M A X P L A N C K S O C I E T Y
Preprints of the
Max Planck Institute for
Research on Collective Goods
Bonn 2008/11
Corporate Governance
and Incentive Contracts:
Historical Evidence from
a Legal Reform
Christian Bayer / Carsten Burhop
Preprints of the
Max Planck Institute
for Research on Collective Goods Bonn 2008/11
Corporate Governance and Incentive Contracts:
Historical Evidence from a Legal Reform
Christian Bayer / Carsten Burhop
March 2008
Max Planck Institute for Research on Collective Goods, Kurt-Schumacher-Str. 10, D-53113 Bonn
http://www.coll.mpg.de
Corporate Governance and Incentive Contracts:
Historical Evidence from a Legal Reform
*
by
Christian Bayer
IGIER – Università Commerciale Luigi Bocconi
Via Salasco 5, 20136 Milano, Italy
Email: christian.bayer@unibocconi.it
and
Carsten Burhop
Max Planck Institut zur Erforschung von Gemeinschaftsgütern
Kurt-Schumacher-Str. 10, 53113 Bonn, Germany
Email: burhop@coll.mpg.de
First version: 5 June 2003
This version: 31 March 2008
* We would like to thank Martin Hellwig, Bengt Holmstrom, Kornelius Kraft, Michael Roos, Richard
Tilly, Eugene White (our commentator at the 2007 ASSA meeting), participants of the RES Meeting
2004, the EEA Meeting 2004, the GEABA Meeting 2004, the EHS Annual Conference 2006, the German
Clio 2006, the 14th IEHA Congress 2006, the ASSA Meeting 2007, and seminar participants at the Uni-
versity of Dortmund for helpful comments and suggestions. The authors would like to thank the Deutsche
Forschungsgemeinschaft for financial support (grant no. BU 1805 / 2-1) and Marina Boland, Kathrin
Datema, Eva große Kohorst, and Annika Petersen for assistance in collecting the data. A previous version
of this paper was circulated under the title “A corporate governance reform as a natural experiment for in-
centive contracts” and was written while Christian Bayer was Jean Monnet Fellow at the European Uni-
versity Institute and Carsten Burhop was Research Fellow at the Center for Development Research, Bonn
University. The financial support of these institutions in gratefully acknowledged.
2
Corporate Governance and Incentive Contracts:
Historical Evidence from a Legal Reform
Abstract
This paper proposes to exploit a reform in legal rules of corporate governance to identify con-
tractual incentives from the correlation of executive pay and firm performance. In particular,
we refer to a major shift in the legal and institutional environment, the reform of the German
joint-stock companies act in 1884. We analyze a sample of executive pay for 46 firms for the
years 1870 to 1911. In 1884, a law reform substantially enhanced corporate control, strength-
ened the monitoring incentives of shareholders, and reduced the discretionary power of execu-
tives in Germany. Pay-performance sensitivity decreased significantly after this reform. While
executives received a bonus of about three to five per cent in profits before 1884, after the
reform this parameter decreased to a profit share of about two per cent. At least the profit
share that is eliminated by the reform must have been incentive pay before. This incentive
mechanism was replaced by other elements of corporate governance.
JEL-Classification: G30, J33, N23
Keywords: pay-performance sensitivity, natural experiment, legal reform, corporate governance
1. Introduction
Providing the right incentives for corporate executives was and still is of great concern to
shareholders. More than a century ago, lawyers lamented that a cozy frivolousness got a grip
on many joint-stock companies.
1
In a similar spirit, economic scholars highlighted the infor-
mational advantages that executives naturally had compared to shareholders. Moreover, they
were pessimistic about the means and abilities of the shareholders to effectively monitor man-
agers given their natural informational advantages.
2
Under these circumstances, they argued
in anticipation of modern economic theory, executives should receive monetary incentives to
align their interests with the shareholders’ aims.
3
In the light of this basic economic insight, an optimal compensation package tames the self-
interest of the management such that shareholders’ and management’s interests align. Share-
1 „[…] so herrscht doch in vielen, namentlich neuen Aktiengesellschaften eine Atmosphäre des gemüthli-
chen Leichtsinns, der Bequemlichkeit, der Verschwendung“, Oechelhäuser (1878, pp 4).
