Pay More Stocks and Options to Directors? Theory and Evidence of Board Compensation

Chapter

Abstract

The compensation of board directors has received much attention, along with the growing debates on corporate governance in recent years, partly due to the ongoing financial crisis. While prior studies including Hall and Liebman (1998) have shown evidence of a dramatic increase in the use of equity-based incentives, resulting in an increase in the sensitivity of executive pay to firm performance, we ask whether it benefits shareholders to offer similar incentive contracts to board directors. This paper suggests that equity-based compensation for board directors is necessary and the level of incentives depends on directors’ effectiveness in monitoring and friendliness in advising CEOs. Using the market competition and pay correlation to proxy for monitoring effectiveness and advisory friendliness, we report empirical evidence supporting our hypotheses.

Keywords

Corporate Governance Market Competition Supervisory Board Executive Compensation Board Director 
These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.

1 Introduction

In large publicly owned firms shareholders delegate decision rights to top executives, who have the ability to manage resources to their own advantage but often hold insignificant ownership positions. Executives may have the incentive to pursue activities that maximize their own utility, but decrease the firm value. The separation of ownership and control has induced potential conflicts and incentive problems between the interests of executives and shareholders, generally referred to as the agency problem (Jensen and Meckling 1976). To alleviate the agency problem, shareholders can directly monitor the management or offer them incentive plans that align managerial interests with shareholders’ interests as commonly known as ISO (Incentive Stock Options) in practice. A large theoretical literature, which includes Harris and Raviv (1978), Holmstrom (1979) and Holmstrom and Milgrom (1987), studies this issue using principal-agent models. In these models, the principal offers the agent an incentive plan that induces the agent to act in the principal’s best interest. However, public firms are generally widely held by a large number of shareholders, and hence shareholders have neither the incentive nor the ability to effectively monitor and evaluate top executives.1 Instead, shareholders delegate these roles to a group of elected directors. Due to their fiduciary responsibility and access to proprietary information, the board of directors potentially represents the most efficient method of monitoring and evaluating executives. However, directors have received substantial criticism (see Lorsch 1989) for a lack of effective governance and for designing managerial contracts with a weak relationship between managerial pay and firm performance. Recently, institutional investors and other stakeholders have placed pressure on firms to institute specific governance aimed to increase board accountability and independence as an attempt to improve managerial oversight (see evidences in Guercio et al. 2008).

Prior studies including Hall and Liebman (1998) have shown evidence of a dramatic increase in the use of equity-based incentives, resulting in an increase in the sensitivity of executive pay to firm performance during the 1990s. These findings suggest that managerial incentives are arguably more closely aligned with the shareholders’ goal of firm value maximization now than in the past. If the managerial incentive compensation has worked for executives in terms of maximizing their efforts to run the firms on behalf of shareholders, do we need to offer similar incentive contracts to board directors in order to maximize their efforts to monitor and advise executives? This is the research question we are trying to address theoretically and empirically in this paper. Specifically, we argue that the level of incentives embedded in the compensation contracts of board directors depends on their effectiveness in monitoring and friendliness in advising executives.

This is not the first paper to report the increasing use of incentive contracts for board directors, but it is among the first ones to systemically address the relationship among the effective monitoring, friendly advising, and incentive contract of board directors in large publicly owned firms (see Adams and Ferreira 2007 for the theory of friendly boards). In prior research, Yermack (2004) reports a rising equity ownership by outside directors after studying a panel of 734 directors elected to the boards of Fortune 500 firms in 1994–1996. Farrell et al. (2008) document a trend towards more equity compensation and away from cash only compensation by extending Yermack (2004)’s dataset to a period from 1998 to 2004. Motivated by these empirical findings of rising incentive pay for board directors, this paper investigates the effects of equity-based compensation on board directors’ effort to monitor and advise executives. Theoretically, we set up a principal-agent problem with a simplifying assumption that the efforts of both the director and the CEO will affect the firm’s outcome. We characterize the effects of board directors on firm performance by two factors, namely effective monitoring and friendly advising the CEO, as Adams et al. (2010) show that the board of directors functions as both a monitor and an advisor. The optimal contract suggests that the director’s profit sharing is positively related to its effectiveness in monitoring and friendliness in advising the CEO.

The economic interpretation of this result is straightforward. A more friendly board is given higher incentive compensation to exert more effort to play the advisory role, even though its monitoring effectiveness might be very poor. A board that can effectively monitor the CEO is given higher incentive compensation for the same reason. While measuring the friendliness between directors and CEOs is difficult, Brick et al. (2006) report a significant positive relationship between the director compensation and CEO compensation after controlling for firm characteristics. One possible reason for this positive correlation is that director and CEO compensation levels are positively related to firm complexity and the talent and effort that are needed to manage and direct such companies.2 An alternative explanation is that the positive relationship between these variables reflects cronyism, whereby the board and CEO are more concerned with selfish objectives than with protecting shareholder interests. Although the authors provide evidence of negative relationship between firm performance and excessive pay of directors and CEOs, and attribute it to cronyism, we do not take a stand to argue which interpretation is correct, instead, we are interested in using the pay correlation to measure the director’s friendliness in advising the CEO. Specifically in the empirical section of this paper, we use the difference between excessive CEO pay and excessive director pay to proxy for the friendliness between CEOs and board directors.3

On the other hand, a well-functioning competitive market plays the external monitoring role and hence reduces the effectiveness of monitoring by the board directors. Randøy and Jenssen (2004) have a similar argument that firms in highly competitive industries should have fewer outside board members, whereas companies in less competitive industries should have more outside directors. We use market competitiveness to proxy for directors’ effectiveness in monitoring executives and pay correlation to proxy for friendliness in advising CEOs. We empirically test the hypothesis that market competition reduces the need of incentive contract, and board directors’ friendliness to CEOs induces more equity in directors’ compensation contract. The results of multivariate regression and quasi-experiment design using the entire sample and the sub-sample of industrial firms from 2006 to 2010 provide empirical evidence supporting the hypothesis, but the result using the sub-sample of financial institutions is not significant for the same period. The inconsistency in the empirical findings between industrial firms and financial institutions raises the question of whether managerial pay for bank directors is optimal.4

This paper suggests, theoretically and empirically, that aligning board directors’ interests with shareholders’ interests using equity-based compensation is necessary; however, the level is subject to board directors’ effectiveness in monitoring and friendliness in advising top executives. The remainder of the paper is organized as follows. Section 2 reviews the relevant prior research and develop the hypotheses. Section 3 describes the data and empirical tests. Section 4 reports and discusses the empirical results. Section 5 designs a quasi-experiment to address the endogeneity concern and draws causal inference, and Sect. 6 concludes.

