Executive Compensation, Firm Performance and Governance An Empirical Analysis
This paper investigates the determinants of executive compensation using the most recent data on firm performance, corporate governance and managerial compensation from a large sample of Indian firms. A linear regression model is used to develop explanations for total chief executive officer compensation and the proportion of incentive pay that forms a part of the CEO’s compensation. It is found that firm size is a significant determinant of both these aspects of CEO compensation. The results also show that CEOs who are promoters of their firms earn significantly more than their ordinary counterparts. Such individuals also earn a much larger component of their compensation as incentive pay. In addition, this study also quantifies the significant divergences in compensation policies between private and public sector firms.
ADITYA PARTHASARATHY, KRISHNAKUMAR MENON, DEBASHISH BHATTACHERJEE
I Introduction
C
Both organisational and finance theories state that the distribution of power among corporate managers and shareholders has significant implications for firm performance. The problems of managerial motivation, behaviour and compensation can be seen under this larger framework wherein the contractual relationship that is defined to solve these problems ultimately has an impact on how power is distributed between the two groups. The critical questions that arise from this for the shareholders are whom to appoint as managers and how to incentivise them so that their performance leads to wealth maximisation after accounting for the costs of such processes. The presence of reasonably well functioning labour markets for managers, consisting of people with the skills to carry out the expected activities, solves the former problem. But historically, it is the latter problem, that of incentivising appropriate behaviour and rewarding performance that has proved to be the more troublesome.
Standard economic solutions for incentives include designing remuneration packages that are “tied” to either firm performance or increases in shareholder wealth. This is usually achieved by a number of ways including performance-based variable pay or commission, stock options etc. However, such measures in isolation do not solve the problem of alignment of objectives. The question of how such a solution is arrived at and the role played by each party in such a process still remains. Economic theory states that the right to appoint agents and fix their compensation (a “control” right under the principal agent framework) should always be in the hands of the principals, i e, the shareholders (as opposed to the “decision” rights that are needed to run the corporation, which can be delegated to the agents). However, given that most shareholders in a corporation are dispersed and do not own a “controlling” stake in the firm, it often becomes too costly to be involved in this process. In effect, the agency costs1 increase. This has severe implications for the problems relating to fixing managerial compensation, i e, are the shareholders, in effect, giving up their control rights when they do not actively participate in the decision-making process?
The functioning of a board of directors in modern corporations serves as a mechanism for institutionalising the process of fixing managerial compensation and monitoring performance, thereby ensuring that the wealth maximisation objective of the shareholders is maintained. The members of the board have the responsibility of ensuring that the interests of the shareholders are upheld and that the actions of the managers do not sideline them in any way. In effect this mechanism places certain restraints on the power that managers enjoy and the degree of control that they can exercise on shareholder wealth.
At the same time, members of the top management like the chief executive officer (CEO) are often members of the board. So there is a possibility of collusion between the members of the board leading to a situation wherein the process of “incentivising” performance in the interests of the shareholders may break down. It is here that factors like board composition and division of responsibilities among board members become important.
In recent years, the notion of “corporate governance” has gained a lot of attention in the study of corporate objectives and performance. Corporate governance is commonly understood as the set of processes and conventions that affect the way a corporation is directed, administered or controlled.2 The principles of corporate governance lay out a set of practices that the board of directors needs to adopt to ensure economic efficiency and the alignment of interests between all the stakeholders of the organisation. In the context of executive compensation, good corporate governance requires certain mechanisms in the process of fixing compensation and monitoring top management performance. These include the presence of “independent” directors on the board, division of responsibilities between the chairman and the CEO and the establishment of compensation committees. The strengthening of corporate governance norms all over the world and the increasing importance given to it by financial markets has forced companies to adopt suitable reforms in their compensation policies for top executives.
In the Indian context, the issue of executive compensation has been seen with greater interest since the start of economic liberalisation in the early 1990s. The post-liberalisation periodhas also seen a steady increase in managerial salaries at all levels. Increasing profitability of companies, competition in the market for managerial talent and the practice of benchmarking company policies with global standards have all contributed towards the rise in executive compensation. All these changes have resulted in new ways in which top management compensation is decided and enforced in Indian companies. Another feature unique to the Indian context (vis-à-vis western countries) is the dominance of “family-owned” companies. These companies in effect have “owner-managers”, with the same group of people who own the company being members of its top management. Therefore, the study of compensation policies in the Indian context can potentially serve as a useful way of analysing the effect of the presence of owner managers.
This paper attempts to establish the interrelationships between executive compensation, firm performance and various corporate governance parameters by studying a large sample of Indian companies. A linear regression model that captures compensation data along with key financial performance and corporate governance parameters is used to explain the determinants of executive compensation.
The rest of this paper is organised as follows: Section II contains an overview of the existing literature on executive compensation, firm performance and other factors. Section III describes the empirical model used and hypotheses tested. Section IV describes the data that has been used for this study. Section V presents and discusses the results and Section VI provides a conclusion and suggests possible future research themes in this area.
II Literature Review
The link between executive compensation and corporate performance has been explored extensively in western countries, especially in the US. Public debate in these countries revolving around executive compensation focuses mainly on the link between company performance and executive compensation. The question of whether executive compensation reflects company performance is a controversial one, with different authors taking up widely different positions on the issue.
