ESSAYS ON EXECUTIVE COMPENSATION

AND MANAGERIAL INCENTIVES

Xianming Zhou

A thesis submitted in conformity with the requirements for the degree of Doctor of Philosophy Graduate Department of Economics

University of Toronto

o Copyright by Xianming Zhou 1997

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Essays on Executive Compensation and Managerial Incentives

Xianming Zhou

Doctor of Philosophy 1997

Graduate Department of Economics

University of Toronto

Abstract

The first chapter of this dissertation examines the regdatory impact of executive

compensation disclosure on managerial pay schemes. Analysing a three-level agency mode1

arnong the shareholders, directors, and manager of a firm, this chapter shows that before

disclosure, the directors may underinvest in monitoring the manager's activities because of

asymmetric information on the penomance of the directors and a divergence of interests between

them and other shareholders. Compensation disclosure rules mitigate this ineficiency and

increase the pay-performance linkage. Empincaily, this chapter examines the impact of

compensation disclosure by comparing the sensitivity of CE0 pay to finn performance, before

and after the new Ontario disclosure regulation (1993), between groups of firms that were

differentidly afEected by the legislation. It is found that after introducing the Ontario regulation,

the pay-performance sensitivity increased much more in the firms that were affected by the

regulation than in those that were unaffected by the regulation. In contrast to previous studies,

these findings suggest that disclosure of executive compensation strengthens the pay-performance

. . 11

relationship.

The second chapter provides the first systernatic examination of the relationship between

CE0 compensation. fimi size, and corporate performance for Canadian f m . Consistent with

previous studies, t h i s chapter fmds that C E 0 pay rises with fm size and that compensation

is tied to Company performance. Some novel fmdings are also documented. First, options and

stock ownership tend to play a relatively more important role for CE0 incentives in small firms.

And second, while CE0 turnover probability is generally negatively related to the firm's stock

performance, the threat of dismissal is less pronounced in small firms.

The third chapter compares executive pay-performance sensitivities between Canadian

firms and US firms. Examining the data for 365 Canadian h s and 678 US f m s over the years

199 1 - 1994, it is found that the pay-performance sensitivity associated with direct pay and stock

ownership is smailer in Canadian fimis than in US firms but that the difference diminishes as firm

size increases. This finding, together with poorer corporate performance and lower CE0 pay of

Canadian firms, is consistent with the hypothesis that managerial incentives affect firm

Acknowledgements

1 would like to thank Dwayne Benjamin, Morley Gunderson, Michael Berkowitz, and

Michael Baker for their comments and encouragement. Specid thanks go to Aloysius Siow who

paid close attention to my progress, spent countless hours discussing various issues with me and

provided many valuable suggestions. I am especially grateful to my supervisor. Arthur Hosios,

for his guidance and inspiration, his constructive criticism and insighdul suggestions at every

stage of my research, and for his effort in the many revisions of this dissertation. Finally, 1 want

to express my gratitude to my farnily to whom 1 dedicate this work.

Table of Contents

Chapter 1 Executive Compensation Disclosure and Management Incentives

1 . t Introduction ..................................................................................................................... 1

.................. ............... 1.2 The Issue and the Literature ................................................... 5

1.3 The Mode1 ..................................................................................................................... 10

1 .3.1 The Basic Mode1 ..................................... ,., ................................................... 10

1.3.2 Political Pressures ......................................................................................... 12

1.3.3 Pay Envy ....................................................................................................... 14

1.3.4 S hareholden' Scmtiny ................................................................................... 15

1.3.5 A Surnmary of Disclosure Effects .............................................................. 25

.. .... 1-4 Evidence for Chief Executive OFficers ............................................................ 26

1.4.1 The Ontario Regulation Act ........................................................................... 26

.................................... 1 .4.2 The Methodology and the Data .... ......................... 28

1.4.3 Empiricd Results .......................................................................................... 32

.................................................................................................................. 1.5 Conclusion 38

...................................................................... ..................................... Tables and Figures .. 40

Appendices ......................................................................................................................... 44

.......................................................................................................................... References 52

Chapter 2 CE0 Pay. Firm Size. and Corporate Performance: Evidence From Canada

................................................................................................................. 2.1 Introduction 56

2.2 The Data ...................................................................................................................... 58

....................................................................... ................... 2.3 CE0 Pay and Firm Size .. 62

........................................................................ 2.4 C E 0 Pay and Corporate Performance 65

....................................................................... 2.4.1 Pay-Performance Sensitivity 67

2.4.2 C E 0 Stock Ownership .............................................................................. 70

2.4.3 CE0 Turnover and Corporate Performance ............................................. 7 1

.................................................................................................................... 2.5 Conclusion 75

Tables and Figures .............................................................................................................. 76

Appendices ......................................................................................................................... 87

References ........................................................................................................................... 93

Chapter 3 Executive Compensation and Managerial Incentives: A Cornparison

Between Canada and the United States

3.1 Introduction ................................................................................................................ 96

.................................................... ......................... 3.2 The Methodology and the Data .. 98

3.2.1 Previous Studies ............................. ... ................................................. 98

3.2.2 Mode1 Specification ................................................................................... 100

3.2.3 The Data ................................................................................................... 102

3 -3 Incentive Strength ..................................................................................................... 105

............................................................... 3.3.1 Incentives fiom Direct Payments 105

.............................................................. 3.3 -2 Incentives fiom Stock Ownership 110

3.3.3 nie Effect of Stock Options ....................................................................... 113

3.4 Incentives and Performance ................................................................................. 114

3.5 Conclusion ................................................................................................................ 1 17

Tables and Figures .......................................................................................................... 118

References ....................................................................................................................... 129

List of Tables

Chapter 1

Table 1.1 Selected Statistics ............................................................................................... 40

Table 1.2 Changes in Pay-Performance Sensitivity (Canadian fimis) .................................. 41

Table 1.3 Changes in Pay-Performance Sensitivity : Compustat Fims

vs . non-Compustat fims .............................................................................. 42

Table 1.4 Changes in Pay-Performance Sensitivity: US firms vs . Compustat

.................................................................. and non-Compustat Canadian Firms 43

Chapter 2

.................................................................. Table 2.1 A Bief Comparison of the Evidence 76

................................................ Table 2.2 Nurnber of Firms with Different Incentive Plans 76

........................................................................... Table 2.3 Surnmary of Selected Statistics 77

................................................................ Table 7.4 Firm Size Elasticity of CE0 Total Pay 78

............................................................ Table 2.5 Firm Size Elasticity of CE0 Relative Pay 79

.................................................. Table 2.6 Pay-Performance Sensitivity (OLS estimation) 80

........................................................................................ Table 2.7 C E 0 Stock Ownership 81

Table 2.8 C E 0 Turnover and Firm Performance (Probit estimation) ................................. 81

.............................................................................. Table 2.9 Probability of C E 0 Turnover 82

Chapter 3

............................................................................................... Table 3.1 Selected Statistics 118

................................. Table 3.2 Estimation of Pay-Performance Sensitivity (total sample) 119

Table 3.3 Selected Statistics about Sample Heterogeneity ................................................. 120

Table 3.4 Estimation of Pay-Performance Sensitivity (subsample 1 and 2) ....................... 121

vii

Table 3 -5 Estimation of Pay-Performance Sensitivity (subsarnple 1 ) ............................. .. 122

Table 3.6 Estimation of Pay-Performance Sensitivity (subsarnple 2) .............................. 123

Table 3.7 The US-Canada Differential and Firm Size (total sample) ................................. 124

Table 3.8 CE0 Stock Ownership as the Percentage of Shares Outstanding ...................... 125

Table 3.9 Regressions of C E 0 Stock Ownenhip Against F im Size ................................. 125

Table 3.10 The Ratio of Stock Gains from Exercising Previously Granted

........................................................................... Options Over Total C E 0 Pay 126

............... ......................... Table 3.1 1 Cornparison of Fims' Systematic Performance .. 126

Table 3.12 Cornparison of the CE0 Pay Level ................................................................. 127

viii

List of Figures

Chapter 2

Figure 2.1 Distribution of Firm Size ................................................................................. 83

....................................................................................... Figure 2.2 Distribution of CE0 Pay 84

....................................................................................... Figure 2.3 Components of CE0 Pay 85

Figure 2.4 Structure of CE0 Pay .......................................................................................... 86

Chapter 3

Figure 3.1 Distribution of Firrns ..................................................................................... 128

List of Appendices

Chapter 1

A . Proof of Proposition 1 ....................................................................................................... 44

B . Proof of Proposition 2 ...............................................................................-................... 45

C . Proof of Proposition 3 ................... .... ............................................................-............... 46

D . Proof of Proposition 4 ...................................................................................................... 47

E . Proof of Proposition 5 ..................................................................................................... 48

F . The Integrated Post-Disclosure Model ............................................................................. 49

Chapter 2

List of Finns ......................................................................................................................... 87

Chapter 1

Execut ive Compensation Disclosure and Management Incent ives

1.1 Introduction

Since the Seciuity Exchange Commission of the United States enacted its first regda-

tion regarding execiitive compensation disclosure more than half a centiiry ago, execiitive

compensation has becorne a controversial corporate govemance topic. In recent years,

the level and structure of executive compensation have attracted considerable academic

and public interest. CE0 compensation, in particidar, has fascinated many scholars. and

in one form or another it has been studied by economists. sociologists and experts in

management and industrial relations. The debate on executive pay seems to have been

part of the national agenda in the United States and becarne a widely disciissed popiilist

topic diiring the 1992 election year.

There are two major issues in the debate. One concerns the level of execiitive pay

which inqtures whether or not executives earn "excessive" compensation. The other

concerns the pay structure, fociising on the relationship between execiitive pay and cor-

porate performance. On one side of the debate are critics who argue that execiitive pay

is tuirelateci to firm performance and is excessive.' On the other side of the debate are

those who believe some execiitives may, in fact, be underpaid becaiw of the inherent

iinfairness of arbitrarily Limiting an individual's wort h under public pressiires.2 m i l e

'A representative view of excessive executive pay is presented by Graef Crystal. In his book of In Seamh of Ezcess (1991), Crystal has siibstantiated the Ievel of overcompensation and has describeci the skewed procedure for setting compensation packages.

'See, e-g., the comment of Whitworth (1989).

1 . 1 INTRODUCTION 2

the viewpoints in the debate &en contrast sharply with one another. there seems to be

a consensus that the Linkage betaieen executive pay and corporate performance is

Explanations of a weak pay-performance linkage differ dramatically. Some critics

link it with excessive compensation and attribiite it to corporate dysfimction. They

argue that executives siiccessfully lise an increase in company performance to jitsti@

large pay raises while poor performance still resirlts in siibstantial pay. According to th i s

populist view: there exists a fiindamental problem in corporate govemance - the board

of directors is not making compensation decisions in the best interests of the company

and its shareholders. This view contends that regdatory measlires regarding executive

compensation are both necessary and desirable to ensiire order- corporate operation and

protec t the interests of the individual investors. Some economists. however. argue that

a lack of pay-performance iinkage may actiially result from govemment disclosine niles.

It is the visibility of high executive pay that has caiised public concem. fiieled criticism.

and tiuned the debate into an emotional issue. Piiblic disapproval of high execiitive pa?

fosters political pressires which constrain the types of contracts that are m i t ten berneen

managers and firms. With the market failing to freely set compensation. the pay system

becomes less efficient than it shotdd be-

These two viem depict quite Werent perspectives concerning the impact of goy-

eniment disclosiire ndes on evecutive compensation. Thoiigh it is both interesting and

important to i d e n t e the effects of disclosiire. few stiidies have directly examined this

issue. The reason is the la& of information. Cjntil the early 1990s. the regdations re-

garding this issue were the US disclosure d e s implemented in the 1930s and the 1967

Companieç Act in Bntain.' Most stiidies have fociised on 5s execiitive compensation

3Jensen and S f i q h y (1990a) give a bench mark estirnate of the intensity of the pay-performance relationship. Examining the Forber sample of CE0 compensation during the years 1974-1986. they find that CE0 compensation increases o d y S3 for each S10ûû increase in shareholder value.

'Japanese regdations do not require firrns to disclose execiitive compensation. The stiidies for

1.1 INTROD UCTION 3

perhaps becaise it contains the rnost detailed information concernuig the remmeration

of executived Since the US regulation has existed for more than half a century, it is dif-

ficult to document its iduence because of both insufEicient data and siibstantial changes

in the institutional and market environment diiring siich a long period of t h e .

In October 1993, the province of Ontario enacted the first Canadian regdation re-

garding compensation disclosure of top exec~tives.~ All publicly-traded b s in Ontario

were reqtùred, beginning in fiscal year 1993, to disclose the compensation of their five

highest paid execiitives including the CE0 for the ciment fiscal year and the two immedi-

ate preceding years. Because a majority of large Canadian firw are traded on the Toronto

Stock Exchange,' the regdation affects most large publicly-held Canadian corporations.

The implementation of this new legislation provides a natiud experiment in which to

evaluate the regdatory impact of disclosiue. Using the residting C E 0 compensation

data, this paper condiicts a stiidy of the effects of disclosiire on the firms' managerial

pay schemes nith an emphasis on the impact on the pay-performance relationship.

In the public debate and law and econornics literatiue there have been meren t in-

formal arguments made regarding the impact of disclosiue. In this chapter 1 first develop

a mode1 to analyze the issue. It extends a conventional owner-manager relationship to

a s hareholder-direct or-manager relationship. 1 show t hat , before disclosiire, the board

of directors may underinvest in monitoring the manager's activities because of asyrn-

metric information on the performance of the directors and a divergence of interests

between thern and other shareholders. In addition to generating inefficient managerial

Japanese h s either use the total salary and bonus earned by al1 directors as a proxy of execirtive compensation (Kaplan, 1994) or use tax returm to estimate the compensation of Japanese execiitives (Kato and Rockel, 1992).

'The British Act required firrns to show only the aggregate ernoltunents of the Chairman and the highest-paid director when other than the Chairman (see Cosh, 1975).

'Ontario Regdation 638, filed on October 14, 1993. 7For example, by either total assets or sales in fiscal year 1993, more than 90 percent of the 300

largest Canadian firms are traded on the Toronto Stock Exchange.

1.1 INTRODUCTION

incentive schemes, the model shows that the manager may also "bribe" the board of

directors and obtain rents. Pay disclosine ndes mitigate this inefficiency and increase

the pay-performance linkage. For cornparison, 1 also consider a simple model of the ef-

fec t of polit ical pressures on managerial pay schemes (the Jensen-h.Iiirphy hypothesis) .

This model shows that public disapproval of high payments, when it imposes a cost on

the firm, weakens the pay-performance linkage. Additionally, 1 show that pay envy or

jealousy among managers enhances incentives and strengt hem the pay- p erforxnance re-

lationship. The total regdatory impact of disclosure on manageriai incentives is thiis

theoreticdy arnbigiioiis.

1 then proceed to examine the evidence concerning disclosiue. Exarnining CE0 com-

pensation of 384 large publicly-held Canadian firms, 1 find that the sensitivity of C E 0

pay to firm performance (the ratio of changes in CE0 pay over changes in shareholder

wealth) increased significantly after the new regdation. To control for the effects of other

potential factors, 1 also examine the evidence by a "difference in differences" analysis.

This is done by comparing pay-performance sensitivity, before and after the regdation.

between Canadian firms whose shares were piiblicly traded in the United States before

1991 (and were siibject to US disclosiire regtdations) and those whose shares were not,

and between Canadian firm and US b s . 1 End that after the Ontario regulation, (i)

the pay-performance sensitivity increased siibstantidy more for Canadian firms whose

shares traded excliisively in Canada than for Canadian firms that also traded in the

United States, and (ii), whde the sensitivity increased less in US firms than in Canadian

h s whose shares traded excliisively in Canada, there is Little difference between US

firms and other Canadian that also traded in the United States. In contrast to pre-

vious stuclies, these findings siiggest that executive compensation disclosure regtdations

strengthen the pay-performance retationship.

1.2 THE ISSUE AND THE LITERATURE 5

This chapter proceeds as follows. Section 1.2 introduces the issue and briefly reviews

some related st~idies. Section 1.3 develops a model to characterize regdatory effets

of governent disclosure d e s on managerial pay contracts. Section 1.4 disciisses the

evidence. The conclusion is provideci in Section 1.5.

1.2 The Issue and the Literature

An incent ive problem arises when the individiial wit h ownership rights, the principal.

delegates decision-making or prodiiction tasks to anot her individiial, the agent, and where

the principal cannot observe the agent's effort. According to standard agency theory? the

reward scheme must be a fimction of the agent's performance t o provide incentives for

the agent to work in the interest of the principal. Agency costs imavoidably occiu in

stich an environment due to the CO-existence of privately observed effort and ris k-averse

agents, and so the pay scheme mwt be constructed to strike a balance between incentives

and insurance,

The relationship between a h ' s shareholders and its CE0 has been modeled as a

principal-agent relationship and extensively analyzed in the economics literatiue. In this

context, the compensation scheme is designeci so that the pay-performance Linkage reflects

the incentive-insimance trade off and, with a cornpetitive managerial labo1 ir market the

base sa laq adjiists so that total expected compensation eqtials the CEO's expected

marginal prodiict. This model suggests that piiblic concern with C E 0 pay is a piizzle.

The problem, however, is that the relationship between shweholders and managers

in the real world does not present a simple agency problem. It is often argued that the

compensation system is not working in the best interests of the shareholders becaiise the

pay scheme is not controlled directly by the shareholders but by the board of directors.

Commenting on the disciplining role of corporate democracy, Car1 (1993, p8) notes,

1.2 THE ISSUE -4ND T H E LITERATURE

'In theory, directors set an executive's compensation and, in accordance with their fiduciary duties to the shareholders, compensate execiitives in the man- ner most advantageous to the Company and its stockholders. if the directors fail to do so, the shareholders shoidd, in theory, elect new directors.'

This raises the key issue: do directors have the incentive to perform their fidiiciary diities

in the best interests of the shareholders? Doiibts exist. Becaiise directors and execiitives

are often bowd by reciprocal self-interest , it may not be in the best interests of directors

for them to be honest with shareholders. It is widely believed that directors are captive.

"The independent director has tunied out to exist only in theory; in the real world al1

direct ors are beholden to management" (Cari, 1993, p34) .8 Withoiit information aboiit

how managers are rewarded, it is difficult for shareholders to know how the directors

perform their diities in monitoring and motivating the management. Becaiise the market

may, in consequence, fail to implement an effective compensation system, governrnent

intervention that makes execiitive compensation public may be needed.

Governrnent disclosure d e s me a direct regdatory response to shareholder concern

aboiit potential 'looting' by managers in colliision with directors. As execiitive pay is

exposed to the public, both insiders (shareholders and managers) and outsiders respond

accordingly. Varioits informa1 arguments have been put forth to describe the impact of

disclosure. The following are some often mentioned influential factors.

(1) Shareholders' scmtiny of pay schemes

With disclosiire, the informational asymmetry concerning managerial pay between

shareholders and the board of directors is removed; shareholders becorne aware of how

' ~ o k (1993) condiided: "Most top execritives are in an ~musiiaily strong position to strike a favorable bargain, because t hey exert such idtience over the process (fixing exectit ive compensation). CEOs almost always serve as chairman of the board. They typically have a good deal to say aboiit the choice of new board members. They are the key people who decide on the fees paid to the directors, fees that average over $40,000 for only a few days of work each year."

1.2 THE ISSUE AND THE LITERATURE 7

much and, to some extent, how the management is paid. This provides a monitoring

scheme that disciplines the behavior of the firm's board compensation committee."~ the

directors of the committee becorne more focilsed and more concerneci about the relation-

ship between executive compensation and corporate performance, the pay-performance

relation is intensifieci. Cornmenthg on the new Ontario disclosure niles, Dimma (1994)

predicts that they d reçult in more emphasis on both short-term cash boniises and long-

term stock options or stock appreciation rights, with less emphasis on salaries. Dimma

(p45) explains this impact as the fouowing:

'With increased disclosure, shareholders activism - primarily but not en- tirely that of institutional investors - wïll increase. As aiways, knowledge is power. Fiirthermore, compensation commit tee mernbers will be incres- ingly sensitive to charges of being captive to management or of looking sok or ganting increases out of line with what their peers, sitting on compen- sation cornmittees of companies in the same indiistry cr in broadly similar industries, are approving. '

(2) Political pressures on high payments

The visibility of manageriai compensation is the source of the piiblic debate concern-

ing excessive executive pay. In response to a gronring piiblic concern that execiitive pay

is imjiistifiably high in the United States, some large corporate shareholders. labor and

consimer representatives, and public officials have c d e d for imposing constraints on ex-

eciitive compensation. These constraints can be in the form of either regdatory measiires

or mord sua~ion. '~ While the purpose of these constraints is to ciirb high payments, they

are expected to result in a lower compensation package and a weaker pay-performance

relation as well. Jensen and Miirphy (1990a, p262) provide an explanation for this effect:

gSome commentators point out that a thorough disclosiire reqiiirernent paves the way for shareholders to take back their companies (see Johnson, 1995).

loin the early 1990s, the media and the recession combined to focils public attention on the payments of America's CEOs, and excessive execiitive compensation was publicly targeted. As a response to the public otitcxy to control excessive execiitive pay, the Secirities and Eschange Commission, the Financiai Accounting Standards Board, and even Congress were moving to change the rides. See Walters, Hardin, and Schick (1995), and Brownsterin and Panner (1992).

1.2 THE ISSUE AND THE LITERATURE

' h c a t i n g the iipper tail of the payoff distribution reqiiires that the lower tail of the distribution also be truncated in order to maintain levels of corn- pensation consistent with eqiiilibriiim in the managerial labor market.'

(3) Pay envy among managers

It has been argueci that pay cornparisons can lead to higher levels. Some call it a

bootstrap effect while some others call it pay envy or jealoiisy. In disciissing the changes

in Canadian CE0 compensation due to the new Ontario disclosiire law, PvlcHiitchion

(1996) notes that compensation experts believe that

'the disclosiire law has actually helped to drive iip execiitive pay packages. ... Elvecutives tend to develop a case of s d q envy and Say "me too," when they see what other corporate heads in their industry are making.'

While this behavior-related managerial effect is widely believed to raise pay levels, its

relevance to the pay-performance linkage has not been noted.

As yet, there has been no (theoretical or empirical) stiidy in the economics literattire

that directly investigates the disclosiire issiie. Given the empirical natiire of the issiie

and a lack of data, this is not siirprising. Nevertheless. there have been some empirical

stiidies that either indirectly investigate the regdatory effect or deal with a related issiie.

Among these stiidies notable are Jensen and hliuphy (1990a), Joskow, Rose, and Sheperd

(1993)' and Hiibbard and Palia (1995).

To explain why the linkage between CE0 pay and corporate performance is very

weak in large US firms, Jensen and Mv~iirphy examine the difference in pay-performance

sensitivity and pay levels between the ûrms in the 1980s and those in the 1930s (when

regdatory pressures were less evident). They fhd that both the sensitivity and pay level

(with inflation adjiisted) have declined since the 1930s. They attribiite this observation

to the idhience of public and private political forces that residt frorn the visibility of

1.2 THE ISSUE AND THE LITEMTURE 9

executive compensation and which impose constraints on managerial pay contracts ,and

conseqiiently suppress the pay-performance sensitivity. Joskow, Rose, and Shepard ad-

dress a sirnilar issue using a different approach. To explore whether political pressures

impose a constraint on management compensation, they compare CE0 compensation

between regiilated fkns (which are presumably siibject to the direct infiilences of po-

litical forces) and linregdateci firms. They h d that CEOs of regidated firms are paid

less than those of iuiregulated h s , and that the compensation eanied by CEOs of

regulated finns is l e s responsive to Company profitability than is the compensation for

CEOs of iinregdated firrns. They concliide the observation is broadly consistent with

the presence of binding political constraints on CE0 compensation, as mediated throiigh

regdatory rneasiires and an increased visibility of execiitive pay. Comparing CE0 pay in

the banking industry before and after deregdation of interstate banking, Hiibbard and

Palia reach a similar concliision.

While these studies are consistent with a negative impact on the pay-performance

relation of increased pay visibility, the evidence so far is inconcliisive. Becaiise they

examine the issue only indirectly, these stiidies have difficiilty in disentangling the impact

of disclosiue due to political pressures from other potential factors. l' Besides, t hese

stiidies are miite on the role of siibstantially increased shareholderç' scriitiny of the pay

system which is the most debated issue concerning governrnent disclosiire rules. Direct

stiidies are needed before a firm conclilsion can be reached.

"For example, in the comment on Joskow, Rose and Shepard, Meyer points out that it is difEctdt to disentangle political constraints from prodtictivity difierences between regidated firms and iinregidated firms.

1.3 The Model 1.3.1 The Basic Model

1 start with a standard simple agency mode1 withoiit disclosiue. Consider a fim and

a single worker, the manager, in a one-period contract. To obtain an anaiyticai soliition.

1 adopt the following commonly used assumptions: a risk-neiitrd h, a risk-averse

manager, a linear production technology for the manager, and a linear pay contract. The

production function is

where e is the input of the manager's effort in production which is imobservable to the

firm, and E is a normdy distributed noise with zero mean and variance 0'. The linear

pay contract is

where a is fked pay, and 0 is pay-performance sensitivity or incentive dope.

The manager has an exponential iitility U(W, C) = - exp [-p(GV - C)] where C =

'ke2 is cost of effort, p is the coeficient of absoliite risk aversion, and k is a constant. For 2

a normally distribiited random variable X with mean E ( X ) and variance V(X) there is

E [ e ~ p ( - ~ x ) ] = exp[-pE(X) + + p 2 v ( ~ ) ] . Hence the manager's expected iitility is

1 E(U(W, C)) = - eup - p ( a + @e - -ke2) +

2

The manager chooses effort e to maximize the expected utility, which gives the incentive

compatibility constraint: p - ke = 0.

The k m maximizes expected profits E(II) = E(Y - W ) by solving the following

op t imization pro blem:

1.3 THE MODEL

siibject to

where Ur is the manager's reservation utility. It is straightforward to obtain the following

solution for the incentive slope:

This solution has been disciissed in many previoiis studies.12

Given ,B and a binding participation constraint, the soliition for fixed pay can be

expressed as

The h s t term describes the linkage between the pay level and the worker's ability (re-

flected in reservation iitility). The second term reflects the incentive-insixance trade off

of the pay scheme. The expected total pay is

which increases with P. Eqiiation (1.4) and (1.5) characterize the pre-disclostue optimal

incent ive contract.

