Corporate Governance and Incentive Contracts: Historical Evidence from a Legal Reform

TL;DR: In this paper, the authors proposed to exploit a reform in legal rules of corporate governance to identify contractual incentives from the correlation of executive pay and firm performance and found that pay-performance sensitivity decreased significantly after this reform.

Abstract: This paper proposes to exploit a reform in legal rules of corporate governance to identify contractual 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, strengthened the monitoring incentives of shareholders, and reduced the discretionary power of executives 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.

Summary

1. Introduction

• 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.
• 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.

4.1. Sources

• 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.
• 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.

6. Conclusion

• 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.

Figures

Table 5: Pay-performance sensitivity (Robustness Check IV) – Sample Split for the Sub-Periods 1870-1884 and 1885-1911

Table 6: Pay-performance sensitivity (Robustness check V) - Outside Control

Table 2: Pay-performance sensitivity - Baseline Regression Results

Table 1: Descriptive Statistics for the full sample 1870-1911

Table 3: Pay-performance sensitivity (Robustness Check I) – Controlling for trends in managerial compensation

Table 7: Real effects of the 1884 reform

Table 4: Pay-performance sensitivity (Robustness Checks II and III) – Evidence from Banking and Single-Manager Firms

Full text

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-

Frequently asked questions

Q1. What are the contributions in "Corporate governance and incentive contracts: historical evidence from a legal reform" ?

This paper proposes to exploit a reform in legal rules of corporate governance to identify contractual incentives from the correlation of executive pay and firm performance. The authors analyze a sample of executive pay for 46 firms for the years 1870 to 1911. 

Q2. How many companies are included in the final sample?

The final sample consists of 46 corporations, 37 from manufacturing and nine banks, with a total of 1,140 observations, making an average of 24.9 years per firm. 

Q3. What is the standard approach to measure whether remuneration packages are justified by good performance?

A standard approach to measure whether remuneration packages are justified by good performance is the pay-performance correlation. 

Q4. What is the only remark in the whole motivations and reasons for the 1884 reform?

The only remark in the whole motivations and reasons for the 1884 reform that comes close to a debate on compensation schemes is a debate on the compulsory shareholding of executives. 

Q5. What information was provided about the company’s charter that was relevant to potential investors?

In addition, it provided information about the company’s charter that was relevant to potential investors, e.g., information about voting rights and the distribution of profits. 

Q6. What is the reason for the third robustness check?

Their third robustness check investigates whether the reform effect found may be due to changes in the composition of the executive board, in particular in the number of board members. 

Q7. How did the authors make this data usable?

To make this data usable, the authors partly rely on existing digitalized data sets collected from “Saling’s Börsenpapier”, and the authors digitalized additional data ourselves. 

Q8. What was the effect of the reform on the economic relationship between principals and agents?

In particular, the discretionary power of managers declined and misbehavior was more costly to managers after 1884; this can be expected to have had a substantial influence on the economic relationship between principals and agents. 

Q9. How much did the effect of the reform on the compensation of manufacturing firms decrease after 1884?

In fact, for manufacturing firms, the estimated influence of profits on managerial compensation declined by about two-thirds after 1884. 

Q10. How many long-living firms were listed in Germany in 1880?

their sample covers about one quarter of the entire population of listed manufacturing corporations in 1880, and a significantly larger fraction of long-living firms. 

Q11. What was the only way for shareholders to exercise their rights?

The only way for shareholders to exercise their rights was to vote at the annual general meeting, the Generalversammlung (§§ 209, 224 ADHGB; Renaud 1875, pp 458; Gareis 1880, pp15 ADHGB = Allgemeines deutsches Handelsgesetzbuch (General German commercial law).10207).