Murphy (1986) states that the belief that top executives in companies are excessively paid is flawed and displays a lack of understanding about the managerial labour market. He points out that cross sectional studies that analyse executive compensation across companies at a point in time cannot point out the correlation between pay and performance. Instead it is the correlation between pay and performance over time for a company that can provide insights into whether pay and performance are correlated. Such a study showed that pay and performance of top executives are strongly and positively correlated. Besides this, short-term and long-term incentive plans benefit shareholders by “incentivising” managers to perform better in their interests.
In a similar vein, Jensen and Murphy (1990a) question the importance of excessive compensation in public debates. They instead propose that it is the mode in which CEOs are paid (cash, stock options, bonuses, etc) that should be analysed rather than just focusing on how much CEOs are paid. Based on a large sample of data on executive compensation spanning half a century, they conclude that changes in compensation do not reflect changes in corporate performance because a $ 1,000 change in market value of a company resulted in just 6.7 cents increase in the salary and bonus of the CEO. They go on to recommend that in the shareholder’s interests, managers need to be given big rewards for outstanding performance and suitable penalties for underperformance.
Murphy and Jensen (1990b) also state that the level of pay affects the quality of managers an organisation can attract. They argue that if pay and performance are not strongly correlated in companies, the phenomenon of “corporate brain drain” where the most skilled persons will self select into other rewarding professions (like lawyers, consultants, etc) is inevitable.
Another interesting area of research regarding executive compensation is whether the level and mode of compensation has any effect on future firm performance. Abowd (1990) using a data set of more than 16,000 managers in 250 large corporations in the early 1980s, shows that paying an incremental 10 per cent bonus for good performance results in a 0.3-0.9 per cent increase in economic performance in the subsequent fiscal year. Further, paying an incremental 10 per cent bonus for good stock performance results in a 4 per cent-12 per cent increase in stock performance in the subsequent period.
The broad theme in the above studies is to study the relationships between pay and performance and the effect of modes of compensation like stock options, bonuses, etc. The underlying assumption is that structuring suitable compensation contracts can serve as a remedy to the principal agent problem.
There have been attempts to develop alternative explanations for executive compensation different from the above approach. One of the alternative frameworks is that of “managerial power”. According to this approach, the design of executive compensation contracts is seen not as a remedy for the principal agent problem, but as a part of the principal agent problem itself. According to Bebchuk and Fried (2003), managers are in a position to affect their own pay and will do so in a way that will weaken the link between their pay and performance. They question the effectiveness of the board of directors to fix an effective compensation contract and monitor managerial performance. Since the executive directors on the board (consisting of the CEO and other top managers) wield influence on the appointment and compensation of the other members of the board, there is the possibility of collusion as the other directors can maximise their utility by either seeking reappointments or increasing their remuneration with the help of the CEO. Consequently, there is little possibility of arms length bargaining between the board and the top management when deciding the compensation contract.
The increasing importance given to corporate governance in public discussions about corporate performance has led researchers to study the impact of various corporate governance parameters on executive compensation. The focus of such studies has been to explain the differences in compensation across firms based on the differences in corporate governance practices.
Pukthuanthong et al (2004) and Talmor and Wallace (2001) studied CEO compensation in the US financial services sector. They found that corporate governance parameters like board characteristics and ownership structure are leading determinants of pay variation across firms. Davila and Penalva (2004) find that weak corporate governance results in compensation contracts that put more weight on accounting measures rather than market based returns. They also report that weaker corporate governance is associated with lower variability in executive pay and higher cash components of total pay.
The above results are corroborated by Core et al (1999) by studying a sample of large US firms over a three-year period. They report that variation in CEO compensation across firms is explained to a significant extent by board and ownership structure. CEOs also earn greater compensation when corporate governance structures are less effective. The conclusion being that firms with weaker corporate governance mechanisms face higher agency costs and the CEOs of such firms earn higher levels of compensation.
It must be noted that the way corporations are governed varies significantly across countries due to the differences in institutional and legal frameworks. Countries in North America and western Europe have well evolved systems of corporate governance unlike countries in eastern Europe and Asia where the introduction of western style corporate governance practices is a recent phenomenon. At the same time, most of the studies on executive compensation have been carried out in the context of American and European organisations. Management authors like Khanna and Palepu (1997) have pointed out the significant differences in the “institutional context” in which firms in emerging markets operate. The institutional context is defined as the set of product, capital and labour markets along with their associated regulatory and legal systems. The authors argue that the capital and labour markets are quite underdeveloped in these countries. In light of this, the relevance of research on executive compensation carried out in western countries in the context of emerging economies can be questioned.
The work by Fung et al (2001) is an attempt to examine the issue of executive compensation in the Chinese context. They find that corporate governance has a significant impact on compensation. However, the nature of relationship between variables is quite different from earlier studies. Firms with a larger number of directors tend to restrict CEO compensation which is in contrast to studies carried out in the US.
In the Indian context, interest in the study of managerial labour market and executive compensation has increased only in the last 10-15 years. The effect of economic liberalisation along with the wide-ranging changes in the market for managerial talent has resulted in significant changes in the compensation policies adopted by Indian companies. The issue has also seen greater public attention (especially seen in the business press in India) even though there have been very few debates on the excesses of executive compensation. Annual compensation surveys are now a common feature in business magazines and newspapers. In one such recent survey, Swami (2005) reported that CEOs of many Indian companies saw salary increases of the order of 300 per cent in the year 2004. The study also reported that variable pay is increasingly becoming the highest contributor to the salary package.
