Compensation Consultant Independence and CEO Pay. Wei Cen Cornell University Naqiong Tong 1 University of Baltimore

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1 Compensation Consultant Independence and CEO Pay Wei Cen Cornell University Naqiong Tong 1 University of Baltimore Jan 2011 Preliminary Version 1 Contact Author: Naqiong Tong, Merrick School of Business, University of Baltimore, 1420 N. Charles St, BC 450, Baltimore, MD 21201, Phone: , Electronic copy available at:

2 2 Abstract: Critics allege that executive compensation consultants face potential conflicts of interest (lack of independence) that might lead to higher CEO pay. Conflicts of interest include the desires to cross-sell service and to secure repeat business. Using a unique dataset of compensation consultant service fee in U.S. S& P 500 firms in 2009, we find strong evidence that compensation consultant s conflicts of interest is associated with higher CEO pay. We find that CEO bonus and total compensation are higher in companies where the consultant charges higher compensation-related service fees ( repeat business ). We also find that CEO salary, bonus and total compensation are higher in firms where the consultants provide other service and that pay is higher when the fees paid to consultants for other services are larger ( cross-sell service). In particular, evidence shows that that CEO receives 7% more salary, 22.9% more bonus and 15.6% more total compensation in firms where compensation consultants provide other services than that of firms where the consultants do not provide other service. In addition, we also document that CEO s pay-for-performance-sensitivity (PPS) is lower in firms where the consultants have potential conflicts of interest. In particular, CEO s PPS over cumulative equity pay (annual equity pay) is 30.12% (256.41%) lower in firms that retain compensation consultant to engage other services than those retain consultants without other services. Keywords: Executive Compensation, Compensation Consultant, Conflicts of Interest, CEO Pay, board of directors, corporate governance, disclosure Electronic copy available at:

3 1. Introduction 3 Most large companies rely on executive compensation consultants in designing CEO pay, including making recommendations based on survey, competitive-benchmarking information of industry practice and designing and implementing incentive plans to align CEO pay with a firm s long/short term strategies. 2 Understanding the influence of consultants has become an important question as the use of compensation consultants by boards of directors has risen (Higgins, 2007). While consultants can use their expertise to assist the compensation committee in designing compensation packages to maximize shareholder value, critics accuse them of aiding executives at the shareholders expense and focus on their conflicts of interest (Bebchuk and Fried, 2006; Morgenson, 2006; Higgins, 2007 and Waxman 2007). This study examines whether potential conflicts of interest of compensation consultants influence CEO pay for a sample of S & P 500 firms, using the new disclosure data of consulting fees required by Security and Exchange Committee (SEC) in August Compensation consultants are often subject to conflicts, including repeat business and non-compensation-related service interest (Murphy and Sandino, 2010). 3 If consultants do respond to conflicting incentives, they might compromise their independence and recommend overly generous compensation for client CEOs. We thus examine the effect of conflicts of interest of consultants on the level of pay and pay-for-performance sensitivity (PPS). Although compensation committee almost always has the sole authority to hire a compensation consultant, CEOs make recommendations of the consultant selection. In addition, the hiring 2 Beyond routine CEO pay, compensation consultants also provide guidance on change-in-control and employment agreements, and other complex accounting, tax, or regulatory issues related to executive pay. As consultants, they might also provide other consulting service to their client firms, including actuarial services, employee pay services benefits-administration services, and non-pay consulting, employee training, outsourcing HR functions, tax services, and investment services for pension funds. 3 Repeat business interest refers to the consultants concern with being reappointed, while non-compensation-related service interest refers to the provision of non-compensation-related services is under the decisions of the same top executives whose pay packages are designed by compensation consultants. Electronic copy available at:

