Performance and Compensation – evidence of optimal contracting by Sun, Li and Liu

1. Performance and Compensation – evidence of optimal contractingby Sun, Li and Liu Discussant: Oliver M. Rui The Chinese University of Hong Kong

2. Overview • This paper studies the relationship between executives’ compensation and ROE using the data of listed firms in China to test the optimal contracting hypothesis. • The results support the hypothesis after controlling for the governmental interference and related party transaction.

3. Compensation measure • The optimal contracting approach states boards are assumed to design compensation schemes to provide managers with efficient incentives to maximize shareholder value. • Most executive pay packages based on the optimal contract hypothesis contain four basic components: a base salary, an annual bonus tied to accounting performance, stock options and long-term incentive plans (including restricted stock plans and multi-year accounting-based performance plans).

4. Compensation measure • What is the composition of the executives’compensation package in China? • Who determines the executives’ pay in China (compensation committee)? • How important is the compensation in the executives’ utility function? Do political career and market control play any role here in China?

5. Compensation measure • What is the ratio of executives’hidden income and her compensation? • What is the executives’ ownership? • Why do you use the highest pay as the proxy for compensation? Who does receive the highest pay?

6. Performance measures • How reliable ROE is? It is used by the CSRC to determine the rights offering and ST and PT. The managers have the incentive to manipulate earnings. • Use other accounting performance measures as robust tests • Tobin’s Q • Stock returns • Relative performance measures

7. Omitted variables • Characteristics of executives (age, tenure, educational level, professional knowledge and duality) • Ownership structure (who are the ultimate owners? Do different owners share the same objective?) • Board composition • Monitoring difficulty: risk, and growth opportunities • Lagged performance measures

8. The form of regression • Pay-performance sensitivity (sensitivity has a more economic interpretation) • Elasticity of compensation with respect to performance • The function could be nonlinear

9. Pooled cross-regression • The market index did not change over time. A given firm is included five times. Without an adjustment, the t-statistics are artificially inflated. A fixed effects panel data analysis method should be adopted to test for temporal instability in the regression coefficients.

10. Minor issues • RPT is a dummy variable which equals to 1 if the proportion of four types of related party transactions between the firm and its large shareholders is less than 5% of similar transactions. Why do you use 5% as the cutoff point for RPT? What is the basic statistics of RPT activities in China? • How is MARKET correlated with AREA? Could these two variables measure the same thing?

11. Sensitivity analysis • The managerial power approach predicts that pay will be higher and /or less sensitive to performance in firms in which managers have relative more power. • Other things being equal, managers would tend to have more power when (1) the board is relatively weak or ineffectual; (2) there is no large outside shareholder; (3) there are fewer institutional shareholders; or (4) mangers are protected by antitakeover arrangement. • How to test this hypothesis? • What do EXP (Administrative fees/Sales) and Revues/Total Assets) measure?

12. Sensitivity analysis • The pay control hypothesis suggests that the government controls the pay level of executives for social equality. Who determines the pay, government or board?