BOARD REMUNERATION, PERFORMANCE, ANDCORPORATE GOVERNANCE IN LARGE SPANISH

COMPANIES.

Rafel Crespí

(UAB,UIB)

Carles Gispert

(UAB)

VersionDecember1998

Departament d'Economia de l'EmpresaUniversitat Autònoma de BarcelonaEdifici B 08193 BellaterraPhone: +34 3 581.14.51Fax: +34 3 581.25.55E-Mail: Rafel.Crespi@uab.esE-Mail: Carles.Gispert@uab.es

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BOARD REMUNERATION, PERFORMANCE, AND CORPORATE GOVERNANCE

IN LARGE SPANISH COMPANIES ..

Abstract:

In this paper we present empirical evidence on the relationshipbetween board remuneration of a sample of large Spanish companiesand a set of explanatory variables such as performance and size ofthe company. The objective is to contrast the existing evidence basedon the agency theory in an institutional environment with differencesfrom the literature.

We focus on the impact of company’s governance structure on therelation between pay and performance. Specifically we consider theownership concentration and the firm leverage as key determinat ofthe board-shareholders relationship.

Our results confirm the positive relationship between boardremuneration and company performance, which is stronger for bookvalues than for stock market measures. Industry performance alsoexplains the remuneration and provides useful information toevaluate board behaviour. Company size is also related to boardremuneration, and affects the pay-performance relationship, althoughis not relevant when we use an elasticity approach. Finally, thegovernance structure of companies is relevant when explaining thepower of the compensation-performance relationship, and differencesbetween the impact of ownership concentration and firm leverage onthis relationship are found.

JEL Classification: G3, J33

Keywords: Board Remuneration, Company Performance, Firm Size, Corporate

Governance.

The authors thank on Vicente Salas and Luc Renneboog for their comments toprevious versions of the paper. We also thank the participants, specially to MartinConyon, at Workshop on Corporate Governance, Contracts and Managerial Incentives(Berlin, July 1998) and Cambridge (1998) workshop on Corporate Governance. Theusual disclaimer applies. This work has received financial support from the DGCYT,Project Number PB-94-0708.

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1. Introduction

What determines the company board’s remuneration? Are the board compensation

schemes related to the company performance figures or just to firm size? Is the

governance structure important when explaining the relationship between board

remuneration and company performance?

Some answers to these questions have been given in papers by Murphy (1985) or Gregg

et al (1993), who related executive compensation to corporate performance. Jensen and

Murphy (1990) estimate the pay-performance relationship for executives. Main et al.

(1996) relate boardroom pay and company performance, and in a recent study by

Conyon (1997) the impact of corporate governance innovations on top director

compensation is analysed. The mentioned studies link the performance of US and UK

companies with the remuneration of their top managers. The economics of these finding

are the existence of incentive contracts that reduce costs associated to the agency

relationship between shareholders and managers. The results are consistent with the

predictions of the agency model.

Only one of these papers (Main et al., 1996) considers the total board remuneration as a

magnitude of the pay side in its relationship with performance. This approach is

justified by the redefinition of the agency problem. On the principal side there are

shareholders and the agent is board of directors. The board has the attribution to

allocate company resources, acts on behalf of shareholders (the principal), and is only

under control of the stock market, the products market and shareholder meetings. Our

approach, is based on the legal rules that make company managers responsible in front

of the board, and the board responsible toward the shareholders.1 We have an additional

justification to use the total board compensation instead of top executives remuneration,

which is the availability of data that will be detailed in the Data and Methodology

section.

1 It’s important to underline here that in Spanish firms, the CEO and top executives are

usually board members. This category is known as insider board members, opposite to

outsider board members, who do not perform executive tasks in the company.

4

There is also empirical evidence on the impact of governance characteristics on the pay-

performance relationship. Conyon (1997) justifies the introduction of governance rules

and characteristics in the compensation-performance dependence in order to identify the

degree of potential agency problems and to evaluate how successful remuneration

schemes are in curbing this kind of problems. Ownership concentration and firm

leverage are two components of the company governance structure that we consider. An

extension of the model developed by Salas (1992) presents a theoretical framework in

which some corporate governance characteristics can be a substitute for compensation

schemes based on company performance. The aim is to detect, as the agency theory

predicts, differences in the determinants of board compensation depending on the level

of supervision that shareholders or creditors exert over the management.

Our empirical study is based on a data set of large and listed Spanish companies during

the period from 1990 to 1995. Peña (1978) and Ortín (1997) are examples of empirical

papers in Spain, and they focus on the company size as a key point to justify the

managers’ remuneration. The Spanish institutional environment as a thin, but growing,

stock market and the presence of significant shareholders with important ownership

participations allows us to compare the results of this "non market-oriented system"

with the "Anglo-Saxon system". Effectively, the conclusions of the literature come from

research applied to UK and USA data, where the level of ownership dispersion is higher

than in continental Europe and Japan. Therefore the control mechanisms of the agency

problem can rely more on market devices, like takeovers, than on direct contractual

incentives between shareholders and managers. In our context we expect board

remuneration to be less performance-dependent to the extent that governance structures

differ. It is also important to know to what extent these determinants of board

remuneration differ among corporate control systems.

