Evidence of Managerial Power in Annual Bonus Payouts in the Netherlands and the United Kingdom

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Executive Bonus Payouts and Managerial Power

Evidence of Managerial Power in Annual Bonus Payouts in the Netherlands and the United Kingdom

Daniel den Hengst

June 2009

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Executive Bonus Payouts and Managerial Power

Evidence of Managerial Power in Annual Bonus Payouts in the Netherlands and the United Kingdom

Amsterdam, June 2009

University of Groningen, the Netherlands Faculty of Economics and Business Department of Auditing

In association with:

Ernst & Young Accountants LLP

AM MNC Amsterdam, the Netherlands

Document Type: Master Thesis

Author: D. (Daniel) den Hengst

Student Number: 1405942

Email: danieldenhengst@gmail.com

Supervisor: Dr. R.B.H. (Reggy) Hooghiemstra 1 Second Supervisor: Prof. Dr. C.L.M. (Niels) Hermes 2 Supervisor Ernst & Young Drs. W.E. (Wim) Wesdorp RA 3

1 Dr. R.B.H. (Reggy) Hooghiemstra is Assistant Professor at the Department of Auditing, Faculty of Economics and Business, University of Groningen, the Netherlands

2 Prof. Dr. C.L.M. (Niels) Hermes is Professor of International Finance at the Department of Finance, Faculty of Economics and Business, University of Groningen, the Netherlands

3 Drs. W.E. (Wim) Wesdorp RA is Manager Audit MNC, Ernst & Young Accountants LLP Amsterdam, the Netherlands

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Executive Bonus Payouts and Managerial Power

Evidence of Managerial Power in Annual Bonus Payouts in the Netherlands and the United Kingdom

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Abstract

In this research, the extent to which executives use their power to manipulate their bonus payouts is investigated. Comparison of the achieved, target and maximum bonuses of Dutch and UK executives leads to the following main conclusions. First, bonus payouts are influenced to reach the targeted bonus by (especially short serving) CEOs, but not by UK CEOs. Second, there are a high number of high and maximum bonus payouts for both countries; also the shape of the payout distributions does not match theoretical expectations. Third, a lower CEO’s tenure and a minimum ratio of 60% of non executives in the board can limit the influence executives have on their bonus payouts. Taking all results into account, Managerial Power is better at explaining bonus payouts than Agency Theory. Likely, CEOs use their power to influence their measured performance and contract conditions to maximize their bonus payouts.

Keywords: Executive compensation, Annual Bonus, Managerial Power

4 I would like to thank my supervisor at the University of Groningen, Reggy Hooghiemstra, for his valuable and quick responses, constructive comments but also for the freedom I enjoyed during the writing of this thesis. I would like to thank Ernst & Young for giving me the opportunity to and facilitate me in writing my thesis at their Amsterdam office, in particular Wim Wesdorp for his comments and helpful discussions to get me quickly (back) on the right track. Also I would like to thank the colleagues at Ernst & Young, in particular Alex, Dieuwke, Lisa, Tanja and Tanya for their support, ideas and lots of fun we had during the writing of our theses. Furthermore I would like to thank the other reviewers of this paper, in particular Jan den Hengst. Most important again, was the moral support and unconditional belief in me of my family and friends. Because you all were more certain that I could write two theses in this time than I was, this goal became reality.

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Introduction

In April 2009, the protest of 4.000 anti capitalists in London against the high bonus payouts of bankers ended violent; 32 arrests, officers and protesters suffering injuries, broken windows and smoke bombs at a branch of the Royal Bank of Scotland (FT 01-04-09). In May 2009 in the Netherlands, the DNB 5 and AFM 6 are granted the power to intervene in executive compensation plans of financial institutions.

According to these Dutch bodies, perverse incentives in annual bonus plans are one of the causes of the financial crisis the world currently is experiencing (FD, 07-05-2009). Media attention to the executive compensation discussion seems to keep increasing, and the press has a twofold role in this; though they use a sophisticated approach by putting more attention to excess pay than raw pay, they do engage in some degree of ‘‘sensationalism’’ (Core, Guay et al. 2008). Besides the interest in executive compensation by the public and the press, an increasing number of shareholders rebels against new bonus plans for top executives in 2009 (e.g. ASML, BP, DSM, Randstad, RBS and Shell). The attention to payouts in the public domain, fueled by the financial crisis, also puts the academic interest in bonus payouts in the spotlight. Recent academic work both criticizes (Bebchuk, 2009) as praises (Kroos, 2009) current executive compensation plans. One important question that puzzles all participants in the discussion, but is not yet solved by academics, is how executives gain the power and how they use this to receive the bonuses that are the topic of the discussion.

The size and ferocity of the discussion about executive bonuses, together with the academic interest in the field, makes the influence of executive power on bonus payouts a very interesting starting point for this research. The goal of this research is to get a better understanding of how managerial power influences bonus payouts, and therefore a sophisticated research framework is used. In short, achieved bonus payouts of Chief Executive Officers (CEOs) in the Netherlands and the United Kingdom will be linked to their contractual target and maximum bonuses. The paid out bonus relative to the contract for a group of executives results in a payout distribution, and discontinuities in this distribution signal if there are opportunities to “manage” bonuses. Comparing the discontinuities in payout distribution for the Netherlands and the United Kingdom gives us information about the extent to which executives are able to manage their bonuses in both countries, where CEOs are expected to be more powerful in the Netherlands because of a less strict Corporate Governance framework. Besides corporate governance

5 The Dutch Central Bank

6The Dutch supervisory authority for savings, lending investment and insurance markets

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frameworks, other possible factors that could influence CEO bonus payouts (board duality, CEO tenure, and the ratio of non executives) are considered as well.

This thesis is organized as follows: In the Problem Formulation, some of the extensive available literature on executive pay is discussed, resulting in the formulation of the research question and sub-questions that will be answered in this research. In the Literature Review, a comprehensive background of executive compensation practices and executive bonus plans, needed for this research, is presented. In this section, the characteristics of an annual bonus plan, undesirable effects of it and expected annual bonus payouts are discussed. Together with the expected influence of Dutch and UK corporate governance frameworks, the hypotheses are stated that will be tested in this research. In chapter 3, the methodology that is used to investigate bonus payouts is presented. In the Results section, characteristics of bonus payouts and other results are presented and linked to the hypotheses stated before. In the discussion chapter, the results are interpreted in more detail and linked to the literature review. Finally, conclusions are drawn and limitations and suggestions for further research are presented.

