Shareholder Influence on Board of Directors and CEO Remuneration: A Literature Review
Peter Rampling*
*Southern Cross Business School: Southern Cross University: Tweed Heads NSW Australia ** Corresponding Author:
[email protected] JEL Codes: D21, D22, D31, D79, G35, L25, M41, Key Word: Shareholder Influence Executive Remuneration Compensation CEO Financial Performance Corporate Governance
Electronic copy available at: http://ssrn.com/abstract=2102136
Abstract Purpose – This paper develops a discussion for the shareholder influence on board of directors and CEO remuneration of public listed corporation. Design/methodology/approach – This study entails Australia, The United States of America and The United Kingdom. Findings – The findings show that there is a proportionate mix of direct correlation between the influence of shareholders and the remuneration of executive directors and the CEO of public listed corporations. Originality/value – The paper will be of vital importance to other academics looking at this question, and to both public and private sector entities. Keywords – Board Remuneration, Corporate Governance, CEO, Shareholder Influence. Paper type – Research Paper
Electronic copy available at: http://ssrn.com/abstract=2102136
1.1
Introduction
This paper discusses the relationship of shareholder influence on the firm’s board of directors, primarily to extend on the work of Bebchuk and Fried (2004) and Bebchuk and Jackson (2005). From 1990 Bebchuk, singularly and with co – authors have been looking at the subject of executive remuneration and the relationship with alignment of shareholder interests and financial performance of corporations. Weisbach (2006) applauds Bebchuk and Fried for examining and critiquing the work of Jensen and Murphy (1990) and highlighting that looking at executive remuneration solely from the point of view of agency, was not the optimal or best way to examine the relationship between executive pay and performance. The alternative view concerning executive remuneration has been developed by Bebchuk and Fried (sometimes with other co authors as well) in an influential series of articles. They recently summarized and further developed this work in a book entitled Pay without Performance: The Unfulfilled Promise of Executive Remuneration, which was published in 2004. In the course of developing this view, the authors summarize and synthesize the academic literature on executive pay in a way that is likely to appeal to a broader audience. Bebchuk and Fried’s central hypothesis is that observed executive pay practices cannot be explained by a model in which shareholders contract optimally with shareholders. Rather, they argue that a more accurate characterization of the CEO pay process is one in which the CEO effectively sets his own pay, subject to some constraints by the market. Of course, CEO pay, although large, is nonetheless finite, so there must be some constraints that impose limits on its size. Bebchuk and Fried refer to these constraints as “outrage” constraints, as they stem from the public reaction to extremely high CEO pay. In Pay without Performance, Bebchuk and Fried develop both the principal-agent and the managerial power hypotheses non-technically in a way that a general audience can understand. They then do an extensive review of the empirical evidence that, in their opinion, distinguishes these two views. Their conclusion is that the evidence overwhelmingly supports the notion that CEOs have great sway over their own pay, and that executive remuneration is best understood through this lens, rather than through an optimal principal-agent contract in which the shareholders capture all the rents. They also provide some suggestions for reform, which they believe will ultimately improve corporate governance For the purpose of this study more particularly executive board directors and the chief executive officer (CEO).
Shareholders exerting their influence through increased shareholder activism can bring about desired change in the strategic direction of the firm of both short tem and long term objectives. Institutional shareholders potentially can use their voting influence and individual shareholders their collective voting power, i.e. through shareholder advocacy groups to bring about this change as stated by Porter (1992) who argues that institutional investors are overly focused on short-term earnings. In contrast, institutional investors are often characterized as sophisticated investors who have advantages in acquiring and processing information compared to individual investors (e.g., Hand 1990; Kim, et al. 1997; Bartov et al. 2000). If institutional investors are sophisticated, they should be better able to utilize current period information to predict future earnings (compared to other investors) and current period stock prices should reflect more of the information in future period earnings as institutional ownership increases. 2.1
Literature Review
Types of Shareholder Influence As stated by (Prigge, 2007) ownership structure analysis is a major part of corporate governance research. Transforming a shareholder structure into figures that represent the power structure among the shareholders is a precondition to conducting more advanced studies such as a regression of corporate performance on the ownership structure. Contemporary research mainly applies the shareholder’s share in votes (or in capital). However, the share in votes suffers from conceptual drawbacks, e.g., it assumes that a shareholder’s power is a linear function of his share in votes. Power indices, originally developed in game theory, possess some theoretically attractive features. They have been utilized in empirical ownership research for quite some time (see Rydqvist (1987) for an early application), but although usage seems to have been growing recently, their adoption is still not overwhelming so far. It seems that the scientific community is undetermined in its verdict on power indices. Rydqvist’s article contributes to this discussion by comparing the performance of power indices with that of the share in voting rights. However, the plural in the notion indices already hints at the fact that there are several ways to calculate power values. To evaluate the measures it must be specified which quality of a shareholder they should quantify. In the context of the stock corporation, Leech & Manjón (2002: 848) define power as “the a priori capacity of a large shareholder to influence a vote in a
hypothetical company meeting.” Instead of power, the notions of influence and control can be found quite often in the context of shareholder structure analysis. Leech & Leahy (1991: 1418) define control as “the power to exercise discretion over major decision making, including specifically the choice of directors.” Looking at the historical development of academic ownership structure analysis, Short (1994: 207) states: “Most of the earlier empirical studies differentiate between owner-controlled firms and management-controlled firms, based on a percentage ownership criteria.” This kind of classification goes back to the influential study of Berle and Means from 1932. They concluded that 20% of the voting rights are sufficient to supply a shareholder with the dominating position. Further stated the cut off points in the literature vary from 10% to 50%. According to this method, at least implicitly, all shareholders but the principal shareholder who is exceeding the cut off point is assumed to have little or no influence in the company. This dichotomy is simple, even trivial, if the principal shareholder owns more than 50% of the votes. This procedure becomes problematic if the principal owner disposes of 50% or less of the voting rights. Assume, for instance, the principal owner holds 30% of the votes and the second largest shareholder 25%. In this case, the principal owner cannot take the continuity of his control for granted, because the second largest shareholder may form a coalition with other bloc holders or he may purchase additional voting rights at the stock exchange to take over the dominating position in the corporation. The situation is rather different, if there is only one bloc holder in the corporation disposing of 30% of the votes and the remaining shares are being widely held. In this case, the principal owner will take up a position of power that is similar to, though still somewhat weaker than, that of a majority owner. The small shareholders would behave rationally passive, but the principal shareholder’s position could be contested by a competitor who is concentrating the dispersed shares. This suggests that the power of the principal shareholder is not only a question of the pure size of his voting bloc, but also of the contestability of his leading position (see the model by Bloch & Hege (2000) on this issue). The contestability is determined by the voting shares of the bloc holders, the free float, and the majority rule. Methods of ownership structure metrics should consider all of these factors as much as possible.