4 decisions for non-compensation-related services are ultimately under the CEO s control, thus the consultant have the potential conflicts of interest as the desires to secure repeat business and to cross-sell service. For example, both Higgins (2007) and Waxman (2007) concluded that companies using consultants offer significantly higher pay than companies not using consultants. They also concluded that CEO pay is higher in firms when the consultants are simultaneously receiving millions of dollars from the corporate executives whose companies they are supposed to assess. Interestingly, empirical studies find little evidence that support above alleged critics. In particular, academic studies failed to document consistent evidence about whether the usage of compensation consultant is associated with a firm s optimal contracting (Armstrong, Ittner and Larcker (2010), Conyon, Peck, and Sadler (2009) Voulgaris, Stathopoulos and Walker (2010) and Kabir and Minhat (2010)) or whether cross-sell service of compensation consultant leads to CEO excess pay (Murphy and Sandino (2010), Cadman, Carter and Hillegeist (2010), Armstrong, Ittner and Larcker (2010)) and Goh and Gupta (2010)). Data unavailability in US might have limited researchers to investigate this important issue since the actual consultant fee data is not available until December Although the Security and Exchange Commission (SEC) required firms in 2006 to disclose whether firms engage any consultants and whether the consultants are engaged directly by the compensation committee rather than by management in 2006, the 2009 regulation requires firms to disclose fees paid to consultants for any additional services provided to the company by the consultants and their affiliates if the fees in non-compensation-related services are more than $120, To examine the effect of potential conflicts of interest as repeat service and cross-sell service, we take advantage of new SEC rules requiring companies to disclose the use of

5 compensation consultants in proxy statements in We hand collect compensation consultants and related service fees data on SP 500 firms for 2009 fiscal-year. To test the repeat business effect (i.e., the consultants concern with being reappointed and its impact on the compensation-related fees), we use the compensation-related fees as a measure of repeat business and examine the association between the compensation-related service fee and CEO pay (level of salary, bonus, equity and total compensation and pay-performance sensitivity (PPS)). To test the cross-sell service argument, we examine whether CEO pay is higher when the consultant provides services beyond executive compensation advice. We use three proxies to measure the cross-sell service. First, client firms who affirmatively disclose that their compensation consultant provides non-compensation-related services; second, we use the other-service-related fees; third, we use the fee ratio of non-compensation-related service fee and compensation-related service fee. 5 Using the actual service fee data, we find strong evidence that compensation consultant s conflicts of interest (both repeat business and cross-sell service) is associated with higher CEO pay. In particular, we find that CEO bonus and total compensation are higher in companies with higher compensation-related service fees ( repeat business ). We also find that CEO salary, bonus and total compensation are higher in firms where the consultants provide non-compensation-related service and when the fees paid to consultants for non-compensation-related services are larger ( cross-sell service). In particular, evidence shows that that CEO receives 7% more salary, 22.9% more bonus and 15.6% more total compensation in firms where compensation consultants provide non-compensation-related services than that of firms where the consultants do not provide non-compensation-related service. In addition, we also document that CEO s

6 pay-performance-sensitivity (PPS) is lower in firms where the consultants have potential conflicts of interest. CEO s PPS of total equity value change (annual equity pay) is 30.12% (256.41%) lower in firms that retain compensation consultant to engage non-compensation-related services than those retain consultants without non-compensation-related services. 6 Our research contributes to the literature related to executive compensation in general, and more specifically to the emerging literature on the role of compensation consultants. By taking advantage of the new disclosure rule in 2009, this paper is the first study that uses the actual disclosure data, which provides more accurate information on the role of compensation consultants and their impact on executive pay. This is a unique contribution since most previous studies such as Murphy and Sandino (2010) and Cadman et. al. (2010) were not able to obtain the actual compensation-related service fees and non-compensation-related service fees and use other proxies to measure compensation consultant s conflicts. 4 In particular, using actual compensation consultant data, this study finds that compensation consultants potential conflicts of interest also are associated with CEO pay-performance sensitivity, which contrasts to Cadman et. al (2010) s failure to document any evidence. We begin in Section 2 with a discussion of US institutional environment and related literature, followed by hypothesis development and model specification in Section 3. Section 4 reports a 4 Since the US firms were not required to disclose actual compensation consultant fees before 2010, Cadman (2010) and Murphy et al (2010) both use proxies, which might create measure error. In particular, Cadman (2010) uses three proxies that they can identify in firms 2006 disclosures (1) client firms who affirmatively disclose that their compensation consultant provides non-ec services; (2) firms that are not clients of Frederic W. Cook or Pearl Meyer, large consultants that focus exclusively on executive compensation services and thus do not have cross-selling incentives; and (3) firms that hire their auditor for significant non-audit services, indicating a willingness to allow possible conflicts of interest among their professional service providers. Murphy and Sandino (2010) use the compensation consultant s actuaries fees as identified from IRS and Department of Labor filings. The actual compensation consultant fee data is available for Canadian firms, so Murphy et al. were able to obtain 124 Canadian companies that retained compensation consultants.