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1 Problem Formulation

“The dramatic growth in executive compensation during the 1990s was outpaced by the increase in the volume of research papers on the subject” according to Kevin J. Murphy (1999), one of the most important authors in the field of executive compensation. However, there is still more research needed to fully understand practices in executive compensation. In this section, an overview of the current questions and available answers in the executive compensation field is presented and based on this the research question, which is the foundation of this research, is formulated.

In short, ideas that form the outline of this research are the following (based on Jensen and Murphy, 1990; Tosi, Werner et al., 2000; Bebchuk, Fried et al., 2002; Bebchuk and Fried, 2004)

1. Annual bonus payouts do not seem not to be (only) depending on executive’s performance 2. It seems that executives have both the incentive and the power to influence their annual

bonus payouts

3. A strong corporate governance framework can limit the power of executives

These ideas will be tested in this research and therefore will be investigated (a) what expected and real bonus payout distributions look like, (b) how bonus payout distributions and discontinuities in bonus payouts differ between countries with different corporate governance frameworks and (c) if the results from (a) and (b) support the assumption that annual bonus payout practices can be explained by executive’s power. The extensive logic behind this reasoning will be discussed next, and will be complemented with the importance of this research.

1.1 Towards a research question

In the current debate about executive remuneration, public outrage and scientific interest focused on both the level of the executive compensation as well the pay-performance relation. The main determinant of the total level of pay is company size, accounting for more than 40% of the variance in total CEO pay (Tosi, Werner et al., 2000). One explanation for this is that larger firms may employ better- qualified and better-paid managers (Rosen, 1982; Kostiuk 1990; Rosen, 1990). Another explanation (Bebchuk and Fried, 2003) is that managers try to make firm size the main determinant of executive pay, since they can take expansion decisions that raise the executive’s future compensation, because a larger firm size can be used to justify higher pay. Firm size as a determinant for executive pay can also be explained by the so called “keeping up with the Joneses” theory (Peterson, 2006); Managers inform

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themselves about compensation levels of other executives at similar sized firms and after comparison with their peers, managers with the lowest compensation demand an increase in compensation. Others however doubt if the total compensation level itself (the amount that is paid out) should be part of executive compensation discussion (Bebchuk and Fried, 2004). In Bebchuk and Fried’s view, the discussion about executive compensation should only focus on the question whether pay is based on performance; the level of pay does not matter as long as it serves the shareholders. Other stakeholders do express their concerns about the level of pay. FNV Bondgenoten, the largest trade union in the Netherlands, recently proposed a maximum of 20 times the minimum wage for top management (Volkskrant, 02-03-2009). Also, Dutch consumers boycotted grocer Albert Heijn, the largest subsidiary of Ahold in the Netherlands, after details of the remuneration package of Aholds CEO Anders Moberg led to public discussion. Thus, while at this moment the level of compensation itself is part of the discussion, the question remains whether it should be part of the executive compensation discussion.

All participants in the executive compensation discussion agree however that pay should be awarded based on managerial performance. The relation between managerial pay and performance is therefore frequently investigated, but so far no convincing evidence for this relation has been found. Jensen and Murphy (1990) investigated CEO pay at 1295 companies listed in Forbes between 1974 and 1986. They found that the pay performance sensitivity for executives is approximately $3.25 per $1,000 change in shareholder wealth; “small for an occupation in which incentive pay is expected to play an important role”. According to Bebchuk and Fried (2004), during the 1980s some correlation between pay and performance may have existed, but in the 1970s or 1990s there was none found. According to Murphy (1999) “there is a plethora of evidence on dysfunctional consequences of poorly designed pay programs, and surprisingly little direct evidence that higher pay-performance sensitivities lead to higher stock-price performance. Exceptions include Masson (1971) and Abowd (1990), who offer evidence suggesting that stock-based incentives improve subsequent stock-price performance.” Recent research in the Netherlands investigated the relation between pay and four different proxies of performance, reflecting both accounting-based and capital market-based definitions, for pay practices between 1998 and 2001 (Duffhues and Kabir, 2008). In this research, no systematic evidence that executive pay of Dutch firms is positively related to corporate performance is found; the researchers even find a statistically significant negative pay-performance relationship.

This relation between pay and performance is an important element in the executive compensation discussion. The total pay level and the level of fixed pay can be explained by firm size. Variable pay has

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an extra dimension, since there is a difference between the ex ante (expected) and ex post (realized) pay. The expected and realized pay differs since the definitive payout is based on achievement of certain goals. However, since previous research failed to detect a relationship between managerial pay and performance, the question remains what the main determinant for the payout of variable pay is. One of the possible determinants for payout of variable pay is the Managerial Power Approach, introduced by Bebchuk, Fried et al. (2002). This approach explains practices in the corporate governance field by the excess of “power” that executives have in determining their own pay. Classic theory (e.g. agency theory) focuses on an equal relation between shareholders and managers, but in their book “Pay without Performance; the unfulfilled promise of executive compensation” Bebchuk and Fried (2004) show that executives have power over shareholders and use this to receive large amounts of compensation at the expense of the shareholders. However, these executives “camouflage” their income. Also, an executive’s

“power” is hard to measure, which makes it is hard to directly link compensation practices to it.

Therefore, the Managerial Power approach works well theoretically but it is hard to find empirical evidence for it.

Related to Bebchuk and Fried’s findings, executives have an incentive to “manage” or “manipulate” their bonuses. Since executives operate under a variable compensation pay plan for multiple years, they have the incentive to shift “goal achievement” between different periods to maximize the total level of compensation (e.g. managers could save “goal achievement” for next year if a year’s maximum is reached). Furthermore, in a typical variable compensation plan, the payout structure does not always seem to be aligned with the executive’s motivation to perform. Psychological and other factors can distort the targeted pay-performance relation as will be discussed in more detail later (e.g. Kahneman and Tversky, 1979). Therefore, actual benefits associated with a performance level could be higher (or lower) than would be expected under the executive’s contract. Since “performance” is only to a certain extent influenceable, the difference between pay-performance leads to increasing incentives to influence the bonus in other ways.

We are thus at a point that we know that it does seem likely that executives have the power and incentive to influence their variable pay. The extent to what this power is used to receive payouts has important implications for the executive compensation debate. Therefore, the research question is:

To what extent can variable payout practices be explained by executives’ power instead of executives’

performance?

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1.2 Making the research question operational

This section explains how the research is organized to investigate whether payout practices can be explained by executive power or performance.