Now 1 turn to the issue of compensation disclosiire. To keep the analysis simple, 1

deal with the effect of different factors separately while leaving an integrated mode1 to

12See, e.g., Holmstrom and Milgrom (l98?), Rosen (l992), and Garen(l994).

1.3 THE MODEL 12

an appendix. 1 e s t analyze the regulatory effect associated with political pressures and

psy envy imder the conventional owner-manager Framework, assiuning that shareholders

of the h behave as a single owner. 1 then open the black box of firm ownership by

distinguishing shareholders who are directors from non-direct ors and describe a three-

level (shareholder-director-manager ) model to analyze the effect of shareholders' scnitiny

of the pay system.

1.3.2 Political Pressures

Political pressures influence the firm's compensation practice mainly in two ways.

One way is negative piiblicity, a direct effect of piiblic disapproval of hiige managerial

pay fueled by the criticism from piiblic activists. The other channe1 is regdatory mea-

siires imder government intervention, an indirect effect of the piiblic opposition t o high

compensation. A featiue of politizal pressure effects is that they impose unfavorable con-

straints on the h m ' s operation. To describe the effects, 1 assume that when the piiblic

observes managerial pay beyond a certain level. political pressures emerge t hat explicitly

or implicitly impose a cost on the firm. Because political pressures do not impose a

clear-ciit iipper limit on managerial pay.13 1 model the effects by defining a probability

that the paÿ to the manager is higher than a piiblic norm, Prob(W > W). Above W the

pay is considered imacceptable by the public. W reflects piiblic opinion on the value of

managers, and is exogenoiis to this model.

Let d ( ~ ) denote the probability density fimction of E . The probability is

where 9 is a normal distribution function. The more often W exceeds W, the larger

I3Commenting on the position of the U.S. Congress in the debate on execritive compensation in 1992, Johnson (1995) noted, "while dissatisfied, Congres appeared hesitant to act so drasticallÿ as to set explicit lirnits on execirtive compensation."

1.3 THE MODEL 13

the probability Prob(CV > W) and the higher political pressures. The cost associateci

with political constraints thiis increases with the probability. Introdticing cost parameter

0 3 0, the objective fimction of the firm becomes

In particidar, 6 = O when there are no political pressures or when there is no piiblicly

available information on W.

With other conditions unchangeci fiom the basic model, solving the problem leads to

the following concliisions:

Proposition 1 When political pressures impose a cost on the fin. compensation dis-

closure reduces the incentive paramefer, 8, reduces the fked composent 01 pay, a. when

kpa2 > 1 , and reàuces the ezpected wage, E(M7).

Proof. Appendix A.

Proposition 1 predicts a negative impact of political pressiires on the incentive slope.

It conf~rms the hypothesis of Jensen and hlurphy (199Oa) that public and private political

forces suppress the pay-performance sensitivity. However. the intuition here is somewhat

different. Because a higher pay-performance sensitivity causes an iipward shift of the

pay clistribiition and thus more Likely poiitical presstues, the marginal benefit hom an

increased sensitivi ty is rediiced compared to the situation wit hoiit political pressures.

The effect on h e d pay is arnbigiiotq and depends on model parameters. This am-

biguity reflects the trade off between incentives and insurance. When the manager is

sufficiently risk-averse or when production is siifficiently risky, the trade off will dictat e

that k e d pay changes in the sarne direction as does the incentive slope. With reserva-

tion utility imchanged, the expected total pay is bound to change with pay riskiness, and

1.3 THE MODEL

conseqtiently, i t is lower with poli tical pressures.

1.3.3 Pay Envy

Supposing that there exists pay envy or jealoiisy among managers, a manager's iitility

is increasing in the difference between her pay and those of her peers. To determine the

effects of pay envy, I assume a manager's u t i l i ~ declines as the expected pay differential

E (W, - W ) rises, where W, is the wage of peers. With this assiunption the manager's

utility fimction is rewritten as

U(cK Co W,) = - exp [-p(W - C - hE(Wp - W ) ) ]

where h 2 O. Siich a treatment is similar to that of peer pressure in Kandel and Lazear

(1992) where peer pressure is a coût to utility.

Parameter h characterizes the intensity of the manager's concern aboiit a lower pay.

Though the nature of the manager's tastes do not change nith the openness of managerial

compensation, the intensity of envy and its effect on iitility certainly depend on the

available information and piiblic attention. So. h = O is iised to mode1 the pre-disclosine

effect of pay enky.

With the sarne information on other managers' pax the firm and its manager wil1

form the same belief on the expected pay of other managers. U$. Under production

Y = e + E and pay contract W = cr + PY, the expected iitility of the manager becomes

Talung W,b as given, the manager maximizes the expected iitility. The incentive compat-

ibility constraint becomes (1 + h)B - ke = O. Given 0 , the manager woidd now like to

work more. Because pay envy stimulates the manager to earn more, it enhances working

incentives.

1.3 THE MODEL 15

When the belief on other managers' expected pay is correct and when managers are

hornogenoiis, t hen

With siich a setiip, the following proposition follows immediately:

Proposition 2 When managers exhibit pay en% compensation disclosure increases the

incentive parameter, ,O, increases the jixed component of pay. a . when kpa2 + h2 > 1.

and increases the expected wage. E(W).

Proof. AppendixB.

Piiblic critics have attacked executives for seeking high compensation. They are

rnissing an important point: the desire to earn more than others encourages managers to

work more and, thus, to accept a more risky contract. which is beneficial to mitigating

agency costs. The expected total pay is increased because pay is tied more closely to

performance. The public is right in assuming that the race for earnings among managers

resiilts in higher pa-yments. However, Proposition 2 gives an efficiency e.xplanation of this

phenomenon. Cornpetition for earnings stirnidated by pay envy acts iike a toiunament

incent ive scherne.

1.3.4 Shareholders' Scrutiny

In the above analyses, the firm is synonymous with shareholders who contract di-

rectly with the manager. When shareholders are divided into two groiips , directors and

non-directors, the ''£km" no longer refers to a i d e d groiip of investors, and a conflict of

interest may mise between the board of directors and other shareholders. As the black

box of h m ownership is opened, another agency problem emerges: how are directors

1.3 THE MODEL 16

induced to perform their fiduciary diities in the best interests of ail shareholders? The

incentive issues in such an environment call for a model describing the relationship be-

tween shareholders, directors, and managers. In this section 1 fbst describe a three-level

pre-disclosure mode1 in which, by assumption, the directors and manager are inclined

to collude (at a cost to shareholders) and then introdiice disclosiire to determine its

disciplining effects. The issues of political pressures and pay envy are ignored in this

model.

The Pre-Disclosure Mode1

Consider a piiblicly-held h m wit h many risk-neutral shareholders. The shareholders

delegate decision making aiithority to their representative, the board of directors, to

design and implement the managerial pay contract. For simplicity, there is assiunecl to

be only one director on the board. The non-director shareholders will simply be called

shareholders.

There are two activities in the model: the manager exerts effort to prodiice firrn

oiitpiit; and the director monitors the manager, and designs and implements the man-

agerial reward scheme. The folIowing assiunptions define the informational asymmetries

between the shareholders, director, and manager. (i) PNhile the shareholders h o w the

director's ability, they observe neither the director's monitoring effort nor her choice of

managerial contract." (ii) The director knows the ability of the manager, observes the

b ' s performance, but does not observe the manager's effort. (iii) The manager observes

both the ability and monitoring effort of the director.

There are two agency relationships, one between the shareholders and the director

''In reality, shareholders certainly have information, other than executive compensation, on the direc- tors' performance. We assume here that this information is irrelevant to manageriai pay schemes, and does not reveal what directors do in motivating the manager. Later, disclosilre will reveal the managerial contract to shareholders.

and the other betnreen the director and the manager. The foilowing time line depicts the

seqiience of events in the model:

S hareholders Director Production F irm Paj-ments choose director's chooses manager's and monitoring output

contract F contract W effort invested obsewed made

The shareholders offer to pay F to the director for her fiduciary dtities? and then the

director contracts with the manager with pay scheme W for the task of prodiiction.

There is only one period of production. Both F and W are specified before prodiiction

and monitoring activities begin. At the end of the period, the otitcome of h m prodiiction

is observed and payments are made accordingly.

( 1) The Shareholders

The firm's net profit is Ii = Y - CV - bT where Y is total revenue net of prodiiction

costs. bT is a benefit (side payrnent) obtained by the director that is privately paid by

the manager to the director at a cost to the firm. T denotes the managerial rente and

is described in more detail below. The shareholders observe II but cannot identib its

components because they are rmable to distinguish W + bT from other prodiiction costs.

The shareholders choose the director's pay scheme, F, to mavimize the expected net

payoff:

(2) The Director

1.3 THE MODEL 18

Given F , (which is detailed later below), the director faces a three-fold decision:

choosing the managerial pay scheme W , deciding the monitoring effort m, and determin-

ing the rent T received by the manager. The objective fimction of the director is

where O 5 S < 1 is the portion of the director's interest in total shrtreholder wealth.

kgm2 is the cost of monitoring effort, where g 2 O and m 2 0.

In conventional incentive models the performance measure for the manager is well-

d e k e d and observable to both the principal and the agent, and so it is costless to the

principal. In reality, however, performance measiirement is far more complicateù where

smbiguities abotmd. It is the complexity of performance measilrement that calls for

monitoring effort from the director. Taking Y = e + E as a costless performance measiue.

an adjiisted measiue of performance imder monitoring becomes15

Q = e + ~ ( 1 - m). (1.10)

The key feattue of (1.10) is that the director's effort rediices the noise in Y. When

m = O, Q = Y which is the case withoiit the director. &%en m = 1' perfect monitoring

is achieved and managerial effort becomes observable to the director. Based on Q, the

pay contract for the manger is

W = a + O Q

(3) The Rilanager

151t is implicitly assimed that rn 5 1.

1.3 THE MODEL 19

The manager is risk-averse and with exponential iitility U = - exp [-p(CV - C)]

where C = $ke2 is the cost of managerial effort. The participation constraint is now

revised to d o w a rent for the manager:

Ur is the component of reservation utility corresponding to the manager's prodiictivity.

deterrnined imder a cornpetitive market. T is non-negative. This formulation allows the

director to collude ni th the manager by setting T > 0: the director pays the manager

excessively (T > 0); and the manager provides a benefit, bT, to the director at a cost to

s hareholder weal t h.

{T: b} is assimed to be an implicit contract between the director and the manager

that is enforced through bilateral reputational concems. Becaiise b does not impose a

cost on the manager and the director dways prefers a higher 6, it woidd be imboimd in an

one-period model (siibject to a constraint on reolized valiies of ri - F). So b is taken here

to be exogenoiis. The model, therefore, does not endogenoiisly determine the existence

of a managerial rent. It will identiS the lower boiind of b that @es the necessary and

sificient condition for T > 0.

(4) The Soliition

The model is solved by backward indiiction. The manager's problem is straightfor-

ward. Taking the director's monitoring effort m as given, the manager chooses e to rnrru-

1 imize the eiupected iitility, E(U) = - exp { - p [(a + B e ) - $e2] + ip2a2(1 - n ) 2 ~ 2 ) .

which gives the incentive compatibility constraint: ,L? - ke = 0.

To solve the director's problem, the pay scheme for the director needs to be specified.

Without information on the director's actions and decisions, the h m ' s net profit is the

1.3 THE MODEL 20

only observable and verifiable measiire on which the director's pay c m depend. Consider

a linear scheme,

where O 5 sl < 1. In a piiblicly-held firm, the director wodd not be a residiid claimant. l6

Therefore' st is smaller than imity.

The director chooses {a, 0, rn, 2') by solving the following problem:

subject to

Proposition 3 siunmarizes the main results of the solution to (1.14): given {so, SI} .

Proposition 3 (2) The director rnonitors the manager (m > 0 ) and specifies excessive

incentives for the manager (0 > &) ij she is also a shareholder (6 > O ) ; (ii) 2 > O

1- 6+( 1-613,) p(-Ur)) , and > 0; and (iii) the manager captures rents (T > 0 ) if only if ( 6+(L-6)?i

1.

Proof. Appendk C.

Parts (i) and (ii) are intuitive. As long as the director shares some interests with

the shareholders, as is the mual case in reality, the director will invest effort

management, i.e., rn > O. This resiilts holds even if the director is paid

16Risk-sharing and public financing are two important reasons for the existence of a Company, which excliide the possibility for the director to be a residiid claimant.

to monitor

a fixed fee

pu blicly-held

1.3 THE MODEL

(sl = O). With monitoring effort, the managerial pay scheme becomes more efficient

because of the rediiced noise in the performance measure. Both monitoring effort and

incentive dope increase with the common interest parameter, 6. As shown in the proof

of the proposition, f l = ,++. 2 when m = O, which is the zero-monitoring solution of the

basic mode1 without the director. When 6 = 1, the director's problem rediices to the one

where the shareholders directly rnonitor the manager, and t hm, the ideal investment of

effort is achieved and ,O is optimized in the interests of the shareholders.

Part (iii) airns at a controversial issue: are managers paid excessively? The answer

is inconcliiçive yet interesting. Mihen T > O, both the manager and director receive

excessive pay and the payoff to the shareholders is accordingly rediiced. The proposition

gives the condition under which director-manager coilitsion occius. Several factors affect

this condition. Because of the conflict between the collusive benefit received by the

director and the cost of collusion associated with the rediiced firm profit, the director's

willingness to collude depends cnicially on 6. T becornes zero when 6 is sificiently close

to iinity. Another factor is b which reflects the marginal benefit to the director from a rent

captiired by the manager. The value of b is related to the ways in which a benefit from

colliision can be delivered and the intensity of public scriitiny of the colliisive condiict.

Finally, the shareholders' problem is to choose {so. s 1 ) to rnaxirnize the e'ipected

payoff, E(I1 - F ) . Consider two sitiiations. (i) The shareholders do not know the

manager's ability (Le., k and L& are iinknown parameters to the shareholders) or they

are unaware of the constraints on the fiinctional form of the managerial pay contract.

In this situation, niithoiit the information needed to solve a maximization problem. the

shareholders simply pay the director a k e d fee at reservation wage Fr. Or equivalently,

so = Fr and si = O. (ii) Alternatively, suppose the shareholders know k and Ur, and have

the knowledge of the stochastic process of Q and functional form of W even thoiigh they

do not directly observe Q and W. Then the shareholders solve the following problem to

determine {sot sl}:

Max E(II - F ) = ( 1 - s l ) [(l - ,O)e -a] - b ( l - s l ) T - so {so*s1)

(1.15)

The first and the forth constraint are the incentive compatibility constraint for the man-

ager and the director respectively. The second and fifth are participation constraints.

Both the third and forth constraint corne from the first-order conditions of the direct or's

pro blem.

In either situation, the following concliiçions hold.

Proposition 4 Before disclosure. ( i ) directors underinuest in monitoring managers and

the incentive parameter, ,O, zs consepently smaller than is the parameter when share-

holders directly monitor managers; and (zi), both the directors' monitoring effort and

incentive parameter' 0, are independent ofmanagena1 rents. T .

Proof. AppendixD.

Clearly, the director woidd not be a perfect representative of t,he shareholders. The

imder-invat ment of monitoring effort occurs becarise of the divergence of interests be-

tween the director and the shareholders. This agency cost, unlike that in standard agency

rnodels (which exists because of privately observable effort and risk-averse agents), restdts

Erom privately observable performance and the ownershipsharing nature of a piiblicly-

held fum. Even a firm performance-based pay scheme for the director would not eliminate

1.3 THE MODEL 23

the agency cost, becaiise siich a scheme only increases the direct or's interest share in the

£km and does not change the nature the problem.

The second part of the proposition disentangles the incentive issue from excessive

managerial pay. Public critics attribute both high execiitive pay and a weak pay-

performance relation to director-manager collusion. The proposition dismisses siich a

linkage. Thoiigh the director may have an incentive to pay the manager excessively. it is

not in the interest of the director to weaken the incentive strength.

The Post-Disclosure Mode1

Under disclosiue niles, the board compensation committee has to detail both pay

and performance related information. and thiis, imder ideal sitiiations all a. 3. Q. and

Y become piiblicly observable. Two things happen accordingly. First. a managerial rent

no longer exists. Though the shareholden do not observe T. piiblic information on CV

and Ur forces the participation c0nstra.int to be set as E(U) 2 Ur.

Second, with information on Y, I.V and Q, the shareholders can evaliiate the per-

formance of the director.li For simplicity. assiune a linear performance measiire for the

director's monitoring activity, ill = rn + [, where [ is normally distributed with zero

mean. hl is public information. The shareholders sign a Linear pay contract with the

direct or,

Disclosiue d e s do not change the information flow between the director and the

manager, and so the manager's problern remains imchanged. But the problem for the

- - .. . . - - - - - --

17For example, Y - Q = rn can serve as an performance measure.

1.3 THE MODEL

direct or becomes the foilowing:

subject to p - ke = O and E(U) 2 Ur.

With the director-manager problem being determined by ( 1.17). the shareholders

solve the following optimization problem to determine { fo, fi):

Max E ( n - F ) = (1 - 0 ) e - a - fo - f im I j o J i )

The constraints in (1.18) correspond to those in (1.15).

Proposition 5 ,4fter disclosure. (i) m = m* and 9 = 0' where m* and 8' are the jirst-

best moniton'ng solution (when the shareholders directly contract with the manager): ( i i )

the f i e d component of pay, a? is increased if kpa2 > 1 and T = O be fore disclosure: and

(iii) T = O before disclosure 2s a suf ic ient condition for the expected wage. E ( W ) . to

increase, and T > O before disclosure i s a necessary condition for the expected wage to

decrease.

Proof. Appendix E.

As the shareholders can direc tly evaliiate the direct or's performance, the reward

scheme for the director becomes efficient. The solution to (1.18) is the same as that to

the pre-disclosure mode1 with 6 = 1. In other words, after disclosiire, the director is

indiiced to perform as a perfect representative of the shareholders. This residt is not

1.3 THE MOD EL 25

surprising. Since the director is risk neutral, the unobservability of the director's effort

is not sificient to pose a moral hazard problem. The public scrutiny of the managerid

pay scheme thus solves the agency problem between the shareholders and the director.

The incentive slope of the managerial pay scheme is increased becaise of the increased

monitoring effort from the director. The positive disclosiire effect on the pay-performance

linkage is anticipated by many public commentators. The intuition is simple: shareholder

scriitiny of the compensation system forces the board of directors to invest more effort

in monitoring management and to better perform their Bdiiciary duties.

Changes in fixed pay and e-xpected total pay are arnbiguoiis, depending on mode1

parameters. It is worth noting that part (iü) of the proposition points otit a possibility

to identi& the existence of pre-disclosiire managerial rents.

1.3.5 A Summary of Disclosure Effects

It is straightforward to incliide political pressires and pay envy into the shareholder-

àirector-manager hamework. However, since none of above residts will change qiialita-

tively, 1 leave the description of the integrated mode1 to an appendk. The following table

s ima r i ze s the partial effects disciissed above.

Influencial Factors

Shareholders' scriitiny + + or - + Pay Envy + + or - + Polit ical Pressures - - or + -

Pre-disclosiue rent (T > 0) no - -

- - - - . . -- - -

A@, Acr, AE(W) denote changes due to compensation disclosiire in incentive slope, Lxed

pay, and expected total pay r e s p e c t i ~ e l ~ . ~ ~ - - - pp - -

181t needs pointing out that there is a difference between the table and Proposition 5 with respect to the effect of shareholders' scnitiny on E(W). In the table, the effect of pre-disclostire rent is separately iisted.

1.4 EVTDENCE FOR CHIEF E X E C U T m OFFICERS 26

In the public debate and economics literatiire, arguments iisiiaily focus on one ef-

fect while ignoring the others. When all these effects are taken into accoimt, the total

regdatory impact on both the pay-performance sensitivity and expected wage becornes

ambigioiis. I t is essentially an empirical matter. Now 1 proceed to examine the evidence.

Because the post-disclosure period is short in the current data, it is difficidt to estimate

changes in the expected wage. Given the general interest in the efficiency of the pay

system, 1 wili focus on the impact on the pay-performance sensitivity.

1.4 Evidence for Chief Executive Officers

1.4.1 The Ontario Regulation Act

Until October 1993, proxy disclosiire reqiurements imder the Ontario Security Act

called for disclosure of aggregate total compensation for ail execiitives. In contrast, US

niles governing disclosiire of execiitive compensation reqilired individual named disclo-

s u e , in addition to aggregate information. As a response to piiblic criticism of the

disparity between Canadian and US reqiurements, in the fall of 1990 the Ontario Se-

ciirity Commission began to review executive compensation disclosiire reqiiirements. In

early 1992, the commission settled iipon a proposa1 for aggregate disciosiire of the top

five executives with individual disclosiire only when an execiitive e m e d more than forty

percent of the total compensation received by the five persons receiving the highest aggre-

gate compensation. The new regulation was announced on October 14' 1993, which went

much hirther than the proposal. requiring thorough, named disclosiire of the five highest

paid executives' compensations. The new regdation makes the disclosiire reqilirements

very sirnilar to those in the United States, piitting "Ontario at the forefront of openness

and accoimtability to shareholders" (Laiighren, p5106).

The regulation took effect on October 31, 1993. The disclosure rides include three

1.4 EVZDENCE FOR CHEF EXECUTWE OFFICERS

main components. First , corporations must detail total execut ive compensation in sev-

eral tables with a standardized format. Completing the tables reqiiires compensation

information for the ciment fiscal year and the two immediately preceding years. The

ndes reqtiire compensation disclosure regarding the CE0 and the f o u highest paid ex-

ecutives with total compensation in excess of $100,000 in the most recent fiscal year.

Such a reporting format provides shareholders with a concise, comprehensive o v e ~ e w

of compensation awarded, earned or paid in the reporting period, and makes it easy for

shareholders to compare compensation practices between reporting corporations.

Second, the compensation cornmittee of a corporation mtist disclose to the sharehold-

ers its compensation policy - the b a i s for the compensation granted to senior execiitives.

While a general statement of compensation policy is reqiured for all reported senior mec-

utives, a specific statement is required for the CE0 to specify the relationship of corporate

performance to compensation. The compensation committee report reqiiirement permits

shareholders to assess how well directors are representing their interests. In order to

ensure that shareholders know which directors are to be credited or blamed for rompen-

sation polices. the report is made dong with the names of the directors serving on the

compensation comrni ttee.

Third, the disclosiire rtdes reqiure a corporation to graphically present the corpora-

tion's performance by cumulative total shareholder rettun. This figue miist be compared

to both a market index and an indiistry or peer group index. The graph m u t show data

for a minimiun of five years incliiding the base year. This reqtlirement complements

the compensation committee report and siunmarizes information on the relationship of

executive compensation to corporate performance in a given fiscal year.

Given the close relationship between the Canadian and the US market, it is im-

portant to understand the US disclosure rides to properly document the impact of the

1.4 EWDENCE FOR CNlEF EXECUTWE OFFICERS 28

Ontario regdation. Ever since corporations began ta disclose top execiitives' compensa-

tion in the 1 SOS, compensation practices i ~ e d by corporate directors to motivate senior

managers have corne under public scrutiny in the United States. In the early 1990s ex-

ecritive compensation becarne an issue for public debate. blany believed that sornething

was wrong: "First, executive compensation was disproportionate when compared wit h

the salaries paid to the senior exeçiitives of foreign corporations. Second, the level of

execritive compensation had increased much more rapidly than salaries of the remainder

of the American work force. Third, executive compensation was not related to corpo-

rate performance." (Johnson, 1995, p191) Institutional investors were bringing increasing

pressures to bear on the regulatory agencies to support mechanisms which wodd increase

institutional investor influence on corporations. Faced with the threat of impending Con-

gressional action, the Seciui ties Exchange Commission responded by adopting regdatory

changes in late 1992. The regdation was rehed by a second set of changes near the end

of 1993.

There are three changes in the US law. First, the new regidation reqtùres corporations

to disclose senior execiitives' compensation iising a standard format. As for the visibility

of executive pay, this reqiiirernent is not miich different barn the early niles. Second, the

new regulation reqiiires the compensation cornmittee to disclose its compensation policy

to the shareholders. Third, cornpanies are reqillred to provide a performance graph. as

described above for the new Ontario regdation. The new Ontario regidation was clearly

influenceci by, and siibstantially similar to, the new US disclosiire reqiiirements adopted

in late 1992.

1.4.2 The Methodology and the Data

Regdatory impact is evamined in two ways. First. 1 examine the pay-performance

relation before and after the regdation was introduced for all piiblicly- traded Canadian

1.4 EVIDENCE FOR CHIEF EXECUTIVE OFFICERS 29

firms. Second, I compare post-disclosure changes in the pay-performance Linkage between

firms affected by the regulation and others that are less dec ted or imaffected by the

regulation. The latter is a "ditference in difFerences" approach. which has an advantage

in controbng for the effects of factors other thao the regulation.

The "difference in differences" analysis includes two comparisons. One comparison

is made between Canadian fLms whose shares were exclusively traded in Canada before

1991 and other Canadian firms whose shares also traded in the United States. Before

1991 Canadian compaoies publicly-traded in the US. were bound by the U.S. regulations

and so the information on top executives' compensation for these companies were acces-

sible to shareholders through the US. market. I thus identify these firms as ones that

were already rdFected by the US. disclosure rules and would be less a£Fected by the new

Ontario regulation. The other comparison is made between Canadian firms and US firms

(which were not affected by the Ontario regulation). Under the assumption that the

compared samples were subject to different regulatory 'shocks' and in an otherwise sim-

ilar environment,'"he difference in post-disclosu~re changes of managerial pay schemes

is expected to reflect the regulatory change in Ontario.

