"Ceo Employment Contract Granting Stock"
Comparing CEO Employment Contract Provisions: Differences between Australia and the U.S. Jennifer Hill Sydney Law School and Vanderbilt Law School Ronald Masulis Vanderbilt Law School and Owen Graduate School of Management Randall Thomas Vanderbilt Law School and Owen Graduate School of Management Please Do Not Cite or Quote Without Authors’ Express Permission Draft of April 5, 2010 Abstract This study compares CEO employment contracts across two very different common law countries, the US and Australia after creating pairs of Us and Australian firms that are matched on a number of dimensions including firms size and industry. We find that Australian CEOs have substantially greater base salaries than their US counterparts, while US CEOs have greater restricted stock and stock options than their Australian counterparts. More striking is the fact that US CEO contract tend to last longer than Australian contracts, while Australian long term incentives tend to be concentrated in stock and stock options with significant performance hurdles requirements. 1 Introduction Executive compensation has been front page news throughout the world in the wake of the financial crisis. The soaring rhetoric about excessive pay to ungrateful bank employees, coupled with personal attacks on CEOs and other executives, have revealed a strong public anger toward the highly paid employees of public companies. Frequently missing from the discussion are basic facts surrounding the terms and conditions of the managers’ relationships with their firms, especially their companies’ ex ante contractual obligations to these executives. While several recent studies in the U.S. have begun to fill in some of the details surrounding the American contracts, or the lack thereof, 1 none have fully captured the U.S. experience, especially from a legal perspective, or even touched on Australian CEOs’ contractual employment relationships. In this paper, we are the first to compile, compare and statistically analyze CEO employment contracts for both U.S. and Australian CEOs. We find that there are many statistically significant differences between the provisions of these agreements, some of which reflect underlying differences in the legal and regulatory environment, while others are not so easily explained. For instance, many more American CEOs have change-in-control provisions in their employment agreements than Australian CEOs, but this difference may well stem from more stringent stock exchange listing requirements at the Australian Stock Exchange. Vast differences in the use of arbitration provisions though cannot be explained by legal rules, but may instead reflect cultural differences in that arbitration has historically been employed in Australian as a dispute resolution device in labor union relations with their employers. We begin with a brief overview of the differences in the underlying legal and regulatory regimes of the two countries. We then provide a literature review of existing empirical studies in the U.S. of various contracts between the American CEO and his/her firm. In Section III, we lay out our empirical analysis, beginning with a detailed description of our data and finishing with our multivariate regression analysis. We conclude with some brief remarks about the implications of our findings. I. Differences in the Regulation of Executive Pay in the United States and Australia 1 See section II for a review of the recent literature. 2 [In the next revisions to this section, we need to add discussion of differences in firm size and overall market size; differences in stock ownership patterns, both institutional and control shareholders; discussion of the internationalization of the different labor markets; comparisons of the overall levels of pay and the differences in the rates of growth of those levels with more detail about the composition of pay on an aggregate basis] The U.S. and Australia have followed different paths in the regulation of executive pay. Beginning with the U.S., the general regulatory response prior to the global financial crisis to allegations of abusive practices related to executive compensation was to focus on broad corporate governance issues. Rules and regulations related to board structure 2 and auditor independence, 3 for example, assumed center stage for the purposes of reform initiatives. 4 This minimalist approach continued post-Enron, in the United States, as only two provisions of the Sarbanes-Oxley Act of 2002 (“the Sarbanes-Oxley Act”) 5 dealt directly with pay-related issues. The first was § 304 of the Sarbanes-Oxley Act. This was a statutory claw back provision, permitting recovery of bonuses, incentive-based or equity-based compensation received by the CEO or chief financial officer (“CFO”), if the corporation is required to restate earnings due to material non-compliance with financial reporting requirements as a result of misconduct. 6 In spite of the plethora of financial restatements in US corporations since the 2 See Sonnenfeld, What Makes Great Boards Great, HARV. BUS. REV., Sept. 2002, at 106. For example, the United States’ 2002 reforms require listed company boards to have a majority of independent directors and to have compensation, nominating and audit committees composed entirely of independent directors. See Sarbanes-Oxley Act, Pub. L. No. 107-204, § 301, 116 Stat. 745, 775-77 (2002); NYSE, Inc., Listed Company Manual §§ 303A.01, 04-06 (2003). 3 See generally Coffee, Jr., Understanding Enron: “It’s About the Gatekeepers, Stupid”, 57 BUS. LAW. 1403 (2002); Coffee, Jr., Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms, 84 B.U. L. REV. 301, 321 (2004); Gordon, What Enron Means for the Management and Control of the Modern Business Corporation: Some Initial Reflections, 69 U. CHI. L. REV. 1233, 1237-1240 (2002); Fogarty & Lansley, Sleepers Awake! Future Directions for Auditing in Australia, 25 U.N.S.W. L.J. 408, 421 (2002). 4 A significant proportion of the Sarbanes-Oxley Act 2002 was, for example, devoted to issues involving auditor qualifications, independence and oversight. See Sarbanes-Oxley Act, Pub. L. No. 107-204, §§ 101-301, 116 Stat. 745, 750-77 (2002). 5 Sarbanes-Oxley Act, id. 6 Simmons, Taking the Blue Pill: the Imponderable Impact of Executive Compensation Reform, 62 SMU L. REV. 299, 347-349 (2009). 3 introduction of § 304, 7 successful actions under the provision have been rare indeed. 8 Secondly, § 402 of the Sarbanes-Oxley Act prohibited the granting of personal loans to directors or executive officers. It appears that this was previously a widespread practice, which figured prominently in the Enron and WorldCom scandals. 9 The most recent U.S. proposals concerning executive remuneration have been more invasive. Originally focused on a narrow, specialized group of U.S. namely those receiving government bail-out funding, 10 many reform proposals have subsequently become more general in scope. Between October 2008 and February 2009, the U.S. Treasury Department and Congress introduced an array of legislation and guidelines aimed at controlling executive pay at institutions receiving federal financial assistance under government bail-out programs, including rules created under the Emergency Economic Stabilization Act of 2008 (“EESA”). 11 Treasury released new guidelines (“Treasury guidelines”) under the EESA, restricting executive pay at companies receiving future federal financial assistance. 12 The guidelines created a two-tier 7 See Schwartz, The Claw back Provision of Sarbanes-Oxley: An Underutilized Incentive to Keep the Corporate House Clean, 64 BUS. LAW. 1, 2, 13-15 (2008). 8 Id, noting that six years after the introduction of the Sarbanes-Oxley Act, the SEC had successfully obtained claw backs only twice. A range of factors that he have compromised the effectiveness of § 304. For example, private claw back actions have been proscribed. See Gordon, ‘Say on Pay’: Cautionary Notes on the U.K. Experience and the Case for Shareholder Opt-In, 46 HARV. J. ON LEGIS. 323, 334, n 39 (2009). Also, it is unclear whether the requisite “misconduct” under § 304 must be directly attributable to the officer against whom reimbursement is sought. See Hill, New Trends in the Regulation of Executive Remuneration, in DIRECTORS IN TROUBLED TIMES 100, 101 (Austin & Bilski, eds., 2009). 9 Roberta Romano, The Sarbanes-Oxley Act and the Making of Quack Corporate Governance, 114 YALE L.J. 1521, 1538 (2005). 10 See generally Core and Guay, Is There a Case for Regulating Executive Pay in the Financial Services Industry?, 13ff, Working Paper, Jan. 25, 2010 (available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1544104). 11 The Emergency Economic Stabilization Act of 2008 (EESA), which was signed into law on 3 October 2008 and authorized Treasury to access up to US$700 billion to protect and restore confidence in US financial markets. See Davis Polk & Wardell, “Executive Compensation Rules under the Emergency Economic Stabilization Act of 2008”, 23 October 2008 (available at http://www.dpw.com/1485409/10.23.08.epg.tarp.memo.pdf). The first program under the EESA, the Capital Purchase Program, introduced new rules on executive compensation for participating institutions. For a summary of EESA rules on executive remuneration applying to various categories of EESA participants, see id, 15-18. The initial participants in the Capital Purchase Program were nine of the largest US banks, which received US$125 billion under the program. Id, 2. 12 See US Department of the Treasury, Press Release, Treasury Announces New Restrictions On Executive Compensation, 4 February 2009 (available at http://www.treasury.gov/press/releases/tg15.htm); Davis Polk & 4 assistance regime, distinguishing between institutions receiving funds under “generally available” capital programs, and those requiring “exceptional assistance”. Thus, for example, firms receiving exceptional assistance became subject a range of new restrictions concerning executive compensation, including an executive pay cap; 13 a non-binding “say on pay” shareholder vote requirement; expanded claw back and golden parachute restrictions; required certification that the compensation does not encourage excessive risk-taking; and disclosure of policies on luxury expenditures. 14 The American Recovery and Reinvestment Act of 2009 (ARRA), or “stimulus bill”, included additional Congress-demanded limitations on executive compensation for institutions participating in the Troubled Asset Relief Program (TARP), 15 including a limitation on bonus payments. 