Firm performance, corporate governance and executive compensation in Pakistan

TL;DR: In this paper, the authors examined the effects of firm performance and corporate governance on chief executive officer (CEO) compensation in an emerging market, Pakistan using a more robust Generalized Method of Moments (GMM) estimation approach for a sample of non-financial firms listed at Karachi Stock Exchange over the period 2005-2012.

Abstract: This study examines the effects of firm performance and corporate governance on chief executive officer (CEO) compensation in an emerging market, Pakistan. Using a more robust Generalized Method of Moments (GMM) estimation approach for a sample of non-financial firms listed at Karachi Stock Exchange over the period 2005–2012, we find that both current- and previous-year accounting performances has positive influence on CEO compensation. However, stock market performance does not appear to have a positive impact on executive compensation. We further find that ownership concentration is positively related with CEO compensation, indicating some kind of collusion between management and largest shareholder to get personal benefits. Inconsistent with agency theory, CEO duality appears to have a negative influence, while board size and board independence have no convincing relationship with CEO compensation, indicating board ineffectiveness in reducing CEO entrenchment. The results of dynamic GMM model s...

Summary

Introduction

• There has been an enormous growth in research on executive compensation over the last two decades with primary focus on compensation of chief executive officer (CEO).
• The objective of this study is to examine whether CEO compensation is influenced by firm performance and corporate governance practices in an emerging market, Pakistan, where CEOs are presumed to be more powerful than the boards of directors and where family or controlling shareholders are more likely to exploit interests of minority shareholders.
• Moreover, Pakistani economy is plagued with more corruption than many other Asian countries.
• These models, however, do not control for potential endogeneity problems.
• Section four provides empirical results while conclusions are presented in section five.

CEO Compensation and Firm Performance

• In agency theory, the corporate boards, assuming the power to look after the firm, involve in arm's length transaction with CEO and design such compensation plans which provide CEO with efficient incentives to maximize the shareholder value, and hence reduce moral hazard problem arising from separation of ownership from control (Bebchuk and Fried, 2003) .
• According to managerial power theory (MPT), if the balance of power shifts towards CEOs and they behave opportunistically then there is likelihood that CEOs would involve in rent extraction through setting their compensation high that is not in the interests of shareholders (Bebchuk and Fried, 2003) .
• With increased power of CEO, the board of directors and compensation committee, under the influence of CEO, compromise their fiduciary duties and settle upon excessive CEO compensation possibly not linked to firm performance (Bebchuk and Fried, 2003) .
• The strong ties between CEOs and family/controlling shareholders suggest greater possibility of expropriation of minority shareholders' interests (Type II agency problem).

CEO Compensation and Corporate Governance

• Corporate governance assumes the role of monitoring and curbing managerial opportunism so that shareholder's interests are protected (Fama and Jensen, 1983) .
• As an efficient corporate governance structure provides close monitoring and oversight of management, therefore in the presence of strong corporate governance, the executive compensation would be low.

Ownership Concentration, Family Ownership and CEO Compensation

• Concentrated and family ownership can affect CEO compensation contract in two competing ways, 1) interest alignment effect and 2) entrenchment effect.
• According to interest alignment effect, which relates to agency theory, large or family shareholders have strong incentives to oversee agents' activities because of being insiders, strong commitment and better firm specific knowledge (Bertrand and Schoar, 2006 , Harris and Raviv, 2008 , Jensen and Warner, 1988 , Su et al., 2010) .
• Entrenchment effect suggests that family or controlling shareholders can expropriate minority shareholders' interests through many ways including excessive compensation packages (see, Croci et al., 2012 , Su et al., 2010 , Wang and Xiao, 2011) .
• Such expropriation is very likely in emerging markets where formal institutions are weak to support mutually beneficial impersonal exchange between economic players (see, Jameson et al., 2014 , Young et al., 2008) .
• Since Pakistan is an emerging market with weak legal systems, therefore the authors hypothesize that: H2a: Ownership concentration has a positive impact on CEO compensation H2b: CEO compensation is higher in family firms than in non-family firms.

Board Size and CEO Compensation

• It has significant contribution towards quality of governance (Jensen, 1993, Lipton and Lorsch, 1992) .
• They may become so heavy, leading to ineffective executive monitoring (Jensen, 1993) .
• Thus, larger boards are assumed to compromise their monitoring role and hence weaken the internal governance structure.
• Executives gain more power over the internal control mechanisms, leading to more influence on their own pay, resulting in higher executive compensation.

