HEADS I WIN, TAILS YOU LOSE: INSTITUTIONAL MONITORING OF EXECUTIVE PAY RIGIDITY

• DOI: http://doi.org/10.1111/jfir.12196
• Author: Ji Hoon Hwang,Chang Liu,Paul Moon Sub Choi,Chune Young Chung
• Published date: 01 December 2019
• Date: 01 December 2019

The Journal of Financial Research Vol. XLII, No. 4 Pages 789–816 Winter 2019

DOI: 10.1111/jfir.12196

HEADS I WIN, TAILS YOU LOSE: INSTITUTIONAL MONITORING OF

EXECUTIVE PAY RIGIDITY

Paul Moon Sub Choi

Ewha Womans University

Chune Young Chung

Chung‐Ang University

Ji Hoon Hwang

University of Arizona

Chang Liu

California State University, Sacramento

Abstract

Agency theory argues that pay for performance alleviates the conflict of interest

between managers and shareholders. Furthermore, the literature finds that institutional

monitoring tends to promote the performance–pay linkage, thus aligning the two

parties’incentives. We find that executive compensation rigidity is negatively and

significantly associated with firm value. Moreover, ownership by long‐term

institutional investors reduces the pay rigidity of top managers in underperforming

firms, thus decreasing the value‐destroying effect of the rigidity. Overall, these results

reaffirm the role of institutional monitoring in mitigating managerial rent extraction.

JEL Classification: G23, G34, J33, M41

I. Introduction

Incentive compensation has long been a pivotal internal governance mechanism.

Compensation policies that closely tie managerial emoluments to firm performance are

deemed effective schemes that align the interests of corporate executives and outside

shareholders, thus reducing agency costs (Core, Holthausen, and Larcker 1999; Grossman

and Hart 1983; Hölmstrom 1979; Jensen and Meckling 1976; Jensen and Murphy 1990;

Special thanks are due to William Elliott (the editor) and an anonymous referee. We also thank Warren Bailey,

Lucian A. Bebchuk, Joung Hwa Choi, Ji‐Woong Chung, Yaniv Grinstein, Byoung‐Hyoun Hwang, Rajkamal Iyer,

Andrew Karolyi, Hyunseob Kim, Y. Han (Andy) Kim, Jaehoon Lee, Bala Maniam, Jiangang Peng, and seminar

participants [Correction added on 15 November 2019, after first online publication: The word “seminar”has been

added before “participants”] at Hunan University (Changsha, Hunan, China), ISESS 2018 (Okinawa, Japan), and

RICBFM 2019 (Kota Kinabalu, Malaysia). Part of this research was conducted while Choi was a visiting scholar at the

Samuel Curtis Johnson Graduate School of Management, Cornell University, funded by the grant provided by the

Fulbright Scholarship Program. This work was supported by the Ministry of Education of the Republic of Korea and

the National Research Foundation of Korea (NRF‐2018S1A5A2A01029148). The authors contributed equally to this

work. Standard disclaimer rules apply, and all errors are our own.

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© 2019 The Southern Finance Association and the Southwestern Finance Association

Murphy 1999). However, performance‐related pay is called into question when managers

receive increasingly outsized compensation packages that are not justified by the growth

of their firms (Crystal 1991; Blanchard, Lopez‐de‐Silanes, and Shleifer 1994; Bebchuk

and Grinstein 2005). Moreover, the problem is exacerbated by the downward rigidity of

pay‐for‐performance sensitivity (PPS), known as “pay without performance,”which

implies that executive compensation does not diminish proportionally following poor firm

performance (Garvey and Milbourn 2006; Gaver and Gaver 1998; Shaw and Zhang

2010). Some studies argue that the reduced PPS and pay without performance arise from

the proclivity of top managers for rent extraction and directors’inability to engage in

arm’s length negotiations with managers over chief executive officer (CEO) compensa-

tion (Bebchuk, Fried, and Walker 2002; Bebchuk and Fried 2004). In a weakly governed

firm, executives tend to receive non‐performance‐based pay, and incentive‐based pay

(e.g., stock options) is more likely to be timed opportunistically (e.g., Core, Holthausen,

and Larcker 1999; Bertrand and Mullainathan 2001; Yermack 1997; Bebchuk, Grinstein,

and Peyer 2010). In this article, we investigate whether institutional investors can

ameliorate the suboptimal executive pay structures observed in corporate America and

how these institutions are associated with shareholder value.

The prominent role of institutional investors in corporate governance has

been well documented in the literature as their ownership of U.S. equities has

increased steadily over time. Shleifer and Vishny (1986) contend that large equity

stakes held by institutional investors allow them to engage in shareholder activism,

which provides sufficient benefits to overcome the associated costs. Extending this

theoretical work, numerous empirical studies suggest that institutional investors can

effect positive changes in corporate policies and internal governance structures

(e.g., Chen, Harford, and Li 2007; Appel, Gormley, and Keim 2016; Harford,

Kesckes, and Mansi 2018). The role of executive compensation as a major

incentive‐aligning scheme has been scrutinized closely. Evidence suggests that

institutional investors not only prefer certain compensation structures, but also

actively influence pay levels, PPS, and the pay‐setting process through channels

such as increasing the independence of the board compensation committee and

sponsoring “say‐on‐pay”proxy campaigns (e.g., Hartzell and Starks 2003;

Almazan, Hartzell, and Starks 2005; Chowdhury and Wang 2009; Ertimur, Ferri,

and Muslu 2011; Ozkan 2011; Shin and Seo 2011). Improved pay structures lead to

higher shareholder value and better firm performance.

However, a notable gap in the literature is the limited attention paid to the

asymmetric nature of PPS. On the one hand, high PPS is not necessarily associated

with improved shareholder value, particularly if shareholders are disproportionately

burdened with excessive executive compensation or if executives’pay responds as

much to lucky market movements as it does to performance attributable to managerial

success (Bertrand and Mullainathan 2001; Blanchard, Lopez‐de‐Silanes, and Shleifer

1994). On the other hand, when executives reap upside benefits from stellar

performance, but are immune to downside operational losses, they tend to take

unnecessary risks at the expense of shareholder value. In this study, we fill this void in

the literature by adopting a new framework that specifically addresses downward

executive compensation rigidity (ECR).

790 The Journal of Financial Research