Incentive Effects of Extreme CEO Pay Cuts*

Huasheng Gao Sauder School of Business

University of British Columbia 2053 Main Mall, Vancouver, BC V6T 1Z2

604.657.4458 huasheng.gao@sauder.ubc.ca

Jarrad Harford

Foster School of Business University of Washington

Box 353200, Seattle, WA 98195-3200 206.543.4796

jarrad@u.washington.edu

Kai Li Sauder School of Business

University of British Columbia 2053 Main Mall, Vancouver, BC V6T 1Z2

604.822.8353 kai.li@sauder.ubc.ca

First version: November, 2008 This version: February, 2009

Abstract: We examine the causes and consequences of sharp CEO pay cuts, a phenomenon that has been mostly overlooked in the attention paid to overall rising executive pay. We find that a large CEO pay cut is not uncommon and is typically triggered by poor stock performance. Good corporate governance structures strengthen the link between poor performance and CEO pay cut. After the pay cut, the CEO can restore his pay level by reversing the poor performance. Pay cuts are only a short-term substitute for dismissal—a pay-cut CEO with continued poor performance is just as likely to be dismissed as a CEO with similar performance whose pay was not cut. On average, CEOs respond to their pay cut by curtailing capital expenditures, reducing R&D expenses, and allocating funds to reduce leverage. For most firms, performance improves and the CEO’s pay is restored. Compared to option repricing, pay cuts appear to be more effective in improving firm performance. Together, our results show that the possibility of these compensation cuts provides ex ante incentives for CEOs to exert effort to avoid poor performance and ex post incentives to improve poor performance once pay is cut.

Keywords: CEO turnover; corporate governance; executive compensation; pay cuts; pay-to-performance sensitivity JEL Classification: G34 * We thank helpful comments from Joy Begley, Sandra Chamberlain, Fangjian Fu, Avi Kamara, Jane Saly, Rong Wang, and seminar participants at the University of British Columbia, and conference participants at the Pacific Northwest Finance Conference. We acknowledge the financial support from the Social Sciences and Humanities Research Council of Canada. All errors are ours.

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1. Introduction

Executive compensation has received enormous attention from both academics and the

popular press. However, most of that attention has focused on the overall rise in pay, the

increasing use of equity-based compensation, and the debate over whether pay is

appropriately sensitive to performance (see for example, Jensen and Murphy (1990), and

Bebchuk and Fried (2003)). In this paper, we study one aspect of compensation in

corporate governance that has been largely overlooked—large, discrete pay cuts. Our

study fits within the general question of how do boards alter compensation to motivate

CEOs (see Core and Guay (1999), for example)? While some prior studies such as

Acharya, John, and Sundaram (2000) have examined the practice of repricing executive

stock options after a performance decline in order to preserve incentives, we examine what

is effectively the opposite practice—sharply reducing CEO pay following poor

performance with the implicit or explicit promise of restoring it if performance improves.

Our study is increasingly relevant given the US government’s effective adoption of this

practice on a broad basis in the financial industry bailout.

For ExecuComp firms over our sample period of 1994-2005, we identify over

1,000 instances of extreme pay cuts where a CEO’s pay is reduced by at least 25% from

the prior year, representing roughly 10% of the firm-year observations. The average

(median) pay cut in our sample is 46% (42%) of the CEO’s pay in the prior year. We

ensure that these cuts are not mechanical reversals of a prior pay spike. Further, using a

model of normal compensation, we show that only about 60% of our sample CEOs have

abnormally high compensation in the year prior to the pay cut. The reduction in total pay

is mainly due to a decrease in the units of stock and options grants leading to a major

reduction in the value of equity-based compensation. In our sample of extreme pay cuts,

the median CEO experiences a 75% reduction in his equity-based pay but only a 21%

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reduction in his salary and bonus.

We find, unsurprisingly, that poor firm performance predicts a pay cut. The CEO

of a firm with an industry-adjusted return of below −15% has a 13% probability of seeing

his pay cut by 25% or more. However, we also find that the likelihood of receiving a sharp

pay cut following poor performance is higher in firms with stronger governance

mechanisms.

The pay cut is not a long-term substitute for dismissal. About one quarter of our

sample CEOs is dismissed in the year following the pay cut. However, those CEOs who

do engineer a turnaround see their pay restored to normal levels. The performance

turnaround is accompanied and aided by abnormal reductions in capital expenditures and

R&D expenses, and a sharp reduction in leverage through active debt retirement.

We implement extensive additional investigation to understand the incentive

mechanism underlying this extreme form of pay cut documented in the paper. We first

provide evidence that the pay cut is not limited to the CEOs but also applies to other

members of the top management team. We then single-out the cluster of pay cuts during

the economic and stock market downturn of 2000-2001. Reflecting some degree of

relative performance evaluation (Holmström (1979)), boards are less likely to cut pay and

to dismiss CEOs for poor performance during a market downturn. However, those that do

cut see greater performance improvement than those cutting outside the downturn period

do. Notably, CEOs whose pay is cut during the downturn experience less pay recovery,

consistent with the outside employment opportunity theory of CEO pay (Oyer (2004)).

Finally, we investigate whether the level of CEO (excess) pay prior to the pay cut

is important in the pay-cutting decision. While CEOs with excess pay are more likely to

have their pay cut and tend to have smaller pay recovery later on, the level of pay before

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the cut has little influence on retention or performance change following the cut.

In summary, we conclude that boards use extreme pay cuts to motivate poorly

performing managers to improve performance. In contrast to the way repriced options are

used to maintain incentives, these boards use the pay cut to penalize poor performance and

the (likely explicit) promise of restored pay to provide incentives to improve. The

approach is generally successful, with firm performance strengthening and the CEO

remaining in his post with restored pay following the pay cut.

Our paper contributes to the literature on executive compensation by providing the

first systematic examination (to our knowledge) of CEO pay cuts. We demonstrate that

boards’ use of sharp cuts to CEO pay provides effective ex ante incentives for them to

exert effort to avoid poor performance and ex post incentives to improve poor

performance if it occurs. Our evidence is generally supportive of the optimal contracting

view of current compensation practice.

The plan of the paper is as follows. We review the literature and develop our

hypotheses in the next section. We describe our sample and variable construction in

Section 3. We explore the causes and consequences of extreme pay cuts in Section 4.

Additional investigation is implemented in Section 5, and we conclude in Section 6.

2. Prior Literature and Hypothesis Development

2.1 Literature Review

The principal-agent conflict is one of the most well-known conflicts in corporate

finance. Since the seminal work by Jensen and Meckling (1976) that identifies the agency

costs associated with the separation of ownership and control in modern corporations,

many papers have explored the incentive mechanisms that overcome this conflict. It is

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well recognized that an efficient compensation system should reward executives for their

effort and resulting good firm performance and punish them if they fail to deliver.

In a standard principal-agent model where managerial ability is unknown and is

revealed over time by observing performance, Murphy (1986) shows that shareholders

adjust the pay level over time to match the observed ability of their managers. When poor

performance indicates that the executive’s ability is overestimated, he will get a pay cut.

Jensen and Murphy (1990) provide the first systematic evidence on executive

compensation in the US. They show that senior managers on average experience relatively

little reduction in their personal wealth when their firms are unprofitable: CEO wealth

typically decreases by only $3.25 (per $1,000 decrease in shareholder wealth) for a sample

of 2,213 CEOs listed in Forbes’ Executive Compensation Surveys from 1974-1986. Hall

and Liebman (1998) find that by the end of the 1990s, the pay-to-performance link for

CEOs jumps almost ten folds since 1980.

CEO pay and the use of equity-based pay experience phenomenal growth since the

1990s (Murphy (1999)). This raises the questions of whether the pay is excessive and

whether it is appropriately sensitive to performance. Defining luck as shocks to firm

performance that are beyond the CEO’s control, Bertrand and Mullainathan (2001) find

that CEO pay responds to luck as much as to general firm performance. They further show

that firms with better governance tend to pay their CEOs less for luck. Garvey and

Milbourn (2006) show that there is an asymmetry in executive compensation

benchmarking; there is significantly less pay-for-luck when luck is down than when it is

up. Harford and Li (2007) flesh out the asymmetric benchmark puzzle: This asymmetry is

stronger following acquisitions and acquisitions are an important channel through which

CEOs achieve asymmetry in pay for performance overall. Gopalan, Milbourn, and Song

(2008) posit that when the CEO is responsible for selecting his firm’s exposure to sector

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performance (they call it strategy flexibility), optimal pay contracts will involve both pay

for luck and the asymmetry in pay for performance.

On the other hand, using a large sample of over 1,600 CEO turnovers from

1993-2001, Jenter and Kanaan (2008) show that CEOs are more likely to be fired when

there is bad industry or market performance. They conclude that boards fail to separate

industry or market performance from CEO performance in their CEO retention decisions.

Our paper is most closely related to studies demonstrating that the CEO suffers

significant wealth loss when his firm is in financial difficulty and the importance of

equity-based compensation in corporate restructuring. Under the first strand of this

literature, based on a sample of 77 financially distressed firms between 1981-1987, Gilson

and Vetsuypens (1993) show that about one third of the CEOs in their sample are replaced

in a given year around default, and those who remain experience significant salary and

bonus reductions, and are often granted new stock options in an attempt to closely align

the interests of CEOs and shareholders. Using a sample of 263 Swedish bankruptcy cases,

Eckbo and Thorburn (2003) find that the median income loss of CEOs of bankrupt firms is

−47% as compared to the contemporaneous income change of CEOs of nonbankrupt

industry rival firms of similar size. Using more recent data and the entire population of

ExecuComp CEOs, Bebchuk and Grinstein (2007) show that there is an asymmetry in

CEO pay responses to size increases and decreases: Firm expansion is positively

correlated with subsequent CEO pay, while firm contraction is not correlated with

subsequent CEO pay.

Under the second strand of this literature focusing on CEO incentives during

downturns, Dial and Murphy (1995) document significant increases in equity-based

compensation at the defense contractor General Dynamics when the entire industry was in

decline following the end of the Cold War. Mehran, Nogler, and Schwartz (1998) study the

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effects of managerial equity ownership and compensation on voluntary liquidation

decisions and find that at least 41% of CEOs who close down their firms are personally

better off. They conclude that current compensation plans motivate CEOs not only to

expand but also to downsize for the purpose of value creation.