Our findings support the hypothesis that performance explains board remuneration. We

also find a positive relationship between company size and board remuneration. This

positive relation is not significant when the link is between changes in compensation and

changes in company size. Finally, governance structure in terms of ownership

concentration is relevant to explain the remuneration performance relationship, but is

not relevant in terms of firm debt leverage.

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The paper continues developing the theoretical framework. Section 3 is devoted to data

and methodology explanations, and the results are presented in Section 4. The paper

concludes in Section 5.

2. Determinants of Board Remuneration.

2.1 Remuneration and Company Performance.

From a theoretical perspective, the design of compensation contracts for the company

managers in an agency context has been an important subject in the microeconomic

literature2. The problem to solve is the determination of an optimal compensation

scheme that motivates managers to make a maximum effort, taking into account that

managers are risk-averse, and that contract is done in a context of asymmetric

information. The conceptual framework of the agency theory provides a set of useful

elements to evaluate the manager-shareholder relationship.

The assumption of non-observable costs for both parts in the relationship presents a key

difference from the neo-classical postulates (see Hart 1995). In a principal-agent model

the level of effort of the agent is private information, which is a basic condition for a

potential opportunistic behaviour. The model explains the outcome (y) of a company as

a function of the real effort carried out by mangers (e) and a set of variables which are

not under a manager’s control which are assumed randomly distributed (ε).

y = f(e,ε)

To motivate the agent’s best course of action, and punish him if fails to do so, the

principal should offer a contract where the manager’s compensation is based on

observable outcomes. The outcome has to be highly correlated with the non-observable

measure (e).

Tirole (1988), Rosen (1992) and Hart (1995) justify the use of a contract where

manager compensation (w) is based on an observable outcome of the company

w = g(y)

2 See, for example, Ross (1973), Mirrlees (1976) or Grossman and Hart (1983).

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There is the assumption that effort (e) and results (y) move together, otherwise the

observability of y would be irrelevant in pushing managers toward higher effort levels

(e). In case of risk-neutral agents, the first best solution would be a contract with the

following form

w(y) = y - F

where shareholders sell the company to the agents, who would pay a fixed amount F to

them. With risk-averse agents, the second-best solution is a contract with a trade-off

between incentives and risk. If the aim of the contract is to achieve a higher level of

effort, the incentives should be very sensitive to results, which means that the risk borne

by the agent is very high. On the other hand, if the objective is to minimise the risk

borne by managers, the incentive contract would not be connected with performance

measures, and effort and motivation are values expected to be lower.

An expected consequence is that risk-averse agents would only accept expensive

contracts that compensate for the risk they bear. The amount of this premium could be

justified by the individual risk aversion coefficient and by the implicit risk of the

company performance measure.

The theory predicts a positive relationship between manager’s remuneration (measured

in different ways) and company results or performance. Several empirical papers

present evidence in this sense. Murphy (1985), Jensen and Murphy (1990) Gregg et al

(1993), Conyon and Peck (1996), Conyon (1997) and Main et al (1996), are relevant

references that support the previous reasoning.

Our approach considers board members as the first level of delegated authority from

shareholders in the agency relationship. They have to report the outcome of their

decisions to the shareholders and according to the incentive constrain, we expect that

their compensation will be linked to company performance measures.

Hypothesis 1: There exists a positive relationship between company performance and

board remuneration.

One of the factors which can affect compensation-performance based contracts is the

noise level of the performance measure. Holmstrom (1979) shows how the principal is

always better off with more information about agent behaviour than with less

information. The introduction of new observable variables (z) to the former contract

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w = g(y), and a more accurate measure of the real effort applied by managers would

reduce the associated risk to the performance measure, decreasing the variance of

observable outcomes. Additional information can be introduced in the compensation

contract from the behaviour or performance of comparable managers in companies with

similar activities. Our contract would be then

w = g(y,z)

Gibbons and Murphy (1990) show evidence about the relative importance of the

evaluation of a manager’s behaviour. Poor company results can be caused by external

factors, which affect companies belonging to the same industry. In this case, a correct

evaluation of management effort would consider not only the company performance

figures, but also industry measures of performance (see also Lazear 1995).

According to this we expect a negative relationship between board compensation and

industry performance measures, balancing the positive relationship of the remuneration

and company performance. Empirical evidence with data sets of UK and US companies

is provided by Gibbons and Murphy (1990), Conyon and Leech (1994) and Conyon

(1997).

Hypothesis 2: There is an inverse relationship between industry performance and

board remuneration.

