Equity‐based incentives and shareholder say‐on‐pay

• Author: Blair B. Marquardt,Denton Collins,Xu Niu
• Published date: 01 May 2019
• Date: 01 May 2019
• DOI: http://doi.org/10.1111/jbfa.12373

DOI: 10.1111/jbfa.12373

Equity-based incentives and shareholder

say-on-pay

Denton Collins1Blair B. Marquardt2Xu Niu3

1School of Accounting, Rawls College of Business

Administration,Texas TechUniversity, Lubbock,

Texas79409, USA

2Department of Accounting, G. Brint Ryan

College of Business, University of North Texas,

Denton, TX 76203, USA

3School of Business, Stockton University,

Galloway,NJ 08205, USA

Correspondence

BlairB. Marquardt, Department of Accounting,

G.Brint Ryan College of Business, University of

NorthTexas,Denton, TX 76203, USA.

Email:blair.marquardt@unt.edu

Fundinginformation

TexasTechUniversity Rawls College of Business

Administration

JELClassification: G34, G38, M48, M52

Abstract

We study the relationship between CEO pay-performance sensitiv-

ity, pay-risk sensitivity,and shareholder voting outcomes as part of

the “say-on-pay” provision of the 2010 US Dodd-Frank Act. Con-

sistent with our hypothesis, we provide evidence that shareholders

tend to approve of compensation packages that are more sensitive

to changes in stock price (pay-performance sensitivity). Our find-

ings are consistent with theoretical predictions that outside own-

ers approve of equity incentives as a means of aligning managers'

interests with those of shareholders. We also document that future

changes to equity-based incentives are related to voting outcomes

and that shareholders incorporate CFO incentives into their votes.

Collectively, these results provide evidence of the importance of

equity-based incentives from the perspective of those most con-

cerned with firm value and of the effectiveness of say-on-pay as a

governance mechanism.

KEYWORDS

executive compensation, pay-performance sensitivity, pay-risk

sensitivity,shareholder voting

1INTRODUCTION

The Dodd-Frank Wall Street Reform and Consumer Protection Act (hereafter “the Dodd-Frank Act” or “the Act”)

was enacted in July 2010 in response to the 2008 financial crisis. The Act requires shareholder “say-on-pay,” a

mandated advisory vote by shareholders on the compensation of top executives of public companies. This provision

of the law arose from concerns that executives were excessively sheltered from the risks born by investors (US

Senate Committee on Banking, Housing, and Urban Affairs, 2010). We examine the outcomes of these votes to study

shareholders'response to pay-performance sensitivity (Core & Guay, 1999) and pay-risk sensitivity (Guay, 1999).

Pay-performance sensitivity ties executivewealth to stock returns, while pay-risk sensitivity attempts to increase the

executiv e's risk appetite. These incentives typically arise from equity-based compensation, such as stock awards and

stock options. Together, they are intended to mitigate the moral hazard faced by managers by linking theirwealth to

that of shareholders.

Our motivation to study this relationship is threefold. First, we utilize this setting to study whether shareholders

express views consistent with performance- and risk-based equity incentives as net beneficial or costly. A large

literature is dedicated to the effects of equity-based incentives, documenting both value-adding and value-destroying

J Bus Fin Acc. 2019;46:739–761. wileyonlinelibrary.com/journal/jbfa c

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740 COLLINS ET AL.

consequences. Theory suggests that shareholders are concerned with a potential misalignment of interests with man-

agement and attempt to mitigate this via incentive compensation that ties executivewealth to improvements in firm

value (Core & Guay, 1999; Murphy, 2013). Theory also suggests that incentive compensation can encourage invest-

ment in value-enhancing, risky projects (Guay, 1999; Prendergast, 2002). While some empirical evidence supports

these assertions (e.g., Coles, Daniel, & Naveen, 2006), other evidence suggests these incentives can haveunintended

consequences (e.g., Bergstresser & Philippon, 2006). Prior evidence of shareholder perceptions of equity-based

incentives is also mixed.For example, markets tend to react favorably to the announcement of incentive compensation