2 Hypotheses and Related Literature

Before we analyze the compensation design of board directors, we need to explore their roles and responsibilities. There are a variety of views about what a board of directors really is in a for-profit corporation and most of these views share a common theme: it is a group of people legally charged with the responsibility to govern a corporation. The board of directors is responsible to the stockholders or sometimes even to the stakeholders, that is, to everyone who is interested and/or can be effected by the firm. Adams et al. (2010) define the responsibilities of board directors as: advisory role, disciplinary role, management selection, performance assessment, and strategy setting.5

The modern industrial firms can be characterized by a separation of ownership and control, a situation that produces both costs and benefits. One benefit arises from the owners’ ability to hire agents with specialized managerial skills, and thus delegate the operation of the company. The conflict arises out of the owners’ inability to directly monitor and evaluate all actions taken by management, and thus prevent managers from taking actions that maximize their own utility while lowering firm value (Jensen and Meckling 1976). This conflict, referred to as the agency or moral hazard problem, can be alleviated by directly monitoring top management or by aligning managers’ interests with those of the firm’s shareholders through effective incentive compensation contracts (Harris and Raviv 1978, Holmstrom 1979, Holmstrom and Milgrom 1987).

The board of directors represents the most direct, and potentially most efficient method of mitigating the agency problem. The shareholders elect a board of directors to serve as their agent in overseeing top management and guiding the strategic direction of the firm. The directors have a fiduciary duty to protect the shareholders’ investment in the company. Furthermore, directors’ access to strategic and proprietary information not available to outside stakeholders enables them to be informed evaluators of top management’s actions. In spite of this legal obligation, corporate governance critics argue that the directorial nomination and election process may result in the election of directors whose incentives are more closely aligned with the firm’s management than with those of the firm’s shareholders. As Lorsch (1989) and Blair (1995) documented that board directors have been criticized for their lack of oversight and strategic guidance, and for designing executive compensation plans which reward short-term financial results.

The emergence of institutional investor and other stakeholder activist groups in the mid-1980s, however, placed pressure on firms to institute board governance structures designed to facilitate more active monitoring and evaluation of managers’ stewardship of the firm’s assets (see evidences in Guercio et al. 2008). Furthermore, new regulations instituted by the SEC in the early 1990s required that executive pay be disclosed in more detail in the company’s proxy statements and be approved by a compensation committee composed entirely of independent directors. The collective force of these events increased the likelihood that the board of directors has the incentive and ability to be a more effective monitor and evaluator of management’s stewardship of the firm’s assets.

However, a well-functioning competitive market also plays an important external monitoring role and hence it might reduce the effectiveness of monitoring by the board of directors. Randøy and Jenssen (2004) have a similar argument that firms in highly competitive industries should have fewer outside board members, whereas companies in less competitive industries should have more outside directors. We hypothesize that the increasing market competition in an industry reduces the need of incentive contract for the board of directors.

Monitoring by the board of directors and the use of incentive pay are only two of the control mechanisms suggested by the corporate governance literature, for example, Shleifer and Vishny (1997). However, as the Economist (2001) suggests, “too much emphasis on monitoring tends to create a rift between non-executive and executive directors, whereas the more traditional job of forming strategy requires close collaboration. In both activities, though, independent directors face the same problem: they depend largely on the chief executive and the company’s management for information.” It is noted by Adams and Ferreira (2007) that the advisory role of the board exists not only in the sole board system in the United States but also in Europe where boards are usually separated into a management and a supervisory board. While the monitoring role of the board has been studied extensively in a large, mostly empirical, literature (Hermalin and Weisbach 2003), the advisory role has received little attention. Song and Thakor (2006) and Adams and Ferreira (2007) develop and analyze the theoretical models of combining the board’s two roles (monitoring and advisory) in the sole board system. Warther (1998), Herman (1981), Whisler (1984) and Mace (1986) argue that individual board members are reluctant to step forward and oppose management, because management’s power to select and eject board members affects the behavior of the board. Therefore, the more friendly a director to the top executives the more likely his advice is accepted by them.

Tirole (1986 and 1992) discuss the three-level hierarchy of shareholder-director-manager to analyze the organization behavior with possible collusion between directors and management. Particularly in finance literature, Kumar and Sivaramakrishnan (2008) examine the role of the board in setting the CEO’s incentive compensation, and study the role of incentive pay for directors with respect to the performance of their duties. They find that board independence and board incentive pay could be substitutes; independent boards could be less diligent monitors than less-independent boards, thus, having a maximally independent board need not to be optimal for shareholders. In a similar fashion but a much simpler model, we argue that the optimal incentive contract for board directors depends on its effectiveness in monitoring and advisory efforts. It is different to Kumar and Sivaramakrishnan (2008) in the sense that it focuses on the optimal compensation of both the CEO and the director, versus their interest in board design. We assume that the adverse selection problem and bargaining problem between these two players in this parsimonious model is not as severe as the moral hazard problem between the shareholder and the director-manager as a whole; therefore, we are able to simplify the three-level principal-agent problem to a two-level three-party principal-agent problem. The result of this paper is consistent to Adams and Ferreira (2007)’s conclusion that shareholders can sometime be better off with a friendly board. In our model, shareholders are better off with a friendly board when the monitoring channel is not effective. Finally, this paper does not deal with the hiring and firing of CEO as extensively analyzed and surveyed by Hermalin and Weisbach (1998, 2003). The main interest of this paper is to address the question of how to compensate the director so that all parties are better off. In the Appendix section, we formally develop a model with one-principal and two-agents based on the standard principal-agent problem of Holmstrom and Milgrom (1987). The solutions of the model suggest that aligning outside directors’ interest with shareholders’ interest using equity-based compensation such as stocks and options is necessary but the level of such incentive pay is subject to the director’s effectiveness in monitoring and friendliness in advising top executives.