Our work is also related to the literature on option repricing. Repricing refers to the

practice of canceling out-of-the-money options and reissuing options with a lower strike

price. Prior work has shown that repricings are economically significant compensation

events: The new strike prices are often 30%-40% lower than the old strike prices (see for

example, Chance, Kumar, and Todd (2000)). Using a sample of ExecuComp firms from

1992-1995, Brenner, Sundaram, and Yermack (2000) find an incidence of repricing of less

than 1.3% per firm year, and there is a strong negative relation between repricing and firm

performance even after correcting for industry performance. Using a sample of 213

instances of repricing from 1992-1997, Chidambaran and Prabhala (2003) show that

negative shocks to firm performance lead to repricing and the performance is not reversed

in the next two years. Following repricing, CEOs still experience high turnover rates.

Overall, there is some debate in the literature about whether repricings are

effective governance mechanism. In our paper, we examine the efficacy of significantly

reducing CEO pay following poor performance. Ostensibly, the two practices can be

aimed at achieving the same goal—giving managers incentives to improve performance.

2.2 Our Hypotheses

Our general hypothesis is that the threat of sharp pay cuts is one way boards

provide managers with incentives to maintain strong performance. In this way, the cuts are

a form of the ex-post settling-up incentives discussed in Fama (1980). Once the pay cuts

are enacted, a promise of restored pay (and retaining his job) provides incentives to

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improve performance. Several specific hypotheses follow from the general hypothesis

above in which pay cuts are viewed as part of the optimal contracting environment.

H1: Poor performance increases the likelihood of a sharp pay cut and the link is

stronger in firms with better governance.

H2: Relative performance evaluation will cause the likelihood of a pay cut to be

insensitive to industry performance.

In order for pay cuts to be optimal, on average they should be effective in

producing improved performance. Thus, we hypothesize the following:

H3: Following pay cuts, managers will take actions that effect a turnaround in

performance. For a given level of performance, pay cuts will make such actions more

likely and hence pay cuts will lead to greater performance improvements.

Finally, for the pay cut to have the appropriate ex ante incentives, improved

performance must be met with restored pay and continued poor performance should result

in dismissal such that the pay cut is only a short-term substitute for performance-driven

dismissal.

H4: CEOs who are successful in improving performance will have their

pre-pay-cut pay restored.

3. Sample Formation and Variable Construction

To construct our sample, we employ the ExecuComp database for the period of

1994-2005.1 We first identify CEOs who experience an extreme form of pay cut of at

least 25% in total compensation (2,633 firm-year observations). CEO pay will fluctuate 1 The ExecuComp database starts in 1992, but our sample identification scheme requires information on CEO pay for at least two years before a pay cut. As a result, our final sample period is from 1994-2005.

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over time if stock and options grants, the largest component in CEO compensation, are not

granted every year. Suppose a CEO is granted stock and options awards once every two

years, we will mechanically observe “compensation reductions” every second year. To

address this issue, we further require that the increase in CEO pay in the year prior to the

pay cut is no more than 25% (1,572 firm-year observations). This additional filter helps

ensure that pay cuts identified in our sample are not due to the normal fluctuation in pay.

As we discuss later, Figure 1 shows that our sample of CEOs do not experience a spike in

pay in the year prior to the cut. In summary, a CEO experiences a major pay cut and thus

is included in our sample if (1) the same CEO keeps his position from year -2 to the pay

cut year 0; (2) his total pay in year 0 is no more than 75% of his pay in year -1; and (3) his

total pay in year -1 is no more than 125% of his pay in year -2. Our final sample consists

of 1,061 instances of pay cuts.2

Table 1 presents an overview of our pay cut sample. Panel A reveals that the

frequency of pay cuts has increased over time. It also reveals that the majority of the pay

cuts took place during the early 2000s as the economy entered into a recession and the

stock market fell considerably from its peak. Panel B shows that the vast majority (85%)

of our sample firms reduce their CEOs’ pay by between 25% and 65% of their pay in the

prior year. Unreported in the table, the average (median) size of pay cut is 46% (42%) of

the CEO’s pay in year -1. In untabulated analysis, we find that three Fama-French

industries (Fama and French (1997)): computers, electronic equipment, and measuring and

control equipment, have a noticeably higher representation in our pay cut sample (17.3%) 2 In our sample, there are 662 firms experiencing only one CEO pay cut, 169 firms with two pay cuts, 19 firms with three pay cuts, and one firm with four pay cuts (Alcoa made a pay cut to its CEO Paul O’Neill in 1997, and made three consecutive pay cuts to its CEO Alain Belda in 2003-2005). Among the 169 firms that make two pay cuts (338 pay cuts), 45 firms make pay cuts to different CEOs and 124 firms make pay cuts to the same CEO. With the latter set, 59 firms make pay cuts in consecutive years, 13 firms make pay cuts within three years (e.g., year t for the first pay cut and year t+2 for the second one), 24 firms within four years, and 28 firms make pay cuts with a window greater than five years.

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than in the overall ExecuComp population (11.4%). Given that our pay-cutting sample is

formed from ExecuComp and the ExecuComp firms are not random draws of the US

listed companies (as they tend to be larger than the overall Compustat population), we will

employ the ExecuComp firms to establish performance benchmarks in our later analyses.

Table 2 reports CEO pay and firm characteristics from the year before (year -1) to

the year after the pay cut (year +1). All dollar values are in 2006 dollars. To mitigate the

effect of outliers, we winsorize all continuous variables at the one percent level in both

tails of the distribution.

We define an executive’s total compensation (Totalpay) in a given year as the sum

of the executive’s salary, bonuses, long-term incentive plans, the grant-date value of

restricted stock awards, and the Black-Scholes value of granted options. Panel A shows

that the median CEO receives Totalpay of $2.9 million in year -1 and experiences a drastic

pay reduction to $1.5 million in the pay cut year. Afterwards, the median Totalpay

increases to $2.5 million in year +1.

We also decompose Totalpay into Cashpay and Equitypay, where Equitypay is the

value of restricted stock granted and the Black-Scholes value of stock options granted, and

Cashpay accounts for the remainder. The majority of the compensation reduction is due to

Equitypay, as Cashpay is stable over time. Specifically, from year -1 to the pay cut year

the median Equitypay decreases from $1.7 million to $429,000. In contrast, the

corresponding change in Cashpay is from $1.1 million to $853,000. Put differently, the

median CEO experiences a 75% cut in Equitypay, but only a 21% cut in Cashpay.

A CEO at a firm that has a policy of granting a constant number of options would

experience fluctuations in Equitypay simply due to increases and decreases in the stock

price. To rule out the possibility that the pattern in Equitypay is being caused by

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fluctuations in the firm’s stock performance, we examine the units of stock and options

granted. Stockshare is defined as the number of shares of the CEO’s annual stock grant,

normalized by the total number of shares outstanding. Optionshare is the number of shares

underlying the CEO’s annual options grants, normalized by the total number of shares

outstanding. The last three rows in each sub-panel of Panel A indicate that the number of

CEO stock and options grants displays exactly the same pattern as the value of Equitypay

and Totalpay. The mean Stockshare is reduced sharply from 0.03% in year -1 to 0.01% in

the pay cut year (the corresponding median value is zero). In the meantime, the median

Optionshare drops from 0.19% to 0.03%.

In the year before the pay cut (Table 2, first sub-panel of Panel B), the median

sample firm has poor stock performance with the raw stock return of −4.5% and

industry-adjusted return of −19%, while its accounting performance looks normal with

ROA of 12%, and industry-adjusted ROA of 0%. Noting that the 95th percentile of

industry-adjusted return is 52.3%, we are concerned about the noise in our performance

measure and for some of our analyses later on, we will also employ a subsample of

pay-cutting firms that, by construction, underperform their industry peers. The fact that

pay-cutting firms have poor stock returns, but relatively good accounting performance,

implies that the stock market attributes low potential for growth to the firm. The median

sample firm is quite large with annual sales of $1.1 billion and the market value of total

assets of $2.4 billion. The median M/B ratio is 2.1, and the median volatility is 0.42.

Turning to governance measures, Democracy takes the value of one if the value of the

G-index is less than the median of ExecuComp companies (9), and zero otherwise. 43% of

the sample firms have good governance as measured by Democracy, and the median

Institutional Ownership is 64%. The median firm has sizeable capital expenditures of

4.7% of total assets, which is about one percentage point higher than the industry median,

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while the median R&D is close to zero. The median Book Leverage is 22%, the median

Market Leverage is 14%. The median CEO age in the year before the pay cut is 55. About

5% of the sample CEOs is at the retirement age (between 63 and 65 years old). Finally,

about three quarters of the pay cut CEOs remain on their posts after the pay cut (last

sub-panel of Panel B).

Figure 1 presents the trend in CEO pay from three years before (year -3) to three

years after the pay cut (year +3). In Panel A, we present the raw levels of our three pay

measures. We show that CEO Totalpay increases from year -3 to -2 followed by a drop in

year -1 and a further bigger drop in the pay cut year, and then the compensation level goes

back up in year +1 and stays stable subsequently.3 It is clear that Totalpay and Equitypay

move in tandem, while Cashpay is stable over the entire seven year period we cover.4

The plot in Panel A could be misleading if firm, industry, and CEO characteristics

justify the high level of pay before the pay cut. As a result, we also compute a measure of

abnormal pay, which is the difference between the actual level of pay and the “normal”

level of pay implied by firm, industry, and executive characteristics. Using the CEO

population in ExecuComp, we estimate our benchmark model for expected compensation

following prior research in this area (for example, Core, Holthausen, and Larcker (1999),

and Murphy (1999)):

0 1 2 3 4

5

( ) ,

it it it it it

it it

Ln Pay a a Stockreturn a ROA a Firmsize a Volatilitya CEOtenure Year Fixed Effects Industry Fixed Effects ε

= + + + +

+ + + + (1)

where i indexes firm and t indexes year. The estimated residual, actual Ln(Pay) −

3 While it appears that one could say that the paycut event started in year -1, this is an artifact of our requirement that pay not increase substantially in year -1 to avoid mechanical reversals. If we drop that requirement, the graph does not show a decrease in year -1. 4 As a robustness check, we also plot CEO pay based on a subsample of 297 CEOs with the same CEO over the entire seven year period. The pattern in pay remains the same.

