2.1 Family-controlled firms, dual-class shares and CEO pay-performance sensitivity
Two main perspectives that explain CEO pay are the ‘optimal contracting’ and ‘managerial power’ theories. According to the ‘optimal contracting’ theory CEO pay is one solution to the agency problem between managers and shareholders (Jensen and Murphy
1990,
2010; Core et al.
2001; Conyon
2006). While managers, unlike shareholders, are usually risk-averse and more inclined towards fixed pay (Jensen and Meckling
1976; Devers et al.
2008; Elsaid and Davidson
2009),
6 linking CEO pay with firm’s financial performance creates incentives towards creating shareholder value. CEO pay can thus substitute for shareholder monitoring. Previous research within the optimal contracting paradigm finds, for example, that ownership concentration is associated with lower pay-performance sensitivity (Ke et al.
1999; Gao and Li
2015). In contrast, the ‘managerial power’ theory suggests that powerful managers with ties to the board may exacerbate agency problems by abusing the contracting environment and extracting rents in the form of excessive compensation (Bebchuk and Fried
2003,
2004; Muslu
2010; Morse et al.
2011). In line with this theory, research by Elsaid and Davidson (
2009) finds that high bargaining power of newly appointed CEOs vis-à-vis board (as measured by chosen CEO and board characteristics) is linked with greater proportion of salary in total pay.
Both ‘optimal contracting’ and ‘managerial power’ theories on executive compensation originate within the Anglo Saxon context, where type I agency conflict is especially pervasive due to mostly dispersed ownership structures of listed firms (Croci et al.
2012). In continental Europe and in other contexts with concentrated ownership structures and stronger presence of family control (Faccio and Lang
2002; Courteau et al.
2017) controlling shareholders may limit expropriation by managers through monitoring. Controlling shareholders may also provide stability and continuation of strategy, whilst concurrently creating agency conflicts of type II between controlling and non-controlling owners (Shleifer and Vishny
1986,
1997; Faccio and Lang
2002; Cronqvist and Nilsson
2003; Barontini et al.
2017; Courteau et al.
2017). Such conflicts include direct expropriation of value from minorities, for example through related party transactions (Enriques
2015; Courteau et al.
2017), or distorted decisions about firm size, investment decisions, or transfer of control (Claessens et al.
2002; La Porta et al.
2002; Cronqvist and Nilsson
2003; Masulis et al.
2009). The concerns about non-optimal decisions are especially pertinent when controlling shareholders use dual-class shares
7 (Bebchuk et al.
2000; Cronqvist and Nilsson
2003; Masulis et al.
2009). In the presence of divergence between voting and cash flow rights, controlling shareholders internalize only a fraction of negative corporate valuation consequences in case of value destroying decisions (Cronqvist and Nilsson
2003). In contexts characterized by concentrated control, I suggest a ‘controlling shareholder power’ perspective on CEO compensation.
Several studies document impact of family control on compensation practices in firms. Cohen and Lauterbach (
2008) report significantly higher pay to the CEO when he/she is a family member and Barak et al. (
2015) find the ‘excess’ pay is negatively correlated with end of period Tobin’s Q when CEO is the family member. This is interpreted as expropriation of value by controlling shareholders through excessive pay. In a similar vein, Barontini and Bozzi (
2011) find a positive association between high board compensation and the proportion of family members on board. Conversely, Croci et al. (
2012) and Collin et al. (
2014), document a lower pay level for CEOs in family-controlled firms. They interpret the finding as a lack of expropriation of value in family-controlled firms (Croci et al.
2012), or even a better governance in these firms compared to firms with other owners (Collin et al.
2014). Similarly, Gomez-Mejia et al. (
2003) find that compensation of family CEOs is lower than of non-family CEOs. However, lower CEO compensation in family-controlled firms overall, or for family CEOs in particular, can be a consequence of higher job security enjoyed by the CEOs, especially when they are members of the owner family (Gomez-Mejia et al.
2003). Similarly, a smaller fraction of equity-based pay for family CEOs may result from an already high ownership of the company shares by the CEO. By the same token, I suggest that family ties between family owners and CEOs shelter family CEOs from decreased compensation in case of poor financial performance. In result, pay-performance sensitivity is lower, ceteris paribus, in family-controlled firms with family CEOs. While according to the ‘managerial power’ theory managers with power influence the compensation process, here what matters is the biological and social factor in the form of the family tie.