7 summary of data and a description of the compensation consulting industry. Section 5 presents our primary findings on examining the influence of conflicts of interest on CEO pay. Section 6 concludes the study US Institutional Changes in 2009 and Related Literature Review Historically, US firms were not required to disclose their utilization of compensation consultants and the names of the consultant. A recent Congress report (Waxman, 2007) suggests that cross-selling conflicts may influence pay. Using proprietary data obtained from six compensation consultants, this report examines pay in Fortune 250 companies between 2002 and 2006 and finds that firms with the highest conflicts of interest with their consultants, as measured by the ratio of fees for non-compensation-related services to fees for executive pay advice, had higher median compensation than other firms. Concerns over the role of compensation consultants led the US Securities and Exchange Commission (SEC) in 2006 to require companies to identify and describe the role of all consultants who provided advice on executive compensation, and to disclose whether the consultants are engaged directly by the compensation committee rather than by management. This new regulation stirs the research interest and two streams emerged. The first research stream (Armstrong, Ittner and Larcker (2010), Conyon, Peck, and Sadler (2009) Voulgaris, Stathopoulos and Walker (2010) and Kabir and Minhat (2010)) focuses on whether the use of compensation consultants helps a firm achieve optimal contracting. In particular, Armstrong et al (2010) find that the association between CEO pay and compensation consultant is conditional on the corporate governance. Higher CEO pay is present in firms with weaker governance and they are likely to use compensation consultants. In UK, Conyon et al (2009) finds that the level of CEO pay (and equity

8 incentives) is generally greater in firms that use compensation consultants. 5 Voulgaris et al (2010) examine the impact of hiring a compensation consultant using managerial power approach (MPA) to corporate governance and find that positive effect of consultants on CEO pay levels mainly stems from an increase in equity-based compensation. In addition, Kabir and Minhat (2010) examine the impact of multiple compensation consultants on CEO pay and find that CEOs receive higher equity-based pay when firms with multiple compensation consultant and the market shares of compensation consultant are positively related to CEO compensation. 8 The second research stream focuses on whether the use of same compensation consultant on non-compensation-related service besides compensation service generates a conflict of interest, which might lead to CEO excess pay (Murphy and Sandino (2010), Cadman, Carter and Hillegeist (2010), Armstrong, Ittner and Larcker (2010)) and Goh and Gupta (2010)). Although SEC regulation has required firms to disclose whether they use compensation consultant and their roles, it did not require the firms to disclose the service fees paid to compensation consultants. Therefore, most of the previous studies use different approaches to proxy the conflict of interest. In particular, Murphy et al (2010) utilize Canadian firms and Cadman et al (2010) use four proxies in US firms, including a dummy variable (takes one if the firm voluntary disclosure the usage of compensation consultant on non-compensation-related services. zero otherwise), the use of auditor on other consulting services, the importance of the individual client to the consulting firms (total assets of one client/total assets combined by other clients. Due to lack of data, Cadman et al (2010) and Armstrong et al (2010) fail to find widespread evidence of association between higher levels 5 Their explanation of the excess pay is based on the following arguments: Survey by compensation consultants usually report information about salient parts of the pay distribution, such as the 25th, 50th, and 75 th percentiles. Compensation at or below the median is often treated as below market, where as pay in the 50 th to 75 th percentile is deemed competitive. Consultants are unlikely to recommend below market CEO pay. By benchmarking, consultants tend to ratchet pay upward as firms seek to give their CEOs competitive (i.e., above median) pay.

