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Director compensation and related party transactions

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Abstract

This paper examines whether independent directors’ compensation is associated with related party transactions. We focus both on directors’ total compensation and their equity-based compensation. Employing hand-collected data for S&P 1500 firms, we find that independent directors’ compensation is significantly associated with related party transactions. Specifically, we find that the level of compensation is positively related to these transactions, but we do not find equity-based compensation to be associated with them. Next, we decompose the compensation measures into “market” (i.e., predicted) level and “excessive” components and find that the results are driven by the excessive components. This association between related party transactions and director compensation is moderated by corporate governance mechanisms, suggesting that the association between the two reflects a conflict of interest between insiders and shareholders.

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Notes

  1. To comply with listing requirements from the SEC and stock exchanges, U.S. public firms generally designate the board of directors or a specific committee of the board to review and approve RPTs. Consequently, we expect that the effect of directors’ compensation on RPTs should be more pronounced for directors who have the authority to approve RPTs than for directors who do not. We find some empirical support for our prediction that, when firms designate the audit committee to approve RPTs, the compensation of audit committee members impacts RPTs (but not so for non-committee members).

  2. These two views are consistent with the SEC’s and FASB’s views on RPTs. Specifically, the regulators are concerned that the non-arm’s length nature of RPTs can enable insiders to extract firm wealth at the expense of other stakeholders (e.g., Kohlbeck and Mayhew 2017). The FASB and SEC mitigate this concern by setting RPT disclosure requirements. The fact that RPTs are not banned, however, implies that, despite this concern, the FASB and the SEC recognize that not all RPTs are illegitimate and prone to insider opportunism.

  3. Kohlbeck and Mayhew (2010) define simple transactions as “straight-forward transactions that involve relatively few financial statement accounts and related parties; and are typically avoidable in the sense that a third-party could replace the RP transactions.” They define complex transactions as those that “involve a number of financial statement accounts and related parties, often include a number of conditions, and impact the financial statements in less obvious ways. Complex transactions include related business, unrelated business, overhead, and stock transactions.”

  4. Ryngaert and Thomas (2012) define ex ante RPTs as transactions that are initiated before a firm goes public or before the counterparty becomes a related party. They define ex post RPTs as transactions that are originated after a firm goes public and after the counterparty becomes a related party. They view the former consistent with the efficient contracting theory and the latter consistent with the conflict-of-interest theory.

  5. “Cronyism” refers to the association between excessive compensation and weak monitoring. The press sometimes refers to this as “mutual back scratching” (Brick et al. 2006).

  6. Consistent with prior studies (e.g., Kohlbeck and Mayhew 2017), we focus on S&P 1500 firms and collect data for every three years, due to high cost of hand-collecting detailed RPT data. Our sample starts in 2007 because the ISS database we use to obtain directors’ ages and their committee membership starts from 2007.

  7. As explained below, we additionally employ a two-stage approach and explicitly model the expected portion of compensation in the first stage.

  8. No inferences are affected if we exclude CGQ from the regression analyses.

  9. Although our approach is motivated by prior research, we acknowledge that there is no perfect way of estimating the “market” level of compensation. Our results should be interpreted with this caveat in mind.

  10. In untabulated results, we reach consistent conclusions when we use the number of RPTs as our outcome variable.

  11. The last two columns report the differences between the coefficients across partitions. Although the coefficient magnitudes for Excessive DEC are 4.3 and 1.7 times larger, when comparing columns (1)–(2) and (3)–(4), these differences are not statistically significant.

  12. The last two columns report that the difference between the coefficients on Excessive DCL for Non-Bus_RPT and Bus_RPT is statistically significant at the 1% level for the ERPT specification, while insignificant for the $RPT specification. The difference between the coefficients on Excessive DEC for Non-Bus_RPT and Bus_RPT is statistically significant for the two specifications.

  13. The “ex ante” vs. “ex post” RPTs analysis is performed using 2013 data only, due to the high cost of hand-collecting data.

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Acknowledgements

We appreciate valuable comments from Russel Lundholm (the Editor), an anonymous reviewer, Gus De Franco, Mark Kohlbeck, Shibin Tang, Baohua Xin, Ping Zhang, and seminar participants at the Rotman School of Management, the EAA conference, AAA conference, CFEA conference, and the CAAA conference. Hope gratefully acknowledges funding from the Deloitte Professorship.

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Authors and Affiliations

  1. Rotman School of Management, University of Toronto, Toronto, Canada

    Ole-Kristian Hope

  2. BI Norwegian Business School, Oslo, Norway

    Ole-Kristian Hope

  3. School of Accounting and Finance, University of Waterloo, Waterloo, Canada

    Haihao Lu & Sasan Saiy

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  1. Ole-Kristian Hope
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Correspondence to Ole-Kristian Hope.

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Table 9 Variable definitions
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Hope, OK., Lu, H. & Saiy, S. Director compensation and related party transactions. Rev Account Stud 24, 1392–1426 (2019). https://doi.org/10.1007/s11142-019-09497-w

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