Compared to the number of empirical studies on executive compensation, there are relatively few studies on board compensation. Yermack (2004) finds evidence that the average pay-for-performance sensitivity of an outside director of a Fortune 500 firm is 0.011 %, or equivalently the director gains 11 cents for each $1,000 increase in firm value. This incentive contract is much lower than the average pay-for-performance sensitivity of a CEO which is estimated by Gao (2010) as 2.6 % and by Hall and Liebman (1998) as 1.1 %. Yermack (2004) also reports that a one standard deviation change or $2.6 million in the market capitalization of the median sample firm results in a $285,000 change in an outside director’s wealth. Farrell et al. (2008) document a trend towards fixed-value equity compensation and away from cash only and fixed-number equity compensation.

Most of empirical research in board compensation has focused on the determinants of board compensation rather than the effects of compensation on director behavior. Boyd (1996), Tufano and Sevick (1997), and Linn and Park (2005) find that firm and board size are positively associated with higher board compensation. Ryan and Wiggins (2004) report that boards with more outside directors are awarded more equity-based compensation. Vafeas (1999) and Bryan and Klein (2004) suggest that firms with greater agency problems use more contingent compensation. On the other hand, it is possible that, instead of being a solution to an agency problem, director compensation plans are evidence of an unsolved agency problem. Brick et al. (2006) suggest that outside directors’ excessive compensation is largely due to mutual back scratching or cronyism.

There is some empirical evidence that directors respond to incentives. Hempel and Fay (1994) find that the amount of work required by a particular board is positively associated with director compensation. Yermack (2004) and Fich and Shivdasani (2005) report that directors receive significant performance-based compensation that helps align the directors’ incentives with shareholders and positively impacts firm value. Adams and Ferreira (2008) suggest that even relatively small sums of money can influence director behavior because meeting fees increase directors’ attendance.

3 Empirical Analysis

In this section, we will empirically test the hypothesis that the use of incentive pay for directors is positively associated with their effectiveness in monitoring and friendliness in advising CEOs. We use the pay-for-performance sensitivity to measure the incentive embedded in the director compensation, the level of market competitiveness to measure the director’s effectiveness in monitoring the CEO, and the pay correlation in excessive compensation between the director and the CEO to measure the director’s friendliness in advising the CEO. The regression specification is straightforward with the pay-for-performance sensitivity on LHS, and the level of market competiveness and the pay correlation of excessive compensation on RHS. The endogeneity concern is addressed using a quasi-experimental design with the shocks indentified from sudden changes in market competitiveness and pay correlation. The pay-for-performance sensitivity is measured as the board director’s ownership of the firm, or the number of shares granted to him every year divided by the firm’s total number of shares outstanding during the same year. The number of shares includes both stocks and options adjusted by the option delta. Gerhart and Milkovich (1990) found that incentive pay is related to financial performance, but salary is not. Leonard (1990) also found that the presence of long-term incentive plans was associated with greater increases in ROE than in those firms without long-term incentive plans during the 1980s. Hence, the ownership in board directors’ compensation incentivizes them to monitor and advise CEOs under the optimal contract.

We obtain the executive and director compensation data of 2006–2010 from Standard & Poor’s ExecuComp database,6 which provides information on firms in the S&P 500, the Midcap 400, and the Smallcap 600. We are only interested in the equity compensation which includes restricted and unrestricted shares, and the pay-for-performance sensitivity for each director is estimated by summing up the number of equity grants with option delta adjustment and divided by the firm’s total number of shares outstanding of the previous fiscal year. We then collect each firm’ market data and financial accounting data including year-end stock price, shares outstanding, total asset, long-term debt, market to book, net income, R&D and total revenue from CRSP and Computstat databases. The two datasets of managerial compensation and company fundamentals are merged using CCMXPF_LINKTABLE.

Firms that offer their directors equity-based compensation generally award stock and stock option grants on a regular annual schedule. Some firms only pay cash to directors in a fiscal year, and we include these samples as well since we do not want to ignore a source of compensation that does not aligns the interests of directors and shareholders. The structure and level of equity-based compensation vary across different industries, in particular the difference between industrial firms and financial institutions is dramatic. We use an industry fixed effect of two-digit SIC code to control for the heterogeneity in board compensation. As we present later in the robustness section, we split the sample to two and repeat our analysis on these two samples based only on industrial firms and financial institutions with results similar to those reported in the tables.

The director can be both insider and outsider. Directors who are also officers of the firm are usually classified as insiders, whereas directors who work for service firms can obtain fee income from the firm, which creates an incentive conflict, are commonly classified as outsiders 7. In this study, we exclude the insiders and only consider the outsiders in our sample of directors. To measure the incentives embedded in the equity-based compensation we calculate the pay-for-performance sensitivity by summing up the total equity grants in stocks and options adjusted by option delta, and divided by the total number of common shares outstanding. To control for the firm’s characteristics and the nonlinearity effect of firm size, we choose the total assets, the square of total assets, financial leverage, R&D and return on assets as our main control variables. We use the positive relationship between CEO and director compensation of Brick et al. (2006) to measure the friendliness of board director to firm executives, as the authors provide evidence of cronyism based on the correlation between the compensation of CEOs and directors, and we call this variable Pay Correlation. Specifically, it is the difference between the excessive CEO pay and the excessive director pay. The excessive pay is the difference between the observed pay and the optimal pay. We calculate the optimal pay in two stages: the first stage estimates the coefficients for a pooled regression with executive or director pays on LHS and firm characteristics on RHS, and the second state predicts the optimal pay for each director using the estimated coefficients from the first stage. This is similar to Brick et al. (2006). The director’s friendliness to executives has two effects on the compensation design and firm performance. First, cronyism tends to offer directors more compensation, and second, a friendly director provides more ideas and advices to the CEOs and this can in turn improve the firm’s outcome. We hence hypothesize that the correlation between the pay correlation and the director’s PPS is positive. To measure the board director’s monitoring effectiveness on top executives, we take the Herfindahl index (HHI) of firms’ sales revenue in a sub-industry (4-digit SIC) as a proxy for the efficiency of a representative board director to monitor the agent (CEO).8 As Randøy and Jenssen (2004) argue that firms in highly competitive industries should have fewer outside board members, whereas companies in less competitive industries should have more outside directors. We hypothesize that market competition provides monitoring mechanism and hence reduces the efficiency of monitoring from the directors. The correlation between the HHI and the director’s PPS is positive. Reference Table 1 for detailed definition of all variables.
Table 1

