Continuous Evaluation of the Two-Strikes Rule: Long-Term and Spill-Over Effects

Abstract

This thesis presents three essays that have a shared objective, which is to evaluate the impact of introducing and implementing the two-strikes rule in Australia. The failure to remunerate chief executive officers (CEOs) appropriately caused a series of corporate collapses in the early twenty-first century and led to the global financial crisis (GFC) in 2007. As a result of regulators’ efforts, since 2011, shareholders have been able to participate in the setting of remuneration under the two-strikes rule. According to this rule, non-executive directors may stand for re-election if 25% of shareholders vote against the remuneration report in two consecutive years. This unique mechanism renders this rule more controversial than the remuneration of CEOs. Concerns about remuneration practices persistently appear in the financial press, independent organisation reports and empirical studies which consistently indicate a rise in CEO remuneration. Moreover, concerns have been raised regarding the ability of shareholders to vote appropriately. In this situation, the response of boards on behalf of shareholders results in unfair remuneration settings from the CEOs’ perspective, thereby adding more pressure on CEOs. Therefore, the first essay aims to test whether the two-strikes rule is able to effectively curb the increase in CEO remuneration and whether it can bring about positive changes in the remuneration structures of CEOs in the long-term. It also identifies the reasons for the high levels of dissent and the resulting strikes. The second essay aims to investigate CEOs’ proactive response strategies in terms of earnings management following the introduction of the rule. The third essay aims to investigate CEOs’ reactive response strategies after experiencing a high level of dissent. This thesis contributes to the existing body of research literature by responding to the concerns regarding the increase in remuneration and shareholder voting behaviour and by exploring the relationship between the implementation of the two-strikes rule and earnings management. Chapter One presents the background information and motivation for this thesis. It also summarises the results of the three essays and their contributions to the existing body of knowledge. Chapter Two identifies the direct impact of the two-strikes rule on the level and structure of CEO remuneration as well as determining the shareholder vote. The descriptive and univariate analyses indicate that the two-strikes rule effectively reins in increases in CEO remuneration and also brings about changes the remuneration structure. During 2019, total CEO remuneration and cash bonuses were at their lowest levels since 2007 and 2004, respectively, but equity-based pay as a proportion of total remuneration was at its highest level across 16 years. With regards to voting results, shareholders are more inclined to object to remuneration reports when CEOs receive high levels of remuneration, when firms have poorly structured corporate governance and when firms’ performance is unsatisfactory. In addition, shareholder dissent is significantly greater under the two-strikes rule than that under the Corporate Law Economics Reform Program 9 (CLERP9), especially in sectors experiencing significant increases in remuneration. Therefore, the findings do not suggest any further regulatory reforms regarding CEO remuneration in Australia at this time. However, the findings should motivate countries facing CEO remuneration increase to adopt the two-strikes rule. Chapter Three aims to identify the impact that the introduction of the two-strikes rule had on CEOs’ earnings management activities. The results indicate that CEOs shifted away from accrual-based earnings management to real earnings management, which is most obvious when the proportion of a CEO’s bonus paid in cash is high. However, CEOs with high equity-based remuneration and high total remuneration have been cautious about engaging in earnings management activities since the rule’s passage. Also, a good corporate governance structure would prevent CEOs from shifting to real earnings management. Therefore, legislators should not neglect the continuous strengthening of corporate governance, especially when shareholders have a role in determining remuneration. Additionally, board members should be cautious about rewarding CEOs with cash bonuses in these circumstances and instead replace them with equity-based remuneration. Chapter Four examines the relationship between shareholder voting outcomes and CEO earnings management activities in the subsequent year. The findings indicate that shareholder dissent is positively associated with accrual-based and real earnings management in the following year. This association is most apparent when CEOs receive significant cash bonuses. However, CEOs receiving high equity-based remuneration have been cautious about engaging in earnings management activities post-dissent. Nevertheless, a shift from accrual-based to real earnings management can be observed among CEOs receiving a high level of total remuneration. This shift tends to be favoured by boards that are gender diverse and have long tenures. However, active boards, as proxied by the number of board meetings, constrain only accrual-based earnings management, and large boards fail to restrain real earnings management after facing dissent. The accounting expertise of directors and independent directors enhance financial reporting monitoring because they have the ability to mitigate both forms of earnings management. Regulatory and supervisory authorities must be discerning regarding shareholders' dissent to remuneration reports, even if this opposition does not lead to registering a strike. The Board of Directors should ensure that CEO remuneration structures consist of a small proportion of cash bonuses versus a large proportion of share-based remuneration. Chapter Five presents the conclusion, along with the limitations of this thesis and directions for future studies.