Executive Remuneration and the Payout Decision

• Published date: 01 January 2016
• Author: Luc Renneboog,Philipp Geiler
• Date: 01 January 2016
• DOI: http://doi.org/10.1111/corg.12127

Executive Remuneration and the Payout Decision

Philipp Geiler, and Luc Renneboog*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paperinvestigates whether corporatepayout policies (dividends,share repurchases,a combina-

tion of dividends and share repurchases, and full earnings retention) are set by CEOs who intend to maximize their personal

wealth.

Research Findings/Insights: For all listed UK companies we study whether the payout channel choice is affected by investor

sentiment, taxation, major shareholder ownership, and in particular the CEO’s compensation package. The payout choice

has an immediate effect on the value of the CEO’s stock options and restricted stock, as anticipated dividends drive down

the value of his equity-based pay (if it is not dividend-protected), and share repurchases have a positive impact on pay. By

means of a quantile regression approach and nested logit models, we f‌ind that CEOs adopt a payout policy that increases

the value of their equity-based pay.

Theoretical/Academic Implications: Traditional research shows that corporate payout policies cater to shareholder clienteles

who have preferences for specif‌ic types of payout induced by e.g. differences in taxation on dividends and capital gains, or

market sentiment. We demonstrate that it is a CEO’s personal wealth as ref‌lected by his compensation package rather than

shareholder preferences that has the strongest impact on the payout policy.

Practitioner/Pol icy Implications: This research encouragesf‌irms/remuneration consultants to make top management’sremu-

neration packages ‘dividend-neutral’, in other words to remove the negative impact of the dividends on pay such that the

payout and payout channel choice will not be inf‌luenced by the CEO’s wealth. In addition, this research encourages

shareholdersto contemplate whether the payoutis benef‌icial for them and to vote on theproposed payout policy at the annual

general meetings.

Keywords: Corporate Governance, Executive Compensation, Payout Policy, Dividends, Share Repurchases

INTRODUCTION

“The American craze for share buybacks shows no sign

of abating. Returning capital to shareholders by

repurchasing stock may soon be more popular than paying divi-

dends. Investorsmay cheer because they payless tax on buybacks.

But they should also worry. because buybacks may be enriching

managers at their expense.”(The Economist,April23,1998).

Are dividends and share repurchases substitutes forcorpo-

rate payouts? The economic answer to this questionis simple.

In a nutshell,dividends are paid out of earningsand result in a

reduction of sha reholders’equity. Repurchases reduce both

the cash position and the number of shares outstanding, i.e.

the leverage ratio increases. As these payout methods do not

alter the f‌irmvalue in perfect capital markets,investors should

be indifferent as to the payout channel (Miller & Modigliani,

1961). Considering dividends and share repurchases as

perfect substitutesignores the many capital market imperfec-

tions induced by informational asymmetries, taxation, share-

holder expectations, and managerial personal rent-seeking.

Accordingly, the two payout methods are inherently distinct

and cannot beregarded as substitutes. Stephensand Weisbach

(1998) suggest that repurchases offer greater f‌lexibility in

quantity and timing than dividend payments. This is consis-

tent with the idea by Jagannathan, Stephens, and Weisbach

(2000), who observe that dividends are usually paid out of

sustainable cash f‌lows (operating cash f‌lows), while stock

repurchases are typically paid out of temporary cash f‌low

surplus (non-operating cash f‌lows). Amihud and Li (2006)

support the idea that, unlike dividends, stock repurchases

preserve f‌inancial f‌lexibility.

While many theories have been proposed to explain the

surge in stock repurchases, there is some evidence that

executive pay practices play an important role in the payout

decision in the US (Fenn & Liang, 2001) and Finland

(Liljeblom & Pasternack, 2006). Whereas in the US study,

executive remuneration has a signif‌icant impact on dividend

policy, the latter study, which is based on a unique dataset

that includes information on the dividend protection of

*Addressfor correspondence:Luc Renneboog,CentER, TilburgUniversity,PO Box 90153,

5000LE Tilburg, the Netherlands. Tel: +31 13 466 82 10; E-mail: luc.renneboog@

tilburguniversity.edu

© 2015 JohnWiley & Sons Ltd

doi:10.1111/corg.12127

42

Corporate Governance: An International Review, 2 016, 24(1): 42–63

equity-based compensation contracts, f‌inds that the Finnish

companies that have adopted such an option program

show no tendency to avoid dividends. While executive

compensation in general and equity-based pay in particular

are meant to function as a corporate governance mecha-

nism that incentivizes management to pursue actions bene-

f‌icial to shareholders, there are doubts about this idea, as

the f‌irm’s payout decision may be inf‌luenced by incentive

pay to the detriment of shareholders. Therefore, Bebchuk,

Fried, and Walker’s (2002) managerial power argument

may be valid, which s tates that the popul arity of executive

stock options results from the fact that, in the eyes of CEOs,

they are the most effective way to extract wealth from the

f‌irm without provok ing “shareholder outrage.”In this pa-

per, we ask how the different components of CEO remuner-

ation affect the le vel of corporate payo ut and the choice

between the diffe rent payout channels i n the UK.