16 Treasury issued an interim final TARP rule in June 2009. 17 Wardell, “New Executive Compensation Restrictions under the Emergency Economic Stabilization Act of 2008”, 6 February 2009 (available at http://www.dpw.com/1485409/clientmemos/2009/02.05.09.ec.pdf). 13 Stricter constraints apply in this regard for firms receiving “exceptional assistance” than for institutions receiving funds under “generally available capital programs. For example, although both categories of funding assistance attract a senior executive pay cap of $500,000 on total annual compensation (excluding restricted stock), this cap could in certain circumstances be waived by shareholders of institutions receiving financial assistance under generally available capital access programs. Davis, Polk and Wardell, id, 3. For criticism of this waiver power, see Bebchuk, “Pay Caps Debate: They Don’t Go Far Enough…”, Wall Street Journal, 6 February 2009, A11. 14 See generally Farrell, “US Bank Chiefs Face $500,000 Limit”, Financial Times, 5 February 2009, 05; Davis Polk & Wardell, ibid. 15 See generally Bachelder, Executive Compensation under TARP, THE HARVARD LAW SCHOOL FORUM ON CORPORATE GOVERNANCE AND FINANCIAL REGULATION, April 28, 2009 (available at http://blogs.law.harvard.edu/corpgov/2009/04/28/executive-compensation-under-tarp/#more-966); Morphy, ECONOMIC ‘STIMULUS’ LEGISLATION TO IMPOSE NEW EXECUTIVE COMPENSATION RESTRICTIONS, THE HARVARD LAW SCHOOL FORUM ON CORPORATE GOVERNANCE AND FINANCIAL REGULATION, Feb. 16 , 2009 (available at http://blogs.law.harvard.edu/corpgov/2009/02/16/economic-%e2%80%9cstimulus%e2%80%9d-legislation-to- impose-new-executive-compensation-restrictions/#more-870). 16 Bonus payments were limited to one third the value of total annual compensation the under American Recovery and Reinvestment Act of 2009. 17 See US Department of Treasury, Interim Final Rule on TARP Standards for Compensation and Corporate Governance (available at http://www.treas.gov/press/releases/reports/ec%20ifr%20fr%20web%206.9.09tg164.pdf). See generally Core and Guay, Is There a Case for Regulating Executive Pay in the Financial Services Industry?, 13- 14, Working Paper, Jan. 25, 2010 (available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1544104). 5 Executive remuneration received more attention under Australia’s post-Enron reforms. 18 However, the Australian reforms followed a different regulatory pathway to the United States, in that they enhanced shareholder power. The reforms introduced section 250R(2) of the Corporations Act 2001 (“Corporations Act”), 19 which was based upon an analogous UK provision introduced in 2002, 20 and requires shareholders of an Australian listed company to pass a non-binding advisory vote at its annual general meeting, indicating whether they adopt the directors' remuneration report. 21 The explicit goals of §250R (2) were to provide shareholders with greater voice concerning remuneration issues, 22 and to encourage more consultation and information flow concerning compensation policies between directors and shareholders. 23 Another significant factor relates to the Australian Securities Exchange (ASX) Listing Rules (LR). ASX LR 10.14, for example, requires shareholder consent for the issue of securities to directors under an employee incentive scheme. 24 A number of protest votes were recorded at 18 Australia’s post-Enron legislative reforms were located in the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act, 2004 (Austl.). 19 Corporations Act, 2001, c. 2G, § 250R(2) (Austl.). See also Corporations Act, 2001, c. 2G, §§ 249L(2), 300A (Austl.). 20 The provision requiring shareholder approval of the directors' remuneration report is now found in § 439 of the U.K. Companies Act 2006. See Companies Act, 2006, c.46, § 439 (U.K.). The required content of the remuneration report is detailed in Schedule 8 of the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations. See Director's Remuneration Report Regulations, 2002, S.I. 2002/1986 (U.K.). The Australian section is broader in scope than the analogous U.K. provision. Under the Australian regulatory regime, the nonbinding shareholder vote encompasses remuneration of each director and certain senior executives; however, the U.K. provision only applies to directors' remuneration. Corporations Act, 2001, c. 2G, §§ 250R(2), 300A(1)(c)(i)-(iii) (Austl.). See also BUS. COUNCIL OF AUSTL., SUBMISSION TO THE PARLIAMENTARY JOINT COMMITTEE ON CORPORATIONS AND FINANCIAL SERVICES ON THE CORPORATE LAW ECONOMIC REFORM PROGRAM (AUDIT & CORPORATE DISCLOSURE) BILL 14, comparing the Australian and U.K. regimes. 21 See generally Chapple & Christensen, The Non-Binding Vote on Executive Pay: A Review of the CLERP 9 Reform, 18 AUSTL. J. CORP. L. 263 (2005). 22 Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Bill, 2003, Austl. H.R. Bill, Explanatory Memorandum paras. 5.434-5.435 (2003), 23 Id. at paras [4.353], [5.413]. 24 Australian Securities Exchange, ASX Listing Rule 10.14 (2003), available at http://www.asx.com.au/ListingRules/chapters/Chapter10.pdf. 6 companies using exemptions or ASX waivers to avoid the need for shareholder consent under ASX LR 10.14 in relation to executive pay. 25 Several other executive pay regulations were introduced in Australia after the Enron scandal. 26 These included heightened remuneration disclosure, 27 modification of provisions relating to termination pay, 28 and the introduction by the Australian Securities Exchange (“ASX”) of principles-based regulation 29 in a range of corporate governance areas, including executive remuneration. 30 The APRA guidelines introduce industry specific regulation of executive pay. In a related initiative in 2009, the Australian Productivity Commission undertook a more general review of the remuneration framework for directors and executives 31 under the Corporations Act 2001 32 (Austl.) (Corporations Act). The Productivity Commission’s final report, Executive 25 Washington, Executive Rewards Wake a Sleeping Giant, SYD. MORNING HERALD, Nov. 12, 2007, 19. 26 See Sheehan, The Regulatory Framework for Executive Remuneration in Australia, 31 SYD. L. REV. 273, 275-76 (2009). 27 See Corporations Act, 2001, § 300A (Austl.). 28 See generally Stapledon, Termination Benefits for Executives of Australian Companies, 27 SYD. L. REV. 683 (2005). See also Sheehan and Fenwick, Seven: The Corporations Act 2001 (Cth), Corporate Governance and Termination Payments to Senior Employees, 32 MELB. U. L. REV. 199 (2008). 29 At the time of the introduction of its principles of good corporate governance, the Managing Director and CEO of the ASX stated that “[t]hrough a disclosure based approach, the ASX is keen to avoid a U.S. style Sarbanes-Oxley legislative solution”. See Humphry 2003, ‘If Not, Why Not?’, Address to the Australian Institute of Company Directors Forum, Sydney (2003). 30 ASX Corporate Governance Council, Principles of Good Corporate Governance and Best Practice Recommendations (2003), Principle 9 – “Remunerate Fairly and Responsibly” (Austl.). See also ASX Corporate Governance Council, Revised Corporate Governance Principles and Recommendations (2nd ed, 2007), Principle 8 (Austl.). See generally Ablen, “Remunerating ‘Fairly and Responsibly’: The Principles of Good Corporate Governance and Best Practice Recommendations’ of the ASX Corporate Governance Council, 25 SYD. L. REV. 555 (2003). 31 The review related to remuneration of directors and executives of “disclosing entities”. Under s 111AC of the Australian Corporations Act, disclosing entities are listed companies and managed investment schemes, with at least 100 investors. The review considered a range of regulatory mechanisms such as shareholder voting, disclosure and reporting practices. See Treasurer, Joint Media Release with Assistant Treasurer and Minister for Competition Policy and Consumer Affairs and Minister for Superannuation and Corporate Law, Productivity Commission and Allan Fels to Examine Executive Remuneration, 18 March 2009, “Terms of Reference: Review into the Regulation of Director and Executive Remuneration in Australia”. 32 See Treasurer, Joint Media Release with Assistant Treasurer and Minister for Competition Policy and Consumer Affairs and Minister for Superannuation and Corporate Law, Productivity Commission and Allan Fels to Examine 7 Remuneration in Australia, was released in December 2009. 33 The Productivity Commission made 17 recommendations in total, the majority of which related to ensuring procedural integrity in relation to the pay-setting process and shareholder approval of the remuneration report under §250R(2) of the Corporations Act, 34 in addition to increased disclosure and reporting requirements. Finally, Australia has introduced specific legislative reforms, Corporations Amendment (Improving Accountability on Termination Payments) Act 2009, 35 to deal with “golden handshakes.” 36 There had been strong criticism of the previous law concerning termination pay, 37 on the basis that it was overly generous to executive officers 38 and potentially delivered “rewards for failure.” 39 A key aspect of the 2009 Act is that it caps a director’s termination pay Executive Remuneration, 18 March 2009, “Terms of Reference: Review into the Regulation of Director and Executive Remuneration in Australia”. 33 Australian Government Productivity Commission, Productivity Commission Inquiry Report No. 49, Executive Remuneration in Australia, 19 December 2009. The Productivity Commission published several interim papers prior to release of its final report. See Australian Government Productivity Commission, Regulation of Director and Executive Remuneration in Australia, Issues Paper (April 2009) and Australian Government Productivity Commission, Discussion Draft, Review into the Regulation of Director and Executive Remuneration in Australia, 30 September 2009. 34 See e.g., Banks (Chairman, Productivity Commission), Executive Pay: Economic Issues from the Commission’s Report, speech to the Economics Society of Australia, 14 October 2009, 13, stating that the Commission had “focused more on the integrity of the sausage-making than the sausage” in its inquiry into executive remuneration in Australia. 35 The Corporations Amendment (Improving Accountability on Termination Payments) Act 2009 received Royal Assent on November 23, 2009. 