Role of Major Shareholders Gillan & Starks. (2000) state the role of institutional shareholder activism arises due to the conflict of interest between managers and shareholders. To control such conflicts, special market and organizational mechanisms have evolved. For example, there is an inherent monitoring function in the stock market itself that pressures managers to orient their decisions toward stockholder interests. In addition, Fama and Jensen (1983) note that the market for takeovers provides competing management teams the ability to circumvent existing poor managers. However, Jensen (1993) argues that with the downturn in mergers, acquisitions, and other corporate control activity over the early 1990s, the capital markets have not been as elective and there has been a shift to reliance on often ine!ective internal control mechanisms. Thus, large shareholders, i.e., individuals or institutions that simultaneously hold large debt and/or equity positions in a company, have been motivated to actively participate in the company's strategic direction. Gillan & Starks. (2000) further state that due to a free rider problem, it has been argued that only a large shareholder has the incentive to undertake monitoring or other costly control activities. All shareholders benefit from such activities even if they don't bear the costs of the process. The investor with a larger stake in the firm has stronger incentives to undertake monitoring activities, as it is more likely that the large shareholder's increased return from monitoring is sufficient to cover the associated monitoring costs. Evidence of Shareholder Influence Berle and Means (1932) claimed that the modern corporation’s main characteristic feature lies in the separation between ownership, scattered among a great number of small outside shareholders, and control, exerted by professional managers who own, at best, a paltry fraction of its capital. The huge ensuing literature on corporate finance took for granted that this characterization of the agency problem — circumscribing it to the potential conflict between shareholders and management — fitted all countries. Since the late 1980s, however, studies both at a theoretical and empirical level have also focused on the agency problems between minority and controlling shareholders. Holding a large block of voting shares in the firm, controlling shareholders would have incentives and power to expropriate minority shareholders. To a great extent, the costs and benefits of ownership concentration can be grasped through the lens of the trade-off between, on the one hand, incentives to monitor
management and, on the other hand, liquidity and risk diversification. Indeed, holders of a big chunk of shares may contribute to increasing firm value because, if they are outsiders, they are likely to have the right incentives to monitor the managers, therefore mitigating the free-rider problem. If they are managers themselves, they would have direct incentives to be efficient. Nonetheless, to compensate for the consequent relinquishment of the benefits of diversification and liquidity, a shareholder who concentrates his wealth on the ownership of a large stake in the firm would arguably pursue private benefits of control, such as those resulting from self dealing. The empirical literature assessing the effects of firms’ ownership and control structures on their performance has been copious. Morck et al. (1988), a pioneering analysis on that issue, distinguish two opposing effects on the market valuation of the firm’s tangible assets stemming from management capital ownership. The convergence-of-interest effect means that increasing management stake in the firm’s capital makes them more willing to be efficient; otherwise they would have to bear a larger burden of the costs associated with deviation from value-maximization behaviour. Thus, larger managerial ownership can generate positive incentives that might be translated into higher market valuation. The “entrenchment” effect, in turn, is related to the private benefits controlling shareholders may obtain at the expense of minority shareholders thanks to their ownership of a substantial fraction of the firm’s voting capital. Based on a sample of 371 firms out of the 1980 Fortune 500 firms, they provide empirical evidence of a non-monotonic relationship between managerial stake and firm valuation. Focusing on Italian firms, Bianco and Casavola (1999) estimate the effect of both pyramidal structures and the largest shareholder’s identity on firms’ returns. They hold that ex ante the net effect of pyramidal structures on the firm’s performance is ambiguous. On the one hand, that type of structure leaves plenty of room for expropriating outside investors and for dynamic inefficiency, since it facilitates the controlling shareholder’s entrenchment and hinders its contestability. On the other hand, by creating an internal capital market that mitigates informational asymmetries, pyramidal arrangements may overcome financial constraints that prevent good projects from being undertaken. Their empirical model provides two main findings. First, a significant negative effect on the rate of return of the dummy representing the existence of one controlling shareholder holding more than 66 percent of the firm’s
voting rights. Second, belonging to an economic group tends to engender a significant negative impact on the firm’s rate of return on investment. In the same manner, Claessens et al. (2002) attempt to disentangle the incentive and entrenchment effects of large ownership stakes using a sample of publicly traded corporations in eight East Asian countries. Their regression analysis found that the firms’ market-to-book ratio increases with the share of cash-flow rights in the hands of the largest shareholder (the positive incentive effect) and decreases with the share of its control rights (the negative entrenchment effect). They also show that corporate valuation is negatively correlated with the magnitude of deviations between control rights and cash-flow rights for the largest shareholders, suggesting that these discrepancies widen agency costs. Further evidence on the links between ownership structures and performance of firms is provided by La Porta et al. (2002). They built a model to evaluate the influence of outside investors’ legal protection and of controlling shareholder’s cash-flow rights on corporate valuation, applying it to data comprising the largest 20 firms by market capitalization of 27 developed countries. Using Tobin’s q as a proxy for the valuation of the firms, they show that controlling shareholder’s higher fractions of cash-flow ownership (a measure of its incentive to maximize firm value) are associated with higher valuation, notably in countries with poor protection of investor rights. They also find that deviation between the controlling shareholder’s control rights and cash flow rights may lead to minority shareholders’ expropriation. Carrying out a microanalysis of the determinants of the profitability rate for Korean firms subject to outside auditing during the period of 1993-1997, Joh (2003) shows that, controlling for firm and industry characteristics as well as for macroeconomic effects, firms with low ownership concentration or a high disparity between control rights and ownership rights tend to yield low rates of return. The investigation also furnishes some empirical support for non-linear ownership effects on firm profitability. Some analysts have pointed out that investors’ poor legal protection can magnify agency costs by facilitating the leverage of voting power over ownership through pyramidal arrangements of ownership, dual-class shares, and cross-shareholdings. They claim that, notwithstanding the potential advantage of promoting monitoring without greatly impairing liquidity, the divergence from the “one-share-one-vote” rule would have the drawback of strengthening the controlling shareholder’s incentive
and power for expropriating minority shareholders.1 Contesting this view, Almeida and Wolfenzon (2006) argue that the emergence of pyramidal ownership can represent an efficient response to financial market failures, notably in countries with undeveloped capital markets and where investor protection is poor. They present two reasons to uphold the claim that the choice of a group structure is biased in favour of pyramidal arrangements when poor investor protection leaves ample latitude for diversion of cash flows. First, the separation between cash-flow rights and voting rights, allowing the extraction of high private benefits of control, provides a payoff advantage. Second, the controlling family also enjoys a “financing advantage.” Expectations of cash-flow diversion posed by the divergence of rights are reflected in the conditions under which outside investors are willing to supply capital, rendering external finance too expensive or not at all available. The controlling family can tap the retained profits from the firms it already controls to finance the set up of new enterprises, sharing with the former firms’ shareholders the latter’s “security benefits”, that is, the fraction of the firm’s returns not appropriated as private benefits by the controlling family. Furthermore, they contend that firms with high investment requirements and/or yielding low cash flows would tend to structure pyramidal ownership schemes since firms with those characteristics are likely to face harder financial constraints and, consequently, would be the most benefited from intra-group transfer of resources. Conceptual Frame Work Relationship to Executive Remuneration Alshamlan, Abdulrahman S. (2006) states accounting standard setting bodies and International Accounting Standards Board are known as the accounting professions. The accounting professions came to realize that the major changes to business and commerce led to the need to upgrade book keeping, accounting and accounting reporting requirements (Williamson, 2002). Modern book keeping and accounting systems have been developed with the aid of computers. The development of computer based book keeping and accounting systems that can be used for virtually any business, large or small, complex or simple have introduced techniques and methodologies that known as accounting information. Nowadays, the main users of accounting information are shareholders, investors, security analysts, managers, employees, lenders, suppliers, customers, and governments and their agencies (Williamson, 2002).