There have been very few empirical studies on the determinants of managerial compensation in the Indian context. Bhattacherjee et al (1998) explored the effects of economic liberalisation on managerial compensation policies in Indian firms. They hypothesised that the pay of executives became more sensitive to firm performance after liberalisation. Using 237 CEO years of data covering the period before and after liberalisation, it was found that a Rs 100 increase in either sales or shareholder’s wealth increased the pay of the CEO by 15 and 22 paise respectively. Accounting based performance measures were not found to be significant in explaining CEO pay. There was also a clear increase in sensitivity of pay to firm performance post liberalisation in large firms.
Ramaswamy et al (2000), using a sample of the top 150 Indian firms hypothesised that human capital, firm performance and corporate governance variables jointly determine CEO remuneration. They found that firm size was not a significant explanatory variable of CEO compensation, rather firm performance (as measured by Return on Assets) was. Family ownership of a firm was negatively related to CEO pay. The authors explain this by postulating that family ownership and management significantly reduces the divergence of interests between managers and shareholders. They also found that CEO duality (i e, the same individual occupying the CEO and chairman positions) and the proportion of insider directors has no relation to executive compensation in family owned firms whereas they are key variables in explaining compensation in non-family owned firms.
Ghosh (2003) studied the compensation of the board of directors along with CEO compensation to capture the effects of inefficient monitoring by the board. The model that was used included firm performance, corporate governance and corporate diversification measures as determinants of CEO and board compensation. Using data from a large number of firms in the manufacturing sector, it was found that board compensation depends on current and past year performance while CEO compensation depends on only current year performance. Conventional personal attributes of the CEO like education, experience, etc, were found to be ineffective in explaining CEO compensation. Firm size was found to be a significant variable in explaining inter-firm differences in compensation.
This paper attempts to integrate the approaches followed in the above works by looking at multiple factors including firm performance, shareholder wealth changes and corporate governance parameters to develop an explanatory model for executive compensation in Indian firms. The data set used is recent and large, covering a wide cross section of firms across industries. This paper considerably adds to the Bhattacherjee et al (1998), Ramaswamy et al (2000) and Ghosh (2003) papers while incorporating features from all of them.
III Empirical Procedures
This paper deals with four broad sets of factors that jointly determine executive compensation in Indian firms: firm performance, firm-specific characteristics, shareholder wealth changes and key corporate governance parameters. Thus, our basic model is:Executive Compensation = ƒ (firm performance, firm characteristics, shareholder wealth, corporate governance indicators)
Two different aspects of executive compensation are modelled in this paper. They are total pay of the CEO and the ratio of variable (or incentive) pay to total pay of the CEO. It is assumed that the same set of independent variables determine both these dependent variables.
Executive Compensation and Firm Performance
There are a number of ways to measure firm performance, but the easiest and most commonly used method is to use its financial performance measures. Definitions of financial performance measures are quite standardised and used widely to study firm performance. It is also easy to obtain as public limited companies have to publicly disclose their financial results to fulfil regulatory requirements.
Out of the number of financial performance measures available, profitability measures are used in this study to measure firm performance. These profitability measures can be derived from the accounting information that firms disclose periodically. Two of the most commonly used profitability measures are net profit margin (NPM) and return on assets (ROA).3 Being ratios, these measures are normalised for any size effects among different firms.
The use of incentive or performance-linked pay, as a tool to motivate managers and induce risk taking, has been widely recognised in the economic literature.4 An employment contract that contains provisions for incentive pay will result in managers being paid higher amounts of variable pay on achieving higher levels of profitability. Paying incentive pay in the current period can also be seen as a tool for motivating managers to achieve superior performance in subsequent periods. Therefore, the two propositions above give rise to the first set of hypotheses tested in this paper.
Hypothesis 1A: Ceteris paribus, NPM (or ROA) of a firm and total CEO pay will be positively associated.
Hypothesis 1B: Ceteris paribus, NPM (or ROA) and the ratio of variable to total CEO pay will be positively associated.
The values of NPM and ROA capture the firm’s performance in a single time period only. It must be kept in mind that generally the appointment of managers by shareholders is for more than a single time period. So, shareholders expect managers to deliver profits for an extended period of time. An efficient contract would therefore be one where managers are rewarded for achieving incremental profits across time periods. The effect on compensation can be studied by looking at the values of “incremental” NPM and ROA where incremental NPM (and ROA) is defined as:
Incremental NPM = NPMt – NPMt–1 where the two values of NPM are for two consecutive time periods (t and t–1).
Using similar arguments as before, it can be hypothesised that:
Hypothesis 2A: Ceteris paribus, Incremental NPM (or ROA) and total CEO pay will be positively associated.
Hypothesis 2B: Ceteris paribus, Incremental NPM (or ROA) and the ratio of variable to total CEO pay will be positively associated.
Executive Compensation and Firm Characteristics
A number of firm specific characteristics can be thought as influencing executive compensation. Earlier studies in the Indian context [Ramaswamy et al 2000; Ghosh 2003] have used different characteristics like size, extent of diversification, complexity of the firm’s business and characteristics of the industry the firm operates in. The firm-specific characteristics that are used in this study are:
Firm Size
A number of earlier studies [Core et al 1999; Murphy 1999; Ramaswamy et al 2000; Talmor and Wallace 2001; Fung et al 2001; Ghosh 2003] on executive compensation have incorporated firm size as an explanatory variable. The basic intuition behind this is that larger firms will be in a position to pay their managers more because the size of their businesses is bigger resulting in greater revenues and profits (after adjusting for the sizes of their managerial workforces). Some of the studies [Core et al 1999; Talmor and Wallace 2001; Ghosh 2003] have also found firm size to be a statistically significant variable in determining managerial compensation. In this paper, firm size is used as a control variable so that any differences in compensation due to firm size across companies in the data set are captured.
