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Universal Demand Laws and Compensation
Mark Humphery-Jenner*, Emdad Islam†, Lubna Rahman‡
Abstract
How do firms respond to a regulatory induced increase in managerial entrenchment? We use the staggered passage of Universal Demand (UD) laws as a natural experiment with which to answer this question. Universal demand laws insulate managers from derivative litigations, thereby entrenching them from a form of external discipline, which would facilitate shirking and reduces managerial discipline. We hypothesize and show that firms respond to this by increasing risk-taking incentives.
This effect is stronger in firms with more institutional investors (who might pressure for compensation changes) but weaker in high competition industries (where competition itself can mitigate a deterioration in governance). We take steps to mitigate endogeneity, identification, and other econometric concerns.
JEL Codes: G34
Keywords: Litigation, Universal Demand, Compensation, Governance
* UNSW Business School
† Monash University
‡ Monash University
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Universal Demand Laws and Compensation
Abstract
How do firms respond to a regulatory induced increase in managerial entrenchment? We use the staggered passage of Universal Demand (UD) laws as a natural experiment with which to answer this question. Universal demand laws insulate managers from derivative litigations, thereby entrenching them from a form of external discipline, which would facilitate shirking and reduces managerial discipline. We hypothesize and show that firms respond to this by increasing risk-taking incentives.
This effect is stronger in firms with more institutional investors (who might pressure for compensation changes) but weaker in high competition industries (where competition itself can mitigate a deterioration in governance). We take steps to mitigate endogeneity, identification, and other econometric concerns.
JEL Codes: G34
Keywords: Litigation, Universal Demand, Compensation, Governance
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1 Introduction
Derivative litigations enable shareholders to sue on behalf of their companies for wrongs done to those companies, including by officers and directors. However, Universal Demand (UD) laws require shareholders to have board approval before launching such litigation, thereby shielding managers from disciplinary action. Such entrenchment can enliven managerial agency conflicts, enabling managers to exert too little discipline and to shirk. We use the staggered passage of UD laws in different states in the US to hypothesize and show that firms respond to such an exogenous increase in entrenchment by increasing managers’ risk taking incentives and that this effect is moderated by the firm’s circumstances.
Derivative litigations are an important way for shareholders to seek recourse for wrongs done to the company. They differ from securities class actions (SCAs) in that SCAs involve shareholders suing the company for wrongs done to them via violations of disclosure requirements (i.e., the company is the defendant). Derivative litigations often name officers and directors, potentially implying some form of wrongdoing done to the company (i.e., the company is not the defendant, and instead is effectively the plaintiff). However, both SCAs and derivative litigations can discipline managers. SCAs – and their allegations of wrongdoing – can harm executives’ career outcomes (Humphery-Jenner, 2012; McTier and Wald, 2011). Similarly, derivative litigations are more common in firms with worse agency conflicts and can encourage firms to improve governance, increase outside board representation (Ferris et al., 2007). Therefore, all else equal, managers would prefer to avoid litigation and litigation – or the threat thereof – can have an important disciplinary effect.
UD laws require shareholders to obtain board approval before launching a derivative litigation. Absent a UD law, shareholders can sue on behalf of the company if the managers (and board) refuse to do so, or it would have been “futile” to request their approval (i.e., because it was directly in relation to their fraud). By contrast, UD laws make that board approval necessary, thereby inhibiting derivative litigations. The policy purpose behind UD laws is to prevent shareholders launching frivolous litigations that waste managers’ time or resources (see e.g., Nguyen et al., 2018), and indirectly make the firm look petty or vexatious by name association with the litigation. UD laws are enacted at the state level and have come into operation at different times in different states. This gives rise to staggered quasi- exogenous natural experiments, facilitating a difference-in-difference experimental design.
UD laws can facilitate agency conflicts. While UD laws do not protect managers from the full gamut of disciplinary options, they do help to insulate managers from one important disciplinary mechanism, thereby incrementally increasing entrenchment. Entrenchment-related agency conflicts can manifest in managers acting self-interestedly, perhaps to increase their own power base through the nature of the transactions they undertake (Harford et al., 2012). It might also simply enable managers to shirk
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or exert inadequate discipline safe in the knowledge that outside disciplinary options have reduced (Bertrand and Mullainathan, 2003). In the context of UD laws, prior evidence is mixed, but tends to suggest that UD laws increase firms’ cost of debt (Ni and Yin, 2018) and lower firms’ investment efficiency (Li et al., 2018), for example.
We hypothesize that firms will respond to this quasi-exogenous increase in entrenchment by increasing managers’ risk taking incentives. This is because if UD laws enable shirking, firms would logically aim to encourage managers to take more entrepreneurial risk by – for example – increasing option based compensation and compensation vega. We also expect that this effect will concentrate in specific types of firms where there is outside monitoring of compensation (i.e., through institutional investors) or there is no other external disciplinary mechanism – such as product market competition – to make up for the passage of UD laws.
We start our analysis by collecting data on UD laws in the United States. We begin with the universe of CRSP/Compustat firms for which we can obtain data on executive compensation from Execucomp.
We restrict the sample to begin in 1992 (the commencement of Execucomp data) and end in 2005.
We end the sample in 2005 because the accounting rule FAS 123R significantly altered firms’ capacity to pay with options and because the last UD law in our sample is in 2005. The results are robust to extending the sample to 2010 (i.e., five years after the last UD law). We use the staggered passage of UD laws to implement a staggered difference-in-difference analysis.
We first explore the impact of UD laws on managers’ risk taking incentives in general. UD laws are staggered quasi-exogenous shocks that occur at different times in different states. Therefore, our experimental design helps to mitigate endogeneity and identification concerns. We further help to mitigate identification concerns by using myriad fixed effects, including executive x firm effects, industry x year effects, and state x year effects. We hypothesize and show that firms increase compensation vega after UD laws. We find that this mainly comes through an increase in option-based incentives and not through any increase in stock based incentives. Such option compensation increases both as a proportion of compensation and in terms of the number and value of options granted.
