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Executive Compensation and Corporate Strategies Ji-Chai Lin Louisiana State University For 2014 Workshop at UESTC. A Theory of Friendly Boards by ADAMS and FERREIRA (2007, JF). This paper analyzes the consequences of the board’s dual role as advisor as well as monitor of management.

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Executive Compensation and Corporate StrategiesJi-Chai LinLouisiana State UniversityFor 2014 Workshop at UESTC

a theory of friendly boards by adams and ferreira 2007 jf
A Theory of Friendly Boardsby ADAMS and FERREIRA (2007, JF)
  • This paper analyzes the consequences of the board’s dual role
    • as advisor as well as monitor of management.
  • Given this dual role,
    • the CEO faces a trade-off in disclosing information to the board:
      • If he reveals his information, he receives better advice;
      • however, an informed board will also monitor him more intensively.
the monitoring role of the board
the monitoring role of the board
  • The board of directors must review and approve
    • fundamental operating and financial decisions, and
      • other corporate plans and strategies.
  • Because managers’ preferred projects are not always those that maximize shareholder value,
    • directors must be willing to withhold approval and insist on change.
  • This active participation in the firm’s decision making characterizes
    • the monitoring role of the board.
the advisory role of the board
The advisory role of the board
  • The board takes a more hands-off approach in its advisory role.
  • The board draws upon the expertise of its members
    • to counsel management on the firm’s strategic direction.
      • They contribute their opinions as to general policy, and their judgement whenever a problem comes up.
  • However, since many board members have full-time jobs in other corporations,
    • they rely on the CEO to provide them with relevant firm-specific information.
  • The better the information the CEO provides, the better is the board’s advice.
moral hazard problems and monitoring
moral hazard problems and monitoring
  • Moral hazard problems arise
    • because the CEO’s preferred projects differ from those of the shareholders.
  • When monitoring by the board is successful,
    • the board effectively controls project selection, and
    • the CEO, unable to implement his preferred projects, loses valuable control benefits.
a trade off in disclosing information to the board
a trade-off in disclosing information to the board
  • the CEO faces a trade-off in disclosing information to the board:
    • If he reveals his information, he receives better advice;
    • however, an informed board will also monitor him more intensively.
independent boards
independent boards
  • Independent boards monitor management more intensively.
  • Thus, the CEO faces a trade-off in sharing information.
    • On the one hand, the board will give better advice if the CEO shares his information.
    • On the other hand, information revealed by the CEO helps the board determine the range of options available to the firm.
  • The more precise the board’s information about these options,
    • the greater the risk to the CEO that the board will interfere in decision making.
  • As a result, they show that
    • the CEO will not communicate firm-specific information to a board that is too independent.
management friendly boards can be optimal
management-friendly boards can be optimal!
  • To encourage the CEO to share information,
    • shareholders may optimally elect a less independent or friendlier board
      • that does not monitor the CEO too intensively.
  • In other words, in selecting their boards,
    • shareholders may choose to play off one role against the other.
a dual board system
a dual board system
  • When the two roles are separated,
    • the CEO does not face a trade-off in providing information.
  • Their model therefore shows that, under certain conditions, shareholders prefer
    • a dual board system, the separation of the board’s advisory and monitoring functions,
      • to a sole board system.
  • While the dual board structure allows for the cleanest separation of the board’s two roles,
    • it is possible to replicate this structure by separating the roles through the use of board committees,
      • like audit committee as fulfilling some of the functions of a supervisory board.
policy implications
policy implications
  • Because boards have been criticized for being too friendly to managers,
    • the NYSE, and NASDAQ now require that
      • independent directors play a more important role in firm governance.
  • In the context of their model, policies that enhance board independence
    • may be detrimental for shareholders in a sole board system,
      • but not for shareholders in a dual board system.
  • Shareholders are always at least weakly better off
    • if the board has an advisory role.
Strategic flexibility and the optimality of pay for sector performanceby Gopalan, Milbourn, and Song (2010, RFS)
  • One of the basic tenets of compensation theory is that
    • optimal incentive-based pay should depend on variables under the manager's control
    • and not on those over which she has no control.