We may assume that the disclosure rules were not anticipated in early 1993. and

so take the fiscal years before and including 1993 to be the predisclosure period. This

assumption is based on the following discussion. The proposal of new disclosure rules

was put forth to the public in March 1992.~' The proposed rides require disclosure of the

aggregate compensation of the five highest paid executives, which is similar to the existing

lg More specifically, this assumption includes: (i) the introduction of the disclosure law provides an exogenous variation in exec~~tive compensation schemes, (2) all other factors including secular trends, but other than the discloslue law, are common to the compared samples. While this assumption defines the ideal conditions for the "difference in differences" approach, it describes qttite closely the situation between Cornpustat and non-Cornpustat Canadian firms. The second condition, however, may not be held desirably for the relationship between Canadian firms and US firms due to the 1992 and 1993 revisions of US disclosure laws. This issue is addressed in the next section in the discussion of the results for the comparison between Canadian firms and US firms.

20 See Wright (1992).

1.4 EVIDENCE FOR CHrEF EXECUTIVE OFFICERS 30

disclosure requirements in regard of the opemess of execiitive compensation. Althoiigh

disciissions on possible regulatory changes in Ontario can be traced to as early as April

1991,2i the public did not seem to anticipate the new disclost~re ndes before mid-1993.

For example, the editorial article in the Financial Post on May 12, 1993 complained that

"As the U.S. moves forward, Canada treads water. The Ontario govenunent cannot even

bring itself to adopt the OSC proposal for limited disclostue." Given that companies

rnake decisions on pay schemes iisudy at the beginning of a fiscal year and that the new

regulation was annomceci in late 1993, it is then reasonable to take fiscal year 1994 to

be the k s t year when the new regdation infltienced the compensation system.

Canadian CE0 compensation data are compiled hom the corporate proxy statements

aed with the Ontario Seciirity Commission and mailed to shareholders. The data cover

a l l proxy statements 6led diuing October 1993 to July 1995, which report execritive

compensation for fiscal year 1991 throtigh 1994. The data contain detailed information of

diffesent cornponents of exectitive remuneration. Ciment cash payments sala^, anniial

boniiç, and varioiis benefits) are reported, dong with stock options (or stock appreciation

rights), grants of restricted stock shares, and long-term incentive plan payoiit. Financial

data are obtained fiom the Financial Post data files. Excliiding partial compensation diie

to turnover and firm reorganization, and eluninating observations mith missing data after

matching CE0 compensation with fim financial data, the Canadian sarnple contains 381

firms for a total of 1209 observations. Becaise some firms do not have complete f o u years

of data, the sample constitiites an unbalancd panel.

1 identify the Canadian fimis that were publicly traded in the United States before

1991 as those that appeared in the Compustat data file for fiscal year 1991. I cal1 them

Compustat £hm. Arnong the Canadian companies piiblicly-traded in the United States

* ' ~ h e first article in the Financial Post that mentioned the Ontario Seciwities Commission's plan to introduce regulatory proposais was piiblished on April 15, 1991 (see Whyte).

2.4 EVTDENCE FOR CHlEF EXECUTWE OFFICERS 31

in 1991, more than 500 were listed in the file. Because the CE0 compensation data

essentidy cover all large publicly-traded Canadian firms, those included in the sample

and also traded in the US market are expected to be listed in the Compustat data file.

Of the total h s in the sample about 70 percent are Compiistat finns.

A Forbes sample over the period 1991-1994 is used for US 6rms. The Forbes report

of CE0 compensation includes total salary and bonis, stock gains. and other payments.

Total salary and bonus is the same as the siun of sdary and annual bonus in the Canadian

CE0 compensation data. Stock gains are the net value realized fiom the exercise of op-

tions or stock appreciation rights previoiisly awarded. Other payments inclitde long-term

incentive payments and varioiis benefits. The financial data for US firms are obtained

fkom the Compustat data files. The US sample contains 666 firrns Mth a total of 2133

observations.

Selected statistics of CE0 pay as well as some f k n variables are siimmarized in

Table 1.1. There are two things worth mentioning. First, there is a notable difference

in firm size between Compustat and non-Compiistat Canadian firms, and a siibstantial

difference in h m size between Canadian firms and US finns. Second, cornpared with the

pre-disclosiue period, fhns generally performed poorer in 1994. Because of limitations

of the data,22 the investigation of this paper will focus on C E 0 direct pay excliiding

stock options. Specifically, the disciiçsions will be based on two pay variables: salary

plus bonus and total direct pay which apply to both the Canadian sample and the US

sample. The effects of stock ownership and options will be briefly disctissed later.

22~tock option data are incomplete: the Forbes stirvey does not report ciirrently awarded stock options the Canadian firms' proxy statements did not disclose the relevant stock market price, exercise price, and expiration date for stock options granted in previoiis fiscd years.

1.4 EVIDENCE FOR CHIEF EXECUTlVE OFFICERS

1.4.3 Empirical Results

As in Hubbard and Palia (1995), the foilowing specification is iised to estimate the

pay-performance sensitivity:

(CE0 Pay), = a + Bi (Shareholder Wealth), + & (Shareholder Wealth),-, .

CE0 pay is either salary pliis bonus or total direct pay. Total direct pay incliides sala%

boniis, long-term incentive payrnents and fringe benefits, excliiding stock options. S hare-

holder wealth is defined as the stock retiirns earned diring the year, times the price at

the beginning of the yearo times the niimber of shares otitstanding. As past performance

may also have an influence on ciment compensation,23 a lag term of shareholder wealth

is included as a regressor. The total sensitivity is ,BI + ,O2. A diunmy variable for fiscal

year 1994 is introdiiced to captiire post-disclosiire changes in CE0 pay schemes.

1 first examine how the pay-performance sensitivity changed in Canadian firrns after

the new Ontario regdation. Table 1.2 presents the regession restdts with all Canadian

firms. The pre-disclosiire sensitivity for CE0 salary+bonits and total pay is abolit 8

cents and 11 cents, respectively, in response to every $1000 change in shareholder wealth.

Mter disclosiire the sensitivity increased to 34 cents for salary+boniis and 30 cents for

total pay respectively. The large magnitude and high significance level of the sensitivity

increase siiggest a substantially strengthened pay-performance linkage. To the extent

that sensitivity declines with h m size and increases Mth a firrn's market perf~rrnance ,~~

the changes in sensitivity may be imderestimated because Brm size was larger and per-

formance poorer in fiscal year 1994 (see Table 1.1).

An obvious criticism on these estimates is that there may exist other factors that - - pp - -

23See, e.g., Jensen and hIiirphy (l990a) and Joskow and Rose (1994). 2 4 ~ t is well documented that the pay-performance sensitivity changes inversely with firm size (sw

Jensen and Miirphy, 1990a; and Garen, 1994). Some early studies note that managerial pay is relâtiveIy less reçponsive to poor performance than to good performance.

1.4 EVlDENCE FOR C H E F EXECUTWE OFFICERS 33

caused the observed changes in the sensitivity. To address this issiie. 1 examine the differ-

ence in the post-disclosure changes of the pay-performance sensitivity between Cornpiistat

£hm and non-Compustat firms. Recd Compustat firms are Canadian fbms siibject to

US disclosure ndes, which were, presumably, less aifected by the new Ontario remdation

than were non-Compiistat Canadian firms. Assiiming that the eifects of non-regdatory

economic factors are common to both groups of firms, the difference in their response to

the regdation (and therefore, different changes in sensitivity &ter disclosiue) will reveal

the regdatory impact.

The residts with a diimmy variable for non-Compiistat firms are presented in Table

1 . 3 . ~ ~ The coefficients on the difference in post-disclostue changes (i.e. the terms with

d i m y variable YEAR94x NONCOLIPUSTAT) are ail positive, and becorne simgpifmint

at the one percent level for the regression with salary and bonus. Incliiding the coefficients

on both the ciment and the previous year's performance, the sensitivity increased by

0.000155 with salary plus boniis, nnd by 0.000353 with total pay. for Cornpiistat fums.

The increase is as high as 0.000814 with salary pli= boniis and 0.000779 with total pay,

respectively, for non-Compiistat f i rm. After disclosiue. while the sensitivity increased in

both Compiistat and non-Compiistat firms, i t increased much more in non-Compristat

kms. These results strongly siipport the view that disclosiue riiles strengthen the pay-

performance linkage.

Fiirther, if Compustat firms and non-Compustat firm were in a different regdatory

environment before the new Ontario regdation, we shoidd be able to observe a difference

in their pre-disdosure sensitivity consistent with the regdatory infliience. This is also

verified in Table 1.3. The pre-disclosure sensitivity is estimateci by the coefficients on

2 5 ~ h e estirnates are adjusted for hetemscedasticity between Cornpiistat and non-Compiistat firms irsing the two-step, GLS estimator. This adjistment is applied also to the regressions in Table 4 which compare US firms with Compiistat and non-Compuçtat Canadian finns.

1.4 EWDENCE FOR CHIEF EXECCTTm OFFICERS 34

performance variables withoiit diunmy variable YEAR94. It is 0.000093 with salary and

bonus and 0.000123 with total pay for Compiistat firms, and 0.000052 and 0.000094,

respectively, for non-Cornpustat Consistent with a positive regdatory impact on

the pay-performance relation, the sensitivity is Iarger for the firms that were afFected by

the US disclosiue regidations. Taking into accoimt both the pre-cùsclosiue sensitivity and

the post-disclosirre changes. the above estimates indicate that the percentage increase in

sensitivity for non-Compiistat firms is 3 to 9 times as large as for Compiistat firms.

Because the non-Compiistat sample is made tip of s m d capitalization firms, one

may argile that the effect of disclosure disciissed above rnerely represents a year (1994)

specific effect on C E 0 compensation in s m d firms. Fiirther, becaise small Enns are

iisually relatively young, the residts may reflect the effects of aging. To clai@ this

problem, 1 divide the total sarnple into srnail h s and large firms while ignoring the

"Compiiçtat" dimension. The mode1 is reestimated by introdiicing a d i m y variable for

small firms. While the increase in the post-disclosiue sensitivity is rnodestly larger in

s m d firms than in large firrns, the difference is statistically insignificant. -4s the pre-

disclosiire sensitivity is taken into accoimt the difference between small firms and large

firms becomes even more obsciired.

In siunmary, the residts in Table 1.3 show that (i) before the Ontario regdation

was introdiiced, the firms that were not affected by US disclosiue rides had a smaller

pay-performance sensitivity, and (ii) after the Ontario regdation was introdiiced, the

sensitivity of these firms increased siibstantially relative to those firms that were al-

ready covered by the US regulations. This observation is consistent with many public

2 6 ~ î needs pointing out that the significance level is quite low for the difference in the pre-disclosire pay-performance sensitivity between Compiistat and non-Compustat fkms. This is expected to reflect a firm-size effect. As mentioned earlier, non-Compustat h s are small and the sensitiviw parameter is larger in smaü firms. The observeci difference in the pre-diçclosiire sensitivity is downward biased when f ims that have a smaller pre-disclosiue sensitivity are with a s m d e r size. This discussion aiso applies to the residts for the cornparison between Canadian firms and US firrns.

1.4 EVIDENCE FOR CHIEF EXECUTWE OFFICERS 35

commentators' prediction of the regulatory impact: Execiitive compensation disclosiire

increases the public scnitiny of the pay system, and thiis forces the board of directors to

tie managerial pay more closely to corporate performance.

Given the observed difference between Compiistat and non-Compiistat firmso i t is

natiital to ask how the two groups of Canadian firms are different from US firms in re-

sponse to the new Ontario regdation. Presumably: Compustat Canadian 6rms were in

a similas regulatory environment as were US £hm regarding to execiitive compensation

disclosine. So, if the difference between Compustat and non-Cornpiistat firms reflects the

effects of disclosure, then we should be able to observe similar post-disclosiue changes in

sensitivity between Compustat Canadian hm and US firms, and to observe a larger in-

crease in sensi t ivity for non-Compiistat h s t han for US firms. To verify this conject lire,

1 nin regressions for the pooled sample of ail Canadian and US firms, and use a diunmy

variable for Compustat and non-Compustat fkms respectively. The resiilts are presented

in Table 1.4, and are consistent with the conjecture. The terms with diunmy variable

COMPUSTAT capture the difference between Compustat Canadian firms and US firrns.

and the terms with diunmy variable NONCOhIPUSTAT capture the difference between

non-Compiistat Canadian fhms and US firms. On one hand, after the Ontario regdation

was introdiiced, the sensitivity increased rniich more for non-Computat Canadian firms

than for US firms. With salary and bonlis. the post-disclosine (absolute or percentage)

change for non-Compiistat firrns is about 4 tirnes as large as that for US firms, and

the difference is statistically si,dficant. While the estimate for total pay is weaker, the

qiialitative resiilt remains the sams. On the other hand, there is no sigdicant differ-

ence between Cornpustat Canadian b s and US firms. even though the post-disclosiue

changes are slightly smaller for Cornpiistat firms. This observation tends to siiggest that

the Canadian firms that were already subject to the US disclosiire regdations were not

1.4 EVIDENCE FOR CH1.F EXECUTTVE: OFFICERS

affecteci by the new Ontaxio regulation.

While an increase in the sensitiviiy of both Canadian f ims and US firms may partly

result from similar stock market fliictuationç, it is possible that there existeci similar reg-

ulatory effects on US fkms in 1994. As mentioned earlier, the Seciinties and Exchanges

Commissions in the United States revised the long-standing US disclosiire ndes in late

1992 and 1993. While the new disclosiire rules do not change the visibility of execiitive

compensation (and thiis the effect of public pressure and managerial behavior), they siib-

stantially increase the public scnitiny of the b ' s compensation poiicy. The revision of

disclosiire ndes is widely believed to have a profoimd influence on the fu?n's compensation

practices in tying executive pay more closely with corporate performance.

There was another event occ~med in 1993 in the United States that was also ex-

pected to increase sensitivity. In response both to the public oiitcry concerning excessive

execiitive compensation and the administration's need to raise federal reveniie, the US

congress passeci new restrictions on the arnoimt of execiitive compensation rvhich corpo-

rations can dediict from their income (the Revenue Reconciiiation Act of 1993). Under

the new t a codeo a publicly-held corporation generally cannot dediict any compensation

over $1 million paid to eseciitives from its goss income. To encourage corporations to

adopt performance based compensation practices, however, a corporation can avoid this

lirnit if the compensation is characterized as performance related. The new bill. dong

with the revised disclosure niles, woidd aùnost certainly force ptiblicly held corporations

to strength the linkage of execiitive pay to firm performance. So, becaiise of these possi-

ble regdatory effects on US firms, the observed difference in the post-disclosive changes

in the pay-performance sensitivity between US firm and non-Compiistat Canadian firms

may underestimate the regdatory impact of the introdiiction of the new Ontario regda-

tion.

1.4 EVIDENCE FOR CHIEF EXECUTWE OFFICERS 37

The discussions above do not consider incentives from CE0 stock ownership and

options which, as previous studies note, provide important components of incentives

for executives. Thus, there may be concem for whether or not the changes in direct

compensation accurately reflect the total change in managerial incentive strength. Siich

a concern, thoiigh reasonable, does not seem to seriously adfect the above discussions.

First, in a short post-disclosilre period, executive stock holdings are iinlikely to be affectecl

by her firm's irnmediate change in compensation strategies. Also, execiitive stock gains

from exercising previoiiçly ganted options (which reflect long-term incentives of stock

options) are largely independent of policy changes that affect the crirrent or very recent

option grants. Second, because direct compensation (incliiding salary? boniis, gants of

stock shares, long-term incentive plan payout. and vmiciis benefits) axe the most visible

components of CE0 pay and are iuider a close public scnitiny, they are expected to be

most sensitive to govenunent disclosiue n~Jes.*~ This siiggests that changes in direct

pay are more indicative of the total incentive change in response to the new regdation.

Thoiigh a shift of pay striictiue may occiir in response to disclosixe regiilations. changes

in the most visible components of pay are expected to coincide with the total chcange in

incent ive strengt h.

Finally, 1 briefly look at the estimates of the 6xed pay component. As shown in Table

1.2 throiigh 1.4, the fixeci component increased in 1994 for ali samples. The absoltite

changes can be directly trnnsformed into percentage changes so as to minirnize the effect

of firm size on the estirnates. The resiilts are m L d : there is no particidar pattern

for the difference either between Compiistat firms and non-Çompustat h m s or between

27Given a comparable si& of wealthTbenefits h m options and stock ownership are les visible than direct payments. In fact, many Canadian h s note in proxy statements that the information on directors' (incliiding the CE0 in most cases) stock shares is beyond the knowledge of the finri and is provided by directors thernselves. &O, many firms claim that they do not know how to value execirtive options.

Canadian tirms and US fkm. The general increase in the h e d pay cornponent for a.ll

samples seems to siiggest a cornmon trend of changes in the level of CE0 compensation.

Since the model described in the last section does not give an imambiguous prediction to

fixed pay, no conclusion can be drawn with these estimates abolit the effect of disclosiire

on the fixed component of CE0 pay.

1.5 Conclusion

Discussions of the regulatory impact of execiitive compensation disclosiire on incen-

tive contracts have recently focined on political forces that, explicitly or implicitly, im-

pose conçtraints on the firm's compensation practice and adversely affect the effectiveness

of managerial pay schemes. Little has been done, however. to examine the regulatory

impact on the pay-performance relation of the piiblic scriitiny of the pay system and

managerid behavior. Analyzing an agency model with a shareholder-director-manager

stnict lire, this chap ter has shown that governrnent disclosiire rides have a two-fold effect

on the optimal incentive contract. WXle political forces due to piiblic disapproval of high

payments suppress the pay-performance sensitivity, shareholders' scriit iny enhances the

effectiveness of the pay system and strengthens the pay-performance Unkage. -4s well.

pay envy among managers encoirages them to accept a more risky pay contract and also

helps the firm to tie compensation more closely with performance.

Examining CE0 compensation for 384 large Canadian firms and 666 large US firms

before and after the introduction of the new Ontaxio disclosiire regdation, this paper

obtains two empirical residts. First, following the introduction of disclosiue regdation in

Ontario, the pay-performance sensitivity increased for al1 Canadian finns, but increased

siibstantially more in those firms which were not already siibject to the US disclosilre reg-

~dations. Second, while the pay-performance sensitivity increased less at US firrns than

at Canadian firms that were unaffectecl by the US regtdations, there was Little difference

between US frm.s and other Canadian firms that were already boimd by the US regu-

lations. These findings are consistent with a positive impact of regdatory disclosiue on

the pay-performance linkage. They confirm the widely-held belief of legislators and piib-

lic cornmentators: with disclosure, increased piiblic scrutiny of compensation decisions

made by corporate directors further aLigns managerial pay with corporate performance.

Sorce caveats: Post-disclosiue sensitivity increased by more than 200 percent for all

sarnples. This change in sensitivity seems to be large. As weU, the significance level

is generdy low for the estimates with total pay. A possible explanation is that the

post-disclosire period is too short, which affected both the magnitude and efficiency of

the estimates. In particidax, because of the short post-disclosiire period, the evidence

obtained with the ciment data may not reflect the long-term effects of goverment dis-

closiire rules. It is possible that the downward effect of political constraints is not evident

at the early stage of disclosiue, becaiise piiblic pressures take time to biuld and to exert

an influence on firrns' compensation practices. Therefore, the residts of this stiidy do not

necessarily conflict wit h t hose of earlier stiidies t hat srigges t a negative disclosrue effect

on managerial incent ive strength (e.g., Jensen and Miirphy, 1990a; and Joskow. Rose.

and Shepard, 1993). The difference between the Ontario and US disclosure reqtiirements

may also play a role. Compared with the US disclosiire regidation enacted in the 1930s,

the new Ontario regdation (and dso the revised US regdation) added reqiurements that

reved aspects of a h ' s compensation policy in addition to the amoimts actiially paid.

This change would certainly strengthen the influence of piiblic scnitiny of h m ' s execiitive

compensation syst ems.

Table 1 . 1 Selected Statistics

- - - - -

Canndian Fims US Firms

The Tolal Sumplc Compustat Firms Non-Compusiat Finns

Mcdian Mcan Obs. Mcdian Merin Obs. Median Merin Obs. Median Mean Obs.

The Pre-Disclosure Period: 1991-3993

ÇEO Pav (Sthousand)

Salory+Bonus Total Pay

Finn Vnriables (SrniIlion)

Assets Sales Market Value Shareholder Rctiim

The Post-Disclosure Period: 1994

ÇEO Pnv (Sthousrmd)

Salaryt Bonus Total Pay

Assels Sales Market Value Shareholder Reiurn

Note: AI1 variablçs rire annual and in 1991 US dolltirs. Coriipustut liniis arc thosc ihai appcnr in th;: 1991 C'OMPUSTJTda!a file.

Table 1.2 Changes in Pay Performance Sensitivity (Canadian firms)

-.

Dependent Variables

Independent Variables Salary+Bonus Total Pay

Shareholder Wealth

(Shareholder Wea1th)-,

YEAR94x(SharehoIder Wealth)

YEAR94x(Shareholder Wealth)., O. 106~ IO-' (3.20)

Observations 1,309

- - - - - - - . . - -- - - --

Note: Individual (fixed) effects are controlled. t-statistics are in parentheses. YEAR94 is a dummy variable for fiscal year 1994.

Table 1.3 Changes in Pay Performance Sensitivity : Compustat Firms vs. non-Compustat Firms

Independent Variables

Dependent Variables

SaIary+Bonus Total Pay

Y EAR94

YEAR94x NONCOMPUSTAT

Shareholder Wealth

(Shareholder Wea1th)-,

NONCOMPUSTATx(S harehoider Wealth)

NONCOMPUSTATx(Shareho1der Wealth)_,

YEAR94x(Shareholder Wealth)

Y EAR94x(Shareholder Wea1î.h)-,

Y EAR94xNONCOMPUSTATx(Shareholder Wealth)

Y EAR94x NONCOMPUSTATx(Shareho1der Wea1th)-,

RZ

Observations

95.48 (3.63)

-14.80 (-0.23)

0.079 x 1 O-J (2 -3 5)

0.043 x 1 O-' ( 1.20)

-0.046 x 1 O" (-0.45)

0.0 18x 1W3 (O. 13)

0.243 x 1 O-3 (2.14)

0.1 10x IO-) ( 1 .94)

0.295~ IO-^ (0.82)

0.131~10-~ (0.66)

0.0635

1,209

Note: Individual (fixed) effects are controlled. t-statistics are in parentheses. YEAR94 is a dummy variable for fiscal year 1994. NONCOMPUSTAT is a durnmy variable that equals one for Canadian firms that did not appear in the 1991 COMPUSTATdata file.

Table 1.4 Changes in Pay Performance Sensitivity : US Firms vs. Compustat and non-Compustat Canadian firms

Independent Variables

Dependent Variabtes

Salary+Bonus TotaI Pay

YEAR94xNONCOMPUSTAT

Shareholder Wealth

(Shareholder Wealth).,

COMPUSTATx(Shareho1der Wealth)

NONCOMPUSTATx(Shareho1der Wealth)

NONCOMPUSTATx(Shareho1der Wealtfi).,

YEAR94x(Shareholder Wealth)

Y EAR94 x(Shareho1der Wealth).,

Y EAR94xCOMPUSTATx(Shareholder Wealth)

YEAR94xCOMPUSTATx(Shareholder Wealth).,

YEAR94xNONCOMPUSTATx(Shareholder Wealth)

YEAR94xNONCOMPUSTATx(Shareholder Wealth)-,

R2

Observations

205.14 (8.26)

-1 11.62 (-3.0 1 )

- 169.60 (-4.1 0)

0.03 1 x 1 0 ' ~ (3.40)

0.022~ 1 O" (2.9 1 )

0.024~ 1 O-' (0.65)

0.016x 1 0-3 (0.42)

-0.0 1 5 ~ 1 O-' (-0.27)

0.014~ lC3 (O. 18)

0.084~ 1 O" (3.78)

0.125~ IO4 (5.83)

-0.0 IO^ 104 (-0.10)

-0.044~ 1 O-' (-0.70)

0.466~ 1 O-' (2.45)

0.139~10" ( 1-29)

0.09 15

3.342

222.78 (4.03)

- 127.30 (- 1-87)

-142.10 (- 1.35)

0.047 x 1 (2.29)

0 .053~ 1 O" (3.10)

0.032~ 1 0m3 (0.59)

-0.0 1 o x 104 (-0.17)

-0.0 14% 1 om3 (-0.1 O)

0.008% 10" (0.04)

0 .200~ 1 O" (4.03)

0.200 x 1 (4.20)

0.043 x IOJ (0.24)

-0.090~ 1 O'3 (-0.92)

0.337~ 10" (0.66)

0.042 x 1 O" (O. 14)

0.0447

3.342

Note: Individual (fixed) effects are controlled. t-statistics are in parentheses. YEAR94 is a dummy variable for fiscai year 1994. COMPUSTAT is a dummy variable that equals one for Canadian fims that appear in the 199 1 COMPUSTATdata file.

Appendix A. Proof of Proposition 1

The Lagrange of the optimization problem for the firm is

where E(U) = - exp [-& + Be - $ke2) + $~?a'fl~], and XI and A? are rniiltipliers for

the constraints. The first order conditions are

- 0 w-a! -1- - - @ ( -.) -&E(U)p=O, B

O - ke = 0. and E(U) - Ur = 0.

Jointiy solving these conditions yields

( A l )

The first term is the pre-disclosiue pay-performance sensitivity, ,& = *. The second

term characterizes the effec t of political pressures.

Becaiise t9 > O, to prove f i < Bo we need to show W - a + p'P2 > O. This is

accomplished by contradiction. Suppose there is W - a + ,oo2/3* 5 O. From (Al ) this

means & or P( l + k p o 2 ) 2 1. RecaUing ,6' = ke, we have

- W-cr+pa3$ 2 W + ( i - f i ) e - a

- = W + E(Y - W ) .

For the firm to accept the contract, there miist be E(Y - UT) 2 O. Then there is - CI/ - 4 + 2 W > O. This contradicts the presiunption. Therefore. 4 < oO.

F u t her, kom the participation constraint it is straightforward to obtain

l = -- 1

log (-Ur) + - (kprr2 - 1) p2. P 2k

Comparing (A2) and (A3) with (1.5) and (1.6), and noticing the chcange of 3. part (ii)

and (iii) become obvioiis. Q.E.D.

