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E-MailDenton Collins is a Jerry S. Rawls Professor of Accounting at Texas Tech University Rawls College of Business. This post is based on a paper authored by Professor Collins, Blair B. Marquardt, and Xu Niu. Related research from the Program on Corporate Governance about CEO pay includes Paying for Long-Term Performance (discussed on the Forum here) and the book Pay without Performance: The Unfulfilled Promise of Executive Compensation, both by Lucian Bebchuk and Jesse Fried.
Equity-based compensation has interested business leaders, regulators, and researchers for decades, and remains a significant but controversial form of executive compensation. On the one hand, stock options and stock awards align the interests of managers and shareholders at a fundamental level—directly associating compensation to changes in shareholder wealth. Thus, equity-based compensation serves as a governance mechanism and provides strong incentives for management to create value to shareholders. This has generally been supported by research. On the other hand, equity-based compensation has been linked to many unintended consequences that can negatively affect shareholder value (e.g., earnings management, excessive risk taking). Further, equity-based compensation is generally complex and opaque relative to other forms of compensation.
Despite decades of research into the firm-level outcomes of equity incentives, relatively little empirical research has studied shareholder perceptions of executive compensation. In our paper, CEO Equity-based Incentives and Shareholder Say-on-Pay in the U.S., we fill this gap by examining the relationship between shareholder approval of executive compensation packages and two equity-based incentives, pay-performance sensitivity and pay-risk sensitivity. Pay-performance sensitivity refers to the sensitivity of equity awards’ value to changes in the stock price, and incentivizes management to maximize stock price. Pay-risk sensitivity refers to the sensitivity of equity awards’ value to changes in stock price volatility, and incentivizes management to engage in risky projects. Together, they signify the underlying ability of equity-based compensation to promote value creation by management.
We consider this an important relationship to study. Given the multitude of consequences associated with equity-based compensation, its usefulness as a governance tool is debatable ex ante. Our study asks whether shareholders—those with the greatest and most direct concern for the maintenance of and increase in firm value—consider whether the benefits of equity-based compensation outweigh its costs when voicing their approval/disapproval of the compensation package. We emphasize that our study measures the sensitivity, not level, of stock options and stock awards to changes in performance and risk. Thus, we target the incentive effect, while holding constant absolute levels of compensation. This creates a powerful setting for evaluating the perceptions of the investing public of equity-based compensation as a governance mechanism.
Beginning in 2011 as part of the Dodd-Frank Wall Street Reform Act, shareholders of public U.S. companies vote on the compensation package of top executives. This vote is commonly referred to as “Say-on-Pay” in business media and research. We take advantage of the abundance of new shareholder voting data created by this exogenous event to address our research question. More specifically, we use the proportion of favorable votes as a gauge of shareholder approval of various compensation factors. In the majority of our analyses, we focus on the executive with greatest visibility and influence over the company—the CEO.
We document several findings of note. First, we document a significant positive association between shareholder approval and both pay-performance sensitivity and pay-risk sensitivity. On average, shareholders appear to prefer greater sensitivity of CEO equity awards to shareholder wealth factors, performance and risk. Our results suggest that shareholders consider equity-based incentives to be value-enhancing, and that shareholders reward greater sensitivity with greater approval during the vote. The relationship is especially strong for pay-performance sensitivity.
Second, we find that the association between shareholder approval and equity-based incentives is stronger in settings where theory suggests that demand for equity-based incentives will be higher. Specifically, we find the effect is stronger at firms with relatively sophisticated ownership, as represented by proportion institutional ownership, and at growth firms, as represented by high market-to-book ratio. These findings corroborate our main findings in salient settings of high demand for executive incentives.
However, we also document evidence that shareholders perceive the benefits of equity-based incentives, specifically pay-performance sensitivity, as diminishing in nature. We find that, while the relationship between pay-performance sensitivity and favorable vote is positive, the association becomes less positive as pay-performance sensitivity increases. In other words, we identify a concave relationship between the proportion of favorable votes and pay-performance sensitivity. This is consistent with shareholders voting according to an understanding of the mixed consequences of equity-based compensation identified by prior research.
Our study provides encouraging evidence regarding shareholder activism and participation in the setting of executive compensation. We demonstrate a significant link between shareholder approval of the compensation package and measures of pay-performance sensitivity and pay-risk sensitivity. This implies not only that shareholders consider equity-based compensation as value relevant, but that they demonstrate a relatively sophisticated understanding of the incentive effects of compensation. Furthermore, since a goal of the Dodd-Frank Act was to reduce the agency problem between management and shareholders at large through greater shareholder monitoring, our findings support the interpretation that the vote serves an effective monitoring tool over the board of directors and top management. Finally, our results imply that shareholders make their opinions heard. Our research, along with that of our peers, indicates that shareholder voting is not random and that shareholders actively participate in the opportunity to influence executive compensation. We expect the article to be of interest to professionals, policymakers, and academics in the business domain.
The full paper is available for download here.