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predicted Ln(Pay), is our measure of abnormal pay. The industry classification is from

Fama and French (1997). Figure 1, Panel B presents the trend of abnormal CEO pay.

Panel B shows a very similar pattern to that of Panel A: Abnormal CEO pay

increases from year -3 to -2 followed by a continued decline between year -2 and the pay

cut year, a reversal in year +1, and then stays stable afterwards. During the three years

prior to the pay cut, the CEO is receiving sizeable abnormal pay. However, in the period

after the pay cut, his pay is pulled back to normal (the level of abnormal pay is down to

zero). As before, the change in abnormal Equitypay contributes the most to the fluctuation

of abnormal Totalpay.

Panel C presents the number of stock and options grants for the three years before

and three years after the pay cut. It is clear that the change in pay is not driven by the ups

and downs in the stock price, but primarily driven by the change in the units of stock and

options granted.

Figure 2 presents firm performance over the seven-year period surrounding the pay

cut. Panel A presents the stock performance measures, while Panel B presents the

operating performance measures. We show that stock return plunges in the year before and

the year of the pay cut. The raw stock return is about −5% and −8% in year -1 and the pay

cut year, respectively. After adjusting for industry median stock returns, the

underperformance right before the pay cut is even more striking. The industry-adjusted

stock return is around −19% in year -1 and −22% in the pay cut year, suggesting that the

poor stock market performance is more likely to be firm-specific instead of due to

negative industry-wide shocks. After the pay cut, stock return rises back to about 10% per

year and stays the same in subsequent years. Panel A shows that the pick-up in stock

return for pay-cutting companies still does not match the performance of their industry

peers. The temporal pattern in accounting performance measures mirrors that of the stock

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market performance, but at a much smaller magnitude.

4. Causes and Consequences of CEO Pay Cuts

4.1 Why Cut Pay?

In this section, we examine why the board decides to cut its CEO’s pay. Our

predictions are that pay cuts follow abnormally poor performance and that for a given

level of performance pay cuts are more likely when governance mechanisms are stronger.

We estimate the following logit regression:

1 1 1

1 1 1 1

1 1 1 1 1

Pr( ) ( , , ,, ,

, , / , , ( ) ,

it it it it

it it it it

it it it it it

Paycut F Abret Abroa CorporategovernanceAbret Corporategovernance Abroa CorporategovernanceIndret Firmsize M B Volatility Ln Totalpay Year Fixe

− − −

− − − −

− − − − −

=

× ×

, ).

d EffectsFirm Fixed Effects

(2)

The dependent variable, itPaycut , takes the value of one if a CEO pay cut occurs in

firm i and in year t, and zero otherwise. The function F denotes the logit cumulative

distribution function. The independent variables include the industry-adjusted stock return,

industry-adjusted ROA, different measures of corporate governance alone and interacted

with performance, industry median stock return, firm size, market-to-book ratio, stock

return volatility, and CEO total pay. We also include year fixed effects to account for the

time trend, and firm fixed effects to control for the unobserved firm heterogeneity. All the

independent variables are measured in year -1. The sample for estimation consists of firms

that have CEO compensation data in the ExecuComp database and whose CEOs have kept

their job for at least three years. Table 3 presents the results.

Table 3, Panel A Column (1) shows that poor stock performance strongly predicts

CEO pay cut. The coefficient on Abret is significantly negative across all model

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specifications. In the population of ExecuComp CEOs, 4,629 firm-year observations have

Abret less than −15%, and 595 of them experience extreme pay cuts. Put differently, the

CEO of a firm with an abnormal return below −15% has a 13% (= 595/4,629) probability

of seeing his pay cut by 25% or more. Although extant literature such as Garvey and

Milbourn (2006) has found asymmetry in pay for performance, we show that there is some

probability of a large reduction in pay below a certain level of performance. This nonlinear

relation mitigates, but does not eliminate, the overall finding of lower sensitivity of pay to

performance for poor performance.

We do not find that the board’s pay-cutting decision is driven by firm operating

performance.5 This is not surprising if pay cuts are due to pressure from shareholders, and

shareholders are rationally focused on stock returns. Similarly, Gilson and Vetsuypens

(1993) find that earnings performance does not explain cross-sectional variation in CEO

pay when firms are financially distressed.

Further, the coefficient on Indret is negative and significant, suggesting that firms

in poorly performing industries are more likely to cut their CEOs’ pay, similar in spirit to

the findings in Jenter and Kanaan (2008) on CEO turnover. There is overwhelming

evidence that CEO compensation increases when the sector performs well (usually

referred to as pay-for-luck). This fact is often interpreted as evidence in support of the

managerial power hypothesis, which argues that powerful CEOs have exerted undue

influence on the pay process in their favor (Bebchuk and Fried (2003)). Our evidence

suggests that the above view is at least incomplete, as CEOs also suffer major pay cuts

when their sector performs poorly. That is, we have provided evidence on “pay cut for bad

luck,” complementing the literature on pay for luck. Similar to our conclusions for

5 Using other measures of accounting performance, such as net income normalized by total assets, gives the same result.

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asymmetric pay for performance, we conclude that the probability of an extreme,

non-linear reaction to poor overall performance mitigates the overall asymmetry in pay for

luck found in Garvey and Milbourn (2006) and Rajgopal, Shevlin, and Zamora (2006).

CEOs with high compensation in the prior year are also more likely to be subject

to pay cut: The coefficient on Ln(Totalpay) is significantly positive at the 1% level. This

result, while unsurprising, indicates that boards are more likely to employ a pay cut when

pay is high to begin with. In the face of poor performance, activist shareholders are more

likely to target overpaid CEOs for pay cuts, as evidenced by the public call for massive

pay cuts to CEOs of financial companies during the most recent crisis. We note that our

sample selection procedure ensures that these pay cuts are not simply reversals of pay

spikes. Further, these CEOs are not all being overpaid relative to their peers prior to the

pay cut. Slightly less than half (40%) of our sample CEOs have pay at or below the level

predicted by a model of normal pay in the year prior to the pay cut.

We predict that companies with stronger governance will be more likely to use pay

cuts in response to poor performance. There is extensive literature that documents positive

association between effective corporate governance mechanisms and shareholder value.

Gompers, Ishii, and Metrick (2003) construct the “G-index” to measure governance from

the perspective of firm-level anti-takeover protection. They show that better governed

firms (which they call firms with “democracy”) have higher firm value and better

performance.6 Davila and Penalva (2006) show that firms with strong governance

structures as measured by the G-index design compensation contracts that emphasize

stock performance over accounting performance.

We also use an alternative measure of governance: institutional ownership.

6 Using Gompers et al.’s (2003) definition of Democracy (with a cut off of 5) leads to similar results. However, the reduced variation in democracy (fewer firms qualify) reduces the significance.

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Hartzell and Starks (2003) show that the presence of monitoring institutional investors is

positively associated with higher CEO pay-for-performance sensitivity and negatively

associated with the level of CEO pay. Examining acquisition decisions, Chen, Harford,

and Li (2007) find that the presence of long-term institutions increases monitoring.

Table 3, Panel A Columns (2) through (4) show that better governed firms are more

likely to use pay cuts in response to poor performance. Specifically, the coefficient on the

interaction term, Abret×Democracy, is negative and significant at the 10% level. We

continue to find that pay cuts are based on stock performance rather than operating

performance; when we interact Abroa with Democracy in Columns (3) and (4), we find

that its coefficient is positive but insignificant.

In Panel B, we replace Democracy with Institutional Ownership as an alternative

measure for corporate governance, and obtain very similar results. The coefficient on the

interaction term, Abret×Institutional Ownership, is significant and negative at the 5%

level. Consistent with Hartzell and Starks’ (2003) findings on the monitoring role of

institutional ownership, we show that the sensitivity of a pay cut to poor performance is

increasing in the presence of greater institutional ownership.7

In summary, Table 3 shows that a pay cut is more likely to occur when the firm

performs poorly, and the use of a major pay cut to discipline poorly performing CEOs is

more likely to happen in firms with strong governance structures. Both findings are

consistent with our first hypothesis (H1). On the other hand, we also show that when the

firm’s industry performs poorly, and when the CEO is receiving high pay before the cut,

the pay cut is more likely to take place. The former finding does not support our second

hypothesis (H2) on the use of relative performance evaluation.

7 Using institutional ownership by the top five institutional holders provides similar results.

17

4.2 CEO Retention after a Pay Cut

What happens to the career path of a CEO experiencing a major cut in pay? The

pay cut could be a substitute for firing the CEO, or it could be a first step towards the

eventual dismissal. By imposing a pay cut, a board signals its willingness and ability to

take action against a poor-performing CEO. Thus, while it is clearly a substitute in the

year of the pay cut, it likely does not eliminate the threat of dismissal should performance

fail to improve. In this section, we examine whether the incumbent CEO keeps his job in

the year following the pay cut. In particular, we estimate the following logit model:

1Pr( ) ( , , , , ,, , , , / ,

, , ,

it it it it it it it it

it it it it it it

it it it

Retention F Paycut Abret Abroa Paycut Abret Paycut AbroaCorporategovernance Paycut Corporategovernance Indret Firmsize M BVolatility Bookleverage Retirement Y

+ = × ×

× , ).ear Fixed Effects Firm Fixed Effects

(3)

The dependent variable, Retention, equals one if the incumbent CEO remains in

office in year +1, and zero otherwise. 775 CEOs out of our sample of 1,061 instances of

pay cuts remain on their post in year +1. The key independent variable, Paycut, takes the

value of one if the CEO receives a pay cut in year t, and zero otherwise. We also control

for firm and CEO characteristics, and year as well as firm fixed effects. In particular, we

account for voluntary turnover by including an indicator variable, Retirement, which takes

the value of one if the CEO is between 63 to 65 years old, and zero otherwise. The sample

for estimation consists of firms that have CEO compensation data in the ExecuComp

database and whose CEOs have kept their job for at least three years. Table 4 presents the

results.

