Climbing the Corporate Ladder
Are Incentive Contracts Rigged By Powerful CEOs?
Adair Morse, Vikram Nanda & Amit Seru
Journal of Finance, forthcoming
Abstract:
We argue that powerful CEOs induce their boards to shift the weight on performance measures towards the better performing measures, thereby "rigging" the incentive part of their pay. The intuition is developed in a simple model in which some powerful CEOs exploit superior information and lack of transparency in compensation contracts to extract rents. The model delivers an explicit form for the rigging of CEO incentive pay along with testable implications that rigging is expected to (1) increase with CEO power; (2) increase with CEO human capital intensity and uncertainty about a firm's future prospects; and (3) negatively impact firm performance. Using measures of CEO power and board independence on a large panel of firms in the U.S., we find support for these predictions. Our results provide evidence supporting the entrenchment skimming theory and advocate for requiring ex ante disclosure of incentive contract terms.
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Inside the black box: The role and composition of compensation peer groups
Michael Faulkender & Jun Yang
Journal of Financial Economics, forthcoming
Abstract:
This paper considers the features of the newly disclosed compensation peer groups and demonstrates their significant role in explaining variations in chief executive officer (CEO) compensation beyond that of other benchmarks such as the industry-size peers. After controlling for industry, size, visibility, CEO responsibility, and talent flows, we find that firms appear to select highly paid peers to justify their CEO compensation and this effect is stronger in firms where the compensation peer group is smaller, where the CEO is the chairman of the board of directors, where the CEO has longer tenure, and where directors are busier serving on multiple boards.
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Quadrophobia: Strategic Rounding of EPS Data
Joseph Grundfest & Nadya Malenko
Stanford Working Paper, October 2009
Abstract:
We hypothesize that earnings management causes quadrophobia, the under-representation of the number four in the first post-decimal digit of EPS data. We demonstrate that quadrophobia is pervasive, persistent, and follows economically rational patterns. Consistent with analyst coverage being a determinant of earnings management, quadrophobia increases (declines) when companies gain (lose) analyst coverage, and is more frequent when earnings are close to analyst forecasts. Persistent quadrophobes are more likely to restate financials and to be sued in SEC proceedings alleging accounting violations. Quadrophobia, even if itself legal, therefore appears to signal a propensity to engage in problematic accounting practices.
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Lauren Cohen, Andrea Frazzini & Christopher Malloy
Journal of Finance, forthcoming
Abstract:
We study the impact of social networks on agents' ability to gather superior information about firms. Exploiting novel data on the educational backgrounds of sell side analysts and senior corporate officers, we find that analysts outperform by up to 6.60% per year on their stock recommendations when they have an educational link to the company. Pre-Reg FD, this school-tie return premium is 9.36% per year, while post-Reg FD the return premium is nearly zero. In contrast, in an environment that did not change selective disclosure regulation (the UK), the school-tie premium is large and significant over the entire sample period.
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Gaming Performance Fees by Portfolio Managers
Dean Foster & Peyton Young
Quarterly Journal of Economics, forthcoming
Abstract:
We show that it is very difficult to devise performance‐based compensation contracts that reward portfolio managers who generate excess returns while screening out managers who cannot generate such returns. Theoretical bounds are derived on the amount of fee manipulation that is possible under various performance contracts. We show that recent proposals to reform compensation practices, such as postponing bonuses and instituting clawback provisions, will not eliminate opportunities to game the system unless accompanied by transparency in managers' positions and strategies. Indeed there exists no compensation mechanism that separates skilled from unskilled managers solely on the basis of their returns histories.
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Alexi Savov
Journal of Finance, forthcoming
Abstract:
A new measure of consumption - garbage - is more volatile and more correlated with stocks than the standard measure, NIPA consumption expenditure. A garbage-based CCAPM matches the U.S. equity premium with relative risk aversion of 17 versus 81 and evades the joint equity premium-risk-free rate puzzle. These results carry through to European data. In a cross section of size, value, and industry portfolios, garbage growth is priced and drives out NIPA expenditure growth.
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Economic and psychological perspectives on CEO compensation: A review and synthesis
Charles O'Reilly & Brian Main
Industrial and Corporate Change, forthcoming
Abstract:
To many, the principal-agent model is the obvious lens through which executive pay should be viewed. Such a sentiment sits uncomfortably with a large number of empirical studies suggesting that the process of determining executive pay seems to be more readily explained by recourse to arguments of managerial power and influence. This article investigates the micro-underpinnings of boardroom behavior in order to explain this departure from principal-agency theory's argument that executive compensation serves to align interests between the owners of the company and its senior managers. We find that there are strong interaction effects among social influence variables and the social setting of boardroom activity. Generous pay awards, bearing only a weak connection to corporate performance, are explained in the context of the social psychology of the boardroom. These results and a review of the empirical research, suggest the need for a more comprehensive model of executive compensation that incorporates both economic and psychological determinants.
