T
HE
E
FFECTS OF
M
ANAGERIAL
P
OWER ON
E
XECUTIVE
S
TEALTH
C
OMPENSATION
by
Shu Li
MSc BA Organizational & Management Control
Thesis
(Words: 13, 128)
University of Groningen
Faculty of Economics and Business
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ABSTRACT
This paper provides a comprehensive theory to explain executive stealth compensation, which examines the associations between stealth compensation, managerial power, interest alignment, performance-induced CEO turnover, and firm performance. Based on the agency assumption that managers are self-interested as well as managerial power, the current study argues that stealth compensation can be a mechanism for powerful CEOs to extract rents from the shareholders. Using a sample from 242 UK listed firms, this study finds consistent evidence that: 1) managerial power is a determinant of stealth compensation; 2) greater use of stealth compensation is associated with weaker pay-for-performance sensitivity, less pay-for-performance-induced CEO turnover, and worse firm performance. The results indicate that confronted with outrage constraints powerful CEOs may rig stealth compensation for camouflage purpose and that stealth pay for those managers is detrimental to corporate governance.
Key words: Managerial power; Stealth compensation; Firm performance
Supervisor: dr. Bo Qin
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1. INTRODUCTION
Increasing number of academic papers pay attention to chief executive officers’ (CEOs) compensation package in the past many years (McConvill, 2006; Kuang and Qin, 2009; Minnick and Rosenthal, 2010; Victoravich, Buslepp, Xu and Grove, 2011; Agrawal and Nasser, 2012). Each component of executive compensation contract is studied carefully by large number of scholars and public investors. According to the Compdata Surveys’ “Executive Compensation 2012/2013” survey, executive perquisites play a significant role in total executive pay. Supplemental life insurance is the most common perk, offered to CEOs at 43.3% of companies surveyed. Other major perks include car allowance (36%), voluntary deferred compensation (31.2%), club memberships (25.3%), supplemental medical coverage (13.9%) and spousal travel allowance (8.2%). These perquisites are provided to CEOs nowadays by many firms. Companies offer them as a way to attract and retain strongest leaders originally. However, Bebchuk and Fried (2004) suspect the use of such perks, and name them as stealth compensation. This paper aims to explain the occurrence of stealth compensation though agency theory and managerial power theory.
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Bebchuk and Fried (2004) develop managerial power theory (MPT), which states that executive compensation can be viewed as a mechanism through which powerful chief executive officers extract rents from shareholders, rather than a resolution to principal-agent problem. The primary condition for MPT is weak corporate governance, which leads powerful CEOs to influence pay-setting process so that they can seek rents from their compensation package. The results from Choe et al. (2008) are consistent with managerial power assumption that CEO power leads to higher total payment. They also find that CEOs can extract rents largely through two channels: salary or stock-based pay. Abernethy, Kuang and Qin (2013) use a full model to test the relationship between CEO power, public outrage, and camouflage in the context of the adoption of performance vested stock option (PVSO) adoptions. Their findings suggest that it is the combination of public outrage, CEO power, and camouflage that determines the design of executive compensation.
This study agree with van Essen, Otten and Carberry’s (2012) argument that, MPT is not to refute agency theory but to deepen it by arguing that managerial power and its influence on executive compensation cast doubt on the assumption of optimal contracting. It might be more comprehensive when combining agency theory and managerial power theory to discuss executive compensation. Agency theory argues that when meeting conflicts of interests between shareholders and managers, compensation contract is the solution, but this ignores the effect of managerial power. For firms with weak governance, executive compensation might be utilized by selfish managers to extract own rents at the expenses of shareholders. Therefore, managerial power theory complements the weakness of standard agency theory. On the basis of agency assumption that managers are self-interested, managerial power theory proponents discuss the design of executive compensation contract by taking managerial power, outrage and camouflage into consideration.
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measurement in their adoption of PVSO plans such as they use easily achievable performance targets to secure easy payoff in PVSOs in the meanwhile powerful CEOs can deflect public outrage over compensation practices. In other words, the adoption of such a compensation reform is a camouflage and more likely to be so in firms with powerful CEOs.
Unlike salary, bonus and equity-linked compensation, stealth compensation offered to CEOs is not required to be disclosed in firms’ annual reports. Because of this loose disclosure requirement, stealth compensation can be considered as an efficient way to camouflage. Therefore, the goal of this paper is to discuss the role of stealth compensation. In order to solve this problem, two main research questions are attempted to answer. First, what is the determinant of stealth compensation? Does managerial
power determine the use of stealth compensation? Second, what are the probable consequences by using stealth compensation? Similar to Abernethy et al. (2013), this
paper focuses on UK listed firms because UK listed firms disclose more detailed executive compensation than US firms. Based on 1527 observations from 242 largest UK listed firms within 12 industries between the year 2002 and 2008, this study find managerial power is an important determinant of executive stealth compensation. In addition, the use of stealth compensation changes interest alignment, performance-induced CEO turnover and firm performance.
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shareholders and managers, which is a sign of weakened corporate governance; 2) stealth compensation leads to lower performance-induced CEO turnover because of poor performance, which again indicates poor governance; 3) stealth compensation is associated with poor firm performance.
The remainder of this paper is structured as follows. Section 2 provides an overview of related previous literature regarding to stealth compensation and managerial power theory. Additionally, it also provides supports for the three consequences of using stealth compensation. The hypotheses are also listed at the end of the theory. In section 3, sample selection, data sources, variables explanation and empirical models are all explicitly described. Section 4 presents the empirical results and robustness checks. This paper ends with conclusion section, which is combined with probable future research discussions and limitations of this paper.
2. LITERATURE REVIEW
2.1 Executive Stealth Compensation- -
However, this paper is not focusing on incentive pay system, but an alternative compensation component called stealth compensation which is also derived from agency theory. Frydman and Jenter (2010) indicate that most CEO compensation packages consist of five basic components: salary, annual bonus, payouts from long-term incentive plans, restricted option grants, and restricted stock grants. Apart from the five main components, four other major important components of CEO compensation have received less attention during the previous many years, which are: perquisites, pensions, severance pay and deferred compensation. The information for such kinds of payments are quite difficult to obtain because of insufficient disclosure, and they are labeled as “stealth compensation”.
