DEWEY
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Massachusetts Institute of Technology
Department of Economics
Working Paper Series
AGENTS WITH AND WITHOUT PRINCIPALS
NBER
MIT & NBER
Marianne Bertrand, UChicago &
Sendhii Mullainathan,
Working Paper 00-31
January 2000
Room E52-251
50 Memorial Drive
Cambridge, MA 02142
This paper can be downloaded without charge from the
Social Science Research Network Paper Collection at
http://www.ssrn.com
MASSACHUSETfsliSTITTJTr
OF TECHNOLOGY
NOV
8 2000
LIBF?ARIES
Agents with and without Principals
Marianne Bertrand
Sendhil MuUainathan
January
Who
sets
CEO
CEO
shareholders set
states of
pay? Our standard answer to
pay.
They use pay
CEOs. Through bonuses,
14,
*
2000
this question
has been shaped by principal agent theory:
to limit the moral hazard problem caused by the low ownership
options, or long term contracts, shareholders can motivate the
maximize firm wealth. In other words, shareholders use pay to provide
incentives, a view
we
CEO
to
refer to as the
contracting view.
An
own
alternative view,
pay.
championed by practitioners such as Crystal (1991), argues that
They manipulate the compensation committee and hence the pay
what they
can.
The
only constraints they face
may be
I
We
mid
The
we
set their
process itself to pay themselves
the availability of funds or more general fears, such
as not wanting to be singled out in the Wall Street Journal as being overpaid.
as the skimming view. In this paper,
CEOs
We
refer to this
second view
investigate the relevance of these two views.
Effect of Takeover Threats
on
CEO
Pay
begin with some illustrative findings from an earlier paper (Bertrand and MuUainathan, 1999a). In the
1980s, several
likely
US
states passed legislation
making
hostile takeovers
more
difficult.
These laws very
reduced the power of an important disciplining mechanism, the threat of being taken over
in case
of
'Bertrand: Department of Economics, Princeton University, CEPR and NBER; MuUainathan: Department of Economics,
Massachusetts Institute of Technology and NBER. e-mail: mbertran@princeton.edu and mullain@mit.edu. Address: Marianne
Bertrand, A-17-J-1, Industrial Relations Section, Firestone Library, Princeton University, Princeton, NJ 08540, US.A.; Sendhil
MuUainathan, E52-380a, Department of Economics, MIT, 50 Memorial Drive Cambridge,
02142, USA. We thank our
discussant, George Baker, for many helpful comments.
MA
How
poor management.
do we expect
CEO
pay to respond to
CEO
contracting model, where shareholders set
for performance. Shareholders, seeing the
pay
pay, the
change
main
this
in the legal
environment? In the
effect of the anti-takeover
laws should be on
weakening of one disciplining mechanism, should respond by
strengthening another, pay for performance. In the skimming model, on the other hand, the main effect
mean
should be on
from their
pay.
CEOs
facing a reduced threat of a hostile takeover can
now skim more
resources
firm.
In Bertrand and Mullainathan (1999a), using panel data on about 600 firms between 1984 and 1991,
study the impact of the legislative changes on the
level of
CEO
pay and
focus on the adoption by states of Business Combination Statutes.
its
sensitivity to performance.
we
We
These statutes impose a moratorium
period (3 to 5 years) on specified transactions between the target and a raider holding a certain threshold
percentage of stock unless the board votes otherwise. They were adopted by several states at different times
through the 1980s and early 1990s. The staggering of the laws over time allows us to identify the
effect of
the laws after controlling for year and firm fixed effects.
For the
for
full
sample,
we found an
accounting measures of performance)
views of
CEO
pay.
Mean pay
also rises as the contracting
To help
and
in
new
laws.
pay
rises as
.
