Shareholder Sentiment and Executive Compensation

Transcription

1 Shareholder Sentiment and Executive Compensation Christopher S. Armstrong The Wharton School University of Pennsylvania Ian D. Gow Harvard Business School David F. Larcker Graduate School of Business Rock Center for Corporate Governance Stanford University Draft: September 18, 2011 Abstract: This study examines the effects of shareholder support for equity compensation plans on subsequent chief executive officer (CEO) compensation. Using a traditional regression and regression discontinuity design, we find very little evidence that lower shareholder voting support for proposed equity compensation plans leads to decreases in future CEO compensation. Even in cases where the equity plan is rejected by shareholders, we find that firms typically gain approval in the subsequent year. Collectively, our results suggest that shareholder votes have little impact on firms compensation policies and that recent regulatory efforts aimed at strengthening shareholder voting rights, particularly in the context of executive compensation, may have limited effect on firm policies. JEL Classification: G3; J33; M52 Keywords: stock-based compensation; shareholder voting We thank Balfe Morrison for excellent research assistance. Larcker is grateful for financial support from the Joseph and Laurie Lacob Faculty Fellow Award.

2 1. Introduction Enhancing the ability of shareholders to affect corporate policy has been the focus of several recent efforts to reform corporate governance, such as requirements for votes on stockbased compensation plans, mandatory reporting of mutual fund voting, vote-no campaigns, calls for elimination of broker non-votes, and legislation requiring say on pay votes and proxy access. 1 Much of this regulatory activity and debate is predicated on the notion that shareholder voting is an effective tool for influencing corporate behavior (e.g., Dodd Frank Wall Street Reform and Consumer Protection Act). Although shareholder voting has been the subject of some prior research (e.g., Cai, Garner, and Walkling, 2009; Choi, Fisch, and Kahan, 2011), the efficacy of shareholder voting as a mechanism to effect changes in corporate policy is an open question. The purpose of this paper is to examine whether shareholder sentiment, expressed through votes on equity-based compensation plans, affects firms compensation policies. 2 Although Yermack (2010, 2.13) argues that circumstantial evidence suggests that many firms have reacted to the rising tide of negative votes [for share authorization] by scaling back their equity compensation plans, there is little rigorous evidence of this. We aim to fill this gap in the corporate governance literature by examining the effect of shareholder votes on directors and equity pay plans including the outright rejection of plans on firms compensation policies. Using a comprehensive sample of shareholder votes from 2001 to 2010, we first examine the determinants of shareholder support for directors and equity compensation proposals. We expect that shareholders dissatisfaction with executive compensation will be directly reflected in 1 See Yermack (2010) for a discussion of these developments. 2 Based on data from ISS Voting Analytics on shareholder votes between 2001 and 2010, equity compensation plans account for 30% of rejections of management-sponsored proposals, suggesting that votes on such proposals are the natural setting to examine the effectiveness of votes in effecting changes in corporate policy

3 votes on equity compensation plans, as opposed to votes for individual directors, since directors are charged with other responsibilities in addition to setting executive compensation. We find evidence that measures of excess compensation and shareholder dilution that are similar to those used by RiskMetrics Group (RMG) and Fidelity Investments are negatively related to shareholder support for equity compensation plans. 3 However, consistent with our predictions, these measures have no association with shareholder support in director elections that occur at the same annual meeting. 4 To examine the effect of shareholder sentiment on executive compensation, we examine two measures of such sentiment. The first measure follows prior literature by examining shareholder support for directors up for election (Cai et al., 2009; Fischer et al., 2009) as a measure of shareholder sentiment that may affect directors future compensation decisions. Cai et al. (2009) and Fischer et al. (2009) provide evidence consistent with directors reducing future CEO compensation in response to negative shareholder sentiment (i.e., lower voting support in director elections) in certain circumstances (Cai et al., 2009, find effects only for compensation committee members, while Fischer et al find effects only for CEOs up for election as directors). Similar to Cai et al. (2009) and Fischer et al. (2009), our tests use standard crosssectional regressions, however our analyses differ from prior research in two respects. First, because the potentially complex interaction between executive compensation and shareholder support makes it reasonable to believe that causality may occur in both directions, we attempt to control both for prior compensation and other factors that are likely to affect both shareholder support and future compensation outcomes. Second, we note that the complexity of determining 3 Risk Metrics Group is now known as Institutional Shareholder Services (ISS) and is owned by MSCI. 4 For discussion of the policies of RMG, Fidelity and other institutional investors, see (accessed November 14, 2010)