Frydman and Jenter (2010) define the perquisites as perks that encompass a wide variety of goods and services provided to the executive, including the personal use of company aircraft, cub memberships, and loans at below-market rates. An example mentioned by Bebchuk and Fried (2004) with regard to post-retirement perk is, Terrence Murray, former CEO of FleetBoston, received 150 hours of company aircraft use, a chauffeured car, an office, office assistant, financial planning, and a home-security system. Perks appears to be a more general signal of weak corporate governance, as reductions in firms value upon the revelation of perks substantially exceed their actual cost (Yermack 2006; Grinstein, Weinbaum and Yehuda, 2009). Fryman and Jenter (2010) agree with this argument and state that at least some perk consumption is a reflection of managerial excess and reduces shareholder value. There are different types of perks, and the information for perks are always not available in firms’ annual reports.
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significant underestimation of total CEO pay (Frydman and Jenter, 2010). However, this paper uses data from UK listed firms and pension must be reported for UK listed firms according to London Stock Exchange (LSE) disclosure rules since 1987. US Securities and Exchange Commission (SEC) disclosure rules also require firms report executive pensions to public after December 2006. For those companies who are not required to publish pension plans, pension should be considered as stealth compensation.
Severance pay is the third type of stealth compensation, which refers to the separation pay that is awarded to the retiring or fired CEOs (Frydman and Jenter, 2010). In other words, normally company is required to offer certain payments to CEO if the board decides to fire the CEO or the CEO retires. The information on severance pay is also not available in annual reports, so little research has been done with regard to this payment. Deferred compensation mentioned by Bebchuk and Fried (2004) is a technique used to transfer large amounts of mostly performance-incentive value to executives without attracting much shareholder attention. Many firms offer programs that permit executives, or sometimes even require them, to defer receipt of compensation until some future date. In the meantime, the deferred compensation is built according to a formula devised by the firm. Executives do not pay taxes on the original compensation or on the accumulated increase until they receive payment, which often occurs after they leave the company. At that time, firm takes a tax deduction for the amount paid.
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According to the definition of Gioia, Sims and Henry (1983), power is simply viewed as the ability to exercise influence over others. French and Raven (1959) identify five sources of managers’ power in general: reward power, coercive power, legitimate power, expert power, and referent power. Different from general managers, top managers’ power stems from four sources introduced by Frinkelstein (1992): structural power, expert power, ownership power and prestige power. The structural power is based on formal organizational structure and hierarchical authority, while the ownership power is determined by the strength of a manager’s position in the agent-principal relationship. Expert power is the ability of top managers to deal with environmental contingencies and contribute to organizational success, and prestige power derives from managers’ reputation in the institutional environment. CEO power refers to how much decision-making power is concentrated in the hands of the CEO (Liu and Jiraporn, 2010).
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The recognition of such incentives challenges the assumption of arm’s-length transactions that represent the core insights of MPT (van Essen et al., 2012). These incentives make it possible that executives align board members to design compensation arrangements favor CEOs. The absence of strong corporate governance enables powerful CEOs to seek own rents (Abernethy et al., 2013). As a consequence, if executives have more power over the board, they will have more power to influence the design of their compensation arrangements (Jensen and Murphy, 1990; van Essen et al., 2012).
CEO power over the board comes from three sources mentioned by Choe et al. (2008): board characteristics, shareholder rights, and ownership structure. For board characteristics, CEO is powerful when: 1) the board size is large; 2) there are less independent directors on the board; 3) CEO also serves as board chair; 4) CEO serves several board committees; and 5) CEO serves the board for a long period. Shareholder rights can be considered as weak when corporate governance is poor. Gompers, Ishii and Metrick (2003) indicate that worse governance score is associated with larger CEO power because shareholders are less protected. The third source is based on the ownership structure. The higher proportion of outside shareholders’ ownership and lower CEO ownership, the more implying smaller CEO power.
2.3 Stealth Compensation and Managerial Power
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condition is that managers must have the ability to influence compensation contracts. The ability to influence compensation contracts is the managerial power mentioned before. As the executive compensation package is determined by board of directors, executives must have considerable influence on the compensation decision making process through controlling board of directors. They will be better able to negotiate for higher pay and pay that is less sensitive to their firm’s performance (van Essen et al., 2012). Since managers are motivated to pursue benefits and they have power to do so, compensation contract design cannot resolve agency problem anymore.
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Perceptions are crucial. In order to avoid outrage costs, “camouflage” occurs through changes to the composition of compensation contracts that obscure and/or legitimize CEO extraction of rents. Camouflage is a response to external pressure (Abernethy et al., 2013). Bebchuk and Fried (2004) declare that the more reasonable and defensible a compensation package appears, the more rents managers can enjoy without facing significant outrage. However, as the disclosure requirements for the main components of CEO compensation have already become stricter, and media pay more attention on executives’ compensation in recent few years; it is quite difficult for managers to hide their compensation rents. According to 2013 “LSE disclosure requirements”, the remuneration report for UK quoted companies must include information on each directors’ compensation (salary, fees, bonus, expenses, exit payments, other non-cash benefits); share options awarded, exercised, expired and varied and prices paid or to be paid, performance criteria and market prices; interests in long-term incentive schemes, qualifying conditions fulfilled and vesting; changes to pension scheme benefits, accrued benefits and transfer values; and other retirement benefits, significant awards or payments to third parties in respect of a director’s services. When having a look at the detailed disclosure requirements, the only flaw might be the stealth compensation (other non-cash benefits and some differed compensation) because of opacity. Bebchuk and Fried (2004) state that camouflage is successful as long as the rent extraction is not apparent to those outside observers whose outrage would be particularly costly for directors and managers, even if other observers are aware that the executives are enjoying large rents. Thus, the notion of camouflage is consistent with the possibility that an outsider might identify the hidden rents of compensation arrangements. The compositions of stealth compensation are unclear to outsiders, and such unclear payments are not easy to be perceived if they are controlled within certain amounts. Thus, stealth compensation is the best form because of its camouflage benefits.
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outrage and camouflage, so this study examines whether managerial power relates to stealth compensation. Therefore, the first hypothesis is:
H1: Managerial power is positively associated with CEOs’ stealth compensation.
