Academic journal article Financial Management

Do Shareholders Benefit from the Adoption of Incentive Pay for Directors?

Academic journal article Financial Management

Do Shareholders Benefit from the Adoption of Incentive Pay for Directors?

Article excerpt

Ashok Robin(*)

We assess the stock market reaction to proposals of incentive plans for directors in a sample of 289 firms. The reaction is both economically and statistically insignificant. This result suggests that shareholders do not necessarily benefit from the adoption of such plans. Across firms, we find that the market reaction depends on whether the CEO is involved in director selection; stock markets react negatively to plans proposed by firms without nomination committees. These findings highlight the important link between corporate governance and the effectiveness of director incentive plans.

In the United States, most publicly traded firms use incentive pay to motivate senior managers. This is accomplished by using stocks, stock options, and other equity-based compensation as an integral part of managerial compensation contract. Recently, there has been a move to offer incentive pay to corporate directors. For example, the National Association of Corporate Directors issued a Blue Ribbon Report in 1995 that advocates the use of equity-based compensation to align the interests of shareholders and directors. Although many firms have adopted this recommendation, there is little empirical evidence on whether shareholders actually benefit from providing directors with incentive pay.

In this paper, we provide direct evidence on the issue of incentive pay by analyzing the impact on shareholder wealth of proposals to adopt such pay for directors. If the proposed plans create a significant alignment of incentives between shareholders and directors, we would expect a favorable stock market reaction. But, if the plans do not modify director incentives in favor of shareholders, we would expect either a zero or perhaps even a negative stock market reaction.

Using proxy statements between 1988 and 1998, we obtain a sample of 289 firms that make such proposals. The sample covers 11 years and represents the initial experience of firms that provide incentive pay for directors. A standard event study method is used to examine whether shareholders benefit from providing directors with incentive pay.

For the overall sample, we find a statistically and economically insignificant reaction. During the sample period, it appears that firms have not been successful in using director incentive pay to enhance shareholder value. The benefits of incentive alignment between directors and shareholders have not been realized.

This study also extends the findings of recent studies that suggest an association between corporate governance and the effectiveness of incentive compensation for managers. We investigate whether the stock market reaction to director incentive pay depends on the quality of the corporate governance structure. We do this by looking at the extent of CEO involvement in director selection. When the CEO has greater influence over the director selection process, the board of directors is less effective in monitoring managerial discretion. Therefore, we expect a less favorable stock market reaction to the adoption of director incentive pay plan when the CEO is involved.

The results support this hypothesis by showing that stock markets react negatively to plans proposed by firms with involved CEOs. Cross-sectional tests confirm that, after controlling for board characteristics, firm performance, and variables capturing both firm characteristics and plan attributes, the event study results are robust. Based on this, we conclude that corporate governance structure affects the effectiveness of incentive pay for directors.

Other evidence on plan characteristics supports the results on CEO involvement. Firms with involved CEOs tend to use director incentive compensation in a somewhat ineffective manner; this might explain their lower abnormal returns. These firms are more likely to use incentive pay to increase the directors' overall compensation while preserving the directors' existing annual retainer, and they also tend to grant their directors options and restricted shares with more favorable, shorter, vesting requirements. …

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