The impact of equity-based compensation of
outside directors on their quality of supervision
Master Thesis Business Administration – Organization & Management Control
The impact of equity-based compensation of
outside directors on their quality of supervision
Christien Speelman Studentnumber: S2072793
Hoofdstraat 7
9315 PA Roderwolde, The Netherlands + 31. 6. 42 44 95 91
s.j.h.speelman@student.rug.nl June 24th, 2013
University of Groningen, the Netherlands Faculty of Economics and Business
First supervisor: dr. Bo Qin
Second supervisor: drs. Abdul Rehman Abbasi Words: 11,646
ABSTRACT
This study examines the association between outside directors who are rewarded by equity compensation and the effectiveness of their supervision. Drawing on a dataset of 257 London Stock Exchange listed firms, in total 2,055 firm-year observations. The current study focuses on the link between outsiders’ equity-based compensation and CEO-shareholders interest alignment, as well as the relation between equity compensation and CEO performance-induced turnover. The results of this research show that equity compensation paid to outside directors do not significantly influence the quality of their supervision.
Keywords: Outside directors; Equity-based compensation; Interest alignment; CEO
INTRODUCTION
Previous studies have investigated that boards with more outside directors will lead to improved board decisions and, as a consequence, better corporate performance (Cordeiro, Veliyath, & Neubaum, 2005; Dahya & McConnell, 2007). So outside directors in the board are of main importance to the company. But what is the reason that the outside directors have so much positive influences on the board decisions and under which conditions outside directors can best perform. A growing number of firms have awarded equity-based compensation to outside directors (Ertugrul & Hegde, 2008). Many research has been done on the topic of the compensation of outside directors in relation to the CEO compensation (Dalton & Daily, 2001), or the compensation of outside directors in relation to the firm performance (Cordeiro et al., 2005).
However, outside directors do not have direct influences on the firm performances because they are responsible for monitoring the management and supervising the firm operation (Boumosleh, 2009), providing advice to the management (Hempel & Fay, 1994; Johnson, Daily, & Ellstand, 1996; Zahra, 1990), hiring and firing (new) board members, and determining the compensation of managers (Dalton & Daily, 2001). Outside directors can influence the quality of supervision but cannot directly influence the firm performance. Because much research is already done on the total compensation of outside directors, this research is focused on the equity-based compensation of outside directors in relation to the effectiveness of their supervision.
It is meaningful to know if there is a relationship between equity-based compensation and the quality of supervision. If this relation exists it is also important to investigate the proportion of equity-based compensation of the total compensation of outside directors. It is meaningful to know which compensation of outside directors leads to a higher quality of supervision. Since a higher quality of supervision leads to better firm performance. When firm performance is superior because outside directors are paid by equity-based compensation it is interesting to look at the proportion of equity-based compensation of outside directors’ total compensations. Also when firms perform better when outside directors are paid by a cash compensation it is important to look at the proportion of cash compensation of the outside directors’ total compensations. To sum up, if there is a relationship between equity-based compensation and the quality of supervision, it is important to know the ratio of equity-based compensation in the total compensation which leads to the highest firm performance.
This research has investigated the relationship between equity-based compensation of outside directors and the quality of supervision of these outside directors. I have tested two relationships. The relationship between equity-based compensation of outside directors and CEO-shareholder interest alignment is the first relationship. The relationship between equity-based compensation of outside directors and CEO performance-induced turnover is the second relationship. The first relationship is tested by an Ordinary Least Square (OLS) model and the second relationship is tested by a Binary Logistic Regression. The results show that outside directors in the UK who are rewarded by equity-based compensation do not significantly influence the quality of their supervision.
This study aims to contribute to the literature in two ways. Firstly, this research will contribute significantly to the scant literature on equity-based compensation of outside directors. Prior literature has focused mostly on the compensation of CEOs in comparison to outside directors and is less focused on the composition of the compensation of outside directors and their quality of supervision. Secondly, this study will contribute to the economic incentive theory (e.g. agency theory) by explaining the effects of the compensation of outside directors in relation to the agency theory.
LITERATURE REVIEW & HYPOTHESES DEVELOPMENT
Most of the research about outside directors is mainly focused on the outside directors’ compensation in relation to the CEO compensation (Dalton & Daily, 2001) or the firm performance (Cordeiro et al., 2005; Dahya & McConnell, 2007). However, outside directors are not direct responsible for the firm performance but they are held responsible for the supervision of the board members. Because there is very limited exploration with respect to the incentive effect of outside directors’ payment, this paper focuses on the compensation structure of the outside directors in relation to the quality of supervising board members. The board of directors consists of inside directors and outside directors. An alert board of directors proactively participates in strategic decisions; asks management though questions; oversees the plans of the management, decisions and actions; and monitors the ethical conduct of the management, financial reporting and legal compliance of the management (Groot & Kuang, 2008). Solomon (2011) argued that the board of directors falls into two general models; one-tier and two-tier boards. The one-tier board structure is usually observed in countries that are influenced by the Anglo-Saxon style of corporate governance. These boards include both executive and non-executive (outside) directors and decisions are usually made together. In contrast, two-tier boards have two separate boards, a management board consisting solely of executives and a supervisory board consisting exclusively of non-executive (outside) directors. The management board focuses on operational issues, while the supervisory board deals with major strategic decisions and oversees the management board. Groot & Kuang (2008) argued that the separation of the two boards has improved the independence of the outside directors in their execution of the supervisory role.
directors. This influences the characteristics of the outside directors. Therefore, outside directors should be able to focus more on the monitoring function and should take decisions more easily compared to inside directors.
Compensation of outside directors
Actions of outside directors are not perfectly observable by shareholders due to the information asymmetry. Shareholders are often not aware of the actions that outside directors can take or which actions can increase the shareholders’ wealth. Therefore, the agency theory stated that compensation policy can be designed to give outside director incentives to select and implement actions to increase shareholders’ wealth. Shareholder wealth is affected by many factors, including actions of other managers and employees, demand and supply conditions, and public policy (Jensen & Murphy, 1990).
The compensation for outside directors has increased by 70 percent over the past five years, due to the growth of equity compensation, like stock and stock options (Bryan, Hwang, Klein, & Lilien, 2000). During the last decade a growing number of firms have awarded equity compensation to outside directors to enhance their performance (Ertugrul & Hegde, 2008). The growing barriers to monitor outside directors are the result of a growing equity compensation of outside directors (Feng, Ghosh, & Sirmans, 2007).