2.4 Consequences of Stealth Compensation
The critical role of outsiders’ perception of executive compensation, and the significance of outrage costs, explain the importance of camouflage (Bebchuk and Fried, 2004). Camouflage thus allows powerful executives to reap benefits at the expenses of shareholders. The attempts to camouflage may result in the adoption of insufficient compensation structure, such as the use of high proportion stealth compensation. According to the assumption in the first hypothesis, CEO power is the determinant of stealth compensation. In other words, the use of stealth compensation represents strong CEO power. Insufficient compensation structure and strong CEO power might cause some problems.
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Their only incentive is to acquire own benefits at the expenses of shareholders wealth, and shareholders value will decrease. Stealth compensation satisfies their interests, and weakens interest alignment as a result. In order to check the appropriateness of the assumption regarding to the effects of the stealth compensation on the agency problem, the prediction is that the interest alignment is weakened while managers get their benefits through stealth compensation.
H2: CEOs’ stealth compensation weakens the interest alignment between shareholders and managers.
In addition, CEOs are less likely to be removed by the board no matter whether they perform well or not. Bebchuk, Cremers, and Peyer (2011) investigate the relation between CEO Pay Slice (CPS) – the fraction of the aggregate compensation of the top-five executive team captured by the CEO – and CEO turnover. Their result suggests that turnover is less performance-sensitive for high CPS CEOs. CPS reflects the ability of the CEO to extract rents. It seems that CEO power is associated with CEO turnover. Morck, Shleifer, and Vishny (1989) find that more powerful CEOs are not easy to be replaced by the board but more likely to be replaced through a hostile takeover. Jenter and Lewellen (2010) estimate the degree to which bad firm performance leads to CEO turnover, and they state that the sensitivity of CEO-turnover to performance becomes even more impressive for firms with strong boards, defined as small boards with a majority of independent directors and high director ownership. In other words, the frequencies of CEO turnover differ a lot between firms with strong and weak board when firm performance is low, which suggests that firms with weak boards may fail to act against their executives because of strong CEO power. Therefore, the CEO turnover is more sensitive to performance under strong board and less sensitive with weak corporate governance. While stealth compensation stands for strong CEO power, and CEO has the possibility to influence the board of directors. In this case, even though the CEO performs badly, he/she can still stay within the firm because the board is under his/her control. Based on this argument, this paper hypothesize that CEO turnover is less sensitive to firm performance by using stealth compensation.
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The third consequence of using stealth compensation is that firm performance decreases with stealth compensation. The relationship between firm performance and CEO compensation has been investigated by many scholars, but this relationship has not been answered yet because there are many implications. This paper predicts a negative association between stealth compensation and firm performance. This assumption can be explained through two perspectives. The first perspective is on the basis of CEO power. Adams, Almeida and Ferreira (2005) hypothesize that firms in which the CEO has less power to influence decisions will have less extreme performance, and they find evidence to support, firm performance might be worse as decision-making power becomes more centralized in the hands of the CEO. Choe et al. (2008) find that firm performance would be worse in firms where the CEO has more power because of rent extraction by the CEO. To be more specific, if powerful managers can easily camouflage their payments through stealth compensation, their incentives to perform well for this organization will be lower in turn because they won’t put enough efforts into firm’s operation. The other explanation for the negative effects of stealth compensation on firm performance is agency problem. Bebchuk et al. (2011) state that firm value will decrease with strong agency problems. Charitou and Louca (2013) find similar results to support that firm performance is positively related with governance quality. As indicated earlier, stealth compensation is viewed as a product of agency problem. For companies with strong agency problems, managers are less likely to act on the interests of shareholders because of different interests. Both perspectives can be summarized as managers’ motivation to perform well decreases. When toop managers are not strongly motivated to perform well, the firm performance will be worse than before. Consequently, the third assumption is that when managers successfully extract rents through stealth compensation, the firm performance is worsened.
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3. METHODOLOGY
3.1 Sample Selection and Data SourcesThe initial data for this paper stems from the FTSE 350 non-financial companies in UK based on their market capitalization in 2004. Financial institutions are excluded because of their unique regulatory status and special compensation contracts. UK companies are selected because the disclosure rules for remuneration report are more concrete than US companies, and it is easier to find the detailed components of CEO compensation contracts. In addition, large firms are focused for two reasons. One is that they normally disclose sufficient remuneration information than small ones, and stealth compensation could be found; the other one is that the agency problems (interest conflicts) are more obvious in large firms than small firms which is more relevant for the assumptions of this study. The firms without stealth compensation are also removed from my data. The final data includes 1527 observations from 242 firms over 2002-2008 within 12 industries. The data for this paper comes from several sources. Firstly, information regarding to board characteristics, executive compensation and demographics is from BoardEx database. Secondly, Firm-level financial information derives from Compustat Global Industrial and Commercial files. Additionally, Datastream provide information about capital market information. Finally, the information with regard to ownership structure is from firm’s annual reports.
3.2 Variable Explanation
Measuring stealth compensation
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compensation to total compensation is used to measure stealth compensation (%STEALTH_PAY).
Measuring CEO power
The paper follows Choe et al. (2008) and Abernethy et al. (2013) to measure CEO power in two ways: board characteristics and ownership structure. Abernethy et al. (2013) argue that CEO power increases when corporate governance is weak. Therefore, the paper first looks at the CEO power from the perspective of board characteristics. Board size (BOARD_SIZE), which is the number of directors sit on the board, may affect the power of CEOs. Bebchuk and Fried (2004) give several reasons to support that larger boards are less effective and easier to be influenced by the CEO. The results from Core, Holthausen, and Larcker (1999) and Sapp (2007) also support this argument. Knop and Mertens (2010) indicate a strongly positive relation between board size and total compensation, base salary or variable. Thus, we expect that CEO power will influence the stealth compensation more when the board is larger.
The second variable to measure CEO power is CEO duality (DUALITY), which is a dummy variable that equals 1 when the CEO also serves as the board chair, and 0 otherwise. Pathan (2009) argues that CEO power originates from two main sources: CEO duality and internally hired CEO. Victoravich et al. (2011) depict that CEO-chairman duality would aggravate information asymmetry, and the combination of two leadership roles would constrain the chairman from taking on an effective and objective monitoring role so that promote CEO entrenchment and intensify agency conflict. Yermack (1995) also indicates that CEO duality increases CEO power. Therefore, the paper expects that CEO-chairman duality will lead to higher CEO power.