We next explore the types of firms that this effect concentrates in. Our next hypothesis is that the effect concentrates in firms that lack other outside disciplinary mechanisms. A key such mechanism is product market competition, which can help to discipline managers and assuage other governance problems (Giroud and Mueller, 2011, 2010). Consistent with expectations, we find that firms increase risk-taking incentives mainly in industries with relatively low product market competition. This is consistent with the idea that governance effect of PMC.
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We further explore how the firm’s ownership structure impacts how firms respond to UD laws.
Institutional investors typically monitor firms and often push for improvements in governance, including through better quality executive compensation. Thus, while institutional investors can provide external governance – much like PMC – the mechanism of action through which they achieve this is at least partially by improving the firms’ operations , management, and governance. Therefore, we hypothesize and show that the increase in risk-taking incentives mainly occurs in firms with relatively higher levels of institutional ownership, highlighting the importance of institutional investors in improving governance.
The results make a significant contribution to the literature. We highlight how firms respond to regulatory shocks that potentially entrench managers and insulate them from outside discipline. We highlight that firms rationally respond to this by increasing risk-taking incentives, deterring managers from ‘living the quiet life’ (cf. Bertrand and Mullainathan, 2003). This demonstrates that while UD laws might entrench managers, firms can take steps to ameliorate the ensuing agency conflicts.
The results further shed light on the heterogeneity in compensation contracts across firms.
Unsurprisingly, different firms structure compensation differently, reflecting myriad corporate-level and executive-level characteristics. However, the role of different regulatory regimes remains relatively under-explored. Our results use a specific, and relevant, regulation – UD laws- to highlight the need to control for jurisdictional differences when analysing and comparing compensation contracts.
2 Hypotheses
Universal demand laws insulate managers and firms from derivative litigations. A derivative litigation involves shareholders suing on behalf of the company for damage caused to the company. The defendant could be a third party (such as a customer or supplier) or a company officer, such as the CEO. Absent a Universal Demand (UD) law, shareholders can sue if the directors refuse to sue for the wrong committed to the company or it would be futile to ask directors. However, in a UD law, shareholders must seek and obtain board approval before being able to litigate.
The policy purpose behind UD laws is to prevent shareholders launching frivolous, ill-informed, or uneconomic litigations. While the shareholder plaintiff must finance the litigation, the company would tautologically become part of the proceedings. This would distract directors and officers from their core responsibility of running the company. Such frivolous litigations would also tarnish the company’s reputation. Further, in many instances, a wealthy, but minority, shareholder could launch a litigation without the approval of other shareholders, ultimately co-opting those other shareholders to the
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plaintiff’s pet cause. Thus, UD laws are also premised on the idea that officers and directors manage the day to day operations of the company whereas shareholders are passive.
There is some evidence in support of this policy purpose. For example, Nguyen et al (2018) find that UD laws induce firms to reduce cash holdings and increase the value of the remaining cash holdings.
They argue that this is because removing the threat of derivative litigations enables firms to free up cash. However, it is important to note that the firm itself is not a defendant in a derivative litigation, and the cash benefits of removing litigations mainly relate to ancillary costs, such as managers’ time and legal fees.
There is the assertion that derivative litigations can discourage risk-taking. However, such an impact is tangential. The business judgment rule protects managers from litigation targeting operational decisions, even if they ultimately fail. A derivative litigation could not target a manager for mere risk taking. Even absent a universal demand law, litigation involving ordinary business decisions would be short lived.
UD laws can have downsides. In many instances, derivative actions name officers as defendants. They are designed to punish officers for alleged wrongdoing against the company. This has a disciplinary effect: Related literature shows that securities class actions (Humphery-Jenner, 2012; McTier and Wald, 2011), and SEC enforcement actions (Karpoff et al., 2008), can help to discipline CEOs. For example, after class actions, firms reduce CEOs’ compensation, and CEOs face greater difficulties finding equivalent jobs at other firms (Humphery-Jenner, 2012). Derivative litigations differ from class actions and they are often targeted at different conduct. But, they have similarities in that they involve alleged wrongdoing potentially involving officers and directors. Indeed, Ferris et al (2007) highlight that they can have positive effects on corporate governance. Thus, by making derivative litigations more difficult, UD laws remove a key disciplinary mechanism.
Removing external disciplinary mechanisms can create problems for firms. Removing litigation threats can increase managerial entrenchment. Entrenching managers reduces the pressure on them to properly evaluate investments. For example, anti-takeover provisions, which entrench managers, can facilitate ill-disciplined investments, which ultimately do not create shareholder value (Harford et al., 2012; Masulis et al., 2007). Further, by removing the pressure on managers to create value, such entrenchment can enable managers to shirk and live the “quiet life” (Bertrand and Mullainathan, 2003), causing them to underinvest and take less risk than shareholders would like. There is some evidence that UD laws can drive these types of problems. For example, Li et al (2018) find that UD laws reduce investment efficiency, and Ni and Yin (2018) highlight UD laws increase firms’ cost of debt, evidencing reduce discipline when making investments.
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Firms could attempt to mitigate the impact of UD laws by changing managerial compensation plans.
Firms do not control whether UD laws are enacted. However, firms can respond to UD laws to help offset their effects. For example, firms might attempt to recruit higher quality directors to make up for the diminution in external discipline (Masulis et al., 2019). Additionally, firms can control how they compensate managers. If firms fear that UD laws will cause managers to take too little risk, they can respond by increasing risk-taking incentives. This would manifest in increasing the CEO’s compensation vega (i.e., sensitivity to stock price movements). This would ordinarily be achieved by increasing the option-based component of the compensation package, which would reward the CEO for risk-taking while avoiding penalizing the CEO if those risks do not pay off. We capture this in the following hypothesis.
Hypothesis: After UD laws, firm’s increase the CEOs’ compensation vega and the proportion of compensation coming from options.
Institutional ownership will moderate the impact of UD laws on compensation; however, we have mixed predictions. Institutional investors are important monitors. They can help to improve governance by scrutinizing managers’ actons and then either engaging with managers to improve performance, or threatening to sell their stock if managers continue to underperform (McCahery et al., 2016). For example, institutional investors’ threats to exit the company can have tangible benefits for firm performance (Chang et al., 2013; Gallagher et al., 2013).