There are twelve objectives of financial reporting. These are decision making, financial statement, cash flows, earnings, management ability, and disclosure, statement of financial position, uncompleted transactions, expected information, forecasts, and governmental and social concerns. The interrelated objectives and fundamentals have formed a conceptual framework where objectives identify the goals and purposes of financial reporting and the fundamentals are the underlying concepts that help achieve those objectives. The FASB has issued Concepts Statement No. 6, Elements of Financial Statements. The financial statement defines the elements such as assets, liabilities, revenues and the use of cash flow and present value information in accounting measurements (Williamson, 2002). The conceptual framework is a set of concepts that can provide guidance in selecting the transactions, events and circumstances to be accounted for, how they should be recognized and measured and how they should be summarized and reported. It is a body of interrelated objectives and fundamentals. The objectives identify the goals and purposes of financial reporting and the fundamentals are the underlying concepts that help achieve those objectives. The FASB has issued Concepts Statement No. 6, Elements of Financial Statements. The statement identify and explain objectives of financial reporting by business enterprises and non profit organizations, qualitative characteristics of useful accounting information, elements of financial statements which are the definitions of assets, liabilities, revenues and so forth; criteria for recognizing and measuring those elements, and the use of cash flow and present value information in accounting measurements (Williamson, 2002). A conceptual framework would provide accountants and the users of accounting information with a standard set of rules, principles and procedures that would accomplish the picture of accounting and accounting information that can satisfy the needs of all user groups. Also, a conceptual framework might not make accounting standard setting and implementation easier; it would add a set of guidelines and procedures that would make those processes more certain which can reduce the political interference (Williamson, 2002). The framework can narrow the range of alternatives to be considered by eliminating some that are inconsistent with it. The standard setting process can avoid the necessity of having to re-debate fundamental issues such as what is an asset. And by providing a common terminology and frame of reference, it should facilitate any debate about specific technical issues. The framework can be used to guide the development of
accounting standards that are intended to facilitate the provision of even handed, or neutral, financial and related information. Without the guidance provided by an agreed upon conceptual framework, standard setting would be quite different. And rational debate won't occur because positions about the appropriate accounting treatment for a given transaction can neither be defended nor refuted (Williamson, 2002). In conclusion, the framework can help users of financial reporting information to better understand that information and its limitations. It can be reference for understanding the resulting standards. Then, the reference will be useful to apply those standards and to auditors who will examine the resulting reports (Williamson, 2002). Executive Director/CEO Remuneration Ruiz-Verdú, Pablo & Singh, Ravi 2011 argues that reputational concerns are arguably the single most powerful incentive for board directors to act in the interest of shareholders. They propose a model to investigate the impact of boards' reputational concerns on the level and structure of executive remuneration, the use of camouflaged pay, and the relation between board independence and remuneration decisions. They show that, in order to be perceived as independent, boards lower managers' pay, but may also pay managers in hidden ways or structure remuneration inefficiently. Interestingly, independent boards, not manager-friendly boards, are more likely to make use of hidden remuneration. They apply their model to study the costs and benefits of greater pay transparency and of measures, such as say-on-pay initiatives, that increase boards' accountability to shareholders. In the ongoing debate about executive pay, critics of current remuneration practices argue that pay packages are designed to facilitate rent extraction by managers rather than to provide those managers incentives to maximize shareholder wealth. In this debate, particular attention has been directed to the use of hidden or camouflaged" forms of pay, which appear to be inconsistent with the maximization of shareholder value (Bebchuk and Fried, 2004; Bebchuk and Jackson, 2005; Weisbach, 2007). Since boards of directors set executive remuneration and monitor management, the debate about executive pay has brought to the fore the unresolved question of board incentives: What determines the incentives of board directors? And how do those incentives affect directors' choice of executive remuneration packages?
Despite the key role played by boards of directors, the theoretical analysis of director incentives has been limited. In particular, while executive pay is not set by shareholders but by board directors, the agency problem between shareholders and the board in the determination of executive remuneration is often ignored, at least as a first approximation, with the argument (Fama, 1980; Fama and Jensen, 1983) that reputational concerns by board directors align their incentives with those of shareholders. The debate about executive remuneration, however, highlights the need to investigate how these reputational concerns shape director incentives and their choice of remuneration policies for managers. In their paper, they propose a model to analyse how boards' incentives affect their decisions regarding the level and structure of executive remuneration and the use of hidden forms of pay. In the model, they analyse a standard managerial agency problem in which a remuneration contract is used to provide incentives to a riskaverse manager to exert effort. They depart from the conventional treatment of