In Table 4 Column (1), the coefficient on Paycut is −0.45 and is significant at the

1% level. This result indicates that CEOs who have received a pay cut are less likely to

remain in office in the subsequent year. In a different setting, Chidambaran and Prabhala

(2003) show that repricing companies have abnormally high CEO attrition rates. The

18

coefficients on Abret and Abroa are significant and positive, suggesting that CEOs with

good (industry-adjusted) performance are more likely to keep their jobs. The significant

result on Abroa also suggests that when boards make the CEO retention decisions, they

consider additional measures of performance other than just stock returns. The coefficient

on Indret is negative but insignificant, indicating that shocks to industry have no

significant impact on CEO retention decisions. This result is consistent with the theory on

relative performance evaluation that CEO retention decisions should not be based on

factors that are out of the CEOs’ control. Further, consistent with DeFond and Park (1999)

we find that CEOs in firms with volatile stock returns are less likely to be retained.

DeFond and Park (1999) suggest that firms with volatile performance are more likely to

experience the severe negative shocks that lead to CEO turnover. As expected, CEO

turnover is higher at retirement age.

In Columns (2) and (3), we successively include the interaction terms Paycut×

Abret and Paycut×Abroa, respectively. None of the coefficients on these interaction terms

is significantly different from zero, suggesting that a pay cut does not change the

subsequent sensitivity of retention to firm performance. That is, while the board decides

that following the initial performance decline, it will cut the CEO’s pay severely rather

than fire him, it is only a one-year reprieve; in the following year, for a given level of

performance, he is just as likely to be fired as another CEO. Combined with the negative

coefficient on Paycut, a CEO is less likely to be retained following a pay cut.

In Columns (4) and (5), we investigate the role of corporate governance in CEO

retention decisions by successively including Democracy and Institutional Ownership and

their interactions with Paycut. The coefficient on Institutional Ownership is positive and

significant, showing that, controlling for performance, CEOs of firms with greater

institutional ownership are more likely to be retained. This effect is canceled if the CEO’s

19

pay has been cut.

In Column (6), we introduce a new indicator variable Underperforming Paycut

that takes the value of one if the firm makes a pay cut and its stock return underperforms

its industry median in year -1, and zero otherwise. Thus, this Underperforming Paycut

variable captures the subsample of pay-cutting firms that experience poor stock

performance relative to their industry peers before the pay cut (687 of them from our pay

cut sample). The coefficient on Underperforming Paycut is negative and significant,

indicating that those underperforming pay-cutting firms are also less likely to retain their

CEOs afterwards.

Overall, Table 4 reveals that a pay cut appears to be the first step towards CEO

dismissal: Boards making large CEO pay cuts are less likely to retain their CEOs in the

following year.

4.3 Firm Performance after a Pay Cut

In this section, we examine firm performance after the pay cut. Table 2 and Figure

2 reveal that, on average, there is a significant rebound in stock return in the year

following the pay cut. In particular, from the pay cut year to year +1, the median stock

return increases from −7.8% to 11.1%. This contributes to an increase in the

industry-adjusted stock return from −21.9% to −6.2%. Accounting performance improves

as well during the same period. Figure 2 shows that after the improvement, firm

performance remains stable out to at least year +3 relative to the pay cut.

To further investigate the effect of a pay cut on subsequent firm performance, we

estimate the following regression to explain the change in performance in the year

following the pay cut:

20

1 0 1 2 3 4

5 6 1

/ .

it it it it it

it it it

Performance Paycut Firmsize M B VolatilityBookleverage Turnover Year Fixed Effects Firm Fixed Effects

β β β β ββ β ε

+

+

Δ = + + + +

+ + + + + (4)

The dependent variable is the change in firm performance from the pay cut year to

year +1. Our variable of interest is the indicator variable Paycut. We add one new

control variable, Turnover, which takes the value of one if the incumbent CEO leaves

office in year +1, and zero otherwise. Table 5 presents the results.

In Column (1) where the dependent variable, △Abret, is the change in the

industry-adjusted stock return from the pay cut year to year +1, the coefficient on Paycut

is 0.14 and is significant at the 1% level. The effect is also economically significant: For a

pay-cutting company, △Abret increases by 14 percentage points compared to the

population median of zero. The coefficient on Turnover is positive and significant,

indicating that CEO turnover is also associated with improvement in firm performance.

In Column (2), instead of △ Abret, we use △Abroa, the change in the

industry-adjusted ROA from the pay cut year to year +1, as the dependent variable. The

coefficient on Paycut is 0.013 and is significant at the 1% level, indicating a pay-cutting

company experience an increase in △Abroa by 1.3 percentage points relative to the

population median of zero.

We again analyze the subsample of pay-cutting firms that are underperforming their

industry peers at the time of the pay cut. Specifically, we estimate the change in

performance regressions replacing the Paycut indicator variable with Underperforming

Paycut indicator variable in the last two columns of Table 5. Similar to results reported in

Columns (1) and (2), the coefficients on Underperforming Paycut are positive and

significant. The pay-cutting firms that underperform their industry peers show a significant

performance improvement after the pay cut.

21

In summary, firms that cut their CEOs’ pay on average experience significant

performance improvement in the year following the event, consistent with our third

hypothesis (H3).

4.4 Corporate Policies after a Pay Cut

In this section, we explore the actions taken by the CEO to effect the performance

change. Specifically, we study capital expenditures, R&D expenses, and capital structure

decisions after a CEO pay cut.8

Figure 3 presents the trend in corporate investment and financing in the seven-year

period surrounding the pay cut. Panel A shows that capital expenditures stay constant at

around 5% of total assets from year -3 to -1, decrease to 4% in the pay cut year, and

further decrease to about 3% in year +3. The industry-adjusted measure gives a similar

story, showing that capital expenditures are slightly above the industry norm until the pay

cut, at which point they drop down to the industry median level.

Panel B shows a small decline in R&D expenses around a pay cut. The average

R&D is around 3.8% of total assets before the pay cut, and it shrinks to about 3.6%

afterwards.9 The industry-adjusted R&D presents the same pattern; it stays roughly at

1.5% of total assets in the year of pay cut and decreases to about 1.4% of total assets from

year +1 to +3.10

The funds freed-up by the declines in capital expenditures and R&D go toward

8 In unreported analysis, we find that the number of employees generally increases after the pay cut. This evidence supports our overall message in the paper that we are not simply observing firms in distress taking distress-mitigation actions and are instead truly capturing managers taking discretionary actions to increase performance after being “told” to shape-up. 9 The median value of R&D is always zero from year -3 to +3 around the pay cut. 10 Most of the industry median R&D is zero; therefore we compute the industry average R&D as the benchmark.

22

debt reduction. Panel C shows that leverage ratios increase before the pay cut and decrease

afterwards. For example, Book Leverage is around 20% in year -3, and rises to 23% in the

pay cut year, followed by a gradual decline reaching 20% in year +3. A similar pattern can

be found by examining industry-adjusted leverage ratios. Industry-adjusted Book Leverage

is close to zero from year -3 to -1, rises to about 2.5% in the pay cut year, and gradually

declines to 2% in year +3. Market Leverage shows a similar trend around the pay cut.

We further explore what proportion of the decrease in leverage is due to debt

reduction versus equity issuance. Panel D shows that the median value of gross debt

issuance relative to total assets drops from about 1.6% in year -1 to about 1.0% in year +1;

in the meantime the median gross debt retirement relative to total assets increases from

1.7% to 2.3%. Over the seven-year period surrounding the pay cut, the amount of gross

equity issuance and the amount of equity repurchase relative to total assets are quite stable

at 0.6% and 0.2%, respectively. Panel E presents similar decomposition using

industry-adjusted measures. Again, we see that debt retirement is rising above the industry

level, while both equity issue and retirement are converging to the industry norm after the

pay cut. Industry-adjusted debt issuance is always at zero, suggesting that the median

pay-cutting firm is issuing as much debt as the industry median. In summary, we conclude

that the decrease in leverage is mainly driven by the reduction in debt.

We formally examine the changes in corporate policy associated with pay cut by

estimating the following regression:

1 0 1 2 3 4

5 6 1

/ .

it it it it it

it it it

Coporatepolicy Paycut Firmsize M B VolatilityStockreturn Turnover Year Fixed Effects Firm Fixed Effects

γ γ γ γ γγ γ ε

+

+

Δ = + + + ++ + + + +

(5)

The results on capital expenditures surrounding a pay cut are reported in Table 6.

We examine the change in capital expenditures subsequent to a pay cut in Column (1). The

coefficient on Paycut is −0.30 and is significant at the 1% level. Given that the median

23

growth rate in capital expenditures is actually −0.04%, a slight decline, we show that

pay-cutting firms further reduce capital expenditures by 0.30 percentage points. Column

(2) confirms the result for the underperforming subsample. We conclude that after a pay

cut, firms tend to invest less. The findings in Titman, Wei, and Xie (2004) on poor returns

following capital expenditure increases, as well as the turnaround in performance

documented in our sample, suggest that the decision to curtail investment is probably

value enhancing.

In Table 7, we conduct regression analysis on the effect of pay cuts on R&D

expenses. The dependent variable is the change in R&D from the pay cut year to year +1.

The coefficients on both Paycut and Underperforming Paycut are −0.15 and are

significant at the 1% level, indicating that the company that makes a pay cut experiences

less R&D growth in the subsequent year. Given that the sample average growth rate in

R&D is 0%, pay-cutting firms then reduce R&D by 0.15 percentage points.

Table 8 reports the regression results using capital structure measures as the

dependent variables. The dependent variable in Column (1) is the change in Book

Leverage from the pay cut year to year +1. The coefficient on Paycut is −1.07 and is

significant at the 1% level. Thus, relative to non-pay-cutting peers, firms cutting their

CEOs’ pay, have a subsequent negative growth in leverage of 1.1% on average. Using the

change in Market Leverage as the dependent variable in Column (2) yields a similar result.

We further confirm the capital structure results on the underperforming subsample.

Consistent with Baker and Wurgler (2002) who show that higher stock returns are

positively associated with the greater use of equity, we find significantly negative

coefficients on Stockreturn when different leverage measures are used as dependent

variables. Dierkens (1991) argues that higher stock volatility, a proxy for greater

asymmetric information, should be positively associated with use of debt. However, the

24

empirical evidence about the relation between stock return volatility and financing

decisions is quite mixed (Dierkens (1991), Denis (1994), and Jung, Kim, and Stulz (1996)).

We find that firms with high return volatility tend to use less debt. In summary, the CEO

changes his firm’s capital structure after pay cut by reducing debt.