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The fourth variable to measure CEO power from the perspective of board characteristics is CEO tenure (TENURE), which is the number of years CEO sit on the board. Finkelstein (1992) argues that CEO power stems partly from gaining support from board of directors. Knop and Mertens (2010) support this view and interpret that a longer managerial tenure is associated with more managerial power as the historical relation with the board of directors become stronger. In other words, longer tenure CEOs seem to be more influential over the board decisions. Consequently, a positive relationship between CEO power and CEO tenure is expected.
Finally, independent directors (%IN_DIRECTOR), which is the proportion of independent directors to all directors on the board. According to the definition of Chhaochharia and Grinstein (2009), an independent director refers to a director who is neither affiliated nor currently an employee of the company, and they lack prior employment experience with the firm. For this reason, independent directors are less vulnerable to conflicts of interest with corporate insiders or other board members (Bebchuk and Fried, 2004; Sapp, 2007; Abernethy et al., 2013). Independent directors are supposed to limit managers’ selfish behaviors because of their incentives to protect their own reputation as professional representations of shareholders. Therefore, the paper expects a negative relationship between proportion of independent directors and managerial power.
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Institutional ownership (INST), which is the percentage share ownership of the firm’s institutional investors, indicates a higher degree of monitoring of executive compensation practices because institutional investors maintain substantial investment stakes and have fiduciary obligations to improve investment returns to their clients (Abernethy et al., 2013). Pound (1988) argues that institutional investors may affect firm value positively by effective monitoring, such as constraining managerial power. Thus, this paper expects that higher proportion of institutional ownership will lead to less CEO power.
Similar to the paper from Abernethy et al. (2013), this study also follows principal component analysis (PCA) and construct a single factor CEO_POWER based on the seven individual managerial power variables to represent a composite measure of managerial power. In other words, this paper uses seven dimensions to measure the single factor CEO_POWER, and we believe that BOARD_SIZE, DUALITY, IN_ROLE and
TENURE have a positive relationship with CEO_POWER, while %IN_DIRECTOR, OWNER and INST have a negative relationship with CEO_POWER.
Measuring firm performance
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year-end book value of total debt divided by the book value of total assets at the end of that fiscal year (Choe et al., 2008).
Interest alignment – Pay performance sensitivity
The level of interest alignment between shareholders and managers is measured by pay-performance sensitivity (PPS) (Jensen and Murphy, 1990). According to Kuang and Qin (2009), the relation between executive pay and shareholder value (PPS) measures how executive compensation changes with firm performance and shareholder wealth, and a high sensitivity indicates a large degree of interest alignment between shareholders and managers. Different from prior studies, this paper focuses on the stealth payment and CEO’s pay performance sensitivity.
Performance-induced CEO turnover – Turnover performance sensitivity
Similar to the paper from Agrawal and Nasser (2012), the performance-induced CEO turnover is measured by turnover performance sensitivity (TPS). Bebchuk, Cremers and Peyer (2011) investigate the interaction between CEO pay slice and CEO turnover, and they find turnover is less performance-sensitive for high-CPS CEOs. Agrawal and Nasser (2012) examine the positive relation between independent directors who are blockholders (IDB) and CEO turnover. Unlike the two studies, this paper concentrates on the relation about stealth compensation and turnover performance sensitivity.
Control variables
This paper controls firm-level variables that may influence the CEO stealth compensation, turnover and firm performance. The firm-level variables include three main parts: firm size, leverage and growth opportunities. In addition, I also take different years and industries into control.
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compensation, because large firms are more difficult to operate and more specific knowledge regarding to management are required. For this paper, firm size is measured by natural logarithm of market capitalization (InMV).
The second firm-level control variable is the leverage ratio, which is measured as the ratio of total liabilities to total assets (LEVERAGE). On one hand, Jensen (1986) provides some arguments with regard to the relationship between company free cash flow and principal-agent conflict interests. On the other hand, a higher leverage ratio increases the risk of the company, and the firm risk is a potential determinant of executive compensation.
The third one is firm growth opportunities. Agency problems emerge often in firms with more growth options, because it is more difficult to observe managers’ actions since the results of these actions are more likely to materialize in future years (Knop and Mertens, 2010). According to Core et al. (1999) and Bryn, Nash and Patel (2006), the total executive pay level is higher in firms with more growth opportunities. The reason is that self-interested managers are more likely to make use of stock based incentive payments, and stock price normally increases with more growth opportunities. The market to book ratio is used to measure firm growth opportunities, which is year-end market capitalization divided by the book value of equity (MtB).
In addition to some firm-level variables, year (YEAR_DUMMY) and industry (INDUSTRY_DUMMY) are also important to control. Different industries have different compensation level for executives, and the payment level also changes in different years. 3.3 Empirical models
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managerial power and executives’ stealth compensation (H1), the regression Model (1) is
set as below:
[%STEALTH_PAY]i,t = β0 + β1*CEO_POWERi,t + β2*FIRM_PERFORMANCEi,t + β3*InMVi,t +
β4*LEVERAGEi,t + β5*MtBi,t + ∑β*YEAR_DUMMY +∑β*INDUSTRY_DUMMY + ε (1) where CEO_POWER denotes the seven individual dimensions of managerial power, namely:
BOARD_SIZE, DUALITY, IN_ROLE, TENURE, %IN_DIRECTOR, OWNER and INST, as well as
a composite measure of power based on all individual proxies. FIRM_PERFORMANCE stands for ROA, ROE, and Tobin’s Q. In addition, i and t denote firm and year, respectively.
The second hypothesis uses PPS, which aims to test the influence of stealth compensation on interest alignment between shareholders and managers. In this case, the natural logarithm of total CEO compensation (In(TOTAL_PAY)) is the dependent variable. I control for FIRM_PERFORMANCEi,t by using ROA, ROE or Tobin’s Q respectively. I
also create an interaction term, FIRM_PERFORMANCEi,t*%STEALTH_PAYi,t. I expect a
negative coefficient β3 in order to explain stealth compensation weakens the interest
alignment. If β3 is negative, pay-performance sensitivity is low and this can explain the
weakened interest alignment. In addition, the regression model also controls for CEO education level (EDUCATION), the number of years CEO manage the firm (Management-TENURE), InMV, MtB, LEVERAGE, BOARD SIZE, %IN_DIRECTOR,
TENURE, YEAR_DUMMY and INDUSTRY_DUMMY. Therefore, Model (2) is employed: [In(TOTAL_PAY)]i,t = β0 + β1*FIRM_PERFORMANCEi,t + β2*%STEALTH_PAYi,t +
β3*FIRM_PERFORMANCEi,t*%STEALTH_PAYi,t + ∑β*[Controls] + ε (2) where i and t denote firm and year, respectively.