There can be a number of variables that measure firm size: revenues, profits, number of employees, etc. In the above studies, the sales or revenue of a company from its operations is used to represent firm size. We too use the firm’s sales or revenues from its operations as a control variable.
Hypothesis 3A: Ceteris paribus, the sales (or revenue) of a firm and total CEO pay will be positively associated.
Hypothesis 3B: Ceteris paribus, the sales (or revenue) of a firm and the ratio of variable to total CEO pay will be positively associated.
Firm Being a Public Sector Undertaking
The case of public sector undertakings (PSU) is unique to the Indian context where these companies are owned and managed by the government. From the viewpoint of managerial compensation, there are a few factors that make these set of firms unique. Firstly, the process adopted for deciding managerial compensation in these firms in widely different from the practices in the private sector. Compensation in PSUs is decided by the government and is subject to government rules and regulations, i e, a “pay commission” model of “administered pricing”. The firm on its own has little or no autonomy in deciding its managerial salaries. It has also been reported that the absolute levels of compensation at all levels in PSUs is far less than in the private corporate sector and that the PSUs do not usually adopt any significant incentive pay plans to reward performance [Swami 2005]. Therefore, a dummy variable representing whether a firm is a PSU or not will be used as a control variable in our model.
Hypothesis 4A: Ceteris paribus, total CEO pay will be lower for firms that are PSUs.
Hypothesis 4B: Ceteris paribus, the ratio of variable to total CEO pay will be lower in firms that are PSUs compared to firms that are not.
Firm Being Part of a Multinational Corporation
This study also aims to account for the presence of multinational corporations (MNCs) in the Indian corporate sector. These firms usually adopt policies that closely resemble the compensation policies adopted by them in other parts of the world. This would result in a difference from other Indian firms in terms of compensation policies. Again therefore we use a dummy variable representing whether a firm is a MNC or not in the model.
Hypothesis 5A: Ceteris paribus, total CEO pay will be higher in an MNC when compared to other firms.
Hypothesis 5B: Ceteris paribus, the ratio of variable to total CEO pay will be higher in a MNC.
Executive Compensation and Shareholder Wealth
Since the issue of executive compensation is most often discussed from the perspective of the shareholders it is always instructive to study whether managerial performance results in increasing shareholder wealth by increasing the return on the investments they have made in the firm. The gains to the shareholders are commonly measured through the appreciation in the value of the stock that they hold. Apart from this, dividends declared by the firm are also a source of monetary gain for the shareholders. The sums of the gains from stock price appreciation along with those from dividends constitute the total returns to shareholders (TRS).
Hypothesis 6A: Ceteris paribus, total CEO pay and TRS are positively associated.
Hypothesis 6B: Ceteris paribus, the ratio of variable to total CEO pay and TRS are positively associated.
Executive Compensation and Corporate Governance
The practices related to corporate governance that a firm adopts can significantly affect the nature of managerial salaries. These practices aim to curb managerial power in ways that harm shareholder interests while at the same time encouraging behaviour that results in greater economic efficiency. The extent to which good corporate governance practices are followed in a firm can be studied and quantified by looking at a number of parameters. In this paper, four parameters are used: separation of power between CEO and chairman, presence of owner-managers, constitution of the board in terms of independent directors and the extent of institutional shareholding in the company.
Separation of Power between Chairman and CEO
The separation of power between the chairman of the board of directors and the CEO is a key issue in corporate governance. According to Bhattacharya and Rao (2005), a dual leadership structure refers to a situation where the CEO of the firm is also the chairman of the board of directors. A separate leadership structure on the other hand, will have two different individuals occupying the two positions.
Finkelstein and D’Aveni (1994) argued that a separate leadership structure will lead to a greater degree of independence to the board in various issues related to monitoring managerial performance. It is expected that a board that has an independent chairman will be more effective in designing a compensation contract and monitor the performance of the managers in a way that serves the interests of the shareholders.
Hypothesis 7A: Ceteris paribus, a dual leadership structure will lead to higher total CEO pay.
Hypothesis 7B: Ceteris paribus, a dual leadership structure will lead to a higher ratio of variable to total CEO pay.
Presence of Owner-Managers on the Board
The Indian corporate sector is dominated by “family-owned” businesses where either a majority or a controlling stake in the shareholding of a firm is owned by a particular family. The members of the family are also usually part of the management thereby resulting in the presence of owner-managers (very often referred to as “promoters” in the Indian context) at the highest levels of the firm’s management. This gives rise to a situation wherein a group of the principals of the firm are also its agents. In such a situation, the principal agent framework cannot be strictly used for analysis as the conventional framework assumes a complete separation between ownership and management.
Ghosh (2003) reported that a dual leadership structure leads to a statistically significant increase in CEO compensation to the extent of 7.3 per cent. On the other hand, Ramaswamy et al (2000) showed that family ownership was not a significant determinant of CEO pay. This presence of owner-managers can be investigated by positing the following hypothesis:
Hypothesis 8A: Ceteris paribus, a CEO who is an owner (or promoter) will receive higher total pay when compared to a CEO who is not.
Hypothesis 8B: Ceteris paribus, a CEO who is an owner (or promoter) will receive a higher proportion of variable to total pay when compared to a CEO who is not.