the managerial agency problem in that in their model board directors, not shareholders, design the manager's remuneration contract and they explicitly analyse reputational concerns as a major determinant of director incentives. Their model has four key ingredients. First, directors that are perceived as more independent from management are more likely to keep their board seats or be elected to serve at other boards. Second, they distinguish between formal and true independence: While shareholders can observe the former, they can only infer the latter from directors' actions. Third, following on the perception that executive remuneration is the “acid test" of corporate governance, shareholders use executive remuneration decisions as a metric to assess boards' true independence. Finally, the board has the ability to pay the manager in hidden but inefficient ways. With this last assumption they aim to shed light on the reasons why boards may pay managers in camouflaged ways, such as difficult to observe perks, poorly disclosed pension plans, option backdating, strategically timed option grants, the manipulation of performance measures, or the use of stock options, to the extent that shareholders underestimate the cost of these options for the firm. They show that if boards are not concerned about investors' perceptions of their independence, all boards choose efficient remuneration contracts regardless of their degree of independence. Manager- friendly boards pay managers more than relatively
independent boards, but do so by increasing the non-contingent portion of executive remuneration rather than by tinkering with the pay-performance sensitivity of the remuneration contract or by paying managers in hidden ways. If directors can benefit from being perceived as independent, independent boards will lower executive pay to signal their independence to investors. However, if independent boards have to lower executive pay below their preferred level to signal their independence, they will allow the manager to “claw back" some rents in costly undisclosed ways. Therefore, although reputational motives generally lower managerial pay, they may also lead boards to use inefficient hidden pay. Further, as long as independent boards succeed in signalling their independence to investors, manager-friendly boards will not make use of hidden pay in equilibrium: If they cannot pass as independent, manager-friendly will not deviate from their preferred remuneration contract nor pay the manager in costly hidden ways. Thus, the model explains hidden pay not as a way by manager-friendly boards to deceive shareholders, but, rather, as part of a strategy that allows independent boards to signal their independence to investors. Further, they show that reputational concerns may also lead independent boards to set inefficiently structured remuneration contracts. If independent boards cannot signal their independence even if they keep the manager at his reservation utility level, they may preclude imitation by management- friendly boards by choosing inefficient remuneration contracts, which effectively reduce shareholder wealth. As with hidden pay, the model implies that independent boards, rather than manager-friendly boards, are the ones that engage in inefficient pay practices. Although they focus on remuneration decisions, these predictions potentially apply to other board decisions. For example, Fisman et al. (2005) argue that boards sensitive to shareholder pressure may inefficiently terminate their CEO's in response to such pressure. They apply the model to analyse the potential impact of recent regulatory changes and corporate governance trends. They show that pay disclosure requirements that seek to make executive remuneration more transparent will generally have the intended effect of discouraging the use of hidden pay. Interestingly, however, greater transparency may have the effect of reducing shareholder wealth. The reason is that greater transparency makes it harder for manager-friendly boards to compensate managers in undisclosed ways for a reduction in disclosed pay and, thus, makes it more costly for these boards to imitate the
remuneration policies of independent boards. Therefore, greater transparency reduces the pressure on independent boards to lower executive remuneration to signal their independence and, as a result, may lead to higher managerial pay and lower shareholder profits. Indeed, they show that some pay opacity is optimal for shareholders. They also study the impact of corporate governance trends, such as the increase in institutional ownership, the adoption of voting rules that increase the influence of investors over the election of board directors (such as replacing plurality rules by majority rules in board elections), or the passage of “say-on-pay" legislation. They show that greater influence by investors will generally reduce executive remuneration, but may have the unintended effect of increasing the use of hidden pay. In fact, when investor pressure is strong enough, the distortions induced by greater director accountability to shareholders may reduce shareholder wealth. A key assumption of their model is that boards' executive remuneration decisions have reputational consequences. At least in recent years, directors indeed risk being singled out for their remuneration decisions. Corporate governance watchdogs, such as Institutional Investor Services or the Corporate Library, or activist institutional investors, such as CalPERS, publish corporate governance ratings and watch lists, and boards' remuneration decisions are a key factor determining those ratings. Moreover, executive remuneration often receives negative coverage by the media. Thus, Core et al. (2008) and that excess CEO pay leads to negative press coverage of firms' remuneration practices. Kuhnen and Niessen (2010) document that CEO pay is responsive to the negativity of the average media coverage of executive remuneration. In particular, they find that firms reduced stock option remuneration (the form of remuneration receiving the greatest attention by the press in the period 1997-2004) following generally negative press coverage of executive pay. Kuhnen and Niessen's findings, thus, support the hypothesis that CEO pay is responsive to reputational concerns. The predictions of the model shed new light on empirical results relating corporate governance and pay-performance sensitivity. For example, Bertrand and Mullainathan (2001) and Hartzell and Starks (2003) found that pay-performance sensitivity is greater in firms with a large shareholder or high institutional ownership concentration. Their theory suggests that the higher pay-performance sensitivity in firms with higher institutional ownership may not be optimal and thus, may not be considered as a
