Corporate Governance and Incentive Contracts: Historical Evidence from a Legal Reform
Summary (3 min read)
- Providing the right incentives for corporate executives was and still is of great concern to shareholders.
- The Sarbanes-Oxley-Act of 2002 may well qualify as a major reform.8.
- Conyon (1997) and Core et al. (1999) find that changes in corporate governance significantly influence the level of managerial compensation.
- This means that the 1884 legal reform reduced the sensitivity of executive pay to performance by about two-thirds for manufacturing firms and by about one-third for banks.
- Section 5 presents the results of their empirical analysis, and finally Section 6 concludes.
2. Literature, Theory, and Econometric Background
- Earlier empirical studies of managerial incentive pay concentrated on the reduced form relation of pay and performance.
- A correlation of pay and performance can result from a number of other factors besides managerial contracts which reward performance to induce effort.
- General overviews of the executive remuneration and corporate governance literature are given by Core et al. (2003), Murphy (1999), Hart (1995), Tirole (2001), and Shleifer and Vishny (1997).
- To achieve identification nonetheless, a typical estimation strategy has since consisted in the use of difference(-in-difference) methods.
- Stricter accounting rules restricted the set of possible actions of the agent (e.g., ‘cooking the books’); it increased the liability of the agent if she presented incorrect figures in the accounts; and it improved the set of information available to investors (e.g., whether they received a profit and loss statement).
3. Historical background
- Germany’s financial history of the 1870s and 1880s is shaped by the repercussions of the Gründerzeit (foundation or promotion period).
- 9 German states to found a joint-stock company, whereas after the liberalization, basically every citizen could found such a company.
- Thereafter, the supervisory board could co-opt further members at will without the actual shareholders taking part in this decision, i.e., supervisory board members were not necessarily elected by the shareholders but by the other members of the supervisory board (Renaud 1875, p 628).
- First of all, the new law clarified that the intentional misbehavior of executives or supervisory board members was a criminal offence, which was to be punished by imprisonment and a fine (§ 249 ADHGB).
- What is important for their research question and strategy is to keep in mind that while the reform in 1884 was intended to solve problems of incorporation, it also had strong and important implications for corporate governance.
- The authors database is derived from a number of sources for accounting, stock market, and executive data on German corporations between 1870 and 1911.
- Since not all corporations listed in 1880 survived for a long period thereafter, the population of firms usable for their research is even smaller.
- While inspection of actual contracts leads us to consider that “excess profits” are the relevant performance measure, this choice has a positive side effect.
- The relevant accounting, stock market, and executive data for the 1870s were collected from the few published issues of „Saling’s Börsenpapiere“ and from the “Berliner Börsenzeitung”, Germany’s leading financial daily at the time.
- Some firms report only the bonus payment to both boards, the executive and supervisory board, as a whole.
4.2. Data Quality
- For the US and Britain, the quality of historical accounting data is known to be problematic, since accounting principles and coded standards developed mostly during the 20th century.
- By contrast, most of today’s German system of accounting rules and its legal codification was developed during the second half of the 19th century.
- Accounting standards were introduced in 1906.
- Moreover, Cunat and Guadalupe (2005) use an unexpected shift in competition as a natural experiment to identify the incentive component of managerial compensation.
- Moreover, while the New York Stock Exchange introduced disclosure, it did not enforce accounting standards (Baskin, 1988).
4.3. Descriptive Statistics
- Table 1 presents descriptive statistics for their data set.
- On average, these excess profits amount to approximately 298,000 Mark for manufacturing firms and came to 3.74 million Mark for banks.
- Regularly, a bonus was only paid if at least the threshold performance was met.
- The number of executives varies between banks and manufacturing firms, reflecting the difference in size as well.
- In their sample, almost all manufacturing firms restricted voting rights in their charter before 1884 (94.7 per cent of all observations of manufacturing firms, 59.6 per cent for banks).
5.1. Main results
- The authors baseline specification is a random-effects Tobit model, where the authors employ the whole universe of manufacturing firms that is in their sample.
- After the reform, the marginal share of profits paid to executives is about 3.4 percentage points smaller than before the reform.
- First, the size of fixed assets was included since studies from modern Germany show a strong and positive correlation between firm size and executive compensation (e.g., Schwalbach and Graßhoff, 1997).
- Therefore, the authors cannot check the effect of the legal reform on base salaries.
- Inspecting the parameter estimates for the constant and the post-1884 dummy, the authors see that the estimated bonus pay at average performance (defined for both sub-periods separately) is 3,780 Mark before 1884, with an increase after 1884 of 3,326 Mark.29.
5.2. Robustness tests
- The authors check for the robustness of their findings from this specification and complement it with five additional model estimations in this section.
- For this purpose, the authors split the sample into two subperiods 1870-1884 and 1885-1911 and perform the estimation for both sub-samples separately.
- This allows us to see whether there are systematic changes in the managerial compensation beyond the 1884 reform (i.e. further structural breaks).
- The authors fourth robustness check splits the sample at the time of the reform.
- 24 Finally, the authors check whether the outside control of executives by bank managers or the extent of shareholders’ voting rights matter.
5.3. Real Effects
- While this is the aspect of their interest in this paper, this is but one possible focus on the effect of a legal reform of corporate governance.
- Lately the literature has highlighted the importance of corporate governance for the performance of companies.
- Returns on assets increased from 5.4 per cent before the reform to 6.6 per cent after the reform.
- Conversely, high growth expectations are reflected by lower dividend yields, which, however, become steadier.
- This finding cannot, however, be causally related to the reform of corporate law, because it may well reflect several other uncontrolled macro- as well as microeconomic changes.
- The authors have used a fundamental reform of the German corporate-governance code – the 1884 joint-stock companies act – as an identification scheme for incentive contracts.
- The estimated coefficient also absorbs the correlation between pay and performance induced by other variables, 27 e.g., business cycle effects.
- Thus, any shift in the correlation between managerial compensation and firm performance can be interpreted as an incentive component under the old regime of corporate governance.
- This incentive component was substituted for by better institutions under the new system of corporate governance introduced in Germany in 1884.
- Naturally, the authors cannot exactly differentiate between general equilibrium, business cycle, and incentive effects in this empirical pay-performance sensitivity for the years after 1884.
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