The total compensation of outside directors is divided in two parts, cash and equity compensation. The cash compenstion of outside directors comprises the annual cash payments, fees, and bonus amounts (Feng et al., 2007). The equity compensation of outside directors includes the stock option compensation and the stock compensation (Certo, Dalton, Dalton, & Lester, 2008). The total compensation of outside directors can be built up in many different ways (Groot & Kuang, 2008).
Deutsch, Keil, & Laamanen (2011) pointed out that outside directors often possess alternative income streams and are therefore less dependent on the income they receive from the local firm. This diversification in income should make the outside directors less risk-averse compared to inside directors, this leads to different decision-making in the board.
Cash compensation
working activities. Fees are paid to directors for attending board meetings or for chairing a committee (Ertugrul & Hegde, 2008; Bryan et al., 2000). The amount of fees depends on the number of board meetings in a year. When companies have a large amount of board meetings a higher amount of cash compensation per director will be registered (Bryan et al., 2000). The height of bonus amounts depends upon performance conditions, and divisional targets (Fattorusso, Skovoroda, Buck, & Bruce, 2007). Cash compensation of outside directors is not the most important compensation anymore. Brick, Palmon, & Wald (2006) have investigated that 38 percent of the compensation of outside directors is cash compensation, against 46 percent in 2000 (Focus, 2001). Beside this, cash compensation of outside directors may also result in an environment of nepotism where outside directors do not care about shareholders’ interest (Brick et al, 2006).
Equity-based compensation
Equity-based compensation is intended to align the incentives of outside directors and shareholders (Fich & Shivdasani, 2005). Therefore, incentive compensation for outside directors is typically equity-based (Linn & Park, 2005). Over the past five years equity-based compensation has increased a lot. This is because of the reducing of the agency problems and the enhancing of the firm performances due to the incentive-based compensation (Bryan et al., 2000; Ertugrul & Hedge, 2008; Groot & Kuang, 2008). Groot & Kuang (2008) stated that in the period between 2000 and 2002, an average outside director in a S&P 500 firm earns 59 percent of his/her compensation in equity-based incentives, mainly in the form of stock options. When equity-based compensation leads to a higher quality of supervision it would make sense to reward outside directors with a higher equity-based compensation. Equity compensation consists of the value of stock and their options (Feng et al., 2007). The value of outside directors’ stock compensation consists of the number of shares in the outside director compensation plan multiplied by the stock price at the end of the prior year (Certo et al., 2008). The value of outside directors’ stock option compensation consists of the number of stock options granted to an outside director during a firm’s fiscal year multiplied by the average value of a firm’s stock options granted to the company’s manager during that fiscal year (Deutsch, Keil, & Laamanen, 2007). Stock options are the only long-term incentives contained in the outside directors’ compensation plan (Gigliotti, 2013; Gomez-Mejia, Berrone, & Franco-Santos, 2010).
Shivdasani, 2005; Bryan et al., 2000; Hermalin & Weibach, 1998). The theory in which the use of incentive-based compensation is advocated in order to align the outside directors’ behaviors to the interest of shareholders rather than the interest of the outside director himself is called the agency approach (Groot & Kuang, 2008). Opponents, believe that excessively emphasizing incentive-based compensation will lead to behave outside directors in the same way as executives who are supposed to supervise. This will jeopardize the quality and independence of supervision. Firms in the UK rely more on the directors’ individual need for achievement, growth, and self-actualization, these elements are predominant motivators to work. These firms do not use incentive-based compensation. When a person becomes more senior in the company, money becomes less important as the predominant motivation to work (Groot & Kuang, 2008). Equity-based compensation also induce outside directors to favor more risky investment because they also gain alternative incomes. This makes the outside directors less dependent on the income of the local firm and makes the outside directors less risk averse compared to the inside directors (Ertugrul & Hegde, 2008; Deutsch et al., 2011). Furthermore, excessively relying on extrinsic motivations such as money may even conflict with intrinsic motivations and may involve adverse effects on performance outcomes. The strategy in which outside directors place higher value on cooperation in order to attain the company’s objectives instead of individualistic self-serving behavior is called the stewardship theory. In this theory, intrinsic motivations play an important role in motivating outside directors (Groot & Kuang, 2008).
There is a difference in the use of equity-based compensation between the U.S. and the UK. Firms in the U.S. use mostly incentive plans, like stock and stock options, to reach the optimal performances. However, in the UK they almost never use incentive plans to maintain the independency of supervision (Groot & Kuang, 2008). Because of the difference between these two countries, it is interesting to investigate the use of equity-based compensation in relation to the quality of supervision of outside directors in firms in the UK to see if there is a relation between these two variables. In the U.S. it worked out, so I assume that it is valuable to use equity-based pay in the UK to enhance the quality of supervision and with it the firm performance. If there is a relation between equity-based compensation and the quality of supervision it is important for all companies in the UK to reward their outside directors with equity-based compensation in addition to their cash compensation.
Mehran (1995); Becher, Campbell, & Frye (2005); Bryan et al. (2000); Ertugrul & Hedge (2008); Groot & Kuang (2008) show that the increase in the use of equity compensation for outside directors is associated with improved firm performance. A higher proportion of equity compensation leads to better firm performance. Besides this major advantage, higher equity compensation leads also to less agency problems (Bryan et al., 2000; Ertugrul & Hedge, 2008; Groot & Kuang, 2008), an increase in the monitoring of outside directors, and to the alignment of interest of outside directors and shareholders. (Hoi & Robin, 2004; Fich & Shivdasani, 2005; Bryan et al., 2000; Hermalin & Weibach, 1998). In contrast, a higher equity compensation for outside directors leads to growing barriers to monitor outside directors (Feng et al., 2007) and to less risk averse behavior of outside directors (Deutsch et al., 2011).
Quality of supervising boards
Outside directors do not have direct influences on the firm performance because the board of directors has to monitor the management, supervise the firm operation (Boumosleh, 2009), provide advice to the management (Hempel & Fay, 1994; Johnson et al., 1996; Zahra, 1990) hire and fire (new) board members, and determine the compensation of managers (Dalton & Daily, 2001). Outside directors influence the quality of supervision but cannot directly influence the firm performance. Therefore, it is important to know how efficient outside directors are.
efficiency of interest alignment between top managers and shareholders will be investigated. Secondly, the efficiency of replacing incapable managers will be investigated.