4 the appropriate level and composition of executive compensation makes it difficult to determine a priori the precise timing or elements of future compensation that should be affected by shareholder voting. Accordingly, we examine a variety of compensation variables over different horizons, whereas prior literature has typically focused on only a single measure of compensation during a single year. Despite using a larger sample (i.e., more firms and more years) and multiple measures of executive compensation measured over multiple future periods, we find no evidence that negative shareholder sentiment expressed in director elections leads to lower future CEO compensation. We then examine whether shareholder sentiment as expressed in votes on equity compensation plans has an impact on future compensation policy. We expect this measure of shareholder sentiment to be more powerful because, as our analysis of the determinants of shareholder voting confirms, votes on equity compensation plans are arguably a more direct and precise measure of shareholder sentiment regarding executive compensation than support in director elections, in part because shareholder sentiment for directors is likely to be affected by a broad range of issues in addition to executive compensation policies. In this analysis, we supplement standard cross-sectional regression analysis, as used in our analysis of director elections, with a regression discontinuity design (RDD). This design capitalizes on both the discrete nature of the level of voting support (typically 50%) required for an equity compensation plan proposal to pass, and the fact that such proposals are formally binding. In the terminology of the RDD literature, we use the existence of a discontinuous, deterministic function assigning treatment based on a continuous variable to recover the effect of treatment. In the context of shareholder voting on stock-based compensation plans, the treatment variable of interest (i.e., whether the plan passes) is a deterministic function of a continuous running variable (i.e., the - 3 -

5 percentage of votes for the plan). Specifically, if the percentage reaches or exceeds the cutoff then the plan passes. With relatively minor assumptions (essentially continuous density functions) about the various variables, RDD allows a researcher to recover an unbiased treatment effect even when the running variable is jointly determined with the endogenous outcome variables of interest (e.g., future CEO compensation). Our collective findings from both research designs are that there is surprisingly little evidence that the failure to receive shareholder approval for additional shares has an effect on subsequent executive compensation. Our inability to find effects is particularly surprising given the relatively large sample and the fact that we use a sharp regression discontinuity design that has proven powerful in a variety of settings (Lee and Lemieux, 2010). Given that shareholder votes on equity-based pay plans are binding, lack of an effect on future equity-based compensation in particular is puzzling. One possible explanation is that management responds to the rejection in one year by requesting additional shares in the subsequent year. To the extent that such requests are approved by shareholders, the total effect of shareholder rejection on equity-based compensation may be negligible. We examine this possibility and find that firms whose plans are rejected by shareholders are significantly more likely to request shares in the subsequent year. 5 However we find that the level of shareholder approval for these follow-up requests is not related to whether the original request was approved. Collectively, our results are at odds with from those of prior research, as they suggest that shareholder sentiment expressed through voting support does not impact firms compensation policies. Our findings therefore suggest that recent regulatory effort, which focus on strengthening the ability of shareholder to express their view through shareholder voting, 5 As we discuss in further detail below, these findings help to assuage concerns that our empirical tests lack sufficient power to detect the effects of shareholder sentiment

6 particularly in the context of executive compensation (i.e., say on pay ), may not have the desired effect on firm policies. 2. Institutional background 2.1 Votes on equity compensation plans On June 30, 2003, the U.S. Securities and Exchange Commission (SEC) approved new rules, proposed by the New York Stock Exchange (NYSE) and the Nasdaq Stock Market, requiring shareholder approval of equity compensation plans, including stock option plans. 6 The new rules also require approval for repricing options and material changes to existing plans. The NYSE s new rules replaced its pilot program, which exempted broad-based equity compensation plans from shareholder approval. At the same time, the SEC also approved changes in NYSE rules restricting a broker that is a member of the Exchange from voting shares held in street name on equity compensation plans in the absence of instructions from the beneficial owner of the voting securities. Relative to most matters put to shareholder vote, equity compensation proposals are highly controversial. Of the 619 management-sponsored proposals rejected by shareholders between 2001 and 2010, 183 (30%) related to equity compensation plans. 7 Similarly, of the 2,659 management-sponsored proposals where RiskMetrics Group recommended a vote against, 1,719 (65%) related to equity compensation plans. RiskMetrics Group recommended that its institutional investor clients vote against 27% of the 6,270 equity compensation plans considered between 2001 and And, although only 2% of equity compensation proposals fail to receive the required level of shareholder support, this is substantially larger than the 0.07% failure rate 6 See the SEC s website for more detail. 7 Statistics based on data from the ISS Voting Analytics database