  • While standard contract theory suggests that
    • a CEO should be paid relative to a benchmark that removes the effects of sector performance,
    • there is evidence that CEO pay is strongly and positively related to such sector performance.
  • Many have coined this relationship as pay for firm performance due to luck.
  • This paper provides an alternative explanation …
strategic flexibility
Strategic flexibility
  • They model a CEO charged with selecting the firm's strategy,
    • which determines the firm's exposure to sector performance.
  • While there are clearly market forces at work that are beyond the executive's control,
    • the CEO typically has at least some discretion over the firm's exposure to such forces
      • through the choice of the firm's strategy.
  • To incentivize the CEO to choose optimally,
    • pay contracts will be positively and sometimes asymmetrically related to sector performance.
ceo s job
CEO’s job
  • To understand CEO pay,
    • we should first specify what CEOs actually do in that role.
  • The Board of Directors is not primarily concerned with
    • how hard the CEO is actually working,
    • but whether she has the vision to choose the right strategy for deploying the firm's assets.
  • In doing so, the CEO concerns herself with
    • the firm's strategic direction in lieu of its surrounding market environment:
      • Where is the sector going and how does the firm fit into it?
      • What type of exposure to the sector is optimal for the firm?
  • Thus, choosing the firm's strategy,
    • CEO affects the firm's exposure to sector movements.
ceos actively influence firm strategy
CEOs actively influence firm strategy
  • CEOs have become more highly valued for their general management skills, rather than for their firm-specific knowledge.
  • This is akin to a world where CEO ability is linked explicitly to navigating the firm within the broad market.
optimal incentive contracts
optimal incentive contracts
  • The optimal contract rewards the CEO for firm performance
    • induced by sector movements so as to provide her incentives to
      • exert effort to forecast the sector movements and
      • choose the firm's optimal exposure to them.
  • Benchmarking the CEO's performance against her sector
    • is the same as not offering her pay for sector performance and
    • will make firm investment decisions insensitive to sector movements.
  • This practice is suboptimal if sector performance affects firm performance.
main findings on the sensitivity of pay to sector performance
Main findings on the sensitivity of pay to sector performance
  • 1. Multi-segment firms,
      • especially those in which the sector performances of the different segments are less positively correlated,
    • will offer pay contracts that are more sensitive to sector performance as compared to single segment firms.
    • This is because such firms provide greater opportunity to the CEO to actively shift resources towards sectors that are likely to outperform.
  • 2. The sensitivity of pay to sector performance will be greater in any firm that
    • offers greater strategic flexibility to the CEO to alter firm exposure to sector movements and for more talented CEOs.
asymmetric pay
Asymmetric pay
  • the optimal contract
    • rewards a risk-averse CEO more when sector performance is good than
    • punishes her when sector performance is bad;
  • that is, the optimal contract is asymmetrically sensitive to good and bad sector performance.
two proxies for strategic flexibility
Two proxies for strategic flexibility
  • 1. the industry market-to-book ratio.
    • Industries with high market-to-book ratios are likely to have greater investment and growth options and
    • thereby offer CEOs greater strategic flexibility in timing the exercise of those options.
  • 2. the level of R&D expenditures in an industry.
    • Firms in industries with higher levels of R&D expenditures are likely to provide their CEOs with greater strategic flexibility.
    • In these industries, the CEO has more latitude to scale up or down such expenditures and thereby change the firm's exposure to market conditions.
pay and strategic flexibility
Pay and strategic flexibility
  • Pay for sector performance is in fact greater
    • for the subsample of firms in industries with high market-to-book ratios.
  • Similar results hold when they measure strategic flexibility using industry R&D expenditures.
evidence of strategic flexibility
evidence of strategic flexibility
  • firms with greater pay for sector performance to show some evidence of CEOs exploiting their strategic flexibility to a greater extent at the firm level.
  • CEO pay is more sensitive to sector performance in firms that have
    • positive industry-adjusted R&D expenditures the following year and
    • positive industry-adjusted asset-growth rates during the sample period.
  • the likelihood of a disciplinary CEO turnover is sensitive to sector performance
    • only in firms from industries with high market-to-book ratios and R&D expenditures.