36 See Bills Digest No 6 2009-10, Corporations Amendment (Improving Accountability on Termination Payments) Bill 2009 (available at http://www.aph.gov.au/library/pubs/BD/2009-10/10bd006.htm), “Purpose”. For an overview of key policy issues relating to termination pay, see Stapledon, Termination Benefits for Executives of Australian Companies, 27 SYD. L. REV. 683 (2005). 37 See, for example, Sheehan and Fenwick, “Seven: The Corporations Act 2001 (CTH), Corporate Governance and Termination Payments to Senior Employees”, 32 MELB. U. L. REV. 199 (2008); RiskMetrics Group, Press Release, Shareholders Pay the High Cost of Failure: Average CEO Gets $3.4 Million to Walk, Nov. 26, 2008. 38 Under Part 2D.2 of the Corporations Act (former § 200F), shareholder consent was only required if termination benefits exceeding seven times a director’s annual remuneration package. See, for example, Paatsch and Lawrence, Money for Nothing, BUS. SPECTATOR, Jul. 17, 2008, describing Part 2D.2 of the Corporations Act “in reality a dead letter”. 39 Rewards for failure” became topical following the U.K. government’s release in 2003 of two reports on this issue in 2003 – (i) Department of Trade and Industry (DTI), “Rewards for Failure”: Directors’ Remuneration – 8 at one year’s average base salary – a significant reduction from the previous seven year threshold - unless shareholder approval is obtained. 40 For our project, it is important to be conscious of the underlying differences in these two national legal systems. Executive employment contracts, or service agreements as they are called in Australia, are written against the backdrop of these specific rules and regulations, but also with the underlying regulatory culture in mind. As we will see in the subsequent sections, many of the differences in the contracts we examine may well be directly related to differences in the background legal rules. At the same time, there are many similarities between the contracts from the two countries even though the two legal systems are different. We turn next to a brief overview of the prior literature. II. Literature Review Theorists have discussed contracting between firms and their executives extensively over the years, 41 but only recently, and largely in the U.S., have the actual agreements been examined by empiricists. Researchers have found a complex set of contracts that govern the relationships between American CEOs and their publicly held firms, most of which are publicly disclosed in various degrees of detail because of Securities and Exchange Commission (SEC) requirements. Outside the U.S., however, it is rare to see disclosure of any information concerning these contracts, although recently in Australia, there has been mandatory disclosure of summaries of certain key agreements, such as the CEO’s employment contract. Given the lack of data, we Contracts, Performance & Severance (June 2003); (ii) UK Parliament, House of Commons, Trade and Industry Committee, Rewards for Failure (September 2003). See generally Stapledon, Termination Benefits for Executives of Australian Companies 27 SYD. L. REV. 683, 691-693 (2005). The UK government subsequently announced that it did not intend to legislate to control termination payments. Cf Harrison, Dismay as DTI Baulks at Limits on Fat Cat Pay, THE INDEPENDENT, February 26, 2004, 42; Tucker and Wright, Excessive Pay-offs Decision Welcomed – Executive Rewards, FIN. TIMES, Feb. 23, 2004, 2. 40 A number of changes were made during the passage of the Corporations Amendment (Improving Accountability on Termination Payments Bill 2009. For a summary of differences between a May 2009 Exposure Draft of the Bill and the actual Bill, which was introduced into the House of Representatives on 24 June 2009, see Freehills, Limits on Termination Payments: Bill Introduced into Parliament, JUN. 26, 2009 (available at http://www.freehills.com/5121.aspx); Mallesons Stephen Jacques, Government Introduces Executive Termination Payment Laws into Parliament, JUN. 24, 2009 (available at http://www.mallesons.com/publications/2009/Jun/9966946W.htm). 41 Cites to literature 9 believe that we are the first paper that compares U.S. and Australian CEO employment contracts. There are, however, a number of earlier empirical studies of U.S. CEO employment contracts and other contractual agreements with their firms. We summarize the most relevant ones of these below. A. Employment Contracts Schwab and Thomas conduct a legal and empirical analysis of American CEOs’ employment contract terms. 42 After providing an overview of the process by which these agreements are negotiated, they examine the key legal characteristics of 375 employment contracts. In addition to reporting descriptive statistics on these legal features, they also compare the employment contract provisions with those found in a sample of 121 change-in-control agreements. They find several significant differences between these two types of contracts. A second paper examining CEO employment contracts is Gillan, Hartzell and Parrino. 43 They ask why firms enter into explicit as opposed to implicit employment contracts with their CEOs. They examine all of the firms in the S&P 500 as of January 1, 2000. They find that of these firms, 184 have explicit CEO employment contracts, 41 firms disclose the existence of such an agreement but the researchers cannot find it, and 269 firms have no written agreement with their CEO. They find that explicit employment agreements are more common for firms: operating in risky business environments; with “outside” CEOs that come in to the job from another firm; and with CEOs that have more to lose if the firm breaches because they have higher abnormal compensation levels or larger fractions of their pay in the form of incentive- based pay. Moreover, they show that the length of a CEO contract depends on the same set of factors as the decision to award an explicit contract, so that longer contracts are awarded to outside CEOs and those CEOs more at risk of having their firm renegotiate their contract. 42 Stewart J. Schwab and Randall S. Thomas, An Empirical Analysis of CEO Employment Contracts: What do Top Executives Bargain For?, 63 Washington and Lee Law Review 231 (2006). For a model form executive employment contract, see Joan MacLeod Heminway and Trace Blankenship, Executive Employment Agreements in Tennessee: An Annotated Model Tennessee Executive Employment Agreement, 10 Tennessee Journal of Business Law141 (2009). 43 Stuart L. Gillan, Jay C. Hartzell, and Robert Parrino, Explicit versus Implicit Contracts: Evidence from CEO Employment Contracts, 64 Journal of Finance 1629 (2009). 10 B. Severance Agreements A second set of studies examine severance pay and agreements for American CEOs. Yermack’s article on severance pay for dismissed or retired executives asks whether there is any correlation between the existence of formal severance contracts and the award of severance pay. 44 He finds that more than half of a sample of 179 CEOs of Fortune 500 companies who left firms between 1996 and 2002 receive severance pay with a mean value of $5.4 million, although this is less than one year’s average CEO compensation. However, the large majority of these payments (83%) are paid at the discretion of the board and not pursuant to a previous employment agreement. CEOs that are dismissed are much more likely to be paid separation payments than those that retire voluntarily and they receive much larger amounts of pay. Rusticus studies severance agreement’s relationship with CEO turnover. Using a sample of 305 newly hired CEOs at S&P 1500 firms between 1994 and 1999, he finds that about half of them have severance agreements and the median amount paid is two years cash compensation. He finds that their presence is positively correlated with uncertainty about the CEO’s abilities as measured by their number of years with the firm before becoming a CEO, the degree of uncertainty about the firm’s operating environment, and higher amounts of compensation awarded to the executive. The dollar amount of the payments is correlated with the size of their annual cash compensation, firm size and whether the CEO is an outsider. A contemporaneous paper by Sletten and Lys uses a sample of 150 CEOs that started at their position between 1992 and 2003. 45 They find that 50% of these executives have formal ex ante severance agreements, while 65% of all these CEOs receive separation payments at their departure. The mean payments are $5.37 million in 2003 dollars. They argue that ex ante severance agreements offer payments as a form of insurance as executives joining riskier firms, outside CEOs, and CEOs whose predecessors were forced to leave the firm, all contract for higher severance payments. They also find support for the claim that CEOs with confidentiality agreements are more likely to contract for higher ex ante severance, although not so for CEOs with non-competition agreements. 44 David Yermack, Golden Handshakes: Separation Pay for Retired and Dismissed CEOs, [published citation] golden handshakes refer to separation packages awarded to CEOs when they retire or are dismissed. 45 Ewa Sletten and Thomas Lys, Motives for and Risk-Incentive Implications for CEO Severance, [citation to published paper]. 11 Rau and Xu analyze 2,192 severance agreements for 1,788 high level executives at 862 firms listed on the COMPUSTAT database in 2004. They define severance agreements to cover both change-in-control agreements as well as contracts that provide for termination with good reason/without cause. They find that severance pay increases as firm risk increases, particularly for small firms and firms that are likely takeover targets. Change-of-control agreements lead to significantly higher severance pay and are more common at firms with high institutional ownership levels if the executive is a CEO or Board Chairman. C. Bonus Agreements Bonus contracts have been examined by several different researchers. Murphy has an early study of the use of performance standards in executive bonus contracts using proprietary data on 177 plans collected by a compensation consulting firm. He finds that “internal” performance standards, which are based in large part on management’s actions or performance in the current or prior year, are of one of two types: prior-year performance or based on the company’s business plan or budget. Eighty-nine percent of companies rely on internal standards for their bonus plans. The remainder of the plans use “external” standards based on measures such as the performance of external peer companies. Companies are more likely to choose external measures when prior year performance is a noisy measure of current performance. He also finds that income smoothing is prevalent at companies using internal standards, but not in companies using external standards. Carter, Lynch and Zechman look at the impact of the Sarbanes-Oxley Act on bonus agreements, hypothesizing that firms would place greater emphasis on bonus arrangements after financial reporting discretion decreased following the passage of the Act and other reform bills. 