2.2 Remuneration and Firm Size.

Company size has usually been introduced in empirical research as a controlling

variable to explain levels of manager compensation.3 Empirical findings are supported

on the Rosen’s (1992) argument that the cost of wrong decisions and the benefits of

correct managerial behaviour are higher the larger is the company. A consequence is

that managers should be better paid to the extent that the company is larger. Larger

firms may employ better-qualified and better-paid managers. Anyway, as Murphy

(1998) exposes, recent data suggest that the positive relation between CEO pay and

company size has weakened over time, although it remains positive. For companies of

3 See Murphy (1985), Jensen and Murphy (1990), Gregg et al (1993) and Conyon

(1997). Also see Ortín (1997) for the Spanish case.

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significantly different sizes, we expect that larger firms will pay more to their board

members than smaller ones.

Hypothesis 3: There is a positive relationship between company size and board

remuneration

A further step is to evaluate the impact of firm size on the board remuneration-firm

performance relationship. As Murphy (1998) and Gibbons and Murphy (1992) assert

empirically, the pay-performance relationship is smaller in large firms. They state that

the optimal pay-performance relation may decline with firm size for two reasons: (i) the

variance of changes in shareholder wealth increases with firm size, and (ii) the CEO’s

direct effect on firm value may decrease with firm size (Gibbons and Murphy, 1992, p.

489). The underlying proposition of the second point is the incentive principle of

Milgrom and Roberts (1992), where the level of performance incentives depends on the

marginal contribution of manager effort to company profitability. For larger firms is

more difficult that additional manager efforts will have the same positive impact on the

principal outcome as we could expect in smaller firms. For this reason, it will not be

worthy to introduce high-powered incentives that will only serve to increase the agent’s

exposure to income variations.

Hypothesis 4: The positive relationship between board compensation and company

performance is expected to be lower for larger companies than for

smaller ones.

Furthermore, Gibbons and Murphy (1992) also show that while the pay-performance

relationship varies significantly with firm size, the pay-performance elasticity is almost

invariant to firm size. The sensitivity approach in the pay for performance relationship

establishes the effect of increases of one monetary unit in the performance measure over

the shareholder's wealth amount. On the other side an elasticity approach in the pay

performance relationship does not require a correction for firm size (Murphy,1998). We

follow this our approach, as we comment in the next section.

2.3 Remuneration and Governance structures

A contract that establishes a compensation scheme depending on the company results

would be optimal in the absence of transaction costs. In a world of incomplete

contracts, where agency problems arise, the companies’ governance structures play an

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important role. They are important as a decision-making mechanism for situations that

have not been specified in the initial contract (Hart 1995). These contracts contribute to

overcome the agency costs that appear from limited specifications in the initial

negotiation.

Governance peculiarities come from the institutional rules and markets where the

company operates and form the company governance characteristics. Institutional and

market characteristics such as the development of financial markets, the activity of the

market for the corporate control, the importance of banks as monitors, the legal rules

protecting the shareholder’s investments or the role of institutional investors are

important. The firm specific governance conditions refer, among others, to the structure

and composition of ownership, the creditor's control or the board composition. Both

kind of attributes are able to influence the board-shareholders relationship moderating

the problems of information asymmetries, increasing the supervisory activity or

avoiding free riding behaviour.These variables can influence the way in which control

and supervision of company managers is exerted. The higher the control and supervision

intensity, the higher will be the knowledge about the real effort made by managers in the

performance of their contracts.

This leads us to hypothesise that board remuneration will be influenced by the

governance structures. In companies where shareholders have less control over

managers (manager-controlled companies in the terminology of Berle and Means), the

discretionary power for managers will be higher, and a more powerful compensation

performance scheme is need. The impossibility to observe makes it more dependent upon

an indirect yardstick which is observable.

The justification is based on the idea that the impossibility to observe directly (and

supervise) the managers’ behaviour makes their remuneration more dependent on an

observable measure of their effort, which could be company performance. On the other

hand, in governance structures where shareholders can directly supervise4 the managers’

decision process, the compensation-performance relationship could be weaker. In this

4 In this context, there is the case where managers are board members and significant

shareholders. Boards of companies with highly concentrated ownership usually

represent an important proportion of the outstanding equity.

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case shareholders would have superior information about the managers’ effort and the

remuneration could depend on the observation of the real variable (effort) in the

contract.

Salas (1992) presents a model of incentives and supervision where a risk-neutral

principal (in our case the shareholders) contracts a risk-averse agent (managers or

board members). The principal offers this efficient contract to the agent5

R y x y x( , ) = + +α β µ

where R is total compensation, βα, and µ are parameters to estimate when solving the

problem of maximising the principal expected return. Two related measures give

information about the real effort made by the agent: the company outcome (y) and the

manager's observed effort (x). Both measures provide imperfect information about real

effort because some noise randomly affects this. The following expression considers this

fact

2

1

εεδ

+=++=

exey

where e is the real effort, δ is a constant and ε ε1 2, are random variables with a mean of

0 and variances σ σ12

22, , respectively. These random variables include, among other

factors, the mentioned lack of precision in the measures.

