Firms use subjective evaluation after a shock, when little is known about post-shock performance measures, writes Claudine Mange

Mangen, Claudine

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7/6/2017 LSE Business Review – Economic shocks affect how a CEO is evaluatedhttp://blogs.lse.ac.uk/businessreview/2017/06/21/economic-shocks-affect-how-a-ceo-is-evaluated/ 1/4Economic shocks affect how a CEO is evaluatedFirms use subjective evaluation after a shock, when little is known about post-shock performance measures, writes Claudine MangenBetween May and December 2008, Western Digital, one of the largest computer hard diskmanufacturers in the world, experienced a severe shock*. Its stock price fell from $37.53 to $11.45. In2009, the company reported in its proxy statement that it used discretion, as opposed to objectiveperformance metrics, for evaluating its CEO. In 2008, it had not used discretion in the executive’sperformance evaluation. Western Digital thus changed how it evaluated its leader after the 2008shock. This example illustrates the argument of my recent study that shocks have implications forhow firms evaluate their CEOs.Normally, when a firm’s compensation committee evaluates the CEO, it is well informed about themand their role in generating firm value. This changes when a shock, like the one Western Digitalexperienced in 2008, occurs. After the shock, the compensation committee lacks information aboutthe post-shock environment. It does not know how the CEO will cope with this new environment, norhow they will contribute to objective measures of firm performance that are commonly used as abasis for compensating them (e.g., reported income).In the aftermath of a shock, the compensation committee needs to estimate the role of the CEO indriving objective performance measures. This estimation process introduces estimation risk into theperformance evaluation. Estimation risk refers to the possibility that the compensation committee maymisestimate the CEO’s contribution to objective performance measures, and attribute too much or toolittle responsibility to the executive.CEOs are risk-averse and dislike any type of risk, including estimation risk. To lower the executive’sexposure to estimation risk, the compensation committee reduces the role of objective performancemeasures in their performance evaluation. As a result, CEO compensation will depend less onobjective performance measures like reported income.7/6/2017 LSE Business Review – Economic shocks affect how a CEO is evaluatedhttp://blogs.lse.ac.uk/businessreview/2017/06/21/economic-shocks-affect-how-a-ceo-is-evaluated/ 2/4In a recent study, I test this conjecture using data on 2,737 U.S. firms. Of these firms, 1948 (71.2 percent) experienced at least one shock between 1950 and 2012 (see the notes below for how I defineshocks). I document that CEO compensation is less sensitive to reported income in the year after theshock than before the shock.An important question then arises: if, after a shock, the compensation committee relies less onobjective performance measure for CEO evaluation, how does it go about evaluating the CEO? Iargue that it waits until year end to appraise the CEO using discretion. This approach offers thecompensation committee time to gather additional information about the firm’s post-shockenvironment; it can wait until the year is over to adjust CEO pay subjectively based on informationobtained during the year.My study shows that, after a shock, firms emphasize subjective CEO performance evaluation and usediscretion at the end of the year to appraise them. Figure 1 indicates that 70 per cent of the firms Iexamined use some form of discretion for evaluating their CEO in the year after a shock, up from66.3 per cent before. During the same time period, control firms without a shock that were similar insize to firms with a shock and operated in the same industry, decreased their use of discretion inCEO performance evaluation: 59.8 per cent of them evaluated their CEOs using some form ofdiscretion, down from 64.9 per cent.Figure 1. Percentage of firms that use subjective performance evaluation for appraising their CEOAs time passes since the shock occurred, the compensation committee accumulates informationabout the post-shock environment in which the firm operates, and learns about the CEO’s role indriving objective performance measures. It then has again more precise information about theircontribution to objective performance measures. Estimation risk declines, and the compensationcommittee relies to a larger extent on objective performance measures when evaluating the CEO.Their compensation will depend again more on objective performance measures.Consistent with this conjecture, my study indicates that, as a shock recedes further into the past,CEO compensation becomes more sensitive to objective performance measures such as reportedincome. Figure 2 shows that, in the first year after a shock, the sensitivity of their compensation toreported income is such that a 10 per cent increase in reported income results in a 3.37 per cent7/6/2017 LSE Business Review – Economic shocks affect how a CEO is evaluatedhttp://blogs.lse.ac.uk/businessreview/2017/06/21/economic-shocks-affect-how-a-ceo-is-evaluated/ 3/4boost in their pay. By the fifth year after the shock, the sensitivity of compensation to performancehas increased such that a 10 per cent increase in reported income is associated with a 4.04 per centrise in the leader’s pay, which represent 20 per cent more than in the first year after the shock.Figure 2. Percentage increase in CEO compensation when reported income increases by 10%. For each year between Year +1and Year +5 after a shockEconomic shocks, then, have implications for CEO performance evaluation, which is not static in anenvironment characterized by shocks. Instead, their performance evaluation fluctuates between itsobjective and subjective variants: firms rely less on objective evaluation after a shock, when little isknown about post-shock performance measures, only to progressively use it more intensely again astime passes since the shock occurred. Moreover, firms replace objective with subjective evaluationright after a shock.Also, learning plays a key role, especially after an economic shock. Compensation committees needto learn about the new environment that a shock creates, specifically the role of the leader in drivingobjective performance measures. While they learn, they put objective performance evaluation on holdand, instead, emphasize a subjective one. Once their understanding of the CEO’s role in drivingobjective performance measures is again more solid, they re-emphasize objective performanceevaluation.Author notes:1. * My main measure of economic shocks is a firm’s market-adjusted stock returns: when thesereturns are extremely high or low, the firm experiences a shock. I also measure shocks usingdata on recessions and expansions from the National Bureau of Economic Research.2. I address two alternative explanations for my results. First, a firm could change CEOperformance evaluation after a shock not because it fails to understand objective performancemeasures in the post-shock environment, but because this environment is different from the7/6/2017 LSE Business Review – Economic shocks affect how a CEO is evaluatedhttp://blogs.lse.ac.uk/businessreview/2017/06/21/economic-shocks-affect-how-a-ceo-is-evaluated/ 4/4June 21st, 2017 | Claudine Mangen, Performance Measurement | 0 Commentsenvironment before the shock, and requires distinct performance measures for CEOperformance evaluation. Second, firms experiencing fewer shocks have distinct investment,financing, and governance policies that differentiate from firms experiencing more shocks; thesedistinct policies may account not only for the firms’ shocks but also for how they evaluate theirCEOs. I test for these two explanations, and find that they fail to explain my results.♣♣♣Notes:This blog post is based on the author’s paper Implications of Economic Shocks for CEOPerformance Evaluation, in the European Accounting Review.The post gives the views of its author, not the position of LSE Business Review or the LondonSchool of Economics.Featured image credit: CEO, by Joshua Ness, under a CC0 licenceBefore commenting, please read our Comment Policy.Claudine Mangen is the RBC Professor of Responsible Organizations and AssociateProfessor at the John Molson School of Business at Concordia University in Montreal,Canada. Her research concentrates on corporate governance, disclosure, and power.She tweets at @ProfMangen.   

Economic shocks affect how a CEO is evaluated

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