The third hypothesis identifies the change of CEO through examining the relation between the use of stealth compensation and CEO turnover-performance sensitivity. The dependent variable is CEO turnover (CEO_TURN), which is a dummy variable that equals 1 if the CEO changed in the current year, and equals 0 otherwise. I control for
FIRM_PERFORMANCEi,t-1, by using ROA, ROE or Tobin’s Q respectively. In addition,
the interaction term is added, FIRM_PERFORMANCEi,t-1*%STEALTH_PAYi,t-1, as an
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interaction is positive, because positive β3 interprets that CEO turnover is less sensitive to
performance by using stealth compensation, which supports performance-induced CEO turnover is weakened. Besides the explanatory variable, several variables are controlled by the regression. The first one is CEO retirement. Jenter and Lewellen (2010) mention that CEO may leave the company because of normal retirement, which is not forced by the board of directors. Ignoring the normal retirement may influence the relevance of results. For this reason, I control CEO retirement (RETIRE) by using a dummy variable, which equals 1 if the CEO has less than 1 year to retirement, and 0 otherwise. Similar to Agrawal and Nasser’s (2012) paper, TENURE, BOARD SIZE, OWNER,
DUALITY, %IN_DIRECTOR, InMV, MtB, LEVERAGE, YEAR_DUMMY and INDUSTRY_DUMMY are also controlled. Therefore, Model (3) is formulated:
[CEO_TURN]i,t = β0 + β1*FIRM_PERFORMANCEi,t-1 + β2*%STEALTH_PAYi,t-1 +
β3*FIRM_PERFORMANCEi,t-1*%STEALTH_PAYi,t-1 + ∑β*[Controls] + ε (3) where i and t denote firm and year, respectively. FIRM_PERFORMANCE stands for ROA, ROE, and Tobin’s Q.
The last hypothesis aims to find stealth compensation worsens firm performance. The dependent variable is FIRM_PERFORMANCE, and the independent variable is %STEALTH_PAY. A negative sign of β1 is expected in this model. Model (4) is
conducted as follows:
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Table 1 Variable Definition Variable Name Definition
Compensation Variables
In(TOTAL_PAY) Natural logarithm of CEO’s total compensation, which includes salary, bonus, pension, other direct compensation, and equity linked compensation
%STEALTH_PAY The proportion of CEO’s other direct compensation to total compensation Managerial Power Variables
BOARD_SIZE The number of board members
DUALITY A dummy variable that equals 1 when the CEO also serves as the board chair, and 0 otherwise
IN_ROLE The number of board committees on which the CEO has a role TENURE The number of years CEO sits on the board
%IN_DIRECTOR The proportion of outside directors among all board members OWNER The fraction of shares owned by the largest owner
INST The percentage share ownership of the firm’s institutional investors Firm Performance Variables
ROA Return on total assets
ROE Return on total equity
Tobin’s Q The sum of market capitalization and the year-end book value of total debt divided by the book value of total assets at the end of that fiscal year
Other Variables
CEO_TURN A dummy variable that equals 1 if the CEO has been replaced, 0 otherwise
RETIRE A dummy variable which equals to 1 if CEO has less than one year to retirement, and 0 otherwise
EDUCATION The education level of CEOs
Management-TENURE The number of years CEO manage the firm Control Variables
InMV Natural logarithm of market capitalization LEVERAGE The ratio of total liabilities to total assets
MtB Year-end market capitalization divided by the book value of equity
YEAR_DUMMY 6 dummy variables are used to measure the year of observation: Year_2002, Year_2003, Year_2004, Year_2005, Year_2006, Year _2007. The dummy equals 1 if the year is 2002, 2003, 2004, 2005, 2006, 2007, respectively; and 0 otherwise INDUSTRY_DUMMY Based on Fama-French 12-industry classification, 11 dummy variables are used to
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4. EMPIRICAL RESULTS
4.1 Descriptive StatisticsTable 2 shows the summary of descriptive statistics. All the variables are winsorized at the top and bottom 1%. The average proportion of CEOs’ stealth compensation is 6.1%, and more than 75% of CEOs’ stealth compensation proportion is lower than 5%. This indicates that the stealth compensation does not occupy a large proportion in most large firms, and most board of directors compensates their managers with low proportion of stealth pay. Nevertheless, there are still several firms compensate stealth payment to CEOs with approximately 50% of their total pay. The majority of CEOs in UK listed firms do not serve as the board chair, and they also do not serve large number of board committees. Half of the CEOs sit on the board more than 5 years. In addition, the average number of board members within a firm is around 9, among which, half of the members are independent. The largest owner of one firm holds approximately 11% of the total number of shares on average, and the average institutional ownership is around 22%. 4.2 Correlations
Table 3 presents both the Pearson correlations and Spearman correlations, and main variables are listed. For Pearson correlations, among the seven CEO power dimensions, five of them are related to stealth compensation: board size, CEO-chairman duality, board independence, institutional ownership and ownership concentration; in role and tenure are not correlated with stealth compensation. Board size and duality have positive correlation with stealth pay, and board independence is negatively correlated. Institutional ownership and ownership concentration are positively correlated with stealth compensation, which are contrary to the assumptions before. Based on the results of Spearman correlations, in role and CEO tenure are negatively correlated with stealth compensation, and these are also contrary to the assumptions.
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ownership concentration. Duality is correlated with all the others except ownership concentration. The high correlations among all the individual factors indicate the appropriateness of using these dimensions to measure CEO power.
In addition, stealth compensation has a significant negative association with total compensation. It shows no relationship with CEO turnover. Furthermore, none of the three measurements for firm performance are significantly correlated with stealth compensation. However, all firm performance measurements have strong positive correlation with CEO total compensation, which indicates that better performance can lead to higher total compensation. Firm size, leverage ratio, and firm growth opportunities are also strongly significant with total compensation.