Independent Directors on the Board
All companies are required by law to appoint “independent” directors on their boards. Clause 49 of the Listing Agreement of the Securities and Exchange Board of India (SEBI) lays down the definition of an independent director. The objective is to ensure the presence of truly independent directors on the board so that they can play an active role in upholding shareholder interests. Regulators have also focused on the composition of the board in terms of the strength of the independent directors. According to the latest amendment to clause 49 of the Listing Agreement of SEBI, the number of independent directors on the board should not be less than half the total strength of the board when the chairman is an executive director and should not be less than one-third the total strength of the board when the chairman is a non-executive director.
With respect to executive compensation, Clause 49 of the SEBI act states that all companies have to constitute a remuneration committee consisting of directors, all of whom are non-executive, with the chairman of the committee being an independent director. It is the remuneration committee that recommends the compensation that is paid out to the CEO and other executive directors on the board. So in theory, the independent directors play a critical role in designing the compensation of the CEO apart from their monitoring roles.
Hypothesis 9A: Ceteris paribus, the proportion of independent directors and total CEO pay will be negatively associated.
Hypothesis 9B: Ceteris paribus, the proportion of independent directors and ratio of variable to total CEO pay will be negatively associated.
Impact of Institutional Shareholding
Institutional shareholders are institutions that hold substantial blocks of a company’s shares and thereby control a considerable number of voting rights to influence board decisions. Typical institutional investors include banks, financial institutions, pension funds, mutual funds, etc. They are different from individual shareholders as it is much easier and less expensive for them to play an active role in shareholder meetings, voice their opinion and ensure that managers need to win their support on matters that require shareholder approval.
Institutional shareholders can play a monitoring role simila to that of the independent directors. They can easily oppose compensation plans for the CEO and other executive directors if they view it as being inimical to their well being as shareholders. Thus, we hypothesise that:
Hypothesis 10A: Ceteris paribus, the proportion of institutional shareholding and total CEO pay are negatively associated.
Hypothesis 10B: Ceteris paribus, the proportion of institutional shareholding and ratio of variable to total CEO pay are negatively associated.
The Regression Models
Having stated the factors that are proposed to be used as explanatory variables for executive compensation and the associated hypotheses that are to be tested, a standard OLS regression model is used to carry out a cross sectional study of executive compensation. The regression model for total CEO compensation can be written out as:
ln(CEO Compensation)=a+b1 (NPM) + b2 (ROA)+b3 (Inc. NPM)+b4 (Inc. ROA)+b5 (TRS)+b6(CEO–Chairman) +b7(CEO–Promoter)+b8(Per cent Independent Directors)+b9 (Per cent Institutional Shareholding)+b10(Firm–PSU)+b11 (Firm–MNC)+b12 (ln(Sales)) + e
A similar model for the ratio of variable to total pay of the CEO
would be: Variable Component of Compensation/Total Compensation = a+b1(NPM)+b2 (ROA)+b3(Inc NPM)+b4 (Inc ROA) +b5 (TRS)i + b6(CEO–Chairman)+b7(CEO–Promoter) +b8(Per cent Independent Directors) +b9 (Per cent Institutional Shareholding) + b10(Firm–PSU) +b11(Firm–MNC)+b12(ln(Sales)) + e
where: CEO Compensation: Total value of compensation paid to CEO in current year NPM: Net profit margin in current year ROA: Return on assets in current year Inc NPM: Incremental NPM over previous year Inc ROA: Incremental ROA over previous year TRS: Total returns to shareholders in current year CEO-Chairman: a dummy variable, = 1 if CEO is the chairman of the board, 0 otherwise CEO-Promoter: a dummy variable, = 1 if the CEO belongs to the promoter group, 0 otherwise Per cent Independent Directors: Percentage of independent directors on the board Per cent Institutional Shareholding: Percentage of total institutional shareholding in the company Firm-PSU: a dummy variable, = 1 if company is a PSU, 0 otherwise Firm-MNC: a dummy variable, = 1 if company is an MNC, 0 otherwise Sales: Sales of the company in current year in rupees.
e: Error term which we assume to be normally distributed.
IV The Data
The primary source of our data comes from the electronic database Capitaline.5 It is a large repository of financial and nonfinancial information of more than 10,000 Indian companies. It contains detailed time series information on the financial performance of various companies along with company specific information including the digital formats of the annual reports filed by companies. Apart from this database, the other sources used included the annual reports of companies available at the specific company websites and the website of the National Stock Exchange.6 These sources were used to either cross check certain data points obtained from Capitaline or to obtain data that was missing. Prowess, the corporate database of the Centre for Monitoring of the Indian Economy (CMIE) was used to obtain data on stock prices.
Since this is a cross sectional study of executive compensation the compensation data and other independent/control variables covers a single time period: we use the last complete financial year for each company. Most Indian companies have their financial years running from the April 1 to the March 31 of the following year. For these companies the financial year April 2004 to March 2005 is considered. Other companies having financial years ending at different points like December 2004 or June 2005 were also present in the data set. All data related to compensation, firm performance and corporate governance was valid as on the last date of each company’s financial year (March 31, 2005, December 31, 2004, June 30, 2005, etc, as the case maybe).
A cross sectional study like this one needs a fairly large data set to establish the correlations between the various parameters put forth in the model. The data in the sample must also capture the variations in the values of the independent variables and should also consist of firms for which data on CEO compensation, financial results and other firm characteristics needed by the regression model are easily available. Hence, the data set will be limited to the universe of public limited companies that are traded on stock exchanges. For this study, companies whose stocks are a part of the BSE 500 index were chosen. The BSE 500 index is a wide-ranging index consisting of a basket of 500 stocks that are listed and traded on the Bombay Stock Exchange. The BSE 500 index represents almost 93 per cent of the total market capitalisation of stocks listed on the BSE. It is considered to be an index that very closely represents the total secondary market. It consists of the stocks of firms in all the major industries in India. The index also has considerable variation in the size of the representative companies. Hence, companies that are part of this index are suitable for use in this study.