The purpose of this paper is to provide new empirical evi-

dence on the relation between, on the one hand, the level of

dividend and total payout, and the payout channel choice,

and, on the other hand, executive pay practices in the UK,

while accounting for taxation, market sentiment, major

blockholderconcentration, and other controlvariables. Wean-

alyze these relations by means of quantile regressions, which

enables us to study the payout decision at various levels. We

f‌ind that CEO stock options are strongly associated with a

lower dividend payout, which supports the managerial

power hypothesis: CEOs holding non-dividend protected

stock optionsprefer to avoid dividend paymentsas the reduc-

tion in share price following a dividend announcement hurts

the value of their stock options. We use a nested logit model

to investigate the payout channel choice conditional on the

f‌irm committingto payout earnings. Weshow that a CEO f‌irst

determines the level of payout (relative to the previous year)

and then decides about the payout channel. We conf‌irm that

CEO stock options and restricted stock in f‌irms that increase

their payout are negatively associated with dividend payout

and positively with share repurchases.

While the relation between executive remuneration and

payout decisionshas been studied for the US andFinland, this

is the f‌irst study on the UK. Whilethe UK is similar to the US

concerning the breadth and maturity of its capital market

(Ferris, Sen,& Yui, 2006) and its corporategovernance regime,

the results of previous US studies cannotbe readily applied to

a UK setting due to, for example, differences in taxation of

dividends and share repurchases, and the concentration of

ownership (Renneboog & Trojanowski, 2011). Our study uses

a unique data set that combines both actual share repurchase

information and detailed information on the various compo-

nents of pay. As we dispose of detailed information regarding

all the equity-based components of pay, we explicitly test the

impact of stock options and restricted shares on the f‌irm’s

payout choice. We draw on long-term payout data for virtu-

ally all listed f‌irms.

The paper is organized as follows.In the next section, we re-

view the recent payout literature and formulate our hypothe-

ses. The third section presents the estimation methods, while

we present thedata, provide descriptivestatistics, and discuss

the regulatory settings in the fourth section. The f‌ifth section

discusses the empirical results. A summary and a discussion

of our f‌indings is presented in the f‌inal section.

LITERATURE AND HYPOTHESES

In this section, we discuss how we expect executive remuner-

ation contracts to affect the payout decision and discuss alter-

native motives to pay out earnings such as market sentiment,

taxes, the role ofownership concentration, and aspects of cor-

porate governance.

Executive Remuneration

The main justif‌ication to introduce equity-based compensa-

tion is the reduction of agency costs as the incentives of top

managementand stock owners are then morealigned. Indeed,

executive directors

1

with incentive-oriented remuneration

packages (stock options and/or restricted stock) are also co-

owners and hence are expected to focus on value creation.

However, a payout decision that is favorable to management

as it makes their compensation packages more valuable,

may not necessarily be the best decision for all shareholders.

Usually, share repurchaseshave an immediate positiveimpact

on the share prices because a repurchase may signal to the

market that the stock is underpriced andenable the most pes-

simistic shareholders to sell their stake. Still, how credible is

this signal of undervaluation when one realizes that for the

top managers a (short-run) increase in share price leads to a

rise in the value of their stock options and restricted stock?

For the US, Fenn and Liang (2001) suggest that the growth

in share repurchases is related to the increasing use of mana-

gerial stock incentives since the 1990s. This stock option hy-

pothesis is in line with the f‌indings of Kahle (2002), who

details that f‌irmsthat rely heavily on stock option-based com-

pensation are more likely to repurchase their stock. Still,

Aboody and Kasznik (2008) demonstrate that the lower divi-

dend payout in f‌irms with large equity-based compensation

is only partly offset by stock repurchases. In other words, ex-

ecutive stock options and restricted stock lead to a reduction

in payout, and induce self-interested managers to favor

repurchases over dividends.

Therefore, we conjecture that:

H1. EOs with high levelsof executive stock options or restricted

stock prefer share repurchases overdividends, and prefer no pay-

out over a dividend payout

The above conjecture implicitly assumes that equity-based

compensation is not dividend protected. This means that the

management does not receive dividends on restricted shares

that have not yet vested as the management does not legally

own these share as yet. Likewise, the management does not

get any dividends on stock options (regardless of vesting).

Without dividend protected equity-based pay, top manage-

ment can indeed shy away from paying out dividends be-

cause anticipated dividends drive the share price down,

which decreases the value of equity-based pay. Liljeblom

and Pasternack (2006) show that Finnish f‌irms do not avoid

paying out dividends if the managerialstock options are div-

idend protected,but they do so in the case of no dividend pro-

tection. If dividend protection is widely used, the above

conjecture will notbe empirically supported as dividendpro-

tection turnsthe payout channel choice into a neutraldecision

43EXECUTIVE REMUNERATION AND THE PAYOUT DECISION

© 2015 JohnWiley & Sons Ltd Volume 24 Number 1 January 2016