Incentive Alignment through Performance-Focused Shareholder Proposals on Management Compensation
McGill University – Desautels Faculty of Management
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University of Texas at Arlington – Department of Accounting
Xu (Frank) Wang
Saint Louis University
Sanjian Bill Zhang
May 28, 2014
Journal of Contemporary Accounting and Economics, Forthcoming
We investigate an emerging pay-performance activism under a natural setting of performance-focused shareholder proposals rule (PSPs) (Rule 14a-8) established by the Securities and Exchange Commission (SEC) for top management compensation. We find that: (1) PSP sponsors successfully identify firms that suffer from a misalignment of managers and shareholders’ interests; (2) CEOs’ pay-for-performance sensitivity increases in the post-proposal period; and (3) shareholders benefit through positive stock returns as related to proposal filing dates; while (4) bondholders suffer significant negative returns and even more so for high-leverage firms. Our additional analyses suggest that perceived risk increase is the main driver of observed negative abnormal bond returns. However, we fail to find similar results for shareholder proposals not focused on performance (NPSPs). Collectively, our results indicate that shareholders benefit from this pay-performance activism through PSPs (but not NPSPs), but potentially at the expense of bondholders.
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 this paper, 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.1 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.
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