Efficiency of interest alignment
The fundamental objective of a publicly-traded firm is to maximize shareholder wealth. However, outside directors seek to maximize their individual utility to increase their total compensation. Compensation plans are used to solve these agency problems. Incentive-based payment is a component of compensation plans. The compensation plans stimulate managers to make decisions that are beneficial to the shareholder by providing a direct link between realized compensation and firm stock price performance (Wallace, 1997; Gigliotti, 2013; Hall & Murphy, 2003). Therefore, offering equity-based compensation represents an effective method for reducing the gap between the interests pursued by the top managers and shareholders (Gigliotti, 2013). The possession of stock options is not only an instrument to reduce the gap between the interests of the principal and the agent but also an instrument which links the compensation of outside directors to firm performance. However, Groot & Kuang (2008) argued that equity-based compensation jeopardizes the quality and independence of supervision boards that leads to an inefficiency of interest alignment.
Total compensation plans include more and more stocks and stock options to decline the agency problems in firms in the U.S. This leads to a higher quality of supervision and consequently stronger firm performance. However, incentive-based payment in the UK is not very popular. Therefore, it is interesting to investigate the equity-based compensation in relation to the quality of supervision of outside directors in the UK. If there is a relation between these two variables, this might have a major impact on the compensation of outside directors in the UK. I expect that when equity-based compensation is applied, the gap between the top managers and the shareholders decline and the interest alignment between these two parties increased. This is also the case in the U.S (Groot & Kuang, 2008; Ertugrul & Hedge, 2008). So it is interesting to investigate if this relation also exists in the UK. This research examines the positive relation between equity-based compensation and the relation between top managers and shareholders, called interest alignment, where the level of interest alignment is measured by pay-performance sensitivity (PPS) (Jensen & Murphy, 1990; Conyon, Peck, Read, & Sadlaer, 2000). This leads to the first hypothesis:
I predict that when there is a high proportion of equity-based compensation, outside directors will take more decisions in the interest of shareholders which lead to a decrease in the gap between top managers and shareholders. This means a higher quality of supervision and stronger firm performances. For example, when the compensation plans of outside directors consist mainly of cash compensation the focus should be on their own compensation. This leads to a bigger gap between the top managers and the shareholders. When outside directors receive equity-based compensation, the performances are more focused on the shareholders’ wealth. This leads to a stronger relationship between the top managers and the shareholders and causes a higher interest alignment.
Efficiency of replacing incapable managers
Dismissals are a unique form of involuntary turnover whose causes differ from those of voluntary dismissals such as retirements (Friedman & Singh, 1989). The effects of dismissal can be disruptive, renewing, or of no consequence, but an understanding of the effects of dismissal must begin with its causes (Fredrickson, Hambrick, & Baumrin, 1988). Unnecessary dismissals lead to an economic waste of shareholders, managers and the society.
The board of companies with more inside than outside directors should retain more power over the board and, in turn, should be less likely to face replacement when firm performances are bad. Therefore, firm performances and the composition of the board of directors influence both the dismissal of managers (Boeker, 1992). It is not surprising that managers of companies that perform well enjoy longer tenures and have a lower chance of dismissal than managers of companies that perform badly (Lieberson & O’Connor, 1972; Helmich, 1977). The analysis of Jenter & Lewellen (2010) uncovers the large effects of firm performance on CEO turnover in the U.S. They investigated that during the first two years of tenure, 23 percent of the CEOs with performances in the bottom quintile left their job, compared to only 2 percent of the CEOs in the top quintile. At the end of year four, 52 percent of the CEOs with performances in the bottom quintile have left, compared to only 8 percent of the top quintile. So the performances of CEOs have a strong influence on the turnover.
Managers suffer only a short negative period in their operating performance followed by a quick recovery when boards of companies early fire managers. In contrast, when boards fire managers at a later date, operating performance take several years to recover. Also, boards that wait to discharge their CEO are 4 percent more likely, compared to boards that discharge their managers early, to end up in bankruptcy and 8 percent more likely to delist their stocks (Martin & Combs, 2011).
Agency theorists have argued that the board act only as an effective governing and monitoring mechanism if it is independent (Fama, 1980). Outside directors fulfill this monitoring role more effectively because inside directors’ objectivity will be impaired by their dual role as full-time managers. Therefore, the higher the amount of inside directors in the board, the higher the probability that the board will be dominated by the management of the companies (Fama & Jensen, 1983). The monitoring task of the outside director and the influences on the board should make the CEO retention decision more sensitive to the firm performance. This is the reason that firms with an outside director should display higher CEO turnover-performance sensitivity. However, Groot & Kuang (2008) argued that when outside directors are rewarded with equity-based compensation and become more senior in the company, money becomes less important as the predominant motivator to work. This means that the outside director does not follow the strict rules because the extra incentive compensation is not so attractive anymore. This results in the inefficiency of replacing incapable managers.
Fama & Jensen (1983) stated that outside directors fulfill their role more effectively than inside directors. Outside directors are more independently in their activities and will therefore more easily dismiss managers. This should only be the case if outside directors are supported to work in the interest of shareholders. To mitigate the agency problems, compensation plans include more and more equity-based compensation that leads to a higher quality of supervision and stronger firm performance. This method is often applied in the U.S. In the UK they almost never use equity-based compensation. So it is interesting to investigate the relationship between the equity-based compensation of outside directors and the CEO turnover. To discover if the compensation package for outside directors in the UK plays an important role in reaching a higher level of supervising quality. This research examines the positive relation between equity-based compensation of outside directors and the performance-induced CEO turnover. This leads to the following hypothesis:
I predict that when the amount of equity-based compensation is high the performance-induced CEO turnover will also be high. Because, if the equity-based compensation of outside directors is high, the performances of this outside director will be more focused on the whole company instead of only their own compensation. The outside director takes the right decisions that means that incapable managers will be dismissed and creates a higher CEO turnover. When the equity-based compensation of outside directors is low outside directors are more focused on their own compensation. This results in decisions of outside directors which are not focused on the performance of the company. This means that incapable managers will be longer on their seat compared to the situation in which outside directors will be paid by equity-based compensation.