Institutional investors are likely to try to offset any regulation that would otherwise reduce managerial discipline. Superficially, it might appear that if the firm has institutional investors, then the passage of UD laws should not matter because investors are monitoring the firm. However, this ignores an important mechanism through which that monitoring occurs: pressuring firms about compensation.
Indeed, investors monitor CEO compensation and push for greater pay-to-performance sensitivity (David et al., 1998; Hartzell and Starks, 2003). This mainly concentrates in companies that are easier for institutional investors to monitor (Almazan et al., 2005). Thus, if UD laws insulate managers, and potentially enable them to shirk or make ill-disciplined decisions, institutional investors could push for better performance-linked compensation. We capture this in the following hypothesis.
Hypothesis: Post-UD law increases in pay-to-performance sensitivity are greater in firms with more institutional ownership.
Product market competition (PMC) is also likely to affect how firms respond to UD laws. Much like institutional investors, PMC can discipline managers. However, the mechanism-of-action differs.
Whereas institutional investors engage with firms to improve governance mechanisms (i.e., pay
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schemes), PMC disciplines managers by forcing them to perform lest they underperform their industry and potentially be fired or taken over.
Existing evidence shows that PMC significantly improves corporate governance. For example, Groud and Mueller (2010) show that PMC helps to off-set worsening governance, as manifested in restrictions on takeover activity. They show that such restrictions are most detrimental in industries with low PMC. Similarly, Giroud and Mueller (2011) show that firms with weak governance mainly underperform in non-competitive industries, implying that PMC can help to offset deficient governance.
We expect that PMC will moderate the impact of UD laws on compensation. UD laws worsen governance. As indicated, we expect that firms will mitigate this by adjusting managers’
compensation. However, this should be less operative in industries with high product market competition, as outside competitive forces will discipline managers. Therefore, we expect that the impact of UD laws on compensation will mainly be in low PMC industries. Thus, we make the following hypothesis.
Hypothesis: The impact of UD laws on compensation is stronger in low competition industries.
We anticipate that CEO power will influence the impact of UD laws. Powerful CEOs have more scope to act self-interestedly, and this can exacerbate agency conflicts. They can operationalize this by exerting greater control over the board or directors. In turn, this can enable managers to act self- interestedly. In general, such agency conflicts can manifest in higher pay despite worse performance (following Masulis et al., 2009). This implies, that entrenched managers have more scope to shape their compensation contracts, potentially avoid incentive-linked compensation structures, and focus more on cash compensation.
Prior evidence highlights that powerful CEOs can act on agency conflicts and can harm firms. For example, firms with more powerful CEOs tend to have worse credit ratings and credit spreads (Liu and Jiraporn, 2010), and potentially, adopt sub-optimal capital structures (Chintrakarn et al., 2014).
Powerful CEOs are also associated with worse performance and payout ratios (Onali et al., 2016).
Therefore, unsurprisingly, a common proxy for CEO power is the CEO’s “compensation pay slice”; the ratio of the CEO’s to the aggregate pay of the next five highest paid executives (Bebchuk et al., 2011).
Such power is also associated with worsened pay-to-performance sensitivity (Ntim et al., 2019).
Therefore, we expect that UD laws will have less impact on compensation structures in firms with powerful CEOs. We capture this in the following hypothesis.
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Hypothesis: The impact of UD laws on compensation is lower for firms with powerful CEOs.
3 Data
We start with the standard universe of CRSP/Compustat firms. We collect data on firms listed in the United States from 1992 – 2005. We end the sample in 2005 in order to avoid contamination from FAS 123R, which increased the expense of paying CEOs with options, and reduced option-based compensation (Hayes et al., 2012). Nevertheless, the results are robust to extending the sample. We identify which states adopt universal demand laws and when. Table 1 details the years in which US states adopt UD laws. For all firms, we collect data on the myriad firm-level characteristics that can influence compensation levels. We use these as control variables. For each executive, we obtain data on the executive’s compensation plan and tenure from Execucomp. We winsorize continuous variables at 1%. The variable definitions are in the appendix.
We use several metrics in order to analyze CEOs’ compensation plans. Our baseline measure is the CEO’s compensation vega, which represents risk taking incentives. The vega represents the sensitivity of the CEO’s compensation to changes in corporate volatility. We also calculate the proportion of the CEO’s compensation that comes from stock or from options, and the dollar value of such compensation. We further calculate the CEO’s compensation delta, representing the sensitivity of the CEO’s compensation to changes in the firm’s share price.
The summary statistics are in Table 2 and they are consistent with prior literature using like data. For example, the median book-to-market ratio is 1.7. The median CEO tenure is around 7 years, and around 20% of the CEOs in the sample are classified as founder CEOs. Approximately 31.5% of compensation comes from options and 5.8% from stock, consistent with Humphery-Jenner et al (2016). The CEOs are also paid around $1.9m on average.
4 Empirical analysis
4.1 UD laws and compensation
We start by exploring how UD laws influence compensation packages. We hypothesize that UD laws will cause firms to adopt greater risk taking incentives. We do this by using the staggered passage of UD laws in different states as a natural experiment, which gives rise to a difference-in-difference set- up. The regression has the following general form:
10 𝐶𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛𝑖,𝑡+1 = 𝛽𝑈𝐷𝑖,𝑡+ ∑ 𝜃(𝑗)𝑥𝑖,𝑡(𝑗)
𝑁
𝑗=1
+ 𝐹𝐸𝑖,𝑡+ 𝜀𝑖,𝑡
(1)
Where, 𝐶𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛𝑖,𝑡+1 denotes the compensation variable (i.e., compensation vega, option intensity, etc) for the CEO at firm 𝑖 in year 𝑡 + 1. 𝑈𝐷𝑖,𝑡 denotes an indicator if a UD law exists in firm 𝑖’s state in year 𝑡 and equals zero otherwise. To be clear, the UD indicator will always equal one so long as a universal demand law is in place and equal zero otherwise (i.e., it is not just an indicator for the year of the UD law passage). The treated firms are those who presently have a UD law whereas the control firms are those who do not. The item 𝑥𝑖,𝑡(𝑗) denotes the 𝑗𝑡ℎ control variable for firm 𝑖 in year 𝑡, and 𝐹𝐸𝑖,𝑡 denotes the fixed effects used in the regression. We use several different fixed effects in the regressions, including executive x firm effects, firm effects, industry x year effects, and state x year effects. These help to mitigate concerns that other state, industry, firm, or executive factors drive the compensation characteristics. We also cluster standard errors by firm.