The solution to the problem requires the following condition6

βµ

σσ

∗

∗ = 22

12

This necessary condition indicates that higher supervision, when reducing the variance

σ22 , also reduces the weight assigned to β , so compensation should be less

performance-dependent. On the other hand, a weak supervision would mean that

5 According to Wilson (1968), cited in Salas (1992).

6 For more details, see Salas (1992) , pp. 133.

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compensation ought to be highly correlated with company performance, and risk is

transferred from the principal to the agent.

This theoretical approach provides us with a starting point to evaluate the expected

impact of governance mechanisms, such as supervision devices, on the compensation of

board members.

The level of ownership concentration can be considered as a proxy of intensity of

shareholders supervision. Lower levels of ownership concentration increase the

probability of shareholder’s free rider behaviour, decrease ownership control and allow

for higher discretionary power (less supervision) for board members. The expected

relationship is as follows:

Hypothesis 5: The intensity of the board pay for performance relation is inversely

related to the ownership concentration

The shareholder’s control of managers is complemented with the creditors ability to

monitor the debt contracts. In this sense the board members obligation to fulfil an

enforceable contract decreases the possibility of opportunistic behaviour. This also

reduces the amount of cash flow that they can freely allocate (Jensen, 1986). We

consider the firm leverage as a proxy of intensity of creditors supervision and free cash

flow availability, and lower levels of leverage can be interpreted in terms of higher

discretionary power for board members, and we expect the following relationship:

Hypothesis 6: The intensity of the company performance and board compensation

relationship is inversely related to the firm leverage

3. Data and Methodology

Connecting the six hypotheses introduced in a testable model lead us to consider the

explanatory variables of board remuneration as performance, size and governance

attributes. Governance characteristics and also company size are explanatory to the

board remuneration-performance relationship. Thus, the board remuneration equation

could be specified as:

titititit SIZEAIPERFPERFREM ,1,31,21,121iti, )ln( εβββαα + )( + )( +)(++= −−−

To estimate the model we use first differences, so the transformed model is

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tittititi SIZEAIPERFPERFREM ,1,31,21,1ti, )ln( υψβββ + + )(∆ + )(∆ +)(∆=∆ −−−

where ∆ is the first difference operator (∆Xit = Xit - Xit-1) , REM is the average

board-member remuneration which comes from the division of total board remuneration

by the number of board members of company i for the year t7 This remuneration figure

includes salary, allowances, and any other kind of remuneration received by board

members when performing their functions and other minor causes that current Spanish

Company Law states.8 This measure does not include the surplus, dividends or returns

attributed to the board members as owners of shares of the company. Murphy (1985)

argues that the objective is not to evaluate the direct and obvious relationship between

returns and profitability, but the more subtle and indirect one between performance and

the remuneration received for exerting the function of manager or board member.

PERF is a measure of company performance. We have used two types of data for this

figure. The first one is an accounting measure of profits )1ln( ROAPERF += , where

ROA is calculated dividing the accounting profits by the book value of assets. The

second measure is based on capital market information (shareholder return), which is

similar to measures used by Murphy (1985) and Conyon (1996).

)ln( turnstockPERF Re= is the level, and changes in shareholders' returns are

calculated as follows

∆PERFP DIV DPS

PSHRt

t t t

tt=

+ +

=

−

ln1

where tP is the share price at the end of period t, tDIV is the dividend paid to

shareholders during the period t and tDPS refers to the rights attached to shares in case

of new equity issues for the same period. The book based performance measure is

referred to period t-1 given that from some companies’ statutes, we know that the board

compensation is based on the previous year profits. Stock market performance measure

7 We tested also the model considering total board remuneration divided by the number

of executive members of the board (not shown). The results are similar in terms of

significance. Only the magnitude of the estimated coefficients varies slightly.

8 Ley de Sociedades Anónimas specifies in the art. 200. We do not have information

about option contracts or preformance related bonuses.

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is lagged one more period in relation to accounting values once checked that the market

anticipates the accounting profits.

The use of two measures is based on two reasons. First, because it is possible to

compare both values to the extent that they measure different concepts of performance.

A second reason is our objective to test to what extent the use of market or accounting

measures of performance is related to the amount of “noise” inherent in both signals,

and their sensitivity to board actions. As Lambert and Larcker (1987) point out, firms

should place weight on one measure for situations in which the variance of the

alternative measure is relatively high compared to the variance of the former. There is a

substitute effect depending on the variance of measures.

AIPERF reflects industry performance variables, which have also been calculated from

market information (AISHR= the industry return on equity), and from aggregated book

values, )1ln( industryROAAIROA += . The objective of these measures is to capture the

relative performance of companies compared with industry averages.

