THE INFLUENCE OF MANAGERIAL POWER ON PERFORMANCE TARGET CHOICES IN EXECUTIVE REMUNERATION: THE U.K. EVIDENCE

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University of Groningen

Faculty of Economics and Business

MSc Business Administration -

Organizational & Management Control

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ABSTRACT

This thesis provides an empirical analysis of the influence of managerial power on performance target choices in executive remuneration plans. From 31 December 2002, U.K. firms are mandated under the Directors’ Remuneration Report Regulations 2002 to disclose performance targets and benchmarks used in executive remuneration plans in the Remuneration Report. This study uses the disclosure of the targets from the financial years 2002 to 2009 for a sample of 1840 plans from 257 U.K. firms (FTSE 350 and SmallCap). Managerial power is proxied by five measures: CEO duality, board independence, board size, CEO tenure, and largest holding. Results indicate that EPS and TSR are the two most popular performance measures used in PVSOs and LTIPs, with PVSOs often employ the former and LTIPs the latter. Moreover, my results implies that powerful CEOs have significant influence in the PVSO and LTIP target setting, such that firms led by powerful CEOs attach less challenging performance targets to

PVSO and LTIP vesting.

Key words:

Corporate Governance, Executive Remuneration, Managerial

Power, Performance Target Choice

Supervisor:

Dr. B. Qin

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3 L IST OF A B BR EV IAT IO NS

AGM Annual General Meeting BODs Board of directors CEO Chief Executive Officer COB Chairman of the board

DRR Directors’ Remuneration Report

ECGI European Corporate Governance Institute EPS Earnings per share

FRC Financial Reporting Council (U.K.)

FTSE Financial Times and the London Stock Exchange LTIPs Long term incentive plans

MtB Market to book value OLS Ordinary least squares PCA Principal component analysis PVSOs Performance-vested stock options ROA Return on total assets

RPE Relative performance evaluation RPI Retail price index

SEC Securities and Exchange Commission (U.S.) S&P Standard & Poor's

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1. INTRODUCTION

Contemporary, executive remuneration has been the focus of considerable attention from the public, media, academics and policy maker. It is a typical corporate governance issue with many different views and opinions. According to the European Corporate Governance Institute (hereafter ECGI), the executive remuneration debate can be approached from several perspectives: (i) as optimal contracting theory and agency theory which focus on aligning pay with performance in order to reduce agency costs; (ii) as a regulatory matter with the objective of remedying any system imperfections; (iii) and as a public policy concern. Besides the various perspectives of executive remuneration the debate is also multi-jurisdictional. This reflects the changing dynamics of remuneration, regulation and corporate efficiency in different governance systems.

The regulation aims to harmonise disclosure at the European level, EU-member states have transposed this EU regulation to diverse extents. The American and European approaches picture several divergences in regulation and practice, but also similarities that aim to create a global best practice environment (ECGI, 2009). The U.S. Securities and Exchange Commission (hereafter SEC ) and the U.K. Financial Reporting Council (hereafter FRC) both address the fundamental corporate governance issues of disclosure, board accountability, enhanced monitoring role and a much improved and empowered audit committee (Ofori, S.K.A., 2005). In 2012 the U.K. Combined Code 2003 has been revised and is now called the U.K. Corporate Governance Code. In December 2006, the U.S. SEC issued new disclosure requirements regarding executive compensation. These requirements came as a response to shareholder concerns that the compensation packages to executives in recent years are not properly disclosed or well understood. According to these requirements, firms need to provide additional information about the contractual terms of their compensation to the executive. Especially, firms need to disclose the types of performance measures that they use to determine the chief executive officer (hereafter CEO) rewards, the performance targets and the performance horizon. These regulations introduced the advisory ‘say on pay’ and required more detailed disclosure through a remuneration report requirement which recommend a closer link between incentives and the achievement of targets and focus on the importance of rewarding of the performance.

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7 compensation with an approach that is more conventional among academics: that CEO compensation arrangement can generally best be understood as instruments that the board uses in the shareholders’ interest to address the agency problem. This is also called the optimal contracting theory or better known as the agency theory.

However, recent empirical studies (e.g., Bebchuk et al., 2002; Bebchuk, Fried, and Walker; 2002, Bebchuk, Fried; 2004, Abernethy, Kuang and Qin; 2012) have emphasized managerial power as a dominant influence in explaining the level and characteristics of executive remuneration. They suggest that CEOs with more power are able to use compensation contracts to extract more rent; defined as value in excess of what they would receive under optimal contracting. Therefore, the efficiency of remuneration contracts would be discounted in some circumstances where remuneration committees are less effective in fulfilling their duty or where it is easier for CEOs to shape their own compensation arrangements (Sun, Cahan, and Emanuel, 2009). Thus, according to Sun, Cahan, and Emanuel (2009), using incentive-based compensation contracts may not solve agency problems between CEOs and shareholders. Instead, the agency problems can lead to rent extraction. Therefore this thesis questions the dominant approach in the academic work on executive compensation; namely the; optimal contracting approach. I seek to put forward a systematic and comprehensive account of an alternative approach to study CEO compensation; the managerial power approach, which focuses on the role of managerial power in shaping CEO compensation practices. According to Bebchuk et al. (2002), although recognition of the role of managerial power lies at the heart of much of the public criticism of pay levels and practices, this role has attracted relatively little attention and analysis in the academic literature. Furthermore, the evidence about the association between CEO power and equity-based incentives is somewhat mixed (Abernethy et al.; 2012, Larcker and Yayan; 2012) and Van Essen et al. (2012) argue that although studies about the determinants of CEO compensation are ubiquitous, the balance of evidence for one of the more controversial theoretical approaches, managerial power theory, remains inconclusive.

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8 assessed (Zakaria, 2008). The consensus in the target setting literature is that ‘challenging’ targets, i.e. targets that are achievable by exerting high effort, are associated with improvements in firm performance (Jensen et al.; 2004, Zakaria; 2008).

The practice of performance targets in executive compensation plans in the U.K. were first suggested by Greenbury (1995) in the Greenbury Report on Executive Remuneration (Zakaria, 2008). This has become a common feature of both stock option (hereafter PVSOs) and long term incentive plans (hereafter LTIPs). However, it was only since 2002, after the implementation of the Directors’ Remuneration Report Regulations (hereafter DRR Regulations) in 2002 that firms were mandated to disclose performance measures, targets and related benchmarks to their shareholders (Zakaria, 2008). The mandatory remuneration report in annual reports of firms provides transparency on the target setting process at the executive level of U.K. firms. Greenbury (1995) suggested that performance targets would increase the pay to performance sensitivity. However, this depends on the targets being set at an appropriate level of difficulty. Targets that are difficult to realize may demotivate managers, whereas targets that are highly achievable would reward managers for poor performance and extract rent from the shareholders.

