Incentive Alignment through Performance-Focused Shareholder Proposals on Management Compensation

Corporate boards are conscious of the role that executive pay practices play in improving corporate governance and increasing shareholder wealth (Gammeltoft, 2010). Economic theory suggests that the key to aligning managerial compensation with shareholder interest is to increase the sensitivity of executive compensation to firm performance (Core et al., 2005; Jensen and Meckling, 1976). Firms finance their operations, however, with funds from both shareholders and creditors, e.g., bondholders. Thus, agency theory also concerns shareholder-bondholder agency conflict and the difficulty of concurrently aligning the interests of shareholders, bondholders, and managers (Ahmed et al., 2002; Jensen and Meckling, 1976; Ortiz-Molina, 2007). In the past decade, the business press has focused on excessive CEO pay, observed during the 2001 Enron/Worldcom scandals as well as the recent 2007–2008 credit crisis, e.g., AIG. Critics contend that contracting between CEOs and boards has been shadowed by pervasive managerial influence (Bebchuk and Fried, 2005; Crystal, 1992). Consistent with these concerns, shareholders have begun to use the “shareholder proposal rule” (Rule 14a-8) established by the Securities and Exchange Commission (SEC) to defend their interest and have submitted hundreds of proposals to many of the largest U.S. corporations.

In our paper, Incentive Alignment through Performance-Focused Shareholder Proposals on Management Compensation, forthcoming in the Journal of Contemporary Accounting and Economics, we document a related concept, emerging pay-performance activism sponsored by shareholders, and examine how bondholders perceive such activism. We identify pay-performance activism as those shareholder proposals with a sharp focus on executive compensation issues tied to financial performance. Such performance-focused shareholder proposals (PSPs) are theoretically and practically different than those proposals that call only for CEO pay constraints or that tie CEO pay to certain social and environmental actions (non-performance-focused shareholder proposals [NPSPs]). The appendix provides two examples of both types. Our study centers on PSPs that demand that directors tie executive compensation more closely to firm performance, thereby realigning manager interests with those of their shareholders.

Our first research question, a building block for our next and primary question, rests on the uniqueness of the increasing number of PSPs filed by investors. There has been some research into the effects of shareholder concerns or threats on stock price, financial performance, or executive compensation (Johnson and Shackell, 1997; Johnson et al., 1997; Karpoff et al., 1996). From a rational shareholder’s perspective, performance-focused proposals should be most beneficial to shareholder interests. Given that Section 953a of the Dodd-Frank Act of 2010 requires firms to disclose more details of their pay-for-performance practices, an examination of PSPs has the potential to provide timely insights to the SEC, the designated market regulator. Little is known, however, about the determinants and market impact of performance-focused shareholder proposals. Thus, we extend prior research by providing new evidence on the differences between PSPs and NPSPs in terms of their economic determinants and consequences.

Our primary research question is related to the probable negative side effects of PSPs on bondholders and their regulatory implications. Equity-linked compensation (especially CEO executive compensation, heavy with stock options) can increase risk-taking incentives for managers (Jensen and Meckling, 1976; Jensen and Murphy, 1990). Bebchuk and Spamann (2009), in reflecting on the crisis between 2007 and 2009, attribute bankers’ excessive risk-taking behavior to the high equity component in executive compensation. They noted that, with the increase in executive pay sensitivity to stock price as well as to stock price volatility, management may serve the interests of shareholders through further risk-taking and at the expense of all other stakeholders, including bondholders.

By constructing a sample of 136 S&P 500 companies that received at least one PSP between 1996 and 2006, we first test whether targeted firms that receive PSPs have, ex ante, pay practices that are suboptimal from an alignment perspective, as compared with control firms. The first of our two control groups consists of 262 S&P 500 companies that were not targeted by either PSPs or NPSPs between 1996 and 2006. Our second control group is comprised of 51 firms that received NPSPs during the same period. We start by studying the determinants of a firm that received a PSP relative to no proposals and/or received an NPSP. Next, we test for improvement in management incentive alignment following the proposal year by studying changes in pay-performance sensitivity for PSP firms, compared with control firms. Third, we examine stock returns as related to the proposal day to determine the effect of proposals on shareholders and the bond market reaction around the proposal day. We test our bond results at both the firm and bond levels and find that our results are robust under both settings.