B. Proof of Proposition 2

The Lagrange of the optirnization problem is

where E(U(W C, W,") = - exp { - p [ ( 1 + h)(a + pe) - ?lie2 - hW;] + ~ p b 2 , 3 ' ) ~ and XI

and AL> are miiltipliers for the constraints. The solution for the incentive dope is

With a similar analysis to that in the proof of Proposition 1, the Obviously, > W.

conclusion on a and E(W) foilows. Q.E.D.

APPENDLX

C . Proof of Proposition 3

The Lagrange of the problem is

1 --gm' + XI [O - ke] + X2 [E(U(CV. C ) - 0; - Tl

2

1 9 2 where E(U(W. C) = - exp {-p(a + ,3e - $e2) + 2p-rr (1 - m)2,32), and A l and X2 are

rniiltipiiers for the constraints. Solving the k t -order conditions yields the following

resillts:

[6 + (1 - 6) s 1 ] 1 m = i? =

g + [6 + (1 - 6 ) sl] pu2@*' 1 + kpo2(1 - r r ~ ) ~ '

Part (i) and (ii) of Proposition 4 become obvioiis.

To allow the corner solution with T = 0, the first-order conditions Nith respect to T

are written as

[l - (6+ (1 - 6)s l ) l b -X2 5 O. T 2 O.

b+ 1-6 SI Using A? = && from 2 = O, these conditions are rewritten as

There are two possibilities. If T = O, there is [l - (6 + (1 - 6) s i ) ] p [-E(U)] b -

(6+ (1 - 6 ) s l ) 5. 0. Because E(U) = Ur, it follows

If T > O, there miist be [l - (6 + (1 - 6) sl)] p ( - U r ) b - (6 + (1 - 6 ) s l ) = O. Becaise

E(U) = U,. + 5"' there is then

Since the direction of the above reasoning is reversible, the third part of the proposition

is proved. Q.E.D.

D. Proof of Proposition 4

To obtain the first-best monitoring solution m* and 3' , set 6 = 1 in the director's

problem. Then,

subject to ,O - ke = O and E(U) 2 U,. Since E ( D ) = E(l3 - fgm2), (AG) is eqilivalent

to the problem when the shareholders contract directly Mth the manager. Solving (A6)

for m* and 9' yields

Now, I compare (A7) with the solution to the shareholders' problem in the two

situations.

(i) The shareholders pay the director a h e d fee. Because sl = 0' the solution to the

director's problem, (A5), gives

Given the hmctional Eom of m(-) and 4 (-), it can be easiiy shown that m < rn* and

B < O* becaiwe 6 < 1. Obvioiisly, both rn and 4 are independent of T.

(ii) The shareholders solve (1.15) to determine {sa, si). For ~ m y s 1 < 1, the solution

of rn and ,û is deterrnined by (A5). Since [6 + ( 1 - 6) s l ] < 1 becaiise s i < 1 and

6 < 1, there is again rn < m' and B < 3'. Fiuther, both T and a appear only in the

shareholders' objective fimction and in the manager's participation constraint . WXle

the determination of T and a cnicially depends on the shareholders' information of Ur.

theyareirrelevanttosl,andthuç, t o m a n d p . Q.E.D.

E. Proof of Proposition 5

Solving problem (1.17) gives the following conditions:

These two conditions are iised in the shareholders' problem, (1.18).

Instead of directly solving (1.18), 1 compare it with (AG), the mode1 when the share-

holders contract directly with the manager. At optirniun the participation constraint for

the director miist be binding in (1.18). Then the main difference between (1.18) and

(A6) is that the shareholders' problem in (1.18) is also siibject to (A8) and (Ag). Now 1

show that the solution of the two problems are the same.

Consider the following arrangement: choosing a value for fi siich that the monitoring

effort determined by (AS) and (Ag) satisfies

Using (A7), this means

One one hand, with fi being determineci by ( A i l ) , solution (A7) satisfies ( M O ) : amd is

also feasible to (1.18). On the other hand, becaiise the shareholders can not do better

imder (1.18) than imder (A6), the solution m i ~ t also be optimal to (1.18). Therefore. on

the optimum, rn = m* and B = ,ûa.

The pre-disclosiue solution for CI and E( W ) is

1 1 a = -- log (4,. - T ) + - (kpo2 - 1) P':

P 2 f

Because ,B i s increased-der discbsnr< p a r t (fi) -ad (Tiir bëcome obVioiis.

F. The Integrated Post-Disclosure Model

(1) The manager

With a concern about E(WP - CV), the manager's expected iitility is

1 7 1

(A12)

(-413)

- -

Q.E.D.

Taking a, ,û, W;, and m as g jven, the manage chooses e to rnaximize E ( U ) .

(2) The director

Under political pressiues, the h ' s profit becomes II - O(1- <P). Given pay contract

F = fo + f 1 M , the director solves the following problem:

siibject to

(1 + h)O - ke = 0, E(U) 2 Ur, ~ , b = E(Wp) = E(LV).

The following constraints are obtained from the first-order conditions:

(3) The shareholders

The shareholders solve the foilonring problem to determine {fo7 f 1):

sitbject to the manager's ICC and IPC,

(1 + h ) P - ke = 0, E ( U ) 2 Ur,

the director's participation constraint,

APPENDIX

the conditions for rational beliefs and market eqidibritm,

and (A14) and (A15).

Use the same strategy as that in the proof of Proposition 5 to solve the problem. It

can be stiom that the &st-best monitoring solution for m and ,8 is

- k8@ pa2(1 - r n * ) * ~ * ~ " -*]) [l+ / q - ~ z ( l - { [ ( l + h ) ? + l + h (1 f h)' 1 - l . (A181

1 then show that there exists f i > O sttch that the soliition of m and ,3 deterrnined by

(AM) and (A15) satisfy (A17) and (A18). Solve (A15) for m and let it eqiial m*. Then.

Equation (A14), (-415): (A19) and E(U) = Ur jointly determine the soliition of a , 8 ,

f, and m. They are the first-best monitoring solution as long as ( A U ) and (A18) are

satisfied. With the same argument as that in the proof of Proposition 5, they are also the

solution to (A16). In (A17) and ( A B ) , while all partial effects of each influentid factor

on p and m are qualitatively the same as those of Proposition 1 through 5: the total

disclosrire impact is ambiguous, depending on the relative strength of different partial

effects.

Further, letting E(U) = Ur gives

Cornparing (A20) with the pre-disclositre solution, (A12), and the change of P. the resiilt

is consistent with Proposition 1 throiigh 5 in regard of the partial e f k t of different factors

on a. The total impact is again ambiguous.

Findy, I check the change in the total expected managerial pay. From the partici-

pation constraint for the pre-disclosiue and post-disclosiire model, there is

1 u 1 AE(1V) = -- log ( ) + - [ (1+ /-#p' - &]

P Ur + T 2k

where mo and Po are the pre-disclositre solution defined by (A5). CVhen T = 0, obvioiisly,

sign[AE(W)] = sign[P - Po]. When T > 0, however, this relation may not hold. which

is consistent with the residts siunmarized in Section 1.3.5. Q.E.D.

References

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Bogus, Car1 T., "Excessive Execiitive Compensation and the Failiire of Corporate

Democracy," Buffalo Law Review, vol. 41, Winter 1993: 1-83.

Brownsterin, Andrew R. and Morris J Panner, "Who Shoidd Set C E 0 Pay? The Press*?

Congress? Shareholders?" Haniard Business Review, May- Jime 1992, 28-35.

Crystal, Craef S., In Search of Ezcess: The Overcompensation of American Executives,

New York: W.W. Norton, 1991.

REFERENCES 53

Dirnma, William, "A Peek Into the Boss's Pocket Book," Business Quaderly. Aiitiunn

1994, 41-45.

Dnicker, Peter F., "Reform Executive Pay or Congres WLII," The Wall Street Journal.

.4pril 24, 1984.

Editorial, "Time for fider s a i q disclosiue," The Financial Post, May 12_ 1993.

Garen, John E., "Execiitive Compensation and Principal-Agent Theory," Jovnlal of

Political Economy, 102, 1994, 1175-1 199.

Gibbons, Robert and Kevin J . Miirphy, "Optimal Incentive Contracts in the Presence of

Career Concerns: Theory and Evidence," Journal of Political Economy, 100, 1992.

468-505.

Holmstrom, Bengt , "Moral Hazard and Observability," Bell Journal of Economics. 10.

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Holmstrorn, Bengt and P a d R. Milgrom, "Aggregation and Linearity in the Provision

of Intertemporal Incentives?" Econornetrica, 55, March 1987, 303-328.

Hiibbard, R. G. and Darius Palia, "Execiitive Pay and Performance Evidence from the

US Banking 1ndiistr-y." Journal of Financial Econornics, 39' 1995. 105-130.

Jensen. hlichael C. and Kevin J- hlilrphy, -Performance Pay and Toph~ianagement

Incentives," Journal of Political Economy, 98, I990rr, 225-264.

Jensen, hlichael C. and Kevin J. Mruphy, "CE0 Incentives - It's Not How hliich Yoii

Pay, But How," Harvard Business Review, May-Jiine 1990b, 138-149.

Johnson, Tracy S., "Pay for Performance: Corporate Execiitive Compensation in the

1990s," Delaware Journal of Corporate Law, 20, 1995, 183-224.

Joskow, Paul, Nancy Rose, and Andrea Shepard, "Regdatory Constraints on CE0

Compensation," with discussions, Brookings Papers: M~c~oeconomics 1993. 1-69.

Kandel, Eiigene and Edward P. Lazear, "Peer Pressiire and Partnerships," Journal of

Political Economy, 100, 1992, 801-517.

Kaplan, Steven N., "Top Execiitive Rewards and Firm Performance: A Cornparison of

Japan and the United States," Journal of Political Economy, 102- 1994. 51û-546.

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Kato, Takao and Mark Rockel, "Experiences, Credentials, and Compensation in the

Japanese and US Managerial Labor Markets: Evidence hom New Micro Data."

Journal of the Japanese and International Economics7 6, 1992, 30-5 1.

Kesner, Michael S.: "Execiitive Compensation in the US: A More Objective Evaliiation

and Examination," a speech to the National Association of Corporate Directors.

December 199 1.

Laughren, Floyd, "Statement to the Legislatiire on Disclosiire of Execiitive Compensa-

tion," Ontario Securities Commission Bulletin, October 15. 1993, 51045106.

Loornis, Carol J., "The Madness of Execiitive Compensation," Fortune Magazine, Jidy

12, 1982, 42-53.

hlirrlees, J. A., "The Optimal Striictiire of Incentives and Aiithority within i\n Orga-

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bfurphy Kevin J., "Top Executives are Worth Every Nickel They Get." Harvard Busi-

ness Reuzew, hkrch- April 1986, 125-131.

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4, October 1995, 633-667.

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edited by Lars Werin and Hans Wijkander, bfassachiisetts: Basil Blackweil Ltd.,

1992.

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Whitworth, Ralph, "How Lhch Pay 1s Too Miich? Michael Milken's Hiige Compensa-

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Commission Bulletin, May 1, 1993, 1845-1847.

Chapter 2

C E 0 Pay, Firm Size, and Corporate Performance: Evidence frorn Canada

Int rodudion

In recent years a nimber of empirical stiidies have examined the determinants of

managerial pay and its relation to corporate performance. These stiidies fociis on large

companies in the United States (e-g., hliirphy, 1985; Coughian and Schmidt. 1985; Jensen

and kliirphy, 1990), Japan (Kato and Rockel, 1992; and Kaplan, 1994). and Britain

(Cosh, 1975). It only became possible to condiict such stiidies with Canadian firms after

1993, when ail piiblicly-traded companies in the province of Ontario were reqiured to

disclose top execiitives' compensation imder the new Ontario Seciirities Regdation.

It is interesting to duciment the Canadian evidence concerning execiitive compensa-

tion both becaiise it has not been described in the literatiire and becaiise it yields resiilts

that complement those of earlier stiidies. h4ost of the previoiis stiidies examine large US

and Japanese hm, and so little work has been done on smaller firms. Bas& on total

assets or sales, the Canadian firms in oiu sarnple are, on average, abolit ten percent as

large as the US firms in the widely tised Forbes sarnple. So, examining the Canadian data

provides an opportunity to determine whether or not the widely docimented empirical

regiilarities regarding managerial pay schemes hold for relatively small Brm as well.

The execiitive compensation data used in this stiidy are the first piiblicly available

data that cover al1 Çrns whose shares were piiblicly traded on the Toronto Stock Ex-

change (TSE) in fiscal years 1993 or 1994. Discussion in this paper fociises on the

2.1 INTRODUCTION 57

compensation of chief executive officers. Section 2.3 examines the relat ionship between

CE0 pay and h m size. It is found that CE0 eamings from direct compensation increase

by about 0.25 percent for every one percent increase of the firrn's total assets or sales.

This elasticity is surprisingly close to that identified in previoiis stiidies with large US,

Japanese, and UK h s . Table 2.1 summarizes the major findings of this chapter in

cornparison with the evidence dociunented in some representative earlier stiidies. I t has

been a piizzling phenornenon that the elasticity changes little across time, industries, and

countries. Given the siibstantial difference in firm size between the Canadian sample and

those of previoiiç stiidies, this finding makes the iinifonnity of the fîrm-size elasticity of

CE0 compensation even more puzzling: it also holds for miich s m d e r firms.

Section 2.4 disciisses the pay-performance relation. With the widely iised Linear sen-

sitivity measiire that linlis changes of CE0 pay with changes of shareholder wealth. 1

estimate a sensitivity of 0.00018 with CE0 direct compensation. When CE0 stock hold-

ings and options are incliided, the sensitivity increases to 0.00355. Siich a sensitivity

means that for every $1000 change in shareholder wealth, CEOs7 earnings change by

$3.55. This residt is qiialitatively similar to those of earlier stiidies: CE0 compensation

is positively related to firm performance, but the pay-performance lidcage appears to

be weak. As shown in Table 2.1, the sensitivity (based on ~al~aryiboniis or total corn-

pensation including options and stock holdings) is notably larger than that for US and

Japanese firms. Because the pay-performance sensitivity is inversely related to firm size

(see Garen, 1994; and Schaefer, l995), this difference reflects the siibstantial difference

in fim size bet~veen the Canadian sample and the US and Japanese samples.

Some novel findings are also docilmenteci. First, options and stock onmership tend

to play a relatively more important role for CE0 incentives in small &m. And second'

while CE0 turnover probability is, in general, negatively related to the firm's stock

3.2 THE DATA

performance, the threat of dismissal is Iess pronounced in small firms.

2.2 The Data

The C E 0 compensation data are compiled £kom the firms' corporate pr0.q state-

ments fileci with the Ontario Seciirity Commission and mailed to shareholders. Since

October 1993: ail companies publicly traded in Ontario have been reqiiired to disclose

the payments to their CE0 and their other four most highly paid execiitive officers.'

The data cover dl companies that siibrnitted corporate proxy statements during October

1993 to Jiùy 1995, with most firms' reporting executive compensation for two conswiitive

years. Becaiise firms are reqiured to disclose execiitive compensation for both the ciment

fiscal year and the last two previois years, the sarnple contains execiitive pay data for

fiscal year 1991 through 1994. A total of 939 firms are incliided in the sample. among

which 778 have at least two years' data (see the appendiw for a list of firms). Thoiigh

the sarnple is based on the firms siibject to the Ontario regiùations, most large Canadian

companies are piiblicly traded on the Toronto Stock Exchange. Based on the Financial

Post fhn ordering, more than 90 percent of the 300 largest Canadian firms (by either

total assets or sales) in fiscal year 1993 were traded on TSE. The compensation data

incliide 98 percent of TSElOO h s and 91 percent of TSE300 &m. So the companies

in our sample have a reasonable representativeness of large Canadian hms.

The disclosure reqiiirements imder the Ontario regdation are ver). simila to the US

disclosiire d e s that reqiUre corporations to detail total execiitive compensation in sev-

eral tables with a standardized f ~ r r n a t . ~ There is a variety of components of executive

remuneration. Ciment cash payments are reported, dong with stock options (and stock

lExecutives apart From CEOs who earn less than $100,000 (Canadian) a year in salary and bonus are exempt from disclosiire.

*Se Laughren (1993) for a brief summary of the disclosure reqiiirements.

2.2 THE DAT4

appreciation rights) , grants of restricted stock imits, long-term incentive plan payoiits,

and fiinge benefits? Indirect-pay related earnings reported in pro- statements include

stock gains from exercising previoiisly rewarded stock options and stock holdings of direc-

tors (in most cases a CE0 is also a director). Becatise the disclosure rides reqillre fmm to

provide only the current year's information on execiitive stock gains and directors' stock

ownership, the data of these hÿo items are only available for fiscal years ending 1993 and

1994. There is also no information on the relevant stock market price, exercise price and

expiration date for options granted in previous fiscal years, which is needed to estimate

the Vitliie of option grants. Sol disciissions concerning stock ownership and options will

focus on fiscal year 1993 and 1994.

In a broad sense, the components of CE0 compensation c m be classified into Eoir

categories: salary, bonus, long-term incentive rewards, and benefits. Salary is the major

component of execiitive pay in Canadian h. Bonis is the anniid variable cornponent

of remuneration or short-term incentive pay. Long-term incentive rewards contain three

i terns: options, restricted shares, and Long-term incentive plan payoiits. Table 2.2 de-

scribes the niunbers of firms that adopted different incentive plans by the end of fiscal

year 1994. Anniial bonuses and option gants axe the two most important schemes that

are cornrnonly used, particularly, in large firrns. Among TSE300 firms. about 94% had

an annital boniis plan and had iised stock options in compensating their execiitives. Ben-

efits incliide all other payments that can not be adeqiiately reported imder any above

pay components, siich as payments for life insurance, contributory pension plan. impiited

interest benefits for debt, tax subsidy, car and hoiising allowance, etc. Excliiding par-

tial compensation due to turnover, firm reorganization, fiscal year change, and part-time -- - - - -

3Stock appreciation rights d o w an employee to realize the appreciation in value of a specified nimber of common shares withoiit req~iiring the employee to make a cash investment in the stock or caiising dilution of the employer's shareholder eqiuty. A long-tenn incentive plan provides compensation intended to serve as incentive for performance to occiu over a period longer than one financiai year.

2.2 THE DATA

service,' the compensation data contain 830 firms for a total of 2472 observations.

Financial data are obtained from the Disclosure tape of Financial Post data files.

Table 2.3 summarizes selected statistics of CE0 pay and h variables. As s h o m in the

table and by Figure 2.1, the distribution of firm size is highly skewed to the right.' For

example, the smple mean of fimi sales is more than six times as large as the sample

median. The distribution is even more skewed when based on total assets. Because of this

featiire of the data, and given the observation fkom earlier stiidies that the responsiveness

of execiitive pay to f k n performance changes markedly nith fùm size, the disciission of

the pay-performance relation in Section 2.4 will highlight the difference between large

6rms and s m d firm.

In the firms' proxy statements all components of execritive compensation except stock

options are reported in values. The value of options shown in Table 2.3 is the s im of the

ex ante value of ciirrently granted options estimated by the Black-Scholes (1973) f omda

and stock gains from exercising previoitsly awarded options. Figure 2.2 presents the

distribution of C E 0 total pay incliiding options for fiscal years 1993 and 1994. The pay

distribution is also skewed, thoiigh not as strong as that of firm size. In these turo years

CEOs earned a total of $708,000 on average while the median CE0 earned $319.000.

The statistics of the pay variables show that salary is the most important pay corn-

ponent of direct CE0 compensation (which excliides options): on average, s a l q con-

stitutes 76% of to td direct pay. The next important component is a m i d boniis which

contributes about 19% of total direct pay. This is close to what firms often report: anniid

bonus is set at roughly one third of base salary6 Stock options have become increasingly

"here are some small firms wbich do not have a fidl time chef execiitive office and the service of siich a position is provided by an executive from another Company on a part-time basis imder certain inter-company employment contract.

'The true distribution of firm size is more skewed than that is showm by Figue 1 because, for the convenience of presentation, the horizontal axis is not evenly scded.

6~siially, there is a performance target t hat has to be met for execiitives to receive a bonus. Among

2.2 THE DATA 61

important in executive compensation in recent years, whose value, based on the sample

mean, is about 15% of total direct compensation.

Figures 2.3 and 2.4 illustrate the relationship between the composition of CE0 pay

and firm size for fiscal years 1993 and 1994. As shown by Figure 2.3, ail pay components

are higher in larger £hm, and there is obviously a strong positive correlation between

firm size and CE0 total compensation. It is interesting to notice that the role of different

pay components tend to be different among h s of different size. This is illiistrated in

Figure 2.4. As firm size increases, salary consistently becomes less important. For the

bottom 25% of firms, the percentage of salary and incentive pay (bonus, stock options,

and long-term incentive pay) in total compensation is aboiit 76 and 18 respectively. The

percentage becomes 52 and 44 for salary and incentive pay, respectively, for the top 25%

of £inm. Because the portion of long-tem incentive payments is negligible, Figure 2.4 also

siiggests that stock options tend to be relatively more important than other components

of incentive pay in smaller firms.

Two things need pointing out here about the sample of this chapter relating to that

tised in Chapter 1. First, the sarnples are both from the period of 1991-1994. Becaiise the

fociis of this chapter is the Canadian evidence of the general relationships between C E 0

pay, firm size and corporate performance, differences in pay schemes between different

years are ignored in this ~ h a ~ t e r . ~ Second; the sample of this chapter also incliides the

firms that do not have complete information on stock performance which is needed in

Chapter 1 where the fociis is the linkage between C E 0 pay and shareholder wealth.

the firms with a bonus plan, aboiit 30 percent, each year, did not grant a bonus to their CEO. ' ~ t can be easily verified that the estimate of the pay-performance sensitivity changes from year

to year. Many factors incltiding stock market fluctuations rnay play a role. While the strategy that assumes a constant pay-performance sensitivity over certain period of time may have an iintriviai effect on the test, it is widely adopted in the literatiire of execiitive compensation for simplicity and discussion convenience.

2.3 CE0 PAY AND FIRM SIZE

2.3 CE0 Pay and Firm Size

Executive Compensation bas attracted considerable piiblic attention and academic

interest because of both the magnitude of pay and its relation to corporate performance.

Early stiidies of managerial pay schemes focus on the determinants of pay level, par-

ticdarly, the role of firm size on CE0 earnings. According to the allocation theory of

control, "in a market eqiiilibrium, the most talented execiitives occupy top positions in

the largest firms, where the marginal prodiictivity of their actions is geatly magnifieci

over the many people below them to whorn they are linked." (Rosen, 1992, p182) This

provides the theoretical groimd for a positive relationship between execittive pay and firm

size. Evidence has b e n reported that iuianimously supports a strong positive pay-size

relation (see, e-g., Roberts, 1956; Cosh, 1975; hIiirphy, 1985; and Kostiuk, 1989).

1 use the widely employed elasticity specification to examine this relationship, which

takes the following form:

where siibscript t denotes fiscal year. To be consistent with previoiis stiidies, CE0 total

direct compensation excliiding stock options is iised as the dependent variable. Firm

size is iiçually proxied by either total assets and sales, and so, both are examineci in

regressions. Firm-size elasticity of CE0 pay is estimated by b. Retiun denotes annual

rates of retiirn. The effect of performance on CE0 pay is captiued by semi-elasticity c.

To take into account the debate on the choice of firm performance measiues in siich a

test, three often discussed rates of return axe iised; the accounting retiini on total assets,

retiini on equity, and the market return on common stock.$

8~ccoiuiting retirn on assets (ROA), retiini on eqiiity (ROE), and market retirn to common stock (RTS) are defined as foilows:

2.3 CE0 PAY AND FTRn/I SIZE

Table 2.4 presents the estirnates of fim size elasticity of CE0 total pay. Coliimnç 1

to 3 of Panel A report the OLS estimates of the total assets elasticity and Columns 4 to

6 report the estirnates of sales elasticity. The estimate is very robtist to the size variable

and to the choice of ret im Mnables, indicating ~manimously an elasticity of about 0.25.

For every ten percent increase in either total assets or sales, the total compensation paid

to the average CE0 increases by 2.5 percent. This resiilt is very close to the finding of

many previoiis stiidies that identiS a firm size elasticity between 0.2 to 0.3 for large USI

UK, and Japanese f i r m ~ . ~ To accoimt for a possible difference in the elasticity between

large fhx and srnall firms, the mode1 was reestirnateù by dividing the total sample into

large firms and s m d firm according to total assets or sales. Biit little difference is foimd

in the elasticity between small firms and large firms.

After reviewing the evidence doc~imented by previoiis stiidies, Rosen (l992. p 186)

concliides that 'The relative iiniformity of the elasticity of execiitive pay with respect

to scale across h m s , indiistries, coiintries, and periods of time is notable and ptuzling

becaiise the technology that siistains control and scale shoidd vary across these disparate

after-tau income to total assets ROA =

(toal assets + total assests- l)/2 '

after-tax income to common equity ROE =

(comrnon eqiuty + common eqiiity, 1 )/2 '

stock price - stock price- 1 + dividends RTS =

stock price-1

Siibscript '-1' denotes previoiis-year valiles. Following Leonard (1990), after-tax income to total assets is cdcdated as "net income i interest expenses x (1-tax rate)", and after-tau income to comrnon equity is calcidated as "net income - minority interest income - preferred dividends paid."

'For example, with CE0 salary and bonus data for 73 large US corporations over the 1969-1981 period, Kostiuk (1989) obtains an estimate of sales elasticity of abolit 0.24. Exarnining a Forbes sample over the 1970 through 1990 period, Joskow and Rose (1994) estimate a sales elasticity of C E 0 total compensation of about 0.28. Baker, Jensen, and Murphy (1988) give a simmary of sales elasticity changes over time and cross firm for large US cornpanies. Similar residts are aIso reported for UK and Japanese firms (see Cosh, 1975; and Kaplan, 1994).

2.3 CE0 PAY AND FIRn/I SUE

units of cornparison." Given that the average fmn size of the Canadian sarnple is sub-

s tant idy s m d e r than those of other studies, the above resiilts make the iuiiformity of

the elasticity even more plizzling: it also holds for miich smaller firms.

