Powerful CEOs, cash bonus contracts and firm performance

• Author: Anna Loyeung,Helen Spiropoulos,Zoltan P. Matolcsy,Rebecca L. Bachmann
• DOI: http://doi.org/10.1111/jbfa.12410
• Date: 01 January 2020
• Published date: 01 January 2020

DOI: 10.1111/jbfa.12410

Powerful CEOs, cash bonus contracts and firm

performance

Rebecca L. Bachmann Anna Loyeung ZoltanP. Matolcsy

Helen Spiropoulos

University of TechnologySydney, Australia

Correspondence

RebeccaL. Bachmann, PO Box 123, Broadway

2007,NSW, Australia.

Email:Rebecca.Bachmann@uts.edu.au

Abstract

We investigate whether powerful chief executive officers (CEOs)

influence the conditions of their cash bonus contracts. Specifically,

we examine (i) the association between CEO power and the pro-

portion of ex-ante cash bonus to base salary (bonus ratio), (ii) the

associationbetween CEO power and the relative use of non-financial

to financial performance targets in cash bonus contracts, and (iii) the

performance consequences of incorporating non-financial targets

in cash bonus contracts. Results show that powerful CEOs are

associated with greater ex-ante bonus ratios and higher proportions

of non-financial performance targets compared to less powerful

CEOs. Furthermore, the use of quantitative and corporate social

responsibility (CSR)-related non-financial performance targets is

positively associated with subsequent firm performance, and the use

of undefined non-financial performance targets is negatively associ-

ated with subsequent firm performance. These results are robust to

alternative econometric specifications and variable definitions.

KEYWORDS

cash bonus, CEO compensation, CEO power, CSR, performance

targets, short-term incentives

JEL CLASSIFICATION

J33, M12, M52

1INTRODUCTION

There are two alternative theoretical explanations for CEO incentive compensation; efficient contracting theory

(Jensen & Meckling, 1976) and managerial power theory (Bebchuk & Fried, 2003, 2005). While much of the earlier

empirical evidence is consistent with efficient contracting theory (Conyon, Fernandes, Ferreira, Matos, & Murphy,

2011; Frydman & Jenter, 2010; Murphy, 2013; Shan & Walter, 2016), there is an emerging body of literature that

supports managerial power theory. This literature suggests that CEO attributes and power influence many aspects

100 c

2019 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2020;47:100–131.

BACHMANN ETAL.101

of corporate decision making, including compensation arrangements (Abernethy,Kuang, & Qin, 2015; Morse, Nanda,

& Seru, 2011; Song & Wan, 2019). To date, empirical studies have mainly focused on CEOs’ equity-based pay (e.g.,

restricted stock grants and stock options). However, the influence of powerful CEOs on their cash bonus conditions

remains unexplored, despite cash bonuses representing an ongoing and substantial part of CEOs’ compensation

package (Conyonet al., 2011; Frydman & Jenter, 2010; Murphy,2013; Shan & Walter, 2016).1

Accordingly, we examinewhether powerful CEOs influence the conditions of their cash bonus contracts and how

these contracts impact on subsequent firm performance. Specifically,the objectives of this study are to provide empir-

ical evidence on (i) the association between CEO power and the proportion of ex-ante cash bonus to base salary (here-

after referred to as bonus ratio); (ii) the association between CEO power and the proportion of non-financial targets

(such as product quality, strategicplanning and leadership skills) to financial targets (such as firm sales and profits) in

cash bonus contracts, and (iii) the performance implications of incorporating non-financial performance targets into

CEOs’ cash bonus contracts. Consistent with prior studies, CEO power is defined as the ability of the CEO to signifi-

cantly influence firm directors and corporate decision-making, thereby revokingthe effectiveness of corporate gover-

nance mechanisms (Bebchuk & Fried, 2003, 2005).

The motivation for this study is twofold. First, executivecompensation has received renewed scrutiny following the

global financial crisis and the introduction of say-on-pay legislation (Alissa, 2015; Clarkson, Walker, & Nicholls, 2011;

Collins, Marquardt, & Niu, 2019; Correa & Lel, 2016; Grosse, Kean,& Scott, 2017; Iliev & Vitanova, 2019). In response,

many companies attempt to justify large compensation packages by offering performance-based pay in the form of

equity grants and options. However,the performance targets used in these contracts may offer an avenue for firms to

camouflage higher pay (e.g.,Abernethy et al., 2015). While the literature is informative about the strategic use of stock

and option grants, we argue that cash bonuses may be used as another means to camouflage high levels of executive

pay. This isparticularly relevant within the Australian setting where equity-based compensation is still emerging and

cash bonuses are not subject to tax deduction limits.2Specifically,cash bonuses can be as much as five times the CEO’s

base salary. Moreover, the comprehensive disclosure of compensation-related performance targets in firms’ annual

reports in Australia (Clarkson, VanBueren, & Walker, 2006), allows us to perform a detailed examination of the types

of performance targets used in cash bonus contracts and their association with subsequent firm performance.

Second, while concernshave been raised about the use of non-financial targets in compensation contracts, empirical

evidence is limited. In particular,practitioners and regulators have expressed growing discontent about the use of non-

financial targets due to the prevalence of high bonus payments (Bennett, Bettis, Gopalan, & Milbourn, 2017; Rose,

2017; Yeates,2017). Specifically, the perceived fairness of CEOs’ cash bonus contracts plays a major role surrounding

the outrage about executivecompensation (Arnold & Grasser, 2018). Concerns are that non-financial targets may be

easierto manipulate, hence reward CEOs for activities which should be considered part of their job description (Knight,

2016; Robertson, 2016). Knight (2016) reports in the financial press that:

[…] some shareholdersrallied against what they considered the easiness of meeting these [non-financial] hurdles

which they believe is due to the fact they arenot sufficiently focused on hard quantitative financial measures like

total shareholder returnsor returns on investment or even just statutory profit.

