Managerial liabilities and executive compensation structure evidence from an exogenous shock

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VIETNAM NATIONAL UNIVERSITY HO CHI MINH CITY

HO CHI MINH CITY UNIVERSITY OF TECHNOLOGY

NGUYỄN MINH CHÂU

MANAGERIAL LIABILITIES AND

EXECUTIVE COMPENSATION STRUCTURE: EVIDENCE FROM AN EXOGENOUS SHOCK

TRÁCH NHIỆM QUẢN LÝ VÀ

CẤU TRÚC LƯƠNG THƯỞNG ĐIỀU HÀNH: BẰNG CHỨNG TỪ MỘT CÚ SỐC NGOẠI SINH

Major: Business Administration

Major ID: 8340101

MASTER’S THESIS

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THIS THESIS IS COMPLETED AT

HO CHI MINH CITY UNIVERSITY OF TECHNOLOGY – VNU-HCM

Supervisor : Nguyễn Thu Hiền, Ph.D

Examiner 1 : Phạm Hà, Ph.D

Examiner 2 : Lê Thị Phương Vy, Ph.D

This master’s thesis is defended at HCM City University of Technology, VNU- HCM City on 12/06/2023

Master’s Thesis Committee:

1 Chairman: Assoc Prof Vương Đức Hoàng Quân, Ph.D 2 Secretary: Dương Như Hùng, Ph.D

3 Examiner 1: Phạm Hà, Ph.D

4 Examiner 2: Lê Thị Phương Vy, Ph.D 5 Member: Nguyễn Thu Hiền, Ph.D

Approval of the Chairman of Master’s Thesis Committee and Dean of School of Industrial Management after the thesis being corrected (if any)

CHAIRMAN OF THESIS COMITTEE DEAN OF SCHOOL

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VIETNAM NATIONAL UNIVERSITY - HO CHI MINH CITY SOCIALIST REPUBLIC OF VIETNAM HO CHI MINH CITY UNIVERSITY OF TECHNOLOGYIndependence – Freedom - Happiness

THE TASK SHEET OF MASTER’S THESIS

Full name: Nguyễn Minh Châu Student ID: 2070224 Date of birth: 12/07/1993 Place of birth: An Giang Major: Business Administration Major ID: 8340101

I THESIS TITLE:

Managerial Liabilities and Executive Compensation Structure: Evidence from an Exogenous Shock

(Trách Nhiệm Quản Lý và Cấu Trúc Lương Thưởng Điều Hành: Bằng Chứng Từ Một Cú Sốc Ngoại Sinh)

II TASKS AND CONTENTS:

- Propose a model that examines the impact of manager responsibilities on executive compensation structure

- Analyze and test the above model

- Suggest managerial implications based on the research results

III THESIS START DAY: 15/06/2022

IV THESIS COMPLETION DAY: 04/05/2023 V SUPERVISOR: Nguyễn Thu Hiền, Ph.D

Ho Chi Minh City, date…

SUPERVISOR HEAD OF DEPARTMENT

(Full name and signature)(Full name and signature)

DEAN OF SCHOOL OF INDUSTRIAL MANAGEMENT

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ACKNOWLEDGEMENT

First of all, I would like to thank the profressors of School of Industrial Management – Ho Chi Minh City University of Technology – VNU-HCM, who have taught valuable knowledge to me during my study

I am deeply grateful to Dr Nguyen Thu Hien, who dedicatedly guided me so that I could successfully complete this research Thanks to her guidance and help, I was able to complete this thesis

I would like to thank my friends and fellow students who have supported me during the last period of study and research

In particular, I would like to thank my family for always supporting and encouraging me throughout my study My family's support is essential to my success in completing my thesis and achieving my goals

In the process of writing the thesis, it is inevitable that mistakes can be made I would like to receive your comments and suggestions so that the thesis can be better

Ho Chi Minh City, 21 July 2023 Author

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ABSTRACT

To analyze how the legal responsibilities of D&Os affects their compensation package, this study makes use of an exogenous shock caused by a change in Nevada corporation law in 2001 that greatly improves the protection of D&Os from litigation risks Research results show that companies incorporated in Nevada had a larger proportion of long-term incentive plans (LTIP) than a sample of control companies that were formed outside of the state The enterprise's use of LTIP as a tool to align the interests of D&O with the interests of the shareholders of the enterprise is effective, supporting the hypothesis that there is an agency problem,

according to the litigation discipline hypothesis; therefore, the legal protection