9 of pay (or lower pay-performance sensitivities) and potentially greater conflicts of interest. Similarly, Murphy et al (2010) find that pay is higher in US firms where the consultant works for the board rather than for management. In Canada, CEO pay is higher in companies where the consultant provides non-compensation-related services ( cross-sell services), and that pay is higher in Canadian firms when the fees paid to consultants for non-compensation-related services are large relative to the fees for executive-compensation services. In UK, Goh and Gupta (2010) study the impact of consultant change on managerial compensation and find that, in the year of the switch, CEOs of switch firms receive higher salary increments (both absolute and adjusted for median peer levels) and a less risky compensation package, through a higher proportion of bonus and a lower proportion of equity pay. 9 In response to increased concerns over executive pay, the SEC expanded its disclosure rules in August The expanded rule requires firms to disclose fees paid for both compensation consulting and non-compensation-related services if a firm purchases more than $120,000 in non-compensation-related services from its executive-pay consultant. Under the new regulations, firms can avoid such disclosures if the board retains its own compensation consultant (and if that consultant provides no non-compensation-related services). In fear of public anger of the potential conflicts of interest, the consulting firms lobbied the SEC intensely over the summer of 2009, holding eight meetings with various SEC commissioners and staffers over a period of 11 and a half weeks. However, the lobbies did not prevent the passage of the regulation and the fall in 2009 witnessed dramatically changes in the consulting industry, especially among the biggest four consulting firms (Tower Perrin, Hewitt, Mercer and Watson Wayatt) that historically provide other non-compensation-related services. In September 2009, a leading consultant left Mercer to form

10 Compensation Advisory Partners ( CAP ). In early 2010, Watson Wyatt merged with Towers Perrin to form Towers Watson & Co. on January 4, Later in July 2010 Pay Governance was spun-off from Towers Watson. Furthermore, Hewitt spun-off part of its North American Executive Compensation business into a new and independent consulting firm, Meridian Consulting Partners on January 29, In addition, the individuals at Hewitt joined another firm, Exequity in early 2010 and later in 2010, Aon Corporation merges with Hewitt Associates, creating Aon Hewitt, the world s premier human capital solutions firm on October 1, The dramatic changes in the consulting industry trig the public s concerns of compensation consultants conflicts of interest. In particular, how independent the compensation consultants are. This study aims to utilize the 2009 SEC regulation and use the actual consulting fee data to examine whether the conflicts of interest of consultant is associated with higher CEO pay. 3. Hypothesis and Model Specification Compensation consultants have various types of expertise and can assist compensation committees in two primary ways. 6 First, they provide expertise on compensation-related issues to tailor executive pay packages for the board, including knowledge of relevant laws and an understanding of executive compensation practices in general and for organizational changes such as mergers, acquisitions, and restructurings. Second, they typically have access to detailed, proprietary information about pay practices for specific industry or market. Based on peer group information, they can make recommendations to compensation committee about pay package. 6 Insight and advice about wider trends in executive compensation, analysis of managerial labor markets (e.g., how tight or slack the market for executive talent is), advice on performance measures and standards in compensation contracts, advice on compensation and benefits practices relative to peers, advice on pensions, an assessment of executive compensation relative to executive performance, and insight and advice on the level and mix of pay and benefits

