Corporate Control and Management Compensation: Evidence on the Agency Problem

Corporate Control and Management Compensation: Evidence on the Agency ProblemAuthor(s): Edward A. DylSource: Managerial and Decision Economics, Vol. 9, No. 1 (Mar., 1988), pp. 21-25Published by: WileyStable URL: http://www.jstor.org/stable/2487689 .

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MANAGERIAL AND DECISION ECONOMICS, VOL. 9, 21-25 (1988)

Corporate Control and Management Compensation: Evidence on the Agency Problem

EDWARD A. DYL Professor, Department of Business Administration, University of Wyoming, USA

This paper finds a relationship between management compensation and corporate control consistent with the hypothesis that in closely held companies major shareholders engage in monitoring activities that reduce the residual loss portion of agency costs. This result is incosistent with Fama's (1980) suggestion that the wage determination process in managerial labor markets may resolve the agency problem.

INTRODUCTION

The agency problem caused by the separation of ownership and control in large corporations has been discussed by numerous researchers interested in the corporate form of organization, ranging from the early work of Adam Smith (1776) and Berle and Means (1932) to the publications of Jensen and Meckling (1976) and Fama (1980). Jensen and Meckling (1976, 308) define an agency relationship as '... a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent'. The agency problem arises because the agent may not always act in the best interests of the principal. This possibility gives rise to agency costs, which may include monitoring costs incurred by the principal to limit the discretionary behavior of the agent, bonding costs incurred by the agent to put limits on and/or provide guarantees about the agent's discretionary behavior and residual losses to the principal(s) resulting from the agent's discretionary behavior. One aspect of this latter component of agency costs-residual losses due to 'excessive' levels of management compensation-is the focal point of this study.

The agency problem is particularly relevant when ownership and control are separate, as is frequently the case in the large publicly held corporation, because it is virtually impossible for a diverse group of atomistic shareholders (the principals) to monitor the behavior of a corporation's management (the agent). Much of the corporate America is characterized by this 'separation of ownership and control'. Regarding possible agency problems arising from this situation, Fama (1980) offers the hopeful conjecture that if managerial labor markets function efficiently in the sense that they are characterized by a wage revision process that is

equivalent to a full ex post 'settling up' by the agent for his past performance, then the managerial incentive problem will be resolved by market forces. Unfortu- nately, however, there is no empirical or even anecdotal evidence that managerial labor markets function in this manner.

This study attempts to examine the effect of monitoring activities on managerial compensation. In closely held corporations certain individual owners (i.e. the major shareholders) have substantial economic incentives to monitor management's conduct because their investment in the firm is very large, whereas in widely held corporations no individual shareholder is likely to have a sufficient incentive to engage in such monitoring activities. We hypothesize that excessively high levels of management compensation, relative to normal or expected levels, are an important component of the residual loss resulting from the agency problem, and we examine the presence of this agency cost in closely held versus widely held corporations. A finding of no meaningful relationship between the degree of concentration of corporate control and the level of management compensation in the corporation would support Fama's conjecture that efficient managerial labor markets will and do effectively discipline corporate managers. Conversely, the finding of a significant inverse relationship between the degree to which a firm is closely held and the level of management compensation would suggest the presence of higher agency costs in widely held firms and would call into question the assumption of managerial labor market efficiency (at least with regard to its ability to discipline some aspects of manager's behavior).

METHODS

To test the Fama conjecture that managerial labor markets discipline corporate managements and thus

0143-6570/88/010021-05$05.00 © 1988 by John Wiley & Sons, Ltd.



22 E. A. DYL

effectively resolve the agency problem we examined the relationship between the degree of corporate control and the level of management compensation using a model of the following form:

Si = (ci, ViJ)(1

where Si is the level of management compensation in firm i, ci is a measure of the degree to which firm i is closely held and the vij are other variables pertaining to firm i that are likely to be important determinants of the level of executive compensation. Numerous earlier studies have shown that such variables include the size of the firm, measures of the firm's profitability and other industry-specific measures.1

The objective of many of the studies cited in note 1 was to test whether the 'neo-classical' or the 'managerial' view of the firm appeared to have the most validity. Th neo-classical theory of the firm was based on the assumption that managers behaved as profit maximizers, whereas managerial theories of the firm posited satisficing behaviors by managers with regard to profits so that managers could pursue other objectives-perhaps including the enhancement of their own welfare. This has been an important con- troversy for a number of years, especially since Baumol (1959, 46) observed that '. . . executive salaries appear to be far more closely related to the scale of operations of the firm than to its profitability'. Baumol suggested the managers might therefore pursue a sales maximization goal rather than a profit maximization one. It appears that these two theories of the firm (or, more precisely, theories of managerial behavior) are really simply extreme poles on the continuum of agency problems that Jensen and Meckling's (1976) work would lead us to expect in the normal course of events. Our objective in examining the determinants of executive compensation in this study is not to resolve the neo-classical versus managerial issue, which, in any event, appears to be an artificial dichotomy at best. Rather, we simply develop a model that illustrates the effect of corporate control and other variables on the level of management compensation and interpret our results in the context of the agency issue.

