Frederick L. Bereskin and David C. Cicero
CEO compensation contagion: Evidence from an exogenous shock
Journal of Financial Economics | Volume 107, Issue 2 (Feb 2013), 477–493

Throughout 1995, there were a number of court rulings dealing with Delaware law that strengthened firms' ability to use poison pills to resist hostile takeover threats. A “poison pill” enables a firm to dilute a shareholder's stake in the firm when it crosses a certain threshold. The general objective of a poison pill is to enable a firm to resist a hostile takeover. The effect of a poison pill is particularly strong at a firm with a classified board, since the poison pill would generally necessitate the nominees of the hostile bidder to be reelected over two consecutive years. In 1995, Delaware court rulings provided increased validity to poison pills, and enabled managers of firms to “just say no” to threatened hostile takeovers. These developments in effect shielded CEOs from the pressures of the corporate control market, and may therefore have led to increased CEO entrenchment which could exacerbate agency problems under certain circumstances. The exogenous nature of these court rulings, and the fact that they only applied directly to a subset of firms, enables us to study their impact on CEOs ability to extract managerial rents. One of the most direct aspects of corporate contracting to examine in light of these legal changes is CEO compensation.

There are competing theories for how compensation might change in response to a change in takeover pressure. Under a hypothesis that boards of directors design compensation contracts that maximize shareholder value (“optimal contracting”), CEO compensation should not generally increase in response to the reduced likelihood of hostile takeovers. In fact, to the degree that these CEOs' tenures are less risky after the rulings, it is possible that optimal CEO compensation levels would decrease. In contrast, managerial entrenchment would suggest that CEOs with less vulnerability to hostile takeovers would have greater power to negotiate, or “skim”, higher compensation.

Managerial compensation increases when laws protect managers

We show that firms susceptible to managerial entrenchment increased their CEO compensation after the Delaware legal rulings. These include Delaware-incorporated firms with staggered boards that do not have a large outside blockholder. Although the court rulings applied to all Delaware-incorporated firms, managers at firms with these conditions arguably enjoyed the greatest increase in protection since there is no powerful outside shareholder to counter management and a capture of the board of directors by a bidding firm following a failed hostile takeover would take multiple years. As a result of this unexpected, exogenous shock to their corporate governance system, we estimate that the decisions led to an increase in abnormal CEO compensation at these firms of approximately $694,000 (32.9%).

The exogenous nature of this shock to CEO compensation enables us to establish this result (and argue for causality) using a “differences-in-differences” methodology, where we examine the effect of the shock on the treated group of firms compared to a group of control firms. We use this framework to identify changes over time in compensation across firms sorted by their susceptibility to the new rulings. The general form of our differences-in-differences regression is yi,t = αt + βi + γ · Xi,t – 1 + δ1 · Deli × ClassBoardi + δ2 · Deli × Aftert   qquad +  delta_3  cdot Del_i  times ClassBoard_i  times After_t +  epsilon_{i,t}, ;/var/tmp/iawltxhtml/mathcache//udisplaymathb521ede0194f029e15c498e9cd013e2f.svg where i indicates firm; t indicates year; Xi,t – 1 is a vector of firm-specific control variables; Deli is defined as one if the firm is incorporated in Delaware as of 1994, and zero otherwise; ClassBoardi is defined as one if the firm has a classified board as of 1994, and zero otherwise; and Aftert is defined as one if the year is after 1995, and zero otherwise. The dependent variable of interest is the log of the total level of compensation. The coefficient of interest in our analysis is δ3; this coefficient indicates how much of a change in compensation for Delaware-incorporated firms with staggered boards around the legal changes is different from the change observed among other firms.

1: Effect of Delaware anti-takeover rulings on CEO compensation
Variable Firms with no blockholder Firms with blockholder
DelawareAfter –0.257** 0.128
ClassBoardAfter –0.056 0.085
DelClassBoardAfter 0.284** –0.181
ScaledWPS –0.173* –0.168***
PPSGrant 0.117*** 0.121***
Other control variables Yes Yes
Firm fixed-effects Yes Yes
N 1,145 1,472
R2 52.5% 64.6%
One, two, and three stars mark statistical significance at the 10%, 5%, and 1% level, respectively.
This table examines the determinants of CEO compensation prior to and following the legal rulings in 1995. The dependent variable is the natural log of total compensation. DelawareAfter is a dummy variable equal to one if the firm was incorporated in Delaware in 1994, and the year is 1997 or later. ClassBoardAfter is a dummy variable equal to one if the firm had a classified board in 1994, and the year is 1997 or later. DelClassBoardAfter is a dummy variable equal to one if the firm was incorporated in Delaware in 1994, had a classified board in 1994 and the year is 1997 or later. ScaledWPS is the scaled wealth-performance sensitivity from Edmans-Gabaix-Landier (RFS 2009) divided by 100. PPSGrant is pay-for-performance sensitivity derived from option and stock grants in that year. Other control variables included are discussed in our JFE article.

Table 1 shows that the effects of the rulings are concentrated among those firms that have less powerful external monitors (the full results, with additional robustness specifications of the table are in our paper published in the JFE). The first column of this table shows that CEOs at firms without blockholders receive higher compensation following the court rulings. The coefficient of DelClassBoardAfter in our first specification is 0.284, reflecting an increase in CEO compensation of approximately $694,000 (32.9%) at affected firms, following the rulings. In contrast, we do not find significant evidence that CEOs at firms with blockholders experienced compensation increases. We also find that the increases in CEO compensation are larger among firms with weaker governance across other dimensions (measured with the level of CEO ownership, and the proportion of inside directors on the board).