Variable definition

Variable

Definition

Data source

Total asset

Total asset (AT)

Compustat fundamental annual

Market value

Stock price (PRC) × shares outstanding (SHROUT)

CRSP

Market-to-book

Market value/book equity (SEQ)

Compustat fundamental annual, CRSP

Financial leverage

Total asset (AT)/book equity (SEQ)

Compustat fundamental annual, CRSP

R&D-to-asset

R&D expense (XRD)/Total asset (AT)

Compustat fundamental annual

ROA

Net income (NI)/total asset (AT)

Compustat fundamental annual

Director PPS

Total stocks and options adjusted by option delta/shares outstanding (SHROUT)

Compustat ExecuComp

HHI

Σ i Revenue2, for total revenue (REVT) of firm i to N

Compustat fundamental annual

Pay correlation

Difference between excessive director pay and excessive pay, where

Excessive pay = actual pay – predicted pay

The predicted pay is based on the regressions in Brick et al. (2006)

Compustat ExecuComp

Because the market competition is measured by revenue HHI for each sub-industry, we aggregate the director compensation data within four-digit SIC code and the final sample comprises 1,250 observations. The summary statistics on director compensation and control variables are shown in Table 2.
Table 2

Summary statistics

Variable

N

Mean

Std Dev

Min

Max

Median

log(Total asset)

1,250

9.49

2.248

3.59

15.53

9.55

log(Market value)

1,250

16.0

2.003

9.58

20.81

16.15

Market-to-book

1,250

3.77

20.5

0.11

688.9

2.17

Financial Leverage

1,250

5.26

39.9

1.13

1341

2.47

R&D-to-asset (%)

1,250

6.22

2.04

0

28.5

1.8

ROA

1,250

0.0083

0.298

−1.73

9.243

0.025

Director PPS (10−6)

1,250

68.7

293.2

0

5280

6.88

HHI

1,250

0.462

0.2542

0.018

0.9

0.43

Pay correlation

1,250

2.61

2.40

0.0051

25.24

2.06

On average, total asset is $14 million, market value of equity is $8.9 billion and market-to-book ratio is 3.8. Most of firms are leveraged with asset-to-equity ratio of 5.3 and have R&D-to-asset ratio of 6.22 %. Within each sub-industry, the HHI is 0.46 and on average each director receives roughly 68.7 × 10−6 shares equity of his firm’s total common shares outstanding, which is about six times of Yermack (2004)’s 11 × 10−6 in the 1990s. The correlation matrix is reported in Table 3.
Table 3

Correlation matrix

Variable

log(Market value)

Market-to-book

Financial leverage

R&D-to-asset (%)

ROA

Director PPS

HHI

Pay correlation

Market-to-book

−0.03

       

Financial leverage

−0.06

0.93

      

R&D-to-asset

0.25

−0.01

−0.02

     

ROA

0.10

0.19

−0.01

0.02

    

Director PPS

−0.46

0.01

0.02

−0.07

−0.02

   

HHI

−0.50

0.05

0.06

−0.03

−0.06

0.16

  

Pay correlation

0.30

0.01

0.01

0.15

0.04

0.01

−0.13

 

log(total asset)

0.93

−0.04

−0.03

0.28

0.10

−0.41

−0.45

0.30

Notably, the director’s pay-for-performance sensitivity is negatively correlated with the market value, total assets and the market competition.9 The friendliness of the director to top executives as measured by Pay Correlation of excessive compensation between directors and CEOs is positively related to the firm’s size and market competition (HHI). The positive correlation among HHI, Pay Correlation and PPS is consistent with our hypothesis that market competition reduces the director’s monitoring effectiveness due to the external monitoring force from the market (Randøy and Jenssen 2004), whereas the director’s friendliness in advising CEOs improves the firm’s performance because of coordination and cooperation (Warther 1998).10

4 Empirical Results

Whereas the above correlations were suggestive, we hence run a multivariate regression, the results of which are given in Table 4. The dependent variable is the board director’s pay-for-performance sensitivity (PPS) as measured by the number of granted equities, including stocks and options (beta adjusted), divided by the firm’s total shares outstanding. The regression includes year and industry (two-digit SIC) fixed-effects. The t-statistics are calculated using Newey-West standard errors which rectifies for heteroskedasticity.
Table 4

All firms: Market competition, pay correlation and pay-for-performance sensitivity

Dependent variable: Director PPS

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

log(Total asset)

−245.0***

−226.2***

−230.6***

−245.3***

−226.3***

−230.8***

−243.5***

−224.8***

−230.0***

(−12.06)

(−11.55)

(−11.75)

(−12.06)

(−11.55)

(−11.75)

(−11.84)

(−11.37)

(−11.59)

log(Total asset)-square

10.18***

8.805***

9.261***

10.19***

8.812***

9.272***

10.03***

8.669***

9.197***

(9.180)

(8.285)

(8.609)

(9.181)

(8.284)

(8.610)

(8.770)

(7.962)

(8.304)

Market-to-book

   

−0.464

−0.475

−0.435

−0.377

−0.684

−0.629

   

(−0.422)

(−0.448)

(−0.412)

(−0.297)

(−0.560)

(−0.515)

Financial Leverage

   

0.136

0.163

0.125

0.0922

0.263

0.219

   

(0.240)

(0.299)

(0.230)

(0.143)

(0.424)

(0.353)

ROA

      

−4.705

12.11

11.00

      

(−0.132)

(0.353)

(0.321)

R&D-to-asset

      

0.0253

0.0265

0.0126

      

(0.573)

(0.628)

(0.296)

HHI

94.48***

 

87.80**

94.97***

 

88.28**

92.21**

 

86.74**

(2.602)

 

(2.514)

(2.612)

 