4.5 CEO Pay Recovery after a Pay Cut

Finally, we examine the effect of performance improvement and changes in

corporate policies on CEO pay going forward. We hypothesize that extreme pay cuts can

be effective in providing incentives if there is an explicit promise of restored pay should

the CEO improve performance (H4). We investigate the CEO’s pay in the year following

the pay cut by estimating the following regression model:

1 0 1 2 3 4 5

6 7

/ .

it it it it it it

it it it

Pay Abret Abroa Indret Firmsize M BVolatility CEOage Year Fixed Effects Firm Fixed Effects

δ δ δ δ δ δδ δ ε

+Δ = + + + + +

+ + + + + (6)

The sample for estimation consists of 689 instances of pay cuts where the same

CEO remains on his post in the year after the pay cut. The dependent variable is △Pay,

the percentage change in CEO total pay from the pay cut year to year +1. The coefficient

on Abret is 0.33 and is statistically significant at the 10% level. In terms of economic

significance, a one-standard-deviation increase in Abret is associated with an increase in

△Pay by 0.15 (= 0.445×0.33), relative to the sample median of 0.30. Column (2) presents

the similar regression result based on the subsample of pay cuts where the pay-cutting

firms have poorer stock performance than their industry peers prior to the pay cut. The

coefficient on Abret is 0.29 and is significant at the 10% level.

In both specifications, the coefficient on either Abroa or Indret is not significantly

different from zero. This result suggests that the recovery in CEO pay is mainly driven by

firm-specific stock performance but not operating performance or industry-wide factors.

25

In summary, CEO pay increases in tandem with improved firm performance after

the pay cut, consistent with our final hypothesis (H4). In untabulated results, we examine

the effect of CEO turnover on pay changes. We find that if the board turns to a new CEO,

his pay is much higher, consistent with a premium for running a distressed company and

with the fact that the original poor performance is not his fault.

5. Additional Investigation

5.1 Pay Change for Top Management Team

So far, our analysis focuses on CEO pay cuts. Chidambaran and Prabhala (2003)

show that in their sample of option repricers, a significant 40% of repricings does not

include CEOs. They interpret their finding as companies use repricing to deal with

within-management incentive distortions created by negative return shocks. To further our

understanding of how the board uses changes in compensation to manage the executives’

incentives, we examine how widespread the pay cut is within the senior management

ranks.

The ExecuComp database includes compensation information for up to the five

highest paid managers. After excluding the CEO, we compute the median pay for

members of the senior management team in each year from three years before to three

years after the pay cut. Figure 4 presents the trend in top management pay over the

seven-year period surrounding the CEO pay cut.

Both Totalpay and Equitypay drop in the pay cut year. For example, the median

Totalpay for top executives is around $1.2 million between year -3 to year -1. It goes down

to $900,000 in the pay cut year, goes back up to about $1.2 million in year +1, and stays

constant up to year +3. Similar to our findings on the cash pay of CEOs, the cash pay of

26

top management team stays relatively stable over the entire seven-year period. We

conclude that when the CEO receives a pay cut, the whole senior management team is

subject to similar cut in their pay as well.

5.2 Controlling for Business Cycle

Table 1 Panel A revealed a clustering of pay cuts during the market decline and

recession in 2000 and 2001. Our base specifications control for industry performance and

year fixed effects, but we are also interested in specifically isolating the effect of a

market-wide downturn on pay cuts. The clustering of pay cuts during a downturn suggests

a general lack of relative performance evaluation with respect to economy-wide

performance. Also, one could expect the actions taken by a CEO responding to a pay cut

during a downturn to be different from those taken outside a downturn. Finally, we will be

able to determine whether our results are driven by the downturn subsample or are more

general.

We add an indicator variable, Downturn, which is set equal to one if the firm-year

observations are in 2000 or 2001, and zero otherwise, to our specifications on its own and

interacted with the appropriate variables. We use this variable to investigate whether the

overall market downturn during our sample period influences the CEO pay cut and

retention decisions, subsequent performance changes, and CEO pay recovery (results

available upon request).

We find that during the period of overall market downturn, the board is less likely

to cut its CEO’s pay in response to poor performance. Thus, the CEO benefits from some

form of relative performance evaluation. Nonetheless, we note our finding in Table 3 that

poor industry performance still is significantly and positively associated with subsequent

pay cuts. Further, the board is less likely to dismiss its CEO in the period of overall stock

27

market downturn. However, we also find that the negative association between pay cut and

CEO retention is not moderated by the overall stock market performance. Thus, once the

board has enacted a pay cut, it is just as likely to follow-up with a dismissal inside a

downturn as it is outside a downturn.

As for CEO actions following a pay cut in a downturn, we find that the CEO

reduces leverage, but not investment, more dramatically after a pay cut in the downturn

period than after a paycut outside that period. At the same time, we find that CEOs going

through pay cuts during market downturns experience more negative growth in pay. This

result is consistent with the outside opportunities theory of CEO pay, that is, when the

opportunity cost of CEO pay worsens during downturns, the extent of their pay recovery

suffers.

5.3 Controlling for Initial Abnormal Pay

In our sample of 1,061 instances of pay cuts, 602 (about 60%) of these CEOs

receive higher compensation in the year prior to the pay cut than their normal level of pay

based on Equation (1). We are interested in whether a pay cut from abnormally high pay

has differential effects on CEOs than a pay cut relative to normal pay. There are a number

of reasons why a difference would exist. CEOs earning abnormal pay may have perceived

themselves to be strong relative to their boards and the pay cut would indicate a

substantial shift in bargaining power. Further, higher compensation levels should be

associated with greater sensitivity of pay to performance, so for a given level of poor

performance, highly paid CEOs should be more likely to have their pay cut. Finally, pay

cuts relative to normal pay are inherently more punitive than pay cuts relative to

abnormally high pay.

We construct an indicator variable Highpay, which takes the value of one if the

28

CEO receives higher-than-predicted pay in the year prior to the pay cut, and zero

otherwise. Including this indicator variable and interacting it with he appropriate other

variables, we find that companies are more likely to cut their CEOs’ pay in response to

poor performance when their CEOs are overpaid in the first place. Our results are

consistent with standard contract theory which suggests that high compensation level

should be associated with high sensitivity to performance (Holmström and Milgrom

(1987)). We also examine the relation between Highpay and CEO retention decisions by

adding Highpay and its interaction with Paycut in Equation (3). We find that a CEO who

receives abnormally high compensation prior to the pay cut is as likely to be dismissed as

other CEOs.

While a highly paid CEO does not curtail leverage or investment differently from

other CEOs following a pay cut, his firm experiences a smaller improvement in stock

performance and his pay recovers less. Overall, it appears that a pay cut relative to a

normal level of pay imposes more pressure on the CEO than a pay cut on an abnormally

high level of pay.

5.4 Pay Cut versus Option Repricing

As we have noted, pay cuts and repricing are essentially the opposite responses to

poor performance, so it is interesting to compare their efficacy in achieving improved

performance. While our results indicate a strong performance turnaround following a pay

cut, the existing literature fails to find evidence of improvement in firm performance after

an option repricing. For example, Chidambaran and Prabhala (2003) find that

industry-adjusted operating performance of repricers is −0.5% two years preceding

repricing. In the repricing year, it suddenly falls to –6.7% and remains at about –5% for

the next two years. Similar results can be found by using other measures of performance.

29

They claim that “Repricers never regain their historical profitability levels or growth

rates” (page 163). Moreover, the frequency of option repricing is much smaller than that

of pay cut. Based on ExecuComp, Chidambaran and Prabhala (2003) only identify 213

repricing cases in the 1992-1997 period (about 36 events per year). Similarly, in another

study, Callaghan et al. (2004) only identify 236 repricing events during the same period.

Compared to our sample of 1,061 instances of pay cuts from 1994 to 2005 (about 88 pay

cuts per year), option repricing is clearly less frequent and has almost disappeared since

the accounting rule change in 1998, while the phenomenon we study has become more

economically important.

6. Conclusion

Creating incentives for managers to exert effort to perform well and to improve

poor performance is a complex process. In this paper we study changes to CEOs’

compensation packages that have the potential to create ex ante incentives to exert effort

to avoid poor performance as well as ex post incentives to improve poor performance if it

is experienced. Specifically, we examine the causes and consequences of sharp pay cuts,

an occurrence that has been mostly overlooked in the attention given to overall rising pay

levels.

We find that poor performance significantly increases a CEO’s chance of having

his pay cut sharply and that he can restore his pay level by reversing the poor performance.

Pay cuts are only a short-term substitute for dismissal—a CEO continuing poor

performance following a pay cut is just as likely to be dismissed as a non-pay-cutting CEO

with similar performance. On average, CEOs respond to the pay cut by curtailing capital

expenditures and R&D and allocating funds to reduce leverage. For most firms,

30

performance improves and the CEO’s pay is restored. Compared to option repricing, pay

cuts appear to be more effective in improving firm performance.

31

Appendix: Example of CEO pay cut in our sample

1. Edward W. Barnholt, CEO of Agilent Technologies Inc

In 2002, Agilent’s sales were down 28%, the stock was off 35%, and the firm posted a $1 billion loss. So when it came time for the board to decide Barnholt's pay, the board decided to cut his base salary by 10%, to $925,000, and give no bonus or restricted-stock grant for the second consecutive year. Says Barnholt: "I don't expect anything different. If the company doesn't perform, I shouldn't be getting any rewards." Source: Business Week www.businessweek.com/magazine/content/03_16/b3829002.htm 2. Richard M. Rodstein, CEO of K2 INC In determining the CEO’s incentive compensation award for 2001, the Committee considered K2's performance for the year in meeting earnings targets, stock price performance, improvement in margins, returns on investment and meeting cash flow objectives, implementation of cost reduction programs, and augmenting K2's long-term strategic plan for sustainable growth. The Committee noted that while K2's stock price decreased 10% for the year, K2's peer group index decreased 16% in the same period. The Committee also noted that despite a significant decline in the sales of inline skates and a collapse of the scooter market, K2's remaining businesses reported significant improvements in operating earnings in 2001 due in part to sales of new products, to the transfer of certain production to China and an aggressive cost reduction program. The Committee noted the successful transfer of production of alpine skis to China and the implementation of significant cost reduction measures that should benefit future years. Finally, the committee considered the significant cash flow and debt reduction of K2 during the period despite the substantial decline in sales. After consideration of the above factors, the committee elected not to grant any award to the Chief Executive Officer for the year 2001 compared to an award of $285,000 in the prior year. The 2001 total compensation for the CEO represents a 47% shortfall from the 50th percentile for total compensation of the marketplace for similar positions, according to survey data. Source: Def 14A 2002 for K2 INC www.sec.gov/Archives/edgar/data/6720/000091205702012792/a2072243zdef14a.htm 3. Philip J. Purcell, CEO of Morgan Stanley

Morgan Stanley cut the compensation of its chairman and chief executive, Philip J. Purcell, by 26 percent in 2002. The cut in pay follows a 17 percent decline in stock price and a 15 percent decline in net income at Morgan Stanley. The company paid Mr. Purcell $11 million in 2002, down from $15 million in 2001. Moreover, the aggregate compensation paid to the five most highly compensated officers for 2002 also decreased approximately 26% from 2001.