The Role of Stock Liquidity in Executive Compensationby Jayaraman and Milbourn (2012, Accounting Review)
  • Explore the role of stock liquidity in influencing the composition of CEO annual pay and the sensitivity of managerial wealth to stock prices.
main findings
Main findings
  • 1. As stock liquidity goes up,
    • the proportion of equity-based compensation in total compensation increases
    • while the proportion of cash-based compensation declines.
  • 2. The CEO’s pay-for-performance sensitivity with respect to stock prices
    • is increasing in the liquidity of the stock.
  • The main findings are supported by additional tests
    • based on shocks to stock liquidity and
    • two-stage-least squares specifications that mitigate endogeneity concerns.
  • The evidence is consistent with optimal contracting theories.
  • It contributes to the ongoing debate about the increasing trend of both
    • equity-based over cash-based compensation and
    • the sensitivity of total CEO wealth to stock prices rather than earnings.
stock market liquidity and firm value by fang noe and tice jfe 2009
Stock market liquidity and firm valueby Fang, Noe, and Tice (JFE, 2009)
  • In theoretical analyses, liquid markets have been shown to
    • permit non-blockholders to intervene and become blockholders
      • (Maug (1998)),
    • facilitate the formation of a toehold stake
      • (Kyle and Vila (1991)),
    • promote more efficient management compensation
      • (Holmstrom and Tirole (1993)), and
    • stimulate trade by informed investors,
stock liquidity and corporate investments
Stock liquidity and corporate investments
  • Thus, liquid markets improve investment decisions and make share prices more informative
      • (Subrahmanyam and Titman (2001) and Khanna and Sonti (2004)).
  • Therefore, a priori, a positive relation between liquidity and performance is quite plausible.
  • However, empirical researchers have not made this relation the center of systematic empirical investigation.
the goals of this paper
The goals of this paper
  • to fill this gap in the literature by examining whether and why liquidity affects firm performance.
  • Firm performance:
    • Captured by market-to-book
decomposing m b
Decomposing M/B
  • Market-to-book
    • = (Vd + Ve)/(Assets)

= [(Vd + Ve)/Op. Income] × [Op. Income /Assets]

=[Ve/Op Income] × [(Ve + Vd)/Ve] × [Op. Income/Assets]

= (Price to Op. Income) × (Firm Value to Market Value of Equity) ×(Operating Income to Assets)

three components of m b
Three components of M/B
  • Thus, the market-to-book ratio is separated into the following components:
    • price-to-operating earnings ratio (OIP);
    • leverage ratio; and
    • operating return on assets ratio.
empirical results1
Empirical results
  • More liquid stocks have
    • higher operating returns on their assets and
    • more equity in their capital structure.
  • In contrast, their price-to-operating earnings ratios (P/E) are similar to less liquid stocks.
robustness checks
Robustness checks
  • These results hold when they control for
    • industry and firm fixed effects, the level of shareholder rights, stock return momentum, idiosyncratic risk, analyst coverage, and
      • endogeneity using an instrumental variables procedure.
exogenous shocks to stock liquidity
Exogenous shocks to stock liquidity
  • An exogenous shock to liquidity on firm performance:
    • Decimalization increased stock liquidity in general but
    • it increased more for actively traded stocks.
  • The change in liquidity surrounding decimalization is used as an instrument for liquidity:
    • stocks with a larger increase in liquidity following decimalization have a larger increase in firm performance.
how does liquidity improve firm performance
How does liquidity improve firm performance?
  • How does liquidity improve firm performance?
    • Making price more informative to stakeholders
    • Permitting more effective contracting on stock price regarding compensation
    • Allowing non-blockholders to intervene and become blockholders
what types of firms benefit the most from stock liquidity
What types of firms benefit the most from stock liquidity?
  • In support, this study documents that the positive effect of liquidity on firm performance is
    • the greatest for liquid stocks
      • with high business uncertainty (high operating income volatility or high R&D intensity).
  • This paper investigates the relation between stock liquidity and firm performance.
    • firms with liquid stocks have better performance as measured by the firm market-to-book ratio.
  • This result is very robust.