(2.524)

(2.511)

 

(2.456)

Pay correlation

 

13.67***

13.64***

 

13.66***

13.63***

 

13.56***

13.59***

 

(4.073)

(4.072)

 

(4.066)

(4.067)

 

(4.026)

(4.044)

Year FE

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Industry FE

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

N

1,250

1,249

1,249

1,250

1,249

1,249

1,250

1,249

1,249

R-square

0.330

0.337

0.340

0.330

0.337

0.340

0.331

0.337

0.341

Note: This sample contains all firms including both industrial firms and financial institutions. The dependent variable is board directors’ pay-for-performance sensitivity (PPS) as measured by the number of granted equities, including stocks and options (beta adjusted), divided by the firm’s total shares outstanding. To control for the firm's characteristics and the nonlinearity effect of firm size, we choose the total asset, the square of total asset, financial leverage, R&D and return on assets as our main control variables. We use the difference between excessive CEO pay and excessive director pay based on Brick, Palmon and Wald (2006) to measure the friendliness of board director to firm executives, as the authors provide evidence of cronyism based on the correlation between the compensation of CEOs and directors, and we call this variable Pay Correlation. To measure board directors’ monitoring effectiveness on top executives, we take the Herfindahl index (HHI) of firms’ sales revenue in a sub-industry (4-digit SIC) as a proxy for the efficiency of board directors to monitor the agent (CEO). The regression includes year and industry (two-digit SIC) fixed-effects. The t-statistics based on Newey-West standard error is shown in the parenthesis with ***, ** and * indicating its statistical significant level of 1 %, 5 % and 10 % respectively.

We first examine columns 1–3 where we only include our main variable of analysis, namely, the Herfindahl Index (HHI) and Pay Correlation, and only control for the firm size. In doing so, we ensure that our results are not due to some spurious correlation between the various independent variables. We find that both HHI and Pay Correlation are significantly negative related to directors’ PPS, suggesting that weaker market competition requires higher incentives for directors to monitor CEOs and better relationship between directors and CEOs encourages friendly advising which improves the firm’s performance or simply higher pay due to cronyism. In columns 4–6 we include two additional control variables, namely the ratios of Market-to-book and Asset-to-equity (Financial Leverage) to check if our results change. We still find that both HHI and Pay Correlation are significantly negative related to directors’ PPS, and their economic magnitudes remain almost unchanged. Specifically, a one standard deviation positive shock to HHI (increasing monitoring effectiveness due to decreasing competition) increases the directors’ PPS by 32.5 %, and a one standard deviation positive shock to Pay Correlation (increasing advising friendliness or cronyism) increases directors’ PPS by 47.6 %. In columns 7–9 we include two more control variables, namely the ratios of profit-to-asset (ROA) and R&D-to-asset, and still find the same relationship and magnitude among the HHI, Pay Correlation and directors’ PPS. Examining the control variables we find that both small firms (log total asset) and super-large firms (squared log total asset) are associated with high pay incentives of board directors.

In the previous regression analysis we pooled all of the firms in one sample, and now we split the sample to industrial firms and financial institutions to address the concern that our results might be driven by large investment banks and investment companies that have been affected by the financial boom and crisis from 2006 to 2010. We repeat the same regressions for the sub-samples of industrial firms and financial institutions, and the results are reported in Tables 5 and 6 respectively.
Table 5

Industrial firms: Market competition, pay correlation and pay-for-performance sensitivity

Dependent variable: Director PPS

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

log(Total asset)

−224.2***

−201.4***

−207.2***

−224.5***

−201.7***

−207.4***

−224.2***

−201.5***

−209.0***

(−10.33)

(−9.817)

(−9.981)

(−10.33)

(−9.818)

(−9.982)

(−9.937)

(−9.531)

(−9.700)

log(Total asset)-square

9.376***

7.800***

8.280***

9.391***

7.813***

8.294***

9.364***

7.793***

8.409***

(7.624)

(6.775)

(7.003)

(7.627)

(6.777)

(7.007)

(7.092)

(6.406)

(6.649)

Market-to-book

   

−0.373

−0.351

−0.318

−0.515

−0.822

−0.788

   

(−0.341)

(−0.336)

(−0.306)

(−0.401)

(−0.672)

(−0.645)

Financial leverage

   

0.116

0.116

0.0898

0.185

0.347

0.321

   

(0.205)

(0.217)

(0.167)

(0.283)

(0.558)

(0.516)

ROA

      

7.387

24.40

23.89

      

(0.215)

(0.745)

(0.730)

R&D-to-asset

      

0.00321

0.00468

−0.00893

      

(0.0729)

(0.113)

(−0.213)

HHI

69.40*

 

60.87*

69.67*

 

61.16*

69.10*

 

62.29*

(1.905)

 

(1.755)

(1.909)

 

(1.761)

(1.859)

 

(1.761)

Pay correlation

 

14.67***

14.61***

 

14.65***

14.60***

 

14.66***

14.66***

 

(4.409)

(4.397)

 

(4.401)

(4.390)

 

(4.396)

(4.400)

Year FE

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Industry FE

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

N

1,133

1,132

1,132

1,133

1,132

1,132

1,133

1,132

1,132

R-square

0.311

0.323

0.325

0.312

0.323

0.325

0.312

0.323

0.325

Note: This sample includes only industrial firms and excludes financial institutions. The dependent variable is board directors’ pay-for-performance sensitivity (PPS) as measured by the number of granted equities, including stocks and options (beta adjusted), divided by the firm’s total shares outstanding. To control for the firm’s characteristics and the nonlinearity effect of firm size, we choose the total asset, the square of total asset, financial leverage, R&D and return on assets as our main control variables. We use the difference between excessive CEO pay and excessive director pay based on Brick, Palmon and Wald (2006) to measure the friendliness of board director to firm executives, as the authors provide evidence of cronyism based on the correlation between the compensation of CEOs and directors, and we call this variable Pay Correlation. To measure board directors’ monitoring effectiveness on top executives, we take the Herfindahl index (HHI) of firms’ sales revenue in a sub-industry (4-digit SIC) as a proxy for the efficiency of board directors to monitor the agent (CEO). The regression includes year and industry (two-digit SIC) fixed-effects. The t-statistics are calculated using Newey-West standard errors which rectifies for heteroskedasticity. The t-statistics based on Newey-West standard error is shown in the parenthesis with ***, ** and * indicating its statistical significant level of 1 %, 5 % and 10 % respectively.