Since the popularity of the interaction of the managerial power and performance target choice in CEO compensation is scarce, and the availability of newly data (due to the mandated disclosure), I will focus my thesis on the influence of managerial power on the performance target choices in executive remuneration in the U.K.. This empirical research will give an answer at my main research question: What impact does manager power have on the performance target choices in executive remuneration?

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9 shorter tenured CEOs, and have large shareholders will use more challenging EPS or TSR targets in their PVSOs and LTIPs than firms which do not have the aforementioned proxies of good governance structure. Finally, my findings provide clear support that CEOs can and do influence their remuneration arrangements, and their power can be constrained by shareholders and the boards.

The contribution of this paper to the corporate governance literature is fivefold. Firstly, prior studies on corporate governance structure and its effectiveness mainly focus on how corporate governance structure will influence the level of executive compensation. Due to data limitation, those studies did not get deeper into the specifics of the compensation contracts, such as target design. However, the findings on the association between corporate governance and CEO pay can be misleading without taking into account the other important elements in a compensation package. For example, a board may raise a CEO's pay level to compensate the additional risk associated with challenging performance targets. However, even as remuneration has become more sensitive to performance increasing theoretical and empirical evidence doubts on the common assumption that corporate boards actually design managerial compensation in arm’s-length transactions with executives, and thus on whether such transactions really are efficient in mitigating agency problems (Morse et al. 2011). It seems that managerial power influences the shape of the remuneration package. The introduction of the mandatory remuneration report in firms’ annual reports sheds some light on the target setting process at the executive level of U.K. firms. This paper provides an empirical analysis on the influence of managerial power and target setting. Secondly, it has employed a unique data set that has enabled the examination of the determinants of managerial power and exploring the determinants of PVSOs and LTIPs vesting in 257 U.K. listed firms. Thirdly, I have controlled for industry- and year fixed effects in order to account for possible heterogeneity effects between industries and years, respectively. Also prior studies have shown that the use of fixed effects estimation reduces endogeneity bias and produces consistent results (Qin, 2012). Fourthly, with the aim of exploring the determinants of PVSO and LTIP vesting in a broader manner, the current study has been built on multiple theories and perspectives in the remuneration literature in order to address the research question.

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2. THEORETICAL BACKGROU ND AND HYPOTHESES

DEVELOPMENT

The majority of the research on the relationship between executive remuneration and firm performance has been rooted in agency theory, where the remuneration plans are designed to align the interests of the executives with those of shareholders. An alternative approach to study CEO compensation is the managerial power approach, which focuses on the role of managerial power in shaping executive compensation practices. To better link executive remuneration with firm performance, an increasing proportion of executive remuneration is being tied to the attainment of pre-specified targets based on agreed-upon performance measures. I start my theoretical background with the agency theory, the managerial power theory and corporate governance. Next, I will summarize the empirical evidence from the available prior literature on the relationship between executive remuneration contracts, target setting and managerial power in order to develop my hypothesis.

2.1 AGENCY THEORY

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11 According to Tirol (2006), moral hazard comes in many guises, from low effort to private benefits, from inefficient investments to accounting and market value manipulations. These reductions in firm value are called the agency cost.

There are two remedies against the agency cost (Jensen and Meckling, 1976): bonding mechanisms and monitoring mechanisms. First bonding mechanism, these costs refers to the resources expended by the agent (the executives) to guarantee that the agent will not take actions which would harm the principal (the shareholders). It has also a function to ensure that that the principal will be compensated if the agent does take such actions.

Bonding activities has been classified as corporate control mechanism by Ang and Cox (1997). Ang and Cox (1997) in classifying bonding activities as a corporate control mechanism state that, the bonding mechanism includes the following: (i) Level of inside ownership: this variable is calculated as the percentage of the firm’s equity held by all insiders. Leland and Pyle support this view that, higher levels of equity ownership by insiders/managers in a firm encourage the pursuit of objectives that maximize shareholder wealth (Tirole, 2006). (ii) Compensation tied to stock: manager’s incentive that includes firm’s stock, has been proposed to better align management interest with that of shareholders. Jensen and Murphy (1990) develop a measure of the sensitivity of executive compensation to changes in corporate performance (including shareholder wealth). (iii) Dividend pay-out: Ang and Cox (1997) note that, the capital market rewards managers for considering investor demand for dividends when making decisions about the level of dividends. Dividend pay-out contains both bonding and monitoring characteristics.

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12 executives to receive bonuses even when the company performed unsuccessfully. This is made possible since the firm performance might be the worst in the industry, but still exceeds the accounting results of the previous year. Bonus designs frequently provide a payment even when the relative performance is weak (Bebchunk and Fried, 2004).

The agency conflict between the agent and the principal is derived from the tendency of the manager to appropriate perquisites out of the firm’s resources for own consumption. This is imaginable on the part of the manager because of information asymmetry. The agent who directs the physical investment can costless observe the returns to their projects. The outsider (principal) must jointly incur a fixed cost to observe these returns. Townsend (1979) refers to this situation as “costly state verification problem”. Monitoring of the agent’s effort, which is the second remedy, may reduce the information asymmetry between the principal and the agent. It hinders the agent’s behaviour in order to serve the best interest of the principal (Qin, 2012). The term monitoring goes beyond just measuring or observing the behaviour of the agent. According to Jensen and Meckling (1976), it includes efforts on the part of the principal to “control” the behaviour of the agent through budget restriction, compensation policies and operating rules amongst others.

Ang and Cox (1997) view monitoring activity, like bonding mechanisms, as a corporate control mechanism. In their view, the monitoring mechanism includes the followings: (i) Outsider directors: the greater the proportion of outsiders on the board, the greater should be the ability to minimize insider trading excesses. Fama and Jensen (1983) typify outside directors as being professional arbiters and experts in internal organizational control, provided that mechanism to limit the power of executives. (ii) Separation of CEO and Chairman of the Board (hereafter COB): the position of COB and CEO when separated and held by different individuals increases the potential for the board to truly function as the shareholders’ monitor of management behaviour. (iii) Level of institutional ownership: as cited in Ang and Cox (1997), incentives exist for large shareholders since the benefits from their monitoring actions can be large enough to exceed their costs of monitoring. In general, of course, it will pay the principle to engage in monitoring activities as long as the marginal benefits of each are greater than their marginal cost. (iv) Dividend pay-out: this has been classified as monitoring mechanism which minimizes manager – shareholder agency conflicts. Suffice to mention, dividend pay-out is also bonding mechanism, and (v) Amount of debt: Jensen and Meckling (1976) examines the agency problem of managers investing in negative NPV projects or, wasting a firm’s earning when a firm has significant free cash flow. They submit that, debt can be effective in reducing this agency cost by pursuing the management to pay-out future cash flows.