The model specification includes the company size and we measure it as the logarithm

of sales turnover ln( )S t . This measure will capture the influence of firm size on

average member remuneration. A dummy variable has also been included (DS) wich

takes value of 1 if sales turnover is above the median (large firms) and 0 if not.

We have also included dummy variables to correct for non-company specific time

factors ( )tψ , such as economic cycle characteristics, affecting all companies, and the

usual error term (υi,t).

To measure the influence of governance characteristics we have introduced two

variables, ownership concentration and firm leverage. Ownership concentration is

measured by the C1 value, which is the percentage of shares owned by the largest

shareholder, directly or through third parties or companies.9 The firm leverage (LEV), is

calculated dividing the book values of total debt by total assets. The test about the

influence of these governance variables is done in two ways. Ownership concentration is

9 Several alternative measures have been checked, such as C3 or C5. These alternative

measures are highly correlated to the one finally adopted.

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introduced into the model as a dummy (DC) with value 1 in the case of C1 above the

median and 0 otherwise. This dummy interacts with existing variables. The way to

account for the debt influence is by splitting the sample in two subsamples, depending

on the level of leverage. The reason of this is to avoid collinearity problems with the

interacting variables when leverage is introduced as a dummy, and the necessary

reduction of the sample removing banking companies.

Table 1 presents the descriptive statistics of the mentioned variables and Table 2 shows

the correlation matrix.

(INSERT TABLES 1 AND 2 HERE)

There are three considerations to introduce at this point. The first one is that the

proposed model to estimate changes in board compensation for a given period with

changes in performance for the previous periods. We assume that remuneration of

period t is based on past profits, although in the estimation of the model we have

included current performance in certain cases. The second one refers to the linear

relationship proposed to explain board compensation. Holmstrom and Milgrom (1987)

linear model is behind several empirical approaches which allows us to compare results

with reference studies in the literature. Finally, the estimation of the compensation

against a set of explanatory variables would be possible in two forms. One would be

estimating absolute levels of remuneration and another would be via changes in

remuneration. We follow the second one, because a model of changes has advantages in

capturing factors that influence the relationship and remain over time. Conyon (1997)

justifies the estimation with fixed effects because some non-directly observable effects,

such as managerial attitudes or corporate strategy, remain stable over time for a given

company iα , but change from firm to firm. This means an advantage over cross-section

approaches, allowing the control of idiosyncratic firm characteristics on compensation

schemes. There is an additional and convenient reason for using models of changes

instead of level models: they are the most utilised in previous research and our findings

can be better compared.

Additionally, we could choose a regression where the coefficients are interpreted as pay-

performance sensitivities (changes in monetary terms), used i.e. by Jensen and Murphy

(1990) or as pay-performance elasticities (in logarithms), used i.e. by Coughlan and

Smith (1985) or Conyon (1996). Despite that neither the sensitivity nor the elasticity

15

approach strictly dominates each other in the research, we adopt the second approach

because it produces a better fit of the model (Murphy, 1998)

The data comes from a sample of Spanish listed companies during the period from 1990

to 1995. The basic information has been provided by the CNMV, which is the

regulatory and supervisory agency of Spanish stock markets. Companies have to report

regularly accounting information. Significant shareholders have to disclose their share

stakes which are equal or greater than 5% to the CNMV, and board members have to

declare any amount of shares they own. The board remuneration comes from the

companies’ annual report, where under the current law there is a mandatory section to

inform. Stock exchange information has been used to calculate company and industry

market returns.

The selection criteria to construct the sample of companies has been the availability of

information. From listed companies we have considered non-financial companies and

banks. Despite the mandatory rule of disclosing information to the CNMV for all listed

companies, some of them have a lot of missing values in the official files. The filter

applied has been to have complete information of about 5 of the last 8 years. The final

sample is made up of 113 companies in 9 sectors of activity according to the CNMV

classification. This sample represents 29% of all listed companies in 1995, and in terms

of market capitalisation represents 79% of all Spanish stock exchanges. This means

some bias toward large companies, because we have selected a small number of firms

representing a large amount of market capitalisation. In principle, this should not be a

problem given the agency theory context where a separation of ownership and control is

assumed.

4. Results

In this section we test the hypothesis using the OLS method and present descriptive

statistics. Hypothesis 1, which establishes a positive relationship between firm

performance and board remuneration, is tested and the results are shown in column (1)

of Table 3. We estimated it using four performance explanatory variables: the first two

are accounting measures, current and one period lagged; and the last two are market

measures, lagged one and two periods (one period lagged about the accounting measure,

as we commented previously).

(INSERT TABLE 3 HERE)

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From the regression it is possible to assert that hypothesis 1 can not be rejected. There

is a positive relationship between changes in company performance (accounting and

market calculations) and changes in board remuneration. The R-square value, about 22

percent, shows a reasonably high fit of the model, which is larger when using an

elasticity approach instead of a sensitivity technique.