11 The optimal contracting theory argues that under industry reputation self-discipline and effectiveness of the board structure, compensation consultants help to facilitate an efficient contract between the firm and executives, by providing useful labor market information and expertise. This is particular true when the hiring and firing power rests on the compensation committee. First, consultants have strong incentives to develop and maintain their reputations by providing accurate and unbiased advice. In long run their ability to retain a portfolio of customers relies on their credibility when considering the repeat business effect (i.e., the consultants concern of being reappointed) [Murphy and Sandino (2010) and Conyon, Peck, and Sadler (2009)]. To prevent potential conflicts, some consulting firms ensure that the individual who advises the compensation committee does not work on non-ec projects for the same client (Powers, 2007) 7. Second, compensation committees understand the importance of their oversee responsibility on executive pay. Directors are required by many state laws to have a duty of care to exercise due diligence where the use of expert advisors is encouraged. If the advisors are not independent or are deemed to have a conflicting interest, then directors could be at risk of not fulfilling their responsibility to shareholders. Third, compensation committee can take steps to mitigate potential cross-selling conflicts of interests by requiring written approval of the non-compensation-related services (Lublin, 2007) 8. Prior studies suggest that firms that employ compensation consultants have a higher proportion of their compensation packages at risk in the form of equity pay, consistent with the 11 7 Hewitt compensation services are segregated from other consulting services into a single, separate business unit within Hewitt. As part of that structure, the executive compensation consultants are paid solely based on the results of the executive compensation business unit, and not based on the performance of any other business unit or any other aspect of Hewitt s performance. Executive compensation consultants are not eligible for Hewitt equity awards. They also proactively provide summary disclosures to Compensation Committee clients of all of Hewitt s services to the company. 8 Other committees prohibit any non-compensation work from the consulting firm that provides EC services (Powers, 2007; Lowman, 2007). Some committee have written policy of the compensation consultant s independence as the company s total service revenue is less than 1% of their consolidated gross revenues from the Company. For example, one firms states on their proxy statement that an Independence Policy for the Compensation Committee consultant in February 2008 that establishes independence requirements, including that Towers Perrin and its affiliates do not derive more than 1% of their consolidated gross revenues from the Company. The Independence Policy also requires an annual certification from Towers Perrin confirming compliance with the Compensation Committee s Independence Policy. During 2009, Towers Perrin and its affiliates received substantially less than 1% of their consolidated gross revenues from the Company for consulting and actuarial fees.

12 shareholder alignment view (Conyon, Peck, & Sadler [2009]; Voulgaris, Stathopoulos, & Walker [2009]). In this case, we would not expect to find an association between conflicts of interest and the level of CEO pay or pay-performance sensitivity (PPS). 12 However, the rent-extraction theory (management power theory) argues that CEOs can use their power over compensation consultants to extract excess pay, and consultants have strong incentives to keep CEOs satisfied (Bebchuk & Fried [2003]; Morgenson [2006]; Anderson et al. [2007]; Waxman [2007]). Historically, compensation consultants have been retained not by the compensation committee but rather by company management. This situation creates an obvious conflict of interest, since the consultants make recommendations on the pay of the individuals who hire them (and who might hire them for repeat business). Although nowadays most firms assign the power of hiring and retaining compensation consultant in compensation committee, CEOs make recommendations of the consultant selection and CEOs can still influence the board s decision through their powers (Crystal, 1991; Bebchuk and Fried, 2003, 2004 ), thus the consultant have the potential conflicts of interest as the desires to secure repeat business and to cross-sell service (Cadman,2010). Repeat business conflicts of interest arise when the consultant provide repeat business to the same client year after year while cross-sell conflicts of interest arise when the consultant provides potentially more profitable non-executive-compensation services to the client firm beyond advice on executive pay. 9 The cross-sell service can compromise consultants independence, since the other revenues are sometimes more than ten times the client s compensation-related revenue and the profit margin of the other revenues are higher than the compensation revenues (Waxman, 2007). If cross-selling incentives compromise the independence 9 Non-compensation-related services include actuarial services, employee pay services benefits-administration services, and other uncommon services include non-pay consulting, employee training, outsourcing HR functions, tax services, investment services for pension funds, and actuarial services unrelated to pension plans.

