The effect of say on pay on CEO compensation and spill-over effect on corporate cash holdings: Evidence from Australia

Highlights

• We find the Act changes CEO compensation structure.

• We also find the Act has a spill-over effect on cash holdings.

• Our study provides insight to global discussion on say on pay legislations.

Abstract

We examine the impact of Australia's Remuneration Amendment Act 2011 on CEO compensation and its spill-over effect on cash holdings to better understand how the new legislation affects the principal–agent relationship. Using a sample of ASX top 300 firms from 2004 to 2015, we find that the Act leads to more use of equity-based compensation. We also document that, after the introduction of the Act, CEO equity-based and total compensations are negatively related with cash holdings, i.e., more equity and total compensations lead to lower cash holdings (a spill-over effect), indicating alignment of the principal–agent interests. Our results are robust to different estimation techniques. Our findings confirm that the Act is effective in driving a more efficient CEO pay strucure and provide important insights for the global discussion on compensation regulations.

Introduction

Australia introduced a new shareholder ‘say on pay’ legislation, Corporations Amendment (Improving Accountability on Director and Executive Remuneration) Act 2011 (the Remuneration Amendment Act or the Act, hereafter), which took effect on 1 July 2011. The Remuneration Amendment Act sets out unique requirements that enable shareholders to register their dissenting votes more effectually against CEO remuneration plans at the Annual General Meetings (AGMs)¹ and that force firms to face potentially severe consequences if shareholder concerns are not adequately addressed (Monem and Ng, 2013; Grosse et al., 2017). Due to its unique requirements, the Act has undoubtedly the capacity to influence firms' CEO compensation policies directly and other related policies indirectly (Walker, 2010; Grosse et al., 2017). This study examines two related research questions arising from the Act: (1) what impact does the Act have on CEO compensation, in total and in composition? (2) how does CEO compensation relate, after the Act, to corporate cash holdings – a key firm policy?

The Remuneration Amendment Act, widely known as the ‘two-strikes’ rule, provides shareholders, especially the dispersed and minority groups, with a more effective mechanism to register their dissent on CEO remuneration plans with a low cut-off point (i.e., a minimum 25% of votes) to trigger a ‘strike’ against the firm. If a firm receives a strike at two consecutive AGMs, shareholders can vote at the second AGM to decide whether the board should be put up for re-election: if approved, a re-election of the board will take place. The Act also sets out clear process and actions for corporate boards to undertake to address shareholder concerns, and explains the consequences if shareholder concerns are not adequately mitigated. The requirements are specific and the consequences are predictable and potentially severe: dissolution and re-election of boards (Monem and Ng, 2013; Grosse et al., 2017). With the rigorous requirements of the Act, shareholders can expect to obtain their preferred ways to remunerate executives more easily, and firms will amend and implement remuneration policies to satisfy shareholder demands.

Since the two-strikes rule was enacted, a few studies have investigated the effect of the Act on CEO compensation from different perspectives. For instance, Monem and Ng (2013) and Bugeja et al. (2016) examine the impact of receiving a strike on the pay–performance link, and Faghani et al. (2015) and Grosse et al. (2017) investigate the association between CEO pay and the incidence of receiving a strike. These studies employ strike data and matched-pair design: they identify firms that receive strike (either ‘first strike’ only or ‘first strike’ and ‘second strike’) and match each strike firm with a ‘non-strike’ firm to examine the impact of the Act.

While these studies provide useful insight into shareholder dissent votes, they have not examined the intended influence of the Act on CEO pay (in total and in composition) in all the firms under the Act, given that the firms are obliged to implement the regulatory requirements. It is reasonable to expect that, after the Act became effective, all firms (both strike and non-strike firms) would endeavor to review CEO compensation and adjust, if needed, to meet the Act's requirements and the shareholders' expectations, to avoid receiving dissent votes. The analysis of only strike firms, matched with non-strike firms, in these studies does not preclude the possibility that the Act has impacted the CEO compensation of the firms that are not examined.² Consequently, the question regarding the impact the Act has on CEO compensation across the market remains unanswered (Shan and Walter, 2016). We are motivated to fill this research gap by investigating the impact of the Act on CEO compensation in terms of the total pay and three main pay components: stock options, equity-based (including stock options and shares) compensation and cash bonuses.³ We find that, after the Act, Australian firms use fewer cash bonuses and more equity-based compensation, resulting in an increase in total compensation.