standard of good practice|, but rather a way for the boards of these firms to signal their independence to investors. A caveat of this interpretation is that their model does not pin down the particular form in which independent boards will distort pay, so independent boards could have opted to reduce, rather than increase, pay-performance sensitivity. However, they expect independent boards to exaggerate policies that are perceived at a given moment of time to be favourable to investors and shun those that have a negative press, as suggested by Kuhnen and Niessen's (2010) results. Several authors have argued that the widespread increase in the use of stock options in remuneration plans during the 1990s may not have been efficient. Although there are alternative explanations for the proposed overuse of stock options, their results may also help explain this phenomenon. If investors were not really aware of the cost of stock options, their model would explain the excessive use of stock options as a form of hidden remuneration, as proposed by Bebchuk and Fried (2004). However, while Bebchuk and Fried's (2004) explanation of the use of stock options as a rent extraction mechanism has been criticized on the grounds that the increase in the use of stock options in the 1990s coincided with a perceived reduction in the power of top executives (Holmstrom, 2005), their model would predict this very pattern: The increase in the use of hidden pay would have been a response to directors' greater accountability to shareholders. Another critique of the hidden-pay explanation of option remuneration is that the grant value of executive stock options is disclosed to investors. Further, the disclosed value of option grants is commonly their BlackScholes value, which arguably significantly overstates their value to risk-averse executives (Hall and Murphy, 2002). Thus, if investors understand the true cost of stock options, the use of options cannot be explained as hidden remuneration. Their model, however, provides an alternative explanation to the increase in stock option remuneration. To the extent that the amount of stock options granted to executives was indeed inefficient, the excessive use of options could have been part of a strategy by independent boards to signal their independence to investors. They remark again that, according to explanation, independent boards, rather than captured boards, are the ones more likely to use inefficient forms of disclosed or undisclosed remuneration. It is worth emphasizing that their predictions do not relate directly to formal independence (observable by shareholders) but to true independence (which shareholders cannot observe). However, the model can shed light on the relation
between observable measures of board independence and executive pay. Outside directors in boards with a low fraction of formally independent directors may be perceived as having little influence over executive pay decisions (even if the remuneration committee is comprised mostly of independent directors), and, thus, those decisions may have a relatively weak impact on their future career prospects. A higher fraction of (formally) independent directors could then be associated with lower expected pay, but also with a greater incidence of hidden or distorted pay. Although most of the theoretical literature on executive remuneration abstracts from the role of boards, a few articles investigate this role. In an influential article, Hermalin and Weisbach (1998) proposed a model, in which the board decides whether to retain or fire the CEO, and the board and the CEO bargain over the CEO's pay and the composition of the board. However, the focus of Hermalin and Weisbach's article is not the determination of CEO pay contracts. In their model, there is no need to provide incentives to the CEO, who receives a salary. Almazan and Suarez (2003) develop a model in which the CEO's incentives to take a cash-flow increasing action are determined by a remuneration contract designed by the board and by the board's bargaining power when negotiating with the CEO the latter's potential replacement. Almazan and Suarez (2003) show that the optimal payperformance sensitivity is higher when the board is strong and that severance pay will tend to be higher in weak boards. They also show that in some circumstances it is optimal for shareholders to have a weak board. Hermalin (2005) analyses a model in which the board decides whether to replace a CEO of unknown ability. He shows that more diligent boards may lead to higher CEO pay, because they implement a higher level of CEO effort, which has to be compensated. Kumar and Sivaramakrishnan (2008) propose a model in which the board both invests in acquiring information about the firm and select a remuneration contract for the CEO. They find that the equilibrium relation between director independence and equity remuneration is ambiguous. None of these articles consider the impact of director reputation on their choice of CEO remuneration. Several articles have recently provided models of the board as monitor or adviser of the manager. However, none of these models investigates the role of the board in determining CEO remuneration contracts. Further, only Fisman et al. (2005) and Song and Thakor (2006) explicitly analyse board reputation. Fisman et al. (2005) consider a model in