These
increase in pay for performance (especially
results are intriguing because they aie consistent with both
the skimming model would have predicted but pay for performance
model would have predicted.
resolve this ambiguity,
for performance.
mean pay and an
increase in
We
we look more
focus on
how
More specifically, we separate the
closely at
which firms experienced the increases in mean pay
firms with different corporate governance are affected by the
firms in our sample into two groups based on whether the firm has
a large shareholder present or not. Large shareholders are very often thought to be an effective governance
mechanism and are an easy way to measure corporate governance given the
Vishny, 1986)
.
We
define a large shareholder as an
shares in the sample base year. Blocks that are
Table
1
reports our findings for
mean
pay.
owner who has a block of at
owned by the
CEO
The dependent
compensation. Each regression includes, in addition to a
dummy
available data (Shleifer
least five percent of
and
common
are, of course, excluded.
Vciriable is the
logarithm of total
CEO
variable for the adoption of a Business
Digitized by the Internet Archive
in
2011 with funding from
Boston Library Consortium IVIember Libraries
http://www.archive.org/details/agentswithwithouOObert
Combination Statute, year fixed
tenure, the logarithm of total assets
Column
increase in
(1) focuses
mean pay
and the logarithm of
of only
2%
Column
following the laws.
CEO
pay grew by
actually quite heterogeneous.
The
2,
we
(2) focuses
we
see a statistically insignificcint
on firms without a large shareholder.
have just shown that
show no
no
increase.
is
concentrated
we
find the opposite effect.
among the
firms with a large
increase in pay for performance.
in response to the
passage of anti-takeover legislation, firms with a large
shareholder increased pay for performance, while firms without a large shareholder increased
This suggest that the two models of
indeed
may be
in
While firms without a large shareholder experienced a large
increase in the sensitivity of pay to accounting performance
We
firms,
similarly break apart the pay for performance results. Here
shareholder. Firms without one
CEO
age, a quadratic in
time a statistically significant) 7.5%. The increase
(this
increase, firms with a large shareholder experienced almost
In Table
CEO
employment.
total
on firms with a large shareholder. In these
For these firms, in contrast,
mean pay was
firm fixed effects, a quadratic in
effects,
CEO
mean
pay.
pay need not be contrasted. Instead, they may both be true and
quite complementary. This intuition
is
reinforced in the additional tests that follow.
Further Evidence
II
Are CEOs Rewarded
II.l
for
In Bertrand and Mullainathan {1999b),
whether
CEOs
we
find
two further pieces of evidence. In the
are rewarded for observable luck.
beyond the CEO's
CEO
Luck?
By
control. In simple agency models,
luck
we mean changes
in firm
first test,
we examine
performance that are
pay should not respond to luck since by definition the
cannot influence luck. Tying pay to luck doesn't provide better incentives (the
CEO
can't change luck),
but merely adds risk to the contract (Holmstrom, 1979). Under the skimming view, on the other hand, pay
will
be correlated with luck since the
To
CEO
can use lucky dollars to pay herself more.
empirically examine the responsiveness of pay to luck,
we perform a case study
of
oil
we use three
different
extracting firms where large movements in
oil
measures of luck.
First,
prices tend to affect firm
performance on a regular
basis.
Second, we use changes in industry-specific exchange rate for firms in the
traded goods sector. Third, we use year-to-year differences in
economic fortunes of a
overall
fact
we
find that, for
all
sector.
For
all
three luck measures,
three measures,
CEO
pay
mean
we
industry performance to proxy for the
find that
CEO
pay responds to
luck.
In
is
as sensitive to a "lucky dollar" as to a "genered
less
to luck in the better governed firms. Similarly
dollar."
Most importantly, we
to our takeover results,
find that
we
CEO
pay responds
find that the presence of
a large shareholder reduces the amount of pay for luck.
Qualitatively equivalent results hold for other governance measures such as the level of
(measured as
CEO
CEO
tenure interacted with the presence of a large shareholder) and board
entrenchment
size.
Again,
improved governance leads to greater concordance with the contracting view, while weakened governance
leads to greater concordance with the
skimming view.
Are Stock Options Grants
II.2
The second
test presented in
Gifts?
Bertrand and Mullainathan (1999b) focuses on the granting of stock options.
