Shareholder Activism and Middle Management Equity Incentives

• Date: 01 July 2010
• Published date: 01 July 2010
• Author: Christophe Faugère,Janet H. Marler
• DOI: http://doi.org/10.1111/j.1467-8683.2010.00794.x

Shareholder Activism and Middle Management

Equity Incentivescorg_794313..328

Janet H. Marler* and Christophe Faugère

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: We examine how various types of shareholder activists (such as pension funds and large

blockholders) impact the relativeuse of equity incentives at the middle management level of the f‌irm and compare this with

the impact on CEO incentive alignment.

Research Findings/Insights: Using a sample of 124 US technology f‌irms over the period 1997–2001, we f‌ind evidence

indicating voice activist shareholders, using communication pressure, are associated with the greater use of equity incen-

tives, and higher total compensation at middle managerial levels, relative to exit activists,who exert economic pressure. The

results for CEO equity incentives are similar. We also f‌ind that as the presence of institutional ownership siding with

management (banks and insurance companies) increases relative to voice activists, the use of equity incentives at middle

managerial levels declines. Results for CEO equity incentives are not the same.

Theoretical/Academic Implications: In agreement with contingent agency theory, we predict and f‌ind evidence of differing

governance mechanisms used by voice activists (e.g., public pension funds) and exit activists (e.g., large shareholders).

Voice activists face a higher cost of monitoring managers as compared to exit activists, and thus they will advocate for the

heavier use of equity incentive compensation at the middle managerial level. In agreement with a managerial power

perspective, however, we also f‌ind the use of equity incentives for middle managers decreases as the proportion of

institutional ownership siding with the CEO increases.

Practitioner/Policy Implications: Shareholder activism plays a key role in aligning managerial interests below the CEO

level; however, different types of shareholders have different economic and political interests in how equity compensation

is shaped to achieve this. Exit activists use monitoring and voice activists substitute equity compensation for monitoring.

Shareholders siding with management may also reduce the use of equity incentives for middle managers. These differing

interests should be considered in crafting policy responses.

Keywords: Corporate Governance, Equity Compensation, Managerial Incentives, Shareholder Activism

INTRODUCTION

Much of what is known about shareholders’ efforts to

align managerial interests and reign in agency costs

are based on studies of chief executive compensation. Firms

with large shareholders (owning 5 per cent or more of the

f‌irm), and f‌irms with high levels of institutional ownership

have lower CEO pay, which is also more sensitive to f‌irm

performance (Bertrand & Mullainathan, 2000; Core, Holth-

ausen, & Larcker, 1999; Hartzell & Starks, 2003; Tosi &

Gomez-Mejia, 1989). These patterns are consistent with

principal-agent theory (Fama & Jensen, 1983; Holmstrom,

1979; Shavell, 1979). Incentive compensation and monitoring

(observation and information gathering) are key methods

for aligning the agent’s (CEO) actions with shareholders’

interests.

Research evidence, however, on managerial incentive

compensation below the executive level (middle managers)

is sparse. Although it may be reasonable to presume that

middle management compensation is simply a scaled down

replication of the CEO’s, there are reasons why this view

might be challenged. First, in contrast to the CEO, middle

managers’ performance is closely monitored within the

bureaucratic structure, which includes all human resources

practices and policies and layers of managerial oversight.

Second, middle managers have much less individual impact

*Address for correspondence: University at Albany, State University of New York,

School of Business, Albany, NY 12222, USA. Tel: 518-442 4957; E-mail: marler@

albany.edu

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Corporate Governance: An International Review, 2010, 18(4): 313–328

© 2010 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2010.00794.x

on overall f‌irm performance than the CEO, and thus using

equity compensation exposes them to greater risk.

The other reason for the scarcity of studies of middle

management compensation is simply the paucity of data,

which contrary to CEO compensation is typically not made

available publicly. As far as we know, only Werner and Tosi

(1995) and Werner, Tosi, and Gomez-Mejia (2005) have

examined whether shareholders have an impact on the

structure of middle management compensation. These

studies show that the f‌indings at the CEO level carry over to

middle managers, in the presence of large shareholders.

Total managerial cash compensation is signif‌icantly lower

and is more sensitive to changes in year-to-year f‌irm perfor-

mance when large shareholders own a signif‌icant fraction of

the f‌irm’s shares.

However, these two studies ignore other types of inf‌luen-

tial institutional shareholders who may choose a different

assortment of incentives vs. monitoring to solve the agency

problem (Brickley & Smith, 1988; Del Guercio & Hawkins,

1999; Parrino,Sias, & Starks, 2003). For example, Werner and

Tosi (1995) do not investigate whether a high degree of

ownership by public pension funds leads to a greater use of

incentives at the middle managerial level, as shown for the

CEO by David, Kochhar, and Levitas (1998).