which the board decides on the replacement of the CEO and bears a cost for taking a decision contrary to shareholders' desires. If shareholders mistakenly attribute random shocks to firm performance as signals of the manager's ability, they will incorrectly pressure to retain (fire) the manager when the firm is hit by a positive (negative) shock. In this context, some managerial entrenchment may lead to better hiring decisions. In Song and Thakor's model, boards take into account the impact that their decision whether to accept or reject a project proposed by the CEO will have on their reputation as experts. Interestingly, Song and Thakor (2006) allow the board to be concerned either by their reputation with shareholders (as in this paper) or by their reputation with the CEO. The theoretical literature on executive remuneration has, for the most part, ignored hidden remuneration, since it has proven difficult to rationalize as part of a remuneration contract that maximizes shareholder value. An exception is the model proposed by Kuhnen and Zwiebel (2008) in which the CEO is assumed to effectively set his/her own remuneration, both disclosed and hidden, with the constraint that excessive remuneration may lead to shareholder intervention. Kuhnen and Zwiebel (2008) effectively assume no role for the board, however, so their model cannot shed light on the role played by the board in determining executive pay. CEO/Chair Duality Corporate hierarchy, the Chief Executive Officer (CEO) heads the management team while the governing board is led by the chair of the board (Chair). Empirical evidence suggests that the CEO of large U.S. public companies also tends to be the Chair. Because of the recent corporate scandals, regulators and reformers are increasingly demanding that the role of the CEO be separated from that of the Chair (Wilson 2008, Lorsch and Zelleke 2005). Advocates claim that having an independent Chair results in superior monitoring by the board. CEOs become more effective leaders when the two positions are separated because it allows them to concentrate on the firm’s operations while empowering the board (Wilson 2008). Their study examines several inter-related issues with the purpose of providing input to the debate on the dual role of CEOs: (1) they test whether the appointment of a CEO as the Chair is an efficient response to firms’ contracting and information environment (efficient contracting theory), (2) because CEOs with dual positions can misuse their power for personal gains, they investigate whether CEO-Chairs, relative to firms with independent Chairs, have higher remuneration, use accounting discretion
to manipulate earnings, acquire more frequently, are reluctant to pay out cash to shareholders (rent extraction theory), and (3) they examine whether the stock market perceives dual leadership structure as a symptom of agency problems. While the benefits of the separation of the CEO-Chair positions have been publicized recently, firms can profit from one individual holding dual position in several ways (Pozen 2006). First, a CEO who is also the leader of the board is in a powerful position to oversee the directions of a firm relatively unopposed. Conflicts situations are more likely to arise when a CEO is at odds with an independent Chair about the future of the company. A CEO-Chair faces less opposition from the board when initiating major changes within the company than when the two top leadership positions are separated.3 Second, one of the fundamental duties of a board as outside experts is to advise and monitor the top management team (Linck et al. 2008, Raheja 2005). However, outside directors are less effective in their monitoring and advising roles when firm-specific information is high (Coles et al. 2008). Firms with high R&D expenditures, substantial growth opportunities, and high volatility are harder to monitor unless outside board members are privy to the firm’s investment opportunity set. Similarly, they are most effective in their advisory role when management communicates its specific needs to the board (Hermalin and Weisbach 1988). Because directors mostly receive company-specific information from the CEO (Finkelstein and D’Aveni 1994), firms with high insider information benefit from having the CEO communicate directly to the board rather than go through an independent Chair who is much less informed about the firm’s constraints and opportunities. Third, firms are expected to exploit the skills of long-serving successful CEOs by combining the two top positions. This is because CEOs with a proven record of excellence have more to lose when they misuse their power to the detriment of the shareholders. While there are potential benefits from having a dual leadership structure, such arrangements also impose costs. As the Chair, the CEO is more powerful because he/she has a strong say in matters of governance in deciding the agenda, setting board meetings, re-appointment decisions, and selection of various sub-committees such as audit, remuneration and nominating committees. A common perception is that CEOChairs exploit their power to extract private benefits including increasing remuneration or other forms of perquisite consumption (Jensen 1993). They posit that CEO-Chairs are less likely to use their power for personal reasons when firms have strong corporate governance mechanisms. While powerful CEOs are given a free
hand in the firm’s operating decisions for firms with dual leadership structures, having strong governance ensures that CEOs do not misuse the power to enhance their personal welfare. Thus, strong governance is optimal for firms with dual leadership structure because it exploits potential benefits while minimizing costs (efficient contracting). An opposing view is that dual leadership structure is suboptimal because CEO-Chairs use their added power from holding two top positions to extract rents for themselves (rent extraction). Their results from a large sample of firms from 1998 to 2005 are mostly consistent with the efficient contracting and inconsistent with the rent extraction proposition. They find that the likelihood of CEOs holding a dual position increases with volatility, industry concentration, liability, firm size, firm age, CEO tenure, CEO ownership, institutional ownership, board independence, and audit committee size. Thus, consistent with the prediction that CEO-Chair appointment is an efficient response to the firm’s contracting environment, their results suggest that the prospect of a CEO serving as the Chair increases with the riskiness of a firm, industry concentration, CEOs’ ability and track