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13 Williamson (1985) contain the costs of planning, adapting and monitoring these contractual relationships. The potential for opportunism on the part of the agents makes it critical that firms design contracts that limit this possibility (Coles et al., 2001).

2.2 MANAGERIAL POWER THEORY

Corporate boards efficiently design managerial incentive contracts to align the interests CEOs and shareholders (Jensen and Meckling, 1976). However, even as remuneration has become more sensitive to performance increasing theoretical and empirical evidence doubts on the common assumption that corporate boards actually design managerial compensation in arm’s-length transactions with executives, and thus on whether such transactions really are efficient in mitigating agency problems (Morse et al. 2011). It seems that managerial power and influence can shape the remuneration package and the level of managerial compensation. Finkelstein (1992) defines power as “the capacity of individual actors to exert their will” and indentifies four key dimensions of CEO power.

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14 According to Abernethy et al. (2012) and Bebchuk et al. (2000, board of directors (hereafter BODs) have various economic and psychological incentives to go along with arrangements favourable to top management, even at the cost of shareholders’ wealth. Under the optimal contracting approach to CEO compensation, which has dominated academic literature, efficient pay arrangements are designed by the BODs that aims to maximize shareholder value. In contrast, the managerial power approach debates that BODs do not operate at arm's length in devising CEO compensation arrangements; CEOs have the power to influence their own remuneration, and they use that power to extract rents, and do so in a way that "camouflages" pay to mitigate external scrutiny and criticism (Bebchuk et al.; 2002, Murphy; 2002). Despite the supposed independence of remuneration committees, there are numerous reasons to be sceptical that the process of setting executive remuneration approximates the arm’s length ideal. The key problem is the influence of senior management, in particularly the CEO, on all facets of the pay-setting process. Bebchuk et al. (2002) give three limitations of the arm’s length model of BODs.

First, CEOs influence the appointments of independent directors. As most boards employ nominating committees, the CEO often formally serves on the committee1. Which in many cases allow them to block the appointment of new independent directors who are expected to try to bargain with the CEO at arm’s length. Even when the CEO does not sit on the nominating committee, his or her influence on the nomination process is still generally thought to be significant (Bebchuk et al., 2002).

Second, once appointed, independent directors might be influenced by board dynamics that make it difficult for them to deal with CEOs in a truly arm’s length way. Most BODs believe that their main responsibility is to monitor the CEO’s performance and, when necessary, fire the CEO and hire a suitable replacement. However, overall board meetings and processes are characterized by an emphasis on deference to the CEO. Although the use of a remuneration committee comprised solely of independent directors, which mitigates somewhat the influence of the CEO on executive remuneration, it is no panacea (Bebchuk et al., 2002). Moreover, it is well known that individuals working within a group feel pressure to satisfy group members, often at the expense of interests that are not directly represented at the table. Furthermore, there are likely to be a significant number of independent directors who are less interested in establishing reputations as “expert decision makers” than in keeping their current board seats and possibly joining other boards. As I have noted above, CEOs have great influence in the choice of independent directors and will tend to prefer nominees who are unlikely to challenge their remuneration. Thus, the “market” for BODs creates incentives not to challenge the CEO’s remuneration but rather to accommodate the CEO’s wishes (Bebchuk et al., 2002).

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15 Finally, even if independent directors were to bargain with the CEOs at arms’ length they would likely have neither the financial incentive nor sufficient information to do so. Although share-based compensation for outside directors is on the rise, according to Bebchuk et al. (2002), the direct benefit to independent directors of reducing the CEOs remuneration remains insignificant in almost all cases. According to Baker et al. (1988), BODs, who often own only a small fraction of their firm's common stock, are in no sense perfect agents for the shareholders who elected them. BODs are reluctant to terminate or financially punish poor performing CEOs. Baker et al. (1988) argue that BODs personally bear a disproportionately large share of the non-pecuniary costs, but receive essentially none of the pecuniary benefits. Moreover, the CEO, by way of the human resource department, controls much of the information that reaches the remuneration committee. The remuneration committee may employ an independent remuneration consultant. However the firm (in other words the CEO) employs the consultant that provides the data to the remuneration committee.Since CEOs may choose which consultants to hire, the consultants have strong incentives to make recommendations favorable to the CEO. According to Bebchuk et al. (2002) the consultant is somewhat constrained by reputational considerations. Thus they cannot propose a pay package that is obviously excessive but within the range of flexibility that is most beneficial to managers. Obviously, independent directors are not required to follow the remuneration consultant’s recommendation. They may come up with other proposals, however as a practical matter, independent directors have only limited time and resources available to handle complex compensation issues. Consequently, BODs will rely heavily on the information and proposal provided by the remuneration consultant.

According to Bebchuk et al. (2002), it is worth mentioning in this association that the trend among firms in the last decade is to increase the number and power of “independent directors”.Prior research suggest that outside directors have increasing influence over the composition of board committeesand that they constitute a majority of most board committees, including the nominating committee.Thus, corporate governance experts have concluded that boards have become more effective monitors of CEO performance and become more independent (e.g. Mehran; 1995, Mayers et al.; 1997). This trend may have reduced the power of the CEO in certain firms. In some companies, directors are more independent from the CEOs and are thus more willing to fire CEOs when they perform poorly. In fact, during the last twenty years CEO tenure has declined and CEO terminations have increasedtrends that are attributed to boards becoming more independent.

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16 might be adopted that deviate significantly from those suggested by optimal contracting. The remuneration practices can be fully understood only with careful attention to the role of managerial power (Bebchuk et al., 2002). I will take the view that compensation arrangements are shaped both by managerial power and by what would be optimal. To be sure, in the future there could be changes of a more fundamental nature that bring us closer to an arm’s length model. There is good reason to believe, however, that currently negotiations between executives and the board over executive compensation tend to be far from that model (Bebchuk et al., 2002). Accordingly, I will investigate how managerial power affects performance target choices in executive remuneration.

