Abstract
This study focuses on the association of voluntary compensation disclosure and ownership structure. It provides evidence that the detachment of control and cash flow rights in dual class share firms is associated with lower levels of compensation disclosure. This association is incremental to the level of managerial ownership and family ownership. The study attributes these disclosure results to the concealment of excess compensation in dual class share firms. Consistent with this explanation, the study finds that managers in dual class share firms earn higher compensation relative to their single class counterparts. An analysis within dual class firms also reveals that compensation disclosure is decreasing in managers’ voting control but increasing in their cash flow rights consistent with a private control benefits explanation. To examine these research questions, the study develops a contextual measure of compensation disclosure that attempts to capture firms’ economic bases for award of compensation.
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Notes
For example, consider a dual class share firm that issues 100 Class A shares with ten votes each and 500 Class B shares with one vote each, both with equal rights to dividends. A controlling shareholder may hold 90 Class A shares and none of the Class B shares. His control rights are therefore 90*10/(100*10 + 500*1) = 60 % while his cash flow rights are only 90/(100 + 500) i.e. 15 %. High control rights give him the power and influence to divert corporate resources to himself. However, because his equity incentives in the firm are only 15 %, it allows him to escape the consequences of his illegal diversion e.g. the adverse stock price effect on his 15 % equity ownership.
Bebchuk et al. (2000) also argue that the potential for agency conflict between controlling shareholders and outsiders in dual class share firms is higher than that in even single class concentrated ownership firms.
Beller, Alan. Speech by SEC Staff: Remarks Before Conference of the NASPP, The Corporate Counsel and the Corporate Executive, San Francisco, CA, October 20, 2004.
A similar compensation disclosure measure has been developed in a recent study by Laksmana (2008). A subset of the disclosures in her study also appears in the disclosure index independently developed in this study.
A study by Lee (2007) documents a negative association between disclosure and control divergence in Asian firms. His study uses S&P disclosure scores as its measure of disclosure. The disclosure measure employed in this study is a contextually relevant measure given the research question i.e. it uses compensation disclosure to test if managers attempt to conceal excess compensation.
With a pyramid structure, a controlling stake is held in a holding company, which in turn holds a controlling stake in another firm. Cross-ownership occurs when a firm owns portions of other firms in which it does business. In this way, the management group can maintain tight control of the firm through its relationships with its other companies.
The preponderance of dual class structures in other legal regimes may allow a researcher to circumvent the problem of identifying one-vote-one-share firms by examining recapitalizations and unifications of dual class structures. These events may provide unique opportunities to implement time-series analyses and obtain stronger causal inferences on the relationship between such structures or the lack of such structures and issues of reporting and disclosure.
Agrawal and Knoeber (1996) provide many examples on the complementarity of control mechanisms.
Some institutional investors still view dual class equity structures as value reducing governance mechanisms, as illustrated by both TIAA-CREF’s and CalPERS’ public opposition to such structures. Osterland (2001) reports that some institutional investors refuse to even invest in dual class firms.
To preserve objectivity in index construction, no specific weighting criteria are assigned (Marston and Shrives 1996).
For a firm which was not covered by IBES, I assume that the number of analysts covering the firm was zero.
Frequency of forecast guidance is measured the number of management forecasts made in a particular year. Occurrence of forecasts is a binary variable measured as 1 if a management forecast issued in a year; 0 otherwise. The data is collected from the First Call Historical database of Company Issued Guidelines.
To ensure that the one-vote-one-share feature of single class share firm was preserved, firms which exhibited features of control pyramids were excluded. Control pyramids can create a control divergence effect similar to that in dual class firms.
These eight firms were randomly chosen without replacement using the Proc surveyselect command in SAS.
Compensation data is analyzed for 3 years instead of a single year, to acquire more empirical power for the tests.
Option grant values are calculated using modified Black–Scholes model described in the Compustat documentation.
Consistent with Amoako-Adu and Smith (2001), a firm is defined as a family firm if the largest controlling shareholder is an individual or a group linked by family ties.
