John E. Core

Corporate governance, chief executive officer compensation, and firm performance

Abstract We find that measures of board and ownership structure explain a significant amount of cross-sectional variation in CEO compensation, after controlling for standard economic determinants of pay. Moreover, the signs of the coefficients on the board and ownership structure variables suggest that CEOs earn greater compensation when governance structures are less effective. We also find that the predicted component of compensation arising from these characteristics of board and ownership structure has a statistically significant negative relation with subsequent firm operating and stock return performance. Overall, our results suggest that firms with weaker governance structures have greater agency problems; that CEOs at firms with greater agency problems receive greater compensation; and that firms with greater agency problems perform worse.

The use of equity grants to manage optimal equity incentive levels

We predict and find that firms use annual grants of options and restricted stock to CEOs to manage the optimal level of equity incentives. We model optimal equity incentive levels for CEOs, and use the residuals from this model to measure deviations between CEOs’ holdings of equity incentives and optimal levels. We find that grants of new incentives from options and restricted stock are negatively related to these deviations. Overall, our evidence suggests that firms set optimal equity incentive levels and grant new equity incentives in a manner that is consistent with economic theory.

A Review of the Empirical Disclosure Literature: Discussion

Healy and Palepu (2001) provide a broad review of the empirical disclosure literature. This discussion expands on their survey of the empirical voluntary disclosure literature, and offers more specific suggestions for future research.

The Other Side of the Trade-Off: The Impact of Risk on Executive Compensation: A Revised Comment

In contrast to a body of research starting with Demsetz and Lehn (1985) that predict and find a strong positive association between firm percent return variance and incentives, Aggarwal and Samwick (1999) predict and find a strong negative association between firm dollar return variance and incentives. A key assumption of Aggarwal and Samwicks analysis is that firm risk is the sole determinant of the pay-performance sensitivity, and that expected dollar return variance (the product of expected percent return variance and firm market value) is the correct proxy for risk. We demonstrate that dollar return variance is a noisy measure of firm market value and argue that A&S re-documents a size effect that is already well-known from prior literature. Because dollar return variance is shown to be a noisy proxy for firm size, the A&S empirical specification does not include an appropriate proxy for firm risk. The data consistently show that it is important to examine market value and percent return variance as separate determinants of the effects of size and risk on CEO incentives, as is done in the managerial ownership literature. In a model of CEO incentives that includes market value and risk as separate explanatory variables, we find that, contrary to the results in A&S, percent return variance is positively associated with incentives. The A&S empirical work cannot be interpreted as evidence of a negative relation between risk and incentives.

The Relation between Reporting Quality and Financing and Investment: Evidence from Changes in Financing Capacity

We use changes in the value of a firms real estate assets as an exogenous change in a firms financing capacity to examine (1) the relation between reporting quality and financing and investment conditional on this change, and (2) firms’ reporting quality responses to the change in financing capacity. We find that financing and investment by firms with higher reporting quality is less affected by changes in real estate values than are financing and investment by firms with lower reporting quality. Further, firms increase reporting quality in response to decreases in financing capacity. Our findings contribute to the literature on reporting quality and investment, and on the determinants of reporting quality choices.

When Contracts Require Risk-Averse Executives to Hold Equity: Implications for Option Valuation and Relative Performance Evaluation

A growing body of literature suggests that because an executive is risk-averse and undiversified, he values equity compensation and incentives at less than market value. This discount on valuation is driven by the assumption that the executive is constrained from rebalancing his portfolio following an equity grant, and as such, the payment of equity compensation permanently increases the risk and incentives borne by the executive. We relax this exogenous assumption, and assume that firms contract with their executives and agree upon a specified level of risk. Firms expect and require that executives rebalance their portfolios when equity risk rises above or falls below the contracted level. Under these assumptions, we show that the executive does not discount the value of equity compensation or changes in the value of his equity portfolio. The notion that firms write contracts that require executives to hold equity also suggests that executive contracts are more consistent with relative performance evaluation than has been found in prior empirical research. Specifically, this type of contract requires executives to reduce the fraction of their total wealth held in a well-diversified portfolio and to increase their investment in firm equity.

