‘Managerial power’ approach and market based research and the compensation of insider CEOs and outsider CEOs

‘Managerial power’ approach and market based

research and the compensation of insider CEOs and

outsider CEOs

A comparison between different theories on CEO compensation.

TJALLING EDUARD LYCKLAMA À NIJEHOLT

AFSTUDEERSCRIPTIE : MANAGEMENT, ACCOUNTING & CONTROL (DOCTORAAL)

JUNI 2016

RIJKSUNIVERSITEIT GRONINGEN

Abstract

This study focuses on the relationship between the type of CEO, defined as an insider CEO or

an outsider CEO, and total compensation. As controls in this relation, age, gender, firm size,

duality and different industries are defined.

The market based research, as described by Murphy & Zabojnik (2004), states that

CEOs are paid on their specific qualities. The market based theory shows a mixed view on

compensation for insider and outsider CEOs. It shows that the type of CEO that is needed,

and therefore receives the higher compensation, in a company depends on the characteristics

of the company.

The ‘managerial power’ approach as described by Bebchuck et al. (2002) describes the

‘power’ CEOs have in influencing their own compensation. Since executives who are

promoted internally have closer ties with their board of directors the theory implies that CEOs

who are promoted from within the company, the so called insiders, should earn more than

outsiders.

The conclusion from my research is that insider CEOs receive on average 13.16 %

higher compensation. This difference in compensation however is not significant. The

correlation between the variables type of CEO and total compensation is showing a small

positive correlation. This is consistent with the measured small, statistically insignificant,

advantage for insider CEOs in CEO compensation. The regression analysis shows that only a

very small part of the variances in total compensation is explained by the type of CEO.

The conclusion is that statements from the ‘managerial power’ approach and the

market based theory on which type of CEO earns the higher compensation have to be denied.

The type of CEO is of little influence to the total compensation of the CEO. And the

Index

Abstract ... - 2 -

Index ... - 3 -

1. Introduction ... - 5 -

§ 1.1 Motivation for the research ... - 5 -

§ 1.2. Research question ... - 6 -

§ 1.3. Set up of the research ... - 6 -

2. Theory and hypotheses ... - 8 -

§ 2.1. The market based theory ... - 8 -

§ 2.1.1. The reasoning of the theory ... Fout! Bladwijzer niet gedefinieerd. § 2.1.2. A comparison between the firm specific qualities of insider CEOs and the general management skills of outsider CEOs ... Fout! Bladwijzer niet gedefinieerd. § 2.1.3 A comparison between other qualities of insider CEOs and outsider CEOs... - 8 -

§ 2.1.4. Conclusions from the market based theory... - 10 -

§ 2.2. The ‘managerial power’ approach ... - 11 -

§ 2.2.1. The reasoning of the theory ... - 11 -

§ 2.2.2.Implications of the ‘managerial power’ approach for CEO compensation ... - 12 -

§ 2.3. Hypothesis derived from the literature on insider CEO and outsider CEO compensation . - 12 - § 2.4. Insider CEO and outsider CEO compensation in different lines of industry . Fout! Bladwijzer niet gedefinieerd. § 2.5. Controls ... - 13 -

§ 2.5.1. Introduction ... Fout! Bladwijzer niet gedefinieerd. § 2.5.2. CEO age ... - 13 -

§ 2.5.3. CEO gender ... - 13 -

§ 2.5.4. Firm size ... - 14 -

3. Methodology ... Fout! Bladwijzer niet gedefinieerd. § 3.1. The model ... Fout! Bladwijzer niet gedefinieerd. § 3.2. Data collection ... - 15 -

§ 3.2.1. Data ... - 15 -

§ 3.2.2. The data collection process ... - 15 -

§ 3.3. Making the used concepts ready for use ... - 16 -

§ 3.3.1. Introduction ... - 16 -

§ 3.3.2. The CEO ... - 17 -

§ 3.3.4. The type of CEO ... - 18 -

§ 3.3.5. Different lines of industry ... Fout! Bladwijzer niet gedefinieerd. § 3.3.6. The intermediate factors ... - 18 -