record, and strong governance. A more direct test of the rent extraction hypothesis is to examine whether there are adverse consequences from CEOs holding dual positions including excessively high CEO remuneration, use of financial reporting discretion to manage earnings, lower market valuation, more likely to engage in acquisitions, or paying out less cash to shareholders. First, controlling for other determinants of executive remuneration (e.g., Core et al. 1999) and CEO-Chair, they find no evidence to suggest that CEOs’ remuneration is higher when they hold dual positions compared to what they earn when they do not hold dual positions. Second, controlling for factors that influence financial reporting decisions (Ashbaugh et al. 2003, Klein 2002a) and CEO-Chair, they find very little evidence to suggest that the CEO-Chair uses the enhanced power to manipulate earnings. Third, controlling for taxes, investment and financing decisions (Pinkowitz et al. 2006, Fama and French 1998), they do not find that the market valuation is different between the two groups of firms. Finally, they find no evidence to suggest that CEO-Chairs are more acquisitive or that they pay less cash to shareholders. Thus, their examination does not support claims that CEO-Chairs extract rents or adversely affect shareholder welfare. A key contribution of their study is not that they find no evidence of rent extraction by CEO-Chairs but that they provide explanations for why they do not extract rents,
which is linked to the governance structure. CEOs have a relatively difficult time extracting rents (even if they want to) when boards are more independent, stronger, and more effective, and when institutional presence is larger. Also, because the cost of value-reducing actions is high to CEOs, they are less likely to extract rents as CEOChairs when their ownership is high. Further, reputation is another factor that ensures that capable CEOs will use their added power judiciously and not to the detriment of the shareholders. Finally, assuming that their CEO-Chair prediction model is a parsimonious representation of the firms’ underlying optimal economic decision to have CEOs hold dual positions, this model can identify circumstances when CEOs are more likely to use their power to extract rents. According to their model, CEOs with dual positions are expected to extract rents when they serve as CEO-Chairs even though their estimates indicate low probability of a dual leadership structure. The reverse is true when the estimated probabilities are high. Consistent with their expectation, they find that CEO remuneration and earnings management are economically and statistically higher for firms with low probabilities compared to those with high probabilities. Corporate Strategies Parnell (2008) argues Considerable research progress has been made over the past three decades in the competitive strategy arena (Capps, Jackson, & Hazen, 2002; Mauri & Michaels, 1998; Phelan, Ferreira, & Salvador, 2002). Nonetheless, a number of challenges remain (Jarzabkowski, 2003; Kim & Mauborgne, 2005; McDonald, 2006; Van de Ven & Johnson, 2006). Prevailing topics of concern are of keen interest in both domestic and global contexts (Garrigos-Simon, Marques, & Narangajavana, 2005; Jusoh & Parnell, 2008; Rugman & Verbeke, 2008; Spanos, Zaralis, & Lioukas, 2004), as well as content and process dimensions (Richter & Schmidt, 2005; Sorge & Brussig, 2003; Varadarajan, 1999). Competitive strategy scholars have sought to answer three important questions. First, questions arise about what constitutes an effective strategy and how to craft an effective strategy. Key competitive strategy issues in this realm involve both process and content concerns (Richter & Schmidt, 2005; Varadarajan, 1999). Process issues are focused on the nature of strategy, for example, is process an art or a science, as well as whether the strategy is visible or hidden, and the extent to which top managers coalesce around a common strategic approach. Content issues emphasize the defining characteristics of competitive strategies and include traditional efforts anchored in
industrial organization (IO) economics that focus on strategic commonalities across businesses (Porter, 1980, 1985), as well as more recent efforts that accentuate each strategy’s uniqueness, such as the resource-based view (RBV) (Barney, 1991). The recent resurgence in organizational economics, which emphasizes issues such as incentives, agency theory, transactions cost theory, authority and delegation, decentralization, and property rights theory, builds upon both IO and the RBV (Fulghieri & Hodrick, 2006; Foss & Foss, 2005; Gibbons, 2003; Kim & Mahoney, 2005; Whinston, 2003). A second question is how strategies are implemented in organizations. Prevalent issues in this realm are concerned with contingency, fit, and factors that contribute to a strategy’s ultimate effectiveness. Process and content issues are also a focus in this realm, although the distinction between the two categories is not clear (Sorge & Brussig, 2003; Varadarajan, 1999). Broadly speaking, process issues address the management of strategic risk and the strategic roles played by various members of an organization, most notably the top executives, management teams, and middle managers, in the development and execution of strategy. Content issues include strategic change and the notion of dynamic strategies. The third question concerns the evaluation of the effectiveness of a strategy. Issues of interest are related to strategic control, including measuring performance and sustaining it over the long term. Within this realm, process and content distinctions become even more problematic because the two categories tend to converge (Varadarajan, 1999). The three questions can be synthesized into three broad phases: Strategy formulation, strategy execution or implementation, and strategy evaluation or control. Although scholars and practitioners are interested in all three phases, they have approached issues in each area from different perspectives. Scholars tend to be concerned with methods of inquiry and analysis and emphasize precision over practical application. Practitioners are more interested in prescriptions pertinent to their particular situations.