There are also important differences in the influence of performance measures.

Accounting measures present a stronger relationship than market ones (roughly ten

times higher). Our explanation follows from the observed behaviour in the

companies-boards relationship: the contractual arrangements usually state that

compensation of board members is calculated on the previous period profits. The profit

figures are less volatile than stock market returns, even with high correlation values of

both magnitudes. In a context of risk-averse board members, this drives the contractual

solutions toward stable measures like accounting ones, instead of alternative values, but

more volatile, such as market returns.

Note also that the accounting measure one period lagged is more powerful in explaining

board remuneration than the current accounting measure, and market measure two

periods lagged is more powerful than one period lagged. This indicates the time delay

between increases (decreases) in performance and increases (decreases) in board

remuneration.

Another important result from column (1) of table 3 is that coefficients of market

measures are very low compared to the coefficients in a market-oriented system as, for

example, in the US. Following a similar methodology, the articles of Murphy (1985) and

Coughlan and Smith (1985) found stronger relationship between shareholder return and

management compensation. One possible explanation is the different institutional

environment, specifically the characteristics of capital market, and some other

governance attributes that we will introduce later.

The hypothesis 2 establishes a negative relationship between industry performance and

board remuneration. The conclusion from the column (2) of table 3 is that this

hypothesis can not be rejected. Changes in remuneration are inversely related to changes

17

in industry performance, which indicates the importance of relative measures to set up

compensation schemes.10

The parameters associated to industry variables are negative and significant (except for

current accounting measures). The relation between accounting and market performance

coefficients is similar to those of the absolute performance column, and confirms the

differences between measures explaining board remuneration.

Hypothesis 3, anticipates a positive relationship between company size and board

remuneration. The results in table 3 column (3) and table 4 lead us to not reject this

hypothesis, even though they should be interpreted with some caution

(INSERT TABLE 4 ABOUT HERE)

Descriptive statistics of table 4 give us information about company size impact on

board remuneration. We observe that total board compensation and board member

compensation are, in average, higher the larger is the firm (measured by sales turnover).

For larger firms (Q4) total board remuneration is about six times higher than for

smaller ones (Q1), while in terms of board member compensation the relation between

the higher and the lower quartile is about three. As we can see, this is due because large

firms have also boardrooms with more members than small firms.

The regression results from column (3) in table 3, using an elasticity approach, don’t

confirm the positive relationship between firm size and board member remuneration.

This means that board remuneration is not sensitive to firm growth. For this reason, we

have to consider this fact to interpret the positive relationship between size and

remuneration.

The intuition about the impact of firm size on the remuneration-performance

relationship, table 5, does not allow us to reject hypothesis 4, that is, the larger is the

firm, the smaller the intensity of the incentives is.

10 In this specification of the model we excluded the one period lagged market return

measures. The reason is to avoid the problems of collinearity (tolerance below 0.3) with

the other variables.

18

(INSERT TABLE 5 ABOUT HERE)

In table 5 we use the mentioned measures of performance: profits before taxes and firm

market value, both one period lagged. The values are levels of board remuneration (total

and individual) and levels of performance instead of differences. In this sense the values

can be interpreted in terms of sensitivity of compensation to changes in firm size.

Although the methodology is simple, at this stage we can infer the expected sign in the

relationship.

A more accurate analysis, and following the specified model, tests the significance of

these differences. That is, we shall test hypothesis 4 using an elasticity approach and

observe whether the relationship remuneration-performance decreases with firm size (as

the intuitive approach show us) or remain invariant. Column (4) of table 3 present the

results. We observe that, except for the market variable, the coefficients of interaction

terms are not significant. Thus, our results are similar to the results obtained by

Gibbons and Murphy (1992) or Murphy (1998). We find evidence of a decreasing

weight of incentives linked to performance the larger is the firm, but this weight is

invariant to firm size in an elasticity approach.

The last point to analyse in this section is the impact of governance structures in the

pay-performance relationship, which have been postulated in hypotheses 5 and 6.

First, we focus on ownership concentration as governance structure. Table 6 prsents

some intuition when looking at differences between quartile 1 to 4. It seems that board

remuneration-performance relationship decreases as ownership concentration becomes

higher. Anyway, this decreasing function is not clearly monotonic, with non uniform

steps in quartiles 2 and 3.

(INSERT TABLE 6 ABOUT HERE)

This intuition from descriptive statistics is strengthened by the results of column (5) of

table 3, where the interactive variables have been used. This result is compatible with

hypothesis 5. Using accounting values, we observe a substitution effect between

supervision and direct incentives, and these direct incentives are based on a low “noisy”

measure. For more concentrated firms, board remuneration is less “accounting-

dependent” due to higher monitoring activity exercised by shareholders. In this context

it is reasonable to suppose that board remuneration would not be linked to accounting

19

rates, but will depend on shareholder wealth, although with less intensity due to the high

variance of this measure.