Contract theory predicts that when stock options are granted, other components of pay should be adjusted
down
so that
CEOs
are left indifferent between the pay package containing options and the one containing
options. Supporters of the
skimming view, on the other hand, would highlight the
fact that stock options
no
do
not appear on balance sheets. Because of accounting rules, firms do not charge their earnings for the options
they grant.
bottom
CEOs
line. If
can therefore pay themselves through option grants without affecting the company's
shareholders mainly look at this bottom
drawing unwanted attention. Thus, the
components of pay
at
all.
CEO who
line,
options grants are an easy
gives herself options
way
to skim without
would not need to lower the other
Thus, while contracting predicts a charge for options, skimming predicts
little
charge.
In the empirical test,
we
focus on the question of
how
the strength of governance in the firm affects the
charge for options. Using the same governance measures as in the previous
CEOs
are charged less for their
new options
grants. For example,
when
test,
there
we
is
find that poorly governed
no large shareholder
sitting
CEO
on the board, the
resemblance to skimming
Ill
An
charged
is
in the
less for
each dollar's worth of options granted. Again, we find greater
poorly governed firms.
Independent Test
The above findings
point towards the coexistence of skimming and agency models. In this section,
another independent test of this idea by revisiting the evidence
and Samwick's paper
starts with the following
in
we provide
Aggarwal and Samwick (1999). Aggarwal
important prediction of the contracting model: the sensitivity
of pay to performance should decrease as the riskiness or variance of performance increases. In support of
Samwick
that prediction, Aggarwal and
less volatile
find that the sensitivity of
is
larger in firms with
stock prices.
we have shown
In the context of what
performance
volatility
and pay-performance
CEO
test this hypothesis using a
Proxy, 10-K, and 8-K
filings.
sensitivity
CEO
SEC
CEO
Registration statements, firms' Annual Reports, direct correspondence
hires
and departures, and stock
their Forbes rankings. Forbes
must have been
set covers
by Standard
&
Poor's.
magazine publishes annual
and market
one of these Forbes 500 rankings at
1991. In addition, the corporation
it
prices published
sales, profits, assets
in
Aggarwal and Samwick),
corporations over the 1984-1991
Other data was transcribed from the Forbes magazine annual survey of
sample a corporation must appear
data
diflferent
We
SEC
rankings of the top 500 firms on four dimensions:
this
between
appear stronger in the better governed firms?
Compensation data was collected
Firms were selected into the sample on the basis of
and 1991. While
tradeoflf
fi-om the corporations'
compensation as well as from
with firms, press reports of
Does the
before, a natural question arises:
compensation data that covers 792
period, provided to us by David Yermack.
is
pay to performance
value.
least four times
To
qualify for the
between 1984 and
publicly traded for four consecutive years between 1984
a smaller set of companies than the Execucomp database (used by
does contain some information on the structure of corporate ownership, which
not available in Execucomp.
The dependent
variable, total
CEO
compensation,
is
defined as the
sum of salary,
bonus, other compensa-
tion
and the value of options granted
in that year. It
is
a measure of flow compensation. Unlike Execucomp,
Yermack's data does not contain information on the value of stock options and equity shares held by CEOs.
In practice,
we use the logarithm
of total compensation.
We
use the real rate of return to shareholders
(percentage change in the real value of shareholder wealth, including dividend payments) as our measure of
performance.
Our
risk
measure
year. Following
is
based on the sample variance of daily stock returns for the
0;
the largest observed variance has a
We follow
The
CDF
smallest observed variance in the sample has a
value of
fiscal
Bertrand and Mullainathan (1999a) and
yecir (1984),
whether the block holder
is
or
is
CDF
value
I.
split
our original sample into two subsamples of firms
based on whether or not they have at least one block of at least
base
120 days of the
Aggarwal and Samwick, we use the cumulative distribution function (CDF) of the variance
of returns in the sample as our risk measure.
of
last
five
percent of
common
shsires in
the sample
not a director. As before, we exclude blocks that are
owned by the CEO.
