The social context of compensation design: Social norms and the impact of equity incentives

• Author: Don O’Sullivan,Geoffrey P. Martin,Leon Zolotoy
• DOI: http://doi.org/10.1002/hrm.21897
• Date: 01 September 2018
• Published date: 01 September 2018

ORIGINAL ARTICLE

The social context of compensation design: Social norms

and the impact of equity incentives

Leon Zolotoy | Don O’Sullivan | Geoffrey P. Martin

Melbourne Business School, University of

Melbourne, Carlton, Australia

Correspondence

Don O’Sullivan, Melbourne Business School,

University of Melbourne, 200 Leicester Street,

Carlton VIC 3053 Australia.

Email: d.osullivan@mbs.edu

Drawing on arguments from institutional theory, this study examines how social norms—specif-

ically, local religious social norms—affect the motivational impact of equity-based incentives.

We test our model using longitudinal data on local religious norms, CEO equity incentives, and

firm value. Consistent with our theoretical predictions, we find that local religious social norms

attenuate the impact of CEO option incentives upon firm value. Furthermore, we find that the

attenuating impact of local religious social norms increases with managerial discretion. These

findings provide valuable insight for human resource professionals aiming to design compensa-

tion contracts for employees that are aligned with firm goals. Our findings also contribute to

research on the motivational effect of equity incentives by demonstrating the importance of

considering the social context in which executives are embedded.

KEYWORDS

CEO compensation, institutional theory, social networks

1|INTRODUCTION

The role of incentive compensation is a central and enduring focus of

research and practitioner interest in how human resource practices

enhance firm performance (Cohen, 2011; Combs, Liu, Hall, & Kitchen,

2006; Park & Sturman, 2016; Sung, Choi, & Kang, 2017). Recently,

human resource management (HRM) scholars have focused on exam-

ining executive compensation (Bragaw & Misangyi, 2017) and the

interplay between executive incentives and firm outcomes (Martin,

Washburn, Makri, & Gómez-Mejía, 2015). At the executive level, the

design of compensation contracts has been heavily influenced by

agency-based reasoning (e.g., Jensen & Murphy, 1990). However,

notwithstanding exhaustive research attention, agency-based models

have yet to provide strong evidence of a meaningful relationship

between executive pay and firm performance (Seo, 2017). Conse-

quently, the human resource and executive compensation literature

offers limited concrete guidance for practitioners seeking to design

incentive mechanisms that align the interests of executives with firm

stakeholders (Wowak & Hambrick, 2010).

Classical agency theory suggests that executives respond uni-

formly to incentives independent of social norms (e.g., Jensen &

Meckling, 1976). This view has been implicit in human resource litera-

ture exploring the consequences of equity incentives (e.g., Martin

et al., 2015; Pepper, Gore, & Crossman, 2013). However, this expec-

tation sits uncomfortably with insights from institutional theory

(e.g., North, 1990; Scott, 1995) and from HRM studies on the impact

of external contextual factors—and social norms in particular—on the

efficacy of compensation and incentives (Merriman & Sen, 2012;

Schlesinger,1983). From an institutional perspective, social norms

provide actors with a common understanding of appropriate judg-

ment and conduct (Merriman & Sen, 2012). As a result of failing to

“acknowledge the social context in which principal–agent contracts

occur”(Wiseman, Cuevas-Rodriguez, & Gómez-Mejía, 2012, p. 202),

agency-based models are thought to be undersocialized (Donaldson,

2012; Lubatkin, Lane, Collin, & Very, 2007). The principal–agent con-

tract can be generalized to any contract between the firm and an

employee, in which the employee is empowered to make decisions

on behalf of their firm and its shareholders. To the extent that the

principal–agent relationship is socially embedded (Granovetter, 1985),

social norms represent an important consideration for scholars seek-

ing to enhance agency-based predictions on the motivational impact

of equity incentives (Westphal & Zajac, 2013; Wiseman et al., 2012).

Our aim is to extend human resource research on the motiva-

tional consequences of equity-based incentives by casting executives

as socially embedded, rather than socially dislocated, actors. We

focus on local social norms—norms in the area surrounding a firm’s

DOI: 10.1002/hrm.21897

Hum Resour Manage. 2018;57:1233–1250. wileyonlinelibrary.com/journal/hrm © 2018 Wiley Periodicals, Inc. 1233

headquarters. As senior executives tend to live near their firm’s head-

quarters, the norms and expectations of the local community are

thought to influence top management’s cognition and behavior

(Berrone, Cruz, Gómez-Mejía, & Larraza-Kintana, 2010; Gómez-Mejía,

Haynes, Núñez-Nickel, Jacobson, & Moyano-Fuentes, 2007). Hence,

notwithstanding globalizing trends, norms of the area surrounding

firms’headquarters represent a promising unit of analysis for examin-

ing executive behavior and firm outcomes (Marquis & Battilana,

2009; Thornton, Ocasio, & Lounsbury, 2012).

Against this backdrop, we explore how a central component of

local social norms—local religious norms—influences the motivational

effect of CEO equity incentives. At least since Weber (1905), scholars

have explored how religious norms affect perceptions and behaviors

as well as social and economic development (Chan-Serafin, Brief, &

George, 2013; Iannaccone, 1998; Weaver & Agle, 2002). Consistent

with institutional reasoning (Oliver, 1997; Scott, 1995), individuals liv-

ing in areas where a large proportion of the population are religious

adherents tend to conform to religious social norms—even if they are

not personally religious (Boone, Khurana, & Raman, 2013; Stark &

Bainbridge, 1996; van Tubergen, te Grotenhuis, & Ultee, 2005).