While family ties are theorized to have the most impact on CEO pay in family-controlled firms with family CEOs, theoretical predictions about CEO compensation may depend more on the presence and use of dual-class shares in the context of other types of firms, including family-controlled firms with professional CEOs. Dual-class shares serve as a proxy for controlling shareholder preferences regarding strength of control. The divergence between voting and cash flow rights implies that the controlling shareholders value the control more than the cash flows rights stemming from ownership. Controlling shareholders may use compensation to endorse their preferred course of action and align CEOs interests with their own, even at the expense of divergence from minority interests. Previous research documents a positive association between the level of CEO compensation and dual –class shares status (Masulis et al.
2009; Amoako-Adu et al.
2011; De Cesari et al.
2016). In this paper, I instead investigate pay-performance sensitivity in relation to dual-class shares. Besides direct expropriation to gain loyalty of the CEO, type II agency conflict concerns non-optimal decisions driven by the controlling shareholder, which may decrease company value, as mentioned earlier (Claessens et al.
2002; La Porta et al.
2002; Cronqvist and Nilsson
2003; Masulis et al.
2009). The voting wedge implies high involvement of the major shareholder in decision making. Poor financial performance does not necessarily lead to lower compensation in cases where the CEO in essence implements decisions taken by the controlling shareholders; neither would good financial performance result in increased compensation. In result, pay-performance sensitivity is lower, ceteris paribus, in dual-class shares firms. CEO pay in these firms may reflect the alignment with the
will of the controlling shareholder rather than with financial performance.
8 While according to the ‘managerial power’ theory managers with power influence the compensation, in dual-class shares firms it is the ‘controlling shareholder’s power’ that matters.
2.2 Executive compensation regulations and pay-performance sensitivity
The 2004 EC Recommendation focused on disclosure of executive compensation. It included guidelines concerning a clear and comprehensive disclosure of the company’s remuneration policy, as well as individual directors’ pay and its components. Additionally, the recommendation introduced a requirement that any share-based programs needed approval through the annual general meeting and a mandatory or voluntary vote over the remuneration statement. The 2009 EC Recommendation, focused on guidelines concerning the remuneration process, rather than on its disclosure. It included requirements for the creation of a separate remuneration committee, independence of remuneration consultants, linking variable pay with predetermined and measurable performance criteria, vesting period for share-based remuneration, or clawback provisions.
All the requirements introduced by the 2004 and 2009 EC recommendations aim at the eradication of reward for failure or reward for luck, and seek to ensure a tighter linkage between pay and performance. These regulatory implementations thus allow for an investigation into how pay-performance sensitivity has changed over time. Previous research document increased pay-performance sensitivity in other countries. For example, Clarkson et al. (
2011) document an overall increase in pay-performance sensitivity over the years 2001–2009, the study window covering important changes in executive compensation regulations in Australia. Ferri and Maber (
2013) use UK data and show that ‘say on pay’ regulations increased sensitivity of pay to poor realizations of performance. I thus hypothesize that as result of the implementation of the EC recommendations pay-performance sensitivity increased in Sweden.
The executive compensation recommendations included several channels of impact aimed at increased ‘pay for performance’, namely disclosure, guidelines concerning remuneration process and pay structure (European Commission
2009). The impact of disclosure on pay-performance sensitivity has been studied specifically by previous studies in the Anglo-Saxon context. Clarkson et al. (
2011) argue that disclosure of remuneration details may lead companies to reassess their compensation packages to ensure that they are aligned with performance. They show that disclosure significantly and positively increases the slope of performance in the CEO pay regression (ibid). Vafeas and Afxentiou (
1998) find that after introduction of the compensation disclosure rule by SEC in the USA in 1992 the pay-performance sensitivity increased. Both accounting and stock performance explained CEO pay variation to a significantly higher degree when compared to the period before the rule was implemented. Zhou and Swan (
2006) find similar results in their study of the regulatory effects introduced in Canada in 1993; after the implementation of the new disclosure requirements, the pay-performance relationship strengthened. In the context of voluntary disclosure, De Franco et al. (
2013) document stronger pay-performance sensitivity for firms that issue management guidance. Disclosure of corporate information elicits control from outside stakeholders and strengthens corporate governance through putting pressure on remuneration committees to improve the alignment between pay and performance (Vafeas and Afxentiou
1998; Zhou and Swan
2006; Clarkson et al.
2011; De Franco et al.
2013; Leuz and Wysocki
2015). In many European countries, including Sweden, the European Recommendations were incorporated in corporate governance codes. These codes function on a ‘comply or explain’ basis. I hypothesize that firms that comply with the disclosure rules to a higher extent, show stronger pay-performance sensitivity.