In 2008 only 6 percent of the German corporations listed in the Prime Standard seg-ment of the Frankfurt Stock Exchange generated positive shareholder value, but 90 percent of the executives in these firms received bonus payments.1 This is surpris-ing because bonus payments are supposed to reflect managerial performance. Bonus payments without shareholder value creation raise the question whether compensa-tion is related to firm performance at all.
We collect compensation data from German annual reports and study the rela-tionship between firm performance and annual executive compensation, including bonus payments, during 2005-2009. Unlike previous studies, we use detailed infor-mation on the structure of executive compensation in Germany, which is available since 2005. We can identify which payments are predetermined and fixed (base salary) and which are meant to vary with performance (bonuses). We also have information about the grant-date values of stock and option grants. Based on this data we investigate how sensitive these annual payments or grants are to the firm’s stock market performance and accounting performance.2
In our analysis we control for firm risk which was shown to have an impact on pay-performance sensitivity in U.S. firms (Aggarwal and Samwick, 1999). Moreover, we study two distinct characteristics of the German corporate governance system: Con-centrated ownership and employee representation. We investigate whether Bertrand and Mullainathan’s (2000) finding for U.S. firms that the relation between firm risk and pay-performance sensitivity only holds for firms with a large shareholder also holds for Germany. Finally, we analyze whether German executive compensation is influenced by employee representation on the supervisory board. This board over-looks the executive board and has the final say on executive compensation. Since up to one half of the board members represent employee interests and not shareholder interests, supervisory board composition is a potentially important factor to explain
1Own calculation from data in annual reports.
2We do not analyze the relation between firm performance and executive wealth in the form of company stock or option holdings. Data on executive wealth is not readily available in Germany.
However, the relation between direct annual compensation and firm performance is of particular interest in the political debate about executive compensation. Unlike changes in executive wealth, regulators can target this annual flow of compensation, because it is under the control of the board of directors or the firm’s compensation committee (Kaplan, 2012). Other studies that explicitly abstract from changes in executive wealth and study direct, annual or ”flow compensation” include Perry and Zenner (2001) and Aggarwal and Samwick (1999).
executive compensation in Germany.3
We are not the first to study executive compensation in Germany, but our study is the first to estimate pay-performance sensitivities for individual compensation components such as cash bonuses. Early studies on German executive compen-sation such as Schwalbach and Graßhoff (1997), Kraft and Niederpr¨um (1999) or Elston and Goldberg (2003) analyze aggregated compensation data. Most of these studies identify a positive relation between total executive compensation and some accounting-based measure of firm performance. For the recent time period 2005-2007, however, Rapp and Wolff (2010) find a rather low sensitivity of total executive compensation to stock performance, and, unlike earlier studies, an insignificant or even negative relation between total executive compensation and accounting perfor-mance. Hence bonus payments without shareholder value creation in 2008 may be due to German executive compensation being linked to accounting rather than stock performance, as suggested by evidence from earlier studies. On the other hand, the results of Rapp and Wolff (2010) suggest that German executive compensation has become less related to accounting performance in recent years. This conflicting evi-dence motivates us to analyze the individual compensation components separately to clearly identify whether bonus payments in Germany are determined by accounting or stock performance or not related to firm performance at all.
For Germany, the relationship between firm risk and pay-performance sensitiv-ity has not been documented since data has become available for individual ex-ecutives and compensation components. Based on aggregated compensation data and for manufacturing firms only, Kraft and Niederpr¨um (1999) find support that risk has an impact on pay-performance sensitivity in Germany during 1987-1996.
Moreover, the impact of concentrated ownership on the relation between firm risk and pay-performance sensitivity has never been investigated for Germany where most firms are controlled by a large shareholder in the sense of Bertrand and Mul-lainathan’s (2000) definition of an investor holding more than five percent of equity.
Finally, we contribute to the small literature on employee representation and exec-utive compensation in Germany. We are aware of two other studies on this subject.
Gorton and Schmid (2004) and Edwards et al. (2009) study the effect of employee representation4 on pay-performance sensitivity based on aggregated compensation
3German codetermination law requires 33 percent employee representation on the supervisory board in corporations with more than 500 but less than 2,000 employees, and 50 percent employee representation in firms with more than 2,000 employees.
4They compare executive compensation in firms with 50 percent and 33 percent employee
data from the early 1990s. We are the first to provide additional evidence since disclosure of compensation components for individual board members has become mandatory. This new data allows us to investigate the impact of supervisory board employee representation on granting different compensation components and on the pay-performance sensitivity of individual compensation components.
In contrast to Rapp and Wolff (2010), we find no relation between stock perfor-mance and total executive compensation. As suggested by the cited evidence for 2008, the analysis of compensation components reveals that this also holds for cash bonus payments and long-term compensation such as company stock and option grants. However, whereas long-term compensation turns out to be granted also in-dependent of accounting performance, we find that bonus payments are significantly related to firm earnings. This suggests that bonus payments in 2008 were not un-justified, but in Germany performance evaluation for cash bonus payments builds on accounting performance and not on stock performance.
We offer two explanations for this finding. First, German corporate culture is less focused on the stock market, because for German firms banks are a more im-portant source of funds than capital markets. Second, German codetermination law transfers part of the control rights from shareholders to employee representatives who may have different objectives than shareholder value maximization. In fact, unlike in the full sample we find evidence for a positive relation between executive compensation and stock market performance in firms with low employee represen-tation. In such firms the sensitivity of compensation to accounting performance is generally lower than in firms with higher employee representation on the supervi-sory board. Hence unlike Edwards et al. (2009), we identify a significant impact of employee representation on the sensitivity of executive compensation. Gorton and Schmid (2004) estimate that the relation between executive compensation and firm performance is positive in firms with low employee representation, but negative in firms with high employee representation. Our findings suggest that pay-performance sensitivity with respect to accounting performance is positive in both representation regimes, but higher in firms with high employee representation.
Moreover, similar to Kraft and Niederpr¨um (1999) for manufacturing firms, we also find in our broader sample that pay-performance sensitivities are lower in firms with higher firm risk measured by the variance of accounting performance. More
representatives on supervisory boards.
importantly, we also find a negative effect of ownership concentration on compen-sation levels, but no effect of ownership concentration on the relationship between pay-performance sensitivity and firm risk, as documented by Bertrand and Mul-lainathan (2000) for U.S. firms.
The remainder of this chapter is structured as follows. In the next section we briefly review the related literature. We describe our self-collected dataset and present some summary statistics in section 3. In section 4 we derive our hypotheses and introduce our estimation methodology. Section 5 presents the main results of our analysis. In section 6 we show some robustness checks. We conclude in Section 7.