§ 3.4. Methodology ... - 18 -

§ 3.5. Boundary conditions of the research ... - 20 -

4. Results ... - 21 -

§ 4.1. Descriptives and t-test ... - 21 -

§ 4.1.1 Descriptives and t-test on total compensation ... Fout! Bladwijzer niet gedefinieerd. § 4.1.2 Descriptives and t-test on total compensation in the different lines of industry ... Fout! Bladwijzer niet gedefinieerd. § 4.2. The correlation matrix ... - 22 -

§ 4.3. Regression analysis ... - 24 -

5. Discussion ... - 25 -

§ 5.1. Discussion ... - 25 -

§ 5.2. Openings for future research ... - 27 -

1. Introduction

Executive compensation has long attracted a great deal of attention from academics, the media, congress and the public at large. The huge and unprecedented gains for senior executives of public companies are accompanied by a parallel rise in academic work on the subject. Indeed it appears that the rate of growth in such academic work has outpaced even the growth rate of executive

compensation (Bebchuck et al. 2002).

The mounting executive compensation gives the public a feeling of unfairness. In the period of 1970 to 2002, the ratio of CEO cash compensation to average pay for production workers increased from 25 to 90 (Murphy & Zabojnik, 2004). Base salaries and bonuses increased from an average of $700000 in 1970, in 2002-constant dollars, to over $2.2 million in 2000. During the same period the ratio of CEO cash compensation to average pay for production workers increased from 25 in 1970 to nearly 90 in 2000 (Murphy & Zabojnik, 2004). The accounting scandals, from which the Enron case is a prominent example has triggered this feeling of unfairness even further.

The firm is a nexus of contracts (Jensen & Meckling, 1976). One form of a contract within the firm is the contract between the CEO and the owners of the firm, the shareholders. The CEO promises to behave in the interest of the company, in terms of trying to maximize firm value, the shareholders promise the CEO compensation (Jensen & Meckling, 1976).

On one side it is of great strategic importance for organizations to have the best managerial talent in house. To achieve this one needs to pay high prices on the market for CEOs (Murphy & Zabojnik, 2004). On the other side it is important not to enlarge CEO compensation too much in order to keep their employees and the public at large in check.

We can conclude that CEO compensation is an important subject for organizations,

employees, politicians and the public at large. The subject is not as straightforward as it may look on first sight. It is of importance to gain insights in the factors that determine CEO compensation. A way of gaining insight into factors which are important in CEO pay is to divide CEOs in different groups with distinct characteristics and compare compensation between these groups. Insider CEOs and outsider CEOs are two groups of CEOs with distinct specific qualities, which will be described later in this research. Defining these qualities and comparing the pay for an insider CEO with an outsider CEO is of importance in defining which managerial qualities are important in the organization of today. This can also be used to gain insight in factors that determine CEO

There is however a discussion going on in the academic literature on the subject of insider CEO and outsider CEO pay. There are different theories about the amount of pay for insider CEOs and outsider CEOs.

One theory is the market based theory, the market based theory of CEO pay states that the amount of CEO pay is dependent on the specific qualities of the CEO and the relevance of these qualities for the organization. So according to the market based theory we can indeed compare the distinct characteristics of the different types of CEO in order to get an idea of the managerial qualities which are important in the organization of today.

The other theory is the ‘managerial power’ approach. This approach states that CEO pay is not so much dependent on the relevant qualities of the CEO but on the amount of power the CEO has within the organization to influence his own compensation.

§ 1.2. Research question

The research question in this investigation is:

Which factors explain the compensation of the insider CEO and the outsider CEO ?

In order to investigate this a comparison between the compensation of insider CEOs and outsider CEOs will be made. The literature will provide an overview of the reasoning behind the different theories on CEO compensation. This will give an idea of what determines CEO pay and what

characteristics are important for the CEO of the organization of today. The main hypothesis is derived from this literature overview. This hypothesis will be tested in the empirical research.

The research is based on the following idea: Type of CEO → CEO compensation

The research model will be more elaborately described and worked out in section 2.1.

§ 1.3. Set up of the report

theory. The other theory that will be presented is the ‘managerial power’ approach by Bebchuck et al. (2002). The alternative explanations for the relationship between the dependent and the independent factor will be attended to in the final section of the second chapter.

The third chapter will describe the methodology followed in the research. The data, the data collection process, the way of hypothesis testing and the statistical analyses which are used are explained. The final section of this chapter gives an overview of the boundary conditions of this investigation.

2. Theory and hypotheses

The research model is presented in figure 1.