Table 6

Financial institutions: Market competition, pay correlation and pay-for-performance sensitivity

Dependent variable: Director PPS

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

log(Total asset)

−913.0***

−920.8***

−917.8***

−910.4***

−924.8***

−915.4***

−852.4***

−874.3***

−856.5***

(−9.565)

(−10.24)

(−9.503)

(−9.358)

(−10.09)

(−9.301)

(−9.014)

(−10.02)

(−8.913)

log(Total asset)-square

37.53***

37.91***

37.80***

37.58***

38.18***

37.87***

35.34***

36.13***

35.55***

(9.027)

(9.420)

(8.940)

(8.864)

(9.228)

(8.779)

(8.719)

(9.215)

(8.586)

Market-to-book

   

−2.296

−1.668

−2.338

−3.852

−2.944

−3.883

   

(−0.342)

(−0.268)

(−0.347)

(−0.611)

(−0.495)

(−0.613)

Financial leverage

   

−0.937

−0.837

−0.988

−1.594

−1.313

−1.611

   

(−0.328)

(−0.299)

(−0.344)

(−0.587)

(−0.497)

(−0.590)

ROA

      

−2,257***

−2,197***

−2,244***

      

(−3.794)

(−3.737)

(−3.744)

R&D-to-asset

      

74.08

83.50*

75.49

      

(1.429)

(1.704)

(1.442)

HHI

18.03

 

13.57

48.20

 

44.43

80.63

 

75.98

(0.121)

 

(0.0903)

(0.292)

 

(0.267)

(0.482)

 

(0.450)

Pay correlation

 

−5.284

−5.198

 

−5.630

−5.441

 

−4.042

−3.508

 

(−0.413)

(−0.403)

 

(−0.435)

(−0.418)

 

(−0.331)

(−0.285)

Year FE

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Industry FE

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

N

117

117

117

117

117

117

117

117

117

R-square

0.645

0.645

0.645

0.646

0.646

0.646

0.695

0.695

0.695

Note: This sample only includes financial institutions and excludes industrial firms. The dependent variable is board directors’ pay-for-performance sensitivity (PPS) as measured by the number of granted equities, including stocks and options (beta adjusted), divided by the firm’s total shares outstanding. To control for the firm’s characteristics and the nonlinearity effect of firm size, we choose the total asset, the square of total asset, financial leverage, R&D and return on assets as our main control variables. We use the difference between excessive CEO pay and excessive director pay based on Brick, Palmon and Wald (2006) to measure the friendliness of board director to firm executives, as the authors provide evidence of cronyism based on the correlation between the compensation of CEOs and directors, and we call this variable Pay Correlation. To measure board directors’ monitoring effectiveness on top executives, we take the Herfindahl index (HHI) of firms’ sales revenue in a sub-industry (4-digit SIC) as a proxy for the efficiency of board directors to monitor the agent (CEO). The regression includes year and industry (two-digit SIC) fixed-effects. The t-statistics based on Newey-West standard error is shown in the parenthesis with ***, ** and * indicating its statistical significant level of 1 %, 5 % and 10 % respectively.

For non-financial industrial firms, the significantly negative relationship among HHI, Pay Correlation and directors’ PPS remain unchanged although the economic magnitude of HHI is 30 % smaller and the economic magnitude of Pay Correlation is 7 % higher. However, the results change dramatically for financial institutions, and this brings up the concern that our previous results might be driven by firms in the tails of the distribution.

To address the outlier issue, we apply Winsorization to three of our samples, namely all firms, non-financial industrials and financial institutions, and repeat our regression analysis. Winsorization is the transformation of statistics by limiting extreme values in the statistical data to reduce the effect of possibly spurious outliers (Dixon 1960 and Hasings et al. 1947). Because the distribution of our sample statistics can be heavily influenced by outliers, our strategy is to set all outliers to a specified percentile of the data. In this case we use 90 % Winsorisation such that all data below the 5th percentile set to the 5th percentile, and data above the 95th percentile set to the 95th percentile. The regression results are reported in Dong (2012).

We find that the HHI and Pay Correlation are statistically positive related to the director’ PPS but with a much smaller economic magnitude comparing to previous regression results. Specifically, a one standard deviation positive shock to HHI (increasing monitoring effectiveness due to decreasing competition) increases directors’ PPS by 5.6 % for the sample of all firms, whereas a one standard deviation positive shock to Pay Correlation (increasing advising friendliness or cronyism) increases directors’ PPS by 12.2 %. The sample of non-financial industrials has similar regression results, but the sample of financial institutions report much higher economic magnitude (three times of non-financial firms) for the effect of HHI on directors’ PPS and insignificant coefficient for the Pay Correlation. This insignificant effect of Pay Correlation could be due to the increased public scrutiny of bank executive compensation in the 2007–2009 financial crisis. During this turmoil period, a major criticism was that many bank CEOs’ executive pay packages incentivized excessive risk taking which contributed to the financial turmoil. To respond to these concerns, governments and regulators have taken steps to restrict executive pay arrangements in banking industries. For example, under the economic stimulus bill passed in mid-February 2009, TARP recipients are not allowed to deduct for tax purposes senior executive compensation in excess of sum fixed level, and this “cap” on CEO pay might make the PPS of top executives and directors deviate from their historical correlations. Hence, the measure of Brick et al. (2006) might lose track of the real “friendliness” of director-CEO relationship in financial industries during the financial crisis of 2007–2009.