Board Independence and CEO Compensation

• Agency theory suggests that independent directors are likely to play important role in aligning shareholder-manager interests by providing adequate monitoring.
• Independent outside directors are less subject to collude with management and have reputation to protect shareholders in the labor market (Core et al., 1999, Fama and Jensen, 1983) .
• On the other hand, inside directors are more obligated to CEO and can be under greater CEO influence, leading to compromised CEO monitoring to get personal benefits from CEO such as career opportunities (see, Bebchuk and Fried, 2003, Weisbach, 2007) .
• Overall, board independence is expected to be related to less managerial opportunism, leading to lower executive compensation.
• Given the Pakistani context where non-executive directors are generally hired from within the family or obligated to work on behalf of controlling shareholders (Javid and Iqbal, 2008, World Bank, 2005) , the authors may expect so-called board independence to become irrelevant in corporate decision making, leading to non-negative relation between CEO pay and board independence.

CEO Duality and CEO Compensation

• CEO duality (CEO as chairman board of directors at the same time) provides opportunities to "self-interested" CEOs to influence major decisions in order to maximize their own utilities instead of maximizing shareholders' wealth (Core et al., 1999 , Jensen, 1993) .
• CEO duality reduces the board independence and increases the executive powers over control decisions including designing executive compensation contracts, leading to higher executive compensation.
• Thus, CEO duality is considered to be a sign of inefficient corporate governance in both agency theory and managerial power theory.
• In Pakistan, Code of corporate governance encourages companies to separate CEO position from chairman board of directors.
• Accordingly, the authors expect that CEO compensation is higher when CEO also holds the position of chairman board of directors.

Methodology Data

• The authors focus on all the non-financial firms listed at Karachi Stock Exchange (KSE), Pakistan for the period 2005 to 2012.
• Out of 399 non-financial listed companies classified in 12 industrial groups by State Bank of Pakistan (SBP), 139 companies are dropped because either they are declared as defaulted by KSE, newly listed or merged/demerged (86 companies), or their data on corporate governance and compensation is not available (53 companies).
• All the data is extracted from companies' annual reports collected by hand from different sources including SBP, KSE and companies' websites.
• As the authors go farther from 2012, the availability of annual reports decreases therefore sample period is restricted to start from 2005.
• For the remaining 260 companies, the authors managed to collect data for at least three consecutive years, making an unbalanced panel data containing 1836 firm-year observations.

CEO Pay Persistence and Dynamic Panel Model

• Agency theory assumes that executive compensation contracts are static pay-for-performance contracts, where CEO compensation is in equilibrium in each period.
• The employer then gradually learns about capabilities of the employee from his/her subsequent real performance.
• As argued above, the current CEO compensation may be a function of previous year's CEO compensation because of incomplete information and dynamic learning process, and anchoring-and-adjustment heuristic.
• This strategy control for potential endogeneity problem in addition to unobserved heterogeneity.
• On average about 34% CEOs appear to be holding the position of chairman board of directors also.

Correlation Analysis

• Log transformation is performed for compensation variables and firm size proxy i.e., total assets.
• Multicollinearity does not seem to be a problem in the data as none of the absolute values of correlation coefficients between explanatory variables is greater than 0.70.
• This is further confirmed by variance inflation factor (VIF) as none of the VIF is greater than the commonly used threshold level of 10 .
• Both cash and total compensation have positive correlation with accounting performance (ROA) but correlation with market performance (market return) is not significant although sign is positive.
• Board structure variables board size and board independence are also positively correlated with compensation, indicating potential ineffectiveness of board structure in monitoring and reducing CEO compensation.

Estimation Results

• Table 3 presents the estimation results for total compensation and cash compensation as dependent variables.
• Similarly, p-values of over-identification tests, Sargan test and Hansen J test, do not lead to rejecting the hypothesis of joint validity of the instruments used.
• Another possible reason for an insignificant relationship between CEO compensation and market performance could be that Pakistani bourses are considered to be highly volatile (Sheikh and Riaz, 2012) , therefore using market performance as benchmark for setting CEO compensation may not be a good choice.
• Ownership concentration appears to have positive impact on both measures of CEO compensation which is consistent with their hypothesis.
• Similarly, the coefficient of board independence is insignificant in all models, indicating no influence of non-executive directors on CEO pay process.