7 for director elections, which have received considerably greater attention in recent research on shareholder voting and executive compensation. 8 Some additional descriptive statistics help to give some sense for the context of votes on equity compensation plans. ISS Voting Analytics provides data on all votes for a sample of 24,784 firm-years between 2001 and 2010 that includes 4,821 distinct firms. Of the 24,784 firmyears, 8,821 (35.6%) include a vote on an equity compensation plan, suggesting that a typical firm seeks shareholder approval of an equity compensation proposal around once every three years. However, there is wide variation in the frequency with which firms put forward equity compensation proposals. Of the 4,821 firms, more than 70% put two or fewer equity compensation proposals to a vote during , but 151 firms have six or more plans considered. There are also two firms Plantronics, Inc. and Range Resources Corporation that put up an equity compensation plan each year during Say on pay One recent and significant regulatory initiative related to shareholder voting focuses on what is called say-on-pay. Section 951 of the Dodd Frank Wall Street Reform and Consumer Protection Act (Pub. L , H.R. 4173, the Act ), amended the Securities Exchange Act of 1934 to require companies subject to the federal proxy rules to provide shareholders with an advisory vote on executive compensation. 9 These votes are required at least once every three years beginning with the first annual shareholder meeting on or after January 21, One key potential limitation of say-on-pay is that the result of the vote has no binding effect on the board. In contrast, if shareholders reject a proposed equity compensation plan, then 8 Shareholders reject 1.3% of management-sponsored proposals that do not relate to equity compensation plans. 9 Section 971 of the same Act also relates to shareholder voting. This section authorizes the SEC to issue rules permitting the use by a shareholder of proxy solicitation materials supplied by an issuer for the purpose of nominating directors

8 the board cannot issue the options or shares that would have been authorized by the plan. As such, if the primary role of the shareholder vote is to prevent actions from being taken, then we would expect that votes on equity compensation plans would have a greater impact on future compensation than say-on-pay votes Prior research 3.1 Voting and executive compensation This study is closely related to two papers that examine shareholder votes on equity compensation plans. Morgan, Poulsen, and Wolf (2006) examine aggregate shareholder votes for S&P 500 firms during 1992 to 2003 and find evidence of shareholders providing less support for plans that are more dilutive and plans that receive negative recommendations from a proxy advisor. However, the focus of that paper differs from ours, as Morgan, Poulsen, and Wolf (2006) do not examine the consequences of shareholder voting outcomes. Martin and Thomas (2005) examine stock price reactions to management-sponsored executive-only stock option plans and find a negative reaction to plans with higher levels of potential dilution. In addition, they examine effect of voting outcomes on subsequent compensation and find evidence consistent with directors responding to negative shareholder votes by reducing compensation, but no significant association between shareholder support for stock option plans and future stock- 10 There are two potential benefits of say on pay votes relative to the votes we study. The first potential benefit is that say on pay votes allow shareholders to express their approval or dissatisfaction with the broad philosophy of executive compensation proposed by the board. In contrast, votes on equity compensation plans might be narrowly construed as pertaining merely to the proposal at hand. However, it seems likely that shareholders consider executive compensation more broadly even when the vote is specific to a plan; for example, the voting policy of RiskMetrics Group, the leading proxy advisory firm, explicitly considers general pay-for-performance issues when opining on equity compensation plans. So the first benefit might be largely theoretical. The second potential benefit derives from the non-binding nature of say on pay votes. Because shareholders can freely express their opinions without the possibility of direct adverse consequences (e.g., causing an undesirable equity plan to be passed, or a desirable one to fail), they can vote their opinion without concern for such consequences. In other words, say-on-pay votes might be less affected by strategic voting because of their advisory rather than binding nature

9 option pay. A number of studies have examined the effect of shareholder voting on other aspects of firms executive compensation policies. For example, Fischer et al. (2009) examine the effect of shareholder support for the board and CEO in uncontested director elections on compensation. They predict and find evidence that greater shareholder support is associated with higher future excess compensation. Cai, Garner, and Walkling (2009) also focus on director elections and find that future CEO compensation is decreasing in the level of shareholder support for members of the compensation committee. In addition, they examine the effect of shareholder support for directors on subsequent CEO turnover and changes in corporate governance, such as removal of a poison pill or declassification of the board. Cai and Walkling (2009) study the passage of the Say-on-Pay Bill from which the Dodd-Frank Act derives by the U.S. House of Representatives. They find that the firms that are most likely to benefit from such legislation have positive announcement-period stock returns. Larcker et al. (2011) apply an event study methodology to events leading up to the passage of say-on-pay and proxy access legislation and find evidence consistent with proxy access diminishing shareholder value. 11 In August 2002, the United Kingdom (UK) introduced the Directors Remuneration Report Regulations 2002, which require that publicly traded UK firms include an executive pay report in their annual filing and submit this report to a shareholder vote at the annual meeting. Similar to say-on-pay votes required under recent U.S. legislation, these votes are advisory rather than binding. Two recent papers examine the effects of these regulations. Ferri and Maber (2011) find that firms encountering low levels of shareholder support are more likely to amend 11 Prior to this legislation, a relatively small number of U.S. firms had voluntarily conducted say-on-pay votes in 2008 and