A summary outline of the theoretical model is provided below in Figure 1:
METHODOLOGY
number of firm-year observations considered for analysis is 35 years. This gap has emerged due to firms that do not use equity compensation and the exclusion of companies that did not report complete historical data regarding the equity-based compensation and the quality of supervision. The composition of the companies surveyed is shown in Table 1. This research is focused on an UK dataset because it is interesting to know if equity-based compensation to outside directors has a positive relationship on the quality of supervision, because firms in the UK almost do not use equity-based compensation. The UK dataset is a dataset which gives high detailed information about the managerial compensation as compared to the U.S. Why this research is focused on listed companies is because equity-based compensation like stock options is more common in larger, listed companies (Smith & Watts, 2001).
First, I will test the determinants of equity compensation to outside directors. I will also test if there is a fundamentally difference between companies that use equity compensation and companies that do not use equity compensation. For these tests I use an Ordinairy Least Squares (OLS) model analysis, a Tobit regression analysis, a t-test and a Mann-Withney U test.
To test the determinants of equity compensation of outside directors, I use the following empirical model:
Equity_Rat = β0ij + β1Ln_Firmsizeij,t + β2Growthij,t + β3Leverageij,t + β4DummySmallCapij,t +
β5Mark_Retij,t + β6ROAij,t + β7Earn_Per_Shareij,t + β8Board_Sizeij,t + β9Board_Indepij,t +
β10DummyDualityij,t + β11Insti_Ownerij,t + β12Large_Holdingij,t +
β13Quoted_Board_Date_Supij,t + β14Quoted_Board_Currentij,t + β15Years_Sector_Supij,t +
β203_Year_Attri_Supij,t + β21Succession_Fact_Supij,t + β∑DummyYearij,t +
β∑DummyIndustry ij,t.
The independent variables: firm size (Ln_Firmsize), growth (Growth), leverage (Leverage), small cap (DummySmallCap), firm performance (Mark_Ret, ROA, Earn_Per_Share), board characteristics (Board_Size, Board_Indep, DummyDuality, Insti_Owner, and Large_Holding) and supervisory board characteristics (Quoted_Board_Date_Sup, Quoted_Board_Current,
Years_Sector_Sup, Years_Board_Sup, Age, Education, 1_Year_Attri_Sup, 3_Year_Attri_Sup, and Succession_Fact_Sup) could have an influence on the use of equity
compensation. The control variables (DummyYear and DummyIndustry) are strongly influences values. They are held constant to test the relative impact of the independent variables.
Based on the theoretical model in Figure 1, this research uses the following two empirical models to test the first hypothesis:
LnCEO_Tot_Comp_Wins = β0ij + β1Firm_Perfij,t + β2Equity_Ratij,t +
β3Firm_Perfij,t*Equity_Ratij,t + β4Years_Role_CEOij,t + β5Years_Board_CEOij,t +
β6Years_In_Org_CEOij,t + β7DummyDualityij,t + β8Quoted_Board_Currentij,t + β9Ageij,t +
β10Educationij,t + β11DummyGenderij,t + β12Ln_Firmsizeij,t + β13Growthij,t + β14Leverageij,t +
β15Board_Sizeij,t + β16Board_Indepij,t + β17Insti_Ownerij,t + β18Large_Holdingij,t +
β19DummySmallCapij,t + β∑DummyYear ij,t + β∑DummyIndustry ij,t.
LnCEO_Tot_Wealth_Wins = β0ij + β1Firm_Perfij,t + β2Equity_Ratij,t +
β3Firm_Perfij,t*Equity_Ratij,t + β4Years_Role_CEOij,t + β5Years_Board_CEOij,t +
β6Years_In_Org_CEOij,t + β7DummyDualityij,t + β8Quoted_Board_Currentij,t + β9Ageij,t +
β10Educationij,t + β11DummyGenderij,t + β12Ln_Firmsizeij,t + β13Growthij,t + β14Leverageij,t +
β15Board_Sizeij,t + β16Board_Indepij,t + β17Insti_Ownerij,t + β18Large_Holdingij,t +
β19DummySmallCapij,t + β∑DummyYear ij,t + β∑DummyIndustryij,t.
Where i, j denote year and chief outside director (company), respectively;
Equity_Rat = outside directors’ equity linked compensation in proportion to the outside
directors’ direct compensation;
Firm_Perf = firm performance measurements;
Equity_Rat is outside directors’ equity linked compensation in proportion to the outside
directors’ direct compensation as measured for firm i by the end of year t. Firm_Perf measures the performance of firm i during year t by the market return (Mark_Ret), return on assets (ROA), and the earnings per share (Earn_Per_Share). The control variables β4, β5, β6,
β7, β8, β9, β10, β11, β12, β13, β14, β15, β16, β17, β18, β19 (Years_Role_CEO, Years_Board_CEO,
Years_In_Org_CEO, DummyDuality, Quoted_Board_Current, Age, Education, DummyGender, Ln_Firmsize, Growth, Leverage, Board_Size, Board_Indep, Insti_Owner, Large_Holding, DummySmallCap, DummyYear, and DummyIndustry) are strongly influences
values. They are held constant to test the relative impact of the independent variables. I include a dummy variable for the years 2003-2009, to compare the figures with the year 2002, and I include a dummy variable for the twelve industries.
A significant positive β3 would imply that performance-based compensation to outside
directors motivate a higher quality of supervision, suggested by greather interest alignment of CEOs and shareholders (i.e., higher PPS). In contrast, a significant negative β3 would
indicate that performance-based compensation diminishes directors’ intrinsic motivation and the quality of supervision deteriorates with the performance-based pay. These two tests are carried outby an OLS model.
To investigate the efficiency of replacing incapable managers, the following empirical model will be adopted:
logit[Pr(Yij,t =1)] = β0ij + β1Firm_Perfij,t + β2Equity_Ratij,t + β3Firm_Perfij,t*Equity_Ratij,t +
β4Years_Role_CEOij,t + β5Years_Board_CEOij,t + β6Years_In_Org_CEOij,t +
β7DummyDualityij,t + β8Quoted_Board_Currentij,t + β9Ageij,t + β10Educationij,t +
β11DummyGenderij,t + β12Ln_Firmsizeij,t + β13Growthij,t + β14Leverageij,t + β15Board_Sizeij,t
+ β16Board_Indepij,t + β17Insti_Ownerij,t + β18Large_Holdingij,t + β19DummySmallCapij,t +
β∑DummyYearij,t + β∑DummyIndustryij,t
Where i, j denote year and chief outside director (company), respectively;
Yij,t = CEO turnover taking place in year t.