Source: Def 14A 2002 for Morgan Stanley

www.sec.gov/Archives/edgar/data/895421/000095013003001281/ddef14a.htm#tx814_16

32

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35

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36

Table 1. Sample Distribution The sample consists of 1,061 instances of CEO pay cuts from 1994 to 2005. A CEO experiences a major pay cut and thus is included in our sample if (1) the same CEO keeps his position from year -2 to the pay cut year; (2) his total pay is no more than 75% of his pay in year -1; and (3) his total pay in year -1 is no more than 125% of his pay in year -2. In Panel B, pay cut is defined as one minus Pay (t)/Pay(t-1) where Pay(t) and Pay(t-1) refer to the CEO’s total pay in the pay cut year t and year t-1, respectively. Panel A: Distribution of CEO Pay Cut by Year

Year Frequency

(1) Percent

(2)

Number of firms in

ExecuComp (3)

Percentage of firms in

ExecuComp (4)

(1)/(3)

1994 13 1.23% 1540 7.67% 0.84% 1995 53 5.00% 1591 7.93% 3.3% 1996 52 4.90% 1636 8.15% 3.2% 1997 60 5.66% 1661 8.28% 3.6% 1998 78 7.35% 1721 8.58% 4.5% 1999 69 6.50% 1793 8.93% 3.8% 2000 100 9.43% 1779 8.86% 5.6% 2001 120 11.31% 1651 8.23% 7.3% 2002 151 14.23% 1656 8.25% 9.1% 2003 165 15.55% 1678 8.36% 9.8% 2004 90 8.48% 1681 8.38% 5.4% 2005 110 10.37% 1681 8.38% 6.5% Total 1061 100% 20068 5.3%

37

Panel B: Distribution of CEO Pay Cut by Size

Pay Cut Frequency Percent Cumulative Percent [25%, 35%) 358 33.74% 33.74% [35%, 45%) 240 22.62% 56.36%

[45%, 55%) 181 17.06% 73.42%

[55%, 65%) 121 11.40% 84.83%

[65%, 75%) 75 7.07% 91.89%

[75%, 85%) 51 4.81% 96.70%

[85%, 95%) 26 2.45% 99.15%

[95%, 100%] 9 0.85% 100% Total 1061 100%

38

Table 2. Summary Statistics This table reports firm characteristics from one year before the pay cut to one year after. The sample consists of 1,061 instances of CEO pay cuts from 1994 to 2005. Totalpay is the sum of the CEO’s salary, bonuses, long-term incentive plans, the grant-date value of restricted stock awards, and the Black-Scholes value of granted options. Cashpay is the sum of the CEO’s salary, bonus, payouts from long-term incentive plans, and all other cash-based compensation. Equitypay is the value of restricted stock and the Black-Scholes value of stock options. Stockshare is the number of shares in the CEO’s annual stock grants as a percentage of the total number of shares outstanding. Optionshare is the number of shares underlying the CEO’s annual options grants as a percentage of the total number of shares outstanding. Incentiveshare is the sum of Stockshare and Optionshare. ROA is operating income before depreciation over total assets. Abret is the difference between the raw stock return and industry median stock return. Abroa is the difference between the raw ROA and industry median ROA. The industry classification follows Fama and French (1997) 48 industries. MV Equity is the product of total number of shares outstanding and the fiscal year end closing price. M/B is the ratio of market value of equity over book value of equity. Volatility is the standard deviation of stock returns based on the monthly returns over the past 60 months. Democracy takes the value of one if the value of the G-index as constructed by Gompers et al. (2003), is less than the median of ExecuComp firms (9), and zero otherwise. Institutional Ownership is the number of shares owned by institutional investors as a percentage of the total number of shares outstanding. Capex is capital expenditures over the book value of total assets. R&D is research and development expenses over the book value of total assets. Book Leverage is the ratio of long-term debt and current debt over the book value of total assets. Market Leverage is the ratio of long-term debt and current debt over the market value of total assets. Retirement takes the value of one if the CEO is between 63 and 65 years old, and zero otherwise. Retention takes the value of one if the CEO stays on his job in year +1, and zero otherwise. All dollar values are in 2006 dollars. All continuous variables are winsorized at the 1st and 99th percentiles. Panel A: CEO Characteristics

Mean Std 5th Pct Median 95th Pct Year -1 Totalpay ($K) 5917 8265 736 2925 21797 Cashpay ($K) 1505 1499 336 1085 4159 Equitypay ($K) 4350 7452 13 1735 18124 Stockshare 0.03% 0.29% 0 0 0.13% Optionshare 0.35% 0.63% 0 0.19% 1.09% Incentiveshare 0.35% 0.46% 0 0.22% 1.13% Pay Cut Year Totalpay ($K) 2725 3248 394 1474 10139 Cashpay ($K) 1200 1096 290 853 3344 Equitypay ($K) 1508 2603 2 429 7234 Stockshare 0.01% 0.06% 0 0 0.05% Optionshare 0.13% 0.29% 0 0.03% 0.57% Incentiveshare 0.14% 0.24% 0 0.04% 0.58% Year +1 Totalpay ($K) 4811 6477 486 2463 17190 Cashpay ($K) 1402 1346 310 986 3666 Equitypay ($K) 3348 5591 6 1375 13291 Stockshare 0.03% 0.11% 0 0 0.17% Optionshare 0.28% 0.49% 0 0.12% 1.18% Incentiveshare 0.31% 0.53% 0 0.14% 1.29%

39

Panel B: Firm Characteristics

Mean Std 5th Pct Median 95th Pct Year -1 Stockreturn -1.77% 44.6% -67.99% -4.51% 78.24% ROA 11.68% 11.71% -8.07% 12.46% 28.65% Abret -18.51% 41.08% -82.43% -19.05% 52.33% Abroa -0.56% 10.71% -18.48% 0% 14.37% Sales ($M) 4047 8297 103 1135 18211 BV Total Assets ($M) 8524 26538 144 1284 38797 MV Total Assets ($M) 12491 32450 255 2429 57325 MV Equity ($M) 5587 12854 130 1343 27822 M/B 2.85 2.88 0.53 2.08 8.07 Volatility 0.49 0.24 0.22 0.42 0.97 Democracy 0.43 0.49 0 0 1 Institutional Ownership 61% 19% 25% 64% 89% Capital Expenditures 6.21% 5.62% 0.67% 4.71% 18% R&D 3.8% 6.8% 0 0 18.3% Book Leverage 23% 19% 0 22% 57% Market Leverage 17% 16% 0 14% 50% CEO age 55 7.47 43 55 68 Retirement 0.05 0.23 0 0 1 Pay Cut Year Stockreturn -1.37% 48.61% -71.31% -7.75% 83.01% ROA 9.64% 12.2% -11.72% 10.61% 26.66% Abret -19.17% 44.54% -82.02% -21.89% 54.58% Abroa -2.29% 11.46% -23.02% -1.05% 13.11% Sales ($M) 4079 8249 86 1118 19875 BV Total Assets ($M) 9134 28960 139 1347 39925 MV Total Assets ($M) 12599 34383 206 2267 56982 MV Equity ($M) 5140 11476 85 1179 24054 M/B 2.47 2.51 0.37 1.85 7.06 Volatility 0.51 0.25 0.21 0.44 0.99 Democracy 0.43 0.49 0 0 1 Institutional Ownership 61% 20% 23% 63% 91% Capital Expenditures 5.51% 5% 0.64% 4.22% 16% R&D 3.8% 6.8% 0 0 18% Book Leverage 24% 19% 0 23% 59% Market Leverage 18% 17% 0 15% 54% CEO age 56 7.57 44 56 69 Retirement 0.06 0.24 0 0 1

40

Year +1 Stockreturn 20.39% 67.22% -62.86% 11.06% 122.40% ROA 9.83% 10.82% -8.24% 10.47% 24.74% Abret 1.21% 63.34% -74.11% -6.21% 98.00% Abroa -2.25% 10.29% -19.68% -0.96% 11.94% Sales ($M) 4301 8413 86 1268 21896 BV Total Assets ($M) 10053 33401 147 1498 37987 MV Total Assets ($M) 13923 39202 221 2439 58845 MV Equity ($M) 5884 13494 77 1398 27751 M/B 2.37 2.09 0.36 1.90 6.26 Volatility 0.49 0.25 0.20 0.44 0.99 Democracy 0.42 0.49 0 0 1 Institutional Ownership 64% 21% 25% 65% 93% Capital Expenditures 4.72% 4.33% 0.51% 3.38% 13.87% R&D 3.7% 6.7% 0 0 17.6% Book Leverage 23% 19% 0 22% 57% Market Leverage 18% 16% 0 15% 50% CEO age 55.62 7.51 44 56 68 Retirement 0.06 0.24 0 0 1 Retention 0.73 0.44 0 1 1

41

Table 3. What Predicts a CEO Pay Cut? We run a logit regression using the ExecuComp firms whose CEOs stay in office for at least three years during the period from 1994 to 2005. The dependent variable, Paycut, takes the value of one if the firm makes a CEO pay cut in year t, and zero otherwise. There are 1,061 instances of pay cuts in the estimation sample. Abret is the difference between the raw stock return and industry median stock return. Abroa is the difference between the raw ROA and industry median ROA. Indret is the industry median annual stock return. The industry classification follows Fama and French (1997) 48 industries. Firmsize is the natural logarithm of sales. M/B is the ratio of market value of equity over book value of equity. Volatility is the standard deviation of stock returns based on the monthly returns over the past 60 months. Ln(Totalpay) is the natural logarithm of CEO’s total annual compensation. Democracy takes the value of one if the value of the G-index as constructed by Gompers et al. (2003), is less than the median of ExecuComp firms (9), and zero otherwise. Institutional Ownership is the number of shares owned by institutional investors as a percentage of the total number of shares outstanding. Corresponding p-values are reported in brackets. The superscripts ***, ** and * denote statistical significance at the 1%, 5% and 10% level, respectively. Panel A: Using Democracy to Measure Corporate Governance

