The Impact of Corporate Social Responsibility on the Excess Compensation of CEO and CFO
Hung-Chih Li
Department of Accounting
National Cheng Kung University
Syou-Ching Lai
Department of Accounting and Information System
Chang Jung Christian University
Chung-Hao Hsu
Chang Jung Christian University
Tin-Mun Tsai
Deloitte ＆ Touche Taiwan
Abstract
This study investigates the relationship between corporate social responsibility and the excess compensation of CEO and CFO. We find that corporate social responsibility is significantly and negatively related to CEO and CFO excess compensation; in particular, total CSR scores and CSR strengths have a negative effect on CEO and CFO excess compensation, and CSR concerns is positively related to CEO and CFO excess compensation. These results indicate that firms with higher CSR performance may exhibit stricter compensation oversight in order to be responsible to stakeholders and to meet the ethical expectation of society, that is, they may be more inclined to constrain CEO and CFO excess compensation. Additionally, corporate governance is negatively related to CEO excess compensation, suggesting that firms with stronger governance are less likely to pay excessive compensation to CEOs. This finding is congruent with the argument that excess compensation can be regarded as a sign of poor governance. However, we do not observe a significantly negative relationship between corporate governance and CFO excess compensation in our study.
Keywords: Excess compensation of CEO and CFO, corporate social responsibility (CSR), corporate governance.
1. Introduction
In this study, we examine whether socially responsible firms behave differently from other firms in constraining executive excess compensation. Corporate social responsibility (CSR) increases the accountability borne by managers greatly, that is, CSR requires business to behave in a more responsible manner across ethical, social, and environmental ways. Prior research suggests that the importance of executive compensation structure can influence executives’ focus on CSR (e.g., McGuire et al., 2003; Mahoney and Thorn, 2006). They provide important insights into CSR, corporate governance, and guidance to firms when designing compensation plans. Since it is usually hard to determine whether a high or low payment is reasonable, we consider excess compensation to be a better variable in determining a reasonable compensation for executives. Therefore, the purpose of this paper is to investigate whether executive excess compensation is effected by CSR.
Executive compensation at corporations began to soar in the 1990s, and executives received high salary even in the time of economic hardship. Executive compensation is a topic that has alarmed the public, consumed the media and fascinated researchers for years. Core et al. (2008) find that CEO total compensation increases substantially over the period, and at a greater percentage growth rate than firm sales. There are also plenty of news reports and articles arguing about top management’s unusually high level of payment.
After America went through the worst economic year due to financial crisis that it has gone through in decades, the executives’ compensation were still so high when the companies were doing so poorly. This pay without performance relation can be referred to excess compensation, which usually occurs when higher pay to executives than their firms’ performance would justify. Excess compensation is defined as observed compensation less a measure of expected compensation derived from standard economic determinants. Core et al. (1999) find that excess compensation can be regarded as a sign of poor governance, and entrenched managers can influence the level of their annual total compensation and thereby extract excess compensation from the firm. Since most prior studies find that excess compensation has a negative effect on firms’ performance, we consider excess compensation as symptoms of agency problem in our study.
Executive excess compensation continues to be an extremely controversial topic, and the U.S. government had made some efforts to prevent top management to extract excessive compensation. According to U.S. Code Section 4518, the director shall prohibit the enterprises from providing compensation to any executive officer that is not reasonable and comparable with compensation for employment in other similar businesses involving similar duties and responsibilities. Besides, the objectives behind the new SEC Compensation Disclosure Rules and Internal Revenue Code Section 162(m) were to reduce excessive CEO compensation levels and strengthen the pay for performance relation (Perry and Zenner, 2001). The importance of executive excess compensation is highlighted by these provisions, and the U.S. government is still trying to regulate the payments to executives in order to create a safer and more equitable system.