(Figure 1: The Research Model)

In the following sections of this chapter the different parts of the model will be researched in literature. The ‘managerial power’ approach as described by Bebchuck et al. (2002) and the ‘market based’ approach as described by Murphy & Zabojnik (2004) show different views on the determinants of insider CEO and outsider CEO compensation. The different defined controls are also presented in the literature.

§ 2.2. Market based theory

§ 2.2.1. Market based theory and a comparison between characteristics of insider CEOs and outsider CEOs

The market based theory states that CEO compensation is determined by the market for CEOs. On this market different capabilities of CEOs have different prices and pay for a CEO is determined by the

qualities of the manager which are useful for the firm (Murphy & Zabojnik, 2004). Competition between different firms for CEO talent is given as a reason for the rise in CEO compensation levels.

According to the market based theory pay is next to the specific qualities of the CEO also linked to the performance of the CEO, in other words the value which is extracted, and measured, from the specific qualities of the CEO (Merchant & Van der Stede, 2003).

Insider CEOs generally serve longer than outsiders. In the departing class of 2005, insiders had an average tenure of about eight years, more than two years longer than that of outsiders. In the United States insiders’ tenure is about ten years, almost five years longer than that of outsiders. When the time in office stretches past fourteen years only a handful of outsiders remain. They deliver consistently lower results than their insider counterparts (Lucier et al. 2005).

Outsiders excel in shaking up a company: setting a different strategic direction, demanding higher levels of performance, reducing costs, disposing of underperforming assets, and communicating with investors. They bring more objectivity and a willingness to slaughter sacred cows, they benefit from outside business experiences, and they are often hired by a board anxious to make major changes. All of this gives them an edge in fast turnarounds (Lucier et al. 2005).

Outsiders represented 43 per cent of new CEO hires in 2005, up from 34 per cent in 2004 and 35 per cent in 2003, according to an annual survey of CEO departures among Fortune 500 companies. The trend towards hiring outsiders is mainly fuelled by the factors named above. Growing corporate governance concerns and a growing impatience by the board and the shareholders when CEOs do not perform, also play an important part in the hiring of more outsiders (Won, 2006).

While troubled companies are more likely to look for outsiders, the corporate governance movement also prompts healthy companies to look for new faces to fill in CEO positions (Won, 2006). Outsider appointment is not without risks. One of them is that the new chief won’t be able to convince the old guard to make needed changes. And while CEOs from the outside tend to flame at the start, they often later fizzle. ‘’The problem is that a lot of outsider CEOs are really turnaround artists, but not growing artists,’’ the senior vice president of the management consulting firm, Booz Allen Hamilton, Paul Korcourek says (Won, 2006).

Insiders, on the other hand, excel at driving long-term profitable growth and stimulating lasting change in a company’s culture and relationships. Insiders may also have a deep understanding of customers, technology, and operations gained through their years within (Lucier et al. 2005). In other words, the firm specific knowledge of the insider will benefit a company in the longer term, according to this study.

(Lucier et al. 2005) So the research of Lucier et al. (2005) claims a higher benefit for firm specific knowledge than the market based theory as described by Murphy & Zabojnik (2004).

Won (2006) reports, from conclusions of Booz Allen’s studies of CEO successions over eight years at the world’s largest 2500 public companies, that outsiders typically outperform insiders during the first half of their tenure and under perform in the second half.

Overall companies may often be better of appointing insiders. They have more allies and have established goodwill, whereas the new outsider CEO can be faced with overt or covert bitterness. A combination may also be the winning formula. Let the outsider work his magic for three years. In the meantime groom someone from the inside, that is the best of two worlds (Won, 2006).

Recruitment of CEOs from within also has another advantage. The possibility for top class employees within your organization to grow within the own organization will prevent that they will search for positions elsewhere. So to give them a shot at the CEO position may motivate them to stay within the company (Won, 2006).

Competition with outsiders for the CEO position can however be helpful in this perspective. For insiders this competition can be stressful, but if they succeed they have done so in the knowledge that they were compared to the best in their field (Gater, 2005).

McGinn (2005) states that boards are increasingly turning to outsiders to fill the CEO post. He is criticizing this approach. While shareholders want the board to pick the best candidate, imported talent inevitably costs more.

