refers to year t. Executive Compensation: Our analysis involves examination of SOX’s effect on the pay-performance sensitivity of corporate executives. Following Jensen and Murphy (1990), we define pay-performance sensitivity as the change in an executive’s firm-specific wealth associated with the change in the wealth of shareholders. In addition, we include return on equity (ROE) in our analysis to examine SOX’s impact on the sensitivity of an executive’s wealth to changes in an accounting measure of firm performance. Return on equity is defined as the ratio of earnings before extraordinary items to the common equity. Four different proxies of the change in an executive’s wealth are constructed as follows: (1) Δ(stock options) = change in the value of stock options held at the end of the year = sum of the value of stock options awarded during the year, change in the value of all outstanding options during the year, and profits realized from exercising options during the year10; (2) Δ(inside stockholdings) = change in the value of inside stockholdings for the year = the value of the shares held by the executive at the beginning of the compensation year multiplied by the inflation-adjusted realized rates of return on common stocks during the compensation year; (3) Δ(total wealth) = change in total wealth for the year = sum of the change in the value of stock options, change in the value of inside stockholdings, and all direct 10

We consider stock options separately from other compensation component because options make up a significant portion of executive pay and have fueled the growth in CEOs’ remuneration since the mid-1980s (Yermack 1995 & 1998).

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compensation to the executive after excluding the value of stock options awarded during the year = Δ(stock options) + Δ(inside stockholdings) + (salary + bonus + long-term incentive pay + restricted stocks granted + other annual compensation + all other compensation)11; and (4) Δ(total wealth excluding unexercised options) = change in total wealth excluding change in the value of unexercised previously-granted stock options =

Δ(total wealth) - Δ(value of unexercised previously-granted stock options).

We examine the change in the value of stock options separately because stock options constitute a significant portion of CEOs’ compensation and Sanders (2001) documents that stock options and stock holdings can have different effect on management’s decisions. Thus, we are interested in examining whether the pay-performance sensitivity of this major component has changed in the post-SOX period and whether the change in this component is similar to the change in other components of CEOs’ compensation. Ownership Variable: To examine SOX’s effect on ownership structure, we investigate how equity ownership of executives (OWNi,t) changes in the post-SOX period. OWNi,t is the percentage of company shares owned by the individual executive(s) of firm i at the end of the compensation year. Other Contextual Variables: We compute the change in shareholder wealth (ΔSHRWEALTHi,t) for firm i at year t as the value of market capitalization of the firm at the beginning of the compensation year multiplied by the inflation-adjusted rate of return on 11

That is, the sensitivity of total wealth to change in shareholder wealth is the sum of pay-performance sensitivity of stock options, inside stockholdings, and the current compensation. This provides a measure of the overall payperformance sensitivity of the CEO’s compensation and wealth

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common stock during the compensation year. Return on equity (ROEi,t) is computed as the ratio of earnings before extraordinary items to the common equity of firm i during the compensation year.12 We use volatility of stock market returns (SDRETi,t-1) to measure a firm’s risk. SDRETi,t1

is the Black-Scholes volatility, extracted from ExecuComp, of firm i for the year prior to the

compensation year. It is the standard deviation of the monthly stock returns calculated over sixty months. We include a variable to control for time-varying factors (TIMEt) that affect executive ownership of all firms. TIMEt is defined as the calendar year minus 1992. We include an executive’s tenure to control for any effect of long-term employment relationship on stock ownership of executives. For the CEO analysis, this variable is measured by the number of years a CEO has been appointed to the current position (TENUREi,t-1) of firm i till the year prior to the compensation year. For Other Executives, it is the average number of years these executives have been with firm i for the year prior to the compensation year (JOINCOi,t-1).13 We also include the age of an executive (AGEi,t-1) in our analysis. We measure firm size by the natural logarithm of inflation-adjusted market capitalization (SIZEi,t-1) of firm i at the beginning of the compensation year. In addition, we include firm leverage (LEVERAGEi,t-1) and market-to-book ratio of assets (MTBi,t-1) to control for the effect of leverage and investment/growth opportunities on executive stock ownership.

Stulz (1988),

Harris and Raviv (1988) and Israel (1992) observe that insider ownership is affected by a firm’s leverage. LEVERAGEi,t-1 is the ratio of total book value of debt to the sum of market value of equity and the book value of total debt of firm i for the year prior to the compensation year. Demsetz (1983) argues that a firm’s growth potential affects its executive stock ownership. We

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We repeat the analyses using return on assets (ROA) and the results are qualitatively the same as reported. The executive tenure is defined differently for Other Executives as data on the number of years Other Executives have been appointed to their current positions are unavailable.

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use MTBi,t-1, the ratio of the sum of market value of equity and the book value of total debt to the book value of total assets of firm i for the year prior to the compensation year, as a proxy for the firm’s growth potential. We expect a firm’s growth opportunity to be positively correlated with the executive’s stock ownership. We include a firm’s contemporaneous stock return (RETi,t) to control for the effect of market measure of firm performance on executive stock ownership. Seyhun (1998) has shown that corporate executives practice a contrarian trading strategy.

That is to say, executives

purchase their firms’ shares when market performance of their firms is poor but sell when market performance of their firms is good. Thus, we expect contemporaneous stock returns to be negatively correlated with the executive stock ownership.

RETi,t is the inflation-adjusted

percentage rate of return on firm i’s common stocks during the compensation year. We also include the annual percentage change in real Gross Domestic Product (∆GDPt) to control for the macroeconomic condition and the CRSP value-weighted market return (MKTRETt) to control for the overall stock market condition that can have an impact on the executive’s pay-performance sensitivity. To capture SOX’s effect on stock ownership and various measures of pay-performance sensitivity of CEOs, we add a dummy variable (SOX), which takes the value of one if the date of the proxy statement is after July 30, 2002 (the effective date of SOX) and zero otherwise. All variables in dollar amount are deflated by CPI to convert their values to year 2000 price level. A detailed description of all variables employed in this study is provided in the Appendix.

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Research method

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For panel data, it is possible that there are some firm-specific factors that are unobserved and therefore not accounted for by the explanatory variables.

To avoid this unobserved

heterogeneity problem, we follow Himmelberg, Hubbard, and Palia (1999) and use a fixed-firm effect model to examine SOX’s impact on the pay-performance sensitivity for corporate executives. Chang and Lee (1977) illustrate the importance of controlling for time and firm effects in pooled time-series and cross-section analyses. Hence, we also include a control for time effect in our analysis.

To test Hypothesis 1, regarding SOX’s effect on CEO stock ownership, we specify the following estimation model: (1) OWNi,t =

αi + β1SOX + β2SIZEi,t-1 + β3SDRETi,t-1 +β4SDRET2i,t-1 + β5TIMEt +β6MTBi,t-1 +β7LEVERAGEi,t-1 + β8TENUREi,t-1 + β9JOINCO i,t-1 +β10AGEi,t-1 + β11RETi,t + β12∆GDPt + εi,t

where εi,t is the random error of firm i during the compensation year. To evaluate whether the pay-performance sensitivity of CEOs has changed in accordance with our Hypothesis 2, we specify the following estimation model:14 (2) Yi,t =

αi+γ0SOX+β1∆SHRWEALTHi,t+β2∆SHRWEALTHi,t-1 +β3SOX*∆SHRWEALTHi,t+β4 SOX*∆SHRWEALTHi,t-1+β5ROEi,t+β6ROEi,t-1 +β7SOX *ROEi,t +β8SOX *ROEi,t-1 +β9∆GDPt +β10MKTRETt + εi,t

where Yi,t is the dollar change in an executive’s wealth of firm i during the compensation year as measured by the four different variables described in Section 3; ΔSHRWEALTH i ,t and 14

Our results are not directly comparable to that of Jensen and Murphy (1990) because our model specifications are different. Specifically, we use a fixed-effects model; while they use an OLS model.