13 and objectivity of compensation consultants, then we would expect that CEOs of firms that retain consultants with greater potential conflicts of interest would receive higher compensation levels. In addition, compensation schemes link executive wealth to firm performance, typically by including variable cash pay (bonus) and equity-based components. Risk- and effort-averse executives prefer large fixed compensation packages with variable pay that is less sensitive to firm performance. Therefore, in addition to recommending higher levels of pay, consultants with greater conflicts of interest are also likely to advocate contracts that result in weaker PPS. 13 Therefore, based on the above argument, our hypotheses are: Null Hypothesis: CEO pay is not associated with compensation consultant s conflicts of interest. Alternative Hypothesis: CEOs of firms that retain consultants with greater potential conflicts of interest would receive higher compensation levels and larger fixed compensation packages with variable pay that is less sensitive to firm performance To test the hypothesis, we use actual fee disclosure data of SP500 firms in We use four measures to proxy the compensation consultant conflicts of interest: COMPFEE (to test the repeat service conflict), OTHERSERVICE, OTHERFEE and FEERATIO (to test cross sell conflict). COMPFEE represents the service fee related to compensation consultants. OTHERSERVICE is a dummy variable, which takes one if the consultant provides non-compensation-related service, zero otherwise. OTHERFEE represents the service fee related to non-compensation-related service, such as pension, actuaries and general management service. FEERATIO represents the ratio of COMPFEE and OTHERFEE. Our dependent variable is CEO pay. To measure CEO pay, we use the level of the compensation (salary, bonus, equity and total compensation), and pay-performance sensitivity (PPS)

14 on the CEO total pay. The dependent variable in Model A is LnPAY, where LnPAY is defined as the log of one of four measures: Salary, Bonus (bonus and non-equity incentive pay), Equity (sum of stock awards and option awards) and Total (sum of salary, bonus and equity, pension and other compensation) received during the year. Salaries represent the fixed component of pay, while bonus and equity pay are typically tied to performance criteria and represent a variable element of compensation. The dependent variable in Model B is PPS, where PPS is measured by two proxies: PPSCUM is the ratio of total equity value change over 1% change in share price; PPSANN is the ratio of CEO annual equity pay over 1% change in share price. 14 We control other firm and corporate governance factors that might affect the CEO pay: firm economical characteristics, CEO characteristics and governance characteristics. For economical characteristics, studies indicate that CEO compensation levels should be increasing in firm size, operating and stock price performance, and investment opportunities (e.g., Murphy, 1999; Lambert and Larcker, 1987; Smith and Watts, 1992; Core and Guay, 1999). We include both operating income performance (ROA) and stock market performance (RETURN) as our proxies for firm performance. ROA (EBITDA scaled by the average of beginning and end of year total assets) and Lag(ROA)(ROA at time t-1) measure the operating performance, while RETURN (measured by total returns to shareholders, reflecting share price appreciation and dividend yield during the year) and LagRETURN (RETURN at time t-1) is to capture market performance. We also control firm leverage, size and book-to-market ratio, as they may reflect organizational complexity and growth opportunities. Leverage (LEV) is defined as the ratio of long term and short term debt to total assets. Size (SIZE) is the log of the firm s total assets measured at the end of the fiscal year, and investment opportunity (BTM) is measured by the ratio of book value to market value of assets.

15 15 CEO-specific characteristics may also influence compensation levels. First, CEO pay is likely to be higher for more experienced CEOs. We use three variables to capture CEO experience: Age (age of CEO), Tenure (tenure of CEO). The CEO_CHANGE variable is included because firms often provide relatively large compensation packages in the first year equity incentives and to make the CEO whole with respect to any compensation forfeited from his or her prior employer. Moreover, CEOs may have other economic incentives that substitute for annual pay, such as the existing CEO shareholdings. Second, to control CEO s existing equity incentives, we use CEOSHARE to measure CEO s existing shareholdings. There are two possible pay outcomes associated with equity incentives. When equity incentives (and total wealth) are high already, there may be little reason to provide additional incentives using annual compensation, and compensation levels may be lower. In contrast, if the equity incentives provide the CEO with considerable power over the Board, we may observe higher annual compensation. Our other control variables include variables related to corporate governance and management power. Consistent with earlier studies, we use six variables to capture board characteristics. 1. Armstrong et al (2010) argues that when a Board is dominated with CEO as chairman, Board tends to be under the influence of the CEO, therefore, we use a dummy variable (CEODUAL), which takes one if the Chairman of Board is same as CEO and zero otherwise. 2. Core et al. (1999) suggests that board independence is positively influence managerial and board decision-making; therefore, we use the percentage of outside director in a Board (OUTDIR) to proxy board independence. 3. Yermack (1996) and Coles et al. (2008) find that board size negatively influences managerial and board decision-making. We use the number of directors on the board (BSIZE) to