When former General Electric chairman Jack Welch had to choose between three General Electric subordinates to replace him, the two men he passed over wound up making better money than Jeff Immelt, General Electric’s current chairman. Welch says that if more companies developed future CEOs in-house, their pay checks might not be so high (McGinn, 2005).

§ 2.2.2. Conclusions from the market based theory

According to the market based theory on CEO compensation CEO salary is determined in the market for CEOs. Therefore one has to look at the specific qualities which insider CEOs and outsider CEOs have for firms (Murphy & Zabojnik, 2004).

understanding of customers, technology and operations (Lucier et al. 2005). The conclusion is that the preference for an insider CEO or an outsider CEO depends on the demand of the firm for long term growth or major change.

The market based theory therefore shows a mixed view on

compensation for insider and outsider CEOs. The type of CEO that is needed, and therefore

receives the higher compensation, in a company depends on the characteristics of the

company

§ 2.3. The ‘managerial power’ approach

§ 2.3.1. The reasoning of the theory

The market based theory as it was described by Murphy & Zabojnik (2004) was a reaction to another theory, the ‘managerial power’ approach. The ‘managerial power’ approach as described by Bebchuck et al. (2002) is a theory that describes the impact, the ‘power’, of CEOs on the board of directors. The ‘power’ can be used to influence the board on decisions concerning for example CEO pay.

The ‘managerial power’ approach as described by Bebchuck et al. (2002) is a reaction to agency theory. Agency theory as described by amongst others (Fama & Jensen, 1983, Fama & Jensen, 1983, Boatright, 1999, Conlon & Parks, 1990, Eisenhardt, 1988, Eisenhardt, 1989, Ross, 1973, Jensen & Meckling, 1976, Haris & Raviv, 1979, Wilson, 1968) makes the implicit claim that the board of directors deal in the interest of the owners of the company. The board is viewed as seeking to maximize shareholder value, with the compensation scheme being designed to serve this objective (Bebchuck et al., 2002). This claim made by the agency theory is attacked by the ‘managerial power’ approach. Agency theory forms an explanation for the rise in share payment for CEOs. Shares and share options can be used to align the interests of shareholders and CEOs.

While high taxes on

labour income reduced the attractiveness of cash compensation, options had a considerable

tax advantage since the 1950s.

Bebchuck et al. (2002) criticize the agency approach. Bebchuck et al. (2002) state that the board of directors is not acting in the interest of the shareholders. Bebchuck et al. (2002) seek to contrast the agency approach with an approach they label as the ‘managerial power’ approach. Analysis from this perspective focuses on the ability of executives to influence their own

that would be optimal for shareholders. This excess pay constitutes rents (Bebchuck et al. 2002).An alternative name for the ‘managerial power’ approach is therefore the rent extraction approach. According to the rent extraction theory, insider CEOs have more possibilities to do their own performance evaluation (Bebchuck et al. 2002).

Another alternative name for the ‘managerial power’ approach is the fat cat theory. The name fat cat theory can be explained by the hypotheses of the theory that managers use the board of

directors in order to give themselves large increases in pay at the expense of companies’ shareholders (Murphy & Zabojnik, 2004).

The combination of the CEO position and the chairman of the board position is named dualism. The possibilities of the CEO to extract rents are larger when he is also the chairman of the board of directors. Therefore a CEO who is also chairman of the board of directors should receive an even higher compensation, following the ‘managerial power’ logic.

§ 2.3.2.Implications of the ‘managerial power’ approach for CEO compensation

The ‘managerial power’ approach has a few important implications for the compensation of insider and outsider CEOs. The ‘managerial power’ approach claims that every CEO has the possibility of extracting rents, except for CEOs in a company with a dominating shareholder.

Since executives who are promoted internally have closer ties with their board of directors the theory implies that CEOs who are promoted from within the company, the so called insiders, should earn more than outsiders. This is a conclusion Murphy & Zabojnik (2004) draw from the ‘managerial power’ approach, as described by Bebchuck et al. (2002).

The literature on the ‘managerial power’ approach does make a clear statement on the

relationship between the type of CEO and the amount of compensation a CEO receives. When applied to the model presented in section 2.1., the independent factor, type of CEO has a clear influence on the dependent factor, CEO compensation. When the CEO is an insider he should on average earn higher pay according to this theory.