46 Using prior year earnings as the target for the bonus contracts, and an estimated weight on the change in earnings as a proxy for the effort incentive provided to managers, they find that firms place significantly more weight on earnings changes in the bonus contract post-Sarbanes-Oxley than in prior years and that the relationship with bonuses and earnings increases is significantly greater in the post-Sarbanes-Oxley period as well. 46 Mary Ellen Carter, Luann J. Lynch and Sarah L.C. Zechman, Changes in Bonus Contracts in the post-Sarbanes- Oxley Era, (Working Paper November 2007). 12 Kim and Yang document the different characteristics of annual incentive bonus plans for CEOs using the SEC’s newly mandated disclosures that became effective on December 15, 2006. 47 Their sample includes all of the S&P 500 firms for the three years after the reporting change occurred. They report that the five main performance measures are earnings per share (EPS), revenue, operating income, net income, and free cash flow. They find that EPS targets are consistently set below the level of expected EPS, that EPS targets are below the levels projected by analysts and are lower than historical growth levels for the firms. Moreover, they find that actual bonus payouts are 114% on average of target payouts. D. Stock Option Awards and Plans Stock options’ features differ substantially across countries. For example, performance- based vesting conditions are relatively uncommon in the U.S., although widespread in Australia. Bettis, Bizjak and Coles study a sample of 983 of U.S. stock option awards that include either accelerated or contingent-vested provisions based on firm performance. 48 Contingent-vesting awards require one or more performance hurdles to be met for the grant to vest, whereas with accelerated-vesting options, the award vests early if the specified performance condition is met. They find that most performance-vesting grants have significant hurdles that require stock price increases for vesting to occur and firms that award them have significantly better operating performance than control firms. The likelihood of using performance-vesting options is positively related to the proportion of outsiders on the board and the presence of a new CEO, and negatively related to prior stock performance. Dahiya and Yermack study sunset provisions for modifying the terms of company stock option plans when managers retire, die or resign from their firms. 49 Using data for companies in the S&P 500 index in the Fall of 2005, they study 389 firms’ option plans or term sheets to find whether the expiration date of options changes when an executive leaves the firm or whether the 47 Daniel Sungyeon Kim and Jun Yang, Beating the Target: A Closer Look at Annual Incentive Plans (Working Paper December 18, 2009). 48 Carr Bettis, John Bizjak, and Jeffrey Coles, Stock and Option Grants with Performance-Based Vesting Provisions (Working Paper October 2008). 49 Sandeep Dahiya and David Yermack, You Can’t Take It with You: Sunset Provisions for Equity Compensation When Managers Retire, Resign or Die (Working Paper December 2007). 13 vesting or exercisability terms change at that point. They find that managers that retire face stronger sunset rules (and suffer larger value losses) at firms with strong growth opportunities. Such firms exhibit lower management turnover. Executives that resign face very harsh sunset rules, and are generally given very short periods of time to exercise their options. Given the relatively short time period for employment of many corporate executives, their data are consistent with the claim that a majority of option exercises occur after the executive has left the company with a substantial loss in their value being experienced by the executive. E. Retirement Plans and Pensions Pensions and retirement plans normally comprise an important subset of the contracts between a firm and an executive. Although many of the key terms of such plans are not publicly disclosed, Bebchuk and Jackson estimated the annual value of pension benefits for CEOs that left their firms in 2003 and the first five months of 2004. They find that pension benefits constitute a large portion of total executive compensation for many executives. They discover that these benefits are not performance-sensitive because they are largely tied to base salary, or other compensation measures, in the years preceding the executive’s departure. Gerakos focuses on CEOs’ potential tradeoff between pension benefits and other forms of compensation. 50 His sample is comprised of 442 CEOs from S&P 500 companies as of 2005. He finds that CEOs trade off 48 cents of cash compensation and equity grants for every dollar of additional pension benefits they receive from their firms. As this is less than a dollar for dollar tradeoff, he argues that it is consistent with CEOs having a degree of power over their boards of directors. Kalyta uses a sample of the 60 largest firms on the Toronto Stock Exchange to examine supplemental executive retirement plans (SERPs). 51 He finds that while more transparent forms of compensation (salaries, bonuses and stock options) appear to be driven by economic variables at firms, SERP benefits, which are very difficult to observe, are closely related to an executive’s power with respect to their firm’s board of directors. He further finds that where manager’s 50 Joseph Gerakos, Chief Executive Officers and the Pay-Pension Tradeoff (working paper 2008). 51 Paul Kalyta, Compensation Transparency and Managerial Opportunism: A Study of Supplemental Retirement Plans, 30 Strategic Management Journal (2009). 14 SERP benefits are contingent on firm performance, the company will have lower R&D expenditures in the last few years prior to the executive’s retirement, which is consistent with managerial behavior aimed at maintaining higher current earnings at the expense of future returns. F. Other Contractual Clauses There are a wide variety of other provisions that are part of the contractual web between executives and their firms. The enforcement of non-competition provisions or agreements represents another type of restriction that has been examined in a paper by Garmaise. 52 Using a random sample of 500 Execucomp firms, he finds that 70.2% of these firms use these agreements. He analyzes differential enforcement patterns across states for non-competition agreements and finds that stronger enforcement makes it more likely that a firm will employ such agreements. Increased enforceability is also correlated with reduced executive mobility, reduced R&D expenditures and lower capital expenditures per employee. Finally, Thomas, O’Hara and Martin study the use of arbitration provisions in CEO employment contracts. 53 With a sample of 551 contracts, they find that only approximately one half of these contracts contain arbitration clauses. Arbitration provisions are more likely to appear in contracts of CEOs at firms in industries that are experiencing rapid levels of change or that are less profitable. They do not find that arbitration clauses are more likely at firms where the executive has a greater amount of power. III. Data The biggest challenge in this project was to collect comparable sets of employment contracts in the two countries. While the U.S. disclosure rules have for many years required registered firms to disclose all material contracts with their executives, Australian rules are less demanding. 52 Mark J. Garmaise, Ties That Truly Bind: Non-competition Agreements, Executive Compensation and Firm Investment (Working Paper date? ). 53 Randall S. Thomas, Erin O’Hara and Kenneth Martin, Arbitration Clauses in CEO Employment Contracts: An Empirical and Theoretical Analysis, forthcoming Vanderbilt Law Review (2010). 15 Only in 2003 did Australian firms have to disclose any information about these contracts and the mandatory requirements stop well short of forcing them to provide the actual agreements. As we explain below, this made the data collection process a major challenge. A. U.S. Data Collection With the U.S. data, we used the EDGAR, 10-K Wizard and LiveEdgar databases to locate all employment contracts for chief executive officers at S & P 1500 companies from 1995 to 2008. Each of these databases contains all SEC filings made by American registered companies under the federal securities laws. The EDGAR database is maintained by the SEC, while 10K Wizard and LiveEdgar are privately managed. Under existing securities law disclosure requirements, companies are required to disclose on EDGAR their CEOs’ employment agreements. We located these CEO employment contracts using a variety of search techniques. First, we examined each company’s definitive proxy statements for each sample year. In the compensation section of these filings, companies are required to discuss any material contracts that exist between them and their senior officers. We relied on these disclosures to reveal all CEO employment contracts for these companies during this time period. However, as we proceeded in our search, we quickly realized that very few contracts were attached to firms’ proxy statements and that we needed to search through the firms’ other SEC filings in order to find the contracts. We therefore supplemented our initial search by checking SEC filings whose filing dates were close to the date of the contract. In most cases, this resulted in finding the contract. However, if we still could not find the contracts, then we used key word searches of SEC filings made by each company. We searched the following phrases: employment contract, employment agreement, executive agreement, and any title for a contract that was listed in the company’s proxy statement. 