Out of the set of companies belonging to the BSE 500 index, only companies that disclose data on executive compensation for their last financial year can be included in the data set. On examining the data of the companies, it was found that a number of companies were not disclosing data on executive compensation. They had to be excluded from the data set. In the end, 409 companies
Table 1: Variable Definition and Predicted Effect on Executive Compensation
Variable Acronym Definition Predicted Predicted Effect Effect on Ratio on Total of Variable CEO Pay to Total CEO Pay
Net Profit Margin NPM Profit after Tax/Revenue + + Return on Assets ROA Profit after Tax/Total Assets + + Incremental NPM IncrNPM NPMt - NPMt-1 + + Incremental ROA IncrROA ROAt - ROAt-1 + + Firm Size Size Log (Sales or Revenue) + + PSU Comp
PSU Is Firm a PSU? --MNC Comp
MNC Is Firm a MNC? + + Shareholder TRS Total Returns to wealth Shareholders + + Dual leadership CEO-Is CEO also structure Chairman the Chairman? + + Owner-manager CEO-Is CEO an owner/
Promoter promoter? + + Independent IndepDirc Percentage of independent directors directors on the board --Institutional Institu Percentage of institutional Shareholding Holding shareholding --
belonging to the BSE 500 index found their way into the data set, with the other companies being excluded for lack of data.
Data on firm performance measures like NPM, ROA and incremental NPM and ROA was obtained from the annual income and balance sheet statements of each company available in Capitaline.7 The latter also contains the historical records of dividends announced by the company in each financial year. Dividends data for each of the companies for their last financial year was obtained. Using this along with the stock price data for each company obtained from Prowess, the returns to the shareholders in the particular financial year was calculated. The appreciation in stock price was observed for the full financial year and was calculated as the difference between the closing price of the stock on the last and first day of the financial year.
Capitaline also yielded information on the firm characteristics used in the model. Data on the sales or revenue of each company was obtained from the profit and loss statement for the corresponding financial year.8 The database also maintains a classification of companies based on ownership types. This was used to identify the PSUs and MNCs in the data set.
Data on the corporate governance parameters was obtained from the corporate governance reports that are filed by companies as part of their annual reports. The corporate governance reports contain detailed information about the composition and functioning of the board of directors. The report lists out the profiles of the members of the board and their status, thereby identifying the independent directors. The number of independent directors and the total number of directors was thus obtained. The report also contains the designations and the responsibilities of each member of the board who is an executive director. From the classification, the CEO and chairman of the board were identified. Similarly, companies also disclose which of their directors belong to the promoter group. From this information the CEOs who belonged to the promoter group were identified as the owner managers in the sample.
The extent of institutional shareholding in the company was obtained from the shareholding pattern report that companies need to disclose in the annual report. The data that was obtained from the annual reports of companies was also cross checked with the filings made by the company to the stock exchanges (obtained at the NSE website).
The most important part of the data collection process was to find out the compensation level and structure for the CEO of every company. In the first step, the CEO of the company had to be identified. The director occupying the highest executive position on the board was identified as the CEO.9
The data on CEO compensation was obtained from two sources. The section of the corporate governance report dealing with the functioning of the remuneration committee of the board was one such source wherein detailed information was available about the compensation contracts of the executive directors of the board. For some companies, data on compensation was available in the disclosure made in the annual report on employee remuneration as per Section 217 of the Companies Act, 1956.
The total amount of compensation paid to the CEO was considered to be the sum of all components of pay that were disclosed in the annual report. This usually includes the basic salary, house rent, monetary value of perquisites, sitting fees, contribution to retirement fund, performance pay, etc.10 However, the grant of stock options was excluded when calculating the total CEO compensation. Another important piece of information collected was the variable component of CEO pay. A variable component is assumed to be performance-linked thereby “incentivising” the CEO to work for shareholder interests. All the performance-linked components of the CEO’s compensation is assumed to be variable pay. Common names used by companies for variable pay include performance-linked payment, bonus, commission on profits, etc. So any pay that was mentioned under these headings was included as part of variable pay.
Tables 2(a) and 2(b) provide the summary descriptive statistics and characteristics of the data set used.
V Results
Determinants of Total CEO Pay
The OLS regression results of total CEO pay is presented in Table 3. It was hypothesised that measures of profitability and total CEO pay would be positively associated (Hypotheses 1A and 2A). However, the results show that none of the profitability measures can significantly explain the variation in total CEO pay across firms. This is in contrast to the earlier studies of Ramaswamy et al (2000) and Ghosh (2003) where current year’s ROA was found to be a significant determinant of total CEO compensation.
In contrast to Hypothesis 3A, the returns to shareholders, TRS, exhibits a small negative relationship to total CEO pay. However, the relationship is not statistically significant.
Earlier studies on compensation of CEOs in Indian firms have reported contrasting results on the effect of firm size. While Ramaswamy et al (2000) reported that firm size was not a significant explanatory variable, Ghosh (2003) concluded that firm size was indeed a very significant variable in explaining CEO compensation. The results in Table 3 clearly show that firm size [measured in terms of log (sales)] has a positive and very significant (at the 0.001 level) effect on total CEO pay. Hence, Hypothesis 3A is accepted.