10 executive compensation contracts in ways viewed as more shareholder friendly (e.g., removing or reducing severance payments). Carter and Zamora (2009) examine the determinants of shareholder support in say-on-pay votes and find evidence that higher levels of dilution from equity compensation are associated with lower levels of shareholder support. They also examine the consequences of low shareholder support and find modest evidence that future pay is low when shareholder support is low, though the economic magnitudes are small. 3.2 Effect of institutional shareholder activism Another stream of literature examines the efficacy of shareholder activism in effecting changes in corporate policy. Del Guercio et al. (2008) provide evidence of the efficacy of institutional voting in effecting changes, even when such votes related to non-binding proposals. They find evidence that firms respond to campaigns by activist institutional investors to just vote no, with operating performance improvements, greater CEO turnover, and governance changes. Bushee, Carter, and Gerakos (2010) find evidence that firms with a high level of ownership by governance-sensitive institutions exhibit significant future improvements in shareholder rights, consistent with shareholder activism. Morgan et al. (2010) examine mutual fund voting on shareholder proposals and find that greater support by funds leads to a greater likelihood of a proposal s passage and a greater likelihood of its subsequent implementation by management. More closely related to our paper is Ertimur, Ferri, and Muslu (2010), who study vote-no campaigns and shareholder proposals related to executive pay between 1997 and Like us, Ertimur et al. (2010) find that voting support for the proposal (i.e., lower support for managers) is higher at firms with higher (excess) CEO pay. They also find that CEOs with excess pay who are targeted by vote-no campaigns experience a significant reduction in future compensation

11 4. Research Design 4.1 Determinants of shareholder voting support We first examine the determinants of shareholder voting support. Given the recent emphasis on measures of dilution given by RiskMetrics Group and major institutional investors, we include two measures of the dilutiveness of equity compensation, namely Shares Requested, which equals the number of shares requested in the equity proposal divided by the number of shares outstanding as disclosed in the proxy statement, and Shares Available, which equals the number of shares and options available under existing plans as disclosed in the proxy divided by the number of shares outstanding. The sum of these measures may be viewed as a proxy for shareholder value transfer (SVT), which adjusts the numerator to reflect the value of the stock or options that may be issued under the plan relative to the share price of the firm, and which is the primary measure of plan dilutiveness considered by RMG in its analysis of equity compensation plans. We also include the CEO s Compensation Mix and the natural logarithm of the CEO s Total Compensation during the last fiscal year ending prior to the meeting, as disclosed in the proxy filing for the meeting. We also include the determinants of CEO compensation identified in prior research (Core, Guay, and Larcker, 2008). 12 As discussed above, prior research has viewed support for directors and managementsponsored equity compensation proposals as a measure of the appropriateness of compensation practices. Although several papers have focused on director elections (e.g., Cai, Garner, and Walkling, 2009; Fischer et al., 2009), given the multiple dimensions along which shareholders 12 By including determinants of expected compensation in the regression, the coefficient on log(total Comp t 1 ) can be interpreted as the marginal effect of excess compensation (i.e., the level of compensation not explained by the determinants) on shareholder voting support

12 evaluate managers, as well as the more direct relationship between equity compensation proposals and executive compensation, we predict that the relations between the proxies for poor compensation practices and shareholder support for equity compensation proposals will be stronger than the relations between these proxies and shareholder support for directors up for election. To allow for the possibility that proxies for poor compensation practices affect one measure of shareholder support only through their effect on the other measure of shareholder support, we also estimate specifications with the alternative measure of shareholder support as an additional covariate. 4.2 Future compensation: Cross-sectional regression analysis Our first set of analyses is based on a research design that is similar to those in most of the related, prior research. In particular, we model a variety of compensation related variables as a function of shareholder support for directors and equity pay plans. However, unlike prior research (e.g., Fischer et al., 2009), we use the raw values of the compensation variables as our dependent variables and we include a variety of independent variables to control for both for the determinants of the shareholder vote and the benchmark level of the compensation variables. In addition, because causation is likely to occur in both directions, we also include the lagged value of the respective dependent variable in the year prior to the vote (e.g., when examining the effect of shareholder votes on total CEO compensation, we include total CEO compensation in the year ending prior to the year of the vote as a control variable). Inclusion of this variable is also intended to capture the effect of any time-invariant or persistent components of the dependent variable that are associated with shareholder voting on either the directors or the equity plan. This is an important element of the research design when examining the effect of shareholder voting on firm policies because it ensures that the coefficient on shareholder support captures