  • To identify the causal effect of liquidity on firm performance, they study an exogenous shock to liquidity---the decimalization of stock trading---and document that
    • the increase in liquidity around decimalization improves firm performance.
  • The causes of liquidity’s beneficial effect are investigated:
    • Liquidity increases the information content of market prices and of performance sensitive managerial compensation.
duration of executive compensation by gopalan milbourn song and thakor 2013 jf forthcoming
Duration of Executive Compensationby Gopalan, Milbourn, Song, and Thakor (2013, JF forthcoming)
  • executive compensation is an important tool of corporate governance
    • in aligning the interests of shareholders and managers.
  • Jensen and Murphy (1990) argued famously that
    • what matters in CEO pay is not how much you pay, but how you pay.
  • To this end, an active debate has raged on about what should be
    • the optimal duration of executive compensation.
  • excessive compensation short-termism could lead to
    • self-interested and often myopic managerial behavior.
a number of important yet unanswered questions
a number of important yet unanswered questions
  • questions:
    • How do firms determine the duration of their executive compensation contracts?
    • How is compensation duration related to various firm and industry characteristics?
    • How do observed compensation contracts relate to existing theories?
    • How does past stock performance influence compensation duration?
    • Does the duration of the compensation contract affect the executive's incentives to boost short-term performance?
  • Addressing these questions is hampered by an obvious gap in our knowledge
    • since we have no existing measure that helps to quantify the extent to which executive compensation is short-term or long-term.
a novel measure of pay duration
a novel measure of pay duration
  • This measure is a close cousin of the duration measure developed for bonds.
  • The measure is:
    • The weighted average of the vesting periods of the different components of executive pay
      • (including salary, bonus, restricted stocks, and stock options),
    • with the weight for each component being the fraction of that component in the executive's total compensation package.
hypothesis and main findings
Hypothesis and Main findings
  • They hypothesize that
    • firms with more valuable long-term projects and less risky firms offer their executives longer-duration pay contracts.
  • To measure the duration of the firm's projects,
    • they use market-to-book ratio, the fraction of long-term assets and R&D intensity.
  • Finding: Executive pay duration is longer in firms with higher market-to-book ratio, for firms with more long-term assets and in more R&D-intensive firms.
  • Consistent with their hypothesis, they also find that
    • riskier firms offer shorter-duration pay contracts.
main findings 2
Main findings_2
  • the vesting periods of both stock and option grants cluster around three to five years.
  • significant cross-sectional variation in the pay duration across industries.
    • e.g., executive pay duration is correlated with project and asset duration,
      • industries with longer-duration projects, such as Defense and Utilities, offer longer-duration pay to their executives.
      • firms in the Finance-Trading industry have above-median pay duration (they rank 11th among the 48 industries).
main findings 3
Main findings_3
  • the average pay duration increased during the sample period,
    • especially for executives in the manufacturing and utilities industries.
  • The average pay duration for all executives (including those below the CEO) in our sample is around 1.22 years,
    • while CEO pay has a slightly longer duration at about 1.44 years.
  • Executives with longer-duration contracts receive higher total compensation,
    • but lower bonus, on average.
main findings 4
Main findings_4
  • firms with better recent stock performance
    • offer longer-duration pay contracts to their executives.
  • This may be because
    • realized stock returns are positively correlated with inferences about executive ability,
      • so Boards find it optimal to lengthen vesting schedules to increase the cost of voluntary departure for executives with higher perceived ability.
main findings 5
Main findings_5
  • Pay duration is shorter for executives with higher ownerships in their own firms.
  • But, longer in firms with a larger fraction of independent directors on the board.
main findings 6
Main findings_6
  • Managers with shorter-duration pay contracts are expected
    • to have a stronger proclivity to boost short-term earnings, and
      • hence such firms should be associated with higher abnormal accruals.
  • Indeed, they find a strong negative association
    • between CEO pay duration and abnormal accruals:
    • i.e., firms that offer shorter-duration pay contracts to their CEOs have higher abnormal accruals in the current period.
  • The negative association
      • between CEO pay duration and the level of abnormal accruals
    • is stronger for small firms, young firms, and firms with less liquid stocks.