TDC1 is the sum of Salary, Bonus, Other Annual Compensation, Total Value of Restricted Stock Granted, Total Value of Stock Options Granted (using Black–Scholes) and Long-Term Incentive Payouts.
Equation (5) is designed to predict ownership at the time of IPO. To the extent that some dual-class structures are adopted long after the IPO, the selection model may not be complete in capturing all causal factors of dual class equity.
Cram et al. (2009) recommend the use of a conditional logit model when matched samples are used.
Demsetz (1983) argues that because a good part of owner-managers' lives in family firms are on the job, they may prefer on-the-job consumption to higher wages. Thus the lower executive compensation levels observed for family firms simply represent managerial preferences for lower take-home wages instead of on-the-job perquisites.
The optimal contracting view argues that both ownership and compensation are substitutes in incentivizing managers. Bebchuk et al. (2002a) argue that while the managerial opportunism view and the optimal contracts view are not mutually exclusive, managerial opportunism can better explain patterns and practices in executive compensation.
Random firms were chosen according to the methodology described in Palepu (1986). The sample firms were sorted according to company name. Every 8th firm was then chosen from the sorted sample until 50 firms were selected.
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Acknowledgments
This study is partially based on my dissertation at the University of Toronto. I would like to thank my thesis chair, Gordon Richardson and other members of my thesis committee, Jeffery Callen and Craig Doidge for their invaluable support and guidance. This paper has also benefited from the comments of Alexander Dyck, Bipin Ajinkya, Jan-Mahrt Smith,Jenny Tucker, Joseph Fan and workshop participants at the University of Alberta, University of Arizona, Brock University, University of Florida, Florida State University, University of Manitoba, Nanyang Technological University, National University of Singapore, Pace University, the University of Toronto and the 2007 AAA Annual Meeting Concurrent Session. The author would also like to thank the Editor and three anonymous reviewers for their professional work and constructive comments and suggestions.
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Appendices
Appendix 1: Description and scoring of disclosure items
The following is a brief description of each of the disclosure variables used in the study. Detailed examples are provided in Appendix 2.
Does the company discuss the decision making process of manager’ pay? (DM_MGR)
This disclosure variable captures whether the company provides an overall compensation philosophy and policy of the firm at the beginning of the Report. A score of 1 if awarded if the company discloses this information in at least 5 lines; 0 otherwise.
Does the firm disclose if the peer group companies used to set compensation levels are the same companies or a subset of the companies listed in the Performance Graph? (CLARITY)
Companies are required under the disclosure regulations to choose and discuss the nature of the peer group of companies and the performance of that peer group with which the committee is comparing its executive compensation. The motivation is to elicit information on whether the link between firm performance and compensation in the company closely parallels that in other peer group companies. However companies have discretion to disclose whether the peer group whose market performance is disclosed in the Performance Graph is the same group of companies used to determine actual executive compensation levels. A score of 1 is awarded if the company discloses this information; 0 otherwise.
Does the firm clearly disclose the identity of its industry peer group in the performance graph? (PEER_IDENTITY)
While companies are required to identify the peer group, they can choose to be vague in their disclosure on the identity of the peer group. The potential for obscure disclosure is evident in cases where the company uses a self-constructed peer group (as opposed to a market or industry index such as the S&P500 group or companies in the Philadelphia Semiconductor Index) to benchmark its compensation-performance relationship. A score of 1 is awarded if the company clearly identifies the peer group; 0 otherwise.
Does the firm disclose the percentile on which base salaries are formulated relative to peers? (PERCENTILE)
Companies have discretion to report the percentile ranking at which it benchmarks its executive salaries relative to its peer group. The choice of words such as “median” or “75th percentile” may be used to describe these benchmarks. A score of 1 is awarded if the company discloses this information; 0 otherwise.
Does the firm disclose the range of executive bonuses or options offered to its executives as a percentage of base salaries (BONUS1) or as a percentage of certain targeted amounts (BONUS2)?