Robustness Checks

• The authors carry out some further tests of robustness of their results.
• First, all the continuous variables are winsorized using 1% level at both tails to eliminate potential outliers and all models are re-estimated.
• Again, the results remain qualitatively similar to as reported above.
• Third, to control for endogeneity problem, following a number of studies (e.g., Croci et al., 2012 , Ozkan, 2011) current values of all independent variables except firm age and change of CEO in Model (1) are replaced with their lagged values treating them as potential cause of endogeneity.
• The authors also estimate models by incorporating group, family ownership, ownership concentration, institutional ownership individually but results remain largely the same as reported.

Conclusions

• In Pakistan, investor protection and legal systems are weak.
• Further, Code of corporate governance issued to improve corporate governance practices in Pakistan has much emphasis on the board structure.
• Thus, current CEO compensation also depends upon their previous year compensation and their innate time-invariant capabilities which are not fully observable initially but gradually in subsequent periods through their real outputs.
• Inconsistent with agency theory, the authors find that ownership concentration has positive impact on CEO compensation.
• There may be some sort of collusions between management and largest shareholder for rent extraction.

Figures

Table 3 CEO Compensation and Firm Performance

Table 2 Correlation Matrix

Table 1 Descriptive Statistics

Full text

Firm performance, corporate governance
and executive compensation in Pakistan
Item Type Article
Authors Sheikh, M.F.; Shah, S.Z.A.; Akbar, Saeed
Citation Sheikh MF, Shah SZA and Akbar S (2018) Firm performance,
corporate governance and executive compensation in Pakistan.
Applied Economics. 50 (18):2012-2027.
Rights © 2017 Taylor & Francis. This is an Author's Original
Manuscript of an article published by Taylor & Francis
in Applied Economics in 2017 available online at https://
doi.org/10.1080/00036846.2017.1386277
Download date 10/08/2022 08:09:24
Link to Item http://hdl.handle.net/10454/17134

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Firm Performance, Corporate Governance and Executive Compensation in
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1
FIRM PERFORMANCE, CORPORATE GOVERNANCE AND EXECUTIVE
COMPENSATION IN PAKISTAN
Abstract
This study examines the effects of firm performance and corporate governance on chief executive
officer (CEO) compensation in an emerging market, Pakistan. Using a more robust Generalized
Method of Moments (GMM) estimation approach for a sample of non-financial firms listed at
Karachi Stock Exchange (KSE) over the period 2005 to 2012, we find that both current and
previous year accounting performance has positive influence on CEO compensation. However,
stock market performance does not appear to have a positive impact on executive compensation.
We further find that ownership concentration is positively related with CEO compensation,
indicating some kind of collusion between management and largest shareholder to get personal
benefits. Inconsistent with agency theory, CEO duality appears to have a negative influence, while
board size and board independence have no convincing relationship with CEO compensation,
indicating board ineffectiveness in reducing CEO entrenchment. The results of dynamic GMM
model suggest that CEO pay is highly persistent and takes time to adjust to long-run equilibrium.
Key Words: Corporate Governance, Dynamic Panel, Emerging Markets, Executive
Compensation, Firm Performance, Fixed Effects
Please cite this paper as:
Sheikh, M.F., Shah, S.Z.A., and Akbar, S., (2017), ‘Firm Performance, Corporate
Governance and Executive Compensation in Pakistan.’ Applied Economics, DOI:
10.1080/00036846.2017.1386277. Forthcoming.

2
Introduction
There has been an enormous growth in research on executive compensation over the last two
decades with primary focus on compensation of chief executive officer (CEO). Much of this
research focuses on the question whether executive compensation contracts can be justified in
terms of their contribution to the firm financial performance (Devers et al., 2007, van Essen et al.,
2012a). According to agency theory (Jensen and Meckling, 1976), executives are self-interested
and may behave opportunistically at the expense of shareholders’ interests. Therefore, corporate
boards are supposed to confine executive opportunism and align the executives’ interests with that
of shareholders by better monitoring through effective corporate governance mechanisms, and
designing efficient pay contracts that typically link executive compensation with firm
performance.
The objective of this study is to examine whether CEO compensation is influenced by firm
performance and corporate governance practices in an emerging market, Pakistan, where CEOs
are presumed to be more powerful than the boards of directors and where family or controlling
shareholders are more likely to exploit interests of minority shareholders. Specifically, this study
examines the role of firm performance, board structure and concentrated/family ownership in
designing CEO compensation contracts.
The Asian socio-economic and behavioral peculiarities and institutional settings are different
from Western World and studies conducted in Western World have limited implications for Asian
countries (Fan et al., 2011, Ghosh, 2006, Gibson, 2003, Hofstede, 1980, Sun et al., 2010, van Essen
et al., 2012a). While there is some evidence on the link between firm performance, corporate
governance and compensation from other Asian countries, the Pakistani context is peculiar for a
number of reasons. First, concentrated and family ownership is more common in Pakistan than for

