Tag: Peer groups

The Effect of Relative Performance Evaluation

Frances M. Tice is Assistant Professor of Accounting at the University of Colorado at Boulder. This post is based on an article authored by Ms. Tice.

In the paper, The Effect of Relative Performance Evaluation on Investment Efficiency and Firm Performance, which was recently made publicly available on SSRN, I examine the effect of explicit relative performance evaluation (RPE) on managers’ investment decisions and firm performance. Principal-agent theory suggests that firms can motivate managers to act in shareholders’ interest by linking their compensation to firm performance. However, firm performance is often affected by exogenous factors, and as a result, performance-based compensation may expose managers to common risk that they cannot directly control. In such cases, RPE enables the principal to compensate managers on their effort and events under their control by removing the effect of common shocks from measured performance, thus improving risk sharing and incentive alignment. However, RPE use as implemented in practice may not be effective in addressing agency costs because of potential peer group issues, such as availability of firms with common risk or a self-serving bias in peer selection. In addition, prior research also suggests that a large gap in ability between the RPE firm and peers (“superstar effect”) may actually reduce managers’ effort because the probability of winning is low. Therefore, the question of whether explicit RPE use in executive compensation does indeed reduce agency costs remains unanswered in the empirical literature.


Peer Effects of Corporate Social Responsibility

Hao Liang is Assistant Professor of Finance at Singapore Management University. This post is based on an article authored by Professor Liang, and Jie Cao and Xintong Zhan, both of the Department of Finance at the Chinese University of Hong Kong.

Corporate social responsibility (CSR) has increasingly become a mainstream business activity—ranging from voluntarily engaging in environmental protection to increasing workforce diversity and employee welfare—although standard economic theories predict that it should be rather uncommon (Benabou and Tirole, 2010; Kitzmueller and Shimshack, 2012). The neoclassical economic paradigm usually considers CSR as unnecessary and inconsistent with profit maximization (e.g., Friedman, 1970). This discrepancy between theory and real-world observations has attracted much scholarly attention in recent years. One popular view on why CSR prevails is that it creates a competitive advantage for the firm and thus contributes to firm value. Following this line, numerous studies have investigated the causes and consequences of CSR by focusing on its strategic value implications.


Dealing with Director Compensation

David A. Katz is a partner at Wachtell, Lipton, Rosen & Katz specializing in the areas of mergers and acquisitions and complex securities transactions. This post is based on an article by Mr. Katz and Laura A. McIntosh that first appeared in the New York Law Journal; the complete publication, including footnotes, is available here. The views expressed are the authors’ and do not necessarily represent the views of the partners of Wachtell, Lipton, Rosen & Katz or the firm as a whole. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Due to a recent Delaware Chancery Court ruling, the topic of director compensation currently is facing an uncharacteristic turn in the spotlight. Though it receives relatively little attention compared to its higher-profile cousin—executive compensation—director compensation can be a difficult issue for boards if not handled thoughtfully. Determining the appropriate form and amount of compensation for non-employee directors is no simple task, and board decisions in this area are subject to careful scrutiny by shareholders and courts.

The core principle of good governance in director compensation remains unchanged: Corporate directors should be paid fair and reasonable compensation, in a mix of cash and equity (as appropriate), to a level that will attract high-quality candidates to the board, but not in such forms or amounts as to impair director independence or raise questions of self-dealing. Further, director compensation should be reviewed annually, and all significant decisions regarding director compensation should be considered and approved by the full board.


Peer Effects and Corporate Corruption

The following post comes to us from Christopher Parsons of the Finance Area at the University of California, San Diego; Johan Sulaeman of the Department of Finance at Southern Methodist University; and Sheridan Titman, Professor of Finance at the University of Texas at Austin.

Traditional models of crime frame the choice to engage in misbehavior like any other economic decision involving cost and benefit tradeoffs. Though somewhat successful when taken to the data, perhaps the theory’s largest embarrassment is its failure to account for the enormous variation in crime rates observed across both time and space. Indeed, as Glaeser, Sacerdote, and Scheinkman (1996) argue, regional variation in demographics, enforcement, and other observables are simply not large enough to explain why, for example, two seemingly identical neighborhoods in the same city have such drastically different crime rates. The answer they propose is simple: social interactions induce positive correlations in the tendency to break rules.


ISS Updates Proxy Voting Policies, Requests Peer Group Changes

Holly J. Gregory is a corporate partner specializing in corporate governance at Weil, Gotshal & Manges LLP. This post is based on a Weil Gotshal alert; the complete publication, including appendicies, is available here.

On November 21, 2013, Institutional Shareholder Services Inc. (ISS) released updates to its proxy voting policies for the 2014 proxy season, effective for meetings held on or after February 1, 2014. [1] In addition, ISS has requested that companies notify it by December 9, 2013 of any changes to a company’s self-selected peer companies for purposes of benchmarking CEO compensation for the 2013 fiscal year.

This post provides guidance to US companies on how to address ISS policy changes and also highlights recent developments regarding potential regulation or self-regulation of proxy advisory firms.

The amendments to ISS proxy voting policies for the 2014 proxy season relate to:


Do Fraudulent Firms Engage in Disclosure Herding?

The following post comes to us from Gerard Hoberg of the Department of Finance at the University of Maryland and Craig Lewis of the Finance Area at Vanderbilt University.