The variables are defined as before. A significant β3 suggest that performance-based
compensation to outside directors influences the efficiency of the board in replacing incapable managers. More specifically, a significant negative β3 would imply that
performance-based compensation to outside directors is associated with a higher efficiency, because β3 should be negative when a CEO turnover takes place (Yij,t =1), this leads to a
low efficiency of removing incapable managers, because a CEO should not be replaced when the performances are bad. This test is carried out by a Binary Logistic Regression.
Dependent variables
The total compensation of a CEO (LnCEO_Total_Comp_Wins) is the direct compensation together with the equity linked compensation. In the dataset is the direct compensation the sum of the salary and bonus amount. The CEO total wealth (LnCEO_Total_Wealth_Wins) is the value of the cumulative holdings over time of stock, options and LTIPs for the individual director, the executive directors and or the supervisory directors (total equity linked wealth = value of total shares held + value of LTIP held + estimated market value of options held). The CEO turnover is a dummy variable. A variable of 1 if the CEO changed in the current year, and equals zero otherwise.
Independent variables
The firm performances (Firm_Perf) are measured by the market returns (Mark_Ret), the return on assets (ROA), and the earnings per share (Earn_Per_Share). The market return is the one-year buy-and-hold return. ROA is computed by the net income divided by the total assets. ROA explains how efficient management is by using its assets to generate earnings. If the ROA is higher, the company managed more efficient. ROA is displayed as a percentage. The earnings per share is the company’s profit divided by its number of outstanding shares. The equity to cash ratio (Equity_Rat) as defined before is the outside directors’ equity linked compensation in proportion to the outside directors’ direct compensation.
Interaction terms
β3 Is an interaction term, which consists of three measures. The variables of the firm
performances are multiplied by the equity to cash ratio. The three measures of firm performances are market returns (Mark_Ret), return on assets (ROA), and the earnigns per share (Earn_Per_Share). The interaction terms are Mark_Ret*Equity_Rat, ROA*Equity_Rat, and Earn_Per_Share*Equity_Rat.
This research includes several control variables. These variables are held constant because they have strong influences on the values and to test the relative impact of an independent variable. First I control for the length of time the director has been in the current role (Years_Role_CEO). When the director is a longer time in the company it is normal that he earns a higher amount of compensation, this can have influences on the amount of equity compensation. Second, I control for the years that the director is on the board of the company (Years_Board_CEO). When a director is longer on the board he has more experience and is rewarded by a higher compensation, this can have influences on the amount of equity compensation of outside directors. Third, I control for the years that a director is in the company (Years_In_Org_CEO). When a director is longer in the company, he has more experience and the longer the director is in the company the higher his reward, which can have influences on the amount of equity compensation. Fourth, I control for the duality (DummyDuality). Duality is a dummy variable which indicates if a CEO is also chairman of the company or not.
Fifth, I control for the quoted boards currently (Quoted_Board_Current). The quoted boards currently are the total for all directors of the quoted boards that they currently sit on, divided by the number of directors. Sixth, I Control for the age of the directors (Age). The older the director the higher his rewards which has influence on the equity compensation. Seventh, I control for the directors’ education (Education). When directors have more academic and professional accreditations it is normal that they earn a higher reward which can have influence on the amount of equity compensation. Eighth, I control for the gender of the directors (DummyGender). As common, men earn more than women, because of that it is naturally that the equity compensation of men is higher than women.
Ninth, I control for the size of the firm (Ln_Firmsize). Firm size is measured by the market value. The market value is the price at which an asset would trade in a competitive auction setting. The higher the market value the higher the rewards can be which has influences on the amount of equity compensation. Tenth, I control for the growth of the firm (Growth). The growth is measured by the market to book ratio (MtB). The market to book ratio is the market value of the firm divided by the book value of the firm. The market to book ratio measured the performance of the business. A higher market to book ratio means an overvalued company with has enough earnings. If this ratio is high you can also share more equity-based compensation to the outside directors.
assets divided by the total assets minus the total liabilities plus the total assets). A firm with significantly more debt than equity is considered to be highly leveraged. When a firm has more debt it has a higher probabilty to reward the directors with a higher remuneration. Twelfth, I control for the board size of the company (Board_Size). When there are more board members on the board, the success should be greather (Dalton & Dalton, 2005) which influence the reward of the board members. Thirteenth, I control for the independency of the board (Board_Indep). The board independence is measured by the number of outside directors divided by the board size. When board members are more independence, they take easier decisions which can results in more success and influence the reward of the directors. Fourteenth, I use institutional ownership (Insti_Owner) as a control variable. Institutional ownership is measured as the total percentage of ownership held by institutional investors. Fiftheenth, I control for the largest holding (Large_Holding). The largest holding is measured as the total percentage of shares owned by the largest owners. Sixtheenth, I control for small cap. I made a small cap dummy (DummySmallCap) which we can divide in small cap and non-small cap.
EMPIRICAL RESULTS AND DISCUSSIONS
Descriptive statistics
average outside director in the U.S. earns 59 percent of his/her compensation in an equity-based compensation (Groot & Kuang, 2008). The mean of the total compensation of the CEO (CEO_Tot_Comp) is 1,856,367.391 British pounds and the mean of the total wealth of the CEO (CEO_Tot_Wealth) is 17,509,051.630 British pounds.
I have made natural logarithm variables of the total compensation of the CEO (CEO_Tot_Comp), total wealth of the CEO (CEO_Tot_Wealth), and the firm size (Ln_Firmsize). These variables have an immense range. The difference between the lowest and highest amount do not say much. The natural logarithm transformation is used to obtain a more homogeneous variance of series (Lütkepohl & Xu, 2010). I have winsorized the dependent variables CEO_Tot_Comp and CEO_Tot_Wealth because these variables have a wide spread. I have winsorized the variables by top and bottom with 1 percent.