We first analyse the relationship between the passage of UD laws and compensation vega. The results are in Table 3. We use different combinations of fixed effects, including executive x firm effects, firm effects, industry x year effects, and state effects (as denoted in the table footer). The results are consistent with expectations. The passage of UD laws is significantly and positively associated with compensation vega, implying that firms increase risk-taking incentives after the passage of UD laws.
This result implies that firms respond to UD laws by increasing the sensitivity of CEOs’ compensation to volatility (i.e., by increasing risk taking incentives). This is consistent with the notion that firms might try to undo some of the risk-reduction that UD laws might otherwise cause.
The coefficients on the control variables are interesting but intuitive. Larger firms’ CEOs have higher compensation vegas. This might imply that larger firms attempt to encourage CEOs to become more innovative. Additionally, large firms typically pay their CEOs more. But, generally try to avoid paying too much cash compensation, causing these large firms to rely more on option-linked compensation.
Consistent with this, the greater the amount of total pay, the greater the compensation vega. Firms with higher market-to-book ratios exhibit higher vegas. This could be because such firms typically are more innovative and are higher growth, potentially making option-linked compensation more attractive to their CEOs.
We next examine the components of CEOs’ compensation. We expect that following UD laws, firms will prefer to increase option compensation rather than stock compensation. We begin by analysing option intensity and stock intensity in Table 4, where option intensity is the proportion of total compensation that comes from option grants and likewise for stock intensity.
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We find that firms increase option intensity, but decrease stock intensity, following UD laws (Compare Columns 1 and 2 with Columns 3 and 4). This is both economically and statistically significant and is robust across various combinations of fixed effects. For example, UD laws are associated with an increase in option intensity of 3.9-4.2 percentage points. This implies that firms shift incentive compensation towards options rather than stock. This is consistent with the idea of increasing risk- taking incentives, which options enable by providing limited downside but significant upside potential.
The control variables are consistent with those in Table 3, and those reported regarding option intensity and stock intensity in Humphery-Jenner et al (2016).
We further explore the number of options and stock, and their dollar value, in Table 5. This enables us to check whether firms increase the amount of options granted as opposed to (for example) reducing compensation and shifting compensation components. UD laws are associated with a statistically and economically significant increase in both the number, and dollar value of options and a decrease in stock. This is consistent with the prediction that UD laws cause firms to increase risk taking incentives (as opposed to merely restructuring, and potentially downrating, compensation).
These results are robust across multiple combinations of fixe effects.
4.2 Impact of PMC
We anticipate that firms will mainly change compensation mainly when there is weak external governance, such as via Product Market Competition (PMC). UD laws protect managers. However, this protection is weaker if managers are otherwise disciplined through external factors, which force them to exert effort. PMC imposes external discipline on managers. Thus, the increased protection offered by UD laws is less meaningful in high-competition industries. By contrast, firms in low competition industries have weaker external governance. Thus, these firms lack external disciplinary mechanisms to off-set UD laws. Therefore, firms in low PMC industries would be more likely to adjust their compensation practice after UD laws’ passage.
We investigate this by splitting the sample into above median and below median subsamples in terms of PMC. In all models, we control for executive x firm, industry x year, or state x year effects (as denoted in the Column footer). In Table 6, Columns 1-3, we look at the drivers of CEOs’ compensation vega in high PMC industries; Column 4-6 for low PMC industries. The models control for firm and executive characteristics that could influence vega.
The results are in Table 6 and are consistent with expectations. The results indicate that UD laws are positively and significantly associated with compensation vega in low PMC industries but not in high
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PMC industries. This difference is statistically significant regardless of which fixed effects we include.4 The coefficients on the control variables are broadly consistent across the low-PMC and high-PMC sub-samples. The main difference is that Founder CEOs exhibit higher vega in high competition industries but lower vega in low competition industries. This could reflect overconfidence owing to self-attribution bias (Kim, 2013). In this case, founder CEOs would be over-confident about their ability to run the company, causing them to voluntarily accept riskier compensation in a competitive environment. Conversely, such overconfidence, connoting a willingness to take risk, means that vega is less necessary in low competition industries as such founder CEOs would naturally take more entrepreneurial risk, and be more innovative.5
4.3 Role of institutional investors
We next consider the impact of institutional investors on firms’ reactions to UD laws. Institutional investors ordinarily engage with corporations about governance arrangements (McCahery et al., 2016). Thus, we argue that one way that institutional investors oversee firms is by monitoring executive compensation (following Correa and Lel, 2016). Thus, firms with greater institutional ownership are likely to take a more pro-active approach to responding to UD laws. Therefore, we expect that firms will increase risk-taking incentives mainly in firms that have high levels of institutional ownership.
The results are in Table 7 and are consistent with expectations. Columns 1-4 stratify the sample by whether the firm’s institutional ownership is above or below median. Columns 5-8 split the sample by whether the firm’s institutional block ownership is above or below median. Columns 9-12 split the sample based on whether the institutional ownership HHI is above or below median. In all cases, the data is from the Thomson 13f filings. We include relevant firm level controls, executive x firm effects, industry x year effects, and state x year effects (as denoted in the column footer). We include the same set of controls as in Table 3, but they are unreported for brevity.
The results in Table 7 highlight that UD laws drive statistically significant increases in vega, but only in the firms with high levels of institutional ownership. This result holds regardless of which fixed effects we use and regardless of whether we look at institutional ownership per se, block ownership, or institutional ownership HHI. This implies that one channel through which UD laws influence compensation is pressure from institutional investors to help mitigate managerial agency conflicts and better tie managers’ compensation to value-creating risk-taking.
4 The table footer in Table 6 contains difference, and the t-statistic thereof, in the UD coefficient between columns 1 and 4, and 5, and 3 and 6. In all cases, the t-statistic exceeds 3 in absolute magnitude.
5 This follows the notion that inventor CEOs are more likely to be innovative (Islam and Zein, Forthcoming), which connotes a degree of risk taking. Founder CEOs are often a sub-type of inventor CEOs.