Panel B presents the regressions with fkn hed-effects being controlled. The esti-

mates are close to the OLS estimates though sales elasticity is notably smder . This

difference seems to suggest that the sales elasticity is overestimated with OLS estima-

tion. Kowever, becaiise the time series of the data are short and the fit of the fiued-effects

regressions is poor, it is difficdt to draw a conclusion with these residts on the difference.

In both Panel A and B, ail coefficients on rates of retiun are positive. Althoiigh

the magnitude and significance level of the estimate vary among the regressions with

different retirn variables, the sign of the semi-elasticity of CE0 pay with respect to 6rm

retum is robiist, consistently indicating a positive relationship bet-ween CE0 pay and k m

performance. I'U leave detailed discussions of the pay-performance relation to the next

section where I fociis on the responsiveness of CE0 eamings to corporate performance.

A firm-size elasticity larger than zero and smaiIer than imity siiggests that C E 0 pay

increases with firm size at a decreasing rate. In other words, there exists a negative

relationship between h size and CE0 relative pay. WXle this phenornenon has long

been realized, it has caiight little attention from the empirical stiidies of eseciitive com-

pensation. To obtain a direct estimate of this relation, I also estirnate the mode1 with

log(CE0 relative p l ) as the dependent variable. CE0 relative pay is defineci as the

ratio of CE0 total pay over the firm's market value, which gives a reasonable pro.xy of

the CEO's relative importance in a hm.

Table 2.5 presents the regression residts. As expected, the size elasticity of CE0

relative pay is negative in all regressions. The estimates indicate that for every 10 percent

increase in total assets, C E 0 pay relative to the hm ' s market value decreases by about

2.4 CE0 PAY AND CORFORATE PERFOMANCE 65

5.3 percent. The decreasing rate is surprisingly large. For example, for a fkm with

total assets of $10 million and an asset retiun of 5 percent, the relative pay is 0.012;

when the firm's assets rise to $10 billion, the relative pay drops to 0.0003. The public

debate and academic stuàies have extensively explored the linkage between execiitive pay

and 6n-n size, focusing exclusively on the magnitude of top executives' compensation in

large companies. Biit the other side story has essentidy been ignoreci: the portion of

executive earnings declines dramatically as firms grow. Behind this observation there may

be fimdarnental issues related to the structure and efficiency of the firm7s organization

and the match between managerial cspability and the firm's complexi5. While this paper

does not airn to provide an explmation for this observation, it is nevertheles noteworthy

that the relative importance of top exectitives changes inversely with firm size. As argiied

in the next section, this fact may offer some insight to the seemingly small magnitiide of

the pay-performance sensitivity of managerial pay schemes.

2.4 CE0 Pay and Corporate Performance

The relationship between execiitive pay and corporate performance is the foociis of

the recent literatiire of execiitive compensation. The t heoretical literatiire concerning

agency problems develops optimal contracts that iink an agent's pay to variations in her

performance as a means of aligning the interest of the agent with that of the principal

( s e , e.g., Minlees, 1976; and Holrnstrorn, 1979). Taking the shareholders of corporations

to be the principal and the top execiitives to be the agent, a nimber of empirical stiidies

have been undertaken which investigate the relationship between executive compensation

and firm performance.

There are two main issues concerning the pay-performance relation. One is whether

or not executive pay is positively related to corporate performance. If it is, then a firther

2.4 CE0 PAY AND CORPORATE PERFORMAlVCE 66

issue concerns the extent to which executive pay is tied to corporate performance. Early

studies focus on the first issiie but obtain rnixed results ( s e , e-g., Lewellen and Himtsman.

1970; Masson, 1971; and Ciscel and Carroll, 1980). As Miuphy (1985) points out, the

reason why early stiidies fail to identdjr an unambigiioiis pay-performance relation may be

because the data used is cross-sectional in nature. In addition, the sales-profits debate in

early stiidies complicated the issue because of the multicollinearity between size variables

and performance variables (see discussions in Rosen, 1992). Since the late 1980s, most

stiidies have iised longitudinal data and unanimoiisly identified a positive relationship

between corporate performance and managerial pay. h o n g the representative stiidies

are hliuphy (l985), Coiighlan and Schmidt (1985), Jensen and bhrphy (1990). Kaplan

(1994), and Joskow and Rose (1994).

As it has become a well-established empirical regtdaxity that managerial pay increases

with fum performance, more recent stiiùies fociiç on the second issiie and investigate the

intensity of the pay-performance relation or incentive s trength. Using the Forbes sample

of US CEOs' compensation diiring the years 1974-1986 and taking into accoimt cash

payrnents, option, stock ownership and dismissal-related factors. Jensen and RLixphy

( 1990) estimate a pay-performance sensi tivity of 0.003. This means that C E 0 compen-

sation in the largest US firm increases $3 for each $1000 increase in shareholder vdiie.

The magnitude of this pay-performance sensitivity has been extensively disciissed and

debated in the execritive compensation literatiue. While different arguments have been

put forth to explain the seemingly small sensitivity (see, e-g., Haiibrich, 1994; Garen,

1994; and Mclaiighlin, 1994), there has b e n no agreement that it necessarily confirms

an insensitive pay system for the top exectitives of the largest companies.

Wliile disc~issions in this section nriU also be based on the estimate of the pay-

performance sensitivity, 1 will fociis on the qualitative relationship between CE0 pay

2.4 CE0 PAY AND CORPORATE PEWORILfANCE 67

and corporate performance. I k s t examine the pay-performance Linkage in CE0 pay

and then disciiçs managerial incentives associateci wit h execiitive stock ownership and

the threat of dismissal.

2.4.1 Pay-Performance Sensit ivity

There has been little agreement concerning the choices of model specification and

firm performance measures for testing the pay-performance relation. Some favor the

elasticity or semi-elasticity specification (e.g., Joskow and Rose, 1994; and Brian and

Liebman, 1997), while others prefer the anthmetic specification that links, in a linear

fahion, changes of CE0 wealth with changes in shareholder valiie (e-g., Jensen and kliu-

phy, 1990; and Hubbard and Palia, 1995). Also, some argue that the hm ' s performance

shoidd be measured by stock valiie becaiise i t reflects shareholder wealth, but others

contend accoiuiting performance measures are usefid because they are less affected by an

iuicontrollable market environment and hence are more informative concerning manage-

rial contribution (see Rosen ( 1992) for a review). Thoiigh different model specifications

and performance measiires often lead to qiiite different estimates of the performance-

related coefficierit, they ail reveal a statisticaily significant: positive pay-performance

relation.

Follonring some recent stiidies, 1 iise the arithmetic specification proposed by Jensen

and Mtirphy (1990) becaiise of its straightfomard interpretation,

A(CE0 Pay), = a + 0 A (Shareholder WeaIth)t + y A (Shareholder Wealth),-, . (2.2)

The independent variables are changes in shareholder wealth which are defined as the

product of the rate of r e t im on comrnon stock in a year and the h ' s market value at the

beginning of the year. A lagged term is included in the model to dlow past performance

2.4 CE0 PAY AND CORPORATE PERFORI1fANCE

to also have an influence on current c~mpensation.'~ The dependent vanable is changes

in CE0 pay. Three measures of CE0 pay are examineci. They are salary plis bonus.

total direct pay, and stock options.

Table 2.6 reports parameter estimates for the specification above. Column 1 presents

the estimates when the dependent variable is the change in CE0 salary and boniis. The

coefficients on the current year's and the previoiis year's change of shareholder wealth

are positive and statistically significant at the one percent level. The total sensitivity is

0.00011 which is the siun of these two coefficients on the performance measiires. That

is, for every $1000 change in shareholder wealth, the total salcuy plis boniis paid to the

average CE0 increases by 11 cents. Column 3 reports the resiilt with total direct pay.

When stock iinits, long-term incentive plan payoiits, and varioiis benefits are incliided.

the sensitivity increases to 18 cents for every $1000 change in shareholder wealth. These

nimbers are consistent with many previoiis reports that CEOs' eaniings are tied to

corporate performance, but that the linkage appears to be very weak.

These estimates, 11 cents and 18 cents per $1000 for salary plus boniis and total

pay respectively, are miich larger than the corresponding ones. 2.3 cents and 3.3 cents-

estimated by Jensen and Miirphy (1990) for US firms with the Forbes sample diuing

the period of 19741986. There are two factors contributing to this differerice. First, as

indicated by Joskow and Rose (1994) and Hall and Liebman (1997), CE0 compensation

in large US firms has become significantly more sensitive to firm performance since the

1970s. With the Forbes sarnple for the later period 1986-1990, Schaefer (1995) estimates

a sensitivity about three times as large as that of Jensen and Miu-phy. Second, and more

importantly, the pay-performance sensitivity is inverseiy related to firm size (see Garen,

' ' ~0 th Jensen and Murpliy (1990) and Joskow and Rose (1994) confinn a significant influence of t, he firm's previoiis year's performance on CEO's ciment compensaiton.

1994; and Schaefer, 1995). Because the average hxn size for the Canadian sample is much

smaller than that for the US sample siuveyed by Forbes magazine, part of the difference

in the pay-performance sensitivity shodd be explained by h - s i z e ciifferences.

To capture the effect of firm size on pay-performance sensitivity. the total sample is

divided into large firms and s m d firmç at the sample mean of sales and a dummy variable

for large firms is included in the model. The median and mean sales for large firnis are

$773 million and $1.87 billion respectively. For s m d firms: the median and mean are $84

million and $98 million respectiveiy. Coliirnns 2 and 4 report resiilts when a large-firm

diimmy variable is included. As expected, the sensitivity is significantly s m d e r for large

fkms than for s m d firms. The sensitivity from total direct pay is 83 cents for s rnd firrns

but only 14 cents for large firms. This residt verifies the negative relationship between

f3-m size and pay-performance sensitivity. It is interesting to notice that the sensitivity

of large fimm is miich closer to the total sample sensitivity. This siiggests that large h s

tend to play a dominating role in the total sarnple estimation.

The test with stock options is presented in Coliunn 5 and 6. The sensitivity for the

total sample is $1.67 per $1000 change in shareholder wealth which is about 9 tirnes

as large as that from direct p . This difference is much larger than that obsenred for

US firms; Jensen and hfiirphy (1990) and Hubbard and Palia (1995) show that the pay-

performance sensitivity of stock options is three to four times as large as that of total

direct p . This observation seems to siiggest that stock options play a larger role in

incentive pay in smaller firms than in larger firms. This conjectiire is siipported by the

results in Column 6. While the sensitivity £rom stock options is 0.00151 for large £hm,

which is about 11 times as large as that of direct pay, it jiimps to 0.01254 for small firms

which becornes 15 times as large as that of total direct pay. This residt is also consistent

with the evidence in Figure 2.4 that CE0 earnings from stock options plus long-term

2.4 C E 0 PAY AND CORPORATE PERFOIZhIANCE 70

incentive pay is relatively more important than bonus payments in srnaller k m s .

2.4.2 CE0 Stock Ownership

The incentive problem exists because of the separation of ownership and management.

A natural way to mitigate this problem is to increase CEOs' holdings of their firm's

stock shares. Though executive stock ownership is not iisiidy dictated by the board of

directors, the h ' s compensation strategy of rewarding stock iinits and options certauily

has a direct impact on execiitive stock holdings. According to Jensen and Murphy (1990)'

the incentive intemity of CE0 stock ownership in terms of pay-performance sensit ivity

is abolit eight times as high as that of direct payments. Examinhg the elasticity of C E 0

pay with respect to stock performance, Hall and Liebman (1997) even concliide that

managerial incentives are almost entirely from stock ownership. It has been a consensus

in the execiitive compensation literatiire that stock ommership plays the most important

role in mo tivating top executives.

The data on CE0 stock onmership are from the firm' reports of stock holdings

of members of the board of directors for fiscal years ending 1993 and 1994. Because

some CEOs are not directors (thoiigh in most cases they are), these data may slightly

overestimate CEOs' stock holdings; i.e. non-director CEOs who are excliided from the

sarnple are expected to hold Iess stock shares.

Changes of C E 0 wealth frorn stock ownership are perfectly correlated with changes

in shareholder wealth. Hence, the percentage of a firm's total shares outstanding that are

owned by CE0 gives a direct estimate of the pay-performance sensitivity associated with

stock ownership. Table 2.7 siunmarizes the related statistics of CEOs' stock holdings.

The fUst row shows the percentage for the total sample. The CEOs oan an average of

2.89 percent and median of 0.17 percent of their hm ' s stock. In other words, for every

2.4 CE0 PAY AND CORPOUTE PER.FORn/IANCE 71

$1000 hcrease in the h m ' s stock valueo CEOs' wealth £rom stock ownership increases by

$1.7 when she holds a median percentage of her b ' s stock.

The distribution of the stock holding percentage is also skewed. This reflects the

skewed firm size distribution and the fact that CEOs of larger fim hold a smaller

portion of their firm's stock. The second and third row of Table 2.7 verifj- the negative

relationship between fùni size and CE0 stock ownership. While CEOs of 6rms larger

than the sample median hold an average of 1.49 percent of their fim's stock. those of

h m smaller than the sample median hold an average of 4.3 percent. This difference is

miich larger when compared based on the median percentage.

Including total cash pa-nents, options. and stock ownership (median). the above

residts give a total sensitivity of $3.55 for every $1000 change in shareholder wealth for

the total sample. The sensitivity is $2.15 for large firms and $25.57 for srnall firms. A

typical e>cplanation for the negative relationship between the sensitivity and fimi size is

that it reflects a shift of the pay scheme from incentives to insiirance as a response to

a higher output iincertainty of larger fi- (Garen, 1994). The observation that CEOs'

relative contribution decreases with hm size (Table 2.5) may also partly esplain the

negative relationship between the pay-performance sensitivity and firm size. Becaise

CEOs contribute relatively less in larger Enns and because firm performance miist be

balanced with total ernployee contribution, a sensi tivity that Links a CEO's indiviciiial

pay with the h m ' s aggregate performance is boimd to be smaller in iarger fhns.

2.4.3 CE0 Turnover and Corporate Performance

The £inal component of the pay-performance linkage 1 examine is the threat of dis-

missal. The hypothesis behind the dismissal incentiw scheme is that, a change in a

h ' s chef execiitive officer is more likely to occiir after bad years than after good years.

2.4 C E 0 PAY ,4ND CORPORATE PERFORlbIANCE m / 2

1 use probit regression to test the negative relationship between the probability of CE0

turnover and the firm's stock performance: "

where the dependent variable is dichotomoiis, having a value of one when a CE0 turnover

occtirs and a value of zero otherwise. The model estimates the latent variable of CE0

turnover probability (a + Retuml + y - R e t ~ u n ~ - ~ ) which is the standard normal

distribution h c t i o n . The independent vaiables are the firm's market retiirn net of the

retiini to the TSE300 index."

The information on C E 0 timover is directly available Erom the firm's p r o - state-

ments. But for the firmç that changed CE0 at least twice (in different years) and hired

a nea 930 from the market instead of interna1 promotion, the information for 1991 and

1992 is generally incomplete, because these firms usiially do not reveal previoiis turnover

information in their disclosiue dociunent for the current fiscal year. However. becaise

the nimber of siich fimis is small and this incomplete information does not came a Sam-

ple selection problem, al1 four years' (1991-1994) data are incliided in the test. l 3 CE0

turnover can occiir a t any time during a year. It is reasonable to link the performance

impact on turnover with the CE07s previous Ml years' service. So a turnover is recorded

whenever the CE0 senres her last full fiscal year.

Column 1 in Table 2.8 presents the resdts with the base specification. Consistent

"Some studies (e.g., Coughland and Schmidt, 1985; and Jensen and Miuphy, 1990) iise logit regression to test the relationship between management turnover probability and firm performance. Since estirnates in siich a test are quite close between logit and probit rnodels and the choice of the model is risiiaily discretional, 1 use probit regression for presentation convenience (it gives t-statistics and R2, consistent with the reports of other estimates).

121 compared the resiilts between tising the firm's stock rettirn and u ing the net-of-market retiirn. Little difFerence was foiind between the two choices, though the estirnates are slightly irnproved when net-of-market retum is used.

13The estirnates are only slightly different when the data of 1991 and 1992 are excliided.

2.4 CE0 PAY AND CORPORATE PERFOMANCE 73

with previous studies, the coefficient on the net-of-market return to cornmon stock is neg-

ative, confirming that a £km's stock performance and the probability of a change in CE0

are inversely related. The estimate is marginally significant. The explanatory power of

the regression, however, is low. The residt is slightly improved in Coliunn 2 where the

previous year's retuni is included. To illustrate the performance effect on CE0 tiunover

probability, consider a firm that has a return eqiiai to TSEJOO index re t~un for two consec-

iitive yews. The turnover probability, calculateci as (-1.19 - 0.063 x O - 0.013 x O), is

0.117. It rises to 0.1247 when the firm eams a -50 percent net-of-market retint for two

consecutive years. Given the siibstantid change in fhrn performance. the corresponding

change in turnover probability is very small. On the other hand, since the definition

of CE0 tiirnover does not distingillsh a disciplinary leave from a non-disciplinary leave

(due to normal retirement or job switching) , these incent ive intensity es tirnates are best

viewed to be lower boirnds.

It is possible that the threat of dismissal for managers is different among h s of

different size. With the wide distribution of firm size, the Canadian sample provides a

good opportiinity to address this issue. Colimn 3 and 4 present resiilts when a d i m y

variable for firms that have a size larger than the sample median is incltidecl in the

model.14 The resiilts are iuiexpected but interesting: the impact of firm performance on

CE0 turnover is more evident in large firms. For small firms, the coefficients on retiun

variables are s m d and insignificant, though still negative. The large magnitude and

high significance levei of the coefficients on the dummy variable indicate a much stronger

dismissal-performance relation in large firms. Table 2.9 presents some point estimates of

the probability of CE0 tiirnover based on the results of Coliunn 2 and 4 in Table 2.8.

14The number of observations in Column 3 and 4 is reduced because of missing financiai data from some firms that are needed to identify finn size.

2.4 CE0 PAY AND CORPORATE PERFORMANCE

The estimates indicate that the probability of CE0 turnover in small fums is almost

inva,riant to b performance. But for large 6mis, the performance effect is qiiite strong.

For example, after a firm e m s a net-of-market r e t i m of -50 percent for two conseciitive

years the CE0 is about three times as Iikely to leave the h m as when the firm earns 50

percent above the market retim.

This observation seems inconsistent with the finding of Jensen and Murphy (1990).

With the Forbes sample of US k m s they obtain an iipper-boimd estirnate of the dis-

missal related sensitivity of 52.25 for smail firms but rnerely 5 cents for large h n s per

$1000 change in shaxeholder wealth.15 These estimates imply a miich stronger nega-

tive dismissal-performance relation in s m d firms. While it is possible that the effect

of fkn performance on CE0 turnover probability does not change monotonically with

firm size, the large difference between large h s and small Ei.rms in opposite directions

is siiiprising.

Because luge Canadian firms are more iikely to be piiblicly traded in the United

States and then are more iduenced by the US managerid labour market. the residts for

Canadian fkm may reflect a generally greater job sectirity in Canadian firms than in US

h s . This conjecture is natural, given that in the Canadian sample abolit 74.5 percent

of large 6rms (larger than the sample median) and 27.1 percent of small firrns were traded

in the United States before 1991, and that the estimates for large Canadian firms are

qiiite similar to the US resiilts ( s e , e.g., Table 4 in Jensen and Miirphy). To clarify this

issue, the regression of Coliunn 4 in Table 2.8 is estimated, separately, for fimis that

15The iipper-boiind estimate of the dismissal related sensitivity is estimated as the following. The point estirnates of CE0 turnover probability are obtained by assuming the h earns the market rate of retirn for two years versirs when the firm realizes r e t i m 50 percent below the market in two conseciitive years. Assume that the CE0 wiU never work again if dismissed but will work for his fkm until age 66 if not dismissed. Then the expected wealth l o s of the CE0 due to dismissai is the present value of her potential earnings from the year of dismissal to retiring age 66. The àismissal performance sensitiviw is obtained by dividing the CEO's potentid wealth loss by the shareholder loss associated with earning 50% percent below-market r e t i n s for two years.

2.5 CONCLUSION 75

were traded in the United States before 1991 and for those that were not. Thoiigh the

difference between large h s and small h s does become smaller, the qiialitative result

remains unchanged.

2.5 Conclusion

This chapter has provided the first systematic evidence on the relationship arnong

CE0 compensation, firm size. and corporate performance for Canadian companies. The

evidence is consistent with, and large- similar to, the hdings of previous stiidies for

other countries, partic~ilarly the United States: CE0 pay rises with hm size and com-

pensation is tied to Company performance. The similarity in CE0 compensation between

Canada and the United States is not surprising, because "given the e'rtensive economic

(e-g., trade) and institutional (e.g., corporate, labor iuiion) linkages that have developed

between Canada and the United States at both the macro and microeconomic levels,

we rnight reasonably expect significant cross-national influences on compensation prac-

tices." (Chaykowski and Lewis, 1996, p2).

As the first empirical analysis of execritive compensation for Canadian firms. this

chapter has fociised on the evidence parallel to those doclunented by previoiis s tiidies,

althoiigh references have Freqiiently been made to eariier findings. There are impor-

tant issues concerning the Canadian execiitive compensation system imaddressed in this

chapter. For example, how are managerial pay schemes in Canada different from those in

other countries, particidarly, in the United States? Given a nimber of institutional and

market differences between Canada and the United States, the pay systems and their

effectiveness are evpected to be different . Becaiise sample heterogeneity iisiially plays an

important role in an inter-sample cornparison, s~ich an issue can be properly addresseci

with more comparable samples.

Table 2.1 A Brief Cornparison of the Evidence

- - -- - --

U S . Japan Britain Canada

Sales elasticity of CE0 pay 0.282* 0.247*** 0.26 I **** 0.247

Pay-performance sensitivity with CE0 salary+bonus (x 1 O-')

Pay-performance sensitivity with CE0 pay, options, and 2.950** - - 3-55 1

stock holdings (x 1

* Sales elasticiiy of CE0 total compensation for the Frobes sarnple over the years 1970- 1990 (Joskow and Rose, 1994).

** Pay-performance sensitivity for the Forbes sample over the years 1974- 1986 (Jensen and Murphy, 1990).

*** Sales elasticity of per director (as a proxy for the president) salary+bonus and pay-performance sensitivity of per director salary+bonus, respectively, for the Japanese companies From the Fortune sample of foreign industrials in 1980. The pay data are from the 1982 and 1984 Yuka Shoken Hokokurho (Kaplan, 1994).

**** Sales elasticity of CE0 cash compensation for British firms during the years 1969- 197 1. The data are fiom Department of Trade and Industry's standard Company accounts (Cosh. 1975).

Table 2.2 Nurnber of Firms with Different Incentive Plans - - - - - - - - - -- - - - -

Incentive Plans Total

Bonus Options LTIP

Al1 firms 664 8 17 56 945 TSE300 firms 246 247 35 262

- - -

Note: The statistics are fkom the 199 1 - 1994 sample. LTIP denotes long- term incentive pay including grants of restricted shares and long-tenn incentive plan payouts.

Table 2.3 Summary of Selected Statistics

Minimum Median Mean Maximum Observ.

CE0 pay variables ($1000)

Salary Bonus Long-term incentive pay (LTIP) Other payments Total direct pay Stock Options Salary/(Total direct pay) (%)

Bonus/(Total direct pay) (%)

LTIPf(Tota1 direct pay) (%) Other/(Total direct pay) (%) Options/(Total direct pay) (%)

Firm variables ($million)

Total assets O. 1 1 07 1,92 1 168,248 2,245 Sales 0.1 1 04 659 2 1,065 2,068 Market vaIue 0.7 23 7 797 14,708 1,240 Retum on total assets (%) - 1,583 3 2 -1.4 1,053 2,199 Return on equity (%) -2,404 0.5 5.1 1 0,305 2,100 Return to cornmon stock (%) -97.5 1 0.5 55.7 19,400 1,888

- . -- - - - - -

Note: Al1 variables except stock options are ftom the 199 1 - 1994 sarnple. Stock options are for 1993 and 1994, which includes values of currently granted options estimated by the Black-scholes (1973) formula and stock gains Frorn exercising previously granted options. LTIP includes gants of restricted shares and long-term incentive plan payouts. Total direct pay includes ail pay components except options.

Table 2.4 Firm Size Elasticity of CE0 Total Pay - -- -. --

Dependent Variable: log(Tota1 Direct Pay)

(Total assets elasticity) (Sales elasticity) Independent Variables

(1) (2) (3 (4) (5) (6)

A. OLS Estimation

Intercept

log(Totat Assets)

Return on Assets

Retum on Equity

Return to Common Stock

R2

Observations

Fixed-effects Estimation

log(Tota1 Assets)

Retum on Assets

Return on Equity

Retum to Common Stock -

- - -

Note: The data are from the 199 1 - 1994 ~ample. t-statistics are in parentheses.

Table 2.5 Firm Size Elasticity of C E 0 Relative Pay

Dependent Variable: Iog(Tota1 Direct Pay/Firm Value) --

(Total assets elasticity) (Sales elasticity)

Independent Variables ( 1 (2) (3 1 (4) (5 ) (6)

A. OLS Estimation

Intercept

log(Tota1 Assets)

Return on Assets

Return on Equity

Return to Common Stock

R2

Observations

B. Fixed-effects Estimation

log(Tota1 Assets)

Iog(Sa1es)

Return on Assets

Return on Equity - -0.195 - (-4.2)

Return to Common Stock

Note: The data are from the 199 1 - 1994 sample. t-statistics are in parentheses.

Table 2.6 Pay-Performance Sensitivity (OLS estimation)

Dependent Variables

Independent Variables a(Salary+Bonus) total Direct Pay) ~(Options)

Intercept

LARGE

LARGE x ~(Shareholder Wealth) x 1 O-3

a(Shareho1der Wealth) -, x 1 O-'

LARGE x

~(Sharehoider Wealth) -, x 1 O-3

R'

Observations

- - - ..

Note: The data are from the 199 1 - 1994 sample for regressions with saIary+bonus and total direct pay, and are fiom the 1993-1994 sample for regressions with options. LARGE is a dummy variable that equals one for f ims with average sales larger than the sample median. t-statistics are in parentheses.