The
CEO
results for the full sample, not reported here,
pay becomes
less sensitive to
increases. In Table 3,
are estimated by
match the
findings in
the rate of return to shareholders as the volatility of stock returns
we show how the presence
OLS. Each regression contains
measure and the interaction of performance with
of a large shareholder mediates these findings. Regressions
as independent variables the
risk.
This interaction term
the effect of risk on the pay to performance sensitivity. In addition,
effects,
a quadratic in
CEO
Aggarwal and Samwick (1999).
age and a quadratic in
CEO
we
performance measure, the
is
risk
what cJlows us to understand
include firm fixed effects, yeax fixed
tenure (but do not report these coefficients in the
Table).
Column
(1) focuses
on firms with a large shareholder present. Here we find support
model. Higher variance means lower pay for performance sensitivity. Column
there
is
no large shareholder present.
sensitivity does not
performance
depend on the
For this group, there
riskiness of the stock.
affects the sensitivity of
is
no
(2) focuses
relationship:
for the contracting
on the firms where
the pay for performance
Hence the existing finding that the variance of
pay to performance appecirs to be coming from the better governed
firms in the Scimple.
IV
We
Synthesizing the Empirical Findings
have so
far laid out a set of empirical facts that
support the general claim that better governed firms
behave according to the contracting model while worse governed ones behave according to the skimming
model.
A
A
very
key to moving forward will be to develop a model that
first
The apparent
concern that needs to be addressed
is
consistent with
all
these facts.
whether our findings represent a spurious relationship.
is
CEO
correlation between the use of optimal
compensation contracts and the presence of large
shareholders might not reflect a true direct relationship. Instead, skimming and weak governance might be
related to each other through
But what could
for.
of a large flrm
is
some third
this third factor
be? Firm
size
more expensive so that large firms
that
we
see.
is
why
aie not observing or are not adequately controlling
might be one example. Owning 5 percent of the shares
typically have less large shareholders.
appropriately control for size in the above tests and
question, however,
we
factor that
when we did
why would
larger firms (which
respond to takeover legislation with greater mean pay and
luck, charge their
performance sensitivity?
some unobserved
intuitively
If it is
CEOs
less for options
We
consistent patterns that
Assuming that these
so the results did not change.
The deeper
would be correlated with poorer governance)
less
pay
for
and not account
performance increases, reward their
for variance in choosing the
not because of poorer governance, then why?
factor drives our results.
match the
can, of course,
a third factor (such as size) would consistently lead to the pattern of responses
For example,
CEOs more for
We
results are indeed
simply find
we
it
It is
pay
for
always a possibility that
hard to point to any such factor that would
observe.
about governance, the simplest way to explain them seems to be
through a bargaining model. Suppose shareholders and the
could then be modeled as the case where the
CEO
would be the case where shareholders have much or
has
all
CEO
much
or
bargain over the pay package. Skimming
all
of the bargaining power.
of the power. Such a bargaining
Contracting
model would
also
have
the added feature of being able to deal with a continuum of possibilities between skimming and contracting.
While
Theorem
intuitively appealing, this
applies in this model.
model cannot match the
The bargaining power
A CEO
she gets, not the structure of her contract.
pay
for luck.
She
will also
CEO
will
is
want to face the same charge
To
see why, note that the
only determine
with more bargaining power
have luck shocks removed from her pay but
compensation. Similarly, there
will
of the
results above.
average pay
not choose to get more
will
simply expect a higher average
will
no reason that she would want to be charged
for options
how much
Coase
less for
options grants. She
but merely take a bigger compensation package
More
overall.
generally, the optimal contract will always
be chosen with bargaining power simply determining the division
of rents between the shareholders and the
CEO.
An
alternative modeling approach could be to focus on the superior monitoring technology of large
shareholders.