13 primarily time-series (i.e., within-firm), rather than cross-sectional variation in the dependent variable (e.g., future CEO compensation). This research design choice distinguishes our paper from prior studies, and more accurately captures the underlying economic model, which is one of shareholders affecting changes in their firms policies, which predicts time-series rather than cross-sectional variation. Finally, since executive compensation contracting is complex and often occurs over multiple years, it is a priori unclear when to expect the effect of a shareholder vote to manifest in future compensation. We therefore examine compensation (and other outcome) variables over three different horizons: the fiscal year that includes the shareholder meeting at which the vote occurs (labeled year t) and each of the two successive fiscal years (labeled years t + 1 and t + 2, respectively) Future compensation: Regression discontinuity designs There is a recent surge of interest in regression discontinuity designs (RDD). As discussed by Lee (2008), RDDs involve a dichotomous treatment variable that is a deterministic function of a single, observed, continuous covariate. In the context of shareholder voting on stock-based compensation plans, whether the plan fails (the treatment variable ) is a deterministic function of the percentage of votes for the plan (i.e., if the percentage is below the cutoff, typically 50%, then the plan fails). RDD has been used in voting settings in prior literature. For example, Lee (2008) examines the incumbency effect that results from winning elections in the U.S. House of Representatives, a treatment assigned by receiving more than 50% of the vote. RDD has also been applied in the context of shareholder elections. Cuñat, Gine, and Guadalupe (2010) use 13 Fischer et al. (2009) discuss (in footnote 21 on page 183) how they use CEO compensation for the first full fiscal year after the annual meeting, as opposed to compensation in the year of the year of the annual meeting because the compensation in the year of the meeting is likely to have been established before the meeting date

14 RDD to examine the effect of governance changes related to shareholder proposals. One issue with that setting is the heterogeneity of proposals (see Appendix A of Cuñat et al., 2010) and the differing motives of the shareholders making the proposals. Nonetheless, Cuñat et al. (2010) find evidence of a positive stock price reaction to the passage of a proposal, with stronger results when the analysis focuses on proposals related to shareholder rights of the kind examined in Gompers, Ishii, and Metrick (2003). Listokin (2009) uses RDD to examine the effect of dissidents success in proxy fights on stock returns. One issue with this setting is that proxy fights are relatively rare events and Listokin s sample includes only 97 observations. A potential concern that could impair the efficacy of RDD is what is termed manipulation of the running variable. Listokin (2008) provides evidence of management s ability to sway close votes in its favor. Using a sample, collected by Investor Responsibility Research Center (IRRC), that includes 13,360 unique votes on management-sponsored proposals from 1997 through 2004, Listokin (2008) finds 22 votes that receive between 47 and 50 percent support and 167 votes that receive between 50 and 53 percent support. 14 Panel A of Figure 1 reveals a similar pattern, which raises the possibility that non-random factors drive the assignment of firms around the 50% threshold. 5. Sample, Data, and Descriptive Statistics 5.1 Sample selection We construct two primary samples. The first sample relates to our analyses of director elections, the second for our analyses of votes on stock-based compensation plans Sample selection: director elections To construct our sample of director elections, we select all director elections on ISS 14 Note that Listokin (2008) excludes director elections and auditor ratification from his analysis

15 Voting Analytics for which a director name is provided. This yields 120,554 votes related to 50,912 directors at 4,663 firms. We then match these observations with data on committee memberships of directors from Equilar using firm identifiers, such as CUSIPs, and a fuzzy match on director names within each firm-year. 15 This yields data on 104,691 director elections from 2003 through Combining these with data on CEO compensation (as described below) reduces our sample to 102,541 observations for 4,045 distinct firms (18,600 firm-years) Sample selection: stock-based compensation plans We compile data on votes on stock-based compensation plans from two primary sources. The first source, Equilar, provides data about the nature of plans proposed (e.g. stock option or omnibus), whether the proposal relates to a new or an existing plan, the number of shares requested, and details on the votes for, votes against and abstentions. Equilar provides data on 5,791 equity compensation plan proposals (excluding 968 stock purchase plans) over the period The second source, ISS Voting Analytics, provides information about matters voted on at shareholder meetings for 4,759 companies over the period , including details on the votes for, votes against and abstentions for each proposal, the voting standard (typically 50%), the voting base (shares voting on the proposal, shares voting or abstaining, or shares outstanding), whether the proposal passed or failed, and the recommendation by ISS regarding how shareholder should vote their shares. We focus on votes on management-sponsored equity compensation proposals, for which ISS Voting Analytics provides 9,952 observations. Additional data requirements reduce our ISS Voting Analytics sample to 9,735 firm-years and our Equilar sample to 5, The intersection of these two data sets yields our primary sample, which consists of 3,434 observations. For our 15 We use the agrep function available in the base package of R We lose 220 observations because ISS Voting Analytics does not include the data required to calculate % For Pay Plan

