IR Papers: how changes to compensation plans affect value

Oct 30, 2013
<p>A roundup of academic research from the world of IR studies</p>

An unintended consequence

Proxy advisory firm recommendations have substantive impact on say-on-pay voting outcomes. Anticipating this, many boards of directors change their compensation programs before the formal shareholder vote to better align them with the proxy advisory policies. Whether this sequence of events creates or destroys value has remained untested, however.

Now, researchers at Stanford University and the University of Navarra report that the stock market reaction to these changes is statistically negative. Specifically, the average risk-adjusted return on the 8K filing date is 0.44 percent lower among compensation changes aligned with proxy advisory policies than among unrelated changes.

‘Our results suggest outsourcing say-on-pay voting to proxy advisory firms is not innocuous and appears to have a strange and unintended economic consequence,’ says study co-author David Larcker, professor of accounting at Stanford University. ‘Simply put, boards of directors are induced to make choices that decrease shareholder value.’

It’s a TSX peccadillo

Toronto Stock Exchange rules require companies to disclose the reason(s) for a stock repurchase program and promptly report actual share repurchases. A study of more than 1,800 repurchase announcements reveals firms have responded with communications of breathtaking uniformity and sublime meaninglessness.

Nevertheless, some repurchase announcements spark market interest while others fizzle – and now we know why. A Brock University study reveals that higher announcement returns are associated with firms that followed through on previous repurchase announcements and have cash on hand to fund repurchase programs.

‘Credibility is the big issue governing market reaction,’ says James Moore, assistant professor of accounting at Ontario’s Brock University. ‘If you want a good reaction, make sure you have followed through on previous stock repurchase announcements. Nor should you expect a great reaction if you don’t have cash on hand to actually buy back shares.’

Moore says investors do not consider any of the short litany of reasons provided by firms for their repurchase programs – such as preventing dilution due to stock options or using excess funds – as value-relevant. ‘Ultimately, what you say is not as important as what you’ve actually done and can do,’ he concludes.

Proxy contests can hit careers

Using data from all proxy contests from 1996 to 2010, researchers at the University of Illinois and the University of Chicago find proxy contests linked to serious adverse effects on the careers of incumbent directors at both the targeted firm and any unrelated boards.

For an individual director, being up for renomination during a proxy contest is associated with losing more than one board seat over the following five years, which equates to almost $2 mn in forgone income until retirement for the median incumbent director.

‘Shareholder democracy isn’t dead,’ declares study co-author Vyacheslav Fos, assistant professor of finance at the University of Illinois. ‘If companies are poorly managed and poorly performing and directors take no steps to improve it, there are mechanisms to go after these directors and impose severe career costs.’

Fos notes that while all directors of a targeted company feel the proxy mechanism’s career effect, those who happen to be up for re-election during a contest year feel it most. He believes media coverage is responsible for this differential effect. ‘Dissidents and the media will be talking only about directors up for re-election,’ he explains. ‘You don’t want your name mentioned in the media in the context of possibly being fired by shareholders.’

While strong evidence is elusive, Fos believes his research uncovers the most compelling reason for board members to settle with dissidents. ‘Directors are well aware of this effect,’ he says. ‘We’ve just quantified it for them.’

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