Table 2 Descriptive Statistics
Variable Mean Std. Dev. 1st 25th Median 75th 99th
Notes: The Pearson correlations are reported above the diagonal and Spearman correlations below. **. Correlation is significant at the 0.01 level (2-tailed).
*. Correlation is significant at the 0.05 level (2-tailed
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) In(TOTAL_PAY) (1) 1 -.106** -.025 .457** -.124** -.034 -.110** .357** -.042 .022 .135** .089** .147** .092** .754** .181** %STEALTH_PAY (2) -.412** 1 .032 .057* .089** .024 .023 -.062* .062* .149** -.017 .002 -.029 -.002 -.031 .029 CEO_TURN (3) -.015 .035 1 -.006 -.036 -.278** -.128** .063* .022 .044 -.030 .018 .018 -.033 .034 .065* BOARD_SIZE (4) .447** -.145** .000 1 .089** .042 -.013 -.068** -.131** .086** -.030 -.057 .055 .023 .584** .202** DUALITY (5) -.136** .074** -.036 .059* 1 .343** .251** -.197** -.063* .028 .026 -.046 -.001 -.007 -.049 .029 IN_ROLE (6) .010 -.084** -.488** .024 .170** 1 .558** -.174** .009 -.010 .104** .037 .080* .125** -.063* -.177** TENURE (7) -.113** -.052* -.149** .018 .172** .534** 1 -.246** -.035 -.032 .144** .051 .050 .116** -.083** -.221** %IN_DIRECTOR (8) .347** -.067** .057* -.055* -.162** -.113** -.265** 1 .034 -.076** .006 .021 .022 -.011 .310** .085** INST (9) -.034 .001 .031 -.190** -.093** -.012 -.047 .065* 1 .693** -.059* .019 .004 -.003 -.194** .033 OWNER (10) .010 .014 .050 -.104** -.090** -.029 -.078** .045 .810** 1 -.023 .011 .073* .038 -.044 .083** ROA (11) .098** -.110** -.053* -.038 .049 .130** .161** -.011 -.090** -.071** 1 .406** .386** .354** .191** -.084** ROE (12) .061 -.078* -.041 -.005 .027 -.012 .016 .041 .009 -.029 .543** 1 .051 .053 .100** -.009 Tobin's Q (13) .111** -.116** -.008 -.030 -.013 .112** .047 .031 -.029 -.023 .517** -.180** 1 .740** .191** .092** MtB (14) .058* -.108** -.037 -.097** -.001 .165** .148** -.021 -.040 -.024 .582** -.133** .858** 1 .233** -.128** InMV (15) .745** -.248** .043 .557** -.048 -.031 -.078** .283** -.206** -.131** .160** .051 .182** .166** 1 .145** LEVERAGE (16) .210** .006 .049 .171** .006 -.148** -.212** .133** .004 -.001 -.197** .001 .085** -.241** .193** 1
- - 4.3 Regression Analysis
Managerial power and stealth compensation (H1)
Table 4 presents the regression results of the first hypothesis. In order to test the relationship between managerial power and stealth compensation, two methods are used. Firstly, the seven dimensions of CEO power are tested individually. Board size and CEO-chairman duality are positively associated with stealth compensation, and both of them are significant at the level of 5%, which is same as expectation. The numbers of board committees CEOs play a role, CEO tenure on the board and board independence are not significant in explaining stealth compensation. Institutional ownership shows a negative relationship with stealth compensation and supports my hypothesis before. Ownership concentration is strongly significant (at 1% level) with stealth compensation, but this positive relationship is on the contrary of my prediction. The results of the seven individual dimensions are listed in Column (1). Since not all individual factors are consistent with the assumption, a composite measure of managerial power (CEO_POWER) is used. Column (2) reports the single factor of CEO power, which shows a positive relationship and significant at 5% level. Such result supports H1, and it
is concluded that higher CEO power will lead to more stealth compensation. To be more specific, stealth compensation increases: (1) when board size is large; (2) CEO also serves as the board chair; (3) there are less institutional ownerships.
Turning to the results of control variables. None of firm performance measurements explains stealth compensation, which hints that firm performance is not a determinant for stealth compensation. No matter how well firm performance is, executives’ stealth compensation does not change. Firm-level control variables are also not significant with stealth compensation. The exception is that firm size negatively influences stealth compensation (significant at the level of 5%) when I use seven managerial power dimensions. In this case, stealth compensation increases when firm size is smaller. To be concluded, H1 is supported in terms of the composite factor CEO_POWER, and
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ownership. Ownership concentration shows contrary result compared with previous prediction, and CEO tenure, in role and board independence are not associated with stealth compensation. All control variables are not significant, except that firm size reflects a negative result when individual factors of managerial power are used.
Pay performance sensitivity and stealth compensation (H2)
Table 5 presents the comprehensive results of Model (2). The second hypothesis is supported in terms of Tobin’s Q, while ROA and ROE do not support the hypothesis. Pay performance sensitivity in this model is the correlation between stealth compensation and firm performance. In order to explain stealth compensation weakens the interest alignment, the correlation should be negative. The coefficient of the interaction term
Tobin’s Q*%STEALTH_PAY is -0.992 at the significance level of 1% (p<0.001) in the In(TOTAL_PAY) specification. This negative coefficient on the interaction term supports
my second hypothesis that stealth compensation affects pay-performance sensitivity. To be more specific, the use of stealth compensation satisfy managers’ own interests, and they are less likely to act on the shareholders’ interests. As a result, agency problem becomes stronger in the firm. Only by using Tobin’s Q as firm performance measurement, the presence of CEO stealth compensation is associated with interest alignment. Consequently, Tobin’s Q seems to be a better measure of firm performance than ROA and ROE, because Tobin’s Q combines the accounting and market based approach while ROA and ROE are only accounting based performance measurements. Many scholars agree this argument and they are also in favor of Tobin’s Q (Yermack, 1996; Gompers, Ishii, and Metrick, 2003; Bebchuk et al., 2011).
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control variables do not show significant results with total compensation except CEO tenure. CEO total compensation decreases with tenure.