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TÓM TẮT LUẬN VĂN

Để phân tích trách nhiệm pháp lý của thành viên HĐQT và cán bộ quản lý (Directors and Officers - D&O) ảnh hưởng như thế nào đến cấu trúc thu nhập của họ, nghiên cứu này sử dụng cú sốc ngoại sinh gây ra bởi sự thay đổi trong luật doanh nghiệp của tiểu bang Nevada, Hoa kỳ, vào năm 2001 mà đã giúp cải thiện đáng kể khả năng bảo vệ D&O khỏi các rủi ro pháp lý khi thực thi các trách nhiệm của mình Kết quả nghiên cứu cho thấy các công ty được thành lập ở Nevada có chính sách thù lao với tỷ trọng mức thù lao khích lệ dài hạn (Long-term incentive plans, hay LTIP) lớn hơn so với các cơng ty tương tự được thành lập bên ngồi tiểu bang Nevada Điều này được hiểu rằng việc doanh nghiệp sử dụng LTIP như một công cụ để gắn kết lợi ích của D&O với lợi ích của các cổ đông của doanh nghiệp là

hiệu quả, ủng hộ cho giả thuyết cho rằng có tồn tại vấn đề đại diện theo litigation discipline hypothesis; do vậy, các cơ chế bảo vệ pháp lý cho D&O sẽ dẫn đến việc công ty phải tăng tỷ trọng LTIP trong toàn bộ cấu trúc thu nhập của D&O để khích

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THE COMMITMENT OF THE THESIS’ AUTHOR

I hereby declare that in addition to the cited references, the contents of this thesis are the results of my personal research under the guidance of Dr Nguyen Thu Hien

Ho Chi Minh City, 21 July 2023 Author

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TABLE OF CONTENTS

ACKNOWLEDGEMENT I ABSTRACT II TÓM TẮT LUẬN VĂN III THE COMMITMENT OF THE THESIS’ AUTHOR IV TABLE OF CONTENTS V TABLE OF TABLES IX TABLE OF FIGURES X CHAPTER 1: INTRODUCTION 1 1.1.BACKGROUND 11.2.RESEARCH OBJECTIVE 4

1.3.RESEARCH OBJECTS AND SCOPES 4

1.4.RESEARCH METHODOLOGY 5

1.5.RESEARCH SIGNIFICANCE 5

1.6.RESEARCH STRUCTURE 6

CHAPTER 2: LITERATURE REVIEW 7

2.1.CONCEPTS AND DEFINITION 7

2.1.1 Executive Compensation Structure 7

2.1.2 Annual base salary 7

2.1.3 Annual Bonus 8

2.1.4 Long-term Incentives 8

2.1.5 Stock 9

2.1.6 Stock options 10

2.1.7 Option Risk Metrics - Delta 10

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2.1.9 Exogenous shock 11

2.2.THEORETICAL FRAMEWORK 12

2.2.1 Corporate Governance 12

2.2.2 Principal-agent problem 12

2.2.3 Vega and Delta used in measuring incentives pay 15

2.3.PREVIOUS RESEARCHES 15

2.3.1 Research on managerial liability and corporate innovations of Guan, Zhang, Zheng and Zou 15

2.3.2 Research on managerial incentives of Coles, Daniel and Naveen 162.3.3 Research on calculating stock option by Core and Guay 17

2.3.4 Research on CEO compensation of Core, Holthausen and Larcker 17

2.3.5 Research of Liability protection, director compensation and incentives of Aguira, Burns, Mansib and Wald 18

2.3.6 Research on Executive Compensation and the Maturity Structure of Corporate Debt of Brockman, Martin and Unlu 19

2.4.IDENTIFY THE OPPORTUNITY TO RESEARCH 19

2.5.SUGGESTED MODEL AND HYPOTHESES 20

2.5.1 Suggested research model 21

2.5.2 Research hypotheses 22

CHAPTER 3: DATA AND METHODOLOGY 23

3.1.RESEARCH PROCESS 23

3.1.1 First period 24

3.1.2 Second period 24

3.1.3 Third period 24

3.2.DATA SOURCES 25

3.2.1 Data for vega and delta 25

3.2.2 Data for control variables 25

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3.3.METHODS USED IN THE RESEARCH 26