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ΔSHRWEALTH i ,t −1 represent changes in shareholder wealth of firm i during the compensation year and in the year prior to the compensation year, respectively; ROEi,t and ROEi,t-1 are the return on equity of firm i during and in the year prior to the compensation years, respectively; and

all

other

explanatory

variables

are

as

described

earlier.

Coefficients

of

ΔSHRWEALTH i ,t and ΔSHRWEALTH i ,t −1 measure the pay-performance sensitivity in the preSOX era; while coefficients of SOX * ΔSHRWEALTH i ,t and SOX * ΔSHRWEALTH i ,t −1 measure

the effect (if any) of SOX on the pay-performance sensitivity. Similarly, coefficients of ROEi,t and ROEi,t-1 measure the sensitivity of an executive’s wealth to the return on the firm’s equity (an accounting measure of firm performance) in the pre-SOX period; whereas coefficients of SOX*ROEi,t and SOX*ROEi,t-1 measure the change in this sensitivity post SOX. The coefficient of SOX measures SOX’s impact on an executive’s wealth after controlling for all the other factors in the model.

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Empirical results and discussion

5.1

Stock ownership of corporate executives We first analyze the change in stock ownership of CEOs and Other Executives to

examine whether stock ownership of corporate executives decreases in the post-SOX period (Hypothesis 1). Table 2 reports the results of SOX’s impact on executive stock ownership. Consistent with our prediction, the results in Table 2 show that stock ownership of CEOs has decreased significantly (β1 = –0.342) in the post-SOX period; while that of Other Executives, that is, our control group, has remained unchanged. The decline in stock ownership of CEOs is statistically significant at the 1% level. This finding is justifiable because after SOX, profits CEOs realized from trading their companies’ stocks could be taken away from them. Yet, this

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penalty is not applicable for Other Executives.

Thus, our Hypothesis 1 that CEO stock

ownership drops in light of SOX is confirmed. The decrease in stock ownership of CEOs is not driven by changes in total number of outstanding shares. While it is not shown here, we find that the total number of outstanding shares of our sample firms have remained materially the same after SOX. Consistent with the results in Demsetz and Villalonga (2001), we find that firm size is negatively and significantly correlated with CEOs’ stock ownership. Contemporaneous return on common equity (RETi,t) is also negatively and significantly correlated with CEO stock ownership, suggesting that CEOs are probably contrarian traders. That is to say, CEOs sell (buy) their firms’ stocks when market performance of the firms is good (bad). Further, stock ownership of an executive increases with the executive’s tenure.

Specifically, the coefficients of TENUREi,t-1 and JOINCOi,t-1 are

significantly positive at the 1% level. It appears that an executive’s stock ownership is positively correlated with the firm’s leverage but negatively correlated with the firm’s investment growth opportunities. Nonetheless, these coefficients are not statistically significant. Overall, these results point to a reduction in CEO stock ownership in light of SOX, lending support to the claim that ownership structure is endogenously determined and adapts to the new regulatory regime after SOX.

5.2

Pay-performance sensitivity To examine SOX’s effect on the pay-performance sensitivity of corporate executives, we

regress changes in the various measures of an executive’s wealth on SOX dummy terms and other explanatory variables.

Tables 3 and 4 summarize the results of the estimated pay-

performance sensitivities of CEOs and Other Executives, respectively. The regression results

19

represent the following four measures of change in the executive’s wealth: (i) change in the value of stock options [Δ(stock options); column 1]; (ii) change in the value of inside stockholdings [Δ(inside stockholdings); column 2]; (iii) change in total wealth [Δ(total wealth); column 3]; and (iv) change in total wealth excluding change in the value of unexercised previously-granted stock options [Δ(total wealth excluding unexercised options); column 4]. The SOX terms measure two different effects of SOX on the change in an executive’s wealth. The SOX standalone term (SOX) measures SOX’s effect on the average change in an executive’s wealth for reasons not accounted for by our explanatory variables. In contrast, the SOX interaction terms capture the change in the pay-performance sensitivity of the executive because

of

SOX.

Specifically,

coefficients

of

SOX*ΔSHRWEALTHi,t

and

SOX*ΔSHRWEALTHi,t-1 capture the impact of SOX on the change in an executive’s wealth for each $1,000 change (both contemporary and lagged changes) in the market measure of shareholder wealth (that is, the measure of pay-performance sensitivity of an executive’s wealth proposed by Jensen and Murphy (1990)); while those of SOX*ROEi,t and SOX*ROEi,t-1 capture the effect of SOX on the change in an executive’s wealth for every 1% change in the firm’s accounting measure of performance (that is, return on equity). Tables 3 and 4 also provide the statistical test results on the pay-performance sensitivities of CEOs and Other Executives, respectively in the pre- and post-SOX periods.

5.2.1 Sensitivity of stock options Consistent with our second hypothesis, we observe a significant drop in the payperformance sensitivity of CEO stock options in the post-SOX period (Column 1 of Table 3). In the pre-SOX period, the pay-performance sensitivity of CEO stock options is positive and

20

statistically significant at the 1% level. Our estimated coefficients [β1 + β2 = (4.45 + 0.46 ) x 103

= 4.91 x 10-3] imply that in the pre-SOX period for each $1,000 increase in shareholder wealth,

the value of stock options held by CEOs increases by an average of $4.91 ($4.91 x 10-3 x 1,000). However, this pay-performance sensitivity has declined considerably [β3 + β4 = (–2.58 – 0.09) x 10-3 = –2.67 x 10-3; significant at the 1% level] in the post-SOX period. Specifically, after SOX for every $1,000 increase in shareholder wealth, the value of stock options held by CEOs increases by only $2.24 [$4.91 – $2.67] on average. The tie between the value of stock options held by CEOs and the accounting measure of performance is statistically significant in neither the pre- nor the post-SOX periods. For Other Executives, the value of stock options increases by an average of $1.36 [β1 +

β2 = (1.54 – 0.18) x 10-3 = 1.36 x 10-3; $1.36 x 10-3 x 1,000] for every $1,000 increase in shareholder wealth in the pre-SOX period (Column 1 of Table 4).

After SOX, this pay-

performance sensitivity has also decreased (marginally significant at the 10% level) by an average of $0.39 [β3 + β4 = (–0.77 + 0.38) x 10-3 = –0.39 x 10-3; –$0.39 x 10-3 x 1,000] per $1,000 change in shareholder wealth. Numerically, in the post-SOX period, for every $1,000 increase in shareholder wealth, the value of stock options held by Other Executives increases by an average of only $0.97 [$1.36 – $0.39]. In sum, in light of SOX there is a substantial decrease in the pay-performance sensitivity of stock options for both CEOs and Other Executives. This simultaneous drop in the sensitivity of stock options for both groups is not driven entirely by contemporaneous events that are unrelated to SOX. This is because our regression model includes control variables to account for contemporaneous effect, if any, arising from changes in macroeconomics and overall stock market conditions.

In addition, our results

indicate that the drop in this sensitivity is more pronounced for CEOs than for Other Executives.

21

More importantly, our results are consistent with Hypothesis 2 as long as the drop in this sensitivity is larger for CEOs than for Other Executives in the post-SOX period. We reason that SOX has a stronger impact on the pay structure of CEOs than that of Other Executives because various SOX provisions target specifically CEOs and have increased penalties and legal liabilities they have to face. Consequently, in light of SOX the reduction in this sensitivity is expected to be greater for CEOs than for Other Executives. In order to examine whether the drop in the CEO pay-performance sensitivity is attributed, at least in part, to SOX, we perform a difference-in-difference analysis to investigate if the reduction in the pay-performance sensitivity is larger for CEOs than for Other Executives in the post-SOX period. The results of this analysis (to be described in Section 5.2.4) support this claim and find that the drop in this sensitivity is indeed larger for CEOs than for Other Executives. That is to say, our results are not driven primarily by other concurrent events and SOX’s impact on pay structure is stronger for CEOs than for Other Executives.