Table 4 Regression Results for Managerial Power and Stealth Compensation
Independent variable Predicted sign Dependent variable
%STEALTH_PAY (1) %STEALTH_PAY (2) BOARD_SIZE + 0.015** (2.142) DUALITY + 0.105** (1.991) IN_ROLE + 0.000 (0.024) TENURE + 0.002 (0.487) %IN_DIRECTOR – -0.025 (-0.230) INST – -0.242** (-2.234) OWNER – 1.013*** (5.140) CEO_POWER + 0.030** (2.274) ROA 0.029 -0.029 (0.157) (-0.159) ROE 0.006 0.002 (0.369) (0.118) Tobin’s Q -0.028 -0.028 (-1.542) (-1.503) InMV -0.023** -0.009 (-2.079) (-1.149) MtB 0.025 0.025 (1.353) (1.366) LEVERAGE 0.028 0.104 (0.420) (1.549)
YEAR_DUMMY YES YES
INDUSTRY_DUMMY YES YES
Number of observations 1438 1438
R-Square 0.068 0.024
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Table 5 Regression Results for Pay Performance Sensitivity
Independent variable Predicted sign Dependent variable In(TOTAL_PAY) (1) In(TOTAL_PAY) (2) In(TOTAL_PAY) (3) Constant (β0) 10.816***(0.200) 10.827***(0.238) 10.635***(0.235) ROA(β1) 0.395(0.234) %STEALTH_PAY(β2) -0.101*(0.134) -0.330***(0.109) -1.184***(0.61) ROA*%STEALTH_PAY(β3) – -2.219(2.012) ROE(β1) -0.055(0.057) ROE*%STEALTH_PAY(β3) – 1.091(0.803) Tobin’s Q(β1) 0.170***(0.030) Tobin’s Q*%STEALTH_PAY(β3) – -0.992***(0.259) Controls(Firm-level) InMV (β4) 0.337***(0.014) 0.341***(0.016) 0.349***(0.015) MtB(β5) -0.046***(0.015) -0.055***(0.018) -0.155***(0.026) LEVERAGE(β6) 0.179**(0.078) 0.169*(0.093) 0.054 (0.094) BOARD_SIZE(β7) 0.036***(0.008) 0.035***(0.010) 0.030***(0.009) %IN_DIRECTOR(β8) 0.917***(0.129) 0.869***(0.154) 0.871***(0.151) Controls(Executive-level) EDUCATION(β9) 0.020(0.013) 0.015(0.016) 0.014(0.016) TENURE(β10) -0.004(0.004) -0.007(0.005) -0.008*(0.005) Management-TENURE(β11) 0.001(0.004) 0.003(0.005) 0.004(0.005) Controls(Others)
YEAR_DUMMY(β12) YES YES YES
INDUSTRY_DUMMY(β13) YES YES YES
Number of observations 1392 1392 1392
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In conclusion, the negative coefficient on the interaction variable Tobin’s
Q*%STEALTH_PAY indicates that, the use of stealth compensation would weaken the
interest alignment between shareholders and managers. This might result in higher contradict interests between them and should influence CEO turnover. Next regression explains the effects of stealth compensation on performance-induced CEO turnover.
Turnover performance sensitivity and stealth compensation (H3)
Table 6 shows the results of the third model. H3 is supported through ROA and Tobin’s Q,
while ROE cannot support. The third hypothesis aims to find stealth compensation weakens the performance-induced CEO turnover. In other words, by using stealth compensation, CEO turnover is less sensitive to firm performance. Similar to the second hypothesis, performance-induced CEO turnover is weakened if the correlation between stealth compensation and firm performance is positive. In terms of ROA, the coefficient of the interaction variable ROA*%STEALTH_PAY is 3.908; for Tobin’s Q, the coefficient of variable Tobin’s Q*%STEALTH_PAY is 0.460. Both of them are strongly significant at 1% level. The positive sign on this interaction variable indicate that stealth compensation is associated with performance-induced CEO turnover. Specifically, when using stealth compensation, CEO turnover is less sensitive to firm performance. Stealth compensation means strong managerial power, and powerful CEO has control over the board. For such reason, they are less likely to be removed no matter how well perform.
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Overall, the use of stealth compensation hints strong managerial power over board. Therefore, CEO turnover is less sensitive to firm performance. Stealth compensation weakens the performance-induced CEO turnover.
Table 6 Regression Results for Turnover Performance Sensitivity
Independent variable Predicted sign Dependent variable CEO_TURN (1) CEO_TURN (2) CEO_TURN (3) Constant (β0) 0.122**(0.055) 0.105(0.068) 0.127*(0.068) ROA(β1) -0.270**(0.126) %STEALTH_PAY(β2) -0.214***(0.074) -0.029(0.062) -0.618***(0.214) ROA*%STEALTH_PAY(β3) + 3.908***(1.116) ROE(β1) -0.019 (0.032) ROE*%STEALTH_PAY(β3) + 0.367(0.459) Tobin’s Q(β1) -0.018(0.018) Tobin’s Q*%STEALTH_PAY(β3) + 0.460***(0.154) Controls RETIRE(β4) -0.030(0.046) -0.009(0.055) -0.015(0.054) TENURE(β5) -0.009***(0.002) -0.009***(0.003) -0.009***(0.003) BOARD_SIZE(β6) -0.006(0.004) -0.010*(0.005) -0.009*(0.005) OWNER(β7) 0.155*(0.092) 0.218*(0.114) 0.203*(0.114) DUALITY(β8) -0.008(0.034) 0.022(0.041) 0.023(0.041) %IN_DIRECTOR(β9) 0.031(0.070) 0.020(0.086) 0.010(0.085) InMV(β10) 0.011(0.007) 0.017**(0.009) 0.016*(0.009) MtB(β11) -0.007(0.008) -0.009(0.010) -0.006(0.015) LEVERAGE(β12) 0.032(0.042) 0.036(0.052) 0.036(0.053)
YEAR_DUMMY YES YES YES
INDUSTRY_DUMMY YES YES YES
Number of observations 1398 1398 1398
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Firm performance and stealth compensation (H4)
Table 7 presents the regression results of Model (4). Model (4) tests the influence of stealth compensation on firm performance across different firms. This hypothesis is supported in terms of Tobin’s Q, and not supported by ROA and ROE. The correlation β1
is -0.099 and significant at the level of 10%. Although this relationship is not strong, it can still indicate that firms with higher proportion of stealth compensation lead to worse performance. In this model, only three control variables show strong relationships with Tobin’s Q. The first one is MtB. The negative sign indicates that firm performance is better for firm with more growth opportunities. Leverage ratio also has a positive relationship with firm performance. In addition, the years CEO in management can also affect firm performance. But the negative sign shows that firm performance worsens with the increase of CEO management tenure.