§ 2.4. Hypothesis derived from the literature on insider CEO and outsider CEO compensation

The hypothesis in this report is taken from the ‘managerial power’ approach. The ‘managerial power’ approach does make a clear statement on the relationship between the type of CEO and CEO compensation. CEOs hired from within the company, the so called insider CEOs should earn on average a higher compensation than their outsider CEO counterparts.

Hmain: Insider CEOs receive on average a higher amount of total compensation than outsider CEOs.

This hypothesis forms the main hypothesis in this research. The hypothesis is tested for the year 2004. In order to be able to test this hypothesis in an empirical research the ‘controls’ have to be addressed since these ‘controls’ are alternative explanations or factors that have a specific influence on the connection between the dependent and independent variable. The controls are discussed in paragraph 2.5.

§ 2.5. Controls

§ 2.5.1. CEO age

The human capital literature developed by Becker (1975) as quoted in Abaoub & Chourou (2006) suggests that employee attributes have important value for the employer, because they reveal their managerial talents. One important attribute is experience, which may be proxied by CEO age.

Therefore, by virtue of experience, older CEOs should be more remunerated than younger CEOs. This hypothesis is also supported by the research of Abaoub & Chourou (2006).

Because of the claimed influence of CEO age on CEO compensation, the variable

CEO age will also be used as a control.

§ 2.5.2. CEO gender

Gender is an important control. Mesch & Rooney (2004) found for example a large difference in both salary and bonus between men and women. Men were consistently paid more in both types of

compensation.

Associations, like other organizations, bear a responsibility to ensure that salary and benefits are fairly distributed across genders. For several years, ASAE’s Association Executive Compensation

Namely, women had significant lower compensation levels than men (Mesch & Rooney, 2004). For the CEO position the measured difference was also large.

Renner (2002) also describes the large pay gap between male and female top executives.

Gender pay equity has been a point of interest to the public as well as to business and economic researchers for many years. Recently, Catalyst, an organization established to promote women in business, reported that the gender pay gap among top corporate executives was significant with women executives paid only 68 percent of the earnings of their male counterparts (Renner, 2002).

Since there is a claimed difference in compensation between male and female compensation, gender is an important ‘control’ in the research.

§ 2.5.3. Firm size

Abaoub & Chourou (2006) state, that there is a positive relationship between firm size and

compensation. It is widely recognized, both in the academic research as well as in practice, that firm size is the most important determinant of executive compensation. The positive relationship between firm size and executive compensation has several explications rooted mainly in the economic theory, and the human capital theory. This relationship is also well documented in the empirical literature (Cordeiro and Viliyath, 2003; Carpenter and Sanders, 2002; Core et al, 1999; Tosi et al, 2000) as quoted in Abaoub & Chourou (2006).

Because of the claimed positive relationship between firm size and CEO compensation, this variable will also be taken as a control.

§ 2.5.4. Different industries

Compensation characteristics of managers differ between different lines of industry

(http://asianfa.org/Paper/Industries.pdf). This is dependent upon the characteristics of the industry. Different industries differ for example in the degree in which they are active in international business (http://asianfa.org/Paper/Industries.pdf). Another important factor in CEO compensation is the actual performance of the firms in the industry (Deckop, 1988).

3. Data and methodology

§ 3.1.1. Data

The dataset consists of the data on CEO compensation in the 493 largest firms in the United States of America measured by gross revenue, constituting the Fortune 500, in the year 2004.

(en.wikipedia.org/wiki/Fortune_500)

The dataset gives information on the company name and the industry in which the company is active. The different industries are defined by assigning an industry number to different industries. Industries which are defined in the dataset are energy, materials, industrials, consumer discretionary, consumer staples, health care, financials, information technology, telecommunication services and utilities. The salaries of insider CEOs and outsider CEOs in different industries will be compared.

Furthermore the dataset gives information on the position of the person within the company. CEO, Chief Financial Officer (CFO), other insider director and outsider director are defined as positions within the company. In this research the salary data of different types of CEOs is compared, so we are only interested in the data on the CEOs.

Birth year, CEO gender and total sales, measured in millions of dollars, of the firm in which the CEOs are active are other variables which are named in the dataset. These variables can also be determinants of CEO pay, and are included as dummy variables in the research model. The dataset also gives information on whether the CEO is hired from outside the company, or promoted from within. This information can be used in order to compute the salary levels of the two groups of CEOs.

