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Do Compensation Committee Members Perceive Changing CEO Incentive Performance Targets Mid-Cycle to be Fair?

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Abstract

We examine the influences of social capital, source credibility, and fairness perceptions on the judgments of experienced compensation committee (CC) members who are considering a proposal to reduce management’s performance targets in the middle of a compensation cycle due to difficult circumstances. Eighty-nine U.S. public company CC members participated in a 2 × 2 experiment with social capital and source credibility each manipulated as low or high, and outcome fairness to management, process fairness to shareholders, and outcome fairness to shareholders included as measured variables. While social capital and source credibility are not significant, we find that outcome fairness to the CEO and outcome fairness to shareholders are significantly related to CC members’ support for reducing performance targets during a compensation cycle. In addition, we find that more experienced CC members are less supportive of changing the performance targets. The significant interactions include one between outcome fairness to shareholders and process fairness to shareholders, which suggests that CC member support for the proposal relies on both process and outcome fairness being present. Finally, the participants’ qualitative responses reflect arguments both for and against adjusting performance targets. Overall, the results highlight the important roles of fairness and director experience in boardroom decisions and provide important insights into factors affecting CC judgments.

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Notes

  1. We define social capital consistent with Lin (2001, p. 30) as “an investment in social relations with expected returns.”

  2. In the Results section, we note that process fairness to shareholders is significant if the outcome fairness variables are excluded from the model, suggesting that process fairness is subordinate to outcome fairness (i.e., individuals consider the fairness of the process only when the outcome of the judgment is deemed unfair; see Lind et al. 2001).

  3. The Dodd–Frank Act requires periodic, non-binding shareholder votes on executive pay of the CEO and CFO and three other most highly paid executives as part of the proxy process.

  4. The Economic Policy Institute compensation amounts are presented in 2011 dollars.

  5. As discussed below, our model includes an interaction term (SOCIAL CAPITAL x SOURCE CREDIBILITY), but we do not have a theoretical basis to predict such an interaction. Also, we conduct additional analyses to identify other possible interactions among independent variables.

  6. A limited portion of the case language is from earlier work (Bierstaker et al. 2012), as well as a few actual public companies’ compensation-related disclosures. Some case questions are from earlier work (e.g., Bierstaker et al. 2012).

  7. The variables (SUPPORT, OUTFAIRCEO, PROCFAIRSHARE, and OUTFAIRSHARE) were, consistent with Bierstaker et al. (2012), measured by having the participants place a slash on an unnumbered scale with labeled endpoints (e.g., not likely and very likely, very unfair and very fair), and we convert the slashes to 0-100 values.

  8. We narrowed our sample of potential compensation committee members to those serving in retail, wholesale, and light manufacturing industries, as those industries are most similar to the industry in the background information of our experimental case.

  9. We used a three-year sample period ending December 2010 in Audit Analytics to identify potential public company compensation committee members. We used a three-year period, as most public company boards appoint members to three-year terms, and we wanted to avoid duplications in our sample. We ended our period in December 2010, in an effort to avoid having participants who were very recently appointed to the board/CC and may not have actually participated in a CC meeting.

  10. This response rate is far above some other recent director studies (e.g., Bierstaker et al. 2012) that did not use Internet searches to find the primary business or home address of directors.

  11. In addition, we ran the ANCOVA model including participants who failed the manipulation check but had complete responses (n = 100). The results are qualitatively similar to those presented in Table 3. Specifically, OUTFAIRCEO has p < 0.001, OUTFAIRSHARE has p = 0.084, and CCEXP has p = 0.016.

  12. In addition, we ran the ANCOVA model adding the variables UNDERSTANDABLE, REALISTIC, and CHALLENGING. None of these variables is significant.

  13. When added (one at a time) to the model in Table 3, controls for age, gender, education, CPA status, audit committee service, nominating and governance committee service, company revenue (largest public company currently served), and regulated industry (largest public company currently served) are not significant. Also, five participants do not currently serve on a CC, but have served on several public company CCs in the recent past (1, 2, 3, 3, and 10 total committees ever served, respectively). These participants can be deleted from the sample with results consistent with those in Table 3 (OUTFAIRCEO has p < 0.001, OUTFAIRSHARE has p = 0.037, and CCEXP has p = 0.011).