The dummy variable CompPSU also shows a strong negative and significant (at the 0.001 level) relationship with total CEO pay. This is in line with Hypothesis 4A. The results imply that ceteris paribus, a CEO of a non-PSU firm receives close to seven times the total pay of a CEO belonging to a PSU.
It was also hypothesised that firms that are MNCs would pay their CEOs significantly higher when compared to non-MNC firms (Hypothesis 4A). However, the results indicate a very small positive relationship that is not statistically significant. It could be that non-MNC firms in this sample have considerably raised their CEO salaries during the last few years.
From the set of corporate governance variables, only the variables CEO-Promoter and InstituHolding were found to be statistically significant. The positive relationship between total CEO pay and the presence of a CEO who is also an owner is in line with Hypothesis 8A. However, the predicted direction of relationship between CEO pay and extent of institutional shareholding (Hypothesis 10A) is opposite to that obtained in the results. This positive relationship between institutional shareholding and CEO pay may be hard to explain. The results do indicate that the monitoring role of large institutional shareholders is either absent or very weak.
The proportion of independent directors on the board is not a statistically significant variable in explaining CEO pay. Ghosh (2003) concluded that the proportion of non-executive directors was a significant determinant of CEO pay. But there was no distinction made between independent directors and nonexecutive directors.
Total CEO compensation (in Rs lakh) 108.9 62.17 171.35 Percentage of variable pay to total pay of CEO 27.12 22.7 29.61 Net profit margin (NPM) in per cent 9.32 8.67 22.38 Incremental NPM in per cent -3.03 1.82 136.06 Return on assets (ROA) in per cent 14.5 11.04 32.93 Incremental ROA in per cent 5.61 2.43 28.93 Total returns to shareholders (TRS in per cent) 83.28 56.86 97.14 Percentage of independent directors on board 50.61 50 17.31 Percentage of institutional shareholding 17.84 15.47 12.54 Sales (in Rs crore) 2409.05 636 9260
Table 2(b): Characteristics of Data Set Used
Number of companies in data set 409 Number of companies with disclosed policies on incentive pay 374 (including companies that do not pay any incentive pay) Number of companies that use incentive pay as part of compensation 221 Number of companies with dual leadership structure 164 (CEO also occupying the position of chairman) Number of companies with CEOs who are owners/promoters 195 Number of companies that are public sector undertakings 34 Number of companies that are MNCs 52
Table 3: OLS Regression Results for Total CEO Pay
Variable Predicted Sign Coefficient
NPM + 0.008 (1.509) IncrNPM + -0.001 (-1.038) ROA + 0.004 (0.901) IncrROA + -0.007 (-1.552) TRS + -0.001 (-1.074) IndepDirc --0.001 (-0.488) CEO-Chairman + 0.049 (0.434) CEO-Promoter + 0.317** (2.747) InstituHolding -0.01* (2.261) CompPSU --1.899*** (-9.268) CompMNC + 0.129 (0.803) Size + 0.162*** (3.703) N 409 Adjusted R2 0.253 Overall F 12.487***
Notes: *, ** and *** denote significance at 0.05, 0.01 and 0.001 levels respectively (two-tailed t-test). (Unstandardised coefficients, t-statistics in parentheses, dependent variable = Log (total CEO pay)).
Table 4: OLS Regression Results for Incentive Pay
Variable Predicted Sign 1 2
NPM + 0.182 (1.253) 0.238 (1.497) IncrNPM + -0.2 (-0.882) 0.302 (1.301) ROA + 0.204* (1.682) 0.105 (0.739) IncrROA + -0.223* (-1.715) -0.163 (-0.857) TRS + -0.01 (-0.623) 0.19 (0.924) IndepDirc --0.087 (-1.033) -0.16* (-1.936) CEO-Chairman + 2.075 (0.634) 6.131* (1.778) CEO-Promoter + 13.569**** (4.024) 11.776*** (3.229) InstituHolding -0.201 (1.612) 0.025 (0.187) CompPSU --21.667****(-3.773) -25.03****(-3.502) CompMNC + -2.843 (-0.606) -8.212* (-1.722) Size + 3.791*** (3.076) 2.59* (1.759) N 374 221 Adjusted R2 0.141 0.212 Overall F 6.099*** 5.937***
Notes: *, **, *** and **** denote significance at 0.1, 0.05, 0.01 and 0.001 levels respectively (two-tailed t-test). (Unstandardised coefficients, t-statistics in parentheses, dependent variable = ratio of variable to total CEO pay (in per cent)).
The results also show that a dual leadership structure, represented by the variable CEOChairman, has a positive relationship (as per Hypothesis 7A) but the relationship is not statistically significant [in contrast to Ghosh 2003].
Determinants of Ratio of Variable to Total CEO Pay
The data set used in this study consisted of companies that did not disclose details about the break-up of compensation paid to their CEOs in terms of fixed and variable components. The data from these companies was used only for regressing total CEO pay in terms of all the independent variables. To establish the determinants of the proportion of total CEO pay that is variable or incentive in nature, only those companies that provided the full break-up of the total compensation paid to the CEO were included. Out of the total of 409 companies, 374 companies fitted this description. This set of 374 companies also included companies that did not pay any variable or incentive pay. Another data set consisting of those companies whose compensation included some component of variable pay (non-zero variable pay) was created. This data set consisted of 221 companies. Two separate regressions were run using these two data sets (with the same set of independent variables as before). The results are presented in Table 4 below.
