Remuneration committee effectiveness and narrative remuneration disclosure

Highlights

• Examine the effect of remuneration committee on voluntary remuneration disclosure

• Effective remuneration committee ensures narrative remuneration disclosure.

• Explore the impact of global financial crisis on narrative remuneration disclosure

Abstract

This paper investigates the impact of the effectiveness of remuneration committees on narrative voluntary disclosure of information on remuneration. We develop a composite measure as a proxy for remuneration committee effectiveness by incorporating remuneration committee size, remuneration committee independence, remuneration committee chairman's independence, expertise and diligence. We find that both the existence and quality of a remuneration committee play a significant role in the decision to provide voluntary disclosure of remuneration actions and in the extent of this disclosure. Further analysis suggests that remuneration committee independence and diligence enhance the quality of remuneration committees. The results have policy implications for remuneration committees as an effective corporate governance mechanism.

Introduction

Agency theory argues that effective corporate governance mechanisms must be present to minimize information asymmetry and related agency costs through increased disclosure. For example, board sub-committees work to monitor managers to act in the best interests of the firm (Jensen and Meckling, 1976). One important board sub-committee is the remuneration committee, whose role is to support and advise the board on matters relating to remuneration (e.g., the level and composition of remuneration, disclosure of remuneration policies, and the process for setting remuneration and assessing performance). As part of its role, the committee periodically makes recommendations to the board on any specific decisions or actions and disclosures that the board should consider in relation to director remuneration. Thus, the communication of remuneration decisions and actions to shareholders is important in demonstrating the alignment among shareholders' interests, performance and remuneration. Furthermore, a recent opinion survey by PWC (2014) highlights an increasing expectation that directors take greater responsibility in communicating to shareholders on matters pertaining to governance issues, thus indicating calls for greater information transparency. In this paper, we examine how corporate boards via the remuneration committee respond to investor demand for enhanced communication about remuneration matters. Specifically, we examine the association between remuneration committee effectiveness/quality (remuneration committee existence and certain remuneration committee characteristics) and the voluntary disclosure of information, in narrative format, relating to executive remuneration actions.

Examining the reporting of executive remuneration matters provides a natural setting to examine the effectiveness of remuneration committee practices. Section 300A of the Corporations Act 2001 (the Corporations Act) provides a list of remuneration-related items that listed firms are required to publish annually in the ‘remuneration report’ section of the annual report (i.e., within the directors' report). One item that the report does not require is information about decisions relating to remuneration change actions (increase/decrease/freeze), making such disclosures voluntary¹ in nature. Furthermore, narrative voluntary disclosure in annual reports shapes the way investors and shareholders “know/feel” about the firm (Neu et al., 1998), thus assisting in reducing information asymmetry and related agency costs. The disclosure of remuneration change actions is arguably important, as such disclosure explicitly informs investors and shareholders about a firm's seriousness in aligning performance (and risk) with its remuneration strategies. For example during periods of financial crisis, a firm faces considerable uncertainty about its future cash flows, thus reducing investor confidence regarding financial risk. Committed boards and their sub committees that address and voluntarily disclose such financial risk issues (e.g., by reducing or freezing remuneration) are seen positively and, in turn, are expected to improve investors' confidence (e.g., Jorgensen and Kirschenheiter, 2003).² Hence, in this paper, we utilize such voluntary remuneration change actions disclosure as an outcome of effective remuneration committee practices.

The remuneration committee is an important board sub-committee. While prior studies examine the effectiveness of boards and various sub-committees, empirical evidence is limited on the impact of remuneration committees on executive remuneration voluntary disclosure practices. Although prior archival studies relating to remuneration committee characteristics investigate a number of remuneration-related outcomes, such as remuneration disclosure, CEO/executive remuneration and stock options (e.g., Anderson and Bizjak, 2003, Bebchuk et al., 2010, Collins et al., 2009, Conyon and Lerong, 2004, Daily et al., 1998, Laksmana, 2008, Nelson et al., 2010, Sapp, 2008, Sun and Cahan, 2009, Sun et al., 2009), none of these studies examine the critical issue of voluntary narrative disclosure of executive remuneration action and the implications of such disclosures.

The disclosure of information provides a platform for management to communicate their firm's performance and governance to its current and future investors (Healy and Palepu, 2001). In terms of executive remuneration, disclosure of remuneration is argued to reduce agency problems (Bebchuk and Fried, 2003, Morse et al., 2011). However, the effectiveness of such disclosure is argued to be dependent on whether it is mandatory/regulated or voluntary disclosure. While regulated disclosures are said to facilitate reduced information asymmetry, it is also argued that it may be inadequate to render such a mechanism to be effective as executives, being insiders, are always in the position of having superior information compared to outsiders (Sheu et al., 2010, Chen et al., 2004). Thus, any information above mandatory disclosure provides an additional governance mechanism (Healy and Palepu, 2001). Balachandran and Faff (2016) also highlight the need for more extensive research on the linkage between corporate governance and executive remuneration. To date, most of the prior remuneration related studies focus on the mandatory aspect of executive remuneration disclosure with very few studies on voluntary remuneration disclosure. This study takes a further step by not only investigating a voluntary aspect of remuneration disclosure, but also the narrative aspect of this remuneration action voluntary disclosure.