5.2.2 Sensitivity of inside stockholdings Column 2 of Tables 3 and 4 presents the results of the pay-performance sensitivity of inside stockholdings of CEOs and Other Executives, respectively. In line with our expectations, the magnitude of pay-performance sensitivity of inside stockholdings held by CEOs is substantial prior to SOX but has declined considerably since the adoption of SOX. In the preSOX period, for every $1,000 increase in shareholder wealth, the value of CEOs’ inside stockholdings increases by an average of $11.37 [β1 + β2 = (11.26 + 0.11) = 11.37 x 10-3; $11.37 x 10-3 x 1,000], approximately two times larger than that of the CEOs’ stock options. This sensitivity has decreased by $8.60 [β3 + β4 = (–8.49 – 0.11) x 10-3 = –8.60 x 10-3; -$8.60 x 10-3 x

22

1,000] on average in the post-SOX period.

That is to say, the value of CEOs’ inside

stockholdings increases by only $2.77 [= $11.37 – $8.60] on average for every $1,000 increase in shareholder wealth in the post-SOX period. This decline in pay-performance sensitivity is not only large (a drop of about 76%) but also statistically and economically significant. This evidence supports our Hypothesis 2 as inside stockholdings is a key component of the total payperformance sensitivity of CEOs. In contrast, our results (Column 2 of Table 4) indicate that there is an increase rather than a decrease in the sensitivity of inside stockholdings held by Other Executives in the post-SOX era [β3 + β4 = (0.17 + 0.09) x 10-3 = 0.26 x 10-3]. However, the change in this sensitivity of Other Executives is not statistically significant. Overall, our results confirm Hypothesis 2. More specifically, we find that after SOX there is a significant drop in the pay-performance sensitivity of inside stockholdings for CEOs but not for Other Executives. This suggests that CEOs have sold more personal holdings of their companies’ stocks than Other Executives in order to reduce their risk exposure after SOX.

5.2.3 Sensitivity of total firm-specific wealth The total pay-performance sensitivity of an executive refers to the dollar change in an executive’s total firm-specific wealth associated with a $1,000 change in the shareholder wealth. The executive’s total firm-specific wealth includes his/her total pay during the year plus the change in the value of the executive’s inside stockholdings and unexercised stock options. Consistent with our expectations, the total pay-performance sensitivity of CEOs is large prior to SOX but has declined considerably after SOX. Column 3 of Table 3 presents the results of the total pay-performance sensitivity of CEOs. Our estimated coefficients [β1 + β2 = (15.74 + 0.59)

23

x 10-3 = 16.33 x 10-3] imply that total firm-specific wealth of CEOs increases by an average of $16.33 [$16.33 x 10-3 x 1,000] for every $1,000 increase in shareholder wealth in the pre-SOX period. Consistent with our Hypothesis 2, after SOX the total pay-performance sensitivity of CEOs has decreased considerably; while that of Other Executives has remained unchanged. In the post-SOX period, the total pay-performance sensitivity of CEOs has decreased by an average of $11.17 [β3 + β4 = (–11.00 – 0.17) x 10-3 = –11.17 x 10-3], indicating that after SOX the total firm-specific wealth of CEOs increases by only $5.16 [= $16.33 – $11.17] on average for every $1,000 increase in shareholder wealth. This reduction in the total pay-performance sensitivity of CEOs is not only sizable (a drop of about 68%) but also statistically and economically significant. In contrast, the total pay-performance sensitivity of Other Executives has remained unchanged after SOX (Column 3 of Table 4). Aggarwal and Samwick (1999) and Cichello (2005) indicate that valuation of previouslygranted unexercised stock options can involve significant estimation errors. They reason that various assumptions have to be made regarding exercise prices and maturity dates of the option grants. To alleviate any potential effect these estimation errors can have on our results, we exclude these options from the executive’s total wealth and re-estimate the total pay-performance sensitivity for all executives.

Column 4 of Tables 3 and 4 presents the results of the total pay-

performance sensitivity excluding the value of previously-granted unexercised options of CEOs and Other Executives, respectively. Our results are qualitatively similar to the results of total wealth including previously-granted unexercised options. Overall, in light of SOX, we find a significant drop in the various measures of payperformance sensitivity of CEOs: total pay-performance sensitivity (both including and

24

excluding unexercised options) and pay-performance sensitivity of stock options and inside stockholdings. However, there is no corresponding change in Other Executives’ firm-specific wealth, except for the value of stock options. At the very least, our results provide strong evidence that CEOs have taken actions to reduce personal holdings of their companies’ stocks in light of SOX. Hence, the pay-performance sensitivity of inside stockholdings and the total payperformance sensitivity of CEOs have declined in the post-SOX period.

5.2.4 Analysis using difference-in-difference method To prevent our results from being confounded by contemporaneous events, in addition to inclusions of macroeconomic and market condition as control variables, we also use a differencein-difference approach to test whether changes in stock ownership and pay-performance sensitivity of CEOs are significantly different from that of Other Executives in light of SOX. Specifically, contemporary events should alter stock ownership and pay-performance sensitivity for both CEOs and Other Executives to the similar extent. To investigate this, we first compute the difference in the dependent variables between CEOs and Other Executives. For example, D_OWNi,t is computed by subtracting the average stock ownership of Other Executives from the stock ownership of CEOs of firm i at the end of the year in which compensation is awarded. Next, we regress these differenced dependent variables on the same independent variables as in Tables 2−4. Table 5 presents the results using this difference-in-difference method for the ownership comparison between CEOs and Other Executives. Consistent with our Hypothesis 1 and the previous results, stock ownership of CEOs has declined substantially more than that of Other Executives after SOX. Specifically, the coefficient of the SOX dummy is negative (β1 = –0.337)

25

and statistically significant at the 1% level. This result implies that stock ownership of CEOs has decreased by an average of 0.337% (of the total outstanding shares) more than that of Other Executives. In sum, this result confirms our Hypothesis 1 and indicates that our previous results on stock ownership are robust to the difference-in-difference method. Table 6 presents the results using the difference-in-difference method for the comparison of the various measures of pay-performance sensitivity between CEOs and Other Executives. We first examine the difference in the pay-performance sensitivity of stock options between the two groups (Column 1, Table 6). Our estimated coefficients [β1 + β2 = (2.91 + 0.64) x 10-3 = 3.55 x 10-3] imply that prior to SOX for every $1,000 increase in shareholder wealth, the value of stock options held by CEOs increases by an average of $3.55 [$3.55 x 10-3 x 1,000] more than that of Other Executives. However, the pay-performance sensitivity of stock options has declined significantly more for CEOs than for Other Executives [β3 + β4 = (–1.81 – 0.47) x 10-3 = –2.28 x 10-3; significant at the 1% level] after SOX. Specifically, for every $1,000 increase in shareholder wealth in the post-SOX period, the value of stock options held by CEOs has increased by, on average, only $1.27 [$3.55 – $2.28] more than that of Other Executives. Altogether, our results suggest that although there is a simultaneous decline in the payperformance sensitivity of stock options of all executives in the post-SOX period, the drop in this sensitivity is substantially larger for CEOs than for Other Executives. More importantly, this result suggests that SOX is indeed more binding to CEOs than to Other Executives; and that our previous results discussed in Section 5.2 cannot be driven solely by contemporaneous events.15

15

One such contemporaneous event is FASB’s new rule requiring firms to expense employee stock options beginning with annual reporting period after June 15, 2005. This affects year 2005 observations. However, our results continue to hold even after excluding year 2005 observations from the sample.