Werner and colleagues also do not specif‌ically examine

the use of equity incentives as a corporate governance

mechanism. Yet in the years since Werner and Tosi’s study

was conducted in the early 1980s, the use of stock option

equity compensation, particularly for growth f‌irms has

become widespread (Brandes, Dharwadkar, & Lemesis,

2003).

Our study f‌ills these gaps by focusing on a broader

concept of shareholder activism and a more comprehensive

examination of equity incentive compensation in middle

management compensation. In particular, we analyze

whether the choice between equity incentives vs. monitor-

ing to resolve the agency problem for middle managers also

depends on the type of shareholder ownership. We use a

unique data set provided by a compensation consulting f‌irm

for a sample of 124 high tech f‌irms over the period 1997–

2001. This time period represents a key difference from early

middle management compensationstudies in that it covers a

span when the full implementation and force of sweeping

new tax and investment regulatory changes affecting corpo-

rate incentive compensation was in effect (Sun & Cahan,

2009) and when the US economy witnessed an expansion of

broad-based stock option programs, particularly in high-

tech f‌irms (Brandes et al., 2003).

We def‌ine shareholder activism as the range of actions

taken by shareholders to inf‌luence corporate management

and boards (Ryan & Schneider, 2002; Becht, Franks, Meyer,

& Rossi, 2008). We also distinguish between “voice” and

“exit” shareholder activism, in agreement with the general

classif‌ication developed by Hirschman (1970). Exiting rep-

resents an economic response, whereas “voice” represents

political action through communication or complaint. Voice

activists such as public pension funds use political commu-

nication such as proxy votes and public media campaigns to

inf‌luence corporate governance. On the other hand, “exit”

activists such as large shareholders, who actively manage

their investment portfolios can effectively threaten to sell

their holdings in the corporation when they disapprove of

the f‌irm’s management and thus use more economically

focused actions.

The central argument of the paper is that incentive align-

ment and monitoring can be viewed as substitutes for one

another, depending on which approach is more cost effec-

tive (Zajac & Westphal, 2006). Weargue that actions taken by

activists vary according to the magnitude of the costs

incurred in monitoring middle managers. In particular, exit

activists are likely to have a lower monitoring cost linked to

observing managerial behavior and performance than voice

activists and therefore will prefer using less equity incen-

tives in managerial compensation. Voice activist sharehold-

ers on the other hand, incur a higher cost of monitoring

middle-level managers and will favor greater use of incen-

tives throughout the f‌irm as a substitute to monitoring. Our

empirical results largely support these intuitions.

Finally, another contribution of our study is we examine a

growing perspective found in the governance literature,

which suggests that corporations adopt equity incentives for

political reasons as window dressing or camouf‌lage and not

for any intended alignment effects (Bebchuk & Fried, 2006;

Westphal & Zajac, 1998; Zattoni & Minichilli, 2009). In this

regard, we examine whether the compensation patterns

found in CEO compensation are replicated for middle man-

agers, across types of shareholder ownership. As the propor-

tion of owners typically siding with management increases

relative to other (activists) owners, the use of equity incen-

tives in middle management compensationshould diminish

as “form over substance” prevails. Our empirical results

provide support for this political perspective consistent with

the growing literature (Bebchuk & Fried, 2006; Westphal &

Zajac, 1998; Zattoni & Minichilli, 2009).

THEORY AND HYPOTHESES

Contingent Agency Theory and Monitoring

vs. Incentives

In the principal-agent literature(Fama & Jensen, 1983; Holm-

strom, 1979; Shavell, 1979), incentive compensation repre-

sents an optimal solution to the agency problem of aligning

the agent’s self-interest with that of the owners. Underlying

this theory is the idea that an agent’s performance is imper-

fectly correlated to his/her effort because of exogenous

shocks (outside the principal and the agent’s control) that

can affect the agent’s f‌inal performance. A key assumption

underlying the theory is that the cost of monitoring the

agent’s actions or effort is prohibitively high. In that litera-

ture, the term monitoring is def‌ined as observing and gath-

ering information about the agent/managers’ “actions and

effort” (Eisenhardt, 1989; Levinthal, 1988; Sappington, 1991).

It is worth noting that this term does not mean oversight of

executive compensation or incentives.

On the other hand, a parallel strand of the literature

emphasizes monitoring agents’ behavior as a key solution to

the agency problem (Zajac & Westphal, 2006). Monitoring

costs are viewed as variable but not prohibitively high. For

instance, boards of directors have represented the primary

type of monitoring technology to supervise CEOs and senior

executives (Fama & Jensen, 1983; Rutherford, Buchholtz, &

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