An ordinary least square's regression equation of the following form was used to relate management compensation to the explanatory variables:

n

Si=ao+bci+ I ajvij+ei (2) j=l

where Si is the remuneration of the chief executive officer (CEO) in firm i, ao is a constant (the intercept of the regression), b is the regression coefficient on the measure of the degree to which firm i is closely held (ci), the aj are regression coefficients on variables vij and ei is assumed to be a normally distributed random disturbance term with a zero expectation.

The compensation of the firm's chief executive officer (CEO) is employed as a surrogate for the overall level of management compensation in the organization, an assumption that seems reasonable in the light of evidence presented by Henderson (1982, 461) that

salaries and other compensation arrangements at each level in an organization tend to be related to those of the next highest level. For example, vice presidents tend to have higher salaries when the CEO has a high salary, and so forth down through the organization.

Data regarding the total remuneration of the CEOs of 271 major industrial corporations (i.e. Fortune 500 companies) during 1982 were obtained from a survey conducted by and published in Forbes magazine (6 June 1983, pp. 130-54). Total compensation during the year was defined to include salary, bonuses, other benefits and contingent remuneration (e.g. amounts accumulated under deferred compensation agreements during the year, etc.), but does not include common stock gains realized during the year resulting from the exercise of stock options or stock appreciation rights granted in other years.2 The year 1982 was selected because it is the year that most closely coincides with the data on ownership concentration used in the study (see below), and the sample of 271 executives represents the complete set of firms from the Forbes tabulation for which ownership concentration data were also available. The mean level of compensation for these CEOs in 1982 was approximately $662 000. The Forbes survey also provided some demographic information about the executives: the average age of the group of CEOs was 59 years, they had been with their current company for 26 years and had been CEOs of the company for nine years. None of these demographic variables were, however, statistically related to the level of compensation (i.e. when they were included as variables in Eqn (2) they did not contribute to the explanatory power of the regression).3

Data about the ownership of the firms in the sample were obtained from Abrecht and Locker's (1981) Corporate Date Exchange Stock Ownership Directory, which contains information about the holdings of principal stockholders of Fortune 500 companies up- dated through May 1981. This source provides the most recent convenient tabulation of information regarding ownership concentration among Fortune 500 firms. All companies in our sample were publicly held and listed in the Fortune 500.

The natural logarithm of the percentage of the firm owned by the five largest stockholders was employed as the measure of the degree to which the firm was closely held. The choice of the holdings of the 'top five' stockholders as the measure of concentration was essentially arbitrary. Other similar measures, such as the percentage held by the largest stockholders, by the ten largest stockholders, etc., yielded very similar results.4 The logarithmic transformation of this variable and the other scalar variables in the analysis eliminated statistical problems with heteroscedasticity that were encountered in regressions using the raw data. We measure the degree of control as a continuous variable. Although most other studies examining corporate control issues employ the arbitrary dichotomy of 'owner controlled' versus 'manager controlled' firms, characterizing the degree of corporate control as a. continuum appears to be more appropri-



CORPORATE CONTROL AND MANAGEMENT COMPENSATION 23

ate in the agency context.5 (See Cubbin and Leech, 1983, for a general discussion of the issues involved in the measurement of corporate control.)

The other variables included in the regression equation (vij) are a measure of the size of the firm, a measure of the firm's performance during the preceding year and dummy variables denoting specific industries. Earlier studies have generally found that the level of management compensation is related to both the size of the firm and its profitability (e.g. Baker, 1969; Boyes and Schlagenhauf, 1979; Ciscel and Carrol, 1980; Hirschey and Pappas, 1981.)6 A rationale for the importance of the size variable was provided by Simon (1957), who noted that executives of larger firms have more levels of management reporting to them, and that a 'tall' oraganizational structure may create upward pressure on top-management salaries simply to main- tain salary differentials between each level of executives further down in the hierarchy. The measures of firm size and performance employed in this study are the logarithm of total assets during 1981 and the logarithm of return on equity during 1981, respectively. These data were obtained from the Fortune 500 listing as reported in Fortune magazine (3 May, 1982). Again, the logarithmic transformations eliminated problems with heteroscedasticity that arose when the raw measures were employed.