26

We also examine the difference in the pay-performance sensitivity of inside stockholdings as well as the difference in the total pay-performance sensitivity (both including and excluding unexercised options) between the two groups. Our results (Columns 2−4 of Table 6) suggest that the drop in these pay-performance sensitivities in the post-SOX period is again significantly larger for CEOs than for Other Executives. In sum, using the difference-in-difference method, our results indicate that SOX is more binding to CEOs than to Other Executives. Specifically, the drop in all measures of payperformance sensitivity of CEOs is significantly larger than that of Other Executives in the postSOX period. Thus, our results based on the change in the difference of pay-performance sensitivity between CEOs and Other Executives strongly support both of our hypotheses: there is a significant drop in the stock ownership (Hypothesis 1) and the total pay-performance sensitivity (Hypothesis 2) for CEOs after SOX.

5.2.5 Analysis of the impact of SOX on CEOs’ stock ownership and pay-performance sensitivity in regulated industries We use regulated industries as a benchmark to control for any confounding effect. If confounding effects are binding and driving the results in our main analysis, we expect that the confounding effects would affect all firms (that is, regulated firms and non-regulated firms).16 In addition, regulated industries allow us to measure the regulation effect (that is, SOX) on CEOs’ equity ownership and pay-performance sensitivity. between regulated and non-regulated industries.

The impact of SOX is likely to differ With the high degree of monitoring and

16

Bargeron et al. (2010) use U.K. companies as the benchmark in their examination of the impact of SOX on firms’ risk-taking behavior. Unfortunately, compensation data on U.K. firms are not available to us. Therefore, we use the regulated industries as a benchmark in our study.

27

regulation already present in the regulated industries in the pre-SOX period, SOX’s effect on stock ownership and compensation structure of CEOs is expected to be limited and smaller in these industries than that in the non-regulated industries. To investigate if there is any cross-sectional variation in SOX’s impact, we compare changes in stock ownership and various measures of the pay-performance sensitivity of CEOs in the regulated industries with those in the non-regulated industries in the post-SOX period. We expect that the decrease in stock ownership and the total pay-performance sensitivity of CEOs is smaller in the regulated industries than in the non-regulated industries. We classify the financial institutions, utilities and transportation industry sectors as regulated industries. We then perform a separate analysis of the stock ownership and pay-performance sensitivity of CEOs for these regulated industries. Table 7 presents the results using the difference-in-difference method for the ownership comparison between CEOs and Other Executives in the regulated industries. Contrary to the results of the non-regulated industries presented in Table 5, there is no significant change in the difference in stock ownership between CEOs and Other Executives for firms in the regulated industries after SOX. Table 8 presents the results using the difference-in-difference method for the comparison of pay-performance sensitivity between CEOs and Other Executives in the regulated industries. Similar to the results of the non-regulated industries in Table 6, in the pre-SOX period, all measures of the pay-performance sensitivity of CEOs are significantly larger than those of Other Executives. In sharp contrast to the results of the non-regulated industries, after SOX we find no drop in the difference of the various measures of the pay-performance sensitivity between CEOs and Other Executives. Instead, all the differences in the pay-performance sensitivity between the

28

two groups of top executives have increased rather than decreased in the post-SOX period. Overall, our results indicate that SOX’s impact is stronger for CEOs in the non-regulated industries than for those in the regulated industries.

5.3

Robustness checks To check for the robustness of our empirical results, we repeat the above analyses after

making various adjustments. First, we run the analyses including the switching year and the results are similar to those reported in the previous sections.

5.3.1 Percentage measure of change in shareholder wealth Second, we measure changes in shareholder wealth by the percentage change in shareholder wealth rather than the dollar change in shareholder wealth. Specifically, we use the inflation-adjusted rate of return on common stock during the compensation year as a measure of change in shareholder wealth. This measure allows us to examine the change in an executive’s wealth associated with a one percentage change in shareholder wealth. While not shown here, our results are similar to those using the dollar change in shareholder wealth. The only exception is that the change in the total pay-performance sensitivity (including unexercised options) of Other Executives is significant following the introduction of SOX. Yet, the difference-indifference analysis shows that the drop in the total pay-performance sensitivity is significantly larger for CEOs than for Other Executives. We also repeat this analysis using the firm’s marketadjusted return rather than its raw stock return. Our results continue to hold. These results confirm our Hypothesis 2 and suggest that SOX is more binding to CEOs than to Other Executives; and the total pay-performance sensitivity of CEOs has dropped in light of SOX.

29

5.3.2 Change in sensitivity to accounting measure of performance Third, as one of SOX main objectives is to improve the accuracy and transparency of financial information, the quality of accounting measure of performance should presumably improve after SOX. With the improvement of this measure of firm performance, firms are likely to place more weight on the accounting measure of performance and less on the market measure of performance in the post-SOX period. This shift would contribute to a mechanical drop in the pay-performance relation for all executives in the post-SOX period even though the portion of incentive pay and stock ownership of these executives have remained unchanged following the adoption of SOX. To test whether our results are driven by this shift in the relative weight, we examine the change in the sensitivity of a CEO’s wealth to return on equity, an accounting measure of performance, in the post-SOX period. Our results (available upon request) indicate that despite SOX the sensitivity of a CEO’s wealth to return on equity has remained unchanged. This evidence confirms that the drop in the various pay-performance sensitivities for CEOs is driven primarily by a reduction in the CEOs’ stock ownership and the incentive portion of CEOs’ total pay.

5.3.3

Other controls for pay-performance sensitivity analysis Last, we perform a robustness test by controlling for other factors documented in

previous studies—executive stock ownership, firm size, and firm volatility–that could affect the pay-performance sensitivity of executives. Jensen and Murphy (1990) propose that the payperformance sensitivity of executive compensation varies with the executives’ stockholdings in the firm. Aggarwal and Samwick (1999) suggest that firms with high return volatility tend to

30

have lower pay-performance sensitivity. Cichello (2005) further observes that CEOs of large firms have lower pay-performance sensitivity. To control for these potential effects on the payperformance sensitivity, we include six interaction terms in the pay-performance sensitivity regressions.

Specifically, we include an interaction term between (i) the executive’s

stockholdings and change in shareholder wealth; (ii) the executive’s stockholdings and ROE; (iii) volatility (proxied by standard deviation of stock returns) and change in shareholder wealth; (iv) volatility and ROE; (v) firm size (proxied by log of sales) and change in shareholder wealth; and (vi) firm size and ROE. Our results (available upon request) are qualitatively the same as those reported in Section 5.2. Finally, we check for multicollinearity among all independent variables of our regressions. We do not find any evidence indicating a problem of multicollinearity.

6

Conclusion

In this paper, we provide evidence on the effect of the Sarbanes−Oxley Act on stock ownership and the various measures of pay-performance sensitivity of CEOs’ wealth. Using annual compensation data among S&P 1500 firms for the period of 1994−2005, we find that in the post-SOX period:(i) CEO stock ownership has dropped substantially, indicating that ownership structure endogenously adapts to the new regulatory environment;(ii) Payperformance sensitivities of CEOs’ stock options, inside stockholdings and total wealth have decreased substantially, indicating that the incentive alignment between shareholders and CEOs has substantially weakened after SOX. Overall, our results have important implications. Our evidence supports the claim that ownership structure is endogenously determined and adapts to the new regulatory environment. Although the main objective of SOX is to make managers more accountable for their actions, it

31

has produced an unintended consequence. In particular, SOX has induced a weaker association between the wealth of CEOs and the wealth of shareholders. Yet, we find no such change for Other Executives. One possibility for this discrepancy is that CEOs face increased penalties and legal liabilities together with increased monitoring by the regulators after SOX. To partly offset this increased risk borne by CEOs, firms reduce the incentive portion of their total pay. In addition, CEOs are rational and sell personal holdings of their companies’ stocks to lower their exposure to firm specific risk and legal liabilities after SOX. In contrast, Other Executives do not face this increase in scrutiny and/or penalties. As such, we do not observe any significant change in the ownership and pay-performance sensitivity of Other Executives as for CEOs. Finally, we try our best to use different methods (for example including control variables in our analyses and using difference-in-difference approach) to prevent any identifiable concurrent events from biasing our results. Yet, like any other studies, our results are not immune to all confounding factors especially for contemporaneous factors that are unobservable to us.