Executive Director/CEO Incentivisation Sun, Lan & Rath, Subhrendu (2011) argue despite substantial research on earnings management in the U.S. market, Australian academic research has been relatively limited. These authors’s have surveyed Australian studies of earnings management across all possible research databases and the results shows that not only research on earnings management is limited within the Australian context, but also there are gaps have not yet been explored. In reviewing Australian studies of earnings management, they found that during the period of 1998 to 2008 earnings management evidences have been documented in the setting of income-smoothing (Black et al., 1998); price control and political concerns (Lim and Matolcsy, 1999; Godfrey and Jones, 1999; Monem, 2003); takeover (Eddey and Taylor, 1999); CEO changes (Wells, 2002; Godfrey et al., 2003); benchmark beating (Holland and Ramsay, 2003; Coulton et al.,2005); corporate governance and Institutional investor type (Koh, 2003; Hsu and Koh, 2005; Davidson et al., 2005; Koh, 2007); economic setting of Australia’s ‘Old’ and ‘New’ economies (Jones and Sharma, 2001); banking industry (Anandarajan et al.,2007); and earnings restatements (Ahmed and Goodwin, 2007). The review of Australian research not only shows that research on earnings management is limited within the Australian context, but also reveals the gaps within existing studies. For example, the executive remuneration incentives have not yet been well examined in the Australian context. Balachandran et al. (2010) is the few studies examined whether the earnings management behaviour is driven by executive remuneration incentives. Using a sample of 138 Australian firms, they found that managers with option holdings use two mechanisms discretionary current accruals and on-market buyback announcements to drive up share prices which subsequently determine the value of options. Although Balachandran et al. (2010) documented that executive remuneration particular options provide incentives for earnings management, other forms of executive remuneration such as salary, bonus, and shares are not examined. This may limit the generalisability of the findings. Moreover, the capital market in Australia is relatively small and highly concentrated with resource based companies compared to the U.S market. Analysts following Australian markets are fewer and the regulatory scrutiny level of the Australian market is argued to be lower than that of U.S (Chan et al., 2005). Also, the accounting standards, institutional structure, and corporate governance of Australia are different
from those in the U.S. For instance, the required frequency of financial reporting is twice per year in Australia while in the U.S. it is four times per year. More importantly, Australian CEOs are commonly remunerated with salaries and bonuses than with equity-based remuneration; whereas in the U.S. stock options have replaced salaries and bonuses and have become the single largest component of CEOs’ remuneration since 1990s (Izan et al., 1998; Matolcsy and Wright, 2007; and Murphy, 1999). Given all these differences, it is not clear that the evidence gathered from U.S. firms would be applicable to those in Australia. Therefore, further investigation of whether and how executives’ remuneration affects earnings management within the Australian context is necessary. To date, researchers have questioned whether and why earnings management takes place. In theory, executive remuneration incentives are suggested to induce the earnings management behaviour. However, the literature shows that empirical findings are mixed and inconsistent. Given the dynamic nature of earnings management behaviour, the study extends prior research by using more relevant, recent, and large-scale data to detect earnings management, capture earnings management behaviour and its association with executive remuneration incentives. To these researchers’s best knowledge, no studies in Australia exist that assess earnings management in the context of executive remuneration incentives and total CEO remuneration packages. This paper takes a comprehensive view of the remuneration contract and provides evidence on the executive remuneration mix and earnings management. Summary The literature discussed in this chapter found mixed results when looking at the question as to whether their significant influence exerted by shareholders on the board of directors, particularly executive directors and the firm’s CEO to alter strategy as a consequence of this influence and whether any relationship to executive remuneration or incentives bear out. Another inclusive area is whether CEO/Chair duality is a negative or a positive for the firm. The literature in this paper requires further analysis, in view of forming a more solid opinion either way.
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