CEO Compensation and Board Structure Revisited

The following post comes to us from Katherine Guthrie of the Mason School of Business at the College of William and Mary, Jan Sokolowsky of the University of Michigan, and Kam-Ming Wan of the School of Economics and Finance at the University of Hong Kong.

In our forthcoming Journal of Finance paper entitled CEO Compensation and Board Structure Revisited, we reexamine the results of Chhaochharia and Grinstein (CG, Journal of Finance, 2009; available here on the Forum). In response to the corporate scandals in 2001/2002, the NYSE and Nasdaq imposed director independence requirements for listed companies. CG find that CEO pay decreases by about 17% in firms with noncompliant boards relative to firms with a majority of independent directors.

Using CG’s data and methodology, we find that their results are driven by two outliers. First, Steve Jobs’ total pay dropped from a high of $600 million in 2000 to a symbolic $1 per year in 2004 and 2005. Interestingly, the option grant turned out to be worthless due to a fall in Apple’s stock price, but the value of Jobs’ stock holdings increased by $465 million from 2003 to 2005. Second, Fossil’s Kosta Kartsotis himself initiated that his pay be cut from $255,000 to nearly zero in 2005. He and his brother Tom (Fossil’s founder and chairman of the board) owned about 30% of Fossil’s shares at that time. Clearly, neither outlier fits the story that independent boards are able to prevent CEOs from extracting rents in the form of excessive pay.

Excluding just these two firms from the full sample of 865 firms (i.e., 12 out of 5,190 firm-years) reduces the point estimate of the effect of board independence by 74%, rendering it economically and statistically insignificant. Moreover, excluding the two outliers uncovers an increase in CEO pay in firms whose compensation committees were not fully independent prior to the new listing requirements relative to compliant firms, and the increase in CEO pay is most pronounced in the presence of stronger shareholder monitoring (i.e., blockholder directors and concentrated institutional ownership).

Taken together, our evidence casts doubt on the effectiveness of independent directors in constraining CEO pay as suggested by the managerial power hypothesis.

The full paper is available for download here.

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