5 Robustness: Quasi-experimental Design

We now examine if the above results are driven by endogeneity concerns. Specifically, are significant omitted variable(s) correlated with both market competition and pay-for-performance sensitivity driving our results spuriously? In order to do so, we consider the dramatic decrease in market competition in each sub-industry as an exogenous shock. This shock could be due to the sudden bankruptcy of firms in that sub-industry. We employ a difference-in-differences (DID) approach (see Meyer 1995; Angrist and Krueger 1999 for detailed explanations of this methodology). We specifically analyze whether firms change their board directors’ pay-for-performance sensitivity when they face the unexpected shock of market competition. We rank the change of each sub-industry (four-digit SIC)’s Herfindahl index (HHI) every year and assume that sub-industries in the top-quartile (75-percentile and above) of the distribution face a severe shock of market competition in that year, namely a sudden decrease in market competition. Accordingly, the sub-industries categorized by the four-digit SIC code that have such shocks are defined as the treatment group, whereas the sub-industries in the bottom quartile (25-percentile and below) of the distribution are the control or non-treated group. The dummy variable of Lower Competition is set to unity if the sub-industry is in the top-quartile, and zero if it is in the bottom-quartile. The dummy variable of Post-Shock is set to unity if the date is the year after the shock (dramatic decrease of market competition in the sub-industry), and zero if the date is the year before the shock. A third dummy variable Lower Competition × Post-Shock is the cross-product of the previous two dummy variables. The industry (two-digit SIC) fixed effect is still used but the year fixed effect is no longer needed because the dummy variable of Post-Shock serves for the same purpose.

The DID regression results are reported in Table 7. Columns 1–3 are for the shocks of decreasing market competition in all firms, industrial firms and financial institutions respectively. The DID coefficient estimates of the cross-product dummy (Lower Competition × Post-Shock) in all firms and industrial firms are significantly positive, suggesting that firms increase their board directors’ pay-for-performance sensitivity when they face the unexpected shock of market competition. However, such effect doesn’t exist in the financial service industries as the insignificant coefficient estimates indicate.
Table 7

Robustness: DID regression using exogenous shocks

Dependent variable: Director PPS

(1)

(2)

(3)

(4)

(5)

(6)

log(Total asset)

−67.75***

−58.96***

−74.43***

−94.14***

−83.74***

−81.72***

(−7.489)

(−5.621)

(−5.922)

(−6.817)

(−5.241)

(−7.160)

log(Total asset)-square

1.890***

1.252**

2.738***

2.787***

2.021**

3.128***

(3.715)

(2.037)

(4.905)

(3.558)

(2.148)

(6.173)

Market-to-book

1.244

1.595

−0.663

0.689

0.543

−0.456

(0.934)

(1.030)

(−1.008)

(0.353)

(0.221)

(−0.974)

Financial leverage

0.157

−0.0684

1.825**

0.265

0.109

0.568

(0.270)

(−0.109)

(2.030)

(0.302)

(0.115)

(0.643)

ROA

−26.18

−31.16

−103.8*

−17.39

−14.66

−110.0**

(−0.951)

(−1.011)

(−1.802)

(−0.428)

(−0.308)

(−2.060)

R&D-to-asset

0.0539

0.0725

0.543

0.200

0.235

0.378

(0.455)

(0.571)

(1.324)

(1.123)

(1.214)

(1.025)

Post-shock dummy

33.03**

37.24**

−5.949

28.35*

29.56*

10.41

(2.553)

(2.563)

(−0.772)

(1.783)

(1.672)

(1.501)

Lower competition dummy

19.74

21.53

−3.914

   

(1.544)

(1.494)

(−0.522)

   

Lower independence dummy

   

14.30

15.06

1.166

   

(0.758)

(0.706)

(0.177)

Post dummy × lower dummy

38.50**

44.73**

14.08

21.64*

21.03*

13.36

(2.193)

(2.263)

(1.378)

(1.829)

(1.712)

(1.452)

Industry FE

Yes

Yes

Yes

Yes

Yes

Yes

N

1,242

1,096

146

1,282

1,130

152

R-square

0.316

0.318

0.639

0.232

0.233

0.691

Note: In columns 1–3 we consider the dramatic decrease in market competition in each sub-industry as an exogenous shock. This shock could be due to the sudden bankruptcy of firms in that sub-industry. We employ a difference-in-differences (DID) approach (see Meyer 1995, and Angrist and Krueger 1999 for detailed explanations of this methodology). We specifically analyze whether firms change their board directors’ pay-for-performance sensitivity when they face the unexpected shock of market competition. We rank the change of each sub-industry (four-digit SIC)’s Herfindahl index (HHI) every year and assume that sub-industries in the top-quartile (75-percentile and above) of the distribution face a severe shock of market competition in that year, namely a sudden decrease in market competition. Accordingly, the sub-industries categorized by the four-digit SIC code have such shocks are defined as the treatment group, whereas the sub-industries in the bottom quartile (25-percentile and below) of the distribution are the control or non-treated group. The dummy variable of Lower Competition is set to unity if the sub-industry is in the top-quartile, and zero if it is in the bottom-quartile. The dummy variable of Post-Shock is set to unity if the date is the year after the shock (dramatic decrease of market competition in the sub-industry), and zero if the date is the year before the shock. A third dummy variable Lower Competition × Post-Shock is the cross-product of the previous two dummy variables. Similarly in columns 4–6, we rank the change of each sub-industry’s Pay Correlation every year and assume that sub-industries in the top-quartile of the distribution face a severe positive shock of CEO-director relationship or cronyism in that year, probably due to the hiring of friends as new CEOs or directors. The dummy variable of Lower Independence is set to unity if the sub-industry is in the top-quartile, and zero if it is in the bottom-quartile. The dummy variable of Post-Shock is set to unity if the date is the year after the shock (dramatic increase of Pay Correlation between CEOs and directors in the sub-industry), and zero if the date is the year before the shock. A third dummy variable Lower Independence × Post-Shock is the cross-product of the previous two dummy variables. The industry (two-digit SIC) fixed effect is still used but the year fixed effect is no longer needed because the dummy variable of Post-Shock serves for the same purpose. The t-statistics based on Newey-West standard error is shown in the parenthesis with ***, ** and * indicating its statistical significant level of 1 %, 5 % and 10 % respectively.

