CEO power and incentive pay under competition.

Author:Boumosleh, Anwar
Position:Report
 
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  1. INTRODUCTION

    Jensen and Meckling (1976) along with Jensen and Murphy (1990) show that by properly structuring executive compensation plans, firms can motivate CEOs to enhance corporate risk taking and align the interest of managers with those of shareholders. These compensation plans often link CEO and other executive pay to overall firm performance by awarding executives either restricted stock or executive stock options. Indeed, a significant trend of the 1990s was the change in top executives' compensation structure characterized by a significant increase in the proportion of incentive based pay. As Hall (2002) explains, equity based compensation reached more than 60% of top executives pay by the end of the 1990s. Beginning in 2002, executive contracts began concentrating more on stock and performance grants rather than option compensation. The percentage of total compensation representing restricted stock increased from 20% in 2003 to 27% in 2005, accompanied by an increase from 18% to 21% in performance grants.

    Along with this recent shift in compensation structure, market competition has soared across many industries with developments in information technology, reductions in regulation and trade barriers, and the reduction of transaction costs. Under these conditions, CEOs face a constant threat that pushes them for continuously positive results. In fact, their actions become critical due to their sensitive consequences, where optimal decisions grasp higher market share and cause rivals to exit the market. In order to spread the risk and repercussion of every decision, while at the same time protect their personal interest, powerful CEOs negotiate the structure of their compensation contract to be less sensitive to performance and more accounting based (salary and bonuses). As argued by Shleifer and Vishney (1989), such behavior is typical for CEOs who tend to minimize personal risk.

    On the other hand, competition likewise puts immense pressure on the board of directors and shareholders. Due to the high elasticity of aggregate demand in competitive industries, investments and profits become more volatile boosting the overall risk level of a firm. The probability of bankruptcy increases threatening the survival of the firm in fierce market competition. Consequently, boards contract their CEOs with stronger incentive pay to motivate them not only to ensure the survival of the firm, but to also keep it profitable among competitors. In fact, incentive pay is often indexed to the firm's future and relative performance as CEOs are required to fulfill shareholders' long term targets to be rewarded. In this respect, we expect firms to grant their CEOs higher proportions of incentive based pay in more competitive industries.

    In this paper, we examine the struggle of power between the CEO and the board in their endeavor to determine the optimal CEO compensation structure under market competition. CEOs negotiate for safer contracts when seeing their personal reward at risk. However, shareholders require longer term performance based compensation in order to motivate the CEO and secure survivorship. The findings indicate that firms contract their CEO with greater pay to performance compensation the higher the competition within the industry. The results are consistent with the argument that boards have the upper hand in negotiating CEO pay (Rose and Sheppard (1997)). In addition, we investigate how powerful CEOs negotiate the design of their pay. We hypothesize that more powerful CEOs play a significant role in influencing the board and ultimately shaping the outcome of their pay structure. Evidence presented here suggests that powerful CEOs are able to negotiate safer contracts given a certain level of market competitiveness.

    This study provides three contributions to the existing literature. First, it adds to the growing research examining the impact of market competition on the structure of CEO pay, showing that high degrees of competition accompanied with steeper incentive pay is needed to enhance managerial efforts and align the CEO's interest with those of the shareholders. Second, it highlights the struggle of power between the principal and the agent in determining CEO compensation structure under market competition, where ultimately the board is found to have the upper hand in bargaining power and negotiating CEO pay. Finally, it suggests that powerful CEOs who have higher stakes in the firm are able to shape their compensation to be less sensitive to performance.

    The rest of this paper proceeds as follows. Section 2 reviews the literature and discusses our hypothesis development. Section 3 describes the data and methodology. Section 4 contains our results, and section 5 concludes.

  2. LITERATURE REVIEW

    Uncertainty in competitive market environments create incentives for CEOs to pursue their own personal interests which may or may not be aligned with those of shareholders. The board therefore grants CEOs incentive based compensation contingent on firm profitability and relative performance, while the CEO tends to negotiate safer pay structures. Understanding the influence that market competition has on executive's behavior, the board can set optimal compensation contracts and effectively align the interests of CEOs with those of shareholders.

    Existing literature outlines the impact of market competition on managerial behavior and compensation as a function of several factors including: profitability, riskiness of the firm, efficiency of the CEO labor market, and transparency in the information flow between the principal and agent. While there is still room for debate, the general consensus is that market competition diminishes the profit level of corporations. Firms bearing a cost disadvantage face threat of liquidation and are likely to be driven out of the market in the long run, all-the-while firms holding cost advantages pull business from their rivals. Schmidt (1997) argues that efforts to reduce costs become imperative in fierce competitive industries. This important "value of cost reduction" is consistent with an increased level of incentive based pay and reduction in straight salary. However, Schmidt (1997) also claims that the threat of liquidation and bankruptcy, induced by fierce competition, pressures executives and imposes implicit requirements for incentives to enhance their appetite for risk. Thus, the net effect is somewhat ambiguous. More recently, Raith (2003) assigns the increase in competition to the increase in product substitutes with free entry and exit of firms. He explains that when prices and profits deteriorate, unprofitable firms go bankrupt and exit the market, re-establishing aggregate firm profit to its original level. In equilibrium, all firms will make a zero profit and thus the low profit effect ("wealth effect" explained by Schmidt (1997)) vanishes.

    High levels of market competition also alters the overall riskiness of the firm, as the demand curve is more elastic and responsive to price cutting. This translates into higher profit volatility. Raith (2003) illustrates that risk enhanced by volatile profits in a competitive environment is positively correlated with the strength of incentives. Assuming market structure is endogenous, and profits are not affected by changes in competition, firms with competitive cost advantages steal business from their competitors. This "business stealing effect" enhances the marginal benefit of reducing costs. In this sense, boards structure the CEO compensation optimally in a way to motivate them to develop new technologies to reduce cost. Besides, fierce competition doesn't leave room for firms with cost disadvantage as they will lag behind their competitors and eventually be acquired, merged, or driven into bankruptcy. To avoid the liquidation, boards must exert pressure on their CEOs by tying their pay to the firm's future performance. As Raith (2003) finds, the CEO should be unambiguously granted stronger incentive pay.

    Moreover, intense competition increases the CEO's turnover cost, turnover resulting from either underperformances or created by the bankruptcy of the firm. The turnover costs, explained by Schmidt (1997), reflect the CEO's disutility of finding a new job, the likelihood of staying unemployed, and the likelihood of having to move to another location for a new position. DeFond and Park (1999) find that highly competitive industries are associated with high CEO turnover. They also find that relative performance evaluation is employed to dismiss the CEO in competitive industries, while absolute...

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