The first difficulty with this research question is that both executive power and executive performance are hard to measure directly. Since “power” is a force that is often used implicitly and also is subjective, it is not possible to make an executive’s “power” operational (measurable). Making “performance”

operational is possible, but the only way to directly measure performance for an outsider is the executive’s “payout”. However, since we want investigate the role of an executive’s power in the

“performance”-“payout” relationship, using payout as proxy for performance is not possible. Therefore, at the end of this section a framework will be presented that captures both aspects.

The second difficulty is that variable pay often consists of multiple components; e.g. annual bonuses, stock options and share based plans. From these three variable pay components, in this research managerial power will be investigated in the annual bonuses only, based on the following argumentation: First, evidence of Anderson, Banker et al. (1999) shows that cash bonus pay and stock- based awards (options and shares) are each other’s substitutes for 1836 S&P firms between 1992 and 1996. Therefore, investigating annual bonuses only should be enough to draw conclusions for the total variable compensation. Furthermore, disclosure levels are the most extensive at annual bonuses. This disclosure is needed since we will see that the pay-performance relation is sensitive, and without this disclosure it is not possible to distinguish executives “power” and “performance”.

Third, annual bonuses are nearly always based on one year’s performance and stock option and share based plans are often based on multiple year performance. Since for executives forecasting the realized performance (or goal achievement) for a longer period is more difficult, it is also expected that it is harder to distinguish the “power” versus “performance” relation. This in turn makes investigating the

“power” versus “performance” in variable pay harder at multiple year compensation plans.

We thus investigate the role of executive power at variable payout practices specifically at the annual bonus level. This is done using the distribution of paid out Annual Bonuses, in relation to their Target and Maximum bonus, to explain to what extent performance or power influences annual bonus payout.

The distribution of paid out Annual Bonuses is the amount of payouts that occurs on different payout levels (e.g. the numbers of executives with no payout, target payout, maximum payout or payout at a

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level in between). As will be discussed in the Literature review, various forces influence the expected payout distribution, leading to “discontinuities” in bonus payouts. The collected data in this research results in the payout distribution and discontinuities. These bonus payout discontinuities tell us to what extent executives are able to influence their annual bonus.

If we know that an executive can influence his bonus payout we still don’t know if this is due to his

“performance” or his “power”. To answer this question, differences between Corporate Governance in the Netherlands and the UK are investigated. As we will see, Corporate Governance frameworks are likely able to limit the amount of power of an executive, and can therefore help to explain if changes in bonus payout are due to managerial “performance” or “power”. If executives in various situations have different influence on their annual bonus payout (based on comparing distribution of bonus payouts between the Netherlands and the UK) the difference in influence can be explained by Managerial Power.

While it is important to realize that there could be other factors that explain the differences between the two countries, we will see in the literature review that this is not very likely. An overview of the logic behind the research setup is depicted in Figure 1.

Figure 1: Executive Power and Annual Bonus Payout

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1.3 Organization of the research

Recall that the research question that will be answered is:

To what extent can variable payout practices be explained by executives’ power instead of executives’

performance?

To answer the research question, first, in the Literature Review the following questions are answered:

1. What is an Annual Bonus plan and how does it work?

2 What are the undesirable negative effects of Annual Bonus plans and how do these influence bonus payouts?

3. What are the main differences between Corporate Governance in the UK and the Netherlands and how could these influence an executive’s use of power?

Based on these three questions, hypotheses are formed in which the expected payout distributions and expected discontinuities in payout for the UK and the Netherlands will be presented. These hypotheses will be tested in the actual research. Second, in the Methodology section the background of the rest of the methodological choices will be discussed. Third, the bonus distributions for the UK and the Netherlands are investigated and in the Results section the following questions are answered:

4. What does the bonus payout distribution look like in the Netherlands and the United Kingdom?

5. What are the differences in bonus payout distribution between the Netherlands and the United Kingdom?

Sub question six, answered in the Discussion section, combines the insights from the Literature review with the Results section and herewith links theory and practice of bonus payouts:

6. To what extent can Managerial Power explain changes between bonus payout distribution in the Netherlands and the United Kingdom?

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1.4 Relevance

This research is relevant in several ways. Mainly it is a valuable addition to the executive compensation discussion by taking a bright new approach by identifying CEO Power. We know that all related parties in executive compensation value the importance of performance based executive compensation. However, bonus payouts do not seem to be (only) depending on performance. Evidence of Managerial Power and earnings management points in the direction that executives have not only the incentive but also the power to influence their annual bonus payouts (Bebchuk and Fried, 2004; Bebchuk, Fried et al., 2002).

The direct relationship between annual bonus payouts and managerial power has not been tested before, but will be investigated in this research. This makes this research an important addition to both the academic and the public discussion about executive compensation. The executive compensation discussion itself is important because of both the amounts of money involved and the incentives that contracts produce that influence company performance, herewith influencing all company stakeholders (including shareholders, employees, suppliers, buyers, etc.) (Murphy, 1999). To investigate the relationship between bonus payouts and managerial power, discontinuities in bonus payouts in countries with corporate governance frameworks of different strength are compared. Though not empirically tested for bonus payouts before, investigations that used this approach in other settings (e.g. earnings management, see Healy, 1985; Burgstahler and Dichev, 1997) showed how investigating these discontinuities resulted in strong evidence proving the presence of the investigated phenomenon.

Furthermore, previous research focused only on payout levels itself (see for an overview Tosi, Werner et al., 2000) and did not relate the payout level to the expected payout of executives. Therefore, this research also gives information about the quality of the contracts that are currently used to remunerate executives. Several of these contracts have been criticized before because the payout was depending too little on performance (Yermack, 1995). This research adds to the understanding of how widespread this problem is, since it documents the differences between expected and realized payouts which helps to understand how hard it is for executives to reach a certain “performance”. Also, the most used models to understand how executive compensation works (e.g. agency theory and the managerial power approach) will be tested in this research. Underlying ideas and implications of agency theory are now used to prepare annual bonus contracts (Jensen, Murphy, et al., 2004), but if managerial power seems better at explaining practices, this could also influence the preparation of executive contracts.

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2 Literature Review 2.1 Introduction

Executive compensation issues arise mainly because of the separation of ownership and management.

