Monday, August 10, 2009

Papa's Labour of Love (2)

Today, on Mama’s birthday, Papa received another piece of scintillating news via email:

Dear XXXX and YY

Re: MS No. 1475
Title: SYMPOSIUM Remuneration Committee, Ownership Structure and Pay-for-Performance: Evidence from Malaysia

After careful review of your article "SYMPOSIUM Remuneration Committee, Ownership Structure and Pay-for-Performance: Evidence from Malaysia", we believe that your article shows considerable promise.

So we are pleased to inform you that your paper titled has been accepted for presentation at the ZZZZ Special Issue Symposium on "An International Perspective on Performance Evaluation and Executive Compensation" (on Executive Compensation and Performance Evaluation?), to be held at SDA Bocconi School of Management, Milano, Italy, September aa-bb, 2009.


Please note that publication in ZZZZ depends on further work as suggested by the referee and as (will be) indicated by the discussion that will follow the presentation at the Symposium

Alhamdulillah, the referee of that top-tier journal found it "to be an interesting and extremely clearly written paper. The literature survey is useful and the hypotheses fall out nicely from the development.”

Here is the introduction section of the paper, which is based on a nearly completed PhD thesis supervised by Papa.

Executive remuneration has become one of the prominent topics in contemporary corporate governance. The mainstream view, derived from the principal-agent framework, is that a well designed compensation contract helps to incentivize executives to enhance shareholder value (e.g., Jensen and Murphy, 1990; Murphy, 1999). Strong pay-for-performance sensitivity is seen as the key metric in aligning the divergent incentives of executives and shareholders. However, a more skeptical view sees compensation contract as a perverse instrument of greed rather than a shareholder-friendly incentive mechanism (Bebchuk and Fried, 2006). One form of managerial opportunism, or private benefits of control, is when CEOs and top management awarded themselves stupendous pay-without-performance to the detriment of shareholders. In other words, the board of directors sets compensation that deviates from arm’s length contracting. Negative coverage on grossly overpaid top management is regularly featured in the international financial press (Core, Guay, & Larcker, 2008). Malaysia is not spared. In 2007, angry shareholders of Transmile Group voted against the payment of directors’ fees for the financial year ended 2006 after financial irregularities were made public.1

The ample empirical evidence suggests that executive compensation is largely insensitive to firm performance (e.g., Jensen and Murphy, 1990; Garen, 1994; Barkema and Gomez-Mejia, 1998; Zhou, 2000; Firth, Fung, & Riu, 2007; Merhebi, Pattenden, Swan, & Zhou, 2006; Duffhues and Kabir, 2007). This low pay-for-performance sensitivity raises concern that executives pay arrangements do not provide sufficient incentives to deliver performance or they create agency costs in the form of excess pay (Bebchuk and Fried, 2003).
Given the observed decoupling of pay and performance, a number of studies have attempted to unravel how the pay-for-performance link can be strengthened in order to fulfill the promise of executive compensation as a mechanism to align the interests of executives and shareholders by investigating the role of remuneration committee and ownership structure. Conyon (1997) examines the influence of remuneration committee adoption in UK companies, and finds that, in some circumstances, the adoption lower the growth rates in top director compensation. Conyon and Peck (1998) investigate the affect of outside directors in remuneration committee decisions, and report that they enhance the pay-for-performance sensitivity. However, studies in the US by Anderson and Bizjak (2003) and Vafeas (2003) report insignificant results on the influence of remuneration committee independence towards level of CEO pay. A more recent study by Sun and Cahan (2009) attempts to provide explanation for the mixed findings. Using a broader and richer measure of remuneration committee quality instead of just focusing on independence, they show that the sensitivity of CEO compensation to accounting performance is related to the governance quality of the remuneration committee, for US companies with fully independent remuneration committees.

With respect to ownership structure, Gomez-Mejia, Tosi and Hinken (1987) and Tosi and Gomez-Mejia (1989) document that the responsiveness of CEO pay to performance is greater in owner-controlled firm than management-controlled firm in the US manufacturing sector.2 A meta analysis of CEO pay studies by Tosi, Werner, Katz and Gomez-Mejia (2000) concludes that firm size rather than performance is the strongest predictor of CEO pay in management-controlled firms, while performance-related pay is more prevalent in owner-controlled firms. Further evidence on the importance of ownership structure in the pay-for-performance linkage for countries in Asia is provided by Firth et al. (2007) and Kato and Long (2005). Their studies show that in China, the pay-for-performance link is weaker or insignificant in listed firms owned by the state bureaucracy. Meanwhile, Kato, Kim and Lee (2007) document that pay-for-performance link is significant for Korean non-Chaebol firms but negligible for Chaebol firms.

Denis and McConnell (2003) suggest that the interrelationship between executive compensation and corporate governance mechanisms remains a fruitful area for research worldwide. Bruce, Buck and Main (2005) suggest that country-level institution should be factored into in analyzing executive pay. Furthermore, Kabir (2008) observes that not much is known about how firms across the world reward their executives outside the US, primarily due to the lack of publicly available information on executive pay and very intensive data collection requirements. We continue this line of research and investigate whether internal governance mechanisms, particularly the remuneration committee structure and ownership structure, influence the pay-for-performance link using a unique data set on remuneration practices and directors’ remuneration in Malaysia.

