Reputation Penalties for Poor Monitoring of Executive Pay

In the paper Reputation Penalties for Poor Monitoring of Executive Pay: Evidence from Option Backdating, which was recently made publicly available on SSRN, my co-authors (Yonca Ertimur of Duke University and David Maber of the University of Southern California), and I examine whether directors are held accountable for poor monitoring of executive compensation.

Theoretical and empirical work suggests that directors suffer reputation penalties in the director labor market for poor monitoring. However, it is unclear whether these penalties extend to poor monitoring of executive pay. A widely held view—articulated by Prof. Bebchuk and Prof. Fried in their book Pay without Performance—is that there is little or no accountability for excessive or abusive pay practices. However, no study has empirically examined this question. Part of the reason is the difficulty of defining and identifying “poor monitoring” with respect to executive pay. In most cases, pay levels and structures can be justified on economic grounds (e.g. retention, incentives, attraction of talent) and with reference to the behavior of peer firms. Unless these practices are perceived as clearly “outrageous,” it is unlikely that directors will be concerned about reputation costs. Opacity in pay disclosures makes it even more difficult to assess the quality of pay practices.

Our study identifies the option backdating (BD) scandal of 2006-2007 as a powerful setting to empirically examine whether directors are held accountable for poor monitoring of executive compensation. There is little doubt that revelations of the BD practice sparked outrage and that at least some of the BD cases were blatant incidences of “stealth” compensation. BD is also an interesting setting in that there is a time lag between the time it took place and the time it was discovered—thus, board and committee composition may have changed, allowing for tests of “memory” in the director labor market.

Using a sample of approximately 180 BD firms, we analyze the reputation penalties suffered by outside directors subsequent to the discovery of BD. As proxies for reputation penalties, we use votes withheld from directors at elections, director turnover, and the number of seats gained/lost on other boards. We find that the percentage of votes withheld from directors at backdating firms is twice the percentage withheld from their counterparts at non-backdating firms. This voting penalty is more pronounced for directors sitting on the compensation committee (CC), particularly those sitting on the CC during the backdating period, suggesting that shareholders view backdating primarily as a monitoring failure of the CC (rather than the audit committee). Also, the voting penalty is significantly more pronounced in the most severe cases of backdating, with directors at such firms receiving 27% more votes withheld than their peers at non-backdating firms (that is, about six times more). With respect to director turnover, we find that the probability that CC members at backdating firms lose their seats is 27% higher than for CC members at non-backdating firms. The turnover penalty is stronger when backdating is more severe and in poorly performing firms. Finally, we examine whether directors of BD firms experience reputation penalties at other, non-BD firms. Interestingly, we do not find that directors of BD firms receive more votes withheld when up for election at another firm or that they are more (less) likely to lose (gain) another directorship.

The full paper is available for here.