Is There a Case for Regulating Executive Pay in the Financial Services Industry

Since at least as early as the 1950s, the press, general public, politicians, and academic researchers have remarked on the high levels of US CEO pay and questioned whether these levels are fair and appropriate, as well as whether executive compensation provides proper incentives. Undoubtedly, executive compensation and incentives will continue to be a hotly debated issue for years to come and we do not contend to settle these disputes in this article. Rather, we begin by highlighting some basic descriptive analysis of CEO pay levels and incentives, in general, as well as a comparative analysis of CEO pay and incentives in the financial services industry. We then describe recent proposals to regulate executive pay in the financial services industry (and more generally), and discuss the merits of such regulation. In summary, although we agree broadly with regulators’ views on the principles that should guide executive compensation practices, we believe that many of these principles are already engrained in the typical executive compensation plan. We also have serious reservations about whether several of the regulatory proposals would achieve their stated objectives.

Project Selection, Production, Uncertainty, and Incentives*

We model how a firm motivates a risk-averse CEO not only to exert productive effort but also to evaluate and to adopt new projects. Evaluation effort produces better information on risky projects, but the agent may reject a good project in order to avoid risk. Productive effort increases the mean of firm value but the agent faces uncertainty in his productivity due to the externality created by the new project. We examine the effect of uncertainty about the success of the new project on contract slope and convexity. The convexity in the contract protects the agent from uncertainty about the success of the new project, and the contract is more convex when uncertainty is greater. The contract slope encourages the agent to work on both tasks and to make the right project choice. We show conditions under which increases in uncertainty about the success of the new project cause increases in the contract slope. This positive relation between contract slope and uncertainty contrasts with the standard agency models prediction of a decreasing relation. The features of the optimal contract are broadly consistent with prior empirical evidence on cross-sectional variation in CEO incentives. In addition our model suggests that there can be two groups of firms. The first group of firms has high uncertainty, and there is an increasing relation between risk and CEO incentives. The second group of firms has lower uncertainty, and there is the traditional decreasing relation between risk and CEO incentives.

When Efficient Contracts Require Risk-Averse Executives to Hold Equity: Implications for Option Valuation, for Relative Performance Evaluation, and for the Corporate Governance Debate

A growing body of literature suggests that because risk-averse executives are undiversified, they value equity compensation at significantly less (over 30%) than market value. This valuation discount is driven by the assumptions that the firm ignores existing incentives when it grants equity, and does not allow executives to buy or sell firm stock for a multi-year period following a grant. We instead assume that firms contract efficiently, which means that contracts require executives to hold precise amounts of incentives (e.g., Holmstrom, 1979). Under this efficient contracting assumption, we show that executive discounts to the value of equity compensation are small (less than 6%). Finally, when firms write efficient contracts over executive wealth, these contracts are consistent with relative performance evaluation: they require executives to increase their exposure to firm-specific risk by reducing (increasing) the amount of wealth they hold in diversified portfolios (firm equity).

Managerial Incentives to Increase Risk Provided by Debt, Stock, and Options

We measure a manager’s risk-taking incentives as the total sensitivity of the manager’s debt, stock, and option holdings to firm volatility. We compare this measure with the option vega and with the relative measures used by the prior literature. Vega does not capture risk-taking incentives from managers’ stock and debt holdings and does not reflect the fact that employee options are warrants. The relative measures do not incorporate the sensitivity of options to volatility. Our new measure explains risk choices better than vega and the relative measures and should be useful for future research on managers’ risk choices. Data and the online appendix are available at https://doi.org/10.1287/mnsc.2017.2811. This paper was accepted by Shiva Rajgopal, accounting.