The Pearson correlation matrix is depicted in Table 4. Except for Mark_Ret*Equity_Rat,
ROA*Equity_Rat, and Earn_Per_Share*Equity_Rat, most variables are not highly correlated
Main results
I have used an Ordinary Least Squares (OLS) model and a Tobit regression model to test the determinants on equity compensation of outside directors. Table 5 presents the results of the OLS test. The R-Square and the Adjusted R-Square are low. The regression line approximates the real data points by 6.0 percent. Industry dummy and year dummy variables are included in this test, but are not shown.
As shown in Table 5, the variable Years_Sector_Sup has a strong positive relationship with the equity to cash ratio at the 1 percent significance level. The variable Years_Board_Sup has a negative relationship with the equity to cash ratio at the 5 percent significance level.
negative relationship with the equity to cash ratio (p<0.10). I have not enough evidence to conclude a relationship between the other variables and the equity to cash ratio.
Table 6 presents the regression analysis between the independent variables and the dependent variable Equity_Rat one at a time. The regression coefficient of
Succession_Fact_Sup is 1.126 (P<0.05), suggesting a significant positive relationship
between Succession_Fact_Sup and equity to cash ratio. The variables Leverage and
Board_Size have a weak positive relationship and the variable Age has a weak negative
relationship with the equity to cash ratio at the 10 percent significance level. I have not enough evidence to conclude a relationship between the other variables and the equity to cash ratio.
are left censored, none of the records are right censored, and 37 records are uncensored observations. As shown in Table 7, the coefficient of 3_year_Attr_Sup is 0.404 (P<0.01), suggesting a significant strong positive relationship between 3_year_Attr_Sup and equity to cash ratio. All other variables have no relationship with the equity to cash ratio at the 10 percent significance level. These results should treat with care because the data is censored. Industry dummy and year dummy variables are included in the test, but are not shown.
Table 8 presents summary statistics divided in firms that pay equity compensation to their outside directors versus firms that do not pay equity compensation to their outside directors. I conclude that the mean of Leverage is higher for equity-based compensation firms than for non-equity compensation firms. This does also apply to the variables Board_Size,
Years_Sector_Sup, 1_Year_Attri_Sup, and 3_Year_Attri_Sup. The mean of Insti_Owner is
higher for non-equity compensation firms than for equity-based compensation firms. This does also apply to the variables Large_Holding and Age.
their outside directors. The t-test is a parametric test of the joint equality of means of each variable across the two samples. I conclude that differences in the mean exist between the two samples for the variables Insti_Owner, Age, 3_Year_Attri_Sup, and
Succession_Fact_Sup at the 1 percent significance level. Also differences in the mean exist
The Mann-Whitney U test is a non-parametric test with less stringent assumptions that examines the joint equality of medians of each variable across the two samples. The Mann-Whitney U test shows a difference in the median for all variables. However, only the variables Board_Size, Insti_Owner, Age, 3_Year_Attri_Sup, and Succession_Fact_Sup have enough evidence at the 1 percent significance level to conclude that there is a difference in the median grades of the two samples. Large_Holding has enough evidence at the 5 percent significance level to conclude that there is a difference in the median grades of the two samples. Board_Indep has enough evidence at the 10 percent significance level to conclude that there is a difference in the median grades of the two samples. I have not enough evidence for all other variables to conclude a difference in the mean or median of the two samples.
I conclude that differences exists in seven variables of the test between firms that pay equity-based compensation to their outside directors and firms that do not pay equity-equity-based compensation to their outside directors.
Interest alignment
I have used an OLS model to test the influence of equity compensation of outside directors on the interest alignment between top managers and shareholders, measured by the pay-performance sensitivity. First, I have analyzed an OLS model with as dependent variable the total compensation of the CEO (LnCEO_Tot_Comp_Wins). Secondly, I have analyzed an OLS model with as dependent variable the total wealth of the CEO (LnCEO_Tot_Wealth_Wins). This part of the analysis shows three tables. These three tables present each the effect on one of the interaction terms.
Table 9 presents the results of the OLS model with the interaction term
Mark_RetxEquity_Rat. The total compensation of the CEO shows a higher R-Square and
Adjusted R-Square. The R-Square shows that the regression line approximates
LnCEO_Tot_Comp_Wins and LnCEO_Tot_Wealth_Wins with 63.5 percent and 48.6 percent,
Table 9 also presents the effect of the interaction term Mark_RetxEquity_Rat on the independent variables in relation to the dependent variables (LnCEO_Tot_Comp_Wins and
LnCEO_Tot_Wealth_Wins). Column “p-value” shows that the interaction term has no
relationship with the two dependent variables at the 10 percent significance level. The control variables Years_Role_CEO, Quoted_Board_Current, Board_Size, Board_Indep, and
Ln_Firmsize have a strong positive relationship with the dependent variable LnCEO_Tot_Comp_Wins at the 1 percent significance level. The control variables DummyDuality, Growth, and Leverage have a strong negative relationship with the variable LnCEO_Tot_Comp_Wins at the 1 percent significance level. The control variable Education
has a significant negative relationship with LnCEO_Tot_Comp_Wins (P<0.05) and the variable DummyGender has a significant weak negative relationship with
LnCEO_Tot_Comp_Wins (P<0.10). The control variables Years_Role_CEO, Years_Board_CEO, Ln_Firmsize, Growth, and Leverage have a strong positive relationship
variable Board_Indep has a significant positive relationship with LnCEO_Tot_Wealth_Wins (P<0.05).
The results of the OLS model with the interaction term ROAxEquity_Rat are reflected in Table 10. The total compensation of the CEO shows a higher Square and Adjusted R-Square. The R-Square shows that the regression line approximates
LnCEO_Tot_Comp_Wins and LnCEO_Tot_Wealth_Wins with 63.5 percent and 49.5
percent, respectively. The Adjusted R-Square shows that all the variables explain 62.7 percent of the variability of the dependent variable LnCEO_Tot_Comp_Wins and 48.5 percent of the dependent variable LnCEO_Tot_Wealth_Wins. Industry dummy and year dummy variables are included in this test, but are not shown.