CSR policy functions as a built-in, self-regulating mechanism whereby business monitors and ensures its active compliance with the spirit of the law, ethical standards, and international norms. The goal of CSR is to embrace responsibility for the company’s actions and encourage a positive impact through its activities on the environment, consumers, employees, communities, stakeholders and all other members of the public sphere who may also be considered as stakeholders[1]. In recent years, CSR has become increasingly important due to the growth of institutes, mutual funds, online resources and other publications that encouraging corporations to improve their practices according to different responsibility criteria (Bassen et al., 2006). Besides, many major international organizations such as the United Nations, World Bank, Organization of Economic Co-operation and Development and International Labor Organization not only endorse CSR, but also establish guidance and divisions to encourage CSR (Lee, 2008).
Managerial incentives may encourage strategies having positive or negative implications for social performance. According to Jones and Wicks (1999), firm social performance is often subject to managerial discretion, and the nature of executive compensation consequently influences the use of such discretion in the area of social performance. The connection between executive compensation and CSR has been perceived, and considerable researches suggest that the importance of the structure of executive compensation may influence executives’ focus on CSR.
Since CSR requires business to behave in a more responsible manner across ethical, social, and environmental ways, managers in CSR firms should take responsibility for directing their activities in a manner fair to all stakeholders. We question whether CSR firms are more likely to constrain and prevent excess compensation paid to executives than firms that do not meet the same social criteria. The findings of our study can provide additional evidence to the ongoing debate regarding executive excess compensation and corporate social performance.
Our study builds upon prior research in several ways. There are some studies examining the relationship between executive compensation and CSR, some works have examined the association between particular components of executives’ compensation and CSR (e.g., Johnson and Greening, 1999; Mahoney and Thorne, 2005), others have provided integrated understanding of how the structure of executive compensation can be used to encourage CSR (e.g., McGuire et al., 2003; Mahoney and Thorn, 2006). However, the relationship between executives’ excess compensation and CSR remains to be examined. We find that CSR has an effect on executive excess compensation as expected; in particular, firms with higher CSR ratings are more likely to constrain excessive pay to executives. This finding addresses the influence of CSR policy on limiting executive excess compensation, and may encourage firms to emphasize the importance of CSR in order to provide a more equitable compensation plan fair to all stakeholders. Second, studies related to CFO excess compensation are still rare; we contribute to excess compensation literatures by providing evidence on the relationship between both CEO and CFO excess compensation and CSR. Besides, our findings provide some evidence for the importance of a 1-year lagged between executive excess compensation and CSR in performing the analysis, and point to the need for attention to the measures and methodologies used in this stream of study.
The remainder of this paper consists of five sections. Section 2 provides literature review and hypothesis development. Section 3 describes the research design and measurement choices. The regression results are presented in section 4, and following section 5 provides summary and conclusions.
2. Literature review and hypothesis development
2.1 CSR and Executive Excess Compensation
As noted earlier, CSR policy functions as a monitor mechanism that ensures firms’ active compliance with the spirit of the law, ethical standards, and international norms. Prior research suggests that different managerial incentives may encourage strategies having positive or negative implications for corporate social performance.
Marens (2002) and Zalewski (2003) find that if the goals of the board are to encourage executives to further social and environmental objectives, executive compensation structures can be used to align executives’ self-interest with CSR. However, high levels of compensation may divert executive’s managerial attention away from stakeholders’ interest. McGuire et al. (2003) suggest that high levels of executive compensation are indicative of a less socially responsible orientation; they also find that high levels of salary and long-term incentives are related to poor social performance, and firm strengths in social performance is not related to the financial or corporate governance variables used in their study. Mahoney and Thorn (2006) provide evidence supporting the association between executive compensation and CSR in Canada. Their findings suggest the importance of executive compensation structure for influencing executives’ focus on CSR, which particularly refer to stock options and bonus. Taken together, compensation can be regarded as an important mechanism to promote the implementation of the firm’s social objectives, but when executive compensation levels get higher, managerial attention may be less focused on stakeholders’ interests, and managers are therefore less inclined to make decisions that consider the best interests of stakeholders.