In our paper, Do Fraudulent Firms Engage in Disclosure Herding?, which was recently made publicly available on SSRN, we present two new hypotheses regarding the strategic qualitative disclosure choices of firms involved in potentially fraudulent activity. First, these firms have incentives to herd with industry peers in order to escape detection. Second, these firms have incentives to locally anti-herd with the same peers on specific aspects of disclosure consistent with achieving fraud-driven objectives. We use text-based analysis of firm disclosures and compare disclosures across firms involved in SEC enforcement actions to benchmarks based on industry, size and age, and also to each firm’s own disclosure before and after SEC alleged violations.

We hypothesize that firms involved in potentially fraudulent activity face tensions when providing qualitative disclosures to the Securities and Exchange Commission, the agency tasked with enforcing anti-fraud laws. Our focus is on the Management’s Discussion and Analysis section of the 10-K, which is where managers have a high level of discretion to describe the key issues facing their firms and to describe their performance in detail. A primary motive is to escape detection, and managers who assume that the SEC is less likely to scrutinize disclosures that resemble industry peers, or that such disclosure is less likely to raise red flags, have incentives to herd with industry peers. On the other hand, the same objectives that lead managers to commit fraud may also provide incentives to anti-herd in their disclosure from industry peers. However, these latter incentives are likely more localized, and anti-herding would be predicted only on disclosure dimensions that might help managers to achieve these objectives.


ISS Proposes Limited Updates to 2014 Voting Policy

The following post comes to us from Sullivan & Cromwell LLP, and is based on a Sullivan & Cromwell publication by Glen T. Schleyer and Marc Trevino.

Institutional Shareholder Services, the influential proxy advisory firm, has published for public comment two proposed changes to its proxy voting guidelines for U.S. companies. The proposals are limited and do not include any change related to the effect of longer board tenure on director independence. ISS had previously surveyed institutional investors and public companies on the topic of director tenure and received strong, but deeply split, responses from both constituencies. The proposed changes are:


Pay Harmony: Peer Comparison and Executive Compensation

The following post comes to us from Claudine Gartenberg of the Department of Management and Organizations at New York University and Julie Wulf of the Strategy Unit at Harvard Business School.

In our paper, Pay Harmony: Peer Comparison and Executive Compensation, which was recently made publicly available on SSRN, we find evidence consistent with the presence of peer comparison influencing pay policies for executives inside firms. Our underlying approach is to measure changes in pay co-movement, disparity and productivity using a 1992 SEC ruling that mandated greater disclosure of top executive pay. We argue that this ruling led to greater awareness of pay and, hence, greater peer comparison throughout all managerial ranks, particularly in non-proximate managers who had natural information barriers prior to the ruling.

We present the results of three analyses that, taken together, support the argument that firms’ pay policies respond to peer comparison and concerns about internal equity. In general, we find evidence that pay variance within firms, pay distance between managers and division productivity all increased during this period. However, we find that these measures increased less among firms and managers that were more affected by the 1992 SEC disclosure rule. Specifically, after the new regulation, we find increases in PRS (pay-referent sensitivity)—or greater co-movement of division manager pay—and decreases in PPS (pay-performance sensitivity) in geographically-dispersed firms, but not in concentrated firms.


The Dynamics of Compensation Peer Benchmarking

The following post comes to us from Michael Faulkender of the Robert H. Smith School of Business at the University of Maryland and Jun Yang of the Kelley School of Business at Indiana University.

Changes in the level and dispersion of CEO compensation since the early 1990s have triggered an increasingly heated debate over whether current compensation practices primarily reflect the equilibrium outcome of the CEO labor market or the power of entrenched CEOs. One factor in this debate is the practice of compensation benchmarking in which firms justify their CEO’s compensation by comparing it to the pay packages of a group of companies with highly paid CEOs. Firms rationalize this group by claiming they compete for managerial talent with those selected peer companies. In the paper, Is Disclosure an Effective Cleansing Mechanism? The Dynamics of Compensation Peer Benchmarking, forthcoming in the Review of Financial Studies, we examine the dynamics of the peer benchmarking process. Specifically, we investigate whether the 2006 regulation requiring firms to disclose their compensation peer group members has mitigated opportunistic firm behavior in benchmarking against self-selected peer companies with highly paid CEOs.


Executive Superstars, Peer Groups and Over-Compensation

Charles M. Elson is the Edgar S. Woolard, Jr. Chair in Corporate Governance and Director of the John L. Weinberg Center for Corporate Governance at the University of Delaware. This post is based on a paper he co-authored with Craig Ferrere, Research Fellow at the Weinberg Center.

In the paper, Executive Superstars, Peer Groups and Over-Compensation — Cause, Effect and Solution, which was recently made publicly available on SSRN, we develop a pragmatic approach to understanding the run-up in CEO compensation over the past several decades. Rather than looking to markets or captured boards for the explanation, we argue that the actual mechanical process of peer benchmarking by which pay is set is the cause of the present controversy. From this perspective, we present what we believe will be an effective solution; additionally and collaterally, some interesting lessons about executive recruitment, particularly the CEO “superstar” culture, may be gleaned from our findings. We thank the Investor Responsibility Research Center Institute, which has long funded compensation research, for their financial support and helpful assistance in the development of this paper.

The piece makes a contribution to the executive compensation literature as it offers a novel explanation for the perpetual rise in CEO pay and suggests a significantly different solution to the compensation controversy. As boards have typically looked outside the organization to set CEO pay, we argue that this approach, known as “peer grouping,” is seriously flawed as it relies on the notion of an easy transferability of executive talent which empirically, is incorrect. Therefore, boards should look within the organization itself rather than to external comparators to create an appropriate CEO pay structure. We suggest that this approach should begin to resolve the CEO compensation problem.


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