54 Using these search terms, we found a number of additional contracts attached to a wide variety of different SEC filings. Companies did not appear to systematically use any particular type of filing for disclosing these contracts, although we 54 For example, if the proxy statement stated that the company’s CEO had an “Employment Understanding Agreement,” we would specifically search using that term. 16 frequently found them attached to 10-K’s, 10-Q’s, 8-K’s and for companies issuing stock for the first time, S-1’s. We were unable to find contracts that predated the beginning of the subject companies’ EDGAR filings, usually in 1996, and in a limited number of cases, we were unable to find contracts that were disclosed in the company’s proxy statements even after the company commenced filing its disclosure documents because the contracts did not appear to be attached to any of the company’s SEC filings. 55 We read the companies’ proxy statements whenever they discussed their CEOs’ employment contracts. While companies frequently provided extensive disclosures concerning the contents of these employment contracts, once we compared these disclosures with the contracts themselves, we found that there were frequently discrepancies. Therefore we determined that it was necessary to code the contracts themselves in order to ensure greater accuracy in our data. We wrote a coding manual for the contracts so that each variable that we were interested in could be systematically collected. We collected a comprehensive set of important contract information, including basic compensation information, severance, perquisites and various legal constraints on the CEO and the firm. For example, we generally collect severance information from an employment contract under the sub-section, “Compensation after termination of employment/Company obligations after termination of employment/Severance Payments.” We augmented this with data from the Execucomp database, where we extracted further information on CEO compensation details, especially bonuses, CEO age, and CEO tenure and appointment date. In addition, we extracted information on stock daily returns from the CRSP database to calculate daily return standard deviations and extracted GICS industry codes and book value of assets from the Compustat database. B. Australian Data Collection We started by deciding to study the sample of firms in the ASX 200, the foremost Australian stock index. This stock index covers the largest publicly listed firms based in Australia and listed on the Australian Stock Exchange, Australia’s primary stock exchange. To 55 Given that we exhaustively searched through every filing made, we suspect that these contracts were not filed with the SEC, or that the document that they were attached to was not available on EDGAR. 17 assemble our sample of firms, we began by obtaining a list of the ASX 200 firms in 2003 and tracked forward in time to obtain new additions, deletions, and name changes and their dates. This represents the Australian firms in our sample. We also searched for whether any of these firms were cross listed on a major US stock exchange at the CEO contract start date as explained below. To obtain CEO employment contracts of firms in the ASX200, we first individually contacted each firm requesting a copy of their current CEO’s employment contract subject to the terms of a non-disclosure agreement, if they requested one. Using this process, we obtained 34 CEO employment contracts from 31 Australian firms. Next, we examined whether any of our sample firms made filings with ASIC (the Australian Securities and Investment Commission) that included their CEO’s employment contract. We did the same type of search for the firms cross-listed in the US and looked for this information in Securities and Exchange Commission filings. We obtained a number of additional contracts in this manner. In 2003, Australian listed companies were advised by ASX Corporate Governance Council to disclose the senior executive employment package. This required firms to report current contract details and details on any new contracts entered into when CEOs are renewed or replaced (“The Summary Terms of Employment”). CEO employment contract summaries include compensation details such as salary, bonuses, restricted stock and stock options, as well as long term performance incentives and severance agreements. Since 2004, firm annual reports report these contract summaries in the remuneration report, or director's report, section of the annual report and sometimes also include full employment contracts in their appendices. However, the degree of completeness of these contract summaries varies greatly and therefore we were only able to use those summaries that included compensation and severance details. For the purposes of coding these contracts’ primary features, we used a detailed coding manual modified from an earlier coding manual used for coding US employment contracts. In addition, we used the Fin Analysis database, maintained by Huntleys' Investment Information Pty. Limited (a wholly owned subsidiary of Morningstar, Inc.), to locate the ASX Announcement of CEO/ Managing Director Appointment and the change/ renewal of employment agreement. The Summary Terms of Employment was usually attached to the Announcement of Appointment which is categorized under “Company Administration.” 18 The Summary Terms of Employment does not specify all the employment terms, in particular the terms which were disclosed as standard employment policy such as Long Term Incentive Payment Schedule and Trading Policy of equity base rewards. We therefore supplemented the Summary Terms of Employment by retrieving the relevant information from the Annual Report of the respective financial year. We also ran the key phrase searches through the web search engines, Google.com.au and Bing.com. The search phrases were “CEO employment contracts”, “CEO terms of employment” and “CEO appointment announcement”. By going through the first 20 pages of search results of both search engines, we found 14 Summary Terms of Employment of CEO. To obtain information on which stocks are cross listed, we used two databases. One is the EDGAR database to locate the forms of registration and deregistration filed by the Australian companies. We identified using the SEC’s Form List Forms F-3, F-1 and 425, which are related to registration of foreign company, and Form 15F for deregistration. We then searched the EDGAR database in two ways: first, using the “EDGAR Full-Text Search” to search the full text of EDGAR filings from the last four years of the Australian companies; and second, we looked in the “Historical EDGAR Archives” which allows us to retrieve the record of filings from 1994 through 2010. The second database that we used is the Australia database “Fin Analysis”. We searched the Archives of Announcements to locate the announcements of registration and deregistration in the U.S. exchange markets. To obtain information of Australian CEOs nationality, and particularly whether they are US citizens, we used a number of data sources including the ASX Announcement of Appointment, the Annual Report, Company websites and other online databases: Reuters, BusinessWeek, Wikipedia, Who’s Who, Bloomberg, Newsweek, Hoovers-People. To obtain the initial appointment dates of CEOs, we used multiple data sources including the Fin Analysis database, the Dat Analysis database, as well as our CEO employment contracts, their summaries and any news reports about our sample companies. To obtain daily stock returns for the year prior to the contract start date, we used Datastream to download the daily closing price (adjusted) in the last 8 years of the current ASX200 companies. For the delisted companies, we downloaded the daily closing price (adjusted) of the year prior to the contract start date from Morningside’s Dat Analysis database and converted these into daily returns. We then used the prior year of daily returns to calculate 19 return standard deviations. We obtain daily Australian-US dollar foreign exchange rates for the Australian contract start date and the fiscal year ends before the Australian contract start date, which is the date of the book value of total assets, from the Federal Reserve Bank of St Louis website http://research.stlouisfed.org/fred2/categories/94. Our Australian employment contract data is by necessity a combination of full CEO employment contracts and contract summaries taken from two sources: the reports required to be disclosed in annual reports: and company press releases at the time of new CEO contracts are signed. Although the summaries and press releases contain data on major contract features, we want to do further analysis on the reliability of this information. Our concern is that CEO employment contracts of Australian publicly listed firms do not need to be disclosed under current securities regulations, so that for many firms we have only the summaries and press releases. While an implicit assumption of the Australian disclosure regime is that these disclosures are adequate for supplying investors and securities analysts with the details of the economically important elements of the CEO contracts, this is an empirically untested proposition. As an initial approach to assessing the adequacy of the Australian firm disclosures, we had two research associates separately code this subsample of CEO employment contracts, one using the actual employment contract and the other using only the company summaries coming from the press releases and remuneration reports. Of course, this comparison is far from definitive since firms that are willing to voluntarily release their CEOs’ full employment contracts may also be more forthcoming in their contract summaries. On the other hand, it is also possible that even with this potential bias, we may still find that the required summary information is less than adequate when it comes to obtaining a clear picture of the CEO’s economic incentives. In comparing Australian contract features based on the two different data sources, specifically the actual CEO contracts and the contract summaries, we find that the summaries are generally fairly accurate. However, for contract features that are not required to be disclosed, namely items that are not included in CEO compensation or severance agreements, the summaries are not always fully disclosed. This means that for these contract features, we may be unavoidably undercounting occurrences of some of these contract elements. [Further discussion to be added.] 