Similarly, we design another set of DID regressions to check whether the significant omitted variable(s) correlated with both pay correlation and pay-for-performance sensitivity are driving our results spuriously. We rank the change of each sub-industry (four-digit SIC’s) Pay Correlation every year and assume that sub-industries in the top-quartile (75-percentile and above) of the distribution face a severe positive shock of CEO-director relationship or cronyism in that year, probably due to the hiring of friends as new CEOs or directors. Accordingly, the sub-industries categorized by the four-digit SIC code that have such shocks are defined as the treatment group, whereas the sub-industries in the bottom quartile (25-percentile and below) of the distribution are the control or non-treated group. The dummy variable of Lower Independence is set to unity if the sub-industry is in the top-quartile, and zero if it is in the bottom-quartile. The dummy variable of Post-Shock is set to unity if the date is the year after the shock (dramatic increase of pay correlation between CEOs and directors in the sub-industry), and zero if the date is the year before the shock. A third dummy variable Lower Independence × Post-Shock is the cross-product of the previous two dummy variables. Columns 4–6 in Table X are for the shocks of increasing Pay Correlation in all firms, industrial firms and financial institutions respectively. The DID coefficient estimates of the cross-product dummy (Lower Independence × Post-Shock) in all firms and industrial firms are significantly positive, suggesting that firms increase their directors’ pay-for-performance sensitivity when they face the unexpected shock of cronyism. Again, the financial service industries don’t have such effect.

Before we conclude that the statistical results of our robustness checks using identified positive shocks of market competition and pay correlation support the hypothesis that both factors of monitor effectiveness and friendly advising affect the optimal compensation of independent board directors, the design of such quasi-experiments deserves caution. As Shadish et al. (2001) point out, without proper randomization these difference-in-difference (DID) tests could be meaningless because they might not take into account any pre-existing firm characteristics (although we control for size and performance) or recognize that influences outside the experiment may have affected the results (like trade war or financial crisis). However, we acknowledge that it is a common problem in any causal inference using observational data.

6 Conclusion

The compensation of directors has received much attention, along with the growing debates on corporate governance in recent years, partly due to the ongoing financial crisis. While prior studies including Hall and Liebman (1998) have shown evidence of a dramatic increase in the use of equity-based incentives, resulting in an increase in the sensitivity of executive pay to firm performance during the 1990s. These findings suggest that managerial incentives are arguably more closely aligned with the shareholders’ goal of firm value maximization now than in the past. If the managerial incentive compensation has worked for top executives in terms of maximizing their efforts to run the firms on behalf of shareholders, do we need to offer similar incentive contracts to directors in order to maximize their efforts to monitor and advise top executives? This paper specifically addresses this question theoretically and empirically. We argue that the equity-based compensation for directors is necessary and the level of incentives embedded in the contracts depends on directors’ effectiveness in monitoring and friendliness in advising CEOs.

On the one hand, a well-functioning competitive market reduces the monitoring effectiveness of outside directors, whereas directors in an oligopoly industry can monitor executives more effectively, therefore directors are offered higher incentive pay to exert more efforts in monitoring, even if they might be less friendly to top executives. On the other hand, friendly directors are given higher incentive compensation to work harder to advise executives, even if their monitoring effectiveness might be very poor. Specifically, we hypothesize that the pay-for-performance sensitivity of board directors is positively associated to pay correlation in excessive compensation between directors and CEOs and the level of competition in the industry. This paper is among the first ones to systemically address the relationship between directors’ effectiveness of monitoring and friendliness in advising CEOs and the design of incentive contracts for directors in large publicly owned firms. We report empirical evidence supporting the hypothesis using compensation data of U.S. executives and directors. However, the statistical significance disappears for the subsample of financial institutions, whereas the significance remains for the subsample of industrial firms. This inconsistency in the empirical findings between industrial firms and financial institutions raises the question of whether managerial pays for bank directors are optimal. The results are robust after controlling for the endogeneity bias with a quasi-experimental design.

Footnotes

  1. 1.

    It is similar to the debt renegotiation problem with many creditors as analyzed in Bolton and Scharfstein (1996) using an optimal contracting framework.

  2. 2.

    This implies that the control variables and firm fixed effects used in their regressions cannot fully capture the real firm characteristics.

  3. 3.

    The excessive pays of board directors and CEOs are similar to Brick et al. (2006).

  4. 4.

    Competition in banking industry should drive down the incentive pays for directors due to the external monitoring and disciplining by the competitive market. But what we observed is the rising incentive pays for bank directors. This might be due to the global war for financial talents (Chambers et al. 1998) and the rise of hedge funds (Kostovetsky 2009).

  5. 5.

    In some European Union and Asian countries, there are two separate boards: an executive board, also called corporate executive team, for day-to-day business and a supervisory board, also called board of directors (elected by the shareholders) for supervising the executive board. To simply the analysis, this paper considers the boards of directors as a single entity.

  6. 6.

    The ExecuComp database reports detailed information of director compensation from 2006 onwards.

  7. 7.

    Harris and Raviv (2008) studies the optimal condition for inside versus outside directors to control the board, and show that shareholders can sometimes be better off with an insider-controlled board.

  8. 8.

    The extant literature on product market competition, strategic alliances and joint ventures generally uses SIC codes to assess whether two companies are competitors. The approach used in the existing literature (e.g., Grullon et al. 2006) treats two companies as competitors if they have the same 4-digit SIC code. Masulis and Nahata (2009) discuss the pros and cons of this approach.

  9. 9.

    The higher the HHI, the lower the competition, and vice versa.

  10. 10.

    It is consistent with the arguments of Herman (1981), Whisler (1984) and Mace (1986) that individual board members are reluctant to step forward and oppose management, because management’s power to select and eject board members affects the behavior of the board. Therefore, the more friendly a director to the CEO the more likely his advice is accepted by the CEO.

Notes

Acknowledgement

I am grateful to conference participants at SEA (Atlanta), SWFA (San Antonio) and WEA (San Diego). I thank Frederick Bereskin, Ivan Brick, Simi Kedia, Yigitcan Karabulut, Jin-Mo Kim, Peter Klein, Tom Nohel, Darius Palia, Abraham Ravid, Nitish Sinha and Tim Zhou for helpful comments. I acknowledge the research financial support from Rutgers University Graduate School and Rutgers Business School. All errors and omissions remain my own.

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Copyright information

© Springer-Verlag Berlin Heidelberg 2012

Authors and Affiliations

  1. 1.Department of Health Policy and ManagementColumbia UniversityNew YorkUSA

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