Companies have the discretion to report how executive bonuses or option grants are calculated, as a percentage of base salaries or as a percentage of certain targeted amounts. A score of 1 is awarded if the company discloses this information; 0 otherwise.
Does the firm disclose the percentile ranking at which incentive or performance based compensation is targeted relative to peers? (BONUS3)
Companies have discretion to report the percentile ranking at which it benchmarks its incentive compensation relative to its peer group. Companies often disclose this information jointly for salaries and bonuses. In these cases, the disclosure is assumed to occur under the disclosure variable PERCENTILE. A score of 1 is awarded if the company discloses this information; 0 otherwise.
Are details of the CEO’s contract disclosed separately from other executives in the firm? (CEO_CONTRACT)
Companies are required to furnish all the elements of a CEO’s compensation and the criteria for its determination. However they have the choice to club these disclosures along with those for other executives of the firm or to report these disclosures separately for the CEO. A score of 1 is awarded if the company separately discloses the details of the CEO contract; 0 otherwise.
Does the company disclose the specific performance measures and their computation on which performance related pay is based? (EXEC_SPECIFICS)
Companies have discretion in disclosing the actual financial or non-financial metrics and their computations that form the basis of performance related pay. A score of 2 is awarded if the firm discloses the metric as well as its actual computation, 1 if the firm discloses the metric but not the computation and 0 if the firm discloses no metrics. Disclosures of certain self-explanatory GAAP based metrics such as “Net Income” or “Net Sales” or non-financial measures such as “cell phone subscribers” are awarded the full 2 points.
Does the firm disclose the weight on financial, non-financial and personal performance measures for award of performance based compensation, for one or more of its managers? (WEIGHT)
Companies have discretion in disclosing the weights that they place on financial or personal performance for awarding performance-related pay. A score of 1 is awarded if the company discloses this information; a score of 1 is awarded if the company specifically discloses that it does not assign any weight on financial, non-financial and/or personal performance measures for award of performance based compensation; a score of 0 is awarded if company does not disclose weights or does not disclose that it does not use weights for award of performance-based compensation.
Does the firm disclose any specific quantitative targets for award of performance based compensation? (QUANT)
Companies usually have certain quantitative targets for award of performance-related pay. However they have discretion in choosing to disclose this information. A score of 1 is awarded if the company discloses this information; 0 otherwise.
Appendix 2: Disclosure item matrix
Following table shows (i) the definitions of the disclosure items; (ii) examples of the disclosure on the basis of which the items were scored. The primary data source is the Schedule DEF14A (Definitive Proxy Statement) if available and Schedule PRE14A (Preliminary Proxy Statement not related to a contested merger/acquisition), if DEF14A is not available. The basis of scoring disclosure items was “1” for good disclosure and “0” for bad or incomplete disclosure, unless otherwise stated. Examples of certain disclosures in the table below have been slightly modified for succinctness.