  14. Despite the significant correlations, if we use a regression approach, the Variance Inflation Factors (VIFs) on all the variables are 3.8 or below, indicating that multicollinearity is not an issue.

  15. Due to the presence of heteroskedasticity (p = 0.036 using Breusch-Pagan/Cook-Weisberg test), we ran a sensitivity test using the ranks of SUPPORT as the dependent variable (Conover and Iman 1982; Shirley 1981). The results are similar using ranks as the dependent variable (OUTFAIRCEO has p = 0.001, OUTFAIRSHARE has p = 0.095, and CCEXP has p = 0.018).

  16. We report all p-values related to the ANCOVA as two-tailed.

  17. OUTFAIRCEO has a coefficient of −0.595, and OUTFAIRSHARE has a coefficient of 0.282.

  18. We also test whether the three fairness variables are affected by the two manipulated variables (e.g., does process fairness to shareholders vary depending on the level of social capital and source credibility?), using three ANOVA models (Fairness variable = f (SOCIAL CAPITAL, SOURCE CREDIBILITY, SOCIAL CAPITAL x SOURCE CREDIBILITY). None of the three models is significant (p > 0.10 in each case).

  19. The coefficient for CCEXP is −16.029.

  20. If we measure experience as the log of the number of CCs ever served in the participant’s career, then this variable has p = 0.037. If we measure experience as the number of CCs currently served, then this variable is not significant (p = 0.168).

  21. We also ran the model without the insignificant control variables (EVERCONSIDER and CEOEXP), and the results are similar to those in Table 3. Specifically, OUTFAIRCEO has p < 0.001, OUTFAIRSHARE has p = 0.032, and CCEXP has p = 0.007.

  22. We performed a t test to determine if the means of SUPPORT are different between the low social capital and high social capital groups when OUTFAIRCEO is low (<median of 80). There is not a significant difference between groups (p = 0.320).

  23. This effort to identify key themes is a higher-level (i.e., more global) analysis than performing detailed coding of responses to each individual question and tabulating frequencies and inter-rater agreement. Our purpose was to provide evidence of the “main messages” contained in the qualitative responses, considering the open-ended questions collectively. Our approach is consistent with qualitative studies (e.g., Hermanson et al. 2012) that focus on major themes emerging from the data.

  24. The quotes fit into the themes as follows: theme #1 (23 %), theme #2 (20 %), theme #3 (28 %), and theme #4 (5 %). The other quotes do not fit into one of the four themes.

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Acknowledgments

This paper is based on the first author’s dissertation at Kennesaw State University. We thank two anonymous reviewers, Doug Boyle, Todd DeZoort, Audrey Gramling, Travis Holt, Gary Monroe, James Tompkins, Greg Trompeter, and Arnie Wright, as well as workshop participants at Kennesaw State University, Middle Tennessee State University, and the University of Tennessee at Chattanooga for their helpful comments on the case materials and/or paper, and we thank the participating compensation committee members for their time. Finally, we appreciate the support of Joe Mallin at Pearl Meyer & Partners.

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Authors and Affiliations

  1. University of Tennessee at Chattanooga, Chattanooga, USA

    Anne M. Wilkins

  2. Kennesaw State University, Kennesaw, USA

    Dana R. Hermanson

  3. Boston College, Chestnut Hill, USA

    Jeffrey R. Cohen

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  1. Anne M. Wilkins
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  2. Dana R. Hermanson
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Corresponding author

Correspondence to Dana R. Hermanson.

Additional information

“When measuring top executives’ performance for pay purposes, the company [Walmart] says it makes various “adjustments” to its recorded financial results. In 2014, those adjustments resulted in better performance than reported in the audited statements. That enhanced performance meant higher incentive pay for executives” (Morgenson 2014).