Increased compensation also spreads to other firms

After identifying the increase in compensation among firms that are directly affected by the court rulings, we then show how these compensation patterns spread across other firms. We focus on firms in industries with a high proportion of firms that were directly affected by the Delaware legal rulings. This analysis follows from Gabaix-Landier (QJE 2008)'s model. Their highly cited paper develops a competitive equilibrium model of executive compensation and shows empirically that the average firm-size in the economy is a significant determinant of CEO compensation, because it proxies for CEOs' outside opportunities. Of most importance for our purposes, their equilibrium model also predicts a “contagion” effect, whereby competition for CEO labor causes a shock to compensation at a subset of firms to propagate through the economy. Gabaix and Landier suggest that even if 10% of firms pay their CEOs twice as much as competing firms, the compensation of all CEOs would double in equilibrium.

1: Compensation across affected groups, 1992–2000
figbc
This figure presents the median compensation across three groups of firms: (1) Delaware-incorporated firms with a staggered board and no blockholder (“Affected firm”); (2) firms that are not incorporated in Delaware, do not have staggered boards, and in which at least 10% of the firms in the two-digit SIC industry-group are Delaware-incorporated with a staggered board and no blockholder (“Affected ind”); and (3) firms that are not incorporated in Delaware, do not have staggered boards, and in which less than 10% of the firms in the two-digit SIC industry-group are Delaware-incorporated with staggered boards and no blockholder (“Not affected”).

We test the “compensation contagion” hypothesis, focusing on the firms most likely to be indirectly affected by the court rulings: Firms not incorporated in Delaware without staggered boards that are only in industries with a significant proportion of firms that were directly affected by the rulings. We separate firms into three broad groups:

Affected firms group:
Firms that are incorporated in Delaware, have staggered boards, and no blockholder;
Not affected industry group:
Firms that are not incorporated in Delaware, do not have staggered boards, and less than 10% of firms in the SIC two-digit industry-group are “Affected firms”;
Affected industry group:
Firms that are not incorporated in Delaware, do not have staggered boards, and more than 10% of firms in the SIC two-digit industry-group are “Affected firms.” (The median percentage of directly affected firms across industries for our sample period is 10%.)

Our compensation contagion results are best conveyed graphically. Figure 1 shows the sharp increase in CEO compensation among affected firms from 1994 to 1997, consistent with our first set of results discussed above. The figure also shows evidence of compensation contagion, in that CEOs of firms in the affected industry group also experience increased compensation, albeit with a two to three year delay. This finding is reasonable when considering the expected delays of both discovering the compensation at directly affected firms and entering into a new compensation contract.

In Table 2, we show that this contagion effect remains evident when implementing our regression specifications. The variable of interest, A f f ectedIndA f ter, shows that firms that are in the “Affected industry group” experience increased CEO compensation despite not being directly affected by the court rulings. The coefficients in this regression implies an approximate $616,000 (34.1%) increase in CEO compensation among firms in the Affected industry group, compared to firms in the Not affected industry group.

2: CEO compensation contagion
Variable 1992–1995, 1993–1995, 1992–1995, 1993–1995,
1998–2000 1998–2000 1999–2000 1999–2000
AffectedInd –0.111 –0.101 –0.114 –0.105
AffectedIndAfter 0.294*** 0.282*** 0.337*** 0.329***
Other control variables Yes Yes Yes Yes
Year fixed-effects Yes Yes Yes Yes
N 800 753 683 636
R2 71.6% 72.3% 71.7% 72.5%
One, two, and three stars mark statistical significance at the 10%, 5%, and 1% level, respectively.
This table examines the determinants of CEO compensation prior to and following the legal rulings in 1995 for firms without staggered boards that are not incorporated in Delaware. The dependent variable is the natural log of total compensation. AffectedInd is an indicator variable equal to one if at least 10% of firms in the two-digit SIC industry-group have staggered boards, no blockholder, and are incorporated in Delaware. AffectedIndAfter is equal to one if AffectedInd equals 1 and the year is 1998 or later. Other control variables included are discussed in our JFE article.

The final point in our summary is the relevance of our results for understanding the sharp increase in CEO compensation during the 1990s. Our estimates of abnormal CEO compensation across the economy during this period are considerably lower when one accounts for the impact of the Delaware legal rulings. In particular, average annual abnormal increases in CEO compensation are estimated at $741,000 without controlling for the impact of the legal rulings, compared to $570,000 otherwise. Thus, it is important to control for legal changes that impact the corporate-control environment when evaluating the determinants of CEO compensation.

In conclusion, we showed how firms' CEO compensation practices changed in response to exogenous changes at other firms with which they may have competed for executive talent. CEO compensation at a small subset of firms spread to competing firms. A portion of compensation increases during the 1990s appears to have been driven by such a shock that emanated from court interpretations of Delaware corporate takeover law.


16-nizami
Unknown artist: Khusraw discovers Shirin bathing in a pool (miniature in the manuscript by poet Nizami). Persia, 12th century.. Nizami is a celebrated Persian poet from the 12th century. He wrote the famous tragic romance Khusraw and Shirin, which still permeates Iranian folklore and fine arts. The above scene is a famous moment: When King Khusraw lays his eyes on Princess Shirin for the first time, he falls in love with her. Due to several blunders, the lovers never really unite while alive, but are buried together. (Does them a lot of good, doesn't it?) Persian miniature art was widely used in manuscripts for illustrations. It influenced Mughal and Ottoman miniatures in India and Turkey. Some rare manuscripts and miniatures, including some of Nizami's, are owned by the Metropolitan Museum of Art in their Islamic Gallery.