Our
findings could be the result of an optimal contracting process where principals always set
pay, whether governance
effort.
is
weak
or strong, but face different signal to noise ratios
In firms with large shareholders, principals can
movements
in firm performance.
firms without large shareholders.
more
easily separate
CEOs'
Such a view could potentially explain why there
One would, however, need
effort
is
CEO
from other noisy
more pay
to assume that observing
prices or in aggregate industry shocks requires superior monitoring technology
for
when evaluating
for luck in
movements
in oil
and cannot be done
ecisily,
Why
would
example by opening the business section of the daily newspaper.
The monitoring model cannot
at
all
explain our findings on the impact of takeover threats.
principals in firms without large shareholders decide to give higher pay once
raiders?
Their monitoring technology
may be weaker
but they
still
know
CEOs
are protected from hostile
the laws have been passed and
should react to them. Similarly, the trade-off between incentive pay and variance of pay are equally puzzhng.
If
anything,
since they
it is
the principals of the well governed
have access to better signals of
monitoring alone could explain the array of
Thus our
itoring.
care less about stock market price volatility
As a whole,
effort.
it
is
hard to imagine how differences
in
results.
findings suggest that governance
is
Instead, they suggest that governance
we always assume that some metaphorical
who should
not just about increased bargaining power or better mon-
is
about who has
effective control.
principal controls the pay process.
8
In contracting models,
Even when governance
is
weak, this principal
sets
still
pay (perhaps taking into account a worse monitoring technology). Our
suggest that a better model of governance would be one that recognizes that good governance
shareholders to maintain effective control
To be
of, for
When
governance
is
good, such as
when
may
there
is
what allows
example, the pay process.
concrete, consider the details of the pay process.
compensation committee. This committee
is
results
In practice,
CEO
cater to the interests of the
pay
CEO
is
usually set via the
or of the shareholders.
a large shareholder present, this committee
that the pay package looks optimal from the shareholders' perspective.
The committee
will
may make
sure
respond to the
passage of takeover legislation, or will be more reluctant to radse the CEO's bonus just because
oil
prices
rose and so on.
When
governance
is
weak, however, this committee
does the committee set pay then? Even though the
faces constraints.
The committee may be
may be much more
CEO
willing to cater to the
CEO. How
has de facto control of this committee, she
still
quite reluctant to attract the attention of shareholders or of other
important constituencies, such as labor unions or the business press. This places constraints not just on
how much can be skimmed but
when
firms'
performance
is
also
high as shareholders
luck then naturally arises. Also,
compensation committee
on how skimming
will
if
will
take place. For example, more can be skimmed
may be paying
even less attention to the firm.
shareholders mostly pay attention to their company's bottom
Pay
line,
for
the
grant relatively more stock options as they are not charged directly against
earnings.
V
Conclusion
This discussion highlights a set of open questions
First,
we need
process.
What
to better understand
cis
we move forward from the empirical
what happens when the
CEO
regularities above.
has gained de facto control of the pay
are the real constraints on pay setting? This will require a
more rigorous formalization
the skimming view. Second, we need to reinterpret what corporate governance actually does.
We
reconceptualize governance as the transfer of de facto control of important decisions from the
CEO
of
need to
to the
shareholders. Such a reconceptualization will have applications beyond executive compensation. Take for
example the decision by firms to adopt takeover protection such as poison
is
made with
to whether
the interests of shareholders or
we think
CEO
pay
is
management
in
pills.
Should we think this decision
mind? This question
is
somewhat analogous
the result of optimal contracting or skimming. Perhaps governance plays
a central role in this application too, with well governed firms using poison
during takeover attempts and poorly governed firms using poison
pills
pills
to raise bargaining power
to entrench
management. This
example highlights the broader value of a reconceptualization of good governance as being what gives
principals.
10
final
CEOs
References
Aggarwal, Rajesh and Samwick, Andrew. "The Other
Side of the Trade-off:
The Impact
of Risk on
Executive Compensation." Journal of Political Economy February 1999, 107(1), pp. 65-105.
,
Bertrand, Marianne and MuUainathan, Sendhil. "Corporate Governance and E.xecutive Compensation? Evidence from Takeover Legislation."
