1.4.1 Hypotheses for German Compensation
In this section we develop hypotheses about executive compensation in Germany.
We expect that the positive relation between executive compensation and firm per-formance, which is well documented for Anglo-Saxon firms, also holds for German firms. Firm owners link executive compensation to firm performance in order to mitigate agency problems and align management interests with their own. This implies a positive sensitivity of executive compensation to firm performance (pay-performance sensitivity).
Contracting theory suggests that firms choose performance measures based on their informativeness about the manager’s effort.20 Whether accounting perfor-mance or stock perforperfor-mance is the more informative perforperfor-mance measure is not obvious, ultimately this is an empirical question. However, two features of the Ger-man corporate governance system suggest that stock perforGer-mance is not the decisive performance measure for executive compensation in Germany: (1) Compared to the Anglo-Saxon world, German corporate culture is less focused on the stock market21, and (2) German corporate control is organized as a stakeholder system in which not only shareholders influence management decisions but also the interests of employees are represented in a supervisory body.
First, in the literature it is argued that German corporate culture is less focused on the stock market, because for German firms debt financing through banks is a more important source of funds than the capital market.22 Banks only offer funding to firms which have sound earnings and are likely to repay their debt. We expect that the importance of earnings is also reflected in compensation contracts. This suggests that executive compensation is linked closer to accounting performance than to stock market performance.
Second, in the German two-tier corporate control system the members of the separate supervisory board, which is supposed to control the executive board, are only partially shareholder representatives. German codetermination law follows the
20See Holmstrom and Milgrom (1987, 1991), Lambert and Larcker (1987) or Bushman and Indjejikian (1993).
21For an extensive analysis of German corporate governance with less shareholder orientation and more bank influence than in the Anglo-Saxon system, see J¨urgens et al. (2000) or Vitols (2004).
22See Chirinko and Elston (2006) for a critical discussion of the role of bank influence and funding in the German economy.
idea that firm owners and employees run the firm collectively (Gorton and Schmid, 2004) and assigns part of the seats on the supervisory board to employee representa-tives.23 Since the supervisory board has the final say about executive compensation in German firms24, this particularity of corporate control should be reflected in compensation contracts. Employee representatives on German supervisory boards possibly have different objectives than shareholder representatives (see also Gor-ton and Schmid (2004)). We suppose that their main interest is not shareholder value maximization but job security and wages of employees below top manage-ment. Hence we do not expect employee representatives to opt for a tight link between top management compensation and performance measured by shareholder value creation.
Instead, we argue that employee representatives are more concerned with firm earnings. In Germany, the dominant form of employee participation are profit shar-ing schemes and not employee ownership programs. Whereas in the U.S., about one-fifth of American employees hold stock in the company in which they work (see Kruse (2002)), German survey data indicates that one quarter to one third of firms let employees participate in firm earnings, but only around 5 percent report employee stock ownership programs.25 For example, in 2007 German automakers let employees participate in their strong profits by making cash bonus payments at the end of the year. Employees at Daimler received an average payment of 3,750 Euro, their colleagues at BMW 5,600 Euro and Volkswagen employees received a bonus payment of 3,700 Euro. The labor agreement from 2006 between Volkswagen and its employees explicitly states that employees receive 10 percent of operating profits as bonus payments. Hence we expect employee representatives on German supervisory boards to favor a strong link between top management compensation and firm profits instead of stock returns, because they are more interested in sound
23For details on the codetermination rules also see the discussion of Hypothesis 4.
24The duties and responsibilities of the supervisory board in deciding on executive compensation are governed in ’§87 Aktiengesetz’ and in ’4.2.2 German Corporate Governance Code’ from 2002.
The latter has been revised several times with the latest version being from May 2010. Also ’§87 Aktiengesetz’ was revised in 2009 to make the supervisory board’s duties and responsibilities for executive compensation more explicit.
25The ”IAB-Betriebspanel”, a survey by the Federal Employment Agency, reports for the year 2005 (2009) profit sharing programs in 28 (26) percent of the firms with 205-499 employees, and in 34 (35) percent of the firms with more than 500 employees. Employee stock ownership programs were much less frequent with 4 and 7 percent, respectively, in the two firm categories and in both years. Survey results are published in Bellmann and M¨oller (2006, 2011).
firm earnings than in shareholder value creation.26
We summarize the discussion on the importance of accounting-based and stock market-oriented performance measures in our first hypothesis.
Hypothesis 1: Accounting performance is the main performance measure for exec-utive compensation in German corporations.
Our second hypothesis pertains the nature of pay-performance sensitivity. Holm-strom and Milgrom (1987, 1991) argue that pay-performance sensitivity is decreasing in firm risk. In their model risk-averse managers demand compensation for the risk transfer in performance-related compensation. Hence pay-performance sensitivity is lower in (riskier) firms with higher performance volatility.
Many studies test this theoretical result empirically, but only some find sup-port. Prendergast (2002) gives a summary of the empirical evidence on the link between pay-performance sensitivities and risk. He develops a model where risk has a positive impact on pay-performance sensitivity. He argues that firms in uncer-tain environments delegate more responsibilities to managers, because shareholders are less certain about the optimal firm strategy. To constrain managerial action to performance-enhancing activities, shareholders relate management compensation stronger to performance.
Hence theoretical models allow for the impact of risk on pay-performance sensi-tivities to be positive or negative. Empirical studies also deliver mixed findings for this relation. As a result we only hypothesize pay-performance sensitivity is related to firm risk and make no prediction about the sign of this relation.