3.3.1 Propensity Score Matching 26

3.3.2 Variables 28

3.3.3 Measurement of volatility 29

3.3.4 Model Specification – Baseline analysis 29

3.3.5 Dynamic Model 30

3.4.METHOD TO TEST HYPOTHESES 31

3.4.1 Difference-in-differences analysis 31

3.4.2 Rationale to employ difference-in-differences analysis 32

3.5.STEPS TO TEST THE MODEL 33

3.5.1 Treatment group 33

3.5.2 Control group 33

3.5.3 Conducting analysis 34

3.5.4 Robustness Check 34

CHAPTER 4: RESULTS AND DISCUSSIONS 36

4.1.PROPENSITY SCORE MATCHING & BALANCE CHECK 36

4.1.1 Result from Propensity score matching 36

4.1.2 Assessing balance 37

4.2.SUMMARY STATISTICS 38

4.3.BASE LINE REGRESSION RESULT 39

4.3.1 The result with control variables 39

4.3.2 Vega 40

4.3.3 Delta 40

4.4.DYNAMIC MODEL REGRESSION RESULT 41

4.4.1 Vega 42

4.4.2 Delta 43

4.5.ROBUSTNESS CHECK 44

4.5.1 Alternative matching samples 44

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4.6.DISCUSSION 46

4.6.1 Hypotheses that are supported 46

4.6.2 Hypotheses that are not supported 47

CHAPTER 5: CONCLUSION AND MANAGEMENT IMPLICATIONS 48

5.1.RESULTS SUMMARY 48

5.2.MAIN CONTRIBUTIONS 48

5.3.MANAGEMENT IMPLICATIONS 49

5.3.1 Solving the problem of principal-agent 49

5.3.2 The design of compensation structure 50

5.3.3 Compensation structure that attracts talent 50

5.4.LIMITS AND SUGGESTIONS 50

REFERENCES 52

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TABLE OF TABLES

Table 2.1 Research Hypotheses 22

Table 3.1 Variables used in the study 29

Table 3.2 Dummy variables by year 31

Table 4.1 Probit Model 36

Table 4.2 T-test comparison 37

Table 4.3 Descriptive Statistics 38

Table 4.4 Baseline Regression of Vega 40

Table 4.5 Baseline regression of Delta 40

Table 4.6 Dynamic regression of Vega 42

Table 4.7 Dynamic regression of Delta 43

Table 4.8 Regression of vega - Alternative matching samples 44

Table 4.9 Regression of delta - Alternative matching samples 44

Table 4.10 Regression of Vega, controlling for firm age 45

Table 4.11 Regression of Delta, controlling for firm age 46

Table 4.1 Probit Model 55

Table 4.2 T-test comparison 55

Table 4.3 Descriptive Statistics 55

Table 4.4 Baseline Regression of Vega 56

Table 4.5 Baseline regression of Delta 56

Table 4.6 Dynamic regression of Vega 57

Table 4.7 Dynamic regression of Delta 57

Table 4.8 Regression of vega - Alternative matching samples 58

Table 4.9 Regression of delta - Alternative matching samples 58

Table 4.10 Regression of Vega, controlling for firm age 59

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TABLE OF FIGURES

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CHAPTER 1: INTRODUCTION

1.1 Background

Directors and officers (D&Os) of companies are generally risk-averse when making corporate decisions that put the values of the company and the shareholders at risks, while shareholders are interested in risky projects as they could enjoy the most values added from these projects Since incentive compensation, a proportion of compensation package that varies with the value of shareholders, will encourage managers to take value-added and risky projects as doing so will increase the value of CEO’s compensation, executive compensation structure therefore plays a pivotal role to align executive interests with those of shareholders and embolden executives to become more venturous Various prior researches have shown that when there are intense conflicts between shareholders and managers, incentive compensation appears to be effective in aligning the benefits of managers and shareholders

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attempts to see how a change in legal liability influences executive compensation structure

Having an appropriate executive compensation structure can lead to the prosperity of a corporation First and foremost, it motivates the D&Os to align their benefits with the benefits of the company and the shareholders, paving the way for perseverant growth in long-term value of the company An executive compensation structure that places an emphasis on the long-term incentives such as restricted stocks and stock options can encourage the D&Os to make managerial decisions that concentrate on the long-term value of the company rather than short-term goals On the other hand, a large compensation package without a relevant executive compensation structure may not be fruitful Therefore, it is essential to have profound knowledge of the executive compensation structure under the impact of exogenous shock in order to achieve a structure coinciding with corporate strategic priorities

In 2001, corporate law in Nevada experienced an unanticipated change, mandating the exemption of the legal liability of directors and officers This change serves as a useful quasi-exogenous shock to scrutinize the impact that the waiver of D&Os liability has on executive compensation structure The shock facilitates the research due to the abundance of data before and after the event Research of (Guan, Zhang, Zheng, & Zou, 2021) introduces the two crucial hypotheses concerning the

risk-preference of D&Os regarding the change in legal liability: the costly litigation hypothesis and the litigious discipline hypothesis These hypotheses suggest

different directions of effect of change in legal liability on the behavior of D&Os, providing a background for conducting research on the risk-preference of D&Os Following (Guan, Zhang, Zheng, & Zou, 2021), this research examines the impact of waiver of legal liability on the executive compensation structure by observing the change in the behavior of D&Os according to the two hypotheses It is conjectured that the exemption from D&Os liability will render long-term incentives less

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agency problem becomes less intense and D&Os are encouraged to invest in projects that create long-term value for the company without the necessity of utilization of long-term incentives Therefore, when D&Os legal liability waiver is adopted, a reduction in long-term incentives pay is expected The company now does not need to pay a long-term incentives as high as it did before to motivate its D&Os to align their interests with the company

On the contrary, agency theory hypothesis forecasts that due to diminished shareholder discipline as a result of exemption from D&Os liability, the D&Os have a tendency of living a quiet live, avoiding engaging in development projects that create long-term value for the company Therefore, in order to embolden the D&Os to create long-term value for the company, long-term incentive appears to be

more preferable (following litigation discipline hypothesis of (Guan, Zhang, Zheng,

& Zou, 2021)) Since shareholder discipline is lessened, D&Os tend to become less motivated in creating long-term value for the company Using long-term incentives pay as an instrument to align the interests of D&Os and shareholders is vital