20 C. Methodology In comparing Australian and US firms that are publicly listed and represented on the ASX 200 and the S&P 1500, it is immediately obvious that the distribution of firms by industry and by firm size are drastically different, with Australia having a relatively larger number of mining and finance firms and many fewer firms in technology intensive and large scale manufacturing industries. Australia also has a much smaller number of firms and the typical size of these firms is much smaller. With this difference in populations in mind, we concluded that comparing the full populations of firms in the two countries was highly problematic, even in a multivariate regression context, given that we were doubtful that we could adequately control for the differences, which requires a great deal of confidence about knowing the correct specifications to control for such large scale differences. It also requires adequate controls for industry differences that could have a dynamic component, which industry fixed effects were unlikely to fully adjust for. As a result of these considerations, we concluded that we needed to engage in some basic matching of firm characteristics. We also decided that we needed to roughly match contract start dates, since there is a clear temporal trend in certain key contract features, particularly compensation levels. D. Matching Procedure for U.S. and Australian Contracts Our approach to matching the contracts is as follows. We exploit the fact that there is a much larger population of US firms to attempt to select a good match for each Aussie contract that we have detailed information on. To match on industry, we require US firms to be drawn from the same 2 digit GICS industry classification. To match on calendar time, the contract start dates must be within 2 calendar years of each other. Finally, to match on firm size, we require the firms’ book values closest to the contract date (or averaged across the two adjacent fiscal years) to be within 300% of each other. This matching process is complicated by two considerations: first, we need to value all contract features denominated in money into a single currency, which we accomplish by converting the Australian dollars into US dollars on the date of the Australian firm’s fiscal year-end; and second, we need to adjust for the fact that Australian firms generally have fiscal year-ends that fall on June 30, while US firm fiscal year-ends 21 typically fall on December 31. To adjust for these calendar differences, we use the Australian total assets for the fiscal year just prior to or on the contract start date. We then take the two US fiscal year-ends that bracket the Australian fiscal year-end and average them and use this to match with the exchange rate adjusted Australian total assets. After this matching process is completed, we then assess how closely the firms matched in terms of size and start dates and find that the differences are reasonably small. We started with 169 contracts by 111 Australian firms listed on the ASX 200. This included some firms with multiple contracts. Specifically, we have 2 firms with five contracts, 1 firm with four contracts, 5 firms with three contracts and 37 firms with two contracts. After matching, we are left with 102 contracts by 73 Australian firms. We report in Table 1 below, the means, medians and standard deviations for the Australian and US firms’ contract start dates and their total assets. Table 1: Asset Size and Contract Start Date Matches Assessment Australian U.S. T Statistic Australian U.S. Wilcoxin Australian U.S. Mean Mean for Median Median Z value Standard Standard Value Value Mean Value Value Deviation Deviation Difference Asset Size 4707 3682 0.4799 1752 1398 0.9292 12671 7422 Contract 9/23/05 1/25/05 12/1/05 6/3/05 Start Date We see from Table 1 that the differences in the typical contract start dates are quite small, with a mean difference of 8 months. Likewise, the difference in the mean and median size of Australian and US firms, measured by total assets is also small. A standard t test for the difference in mean size of assets is insignificant, as is a Wilcoxon test for the difference in median asset size. IV. Empirical Evidence 22 A. Univariate Analysis of Major Contract Features of Australian and US Corporations We break our descriptive analysis into three major tables that summarize key features of the CEO employment contracts. 56 Table 2 covers major direct CEO compensation elements, Table 3 covers deferred compensation features and contract length, while Table 4 reports on a number of other contract features such as non-compete clauses. In Table 2, we present data on starting salaries (USD), while the other compensation variables are all presented in frequencies as to whether they are mentioned in the employment contract or contract summary. The data are presented in this manner because many of the contracts only specify dollar amounts for the initial salary level with all other compensation parameters being determined by the Compensation Committee, or in Australia, by the Remuneration Committee. We intend to use the actual dollar values for all of the compensation variables in the later drafts of the paper, although collecting these will require examining other sources besides the contracts. The data reveal a number of interesting variations between the two countries. First, the Australian CEOs are paid greater amounts of salary than American CEOs even after converting the Australian currency into US dollars. Furthermore, the mean/median differences are statistically significant. The American contracts are significantly more likely to include restricted stock and stock options, but both groups are equally (and highly) likely to have their contract specify that they will receive annual bonuses. Australian contracts mention long term incentive plans significantly more frequently than those of their U.S. counterparts. It is important to recognize that these plans include restricted stock, performance rights and stock options when payoffs are conditional on meeting particular performance hurdles. It is also noteworthy that the frequency of long term incentive plans is almost double for Australian CEOs. In contrast, we see the opposite pattern for restricted stock, while stock options are four times more frequent in U.S. 56 Another interesting difference that is not shown in these tables is that all Australian CEOs have written contracts according to one distinguished Australian lawyer that handles executive employment arrangements at many public companies. Thomas interview transcript with Attorney 1, at 1-2. By comparison, earlier work has found that in the U.S. less than one half of CEOs in the S&P 500 as of 2000 had written employment contracts. Gillan, et al, Explicit versus Implicit Contracts, supra note at 1629. 23 CEOs’ contracts compared to Australian contracts. Another extremely important difference in these contracts that is hidden by these basic descriptive statistics is that almost all of the Australian contracts that specify restricted stock or stock options include one or as many as three performance hurdles that must be met before the stock or option compensation can be paid. This is in addition to the requirement of continued employment with the firm, which is generally the only requirement that needs to be met in the U.S. contracts. [We are currently coding these three alternative types of Australian long term incentive payoffs for analysis and plan to compare these forms of restricted stock and options with the U.S. analogues that generally lack performance hurdles]. Table 2: CEO Compensation Features: Base Salary and Frequency of Other Features Salary Bonus LT Incentive Restricted Stock (US $) Plan Plan Stock Options Australian Mean (%) 888,886 95 81 22 27 Median (%) 809,750 US Mean (%) 691,477 95 51 46 82 Median (%) 755,000 Difference Mean (%) 197,409 0 29 ‐24 ‐55 T Statistic* 0.004 1.000 0.000 ‐0.011 0.000 Difference Median (%) 54,750 Wilcoxon Z* 0.045 * P Value We were surprised to see higher base salary figures for the Australian firms. In several interviews of Australian corporate governance participants conducted by one of us we inquired about possible explanations for this difference. One corporate attorney explained that in Australia, perquisites were generally rolled into salary, instead of being separately listed because of the higher fringe benefit tax rates that applied to perquisites under Australian tax law. 57 Similarly, the higher prevalence of pension plans in Australia, shown in Table 3 below, likely 57 Thomas interview transcript with Attorney 1, at 10-11. 24 reflects the mandatory nature of company contributions to superannuation plans that would be mentioned in most Australian contracts. 58 So it appears that legal differences may largely explain some of these basic variations in employment contract terms across Australia and the US landscapes. Table 3 examines contract length, deferred compensation terms of the contracts and change-in-control features of these contracts. The contract length variable is in years, while all of the other variables are in frequencies. Again we use frequencies because calculating the dollar values for the deferred compensation variables requires examining other data sources besides the contracts themselves. [We plan to add valuations of these features in later revisions]. Table 3: Contract Length and Frequencies of Deferred Compensation Features Length Pension Profit SERP Change in Gross‐ (Years) Sharing Control Up Australian Mean (%) 1.81 68 0 4 31 25 Median (%) 1.00 US Mean (%) 2.60 38 12 28 80 39 Median (%) 3.00 Difference Mean (%) ‐0.79 30 ‐12 ‐24 ‐48 ‐14 T Statistic* 0.020 0.00 0.083 0.022 0.000 0.261 Difference Median (%) ‐2.00 Wilcoxon Z* 0.048 Closely examining Table 3, we see a number of very interesting differences in the contract features. U.S. contracts are significantly longer than the Australian contracts with the median length of the Australian contracting being a year, while in the US it is three years. Thus, U.S. CEOs generally have much longer contracts than their Australian counterparts. U.S. contracts are also significantly more likely to include mention of in profit sharing plan participation as well as a supplemental executive retirement plan (SERP). American CEOs’ employment contracts are also significantly more likely to contain change-in-control protections 58 Thomas interview transcript with Attorney 1, at 13. 