Column 1 in Table 4 contains the regression results using the entire data set of companies that disclosed the break-up of compensation (i e, 374 companies). Column 2 contains results with the truncated sample of 221 companies whose compensation contains some amount of variable pay.
The dummy variables CEO-Promoter and CompPSU are strong and very significant determinants of the percentage of total CEO pay that is variable. The results show that ceteris paribus, the percentage of variable to total pay for a CEO who is also a promoter of a company is 13.57 percentage points (11.776 percentage points for the truncated data set) higher when compared to a CEO who is not. For the case of PSUs, ceteris paribus, the variable component of the total compensation of the CEO is 21.667 percentage points
(25.03 percentage points for the truncated data set) lower compared to that of a CEO belonging to a non-PSU firm. These results taken together therefore validate Hypotheses 4B and 8B.
The results also show that firm size is positively and significantly related to the proportion of variable pay. This would imply that larger firms pay a greater amount of compensation as variable pay. However, it can be seen that in case of the truncated data set, firm size becomes significant only at the 0.1 level (compared to the 0.01 level using the complete data set). This may be due to the fact that the truncated data set may already contain the larger sized firms with lesser variation in firm size when compared to the complete data set.
The dummy variable CompMNC exhibits a negative association with the proportion of variable pay in the results of both regressions. This relationship is significant (at the 0.1 level) in the regression using the truncated data set. This is in contrast to what was hypothesised (Hypothesis 5B) earlier. As before, it could be that non-MNC firms in recent years have considerably increased the variable component of their CEO pay.
The dummy variable CEO-chairman that represents the dual leadership structure of the board is also positively related to the proportion of variable pay of the CEO (Hypothesis 7B). It is found to be a significant variable when using the truncated data set (at the 0.1 level). The result indicates that ceteris paribus, a CEO who also occupies the position of the chairman will receive a greater proportion of variable pay, to the extent of 6.13 percentage points, when compared to a CEO who is not the chairman of the board.
VI Conclusions
It was proposed that CEO compensation was a function of three distinct sets of parameters: firm performance and shareholder wealth, firm specific characteristics and corporate governance parameters. This was done because the issue of executive compensation is fundamentally complex with a number of diverse factors playing a role.
The results obtained show that none of the profitability measures is a significant determinant of total CEO pay. Firm size is a significant variable in explaining both total CEO pay and the proportion of variable or incentive pay that a CEO receives. We also found that CEOs who are promoters or owners receive compensation that is higher and with a greater incentive component compared to other CEOs. This study also provides evidence that CEOs of PSUs are significantly underpaid when compared to their counterparts in other firms.
This paper therefore adds to the limited empirical literature available on the determinants of executive compensation in Indian firms. The few studies that exist [Ramaswamy et al 2000; Ghosh 2003] used data that are quite dated and narrowly focused on firms belonging to certain industries. The data used in this paper is large and encompasses the entire range of industries that are found in the Indian corporate sector. This study also uses data that belongs to the latest time period for which information on firm performance, corporate governance and executive compensation is available to researchers. The effects of the changes that have been seen in the managerial labour market and in the regulatory framework surrounding corporate governance are all captured in this study.
EPWEmail: debashish@iimcal.ac.in adityap2006@email.iimcal.ac.in krishnakumarm2006@email.iimcal.ac.in
Notes
1 Jensen and Meckling (1976) state that the divergence of interests of the manager and the shareholder leads to reduction in the firm value. Thedifference in the value of the firm that is managed entirely by its ownersand when it is managed by an agent is defined as the agency cost. Theagency costs include the cost of monitoring the actions and performanceof the managers.
2 The Narayanamurthy Committee on corporate governance appointed bySEBI quoted the OECD principles on corporate governance that stated“Corporate governance...involves a set of relationships between acompany’s management, its board, its shareholders and other stakeholders.Corporate governance also provides the structure through which theobjectives of the company are set, and the means of attaining thoseobjectives and monitoring performance are determined.”
3 NPM = Profits after tax/revenue; ROA= Profits after tax/total assets. Moststudies incorporate only one of these profitability measures to test sensitivityof compensation to profitability. However, NPM and ROA convey fundamentally different pieces of information on firm profitability. While NPMis seen more as an indicator of the efficiency of the firm in its operations,ROA is an indicator of the effectiveness of utilisation of the firm’s assets.
4 For a complete discussion on compensation, incentives and motivation
see Milgrom and Roberts (1992).5 http://www.capitaline.com6 http://www.nseindia.com7The Capitaline database contains data on “adjusted net profits” for a
financial year. The adjusted net profit for a firm in a particular financialyear is defined as the profit after tax minus all extraordinary accounting items for that particular financial year. The value of NPM used in thisstudy is given by adjusted net profit/revenue.
8 The exact value of sales or revenue picked from the database is that of“net sales”, defined as total sales or revenue minus the excise duty paid.For service companies, the value of “income from operations” was usedto represent revenue and for financial services companies, “net interestearned” was used to represent sales.
9 The formal designation, however, varied significantly across companies
– executive chairman, managing director, chairman and managing director,and chairman and CEO. In cases where no director was identified in the report as a CEO, the executive director on the board receiving the highestcompensation was assumed to be the CEO.
10 It must be noted that companies do not adopt any uniform method forcalculating the different components of remuneration. Therefore, thecomponents of pay (basic, house rent, allowances, etc) that is included whenstating the compensation figure in the annual reports can vary widely across companies. In this study, it is assumed that such differences are small.
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