1.4 Hypothesis Development and Methodology
1.5.5 Executive Compensation and Employee Representa- Representa-tionRepresenta-tion
We investigate potential effects of supervisory board employee representation on executive compensation with respect to (1) long-term compensation and (2) pay-performance sensitivity. We start with the impact of employee representation on long-term compensation (Hypothesis 4a). We create two dummy variables for firms with zero and 33 percent employee representation. We estimate equation (1.1) with the two dummy variables as additional regressors, industry fixed effects42 and with long-term compensation or the ratio of long-term to total compensation as the dependent variable. This regression shows no significant relation between long-term compensation and the two dummy variables indicating zero and 33 percent employee representation, respectively (not reported).
41Note that this does not imply that the pay-performance sensitivities are identical in subsamples with and without a strong owner holding 25 (or 50) percent. Not only compensation levels but also pay-performance sensitivities are lower when strong owners with a 25 (50) percent ownership stake are present (this confirms the findings of Kraft and Niederpr¨um (1999)), but the negative relation between firm risk and pay-performance sensitivity does not depend on the presence of such strong owners.
42Similar to the ownership dummy variable, these dummy variables would be absorbed by firm or executive fixed effects, because no firm changes representation status over the sample period.
However, because employee representation is a function of the number of em-ployees, this approach may be unsuitable to separate the effect of employee repre-sentation from the effect of firm size on executive compensation. To mitigate this empirical identification problem, we use a matching procedure to construct subsam-ples of firms which differ with respect to employee representation on the supervisory board, but not in average firm size measured by total assets.43 In particular, we compare two sets of firms. First, we compare firms with below 50 percent (i.e. 0 or 33 percent) employee representation on the supervisory board and firms with 50 percent employee representation. Second, we compare firms with 33 percent em-ployee representation and firms with 50 percent emem-ployee representation. For both comparisons we create subsamples containing an equal number of firms with low employee representation (0 or 33 percent in the first setup, and 33 percent in the second setup) and high representation (50 percent in both setups). We create these subsamples by matching two firms that are similar in terms of total assets, but differ with respect to employee representation. For each firm in the group with lower em-ployee representation (i.e. 0 or 33 percent in the first, and 33 percent in the second setup), we search for the firm in the much larger pool of 50-percent representation firms which is closest in terms of total assets.44 A test on differences in means shows that in both setups on average firms with low and high employee representation do not differ in terms of firm size measured by total assets.
We include all executives of the matched firms in the subsamples for the two comparison setups and reestimate equation (1.1) for long-term compensation as the dependent variable and with the dummy variables indicating lower employee representation in the two subsamples. We still do not find any significant impact of supervisory board employee representation on long-term compensation (not re-ported).45 Hence, we do not find support for Hypothesis 4a.
Next we turn to the effect of supervisory board employee representation on pay-performance sensitivity (Hypothesis 4b). Again a straightforward test of Hypothesis
43Firms in the subsamples differ in the average number of employees and thus employee repre-sentation on the supervisory board, but not in average firm size measured by total assets. Hence we make use of the fact that there are firms in the sample that are of similar size in terms of total assets, but differ in the number of employees such that they fall into different categories of required employee representation on the supervisory board.
44We require that total assets of the two matched firms differ at most by a factor of 1.5. If no such match is found, we drop the firm from the analysis.
45There is also no significant impact of employee representation on the fraction of executive compensation that is granted as long-term compensation, measured as the ratio of long-term compensation to total compensation.
4b in the full sample would be to interact the performance measures EBIT and stock return with dummy variables indicating the degree of employee representation. How-ever, similar to compensation levels, pay-performance sensitivity may vary with firm size. A dummy variable indicating the degree of employee representation then fails to separate this size effect and a potential employee representation effect. Instead we base the analysis on the two matched subsamples and estimate equation (1.1) with firm fixed effects and interaction terms between firm performance measures and a dummy variable indicating lower employee representation in each setup.46
The results are presented in Table 1.10. Columns 1 and 2 show regression re-sults with total compensation and cash bonuses as dependent variables, respectively, which are based on the subsample containing firms with 50-percent employee repre-sentation and firms with 0 or 33 percent employee reprerepre-sentation on the supervisory board. Columns 3 and 4 show the corresponding results for the subsample contain-ing firms with 50 percent and 33 percent employee representation. Again we find no robust determinants of long-term compensation and skip the regression results.
The coefficient of the interaction term between EBIT and the low-representation dummy47is negative in all specifications, and significant in three out of four (it is not significant in the cash bonus regression for the sample containing only 50-percent and 33-percent representation firms, last column of Table 1.10). The coefficient of the interaction term between stock return and the low-representation dummy is pos-itive in all specifications, and again significant in all specifications but the last one.
These results are supportive to Hypothesis 4b. They suggest that pay-performance sensitivity based on EBIT is higher in firms with 50-percent employee representation than in firms with less employee representation on the supervisory board. Moreover, stock returns determine executive compensation in firms with low employee repre-sentation, but not in firms with 50-percent employee representation. Since the vast majority of firms in our full sample are of the latter type, we did not identify stock returns as a significant determinant of average executive compensation in the full
46Calculating pay-performance sensitivities does not require the coefficient estimate of the em-ployee representation dummy itself. Hence we can include fixed effects on the firm level which capture the employee representation effect on compensation levels. Executive-level fixed effects are unfeasible because the matching procedure does not guarantee that we include executives in consecutive years into our subsamples. Firm fixed effects also control for industries and other firm-level differences between firms with lower and higher employee representation.
47The low-representation dummy itself drops out in a regression with firm-fixed effects, because no firm in our matched subsamples changes from low representation to 50-percent representation status or vice versa.
sample. We conclude that more employee representatives on the supervisory board indeed shift performance-related executive compensation away from stock returns and towards accounting performance.
The proper separation of size and employee representation is a critical issue in this analysis. The number of employees not only determines employee representa-tion, it is also an indicator for firm size. However, a potential size effect in the dummy variable biases the results against finding the effects postulated in Hypothe-ses 4a and 4b. First, consider Hypothesis 4a. The summary statistics in Tables 1.2 to 1.4 show that small firms grant lower long-term compensation than large firms. Smaller firms have less employee representation, but Hypothesis 4a states that firms with less employee representation grant more long-term compensation.
If our dummy is to some extent a small firm dummy, this may offset the employee representation effect. Our results suggest that the employee representation effect is either not there or that it is too weak to dominate a potential size effect. Now consider Hypothesis 4b. Assume that the dummy fails to identify employee rep-resentation status and (at least to some extent) measures firm size instead. This implies that the dummy represents small firms, which according to Cichello (2005) have higher pay-performance sensitivities than large firms.48 Hence, if the dummy captures firm size rather than employee representation status, it should have a pos-itive sign. Our results show a negative sign for the dummy variable, which implies that the employee representation effect is strong enough to outweigh the potential size effect.