Table 10 also shows the effect of the interaction term ROAxEquity_Rat on the independent variables in relation to the dependent variables (LnCEO_Tot_Comp_Wins and
LnCEO_Tot_Wealth_Wins). Column “p-value” shows that the interaction term has no
relationship with the two dependent variables at the 10 percent significance level. As shown in the table, the independent variable ROA has a significant weak positive relationship with
LnCEO_Tot_Wealth_Wins (P<0.01). The control variables Years_Role_CEO, Board_Size, Board_Indep, and Ln_Firmsize have a strong positive relationship with the dependent
variable LnCEO_Tot_Comp_Wins at the 1 percent significance level. The control variables
DummyDuality, Growth, and Leverage have a strong negative relationship with the
dependent variable LnCEO_Tot_Comp_Wins at the 1 percent significance level. The variable Quoted_Board_Current has a significant positive relationship with LnCEO_Tot_Comp_Wins (P<0.05) and the variables Education and DummyGender have a significant weak negative relationship with the dependent variable LnCEO_Tot_Comp_Wins (P<0.10). The control variables Years_Role_CEO, Years_Board_CEO, Ln_Firmsize, and Leverage have a strong positive relationship with the dependent variable LnCEO_Tot_Wealth_Wins at the 1 percent significance level. The control variables Age, Board_Size, Large_Holding, and
DummySmallCap have a strong negative relationship with LnCEO_Tot_Wealth_Wins at the
1 percent significance level. The variables Board_Indep and Growth have a significant positive relationship with LnCEO_Tot_Wealth_Wins (P<0.05) and the variable Insti_Owner has a significant negative relationship with LnCEO_Tot_Wealth_Wins (P<0.05).
Adjusted R-Square. The R-Square shows that the regression line approximates
LnCEO_Tot_Comp_Wins and LnCEO_Tot_Wealth_Wins with 63.6 percent and 50.0 percent,
respectively. The Adjusted R-Square shows that all the variables explain 62.8 percent of the variability of the dependent variable LnCEO_Tot_Comp_Wins and 48.9 percent of the dependent variable LnCEO_Tot_Wealth_Wins. Industry dummy and year dummy variables are included, but are not shown.
Table 11 also presents the effect of the interaction term Earn_Per_SharexEquity_Rat on the independent variables in relation to the dependent variables (LnCEO_Tot_Comp_Wins and
LnCEO_Tot_Wealth_Wins). Column “p-value” shows that the interaction term has no
relationship with the two dependent variables at the 10 percent significance level. The control variables Years_Role_CEO, Quoted_Board_Current, Board_Size, Board_Indep, and
Ln_Firmsize have a strong positive relationship with the dependent variable LnCEO_Tot_Comp_Wins at the 1 percent significance level. Farrell, Friesen, & Hersch
(2008) have also examined that if the firm size rises the total compensation also increases. The control variables DummyDuality, Growth, and Leverage have a strong negative relationship with the variable LnCEO_Tot_Comp_Wins at the 1 percent significance level. The variable Education has a significant negative relationship with the dependent variable
LnCEO_Tot_Comp_Wins (P<0.05) and the variable DummyGender has a significant weak
negative relationship with the dependent variable LnCEO_Tot_Comp_Wins (P<0.10). The control variables Years_Role_CEO, Years_Board_CEO, Board_Indep, Ln_Firmsize, Growth, and Leverage have a strong positive relationship with the dependent variable
LnCEO_Tot_Wealth_Wins at the 1 percent significance level. The control variables Board_Size, Large_Holding, and DummySmallCap have a strong negative relationship with LnCEO_Tot_Wealth_Wins at the 1 percent significance level. The variables Age and Insti_Owner have a significant negative relationship with LnCEO_Tot_Wealth_Wins
(P<0.05). The variable DummyDuality has a significant weak positive relationship and the variable Education has a significant weak negative relationship with
LnCEO_Tot_Wealth_Wins (P<0.10).
I conclude that no interaction effect exists between the equity to cash ratio and the firm performances; market return, return on assets, and earnings per share on the total compensation and wealth of the CEO. However, I conclude with enough evidence that several control variables have a relationship with the dependent variables
The analysis of the multicollinearity illustrates that almost all the variables are acceptable. Almost all Variance Inflation Factors (VIF) are below 10 which is the indicator of multicollinearity.
No interaction term shows a relationship between the equity to cash ratio and the firm performances on the total compensation and wealth of the CEO at the 10 percent significance level. Several control variables have a relationship with the dependent variables (LnCEO_Tot_Comp_Wins and LnCEO_Tot_Wealth_Wins). So I conclude that no moderating effect exists of equity pay of outside directors on pay-performance sensitivity. Because I do not find support for hypothesis 1, I reject the first hypothesis.
CEO turnover
The number of CEO changes is 206 times in our dataset. The number of no CEO changes is 1,303 times. This research has 331 missing values because it is unknown if the first year of each company in our dataset is a CEO change or not. The three tables in this part of the analysis present each the effect on one of the interaction terms.
The results of the Binary Logistic Regression analysis with the interaction term
Mark_RetxEquity_Rat are reflected in Table 12. Column “B coefficient” presents the
estimated effects on the logit. The higher this amount the higher the effect on the logit. As shown in the table, the interaction term Mark_Ret*Equity_Rat has no relationship with the dependent variable CEO_Turnover_Dummy at the 10 percent significance level. I conclude that the control variable Years_Role_CEO has a strong negative relationship with
CEO_Turnover_Dummy at the 1 percent significance level. The control variable Years_Board_CEO has a significant weak negative relationship with CEO_Turnover_Dummy
(P<0.10). I have not enough evidence to conclude a relationship between the other variables and the CEO_Turnover_Dummy. Industry dummy and year dummy variables are included in this test, but are not shown.
Table 13 presents the results of the Binary Logistic Regression analysis with the interaction term ROAxEquity_Rat. Column “B coefficient” presents the estimated effects on the logit. As shown in the table, the interaction term ROA*Equity_Rat has no relationship with the dependent variable CEO_Turnover_Dummy at the 10 percent significance level. The B coefficient of Years_Role_CEO is -1.582 (P<0.01), suggesting a significant strong negative relationship between Years_Role_CEO and CEO_Turnover_Dummy. The control variable
Years_Board_CEO has a significant weak negative relationship with CEO_Turnover_Dummy
(P<0.10). I have not enough evidence to conclude a relationship between the other variables and the CEO_Turnover_Dummy. Industry dummy and year dummy variables are included in this test, but are not shown.