Recent empirical studies (e.g., Bebchuk et al., 2002; Bebchuk, Fried, and Walker; 2002, Bebchuk, Fried; 2004) have emphasized managerial power as a dominant influence in explaining the level and characteristics of executive remuneration. They suggest that CEOs more power are able to use compensation contracts to extract more rent; defined as value in excess of what they would receive under optimal contracting. Therefore, the efficiency of remuneration contracts would be discounted in some circumstances where remuneration committees are less effective in fulfilling their duty or where it is easier for CEOs to shape their own compensation arrangements (Sun, Cahan, and Emanuel, 2009). Thus, according to Sun, Cahan, and Emanuel (2009), using incentive-based compensation contracts may not solve agency problems between CEOs and shareholders. Instead, the agency problems can lead to rent extraction. Bebchuk and Fried (2004) are especially critical of what they call ‘‘conventional” stock option plans, e.g., plans based on at-the-money option grants, without indexing outcomes to benchmark performance, and where CEOs can sell their shares directly after exercise. Prior studies find evidence consistent with this rent extraction or managerial power argument. Core et al. (1999) find that weak corporate governance structure leads to excess compensation paid to CEOs and poorer future firm performance. Similarly, DeFusco, Zorn and Johnson (1991) find that firms that changed their stock option plans over the 1978–1982 period experienced earnings declines relative to industry levels and decline in abnormal firm performances subsequent to the plan adoption. This suggests that the changes were unsuccessful as a means of generating improved performance. Moreover, prior researches find that stock option plans have dysfunctional effects. For example, Aboody and Kasznik (2003) find evidence consistent with the rent extraction hypothesis that CEOs delay good news announcements until after the date of scheduled option awards, and rush bad news before the date of option awards. Their findings suggest that CEOs make opportunistic voluntary disclosure decisions that maximize their stock option compensation (Aboody and Kasznik, 2003). Burns and Kedia (2008) find significant higher option exercises by CEOs for firms that are more likely to deliberately adopted aggressive accounting practices.

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17 increased number or percentage of outsiders on board would diminish managerial power. Muslu (2010) find that executives receive greater equity pay when boards have more outside directors. Furthermore, Cyert et al. (2002) find that equity ownership of the largest external shareholder (also a mechanism to diminish the managerial power) is strongly negatively related to the size of CEO equity compensation. Moreover, Wade et al. (1990) find that as the percentage of the board composed of outsiders appointed after the CEO takes office increases, the more likely it is that the CEO will be able to secure a golden parachute. CEOs are more likely to secure a golden parachute when they exhibit significant influence over the nominations and appointments of BODs. Although outside BODs are often nominated by a committee, the CEO may be is consulted before candidates are put forward. Thus, the CEO is able to nominate and select BODs who are sympathetic to his or her desires (Wade et al., 1990). Furthermore, Morse et al. (2011) find that powerful CEOs get higher compensation. Morse et al. (2011) focus is on how CEOs use their power to manipulate incentive contracts and generate rents from what is supposedly performance based pay and their evidence is consistent with Bebchuk et al. (2002). Bebchuk et al. (2002) argue that rent seeking CEOs may seek to increase their pay through option grants rather than cash in an attempt to camouflage pay to mitigate external scrutiny and criticism.

A recent development has been to attach performance targets to PVSO plans, such that managerial benefits from option compensation are conditional on the achievement of pre-specified performance hurdles. Abernethy, Kuang and Qin (2012), argue that powerful CEOs might extract rents by exerting influence over compensation design and camouflaging their compensation through the adoption of PVSO plans. They suggest that attaching performance targets to PVSO plans removes the influence of market-wide factors on CEO compensation. Moreover, Abernethy et al. (2012) suggest that CEOs are involved in active manipulations through the design of their own remuneration and intentionally select easy targets. Thus, CEO can camouflage their self-serving behaviour while reducing the costs associated with external outrage about the firm’s remuneration practices.

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2.3 CORPORATE GOVERNANCE

Corporate governance codes are sets of business best practices. They have propagated around the world since the publication of the Cadbury Report in 1992 (Akkermans et al., 2007). Overall the objective of corporate governance codes is to enhance the quality and transparency of management, thereby improving firm performance and restoring investors’ confidence (Grant and Grant, 2008). This paragraph presents an overview of the recent developments in the corporate governance codes.

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19 with the best practice provisions of the British codes shows that compliance in generally high (Aguilera and Cuervo-Cazurra, 2004). Moreover Werder et al. (2005) find that company size is positively associated with the extent of code compliance.

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20 standards of good governance practice in a non-binding approach. This is a so-called “comply or explain” approach, a hallmark of U.K. corporate governance. This principle encourages firms to comply with best practice corporate governance (i.e., “comply”), but leaves the door open for companies to deviate from the code. If a company does deviate from recommended best practice rules then it is permitted to do so, but is required to explain and justify why they deviate (i.e., “explain”) (Conyon and Sadler, 2010). The Cadbury Report’s recommendations are highly codified, which allows both companies and stakeholders to benchmark best practices, as well as emulation by other country issuers (Aguilera and Cuervo-Cazurra, 2004). The history of corporate governance policies in the U.K. since the nineties can thus be regarded as a sequence of incremental steps each aimed to mitigate the problems of managerial malfeasance (Bebchuk and Fried; 2004, Jensen and Murphy; 1990, Fama and Jensen; 1983).

The development of codes of good governance across countries did not follow a linear path (Aguilera and Cuervo-Cazurra, 2004). Figure 1 shows the evolution of codes of good governance by country and number of codes developed. The figure illustrate that there is a gap between the first code issued in the USA in 1978 and the second code published in Hong Kong in 1989. After 1989, new codes appeared steadily throughout the early nineties and particularly since the issuance of the Cadbury Report in 1992; there has been an exponential rise in the adoption of codes and overall shareholder activism (Davis and Thompson 1994). Thus, by the end of the nineties, 24 industrialized and developing countries had issued at least one code of good governance, resulting in a total of 72 codes of good governance.