The second variable of corporate governance that we analyse is firm leverage. Table 7

shows us descriptive statistics about pay-performance sensitivity to leverage, in order to

offer some evidence about hypothesis 6.

(INSERT TABLE 7 ABOUT HERE)

From table 6, it is not possible to derive a clear tendency about the impact of firm

leverage in the board remuneration-performance relationship. This intuition is confirmed

in table 8.

(INSERT TABLE 8 ABOUT HERE)

In this table the test of structural changes is significant, this means that there are

differences between the subsamples of high and low level of debt. Some variables take

the expected value supporting hypothesis 6 (market returns) and other do not

(accounting performance). For this reason we can not accept this hypothesis. It seems

that low leverage places more weight to industry performance, which would mean that

there is a substitution effect between creditors monitoring and “industry monitoring”.

That is, if the board has more free cash flow and more discretionary power, their

remuneration will be more “industry-dependent” in order to protect shareholders against

waste of resources out of industry practices.

The evidence is weak and contradictory about the role of leverage in linking board

remuneration and firm performance, and we are not able to confirm that this variable of

corporate governance plays a significant role in establishing board remuneration

policies.

5. Conclusions

Evidence on the compensation-performance relationship in an agency context is

available for the UK and the USA, where the governance structures are based on the

disciplinary role of capital markets. The design of efficient contracts, linking manager’s

compensation to the company performance and company size are complementary ways

to reduce the agency costs which come from the separation of ownership and control.

20

The aim of this paper is to address similar questions about the performance

compensation scheme in a different institutional context where the level of ownership

concentration is higher, the development of capital markets is lower and the legal rules

governing companies are different. We also address the remuneration-performance

problem focusing on the board of directors as first-level agents of shareholders (the

principal, in agency terminology) and directly responsible of company resource

allocation.

With a sample of 113 Spanish listed companies we find a positive relationship with

company performance and board remuneration, even if we measure performance via

accounting variables or stock market returns. The strongest relationship is associated

with performance based on book values, the basis over which remuneration is usually

calculated. We find a negative relationship between board compensation and industry

performance. This is interpreted as the addition of new variables with significant

information improves the remuneration scheme and corrects possible inefficiencies. All

results have been corrected by the variable size, which is significant and positively

related with board remuneration, and exerts weak influence ver the remuneration-

performance relationship. Finally our results find supporting evidence of governance

mechanisms as substitute devices of the compensation-performance relationship, but

only when considering ownership concentration, but not in the case of firm leverage.

21

Table 1

Descriptive Statistics (91-95)

Description Mean(std dev)

Median

REM total (MMpts) Total board remuneration 162.65(232)

85.5

Board members Number of board members 11.20(5.42)

10

REM (boardmember in MMpts)

Board memberremuneration

15.14(41.42)

8.76

∆lnREM Logarithm of changes inboard memberremuneration

0.0131(0.44)

0.038

ROA Accounting profits dividedby total assets

0.0175†(0.12)

0.0249†

AIROA ROA industry 0.0201†(0.03)

0.0233†

SHR Shareholder return (seeequation in text)

0.070†(0.50)

-0.025†

AISHR Average industryshareholder return

0.023†(0.32)

-0.024†

ln(St) Logarithm of total salesturnover

10.37(1.88)

10.55

C1 Percentage of direct andindirect shares owned bythe largest shareholder

46.35(30.08)

42.48

LEV Total debt divided by totalassets

0.465††(0.226)

0.464††

Source: own calculation from CNMV data. All values are expressed in terms of 1995 Spanishcurrency peseta.† average 1990-1994†† banks are not included

22

Table 2

Simple Correlation Matrix

∆lnREM

∆ln(1+ROAi,t-

1)

∆ln(1+AIROAi,t-

1)

SHR(t-2) AISHR(t-2)

∆ln(St)

C1 LEV

∆lnREM 1

∆ln(1+ROAi,t-1) .224** 1

∆ln(1+AIROAi,t-1) -.077 .202** 1

SHR(t-2) .130** .098* .326** 1

AISHR(t-2) -.003 .208** .565** .504** 1

∆ln(St) .094* .104* .076 .072 .025 1

C1 -.090* .002 .052 -.005 .046 .075 1

LEV -.178** -.100 .086 -.240** -.065 .002 .064 1

** Significant at 1%* Significant at 5%

23

Table 3Board compensation, performance, size and ownership concentration

Dependent variable: ∆lnREMit(1) (2) (3) (4) (5)

∆ln(1+ROAi,t-1) 0.389***(0.052)

0.420***(0.051)

0.425***(0.053)

0.426***(0.050)

0.500***(0.057)

∆ln(1+AIROAi,t-1) -0.357**(0.163)

-0.392**(0.174)

-0.398**(0.173)

-0.517***(0.193)

∆ln(1+ROAi,t) 0.096**(0.045)