(1) (2) (3) (4) Abret -0.84***

[0.000] -0.81*** [0.000]

-0.95*** [0.000]

-0.78*** [0.000]

Abroa -0.56 [0.35]

0.12 [0.87]

-0.15 [0.87]

-0.31 [0.74]

Democracy

0.05 [0.83]

0.13 [0.58]

0.12 [0.62]

Abret × Democracy

-0.34* [0.09]

-0.36* [0.09]

Abroa × Democracy

0.73 [0.59]

1.03 [0.46]

Indret -1.53*** [0.000]

-1.63*** [0.000]

-1.64*** [0.000]

-1.63*** [0.000]

Firmsize 0.23* [0.07]

0.05 [0.74]

0.06 [0.69]

0.06 [0.73]

M/B -0.004 [0.84]

-0.02 [0.51]

-0.018 [0.48]

-0.017 [0.51]

Volatility 0.37 [0.52]

0.07 [0.92]

0.08 [0.91]

0.08 [0.91]

Ln(Totalpay) 0.57*** [0.000]

0.64*** [0.000]

0.64*** [0.000]

0.64*** [0.000]

Year Fixed Effects Yes Yes Yes Yes Firm Fixed Effects Yes Yes Yes Yes Observations 11189 9013 9013 9013 Pseudo-R2 8.4% 9% 8.9% 9%

42

Panel B: Using Institutional Ownership to Measure Corporate Governance

(1) (2) (3) (4) Abret -0.84***

[0.000] -0.31 [0.29]

-0.84*** [0.000]

-0.32 [0.28]

Abroa -0.56 [0.35]

-0.57 [0.33]

0.58 [0.68]

0.33 [0.81]

Institutional Ownership

0.002 [0.99]

-0.09 [0.86]

-0.17 [0.72]

Abret × Institutional Ownership

-0.91** [0.05]

-0.88* [0.06]

Abroa × Institutional Ownership

-2.11 [0.37]

-1.66 [0.48]

Indret -1.53*** [0.000]

-1.54*** [0.000]

-1.53*** [0.000]

-1.54*** [0.000]

Firmsize 0.23* [0.07]

0.21 [0.11]

0.21* [0.10]

0.21 [0.11]

M/B -0.004 [0.84]

-0.006 [0.77]

-0.004 [0.83]

-0.005 [0.79]

Volatility 0.37 [0.52]

0.34 [0.56]

0.36 [0.53]

0.33 [0.56]

Ln(Totalpay) 0.57*** [0.000]

0.57*** [0.000]

0.57*** [0.000]

0.56*** [0.000]

Year Fixed Effects Yes Yes Yes Yes Firm Fixed Effects Yes Yes Yes Yes Observations 11189 11189 11189 11189 Pseudo-R2 8.4% 8.5% 8.4% 8.5%

43

Table 4. CEO Retention After a Pay Cut We run a logit regression using the ExecuComp firms whose CEOs stay in office for at least three years during the period from 1994 to 2005. The dependent variable, Retention, takes the value of one if the CEO remains in position in year +1, and zero otherwise. Paycut takes the value of one if the firm makes a pay cut in year t, and zero otherwise. Underperforming Paycut takes the value of one if the firm makes a pay cut and its stock return is less than the ExecuComp industry median return in year -1, and zero otherwise. Abret is the difference between the raw stock return and industry median stock return. Abroa is the difference between the raw ROA and industry median ROA. Indret is the industry median annual stock return. The industry classification follows Fama and French (1997) 48 industries. Firmsize is the natural logarithm of sales. M/B is the ratio of market value of equity over book value of equity. Volatility is the standard deviation of stock returns based on the monthly returns over the past 60 months. Book Leverage is the ratio of long-term debt and current debt over the book value of total assets. Retirement takes the value of one if the CEO is between 63 and 65 years old, and zero otherwise. Democracy takes the value of one if the value of the G-index as constructed by Gompers et al. (2003), is less than the median of ExecuComp firms (9), and zero otherwise. Institutional Ownership is the number of shares owned by institutional investors as a percentage of the total number of shares outstanding. Corresponding p-values are reported in brackets. The superscripts ***, ** and * denote statistical significance at the 1%, 5% and 10% level, respectively.

(1) (2) (3) (4) (5) (6) Paycut -0.45***

[0.000] -0.46*** [0.000]

-0.45*** [0.000]

-0.38** [0.02]

0.079 [0.81]

Underperforming Paycut

-0.52*** [0.000]

Abret 0.24*** [0.003]

0.24*** [0.004]

0.24*** [0.003]

0.21*** [0.02]

0.22*** [0.008]

0.26*** [0.001]

Abroa 2.55*** [0.000]

2.55*** [0.000]

2.55*** [0.000]

2.27*** [0.000]

2.48*** [0.000]

2.61*** [0.000]

Paycut × Abret

-0.02 [0.95]

Paycut × Abroa

-0.03 [0.97]

Democracy

-0.21 [0.19]

Paycut × Democracy

-0.15 [0.48]

Institutional Ownership

1.08*** [0.005]

Paycut×Institutional Ownership

-0.84* [0.09]

Indret -0.18 [0.34]

-0.18 [0.34]

-0.18 [0.34]

-0.19 [0.37]

-0.22 [0.26]

-0.17 [0.37]

Firmsize -0.16 [0.13]

-0.16 [0.13]

-0.16 [0.13]

-0.16* [0.19]

-0.19* [0.08]

-0.17 [0.12]

M/B -0.007 [0.68]

-0.007 [0.68]

-0.007 [0.68]

-0.03 [0.13]

-0.011 [0.51]

-0.008 [0.61]

Volatility -1.39*** [0.002]

-1.37*** [0.002]

-1.37*** [0.002]

-1.49*** [0.004]

-1.22*** [0.008]

-1.41*** [0.002]

44

Book Leverage 0.04 [0.94]

0.04 [0.94]

0.04 [0.94]

0.84 [0.13]

0.14 [0.77]

0.04 [0.93]

Retirement -1.22*** [0.000]

-1.22*** [0.000]

-1.22*** [0.000]

-1.24*** [0.000]

-1.23*** [0.000]

-1.22*** [0.000]

Year Fixed Effects Yes Yes Yes Yes Yes Yes Firm Fixed Effects Yes Yes Yes Yes Yes Yes Observations 11167 11167 11167 11167 9127 11167 Pseudo-R2 9.2% 8.6% 8.6% 8.6% 8.8% 9%

45

Table 5. Firm Performance After a CEO Pay Cut This regression is based on the ExecuComp firms whose CEOs stay in office for at least three years during the period from 1994 to 2005. Abret is the difference between the raw stock return and industry median stock return. Abroa is the difference between the raw ROA and industry median ROA. The industry classification follows Fama and French (1997) 48 industries. △Abret is defined as Abret(t+1) − Abret(t). △Abroa is defined as Abroa(t+1) − Abroa(t). Paycut takes the value of one if the firm makes a pay cut in year t, and zero otherwise. Firmsize is the natural logarithm of sales. Underperforming Paycut takes the value of one if the firm makes a pay cut and its stock return is less than the ExecuComp industry median return in year -1, and zero otherwise. M/B is the ratio of market value of equity over book value of equity. Volatility is the standard deviation of stock returns based on the monthly returns over the past 60 months. Book Leverage is the ratio of long-term debt and current debt over the book value of total assets. Turnover takes the value of one if the CEO is replaced between the pay cut year and year +1, and zero otherwise. Corresponding p-values are reported in brackets. The superscripts ***, ** and * denote statistical significance at the 1%, 5% and 10% level, respectively.

(1) △Abret (2) △Abroa (3) △Abret (4) △Abroa

Paycut 0.14***

[0.000] 0.013***

[0.000]

Underperforming Paycut

0.11***

[0.000] 0.018***

[0.000]

Firmsize -0.15*** [0.000]

-0.024*** [0.000]

-0.15*** [0.000]

-0.023*** [0.000]

M/B -0.11*** [0.000]

0.001** [0.017]

-0.11*** [0.000]

0.001** [0.015]

Volatility -0.001 [0.99]

0.027** [0.023]

0.002 [0.98]

0.027** [0.022]

Book Leverage 1.43***

[0.000] 0.21***

[0.000] 1.44***

[0.000] 0.21***

[0.000]

Turnover 0.058***

[0.002] 0.003

[0.15] 0.06***

[0.001] 0.003

[0.17]

Constant 2.64***

[0.000] 0.37***

[0.000] 2.65***

[0.000] 0.36***

[0.000] Year Fixed Effects Yes Yes Yes Yes Firm Fixed Effects Yes Yes Yes Yes Observations 10466 10484 10466 10484 Adjusted-R2 19% 6% 19.8% 6.1%

46

Table 6. Capital Expenditures After a CEO Pay Cut This regression is based on the ExecuComp firms whose CEOs stay in office for at least three years during the period from 1994 to 2005. Capex is capital expenditures over the book value of total assets, measured in percentage points. △Capex is defined as Capex (t+1) − Capex (t), also measured in percentage points. Paycut takes the value of one if the firm makes a pay cut in year t, and zero otherwise. Underperforming Paycut takes the value of one if the firm makes a pay cut and its stock return is less than the ExecuComp industry median return in year -1, and zero otherwise. Firmsize is the natural logarithm of sales. M/B is the ratio of market value of equity over book value of equity. Volatility is the standard deviation of stock returns based on the monthly returns over the past 60 months. Turnover takes the value of one if the CEO is replaced between the pay cut year and year +1, and zero otherwise. Corresponding p-values are reported in brackets. The superscripts ***, ** and * denote statistical significance at the 1%, 5% and 10% level, respectively.