Our paper is further motivated by the attention focused on executive remuneration during the recent global financial crisis (GFC) and the development of the Australian Securities Exchange (ASX) Code of Corporate Governance, the latter of which provides guidance and recommendations relating to both boards of directors and remuneration committees. The unprecedented level of global economic uncertainty during the GFC and reduced firm profits due to the financial crisis resulted in concerns from various parties about excessive payments to executives. In addressing these concerns, firms (via their boards) are likely to adopt and communicate their remuneration realignment strategies (which may or may not be opportunistic) to influence shareholder perceptions favorably and to gain/retain their confidence.

It is important to note that the remuneration committee composition specified in the ASX recommendations is only a suggestion; hence, the requirement of ‘if not, why not’ does not apply.³ In this paper, we argue that improved narrative disclosures on remuneration action are affected by the existence of a remuneration committee as well as by the quality of such a committee. The rationale for this argument is that a firm's good corporate governance practice is reflected in the quality of the remuneration committee. Sun et al. (2009, p. 1507) argue that high-quality remuneration committees ‘are capable of designing and implementing remuneration arrangements that will lead to stronger incentives for subsequent performance, and reduce the capacity of CEOs to extract rents’. A remuneration committee can be a more efficient mechanism than a full board for focusing the company on appropriate remuneration policies designed to meet the needs of the company in enhancing corporate and individual performance. The existence of a remuneration committee should not be seen as a implying a fragmentation or diminution of the responsibilities of the board as a whole (Corporate Governance Recommendation 8, ASX Corporate Governance Council, 2010). Thus, in this paper we argue that voluntary remuneration action disclosures, and the extent of such disclosures, are contingent on the effectiveness of the remuneration committee as a key corporate governance mechanism established by the board.

Drawing on the ASX Corporate Governance Recommendations (ASX Corporate Governance Council, 2007, ASX Corporate Governance Council, 2010), we argue that for remuneration committees to be effective they must at least exhibit three characteristics. First, the majority of the members should be independent non-executive directors. Second, a minimum size of three remuneration committee members is required for the remuneration committee to function effectively. Third, the remuneration committee chair should be an independent director. Based on recent literature (Zaman et al., 2011),⁴ we include two more characteristics: first, the number of remuneration committee meetings held in a year (diligence) and, second, the requirement that membership of the committee must include at least one director with relevant financial expertise. We combine these five variables to form a composite construct called remuneration committee quality (RCQ).

Prior literature finds the importance of the remuneration committee for firm performance. The use of narrative disclosures in annual reports represent an important medium of communication which plays a key role in company annual reports (Clatworthy and Jones, 2003). In particular, Chung et al. (2015) argue that improvements in financial transparency by enhanced communications via voluntary disclosure can reduce agency conflicts, which in turn influences top managers to improve firm value. In the context of executive remuneration, enhanced communication through narrative remuneration voluntary disclosure (above and beyond mandatory disclosure) is not only an indicator of enhanced firm transparency but also of effective governance and in particular of the remuneration committee. We extend the prior literature to the board governance and narrative disclosure by showing that firms with an effective remuneration committee exhibit enhanced voluntary narrative remuneration disclosure.

Using a sample of Top 200 ASX firms over a period of five years (2007 to 2011), we find our results are generally consistent with our expectations. Specifically, our results show that both the existence and quality of a remuneration committee play an important role in the decision to provide voluntary disclosure of remuneration actions and in the extent of this disclosure. Additional analyses also suggest that remuneration committee independence and diligence are two key attributes that enhance the quality of remuneration committees. Further, we find that the influence of the remuneration committee existence and quality vary by the type of disclosure and across different macroeconomic periods.

While studies on executive compensation are plentiful, prior literature on compensation committees is relatively limited (Hermanson et al., 2012). A more in-depth understanding of the impact of compensation committees on the extent of disclosure is critical for identifying how board sub-committees work to affect governance outcomes, such as voluntary remuneration action disclosures, an aspect which prior literature ignored in the past. To the best of our knowledge, this is the first study that contributes to both the existing corporate governance literature in terms of the existence and quality of the remuneration committee and of voluntary disclosure in terms of narrative remuneration change action decisions in annual reports in the Australian environment.

Further, with the exception of Sun et al. (2009) and Sun and Cahan (2009), most prior studies focus on remuneration committee independence only, which does not capture other important dimensions of the committee. In addition, although other researchers have used a mix of remuneration committee characteristics, these were tested in isolation without reference to firm performance or to a specific remuneration disclosure (see, Doucouliagos et al., 2007, Nelson et al., 2010). Our study thus contributes to the remuneration committee literature by utilizing a composite measure of five characteristics of remuneration committees (size, independence, chairperson independence, expertise and activity). These characteristics are based mainly on corporate governance guidelines to measure overall remuneration committee quality. Zaman et al. (2011) argue that the interaction of these characteristics is likely to influence the effectiveness of corporate governance practices. Utilizing a composite score is attractive as it captures the overall governance of remuneration committees by taking the orthogonal effects between monitoring mechanisms characterized by each of the five remuneration committee characteristics (Sun et al., 2009). Collectively, our results also suggest that studies that attempt to link board governance, particularly with respect to the remuneration committee, to firm performance and voluntary disclosure could benefit by developing a broader and richer measure of remuneration committee quality. This is especially the case as this board subcommittee plays a major role in matters relating to executive remuneration, with executive remuneration being critical in aligning managers and shareholder interests.

The remainder of the paper is structured as follows. Section 2 reviews the literature and outlines development of the research hypotheses. Section 3 describes the study's sample collection and model development, while Section 4 presents the study's results. Finally, Section 5 concludes with a brief summary.