It is intriguing to discover what modification could occur to executive compensation structure when there is an exogenous shock such as change in corporate law In the two hypotheses, the waiver of D&Os legal liability can impact the long-term incentives in two opposite directions Empirically, this research attempts to examine what happens to the compensation structure when managerial liabilities change under an exogenous shock Specifically, the research attempts to comprehend how the weight of long-term incentives (long-term incentives pay as a proportion of total compensation package) in the compensation package changes in correspondence with the change in corporate law

In general, incentive compensation helps reduce D&Os' risk-aversion tendency, lessening the owner-manager conflict of interest As a result of the firm's D&O liability waiver, a reduction in incentive compensation in the CEO pay package is

anticipated (costly litigation hypothesis) Following (Guan, Zhang, Zheng, & Zou,

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However, it is noted that the use of D&O liability waivers may undermine shareholder discipline, potentially leading to a higher need for incentive pay in executive compensation packages Therefore, empirical research is necessary to assess the direction of the influence of D&O liability waiver on incentive pay

1.2 Research Objective

This research has two main objectives:

Firstly, this research endeavors to see whether the introduction of a new corporate law as an exogenous shock to protect the D&Os from the legal liability risk affects the executive compensation structure

Secondly, this research attempts to determine the direction of the impact of liability exemption on the executive compensation structure as evidence for counter hypotheses, costly litigation hypothesis and the litigious discipline hypothesis

1.3 Research Objects and Scopes

Since the introduction of a new corporate law in Nevada in 2001 that affects different corporations in the state, there are several changes in the activities of these corporation The research objects comprise of the companies that incorporated in the state before the passing of the new law and remained incorporated in the state after the passing of the new law in order to discover the impact the law has on the compensation package of D&Os of these companies

The research compares two groups of firms The treatment group includes companies incorporated in Nevada Propensity score matching will be employed to select the companies in the control group, including companies that are never incorporated in Nevada

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how such an exogenous shock influences the change in compensation structure throughout a period of time

1.4 Research Methodology

Following (Guan, Zhang, Zheng, & Zou, 2021), this research employs difference-in-differences method by doing an analysis over the years around the year 2001, when the change in corporate law of Nevada took place This research attempts to see whether executive compensation structures of companies incorporated in Nevada differ before and after the adoption of this law The reason why difference-in-differences analysis is used is that the research desires to attribute the change in executive compensation structure to the change in law on managerial liability, showing that the difference in compensation structure takes place after the law change rather than before the law change

This research also attempts to uncover the difference in the change of executive compensation structure of companies of various market capitalizations Since the results may be inconsistent among enterprises of dissimilar sizes, the research strives to find when and where the change of compensation structure is most pronounced

1.5 Research Significance

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result from the research concurs with the litigation discipline hypothesis, which means the D&Os have a lesser motivation in creating more value for shareholders, the long-term incentives need to be increased to encourage the D&Os due to the alignment of interests between managers and owners

The result from this research can provide management implications in developing a suitable and successful executive compensation package that can generate the largest benefits for shareholders in comparison with the expense of compensation package An appropriate executive compensation structure should be compatible with the interests of both D&Os and shareholders, helping the company achieve its long-term goals and maximize its long-term value However, an irrelevant executive compensation structure proves to be impractical in creating expected value that the shareholders need, and limits the prospects of the company in the competition with other businesses on the market Therefore, this research can provide insight to help the Board of Directors of the company develop a more valuable executive compensation structure for the company and shareholders

1.6 Research Structure

This research has five chapters: Chapter 1: Introduction

Chapter 2: Literature Review Chapter 3: Data and Methodology Chapter 4: Results and Discussion

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CHAPTER 2: LITERATURE REVIEW

2.1 Concepts and Definition

2.1.1 Executive Compensation Structure

According to (Bebchuk & Grinstein, 2005), pay has increased significantly compared to the rise that may be attributed to adjustments in firm size, performance, and industry classification during the period from 1993 to 2003 Research of (Faria, Martins, & Brandão, 2014) shows a significant and favorable relationship between CEO pay and company performance There are multiple components of the executive remuneration package Different firms have fairly different organizational structures However, the compensation package often consists of long-term incentives, which are strongly reliant on the long-term value of the firm, and short-term benefits, which are correlated with the short-short-term performance of the company but not the long-term success Short-term and long-term benefits are incorporated in the remuneration; the former includes an annual salary and short-term incentives like bonuses, while the latter comprises restricted stocks and stock options

According to (Kuepper, 2022), the types of executive compensation comprise of cash compensation, option grants, differed compensation, long-term incentive plans, retirement packages and executive perks The aforementioned elements can also be divided into fixed payments, such an annual base salary, and incentive payments, particularly long-term incentives like stock options and restricted stocks Depending on the firms and the specifics of the economic and regulatory environment, executive remuneration structures vary substantially

2.1.2 Annual base salary

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of an employee may be specified as a weekly, monthly, or yearly compensation as well as an hourly rate

Not all kinds of remuneration are included in base pay Base pay often excludes incentive-based pay An employee's base salary is often the least amount they can anticipate receiving during a given pay period

Although D&Os are paid monthly, the base pay is often represented in the executive compensation package as the amount they earn annually The annually base salary varies significantly between firms