Executive compensation disclosure item | Example of good disclosure | Example of bad or incomplete disclosure | |
|---|---|---|---|
1. | Does the company discuss the decision making process of manager’ pay? (DM_MGR) | The Report on Executive Compensation discusses the executive compensation philosophy with respect to objectives, competitive practices, hiring of compensation consultants etc. in at least 5 lines (Gartner Group Inc) | There is no discussion or a discussion of less than 5 lines of the compensation philosophy for executive officers (Presidential Realty) |
2. | Does the firm disclose if the peer group companies used to set compensation levels are the same ones or a subset of the ones listed in the Performance Graph? (CLARITY) | “The peer group for purposes of determining compensation of executive officers is not the same group of companies which are included in the industry index which appears on the performance graph contained in this proxy statement” (MSC Industrial Direct Co) | “Actual base salaries are kept within a competitive salary range for each position that is established through job evaluation and market comparisons and approved by the Committee as reasonable and necessary”. No further information on peer group/competitive range and their performance is provided (Polymer Group) |
3. | Does the firm disclose or indirectly imply the identity of its industry peer group in the performance graph? (PEER_IDENTITY) | “The following graph compares the cumulative total stockholder return on shares of Common Stock with that of the S&P 500 Index, the S&P Health Care Index, the S&P Household Products Index and the S&P Cosmetics Index” (Revlon Inc) Scoring Rule: If company uses an industry based peer group and discloses identity, 1 point. If company uses an industry based peer group and does not disclose identity, 0 points. If company does not use an industry based peer group, 1 point | “The SIC Code Index is composed of 24 public companies with the same Standard Industrial Classification Code as the Company”. But no SIC code identified or the companies within the industry (Impath Inc) |
4. | Does the firm disclose the percentile on which cash compensation (salaries plus bonuses) or just base salaries, are formulated relative to peers (PERCENTILE) | Key words such as “median”, “mean”, “average”, “third quartile” etc. used to describe percentile levels. No points awarded for keywords such as “above average” or “below average” “Annual compensation levels (salary plus target annual incentive award opportunity) are set at or between the median and the 75th percentile of the compensation practices of comparator companies” (Nabisco Holdings) | “The Committee believes that the base salaries have been reasonable in relation to the Company’s size and performance in comparison with the compensation paid by similarly sized companies within the Company’s industry” (NuSkin enterprises) |
5. | Does the firm disclose the range of bonuses or options offered to its executives as a percentage of base salaries, for one or more of its executives? (BONUS1) | “Individual awards may range from zero to 200 % of the base salary, based on business and/or individual performance” (Grace W R & CO) | No disclosure on potential bonus ranges as a percentage of base salaries (Lamar Advertising) |
6. | Does the firm disclose the range of bonuses offered to its managers as a percentage of certain targeted amounts for one or more of its executives? (BONUS2) | “Actual awards can vary between 0 and 250 percent of target awards based on actual performance” (Hertz Corp) | No disclosure on potential bonus ranges as a percentage of certain targets (Jefferies Group Inc) |
7. | Does the firm disclose the percentile ranking at which incentive or performance based compensation is targeted relative to peers? (BONUS3) | “A target bonus, expressed as a percentage of annual base salary, is specified for each executive officer, corresponding to median cash bonus payments made by comparable companies based upon the competitive consensus data for similar positions” (Gardner Denver Inc.) | No disclosure on specific percentile at which incentive or performance based compensation is targeted (Hollinger International Inc.) |
8. | Are details of the CEO’s contract disclosed separately from other executives in the firm? (CEO_CONTRACT) | The employment agreement of the CEO is listed separately from other executives which discloses any special option grants, retirement benefits, medical coverage and other contractual features (Reynolds & Reynolds) | There is no employment agreement listed separately for the CEO (Nike Inc) |
