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.

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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.

Papa's Labour of Love

UPDATE AUG. 2012
Alhamdulillah,  we are pleased to see that the article has made some impact two and a half years after publication
http://www.journals.elsevier.com/the-international-journal-of-accounting/most-cited-articles/

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Today Papa received an advance birthday present in the form of a sukacita email titled MS-2323 ACCEPTANCE, from the US:

Dear Professor XXXX,

Congratulations! Your paper, “Impact of family firm and board composition on corporate transparency: Evidence based on segment disclosures in Malaysia,” has been accepted for publication in Volume XXX of the Journal. Attached you will find a copyright agreement for you to sign.

Also, please make sure to send to me your final version of your paper so I may prepare for English editing purposes.

Thank you for your contribution!

It has been a long, long road to publishing. Papa was asked to do two rounds of major corrections, and yet he was unfazed. Persevered, he did. Syukur, syukur Alhamdulilah, and syukran to all friends, colleagues and organizations who made this possible. The paper will be published at the end of 2009, but we suspect the article in press will be available online in the third quarter of 2009. For those who are suitably inclined, this is only the beginning ….. section:

Does this mean I can expect to have a grand belated birthday celebration anytime soon?

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1. Introduction
An important area of accounting research, that has been receiving tremendous attention recently, emphasizes the influence that corporate governance may have on corporate transparency (Fan and Wong, 2002; Beekes et al., 2004; Ajinkya et al., 2005; Karamanou and Vafeas, 2005; Beekes and Brown, 2006; Wang, 2006; Ahmed and Duellman, 2007; Ali et al., 2007; Garcia-Lara et al., 2007). The dimensions of corporate transparency investigated include quality of earnings in terms of accruals quality, earnings informativeness and accuracy and bias of management earnings forecast.[i] Two internal corporate governance characteristics that are extensively investigated are ownership structures and board attributes. Given that the two extreme types of ownership structure, namely diffused ownership (widely held shareholder system) and concentrated ownership (controlling shareholder system), give rise to two types of agency problems; Type I (manager opportunism or misalignment effect) and Type II (owner opportunism or entrenchment effect) (see, for example, Gilson, 2006; Villalonga and Amit, 2006), recent studies have begun to focus more on the linkage between family firms and the quality of accounting disclosures (see, for example, Wang, 2006; Ali et al., 2007; Patelli and Prencipe, 2007; Chen et al., 2008).

The effect of ownership structure on corporate transparency is an unsettled area of research interest. For example, Fan and Wong (2002) argue that the entrenchment effect and proprietary information effect associated with concentrated ownership result in corporate opacity and low informativeness of accounting earnings. Wang (2006), on the other hand, argues that founding family firm with its unique concentrated ownership is “less likely to engage in opportunistic behavior in reporting accounting earnings because it potentially could damage the family’s reputation, wealth and long-term firm performance” (p. 622). When alignment effect overwhelms the entrenchment effect, family firm is inclined to report high quality financial information. Ali et al. (2007) show that the difference in Type I agency problem across family firm and non-family firm dominates the difference due to Type II agency problem. Thus, they observe that family firm reports higher earnings quality than non-family firm. This study contributes to the current debate on alignment versus entrenchment effect of family firm by investigating whether family firm is associated with greater corporate transparency.

The proxy used as an indicator of corporate transparency is the early adoption of an accounting standard that is associated with greater disclosure, namely the disaggregation of accounting information by business segments. Companies that adopt Financial Reporting Standard (FRS) 114, previously known as Malaysian Accounting Standard Board (MASB) 22, prior to its effective date, are deemed to be proponents of corporate transparency. The standard on segment disclosure is chosen primarily because during the study period, there is evidence to suggest users’ dissatisfaction with the quality of segment disclosures as illustrated in the AIMR Corporate Disclosure Survey 2000 and OECD White Paper on Corporate Governance in Asia 2003.

In Malaysia, during 1987-2001, companies listed on Bursa Malaysia were required to comply with the original International Accounting Standard (IAS) 14. The revised IAS 14, which became effective for periods beginning on or after 1 July 1998, has not been immediately adopted in Malaysia. With the introduction of MASB 22 in 2001, listed companies in Malaysia are required to disclose segment data similar to the requirements under the revised IAS 14 for the periods beginning on or after 1 January 2002. The FRS 114-cum-IAS 14 (revised) presents major departures from the original IAS 14. The differences include the adoption of two-tier segmentation with either the business segment or the geographical segment as the dominant basis of segment reporting (primary), consistent use of accounting policies across segments and standardized measure of segment results across companies.

By electing to adopt FRS 114 prior to its effective date, companies voluntarily disclose more information especially for the primary basis of segment reporting. This is because they have to provide additional disclosures, such as depreciation and amortization expenses and other significant non-cash expenses by reportable segments, to enable users to "predict the overall amounts, timing, or risks of a complete enterprise's future cash flows". In addition, unlike the original IAS 14, FRS 114 also requires disclosures of segment liabilities in the primary segment reports and capital expenditure in both the primary and secondary segment reports, if any.