Table 2.7 CE0 Stock Ownership

(CE0 shares)/(TotaI shares outstanding) Num ber Obser- of Firms vations

Minimum Median Mean Maximum

Al1 F h s

Large Firms

Srnall Firms

Note: The data are fiom the 1993-1994 sample. Large firms are those that have averages sales larger than the sample median.

Table 2.8 CE0 Turnover and Firm Performance (Probit estimation)

Independent Variables

Dependent variable: CE0 turnover

Intercept

LARGE

Net-of-Market Retum

LARGEx(Net-of-Market Return)

met-O f-Market Retum)-,

R2

Observations

Note: The data are fiom the 199 1 - 1994 sample. The dependent variable equals one when a CE0 tumover occurs and equals zero otherwise. LARGE is a dummy variable that equals one for firms with average sales larger than the sample rnedian. Net-of-Market Retum is the firm's stock return minus the return to TSE300 index. t-statistics are in parentheses.

Table 2.9 Probability of CE0 Turnover

Probability of CE0 Turnover - -

Net-of-Market Retum AI1 Firms Large Firms SmalI Firms

- - . -

Note: The estirnates of the probability are obtained fiom regression (2) and (4) in Table 2.8. Large firms are those that have average sates larger than the sample median.

Figure 2.1 Distribution of Firm Size

5 40 80 150 250 350 450 560 710 900 1100 1300 1500 1700 1900 21002300 20 60 110 200 300 400 500 630 800 1000 1200 1400 1600 t8OO 2000 2200 2400

Average Sales ($million)

Figure 2.2 Distribution of CE0 Pay

Average CE0 Total Pay ($thousand)

Figure 2.3 Components of CE0 Pay

G Salary a LTIP+Options

i Bonus a Benefits

Figure 2.4 Structure of C E 0 Pay

a Salary

Bonus

a LTIP+Options

m Benefits

1 ........ . . t i I IF.. 1 I I 25 50 75 100

Percentile by Average Sales (%)

Appendix: List of Firms

20I20 Financial Corp A.G.F. Management Ltd ABL Canada Inc ACC Telenterprises Ltd AGT Ltd AJ Perron Gold Corp AQM Automotive C o q ARC International Corp AT Plastics Inc ATCO Ltd ATS Automation Tooling Aber Resources Ltd Abitibi-Price Inc Accord Financial Corp Acklands Ltd A c m a International Inc Adex Mining Corp Adrian Resowces Ltd Advanced Gravis Computer Tech Advanced Material Res Ltd Adventure Electronics Inc Agnico-Eagle Mines Ltd Agra Industries Ltd Ainsworth Lumber Co Ltd Air Canada Airboss of Amenca Corp Akita DriIling Ltd Alarmforce Industries h c Alberta Energy Co Ltd AIberta Natural Gas Co Ltd Alcan Aluminium Ltd Alert Care Corp Algo Group Inc Algoma Central Corp Algoma SteeI Inc Algonquin Mercantile Corp Allelix Biopharmaceuticals Alliance ~ommunications Corp Allied Northern Res Ltd Alpine Oil Services Corp Alta Genetics Inc American Barrick Resources Corp American Econornic Corp American Leduc Petr Ltd Amoco Canada Petr Co Ltd Anchor Lamina Inc Anderson Exploration Ltd Andres Wines Ltd Angio-Canadian Tel Co Angoss Software Corp Applied Inventions Management

Arbor Capital Inc Arbor Mernorial Services Archer Resources Ltd Argus Corp Ltd Armbro Enterprises Inc Arrowlink Corp Ashgrove Energy Ltd Ashton Mining of Canada Inc Asia Minerals Corp Astra Finance Ltd Astral Communications Inc Atcor Resources Ltd Atlanta Gold Corp Atlantis Communications Inc Atlantis Resources Ltd Atlantis Submarines (Internation Aur Resources Inc Aurizon Mines Ltd Avco Fin Serv Canada Ltd Avenor Inc BCBancorp B.C.Pacific Capital Corp BC Gas Inc BC Sugar BC Telecom Inc BCE Inc BCE Mobile Communication Inc BPI Financial Corp Ballard Power Systems Inc Ballistic Energy Corp Band-Ore Resources Ltd Banister Inc Bank of Montreal Bank of Nova Scotia Barrick Gold Corp Barrington Petr Ltd Baton Broadcating Inc Baîtery Technologies Inc Battle Creek Developments Ltd Baytex Energy Ltd Beamscope Canada Inc Bearing Power (Canada) Ltd Beau Canada Exploration Ltd Beaufield Consld Res Inc Bell Canada Berna GoId Corp Bethlehem Resources Corp Big V Pharmacies Co Ltd Biochern Pharrna Inc Biomira Inc Bionaire Inc

Bioniche Inc Biovail Corp International Biron Bay Resources Ltd Black Swan Gold Mines Ltd B Iake River Exploration Ltd B lue Range Res Corp Bombardier Inc Bonar Inc Bone Health Inc Boomerang Resources Inc Bovar Inc Bow Flex Inc Bow Valley Energy Inc Bracknell Corp Brarnalea Ltd Brampton Brick Ltd Brandevor Enterprises Ltd Brandselite International Corp Brascan Ltd Brenda Mines Ltd Brick Brewing Co Bruncor Inc Brunswick Mining & Smelt Corp C-MAC Industries Inc CAE Inc CCL Industries Inc CFS Group Inc CGC Inc CG1 Group Inc CHC Helicopter C o q CML Industries Ltd COGECO Inc CS Resources Ltd CSA Management Ltd CT Finanical Services Inc Cabre Exploration Ltd Cadillac Fairview Corp Ltd Caledonia Mining Corp Calian Technology Ltd Call-Net Enterprise Inc CarnVec Corp Carnbior Inc Cambridge Shopping Centres Ltd Carnco Inc Camdev Corp Cameco Corp Campbell Resources Inc Canada Malting Co Ltd Canada Southem Petr Ltd Canada Tnistco Mortgage Co Canada Tungsten Inc

Canadian 88 Energy Corp Cinar Films Inc Czar Resources Ltd Canadian Angus Resources Ltd Cindy Mae Res Inc D.A.Stuart Ltd Canadian Bank Note Co Ltd Cineplex Odeon Corp DMR Group Inc Canadian Conquest Exploration C inmm L td Dalmys (Canada) Ltd Canadian Foremost Ltd Cintech Tele-Management System Davis Distributing Ltd - Canadian Fracmaster Ltd Circo Craft Co Inc Canadian Frobisher Resources Ltd Clairvest Group Inc Canadian Imp Bank of Commerce Claude Resources Inc Canadian Manoir Ind Ltd Clearly Canadian Beverage Corp Canadian Marconi Co Clearport Petroleums L td Canadian Natural Resources Ltd Cliff Resources Corp Canadian Newscope Resources Ltd Co-Steel Inc Canadian ~cciden'tal Pet- Ltd Canadian Pacific Ltd Canadian Pioneer Energy Inc Canadian Satellite Comm Inc Canadian Tire Corp Ltd Canadian Utilities Ltd Canadian Westem Bank Canadian Westem Natural Gas Canam Manac Group Inc Canbra Foods Ltd Canfor Corp Canhorn Mining Corp Canlan Investment Corp Canrise Resources Ltd Canstar Sports Inc Canuc Resources Inc Canwest Global Comm Corp Capilano International Inc Cam Operations Ltd Carena Developments L td Caribbean Utitities Co Ltd Caribgold Resources Inc Carmanah Resources Ltd Cascades Inc Cassidy's Ltd Castle Capital Inc Cathedra1 Gold Corp Celanese Canada Inc Celltech Media Inc Centra Gas Ontario Inc Central Capital Corp Chai-Na-Ta Ginseng Prods Ltd Champion Gold Resources Inc Champion Road Machinery Chancellor Energy Res Inc Channel Resl Ltd Chase Resource Corp Chateau Stores of Canada Ltd Chauvco Resources Ltd Cheni Gold Mines Inc Chesbar Resources Inc Chieftain International Inc Chum Ltd Cimarron Petroleum Ltd

Cobi Foods Inc Coca-cola Beverages Ltd Cogas Energy Ltd Cogeco Cable Inc Cognos Inc Colortech Corp Cominco Fertilizers Ltd Cominco Ltd Cominco Resources International CompAS Electronics Inc Cornputalog Ltd Cornputer Brokers of Canada Inc Comstate Resources Ltd Confederation Life Insurance Co Conpak Seafoods Inc Consld Canna Corp Consld Eurocan Ventures Ltd Consld Firstfund Capital Corp Consld Mercantile Corp Consld NRD Resources Ltd Consld Ramrod Gold Corp Consoltex Group Inc Consumers Gas Consumers Packaging Inc Continental P h m a Cryosan Continental Precious Minerals Contrans Corp Conwest Exploration Co Ltd Corby Distilleries Ltd Corel Corp Cornucopia Resources Ltd Corpome Foods Ltd Coscan Development Corp Con Corp Counsel Corp Crestar Energy Inc Crestbrook Forest Ind Ltd Crown Butte Resources Ltd Crown Life Insurance Co Crown Resources Corp Crownx Inc Cube Energy Corp Current Technology Corp Cycomrn International Inc

Dayton Mining Corp Dedicated Technologies Corp Denbridge Capital Corp Denison Mines Ltd DeprenyI Animal Health Inc Deprenyl Research Ltd Derlan Industries Ltd Develcon Devrar~ Petroleum Ltd Devtek Corp Dia Met Minerais Ltd Dickenson Mines Ltd Difhcto Ltd Discovery West Corp Dofasco Inc Doman Industries Ltd Domco Industries Ltd Dominion Textile Inc Dominion and Anglo Invt Corp Domtar Inc Donohue Inc Dore1 Industries Inc Dorset Exploration Ltd Draxis HeaIth Inc Dreco Energy Service Ltd DuPont Canada Inc Dundee Bancorp Inc Dundee-PaIIiser Resources Inc Dusa Pharmaceuticals Inc Dylex Ltd Dynacare Inc E-L Financial Corp Ltd Eagle Precision Tech Inc Economic Invt Trust Ltd Eden Roc Mineral Corp Edper Enterprices Ltd Eicon Technology Corp Elan Energy Inc Eldorado Corp Ltd Electrohome Ltd Emco Ltd Encal Energy Ltd Enerfiex Systems Ltd Enerplus Resources Corp Enserv Corp Environmentai Techs Internationa Enviropro International Inc Epic Data International Inc Equisure Fin Network Inc Equity Transfer Services Inc Euro-Nevada Mining Corp Ltd

Evans Health Group Ltd Exall Resources Ltd ExceI Energy Inc Exco Technologies Ltd Export Tyre Holding Co Extendicare Inc FCA International Ltd FPI Ltd FT Capital Ltd Fahnestock Viner Iioldgs Inc Fairfax Fin Holdgs Ltd Falcon Point Resources Ltd FaIvo Corp Federal Industries Ltd Fiducie Desjardins Fiming Ltd Firan Corp Fire River Gold Corp First Marathon Inc Firstservice Corp Flanagan McAdam Resources Inc FIeet Aerospace Corp Fonorola Inc Ford Motor Co of Canada Ltd Foremost Industries Inc Fortis Inc Forzani Group Ltd Four Seasons Hotels Inc Franco-Nevada Mining Corp Ltd Fundy Cable Ltd Future Shop Ltd G.E.F. Management Ltd G.T.C. Transcontinental Group GSW Inc Galtaco Inc Gandalf Technologies Inc Gardiner Oil and Gas Ltd Gaz Metropolitain Inc Geac Computer Corp Ltd Gendis Inc Genecan Financial Corp General Leaseholds Ltd General Motors Accept Corp Gemum Corp Gentra Inc Gesco Industries Inc Gibraltar Mines Ltd Glentel Inc Global Eiection Sys Inc Global Govt Plus Fund Ltd Glyko Biomedical Ltd Go Vacations Inc Gold Reserve Corp Goldcorp Inc Golden Eagle Capital Corp Golden Knight Resources Inc

Golden Rule Resources Goldfarb Corporation Goldhwiter Explorations Inc Goran Capital Inc GowIing, Strathy & Henderson Grad & Walker Energy Corp Grand Oakes Resources Corp Graph/Max Inc Great Lakes Minerals Great Lakes Power Inc Great- West Life Assurance Co Greenstone Resources Ltd Greyhound Lines of Can Ltd Greyvest Fin Services Inc Groupe Laperriere & Veneau. Guardian Capital Group Ltd Guilievin International Inc GuIf Canada Resources Ltd Gulf International Minerais Ltd

Hyal Pharmaceutical Corp Xycrofl Resources & Devei Corp 1.S.G. Technologies Inc [PL Energy Inc :PSCO Inc S M Information Systems Imasco Ltd :mperial Life Imperia1 Oil Ltd :mperiai Parking Ltd .mutec Corp In-Flight Phone Canada Inc 1x0 Ltd 'ndustra Service Corp 'ntensity Resources Ltd nter-City Products Corp ntera Info Techs Corp nteraction Resources Ltd nterlock Consld Enterp Inc

Gu1 fsîrearn Resowces Canada Ltd Intermetco Ltd Gwil Industries Inc H Paulin & Co Ltd H. O. Financial Ltd HCO Energy Ltd HEC Investrnents Ltd Haley Industries Ltd Halozone Technologies Inc Hammerson Canada Inc Harnmond Manufachiring Co Ltd Harbour Petr Co Ltd Hard Suits Inc Harris Steel Group tnc Harrowston Inc Hartco Enterprise Inc Harte Resources Corp Hawker Siddeley Canada Inc Hayes-Dana Inc Hees International Bancorp Inc Helix Circuits Inc Hemlo Gold Mines Inc Hemosol Inc Highridge Exploration Ltd Hillcrest Resources Ltd Hillsborough Resources Ltd Hol-Lac Gold Mines Ltd Hollinger Inc Holmer Gold Mines Ltd Home Capital Group Inc Home Oil Co Ltd Home Products Inc Hongkong Bank of Canada Horsham Corp Household Fin Corp Ltd Hudson Bay Diecasting Ltd Hudson's Bay Co Hy & Zel's Inc

International Aqua Foods Ltd International CoIin Energy Corp International Contour Tech Inc International Curator Resources International Datacasting Corp International Dunraine Ltd International Forest Products International Gold Resources International Innopac Inc International Inter-Link Inc International Mahogany Corp International Musto Exploration International Northair Mines Ltd International Pastel Food Corp International Petroleum Corp International Potter Distilling International Pursuit Corp International Semi-Tech Micro international UNP Holdings Ltd International Venfact Inc Interprovincial Pipe Line Sys Interquest Technologies Inc Intertape Polymer Group h c Intrawest Corp Inverness Petroleum Ltd Investors Group Inc Invin Toy Ltd Island Tel Co Ltd Ivaco Inc Jannock Ltd Jean Coutu Group John Forsyth Co Inc Jordan Petroleum Ltd Jordex Resources Inc Joss Energy Ltd Joumey's End Corp

Joute1 Resources Ltd KaufeI Group Ltd Kelsey's International Inc Kerr Addison Mines Ltd Kinross GoId Corp Koivox Communications Inc LSI Logic Corp of Canada Inc Labatt, John Ltd Lafarge Canada Inc Laidlaw Inc Laird Group Inc Lakewood Energy Inc Lander Downs Larr Capital Corp Laurentian Bank of Canada Le Groupe Videotron Ltee Leadley, Gunning & Culp Internat Leon's Furniture Ltd Liberian Iron Ore Ltd Linarnar Corp Lincoln ~ a p k I Corp Liquidation WorId Inc ive Entert of Canada Inc Loblaw Companies Ltd Loewen Group Inc Logistec Corp London Insurance Group Inc Louvem Mines Inc Luscar Oil and Gas Ltd Lynx Energy Services Corp Lytton Minerals Ltd M-Corp Inc MAXX Inc MDC Corp MDS Health Group Ltd MICC Investments Ltd MPACT Immedia Corp MSV Resources Inc MVP Capital Corp MacDonald, Dettwiler & Ass t td MacMillan Bloedel Ltd Mackenzie Financiai Corp Madison Ave Sports Ntwk Ltd Magna International lnc Malahide Petroleum Corp MaIette Inc Mannville Oil & Gas Ltd MapIe Leaf Foods Inc Maritime Elec Co Ltd Maritime Telgh & Tel Co Ltd Mark Resources h c Mark's Work Wearhouse Ltd Markborough Properties Inc MarIeau, Lemire Inc MarshaIl Minerals Corp Marshall Steel Ltd

Maude Lake Gold Mines Ltd M a u Petroleum Ltd McGraw-Hill Reyerson Ltd McNellen Resources Inc Melcor Developments Ltd Memotec communications Inc Merfin Hygienic Prods Ltd Meridian Technologies Inc Metail Mining Corp Methanex Corp Metro-Richelieu Micro Tempus Inc Microbix Biosystems Inc Midland Walwyn Inc Milltronics Ltd Minera Rayrock Inc Mining & Allied Supplies (Cm Miramar Mining Corp Mitel Corp Mobile Computing C o q Modatech Systems Inc Moffat Communications Ltd Molson Breweries Molson Companies Ltd Monarch Development Corp Montreal Trustco Inc Moore Corp Ltd Morden & Helwig Group Inc Morgan Financial Corp Morgan Hydrocarbons Inc Momson Petroleums Ltd

Newbridge Networks Corp Newcourt Credit Group Newfoundland Capital Corp Ltd Newfoundland Light & Pow Co Newhawk Gold Mines Ltd Newport Petroleum Corp Newscope Resources Ltd Noble China Inc Noble Peak Resources Ltd Noma Industries Ltd Noramco Mining Corp Noranda Forest Inc Noranda Inc Norcen Energy Resources Ltd North Arnerican Palladium Ltd North Canadian Oils Ltd North West C o Inc North West Trust Northern Reef Exploration Ltd N o h e m TeIecom Ltd Northern Telephone Ltd Northfield Minerals Inc Northgate Exploration Ltd Northridge Exploration Ltd Northrock Resources Ltd Northstar Energy Corp Northwest Sports Enterp Ltd Northwestem Uti tities Ltd Norwall Group Inc Nova Corp of Alberta Nova Gas Transmission Ltd

Mortgage Insurance Co of Canada Nova Scotia Power Inc Mosaid TechnoIogies Inc Motion Works ~ 6 Ï - p Mountain Beaver Resources Ltd Mr Jax Fashions Inc Mullen Trucking Ltd Municipal Financial Corp Municipal Ticket Corp Muscocho Explorations Ltd Mytec Technologies Inc NI1 Norsat International Inc NQL Drilling Tools Inc Nabors Industries Inc Nalcap Holdings Inc Napier International Technologie National Bank of Canada National Sea Products Ltd National Tmst National Trustco Inc Needler Group Ltd NeoTel Inc New Brunswick Tel Co Ltd New Canamin Res Ltd NewTel Enterprises Ltd Newalta Corp

Novicourt Inc Nowsco Well Service Ltd Nu-Gro Corp NuGas Ltd Nufort Resources Inc Numac Energy Inc OCS Technologies Corp OSF Inc Ocelot Energy Inc Offshore Systerms International Okanagan Skeena Group Ornega Hydrocarbons Ltd Ondaatje Corp Onex Corp Optima Petroleum Corp Orbit 0i1& Gas Ltd Orvana Minerais Corp Oshawa Group Ltd Osprey Energy Ltd Ottawa Structural Services Ltd PWA Corp Pace Corp Pacific Cassiar Ltd Pacific Energy Systems Ltd

Pacific Forest Products Ltd Pacific Northern Gas Ltd Pan Pacific Devel Corp PanCanadian Petr Ltd Pantorama Industries Inc Paragon Entertainment Corp Paragon Petroleum Corp Paramount Resources Ltd Park Lawn Cemetery Co Ltd Parkiand Industries Ltd Peerless Carpet Corp Pegasus GoId Inc Pembridge Inc Pengrowth Gas Corp Penn West Petroleum Ltd Pennington's Stores Ltd People's Telephone Co of Fore Pet Valu Inc Petersburg Long Distance Inc Petro-Canada Petromet Resources Ltd Petrorep Resources Ltd Petrostar Petroleums Inc Philip Environmental Inc Phillips Cables Ltd Pinetree Capital Inc Pinnacle Resources Ltd Pioneer Metals Corp Pipestone Petroleum Inc Place Dome Inc (Placer!) Place Resources Corp Planvest Capitai Corp Plasti-Fab Ltd Plastibec Ltd Platinova AIS Poco Petroleums Ltd Polyphalt Inc Potash Corp of Saskatchewan Power Corp of Canada Power Financial Corp Precision Drilling Corp Premdor Inc Prime Equities Interational Prime Resources Group h c Pnmex Forest Products Ltd Princeton Mining Corp Promatek Industries Ltd Promis Systems Corp Ltd Provigo Inc Prudentid Steel Ltd Qsound Labs Inc Quadra Logic Techs Inc Quadron Resources Ltd Q u m Mountain Gold Corp Quebec-Telephone Quebecor Inc

Quebecor Printing Inc Queenstake Resources Ltd Quest Capital Corp Quno Corp R-M Trust Company RAM Petroleums Ltd Ranchmen's Resources Ltd Rand A Tech Corp Ranger OiI Ltd Rayrock Yellowknife Resources Receptagen Ltd Reclarnation Management Ltd Red Oak Resource Inc Redfern Resources Ltd Redlaw Industries Inc Redstone Resources Inc Regal Greetings & G i a Reitrnans (Canada) Ltd Renaissance Energy L td Repadre Capitd Corp Repap Enterprises Inc Republic Goldfields Inc Resourcecan Ltd Resources Ste Revenue Properties Co Ltd Richards Buell Sutton Richelieu Hardware Ltd Richland Petroleum Corp Richmont Mines Inc Rigel Energy Corp Rimoil Corporation Rio Algom Ltd Rio Alto Exploration Ltd Rising Resources Ltd Riverside Forest Prod Ltd Rogers Cantel Mobile Comm Inc Rogers Communications Inc Rolland Inc Roman Corp Ltd Rothrnans Inc RoyNat inc Royal Aviation Inc Royal Bank of Canada Royal LePage Ltd Rusty Lake Resources Ltd SBN Systems Inc SHL Systemhouse Inc SNC Lavalin Group Inc SR Telecom Inc STN Inc Sagewood Resources Ltd Samuel Manu-Tech Inc Sceptre Inv't Counsel Ltd Sceptre Resources Ltd Schneider Corp Scintrex Ltd

Scott Paper Ltd Scott's Hospitality inc Seagram Co L td Sears Canada Inc Sedona Industries Ltd Seprotech Systems Inc Serenpet Inc Service Corporation Internationa Shaw Communications Inc Shaw Industries Ltd Shell Canada Ltd Shemt Inc Sidus Systems Inc Sifion Properties Ltd Signal Energy Ltd Signature Brands Ltd Silcorp Ltd

Skyjack Inc Slater Industries Inc Slocan Forest Products Ltd Socanav Inc Sodisco-Howde Group Inc SofiKey Software Products Soiid State Geophysical Inc South China Inds (Cnd) Inc Southam Inc Southem Frontier Resources Inc Southernera Resources L td Spar Aerospece Ltd Spectra Group of Great Spectral Diagnostics Inc Spectnim Signnal Procesg Inc Speedware Corp Inc Speedy Muffler King Inc Spirit Corp Spruce Falls Acquisition St Clair Paint & Wallpp Corp St Genevieve Resources t t d St Lawrence Cement Inc Stackpole Ltd Stampeder Exploration Ltd Star Data Systems Inc Startech Energy Ltd Stelco Inc Strike Energy Inc Stroud Resources Ltd Structured Biofogicals Inc Summit Resources Ltd Sun Ice Ltd Suncor Inc Surrey Metro Savings Cdt Un Suzy Shier Ltd S ynergistics Industries L td Synex International Inc TCG International Inc

TFH International Inc TIE/Comms Canada Inc TNT Financial Ltd TSB International Inc TSC Shannock Corp TTY Paramount Partnership TVI Copper Inc TVX Gold Inc Tai Energy Corp Taiga Forest Products Ltd Talisman Energy Inc Tandem Resources Ltd Tarragon Oil and Gas Ltd Tarxien Corp Teck Corp Tecsyn International Inc Teddy Bear Valley Mines Ltd Tee-Comm Electronics Inc Tele-Metropole Inc Telebec Life Teleglobe Inc Telemedia Inc Telepanel Systems Inc Tetular Canada Inc Telus C o q Tembec Inc Tesco Corp Texaco Canada Petroleum Inc Thomson Corp Tirnminco Ltd Tiverton Petroleums Ltd Tm Technologies Corp Tombill Mines Ltd Toromont Industries Ltd Toronto Sun Publishing Corp Toronto-Dominion Bank Toronto-Dominion Centre Ltd Torstar Corp Trader Resources Corp Traders Group Ltd Tram Mountain Pipe Line Co Trans-Dominion Energy Corp TransAlta Corp TransCanada PipeLines Ltd Transat A.T. fnc Transpacific Resources inc Transwest Energy Inc Trenton Industries Inc Tri Link Resources Ltd Tri Origin ExpIoration Ltd Tridel Enterprises Inc Trillion Resources Ltd Trilon Financial Corp Trimac Ltd Trimark Financial Corp Trimin Enterprises Inc

Trizec Corp Ltd XL Foods Ltd Trojan Technologies Inc Xerox Canada Inc Tm-WaiI Group Ltd Zenon Environmental Inc Truax Resources Corp Truscan ReaIty Ltd Trust General Du Canada UAP Inc Ulster Petroleums Ltd Uni-Select Inc Unican Security Systems Ltd Unicap Commercial Corp Union Gas Ltd Union Gold Inc United Canadian Shares Ltd United Corp Ltd United Grain Growers United Rayore Gas Ltd United Reef Ltd United Tire & Rubber Co Ltd United Tri-Star Resources Ltd United Westburne Inc Univa Inc Venezuelan Goldfields Ltd Ventra Group Inc Ventas Energy Services Inc Versacold Corp Viceroy Homes Ltd Viceroy Resources Corp Vitran Corp Inc WF4 Industries Ltd Wajax Ltd Wall Financial Corp Wascana Energy Inc Webex Resources Ltd Weldwood of Canada Ltd West Fraser Timber Co Ltd West Kootenay Power Westar Group Ltd Westcoast Energy Inc Western Corp Enterprises 1nc Western Gamet Co Ltd Western Quebec Mines Inc Western Star Trucks Hldgs Ltd Westfield Minerats Ltd Westmin Resources Ltd Weston, George Ltd Westrex Energy Corp Westward Energy Ltd Wharf Resources Ltd Wheaton River Minerals Ltd Win-Eldrich Mines Ltd Winchester Group Inc Winfield Energy Ltd Winpak Ltd Working Ventures Canadian Fwid X-Cal Resources Ltd

References

Baker, George P., Evlichael C. Jensen, and Kevin J. bIixrphy, "Compensation and In-

centives: Practice vs. Theory," Journal of Finance, vol. XLIII, No. 3. Jiily 1988,

593-6 16.