Early descriptions of this separation can be found in Adam Smiths’ book “The Wealth of Nations”, where he described that “a business owner may completely separate himself from management duties by hiring trustworthy management, thus contenting himself solely with the profits from his ownership interest” (Smith, 1776). This separation leads to incentive problems since decisions are made by managers that are not the firm’s security owners (Berle and Means, 1933). However, this separation can also be seen as an efficient form of economic organization, since the two functions of an entrepreneur, management and risk bearing, can be seen as naturally separate functions which do not have to be integrated (Fama, 1980). If these functions are separated, a set of contracts is needed that aligns the interests of the executives and managers (Jensen and Meckling, 1976). These executive contracts that are used to align these interests are the focus of this research. In this research there will be tested to what extent executives can influence the outcomes of their performance achievement under these contracts by investigating annual bonus payout practices. As explained in the Problem Formulation section, the following three questions are answered in the Literature Review:

1. What is an Annual Bonus plan and how does it work?

2 What are the undesirable negative effects of Annual Bonus plans and how do these influence bonus payouts?

3. What are the main differences between Corporate Governance in the UK and the Netherlands and how could these influence an executive’s use of power?

First, there will be discussed what a bonus plan is and how it works. Second, we move to the undesirable effects a bonus plan has for both the executive and the company. Also, country level corporate governance differences between the Netherlands and the United Kingdom will be discussed to find out how the power of an executive is likely to be different in the Netherlands and the UK. Finally, all above sections are combined leading to the formulation of expectations of bonus payouts and to the formulation of the hypotheses that will be tested in this research.

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2.2 The Annual Bonus Plan

In this section will be investigated what an Annual Bonus plan is and how it works. First, Agency Theory is introduced to further explain the need of incentive based compensation contracts. Second, the goal of using an annual bonus is further discussed and linked to Agency Theory. Third, the pay-performance relation is discussed and finally the dimensions of an annual bonus plan are presented.

2.2.1 Agency Theory

In their classical work, Jensen and Meckling (1976) define an agency relationship as “a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent”. If both parties in the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal. The principal can limit deviations from his interest by establishing appropriate incentives for the agent and by monitoring his actions. The conflict of interest between shareholders of a publicly owned corporation and the corporation's chief executive officer (CEO) is a classic example of a principal-agent problem. Agency theory predicts that compensation policy will be designed to give the manager incentives to select and implement actions that increase shareholder wealth (Jensen and Murphy, 1990). As Shleifer and Vishny (1997) argue, a good way to reduce the agency cost associated to executive compensation is the use of incentive contracts. Conyon (2006) states that an optimal executive contract avoids opportunism and malfeasance by the managers. In short:

Agency Theory suggests that the performance based pay contract is a powerful way of attracting, retaining, and motivating managers to pursue the shareholders’ interest (Jensen, Murphy et al., 2004).

2.2.2 Goal of an Annual Bonus

Virtually all (listed) companies use variable pay to remunerate their top executives (Murphy, 1999). An annual bonus is a yearly form of payout, mostly in cash, and is the most widely used variable pay component. It is used to motivate executives to reach certain short term goals; what these goals are should be depending on the interests of the shareholders. Like other variable pay components, with annual bonuses often differences exist between the ex ante (expected) and ex post (realized) pay. The realized pay depends on the extent to which the executive was able to reach the predetermined performance targets (Jensen, Murphy et al., 2004). There are two important aspects in variable pay target setting. First, there is the amount of influence an agent has on the outcome of the measurement.

One can for example imagine that market related measures are harder to influence by an executive than internal accounting measures. Second, the congruence of the measurement with the company’s goal is

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important; some measures are more in line with achieving the company’s goal than others. Generally an increase in one aspect leads to the decrease of the second one, but ideally these measurements score high on both dimensions (Van Ees, Van der Laan et al., 2007).

2.2.3 The Pay-Performance Relation

The relation between goal achievement and bonus payout is described by Murphy (1999) and depicted in Figure 2. In short, an executive needs to meet a minimal level (threshold) of goal achievement before payout starts. Furthermore, there is a maximum bonus level (cap); additional performance above this level does not lead to extra payments. Between the minimal performance level and the maximum payout level, (mostly) a linear connection exists between performance and payout. Finally, there is a target bonus level (typically exactly between the threshold and cap), that signals the expected performance of the executive as determined by the company.

Figure 2: Components of a Typical Annual Incentive Plan

Murphy (1999) describes this typical bonus plan as the most common payout method and calls it an

“80/120” plan. Under a strict 80/120 plan, no bonus is paid unless performance exceeds 80% of the performance standard, and bonuses are capped once performance exceeds 120% of the performance standard. Although 80 and 120 are the modal choice for the performance threshold and performance cap, other common combinations (in descending order of frequency) include 90/110, 95/105, 50/150, 80/110, 90/120, and 80/140 plans.

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2.2.4 Dimensions of an Annual Bonus Plan

When looking at the content of a variable pay plan, it consists of performance measures, performance standards and a structure of pay-performance relationship. Murphy (1999) points out in his comprehensive paper about executive compensation the following three questions about variable pay (see Table 1):

1. Which performance measures are used?

2. To which benchmark is performance measured?

3. What does the pay-performance structure look like

Having in mind that this research focuses on the extent to which bonus payouts are manageable, these dimensions will be discussed briefly:

Performance Measures are the proxies that are used to determine what an executive’s performance is;

often these are accounting based company performance results. It is important to realize that executives have discretion to determine (some of) the outcomes of these (accounting) measures, and therefore they can to a certain extent “manage” their bonuses, this will be discussed in more detail later.

Performance Standards determine what the score on the performance measures needs to be to obtain the payout. This also influences the executive’s possibilities to manage achievement of a determined goal. For example, one can imagine that for reaching a budget goal only the budget needs to be taken into account while when the standard is a peer group also their performance needs to be considered.

The Pay Performance Structure explains the framework in which bonus setting takes place. In this research we will use bonus plans with a threshold and a cap and (mostly) a linear payout in between.

These multiple dimensions in target setting and performance measures offer companies the possibility to compose a pay package that should closely align interests of the company and the manager. There are no prescriptions in the literature about a best practice in executive remuneration, in every single case different considerations should be taken into account to design an optimal contract (Van Ees, Van der Laan et al., 2007).

