Governance structure and the weighting of performance measures in CEO compensation

Abstract

We empirically examine how governance structure affects the design of executive compensation contracts and in particular, the implicit weights of firm performance measures in CEO's compensation. We find that compensation contracts in firms with higher takeover protection and where the CEO has more influence on governance decisions put more weight on accounting-based measures of performance (return on assets) compared to stock-based performance measures (market returns). In additional tests, we further find that CEO compensation in these firms has lower variance and a higher proportion of cash (versus stock-based) compensation. We further find that CEOs' incentives (measured as changes in CEO annual wealth which includes expected changes in the value of the CEO's equity holdings in addition to yearly compensation) do not vary across governance structures. These findings are consistent with CEOs in firms with high takeover protection and where they have more influence on governance negotiating different contracts. Ó Springer Science+Business Media, LLC 2006through their policy decisions (Hermalin & Weisbach, 2003;Jensen, 1993) and therefore how contracts influence CEO behavior. Internal governance bodies are also directly responsible for the design of CEO compensation contracts and this contracting process is among the main tasks that directors have. Core, Holthausen, & Larcker (1999), using survey-based compensation data, provide initial evidence on the relationship between governance and CEO compensation. Their findings indicate that governance structures subject to more influence from the CEO are correlated with higher level of CEO compensation. They also find that these governance structures are correlated with worse stock returns, and worse operating performance. The authors argue that this evidence is consistent with the presence of agency costs associated with governance structures where the CEO can exert bargaining power to write optimal contracts more favorable to his or her interests.While existing evidence indicates that certain governance structures allow CEOs to write these contracts, it remains unknown how these contracts differ across governance structures. The objective of this study is to examine whether the design of CEO compensation contracts varies across governance structures. We focus on one aspect of contract design: the implicit weight on various performance measures. CEOs may exert their bargaining power by increasing the weight that the contract puts on certain measures; for instance they may prefer more controllable measures that reduce variability in actual compensation. From the CEO's point of view, controllable measures have a better signal-to-noise ratio, which reduces the uncertainty about outcomes and have a more transparent association between certain types of effort and measured outcome-thus, making it easier for the agent to exert the type and level of effort required to achieve the objectives.We focus on two main classes of performance measures: accounting-based measures of perf...

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