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Table 7 Regression Results for Firm Performance and Stealth Compensation
Independent variable Predicted sign Dependent variable
ROA (1) ROE (2) Tobin’s Q (3) %STEALTH_PAY – -0.001 0.024 -0.099* (-0.230) (0.355) (-1.739) InMV 0.010*** 0.096*** -0.014 (5.730) (4.018) (-0.682) MtB 0.022*** 0.015 0.729*** (11.772) (0.557) (31.898) LEVERAGE -0.020** -0.105 0.865*** (-2.005) (-0.755) (7.477) BOARD_SIZE -0.005*** -0.067*** 0.010 (-4.371) (-4.620) (0.820) %IN_DIRECTOR -0.021 -0.446* -0.004 (-1.212) (-1.947) (-0.019) OWNER 0.040 -0.015 0.265 (1.258) (-0.034) (0.734) INST -0.048*** 0.108 -0.195 (-2.770) (0.469) (-1.012) EDUCATION -0.001 0.048** 0.029 (-0.557) (1.960) (1.415) TENURE 0.002*** 0.004 -0.002 (3.037) (0.414) (-0.260) IN_ROLE 0.000 0.003 0.006 (0.071) (0.482) 1.240 Management-TENURE -0.001 0.014** -0.010* (-1.246) (1.972) (-1.784)
YEAR_DUMMY YES YES YES
INDUSTRY_DUMMY YES YES YES
Number of observations 1439 1398 1399
R-square 0.225 0.090 0.585
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Table 8 Regression Results for Future Firm Performance and Stealth Compensation
Independent variable Predicted sign Dependent variable
ROA (1) ROE (2) Tobin’s Q (3) %STEALTH_PAY – -0.002 -0.030 0.214 (-0.077) (-0.410) (0.790) InMV 0.007*** 0.014** -0.056** (3.991) (2.113) (-2.324) MtB 0.025*** 0.003 0.608*** (13.022) (0.461) (23.571) LEVERAGE 0.018* 0.070* 0.742*** (1.735) (1.821) (5.159) BOARD_SIZE -0.004*** -0.007* 0.017 (-3.909) (-1.795) (1.137) %IN_DIRECTOR -0.016 -0.129** 0.225 (-0.895) (-2.024) (0.938) OWNER 0.041 0.003 0.933** (1.270) (0.022) (2.033 ) INST -0.050*** -0.063 -0.884*** (-2.750) (-0.893) (-3.573) EDUCATION 0.001 0.015** 0.039 (-0.565) (2.176) (1.512) TENURE 0.002** 0.003 0.003 (2.289) (1.118) (0.283) IN_ROLE 0.000 -0.002 0.007 (0.000) (-1.488) (1.087) Management-TENURE -0.001* 0.001 -0.017** (-1.710) (0.261) (-2.383)
YEAR_DUMMY YES YES YES
INDUSTRY_DUMMY YES YES YES
Number of observations 1185 1167 1167
R-square 0.232 0.084 0.483
- - 4.4 Robustness Checks
In this section, three additional tests are used to check the robustness of the results presented in section 4.3. The first test uses an alternative way to measure CEO power based on board characteristics and ownership characteristics. The second test adds pension into stealth compensation. In the third test, I select the sample again through removing small-sized firms. The results of robustness checks are not reported because all of them are consistent with previous main results.
Alternative measures of CEO power
In the previous section, seven individual dimensions of CEO power are used to run the first regression, and a composite factor CEO is also used to check its positive relationship with stealth compensation. However, board size, CEO-chairman duality, tenure, in role and board independence belong to board characteristics; whereas institutional ownership and ownership concentration are associated with ownership characteristics. In order to distinguish the two types of managerial power source, principal component analysis is used to construct two factors based on board characteristics and ownership characteristics:
POWER_BC and POWER_OC. The result of the first hypothesis remains same, but both POWER_BC and POWER_OC positively related to stealth compensation at a higher
significance level (1%).
Pension added into stealth compensation
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Small firms deduction
Firm size is one of the largest explanatory powers for variations in all types of CEO compensation (Knop and Mertens, 2010). Howorth and Westhead (2003) argue that agency problem is stronger in large firms than small firms. Agency problem is the key basic assumption in this paper. For this reason, the sample size is selected again by exclude the bottom 20% of the smallest firms. All the results are consistent, and the result for the second hypothesis is even stronger. In the prior section, the stealth compensation and interest alignment can only be explained by Tobin’s Q, but in this test, this relationship can be explained by both ROA and Tobin’s Q. Furthermore, I drop Small Cap firms again instead of excluding the bottom 20% firms. Results still remain consistent with previous results. However, the assumption for future firm performance is still not supported by either firm size deduction.
5. CONCLUSIONS
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firms with higher proportion of stealth compensation is worse than those with lower stealth pay.
Through analyzing the results of stealth compensation, it could be concluded that managerial power is the precondition for high stealth compensation. If executives are truly compensated with high stealth compensation, it reflects that corporate governance is quite weak. Stealth compensation is a product of agency problem. Our second hypothesis and third hypothesis approve this assumption. However, stealth compensation is not widely used in every country and corporate governance structure differs in countries according to the research from Eije (2012). Therefore, it is interesting to see stealth compensation in different countries with different corporate governance structure and shareholder protection. In addition, Hofstede (1991) mentions several different culture dimensions and it is also nice to combine culture with stealth compensation. Jansen, Merchant and Van der Stede (2009) depict the impacts of culture differences on incentive compensation practices, and argue that people in long-term orientation countries have a preference for more stable fixed income rather than incentive payment. For this reason, it is possible to speculate that the CEOs in different countries may have distinct preferences for stealth compensation. Consequently, stealth compensation across different countries could be studied in further research.
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ACKNOWLEDGE
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