Black, Fischer and Myron Scholeç, "The Pricing of Options and Corporate Liabilities,"

Joumal of Political Economy, May/Jime 1973, 637-54.

Chaykowski, Richard P. and Brian Lewiso Compensation Practice and Outcomes in

Canada and the United States, IRC press, Queen's UniversiQ, 1995.

Ciscel, David H. and Thomas M. Carroll, "The Deterrninants of Execiitive Salaries: An

Econometric Survey," Review of Economic and Statzstics, 1980, 7-13.

Cosh, A., T h e Remimeration of Chef Execiitives in the United Kingdom," Economic

Journal, 85? 1975, 75-94.

Coiighlan, Anne T. and Ronald M. Schmidt, "Executive Compensation, Managerial

Tirnover, and Firm Performancet" Journal of Accounting and Economics. T. 1985,

67-84.

Garen, John E., "Execiitive Compensation and Principal- Agent Theory," Journal of

Political Economy, 102, 1994, 1175-1199.

Gibbons, Robert and Kevin Rlurphy, "Relative Performance Evaliiation for Chief Ex-

eciitive Officers," Industrial and Labor Relations Review, 43, 1990. 30-51s.

Hall, Brian J . and Jeffrey B. Liebman, "Are CEOs R e d y Paid Like Biirea~icrats?"

Discussion Paper Nimber 1789, Harvard Institiite of Economic Research, 1991.

Haubrich, Joseph G., "Risk Aversion, Performance Pay. and the Principal-Agent Prob-

lem," Journal of Political Economy, 102, 1994, 258-276.

Holrnstrom, Bengt, "Moral Hazard and Observability," Bell Journal of Econornics, 10,

1979, 74-91.

Hubbard, R. Glenn and Darius Palia, "Executive Pay and Performance Evidence from

the U.S. Banking Indiiçtry," Journal of Financial Economics, 39, 1995, 105-130.

REFERENCES 94

Jensen, blichael C. and Kevin J. Murphy, "Performance Pay and TopEvIanagement

Incentivest7' Journal of Political Econorny, 98, 1990, 225-264.

Joskow, Paul and Nancy Rose, "CE0 Pay and Firm Performance: Dynamics, Asymrne-

tries, and Alternative Measureç of Performance," NBER Working Paper No. 4976.

1994.

Kaplan, Steven N, "Top Execiitive Rewards and Firm Performance: A Cornparison of

Japan and the United States," Journal of Political Economy, 102, 1994, 51û-546.

Kato, Takao and Mark Rockel, "Experiences, Credentials, and Compensation in the

Japanese and U.S. hilanagerid Labor Markets: Evidence Erom New blicro Data,"

Journal of the Japanese and International Economics, 6, 1992. 30-5 1.

Kostiiik, Peter F., "Firm Size and Execiitive Compensation," Journal of Human Re-

sources, vol. XXV, no. 1, 1989, 91-105.

Laughren, Floyd, "Statement to the Legislatiire on Disclosiire of Execiitive Compensa-

tion," Ontario Securities Commission Bulletin, October 15, 1993, 5 104-5 106.

Lewellen, Wilber G. and Blaine Himtsman. "Managerial Pay and Corporate Perfor-

mance," American Econnmic Review, 60, 19'70, 710-20.

Masson, Robert, "Execiitive blotivations, Earnings. and Consequent Eqiuty Perfor-

mance," Journal of Political Econorny, 79, 1971, 1278-92.

McLaiighlin, Kenneth J., "Individual Compensation and F i m Performance: The Eco-

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Economy and the State, University of Chicago, 1994.

Mirrlees, J. A., "The Optimal Stnictilre of Incentives and Aiithority witithin An Orga-

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Murphy, Kevin J., "Corporate Performance and Managerial Remimerntion. An Empir-

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University, 1995.

Chapter 3

Execut ive Compensation and Managerial Incentives: A

Cornparison Between Canada and the United States

3.1 Introduction

Studies of execiitive compensation and managerial incentives have had a long history

in the United States where corporate execiitive compensation has been piiblicly disclosed

for decades. In Canada, it only became possible to condiict stich stiidies after 1993 when

all piiblicly-traded cornpanies in the province of Ontario were reqtured to disclose top

executives' compensation iinder new Ontario Securities Regdations. Using the newly

available piiblic data on executive compensation of Canadian &ms. Chapter 2 identified

a positive relationship between C E 0 pay and firm performance for Canadian fim. This

chapter addresses a related qiiestion: Does the pay-performance relation differ across

Canadian and US firrns? On one hand, the extensive economic and institiitional relations

between Canada and the United States siiggest that managerial compensation schemes

will be similar. On the other hand, becairse of differences between Canada and the

United States in areas siich as labor legislation, regdation intensity and taxation? the

compensation schemes and thus pay-performance relation are expected to be different

between the two coimtries. Understanding this difference may provide fùrther insights

to these factors which influence a h ' s compensation system and internai managerial

incent ives.

This chapter examines a sample of 365 large Canadian firmç and 678 large US firms,

diinng the period of 1991- N94, to compare the intensity of the pay-performance relation-

ship, Le., incentive strength of CE0 compensation, between the two coimtries. Althoiigh

there is no consensus in the literatiue conceming the measurement of incentive strength,

it is usudy taken to be the sensitivity of managerial pay to the firm's stock performance

or to shareholder wealth. This chapter examines both the arithmetic sensitivity of CE0

pay to firm performance (the ratio of changes in CE0 pay over changes in shareholder

wealth), and the elasticity of CE0 pay with respect tv shareholder weaith. The sim-

ilarity in data between the two countries d o w s the cornparison to be made based on

joint-sample regressions for Canadian and US firms.

After firm-size heterogeneity between the Canadian sample and the US sample is ade-

qiiately controlled, 1 find that the incentive strength associateci with direct pay and stock

ownership in Cm-adian firrns is weaker than in US firms biit that the difference dimin-

ishes as h size increases. This resiilt is obtained both with the arithmetic sensitivity

estimator and with the elasticity estimator. While it is difficiilt to provide a cornpiete

explanation for this observation, it is consistent with a positive impact of disclosire reg-

dations on managerial incentive strengths as disciissed in Chapter 1. The US execiitive

compensation systern has been imder public scrritiny since the 1930s, but Canadian firms

did not domestically disclose their top executives' compensation imtil the end of 1993.

This difference in disclosure regdatory environment between the two coimtries is smaller

with large firms because most large Canadian h m were piiblicly traded in the United

States and were siibject to the US disclosire rdes before 1991.

To evaluate the impact of rnanagerial incentive intensity on corporate performance,

this chapter also imdertakes a Canada-US cornparison of the firms' stock performances.

3.2 THE METHODOLOGY AND THE DATA 98

1 find that, diiring the period of 19841994, the average re t im to a h ' s common stock

and the ratio of the average retum to the return standard deviation are both lower

for Canadian than for US b.' Compared with US firms, this poorer stock

performance and the lower compensation paid to Canadian CEOs is evidence of less

productive management of Canadian firms. In t i m , this observation, together with the

weaker pay-performance relationship at Canadian hm, is at least consistent with the

hypothesis that managerial incentives d e c t corporate performance.

The rest of the chapter is organized as follows. Section 3.2 introduces the basic: issiies

concerning the pay-performance relationship; i t briefly disciisses previocis empirical stiid-

ies and then describes the methodology and the data i w d in this paper. In Section 3.3.

a detailed cornparison of incentive strength with C E 0 direct pay and stock ownership is

made between Canadian firrns and US fimis. Comparing the hms ' market performance.

Section 3.4 evaliiates the impact of the Canada-US difference in managerial incentive

schemes on corporate performance. Section 3.5 concludes the chapter.

3.2 The Methodology and the Data 3.2.1 Previous Studies

An incentive problem arises when the owner of a firm, the principal, delegat'es

decision-making or production tasks to ano t her individiial, the agent (manager). and

where the principal does not observe the agent's effort in prodiiction. Standard agency

theory predicts that, to indiice the agent to promote the interests of the principal, the

optimal rewaxd scheme miist have the agent's pay V a r y with his o ~ i t ~ i i t . ~ In other words,

to align the interests of the agent with those of the principal, the agent's pay miist be

lThe ratio is based on the Sharpe measiire for portfolio performance ( s e , e.g., Jobson and Korkie, 1981).

*since Ross (1973) k t posed the principal-agent problem, many stiidies have been done to exam- ine the optimal compensation scheme of the agency model, among which notably ~ u e Mirrlees (1976), HoIrnstrom (19791, Grossman and Hart (1983), and Hart and Holrnstrom (1987).

3.2 TNE METHODOLOGY AND THE DATA 99

performance-based. This is the starting point of varions empiricd stiidies which, from

different perspectives, investigate the relationship between managerial pay and firm per-

formance.

Focusing on cross-sectional analyses, earlier stiidies tried to identify a positive rela-

tionship between managerial pay and firm performance, but the residts were mixed (see.

e.g., Lewellen and Htmtsman, 1970; Masson, 1971; and Ciscel and Carroll, 1980). Since

the late 1980s, most stiidies iise longitiidinal data and overwhekningly co&m a posi-

tive relationship between pay and performance, even thoiigh the estimated performance-

related coefficient depends criticdy on the mode1 specification and choice of performance

measiire (see, e.g., Miirphy, 1985; Coiighlan and Schmidt, 1985: Jensen and hIiirphy,

1990; Kaplan, 1994; and Joskow and Rose, 1994).

Jensen and Miirphy give a bench mark estimate of the intensity of the pay-performance

relationship. Using the Forbes sample of US CEOs' compensation diiring the years 1974-

1986 and taking into accoimt cash payments, options, stock ownership and dismissal-

related factors, they find a pay-performance sensitivity of 0.003. This means that CE0

compensation in the largest US fimu increases $3 for each $1000 increase in shareholder

value. Kaplan (1994) reaches a similar conclusion for the compensation of Japanese

exe~iitives.~ While different agtiments have been put fortli to e-xplain the seemingly

small magnitude of these pay-performance sensitivitie~,~ there is no consensus concern-

3 ~ a p l a n finds that while the relationship of turnover and cash compensation to performance are sirnilar between Japanese execiitives and US. executives, the share ownership of Japanese exec~itives is much lower than that of the US. coirnterparts, and conclitdes that top Japanese exectitives have smaller incent ives to increase stock rettirns than U.S. executives.

'Jensen and Mi~rphy (1990) conjecture that under disclosiue of execiitive compensation, public and private political forces impose constraints on the type of contracts that are written between shareholders and management, and thiis reduce sensitivity. Joskow, Rose, and Shepard's (1993) explanation for regdatory constraints on CE0 compensation d s o belongs to the political pressure argument. Batlbrich (1994) and Garen (1994) tend to explain the small sensitivity in t e m of agency costs. Given the risk- averse behavior of managers, the compensation scheme must be structiued to trade off incentives with insimance. Under this argument, the srnall pay-performance sensitiviw is a response of the pay scherne to large otitput variation in the largest U.S. firms, reflecting the shift of the balance between incentives and insiuance.

3.2 TH% I1fETHODOLOGY AND THE DATA 100

ing whether or not the compensation of CEOs in the largest US firms provides the

appropriate incentives to m a e z e shareholder wealth. Since the general agency model

fails to identi& a quantitative benchmark, it is diEcult to draw a concliiçion conceming

the incentive implications of a s m d pay-performance sensitivity.

Setting the absolute magnitude of the pay-performance sensitivity aside, one can still

profitably piwiie a comparative analysis. In recent years, cornparisons of managerial

incentives have been made between s r n d fhns and large h s (Jensen and hliuphy,

1990; Garen, 1994); regulated fhm and imregulated firms (Joskow. Rose and Shepard.

1993; Smith and Watts, 1992); and Japanese firmç and US firms (Kato and Rockel. 1992:

Kaplan, 1994). In this chapter 1 imdertake a cornparison of Canadian firms and US firms.

3.2.2 Mode1 Specification

There are a variety of different mode1 specifications in the empiricd Literatiire on

managerial incentives. The dependent variable can be the log of compensation. changes

in the log of compensation. or dollar changes in compensation. The measiires of firm per-

formance are even more diverse: stock price, varioiis rates of retiun, changes in these rates

of retiirn, dollar changes in shareholder wealth, etc. As a matter of interpretative conve-

nience, however. the model proposed by Jensen and bhrphy has been increasingly iised

in the literatiire. This model links changes in managerial pay to changes in shareholder

wealth. Denoting CE0 pay as C1/, and hm oiitpiit as x, where siibscript t denotes fiscal

year, a Linear compensation contract pays Wt = a + b x . Jensen and bvlurphy estimate

the model in its differential form:

3.2 THE METHODOLOGY AND THE DATA 101

The regressor, A&, is d e h e d as the change in shareholder wealth cdciilated as rt&-17

where rt is the rate of retiun on cornmon stock realized in fiscal year t and v-l is the firm

value at the end of the previous fiscal year. As a iinear approximation to marginal reward

for fum performance, the arithmetic sensitivity of CE0 pay to shareholder wealth, LI:

measures the strength of the pay-performance relation.

As observed in several previoiis studies, the sensitivity estimated imder (3.1) changes

significantly with firm size.' This featiue of the mode1 imposes a potential problem for

oiir cornparison becaiise of a siibstantial clifference in firm size between Ccmadicm h s

and US firms. For this reason 1 also employ the specification iised by Gibbons and

Murphy (1992) that converts the regression variables to logarithmic changes as follows:

where A log(%) is approximated by log(1 + r t ) . Under (3.2) the effect of firm size on the

estimate of the elasticity of CE0 pay with respect to shareholder wealth, q, is siibstan-

t i d y rediiced.

In the next section, the two specifications, (3.1) and (3.2), are both iised in the

cornparison of incentive strength between Canadian firm and US firms. Recognizing

that p s t performance may also have an infiiience on ciment ~ o r n ~ e n s a t i o n , ~ a lag term

is added in each specification.

'With US. CE0 compensation data, Jensen and Miuphy (1990), Garen (1994) and Schaefer (1995) al1 find an inverse relationship between the sensitivity and firm size.

'Both Jensen and Miirphy (2990) and Joskow and Rose (1994) confirm a significant influence of the previoiiç performance on c ~ u ~ e n t compensation. Stich a phenornenon partly results fiom the ambiguity of the timing of performance payments in both the decision and the firm's report ( s e Jensen and Miirhpy). In addition, various long-tenn incentive payrnents that usually depend on performance over severai years directly link ciment compensation with previous performance.

3.2 THE METHODOLOGY AND THE DATA

3.2.3 The Data The Canadian Data

The compensation data of Canadian CEOs are compiled £rom the corporate pr0.x-y

staternents that are Bled with the Ontario Seciirity Commission and which are also maileci

to shareholders. Under the new Ontario Regdation (1993): aJl piibiicly-traded companies

in Ontario are reqiiired to disclose all payments to their CEOs and their foiu other rnost

highly paid execiitive officers. Thoiigh the sarnple is based on the h subject to the

Ontario regdation, most large Canadian firms are piiblicly traded on the Toronto Stock

Exchange; the resulting sample is certainly representative of large Canadian f k m . ~ . ~ The

compensation data are dram Erom dl corporate proxy statements filed between Janiiary

1994 and July 1995 which separately report executive compensation for fiscal year 199 1

through 1994.

Execiitive remuneration has several components. Current cash payments (salas;

annual boniis. and various benefits) are reported, dong with stock options (and stock

appreciation rights), gants of restricted stock imites, and iong-term incentive plan pay-

oiits. In a broad sense. these components c m be classified into f o t ~ categories: s a l q

anniid bonus, Long-term incentive payments, and other payments. Indirect-pay related

benefits reported in proxy statements include stock gains from the exercise of previoiisly

rewarded stock options or stock appreciation rights and stock holdings of directors."

Financial data on Canadian firms are obtained from the Financial Post data file.

Becaiise the change in CE0 payment will be iised as the dependent variable in the

regression below, those firms that have only one year of data are ignored. Excliiding

'For example, by either total assets or sales levels in fiscal yesx 1993, more than 90 percent of the 300 largest Canadian finns are traded at the Toronto Stock Exchange (TSE in short). The compensation data incltide 98% of TSElOO firms and 92% of TSESOO firms.

'In most cases, a CE0 is also a director. Since the disclosure niles require firms to provide only the ciment fiscal year information on executive stock gains and directors' stock ownership, the data of these two items are only available for fiscai years ending 1993 and 1994.

3.2 THE METHODOLOGY AND THE DATA 103

partial compensation due to tirnover, firm reorganization, Bscd year change and part-

time service, and eiiminating the observations with misshg data after matching CE0

compensation with £hm hancial data, the Canadian sample contains 365 firms for a

total of 1 183 observations.

The US Data

To make the data comparable with previous US stiidies. a Forbes sample of US h s

is iised. The CE0 compensation data are obtained from the Forbes ' anmal report of

executive compensation for fiscal year 1991 to 1994. The report inchides three com-

pensation categories: total salary plus bonus, stock gains, and other. Total s a l q plus

boniis is the same as the s i m of salary and annual boniis in the Canadian data."tock

gains are the net valiie realized fiom the evercise of options or stock appreciation rights

previoiisly anwded. The other category incliides long-term incentive payments (which

are reported separately in Canadian fims' proxy sçtatements) and variotis benefits. CE0

stock ownership is also reported in terms of the value of each executive's holding as a

percentage of the firm's total market valiie. The financial data for US firms are obtained

from the Compustat data files. The US sample contains 678 f ims with a total of 2169

observations.

Selected Statistics

This chapter focuses on CEOs' direct payments and stock ownership. Since there are

only two years of data on stock options available for Canadian fims ( 1993 and 1994), and

no option data in the Forbes' s iwey on US CE0 compensation, the pay-performance

g ~ h e Ontario disclosiire niles closely W o w the US disclositre d e s that reqiùre firrns to disclosiire executive compensation in standardized tables. Before 1993, CE0 salary and boniis are rcported as a total in the Forbes reports.

3.2 THE METHODOLOGY AND THE DATA

links associated with options and stock appreciation rights are ignoreci.'' The effect

of option-related incentives will be discussed in Section 3.3.3 The pay variables in the

Canadian sample include salary, boniis, long-tem incentive pay excluding options, and

other payments. These four components are combineci to form two major pay variables,

sa.lary+bonus and total direct pay, which can be meastireci for each firm in the Canadian

and US sarnples. AU discussions of a Canada-US cornparison are based on these two pay

variables. Table 3.1 summarizes selected statistics of CE0 compensation as well as some

firm variables. The value of Canadian variables is converted into US dollars based on

anniial average exchange rates." -411 variables are in 1991 constant dollars.

There exists a siibstantial difference in h m size between the Canadian sample and

the US sample. Based on median assets and sales, the average size of US firms is about 12

to 15 times as large as that of Canadian firms. The mean total pay to US CEOs is about

4 times as high as that of Canadian CEOs. Stipposing that there is a common managerial

Iaboiir market for Canada and the United States, these observations are consistent with

the allocation theory of control: in a market eqtdibriiun. the rnost talented execiitives

occiipy positions in the largest fums and thiis receive the highest pay (Rosen, 1982). They

are also consistent with the fact that the firm-size elasticity of execiitive compensation

is smaller than one.

Salary and bonus are the most important compensation components in both Cann-

dian and US firms, constituting an average of 94% of total pay for Canadian CEOs and

- - - -- - . - -

1°While CEOs' wealth in stock gains from exercising previously awarded options directly depends on stock price, the relationship between stock performance and the valtie of the ciment option gants remains unclear. Taking into accoimt both the valtie of options and the benefits hom exercising options, Jensen and Murphy (1990) find the change in CEO's option-related wealth is positively related to the change in shareholder wealth. Excliiding stock gains of exercising previoiisly awarded options, however, Murphy (1985) finds a negative relationship between firm performance and the value of options granteci in the current fiscal year.

"To avoid introdiicing noises into the data, al1 Canadian variables remain unconverteci in the regres- sions, which affects the constant term in the joint-sarnpIe estimation but causes little &ange in the performance-related coefficients.

82% of total pay for US CEOs.12 It is interesting to observe that the median and mean

values siiggest a left-skewed distribution for this percentage. Noticing that the distri-

bution of firm size is right-skewed. this seems to suggest that larger firms tend to lise

more long-term incentive payments and other benefits, or ernphasize a variety of incentive

payments.

3.3 Incentive Strength

3.3.1 Incent ives from Direct Payments

The cornparison with direct payments fociises on sdary pliis bonus and total pay.

iising both the arithmetic and the elasticity specifications. In the first stage of the

analysis, the Canadian and US sampleç are cornbined and regressions are performed for

the joint sample iising the two specifications by introdiicing a diimrny variable. CND.

for Canadian firms.

Table 3.2 presents the results. The £irst two coliimns present the resiilts kom the

arithmetic estimation. The siun of the coefficients on changes in shareholder wealth

estimates the pay-performance sensitivity for US firms. The s i m of the coefficients on

the corresponding t e rm with d i m y variable C N D estimates the Canada-US difference

in the sensi tivity. Incliiding the coefficients on the previoiis year's performance. the

sensitivity for US firms is aboiit 8 cents change in salary m d bonus for every $1000

change in shareholder value. Of the change in total pay the sensitivity increases to

20 cents for every $1000 change in shareholder wealth. These estimates are consistent

with, thoiigh higher than, those of previous stiidies. l3 The fociis here is the coefficients

12When stock gains from exercising previoiisly awarded options are incliided in total pay in the US. sample, the percentage of saiary and bonis in total pay for US. CEOs drops to 72. This is consistent with the finding of Joskow and Rose (1994) that salary and bonus averaged 82 percent of total compensation diiring 1972 to 1990, and the percentage declined by an average of 1.1 percentage points per year (p13).

13using the Forbes sarnple during 19741986, Jensen and Murphy report a sensitivity of 0.000022 and 0.000033 with respect to saiary plus bonus and total pay respectively. With a similar sample for the period between 1986 and 1990, Schaefer identifies a sensitivity of aboiit three tirnes as large as that of

on the dummy variable for Canadian firms. The estimates of these coefficients can be

sumrnarized as the following: the sign is mixecl, the magnitude of the coefficients is

relatively small, and none are significant. This result suggests no significant difference in

pay-performance sensitivity between Canadian firms and US firms.

The regressions for the elasticity specification, however, are quite different, as shown

in the third and fourth columns of Table 3.2. AU the coefficients on d i i m y variable CND

are negative and most are statistically significant at the one percent level. Incltiding both

the curent and previous years' performance variables, the elasticity of salary+boniis with

respect to shareholder value is 0.278 for US firm and 0.130 for Canadim. h s . For every

one percent increase in shareholder wealth, US CEOs' salary and boniis increases by about

0.28 percent while the Canadian coiuiterpart increases by 0.13 percent. The difference is

even larger for the elasticity of total pay. The large magnitude and high significance level

of the difference in the elasticity implies that CE0 payments are much less sensitive to

firm performance in Canadian firms than in US firms. This residt, obvioiisly, contradicts

that frorn the arithmetic estimation.

If there exists a significant difference in the responsiveness of CE0 compensation to

k m performance between the two samples, it shodd be shown in both the arithmetic

semi tivity and elasticity. A possible reason for the inconsistency is sample heterogeneity

which poses a problem when it has an asymmetric effect on the two specifications. -4s

observed by eariier stiidies, while the elasticity estimator appears qiiite robiist to firm

size, the arithrnetic sensitivity estimator deciines notably as firm size increases. This

suggests the possibility that the Canada-US difference in pay-performance relation may

not be revealed iising the arithrnetic estimation because of the large difference in b r n size

Jensen and Miirphy. These resiilts are consistent wit h the observation of Joskow and Rose (1994) that CE0 compensation in the US. firms surveyed by Forbes became significantiy more sensitive to firm performance during the 1980s compared to the 1970s.

between the two samples. To clarify this issue, 1 now examine firm-size heterogeneity.

F i m size is usudy proxied by total assets or saies. Noticing that the distribution of

sales is less skewed than that of total assets, 1 use average sales during the years 1991-

1994 as a proxy for h size throiighout the discussion. Figure 3.1 illustrates the 6rm

size distribution for the two samples. While about 80% of Canadian fkms in the sample

have average sales below 500 million, only about 9% of the US firrns in the sample

have average sales below this level. Given such a striking difference in the h - s i z e

distributions between the two samples, a distortion imavoidably occiirs in the arithmetic

estimation. Becaiise finri size is a continuous variable, a dummy variable d l not help

control for the effect of size heterogeneity. In this chapter 1 adopt an approach that

rninimizes size heterogeneity by directly controlling for the sample that is iised. Taking

into acconnt the nimber of firms and the firm-size distribiition, I choose to incliide those

firms with average sales between $400 million and $8 billion; this siibsample contains

35.6% of the total Canadian sample and 78.3% of the total US sample. These fkms are

fiirther divided into two subsamples for both Canadian fkms and US fim. Siibsample

1 incliides firms with average sales between $400 million and $1 billion, and siibsarnple

2 incliides firms with average saies between $1 billion and $8 billion. As shown in Table

3.3,14 the Canadian and US firms have sirnilar median and mean average firm saies in

the two siibsarnples.

After controlling for size heterogeneity, 1 redid the regressions of Table 3.2 for the

joined siibsamples. 1 hst examined the combined subsample which includes 130 Canadian

h m s and 531 US firms. The results are presented in Table 3.4. The two specifications now

provide consistent estimates of the Canada-US difference, and both confirm a weaker pay-

' "~isted in Table 3.3 t here is anot her dimension of sample heterogeneity, indiistry çtnictiue, which is discimeci at the end of this section.

performance W g e for Canadidian firms. The coefficients of the ciment year performance

interacteà with the d t m y variable CND are all significantly negative.15 Incliiduig the

effect of the previoiis year's performance, the anthmetic sensitivity of CE0 total pay to

shareholder wealth for Canadian firms is only aboiit 20% of the corresponding US value.