Appendix

Appendix

Excerpt of Case Materials

Company and Industry Background

Lessco Products, Inc. is a mid-size publicly traded retail company in the consumer products industry, with prior year annual revenues of $650 million. Lessco’s primary customers are middle to upper income consumers in the United States. The industry is very competitive, and availability, reliability, price, and customer service are primary competitive factors. Up until last year, the company maintained solid revenue growth of 4–6 % per year. Consistent with some others in the consumer products industry, Lessco experienced economic challenges during the first two quarters of last year, which limited revenue growth; however, the economy began to stabilize in the third and fourth quarters of last year, allowing the consumer products industry’s (and Lessco’s) economic outlook to improve somewhat for the current year.

Compensation Philosophy and Objectives

The Compensation Committee of the Board of Directors is responsible for administering the Company’s executive compensation program. The Committee’s philosophy emphasizes pay for performance with compensation objectives that support the Company’s strategic plan by:

  • Providing above average compensation relative to industry peers for above average overall performance and below average compensation relative to industry peers for below average performance.

  • Rewarding success in achieving performance goals.

  • Ensuring Lessco’s reputation as a premier retail organization that demonstrates best practices in business and operations to sustain and enhance our corporate success.

The compensation program for the CEO consists of a competitive base salary, annual incentive bonus, long-term incentives, benefits, and limited perquisites. Lessco’s operating results and CEO compensations typically have been comparable to industry averages. Consistent with industry practice, the CEO’s compensation is composed of 20 % annual salary, 30 % performance-based incentive bonus, and 50 % long-term incentive pay (including performance-based restricted stock and stock-settled stock appreciation rights). The performance-based bonus is based on achieving operating profit and earnings per share (EPS) targets. These operating profit and EPS performance targets are set before the beginning of the fiscal year. Lessco’s other top executives have a similar mix of compensation elements, which consists of a competitive base salary, annual incentive bonus, long-term incentives, benefits, and limited perquisites.

The compensation program is designed to attract, reward, motivate, and retain high-quality talent who share and execute the board’s vision for success. Lessco’s top management team, which includes the CEO, CFO, and Executive Vice President, has been stable in recent years and has a positive relationship with the Board of Directors.

Your Compensation Committee

Consistent with regulations, the Compensation Committee only has independent directors as members. The Committee is composed of three members, and it meets face-to-face four times per year and holds three conference calls per year. All of the Committee members were identified as nominees for the Board by an independent search firm [ the Company’s CEO ].

Current Year Executive Compensation Issue

Five months into the current year, another Compensation Committee member similar in experience to you [ the CEO of Lessco ] met with the Compensation Committee Chair about the Company’s expected annual performance. The Compensation Committee member [The CEO] was concerned that the Company would not meet its current year operating profit and earnings per share performance targets due to significantly greater than anticipated charges related to a reduction in workforce and the closing of several underperforming stores. Some other companies in the industry also reduced their workforce and closed underperforming stores. Several board members are of the opinion that management should analyze workforce size requirements and underperforming stores on an ongoing basis.

The Compensation Committee member [The CEO] is concerned that unless the operating profit and earnings per share targets are adjusted downward for these additional expenses, his top management team will not be properly motivated to achieve strategic and management goals for the rest of the year. The Compensation Committee member [The CEO] recommends that the targets be reevaluated (reduced) based on the additional charges. The executive bonus plan allows the Compensation Committee, at its discretion, to adjust (either increase or decrease) its executive bonus performance targets due to extraordinary circumstances.

Decision for the Compensation Committee

The Chair of the Compensation Committee has brought to the Committee the Compensation Committee member’s [ the CEO’s ] request to revise downward the executive bonus performance targets for the current year due to greater than anticipated reduction in workforce and store closing costs.

The questions that follow refer to the proposal to adjust the performance targets downward. Recall, the executive bonus plan allows the Compensation Committee, at its discretion, to adjust (either increase or decrease) its performance targets due to extraordinary circumstances.

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Wilkins, A.M., Hermanson, D.R. & Cohen, J.R. Do Compensation Committee Members Perceive Changing CEO Incentive Performance Targets Mid-Cycle to be Fair?. J Bus Ethics 137, 623–638 (2016). https://doi.org/10.1007/s10551-015-2567-7

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