The results of the Binary Logistic Regression analysis with the interaction term
Earn_Per_SharexEquity_Rat are reflected in Table 14. Column “B coefficient” shows the
estimated effects on the logit. As shown in the table, the interaction term
Earn_Per_Share*Equity_Rat has no relationship with the dependent variable
variable Years_Role_CEO has a strong negative relationship with CEO_Turnover_Dummy at the 1 percent significance level. The control variable Years_Board_CEO has a significant weak negative relationship with CEO_Turnover_Dummy (P<0.10). I have not enough evidence to conclude a relationship between the other variables and the
CEO_Turnover_Dummy. Industry dummy and year dummy variables are included, but are
not shown.
I conclude that no interaction effect exists between the equity to cash ratio and the firm performances; market return, return on assets, and earnings per share on CEO turnover. However, I conclude with enough evidence that two control variables have a relationship with the dependent variable CEO turnover. So I conclude that no moderating effect exists of equity pay of outside directors on CEO turnover. Because I do not find support for hypothesis 2, I reject the second hypothesis.
Robustness test
Because no relation is found between the equity compensation of outside directors and their quality of supervision, an extra measure of firm performance is used. The variable Tobin’s q (Tobin’s_q) is a measure of firm value (Perry, 2000) and can have an influence on the relationship between equity compensation of outside directors and their quality of supervision. With the variable Tobin’s q as firm performance, the OLS regression of the interest alignment and the Binary Logistic Regression of the CEO turnover were re-run. Table 15 and 16 present the results of these analyses. Although slight differences can be detected in the significance level of the coefficients, the main results are qualitatively consistent and robust.
Table 15 shows that the interaction term (Tobin’s_q*Equity_Rat) has also no relationship with the two dependent variables at the 10 percent significance level. The control variables
Years_Role_CEO, Quoted_Board_Current, Board_Size, Board_Indep, and Ln_Firmsize
have a strong positive relationship with the dependent variable LnCEO_Tot_Comp_Wins at the 1 percent significance level. The control variables DummyDuality and Leverage have a strong negative relationship with the variable LnCEO_Tot_Comp_Wins at the 1 percent significance level. The variables Education and Growth have a significant negative relationship with the dependent variable LnCEO_Tot_Comp_Wins (P<0.05) and the variable
dependent variable LnCEO_Tot_Wealth_Wins at the 1 percent significance level. The control variables Board_Size, Large_Holding, and DummySmallCap have a strong negative relationship with LnCEO_Tot_Wealth_Wins at the 1 percent significance level. The variable
Board_Indep has a significant positive relationship with LnCEO_Tot_Wealth_Wins (P<0.05).
The variables Age and Insti_Owner have a significant negative relationship with
LnCEO_Tot_Wealth_Wins (P<0.05). The variable Education has a significant weak negative
relationship with LnCEO_Tot_Wealth_Wins (P<0.10). Industry dummy and year dummy variables are included in this test, but are not shown. This results are almost the same as the results in the tests of the other interaction terms.
As shown in Table 16, the interaction term Tobin’s_q*Equity_Rat has no relationship with the dependent variable CEO_Turnover_Dummy at the 10 percent significance level. I conclude that the control variable Years_Role_CEO has a strong negative relationship with
CEO_Turnover_Dummy at the 1 percent significance level. The control variable Years_Board_CEO has a significant weak negative relationship with CEO_Turnover_Dummy
CONCLUSION
Firms in the U.S. use equity-based compensation to outside directors for several years. The use of equity-based compensation enhances the quality of supervision in the U.S. It is not clear if this relation also exists for the companies in the UK. Fewer firms in the UK use equity-based compensation to outside directors. This study has been one of the first to examine the influence of equity-based compensation on the quality of supervision in the UK. However, this research has investigated that equity-based compensation paid to outside directors do not significantly influence the quality of their supervision in the UK.
Considering the results on the interest alignment. No interaction effect exists between the equity to cash ratio and the firm performances; market return, return on assets, and earnings per share on the dependent variables LnCEO_Tot_Comp_Wins and
Quoted_Board_Current, Board_Size, Board_Indep, Ln_Firmsize, DummyDuality, Growth, Leverage, DummyGender, and Education, have a significant relationship with LnCEO_Tot_Comp_Wins and LnCEO_Tot_Wealth_Wins. Summarized, I have not enough
evidence to validate a relationship between equity compensation and interest alignment, because of that I have rejected the first hypothesis.
The results on the Binary Logistic Regression also presents no interaction effect between the equity to cash ratio and the firm performances; market return, return on assets, and earnings per share on the dependent variable CEO_Turnover_Dummy. Two control variables have a significant relationship with CEO_Turnover_Dummy. Summarized, I have not enough evidence to validate a relationship between equity compensation and the CEO turnover. Because of that, I have rejected the second hypothesis.
Totally, I have rejected both hypotheses so I conclude that there is no significant relationship between equity-based compensation and the quality of supervision of outside directors in the UK. Outside directors in the UK do not reach a higher quality of supervision by rewarding their performances with equity-based compensation.
Limitations and future research directions
The results are subject to limitations. First, I limit this study to the reliability of the data. The dataset consists of 2,055 firm-year observations. However, only 63 firm-year observations use equity compensation. Additionally, 28 firm-year observations do not provide sufficient information, so 35 firm-year observations are used for this research. This is 1,8 percent of the dataset which causes not a high reliability. Future research should investigate a higher amount of firms in the UK that reward their outside directors with equity-based compensation to show higher reliable results.
The second limitation relates to the data variables. For example, Feng et al. (2007) argued that cash compensation consists of the annual cash payment, additional fee, and bonus amounts. However, the variable equity to cash ratio is measured by the average equity linked compensation divided by the average direct compensation. The direct compensation from the dataset consists of the annual cash payment and the bonus amount. The additional fees are not measured in this variable. The results are more reliable when the direct compensation consists of the three parts (annual cash payment, additional fees, and bonus amounts). Future research should investigate more precise data in their dataset.
The results of this research are only focused on the UK and are not generalizable. This research shows that firms in the U.S. use equity-based compensation to reach a higher level of quality of supervision. However, this research has shown that this is not the case for firms in the UK and because of that it is very dependent for each country if this relation exists or not. My third recommendation for future research is to investigate the relationship between the use of equity-based compensation and the quality of supervision in an Asian country. When this relation is investigated in Asia, the results of the three countries can be compared with each other to reach a globally view about this topic.
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