Corporations worldwide have considerably increased their cash holdings over the past two decades (Iskandar-Datta and Jia, 2012; Amess et al., 2015) and Australian firms show similar patterns (La Cava and Windsor, 2016). As excess cash holdings are considered detrimental to shareholder wealth (Jensen and Meckling, 1976; Dittmar and Mahrt-Smith, 2007; Tong, 2010), the phenomenon has attracted enormous research interest in investigating the causes and consequences of cash holdings (Amess et al., 2015). The causes are linked to the management motive for holding cash, while the consequences are examined through different measures, such as the value of cash holdings and firm performance. The management motive for holding excess cash is in turn associated with CEO compensation incentives (Opler et al., 1999; Tong, 2010; Liu and Mauer, 2011).

Excess cash holdings are said to be an agency problem due to managerial opportunism (Jensen and Meckling, 1976). Prior studies have examined how CEO compensation incentives (as an internal governance mechanism) influence corporate cash holding decisions: an efficient CEO pay structure that aligns the interests of managers and shareholders can limit a firm's investment in non-operational cash (e.g., Tong, 2010; Liu and Mauer, 2011). Equity-based compensation (e.g., options and shares) can help overcome managers' aversion to risk, aligning their interests with those of shareholders (Jensen and Meckling, 1976; Jensen and Murphy, 1990; Clarkson et al., 2011). With increased equity components in total compensation, managers would be motivated to pursue profitable investment projects to maximize shareholder value rather than to hold cash. Prior studies, which investigate the relationship between CEO compensation incentives and cash holdings, document that equity-based incentives can limit firms' investment in cash (e.g., Tong, 2010).

The Act's capacity to influence CEO pay composition (resulting in fewer cash bonuses and more equity-based pay) leads to changes in CEO compensation incentives. Knowing that CEO's equity-based compensation better aligns management incentives with shareholders' interests, we expect firms to adopt cash policies that maximize firm value and shareholder wealth. Furthermore, shareholders may also take the opportunity of a dissenting vote to express their concerns over other firm policies such as dividend and leverage (Grosse et al., 2017). Consequently, we expect the Act (as an external governance mechanism) has a spill-over effect on corporate cash holdings. To date, however, no empirical study examines this important relationship. Our study fills this research gap by investigating the interaction effect of the Act and CEO compensation on cash holdings.

Our sample consists of the top 300 capitalized firms listed on the Australian Stock Exchange (ASX) for the period 2004 to 2015, yielding 3064 firm-year observations. We conduct an empirical analysis using several multivariate tests. We find the Act impacts CEO compensation structure, in that Australian firms now use more equity-based incentives (i.e., options and shares) and fewer cash bonuses to remunerate CEOs, which also results in higher total compensation. We also find, after the Act, that CEO's equity-based and total pay incentives are negatively related to cash holdings, a key corporate policy, suggesting that higher CEO equity (thus risk) incentives lead to lower cash holdings. Further, we report a positive relationship between CEO incentives and the value of cash holdings after the Act. Overall, our results indicate that the Act has caused positive changes to CEO equity compensation and has a spill-over effect on cash holdings. Our results are robust to several econometrical techniques including the ordinary least square (OLS), and fixed effect (FE). Our results are consistent and robust to narrow samples, the two-step system generalized method of moments (GMM), and the propensity score matching (PSM) estimators.

We contribute to the CEO compensation literature in the following ways. First, our findings suggest that the Act is effective in changing the CEO compensation structure, leading to more equity-based incentives and fewer cash bonuses to remunerate CEOs. This change is observed across the market of large and established Australian firms, not just in firms that receive strikes (which are small and less profitable, according to Monem and Ng, 2013), and is consistent with shareholders' preferences. Second, the Act leads to an increase in CEO total compensation, as a result of the increase in equity incentives more than the reduction in cash bonuses, due to the risk associated with equity compensation. This finding implies that shareholders do not use the two-strikes rule to target CEO total compensation (consistent with Grosse et al., 2017) as long as CEO pay structure meets their expectations. Third, we demonstrate in a novel piece of evidence that, after the Act, the relationship between CEO equity (as well as total) incentives and cash holdings is negative, indicating that the Act has a spill-over effect on cash holdings. This negative relationship indicates that the Act has the capacity to drive the alignment of the principal–agent interests through its influence on CEO compensation policies. In this regard, we praise the Act for its achievements. Our study, therefore, provides useful insight into this unique legislation and contributes to the global discussion on compensation regulations.

The remainder of the paper is organized as follows: Section 2 reviews related literature and develops the hypotheses; Section 3 describes the research design and models; Section 4 presents the empirical results; and Section 5 concludes this paper.