32

Appendix: Definition of variables a, b Variable Δ(stock options)

Δ(inside stockholdings)

Δ(total wealth)

Δ(total wealth excluding unexercised options) OWN D_OWN

Definition Change in value of stock options held at the end of the year ($000). It is calculated as the value of the stock options awarded during the year plus the change in the value of all outstanding options during the year plus the profits (price minus exercise price) realized from exercising options during the year. All values are adjusted for inflation. The value of the stock options awarded during the year is computed using the modified Black-Scholes formula (Merton, 1973), which adjusts for dividend payouts. The change in the value of all outstanding options during the year is computed as the change in the value of unexercised unexercisable previously-granted options plus the change in the value of unexercised exercisable previously granted options. To compute the value of previously granted options, we follow Core and Guay (2002) and estimate the exercise prices and time-tomaturities of these options because such parameters are not publicly available. Change in the value of the executive’s inside stockholdings at the end of the year ($000). It is computed as the value of the shares held at the beginning of the compensation year multiplied by the inflation-adjusted rate of return on common stocks during the year. Change in the executive’s total wealth at the end of the year ($000). It is computed as the change in the value of inside stockholdings plus the change in the value of stock options plus total pay minus the value of current options awarded (B-S value). Change in the executive’s total wealth minus change in the estimated value of unexercised previously-granted stock options at the end of the year ($000). Percentage of company shares owned by individual executive(s) at the end of the compensation year. CEO’s stock ownership minus average stock ownership of Other Executives in the firm.

33

SOX

ΔSHRWEALTH

ROE SDRET TIME MTB

LEVERAGE

TENURE JOINCO AGE D_AGE SIZE RET

ΔGDP MKTRET a b

Dummy variable, which takes the value of one if the proxy statement was filed after July 30, 2002 and zero otherwise. Market capitalization of the firm ($000) at the beginning of the year multiplied by the inflation-adjusted rate of return on its common stock during the compensation year. Ratio of earnings before extraordinary items to the common equity for the year. Black-Scholes volatility extracted from ExecuComp. Calendar year minus 1992 Market-to-book ratio of assets. Computed as the ratio of the sum of market value of equity and book value of debt to the book value of total assets. Leverage ratio of the firm. Computed as the total book value of debt to the sum of the market value of equity and the book value of debt. The number of years the CEO has been appointed to the current position. The average number of years Other Executives has been with the firm. The age of the executive. The age of CEO minus the average age of Other Executives Natural logarithm of the inflation-adjusted market capitalization of the firm ($000,000) at the beginning of the year. The inflation-adjusted rate of return on the firm’s common stocks during the year. The change in real GDP for the year. The value-weighted stock market return.

All monetary variables are inflation-adjusted and expressed in 2000 dollars. For simplicity, all subscripts of the variables are dropped in the appendix.

34

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Table 1: Sample distribution by year and industry—non-regulated industries

Year

Agriculture, Mineral Construction Manufact- Wholesale Retail Service Forestry & Industries Industries uring Trade Trade Industries Fisheries

Total

1994

0

21

4

193

9

44

37

308

1995

1

22

6

222

11

39

42

343

1996

1

24

6

221

11

41

49

353

1997

2

27

4

242

17

47

51

390

1998

2

29

4

283

16

46

66

446

1999

2

24

6

323

17

54

72

498

2000

2

26

8

290

16

54

75

471

2001

2

24

12

287

20

53

76

474

2002a

0

1

0

13

1

2

3

20

2003

1

29

12

344

24

67

91

568

2004

1

26

11

333

16

62

103

552

2005

1

17

9

195

12

17

40

291

Total

15

270

82

2,946

170

526

705

4,714

Percentage of sample

0.3%

5.7%

1.7%

62.5%

3.6%

11.2%

15.0%

100%

a

Number of observations in 2002 is small relative to other years because we delete observations in the switching year. Observations remaining in year 2002 are those firms with proxy statements for fiscal year 2002 issued before July 30, 2002, the effective date of SOX.

38

Table 2: Empirical results of SOX’s impact on executive stock ownershipa

OWNi,t =

Variables

SOX

αi + β1 SOX + β2SIZEi,t + β3SDRETi,t-1 +β4SDRET2i,t-1 + β5TIMEt +β6MTBi,t-1 +β7LEVERAGEi,t-1 + β8TENUREi,t-1 + β9JOINCO i,t-1 +β10AGEi,t-1 + β11RETi,t + β12∆GDPt + εi,t Predicted signs −

SIZEi,t

−

SDRETi,t-1

+

SDRET2i,t-1

−

TIMEt

+

MTBi,t-1

+

LEVERAGEi,t-1

−

TENUREi,t-1

+

JOINCOi,t-1 AGEi,t-1 RETi,t ∆GDPt Intercept N R2

CEOs

Other Executivesb

-0.342*** (0.130) -0.314*** (0.121) -1.628 (1.954) 0.342 (0.638) 0.011 (0.041) -0.118 (0.208) 0.855 (0.824) 0.086*** (0.022)

-0.046 (0.046) -0.066** (0.031) -0.209 (0.336) 0.063 (0.101) 0.007 (0.008) -0.020 (0.027) 0.293 (0.237)

0.014 (0.018) -0.002** (0.001) 0.024 (0.031) 3.477*** (1.092)

0.014*** (0.004) 0.037*** (0.010) -0.000 (0.000) 0.019* (0.010) -1.324*** (0.569)

4,449 0.770

4,449 0.745

+ + +

*, **, *** indicate significance at the 10-, 5- and 1-percent level, respectively, for a one-sided test. Standard errors are in parentheses. a Firm dummies are included in all the regressions but, for simplicity, are not reported. b Since certain executives have missing value on JOINCO, we include a dummy variable that takes on a value of 1 if the value of JOINCO is missing for that executive in the analysis, and JOINCO assumes a value of 0 in these cases. OWN = Percentage of company shares owned by CEOs or Other Executives; SOX = Dummy variable; takes on a value of 1 if the proxy statement was filed after July 30, 2002, zero otherwise; SIZE = Natural logarithm of the inflation-adjusted market capitalization of the firm ($000,000) at the beginning of the

39

year; SDRET = Black-Scholes volatility of stock market returns extracted from ExecuComp; SDRET2 = The square of the volatility of stock market returns; TIME = Calendar year minus 1992; MTB = Marketto-book ratio of assets; LEVERAGE = Ratio of total book value of debt to the sum of market value of equity and book value of total debt; TENURE = Number of years the CEO has been in the current position; JOINCO = Average number of years Other Executives have been with the firm; AGE = Age of the CEO or the average age of Other Executives; RET = Inflation-adjusted rate of return on the firm’s common stock during the year (in %); and ∆GDP= Change in real GDP during the year (in %). A detailed description of all variables is provided in the Appendix.