16 RDD analyses, we require a precise measure of % For Pay Plan, which requires correct specification of the voting base, a data item that is provided by ISS Voting Analytics but not Equilar. To maximize the power of our RDD analyses, which rely primarily on observations with voting outcomes close to the 50% threshold, we identify 180 observations on Equilar, but for which we lack data from ISS Voting Analytics, and that have voting support greater than 40% (using votes for and votes against as the voting base), but less than 60% (using votes for, votes against, and abstentions in the voting base). We then hand-collect data from 203 proxy filings for these 180 observations with available data from Equilar. We define a close vote as one with voting support measured with the correct voting base, between 45% and 55%. This handcollection adds 131 observations (68 close votes) to the 9,499 (327 close votes) for which we have the necessary data from ISS Voting Analytics and brings our total sample of close votes to 378, and our total sample of votes to 9, Measurement of incentive compensation variables Since it unclear what components of CEO or company-wide incentive compensation policies might be affected by shareholder votes, we examine a comprehensive set of CEO and company-wide incentive compensation variables from data provided by Equilar. The first four variables are related to the CEO s annual compensation. In particular, we include in our analysis (1) Cash Compensation, defined as the sum of the CEO s annual salary and bonus payments, (2) Option Value, defined as the (risk-neutral) value of the CEO s annual option grants, Total Compensation, defined as the value of the CEO s total annual compensation (i.e., salary, bonus, restricted stock and option grants, and long-term incentive plan payouts), and (4) Compensation Mix, defined as one minus the ratio of salary to total annual compensation

17 The next two variables we examine, Portfolio Delta and Portfolio Vega are related to the incentives provided by the CEO s equity portfolio holdings. Consistent with prior literature (e.g., Core and Guay, 1999; Erickson, Hanlon, and Maydew, 2006; Burns and Kedia, 2006), we measure CEO incentives to increase stock price (Portfolio Delta) as defined as the change in the risk-neutral value of the CEO s equity portfolio for a 1% change in the firm s stock price. 17 Similarly, we follow prior literature (e.g., Guay, 1999; Coles, Daniel, and Naveen, 2006) and measure CEO risk-taking incentives (Portfolio Vega) as the change in the risk-neutral value of the CEO s option portfolio for a 0.01 change in the standard deviation of the underlying stock s return. The last three variables that we examine are related to aggregate option usage at the firm level. We define Options Exercisable as the aggregate number of options exercisable by the firm s employees, Options Exercised as the aggregate number of options exercised by the firm s employees during the fiscal year, and Options Granted as the aggregate number of options granted to the firm s employees during the fiscal year (where all three variables are scaled by the total number of shares outstanding at the beginning of the year). 5.3 Descriptive statistics Table 1, Panel A presents the median values of the primary variables in our analysis according to the outcome of the vote on the equity plan. A visual comparison of the second and third columns (i.e., All Passing Votes and All Failing Votes, respectively) suggests that these firm-years differ along many dimensions, including their incentive compensation policies prior 17 The parameters of the Black-Scholes formula are calculated as follows. Annualized volatility is calculated using continuously compounded monthly returns over the prior 36 months (with a minimum of 12 months of returns). The risk-free rate is calculated using interpolated interest rate on a Treasury note with the same maturity (to the closest month) as the remaining life of the option multiplied by 0.7 to account for the prevalence of early exercise. Dividend yield is calculated as the dividends paid over the past 12 months scaled by the stock price at the beginning of the month. This is essentially the same method described by Core and Guay (2002)

18 to the shareholder vote. A comparison of the last two columns (i.e., Close Passes and Close Fails, respectively) suggests that these two sets of firm-years are more similar along most dimensions. This feature is important for the validity of our subsequent RDD analysis. 18 Panel B of Table 1 reports the frequency of the different voting outcomes for each year. Although both failing votes and votes that closely fail (i.e., those that receive between 45% and 50% of the shareholder vote) are relatively rare, they are not confined to any particular subperiod of our ten-year sample period. However, beginning in 2004, there is a noticeable increase in the number of votes that just fail. 6. Results 6.1 Determinants of shareholder support Panel A of Table 3 reports the results of our analysis of shareholder support in years in which equity-based compensation plans are considered by shareholders. The first two columns examine the relations between % For Directors, the number of votes for a director divided by the sum of votes for that director and the votes withheld, and variables that capture firms compensation practices and predictors of expected compensation. Regardless of whether shareholder support for equity compensation plans considered at the same meeting is included in the analysis, we find little evidence that shareholders use votes on directors to express dissatisfaction with elements of the equity-based compensation plan under consideration. The last two columns of Panel A of Table 3 present results for % For Pay Plan, the number of votes for the equity compensation proposal divided by the voting base, which varies by firm, but generally equals the sum of votes for and votes against the proposal, or the sum of votes for, votes against, and abstentions. In both analyses, there is a clear negative relationship 18 We discuss below some possible consequences of failure of this assumption