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Executive Compensation: A New View from a Long-Term Perspective, 1936-2005
Carola Frydman & Raven Saks
Review of Financial Studies, forthcoming
Abstract:
We analyze the long-run trends in executive compensation using a new dataset of top officers of large firms from 1936 to 2005. The median real value of compensation was remarkably flat from the late 1940s to the 1970s, revealing a weak relationship between pay and aggregate firm growth. By contrast, this correlation was much stronger in the past thirty years. This historical perspective also suggests that compensation arrangements have often helped to align managerial incentives with those of shareholders because executive wealth was sensitive to firm performance for most of our sample. These new facts pose a challenge to several common explanations for the rise in executive pay since the 1980s.
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Delaware's Shrinking Half-Life
Mark Roe
Stanford Law Review, December 2009, Pages 125-155
Abstract:
A revisionist consensus among corporate law academics has begun to coalesce that, after a century of academic thinking to the contrary, states do not compete head-to-head on an ongoing basis for chartering revenues, leaving Delaware alone in the ongoing interstate charter market. The revisionist view pushes us to consider how free Delaware is to act. Where and when would it come up against boundaries, punishments, and adverse consequences? When do other states (and Washington) constrain Delaware? Recent state corporate lawmaking helps us to define those boundaries in terms of potential state competition and to see that the critical actors are not other states' lawmakers directly, but Delaware's own corporate constituents who, if disgruntled, can induce other states to enact new laws. Moreover, analysis of previously unassembled chartering revenue data from Delaware's Secretary of State's office displays a vital dimension of state competition, once thought to be relatively unimportant, but that's becoming increasingly powerful: Delaware's tax base is eroding, and it's eroding faster in the past decade or so than ever. Delaware must move ever faster to replenish that erosion. The dynamism of American business interacts with even a lackluster state-based corporate chartering market to put powerful pressure on Delaware, whose business base is persistently eroding as firms merge, close, and restructure.
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Does corporate governance matter in competitive industries?
Xavier Giroud & Holger Mueller
Journal of Financial Economics, March 2010, Pages 312-331
Abstract:
By reducing the threat of a hostile takeover, business combination (BC) laws weaken corporate governance and increase the opportunity for managerial slack. Consistent with the notion that competition mitigates managerial slack, we find that while firms in non-competitive industries experience a significant drop in operating performance after the laws' passage, firms in competitive industries experience no significant effect. When we examine which agency problem competition mitigates, we find evidence in support of a "quiet-life" hypothesis. Input costs, wages, and overhead costs all increase after the laws' passage, and only so in non-competitive industries. Similarly, when we conduct event studies around the dates of the first newspaper reports about the BC laws, we find that while firms in non-competitive industries experience a significant stock price decline, firms in competitive industries experience a small and insignificant stock price impact.
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Who Blows the Whistle on Corporate Fraud
Alexander Dyck, Adair Morse & Luigi Zingales
Journal of Finance, forthcoming
Abstract:
To identify the most effective mechanisms for detecting corporate fraud we study all reported fraud cases in large U.S. companies between 1996 and 2004. We find that fraud detection does not rely on standard corporate governance actors (investors, SEC, and auditors), but takes a village, including several non-traditional players (employees, media, and industry regulators). Differences in access to information, as well as monetary and reputational incentives help to explain this pattern. In-depth analyses suggest reputational incentives in general are weak, except for journalists in large cases. By contrast, monetary incentives help explain employee whistleblowing.