FIGURE 1

Evolution of Codes of Good Governance Worldwide: Countries and Total Number, 1978–1999

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21 The governance of companies has attracted much attention in the past decade. The Boardroom Briefing (2010) published that through the $100 million executive bonus pay-out within the American International Group (American insurance company). The American corporate governance policy has been called “outrageous failure of policy”. Generous remuneration arrangements were approved by the remuneration committee while the firm performance was disastrous. Increased media coverage has turned “transparency,” “managerial accountability,” “corporate governance failures,” “weak boards of directors,” “hostile takeovers,” “protection of minority shareholders,” and “investor activism” into household phrases (Tirole, 2006). The BODs should serve shareholders’ interest in bargaining concerning executives remuneration. However, the directors of the board have non-financial and financial incentives to favour or at least go with the executives (Bebchuck and Fried, 2004). Multiplicities of economic, social and psychological reasons strengthen these incentives (Bebchuck and Fried, 2004). Besides, according to Bebchuck and Fried (2004), the directors from the board usually own only a small proportion of the corporate shares, their holdings may not be enough to offset their own shareholders ‘wealth and therefore they might have the tendencies to get along with the executives. This is called the managerial power theory. An implication of the managerial power theory is that making boards more independent from management is the key for improving the corporate governance. The determination of executive remuneration is typically delegated to a subgroup of the main board, called the remuneration committee. According to the U.K. corporate governance code 2012, the board should establish a remuneration committee of at least three independent non-executive directors, or in the case of smaller companies (below the FTSE 350 throughout the year immediately prior to the reporting year) two independent non-executive directors. Whether board composition affects non-executive remuneration has been the topic of debate for decades.

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22 implications of these. Second, the influence of shareholders in monitoring the U.K. corporate governance code should be improved by better interaction between the boards and the shareholders. To this end, the FRC has the responsibility for a code that will provide guidance on good practice for the shareholders. The U.K. corporate governance code is a guide to an effective board practice which is based on the underlying principles of all good governance: transparency, probity, accountability and focus on the sustainable success of the firm over the longer term (U.K. corporate governance code, 2010).

2.4 DIRECTORS’ REMUNERATION REPORT

The U.K. Corporate Governance Code 2012 sets out certain information that must be disclosed. One of the main principles is the remuneration. The FRC (2012) states: “Levels of remuneration should be sufficient to attract, retain and motivate directors of the quality required to run the company successfully, but a company should avoid paying more than is necessary for this purpose. A significant proportion of executive directors’ remuneration should be structured so as to link rewards to corporate and individual performance”. Furthermore FRC (2012) states: “The board should undertake a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors”. Additionally, FRC (2012) announces that the remuneration committee should consider whether the directors should be eligible for annual bonuses. If so, performance conditions should be relevant, stretching and designed to promote the long-term success of the company.

In order to understand the executive pay in Europe Ferrarini et al. (2009) did a comparative and an empirical analysis in Europe. They reviewed 300 of Europe’s largest listed firms by market capitalisation across 16 European countries, 14 of which were in the EU covering the years 2004 and 2005. They found that only 30% of firms provide sufficient information on the link between remuneration and performance. The highest levels of disclosure are provided by U.K., Dutch and to some extent German firms, while Belgian, Spanish, Italian and Swiss firms are the lowest performers in the EU. The worldwide financial crisis which came to a head in 2008 triggered widespread reappraisal, locally and internationally the governance systems

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23 Australia, the Netherlands, Norway, and Sweden (Conyon and Sadler, 2010). The debate on “say on pay” is raging in the United States and United Kingdom ((Bebchuck and Fried, 2004; Conyon and Sadler, 2010; and Lazear and Gibbs, 2009). Characteristically, the objective of such policies is to reduce managerial excess and alleviate concerns that remuneration packages are not designed in shareholders’ best interests. Executive remuneration remains a highly controversial subject, recently observed in the outrage over compensation paid to executives at many of the financial companies worst hit by the credit crisis. Critical questions remain as to whether levels of executive pay are “too high” and whether overall remuneration packages are designed optimally (Conyon and Sadler, 2010).

The DRR Regulations were introduced in the United Kingdom in 2002. The DRR regulations were originated as an amendment to the Companies Act of 1985, and successively absorbed into the Companies Act of 2006 (Conyon and Sadler, 2010). The novel regulations improved the information available to investors about executive remuneration significantly and incorporated a requirement for the directors to seek approval from the shareholders for the DRR. Consequently, these regulations shall come into force on 1st August 2002 and shall be effective for companies with fiscal year ending on or after December 31, 2002.The Companies Act 1985 requires a company to produce certain information concerning directors’ remuneration by way of notes to the company’s accounts. The DRR regulations 2002 mandated significant new executive remuneration disclosure by firms. According to the DRR Regulations 2002, listed firms are required to publish a directors’ remuneration report for that financial year as part of the firm’s annual report. Moreover, the directors’ remuneration report of the relevant fiscal year shall contain details about each directors’ remuneration package at any time during that year, e.g. details about total amount of salary and fees, total amount of bonuses, total amount of sums paid by way of expenses allowance that are chargeable to United Kingdom income tax. The directors’ remuneration report shall also state the nature of any element of a remuneration package which is not cash. Furthermore, the DRR shall contain a statement of the company’s policy on directors’ remuneration for the following financial year and for financial years subsequent to that, unlike in the U.S.; U.S. firms are not subject to such mandatory disclosure regulations (Morse et al., 2011). Morse et al. (2011) show rigging is facilitated by the lack of complete disclosure about incentive contract terms ex ante. Performance measures are seldom made public for competitive reasons in the U.S. According to Morse et al. (2011), a recent study by a large compensation consulting firm, Watson Wyatt, indicates the difficulty that outside shareholders have in evaluating CEO performance rewards. They report that 46% of the top 100 U.S. firms did not disclose the actual goals on which they based rewards under their 2006 annual incentive plans.

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24 consideration of any such matter. In the case of any person named is not a director of the company; the nature of any other services that that person has provided to the company during the relevant financial year and whether that person was appointed by the committee should be stated. In other words, firms are required to identify all advisors to the remuneration committee, such as remuneration consultants, and a whether they have any other connection with the company (Conyon et al., 2009). Similar disclosure requirements have been made in the U.S., concerns over the role of remuneration consultants led the SEC in 2006 to require companies to identify and describe the role of all consultants. In December 2009, the SEC expanded the rule to require firms to disclose fees paid for any additional services provided to the firm by the consultants (Murphy and Sandino, 2010).

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25 before the impact of these reforms may be properly understood. In particular, guidance will be needed on how long-term remuneration awards should be disclosed in the annual remuneration reports and how firms may vary their executive directors’ contractual rights if the shareholders vote down the proposed remuneration packages (Latham & Watkins LLP, 2012).