(1)

△Capex (2)

△Capex

Paycut -0.30*** [0.01]

Underperforming Paycut

-0.35*** [0.004]

Firmsize 0.17

[0.12] 0.20*

[0.056]

M/B -0.02 [0.15]

-0.013 [0.41]

Volatility 0.63

[0.19] 0.54

[0.24]

Stockreturn 0.84***

[0.000] 0.84***

[0.000]

Turnover -0.025 [0.79]

-0.006 [0.95]

Constant -3.61 [0.13]

-4.22* [0.07]

Year Fixed Effects Yes Yes Firm Fixed Effects Yes Yes Observations 9580 9580 Adjusted-R2 3.8% 4%

47

Table 7. R&D Expenses After a CEO Pay Cut This regression is based on the ExecuComp firms whose CEOs stay in office for at least three years during the period from 1994 to 2005. R&D is research and development expenses over the book value of total assets, measured in percentage points. △R&D is defined as R&D (t+1) − R&D (t), also measured in percentage points. Paycut takes the value of one if the firm makes a pay cut in year t, and zero otherwise. Firmsize is the natural logarithm of sales. Underperforming Paycut takes the value of one if the firm makes a pay cut and its stock return is less than the ExecuComp industry median return in year -1, and zero otherwise. M/B is the ratio of market value of equity over book value of equity. Volatility is the standard deviation of stock returns based on the monthly returns over the past 60 months. Turnover takes the value of one if the CEO is replaced between the pay cut year and year +1, and zero otherwise. Corresponding p-values are reported in brackets. The superscripts ***, ** and * denote statistical significance at the 1%, 5% and 10% level, respectively.

(1)

△R&D (2) △R&D

Paycut -0.15*** [0.01]

Underperforming Paycut

-0.15*** [0.008]

Firmsize 0.079

[0.12] 0.088*

[0.08]

M/B -0.042*** [0.000]

-0.044*** [0.000]

Volatility 0.027

[0.90] -0.029 [0.89]

Stockreturn -0.083** [0.03]

-0.083** [0.03]

Turnover -0.002 [0.97]

-0.003 [0.94]

Constant -1.48 [0.18]

-1.71 [0.124]

Year Fixed Effects Yes Yes Firm Fixed Effects Yes Yes Observations 10523 10523 Adjusted-R2 1% 1%

48

Table 8. Capital Structure After a CEO Pay Cut This regression is based on the ExecuComp firms whose CEOs stay in office for at least three years during the period from 1994 to 2005. Book Leverage is the ratio of long-term debt and current debt over the book value of total assets. Market Leverage is the ratio of long-term debt and current debt over the market value of total assets. △Book (Market) Leverage is defined as Book (Market) Leverage (t+1) − Book (Market) Leverage (t). Paycut takes the value of one if the firm makes a pay cut in year t, and zero otherwise. Underperforming Paycut takes the value of one if the firm makes a pay cut and its stock return is less than the ExecuComp industry median return in year -1, and zero otherwise. Firmsize is the natural logarithm of sales. M/B is the ratio of market value of equity over book value of equity. Volatility is the standard deviation of stock returns based on the monthly returns over the past 60 months. Turnover takes the value of one if the CEO is replaced between the pay cut year and year +1, and zero otherwise. Corresponding p-values are reported in brackets. The superscripts ***, ** and * denote statistical significance at the 1%, 5% and 10% level, respectively.

(1) △Book

Leverage

(2) △Market Leverage

(3) △Book

Leverage

(4) △Market Leverage

Paycut -1.07*** [0.000]

-0.86*** [0.000]

Underperforming Paycut

-1.06*** [0.000]

-0.87*** [0.000]

Firmsize -0.64*** [0.01]

0.41* [0.07]

-0.63*** [0.01]

0.35 [0.11]

M/B -0.14*** [0.000]

0.12*** [0.000]

-0.13*** [0.001]

0.12*** [0.000]

Volatility -6.56*** [0.000]

-9.23*** [0.000]

-5.54*** [0.000]

-8.11*** [0.000]

Stockreturn -0.63*** [0.000]

-0.32** [0.05]

-0.64*** [0.001]

-0.33** [0.044]

Turnover 0.096

[0.67] -0.14 [0.48]

0.11 [0.62]

-0.11 [0.57]

Constant 17.36*** [0.000]

-5.24 [0.28]

16.64*** [0.002]

-4.52 [0.34]

Year Fixed Effects Yes Yes Yes Yes Firm Fixed Effects Yes Yes Yes Yes Observations 10289 10289 10289 10289 Adjusted-R2 2.7% 5.2% 2.5% 5.1%

49

Table 9. CEO Pay Recovery This table examines the recovery in CEO pay after the pay cut. We limit our sample to CEOs without experiencing turnover after the pay cut. There are 689 CEOs in the estimation sample. The regression is based on a subsample of pay cutting firms with the same CEOs from year t to t+1. Totalpay is the sum of the CEO’s salary, bonuses, long-term incentive plans, the grant-date value of restricted stock awards, and the Black-Scholes value of granted options. The dependent variable ΔPay is defined as Ln(Totalpayt+1) − Ln(Totalpayt), measuring the change in the CEO’s total pay from year t to t+1. Abret is the difference between the raw stock return and industry median stock return. Abroa is the difference between the raw ROA and industry median ROA. Indret is the industry median annual stock return. The industry classification follows Fama and French (1997) 48 industries. Firmsize is the natural logarithm of sales. M/B is the ratio of market value of equity over book value of equity. Volatility is the standard deviation of stock returns based on the monthly returns over the past 60 months. CEO age is the age of the CEO. Column (2) is based on the subsample where the pay-cutting firm’s stock return is less than the ExecuComp industry median in year -1. Corresponding p-values are reported in brackets.The superscripts ***, ** and * denote statistical significance at the 1%, 5% and 10% level, respectively.

(1) ΔPay

(2) ΔPay

Abret 0.33*

[0.09] 0.29*

[0.1]

Abroa 0.27

[0.69] 1.28

[0.22]

Indret 0.79

[0.12] 0.55

[0.42]

Firmsize -0.17 [0.38]

-0.11 [0.69]

M/B -0.01 [0.84]

-0.03 [0.61]

Volatility -1.56 [0.21]

-0.42 [0.76]

CEO age -0.01 [0.89]

-0.02 [0.73]

Constant 5.43

[0.23] 4.31

[0.53] Year Fixed Effects Yes Yes Firm Fixed Effects Yes Yes Observations 689 509 Adjusted-R2 21% 49%

50

Figure 1. CEO Pay Around a Pay Cut Panel A: CEO Pay This figure presents the trend in CEO pay over the seven-year period surrounding a pay cut. Year 0 is the year when the pay cut occurs. The median value of CEO pay measured in thousands of 2006-constant dollars is presented.

Panel B: Abnormal CEO Pay This figure presents the trend in abnormal CEO pay over the seven-year period surrounding a pay cut. Year 0 is the year when the pay cut occurs. Abnormal CEO pay is the difference between CEO pay and the predicted CEO pay based on Equation (1).

51

Panel C: Number of Stock and Options Granted This figure presents the trend in the number of stock and options granted to the CEO over the seven-year period surrounding a pay cut. Year 0 is the year when the pay cut occurs. Stockshare is the number of shares in the CEO’s annual stock grants as a percentage of total common shares outstanding. Optionshare is the number of shares underlying the CEO’s annual options grants as a percentage of total common shares outstanding. Incentiveshare is the sum of Stockshare and Optionshare. The median values are presented.

52

Figure 2. Firm Performance Around a Pay Cut Panel A: Stock Performance This figure presents the trend in stock performance over the seven-year period surrounding a pay cut. Abret is the industry-adjusted stock return, based on Fama and French (1997) 48 industries. Year 0 is the year when the pay cut occurs. The median value of various performance measures is presented.

Panel B: Industry-adjusted Performance This figure presents the trend in operating performance over the seven-year period surrounding a pay cut. Abroa is the industry-adjusted ROA, based on Fama and French (1997) 48 industries. Year 0 is the year when the pay cut occurs. The median value of various performance measures is presented.

53

Figure 3. Capital Expenditures, R&D, and Capital Structure Around a Pay Cut Panel A: Capital Expenditures This figure presents the trend in capital expenditures over the seven-year period surrounding a pay cut. Year 0 is the year when the pay cut occurs. Capex is the firm’s capital expenditures normalized by book value of total assets. Abcapex is the industry-adjusted capex, based on Fama and French (1997) 48 industries. The median value is presented.

Panel B: R&D Expenses This figure presents the trend in R&D expenses over the seven-year period surrounding a pay cut. Year 0 is the year when the pay cut occurs. R&D is research and development expenses over the book value of total assets. AbR&D is the industry-adjusted R&D, based on Fama and French (1997) 48 industries. The mean value is presented (The corresponding median value is always zero).

54

Panel C: Capital Structure This figure presents the trend in capital structure over the seven-year period surrounding a pay cut. Year 0 is the year when the pay cut occurs. Book Leverage (Market Leverage) is the ratio of long-term debt and current debt over the book (market) value of total assets. Abbooklev and Abmktlev are the industry-adjusted Book Leverage and Market Leverage, respectively, based on Fama and French (1997) 48 industries. The median value is presented.

Panel D: Decomposing Leverage This figure presents the trend in debt issuance, debt retirement, equity issuance, and equity retirement over the seven-year period surrounding a pay cut. Year 0 is the year when the pay cut occurs. Debt_issue is the firm’s annual debt issuance over book value of total assets. Debt_retire is the firm’s annual debt retirement over book value of total assets. Equity_issue is the firm’s equity issuance over book value of total assets. Equity_retire is the firm’s equity retirement over book value of total assets.The median value of various measures is presented.

Panel E: Decomposing Industry-adjusted Leverage This figure presents the trend in industry-adjusted debt issuance, debt retirement, equity issuance, and equity

55

retirement over the seven-year period surrounding a pay cut. Year 0 is the year when the pay cut occurs. The median value of various measures is presented. The median value of industry-adjusted debt_issue (Abdebt_issue) is always zero from year -3 to year +3.

56

Figure 4. Top Executive (Excluding CEO) Pay Around a CEO Pay Cut This figure presents the trend in top executive (excluding the CEO) pay over the seven-year period surrounding a pay cut. Year 0 is the year when the pay cut occurs. The median value of top executive pay measured in thousands of 2006-constant dollars is presented.