Executive Summary

Financial economists suggest that a combination of market institutions and internal incentive mechanisms can effectively address agency problems in most firms. Given the efficiency implications of good governance, an issue of considerable practical importance for shareholders is the extent to which take-over markets or other external market mechanisms that discipline executive behavior decrease or increase the need for costly internal performance-based incentives. This issue is also important for legislators and regulators who are interested in the economic consequences of their interventions. However, whether (or how) take-over markets affect internal incentives is subject to considerable theoretical debate.

To address this debate empirically, we examine how firms changed their chief executive officer (CEO) compensation practices following the enactment of anti-take-over laws (hereafter “ATLs”) by many states in the 1980s. Because these laws were widely recognized as lowering the disciplining role of take-over markets, their enactment provides a useful setting to draw inferences about the relation between take-over markets and internal performance-based incentives. This experimental setting is also ideal because it lessens omitted-variable and other econometric concerns that often plague studies that use endogenous events such as changes in board structure or firms’ voluntary adoption of internal anti-take-over measures.

Prior literature suggests that the sensitivities of CEO compensation to both stock-based and accounting-based performance are important indicators of the strength of internal performance-based incentives. Prior literature also suggests that accounting-based and stock-based measures of firm performance propel much of the activity in take-over markets. Thus, to the extent that internal incentives effectively substitute for the discipline provided by take-over markets, we expect boards to provide CEOs higher-powered accounting-based and stock-based performance incentives following ATLs. Conversely, if internal performance-based incentives complement the discipline provided by take-over markets, then we expect boards to offer CEOs more muted accounting-based and stock-based incentives following ATLs.

We test our predictions on a sample of 338 unregulated Forbes 500 firms from 1984 to 1991, a period that witnessed the introduction of ATLs. In our first set of tests, we regress changes in CEO compensation (total annual compensation, cash compensation, and noncash compensation) on both accounting-based (change in return on assets) and stock-based (annual stock returns) performance measures, using an indicator variable to represent the passage of ATLs. We find that CEO compensation is both higher (after controlling for performance) and more sensitive to stock returns and change in return on assets after the enactment of ATLs.

Our finding of higher post-ATL pay-for-performance sensitivity suggests that internal incentives substitute for the reduced discipline provided by take-over markets following ATLs. At the same time, our finding of higher post-ATL CEO pay implies that internal governance mechanisms and the market for corporate control are complementary incentive instruments in the sense that post-ATLs CEOs enjoy both greater job security and higher levels of compensation. Thus, on the basis of this evidence alone, it is difficult to ascertain whether CEO compensation practices and the discipline inherent in the market for corporate control are complementary or substitute governance mechanisms.

To provide more convincing evidence concerning the relation between internal governance mechanisms and the market for corporate control, our second set of tests replicate the first set with both stock returns and accounting return on assets decomposed into “luck” and “skill” components. This decomposition is based on the argument that effective or higher-powered incentive compensation arrangements reward executives more so for their managerial skills and contribution to firm performance than for fortuitous (“good luck”) events. We find that the sensitivities of CEO compensation to the “good luck” components of both stock returns and accounting return on assets increased after ATLs, while the sensitivities to the remaining performance components remained unchanged. This suggests that our initial findings of higher pay-for-performance sensitivities after ATLs are attributable to the “good luck” components of stock returns and accounting return on assets. More important, this makes it difficult to claim that internal incentives have strengthened to substitute for less active takeover markets; instead it suggests a weaker pay-for-performance relation following the adoption of ATLs.

Taken together, our findings of higher post-ATL CEO compensation (after controlling for performance) and higher sensitivity of pay to the good luck component of performance suggests that CEO compensation practices and the discipline inherent in market for corporate control are complementary governance mechanisms. That is, an active take-over market is likely to imply effective internal governance or higher-powered internal incentives. Conversely, a weak take-over market (e.g., due to regulatory intervention) is likely to manifest in the form of ineffective internal governance or lower-powered internal incentives.

Our study contributes to the prior literature in a number of important ways. For instance, our findings of a complementary relation in internal and external corporate governance practices contrast with earlier studies. Because regulations and regulatory interventions are central to understanding the role of accounting information and accounting institutions in our economy, our findings also contribute to the literature that examines the role of accounting information in corporate governance. Moreover, unlike other determinants of CEO compensation identified in the literature such as managerial ownership and firm growth opportunities, our findings concerning the market for corporate control are more defensible and less susceptible to alternative interpretations because the market for corporate control can more legitimately be considered exogenous to firm-level corporate decisions. Finally, our study complements previous accounting studies that examine the use of earnings components in setting executive compensation by documenting that CEOs are compensated for the “luck” component of earnings and by suggesting that such compensation reflects managerial negotiation power.

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