As noted earlier, excess compensation can be viewed as a sign of poor governance or pay without performance (Core et al., 1999), we therefore interpret this as concerns of firms that will have a negative effect to firms. Garriga and Melé (2004) classify CSR theories into four groups: (1) ethical theories, (2) political theories, (3) integrative theories, and (4) instrumental theories. Ethical, political, and integrative theories of CSR suggest that firms have the incentive to be honest, trustworthy, and ethical in their business processes, and therefore tend to stand for a high standard of behavior (Kim et al., 2011). Moreover, ethical theories suggest that a firm must accept social responsibility as an ethical obligation (e.g., Carroll, 1979). Such theories require a CSR firm to pay attention to the interests of all stakeholders in reference to the moral principle. Hence, if managers engage in CSR in the context of a moral imperative, we predict that they are more likely to constrain excess compensation and to design reasonable compensation plans as responsible operating decisions, that is, we expect a negative association between executive excess compensation and total CSR scores.
CSR strengths and CSR concerns capture the negative and positive aspects of CSR, respectively. A firm’s CSR strengths and CSR concerns tend to offset each other in arriving at total CSR. Based on the above, we expect a negative association between executive excess compensation and CSR strengths, and a positive association between executive excess compensation and CSR concerns conversely since both of them are considered as negative aspects of firms. We propose the following hypotheses:
H1a: / There will be a negative association between executive excess compensation and total CSR scores.H1b: / There will be a negative association between executive excess compensation and CSR strengths
.
H1c: / There will be a positive association between executive excess compensation and CSR concerns.
2.2 Corporate Governance and Executive Excess Compensation
Numerous studies indicate that firms with weaker governance structures have greater agency problems, and CEOs at firms with greater agency problems receive greater compensation (Core et al., 1999; Basu et al., 2006). In particular, Basu et al. (2006) find that top executive pay is higher in firms with weaker corporate governance mechanisms, and smaller boards and the presence of outside director are associated with lower top executive pay. Core et al. (1999) also suggest that corporate governance is negatively related to executive excess compensation, and poor governance is clearly an important issue for shareholders, employees, suppliers, and society at large.
Overall, the foregoing suggests that firms with stronger general governance characteristics exhibit stricter executive compensation oversight. In order to strengthen previous finding as they consider excess compensation to be a sign of poor governance, we adopt Core et al.’s (2008) model to estimate executive excess compensation, and expect that there will be an inverse relationship between corporate governance mechanism and executive excess compensation:
H2: / There will be a negative association between corporate governance strength and executive excess compensation.3. Research Design
3.1 Data Collection
We estimate the amount of executive compensation in excess of the pay justified by the economic determinants. Following Core et al. (2008), our study obtain the economic determinants of CEO/CFO compensation from Execucomp and Compustat for years from 2005 to 2010. Observations with missing data are excluded, and we match these data with CSR from KLD database to determine the firms included in our sample.
To date, KLD[2] data have been used extensively in scholarly research. One of the advantages of the KLD ratings is that they are based on the extensive research of independent analysts employed by the firm Kinder, Lydenberg, Domini and Company. By obtaining CSR ratings from the KLD database, we are able to assess different CSR dimensions in order to determine if a company is socially responsible.
KLD organizes items related to CSR into two major categories: qualitative issues and controversial business issues. Qualitative issues include corporate governance, community, diversity, employee relations, environment, product, and human rights. Controversial business issues include alcohol, gambling, tobacco, firearms, military, and nuclear power, which are exclusionary categories and the only type of rating for these issues is a concern rating. Therefore, we did not consider these exclusionary categories. In particular, following Kim et al. (2011), we include six social rating categories from KLD database: (1) corporate governance (CGOV), (2) community (COM), (3) diversity (DIV), (4) employee relations (EMP), (5) environment (ENV), and (6) product (PRO). Since corporate governance is perceived as a distinct construct of CSR, we disentangle the effect of CSR and corporate governance by constructing CSR scores based on the last five dimensions, excluding corporate governance (CGOV).