40

Table 3: Empirical results of SOX’s impact on the pay-performance sensitivity of CEOsa

Yi,t =

αi+γ0SOX+β1∆SHRWEALTHi,t+β2∆SHRWEALTHi,t-1+β3SOX*∆SHRWEALTHi,t +β4 SOX*∆SHRWEALTHi,t-1 +β5ROEi,t+β6ROEi,t-1+β7SOX *ROEi,t +β8SOX *ROEi,t-1 +β9∆GDPt +β10MKTRETt + εi,t (1)

(2)

Δ(stock options)

Δ(inside Δ(total stockholdings) wealth)

Δ(total wealth excluding unexercised options)

2,203.67 (2,573.86) 4.45*** (0.13) 0.46*** (0.18) -2.58*** (0.50) -0.09 (0.37) 0.26 (6.95) -0.03 (8.06) -0.27 (7.01) 0.11 (8.11) 524.70 (955.63) -23.04 (65.13) 5,589.95** (3,334.11)

6,139.74 (11,885.3) 11.26*** (0.60) 0.11 (0.85) -8.49*** (2.30) -0.11 (1.70) -2.38 (32.11) 5.56 (37.23) 2.43 (32.35) -5.45 (37.43) -2,170.68 (4,412.83) 22.87 (300.74) 7,452.22 (15,395.93)

8,948.74 (12,998.3) 15.74*** (0.65) 0.59 (0.93) -11.00*** (2.52) -0.17 (1.86) -1.99 (35.12) 5.55 (40.71) 2.04 (35.38) -5.35 (40.94) -1,584.24 (4,826.07) -4.33 (328.91) 14,404.9 (16,837.69)

7,245.83 (11,850.45) 11.44*** (0.60) 0.69 (0.84) -8.59*** (2.30) -0.49 (1.69) -2.46 (32.02) 4.83 (37.12) 2.53 (32.25) -4.68 (37.33) -2,253.34 (4,399.89) -50.17 (299.86) 15,375.85 (15,350.78)

N R2

4,714 0.383

4,714 0.169

4,714 0.223

4,714 0.184

Estimated pay-performance sensitivity prior to SOX (= β1+β2 ; x10-3)

4.91

11.37

16.33

12.13

Change in estimated pay-performance sensitivity after SOX (=β3+β4 ; x10-3) Statistical Tests

-2.67

-8.60

-11.17

-9.08

F-statistic

F-statistic

F-statistic

F-statistic

1. β1+β2 =0

436.46***

109.76***

188.97***

125.49***

Variables

Predicted signs

SOX

−

∆SHRWEALTHi,t (x10-3) ∆SHRWEALTHi,t-1 (x10-3) SOX*∆SHRWEALTHi,t (x10-3) SOX*∆SHRWEALTHi,t-1 (x10-3) ROEi,t

+

ROEi,t-1

+

SOX*ROEi,t

?

SOX*ROEi,t-1

?

∆GDPt

?

MKTRETt

?

+ − − +

Intercept

(3)

(4)

13.14** 6.38*** 9.02*** 7.18*** 2. β3+β4 =0 *, **, *** indicate significance at the 10-, 5- and 1-percent level, respectively, for a one-sided test. Standard errors are in parentheses.

41

a

Firm dummies are included in all the regressions but, for simplicity, are not reported.

Yi,t represents the respective dependent variable in each regression analysis, for example, change in the value of stock options, restricted stocks, and so on, of CEOs; Δ(stock options) = Change in the value of stock options held at the end of the year ($000); Δ(inside stockholdings) = Change in value of the executive’s inside stockholdings at the end of the year ($000). It is computed as the value of the shares held at the beginning of the fiscal year in which compensation is awarded multiplied by the inflationadjusted rate of return on common stock during the year; Δ(total wealth) = Change in the executive’s total wealth at the end of the year ($000). It is computed as change in value of inside stockholdings plus change in value of stock options plus total pay minus current options awarded (B-S value); Δ(total wealth excluding unexercised options)= Δ(total wealth – change in value of unexercised previously-granted stock options); ΔSHRWEALTH = Market capitalization of the firm ($000) at the beginning of the year multiplied by inflation-adjusted rate of return on its common stock during the year; all other variables are as defined in Table 3; SOX = Dummy variable; takes on a value of 1 if the proxy statement was filed after July 30, 2002, zero otherwise; ROE = Ratio of earnings before extraordinary items to the average total equity for the year (in %); ∆GDP = Change in real GDP during the year (in %); and MKTRET = Value-weighted stock market return (in %). A detailed description of all variables is provided in the Appendix.

42

Table 4: Empirical results of SOX’s impact on the pay-performance sensitivity of other executivesa

Yi,t =

αi+γ0SOX+β1∆SHRWEALTHi,t+β2∆SHRWEALTHi,t-1+β3SOX*∆SHRWEALTHi,t +β4 SOX*∆SHRWEALTHi,t-1 +β5ROEi,t+β6ROEi,t-1+β7SOX *ROEi,t +β8SOX *ROEi,t-1 +β9∆GDPt +β10MKTRETt + εi,t (1)

(2)

Δ(stock options)

Δ(inside Δ(total stockholdings) wealth)

Δ(total wealth excluding unexercised options)

-525.78 (897.33) 1.54*** (0.05) -0.18*** (0.06) -0.77*** (0.17) 0.38*** (0.13) -0.16 (2.42) 0.43 (2.81) 0.15 (2.44) -0.42 (2.83) 93.49 (333.16) 6.07 (22.71) 3051.35*** (1162.37)

884.74 (1,078.83) 0.45*** (0.05) -0.04 (0.08) 0.17 (0.21) 0.09 (0.15) 0.41 (2.91) -0.53 (3.38) -0.38 (2.94) 0.53 (3.40) -492.18 (400.55) 43.97* (27.30) 1858.32 (1397.49)

516.76 (1,463.47) 2.00*** (0.07) -0.21* (0.10) -0.57** (0.28) 0.47* (0.21) 0.30 (3.95) -0.08 (4.58) -0.28 (3.98) 0.10 (4.61) -369.35 (543.36) 48.80* (37.03) 5596.17*** (1895.74)

928.03 (1,106.42) 0.45*** (0.06) 0.24*** (0.08) 0.24 (0.21) -0.11 (0.16) 0.57 (2.99) -0.21 (3.47) -0.53 (3.01) 0.22 (3.48) -524.19 (410.80) 14.23 (28.00) 5548.17*** (1433.23)

N R2

4,714 0.385

4,714 0.259

4,714 0.357

4,714 0.293

Estimated pay-performance sensitivity prior to SOX (= β1+β2 ; x10-3)

1.36

0.41

1.79

0.69

Change in estimated pay-performance sensitivity after SOX (=β3+β4 ; x10-3) Statistical Tests 1. β1+β2 =0

-0.39

0.26

-0.10

0.13

F-statistic 275.77***

F-statistic 17.56***

F-statistic 179.60***

F-statistic 46.66***

2. β3+β4 =0

2.24*

0.70

0.05

0.16

Variables

Predicted signs

SOX

−

∆SHRWEALTHi,t (x10-3) ∆SHRWEALTHi,t-1 (x10-3) SOX*∆SHRWEALTHi,t (x10-3) SOX*∆SHRWEALTHi,t-1 (x10-3) ROEi,t

+

ROEi,t-1

+

SOX*ROEi,t

?

SOX*ROEi,t-1

?

∆GDPt

?

MKTRETt

?

