Abstract
We develop a multi-theoretic approach, drawing on economic, institutional, managerial power and social comparison literatures to explain the role of the external compensation consultant in the top management pay setting institutional field. Taking advantage of recent disclosure requirements in the UK, we collect data on compensation consultant use in 232 large companies. We show that consultants are a prevalent part of the CEO pay setting scene, and document evidence of all advisor use. Our econometric results show that consultant use is associated with firm size and the equity pay mix. We also show that CEO pay is positively associated with peer firms that share consultants, with higher board and consultant interlocks, and some evidence that where firms supply other business services to the firm, CEO pay is greater.
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Notes
In separate analysis, we investigated the pure ‘compensation consultant’ effect on pay, namely whether pay was greater in firms with consultants than in those where boards did not consult them. We were unable to isolate a consistent effect on pay, and results were sensitive to econometric methods used.
In the US, the case of Michael Ovitz’s $140 million severance package at Walt Disney is instructive. In litigation, shareholders were ultimately unable to demonstrate that the compensation plan was egregious. In addition, the case lasted 8 years illustrating the complexities involved.
Of course, this does not exclude the possibility that members of the compensation committee themselves are beholden to the CEO, and thus the consultant is under the CEO’s indirect influence.
Indeed, as Bebchuk and Fried (2004, p. 38) remark: “A tilt in favor of executives on the part of compensation consultants could produce outcomes favorable to executives even if directors themselves had no incentives and tendencies to favor executives.” This suggests that even if measures of CEO-Board power that have been used in the literature suggest that boards are not a passive tool of management interests (Vance 1983), failure to account for consultant incentives may omit important explanatory factors.
The total market capitalization of firms with UK origin on the London Stock Exchange in January 2006 was ₤1,867,400 million. The sum of the largest 100 firms was ₤1,477,889 million and the sum of the largest 250 firms was 1,684,791 million. These represent about 79 and 90% of market capitalization respectively.
In the US, restricted stock and option grants typically vest with the passage of time (but not with performance criteria). In the UK, by contrast the vesting of restricted stock and options is typically tied to the attainment of certain performance objectives.
It is well known that the value of a European call option on a dividend paying stock is c = Se−qtN(d1) − Xe−rtN(d2), where d1 = {ln(S/X) + (r − q + σ2/2)t}/σ√t, d2 = d1 − σ√t, and S is the stock price; X the exercise price; t the maturity term; r the risk-free interest rate; q the dividend yield and σ the volatility of returns. N(·) is the cumulative probability distribution function for a standardized normal variable.
The analysis presented here uses the mean of other firms; similar results are obtained if one used the median.
Towers Perrin began life in 1934 as Towers, Perrin, Forster and Crosby in Philadelphia with a Reinsurance Division and a Life Division. It now contains a global executive compensation service as part of its business. New Bridge Street Consultants are an executive pay consulting spin-off the large UK-based law firm Clifford Chance and internationally are linked with US firm Frederick W. Cook and Co. Inc.
Sometimes the fees and compensation received for these other services can be considerable. British Sky Broadcasting Group Plc stated that “The Group uses the services of Deloitte and Touche LLP Executive Compensation Consulting, who replaced Arthur Andersen in providing advice to the Committee. Deloitte and Touche has been appointed by the Group and provide advice as required by the Committee. Deloitte and Touche also acts as the Group’s auditors, and provide other services to the Group as detailed in Note 7 to the financial statements.” Note 7 to the financial statements reads: “In addition to the amounts noted above, the Group understands that during the year its auditors indirectly received from the Group a further 4 million through the performance of sub-contracted services for one of the Groups call centre consultants”.
In separate analysis, we examined the effect of using more than one consultant, namely using the number of consultants used in our pay models. We found no evidence that the pure number of consultants had an effect on pay.
The models in Table 6 are estimated for the restricted sample of those firms that have consultants (n = 206). The significant effect of the consultants having other business is not significant on the full sample described. We suggest this result (of this pay premium) is not particularly robust to alternative specifications and worthy of further research.
Warren Buffett and Charles Munger at Berkshire Hathaway have been critical of the process of how CEO pay is set at major corporations: Mr. Buffet said: “The typical large company has a compensation committee … They don’t look for Dobermans on that committee, they look for Chihuahuas … Chihuahuas that have been sedated”. Mr. Munger added: “I would rather throw a viper down my shirtfront than hire a compensation consultant.” http://money.cnn.com/2004/05/03/pf/buffett_qanda/index.htm. The New York Times (4/10/2006) noted that “Because of what goes on in compensation consulting stays in the hushed confines of corporate boardrooms, the roles of these advisers in determining executive pay have been hidden from investor’s view … the conflicts bedeviling some of the large consulting firms help explain why in good times or bad, executive pay in America reaches dizzying heights each year”.
Interestingly, the company did not continue to provide such details of financial compensation for its executive compensation advisors in it 2005 Annual Report and Accounts.
New York Times 4/10/2006 “Advice on Boss’s pay may not be so independent”.
Failure to vote on the remuneration report can, however, result in significant fines for directors.
We are grateful to the reviewer for making this observation.
The UK legislation means the data is not available pre-2003. The use of consultants is likely to be persistent over short periods of time so we suspect only a few changes would have happened to date. In addition, recall that the additional necessary compensation data is extremely difficult to assemble in the UK since currently it must be collected by hand. Hence, here we present cross-sectional evidence as the first step to understanding the role of pay consultants.
Another interesting approach to this issue would be to examine how a compensation consultants’s US experience or international operations may lead to an upward homogenization of pay. We are grateful to the reviewer for this observation.
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Acknowledgments
We would like to thank seminar participants at the Journal of Management and Governance symposium, Naples, the discussant Sven Collin, the editors of the special issue, Robert Hoskisson, Morten Huse, Riccardo Vigano and Alessandro Zattoni and the anonymous reviewers. We would also like to thank Lucian Bebchuk, Matthew Bidwell, Peter Cappelli, Jay Chok, Gina Dokko, Daniel Forbes, Rob Grant, Lerong He, Sheen Levine, Henry Tosi and Chloe Wayne as well as seminar participants at Case Western Reserve University, Georgetown University, Instituto de Empresa, Singapore Management University, the Wharton School and the Academy of Management Meetings in Atlanta for comments on earlier versions of this paper. We are also grateful to practitioner colleagues at Mercer Human Resource Consulting, Towers Perrin and Watson Wyatt for their advice in the preparation of this paper. The views expressed here are solely those of the authors.
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Conyon, M.J., Peck, S.I. & Sadler, G.V. New perspectives on the governance of executive compensation: an examination of the role and effect of compensation consultants. J Manag Gov 15, 29–58 (2011). https://doi.org/10.1007/s10997-009-9117-6
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DOI: https://doi.org/10.1007/s10997-009-9117-6