9. | Does the company disclose the specific performance measures and their computation on which performance related pay is based? (EXEC_SPECIFICS) | “The Company’s Incentive Bonus Plan includes the traditional ROCE (Return on Capital Employed) measurement standard, but also earnings growth as a critical indicator of financial health of the Company. The formula for ROCE is the sum of pretax earnings plus interest expense divided by the sum of average total assets minus non-interest bearing liabilities” (Harmon Industries—2 points) Scoring Rule: 2 points if specific financial/non-financial criteria disclosed along with their method of computations, 1 point if the above criteria are disclosed without the method of computation, 0 points otherwise. 2 points if Net Income or EPS or Net Sales or EBITDA or non-financial metrics are the only criteria. No points for vague terms such as “earnings targets” or “revenue growth” or “profit” | “The amount of cash bonuses paid to executive officers was determined through a combination of factors including the attainment of certain corporate, business unit & individual objectives (financial and non-financial)” (Commonwealth Telephone Enterprises—0 points) |
10. | Does the firm disclose the weight on financial, non-financial and personal performance measures for award of bonuses and/or options, for one or more of its managers? (WEIGHT) | “In the case of the Chief Executive Officer, the payout is based 2/3 on the financial performance targets and 1/3 on individual objectives set annually by the Committee” (Del Monte Foods Inc) “In determining compensation, the Committee did not use a specific formula in evaluating the various factors, in determining the specific amount of compensation payable or in determining the allocation of compensation to salary, bonus and stock option grants” (American International Group) | No disclosure of weights on financial, non-financial and/or personal performance measures and no disclosure of specific weights not being used in compensation contracts (Sequa Corp) |
11. | Does the firm disclose any specific quantitative targets for award of performance based compensation? (QUANT) | “There is no management profit share paid unless the Company’s net margin is at least 2 % for the fiscal year” (Moog Inc) | No disclosure on specific quantitative targets (Odetics Inc) |
Appendix 3: Selection variables used in Gompers et al. (2010)
Variables | Explanation |
|---|---|
Name | Insiders are more likely to place a high value on the private benefits of control if the company is named after one of its insiders |
Media | Some industries offer more private benefit opportunities than others. As documented in DeAngelo and DeAngelo (1985) and Smart and Zutter (2003), media firms are more likely to have dual class status |
% Firms and % Sales | Private benefits of control are larger when insiders have the opportunity to be the major employer in their region: that is, when the firm is the “only game in town”. In this case, dual class structures are more likely to be observed when there are fewer firms located in the same region. Firms may use dual class status to promise to local authorities that the firm will resist unsolicited takeovers in order to honor implicit contracts with local government and other stakeholders. An alternative possibility is that regions crowded with large firms allow more scope for local M&A activity and dual class status could serve as an anti-takeover protection. The net effect of these two forces is captured by %Firms and %Sales |
Sales Rank | Private benefits of control are stronger for firms where the founders are still active. One proxy for founder status is the age of the firm. The percentile ranking of the IPO-year sales of the firm relative to other firms with the same IPO year measures the fact that sales at the time of IPO is likely to be positively correlated with firm age which in turn is correlated with founder status |
Profit Rank | Private benefits of control are likely to be positively correlated with cash flow and profitability as free cash flows can be diverted towards excess compensation and pet projects. Since investors recognize this relationship, they are likely to demand control discounts that are positively correlated with profitability, thus increasing the private costs of control. The net effect is of these two forces is an empirical question |
State Anti-takeover Index | Dual class equity is a powerful anti-takeover protection. Since this protection may be less valuable for companies incorporated in states with anti-takeover laws, dual class equity is more likely to be observed in states with weak state anti-takeover protection |
Sales/County Sales | An alternative measure of the “only game in town effect” is the ratio of firm sales to the sales of all firms in the same region. This measure is a proxy for the firm’s “share of the local pie” |
Fama–French Industry Indicator Variables | Since private benefits of control vary with industries, dummy variables for each of the industries as defined by Fama and French (1997) are included. Note that these industry dummy variables do not perfectly capture the definition of the media industry, hence a separate indicator variable for media industry is included |
Appendix 4: Regression variables: definition and measurements
This table gives the definition and construction of each variable used in the selection, compensation and disclosure regressions as well as those listed in Descriptive Statistics.