Mimeo, Princeton
University, 1999a.
Bertrand, Marianne and MuUainathan, Sendhil. "Do CEOs Set Their
Principals Do."
Own
Pay? The Ones Without
Mimeo, Princeton University, 1999b.
Crystal, Graef.
In Search of excess:
The Overcompensation
of
American Executives.
New
York:
W.W.
Norton Co., 1991.
Holmstrom, Bengt. "Moral Hazard and
Observability."
Bell Journal of
Economics Spring 1979,
.
10(1),
pp. 74-91.
Shleifer,
Andrei and Vishny, Robert. "Large Shareholders and Corporate Control." Journal
Economy, June 1986,
94(3), pp. 461-488.
11
of Political
Table
1
— The Impact Anti- Takeover Legislation on CEO Pay:
The Role
of Large Shareholders"
Dependent Variable: Log
Large Shareholder?
Anti-Takeover
Law Adopted
of Total
CEO
Compensation
(1)
(2)
Yes
No
.026
.075"
(.040)
(.031)
Adjusted R-
.633
.768
Sample
2281
2268
Size
"Notes:
1.
"Large Shareholder"
positive
number
is
a
dummy
whether the block holder is or
owned by CEOs are excluded.
2.
3.
4.
variable that equals
of blocks of at least five percent of
is
not a director.
1
if the firm has a strictly
shares in the base year (1984),
("Yes")
common
Blocks of at least
five
percent that are
"Anti-Takeover Law Adopted" is a dummy variable that equals 1 after the adoption of an
anti-takeover law (Business Combination Statute) by the state the firm is incorporated in.
Each regression includes
as controls year fixed effects, firm fixed effects, a quadratric in
CEO
age, a quadratic in
CEO
total
employment.
'*
tenure, the logarithm of total assets and the logarithm of
denotes significance at the 5%.
12
Table
2
—The Impact of Anti-Takeover Legislation on Pay
The Role
Dependent Vaxiable: Log TotaJ
Large Shareholder?
Anti-Takeover
Law Adopted
Law Adopted*
CEO
(1)
(2)
Yes
No
.017
.085'"
(.040)
(.030)
1.126**
.316
(.582)
(.584)
Ace. Rate of Return
2.352**
2.533***
(1.116)
(1.08)
Adjusted
Sample
i?^
Size
Performance:
Compensation
Ace. Rate of Return
Anti-Takeover
for
of Large Shareholders"
.641
.782
2281
2268
"Notes:
1.
"Large Shareholder"
is
defined as in Table
Law Adopted"
1.
defined as in Table
2.
"Anti-Takeover
3.
Accounting Rate of Return
4.
Each regression includes
as controls year fixed effects, accounting rate of return interacted with year fixed
effects, firm fixed effects,
a quadratric in
and the logarithm
5.
of total
is
is
1.
the ratio of Net Income over Total Assets.
CEO
age, a quadratic in
employment.
'" denotes significance at the
5%;'*" at the 1%.
13
CEO
It
has been demeaned.
tenure, the logarithm of total assets
—
The Impact of Risk on CEO Pay:
The Role of Large Shareholders"
Table 3
Dependent Variable: Log of Total
Large Shareholdei•?
Performance
Performance*
CDF of Variance
CDF
Compensation
(1)
(2)
Yes
No
.003—
.001-—
(.000)
(.000)
-.004—*
.000
(.001)
(.001)
-.07
-.17'"
(.06)
(.05)
2301
2025
of Variance
Sample
CEO
Size
"Notes:
1.
"Large Shareholder"
2.
"Performance"
payments) and
3.
4.
is
defined as in Table
1.
is
defined as the real growth rate of shareholder wealth (including dividend
is
measured
in
percentage points.
Each regression includes as controls year
age and a quadratic in CEO tenure.
*"* denotes significance at the
1%;'*"
fixed effects, firm fixed effects, a quadratic in
CEO
at the .1%.
14
537k
A3
Date DueDEC
2000
Lib-26-67
3 9080 02237 3465