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4.4 CEO power
We further explore the moderating impact of CEO power. This is to explore the role of CEO power in resisting compensation changes. The analysis also help to test whether the results behave in a sensible way when we split the sample based on a governance characteristic that could influence compensation arrangements. CEO power can be associated with entrenchment, and can exacerbate agency conflicts. Therefore, we expect that UD laws to mainly influence firms with relatively lower CEO power as these are the firms in which CEOs have less scope to resist changes to compensation.
The results are in Table 8. Column 1 looks at the impact of UD laws on firms with high CEO power and Column 2 at firms with low CEO power. We measure CEO power by using the CEO’s compensation pay slice (see Bebchuk et al., 2011). The compensation pay slice (CPS) is the ratio of the CEO’s pay to the aggregate pay of the next five highest paid executives. The CPS aims to represent how much of the firm’s compensation payout the CEO can capture; and thus, how powerful the CEO is. We calculate this using Execucomp data. The results in Table 8 are consistent with expectations: UD laws cause an increase in vega only for low power CEOs, but have no significant impact for high power CEOs. This implies that the impact of UD laws depends on CEO power; and thus, the CEO’s ability to resist compensation changes.
4.5 Robustness tests
4.5.1 Including only treated firms
One concern could be that firms in states that never have a UD law are systematically different from those in states that have a UD law at some point. Therefore, we check that the results are robust to including only “treated” firms in the sample. Here, our sample includes all firms that are in a state that experiences a UD law. The UD indicator equals one if the state has a UD law in that year and equals zero otherwise. The analysis is still a staggered difference-in-difference test (as different states are treated at different times), but we exclude the states that never have a UD law.
The results are in Columns 1-3 of Table 9 and are consistent with expectations. Columns 1, 2 and 3 restrict the time period around the passage of the UD law to four years, three years, or two years either side of the passage (respectively). The main finding is that the UD law indicator remains positively and statistically significantly related to compensation vega, implying that in this sample firms continue to increase managers’ risk-taking incentives.
14 4.5.2 Years surrounding passage of UD law
We ensure that the results are robust to looking at different time periods surrounding the passage of UD laws. One concern with the core results is that other extraneous factors – distant from the passage of the UD law itself – could influence compensation. The core results mitigate this concern by including several fixed effects, including executive x firm, state x year, and industry x year effects. Nevertheless, we ensure that the results are robust to restricting the sample to be four, three, or two years either side of a UD law passage (where one occurs); these are in Columns 4, 5, and 6 of Table 9, respectively.
The results in Table 9 are consistent with the core results in Table 3. UD laws continue to positively and statistically significantly influence compensation vega. The magnitude of this effect is larger if we look at a shorter window surrounding the UD law passage (compare Columns 4 and 6). These results support the idea that firms react to UD law related entrenchment by increasing managers’ risk taking incentives.
5 Conclusion
This paper hypothesizes and shows that firms adjust managerial compensation in response to an exogenous increase in entrenchment via a reduction in litigation risk. We use the staggered passage of Universal Demand (UD) laws in 23 states in the US to employ a difference-in-difference design to examine how firms respond to reduction in litigation risk. UD laws inhibit derivative litigations.
Derivative litigations involve shareholders suing on behalf of the company for wrongs done to that company. Often managers are named in those law suits. UD laws restrict derivative litigations by requiring shareholders have board approval prior to launching the litigation.
UD laws remove one form of disciplinary mechanism: derivative litigations. Prior literature shows that derivative litigations can encourage firms to improve corporate governance (Ferris et al., 2007) and that related litigations – securities class actions – have negative impacts on managers (Humphery- Jenner, 2012; McTier and Wald, 2011). UD laws enable boards to prevent derivative litigations, thereby insulating managers and risking entrenchment.
Entrenching CEOs can be harmful and encourage shirking. While there is an argument that litigation threats can deter risk taking, this argument is tangential to derivative law suits as genuine risk taking falls within the “business judgment” rule and is very unlikely to ground a derivative litigation.
Managerial entrenchment can enable CEOs to exert inadequate discipline or to take less risk than is optimal (Bertrand and Mullainathan, 2003). Thus, the passage of UD laws could cause managers to reduce risk taking. Evidencing this, there is evidence that UD laws tend to reduce investment efficiency (Li et al., 2018), and increase the cost of debt (Ni and Yin, 2018). This is sub-optimal for shareholders,
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who might prefer more risk taking. Indirectly, it is sub-optimal for directors, who could then risk being replaced, as has been noted to be the case following UD laws (Masulis et al., 2019). Therefore, boards might seek to mitigate managerial shirking due to UD laws.
Boards could help to increase risk taking following UD laws by restructuring CEO compensation. We hypothesize that boards would increase CEOs’ compensation vega, and the proportion of compensation coming from options, in order to increase risk taking. We test this hypothesis by collecting data on US listed firms from 1992 (the commencement of Execucomp coverage) through to 2005 (when FAS 123R was implemented and significantly changed compensation practices). We use the staggered passage of UD laws to conduct a staggered difference-in-difference test with multiple different exogenous shocks affecting different firms at different times. Using this data, we find that firms significantly increase risk-taking incentives after the passage of UD laws. This involves increasing the proportion of compensation coming from options, the dollar amount of options, and compensation vega.
We further explore factors that moderate how boards adjust CEO compensation. We hypothesize and show that compensation is mainly adjusted in firms with higher levels of institutional ownership. This is consistent with the notion that institutional owners often interact with firms to encourage improved corporate governance. Conversely, boards react less strongly in industries where there is greater product market competition (PMC). This is consistent with prior evidence that high levels of PMC constitute a form of external governance, which can help to offset other governance problems at firms (Giroud and Mueller, 2011, 2010).
We take steps to ensure that the results are robust to econometric concerns. We ensure that endogeneity concerns do not drive the results by using a staggered difference-in-difference design.
This helps to assuage identification issues as each of 23 states passes UD laws at different times, giving rise to a set of natural experiments. We also mitigate unobserved effects by using high dimensional fixed effects, including executive x firm, state x year, and industry x year effects. We further check that the results are robust to restricting the sample to different windows surrounding the passage of UD laws to ensure that the results are not driven by extraneous or distant events.