19 between shareholder support for the equity plan and the two measures of shareholder dilution, Shares Requested and Shares Available, as well as Compensation Mix, which captures the percentage of pay that is not base salary. These results suggest that rather than shareholders express[ing] their dissatisfaction [with executive compensation] by withholding votes for directors (Cai, Garner, and Walkling, 2009), a more important channel though which shareholders express such dissatisfaction is their votes on equity compensation proposals Shareholder support in director elections and future compensation Prior research has argued that directors respond to lower levels of shareholder support by reducing CEO compensation levels in future periods. However, much of this research has focused on the relations between voting outcomes in director elections and measures of future compensation. For example, Fischer et al. (2009) examine the association between shareholder support in director elections, including elections in which the CEO is a director, and future excess compensation. They find weak evidence of a relation between some of their measures of shareholder support in director elections and future CEO compensation, but a stronger relation when they focus on elections involving the CEO. There are, however, two difficulties with this conclusion from their evidence. First, since formulating his or her own compensation package is unlikely to be a key function of the CEO, this particular voting outcome does not appear to be the correct one for examining shareholder support for the level and design of executive compensation at the firm. Second, it is difficult to draw conclusions about any causal relation between shareholder support and future compensation levels (or other outcomes examined by Fischer et al., 2009). For example, rather than directors adjusting CEO compensation in response to shareholder sentiment, it is instead possible that shareholder support is diminished by poor 19 Note that our analysis is limited to director elections at meetings where equity compensation proposals are also considered. It may be that, absent such proposals, shareholders express their dissatisfaction more clearly through director elections

20 CEO performance that is reflected in measures that are observed by both the board and shareholders, but only reflected in executive compensation with a lag. 20 Cai, Garner, and Walkling (2009) examine the relation between shareholder support in director elections and future changes in excess compensation, but limit their analysis to cases where excess CEO compensation prior to the vote is positive. They find significant relations when the director is a member of the compensation committee, but not for other members of the board or for all board members taken together. The lack of a result for all directors taken together is consistent with the results in Fischer et al. (2009) and those from our analyses below. One important observation is that Fischer et al. (2009) and Cai et al., (2009) both focus only on director elections. Our expectation is that the natural place for shareholders to express dissatisfaction with aspects of compensation is in votes that directly pertain to compensation. The results from our analysis of the determinants of shareholder support in Table 3 are consistent with this conjecture. For this reason, our primary analyses focus on shareholder votes on equitybased compensation plans. Nonetheless, given the focus of prior research on director elections, we also conduct analysis of director elections, but with a larger sample than was available to prior researchers. Table 4 reports the results of OLS regressions of various compensation-related outcomes on shareholder support for director elections. Prior research suggests that directors respond to lower levels of shareholder support by reducing future compensation. If directors, in fact, respond to shareholder sentiment, then we expect a positive association between shareholder support for directors, % For Directors, and measures or components of future CEO compensation, namely Cash Comp, Option Comp, and Total Comp, or future stock grants made 20 Note that this concern applies equally to the analyses we report in Table 4. For this reason, if we had found significant relations in these analyses, we would have interpreted these with caution and emphasized that only the results from the RDD analyses in Tables 6 and 7 lend themselves to a clear causal interpretation

21 to all employees of the firm, Options Granted. Other papers have also suggested that the sensitivity of pay to performance increases in response to lower levels of shareholder support. This argument predicts a positive coefficient on % For Directors when either Portfolio Delta, a measure of the sensitivity of the CEO s option portfolio to changes in firm value, or Comp Mix, the ratio of the CEO s annual variable pay to total annual pay, is the dependent variable. We also include as dependent variables Portfolio Vega, which proxies for the CEO s risk-taking incentives and is measured as the sensitivity of the CEO s equity-based portfolio to changes in the volatility of the firm s stock, and Options Ex able and Options Ex ed, which measure the aggregate number of options available and the aggregate number of options exercised, respectively. The Sample in Panel A of Table 4 consists of all director elections, and the results suggest that, if anything, future CEO compensation is decreasing in the level of director support. In particular, the second column indicates that the value of options granted to the CEO in the year following the director election (Option Comp t+1 ) is significantly negatively related to the percentage of votes for the director (coefficient of and t-stat of -5.20). In the third- and second-to-last columns, we also find that the total number of options exercised by all of the firm s employees and the total number of options granted to all of the firm s employees (Options Ex cized t+1 and Options Granted t+1, respectively) are significantly negatively related to shareholder support for directors. Finally, the final column indicates that CEO turnover in the year following the director election is negatively related to director support. Collectively, the results from this table are generally inconsistent with inferences from prior studies and suggest that, if anything, future CEO compensation and firm-level option exercise and granted is decreasing in director support. Moreover, if directors are responsive to shareholder sentiment, it