This study also addresses another tension in the corporate governance literature namely the efficacy of the two different types of non-executive directors. Various Codes on “best practice” in corporate governance around the world advocate, among others, that the composition of board of directors should have a mix of executive and non-executive directors (see, for example, Cadbury Report, 1992; King Committee Report, 1994; Bosch Committee Report, 1995). The presence of non-executive directors, who are presumably independent of management, provides the essential check and balance as they are expected to monitor and control the actions of self-serving executive directors on behalf of the external shareholders.

In the midst of call for “the more independent directors on corporate board, the better!”, a special report on non-executive directors by The Economist (20 March 2004, pp. 71-73) throws caution that the independent directors may not behave independently and thus compromise their objectivity and loyalty to the shareholders. In addition, the report also warns of the danger that ignorance may be the price of independence. The report, citing Carter and Lorsch (2004), further highlights a special breed of non-executive director who is not independent. This non-independent non-executive director is often known as affiliated or “grey” director. Klein (1998), Hermalin and Weisbach (2003), Matolcsy et al. (2004), Peng (2004) and Fich (2005), among others, highlight the distinction between affiliated director and independent director, who are both non-management members of the board. According to Klein (1998), apart from being a part timer, an affiliated director is usually an ex-employee, or related to the firm’s controlling family, or an interlocking director, or a professional with significant business or financial ties with the firm. Similarly, Peng (2004) defines affiliated and independent directors as “non-management directors who have family and/or professional relationships with the firm or firm management and non-management directors with no such relationship respectively” (p. 454). Since affiliated directors have prior associations with the firm, they often have intimate knowledge of the firm and its industry compared to many independent directors, and thus shareholders may feel affiliated directors rather than independent directors are better serving them.

Although a few studies on board composition and firm performance acknowledge the dichotomy between independent and affiliated directors (see, for example, Daily and Dalton, 1994; Dalton et al., 1998; Hermalin and Weisbach, 2003; Anderson and Reeb, 2004; Peng, 2004), there is a notable lack of empirical evidence on the relative efficacy of the two distinct types of non-executive directors in promoting corporate transparency. Past studies predominantly examine the monitoring role of independent directors or non-executive directors by treating independent and affiliated directors as a homogenous group. As a first attempt to assess the relative influence of independent versus affiliated directors in fortifying corporate transparency, and in response to the call for researchers to focus on how ownership structures shape accounting policies in emerging markets and transition economies (Fan and Wong, 2002, p. 404), this study is motivated to consider whether ownership structure (family firm versus non-family firm) and board composition (independent director proportion and affiliated director proportion) influence the timing of adoption of an accounting standard.

Malaysia provides an ideal setting to investigate the influence of family firm and board composition on corporate transparency. Firstly, family firms are prevalent in Malaysia. An article in the South China Morning Post (dated 28 August 2002, as cited by Jaggi et al., 2007) states Hong Kong has the third highest percentage of family ownership of listed companies in the region after Indonesia and Malaysia. This is further supported by Liew (2007) who concludes, based on evidence presented by Claessens et al. (1999) and World Bank (2001), that “companies in Malaysia are typically controlled by a small group of related parties and managed by owner-managers” (p. 726). Secondly, data on board mix is readily available since the annual reports of listed companies in Malaysia must include the profile of each of the directors and specify whether the director is an executive, non-independent non-executive or independent non-executive.[ii]

The results indicate that family firms (proxied by proportion of family members on board) and boards with greater proportion of affiliated directors are more inclined towards early adoption of FRS 114 in full (disclose all primary segments items) than delayed adoption. The research significance is as follows: Firstly, the finding that family firms are more likely to make greater segmental disclosures is consistent with Wang (2006) and Ali et al. (2007) who show that agency problem II is overshadowed by agency problem I. Secondly, our results show differential effects on the contribution of independent versus affiliated directors in enhancing corporate transparency. Thus, treating both independent and affiliated directors as a homogenous group may mask their equivocal influences on board monitoring and performance.

The rest of the paper proceeds as follows: Section two reviews prior studies and develops the hypotheses. Section three describes the identification of early adopters, procedure to match early adopters against non-early adopters, empirical tests, data collection and sample characteristics. The findings are presented in Section four, and Section five describes the main conclusions, practical implications, limitations of the study and suggestions of avenues for future research.

[i] Earnings informativeness is often measured by the earnings response coefficient (or earnings explanatory power for returns) and earnings conservatism (or asymmetric timeliness of earnings .i.e. speedier recognition of bad news than good news in earnings).
[ii] Paragraph 9.25 of the Bursa Malaysia Listing Requirements states that the particulars of each director shown in the annual report must include the name, age, nationality, qualification and whether the position is an executive or non-executive one and whether such director is an independent director. Among other particular to be disclosed of each director is any family relationship with any director and/or major shareholder.