16
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18
7 Appendix: Variable definitions
Variables Definition
Vega The change in the dollar value of the executive’s wealth for a 0.01 change in the annualized standard deviation of stock returns. (following Guay (1999), Core and Guay (2002a) and Coles, Daniel, and Naveen (2006)) Source: Coles, Daniel, and Naveen (2006)
Options Intensity The proportion of executive’s total annual compensation that comes from option grants. This is the value of annual option awards (ExecuComp:
“option_awards_blk_value” before FAS 123R and “option_awards_fv” after FAS 123R) scaled by the amount of total annual compensation (ExecuComp:
“tdc1”).
Stocks Intensity The proportion of executive’s total annual compensation that comes from stock grants. This is the value of restricted stock granted to the executives (ExecuComp: “rstkgrnt” before FAS 123R and “stock_awards_fv” after FAS 123R) scaled by the amount of total annual compensation (ExecuComp:
“tdc1”).
$ Options The value of stock options granted to the executives
#Options The number of stock options granted to the executives
$ Stocks The value of restricted stock granted to the executives
#Stocks The number of shares of restricted stock granted to the executives.
Firm Size The natural logarithm of total assets (at ).
Market to Book Market-to-book assets is the market value of assets (prcc_f ∗csho + at - ceq ) divided by the book value of assets ( at ).
Cash-Flow Volatility The standard deviation of a firm’s Return on assets over the previous five years (firms are required to have at least three years of data during the prior five years to enter the sample).
Profitability Operating income before depreciation (oibdp ) divided by the book value of assets (at).
Leverage The book value of long-term debt (dltt ) plus debt in current liabilities ( dlc ) divided by book value of assets ( at ) .
Total Pay The dollar value of the executive's total annual compensation (ExecuComp:
“tdc1”)
Stock Volatility The annualized standard deviation of daily stock returns calculated from the square root of the sum of squared daily stock returns over the year. Following Gormley and Matsa (2016), the number of trading days are adjusted. The raw sum is multiplied by 252 and divided by the number of trading days. Source:
CRSP
Current Ratio Current assets sacles by Current liabilities
(R&D+CAPX+ADV)/Assets Sum of R&D, CAPX, and Advertisement Expenditures scaled by Total assets Founder CEO An indicator variable equal to one if the CEO is either one of the founders of
the firm or the CEO of the firm at the year of incorporation and zero otherwise. Source: Hand-Collected data
CEO Tenure The number of years the executive serves as the CEO in the firm. Source:
Execucomp and hand-collected data
19
8 Tables
Table 1: Universal Demand laws over time
This table notes the year in which each state adopted Universal Demand laws.
Year of UD Law Adoption State
1989 GA
1989 MI
1990 FL
1991 WI
1992 MT
1992 VA
1992 UT
1993 NH
1993 MS
1995 NC
1996 AZ
1996 NE
1997 CT
1997 ME
1997 PA
1997 TX
1997 WY
1998 ID
2001 HI
2003 IA
2004 MA
2005 RI
2005 SD
20
Table 2: Summary statistics
Variable Obs Mean SD Q1 Median Q3
Log(1+Vega) (t+1) 16593 3.526 1.685 2.564 3.692 4.712 Options Intensity (t+1) 16545 0.315 0.292 0.000 0.278 0.540 Stocks Intensity (t+1) 16545 0.058 0.138 0.000 0.000 0.000 ln($ Options)(t+1) 16588 4.745 3.386 0.000 6.126 7.416 Ln(#Options)(t+1) 16590 3.204 2.352 0.000 3.932 5.026 ln($ Stocks)(t+1) 16589 1.428 2.761 0.000 0.000 0.000
Ln(#Stocks)(t+1) 16589 0.728 1.493 0.000 0.000 0.000
Firm Size 16593 7.058 1.507 5.981 6.910 8.012
Market to Book 16593 2.241 1.657 1.281 1.702 2.526
Cash-Flow Volatility 16593 0.028 0.032 0.006 0.017 0.036
Profitability 16593 0.075 0.147 0.032 0.085 0.139
Leverage 16593 0.143 0.141 0.019 0.110 0.222
log(Total Pay) 16126 7.581 1.084 6.802 7.520 8.309
Stock Volatility 16581 0.450 0.192 0.299 0.406 0.561
Current Ratio 16140 2.554 2.506 1.352 1.947 2.886
(R&D+CAPX+ADV)/Assets 16593 0.114 0.097 0.051 0.089 0.149
Founder CEO 16364 0.207 0.405 0.000 0.000 0.000
CEO Tenure (Log) 16072 2.003 0.758 1.386 1.946 2.565
21
Table 3: UD laws and compensation vega
(1) (2) (3) (4) (5) (6)
Variables Log(1+Vega) (t+1)
Universal Demand Law 0.132** 0.196** 0.142** 0.130** 0.189** 0.137**
[2.117] [2.115] [2.323] [2.271] [2.411] [2.607]
Firm Size 0.358*** 0.338*** 0.378*** 0.341*** 0.321*** 0.377***
[18.478] [15.689] [12.784] [18.835] [15.929] [16.967]