+ − − +

Intercept

(3)

(4)

43

*, **, *** indicate significance at the 10-, 5- and 1-percent level, respectively, for a one-sided test. Standard errors are in parentheses. a Firm dummies are included in all the regressions but, for simplicity, are not reported. Yi,t represents the respective dependent variable in each regression analysis, for example, change in the value of stock options, restricted stocks, and so on, of Other Executives; Δ(stock options) = Change in the value of stock options held at the end of the year ($000); Δ(inside stockholdings) = Change in value of the executive’s inside stockholdings at the end of the year ($000). It is computed as the value of the shares held at the beginning of the fiscal year in which compensation is awarded multiplied by the inflationadjusted rate of return on common stock during the year; Δ(total wealth) = Change in the executive’s total wealth at the end of the year ($000). It is computed as change in value of inside stockholdings plus change in value of stock options plus total pay minus current options awarded (B-S value); Δ(total wealth excluding unexercised options)= Δ(total wealth – change in value of unexercised previously-granted stock options); ΔSHRWEALTH = Market capitalization of the firm ($000) at the beginning of the year multiplied by inflation-adjusted rate of return on its common stock during the year; all other variables are as defined in Table 3; SOX = Dummy variable; takes on a value of 1 if the proxy statement was filed after July 30, 2002, zero otherwise; SIZE = Natural logarithm of the inflation-adjusted market capitalization of the firm ($000,000) at the beginning of the year; ROE = Ratio of earnings before extraordinary items to the average total equity for the year (in %); ∆GDP = Change in real GDP during the year (in %); and MKTRET = Value-weighted stock market return (in %). A detailed description of all variables is provided in the Appendix.

44

Table 5: Empirical results of SOX’s impact on the difference in stock ownershipa between CEOs and other executives

D_OWNi,t = αi + β1SOX +β2SIZEi,t + β3SDRETi,t-1 +β4SDRET2i,t-1 + β5TIMEt +β6MTBi,t-1 +β7LEVERAGEi,t-1 +β8TENUREi,t-1 +β9JOINCOi,t-1 +β10D_AGEi,t-1 +β11RETi,t +β12∆GDPt + εi,t Variables SOX

Predicted signs −

SIZEi,t

−

SDRETi,t-1

+

SDRET2i,t-1

−

TIMEt

+

MTBi,t-1

+

LEVERAGEi,t-1

−

TENUREi,t-1

+

JOINCOi,t-1 D_AGEi,t-1 RETi,t ∆GDPt Intercept N R2

+ + +

Difference between Ownership of CEOs & Other Executives -0.337*** (0.138) -0.234** (0.118) -1.358 (1.756) 0.256 (0.561) 0.006 (0.036) -0.112 (0.187) 0.481 (0.830) 0.107*** (0.023) -0.034*** (0.013) 0.009*** (0.003) -0.001** (0.001) 0.005 (0.032) 3.525*** (1.016) 4,449 0.767

*, **, *** indicate significance at the 10-, 5- and 1-percent level, respectively, for a one-sided test. Standard errors are in parentheses. a Firm dummies are included in all the regressions but, for simplicity, are not reported. b Since certain executives have missing value on JOINCO, we include a dummy variable that takes on a value of 1 if the value of JOINCO is missing for that executive in the analysis, and JOINCO assumes a value of 0 in these cases. D_OWN = Difference between the percentage of company shares owned by CEOs and Other Executives; SOX = Dummy variable; takes on a value of 1 if the proxy statement was filed after July 30, 2002, zero

45

otherwise; SIZE = Natural logarithm of the inflation-adjusted market capitalization of the firm ($000,000) at the beginning of the year; SDRET = Black-Scholes volatility of stock market returns extracted from ExecuComp; SDRET2 = The square of the volatility of stock market returns; TIME = Calendar year minus 1992; MTB = Market-to-book ratio of assets; LEVERAGE = Ratio of total book value of debt to the sum of market value of equity and book value of total debt; TENURE = Number of years the CEO has been in the current position; JOINCO = Average number of years Other Executives have been with the firm; D_AGE = Difference between the age of CEO and the average age of Other Executives; RET = Inflation-adjusted rate of return on the firm’s common stock during the year (in %); and ∆GDP= Change in real GDP during the year (in %). A detailed description of all variables is provided in the Appendix.

46

Table 6: Empirical results of SOX’s impact on the difference in pay-performance sensitivity between CEOs and other executivesa

D_Yi,t =

αi+γ0SOX+β1∆SHRWEALTHi,t+β2∆SHRWEALTHi,t-1+β3SOX*∆SHRWEALTHi,t +β4 SOX*∆SHRWEALTHi,t-1 +β5ROEi,t+β6ROEi,t-1+β7SOX *ROEi,t +β8SOX *ROEi,t-1 +β9∆GDPt +β10MKTRETt + εi,t (1)

(3)

(4)

Δ(inside Δ(total stockholdings) wealth)

Δ(total wealth excluding unexercised options)

2,729.45* (1,881.78) 2.91*** (0.09) 0.64*** (0.13) -1.81*** (0.36) -0.47** (0.27) 0.42 (5.08) -0.46 (5.89) -0.42 (5.12) 0.54 (5.93) 431.21 (698.68) -29.11 (47.62) 2,538.60 (2,437.61)

5,255.00 (11,910.23) 10.82*** (0.60) 0.15 (0.85) -8.66*** (2.31) -0.19 (1.70) -2.79 (32.18) 6.09 (37.30) 2.81 (32.42) -5.98 (37.51) -1678.50 (4422.09) -21.10 (301.37) 5,593.91 (15,428.22)

8,431.98 (12,691.65) 13.74*** (0.64) 0.80 (0.90) -10.43*** (2.46) -0.65 (1.81) -2.29 (34.29) 5.64 (39.75) 2.32 (34.54) -5.45 (39.97) -1214.89 (4712.21) -53.13 (321.15) 8,808.73 (16,440.45)

6,317.80 (11,935.88) 10.99*** (0.60) 0.45 (0.85) -8.83*** (2.31) -0.38 (1.71) -3.02 (32.25) 5.04 (37.39) 3.07 (32.49) -4.90 (37.59) -1729.15 (4431.61) -64.40 (302.02) 9,827.69 (15,461.45)

N R2

4,714 0.355

4,714 0.163

4,714 0.194

4,714 0.169

Estimated pay-performance sensitivity prior to SOX (= β1+β2 ; x10-3)

3.55

10.97

14.54

11.44

Change in estimated pay-performance sensitivity after SOX (=β3+β4 ; x10-3) Statistical Tests

-2.28

-8.85

-11.08

-9.21

F-statistic

F-statistic

F-statistic

F-statistic

1. β1+β2 =0

426.69***

101.51***

157.09***

110.02***

2. β3+β4 =0

18.01***

6.74***

9.30***

7.27***

Variables

Predicted Δ(stock signs options)

(2)

SOX

−

∆SHRWEALTHi,t (x10-3) ∆SHRWEALTHi,t-1 (x10-3) SOX*∆SHRWEALTHi,t (x10-3) SOX*∆SHRWEALTHi,t-1 (x10-3) ROEi,t

+

ROEi,t-1

+

SOX*ROEi,t

?

SOX*ROEi,t-1

?

∆GDPt

?

MKTRETt

?

+ − − +

Intercept

47

*, **, *** indicate significance at the 10-, 5- and 1-percent level, respectively, for a one-sided test. Standard errors are in parentheses. a Firm dummies are included in all the regressions but, for simplicity, are not reported. D_Yi,t represents the respective dependent variable in each regression analysis, for example, difference in the change in value of stock options, restricted stocks, and so on, between CEOs and Other Executives; Δ(stock options) = Change in the value of stock options held at the end of the year ($000); Δ(inside stockholdings) = Change in value of the executive’s inside stockholdings at the end of the year ($000). It is computed as the value of the shares held at the beginning of the fiscal year in which compensation is awarded multiplied by the inflation-adjusted rate of return on common stock during the year; Δ(total wealth) = Change in the executive’s total wealth at the end of the year ($000). It is computed as change in value of inside stockholdings plus change in value of stock options plus total pay minus current options awarded (B-S value); Δ(total wealth excluding unexercised options)= Δ(total wealth – change in value of unexercised previously-granted stock options); ΔSHRWEALTH = Market capitalization of the firm ($000) at the beginning of the year multiplied by inflation-adjusted rate of return on its common stock during the year; all other variables are as defined in Table 3; SOX = Dummy variable; takes on a value of 1 if the proxy statement was filed after July 30, 2002, zero otherwise; SIZE = Natural logarithm of the inflationadjusted market capitalization of the firm ($000,000) at the beginning of the year; ROE = Ratio of earnings before extraordinary items to the average total equity for the year (in %); ∆GDP = Change in real GDP during the year (in %); and MKTRET = Value-weighted stock market return (in %). A detailed description of all variables is provided in the Appendix.

