Monitoring and CEO Contractual Incentive Pay

• Author: Fan Yu
• DOI: http://doi.org/10.1111/irfi.12238
• Published date: 01 September 2020
• Date: 01 September 2020

Monitoring and CEO Contractual

Incentive Pay*

FAN YU

Department of Applied Finance, Faculty of Business and Economics, Macquarie

University, Sydney, New South Wales, Australia

ABSTRACT

This paper finds that a CEO who is better monitored tends to have smaller

wealth-performance sensitivity (WPS). The results are consistent with the

optimal contracting view and are robust to different measures of WPS. The

findings suggest caution in drawing conclusions when researchers use WPS

as an observable outcome of monitoring to test the effectiveness of monitor-

ing. The association of monitoring and WPS is not necessarily positive, as

assumed by prior corporate governance research.

JEL Codes: G32; G34; M52; M55

Accepted: 26 September 2018

I. INTRODUCTION

Monitoring, whether by the board or external monitors such as blockholders or

analysts, plays an important role in effective governance. Researchers have typi-

cally focused on identifying observable positive outcomes of effective monitor-

ing (e.g., Ajinkya et al. 2005; Chen et al. 2007; Denis and Serrano 1996; Hill

and Snell 1989; Shivdasani 1993). With respect to CEO compensation, it is gen-

erally perceived that a positive association between monitoring and the CEO’s

pay-performance sensitivity (PPS) suggests effective monitoring. For example,

Berger et al. (1997) interpret low PPS as an indicator for management entrench-

ment. Hartzell and Starks (2003) interpret a positive association between active

institutional ownership concentration and PPS as the effectiveness of active

institutional investors. Anderson and Bizjak (2003) aim to examine whether a

greater compensation committee promotes shareholder interests. One of the

* I thank Jarrad Harford, my advisor, Edward Rice, Jonathan Karpoff, Andrew Siegel, and partici-

pants at the University of Washington Brown Bag Seminar, City University of Hong Kong, Univer-

sity of Macau, Fudan University, Southern Finance Association Annual Meeting 2012, 26

th

Australasian Banking & Finance Conference, 3

rd

Edwards CSFM Symposium, American Accounting

Association Annual Meeting 2014, and Financial Markets and Corporate Governance Conference

2018, for helpful comments and suggestions. I am also grateful to an anonymous referee for several

useful suggestions. All the remaining errors are my own. Most of the work was done during my

Ph.D. studies at the University of Washington.

© 2018 International Review of Finance Ltd. 2018

International Review of Finance, 20:3, 2020: pp. 701–736

DOI: 10.1111/irfi.12238

outcomes they investigate is whether the committee increases the sensitivity of

CEO pay to firm performance. However, as implied by traditional contract the-

ory, monitoring can still affect CEO pay even though no positive relation is

observed between them. The relation between effective monitoring and

increases in PPS is thus not a reliable relationship to test the effectiveness of

monitoring. This paper investigates the association between monitoring and a

CEO’s incentive pay.

1

By standard contract theory, monitoring is negatively associated with the

required contractual incentive pay (Holmstrom (1979)). In the absence of addi-

tional information provided by monitoring, a CEO’s contract i s written completely

on observable outcomes, typically stock returns. The link between pay and stock

returnsisstrong,ceteris paribus. As a result, the PPS is at a high level. However, if

additional valuable information is available to evaluate a CEO, her contract is then

written only partly on stock returns. The link of her total pay to stock returns is

therefore weaker, and the PPS is smaller. The more valuable the information that

monitoring provides, the smaller the contractual incentive pay is required.

I construct the measures of contractual incentive pay based on the total delta

of a CEO’s portfolio (including current and existing shares and options). It is

appropriate to use total delta because the firm’s future stock returns not only

affect its CEO’s current pay but also the value of her existing stock and options

holding. It thus captures the total contractual incentives facing the CEO. More

specifically, the three measures of contractual incentive pay are elasticity of a

CEO’s wealth, the dollar change of a CEO’s wealth for each additional $1000

increase in shareholder value, and the dollar change of a CEO’s wealth for a

percent increase in shareholder value.