Again, consistent with institutional reasoning, extensive empirical

studies provide evidence that the strength of local religious social

norms shapes the judgment and behavior of executives of locally

headquartered firms (Callen & Fang, 2015; Hilary & Hui, 2009;

McGuire, Omer, & Sharp, 2012; Shu, Sulaeman, & Yeung, 2012).

Prior work suggests that the motivational effect of incentives

varies with an individual’s subjective perceptions and disposition

(Cadsby, Song, & Tapon, 2007; Pappas & Flaherty, 2006; Wowak &

Hambrick, 2010). As local religious social norms shape managerial

judgment and behavior, we advance the argument that local religious

social norms influence the effort that CEOs of locally headquartered

firms exert in response to equity incentives. Given the unobservable

nature of executive effort (Jensen & Meckling, 1976; Tosi, Werner,

Katz, & Gómez-Mejía, 2000), firm value is a useful proxy for the con-

sequences of executives’effort and actions in response to incentives

(Carpenter & Sanders, 2002; Feldman & Montgomery, 2015;

Sanders & Hambrick, 2007). Hence, we test our arguments by exam-

ining how religious social norms influence the impact of CEO equity

incentives on firm value. While we focus on norms as a source of

institutional conditioning, we recognize that CEOs’personal religious

convictions may also play a role (Chan-Serafin et al., 2013; Weaver &

Agle, 2002). Therefore, in our empirical tests, we address the possibil-

ity that CEOs’personal religious convictions, rather than local reli-

gious norms, explain our results.

We find strong support for our arguments in a sample of 18,647

firm-years. Our study makes several contributions. First, we advance

HRM research on the performance and motivational consequences of

executive incentive mechanisms (cf. Martin et al., 2015; Park & Stur-

man, 2016; Seo, 2017; Sung et al., 2017). We achieve this by demon-

strating the utility of adopting a socially informed approach to

exploring the consequences of equity incentives when designing and

negotiating compensation contracts. Hence, our work responds to

concerns that agency research examining incentive alignment has

been undersocialized (e.g., Berrone & Gómez-Mejía, 2009; Gómez-

Mejía, Wiseman, & Johnson, 2005; Westphal & Zajac, 2013). Second,

we advance the human resource and management literature exploring

institutional influences—via local religious norms—on executive

behavior by infusing insights from the study of executive compensa-

tion and individual agency; in doing so, we address concerns that this

literature and human resource practice has ignored the role of indi-

vidual incentives and self-interest (Granovetter, 1985; Park & Stur-

man, 2016). Third, we advance human resource research on the

relationship between incentives and firm value (e.g., Sung et al.,

2017) and the efficacy of pay-for-performance plans (Gerhart & Fang,

2014; Gerhart & Rynes, 2003; Jenkins, Mitra, Gupta, & Shaw, 1998).

By describing the role of social context as an important contingency

in the outcomes associated with incentives, we provide an important

additional factor that human resource professions should consider

when designing these plans and related contracts.

2|THEORETICAL BACKGROUND

Human resource scholars and institutional theorists argue that the

formal and informal institutional forces prevailing within an actor’s

environment shape cognition and behavior (Merriman & Sen, 2012;

North, 1990; Schmidtke, 2007; Scott, 2001). These institutional

forces include social and cultural norms that generate belief systems

and related practices or “logics”(Scott, 2001). Patterns of behavior

and prevailing ethical standards can emerge as individuals subcon-

sciously conform to the common perceptions and values in their envi-

ronment (Marquis, Glynn, & Davis, 2007). The influence of social

norms is underpinned by the shared interactions, habits, experience,

and language of social networks (Galaskiewicz, 1997; Marquis & Bat-

tilana, 2009). From an institutional theory perspective, recognizing

the social embeddedness of actors provides a basis for predicting

cognition and behavior (Granovetter, 1985; Merriman & Sen, 2012).

Reasoning similar to institutional logic has been advanced in the

psychology and economics literatures. Social cognition theory

(e.g., Tajfel, 1978) describes how actors seek to conform to prevailing

norms as a means of supporting self-concept and enjoying a sense of

membership of a community. Economic theorists (e.g., Elster, 1989)

argue that, due to a sense of membership with a community, actors

tend to conform to social norms—even when their actions are

unobservable—as breaches of social norms give rise to emotional

costs such as feelings of guilt. Hence, even if an actor initially con-

forms to social norms to avoid sanctions or reap the rewards of social

membership, norms become internalized over time, as internal

rewards (sense of membership) and sanctions (guilt) supplement

external rewards (esteem) and sanctions (shame or ostracization). As

a result, norms are also likely to influence behaviors that may not be

transparent to others (Cialdini & Trost, 1998). Of particular relevance,

the tendency toward conformity to social norms is thought to be

more pronounced in settings where individuals experience greater

uncertainty, as is commonly the case in the decisions facing senior

executives (Geletkanycz & Hambrick, 1997).

Drawing on institutional theory and social and cognitive psychol-

ogy, human resource management scholars—and management

scholars more generally—have explored how local social norms and

expectations shape executive cognition and decision making. For

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