According to DRR Regulations 2002, companies also had to supply a narrative on company policy on remuneration. The U.S. has similar regulations regarding performance targets and peer group disclosure. According to Gong et al., (2011), the SEC’s 2006 executive remuneration disclosure rules require firms to provide details on how performance targets, including relative performance targets, are used in setting CEO pay. The U.K. DRR shall contain a statement of the firm’s policy on directors’ remuneration for the following financial year and for financial years subsequent to that. According to DRR regulations (2002), “The policy statement shall include for each director, a detailed summary of any performance conditions to which any entitlement of the director to share options, or under a long-term incentive scheme”. Moreover, the firm should state whether such performance target setting involves any comparison with factors external to the firm. When any of the factors relates to the performance of another firm, or of an index on which the securities of a firm are listed, the identity of each of those companies or of the index should be disclosed (DRR, 2002). One important mechanism for shareholder voice in the U.K. is the capacity to vote on resolutions at the firm’s AGM. According to Conyon and Sadler (2010), management typically tables all resolutions at an AGM although shareholders can table their own resolutions but this requires a minimum five per cent share ownership or the co-ordination of 100 shareholders. Section 338 of The Companies Act 2006 governs the process and as such. However, shareholder requisitioned resolutions are exceptional.

2.5 PAYING FOR LONG-TERM PERFORMANCE

According to Bebchuk and Fried (2003), executive remuneration has attracts a lot of attention from financial economists. The increase in academic literature on the topic of executive remuneration during the 1990s seems to have outstripped even the undisputed escalation in executive remuneration itself during this period as shown in Figure 2: the median cash compensation paid to S&P 500 CEOs has more than doubled since 1970 (in 1996-constant dollars), and median total realized compensation (including gains from exercising stock options) has nearly quadrupled” (Murphy, 1999).

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26 executives’ long-term incentives is desirable, there is much less arrangement about how this should be accomplished. Bebchuk and Fried (2010) seek to contribute by providing a blueprint for tying executives’ equity-based compensation; the primary component of their pay packages to long-term performance. Lazear and Gibbs (2009) argue why paying for performance (or extrinsic information) is important. First, people tend to respond strongly to incentives. This means that when an incentive plan is designed well, it might be an important source of value creation. Moreover, incentives may play an essential role even if an employee has strong intrinsic motivation, because the motivation may not be adequately aligned with firm’s objectives.

FIGURE 2

Median Realized Cash and Total Compensation (including Option Gains) for S&P 500 CEOs, 1970-1996, and Number of Academic Papers Published on CEO Pay

Note: Sample is based on all CEOs included in the S&P 500. Compensation data, in 1996-constant dollars, are extracted from the Annual Compensation Surveys published by Forbes each May from 1971 through 1992; later data from Compustat’s

ExecuComp Database. Cash pay includes salaries, bonuses, and small amounts of other cash compensation; total realized pay includes cash pay, restricted stock, payouts from long-term pay programs, and the amounts realized from exercising stock options during the year. (Total pay prior to 1978 excludes option gains.) The number of academic papers on CEO pay was computed by Kevin Hallock and reported in Hallock and Murphy (1999).

(Source: Murphy, K. J., (1999) Executive Compensation. Yale School of Management's Economics Research Network)

2.5.1 TARGET CHOICE

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27 are required under the DRR Regulations 2002 to disclose performance targets and benchmarks used in executive remuneration plans in the Remuneration Report (Zakaria, 2008). According to Zakaria (2008), in selecting appropriate performance measures for executive remuneration plans, performance measures should be: linked to shareholder value creation, aligned with company strategy and reflects operating performance, emphasise objective and quantifiable measures, and balance growth and returns. Therefore, financial measures are frequently used as they are seen to be objective, quantifiable and have a direct link to shareholder value.

It is common practise to express performance measures in either accounting or market-based terms (Conyon et al.; 2000, Pass et al.; 2000). Firms tend to use share prices as a measure of firm performance against which executives are assessed (Zakaria, 2008). However, according to Sloan (1993), there is a preference for accounting-based measures and provides evidence in support of the hypothesis that earnings-based incentives help shield executives from market-wide factors in stock prices. Sloan (1993) demonstrates that earnings reflect firm-specific changes in value, but are less sensitive to market-wide movements in equity values. Sloan (1993) discusses primacy of accounting earnings over market-based measures in executive remuneration contracts; accounting-based measures better shield executives from changes in firm value that they are unable to influence, thus helping to ensure that they are not punished (or rewarded) for changes in value that are beyond their direct control. Similarly, Murphy (1999) argues that the primary determinant of executive bonuses is accounting profits. Accounting data are verifiable and commonly understood. Moreover, they pass what practitioners call the “line of sight” which is a criterion for acceptable performance measures: managers understand and can “see” how their day-to-day actions affect year-end profitability (Murphy, 1999).

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28 Holmstrom (1979) suggest that firm performance is best measured relative to the performance of others. A relative performance evaluation (hereafter RPE) in CEO remuneration provides insurance against common exogenous shocks (Holmstrom. 1979) and yields a more informative measure to assess the CEOs actions. According to efficient contracting (captured by common risk and economic similarity), the appropriate peer choice depends on industry similarity and firm characteristics (Gong et al., 2011). CEOs might act in a self-serving behaviour and select underperforming peers, also called ‘executive-friendly’ peer groups, to boost their own firms’ relative performance and their incentive compensation (Buck et al. 2003). However, Gong et al. (2011) studied RPE recently, and find significant evidence in support of the efficient contracting hypothesis rather than managerial opportunism. While the DRR Regulation (2002) requires firms to disclose details of peer groups used as performance benchmarks, it provides no guidance or stipulations on peer group member choice. It is therefore the responsibility of individual firms to identify appropriate peer groups, and ultimately to shareholders to question how firms define who their peers are. Albuquerque (2009) proposes firm size and same industry as an important factor in RPE peer selection. Accordingly in line with the recommendations the Greenbury report (1995), targets which are based on an explicitly selected peer group, relative to those based on an index, should be more consistent with the economic incentive of RPE and therefore more challenging (Abernethy, Kuang and Qin ,2012).

2.5.2 TARGET SETTING

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29 Similar theory at the executive level is scarce and observations at the operational level are not automatically generalizable to the executive level of the organizational hierarchy (Zakaria, 2008). Agency problems between operational level employees and senior managers differ from agency problems between executives and shareholders. Fama and Jensen (1983) describe that decision processes that firms undertake involve four steps: initiation, ratification, implementation and monitoring. They advise that in order to minimise agency problems, firms should separate decision management functions (initiation and implementation) from decision control functions (ratification and monitoring). According to Fama and Jensen (1983), within an environment where subordinates are answerable to a superior in the organisational hierarchy, the separation of these two decision functions is clear. In a target setting context, when an employee sets its own target, the target is then subject to ratification a superior at a higher level in the organization. After the target is implemented, the superior will then monitor the employee performance. In this point of view is the employee not setting his or her own target but purely assisting in suggesting a target level he or she is comfortable with, which need to be approved by a manager. However, at the executive level of the management hierarchy, the ratification step is less transparent (Fama and Jensen, 1983). Using the Fama and Jensen (1983) four step process as a framework, the BODs ratifies the targets for executives. However, since senior managers are also part of the BODs, decision management and decision control functions are no longer separated, which provides an opportunity for managerial opportunism (Zakaria, 2008).

