1 Performance and Compensation – evidence of optimal contracting by Sun, Li and Liu Discussant: Oliver M. Rui The Chinese University of Hong Kong

2 Overview This paper studies the relationship between executives ’ compensation and ROE using the data of listed firms in China to test the optimal contracting hypothesis. The results support the hypothesis after controlling for the governmental interference and related party transaction.

3 Compensation measure The optimal contracting approach states boards are assumed to design compensation schemes to provide managers with efficient incentives to maximize shareholder value. Most executive pay packages based on the optimal contract hypothesis contain four basic components: a base salary, an annual bonus tied to accounting performance, stock options and long-term incentive plans (including restricted stock plans and multi-year accounting-based performance plans).

4 Compensation measure What is the composition of the executives ’ compensation package in China? Who determines the executives ’ pay in China (compensation committee)? How important is the compensation in the executives ’ utility function? Do political career and market control play any role here in China?

5 Compensation measure What is the ratio of executives ’ hidden income and her compensation? What is the executives ’ ownership? Why do you use the highest pay as the proxy for compensation? Who does receive the highest pay?

6 Performance measures How reliable ROE is? It is used by the CSRC to determine the rights offering and ST and PT. The managers have the incentive to manipulate earnings. Use other accounting performance measures as robust tests Tobin ’ s Q Stock returns Relative performance measures

7 Omitted variables Characteristics of executives (age, tenure, educational level, professional knowledge and duality) Ownership structure (who are the ultimate owners? Do different owners share the same objective?) Board composition Monitoring difficulty: risk, and growth opportunities Lagged performance measures

8 The form of regression Pay-performance sensitivity (sensitivity has a more economic interpretation) Elasticity of compensation with respect to performance The function could be nonlinear

9 Pooled cross-regression The market index did not change over time. A given firm is included five times. Without an adjustment, the t-statistics are artificially inflated. A fixed effects panel data analysis method should be adopted to test for temporal instability in the regression coefficients.

10 Minor issues RPT is a dummy variable which equals to 1 if the proportion of four types of related party transactions between the firm and its large shareholders is less than 5% of similar transactions. Why do you use 5% as the cutoff point for RPT? What is the basic statistics of RPT activities in China? How is MARKET correlated with AREA? Could these two variables measure the same thing?

11 Sensitivity analysis The managerial power approach predicts that pay will be higher and /or less sensitive to performance in firms in which managers have relative more power. Other things being equal, managers would tend to have more power when (1) the board is relatively weak or ineffectual; (2) there is no large outside shareholder; (3) there are fewer institutional shareholders; or (4) mangers are protected by antitakeover arrangement. How to test this hypothesis? What do EXP (Administrative fees/Sales) and Revues/Total Assets) measure?

12 Sensitivity analysis The pay control hypothesis suggests that the government controls the pay level of executives for social equality. Who determines the pay, government or board?