0.121***(0.045)

0.119**(0.047)

0.123**(0.047)

0.120**(0.051)

∆ln(1+AIROAi,t) 0.006(0.126)

0.011(0.135)

0.048(0.138)

-0.212(0.150)

SHRi,t-2 0.030***(0.009)

0.045***(0.009)

0.048***(0.009)

0.052***(0.010)

0.007(0.012)

SHRi,t-1 -0.005(0.009)

AISHRi,t-2 -0.052**(0.020)

-0.058***(0.021)

-0.057**(0.022)

-0.032(0.023)

∆ln(St) -0.002(0.006)

DS* ∆ln(1+ROAi,t-1) -0.479(0.490)

DS* ∆ln(1+AIROAi,t-1) 0.520(0.646)

DS* ∆ln(1+ROAi,t) -0.186(0.429)

DS* ∆ln(1+AIROAi,t) 0.003(0.505)

DS* SHRi,t-2 -0.061**(0.027)

DS* AISHRi,t-2 0.031(0.40)

DC*∆ln(1+ROAi,t-1) -0.317***(0.114)

DC*∆ln(1+AIROAi,t-1) 0.401(0.265)

DC* ∆ln(1+ROAi,t) 0.023(0.095)

DC* ∆ln(1+AIROAi,t) 0.447**(0.211)

DC*SHRi,t-2 0.075***(0.016)

DC*AISHRi,t-2 -0.028(0.029)

Year Dummies Yes Yes Yes Yes YesObservations 306 315 298 304 315F 11.294*** 12.105*** 10.800*** 7.674*** 10.067***R2 0.219 0.263 0.273 0.286 0.336

Collinearity statistics: all variables have a tolerance above 0.3Standard error in parentheses.*p<0.1, **p<0.05, ***p<0.01

24

Table 4

Board compensation and firm size

Qi= Quartiles of sales turnover (Q1 is the lower)

Q1 Q2 Q3 Q4

Total boardcompensation(average in MMpts.)

66.71 94.65 129.93 374.17

Board membercompensation(average in MMpts.)

8.83 9.35 12.98 23.69

Board members 7.55 10.12 10.01 14.65

N 124 125 124 125

25

Table 5

Pay-performance sensitivity to firm size

Qi= Quartiles of sales turnover (Q1 is the lower)

Q1 Q2 Q3 Q4

Total boardcompensation/Bt-1*

0.1022 0.0849 0.0473 0.0200

Board membercompensation/Bt-1

0.0138 0.0099 0.0043 0.0017

Total boardcompensation/Vt-1**

0.0147 0.0069 0.0044 0.0028

Board membercompensation/Vt-1

0.0028 0.0010 0.0006 0.0003

N 125 125 125 125

*Bt-1= Benefits before taxes one year lagged**Vt-1= Firm market value one year lagged

26

Table 6

Pay-performance sensitivity to ownership concentration

Qi= Quartiles of ownership concentration (Q1 is the lower)

Q1 Q2 Q3 Q4

Total boardcompensation/Bt-1

0.0837 0.0650 0.0667 0.0168

Board membercompensation/Bt-1

0.0115 0.0055 0.0095 0.0005

Total boardcompensation/Vt-1

0.0144 0.0059 0.0053 0.0057

Board membercompensation/Vt-1

0.0025 0.0008 0.0010 0.0010

N 141 141 141 142

Table 7

Pay-performance sensitivity to leverage

Qi= Quartiles of leverage (Q1is the lower leverage)

Q1 Q2 Q3 Q4

Total boardcompensation/Bt-1

0.0386 0.0693 0.0525 0.0764

Board membercompensation/Bt-1

0.0005 0.0087 0.0053 0.0096

Total boardcompensation/Vt-1

0.0066 0.0091 0.0040 0.0103

Board membercompensation/Vt-1

0.0012 0.0019 0.0005 0.0015

N* 81 82 81 82

* Banks are not included

27

Table8Impact of firm leverage on board compensation-firm performance relationship

Dependent variable: ∆lnREMit

LEVt<Median LEVt>Median

∆ln(1+ROAi,t-1) 0.029(0.105)

0.499***(0.083)

∆ln(1+AIROAi,t-1) -0.378*(0.226)

-0.187(0.415)

∆ln(1+ROAi,t) 0.208***(0.067)

0.068(0.083)

∆ln(1+AIROAi,t) -0.168(0.175)

0.306(0.288)

SHRi,t-2 0.051***(0.013)

0.052***(0.019)

AISHRi,t-2 -0.056**(0.027)

-0.061(0.044)

∆ln(St) -0.002(0.006)

0.048(0.029)

Year Dummies Yes Yes

Observations 118 106

F 3.966*** 6.104***

R2 0.270 0.391

Test of structuralchanges (Chow, F)

2.2787**

Standard error en parentheses*p<0.1, **p<0.05, ***p<0.01

28

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