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30 Performance standards are normally based on budgets and/or prior-year performance and frequently allow for some board discretion (Murphy, 1999). According to Murphy (1999), performance standards cause problems whenever the employees measured relative to the standard have influence over the standard-setting process. Standards constructed on budgets and prior-year performances are particularly susceptible to this problem. Standards constructed on prior-year performance may lead to the “ratchet effect” and “shirking”, since managers know that good current performance will be penalized in the next period through an increased performance standard (Murphy, 1999). In contrast, timeless standards, standards based on the cost of capital, and standards based on the performance of an industry peer group are not as easily influenced by the participants in the remuneration plan (Murphy, 1999).

The “incentive zone” in most annual incentive plans contains of a fairly narrow band of performance outcomes straddling the performance standard (see Figure 5) (Murphy, 1999). As bonuses are based on cumulative annual performance, and since senior managers can revise their daily effort and investment decisions based on assessments of year-to-date performance, the nonlinearities in the typical bonus plan might causes predictable incentive problems. Especially, if year-to-date performance suggests that annual performance will exceed that required to achieve the bonus cap, Murphy (1999) argues that managers will withhold effort and will attempt to “inventory” earnings for use in a subsequent year. Likewise, if expected performance is lower than 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 implausible. Moreover, Murphy argues that when the expected performance is moderately below the incentive zone, the discontinuity in bonus payments at threshold yields strong incentives to achieve the performance threshold, through counterproductive earnings manipulation as well as through hard work, because the pay for performance slope at the threshold is effectively infinite.

2.6 PAY COMPONENTS & TARGETS

Even though there is considerable heterogeneity in compensation practices across firms and industries, most executive pay packages contain four basic components: a base salary, an annual bonus (typically related to accounting measures of performance), and PVSOs and LTIPs. See Figure 3 for the components of average U.K. executive compensation (Conyon et al., 2000).

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31 levels for manufacturing CEOs, for example, have increased 55% from $2.0 million in 1992 to almost $3.2 million in 1996. Thirdly, the increase in pay is largely owing to the increases in the grant-date value of stock option grants. During the early 1990s, stock options replaced base salaries as the single largest component of compensation (in all sectors except utilities). Option grants in manufacturing firms increased from 27% to 36% of total compensation.

FIGURE 3

The components of average U.K. executive compensation

(Source: Conyon, M., S. Peck, L. Read and G. Sadler. (2000). The structure of executive compensation contracts: UK evidence.

Long Range Planning)

Figure 4 presents the components of average U.K. executive compensation 2002 until 2009, providing data on a similar scale to Conyon et al. (2000) (see Figure 3 in Section 2.6) for comparison purpose. A conclusion can be made that the landscape of remuneration plans has not drastically changed although the weightings between components of pay have varied. The slight shift of more equity linked compensation from 54% in 1997 (Conyon et al., 2002) to 57% from 2002 until 2009 in my sample can be explained with the pay for performance literature. Jensen and Murphy (1990) suggest that equity-based rather than cash compensation gives managers the correct incentive to maximize firm value. According to Mehran (1995), CEOs are depicted in the literature as being risk-averse. Contrary, Shareholders are considered risk-neutral since they can diversify firm-specific risk simply by holding a diversified portfolio. Additionally, shareholders anticipate that managers will attempt to avoid risks in ways that can reduce firm value (Mehran, 1995). A way to tie compensation to performance is by making a greater proportion of a CEO’s compensation equity-based (e.g. Jensen and Murphy, 1990).

22%

24% 54%

Salary Bonus

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32

FIGURE 4

The components of average U.K. executive compensation 2002 until 2009

Performance targets can be attached to several components of executive remuneration, such as: cash bonus, stock option grants and shares. According to Qin (2012), “ the most prominent innovation in the area of stock option plans is aimed at linking accounting-based (e.g. EPS) and/or market-based (e.g. TSR) performance targets to option vesting, so that managers can only benefit from stock options after having achieved the pre-determined targets.” This is entitled as the ‘performance-vested stock options (PVSO). Another tool to increase performance-pay sensitivity is long-term incentive plans (LTIPs), which can be defined as defined as grants of cash or shares (usually the latter) with performance conditions (Buck et al., 2003).

2.6.1 BASE SALARIES

According to Murphy (1999), executive base salaries are usually determined through competitive “benchmarking,” grounded primarily on general industry salary surveys and supplemented by detailed analyses of selected industry or market peers. Those surveys, which report a variety of pay percentiles (e.g., 25th, 50th, 75th), typically adjust for firm size. The worldwide use of surveys in shaping base salaries has several implications relevant to understanding levels and trends in CEO compensation (Murphy, 1999). Firstly, since salaries below the 50th percentile are often labelled “below market” whereas those between the 50th and 75th are considered “competitive,” the surveys have contributed to a “ratchet” effect in base salary levels. Secondly, while the surveys adjust for firm size and (less frequently) industry, they do not contain criteria many labour economists consider relevant for predicting pay levels, like: age, experience, education, and performance. Thirdly, since base salaries represent the “fixed component” in executive contracts, risk-averse executives will logically prefer a dollar increase in base

25%

18% 57%

Salary Bonus

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33 salary to a dollar increase in “target” bonus or variable compensation. Finally, most components of CEO remuneration are measured relative to base salary levels. For example, target bonuses, are usually expressed as a percentage of base salary, while option grants are expressed as a multiple of the base salary. As a result, an increase in base salary has positive consequences on many other compensation components (Murphy, 1999).

2.6.2 ANNUAL BONUS

Nearly every profit organization offers an annual bonus plan to its top executives and paid annually based on a single-year’s performance. Despite heterogeneity across firms and industries, executive bonus plans can be categorized in terms of three basic components for a “typical” bonus plan: performance measures, performance standards, and the structure of the pay-performance relation (see figure 5) (Murphy, 1999). Murphy (1999) explains that under a typical bonus plan, no bonus will be paid until a threshold performance (generally expressed as a percentage of the performance standard) is achieved, and a “minimum bonus” (generally expressed as a percentage of the target bonus) is paid at the threshold performance. Moreover, target bonuses are paid for achieving the performance standard, and there is usually a “cap” on bonuses paid (also expressed as a percentage or multiple of the target bonus). The range between the threshold and cap is labelled as the “incentive zone,” demonstrating the range of performance realizations are incremental improvement in performance corresponds to incremental improvement in bonuses.