2 […] dass die Direktoren schon kraft ihrer besseren Kenntnis des Geschäfts, ihrer Vertrautheit mit allen
Einzelheiten des verwickelten Geschäftsmechanismus eine natürliche Überlegenheit über die Aktionäre
besitzen, diese aber dasjenige weder wissen noch wissen können, was sie unbedingt wissen müssten, um
die Oberaufsicht und Leitung des Unternehmenswirksam durchführen zu können“, Petrazickij (1906, pp
152).
3 „Was zuerst die Direktoren betriff, so wird sich nichts dagegen sagen lassen, dass sie, als Entschädigung
wie als Sporn, außer dem Gehalt auch eine Tantieme erhalten.“ Oechelhäuser (1878, p 75).
3
holders are not willing to provide huge pay checks to a shirking management, but they are
willing to provide compensation for managerial work for good performance. A standard ap-
proach to measure whether remuneration packages are justified by good performance is the
pay-performance correlation.
4
Although this correlation is important as a measure, it is not
clear that incentive pay is the only reason for high correlations. In particular, pay and per-
formance may be linked by various factors unrelated to managerial effort, e.g., job design,
differences in managerial ability, or cyclical shifts in demand for managerial services.
However, these latter types of correlation do not reflect an incentive phenomenon; they will
be also present in a world with complete and perfect information. In other words, to analyze
contracts empirically, we have to separate the contracted link of pay and performance from
the ex post correlation of pay and performance as a result of market outcome.
5
We propose to
exploit a major shift in the legal and institutional environment to assist identification.
6
Of particular interest for our research strategy are shifts that alter the contractual relation of
pay and performance, but have no significant effect on the correlations between pay and per-
formance that result from other market forces. Such shifts could be legal reforms that do not
affect the abilities or other fixed characteristics of a manager, that are performance-relevant
and observable to the principal, but not to the econometrician. This makes improvements in
legal (minimum) standards of corporate governance particularly promising as object of study.
Such reforms enrich the set of means of corporate control that principals can use, who can
redesign the tasks of executives and then adjust monetary incentives. Therefore, from a theo-
retical point of view, they have clear-cut implications for managerial contracts and as such
they can serve as a test for the incentive theory of contracts.
7
Yet, it is rare to observe a major change of legal institutions that qualifies for this testing
strategy. First of all, the legal reform must lead to unambiguous predictions for the parameters
of contracts between principals and agents. Typically, only a few substantial reforms thus
qualify. Second, we need to observe the contractual relationship for a prolonged period of
time before and after the reform. For example, the Sarbanes-Oxley-Act of 2002 may well
qualify as a major reform.
8
However, for our testing strategy, the time period after the reform
4 See Murphy (1999) for an overview of the literature on executive compensation; and Prendergast (1999)
as well as Lazear (2000) for more general reviews of incentive contracts in firms.
5 For example, Himmelberg and Hubbard (2000) as well as Grossmann (2003) argue that general-
equilibrium effects induce some correlation between performance and pay even without any strategic
considerations when able managers are scarce. Additionally, better-qualified managers will work for
firms that highly reward performance. Thus, incentive contracts become a selection device and increase
performance, but do not induce managers to exert more effort (Lazear 1986).
6 For example, Conyon (1997) and Core et al. (1999) find that changes in corporate governance signifi-
cantly influence the level of managerial compensation.
7 Holmstrom and Milgrom (1991) highlight that job design – e.g., the discretionary power of executives –
and incentive contracts should be analyzed jointly. More specifically, a reduction of the discretionary
power of the executive should go hand in hand with a reduction of incentives.
8 Goldman and Slezak (2006) analyze theoretically the impact of the Sarbanes-Oxley Act on both the mis-
representation of firm performance and managerial contracts and find that the Sarbanes-Oxley Act should
have an important effect on both. Moreover, Chhaochharia and Grinstein (2007), Litvak (2007), and Win-