3
instance, in Japan and Korea. Similarly, while Chinese firms have more ownership concentration
than in Pakistan, the nature of ownership concentration in Chinese firms is different as the State
usually holds high stakes in large firms (e.g., Bryson et al., 2014). On the other hand, concentrated
ownership in Pakistan is maintained by non-government shareholders. Non-government
ownership concentration makes firms like private owned firms which may have different
implications for CEO compensation.
Second, legal and political environment in Pakistan is weaker and the overall governance is
poor (Rehman et al., 2012). The government effectiveness index and regulatory quality index
estimated by World Bank remained negative in the last decade or so. In addition, there is more
foreign influence on governance and corporate environment. Pakistan has been under the influence
of International Monetary Fund (IMF) and other funding agencies for so long. Moreover, Pakistani
economy is plagued with more corruption than many other Asian countries. According to
Transparency International, the Corruption Perception Index (CPI) never cross 30 for Pakistan
(100 shows no corruption). Therefore, people in Pakistan (including executives) are more prone to
unethical and opportunistic behavior (Mujtaba and Afza, 2011). Third, the disclosure requirement
about CEO compensation is stronger in Pakistan. Companies are required to report all the
components of CEO compensation. This is not the case for most of the other Asian countries (see,
e.g., Basu et al., 2007, Conyon and He, 2011, Kato et al., 2007).
Given above differences, Pakistani market provides a unique context to study how the boards
see firm performance as a determinant of CEO compensation? What role concentrated/family
ownership plays in setting CEO pay and how board structure affects CEO compensation decisions?
These questions are particularly interesting in countries like Pakistan as two seminal studies

Frequently asked questions

Q1. What are the contributions mentioned in the paper "Firm performance, corporate governance and executive compensation in pakistan" ?

This study examines the effects of firm performance and corporate governance on chief executive officer ( CEO ) compensation in an emerging market, Pakistan. Using a more robust Generalized Method of Moments ( GMM ) estimation approach for a sample of non-financial firms listed at Karachi Stock Exchange ( KSE ) over the period 2005 to 2012, the authors find that both current and previous year accounting performance has positive influence on CEO compensation. The authors further find that ownership concentration is positively related with CEO compensation, indicating some kind of collusion between management and largest shareholder to get personal benefits. The results of dynamic GMM model suggest that CEO pay is highly persistent and takes time to adjust to long-run equilibrium. 

Q2. What future works have the authors mentioned in the paper "Firm performance, corporate governance and executive compensation in pakistan" ?

Therefore, in order to understand CEO pay puzzle and corporate governance in emerging markets, future research needs to account for differences in institutional context of the market under examination. 

Q3. What is the method for estimating corporate governance?

In addition, system-GMM appears to be the best-performing estimator for the data which is characterized by moderate length of time, low within firm variations in corporate governance variables, possibility of fixed effects driven dependent variable, some variables are endogenous and a dynamic relationship exists between variables (Filatotchev et al., 2013, Nguyen et al., 2015, Zhou et al., 2014). 

Q4. What is the reason why the authors decided to report the results in one model?

Since correlation between these variables and variance inflation factor are within acceptable range therefore the authors decided to report them in one model. 

Q5. What is the role of institutional ownership in corporate governance?

According to agency theory, institutional ownership serves a monitoring role and is related to lower CEO compensation (Hartzell and Starks, 2003). 

Q6. What is the reason for the insignificant relationship between CEO compensation and market performance?

Another possible reason for an insignificant relationship between CEO compensation and market performance could be that Pakistani bourses are considered to be highly volatile (Sheikh and Riaz, 2012), therefore using market performance as benchmark for setting CEO compensation may not be a good choice. 

Q7. Why do CEOs tend to be more powerful than the boards?

In Pakistani context, CEOs tend to be more powerful than the boards because they are eitherheads of the controlling families or have strong ties with controlling shareholders (Javid and Iqbal, 2008, Kamran and Shah, 2014). 

Q8. What is the link between CEO compensation and market performance?

Since CEO compensation in Pakistan rarely includes any restricted stocks, stock options and other stock based bonuses, therefore weak link between CEO compensation and market performance is expected. 

Q9. What are the main factors that affect CEO compensation in Pakistan?

Given the Pakistani context, the authors study how firm performance, concentrated/family ownership and board structure contribute towards CEO pay setting process.