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34 expressed as growth rates (e.g., EPS growth). The most common non-financial performance measure used in annual incentive plans is “Individual Performance,” which includes performance measured relative to in advanced defined objectives as well as subjective assessments of individual performance. Other common nonfinancial measure is customer satisfaction (Murphy, 1999).

According to Murphy (1999), the most frequent used performance standards are; budgets, prior-year, discretionary and peer group standards. Budget standards include plans based on performance measured against the firm’s business plan or budget goals (such as a budgeted-net-earnings objective). Prior-year standards include plans based on year-to-year growth or improvement (such as growth in sales or EPS, or improvement in operating profits). Discretionary standards include plans where the performance targets are set subjectively by the BODs following a review of the firm’s business plan, prior-year performance, budgeted performance, or a subjective evaluation of the difficulty in achieving budgeted performance. Peer group standards include plans based on performance measured relative to other companies in the industry or market (often a self-selected group). Pay-outs from bonus incentive plans are determined in a variety of different ways. According to Murphy (1999), the most common pay-out method is the “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 are possible (e.g. 90/110, 80/140 etcetera). In Murphy’s study 67 of the 177 (38%) sample firms report using the 80-120 approach. Murphy (1999) and Gibbs (2012) find pay-performance relation is linear or piecewise linear between the threshold and cap (the incentive zone) (see Figure 5). In general, pay for performance shapes tend to be quite simple, perhaps because they are easier for employees to understand, which improves trust in the incentive system.

FIGURE 5

Components of a "Typical" Annual Incentive Plan

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35 2.6.3 PERFORMANCE-VESTED STOCK OPTIONS

Interest in executive remuneration has been stimulated by the recent emergence of innovative instruments of executive pay, among which PVSOs have attracted considerable attention (Qin, 2010). Stock options contain the right (but not the obligation) to purchase shares at a fixed price (the exercise price) at a pre-specified date in the future (Conyon, 2000). According to Conyon (2000), executive options typically vest (i.e. can then be exercised) three years after the date the options are granted and generally have terms, that is the period between the date they are granted and the last date on which they may be exercised, of between seven and ten years. Executive options are non-tradable, and are typically forfeited if the executive leaves the firm before vesting (Murphy, 1999).

Researchers have frequently used the Black–Scholes pricing formula, adjusted for continuously paid dividends, to value CEO stock options (e.g. Murphy; 1999, Conyon; 2000). The option delta varies between zero and one. Deep-in-the-money options (where the share price is way in excess of the exercise price) have deltas that are close to one, whereas deep-out-of-the-money options have deltas close to zero. Executives who only hold deep-out-of-the-money options will, independent of the fraction of options on outstanding equity held, have low pay–performance sensitivities (Conyon, 2000).

According to Conyon et al. (2000), even though a few U.K. companies have been attaching performance criteria to executive options from as far back as 1988, such practices were rarely and far between prior to 1994. However, in 1995 the Greenbury code suggested that all long-term incentive schemes, including executive share option schemes, should be subject to “challenging performance criteria”. Conyon et al. (2000) mentioned that “The Greenbury report argued that remuneration committees should consider criteria which measure firm performance relative to a group of comparator companies in some variable, or set of variables, reflecting the company’s objectives such as total shareholder return.” Furthermore it recommended that “executives should not be rewarded for increases in share prices or other indicators which reflect general price inflation, general movements in the stock market, and movements in a particular sector of the market or the development of regulatory regimes.” These recommendations met with widespread agreement, as did their rapid implementation (Conyon et al., 2000). Conyon et al. (2000) illustrate the distribution (of a sample consists of the largest U.K. 200 listed companies in the fiscal year 1997) of performance criteria that are attached to options contingent upon the firm using an option scheme. They show that the vast majority of firms use the accounting performance standards EPS as the performance criteria to attach to stock options. The next main type is a market-based measure, which is the TSR. When TSR is used, option vesting usually depends on the market return of a firm relative to the performance of a peer group (Qin, 2010).

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36 and the (expected) exercise date of the option must exceed the growth in the retail price index by a total of 6%. The specific details vary from firm to firm (although not always in an easily classifiable manner due to some opaqueness and ambiguity in reporting) (Conyon et al., 2000). Moreover, Conyon et al. (2000) mentioned in their paper that the Organisations such as the Local Authority Pension Fund Forum (LAPFF) have questioned the use of annual 2 % real growth in EPS thresholds, stating “EPS growth of 2% a year is easily achievable for most companies while median position represents only average performance’. Additionally, Zakaria (2008) analysed the target attainability, they focussed remuneration plans that employ EPS growth as a performance measure benchmarked against retail price index (hereafter RPI). She found that the median three-year EPS growth targets are set at a rate that is lower than both past performance and forecasted performance. Zakaria (2008) found in the report of Halliwell Consulting (2004) that “while analysts predicted a median three-year EPS growth of 38% for FTSE 100 firms in 2004/2005, less than 2% of firms set targets that exceed this forecasted growth”. Moreover, the average actual performance exceeded the lower target bound. Furthermore, Zakaria (2008) also find that EPS growth targets are set at similar levels in both stock option plans and LTIPs, and across all plans, upper threshold targets are achieved for every six out of ten plans.

2.6.4 LONG-TERM INCENTIVE PLANS

Conyon et al. (2000) explains that LTIPs consist of the award of equity to be received at some future date contingent on performance criteria prior to vesting. More firms are using LTIPs in place of stock option plans relative to observations made by Conyon et al (2000). Conyon et al. (2000) argues that LTIP shares are not comparable to unrestricted shares, since they are potentially subject to forfeiture if certain employment and performance objectives are not achieved.

The Greenbury report focused on the potential shortcomings of executive stock option schemes and highlighted a clear preference for LTIPs, stating that introducing such plans “may be as effective, or more so, than improved share option schemes in linking rewards to performance”. Conyon et al. (2000) find a substitution effect of LTIPs on share option plans. According to Conyon et al. (2000), the split in opinion on the efficacy of the two main strategies is revealing. One director sees share options as an obvious method for rewarding executives. In contrast, one director in support of his firms LTIP scheme, claimed it is: “a fairer, better measure of performance than an option, because I think options are a lottery: if the stock market goes to hell, your options won’t pay out, or (will) pay out very little. Conversely, what we’ve got going now is pretty mediocre companies doing relatively well in stock market terms, and therefore the options being worth a lot of money”.