16 proxy the board size. 4. Yermack (1996) finds that board meeting is positively associated with strong governance, therefore, we use numbers of board meetings (BMEET) to proxy board effectiveness. 5. BAGE is the percentage of Board members who are at least 69 years old. 6. BTENURE is the percentage of board members who have tenure more than 10 years. 7 BBUSY: previous studies (Armstrong et al (2010) have shown that board is less effective if the board members have more positions other than in a particular company. Following Core et al. (1999) and other governance studies, we expect stronger board governance to be positively related to OUTPCT and BMEET, BTENTURE and negatively related to CEODUAL, BSIZE and BAGE. 16 Finally, we follow prior literature and use industry fixed effects to capture industry-specific differences in compensation levels. These fixed effects indicators are based on two-digit SIC codes. The followings are the regression models used to test our hypothesis. ModelA: LnPAY = β + β COMPFEE/OTHERSERVICE/OTHERFEE/FEERATIO + β ROA + β RETURN + β SIZE + β MB + β LEV β BAGE + β BTENURE + β BBUSY + INDUSTRYDUMMY + ε β AGE + β TENURE + β CEOSHARE + β CEODUAL + β OUTDIR + β BSIZE + β BMEET Model B: PPS = β + β COMPFEE/OTHERSERVICE/OTHERFEE/FEERATIO + β ROA + β RETURN + β SIZE + β MB + β LEV β BAGE + β BTENURE + β BBUSY + INDUSTRYDUMMY + ε β AGE + β TENURE + β CEOSHARE + β CEODUAL + β OUTDIR + β BSIZE + β BMEET Model A is to test the association between the compensation consultant s conflicts of interest and the CEO level pay (salary, bonus, equity and total compensation) while Model B is to test the association between the compensation consultant s conflicts of interest and the CEO

17 17 pay-performance sensitivity. 4. Data and Descriptive Statistics Our sample initially consists of SP500 publicly-traded companies with: (1) fiscal years of 2009, that filed their annual proxy statements (DEF 14A) as of December 31. The compensation consultant data is hand collected from the compensation committee report in the proxy statement following the introduction of the new disclosure rules. In most cases, the primary consultant is clearly identified in the text of the proxy. If no consultant is discussed, we classify the company as not using a consultant. In some instances when multiple consultants are used, we use the primary consultant that provides most service to the board. In these cases, we code the consultant used by the company for senior executive compensation. We delete 60 firms missing valid proxy statement due to merge and acquisition. As a result, only 440 firms are selected with proxy statement data available for fiscal year Then we also delete several firms due to data availability from CRSP and COMPUSTAT, ExeComp and Corporate library. Our final data sample has 429 firms. Among these 429 firms, we find that about 24% firms (106) are using compensation consultant along with non-compensation-related services, including actuarial services, employee pay services, benefits-administration services, and other uncommon services. The rest 76% firms (323 firms) do not use compensation consultants for non-compensation-related services. INSERT TABLE 1 Table 2 presents the market shares of the leading compensation consultant firms, including

18 Towers Perrin, Frederic Cook, Hewitt, Mercer, Watson Wyatt, Pearl Meyer and Semler Brossy. Contrasts to previous studies (Murphy and Sandino (2010), Cadman, Carter and Hillegeist (2010)) that identify Towers Perrin with the highest market share, we find that Frederic Cook has the highest market share (25.7 %), followed by Towers Perrin (17.02 %), Hewitt (15.38%), Mercer (9.56 %), Watson Wyatt (7.23%), Pearl Meyer (6.06%). The small boutique consulting firms include Semler Brossy (5.36%), Aon Consulting (2.23%), Hay (1.86%), Deloitt Consulting (1.4%) and Compensia (1.4%). 18 INSERT TABLE 2 Table 3 presents fees of 106 firms where compensation consultants also engage non-compensation-related services. Compensation consultants charge wide range fees for the CEO compensation service, starting from $8,631 (minimum) to $789,000 (maximum), with the mean (median) of COMPFEE as $214,122.5 ($188500). Similarly, we also observe a wide range of fees for non-compensation-related services, starting from $ to $3,583,061, with the mean (median) of OTHERFEE as $2,531,343 ($1,123,477). The FEERATIO is also widely spread, the maximum FEERATIO is 127, indicating that compensation consultant engage non-compensation-related services with value 127 times larger than the compensation-related service fee. Table 3 Panel B also lists the fee distributions of compensation service fees, non-compensation-related service fees and fee ratio. The majority of compensation consultant charge compensation service fees between 100,000 and 200,000 (40 firms, 37.7% of the sample), followed by the range between 200,000 and 300,000 (29 firms, 27.4%). 20 firms (18.9%) have the compensation service fees less than 100,000, while 6 firms have compensation service fees over