Our results show that firms with higher excess CEO compensation are more likely to receive PSPs, compared to firms that receive NPSPs or firms that receive no proposals. Second, firms that receive PSPs see their equity-based pay-for-performance sensitivity increase significantly following the proposal year, compared with control firms that received NPSPs or did not receive proposals. Third, as a result of PSPs, shareholders enjoy significantly positive abnormal stock returns, while bondholders suffer significant negative abnormal bond returns. Further exploratory analyses suggest that high-leverage firms experience more negative abnormal bond returns than do low-leverage firms and that the volatility change after PSP proxy filing dates explains the negative bond reaction. This is consistent with the notion that pay design changes lead to more risk-taking behavior by target firms.

We contribute to the literature as well as to the ongoing regulatory debate in several ways. First, to the best of our knowledge, we present the first evidence of bondholder reaction to shareholder proposals. Specifically, the realignment of manager and shareholder interests due to the PSP is associated with a decrease in bond returns. Because there is a trade-off between shareholder-manager interest alignment and shareholder-bondholder conflict (DeFusco et al., 1990; Klein and Zur, 2011; Ortiz-Molina, 2007), our results suggest that boards of directors and regulators should adopt a balanced approach in dealing with activist shareholder campaigns, particularly those concerning top management incentive compensation. The SEC was established in the 1930s with a mandate to protect investors in securities (both stocks and bonds). To fulfill its duty toward public bondholders, the second SEC chairman William Douglas lobbied Congress to pass the Trust Indenture Act of 1939 and established the bond trustee system in the United States. In response to the Dodd-Frank Act of 2010, the SEC released the new “Say-on-Pay” regulation in January 2011. From a bondholder’s perspective, the new SEC regulation might result in unintended consequences that have the potential to compromise its duty toward bondholders.

Second, we provide the initial evidence that PSPs are very different from NPSPs through our investigation of the determinants and consequences of the emerging pay-performance activism through PSPs. Recent studies focus on the effect of overall shareholder votes and related regulations on compensation issues (e.g., Carter and Zamora, 2009; Ferri and Maber, 2012). Prior research does not, however, differentiate PSPs from NPSPs. We extend the findings of such research by isolating PSPs from NPSPs based on incentive alignment and agency theory (Jensen and Meckling, 1976), on increased investor demand (Rappaport and Nodine, 1999), and on emerging trends in institutional practices (CalPERS, 2010). We find that PSPs and NPSPs are different with respect to the rationale for targeting a specific firm and their impact on firm pay-performance sensitivity.

Shareholder proposals are often perceived by the business community and some popular business newspapers to be submitted by less-sophisticated investors and to have little effect on important governance matters, as compared with activist campaigns by large investors, such as hedge funds. Our results, however, suggest that PSP (but not NPSP) sponsors are more sophisticated investors, who understand the proper use of management compensation contracts in maximizing their own utility. For instance, our results show that PSP sponsors target firm CEOs with excess compensation, while NPSP target CEOs without excess compensation. Firms targeted by PSP (but not NPSP) sponsors increase their CEO pay-for-performance sensitivity. Our evidence suggests that treating shareholder proposals based on whether they are performance-focused can provide additional insight into how different types of shareholders interact with their target firms.

Third, our research also informs the ongoing debate about executive compensation regulation. The business press cites poor incentives as “one of the most fundamental causes” of the recent economic crisis (Blinder, 2009). According to Solomon and Paletta (2009), the Obama administration clearly believes that “more closely align[ing] pay with long term performance” is the lesson from the recent recession. Nevertheless, lack of pay-performance sensitivity does not seem to be the actual cause for the excessive risk taking between 2002 and 2007 (DeYoung et al., 2009). Further, the collapse of any high-leverage business, such as banking, e.g., Lehman Brothers, implies larger losses in absolute dollars for bondholders and average depositors than for shareholders. Interestingly, these anecdotal results are consistent with our untabulated test results that show that the bonds of high-leverage firms suffer more negative returns than do those of low-leverage firms. In summary, we are concerned that more shareholder activism, as further encouraged by the Dodd-Frank Act of 2010, could generate unintended negative effects for bondholders.

The full paper is available for download here.