Furthermore, the fact that equity-based incentives have begun to incorporate non-financial performance targets

highlights the importance of evaluating shareholders’ concerns regarding the legitimacy of these measures (Ryan,

1Figure2.1 in Murphy (2013) illustrates that, while equity-based compensation comprises 21–32% of average total realised compensation of CEOs included in

theS&P 500 in 2011, realised cash bonuses range between 20% and 24%. Similarly, Figure 2.3 illustrates that total cash compensation increased from US$1.1

millionin 1970 to US$4.1 million in 2011.

2Thisis partly driven by Section 162(m) of the Internal Revenue Code 1986 which in the U.S. implements a US$1 million tax deduction limit on CEO compensa-

tionarrangements. Nonetheless, equity-based incentives, such as stock option grants, qualify for the performance-based compensation exemption to Section

162(m).This exemption provides economic incentives that make equity-based compensation attractive to employers,as cash bonuses rarely qualify. The same

exemptionfor equity-based compensation does not apply in Australia.

102 BACHMANN ETAL.

2017). As a result, we shed light on whether practitioners’ concerns about the use of non-financial targets are justified

by the type of non-financial targets used (i.e., qualitative,undefined, quantitative and CSR focused) and their impact on

subsequent firm performance.

The empirical evidence provided in this study is based on a sample of 1,085 firm year observations from the Aus-

tralian Stock Exchange (ASX) Top500 listed firms for the period 2004–2016. The bonus ratio and the proportion of

non-financial to financial targets are calculated based on hand-collected data. Following prior literature, which sug-

gests that a single measure of CEO power fails to capture the overall level of CEO influence within the firm (Core,

Holthausen, & Larcker, 1999; Finkelstein,1992), we construct a CEO power index consisting of eight measures. Our

measure of CEO power contains characteristics which capture historical and new measures of power, including CEO

tenure, shareholdings, board size, board independence, subcommittee membership and co-option of directors on the

remuneration committee (Abernethy et al., 2015; Core et al., 1999; Finkelstein, 1992; Lisic, Neal, Zhang, & Zhang,

2016).3

Our findings support the contention that powerful CEOs influence the conditions of their cash bonus contracts.

Specifically, CEO power is positively associated with the bonus ratio. This suggests that powerful CEOs justify their

compensation by linking a greater proportion of their pay to performance-based bonus compensation as opposed

to base salary. Moreover, we find a positive association between CEO power and the relative weight placed on non-

financial performance targets, suggesting that non-financial targets may be used to compensate powerful CEOs for

facets of their managerial effort. However,this finding may also signify that powerful CEOs incorporate non-financial

targets to increase CEO compensation above what is justified by economic performance of the firm (Ittner,Larcker, &

Rajan, 1997).

Toshed light on these alternative interpretations of our findings, we examine whether the use of non-financial tar-

gets in bonus contracts is associated with subsequent firm performance. If non-financial targets are used to encour-

age powerful CEOs to act in a manner that is consistent with shareholders’ interests, we expect a positive association

between the use of non-financial targets and subsequent firm performance. Alternatively,if non-financial targets are

used by powerful CEOs to increase their compensation beyond a level justified by the firm’s economic performance,

we expect a negative association between the use of non-financial targets and subsequent firm performance. This is

possible as non-financial targets are more prone to manipulation and are rarely subject to external verification (e.g.,

Ittner et al., 1997). We find that the use of non-financial targets, which are quantitative, and consequently verifiable,

is positively associated with industry-adjusted return on assets, as are performance targets linked to corporate social

responsibility (CSR). These findings support the view that the use of objective performance targets (Ittner et al., 1997)

and CSR performance targets (e.g.,Cook, Romi, Sánchez, & Sánchez, 2019; Dhaliwal, Li, Tsang, & Yang,2011; Lev, Petro-

vits, & Radhakrishnan, 2010) has positive firm performance implications. Interestingly,the use of performance targets

that are not defined in annual reports (i.e., when a firm mentions using non-financial performance targets but does

not provide any information as to what these targets are) is negatively related to subsequent firm performance. This

is noteworthy as 44.54% of firms in our sample include targets that are not defined. These findings support the view

that performance targets subject to a greater degree of discretion are a means of camouflaging executivecompensa-

tion levels as such targets do not provide sufficient incentives to increase subsequent firm performance. To address

endogeneity concerns, we perform a two-stage least squares regression and use a propensity score matched subsam-

ple. Although our empirical findings remain consistent, we cannot completely rule out that endogeneity is driving our

results, which is a limitation of this study.

The findings of this study make important contributions to the literature and have implications for regulators.

First, our findings add to the debate concerning whether efficient contracting theory or managerial power the-

ory explains CEO compensation levels and structure (Abernethy et al., 2015; Balsam, Gifford, & Puthenpurackal,

3While prior US studies haveshown that CEO duality increases CEO power, CEO duality is less common in Australia. We find that only one firm in our final

sample (Reece Australia Limited) has a CEO who is also the chairman. This observation is not included in our final sample and as such, CEO duality is not

includedin our CEO Power Index.