The dataset gives information on total compensation which is used in the analysis since we want to compare the complete compensation package that the different types of CEO receive. Total compensation is composed out of base salary, bonus pay and stock options. The dataset also gives information on the amount of irregular pay, for the years 2003 and 2004. The set also states whether a CEO is hired from inside or from outside the corporation. Data for the year 2004 will be used.

§ 3.2.2. The data collection

Information on the directors in the directors in the 493 corporations has been found by research of the documents available on these companies. The SEC-filings have been used as a source of information.

Two forms of SEC-filings have been of particular interest, the DEF form and the 10K form. The DEF form provides information to the shareholders and is interesting because of the compensation and board structure information. The 10K form provides operational information on the corporation on an annual basis, there are also 10Q forms containing quarterly results. Here, the financial statements and statements on the corporation may be found; it can be compared to the annual report. So the DEF filings and the 10K filings have been used to find information on the compensation of directors and on firm specific variables.

The names of the directors in the different companies have been found by accessing the DEF filings at EDGAR company search (http://www.sec.gov/edgar/searchedgar/companysearch.html). In the ‘summary compensation table’ the names of the executives that serve on the board of the company have been found. In the ‘summary compensation table’ also the information on the compensation of the directors, including the CEO is found. The information on the base salary, bonus pay, option payment and irregular pay is taken for the years 2003 and 2004 are taken from this ‘summary compensation table’.

From the ‘summary compensation table’ also information on the position of the person within the company is taken. From this table it has been read who fills in the CEO position within the company.

The DEF forms contain some information on the background of the directors and executives. This information has been used to fill in director, and also CEO specific variables. Examples of this type of information are the gender, birth year, year of appointment, nationality, education and area of expertise.

§ 3.2. Making the used concepts ready for use

§ 3.2.1. Introduction

§ 3.2.2. The CEO

First the position of the Chief Executive Officer (CEO) has to be defined. Examples of definitions of this position are:

1. The highest-ranking executive in a company or organization, responsible for carrying out the policies of the board of directors on a day-to-day basis ( www.answers.com/topic/chief-executive-officer).

2. The executive who is responsible for a company's operations, usually the President or the Chairman of the Board (http://www.investorwords.com/851/Chief_Executive_Officer.html).

For the analysis in the empirical research it is important to state that only one of the executives in each company is the Chief Executive Officer. The salary information of this person is used for the analysis. The Chief Executive officer is the one executive responsible for the company his operations and the person responsible for carrying out the policies of the board of directors on a day-to-day basis. In the dataset the position of the CEO is defined by the variable position. The position CEO has the number 0 in the dataset.

§ 3.2.3. CEO compensation

The dependent factor in this research is CEO compensation. CEO compensation consists of different components. The most important part of their compensation constitutes incentive pay.

Merchant & Van der Stede (2003) notice three separate components of the financial reward for CEOs. The first component is base salary; base salary is paid regardless the performance of the CEO. Base salary has become a smaller percentage of total compensation over the years. Next to base salary there are two variable components of total salary, namely bonuses and stock options. These

components couple the reward of the CEO to the performance of the CEO.

So in this investigation the three different components, base salary, bonus pay and stock options, defined by Merchant & Van der Stede (2003) are used. CEOs are next to the components defined by Merchant & Van der Stede (2003) also compensated in distributed shares and also receive irregular pay. The sum of the components defined by Merchant & Van der Stede (2003) and value of distributed shares and the value of irregular pay forms the dependent factor, total CEO compensation, which is used in the analysis.

§ 3.2.4. The type of CEO

The group of CEOs active in the Fortune 500 in the year 2004 is divided into two groups. These two groups are the types of CEO, insider CEO and outsider CEO. An insider CEO is defined as a CEO who is hired from within the own company. So this person has experience within the company. An outsider CEO is a person who has no experience within the company. This person is hired from outside the company. In the dataset the type of CEO is determined by the variable internal hire. In this dataset, 0 means the CEO is hired from outside the company, 1 means the CEO worked in the

company before becoming a CEO.

§ 3.2.6. Controls

CEO age: The dataset gives information on the birth year of the different CEOs. This variable, birth year, is used as the measure of CEO age.