48

Table 7: Empirical results of SOX’s impact on the difference in stock ownership between CEOs and other executives in regulated industriesa

D_OWNi,t = αi + β1SOX +β2SIZEi,t + β3SDRETi,t-1 +β4SDRET2i,t-1 + β5TIMEt +β6MTBi,t-1 +β7LEVERAGEi,t-1 +β8TENUREi,t-1 +β9JOINCOi,t-1 +β10D_AGEi,t-1 +β11RETi,t +β12∆GDPt + εi,t Variables

Predicted signs

Difference between Ownership of CEOs & Other Executives

SOX

−

SIZEi,t

−

SDRETi,t-1

+

SDRET2i,t-1

−

TIMEt

+

MTBi,t-1

+

LEVERAGEi,t-1

−

TENUREi,t-1

+

-0.123 (0.209) -0.152 (0.149) 1.688 (1.791) -2.442** (1.188) 0.016 (0.047) 0.004 (0.018) -0.234 (0.917) 0.027** (0.014) -0.060 (0.043) 0.001 (0.003) -0.003** (0.002) -0.015 (0.050) 2.301** (1.236)

JOINCOi,t-1 D_AGEi,t-1 RETi,t ∆GDPt Intercept N R2

+ + +

1,325 0.881

*, **, *** indicate significance at the 10-, 5- and 1-percent level, respectively, for a one-sided test. Standard errors are in parentheses. a Firm dummies are included in all the regressions but, for simplicity, are not reported. b Since certain executives have missing value on JOINCO, we include a dummy variable that takes on a value of 1 if the value of JOINCO is missing for that executive in the analysis, and JOINCO assumes a value of 0 in these cases.

49

D_OWN = Difference between the percentage of company shares owned by CEOs and Other Executives; SOX = Dummy variable; takes on a value of 1 if the proxy statement was filed after July 30, 2002, zero otherwise; SIZE = Natural logarithm of the inflation-adjusted market capitalization of the firm ($000,000) at the beginning of the year; SDRET = Black-Scholes volatility of stock market returns extracted from ExecuComp; SDRET2 = The square of the volatility of stock market returns; TIME = Calendar year minus 1992; MTB = Market-to-book ratio of assets; LEVERAGE = Ratio of total book value of debt to the sum of market value of equity and book value of total debt; TENURE = Number of years the CEO has been in the current position; JOINCO = Average number of years Other Executives have been with the firm; D_AGE = Difference between the age of CEO and the average age of Other Executives; RET = Inflation-adjusted rate of return on the firm’s common stock during the year (in %); and ∆GDP= Change in real GDP during the year (in %). A detailed description of all variables is provided in the Appendix.

50

Table 8: Empirical results of SOX’s impact on the difference in pay-performance sensitivity between CEOs and other executives in regulated industriesa

D_Yi,t =

αi+γ0SOX+β1∆SHRWEALTHi,t+β2∆SHRWEALTHi,t-1+β3SOX*∆SHRWEALTHi,t +β4 SOX*∆SHRWEALTHi,t-1 +β5ROEi,t+β6ROEi,t-1+β7SOX *ROEi,t +β8SOX *ROEi,t-1 +β9∆GDPt +β10MKTRETt + εi,t (1)

(2)

(3)

(4)

Predicted signs

Δ(stock options)

Δ(inside stockholdings)

Δ(total wealth)

Δ(total wealth excluding unexercised options)

SOX

−

∆SHRWEALTHi,t (x10-3) ∆SHRWEALTHi,t-1 (x10-3) SOX*∆SHRWEALTHi,t (x10-3) SOX*∆SHRWEALTHi,t-1 (x10-3) ROEi,t

+

ROEi,t-1

+

SOX*ROEi,t

?

SOX*ROEi,t-1

?

∆GDPt

?

MKTRETt

?

-2,501.24 (3,896.78) 1.83*** (0.17) -0.18 (0.25) 1.48*** (0.52) 1.65*** (0.37) 3.79 (13.86) 47.84 (88.80) 202.14* (146.50) 188.73 (162.60) 1,963.70 (816.94) -69.26 (58.91) -3,222.24 (3,001.27) 1,335 0.424

10,306.14 (19,931.85) 5.63*** (0.85) 0.72 (1.25) 11.03*** (2.68) 4.60*** (1.89) 7.48 (70.89) -37.30 (454.22) -543.34 (749.34) -359.73 (831.68) -413.18 (4,178.61) -8.21 (301.30) -2,932.09 (15,351.37) 1,335 0.273

8,012.03 (20,399.36) 7.46*** (0.87) 0.58 (1.28) 12.59*** (2.74) 6.16*** (1.94) 11.29 (72.55) 9.24 (464.88) -329.62 (766.92) -153.16 (851.19) 1,541.72 (4,276.62) -86.57 (308.37) -4,775.03 (15,711.44) 1,335 0.315

9,499.95 (19,974.27) 5.48*** (0.85) 0.86 (1.26) 11.64*** (2.68) 4.38*** (1.90) 9.30 (71.04) -90.53 (455.19) -507.52 (750.94) -216.89 (833.45) -640.08 (4,187.50) -75.85 (301.94) 3,731.59 (15,384.04) 1,335 0.276

Estimated pay-performance sensitivity prior to SOX (= β1+β2 ; x10-3)

1.65

6.35

8.03

6.34

Change in estimated pay-performance sensitivity after SOX (=β3+β4 ; x10-3) Statistical Tests

3.13

15.63

18.75

16.02

F-statistic

F-statistic

F-statistic

F-statistic

1. β1+β2 =0

32.67***

18.40***

28.18***

18.32***

2. β3+β4 =0

17.31***

16.51***

22.68***

17.27***

Variables

+ − − +

Intercept N R2

51

*, **, *** indicate significance at the 10-, 5- and 1-percent level, respectively, for a one-sided test. Standard errors are in parentheses. a Firm dummies are included in all the regressions but, for simplicity, are not reported. D_Yi,t represents the respective dependent variable in each regression analysis, for example, difference in the change in value of stock options, restricted stocks, and so on, of CEOs and Other Executives; Δ(stock options) = Change in the value of stock options held at the end of the year ($000); Δ(inside stockholdings) = Change in value of the executive’s inside stockholdings at the end of the year ($000). It is computed as the value of the shares held at the beginning of the fiscal year in which compensation is awarded multiplied by the inflation-adjusted rate of return on common stock during the year; Δ(total wealth) = Change in the executive’s total wealth at the end of the year ($000). It is computed as change in value of inside stockholdings plus change in value of stock options plus total pay minus current options awarded (B-S value). Δ(total wealth excluding unexercised options)= Δ(total wealth – change in value of unexercised previously-granted stock options); ΔSHRWEALTH = Market capitalization of the firm ($000) at the beginning of the year multiplied by inflation-adjusted rate of return on its common stock during the year; all other variables are as defined in Table 3; SOX = Dummy variable; takes on a value of 1 if the proxy statement was filed after July 30, 2002, zero otherwise; SIZE = Natural logarithm of the inflationadjusted market capitalization of the firm ($000,000) at the beginning of the year; ROE = Ratio of earnings before extraordinary items to the average total equity for the year (in %); ∆GDP = Change in real GDP during the year (in %); and MKTRET = Value-weighted stock market return (in %). A detailed description of all variables is provided in the Appendix.

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