I consider monitoring by two channels: board monitoring and shareholder

monitoring. I do not consider debtholder monitoring for two reasons. Firstly, I

assume that a CEO works for shareholders whose goal is to maximize share-

holder value. Conflicts of interest exist between debtholders and shareholders

(Jensen and Meckling (1976)). Monitoring by debtholders may reduce share-

holder value. Secondly, the measures of wealth-performance sensitivity (WPS) I

use in this paper are based on shareholder value rather than firm value. It is

appropriate to include only the monitors who represent shareholders and to

exclude the monitors who have conflicts of interest with shareholders. I have

two measures for board monitoring. Firstly, I use a dummy variable for board

strength. This is equal to one if a CEO’s tenure is shorter than the median ten-

ure of all the board members, and zero otherwise. In the context of CEO com-

pensation, Hermalin and Weisbach (1998) show that a measure based on CEO

tenure is a robust proxy for the overall strength of the board relative to the

CEO. Secondly, I use the ratio of independent directors. Firms with higher

1 I use wealth-performance sensitivity (WPS) as the measure of incentive pay in this paper.

WPS is a better measure because it captures the change of a CEO’s existing portfolio due to

the change of current performance. In prior research, a more general definition of PPS is the

same as the definition of WPS. Please see Section III.C for more details on WPS.

© 2018 International Review of Finance Ltd. 2018702

International Review of Finance

proportion of independent directors tend to make better—or at least different—

decisions concerning executive compensation, ceteris paribus (Harford

et al. (2008)). This measure has often been used in previous research to capture

board monitoring, though its validity is arguable. Both measures are recalcu-

lated each year. I use long-term block institutional holdings (LT Top5) to cap-

ture shareholder monitoring. Chen et al. (2007) find that firms are more likely

to withdraw bad bids with the presence of LT Top5 blockholders, suggesting

that they are effective monitors. A large body of literature has documented the

effectiveness of institutional monitoring (e.g., Carleton et al. 1998; Ajinkya

et al. 2005; Amihud and Lev 1981).

Ifind evidence that supports the optimal contracting view implied by tradi-

tional contract theory. Firms with strong monitoring use less total contractual

incentive pay in almost all the industries. After controlling for more factors, the

regression analysis and difference-in-differences analysis suggest a negative

association between monitoring and total contractual incentives.

The findings are in contrast to the managerial power view usually assumed in

prior empiricalcorporate governance research.The view implies that strong moni-

toring increases the use of incentive pay.As a result, firms with strong monitoring

have higher WPS. Prior research usually focuses on the relationship between mon-

itoring and the increase of WPS to test monitoring effectiveness in terms of CEO

compensation. However, this relationship is not reliable. As implied by the opti-

mal contracting view, firms endogenouslychoose to use less contractual incentive

pay if additional information collected through monitoring is valuable in reveal-

ing the true effortsof a CEO. Testing based on the positive relationship implied by

the managerial power view could possibly lead to incorrectconclusions.

The contribution of this paper is to show that monitoring and incentive pay

are not necessarily positively associated. They may interact as a system in align-

ing the interests of managers and shareholders. This makes research on the rela-

tionship between monitoring and CEO compensation more complex. Failure in

finding a positive impact of monitoring on WPS does not suggest ineffective

monitoring. Similarly, low WPS does not necessarily suggest inefficient moni-

toring or weak governance.

The remainder of the paper is organized as follows. Section II develops

hypotheses. Section III explains the source of data and introduces the measures

of monitoring, the adjustment for CEO pay, contractual incentive pay, and firm

opacity. Section IV introduces the models used for testing the hypotheses.

Results and discussions follow each test. Section V discusses robustness tests.

Section VI concludes this paper.

II. HYPOTHESES DEVELOPMENT

If managers do not own 100% of the firm, they tend to destroy firm value com-

pared to identical firms that are solely owned by managers (see, Berle and

Means 1932; Jensen and Meckling 1976, etc.). To reduce the agency problem, a

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Monitoring and CEO Contractual Incentive Pay