CEO gender: The gender of the CEO is pointed out by the gender variable. 0 means the CEO is a male, 1 means the CEO is a female.

Firm size: Firm size is determined by the variable total sales of the firm in the year 2004. The total sales figure is shown in millions of dollars.

Different industries: The different industries which are defined and are investigated on the salaries for insider CEOs and outsider CEOs are: energy, materials, industrials, consumer discretionary, consumer staples, health care, financials, information technology, telecommunication services and utilities.

Duality: The variable duality is defined by assigning the number 1 when the CEO is an insider and also chairperson of the board of directors. A 0 is assigned when the CEO is not an insider, and/or not the chairperson of the board of directors.

§ 3.4. Methodology

Not on all CEOs active in the Fortune 500 salary information is available in the dataset. CEOs on which no salary information was available have been left out of the analysis. This means that N=413 in the descriptives on the compensation of CEOs. On the variables birth year, total sales and internal hire less information was available. On these variables N is respectively 412, 400 and 405.

In the empirical analysis a model is used in which the total compensation is the dependent variable. The independent variables are the industries energy, materials, industry, consumer

discretionary, consumer staples, health care, financials, information technology, telecommunication services, utilities and the variables gender, duality, birth year, total sales and internal hire. Energy, materials, industry, consumer discretionary, consumer staples, health care, financials, information technology, telecommunication services and utilities are used as dummy variables. Duality, birth year, total sales are used as controls, forming an alternative explanation for the relationship between the variable internal hire and total compensation.

Data on the average values, minimum, maximum, standard deviation and skewness of the variables are computed in the descriptives. The dummy variables, energy, materials, industry, consumer discretionary, consumer staples, health care, financials, information technology,

telecommunication services, the control variable duality and the explaining variable internal hire are given a value of either 0 or 1. In the case of the dummy variable energy, the 0 meaning that the CEO belongs to the particular group of CEOs in the energy sector, and 1 meaning that the CEO does not belong to the group of CEOs in the energy sector. For the other variables the same pattern applies.

§ 3.5. Limitations of the research

The research and the conclusions which can be drawn from the research are limited for the following reasons:

● the research is limited to firms in the USA;

● only publicly listed firms are comprised in the research;

● a dataset of the Fortune 500 firms is used, firms falling outside the Fortune 500 are excluded from research;

● only the available data on the Fortune 500 firms could be used for this research, this means that less data than the data from all the 493 firms is used in the different analyses;

● only financial data is used, total utility for managers consists of pecuniary as well as non pecuniary benefits (Jensen & Meckling, 1976)

● the definition of duality that has been used actually is a combination between duality and internal hire. Only when a CEO is an internal hire as well as chairman of the board it has been defined as duality. This makes the actual measurement of duality which is the combination between chairman of the board and CEO somewhat impure.

4. Results

The data will be analysed with the use of statistical software. First a description of the data will be given. The subsequently following table gives a description of the mean, minimum, maximum, standard deviation, skewness and the amount of observations.

§ 4.2. Data transformation

The variables total compensation has to be normally distributed. Internal hire is used in the model as the explanatory factor for total compensation, the variable internal hire is given the number zero or one. The other variables are dummy variables. The Kolmogorov-Smirnov (KS-test) can show whether a variable is normally distributed.

Kolmogorov-Smirnov Z Asymp. Sig. (2-tailed) Total Compensation 4.640 0.000

Log Total Compensation 0.990 0.280

§ 4.3. Multicollinearity

* Correlation is significant at the 0.05 level (2-tailed). ** Correlation is significant at the 0.01 level (2-tailed).

Energy Materials INDUSTRY

Consumer Discretionary Consumer Staples Health Care Financials Information Technology Telecommunication

Services Utilities Duality

INTERN _HIRE

BIRTH_

YEAR GENDER Logsales04

§ 4.3. Test

In this section the main hypothesis in this report will be tested. This will be done with the help of a lineair regression analysis. Total compensation is the dependent variable in the analysis. The independent variables are energy, materials, industry, consumer discretionary, consumer staples, health care, financials, information technology, telecommunication services, utilities, gender, duality, birth year, total sales and internal hire.