The joint hypothesis that we test in essence, the antithesis to the null hypothesis suggested by Fama's analysis is that in relatively closely held firms certain owners have an economic incentive to engage in monitoring activities and that, by engaging in these activities, these owners are able to reduce 'excessive' levels of management compensation that would otherwise occur due to the agency relationship. That is, we hypothesize that the level of management compensation is related to corporate control in the following manner:

Si = f(ci, viA , asi/oCi < 0 (3)

A significant negative regression coefficient on the control variable in Eqn (2) would support this hypothesis.

RESULTS

The results of the regression described above are shown in Table 1. The corporate control variable (i.e. the natural logarithm of the percentage of the firm held by the 'top five' stockholders) is significant at the 0.05 level and has the anticipated negative relationship to the level of management compensation. This result is consistent with our hypothesis concerning monitoring activities by major shareholders and the residual loss portion of agency costs, and does not support Fama's (1980) suggestion that managerial labor markets may resolve the agency problem.7

The other terms in the regression equation are consistent with the findings of earlier studies. The major determinants of the level of management com-

Table 1. Determinants of Management Compensation

Coefficient Variable (t-vetue)

Control (In) -64.564 (2.228)

Total assets (In) 129.697 (7.625)

Return on equity (In) 104.602 (4.002)

Food industry (dummy) 186.481 (3.396)

Paper/fiber/wood industry (dummy) -182.179 (2.840)

Metal manufacturing (dummy) -213.326 (2.829)

Motor vehicles (dummy) -219.544 (2.674)

Aerospace industry (dummy) 170.884 (1.981)

Constant (aO) -396.538

sensation are the size of the firm (measured by the natural logarithm of total assets) and the firm's performance (measured by the natural logarithm of return on equity) and, as found in earlier studies, the coefficient on each of these variables is positive.

In addition, 28 industry dummy variables were used in estimating Eqn (2) denoting the 28 different industries represented in our sample of firms. Five of these dummy variables denoting specific industries proved to be significant. The level of management compensation is higher than would otherwise be predicted by the model (i.e. absent the dummy variables) in the food and aerospace industries and lower than otherwise would be predicted in the paper/fiber/wood, metal manufacturing and motor vehicle industries. The number of observations in each of these industries was as follows: food, 24; aerospace, nine; paper/fiber/wood, 17; metal manufacturing, 12; and motor vehicle, 10. The correlation matrix shown in Table 2 indicates that none of these industry dummy variables is highly correlated with the other independent variables in the model. In addition, the five industries do not appear to have any common characteristic such as a similar degree of systematic risk or cyclicality or capital intensity that might be suggested as a general ex- planation for the presence of these industry dummy variables in the model. We therefore conclude that they apparently represent different industry-specific pheno- mena that are for some reason related to management compensation levels.

The overall regression model is significant at the 0.001 level and has a coefficient of determination (R2) of 0.346. There is no significant degree of multicollinearity between the variables (again, see Table 2), the error terms are independent and normally distributed with a constant variance and there is no problem with heteroscedasticity.

If we accept the notion that the total compensation of the CEO is a reasonable surrogate for the overall level of top management compensation within the firm then the relationship between corporate control and



24 E. A. DYL

Table 2. Simple Correlation Matrix Motor

Total Return Food Paper/etc. Metal mfg vehicle Compen- Control assets on equity industry industry industry industry

sation (In) (In) (In) (dummy) (dummy) (dummy) (dummy)

Control (In) -0.2530 - _ Total assets (In) 0.4220 -0.31 81 Return on equity (In) 0.2449 -0.0202 0.0463 Food industry (dummy) 0.1447 0.0521 -0.1244 0.0321 Paper/f iber/wood

industry (dummy) -0.1733 0.0019 -0.0127 -0.1045 -0.0797 Metal mfg. industry (dummy) -0.1482 0.0416 0.0349 -0.0663 -0.0663 -0.0550 Motor vehicle industry (dummy) -0.1015 0.0107 0.0779 0.0156 -0.0603 -0.0501 -0.0417 Aerospace industry (dummy) 0.1168 -0.0134 0.0469 -0.0514 -0.0571 -0.0474 -0.0394 -0.0359

compensation levels can be used to make some crude inferences about the magnitude of the agency costs observed in this study. From Table 1, ceteris paribus, the partial relationship between a change in the corporate control variable (A in ca) and a change in the level of compensation (ASi) may be expressed as follows:

ASi= - 64.564 (A In ca) (4)

for 1 < ci < 100. This same relationship can be expressed in percentage terms as follows:

ASi =-0.0975 (A in c1) (5)

simply by dividing Eqn (4) by the mean level of CEO compensation observed in the study, so that ASi is the average percentage change in compensation associated with a change in the control variable. That is, an increase of one unit in In c' is associated with a 9.75% reduction in the level of top management compensation.

