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Operating performance around the adoption of director
incentive plans
*
Nikos Vafeas
Department of Business Administration, University of Cyprus, Nicosia, Cyprus
Received 13 September 1999; accepted 17 February 2000
Abstract
Recently, numerous firms adopted incentive compensation plans for their outside directors. This study examines empirically the hypothesis that the adoption of such plans helps to improve the adopting firm’s operating performance by aligning the interests of directors and shareholders. The empirical tests do not reveal a significant link between the adoption of director incentive plans and operating performance improvements. Potential explanations for these findings are discussed. 2000 Elsevier Science S.A. All rights reserved.
Keywords: Corporate governance; Director incentive plans; Operating performance
JEL classification: G39
1. Introduction
Corporate boards have become the target of much scrutiny in the public debate on corporate
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governance. Special attention has been paid to the monitoring role of outside directors who carry the primary responsibility of implementing the board’s decision control functions. In response to such criticisms (see NACD, 1995), many firms have adopted incentive compensation plans for their outside directors in an attempt to align the interests of shareholders to the interests of their agent-directors. Interestingly, this trend is not uniform across firms, with some firms adopting director incentive plans and others choosing not to adopt such plans, at least for now. Since director incentive plans are ultimately intended to promote shareholder wealth maximization by reducing agency costs, a reasonable research hypothesis is that firms employing such plans experience improvements in operating performance compared to firms that do not. This study provides an empirical examination of
*Tel.:1357-2-338-762; fax: 1357-2-339-063.
E-mail address: [email protected] (N. Vafeas)
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For a thorough review of this research see Bhagat and Black (1999).
this hypothesis for a sample of 112 US public firms adopting director incentive plans between 1989 and 1995. The empirical results do not indicate a statistical link between director incentive plan adoption and post-adoption operating performance. The study concludes that director incentive plans may not be the remedy they are purported to be by the financial press.
2. The data
The sample of adopting firms is collected in two stages: in the first stage, the 1994 Forbes 800 list comprises the pool of firms. Firms in regulated industries such as utilities and financial firms are excluded from the pool. The proxy statements of the remaining firms are searched for the years from 1989 to 1995. Additional firms are deleted (a) for having adopted such a plan prior to 1989, or (b) for not having adopted a plan by 1995. Given that firm characteristics are likely to be correlated with their size and industry affiliation, in assessing the operating performance of the adopting firms, I employ a matched pairs design. The levels of, and changes in performance of the matched control firms are used as benchmarks for the expected performance of the adopting firms. Thus, firms are also deleted for not having an appropriately matched control firm (i.e. a firm in the same two-digit industry with a sales ratio in the pre-adoption year from 1 / 10 to 10 relative to the adopting firm). Sixty firms are identified as having adopted a director incentive plan during that period and comprise the first part of the sample between 1989 and 1995. Each of these 60 firms proposed the adoption of a director incentive plan as a separate item to be voted upon by shareholders at their annual meeting. The proxy statements of these firms are extracted from the SECONLINE branch of the SilverPlatter database. SECONLINE contains the full text of forms 10K, 10Q, annual reports, proxy statements, 20F, and amendments filed with the Securities and Exchange Commission. Financial information on the sample firms is collected from the 1997 version of COMPUSTAT.
In the second stage, to further expand the size of the sample and increase generalizability of the results to smaller firms, I scanned the proxy statements of all non-Forbes firms for which a proxy statement was available in the SilverPlatter database for 1994 and 1995. This detailed investigation resulted in the identification of an additional 62 director incentive plan adopters that met all the criteria described above, and that could be matched with an appropriate control firm, raising the
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sample total to 122 matched pairs of firms. In 10 cases, either the adopting or the control firm had insufficient financial data available on COMPUSTAT reducing the final sample to 112 matched pairs of firms.
3. Methodology
Three alternative variables are used in measuring the performance of firms in the years surrounding director incentive plan adoption: (1) income before extraordinary items / assets or ROA which measures the profitability of assets employed; (2) total sales / assets which is an asset efficiency proxy;
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(3) income before extraordinary items / sales, or return on sales which measures the firm’s overall profit margin. The return on assets is essentially the product of asset turnover times the return on sales. As it turns out, the use of operating income instead of income before extraordinary items, and the use of the book value of equity as an alternative deflator do not alter the substance of the results. The ‘abnormal’ return on assets (AROA ) is estimated as ROAt t2CROA , where ROA is thet t adopting firm’s ROA in year t relative to the year of adoption (t50), and CROA is the matchedt control firm’s ROA for that year. The control firm-adjusted asset turnover and return on sales are computed using the same method.
Statistical differences in the performance of experimental and control firms for each sample year are assessed using the parametric paired t-test and the non-parametric Wilcoxon matched pairs signed-ranks test. The non-parametric test is useful because it abstracts from the distributional assumptions of parametric tests. The null hypothesis is that control firm-adjusted performance is not significantly different from zero for each of the sample years surrounding director incentive plan adoption.