Hypothesis 2: The sensitivity of German executive compensation to firm perfor-mance is influenced by the riskiness of the firm.
The next hypothesis pertains the influence of ownership structure on execu-tive compensation. Execuexecu-tive compensation is the result of a bargaining process between firm owners (or their representatives on the supervisory board) and exec-utives. Previous research suggests that concentrated ownership has an impact on executive compensation. Concentrated ownership refers to the presence of strong owners who hold a significant fraction of voting rights. Elston and Goldberg (2003), Kraft and Niederpr¨um (1999), Haid and Yurtoglu (2006) and Rapp and Wolff (2010)
26If employee bonus payments are 10 percent of operating profit, firm earnings after such pay-ments and operating profits are still highly correlated.
find that executives at German firms with a concentrated ownership structure earn less than their peers at firms with more dispersed ownership. This finding is ex-plained with the view that strong owners set executive pay, whereas executives pay themselves by manipulating the compensation committee in firms with dispersed ownership (Bertrand and Mullainathan, 2000). This leads to our third hypothesis:
Hypothesis 3: German executives earn less at firms with a more concentrated ownership structure.
Finally, we investigate the influence of employee representation on executive compensation. German codetermination law requires employee representation on the supervisory board for firms with more than 500 employees. One third of the supervisory board members are employee representatives in these firms. When firms have more than 2,000 employees the share of employee representatives is one half of the supervisory board members. If employee representatives on the supervisory board can influence executive compensation, there should be differences in compen-sation between firms with different degrees of employee representation. We first discuss the potential impact of employee representation on long-term compensation and then turn to the link between employee representation and pay-performance sensitivities.
Employee representation may explain why long-term oriented compensation ac-counts for a relatively small share of executive compensation in Germany.27 Long-term compensation consists of company stock, options or company-specific long-term incentives (LTIs) with payouts related to future stock price developments. If employee representatives are less interested in stock returns than shareholder repre-sentatives, then they are unlikely to opt for granting the top management company stock, options or LTIs. This suggests that, ceteris paribus, more employee repre-sentation on the supervisory board should be related to lower long-term compensa-tion.28
Hypothesis 4a: A higher share of employee representation on the supervisory board is related to a lower long-term oriented executive compensation.
27The share of long-term compensation in total compensation of executives in our sample is 11-15 percent, whereas this share is typically 40 percent or more for U.S. executives, see for example Bebchuk and Grinstein (2005) or Fernandes et al. (2013).
28Alternatively, higher employee representation may imply that a lower share of total compen-sation is granted as long-term compencompen-sation.
We argued that employee representatives favor accounting-based performance measures (Hypothesis 1). This should also be visible in pay-performance sensi-tivities. A higher fraction of supervisory board members representing employees is equivalent to a higher fraction of board members who prefer a strong link be-tween executive compensation and accounting performance, and a lower fraction of board members who represent shareholder interests and prefer a strong relation be-tween compensation and stock market performance. This should be visible in higher accounting pay-performance sensitivities and lower stock market pay-performance sensitivities in firms with higher employee representation.
Hypothesis 4b: Executive compensation is more sensitive to accounting perfor-mance and less sensitive to stock market perforperfor-mance in firms with a high share of employee representatives on the supervisory board than in firms with a low share of employee representatives.
1.4.2 Estimation Methodology
We estimate the sensitivity of manager compensation with respect to firm perfor-mance with a panel regression model of executive pay on firm perforperfor-mance and firm risk. In the first specification, executive pay is the total compensation of executive i at firm j in year t and denoted by wijt. The firm performance measure, denoted byπjt, is either the annual stock return or EBIT of firm j in year t. As a measure for firm risk we use the variance of stock returns (EBIT) measured over 3 (10) years prior to yeart and denoted byσjt2. We follow Aggarwal and Samwick (1999) in that we standardize the risk measure by using a rank measure Rank(σjt2). This measure is calculated as the rank ofσjt2 divided by the number of observations in our sample.
All regressions include executive fixed effects to control for executive-specific characteristics which we do not observe although they may have explanatory power for compensation, e.g. biographical variables (age, tenure, education) or bargaining power. Hence we specify the following linear fixed effects model:
wijt =γ1πjt +γ2Rank(σjt2)πjt+γ3Rank(σjt2) +λi+µt+ijt, (1.1) where λi is an executive fixed effect, µt is a year dummy, and ijt is the error term. Note that by using the rank measure we ensure that our estimates of γ2
are not affected by a possible relationship between our risk measure and the level
of compensation.29 Moreover, we do not include control variables such as board size, ownership structure or industry which are (almost) time invariant during the relatively short sample period. Since no executive moves from one firm to another during this period, such (almost) time-invariant differences in the cross section are captured by executive fixed effects. There should be little variation over time in firm size either, but we confirm the robustness of the basic estimation results by adding firm size as a control variable in separate regressions.
The estimated coefficients γ1 and γ2 can be transformed into pay-performance sensitivities at any percentile of the distribution. The pay-performance sensitivity for a manager employed by a firm with given risk is γ1 +γ2Rank(σjt2). Thus the pay-performance sensitivity at the firm with median risk isγ1+γ20.5, and the pay-performance sensitivities at firms with the minimum and maximum observed risk levels (Rank(σjt2) values of zero and one) are γ1 and γ1+γ2, respectively.