MANAGEMENT

Executive Compensation and Firm Performance in the UK



Executive Compensation and Firm Performance in the UK

CHAPTER I: INTRODUCTION

Over the past decades, the total value of executive compensation packages has been rising dramatically, contributing to a wider pay gap between the chief executive officer (CEO) and the average worker. In the midst of the financial turmoil that brought about a massive wave of corporate defaults and failures, the lavish executive compensation package has come under an intense spotlight. Public pressure has mounted to revise both the levels and the structure of CEO pay in a way that will tie more closely the executive wealth to that of shareholders. In response, boards of directors have increased the equity-based component of incentive contracts, routinely awarding generous amounts in stock option grants to the representatives of the top management team and requiring them to hold important ownership stakes in their company. In 2009, almost two-thirds of total compensation was delivered to the CEOs in the form of options and other stock awards (Rappaport, 1983, 49).

Equity ownership and stock option plans have long been viewed as virtually equal mechanisms of incentive alignment that lead to similar types of executive behaviour. In recent years, however, behavioural researchers started to question their congruence and acknowledge that the motivational effects generated by these pay elements do not mimic each other. Stock options, in particular, became the focus of great interest due to boards' heavy reliance on this compensation mode and the controversial role played by options in corporate scandals. As many empirical studies began to report that option pay resulted in extreme corporate performance while option loaded CEOs generated more large losses than large gains, it became clear that the efficacy of stock options as governance mechanisms could no longer be taken for granted (Boudreaux, 1973, 366).

Relying on the idea that various compensation components have asymmetric motivational properties, a solid body of behavioural research developed aiming to uncover the strategic implications of stock ownership and option pay in terms of executive risk taking, such as the initiation of merger and acquisition (M&A) transactions. Surprisingly, the variety of factors that determine the actual structuring of executive compensation contracts did not receive sufficient empirical consideration. Our study seeks to extend the behavioural theory by examining how the modification in board of directors' decision to rely on alternative equity-based modes of CEO pay occurs as a result of the recent past strategic choices of firm leaders. More specifically, we tackle this question in a unique context of active markets for corporate control, suggesting that the incentive design of executive pay contracts might need to be altered based on the evolving nature of the agency problem stemming from the incidence of acquisition deals (Hubbard & Palia, 1994, 105).

1. 1 Research Rationale

M&A activities represent an opportune setting for gauging whether shareholder value creation or managerial opportunism guides CEO compensation. Despite the credit crunch, as many as 64,981 transactions were announced worldwide in 2009, valued at US$ ...