Do Directors Suffer External Consequences for Poor Oversight of Executive Compensation? Evidence from Say-on-Pay Votes

The idea that directors could suffer penalties imposed by the external labor market when they fail in their oversight responsibilities is not a new one. Fama (1980) suggests that external labor market penalties could provide incentives for directors and help ensure shareholder-aligned oversight of firms. That is, ex post settling up in the directorial labor market could create ex ante incentives for directors to provide efficient monitoring of the firm and optimal contracting with managers. Levit and Malenko (2015) further suggest that without external labor market penalties, managers could easily incentivize directors to provide poor oversight. Several studies document evidence of labor market penalties for directors who fail in their duties as board members. For instance, Srinivasan (2005) and Fich and Shivdasani (2007) find that directors suffer significant reputational damage at interlocking firms when the firm issues accounting restatements or is sued for fraud. Similarly, Yermack (2004) notes that directors have reputational incentives tied to the firm’s performance.

On the other hand, there is little evidence of external labor market penalties for directors who fail in their oversight of executive compensation contracting. Ertimur, Ferri, and Maber (2012) examine this issue in the context of option backdating and find no external labor market penalties for directors who serve on boards that backdated managerial stock options. However, the prevalence of option backdating was substantially diminished by changes in reporting requirements prior to the widespread detection of the practice in 2006-2007. Thus, tests of ex post settling up in option backdating may show no substantial external penalties, as markets may fail to penalize a director nearly a decade later for actions taken at another firm that are unlikely to be repeated.

Ongoing concerns over the excessive compensation packages awarded to executives by boards motivated the proposal of the Say-on-Pay bill, considered by the U.S. Congress in 2007. This bill was subsequently incorporated into the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010). The Say-on-Pay (SOP) provision requires all firms to provide shareholders with an advisory vote on the compensation packages of the firm’s named executive officers. Unfortunately for proponents of the provision, extant studies find little evidence that the SOP provision provides shareholders with the power to substantially improve compensation contracting (Brunarski, Campbell, and Harman, 2015; Kronlund and Sandy, 2015). This may be due to the non-binding nature of the vote. However, if the external labor market penalizes directors who fail to properly oversee executive compensation, SOP votes may represent an inexpensive mechanism for shareholders to voice their concerns. As such, these votes could provide an indirect mechanism to influence the efficacy of the corporate pay-setting process.

In our paper, Do Directors Suffer External Consequences for Poor Oversight of Executive Compensation? Evidence from Say-on-Pay Votes, we examine the external labor market consequences suffered by directors when shareholders provide low SOP support for executive compensation contracts. More specifically, we examine the consequences for directors at other firms in which they hold a board seat (interlocking firms) when they receive low SOP support at a voting (focal) firm. We define low support as SOP approval of 70% or less of the voting shareholders because this level of support results in the firm’s addition to the watch lists of proxy advisory firms such as Institutional Shareholder Services and Glass Lewis. In a sample of S&P 1500 firms subject to their first SOP vote, we find that directors experience significant external reputational damage (penalties at interlocking firms) when the focal firm receives a low-support vote. Specifically, following the low-support vote, such directors lose, on average, the present value equivalent of approximately $435,000 in future directorial compensation at interlocking firms. Further, stock prices decline at the interlocking firms when focal firms receive low SOP support. This implies that low support votes cause the market to reduce its estimate of director quality. Additionally, a director of a low-support firm is more likely to lose board seats and compensation committee positions at interlocking firms, and is more likely to experience increased shareholder scrutiny of pay practices at interlocking firms if that director retains his or her external board seat.

Our results further show that the reputational penalties associated with low SOP support occur primarily when the low-support vote is driven by excess compensation, where excess compensation is the difference between actual and expected compensation for the focal firm’s CEO. We find little evidence of external labor market consequences for directors when firms they serve receive low SOP support due to poor firm performance or when the firm’s CEO has high (but not excess) executive compensation.

Our research has three key implications. First, directors appear to experience significant ex post settling up as a consequence of the market recognizing poor executive compensation contracting. The magnitude of this penalty is economically meaningful and should provide directors with the ex ante incentive to contract more efficiently with executives. Second, the Say-on-Pay rule may result in greater shareholder influence over executive compensation. However, this influence appears to be indirect, and depends on the consequences imposed on directors in the external labor market. Third, the external labor market appears to penalize directors in a sophisticated manner. That is, penalties are mainly imposed on directors when their firms receive low shareholder support due to excessively high executive compensation. This suggests that the market distinguishes between highly paid and overpaid managers.

The full paper is available for download here.