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Steven Bank & Brian Cheffins
University of California Working Paper, January 2010
Abstract:
In many parts of the world, it is commonplace for wealthy families and successful entrepreneurs to parlay a relatively small financial investment into control of a sprawling corporate empire through the use of a pyramid-like structure in which they directly control a firm that owns a dominant stake in a company or companies with outside investors, which in turn controls other firms in the same manner and so on. In the United States, however, corporate pyramids are the exception to the rule. Why is this controversial business arrangement, stigmatized as a device economic elites use to disguise market power and manipulate government, largely absent from the U.S. corporate landscape? The conventional wisdom is that they were dismantled by New Deal policymakers who introduced in 1935 a tax on dividends paid to corporate shareholders. We show that this version of events is more fable than truth, relying primarily on a hand collected dataset drawn from filings made with the Securities and Exchange Commission between 1936 and 1938 by companies owning 10% or more of shares of companies registered with the Commission. We account for the rarity of corporate pyramids in the U.S. largely in terms of history, indicating that prior to the New Deal they were only ever extensively used in the utilities sector, where elimination of pyramidal structures was driven primarily by the Public Utilities Holding Company Act of 1935. Tax may have had an effect on corporate structure, but, at least in this instance, it was not the great leveller that the corporate pyramid fable would suggest.
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International Differences in the Size and Roles of Corporate Headquarters: An Empirical Examination
David Collis, David Young & Michael Goold
Harvard Working Paper, December 2009
Abstract:
This paper examines differences in the size and roles of corporate headquarters around the world. Based on a survey of over 600 multibusiness corporations in seven countries (France, Germany, Holland, UK, Japan, US, and Chile) the paper describes the differences among countries, and then applies a model of the factors determining the size of corporate headquarters (Young, Collis, and Goold, 2003) to systematically examine those differences. The data shows that there are significant differences among countries in the size and role of corporate headquarters, and strongly suggests the existence of a developing country model, a European model, a US model, and a Japanese model of corporate headquarters. Contrary to popular expectations, corporate headquarters in the US are about twice the size of European counterparts. Headquarters there exert a higher level of functional influence and have larger staffs in certain key areas, such as IT and R&D. US managers are generally more satisfied than their European counterparts with their larger more powerful headquarters which suggests that, at least in the US context, large corporate headquarters can create value. Japanese headquarters, as might have been expected, are substantially larger than elsewhere - a factor of four times larger than in Europe. However, those headquarters are becoming smaller because of dissatisfaction with their performance. It is clear that having headquarters the size of the Japanese firms in the survey is not conducive to value creation. More specifically, the evidence cannot refute a hypothesis that the slope of the relationship between firm size and the size of corporate headquarters is the same across all countries, but that there are significant differences in the intercept for Chile, the US, Japan, and the European countries. What the data indicates is that at a firm employing 20,000, a European corporate headquarters would on average employ 124 individuals, a US headquarters would have 255 employees, and Japan 467 employees. The paper also examines differences between countries in the extent to which they perform the two key corporate tasks of control and coordination. The US and Chile chose to be somewhat more interventionist in the traditional tools and processes used to monitor and control business units - setting strategy, budgets, and administering capital budgets. However, there was a significant difference in the degree of influence in operational affairs between countries. The US and Japan exerted far more influence than the other countries over every activity from IT and purchasing, to marketing, R&D and HR issues. The US was also found to have significantly larger legal, tax, and treasury functions than the common European model, perhaps reflecting a more legalistic institutional structure. Japan also has significantly larger tax, treasury, and corporate management functions, but overall was not that much larger than the common European model. While the causes of these observed differences cannot be directly determined from the research, suggestions are made that the institutional infrastructure, the size and homogeneity of the domestic market, and cultural factors within countries are important underlying drivers.
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Making imaginary worlds real: The case of expensing employee stock options
Sue Ravenscroft & Paul Williams
Accounting, Organizations and Society, October 2009, Pages 770-786
Abstract:
West [West, B. (2003). Professionalism and accounting rules. London: Routledge] and Chambers [Chambers, R. J. (1966). Accounting evaluation and economic behavior. Houston: Scholars Book Company] have provocatively argued that financial reporting has reached a state of near-total incoherence. In this paper, we argue that a source of this incoherence is the transformation of the US accounting academy into a sub-discipline of financial economics, a transformation in which accounting became a servant of the imaginary world of neoclassical economics. After noting the unusually prominent role of rules within the accounting profession, we describe the displacement of accounting's centuries-old root metaphor of accountability by the metaphor of information usefulness, and situate that displacement within neoliberalism, a broader political movement that arose after World War II. Finally, we use SFAS 123R, the recently issued stock option standard, as a case study of the incoherence that West and Chambers assert. Through various issues - such as reflexivity, theory paradox, and unexplained questions of responsibility - we demonstrate the logical inconsistencies involved in SFAS 123F. The incoherence of stock option reporting rules raises serious questions about the information metaphor as a foundation for either individual rules or the standard setting process. The Financial Accounting Standards Board's (FASB) attempts to make the imaginary world of neoclassical economics real have resulted in rules which are not defensible.