Potential changes in performance following plan adoption may be attributed to size and industry factors as opposed to firm-specific events. In order to distinguish between the two, changes in the post-adoption performance of adopting firms are examined net of the corresponding performance of the matched control firms. For example, in assessing the change in the difference between experimental and control firm ROA from year 21 to year 0 (the change in the abnormal return on assets), a new variable is constructed such that
AROA(21,10 )5AROA212AROA10.
Annual changes in asset turnover and the return on sales are similarly computed. The null hypothesis of no post-adoption change is tested using the paired t-test and the non-parametric Wilcoxon signed ranks test (two-tailed) described above. In both tests of differences in performance between adopting and control firms over a single period and in tests of changes in performance across periods, mean and median values are tabulated together with the t-statistic for the parametric test and the P-value corresponding to the Wilcoxon signed ranks test.
4. Empirical results
Table 1
a
Operating performance of firms adopting director incentive plans
Sample size Adopters Control t-value Wilc. P-value Panel A — return on assets
Return on assets is income before extraordinary items divided by total assets; return on sales is income before extraordinary items divided by net annual sales; asset turnover is net annual sales divided by total assets. For each variable the first and second lines report the sample means and medians. The right hand columns report the t statistic for the difference in means, and the P-value corresponding to the z statistic for the Wilcoxon signed ranks test. *,**Significant at the 0.10 and 0.05 levels, respectively.
adopting and control firms. Together, the evidence presented in Table 1 uniformly contrasts the notion that plan adoptions are related to superior operating performance.
Table 2
a
Changes in the operating performance of 112 firms following the adoption of director incentive plans
Year Return on Asset Return Return Asset Return
assets turnover on sales on assets turnover on sales Panel A — changes in operating performance Panel B — control firm-adjusted
changes in operating performance
21 to 0 Mean 20.33% 0.05 18.49% 20.02% 0.03 19.40%
Median 0.47% 0.02 0.19% 0.31% 0.01 0.27%
t-statistic 20.30 2.25** 0.94 20.01 0.87 0.96
Wilcoxon 0.22 0.03** 0.43 0.68 0.34 0.77
P-value
0 to 1 Mean 0.39% 20.05 10.55% 0.59% 20.06 12.88%
Median 0.01% 20.01 0.15% 20.48% 20.01 0.01%
t-statistic 0.30 21.61 1.17 0.35 21.59 1.38
Wilcoxon 0.91 0.74 0.41 0.99 0.44 0.67
P-value
1 to 2 Mean 21.90% 20.04 21.31% 20.83% 20.03 25.51%
Median 0.27% 20.02 0.33% 0.54% 20.02 0.78%
t-statistic 21.45 21.30 21.24 20.53 20.78 21.14
Wilcoxon 0.95 0.11 0.38 0.35 0.57 0.26
P-value
a
Panel A presents changes in the operating performance of firms adopting director incentive plans between 1989 and 1995. Panel B presents changes in operating performance compared to a sample of matched control firms. The plan adoption is made in year zero. Return on assets is income before extraordinary items divided by total assets; return on sales is income before extraordinary items divided by net annual sales; asset turnover is net annual sales divided by total assets. *,**Significant at the 0.10 and 0.05 levels, respectively.
year 11 casting doubt on the importance of this result. In sum, all insignificant results hold under the parametric t-test and the non-parametric Wilcoxon signed ranks test. Similarly, when performance changes are compared to the corresponding changes of the matched control firms, the paired t-test and the matched pairs signed ranks Wilcoxon test are also insignificant. Moreover, the change in asset turnover in year 0 becomes insignificant when adjusted for the corresponding change of the control firms for that year. Thus, consistent with the evidence in Table 1 and in contrast to expectations, the evidence in Table 2 does not reveal performance improvements for firms adopting director incentive plans. Together, the empirical results in this paper cast doubt on the notion that the provision of financial incentives to outside directors leads to measurable improvements in firm performance.
5. Conclusion
corporate directors. Thirdly, director incentive plans may be used as mechanisms that transfer wealth to outside directors, in the form of equity and option grants. If this is the case, following plan adoption directors will inevitably receive pressure to become more tolerant towards management. This explanation for the adoption of director incentive plans would predict negative post-adoption changes in performance. The non-relation between plan adoption and performance that is documented here is consistent with the benefits of plan adoption being offset by their related costs. Fourthly, it is possible that the effect of such plans will not be discerned until several years following plan adoption. Fifthly, the actual terms of the director compensation arrangements and not their sheer adoption may be what is important. To this end, improved disclosure on the details of director compensation agreements may facilitate the markets in distinguishing between different types of financial incentives for directors. Finally, examining the monitoring quality of corporate boards in settings requiring good decision control, conditional on director financial incentives, (e.g. in takeover-type scenarios, in setting executive compensation, or managerial turnover) may prove to be a fruitful approach in capturing the benefits of using director incentive plans. Nevertheless, the present study has shown that, uncondition-ally, the adoption of director incentive plans is not related to firm performance.
Acknowledgements
I am indebted to Maria Charalambidou for providing research assistance. This project was partly funded by a University of Cyprus research grant.
References
Bhagat, S., Black, B., 1999. The uncertain relationship between board composition and firm performance. Business Lawyer, In press.