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Table 1: Variable pay structure

Dimensions Types Examples

Single or multiple performance Sales

Financial / Qualitative measures Operating income Individual / Group performance EVA

Cash flow EBIT

Pre-tax income Performance

Measures

Net income Absolute or relative standards Budget

Time-frame of standard Prior year standards (growth) Fixed or discretionary standards Discretionary

Peer group Performance

standards

Timeless standards

Type of payout “80/120” Plans, Discretionary plans Shape of payouts Convex, Linear or Concave payouts Bonus paid at threshold Paid at threshold or capped Pay-

performance structure

Bonus capped

Source: Murphy, 1999; Van Ees, Van der Laan et al., 2007

2.3 Undesirable Effects of Annual Bonus Plans

In the previous section, annual bonuses are presented as a powerful tool to align interests of executives and shareholders. There are however several undesirable effects of annual bonus structures. These effects can lead to perverse incentives in goal achievement, which are discussed first. These incentives in turn might lead to the use Earnings Management to influence the outcome of bonus payouts, which is discussed second. Earning’s Management in the executive’s favor can hurt the company’s interest and/or shareholders value. These practices and lack of opposition from shareholders to it can be explained by the Managerial Power approach, which will be discussed third.

2.3.1 Perverse Incentives in Annual Bonus Plans

As we will see, in different situations, executives have incentives to manage their bonuses in various ways. Based on the typical bonus structure as described in Figure 2, four situations and incentives to manage bonuses are identified. These situations are depicted in Figure 3 and will be discussed next:

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Situation 1: Not reaching the payout threshold

One can imagine that when performance is measured by earnings, in the case that earnings are so low that no matter what the target will not be met, managers have incentives to reduce current earnings by deferring revenues or accelerating write-offs, a strategy known as “taking a bath” (Healy, 1985).

Therefore, the incentive exists to shift performance downward in this situation

Situation 2: Almost reaching the payout threshold

Degeorge, Patel et al. (1999) present a model that shows how earnings falling just short of thresholds will be managed upward. This can be explained by the fact that when expected performance is moderately below the incentive zone, the discontinuity in bonus payments at threshold yields strong incentives to achieve the performance threshold (through earnings manipulation as well as through hard work), because the pay-performance slope at the threshold is effectively infinite (Murphy, 1999). In this situation, the incentive exists to increase performance.

Situation 3: Payout in the incentive zone

If performance exceed the lower threshold, but not the upper limit, the manager has an incentive to maximize his performance (Healy, 1985). We will see later how a targeted bonus, typically in the middle of the incentive zone has an extra influence on the incentives to maximize performance.

Situation 4: Performance above the bonus cap

At the end of the “incentive zone”, managers capable of producing well above the “cap” will tend to stop producing once they “max out” on their bonuses and will transfer performance results that could have been realized this period into the next period (Jensen, Murphy et al., 2004). Therefore, executives do not have the incentive to perform if their bonus cap is met.

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Figure 3: Incentives to perform in various situations (based on Murphy, 1999)

So far, we considered the pay-performance relation in the incentive zone as linear. Though other relations exist, these experience the same problem of “trading-off” current for future performance.

When the pay-performance relation is concave (or bowl shaped) managers can increase their total bonus payouts by increasing the variability of their performance. On the other hand, in situations when the pay-performance relation is convex (or upside down bowl shaped) in the relevant range, managers have incentives to smooth performance by capping truly superior performance and saving as much of it as possible for a rainy next period (Jensen, Murphy et al., 2004).

2.3.2 Earnings Management

In the previous section we discussed the incentives to score higher or lower on performance scores. In all these situations managers have different options to manipulate their bonus payouts. This could be done by either slacking or by putting in extra effort, but also by manipulating the proxies that are used to determine the executive’s performance, known as earnings management.

We know that bonus payouts are based on performance measures as Sales, Operating income, EVA, Cash flow, EBIT, Pre-tax income and Net income (Table 1). The discretion executives have over the performance measures, together with the incentive to do so can lead to earnings management. In the literature, evidence of earnings management is well documented; however the goals of earnings management vary. Jones (1991) reports that managers make income-decreasing accruals during import relief investigations, benefiting from this since it increases the likelihood of obtaining import relief

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and/or increases the amount of relief granted. Furthermore, Burgstahler and Dichev (1997) conclude that firms manage reported earnings to avoid earnings decreases and losses. Healy (1985) is one of the first that links earnings management to bonuses. He finds that if year-to-date performance suggests that annual performance will exceed the bonus cap, managers will withhold effort and will attempt to

“inventory” earnings (i.e. keep earnings in stock) for use in a subsequent year. Similarly, if expected performance is far below the incentive zone, managers will again discount the bonus opportunity, especially near the end of the year, when achieving the threshold performance level seems highly unlikely. Ten years after Healy’s research, Holthausen, Larcker et al. (1995) were the first to come up with a vast follow-up study. However, they had access to more confidential data of executive bonus plans and presented a somewhat different conclusion. Unlike Healy, they find no evidence that managers manipulate earnings downwards when earnings are below the minimum necessary to receive any bonus.

However, like Healy, they present evidence that managers manipulate earnings downwards when they already receive their maximum bonus. Though accounting-based annual bonus plans motivate executives to be more productive in the short-term (Holthausen, Larcker et al., 1995), the manner in which firms design and revise accounting-based bonus plans may also encourage executives to misrepresent their reported accounting performance (Guidry, J. Leone et al., 1999). Murphy (2000) analyzes the role of performance standards and show that CEOs in companies using “externally determined” standards have more highly variable bonuses than CEOs in companies with “internally determined” standards; income smoothing is prevalent in companies using internal standards, but not in companies using external standards. Bergstresser and Philippon (2006) find evidence that CEOs whose compensation is more sensitive to company share prices lead companies with higher levels of earnings management. Periods of high accruals coincide with unusually significant option exercises by CEOs and unloading of shares by CEOs and other top executives.

In short, the evidence of earnings management is overwhelming. However, the above section leads to several important observations about earnings management and bonuses. First, not all earnings management serves the goal of increasing bonuses. Second, if earnings management has the goal to increase bonuses, not only annual bonuses (but also Long Term Incentives like option or share rewards) are likely to be influenced.

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2.3.3 Managerial Power Approach

When executives have the incentive and opportunities to influence their own pay, the question arises how this works and what the consequences are. There are two main theories that are used to explain executive compensation practices, Agency Theory and the Managerial Power Approach. Agency theory is discussed before, but has been criticized in the past. Yermack (1995) for example reports that remuneration practices contradict Agency Theory in his research where he investigated stock option awards to CEOs of 792 U.S. public companies between 1984 and 1991. The premise of Agency Theory is that the parties that arrange compensation contracts are on equal footing, but this does not seem to hold (Bebchuk and Fried, 2004). In 2002, Lucian Bebchuk, Jesse Fried and David Walker made an important addition to the field of executive compensation with their article “Managerial Power and Rent Extraction in the Design of Executive Compensation” (Bebchuk, Fried et al., 2002). The follow up of their article, the book “Pay Without Performance, the unfulfilled promise of executive compensation” was presented in 2004 (Bebchuk and Fried, 2004). They introduce the “Managerial Power Approach” as mechanism to explain corporate governance practices. In this view, managers use their power to influence compensation contracts and extract rents from a company while harming shareholders.