(e.g., Kato, Lemmon, Luo, & Schallheim, 2005), but substantial variation exists in opinions of the optimal degree of

incentives (Arnold & Grasser, 2018). Thus, it is worthwhile to consider shareholders'perceptions of equity-based

incentives as observed through the unique lens of the say-on-pay vote. Assuming that shareholders vote according

to their expectations of the effect of these incentives on the return to their investments, we consider this a relatively

clean and powerful setting to revisit the value relevance of equity-based compensation.

Second, our research addresses the effectiveness of shareholder voting. Shareholders delegate daily decision

making to management and monitoring to the board of directors. Nonetheless, the voting mechanism remains an

important external control. Boards at times award executives compensation packages that perpetuate, rather than

mitigate, the agency conflict between owners and managers (Bebchuk & Fried, 2003). Shareholder voting, then,

provides a means for shareholders to express discontent with such misalignment, as well as their opinions on these

types of incentives specifically. While debate on the effectiveness of shareholder votingas a governance mechanism

continues, there is growing evidence that demonstrates its capacity to constrain management (e.g., Thomas & Cotter,

2007). To our knowledge, our research represents a first step in examiningthe shareholder voting response to the

underlying incentives embedded in equity compensation, a feature critical to evaluating the appropriateness of a

compensation package (Murphy,2013). We also examine whether boards respond to an unfavorable vote outcome by

increasing the incentive component of compensation, addressing the effectiveness of the vote as a constraint.

Third, we assess whether shareholders vote in a manner consistent with the intent of the Act. The Dodd-Frank

Act's intention was to promote greater “responsibility and accountability” of executives (US Senate Committee on

Banking, Housing, and Urban Affairs, 2010). Regulators have expressed concerns about potential societal damage

due to rent extraction and excessiverisk taking by insulated executives, and appear to support stronger alignment of

manager and shareholder interests (Securities and Exchange Commission, 2015; US Senate Committee on Banking,

Housing, and Urban Affairs, 2010). For example, US Senator Jack Reed (D, RI) described the goal of say-on-pay

to include, “help[ing] public companies align their compensation practices with long-term shareholder value” (US

Senate Committee on Banking, Housing, and Urban Affairs, 2009). Since we investigate whether shareholders appear

sensitive to equity-based incentives in their votesand whether shareholder voting is related to subsequent changes in

equity-based incentives, our study informs regulatory efforts in this area.

Toshed light on these issues, we examine how the underlying pay-performance sensitivity and pay-risk sensitivity

of a CEO's compensation package explain the proportion favorable votein the say-on-pay referendum. We hypothe-

size that the favorablevote will be increasing with the strength of the linkage between pay and performance and in the

strength of the risk-taking incentive. We measure these incentives,respectively, using CEO delta and vega,bothscaled

bytotal compensation (Core & Guay, 1999; Edmans, Gabaix, & Landier,2009; Guay, 1999).1Assuming that the underly-

ing characteristics of the compensation package will drive shareholder perceptions of its acceptability,we regress the

proportion favorablevote on CEO delta and vega, plus a vector of controls.

Our results support our first hypothesis. We document a statistically significant positive relationship between

CEO pay-performance sensitivity (delta) and the proportion favorablevote, implying shareholders generally approve

of compensation packages designed to align manager and shareholder wealth. An increase across the interquartile

range of CEO delta is associated with a 0.189 percentage point increase in the proportion favorable vote, equivalent

1Deltais the change in the dollar value of equity incentives of the CEO for a 1% change in stock price. It measures the sensitivity of the CEO's compensation to

changesin the stock price. Ve ga is the change in the dollar value of the CEO's incentive options for a 0.01 change in the annualized standard deviation of stock

price.It measures the risk-taking incentive of the CEO's compensation.