Variables (variable name) | Descriptions |
|---|---|
Compensation disclosure index (DDCOMP) | Compensation discretionary disclosure index |
Dual firm dummy | Dummy variable set to “1” if firm has dual class share structure; “0” otherwise |
Voting control | Percentage of total votes held by managers in the firm. For dual class share firms, this is calculated as [Number of superior voting shares (SVS) owned by managers*Votes attached to each SVS + Number of restricted voting shares (RVS) owned by managers*Votes attached to each RVS]/[Total number of SVS issued*Votes attached to each SVS + Total number of RVS issued*Votes attached to each RVS] |
Cash flow rights stake (managerial ownership) | Percentage of cash flow rights held by managers. For dual class share firms, this is calculated as [Sum of superior and restricted voting shares held by managers/Sum of total superior and restricted voting shares issued by the firm]. If the dividends that can be granted on the SVS are lower than on the RVS, the cash flow rights ownership variable is appropriately adjusted |
Family firm | Dummy variable set to “1” if the largest shareholder is an individual or a group related by family ties; “0” otherwise. This is consistent with the definition in Amoako-adu and Smith (2001) |
Firm size | Natural logarithm of Total Assets measured as Compustat Data Item 6 |
External financing | As in Demirguc-Kunt and Maksimovic (1998), measured as the difference between required investment and internally available capital for investment. Required investment is estimated by a 2-year average of annual growth rate in total assets; internally available capital for investment by a 2-year average of ROE/(1-ROE) over the same period |
Firm age | Measured as the natural log of number of years from the year of incorporation. This information was first compiled from the Hoovers website. If the year was not listed, the company website was examined |
Sales growth | Measured as two-year average sales growth |
Institutional ownership | Determined similarly to the managerial ownership variable noted above with respect to shares held by institutions. Data acquired from the Thomson-Reuters database |
Institutional ownership concentration | Determined by the percentage of shares held by the top 5 institutions. Data acquired from Thomson-Reuters database |
Transient institutional ownership (as % of institutional ownership) | Determined by (Transient Institutional Ownership/Institutional Ownership), where “Transient” is based on the institutional classification in Bushee (1998). Data acquired from Brian Bushee |
Return on equity (ROE) | [Net Income (loss)/Shareholders’ Equity]. Net Income (loss) is measured as Compustat data item 172. Shareholders’ equity is measured as Compustat data item 216 |
Leverage | [Long term debt/Total Assets]. Long term debt is measured as Compustat data item 9 |
Asset intangibility | [1 − (Net Property, Plant and Equipment (PPE) + Inventories)/Total Assets]. Net PPE is measured as Compustat data item 8. Inventories are measured as Compustat data item 3 |
Analyst following | The number of analysts following the firm |
Total direct compensation (TDC1) | Sum of Salary, Bonus, option grants, other annual compensation, all other paid compensation, long term incentive payouts and restricted stock holdings |
Excess compensation | Residual from the compensation regression of TDC1on market Capitalization, one year stock return, lagged one year stock return, return on assets, market-to-book ratio, return volatility, institutional ownership concentration, firm age, industry controls and year dummies |
One year stock return | Annualized daily stock return from CRSP |
Lagged one-year stock return | Lagged Annualized daily stock return from CRSP |
Return on assets | [Net Income (loss)/Total Assets]. Net Income (loss) is measured as Compustat data item 172. Total assets is measured as Compustat data item 6 |
Market-to-book ratio | Market value is the value of end-of-fiscal year outstanding shares. For dual class firms, this is calculated as the value of restricted stock outstanding shares. Book value is the stockholders’ equity (Compustat data item 216) |
Return volatility | Annualized standard deviation of daily stock returns for the past 3 years |
Name | Coded as 1 if the company name included a person’s name; 0 otherwise |
Media | Coded as 1 if company belonged to SIC codes 2710, 2711, 2720, 2721, 2730, 2731, 4830, 4832, 4833, 4840, 4841, 7810, 7812, 7820; 0 otherwise |
Sales rank | Percentile ranking of the IPO-year sales of the firm relative to other firms with the same IPO year; 0 = lowest and 100 = highest |
Profit rank | Percentile ranking of the IPO-year net income (before extraordinary items) of the firm relative to other firms with the same IPO year; 0 = lowest and 100 = highest |
% Firms | Percentage of all Compustat firms located in the same county as the sample firm before the sample firm’s IPO |
% Sales | Percentage of all Compustat sales by firms located in the same county as the sample firm before the sample firm’s IPO |
Sales/county sales | Ratio of firm’s sales to all firms in the same region |
State anti-takeover index | The index is taken from Gompers et al. (2003) and is measured on a scale of 0–6 for the state in which the firm was incorporated |
Fama–French industry dummies | See Fama and French (1997) |
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Tinaikar, S. Voluntary disclosure and ownership structure: an analysis of dual class firms. J Manag Gov 18, 373–417 (2014). https://doi.org/10.1007/s10997-012-9229-2
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DOI: https://doi.org/10.1007/s10997-012-9229-2