According to the “Managerial Power Approach”, there are various mechanisms how executives are able to abuse their power and harm shareholders. The Managerial Power Approach suggests that boards do not operate at arm’s length in devising executive compensation arrangements. The director’s desire to be re-elected on the board, interlocking directorships, social and psychological factors as friendship, loyalty, authority and cognitive dissonance are all factors that make the bargaining not at arm’s length.

Furthermore, the “cost” of favoring executives is low so that the “independency” in boards is not only tilted towards the CEO, but there are no countervailing forces to prevent this. In addition, insufficient time and information, the use of compensation consultants, the fact the pay setting process starts after a CEO is hired and the infrequent firing of CEOs all add to the belief that boards are not bargaining at arm’s length. Therefore executives have the power to influence their own pay, and they use that power to extract rents. Furthermore, the desire to camouflage rent extraction might lead to the use of inefficient pay arrangements that provide suboptimal incentives and thereby hurt shareholder value (Bebchuk, Fried et al,. 2002). Otten and Heugens (2007) suggest that “Managerial Power theory can be generalized outside the U.S., but with caution” in a cross national test of 3880 pay levels in 17 countries. Grinstein and Hribar (2004) find that CEOs who have more power to influence board decisions receive significantly larger bonuses for completing M&A deals, and state that their “evidence is consistent with the argument that managerial power is the primary driver of M&A bonuses”. Weisbach (2007) reviews Bebchuk and

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Fried (2004) and finds that “evidence for Managerial Power, especially about the camouflage and risk- taking aspects of executive compensation systems”, is fairly persuasive”. Though evidence of Managerial Power is apparent, when and how this influences annual bonus payouts is not clear yet.

2.4 Expected Annual Bonus Payouts

The previous section discussed the incentives and opportunities that executives have to influence their performance outcomes. Incentives and opportunities to influence company earnings have been documented (e.g. Healy, 1985; Hayn, 1995; Burgstahler and Dichev, 1997). A similar argumentation for managers influencing performance measures related to bonus payouts is put forward in this section.

Therefore, the reported discontinuities for earnings management in previous studies are introduced first.

These discontinuities are linked to executive bonus payout in two sections. First, influence of thresholds and caps on bonus payout discontinuities is discussed. Second, the influence of target bonuses on bonus payout discontinuities is discussed.

2.4.1 Earnings Management and Discontinuities in Reported Earnings

As discussed before, there is clear evidence for earnings management in general. In this section we focus on discontinuities in earnings and performance caused by earnings management, and we discuss in more detail two relevant papers. To start with, Hayn (1995), finds a point of discontinuity around zero at reported earnings for 75,878 observations of reported earnings between 1963 and 1990. “These results suggest that firms whose earnings are expected to fall just below the zero earnings engage in earnings manipulation to help them cross the ‘red line’ for the year”. Explanation for these discontinuities in achieved bonuses could be prospect theory (Kahneman and Tversky, 1979), that proposes that the feeling one experience from gains and losses are not symmetrical. More specifically, looses hurt much more than gains feel good. This suggests that the largest gains in utility, and therefore large incentives to influence performance outcomes, occur when moving from performance right below the target bonus to performance at or above the target bonus. This has been investigated for the cases of earnings decreases and losses by Burgstahler and Dichev (1997). They report discontinuity in reported earnings around zero (i.e. a significantly lower concentration of (small) negative deviations and a significantly higher concentration of (small) positive deviations. To be more specific, Burgstahler and Dichev (1997) estimate that 30-44% of the firms with small pre-managed losses manage earnings to create positive earnings.

In the next two sections expected discontinuity in bonus payouts will be discussed. However, one assumption needs to be introduced first: I assume that the bonus threshold and cap are positioned in a

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way that motivates executives and results in a “fair” bonus payout for executives and shareholders.

However, others suggested that the target, cap and threshold could be positioned in a way favoring the executive (e.g. by putting the target performance below a “normal” performance level) (Bebchuk and Fried, 2004). Therefore, this research takes a conservative approach in measuring CEO power; if target-, threshold- and cap- placement are already favoring the executive this means they have even more power.

2.4.2 Influence of Thresholds and Caps on Bonus Payout Discontinuities

In most executive bonus contracts there is a payout threshold, and it is likely that a group of executives does not meet this threshold. Since the number of executives that earn no bonus at all is the sum of all executives performing below the threshold, it is likely that this group is bigger than the group of executives earning slightly above this point. This logic also applies for the bonus cap, since there is also a group of executives that is performing above the bonus cap level. Therefore, it is expected that the group of executives earning the maximum bonus is larger than the group executives that earn slightly below the maximum level. Therefore, discontinuity in executives paid out below threshold (no payout) or at cap (maximum payout) is expected.

Executives performing slightly below the threshold have a strong incentive to improve their goal achievement just inside the incentive zone. This would result in a somewhat lower level of executives that are “cut-off” below the threshold and a higher number of executives earning the lowest possible bonus. On the other hand, Murphy (1999) documents that these thresholds and caps are usually positioned at 80 and 120 percent of the target. Since this is quite a narrow bandwidth (Jensen, Murphy et al., 2004), quite large parts are expected to be cut-off. Therefore, still more executives are expected to achieve no bonus than that would earn the lowest possible bonus.

2.4.3 Influence of Target Level on Bonus Payout Discontinuities

Besides discontinuities in the number of executives paid around the threshold and caps are expected, also discontinuities around the target level are expected. If there is an incentive zone without a specific target, since there is a linear relationship between pay and performance, this linear relationship implies there would not be large deviations in achieving performance measures. However, the existence of a performance target influences this linear relationship. Like Murphy (2000), I assume that firms set performance targets equal to expected performance. Therefore, (not) meeting the performance target is an important signal about the executive’s performance, with important implications: If an executive

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almost meets his target, the pay performance relationship around this point is extremely sharp (i.e. little extra performance leads to high rewards). This is in line with the “crossing the red-line” argumentation of Hayn (1995) and Burgstahler and Dichev (1997). However, executives that perform above the target level immediately have the incentive to “save” their extra performance for the next year. In the next year, first the payout threshold needs to be exceeded again before payout starts and again the incentive to perform at least at the target level is there. Thus, executive’s rather use their “performance” in the next year instead of this year, which decreases the incentive to perform in this year in the target is met.