Market to Book 0.045*** 0.040*** 0.042*** 0.044*** 0.039*** 0.044***
[6.891] [5.548] [3.986] [6.672] [5.353] [4.067]
Cash-Flow Volatility -0.499** -0.522** -0.645*** -0.329 -0.336 -0.435**
[-2.520] [-2.487] [-3.686] [-1.450] [-1.376] [-2.165]
Profitability 0.246*** 0.287*** 0.200** 0.252*** 0.280*** 0.236**
[3.794] [3.800] [2.543] [3.622] [3.563] [2.702]
Leverage -0.702*** -0.733*** -0.753*** -0.647*** -0.682*** -0.730***
[-6.960] [-6.506] [-6.362] [-6.816] [-6.430] [-7.219]
log(Total Pay) 0.153*** 0.160*** 0.296*** 0.158*** 0.165*** 0.290***
[9.360] [9.073] [19.708] [8.113] [7.784] [15.230]
Stock Volatility -0.344*** -0.358*** -0.494***
[-4.924] [-4.623] [-4.354]
Current Ratio -0.002 -0.002 -0.006
[-0.452] [-0.472] [-1.638]
(R&D+CAPX+ADV)/Assets 0.071 0.033 0.168
[0.754] [0.317] [1.542]
Founder CEO -0.150 -0.907*** -0.310**
[-0.139] [-3.804] [-2.606]
Log(CEO Tenure) 0.021 0.042 -0.082***
[0.492] [1.062] [-4.756]
Executive*Firm FE (SPELL) Y N N Y N N
Executive FE N Y N N Y N
Firm FE N N Y N N Y
Inudstry (FF48)*Year FE Y Y Y Y Y Y
Headquarter State*Year FE Y Y Y Y Y Y
Observations 16,036 16,036 16,036 15,125 15,125 15,125
R-squared 0.872 0.871 0.801 0.870 0.869 0.801
22
Table 4: UD laws and option intensity and stock intensity
(1) (2) (3) (4)
Variables Options Intensity (t+1) Stocks Intensity (t+1)
Universal Demand Law 0.039*** 0.042*** -0.024*** -0.022**
[3.253] [3.802] [-3.532] [-2.516]
Firm Size 0.070*** 0.065*** 0.004* 0.004*
[13.922] [11.916] [1.953] [1.770]
Market to Book 0.015*** 0.015*** -0.001 -0.001
[9.108] [7.948] [-1.120] [-1.280]
Cash-Flow Volatility 0.022 0.020 -0.024 -0.025
[0.325] [0.269] [-0.615] [-0.572]
Profitability 0.134*** 0.134*** -0.003 -0.005
[5.780] [5.095] [-0.445] [-0.674]
Leverage -0.300*** -0.301*** 0.009 0.008
[-13.955] [-12.901] [0.684] [0.540]
log(Total Pay) -0.040*** -0.039*** -0.007*** -0.006***
[-13.724] [-11.590] [-4.724] [-3.933]
Stock Volatility 0.028 0.025 -0.027*** -0.025***
[1.589] [1.276] [-4.089] [-3.446]
Current Ratio 0.003*** 0.003*** 0.000 0.000
[2.995] [2.706] [0.963] [0.567]
(R&D+CAPX+ADV)/Assets 0.136** 0.131* -0.025** -0.029**
[2.321] [1.967] [-2.443] [-2.455]
Founder CEO -0.078 -0.167* 0.045 0.068**
[-0.222] [-1.901] [1.111] [2.575]
Log(CEO Tenure) -0.045*** -0.042*** 0.014** 0.017***
[-5.283] [-4.146] [2.449] [2.723]
Executive*Firm FE (SPELL) Y N Y N
Executive FE N Y N Y
Inudstry (FF48)*Year FE Y Y Y Y
Headquarter State*Year FE Y Y Y Y
Observations 15,410 15,410 15,410 15,410
R-squared 0.567 0.567 0.547 0.547
23
Table 5: UD laws and dollar compensation components
(1) (2) (3) (4) (5) (6) (7) (8)
Variables ln($ Options)(t+1) Ln(#Options)(t+1) ln($ Stocks)(t+1) Ln(#Stocks)(t+1)
Universal Demand Law 0.638** 0.675** 0.409** 0.431** -0.614*** -0.552*** -0.331*** -0.304**
[2.568] [2.582] [2.402] [2.380] [-3.678] [-2.777] [-3.347] [-2.604]
Firm Size 0.758*** 0.704*** 0.522*** 0.484*** 0.144*** 0.133*** 0.049** 0.045**
[12.640] [10.292] [11.366] [8.801] [4.214] [3.471] [2.562] [2.132]
Market to Book 0.117*** 0.113*** 0.052*** 0.050*** 0.001 -0.000 -0.002 -0.003
[6.676] [5.750] [4.692] [3.996] [0.125] [-0.028] [-0.564] [-0.684]
Cash-Flow Volatility 0.488 0.462 0.288 0.267 -1.224** -1.185** -0.682** -0.668*
[0.988] [0.820] [0.754] [0.612] [-2.447] [-2.108] [-2.099] [-1.826]
Profitability 1.082*** 1.089*** 0.588*** 0.590*** 0.002 -0.052 -0.033 -0.067
[5.223] [4.586] [4.123] [3.613] [0.009] [-0.281] [-0.383] [-0.689]
Leverage -3.004*** -3.075*** -1.342*** -1.403*** 0.095 0.103 0.240** 0.228*
[-11.185] [-9.835] [-6.492] [-5.769] [0.434] [0.432] [2.125] [1.884]
log(Total Pay) -0.462*** -0.455*** -0.334*** -0.331*** -0.119*** -0.109*** -0.072*** -0.067***
[-13.495] [-11.290] [-13.127] [-10.958] [-5.836] [-4.714] [-6.704] [-5.471]
Stock Volatility -0.124 -0.161 0.167 0.138 -0.386*** -0.392*** -0.170** -0.172**
[-0.436] [-0.495] [0.716] [0.518] [-3.081] [-2.870] [-2.379] [-2.198]
Current Ratio 0.028** 0.028** 0.020** 0.020** 0.005 0.003 0.003 0.002
[2.478] [2.142] [2.449] [2.138] [0.795] [0.467] [0.778] [0.456]
(R&D+CAPX+ADV)/Assets 1.425** 1.316** 1.024** 0.944* -0.291 -0.408* -0.195 -0.259*
[2.523] [2.039] [2.497] [2.017] [-1.528] [-1.897] [-1.678] [-1.928]
Founder CEO -1.123 -2.091 -1.331 -1.533 1.796 0.726*** 0.819 0.535***
[-0.238] [-1.460] [-0.419] [-1.409] [1.575] [3.253] [1.638] [3.998]
Log(CEO Tenure) -0.300** -0.278* -0.187* -0.173 0.305*** 0.349*** 0.195*** 0.217***
[-2.096] [-1.755] [-1.738] [-1.477] [3.573] [4.115] [4.028] [4.502]