Variable Model Total Compensation

Constant -9605122 Energy 3599181 Materials -833878 Industry 2413579 Consumer Discretionary 1922878 Consumer Staples 1794620 Health Care 1689431 Financials 1734944 Information Technology 1712588 Telecommunication Services 3672174 Utilities 397728.4 Gender 295069.5 Birth Year 6441.454 Duality 4063977 Internal Hire -1425267 N 405 R-square adjusted 0.061 F-value 2.601

5. Discussion

All the analyses have been done with the statistical data of the year 2004. The discussion and conclusion therefore also applies to this year. The descriptives showed that insider CEOs receive on average a total compensation which is 13.16 % higher than the total compensation for outsider CEOs. This difference in total compensation however proved not to be significant. The research question of this study is, Which type of CEO receives the highest compensation, the insider CEO or the outsider

CEO ? This leads to the main hypothesis of this thesis:

Hmainο: Insider CEOs receive on average a higher amount of total compensation than

outsider CEOs.

On the basis of the results from the t-test and the correlation matrix, the null hypothesis, insider CEOs

receive on average a higher amount of total compensation than outsider CEOs, cannot be accepted. The alternative hypothesis, that there is no relationship between the type of CEO and the amount of compensation, has to be adopted. Reflecting this to the theory, the conclusion must be that the statistical analyses in this thesis find little support for the hypothesis derived from the research of the ‘managerial power’ approach, as presented by Bebchuck et al. (2002), for this year.

There is also little support for the ‘market based’ theory as presented by Murphy & Zabojnik (2004). This theory states that CEO compensation is determined on the market for CEOs. Outsider CEOs should earn a higher compensation, since this group of CEOs has qualities which are more useful in the modern organization. Research on other theory comparing the specific qualities of insider CEOs and outsider CEOs already showed a mixed view.

possible explanation for the different conclusion in the financials sector can be that insider CEOs are more popular in established industries. In these sectors there is more need for CEOs who emphasize long term growth (Lucier et al. 2005). The financials sector is a typical example of a long existing established sector in which a focus on establishing long term growth results is likely.

The same logic applies for the materials sector and the consumer staples sector, in these sectors no outsider CEOs are active. The consumer staples sector and the materials sector are relatively old sectors, in which long term steady growth is important. Insiders excel at driving long-term profitable growth and stimulating lasting change in a company’s culture and relationships. Insiders may also have a deep understanding of customers, technology, and operations gained through their years within (Lucier et al. 2005).

The sectors industrials, utilities, information technology and telecommunication services show a diverging conclusion from the conclusion on the main hypothesis in another way. In these sectors outsiders receive a higher compensation. The difference in compensation between insider CEOs and outsider CEOs is in these sectors however also not statistically significant. Therefore we cannot state with an acceptable confidence level that the outsiders actually earn a higher compensation in these sectors. However the difference between the conclusions on the main hypothesis is remarkable.

An explanation for the deviating results in the information technology sector and the telecommunications services sector can be found in the literature on the comparison of specific qualities of insider CEOs and outsider CEOs. Outsiders excel in shaking up a company: setting a different strategic direction, demanding higher levels of performance, reducing costs, disposing of underperforming assets, and communicating with investors. They bring more objectivity and a

willingness to slaughter sacred cows, they benefit from outside business experiences, and they’re often hired by a board anxious to make major change. All of this gives them an edge in fast turnarounds (Lucier et al. 2005).

§ 5.2. Future research

This research has focused on the relationship between the type of CEO, defined as an insider CEO or an outsider CEO, and the compensation of CEOs. This relationship has also been researched in different lines of industry. The research focussed on the link between the type of CEO and the amount of total compensation the CEO gets. Focussing on the ‘managerial power’ approach which states that CEOs will extract rents since executives who are promoted internally have closer ties with their board of directors. My research showed that there was no obvious relation between the type of CEO and CEO compensation.

The analysis has limitations, which could be worked on in future research. In this research no distinction has been made between the difference in managerial power which managers from different companies can exert. This could also have an influence on the rent that a manager can extract. Most research that has been done on this topic has focused on formal board attributes, ownership structures, and CEO characteristics as measures of relative managerial power. These measures are much easier to observe than others that might have more validity, such as the actual decision-making processes of boards and how CEOs might actually influence these decisions. Some work has been done on this topic by for example (van Essen, Otten & Cranberry, 2012; O’Reilly & Main, 2010; Westphal & Stern, 2007) but clearly more work remains to be done.

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