Executive Compensation and Legal Investor Protection: Evidence from China's Listed Firms

• Author: Yanmei Sun,Chao Chen,Li‐An Zhou,Zhigang Zheng
• Date: 01 February 2016
• Published date: 01 February 2016
• DOI: http://doi.org/10.1111/rode.12209

Executive Compensation and Legal Investor

Protection: Evidence from China’s Listed Firms

Zhigang Zheng, Li-An Zhou, Yanmei Sun, and Chao Chen*

Abstract

This paper seeks to relate the increases in executive compensation observed in China to improvement of

the legal environment. We build a simple model and demonstrate that improvement in legal investor

protection reduces the manager’s private benefits of control; in order to make the managerial incentives

compatible, some of the forgone private benefits have to be compensated in the form of increased

executive pay. Using a large dataset on Chinese listed corporations, we find strong evidence that

improvement of the legal environment is significantly associated with both the rise in executive

compensation and the reduction in agency costs, which is consistent with our model predictions.

1. Introduction

Since early 1990s many countries in the world have witnessed the dramatic rise of

executive compensation. This novel phenomenon has motivated numerous studies

to investigate the underlying factors. An influential approach attributes this

phenomenon to the salient fact that firms have rapidly increased equity-based pay

in their executive compensation (Hall and Liebman, 1998; Murphy, 1999; Core

et al., 2008; Sosa, 2004). For example, Murphy (1999) argues that the increase in

pay is largely attributable to increases in the grant-date value of stock option

grants. During the early 1990s, stock options replaced base salaries as the single

largest component of compensation in the S&P 500 firms. Option grants in

manufacturing firms swelled from 27% to 36% of total compensation. Bebchuk and

Fried (2004) stress the significant role of managerial power in the design of

executive compensation. Executives enjoy generous compensation packages since

they are able to set their own pay through captured boards and remuneration

committees.

China, as the largest emerging economy, has also experienced a dramatic increase

in chief executive officer (CEO) compensation in since 2000. According to a report

by global consulting firm Hay Group, during the 10 years from 2001 to 2011,

executive compensation rose significantly in emerging markets—by 3.5 times in

China, 3.0 times in Indonesia and 2.8 times in Brazil.

*Zhou: Guanghua School of Management, Peking University, Beijing, 100871, China. Tel: +86-10-6275-

0431; Fax: +86-10-6275-3590; E-mail: zhoula@gsm.pku.edu.cn. Zheng: School of Finance, Renmin

University, Beijing, 100872, China. Sun: School of Banking and Finance, University of International

Business and Economics, Beijing, 100029, China. Chen: School of Management, Fudan University,

Shanghai, 200433, China. Zheng acknowledges financial support from the Fundamental Research Fund

for Key Universities in Renmin University of China (No. 2011030343), the National Science Foundation

of China (No. 71272159, No. 71472177) and the Program for New Century Excellent University Talent.

Sun acknowledges financial support from the National Natural Science Foundation of China (No.

71202026) and the Fundamental Research Fund for Key Universities in University of International

Business and Economics (13YQ09, CXTD5-03).

Review of Development Economics, 20(1), 39–47, 2016

DOI:10.1111/rode.12209

©2016 John Wiley & Sons Ltd