For the average firm in our sample the percentage of the total shares outstanding owned by the five largest shareholders is 26.78%. This figure suggests that the difference between the actual compensation levels we observe in the sample and those that would obtain if the average corporation were almost completely owned by atomistic shareholders (i.e. so that ci= 1% and in (ci) = zero) would be:

ASi = - 0.0975 (3.288) = - 0.3205 = 32.05%

That is, on average, monitoring activities by major shareholders may have reduced the residual loss portion of agency costs due to excessive top management compensation by approximately 32%. This, of course, is an extremely crude estimate. Note also that this number represents a gross rather than a net reduction in agency costs; the net figure would be the reduction in the residual loss minus the cost of the

shareholders' monitoring activities. In addition, it is probably an overestimate because it assumes a constant 'elasticity' of compensation versus ownership concentration across the full range of the latter variable. On the other hand, not all agency costs are reflected in compensation figures. If monitoring activities by controlling shareholders reduce compensation levels, pre- sumably they also reduce the incidence of excessively large staffs, shirking, excessive consumption of per- quisites, extreme risk aversion and other such residual losses generally thought to result from the agency relationship in corporations.

It is not clear that the existing degree of ownership concentration in the corporate sector (e.g. where the average ownership by the five largest shareholders was 26.78% for our sample of 271 major corporations) is in any sense an optimum. However, it appears that there may be an optimum level of ownership concentration and that this optimum may be related, in part, to agency considerations.

CONCLUSION

This paper has suggested that levels of management compensation are related to the degree to which a firm is closely held because major shareholders have a meaningful economic incentive to engage in monitoring activities that reduce the residual loss portion of agency costs. Our finding of a statistically significant relationship between compensation levels and the degree to which a firm is closely held supports this hypothesis and casts doubts on the results of Fama's analysis, which suggested that the wage determination process in managerial labor markets might resolve the agency problem. It appears that the percentage reduction in 'excessive' management compensation due to monitoring by major shareholders may be substantial.

NOTES

1. Such studies include those by Roberts (1956), McGuire Et al. (1962), Lewellen and H-untsman (1970), Smythe et al. (1975), Ciscel and Catroll (1980) and Argarwal (1981). See also Meeks and Whittington (1975) and Cosh (1975)

regarding executive compensation in the United Kingdom. 2. See Lewellen and Huntsman (1970), Masson (1971) and

Antle and Smith (1985) concerning the measurement of executive compensation.



CORPORATE CONTROL AND MANAGEMENT COMPENSATION 25

3. The simple correlations between these demographic variables and compensation and between the variables themselves are as follows:

Age of Years Compensation CEO with firm

Age of CEO 0.0647 Years with firm - 0.0272 0.3951 Years as CEO 0.0367 0.5005 0.2825

Although age, years with the firm and years as CEO are correlated with each other, they do not appear to be related to the level of compensation.

4. As one would expect, these various measures of ownership concentration are highly correlated . The correlation matrix is as follows:

Largest Top 5 Top 10 Top 15 Top 5 0.8870

Top 10 0.8714 0.9479 - Top 15 0.8319 0.9249 0.9931 Top 20 0.7968 0.8990 0.9782 0.9953

5. Examples of studies using a dichotomus corporate control variable include Berle and Means (1932), Kamerschen (1 968), Larner (1 970), Monsen et al. (1 968), Palmer (1 973), Sorensen (1974) and Stano (1976).

6. An exception is Roberts (1 956), who asserts that size alone is the primary determinant of executive compensation. However, he considers only 'profits' and not 'profitability' in his analysis.

7. After completing this study the author learned of a paper by Gomez-Mejia et al. (1984) reporting a similar result. They conclude that: 'Our data show that executives in 'externally controlled' firms receive lower earnings than executives of Management controlled' firms... after statistically controlling for the effects of scale, performance, and external hires.'

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Corporate Control and Management Compensation: Evidence on the Agency Problem