Sunilarly, the shareholder-value elasticity of total pay in Canadian firms is aboiit 27% of

the US number. These residts establish that the incentive strength of CE0 direct pay is

significantly weaker for the Canadian h s in the total siibsample 1 plis 2.

1 then examine subsamples 1 and 2 separately. Table 3.5 presents the regressions for

siibsample 1. The resiilts are qiialitatively sirnilar to those for the total siibsample in

the sense that both the arithmetic sensitivity and the elasticity are significantly smaller

in Canadian firms than in US fimis. There are some differences thoiigh. Compared

with the residts in Table 3.4, the estimate of the Canada-US difference is larger and

the sio~ficance level is generally higher in Table 3.5. This implies that there is s larger

Canada-US difference in the pay-performance relation for the siibsample of smaller firms.

This observation is strengthened by the regressions for siibsample 2 shown in Ta-

ble 3.6. Althoiigh al1 of the coefficients of firm performance interactecl with CND are

negative in both the arithmetic estimation and the elasticity estimation.16 none is signif-

icant. Compared with the resiilts from siibsample 1, the magnitude of the coefficients for

the Canada-US difference are substantially rediiced with subsample 2. On one Iland' the

ovenvhelmingly negative sign of these coefficients still siiggests a weaker pay-performance

Linkage in Canadian firrns. One the other hand, the low significance level and smaller

I5The two coefficients in the arithmetic estimation are statistically significant a t the 5 percent level and the two in the elasticity estimation are statistically significant a t the 1 percent level. The relatively low significance level in the arithmetic estimation may reflect the effect of the rernaining size difference between Canadian firms and US. fims in the total siibsample 1 and 2, where the average U.S. firms are about twice as large the average Canadian firms.

1 6 ~ h e coefficient on the previoiis performance with dummy variable CND in the regression of changes of total pay becomes zero. Biit the siim of the two coefficients on the performance variables with CiVD is still negative.

magnitude of the coefficients sitggests that there is no real economic différence in incentive

strength for the siibsample of larger firms.

While aJl of the subsample regressions indicate that there is a weaker pay-performance

relationship in Canadian Enns, the regressions for the two separate siibsamples sitggest

that there is an inverse relationship between the Canada-US merence and firm size.

Using an alternative approach, I will provide further evidence for these residts and then

extend them to the total sarnple.

As pointed out by Gibbons and h.Iiuphy (1992), and conf~rmed by the above regres-

sions, the elasticity estimator changes little with firm size among large US h s . Thus, to

proceed, 1 assume that elasticity of CE0 pay with respect to h performance is roiighly

constant within the US sample. Under this assiunption, and introdiicing the variable

SIZE to measiue fkm size and the dilmmy variable CND to denote CanadiCui h s ,

specification (3.2) is revised as follows:

where SIZE is eqiial to the firm's average sales diuing 1991-1994. The sim gi +q2SIZEo

as a linear approximation, characterizes the relationship between firm size and the

Canada-US difference in pay-performance elasticity. A negative value of the s i m means

a weaker incentive strength with Canadian hns. To check whether the Canada-US dif-

ference declines as firm size increases, 1 simply check whether 72 is significantly positive.

Estimates of (3.3) for the total sarnple are reported in Table 3.7. Colurnns 1 and

3 present coefficient estimates when only the crurent year's performance miables are

regressors. In both regressions, coefficient 01 is significantly negative. Coefficient pn is

positive in both regressions and significant at the one percent level for the estimate with

total pay. When SIZE < 3 billion, which is the case with about 93% of all Canadian

h s in the sarnple, the siun of 71 + q2SIZE is negative. These residts veri& an earlier

observation that the pay-performance linkage is weaker in Canadian h than in US

fkms! and that the difference declines as firms become larger. For example, for a Canadian

h with average sales of $100 million, the performance elasticity is 0.101 for salary and

bonus and 0.097 for total pay, which is about 39% and 27%, respectively, of the US

counterparts. For a Canadian firm with average sales of $1 billion, these elasticities rises

to 0.140 and 0.175 respectively, and become 53% and 50% of the US estimates. When the

performance variables of the previous year are incliided, the qtialitative residts remain

the same, as shown in coliunns 2 and 4.

So far 1 have ignored the effect of indiistry heterogeneity. As shown in Table 3.3.

there is a marked difference in indiistry stnictiire between the Canadian sample and the

US sarnple. Dividing 6rms into two categories, resoilrces (mining, rninerals, and oil and

gas) and non-resoiirces, based on the two digit SIC classification, Table 3.3 shows that

18.4% of Canadian firms in the sample fa11 into the resoiirce category, but only 1.3% of

the US f irm belong to the resoiirce indiistry. To capture the effect of this difference, al1

of the regressions iising the total samples were reestimated with an additional diimmy

variable for resource hm. While the signs of the coefficients of the diunmy variable for

resource firms are mixed and most of these coefficients are insignificant, the estimate of

the Canada-US difference in incentive strength rernains essentially the same. As for the

regressions with the subsamples, since the nimber of resolirce firms is very srnall in both

the Canadian sarnple and the US sample, indiistry heterogeneity becomes negligible.

3.3.2 Incentives from Stock Ownership

Stock ownership provides another important contribution to managerial incentives.

Compared with direct compensation, the incentives effects of stock ownership are a-

guably greater. According to Jensen and Murphy, the incentive intensity of CE0 stock

ownership in terms of arithmetic pay-performance sensitivity is about eight times as high

as that of direct payments. Hence, it is necessary to examine the incentives from CE0

stock ownership before a reasonable conclusion can be drawn on the relative intensity of

managerial incentives between the Canadian and US frrrns.

The data of Canadian CEOs' stock ownership are obtained from the km's proxy

statements for the fiscal years ending 1993 and 1994. The stock holdings of US CEOs

for the same fiscal years as the percentage of the £ k n 7 s total market valiie are obtained

from the Forbes' anniial report. The data incliide the shares held by family members but

exclude the shares acquirable throtigh options.

Wealth changes in CEOs' stock ownership are perfectly correlated with changes in

shareholder wealth. This, the percentage of a CEO's stock shares in his firrn's total shares

o i i t s t d n g has the same interpretation as the arit hrnetic pay-performance sensi t ivity in

regard to incentive intensity. I first look at the sample statistics for CE0 stock ownership

percentage s h o m in Table 3.8. For the total samples, Canadian CEOs o m an average of

2.811 percent and a median of 0.161 percent of their firms' stocks, while US CEOs own

an average of 1.823 percent and a median of 0.17 percent." The close medians but miich

higher mean percentage for Canadian CEOs seem to siiggest a higher stock holdings and

thus a stronger incentive strength associated with CE0 stock ownership in the Canadian

sample.

As before, hm-size heterogeneity affects the Canada-US cornparison of CE0 stock

ownership. For this reason, the percentage owned is also calcidateci for the two sub-

samples. Table 3.8 shows that Canadian CEOs in siibsample 1 own an average of 1.124

'?The mean and median levels of U.S. CEOs' stock ownership are similar to, bu t smaller than, that reported by Jensen and Mitrphy (2.42% and 0.25%). O n e possible reason for t h e ciifference is that before 1991 the Forbes ' report on stock ownership inclildes options that can be exercised within 60 days.

percent (a meàian of 0.056 percent) of their firm's stock, compareci with an average of

2.271 percent (a median of 0.360 percent) owned by US CEOS. In siibsample 2, the aver-

age percentage becomes 0.833 (median percentage 0.016) for Canadian CEOs and 2.052

(meciian percentage 0.170) for US CEOs. With 6rm size being controlled, the results

show that Canadian CEOs hold a much smaller percentage of their h s ' stock than

their US coiinterparts do. In other words, the incentives provided by stock onmership

are s m d e r in Canadian firms than in US firms. This obsenration is consistent with the

earlier results for direct payments.

To obtain a more formal and systematic pictiire, 1 firther explore the relationship

between CE0 stock ownership and firm size by analyzing the relation between stock

holdings and f i m size. The following simple mode1 is iised For this piirpose:

where Sharesl is the percentage of CE0 stock shares in the firm's comrnon share out-

standing by the end of fiscal year t.

Estimates of the parameters of (3.4) are presented in Table 3.9. Coliunns 1 and 2

report separate estimates for the Canadian and US saruples. respectively. The coefficients

on log(Salest) are negative and statisticdy significant in both regressions, conkming

a strong negative correlation between the percentage of C E 0 stock ownership and k m

size. Compared with the US sample, a rniich srnaller intercept in the Canadian sample

siiggests a significantly smaller stock ownership of Canadian CEOs, which is verified in

the pooled sample regression, C o l i m 3. The coefficient on CN D - log(Sa1es) in the

pooled sample regression is positive. Thoiigh the significance level of the coefficient is

low, its positive sign is consistent with the earlier comparative residt for direct pay, i.e.,

the Merence between Canadian fkns and US fkms decreases in larger firms.

3.3.3 The Effect of Stock Options

It is widely reco-ed that stock options have becorne an increasingly important

component of execiitive compensation. We thris need to determine whether or not ignor-

ing options imdermines the cornparisons made above.

Jensen and Murphy obtain an estimate of 0.00015 for the pay-performance sensitivity

of C E 0 options for 73 Fortune 500 manufacturing 6rms diiring the period 1969-1983;

they incliide c~vrently granted options and stock gains from exercising previoiisly awaxded

options. This sensitivity is aboiit seven times as large as the sensitivity they estimate for

salary and bonis. Examiniog 147 banks over the decade of the 1980s, Hiibbard and Palia

(1995) find a sensitivity for options that is aboiit six times as large as that for s d q

plus bonlis. Given that the sensitivity of total pay is roiighly twice as large as that of

salary pliis boniis,18 both of these stiidies therefore siiggest that, for large US firms. the

incentive strength associated with CE0 stock options is three to foixr times as large as

that associated with C E 0 total p .

Siipposing that stock options play a similar role in C E 0 compensation across Canada

and the United States' incliiding options in the cornparison made earlier shoidd not

change the qualitative residts concerning the Canada-US difference in managerial incen-

tives. On the other hand, becarise the incentive strength fiom C E 0 stock ownership is

more than 10 times larger than that from direct pay in US firms, and since Canadian

CEOs hold percentages of their £hm' stocks that are, on average, less than half of that of

US CEOs, even a modest difference in option-related incentives between Canadian firms

and US firms is iuilikely to change oiir earlier conclusions.

18See Jensen and Miliilphy (1990) and the above results of this paper.

3.4 INCIENTIVES AND PERFORMANCE 114

To pursiie this matter, 1 also compare, for different samplos and coimtries. the gains

from exercising options as a portion of CE0 total pay (including the stock gains). There

are two reasons for undertaking this cornparison. First, becaise execiitive options are

non-transferable, the stock gain portion of total pay gives an estimate of the relative

importance of options as a pay componento which in tum reflects the relative importance

of option-relateci managerial incentives Second, the data are available for both Canadian

firms and US fkm only for the fiscal years ending 1993 and 1994. As shown in Table

3.10, the ratio of stock gains hom exercising previoiisly awarded options to total CE0

pay is smaller in Canadian firmç than in US fkns for both the total sample and each

siibsarnple. In the two siibsamples, the stock gains constitiite about 5 percent of total

compensation for Canadian CEOs which is only 40% of that for US CEOs. This ciifference

siiggests a notably s m d e r compensation role for stock options in Canadian firrns than

in US h s . This, had we been able to incliide options in the econornetric comparison.

the Canada-US difference in managerial incentive strengths woidd likely have been even

laxger .

3.4 Incent ives and Performance

Managerid incentive schemes are important becaiise of t heir impact on corporate

performance. That is, because managerial effort increaes with incent ive strength. a

stronger pay-performance linkage is e.xpected to lead systematically bet ter firm perfor-

mance. Abowd (1990) obtains evidence siipporting this argument. Examining managerial

compensation for 250 large corporations diring 1981-1986, Abowd fin& that increases in

the sensitivity of compensation to shareholder return enhanced corporate performance.

Given the Canada-US merence in management incentives disciissed above, I now exam-

ine whether or not US £hm have in fact outperformed Canadian h s .

3.4 INCENTIVES AND PERFORhfANCE

A CE0 pay scheme is expected to &ect a firm's fimdamentals. As an approximation,

the average retiun to the firm's common stock during the related period is examineci.

Becaise of a potential positive correlation between average retiun and retiirn variance

(the riskiness), the retiini alone may not teIl the whole story. For this reason. the

performance measiire of the average retiirn to the re t im standard deviation. a Sharpe

mesure for portfolio performance ( s e Jobson and Korkie, 1981) is examined as well.

1 first compare the rnontw retiun. The Canadian data are obtained fiom the Uni-

versity of Western 0nta.rio7s TSE monthly retiun file. The US data are retrieved from

the CRSP stock retiirn file. Since the TSE data are only available for the period before

1992, 1 compare the firm's monthly ret im over the years 1987-1991. The resiilts are

siimmarized in the iipper panel of Table 3.1 1. To be consistent with the disciission of

last section, I fociis on the two siibsamples. As shown in the table, the average retiini to

common stock is s m d e r , and the standard deviation is larger, for Canadian firms than

for US firms. Conseqiiently, the ratio of the average retlun to the standard deviation is

much smaller for the Canadian siibsamples. Based on mean ~~dues, this ratio for Cana-

dian firms is 0.064 and 0.092 for siibsamples 1 and 2, respectively. which are only 15.1%

and 63.0% of the corresponding US niunbers. This indicates a siibstantial difference in

the systematic performances of Canadian and US hm. In tiim? this performance dif-

ference, together with the Canada-US difference in pay-performance linkage? is at least

consistent with the hypothesis t hat managerial incentives &ect firm performance.

1 also examined firrns' annual stock returns during the period of 1984-1994 with

the Cornpustut data for both Canadian firms and US firms. The resiilts are shom in

the lower panel of Table 3.11. The ciifferences in the average retiinis and the ratios

of the average retuni to the standard deviation are similar to these resulting monthly

data, again indicating poorer performance of Canadian firms. It is worth noting that

3.4 INCENTIVES AND PERFOI3.kIANCE 116

the standard deviation of annual retiini is very close between US 6 . m ~ and Canadian

finus. The higher ratio of average return to retiirn standard deviation for US fhns cornes

mainly from a much higher average return.

To eliminate the effect of ciifferences in the risk free retuni, the above cornparison is

also made after the return data are adjiiçted to determine the retiun premiim r - r j ,

where r denotes the r e t m to the fïrm's common stock and r j denotes risk free rates.

Yields on three month Treasury Bills are used as rj. Using r - r f , the Canada-US

increases while the qiialitative resdts remain the same.

Supposing that managerial labour is mobile between Canada and the United States, a

fiirther implication of the siiperior performance of US h is that a management qitality

at US £kms is &O higher. This implication fhds siipport in the difference in pay levels

between Canadian CEOs and their US coimterparts. As s h o m in Table 3.12. diiring

1991-1994 an average Canadian CE0 in siibsample 2 earned a total salary plus bonus

that was about 59 percent of that of an average US CEO. In terrns of total direct pay,

the percentage is only 46. In siibsample 1, these percentages drop to 19 and 37, respec-

tively. The difference in the level of CE0 pay between the two coiintries is siirprisingly

large. There are, of course, indirect pay-related factors that have not been taken into

account, e.g. non-monetary benefits and jo3 seciinty whch may be emphasized more in

Canadian fim. However, since direct paynents are the most important components of

compensation, the difference is iinlikely to disappear even if indirect-pay related factors

are incliided.

These residts are consistent with the possibility that, compareci with US firms, a l e s

performance-based pay system residted in generally poorer performance by Canadian

firms. A natiiral question for fiuther research is, why haven't Canadian h adopted

managerial pay schemes more similar to their US cormterparts.

3.5 Conclusion

This chapter compares managerial incentives from CE0 direct pay and stock owner-

ship between large Canadian fkms and US tirms during the period of 1991-1994. blltch

attention is paid to the effect of firm-size heterogeneity between the Canadian sample

and the US sample, as this proves crucial for the cornparison of incentive strengths. With

firm-size heterogeneity, inter-sample cornparisons may be rnisleading and dependent on

the choice of mode1 specification. This phenornenon occurs becaiise of a different effect of

h size on different specifications. When sample heterogeneity is adeqiiately controlled.

consistent results are obtained with both the arithmetic sensitivity estimator and the

elasticity estimator.

This chapter shows that the incentive strength of CE0 compensation is weaker in

Canadian firm than in US firms and that the difference declines as h m size increases.

For firms with average sales between $400 million and $8 billion (which is the case with

130 Canadian firms and 531 US fkms in the total sample). the sensitivity of CE0 total

pay to shareholder wealth for Canadian firms is aboiit a qiiarter of that for the US

coimterparts. Canadian CEOs hold a percentage of their firms' stocks which is less than

half of the fiaction held by US CEOs.

Examining the return to firms' comrnon stocks, it is foiind that US firms oiitper-

formed Canadian 6.rrn.s diuing the period 1984-1994. This observation, together ni th the

fact that, during 1991-1994, an average Canadian CE0 earned a total direct compensa-

tion that was aboiit 50% of that of an average US CEO, is consistent with there being less

productive management in Canadian fim. In turn, a less performance-sensitive man-

agerial pay systern and generdy poorer performance by Canadian firms are consistent

with the hypothesis that managerial incentives affect corporate performance.

Table 3.1 Selected Statistics

Canadian Firms U.S. F i m s

Median Mean Observation Median Mean Observation

Pav Variables ($000)

Salary+bonus 274 365 1,183 917 1,136 2,169 Total pay 290 404 1,183 1,115 1,584 2,169 (Salary+bonus)/Total (%) 100.0 94.0 1,183 90.1 82.3 2,169

F i m Variables (%miIlion)

Assets 284 2,461 1,180 4,258 12,250 2,160 Sales 21 1 1,180 1,180 2,533 5,189 2,155 Market value 242 795 1,180 1,942 4,123 2,166 Shareholder retum (%) 9.92 25.4 1,183 11.8 23.5 3,169

Note: The data are from 199 1 to 1994. A11 variables are annual and in 199 1 US dollars.

Table 3.2 Estimation of Pay Performance Sensitivity (total sarnple)

Independent Variables

Dependent Variables -

(Arithmetic Estimation) (Elasticity Estimation)

*(Total Pay) ~log(Salary alog(Tota1 +Bonus) +Bonus ) P ~ Y )

lntercept

CND

~(Shareholder Wealth)

CNDxa(Shareho1der Wealth)

~(Shareholder WeaIth).,

CNDxa(Shareho1der Wealth).,

aIog(Shareho1der Wealth)

CNDxalog(Shareh lder Wealth)

alog(Shareho1der Wealth).,

CNDxalog(Shareh1der Wea1th)-,

R'

Observations

Note: t-statistics are in parentheses. CND is a dummy variable that equals one for Canadian firms.

Table 3.3 Selected Statistics about Sarnple Heterogeneity

Canadian Firms U.S. Firms

Media. Mean Num of Median Mean Num of Size Size Fims Size Size Firms

Total sam~le

Total Resource Non-Resource

Total Resource Non-Resource

Total Resource Non-Resource

To ta1 Resource Non-Resource

Note: 1 . Firm size is measured as average sales in 199 1 $US (million). Subsample 1 includes firms with average sales within ($400 million, $1000 million). Subsarnple 2 includes firms with average sales within ($1000 million, $8000 million).

2. Resource denotes firms of mining, minerais, oil and gas.

Table 3.4 Estimation of Pay-Performance Sensitivity (subsample 1 & 2 )

Dependent Variables

Independent Variabtes

-- - - - .

(Arithrnetic Estimation) (Elasticity Estimation)

Intercept

CND

~(Shareholder Wealth)

CNDxa(Shareho1der Wealth)

~(Shareholder Wealth).,

CNDxa(Shareholder Wea1t.h)-,

alog(Shareho1der Wealth)

CNDxalog(Shareh1der Wealth)

alog(Shareho1der Wealth)_,

CNDxalog(Shareh1der Wealth).,

R'

Observations

Note: t-statistics are in parentheses. CND is a dummy variable that equaIs one for Canadian firms. The sample inchdes firms with average sales within ($400 miIIion, $8000 million)

Table 3.5 Estimation of Pay Performance Sensitivity (subsample 1)

lndependent Variables

Dependent Variables

(Arithmetic Estimation) (Elasticity Estimation)

Intercept

CND

A(S hareholder WeaIth)

CNDxa(Shareholder Wealth)

~(Shareholder Wealth).,

CNDxa(Shareho1der Wea1th)-,

alog(Shareho1der Wealth)

CNDxalog(Shareh1der Wealth)

alog(Shareho1der Wealth)-,

CNDxalog(Shareh1der Wealth)-,

R'

Observations

Note: t-statistics are in parentheses. CND is a dummy variable that equals one for Canadian firms. Subsample I includes the fims with average sales within ($400 million, $1000 million).

Table 3.6 Estimation of Pay-Performance Sensitivity (subsample 2)

Independent Variables

Dependent Variables

(Arithmetic Estimation) (Elasticity Estimation)

Intercept

CND

~(Shareho lder Wealth)

CNDxa(Shareho1der Wealth)

~(Shareholder Wealth)_,

CNDxa(Shareho1der Wealth).,

alog(S hareholder Wealth)

CNDxalog(Sharehlder Wealth)

alog(Shareholder Wealth),,

CNDxalog(Shareh1der Wealth)-,

R'

Observations

Note: t-statistics are in parentheses. CND is a dummy variable that equals one for Canadian fins. Subsarnple 2 include firms with average sales within ($1000 million, $8000 million)

Table 3.7 n i e US-Canada Differential and Firm Size (total sample)

Dependent Variables

Independent Variables alog(Sa1ary +Bonus) alog(Tota1 Pay)

( 1 (2) (3) (4)

Intercept

CND

CND x SIZE

alog(Shareho1der Wealth)

CNDxalog(Shareholder Wealth)

CNDxSIZE xalog(Shareho1der Wealth)

alog(S hareholder WeaIth). ,

CND xalog(Shareh1der Wea1th)-,

CNDx SIZE xalog(Shareho1der Wealth).,

R'

Observations

Note: t-statistics are in parentheses. CND is a dummy variable that equals one for Canadian fims. SIZE is measured as firm's average sales in %million.

Table 3.8 CE0 Stock Ownership as the Percentage of Shares Outstanding

Median Mean Observation (%) (W

Canadian CEOs

Total sample Subsample 1 Subsarnple 2

Totai sample Subsarnple 1 Subsample 2

Note: The data are for fiscal year 1993 and 1994. Subsample 1 includes f ims with average sales within ($400 million, !§ 1000 million). Subsample 2 includes firms with average sales within (% 1000 million, $8000 miIIion).

Table 3.9 Regressions of CE0 Stock Ownership Against Firm Size

Dependent Variable: log(Shares in %)

Independent Variables Canada) (US) ( Canada and US)

Intercept

CND

log(Sales)

CNDxlog(Sa1es)

R2

Observations

Note: t-statistics are in parentheses. CND is a dummy variable that equals one for Canadian firms.

Table 3.10 The Ratio of Stock Gains fiom Exercising Previously Granted Options Over Total CE0 Pay

Canadian Fims US Firms

The Ratio Observ. The Ratio Observ.

Total: sample Subsample 1

Subsarnple 2

Note: The data are for fiscal year 1993 and 1994. Subsample 1 inctudes fims with average sales within ($400 million, $1000 million). Subsample 2 indudes firms with average sales within ($1000 million, $8000 million). Total CE0 pay indudes direct payments and stock gains.

Table 3.1 1 Cornparison of Firm's Systematic Performance

Ave Retum P!4) Std Deviation Ave Retl Std Dev Obser- (Median) (Mean) (Median) (Mean) (Median) (Mean) vations

Çanadian Fims TotaI sarnple 0.48 -2.53 0.1 07 0.253 0.050 0.043 355 Submplc 1 0.70 -1 2 3 0.095 0.225 0.098 0.064 53

Monthly Subsample 2 0.76 -3.96 0.084 0.194 0.1 12 0.092 54 Rcturn

U S . Fims (1987-1991) Total sample 1.19 1.44 0.091 0.102 0.150 0.147 581

Subsampte 1 1.1 1 1.37 0.095 O. 105 0.130 0.141 80 Subsample 2 1.16 1.44 0.091 0.102 0.145 0.146 378

Çanadian F i r m ~ Total sample 9.83 19.41 0.331 0.573 0.321 0.295 309 Subsarnple 1 9.47 10.61 0.332 0.362 0.313 0.305 56

Annuai Subsample 2 7.41 8.43 0.265 0.325 0.321 0.308 59 Return

U.S. Firms ( 1984- 1994) TotaI sample 13-00 16.35 0.254 0.357 0.505 0.517 635

Subsample I 15.65 19.89 0.286 0.385 0.544 0.565 9 1

Subsarnple 2 12.13 16.33 0.250 0.373 0.493 0.504 JO2

Note: 1. US monthly return is retneved from the CRSP stock return file. Canadian monthly retum is obtained from the return file of the University of Western Ontario's TSE database. Annud return is calculated fiom the COMPUSTAT files for both U.S. and Canadian firms.

2. Ave Ret and Std Dev are average return and standard deviation of the firm's stock retum respectively. 3. Subsample 1 includes firms with average sales within (5400 million, $1000 million). Subsample 2 includes

fÏms with average sales within ($1000 million, $8000 million).

Table 3.12 Cornparison of CE0 Pay Levels - -

Canadian CE0 Pay U.S. CE0 Pay

(Median) (Mean) (Median) (Mean)

Total sample Subsample 1 Subsample 2

Total Pav

Total sample Subsample 1 Subsample 2

Note: The data are from 199 1 to 1994. AI1 variables are annual and in 199 1 US dollars (thousand).

Figure 3.1 Distribution of Firms

- Canadian

-US 1

O 10 20 30 40 50 60 70 80 9 Average Sales ($1 00 million)

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