Do Contracts for Executive Compensation Maximize Firm Value?

In a recent study, we examine whether executive compensation contracts are designed to maximize firm value. There is considerable debate regarding executive compensation in both the public arena and academia. On the one hand, proponents of the “value maximization” theories claim that executive compensation contracts are optimally designed to attract and provide incentives for executives in a competitive job market to maximize shareholder value. On the other hand, proponents of the “rent extraction” theories suggest that market forces fail in this setting, because executives are able to practically set their own compensation, therefore executive compensation contracts are set sub-optimally and enable executives to extract rents at the expense of shareholders. This debate has important implications in law, finance, and economics. Moreover, this debate has significant policy implications given the numerous proposals to limit executive pay.

Despite the importance of this debate, the question of whether executive pay is set to maximize firm value has not been satisfactorily answered, because significant challenges exist in determining causality in this research stream. Executives, directors, and consultants spend time and effort designing compensation contracts, taking into account unobservable firm, industry, and executive characteristics. As a result, compensation contracts are inevitably correlated with these unobservable characteristics, which in turn affect firm behavior, performance, and value.

To deal with this research challenge, in our study, we use a surprising and quick shock that was outside of firms’ control (i.e., exogenous), and restricted executive pay to a binding upper limit.  This shock enables us to use a standard capital-markets short-window event-study methodology which posits that, on average, in efficient markets, investors correctly and fully account for all the information about the effects of the shock and quickly incorporate them into the market price. With this methodology we can examine the different predictions of the value maximization theories and the rent extraction theories in the short event window around the shock. Under the value maximization theories, compensation contracts are optimally set to maximize firm value, therefore any outside restriction on these contracts, such as a limit on executive pay, is suboptimal and should result in a reduction in firm value. In contrast, under the rent extraction theories, a limit to executive pay can reduce rent extraction and should result in an increase in firm value.

The shock that we use is the Israeli Parliament Treasury Committee’s surprising and unanimous approval on March 16, 2016, of a law that restricts the compensation of executives of insurance, banking, and investment firms (including parent companies of those firms). If a proposed law passes in the Treasury Committee with support from coalition and opposition parties, the actual vote in Parliament is a formality (the formal approval of the law by the Parliament, without change, occurred on March 29, 2016). Hence, the passing of the law in the Treasury Committee is the main event we examine. Until March 16, 2016, all the discussions in the Parliament and its committees on the law were focused on capping the tax deduction of executive compensation, which prior literature shows is an ineffective way to limit executive pay. It was only during Treasury Committee proceedings on March 16, 2016 that a binding pay restriction (not only for tax purposes) was introduced into the bill and was surprisingly backed by the treasury minister and the coalition. The law restricts total compensation (including but not limited to salaries, bonuses, share-based compensation, deferred compensation, benefits, and retirement compensation) to no higher than 35 times that of the lowest-paid employee, including indirect employees such as those of subcontractors hired indirectly by financial institutions. This law creates a significant, binding pay cut for the executives of many of the financial institutions.

Our main finding is that the financial institutions subject to the law experienced statistically significant 1.6 percent abnormal returns in the three-day window surrounding the law’s approval, with approximately 85 percent of the financial institutions in our sample experiencing positive abnormal returns. This significant increase in firm value is inconsistent with the value maximization theories and supports the rent extraction theories. We perform several tests to buttress a causal interpretation of the results. First, we show that the positive and significant effect is concentrated in financial institutions for which the pay limit is binding (an average 1.8 percent abnormal increase in firm value), compared with an insignificant effect on the value of financial institutions in which the pay limit was not binding. Second, we examine the effect of the passing of the law on financial institutions that are not within the scope of the law and find insignificant abnormal returns. Third, we find that financial institutions whose executives received compensation just above the law’s limit experienced positive and significant abnormal returns, while financial institutions with executives just below the pay limit experienced insignificant abnormal returns. Fourth, we find that the correlation between the annual expected pay savings and the increase in firm value around the event date is very high.  These results reduce the possibility that other factors cause the increase in the value of financial institutions subject to the law around the event day.

Our findings may prompt alternative explanations. For example, if executives do not have a viable alternative outside option, the law may simply transfer welfare from optimally paid executives to shareholders (by enabling a non-market mechanism that reduces executive pay). Although, as we discuss in detail in the paper, lack of outside options is not likely in our setting, we perform several cross-sectional tests to rule out this and possibly other unspecified alternative explanations. In a first cross-sectional test, we find that the observed increase in firm value is greater for financial institutions with weak corporate governance. In a second cross-sectional test, we find that the observed increase in firm value is lower for financial institutions whose executives receive more of their compensation in the form of equity. These results provide further support for the rent extraction theories.

Although the setting we use allows us to provide compelling causal evidence, it is unclear whether we would see similar results in other countries and industries. There are a few institutional factors that suggest that our results could be expected in other settings as well. First, Israel is an OECD member with, a developed economy that practices common law, and its corporate governance rules are very similar to those in the United States and other advanced economies. In addition, many Israeli firms, and in particular financial institutions, use international consulting firms in creating executive compensation contracts. Second, Israeli financial institutions have an additional monitoring layer that industrial firms don’t. Israeli banks are supervised by the Bank of Israel, and Israeli insurance firms are supervised by the Capital Market, Insurance, and Savings Supervisor in the Israeli Finance Ministry. These supervisory institutions are widely recognized as some of the best in the world. Third, Israeli financial institutions were among those that suffered the least in the 2008 financial crisis, suggesting that they are well managed and well governed. These factors suggest that our findings that support the rent extraction theories for Israeli financial institutions may underestimate the effect of rent extraction in other countries or industries.

Taken together our results provide causal evidence that, on average, compensation contracts can be designed in a way that does not maximize firm value. Although we believe our study contributes to the debate on executive compensation, we caution readers and policy makers about applying our results to different settings. At a minimum, we provide evidence that executive compensation contracts in a developed, common law country with a modern banking system can be designed in a way that does not maximize firm value.

This post comes to us from Professor Meni Abudy at Bar-Ilan University’s Graduate School of Business Administration, Professor Dan Amiram at Columbia Business School, Professor Oded Rozenbaum at George Washington University School of Business, and Professor Efrat Shust at  the College of Management Academic Studies School of Business. It is based on their recent paper, “Do Executive Compensation Contracts Maximize Firm Value? Evidence from a Quasi-Natural Experiment,” available here.