19 $500,000. We also find wide distribution of non-compensation-related service fees charged by compensation consultants, ranging from over 10 million dollars to less than 120,000 dollars. In particular, we find that the majority consultants provide non-compensation-related service in the range of 1 million and 5 million (40 firms, 37.7%), followed by 22 firms (20.8%) within the range of $120,000 and $500,000. Four firms have non-compensation-related service fees over 10 million dollars, while only 9 firms have non-compensation-related service fees less than 120,000. We then look at the FEERATIO, and find that 5 firms engage compensation consultant to provide non-compensation-related service that is over 100 times of the compensation service fees. The majority of consultants provide non-compensation-related service between 1 and 5 times of the compensation service. 19 Table 3 Panel C and D present the CEO pay for various groups by FEERATIO and non-compensation-related fees, according to percentiles of sample firms. In particular, we group firms into five groups according to the levels of non-compensation-related fees (Group 1: 0 3, Group 2: 3 7, Group 3: 7-13, Group 4: and Group 5: over 30) and FEERATIO (Group 1: million, Group 2: million, Group 3: 1-2 millions, Group 4: 2 5 millions and Group 5: over 5 millions). Panel E clearly presents an up-ward trend of CEO pay (salary, bonus, equity and total compensation), from Group 1 to arrive peak in Group 4. However, after the peak of CEO pay in Group 4, we observe a decline of CEO in Group 5. This is very interesting, since the distribution of CEO pay does suggest that when compensation consultants non-compensation-related fees increase, CEOs receive higher salary, bonus, equity and total compensation. It is strong evidence that suggests that the potential conflicts of interest of compensation consultant do bias their advice towards favorable CEO pay to secure greater revenue

20 from their clients by providing. However, the declines in CEO pay for Group 5 (the group with highest FEERATIO and OTHERFEE) imply that when the consultants receive more revenue from other services, they tend to reward CEO less, in fear of public recognition of their conflicts of interest and to avoid scrutiny from regulatory bodies (such as SEC) or the public. This is particularly true after the passage of SEC regulation in August 2009 when the fees are required to disclose. This pattern is similar to Murphy et al (2010) s findings, where they find that increasing the ratio of non-executive-pay fees to executive-pay fees from 0 to 10 (approximately the average in our sample) corresponds to approximately an 11% increase in pay for Canadian CEOs. 20 INSERT TABLE 3 Table 4 presents the descriptive statistics of variables we used in analysis. The mean (median) of CEO salary during 2009 is $1,082,490 ($1,000,000) while the mean (median) of CEO bonus is $2,169,450 ($1,500,000). The mean (median) of CEO equity is about $5,186,290 ($4,266,100) and the mean (median) of CEO total compensation is $9,897,340 ($8,430,340) respectively. The pay-performance sensitivity of CEO pay of total equity value change in past years has a mean (median) as ( ) and the pay-performance sensitivity of CEO pay of annual equity pay has a mean (median) as ( ). Sample firms have median total assets approaching 9 billion. The mean of ROA is 12.73% and the mean of RETURN is 1.45%. The median market to book ratio is 3.88 and the median leverage level of the sample is 21%. On average, CEO is 55 years of age and has been in his current role for over 5 years and has owned 0.005% of company s outstanding shares. As to the board characteristics, on average, the board has 11 board members, 87.4% of whom are non-executive or independent directors. Board meets on average 9 times, with

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