2.1.3 Annual Bonus

Annual bonuses are adjusted based on performance D&Os have a tendency to add more value to the organization owing to motivation if they are convinced they can benefit from their accomplishments Growth in sales, profit, or market share may be utilized as indicators of performance However, according to (Mcclure, 2021), it might be challenging to calculate the right remuneration for performance using straightforward metrics The effectiveness of an executive's performance is not always accurately measured by financial measures and annual share price increases, considering these measures may be impacted by a variety of events in the corporate environment

A bonus is a type of payment which is not promised and is often given following the conclusion of a certain event It is a form of monetary reward that goes beyond the recipient's typical payment obligations, according to (Bloomenthal, 2022) However, in general, bonuses are performance-based, meaning that a firm distributes them according to how an individual or group of employees performs to company goals There are numerous different sizes and types of bonuses

2.1.4 Long-term Incentives

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management A long-term incentive plan is defined as a corporate rule that compensates employees for achieving particular objectives that boost the value of shareholders (Kenton, 2022) Long-term incentive is the element of the CEO compensation package that has greatest weight D&Os are encouraged to contribute toward the business's strategic goals with long-term incentives, which is advantageous to the shareholders Long-term incentive is provided to D&Os as restricted stocks and compensation that is based on stock such as call options, which often has a performance period of three to five years, during which time the executive is not paid from the incentive until the performance period has ended As a result, the long-term incentive effectively aligns the interests of shareholders and D&Os

2.1.5 Stock

Stock ownership is the most powerful performance driving factor, according to earlier studies The motivation from stocks is far greater than the motivation that comes from options When stock is utilized as an incentive, the D&Os behave more like shareholders since the agency problem is much alleviated According to (Mcclure, 2021), when CEOs own shares rather than options, they may actually have their interests connected to shareholders

The overall indicators used to gauge the success of the company tend to increase when the D&Os are promised equity in exchange for their performance In accordance with the long-term expansion in the company's worth, their entire pay package will increase, and so will the percentage of long-term incentives in that package

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2.1.6 Stock options

In addition to shares, stock options can be used as a mechanism to link the financial gains of D&Os with those of the shareholders However, compared to stock, stock options offer a lot of drawbacks According to (Mcclure, 2021), options may significantly skew risk because executives may profit greatly from options when the value of their shares increases, but executives fare no worse when share prices decline It is obvious that stock options cannot reconcile D&Os and shareholders' interests with the same efficiency as stock does Additionally, because stock options have a time limit, D&Os are encouraged to concentrate on improving financial indicators in the near future, as (Mcclure, 2021) claims that executives are incentivized to merely focus on the upcoming quarter and disregard the longer-term interests of shareholders in order to keep the share price moving up so that options will remain in the money In this case, the link between interests of D&Os and shareholders is not as fortified as in the case of stock incentive

2.1.7 Option Risk Metrics - Delta

According to (Summa, Investopedia, 2022), one of the key risk indicators that experienced options investors examine and use into their trading methods is delta The first Greek, known as Delta, expresses how much the price of an option is anticipated to vary for each $1 that the price of the underlying asset or index moves Since the value of a call option rises in line with the price of the underlying asset, call options have a positive delta (Fernando, 2023) claims that financial contracts known as call options provide the buyer the right, but not the duty, to purchase a

stock, commodity, or other asset at a defined price and within a certain time frame

On the other hand, put options will have a negative delta since the value of the put option is inversely proportional to the value of the underlying asset

2.1.8 Option Risk Metrics - Vega

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volatility, while delta looks at actual price fluctuations According to (Frederick, 2021), Vega measures the rate of fluctuation in the price of an option for each 1% change in the implied volatility of the base asset Volatility increases the underlying asset's susceptibility to significant swings, which Vega takes into consideration when setting option pricing When Vega falls, both call and put options lose value When Vega rises, both call and put options gain value Vega is defined as a fluctuation in the price of a derivative proportional to a 1% fluctuation in the implied volatility of the base asset In order to comprehend what this means, it is necessary to first define implied volatility along with the way it is calculated The projected volatility of the underlying asset is referred to as implied volatility A greater implied volatility indicates that the stock's price is more unpredictable Price fluctuations should become more pronounced as volatility rises Research of (Armstrong & Vashishtha, 2012) also shows that vega provides CEOs with incentives to raise systematic risk but not idiosyncratic risk in their organizations

2.1.9 Exogenous shock

An unexpected incident that has an impact on the economy exogenously is referred to as an exogenous economic shock There are several definitions of economic shock According to (Reed, 2020), economic shock is defined as any unanticipated occurrence that has a significant, unanticipated effect on the economy Exogenous shocks can have a big impact on the economy, triggering abrupt changes in investment, consumption, and production Aside from shifting the supply and demand of goods and services, such shocks can also cause financial market disruptions, currency rate adjustments, and other changes

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2.2 Theoretical Framework 2.2.1 Corporate Governance Definition

There are many ways to define Corporate governance In order to govern themselves and carry out their obligations to investors and other stakeholders, stockholders, executive management, and the board of directors utilize a wide variety of rules and procedures together referred to as corporate governance The protection of shareholders is a key concern of corporation law and corporate governance, while opinions on the most effective approaches vary