In short, executives have a strong incentive to reach the target payout, but after reaching the target level their performance incentive decreases since extra performance can be accrued to next year and in that year help both exceeding the threshold as well as reaching the target level. In short, discontinuities around the target level are expected in payout of bonuses.

The influence of thresholds, caps and target level on bonus payout discontinuities results in expected bonus payouts as presented in Figure 4:

Figure 4: Discontinuities in Bonus Payouts

The first question to be answered in the literature review was how bonus payout distribution looks like under various circumstances. The expected influence of thresholds, caps and targets on bonus payout discontinuities covers this question to a large extent. However, the extent to which this can be linked to managerial power depends on the actual power an executive has to manage his bonus. As we will see in the next section, the corporate governance framework of a country can influence the executive’s power, and therefore we move to investigating differences between corporate governance in the UK and the Netherlands

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2.5 Country Level Corporate Governance Differences

According to Shleifer and Vishny (1997) the fundamental question of Corporate Governance is how to assure financiers that they get a return on their financial investment. They answer this question partly by identifying “legal protection of investors” and “some form of concentrated ownership” as essential elements of good corporate governance system. In this research, it is important to isolate the executive’s

“power” as good as possible from other factors influencing payout discontinuities. In this section, the main differences between Corporate Governance in the Netherlands and the United Kingdom are investigated. We will discuss differences and similarities in Corporate Governance environment and find out that executives in the UK have less power than their Dutch counterparts. More powerful executives have better opportunities to manage their bonus payouts and therefore differences are expected in (dis)continuity of bonus payouts. If these discontinuities can be linked to the power managers have, it makes a strong claim for the presence of Managerial Power in bonus payouts.

2.5.1 Differences in Executive Power between the UK and the Netherlands

UK executives are expected to have less power than Dutch executives because of several reasons. First, and most important, shareholders are better protected in the UK (high anti-director rights). In their research about corporate governance around the world, Porta, Lopez-de-Silanes et al. (1999) divide all investigated countries in two groups based on the so called “anti-director measures”. This anti-director index is an index based on aggregating shareholder rights (e.g. voting rights). Countries with high anti- director rights (e.g. US, UK) have a good protection of shareholders whereas shareholders rights in other countries (e.g. Germany, the Netherlands) are less well protected. Since manipulating earnings increase bonuses is hurting shareholders, it is expected that shareholder protection can limit the power executive’s have in managing their bonuses.

Second, the strong presence of corporate governance codes in the UK is likely having a negative influence on executive’s power. The corporate governance codes in the Netherlands and the UK are both on comply or explain basis. Recent evaluation report of the Dutch Corporate Governance Code (Tabaksblat, 2003) described the extent of compliance with the code. The compliance with best practices about executive compensation is relatively low (Frijns, 2008).

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2.5.2 Corporate Governance in the UK and the Netherlands

Besides the higher anti director rights and a stronger corporate governance code in the UK, several other factors should be considered before the claim can be made that UK executives have less power than their Dutch counterparts. These factors are the following:

One Tier versus Two Tier Board Systems

Major corporate governance difference between the UK and the Netherlands is the difference in one- and two tier board system. The Dutch system is a two tier board structure in which boards consist of a management board (Raad van Bestuur) and a supervisory board (Raad van Commissarissen). This difference between one- and two-tier board structures can have mixed effects on executive power. In the two tier system, the supervisory board consists of less informed non-executives. This can have the advantage that non-executives are less biased in favoring insiders, but since they are less informed it could also give insiders more opportunities manipulate their bonuses without being detected by the supervisory board. Otten and Heugens (2007) investigated cross national managerial power practices.

They tested whether executive pay levels were higher in firms with a one-tier board structure, but no significant effects on CEO pay were noted for one-tiered boards. The fact that both countries have different board systems therefore is not likely to influence Managerial Power.

Similarities in Bonus Structures

It is important that both countries have similar bonus structures to compare annual bonus payouts.

Annual bonuses represent about the same percentage of total compensation in both countries.

Remuneration Agency TowersPerrin in their global remuneration survey show that in 2005 the percentage of the Annual Bonus in the UK and the Netherlands was 41% versus 35% of the total compensation package. Also, the use of non financial measures in executive target setting is similar, presented in Table 2. Furthermore, since both countries have high transparency levels of executive compensation (Ferrarini and Moloney, 2005), the information that is needed is accessible.

Table 2: Use of Non-Financial Measures

Percentage Companies using

non financial measures Percentage of Annual Bonus determined by non financial measures

Netherlands 75% 20%

UK 89% 35%

Source: Van Ees, Van der Laan et al. (2007)

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CEO/ Chair Duality

CEO duality is an important characteristic present in the UK system under which executives can increase their power to a large extent. CEO duality exists when a firm's CEO also serves as the chairman in the board of directors (Conyon and Peck, 1998). Holding the highly symbolic position of board chair would provide the CEO with a wider power base (Boyd, 1994). The UK Cadbury Committee supported the view that boards dominated by executive directors are more difficult to control and regarded the practice as undesirable because it gave one person too much power within the decision-making process (Cadbury, 1992). Weir, Laing et al. (2002) state that the Code of Best Practice therefore recommended that there should be a clear division of responsibilities and if that duality did occur, there had to be sufficient independence on the board to counterbalance the situation. This idea is confirmed by Otten and Heugens' (2007) research about cross national executive power practices, where they find that “CEO duality seems to adequately capture executives’ power in relation to setting pay levels and structures”.

However Weir, Laing et al. (2002) also find that the incidence of duality is relatively low with only 16% of the sample of Times1000 (the largest UK companies) between 1994 and 1996. This factor therefore should be carefully considered when collecting data, but because of the expected low incidence it is not incorporated in the hypotheses. Another three factors that could influence the amount of power an executive has are considered, from which one is dismissed and the other two will be used as control variable.

CEO Tenure

One factor that could influence the CEO’s power is the executive’s tenure. If executives serve at a company for a longer time, they could build a stronger power base. Though no empirical evidence for this is reported yet, the following reasoning shows how this could work. Under Managerial Power theory executives are expected to use their power to maximize bonus payouts. The longer an executive works at a company, his knowledge and skills regarding the company are expected to increase. With this increase, the company becomes more depending on the executive and hence his power increases. Another reason is that the longer an executive serves at a company, the less people there are that possibly can limit his power. Newly appointed (independent/supervisory) board members, elected or supported by the executive, are not likely opposing the executive’s power to maximize his bonus. This factor will therefore be taken into account when collecting the data.