22 is through the indirect channel of CEO turnover. In Panel B of Table 4, we confine our sample to elections of only those directors who chair the firm s compensation committee. Our results are generally consistent with those in Panel A and reveal a negative and significant relationship between director support and the value of options granted to the CEO in the year following the director election (Option Comp t+1 ) and the total number of options exercised by all of the firm s employees and the total number of options granted to all of the firm s employees (Options Ex cized t+1 and Options Granted t+1, respectively). We also fail to find a significant relationship between director support and CEO turnover for this subsample of directors. In Panel C of Table 4, we consider the elections of all directors on the firm s compensation committee. The results are again generally consistent with those in the previous panels, except with also find a negative and significant relationship between director support and future CEO cash and total compensation (Cash Comp t+1 and Total Comp t+1, respectively). We also find a modest positive relationship between director support and CEOs equity portfolio incentives to increase stock price (Portfolio Delta t+1 ) in the next period. Collectively, the results from Table 4 provide little evidence that shareholder support for either firms directors as a whole (Panel A), compensation committee chairs (Panel B), or compensation committee members (Panel C) is reflected in future CEO incentives-compensation. 6.3 Shareholder support for equity-based compensation plans and future compensation Given the focus of our paper and the evidence on which type of votes provide a clearer indication of shareholder views of compensation, in our remaining analyses we focus on shareholder support in votes on equity compensation plans. We conduct two sets of analyses. The first set of analyses uses OLS regressions of future compensation-related outcomes, such as

23 cash and total CEO compensation, option grants to the CEO, and measures of the sensitivity of CEO wealth firm performance ( delta ) and risk-taking ( vega ), aggregate option grants, and the aggregate number of options exercised or outstanding Cross-sectional regression analyses We first estimate OLS regressions to examine the relations between shareholder support in director elections and votes on equity compensation plans and future compensation-related outcomes. Note that it is unclear exactly when compensation can be considered a future outcome relative to the meeting at which a shareholder vote occurred. Clearly compensation reported for the fiscal year ending prior to the proxy filing (which we label as year t 1) is not a future compensation outcome relative to the meeting following the filing. However, it is unclear whether compensation for the fiscal year that includes the meeting date, which we label year t, is a future outcome. Fischer et al. (2009) focus on compensation for the first year beginning after the meeting date, which we label year t + 1, due to concerns that compensation variables measured in year t might not capture the board s response to year t voting outcomes. 21 However, it seems that for several compensation components (bonus is perhaps the clearest case), directors would have some latitude to adjust pay levels in the year of the vote in response to shareholder support from the votes at the meeting. Furthermore, to the extent that directors are concerned about their reputational capital, if they do not adjust compensation for year t, then shareholders will not observe the changes in compensation until the proxy for year t + 2 is filed. 22 However, some elements of compensation (salary is an obvious example) may be set by the time of the proxy filing and shareholder meeting, and thus should not be affected by the voting outcomes at 21 Note that Fischer et al. (2009) label their variables slightly differently, with the meeting occurring after fiscal year t, being labeled as one relating to year t. 22 This assumes that the proxy filing is the primary channel for firms to communicate information about executive compensation. We are not aware of any empirical evidence on firms use of alternative channels to communicate information about executive compensation

24 the annual meeting. To allow for the ambiguity of the timing of effects on compensation, we consider both year t and t +1 realizations of the compensation variables we examine. Additionally, to allow for the possibility that there is some lag in the effect of shareholder votes, we also examine compensation in year t +2 relative to the meeting date. 23 Table 5 reports the results of OLS regressions of various compensation-related outcomes on shareholder support for equity compensation plans. Similar to our analysis of director elections, we expect a positive association between shareholder support, measured as % For Pay Plan, and Cash Comp, Option Comp, and Total Comp, or Options Granted. Again, prior research leads us to predict a positive coefficient on % For Pay Plan when either Port Delta or Comp Mix is the dependent variable. We also include Port Vega, Options Ex able and Options Ex cized as dependent variables. Panel A models contemporaneous incentive-compensation and aggregate options variables and the results reveal that there is a strong negative relationship between shareholder support for the pay plan in every specification, except Portfolio Delta t and CEO Turnover t, for which the relationship is insignificant and positive and significant, respectively. In addition, director support is insignificant in every specification except Comp Mix t, in which it is positive and marginally significant. Given the timing of the outcome variables in Panel A (i.e., measured during the fiscal year that includes the meeting date), these results are consistent with shareholders observing relatively high levels of CEO incentive-compensation, or high levels of aggregate options grants and exercises, and respond with lower support on the equity pay plan Of course, each of these arguments is equally applicable when examining the effect of votes on director elections on future compensation, such as our analyses in Table 4. Given our focus, and consistent with prior research, we limit our analyses of director elections to compensation measures in t + 1; however, we obtain similar results when we examine measures of compensation from periods t or t Recall that including both the lagged value of the dependent variable and the additional determinants as control variables, these specifications can be viewed as models of excess incentive-compensation and excess aggregate option exercises and grants