The main purpose of corporate governance

According to (Claessens, 2006), corporate governance is linked to increased efficiency, higher returns on equity, reduced cost of capital, and better treatment of all stakeholders The interests of shareholders, board members, management, and staff members are all aligned under excellent corporate governance, which establishes transparent rules and regulations It encourages confidence among voters, investors, and public officials Stakeholders and investors can get a clear image of an organization's trajectory and ethical standards thanks to corporate governance It is encouraged to pursue opportunities, incentives, and long-term financial viability It might render raising finance simpler It is a method for enduring success and perseverance Research of (Monica-Violeta, Ligia-Vaidean, Popa, & Safta, 2022) also demonstrates corporate governance's impact on sustainable development

2.2.2 Principal-agent problem

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Definition

There are various definitions of principal-agent problem According to (Kopp, 2021), agency theory is a concept that is applied to clarify and settle problems in the interaction between the principals and the agents This kind of interaction most frequently exists between shareholders acting as principals and firm executives acting as agents

In this relationship, there are two different entities: the ownership and the management The owners of the company have the role of the “principal”, and the managers of the company have the role of the “agent” The divergence between the principal and agent causes the emergence of conflict between the two parties

The agent only receives a fixed payment for the performance of the job, but this fixed payment does not vary in correspondence with the performance As a result, the agent have no incentive in creating better results, while the principal always desire the best possible result Therefore, it is necessary to provide the agent some of the benefits of the success of the jobs based on performance

There are several reasons leading to the principal-agent problem, one of which is the asymmetric information between agents and principals The agent is the one who directly does management, understanding more about the situations than the principals

Problems

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Consequences

With respect to information asymmetries, principals may be reluctant about agreeing to a contract because they are concerned that they will not comprehend what is going on The principal will have to invest money on employees incentives and monitoring As a result, when incentives exist which put the interests of principals and agents against one another or when each participant has different objectives, a conflict between their interests arises, according to (Ross, 2022)

There are many consequences resulted from the principal agent problem For the business, the owners may not gain the most benefit because of the issue The resources are not put to best use According to (Agarwal, 2021), the principal-agent issue is another illustration of a failing market; when resources are misallocated, the market becomes distorted, leading to market failures and the market is rendered inefficient by this distortion It not only affects the principal who loses money as a result of the agent, but it also reduces the market's overall efficiency

Solutions

The compensation should provide enough incentives to motivate the agent to act for the interests of the principal Remuneration must be connected to the agent's performance Subjective evaluation is commonly used to assess agent performance since it is a more flexible and balanced assessment technique for difficult assignments According to (Deckop, 1988), profit as a percentage of sales was favorably correlated with CEO remuneration

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2.2.3 Vega and Delta used in measuring incentives pay

In the financial world, Vega and Delta are two important metrics used to measure the risk and reward of options Vega measures the sensitivity of an option's price to changes in volatility, while Delta measures the sensitivity of an option's price to changes in the underlying asset's price

In the context of incentive pay, Vega and Delta can be used to measure the risk and reward of different incentive plans For example, a company that offers its employees stock options is essentially giving them the right to buy shares of the company's stock at a fixed price in the future The value of these options will depend on a number of factors, including the company's stock price, the strike price of the options, and the time to expiration

Several researches have used Vega and Delta in measuring incentives pay, such as in the research of (Coles, Daniel, & Naveen, 2004), (Core & Guay, 2002), and (Coles, Daniel, & Naveen, 2006)

2.3 Previous Researches

Previous researches on this topic including researches on managerial liability and innovation of (Guan, Zhang, Zheng, & Zou, 2021), research on liability protection, director compensation and incentives of (Aguira, Burnsa, Mansib, & Wald, 2012) and Research on Executive Compensation and the Maturity Structure of Corporate of (Brockman, Martin, & Unlu, 2010)

2.3.1 Research on managerial liability and corporate innovations of Guan, Zhang, Zheng and Zou

Research of (Guan, Zhang, Zheng, & Zou, 2021) have shed light on the influence of managerial liability on the innovation of the business This research shown that enforcing legal liability can discourage D&Os from innovation

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change in the corporate law reduced the legal liability that D&Os have to face when making managerial decisions Therefore, D&Os will invest more in the R&Ds projects, leading to more innovations and larger values for the company

On the other hand, the litigation discipline hypothesis states that because of weakened shareholder discipline, the D&Os will have a lesser motivation to invest in R&Ds projects, leading to fewer innovations

The results of the research of (Guan, Zhang, Zheng, & Zou, 2021) discover that, in comparison to a sample of control firms established elsewhere, Nevada-incorporated businesses produce more innovation after the legislative change, as shown by patent counts and patent citation counts Reduced legal risk also enables businesses to invest more in R&D and pursue riskier, more exploratory, but potentially more profitable innovation These results support the expensive litigation hypothesis that protecting D&Os from litigation promotes innovation and risk-taking (Guan, Zhang, Zheng, & Zou, 2021)