25 (C-in-C) and a tax gross-up provision, with C-in-C provisions being more than twice as frequent and gross-up provisions being about 50% more frequent in US contracts. By contrast, Australian CEO employment contracts are twice as likely to discuss his/her pension funding. In some instances, there are underlying legal rules that may explain several of these differences. For example, the Australian corporation code and Australian Stock Exchange (ASX) listing rules may explain the relatively low incidence of change-in-control provisions. Under section 200B of the Australian Corporations Act, shareholder approval is required if a company pays its CEO or other directors more than a specified threshold level of benefits/remuneration in connection with their leaving office. Prior to 2009, the threshold level was “seven times the average annual [remuneration] over the preceding three years.” 59 However, this portion of the Corporations Act was amended to apply to all contracts introduced or amended after November 23, 2009. The new code provision requires shareholder approval of all termination payments above one year’s base salary for all key management personnel. Furthermore, ASX listing Rule 10.18 “prohibits a senior executive [from] receiving a termination payment due to a change in the control of the company.” 60 Given these rather stringent rules, it is not surprising that we see fewer change-of-control provisions in the Australian contracts. 61 These provisions do raise an important question as to why we see such major differences in corporate governance systems between the U.S. and Australia. Another interesting question is why we observe any change of control provisions in the Australian contracts and how this was legally accomplished. We turn next to Table 4 where we look at some other important features of these contracts that can be viewed as more shareholder friendly. In this table we include data on Do- Not-Compete (DNC) clauses, mandatory arbitration provisions, and several different limitations 59 Kym Sheehan and Colin Fenwick, Severance: The Corporations Act 2001 (CTH), Corporate Governance and Termination Payments to Senior Employees, 32 Melbourne Law Review 199, 212 (2008). 60 Australian Government Productivity Commission, Productivity Commission Inquiry Report No. 49, Executive Remuneration in Australia (Dec. 19, 2009). 61 In practice, Australian lawyers put in “material diminution” clauses into the termination provisions of the CEO’s contract to take the place of a change-of-control provision. These clauses specify that the CEO’s loss of management authority constitutes a termination without cause, and when combined with other commonly included actions that also trigger a termination without cause, they provide the same protections as a change-of-control provision. 26 on the sale, pledge, hedge or other economic transactions involving a CEO’s restricted stock or stock options. All of these variables are measured by the frequency with which they appear in the contracts. Table 4: Frequencies of Other Important Contract Features DNC Arbi‐ Hedge Pledge Stock Sale Other tration Constraint Constr. Constraint Restric‐ tions Australian Mean (%) 63 0 10 2 2 8 US Mean (%) 79 53 0 2 0 2 Difference Mean (%) ‐16 ‐53 10 0 2 6 T Statistic* 0.048 0.000 0.024 1.000 0.322 0.173 Table 4 shows that DNC clauses appear frequently in both Australian and US contracts, although U.S. contracts are significantly more likely to have such clauses than the Australian agreements. Arbitration clauses are also quite common in American contracts, but are non- existent in Australian contracts. Hedging, pledging, sale and other restrictions on the sale of restricted stock and stock options are not popular in either country, though they are noticeably more common in Australian contracts, occurring in as many as 10% of cases. However, these differences across Australian and the US are not statistically significant, with the exception of hedging restrictions. Overall though, the Australian contracts seem to reflect a greater shareholder concern and determination to restrain a CEO’s desire to hedge away the firm risk associated with stock-based compensation, possibly because shareholders have greater power in Australia through more concentrated institutional ownership. Australian corporate lawyers interviewed by one of us offered the following insights into why some of these contract differences exist. For instance, when asked about the absence of arbitration provisions, one well-known Australian corporate lawyer that has drafted many of 27 these agreements stated: “… we have a very strong labor union movement history here and arbitration has industrial connotations. …[G]entlemen wouldn’t engage in that sort of business basically. It’s just not considered desirable.” 62 However, a second experienced attorney was less emphatic when asked if CEO employment contracts ever contained such provisions, saying: “Yes, [but] not all that common. But there is a reasonable incidence of where there is a dispute, it will be subject to arbitration…” 63 B. Regression Analysis While we have found some notable differences in the typical contract features found in Australian and US matched firms, this could easily be due to differences in other firm, CEO and contract characteristics of the two samples. Thus, to further refine our analysis, we move beyond mean and median differences in contract characteristics to multivariate ordinary least squares (OLS) regressions where we can control for a number of key CEO employment contract features in our matched sample of Australian and US contracts. In addition to the key explanatory variable, an Australian firm indicator, we use as explanatory variables the log of total assets to further control for firm size differences, prior return standard deviation to control for firm total risk borne by senior managers, CEO tenure to partially control for CEO influence, an indicator of a newly appointed CEO to control for more CEO negotiating power, and CEO age. Finally, we also include an indicator for Australian contracts where we have the full contract to further assess whether there is an information source induced effect. Following the existing literature, we begin our analysis of these CEO contracts by focusing on CEO base salary. The key question is whether the existing differences in salaries have a national component or whether differences in salary levels are explained by other differences in firm, CEO and contract characteristics. Differences in salary by firm nationality effect could be due to variations in corporate governance, corporation and securities laws, taxation, or other differences across countries. Table 5 summarizes the results of our regression analysis of CEO salaries. We find that the indicator for Australian companies is significantly positive, consistent with Australian firms 62 Thomas interview transcript with Attorney 1, at 8. 63 Thomas interview transcript with Attorney 2, at 18. 28 paying higher fixed salaries than US firms, even after controlling for firm size, stock return volatility, CEO tenure and indicator of a new CEO. Of these variables, firm size and CEO tenure and a new CEO indicator have significant positive effects, which are consistent with the existing literature. We also add a control for firms in the energy industry in the second regression. Table 5: OLS Regressions of CEO Salary The dependent variable is a CEO’s annual cash salary. The sample includes both Australian and US observations where the Australian contract can be matched with a similar US firm in terms of industry, asset size and contract start date. The sample period of contract start dates is 1998-2008. The variable definitions are found in the appendix Variable Estimate t value Estimate t value Estimate t value AU firm .172 3.75 .187 4.64 .185 4.88 Log firm size .230 7.99 .236 8.15 .232 7.41 CEO tenure .015 4.07 .017 5.01 .018 5.18 New CEO .055 0.65 .038 0.43 .044 0.52 Stock ‐.051 1.14 ‐.040 0.87 volatility Inverse stock .002 1.38 volatility Energy ‐.177 4.44 ‐.166 3.90 Industry Intercept 11.735 42.53 11.677 42.62 11.513 47.74 N = 120 R 2 = .57 N = 120 R 2 = .58 N = 120 R2 = .58 We find that energy industry has a significant negative effect on the log of CEO base salaries. Finally in the third regression we replace stock return volatility with its inverse and find that the sign shifts to positive, but insignificant effect. In further analysis, we plan to replace return volatility with residual return volatility and add a market to book ratio to capture growth opportunities. So overall, we find that Australian firms tend to pay their CEOs higher base salaries than US firms, even after controlling for several other differences in firm characteristics. Thus, our matched sample univariate analysis is further borne out in our regression analysis. [We are currently in the process of adding the following new control variables to our regression 29 model: CEO age, the firm’s prior market to book ratio, debt to total asset ratio and operating performance, measured by ROA.] Another important question is whether the Australian CEO compensation is affected by international labor market competition. We explore this question by focusing only on the Australian subsample of observations and add two additional control variables. The first variable is an indicator for Australian firm CEOs who are US citizens. The second variable is an indicator for Australian companies that are cross-listed on a major US stock exchange. For this purposes of this analysis, we estimate OLS regressions on the log CEO salary in Table 6. Table 6: OLS Regressions of CEO Salary in AU Firms The dependent variable is a CEO’s annual cash salary. The sample includes Australian for observations where the Australian contract can be matched with a similar US firm in terms of industry, asset size and contract start date. The sample period of contract start dates is 1998-2008. The variable definitions are found in the appendix. Variable Estimate t value Estimate t value Estimate t value Log firm .336 7.03 .335 6.61 .330 6.28 size CEO tenure .049 4.12 .050 3.39 .050 3.45 New CEO .221 1.46 .229 1.36 .234 1.42 Stock .001 .02 .001 .02 volatility Inverse .001 .38 stock volatility Energy -.254 -3.35 -.263 -4.74 -.258 -4.21 Industry US Cross- -.330 -2.52 -.329 -2.52 -.325 -2.50 listed US CEO .029 .29 .027 .28 Intercept 10.854 30.35 10.854 30.35 10.838 25.32 N = 74 R2 = .48 N = 74 R2 = . 