Executive*Firm FE (SPELL) Y N Y N Y N Y N
Executive FE N Y N Y N Y N Y
Inudstry (FF48)*Year FE Y Y Y Y Y Y Y Y
Headquarter State*Year FE Y Y Y Y Y Y Y Y
Observations 15,427 15,427 15,528 15,528 15,529 15,529 15,529 15,529
R-squared 0.559 0.558 0.545 0.544 0.614 0.613 0.603 0.602
24
Table 6: Product Market Governance: Moderating effects of Product Market Competition
(1) (2) (3) (4) (5) (6)
Variables Log(1+Vega) (t+1)
High Product market Competition
Low Product market Competition Universal Demand Law 0.099 0.117 0.002 0.524*** 0.523*** 0.278***
[1.051] [1.146] [0.060] [7.037] [5.928] [2.854]
Firm Size 0.330*** 0.314*** 0.328*** 0.358*** 0.355*** 0.398***
[7.610] [6.649] [10.726] [7.421] [6.305] [10.241]
Market to Book 0.033*** 0.033** 0.026** 0.052** 0.053** 0.041 [2.911] [2.424] [2.058] [2.481] [2.175] [1.140]
Cash-Flow Volatility -0.917*** -0.858** -0.494 -0.730** -0.712* -0.768 [-3.283] [-2.536] [-1.545] [-2.045] [-1.743] [-1.287]
Profitability 0.301** 0.324* 0.291*** 0.194** 0.195* 0.413**
[2.096] [1.814] [3.605] [2.205] [1.878] [2.238]
Leverage -0.672*** -0.676*** -1.039*** -0.698*** -0.710*** -0.647***
[-6.178] [-5.108] [-10.606] [-4.170] [-3.722] [-3.894]
log(Total Pay) 0.130*** 0.133*** 0.212*** 0.098*** 0.099*** 0.220***
[5.632] [4.942] [9.210] [5.094] [4.309] [8.527]
Stock Volatility -0.194*** -0.210** -0.248** -0.518*** -0.519*** -0.577***
[-2.730] [-2.504] [-2.112] [-8.207] [-6.982] [-6.153]
Current Ratio 0.001 0.002 0.002 -0.024* -0.023 -0.051***
[0.548] [0.768] [0.827] [-1.701] [-1.356] [-4.240]
(R&D+CAPX+ADV)/Assets 0.376*** 0.380*** 0.381*** -0.470 -0.474 -0.082 [3.852] [3.304] [3.405] [-1.362] [-1.173] [-0.163]
Founder CEO 1.445*** 1.426*** -0.390*** -1.222** -0.118 -0.260 [7.400] [6.089] [-2.935] [-2.127] [-0.181] [-1.289]
Log(CEO Tenure) 0.064 0.048 -0.033 0.104 0.083 -0.036
[1.350] [0.851] [-0.927] [1.570] [1.040] [-0.900]
Executive*Firm FE (SPELL) Y N N Y N N
Executive FE N Y N N Y N
Firm FE N N Y N N Y
Inudstry (FF48)*Year FE Y Y Y Y Y Y
Headquarter State*Year FE Y Y Y Y Y Y
Observations 4917 4917 4917 5405 5405 5405
R-squared 0.889 0.889 0.848 0.907 0.908 0.851
Difference
(Low PMC-High PMC)
-0.425 (t=-3.79)
-.406 (t=-3.22)
-0.276 (t=-3.05)
25
Table 7: Role of institutional ownership
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)
Log(1+Vega) (t+1) Institutional
Ownership
Institutional Ownership
Institutional Block ownership
Institutional Block ownership
Institutional Ownership
HHI
Institutional Ownership
HHI
High Low High Low High Low High Low High Low High Low
Universal Demand Law 0.449*** 0.059 0.449*** 0.072 0.329*** -0.005 0.327*** -0.002 0.411*** 0.112* 0.410** 0.104 [5.030] [0.355] [4.236] [0.365] [5.292] [-0.035] [5.252] [-0.011] [2.907] [1.710] [2.364] [1.350]
Baseline Controls Y Y Y Y Y Y Y Y Y Y Y Y
Executive*Firm FE (SPELL) Y Y N N Y Y N N Y Y N N
Executive FE N N Y Y N N Y Y N N Y Y
Inudstry (FF48)*Year FE Y Y Y Y Y Y Y Y Y Y Y Y
Headquarter State*Year FE Y Y Y Y Y Y Y Y Y Y Y Y
Observations 3,701 3,660 3,701 3,660 3,139 4,223 3,139 4,223 3,666 3,696 3,666 3,696
R-squared 0.893 0.920 0.894 0.920 0.907 0.921 0.907 0.921 0.904 0.905 0.904 0.906
26
Table 8: Impact of CEO Power
(1) (2)
above Median CPS Below Median CPS
Variables Log(1+Vega) (t+1)
Universal Demand Law -0.106 0.236**
[-1.113] [2.508]
Baseline Controls Y Y
Executive*Firm FE (SPELL) Y Y
Inudstry (FF48)*Year FE Y Y
Headquarter State*Year FE Y Y
Observations 7,524 7,598
R-squared 0.886 0.893
27
Table 9: Timing of the effect: Shorter Event Window and Separate tests for treated and Untreated
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)
Only Treated firms Both Treated and Control firms
Years Before and Years after the adoption of UD Law Years Before and Years after the adoption of UD Law
4 years 3 years 2 years 4 years 3 years 2 years
Variables Log(1+Vega) (t+1)
Universal Demand Law 0.879* 0.912** 1.125* 1.025* 1.459*** 1.483*** 0.143** 0.166*** 0.190*** 0.228*** 0.235*** 0.224***
[1.887] [2.469] [1.955] [1.996] [4.908] [5.530] [2.336] [2.787] [2.978] [3.581] [2.958] [3.047]
Baseline Controls Y Y Y Y Y Y Y Y Y Y Y Y
Executive*Firm FE (SPELL) Y N Y N Y N Y N Y N Y N
Firm FE N Y N Y N Y N Y N Y N Y
Inudstry (FF48)*Year FE Y Y Y Y Y Y Y Y Y Y Y Y
Headquarter State*Year FE Y Y Y Y Y Y Y Y Y Y Y Y
Observations 877 877 652 652 441 441 15819 15819 15,594 15,594 15,383 15,383
R-squared 0.949 0.920 0.962 0.929 0.975 0.953 0.873 0.801 0.873 0.802 0.874 0.802
28