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Ratio of Non-Executives

Otten and Heugens (2007) report that the ratio of executives to non-executives influences the pay level of executives. However, they find somewhat mixed results for CEO pay. Though their conclusion does not make clear what to expect, since it (possibly) influences bonus payouts it will be considered in this research.

Cultural Dimensions

Besides the role of corporate governance mechanisms, a country’s culture is the last factor that is considered to be important in determining the executive’s bonus payouts. To isolate the role of executive power in bonus achieved in both countries, a similar culture makes inter country comparisons possible Since both countries score similar on Hofstede’s Cultural dimensions (Hofstede, 2005) it is expected that this factor plays no important role.

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Table 3: Corporate Governance Systems and Executive Power

Dutch Corporate Governance System British Corporate Governance System

· Low Anti Director Rights (+)

· Low compliance on best practices for executive compensation (+)

· Two Tier Board Structure (supervisory and management board) (+/-)

· Few controlling shareholders (+)

· Mix between market-based Anglo-Saxon regime and the bank-based Continental-European regime

· Maximum Executive Compensation Transparency

Higher Executive Power

· High Anti Director Rights (-)*

· Strong Influence of Corporate Governance Codes (Cadbury, Greenbury and Hampel Code, together the “Combined Code) (-)

· Boards made up of executive (40-50%) and non-executive (50-60%) directors

· Market Based System

· Maximum Executive Compensation Transparency

Lower Executive Power

* (-) = Resulting in Lower Executive Power, (+) = Resulting in Higher Executive Power, ( ) = No Influence on Executive Power

Sources: Ferrarini and Moloney, 2005; Porta, Lopez-de-Silanes et al., 1999; van Ees, Postma et al., 2003; Murphy, 1999; Murphy, 2000

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2.6 Hypotheses

We go back to the research setup depicted in Figure 1 and discuss how the research setup relates to the Literature Review. In Figure 1 is shown that an executive’s bonus payout is expected to be determined by his contract, performance and power. Contracts and performance are expected to have a similar influence on bonus payout distribution in the Netherlands and the United Kingdom. However, the corporate governance framework in both countries likely creates a difference in the power an executive has in influencing his bonus payout. Furthermore, the influence of thresholds, caps and especially target level on bonus payouts leads to discontinuities in the payout distribution. Therefore, if payout distributions are similar but discontinuities in the Netherlands are larger, it is very likely that executives indeed use their power to influence their bonus payouts. In this research, expectations in the following four sections have to be confirmed to make the claim that executives use their power to influence their bonus payout:

1. The Influence of Thresholds and Caps on Bonus Payout Discontinuities

Discontinuities in the distribution of payouts provide information about the extent to which executives are able to influence their payouts. However, discontinuities in payout distribution also arise because of thresholds and caps that are stated in the contract. To be specific, it is expected that there will be more executives that earn no bonus (the highest bonus) than executives that earn the smallest possible (slightly below the maximum) bonus ⁷. These discontinuities, expected based on the literature review, arise because of contract characteristics and not because of executive power.

2. The Influence of Target Level on Bonus Payout Discontinuities

Discontinuities in the bonus payout distribution are also expected around the target bonus level. From section 2.4.3 follows that executives have a strong incentive to reach the target payout, but after reaching the target level their performance incentive decreases since extra performance can be accrued to next year. Therefore, the following to hypothesis will be tested:

Hypothesis 1a: Much less executives are paid out slightly below target level than at target level.

Hypothesis 1b: Much less executives are paid out slightly above target level than at target level

7 Since there are no statistical tools to confirm this expectation, no hypothesis is stated.

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3. Country Level Differences in Bonus Payouts and Managerial Power

We thus know what the discontinuities in the bonus payout distributions will probably look like.

Furthermore, it is likely that executives in the UK have less power than their Dutch counterparts.

Combining this, it is likely that there are differences in the bonus payout distribution between the UK and the Netherlands, since the Dutch executives seem to have more power in influencing the outcome of their bonus arrangements. Therefore it is expected that the discontinuities in CEO bonus payouts around the target level are larger in the Netherlands than in the UK. ⁸ When these discontinuities are more present in the Netherlands than in the UK, this is makes a strong claim for the presence of Managerial Power in bonus payouts and answers the research question.

4. Similarities in Bonus Payout Distribution in the Netherlands and the United Kingdom

Based on the similarities in bonus structures and country’s culture, similar bonus payout distributions are expected in the Netherlands and the United Kingdom ⁹. This similarity is needed to attribute differences in continuity, described before, to executive power.

Evidence of Managerial Power in Annual Bonus Payouts in the Netherlands and the United Kingdom

Executive Bonus Payouts and Managerial Power

Evidence of Managerial Power in Annual Bonus Payouts in the Netherlands and the United Kingdom

Daniel den Hengst

June 2009

Executive Bonus Payouts and Managerial Power

Evidence of Managerial Power in Annual Bonus Payouts in the Netherlands and the United Kingdom

Executive Bonus Payouts and Managerial Power

Evidence of Managerial Power in Annual Bonus Payouts in the Netherlands and the United Kingdom

Abstract

Table of Contents

Introduction

1 Problem Formulation

1.1 Towards a research question

1.2 Making the research question operational

1.3 Organization of the research

1.4 Relevance

2 Literature Review 2.1 Introduction

2.2 The Annual Bonus Plan

2.2.1 Agency Theory

2.2.2 Goal of an Annual Bonus

2.2.3 The Pay-Performance Relation

2.2.4 Dimensions of an Annual Bonus Plan

2.3 Undesirable Effects of Annual Bonus Plans

2.3.1 Perverse Incentives in Annual Bonus Plans

2.3.2 Earnings Management

2.3.3 Managerial Power Approach

2.4 Expected Annual Bonus Payouts

2.4.1 Earnings Management and Discontinuities in Reported Earnings

2.4.2 Influence of Thresholds and Caps on Bonus Payout Discontinuities

2.4.3 Influence of Target Level on Bonus Payout Discontinuities

2.5 Country Level Corporate Governance Differences

2.5.1 Differences in Executive Power between the UK and the Netherlands

2.5.2 Corporate Governance in the UK and the Netherlands

2.6 Hypotheses