In addition, this study is also motivated by Conyon (2006) who challenged researchers to distinguish between the two competing theories of executive compensation namely the principal-agent and managerial power. Thus, our study also attempts to disentangle the managerial power and principal-agent views of executive pay. As mentioned earlier, the principal-agent (or optimal contracting) view of executive compensation holds that a well designed incentive contract whereby managers are suitably rewarded for generating shareholder value helps to closely align the interests of managers and shareholders (e.g., Jensen and Murphy, 1990; Core, Holthausen, & Larcker (1999). However, Bebchuk and Fried (2003) argue that the promise that managerial incentive contract is a partial solution to the agency problem remains largely unfulfilled. Bebchuk and Fried (2003) are of the view that executive compensation exacerbates the agency problem by promoting rent-extracting on the part of the executives. In their alternative managerial power story on executive compensation, powerful CEOs have great sway over their own pay by capturing the board, resulting in rent extraction in the form of greater CEO pay, or pay-without-performance, to the detriment of shareholders.

Malaysia provides a unique setting to examine the applicability of managerial power and principal-agent views in the determination of executive pay. Following the introduction of the voluntary Malaysian Code on Corporate Governance (MCCG) in 2000, companies listed on Bursa Malaysia are required to make public the Statement of Corporate Governance incorporating disclosure on directors’ remuneration. The MCCG emphasizes the following principles on directors’ remuneration. Firstly, in the case of executive directors, remuneration should be structured so as to link rewards to corporate and individual performance. Secondly, companies should establish a formal and transparent procedure for developing policy on executive remuneration and for fixing the remuneration packages of individual directors. And thirdly, company’s annual report should contain details of the remuneration of each director. Under best practices in corporate governance, the MCCG recommends companies to establish a remuneration committee consisting of wholly or mainly non-executive directors. The committee is allowed to get an advice from consultant relating to executive directors’ remuneration and recommend to the board an appropriate remuneration for the executive directors.
By exploiting the enhanced disclosures on the activities of remuneration committees and directors’ pay, and whether the companies observe the corporate governance principle by linking executive pay to performance, we expect that companies are subject to the dark side of managerial power when they do not subscribe to performance-related pay scheme, and for such companies, at high level of managerial ownership, level of pay is an increasing function of managerial ownership. Specifically, the objectives of this study are (1) to examine whether companies that publicly disclosed that they subscribe to the MCCG’s principles in structuring the executive remuneration so as to link rewards to corporate and individual performance actually practice what they preach, (2) to examine whether strong remuneration committee structure enhances the pay-for-performance link, (3) to examine whether ownership structures influence the pay-for-performance link.

Using data from 2003-2005, our results show that companies that claim that their reward system is related to performance, generally ‘do what they say’, and companies with strong remuneration committees appear to design their executive pay packages so as to reward their executives for creating shareholder value. It appears that institutional investors are associated with higher pay-for-performance relationship. The pay-for-performance relationship seems to weaken when managerial ownership exceeds 35 percent, possibly due to the dark side of managerial power.

Our study contributes to executive pay-for-performance literature in a few ways. Firstly, we extend the measurement of the governance quality of remuneration committee by including the activities of the remuneration committees. And secondly, we show that in situation where managerial power is at its most destructive, i.e. when companies have very high managerial ownership and at the same time they do not subscribe to performance-related pay scheme, rent extraction by executives in the form of excessive pay is likely.

The paper is organized as follows. The next section summarizes the prior literature on pay-for-performance link and develops the hypotheses to achieve our research objectives. This is followed by a description of the pay-for-performance model. Next, we explain the sample selection and data sources. The penultimate section presents the results and the final section concludes the paper and discusses the implications of our study for the governance of publicly traded companies.

[1] Transmile Group, the air cargo carrier, attracted attention in the early part of 2007 when its external auditor Deloitte & Touche blew the whistle after discovering irregularities in prior years’ audited financial statements, involving unsubstantiated sales of more than RM600 million from 2004 to 2006. Subsequently, Transmile Group restated its financial statements from a profit of RM158 million to a loss of RM126 million for the year ended December 2006. In July and November 2007, its former CEO, CFO and two non-executive directors were charged in court with abetting the company in providing misleading financial statements. At the AGM held in September 2007, more than two third of the shareholders voted against the payment of director fees for 2006 totalling RM145,000. The non-executive Chairman of Transmile Group, who is an ex-Transport Minister, resigned shortly before the said AGM. He joined the board of Transmile Group in 2004 when the Kuok Group emerged as a new controlling shareholder.
[2] Firm is referred as owner-controlled when there is single equity holder who controls as little as 5 percent of the voting stock. Meanwhile, firm is referred as management-controlled when there is no equity holder with at least 5 percent of the stock (Tosi and Gomez-Mejia, 1989).

Obviously, Papa looks forward to showcase his supervisee's PhD work in Milan with pride, and Mama can also look forward to receive a helluva birthday present anytime soon. And we shall miss Papa for a week or so during Ramadhan.

Papa last visited Italy in 2004, where he spent a few days in Venice, and was aghast to discover that she's no longer the La Serenissima. The photo above taken during that trip prompted one of his schoolmates, an Oxford graduate, to remark that "you look like an Indonesian movie star attending the Venice film festival". Hmm, a film maker may be.