47 N = 74 R2 = .47 In evaluating our results, we see several interesting findings. First, firms that cross list with the US have significantly lower salaries, consistent with the pattern we observe for the US 30 CEO compensation. Second, we find an insignificant effect of having a US CEO. This result is surprising, but it may reflect at least two possibilities. First, we may simply have too few observations where the Australian firm has hired a US national to be CEO. As we expand our sample, we can reevaluate the validity of this possible explanation. Second, it may be that the US national has been working in Australia so long that he or she no longer views the US labor market as a good alternative due to the strong personal, business and financial ties that he or she has developed in Australia. We next examine the frequency with which we find several other components of compensation to assess how similar these elements are in Australia and the U.S. We start by examining the frequency with which the CEO employment contracts include bonuses, LT performance plans and stock options in Tables 7-9 respectively. We begin with Table 7 presenting an analysis of the likelihood that a firm will include a bonus plan in the CEO compensation package. Table 7: Probit Regressions of Bonuses in Australian and US CEO Employment Contracts The dependent variable is an indicator that takes a value of one when the contract specifies a bonus plan and is zero otherwise. The sample includes both Australian and US CEO salaries for observations where the Australian contract can be matched with a similar US firm in terms of industry, asset size and contract start date. The sample period of contract start dates is 1998-2008. The variable definitions are found in the appendix. Variable Estimate Chi Sq Estimate Chi Sq AU firm ‐.119 0.10 ‐.032 0.01 Firm size .189 1.44 .242 2.19 CEO tenure .034 0.34 .015 0.07 New CEO .648 1.96 .481 1.06 Stock volatility .230 0.90 Inverse stock ‐.015 2.99 volatility Intercept ‐.430 0.08 .617 N = 180 Pseudo R2= .07 N = 180 Pseudo R2= .09 31 The probit regression estimates are presented in Table 7 and they show that bonus plans do not appear to be related to whether the firm is Australian or US domiciled. In addition, the only factor that has a positive impact on the frequency of bonus plans is when the employment contract is with a new CEO. The next question that we would like to examine is whether after controlling for CEO salary this conclusion changes. In Table 8, we present probit estimates of the likelihood of a CEO having a long term incentive plan in place. It is important to recognize that these plans exclude performance rights, restricted stock and stock options. We find that Australian firms are significantly more likely to give their CEOs long term incentive plans than are US firms, even after controlling for firm size, CEO tenure, new CEO appointments and stock return volatility. At the same time, we also find that larger firms are more apt to include such plans. Most interestingly, we find that CEOs with longer tenure, new CEOs and firms with more volatile stock returns are significantly less likely to give their CEOs long term incentive plans. Table 8: Probit Regressions of Frequency of LT incentive plans in Australian and US CEO employment contracts The dependent variable is an indicator that takes a value of one when the contract specifies a bonus plan and is zero otherwise. The sample includes both Australian and US CEO salaries for observations where the Australian contract can be matched with a similar US firm in terms of industry, asset size and contract start date. The sample period of contract start dates is 1998- 2008. The variable definitions are found in the appendix. Variable Estimate Chi Sq Estimate Chi Sq Estimate Chi Sq AU firm 0.973 13.09 0.930 11.36 1.393 8.37 Firm size 0.153 2.49 0.133 1.90 ‐0.260 1.99 CEO tenure ‐0.046 1.99 ‐0.032 1.06 ‐0.080 2.25 New CEO ‐0.665 4.47 ‐0.439 1.90 ‐1.056 4.39 Stock volatility ‐0.164 1.77 ‐0.178 2.08 ‐0.290 1.87 Energy Industry 0.896 2.31 1.169 3.12 Salary 1.563 5.95 Intercept ‐0.342 0.14 ‐0.352 0.15 ‐17.842 5.35 32 N = 144 Pseudo N = 144 Pseudo N = 90 Pseudo 2 2 2 R = .16 R = .16 R = .27 In Table 9, we examine the frequency of stock option grants in CEO contracts across the US and Australia. In our preliminary analysis, we find that Australian contracts are significantly less likely to include stock options, especially stock options without performance hurdles. However, given that none of our current control variables has any significant explanatory power, we are hesitant to place a lot of weight on these preliminary regressions until we further explore whether other CEO or firm characteristics may be useful in explaining option use across firms. [We are currently coding the Australian long term incentive contracts into cash, stock and option payoffs, conditional on meeting performance hurdles. One interesting feature of these performance hurdles is that there are a variety of performance measures used and even in individual employment contracts there can be two or three performance criteria.] [Table 9 to be added] We next examine how severance contracts differ between Australian and US CEO employment contracts. In codifying severance contracts, there are a number of elements that must be taken into account, including whether the payment is lump sum or periodic, the size of the payment as a function of base salary and whether there is also a bonus component, the length that any periodic payment is made and whether this is a function of the remaining life of the employment contract. The contract payment can also be a function of whether the CEO is hired for just cause or without cause or leaves voluntarily. Another key contract feature is the list of CEO actions that represent just causes for terminations. To simplify the discussion, we discount periodic payments based on the risk-free interest rate in the respective country. For contracts that specify payments that last for the reminder of the contract period, we assume that the expected remaining life of the contract, conditional on early termination, is half the contract period. This allows us to convert the uncertain severance payment stream into an equivalent lump sum payment. Key differences between typical Australian and US severance contracts are that ….. 33 [Table 10 to be added] The results of our comparison US and Australian contracts offer some interesting contrast with several earlier studies by Conyon and Murphy (2000) and Conyon, Core and Guay (2009) that compare U.S. and U.K. CEO compensation. In those prior studies, the authors conclude that U.S. CEO compensation is significantly higher than U.K. CEO compensation. What is interesting about our initial results is that U.S. CEOs clearly do not have higher base salaries in comparison to Australia. What we hope to do in further analysis is to assess whether this conclusion also holds for CEO total compensation. The other very interesting set of issues that we plan to analyze shortly is how the structure of severance contracts, bonus plans and restricted stock and stock option plans differ between CEO employment contracts in Australia and the US. What we know from preliminary analysis is that Australian firms have performance hurdles attached to essentially all their restricted stock and stock option plans, which is strikingly different from the typical US CEO employment contracts. V. Conclusions In summary, we find a number of similarities between CEO employment contracts in the US and Australia. However, we also find some interesting differences in contract provisions, not only in terms of compensation, but also with respect other contract terms such as contract length and restrictions on CEO actions that can be viewed as more shareholder friendly. Some of these differences appear to be explained by clear differences in the legal and regulatory environments, such as the relative infrequency of change of control provisions in Australian contracts. Other differences may reflect substitution of one form of performance based compensation for another. However, there remain other contract features such as contract length that are not so easily explained in this way. In these cases, it is interesting to speculate whether other institutional differences such as tax codes, takeover protections, institutional share ownership levels and the relative power of shareholders and boards in the two countries can help explain these remaining contract differences. 34 Appendix: Definitions of Variables Salary CEO base salary. Sources: US – Execucomp, SEC filings, employment contracts and DEF 14A, AU – Contract or Contract Summary Bonus Accounting based cash bonus. Sources: US – Execucomp, SEC filings, employment contracts and DEF 14A, AU - Contract or Contract Summary Restricted stock Stock grants that involve vesting made at the contract start date. Sources: US – Execucomp, SEC filings, employment contracts and DEF 14A, AU - Contract or Contract Summary Stock options Stock option grants that involve vesting made at the contract start date. Sources: US – Execucomp, SEC filings, employment contracts and DEF 14A, AU - Contract or Contract Summary LT performance incentives Compensation plans based on LT stock and accounting hurdles, where payment can be in cash, stock or options. Sources: US – Execucomp, SEC filings, employment contracts and DEF 14A, AU - Contract or Contract Summary CEO age Age at the contract start date. Sources: US – Execucomp, AU- CEO tenure CEO initial contract start date minus the CEO current contract start date. Sources: US - CEO employment contract, AU – employment contract and contract summary. New CEO indicator CEO start date is less than 6 months before the contract start AU indicator Australian headquartered company listed on ASX 200 Firm size Book value of assets at the fiscal year-end closest to the Australian CEO contract start date and for the US matching firm the average of the two year-end figures that bracket the Australian fiscal year-end. Sources: AU - Stock volatility Stock daily return standard deviation over the year prior to the contract start date. Sources: US returns - CRSP, AU returns – Datastream. Stock return performance One year cumulative return over the year prior to the contract start date. Sources: US returns - CRSP, AU returns – Datastream. CEO start date CEO’s Initial appointment date. Sources: US – Execucomp, AU - Fin Analysis database, Dat Analysis database, as well as CEO employment contracts and their summaries and news reports. 35