Research model:

Figure 2.1 Managerial liability and Corporation Innovation model

2.3.2 Research on managerial incentives of Coles, Daniel and Naveen

According to (Coles, Daniel, & Naveen, 2006), a substantial causal relationship between management remuneration and investment policy, debt policy, and company risk is demonstrated empirically by the research Researchers find that

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CEO wealth is more sensitive to stock volatility (vega) when controlling for CEO pay-performance sensitivity (delta) and the feedback effects of firm policy and risk on managerial compensation scheme These risky policy options consist of comparatively higher R&D expenditure, greater concentration, and higher leverage Additionally, the researchers discover that generally speaking, riskier policy decisions result in compensation systems with larger vega and lower delta, and both vega and delta are positively impacted by stock-return volatility

2.3.3 Research on calculating stock option by Core and Guay

In this research, the authors provide methodology to calculate vega and delta According to (Core & Guay, 2002), a substantial causal relationship between management remuneration and investment policy, debt policy, and company risk is demonstrated empirically by the research Researchers find that CEO wealth is more sensitive to stock volatility (vega) when controlling for CEO pay-performance sensitivity (delta) and the feedback effects of firm policy and risk on managerial compensation scheme

2.3.4 Research on CEO compensation of Core, Holthausen and Larcker

The study of (Core, Holthausen, & Larcker, 1999) comes to the conclusion that measures of the Board and Ownership structure account for a large amount of the cross-sectional variance in CEO salary after correcting for the typical economic pay-determinants Additionally, it appears that CEO salary increases when governance arrangements are less successful based on the signs of the coefficients for the board and ownership structure variables

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2.3.5 Research of Liability protection, director compensation and incentives of Aguira, Burns, Mansib and Wald

Research of (Aguira, Burnsa, Mansib, & Wald, 2012) determines the impact of liability protection on the takeover and the executive compensation package The research has several findings, the first one is the relationship between liability protection and director compensation: “Consistent with the hypothesis that directors require additional compensation if they bear liability, we find that director compensation is higher for firms that provide less liability protection” (Aguira, Burnsa, Mansib, & Wald, 2012)

Secondly, the research also discovered the relationship between liability protection and takeovers: “Examining takeovers, we find evidence that takeovers of firms with protected directors are less likely to succeed” (Aguira, Burnsa, Mansib, & Wald, 2012)

Finally, the research shows the opposite relationship between liability protection and bid premium: businesses with protected directors are more likely to accept a smaller offer premium, which is consistent with the fact that protected directors have fewer incentives to push for the best deal feasible throughout the acquisition (Aguira, Burnsa, Mansib, & Wald, 2012)

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Research model

Figure 2.2 Managerial Liability and Compensation package, bid premium and

takeover success model

2.3.6 Research on Executive Compensation and the Maturity Structure of Corporate Debt of Brockman, Martin and Unlu

Research of (Brockman, Martin, & Unlu, 2010) introduces the two concepts of “delta” and “vega”, representing the risk-preference The research shows that through executives' portfolio sensitivity to changes in stock prices (delta) and stock return volatility (vega), executive remuneration affects management risk choices (Brockman, Martin, & Unlu, 2010)

2.4 Identify the opportunity to research

Prior studies have demonstrated that D&Os need a greater compensation package to make up for the potential financial and legal losses caused by the lack of a required statute shielding them from responsibility, as was the case in the study by (Aguira,

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Burnsa, Mansib, & Wald, 2012) The ideas of vega and delta, which characterize the risk preferences of D&Os, are introduced in the research of (Brockman, Martin, & Unlu, 2010)

(Guan, Zhang, Zheng, & Zou, 2021) found that the exclusion of D&Os liability risk can result in greater level of business innovation as executives are relieved of liability concerns and spend more in R&D projects This finding comes from a research of an exogenous shock to D&O liability risk from the implementation of a new legislation According to the research cited above, the D&Os' conduct can be drastically altered by the passing of a new law that shields them from legal responsibility risk

There is still a study gap since prior studies could not demonstrate how a shift in legal responsibility affects CEO remuneration structure In order to contribute to the existing literature on executive compensation packages and offer managerial implications for achieving greater efficiency in business administration tasks, this research aims to fill this gap

2.5 Suggested Model and Hypotheses

Due to the fact that this is an interesting topic with a lot of resourceful direction for development, different hypotheses are suggested for this research These hypotheses try to find an answer to various relationships between the managerial liability and the executive compensation structure Following the researches of (Guan, Zhang, Zheng, & Zou, 2021) and (Brockman, Martin, & Unlu, 2010), this research suggests two hypotheses based on the effects of liability protection and risk preference of the D&Os

The first hypothesis of this research is constructed following the costly litigation hypothesis of (Guan, Zhang, Zheng, & Zou, 2021), which shows that the heightened

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protected from legal liability, the divergence between the interests of D&Os and shareholders is reduced Therefore, D&Os are encouraged to create more value for the shareholders without the necessity of long-term incentives, leading to the reduced long-term incentives as a result of adoption of the new corporate law Therefore, the first hypothesis H1 is stated:

- Legal liability protection reduces the proportion of long-term incentives in the executive compensation package

The second hypothesis of this research is constructed following the litigation

discipline hypothesis of (Guan, Zhang, Zheng, & Zou, 2021), which shows that the

heightened liability protection makes the D&Os become more risk-averse In this circumstance, there is intense principal-agent problem As a result, the relationship between a heightened barrier of protection and long-term incentives required by D&O will be positive Therefore, long-term incentive is needed to encourage the D&Os to align their interests with those of the shareholders The second hypothesis H2 is stated:

- Legal liability protection increases the proportion of long-term incentives in the executive compensation package

2.5.1 Suggested research model

Figure 2.3 Suggested Research Model

Reduced Legal Liability Proportion of long-term incentive in executive compensation package H1: Costly litigation hypothesis (-)

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2.5.2 Research hypotheses

Table 2.1 Research Hypotheses

H1

(costly litigation hypothesis)

- Legal liability protection reduces the proportion of long-term incentives in the executive compensation package

H2

(litigation discipline hypothesis)

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CHAPTER 3: DATA AND METHODOLOGY

3.1 Research Process

Figure 3.1 Research Flowchart

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3.1.1 First period

The subsequent steps are included in the first phase of the research process:

(1) Purpose the research, (2) Theoretical Framework, (3) Model Specification

(1) : Purpose of the research: The purposes of research are outlined in chapter 1

(2) : Theoretical Framework: The theoretical framework are presented in chapter 2

(3) : Model Specification: The suggested model comprises two hypotheses based on the theoretical framework and practice given in previous sections

3.1.2 Second period

Gather data and conduct out the study The data for vega and delta are taken from (Coles, Daniel, & Naveen, 2006), and the data for the control variables are taken from other database The two sources of data were merged to form data used for analysis

Conducting the research, including the following steps: - Propensity Matching by specifying a probit model - Performing the baseline regression

- Performing dynamic regression

3.1.3 Third period

Execute the robustness test and compare the results

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3.2 Data sources

3.2.1 Data for vega and delta

Vega and Delta have been employed in several studies to measure incentives pay, including the studies of (Coles, Daniel, & Naveen, 2006), (Core & Guay, 2002), and (Coles, Daniel, & Naveen, 2006)

As presented in previous chapters, Delta refers to the anticipated change in option price for a $1 change in the price of the underlying asset and Vega calculates the predicted change in option price when implied volatility changes by 1% The projected volatility of the price of the underlying asset is measured by implied volatility

Data for vega and delta used in this research is taken from the calculation of (Coles, Daniel, & Naveen, 2006) These authors calculate the data base on the methodology of (Core & Guay, 2002), which provides a technique for calculating delta and vega utilizing data from Execucomp This research calculate proxies for option portfolio value, using delta as proxy for sensitivity to stock price and vega as proxy for sensitivity to volatility

3.2.2 Data for control variables

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3.2.3 Sample selection

Since it is difficult to investigate the complete population, samples are utilized in research Instead, conclusions about the greater population are drawn from the study of a smaller group or sample To guarantee that samples are representative of the population, they might be selected at random or using certain sampling methods The conclusions about the population can be inferred from a sample with a certain degree of confidence, which is measured by statistical indicators like confidence intervals and p-values However, the precision and dependability of these results hinge on the caliber of the sampling strategy and the sample size In this research, the sample comprises of 12 firms incorporated in Nevada before 2001 and remains incorporated in Nevada after the year of event

To analyze the difference-in-differences impact of the corporate law change on the remuneration package, the research first chooses a sample of companies to form the treatment and control groups The businesses in the treatment group were founded in Nevada before to the event year of 2001, and their data from the year prior to the event year to the year following the event year was complete Companies that were formed in Nevada after 2001 are excluded from the study because they may be particularly vulnerable to the legal change The treatment group including firms that are incorporated in Nevada before the law change and have available data from 1998 to 2003 It is important to ensure that the sample comprises of only companies incorporated in Nevada before the law change and remained the same after the law change In this manner, the research can ascertain how the legislative change would affect the managers' compensation packages

3.3 Methods used in the research 3.3.1 Propensity Score Matching

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baseline traits but varied exposure to the treatment This makes it easier to distinguish any differences in outcomes between the treatment and control groups from other variables that could have affected group assignment It is challenging to draw reliable conclusions regarding the effectiveness of treatments in observational studies because individuals who get the treatment or intervention may differ consistently from those who do not For this reason, propensity score matching is crucial

In this research, the control group is established based on the characteristics chosen to make the two groups similar once the treatment group has been chosen The companies in the control group are those that are not Nevada-incorporated and have continuous data from the year before to the event's occurrence through the following years Propensity score matching is used to equate and compare the two groups The research develops the Probit model shown below, which is used to calculate propensity scores, using data from the year before to the legislative change (2000):

Treat = f(ln_sale, ROA, M2B, firm_age)

The dependant variable Treat is a dummy variable that has a value of 1 for businesses that were founded in Nevada just before the legislation change and a value of 0 for all other businesses