The Corporate Demand for External Connectivity: Pricing Boardroom Social Capital

David Javakhadze is Assistant Professor of Finance at Florida Atlantic University. This post is based on a recent paper by Professor Javakhadze; Stephen P. Ferris, Professor and Director of the Financial Research Institute at the University of Missouri at Columbia; and Yun Liu, Assistant Professor of Finance at the Claremont Colleges’ Keck Graduate Institute.

While there has been considerable public focus and academic research on executive compensation, boardroom compensation has received relatively little attention. Boards perform increasingly crucial functions of advising and monitoring the executive team. Consequently, boardroom performance has important implications for corporate decisions. As a result of the 2008 financial crisis boardroom functioning, including director expertise, oversight practices, compensation, and board structure, has been under careful scrutiny by shareholders as well as by regulators, requiring directors to be more actively involved in strategic decision-making.

Boards set their own pay based on compensation plans approved by shareholders. Overall, boardroom pay has shifted away from paying directors like executives. Outside directors may receive an annual retainer, meeting fees, committee fees, and equity awards. Recent empirical evidence shows that the median director total compensation almost tripled over the last two decades. Determining appropriate outside (non-employee) director compensation is not a simple task. On the one hand, directors should be paid reasonable compensation necessary to attract high-quality candidates. On the other hand, boardroom compensation amounts should not impair director independence and potentially cause self-dealing. Consequently, understanding the determinants of boardroom pay is an important research question.

Scarce prior research looks at director qualifications, experience, and efforts as the major determinants of boardroom pay. We propose that a previously unexamined factor, boardroom social capital, defined as aggregate benefits derived from social obligations and informal contacts formed through social networks, is an important determinant of boardroom compensation practices. Although the boardroom talent search is competitive, in an efficient contracting framework, boards are worth what they are paid. Consequently, we expect to observe a relation between the quality of boardroom functioning and its compensation. We postulate that boardroom social capital plays a key role in the monitoring and advising abilities of the board and thus it should have implications for compensation practices.

The theoretical foundation of our main conjecture that board social capital is valued builds upon agency, resource-dependency, and social network theories. From an agency perspective, we propose that well-connected boards should be better monitors because these directors have greater reputational capital at stake. In addition, management would have less influence over well-connected boards because such directors would have a greater opportunity set for re-employment, even after a forced departure, due to their large social networks. Consistent with the resource-dependency theory, well-connected boards are better advisors because they are more “resource-rich,” having access to crucial information and other resources necessary for optimal decision-making. Finally, from a networks perspective, recent research explicitly shows that firms on average experience a net benefit from having a relatively well-connected board, and boardroom connectedness leads to better future firm performance. The logical next step would be to propose that these benefits should be priced in board compensation.

Next, some firms are more willing to pay more for socially connected boards than others because their need for such connectivity is greater. That is, shareholders might value specific connections of their boards, such as connections with large firms or within industry. In addition, the pay-for-connection premium could be higher for firms most likely to benefit from external connectivity, such as firms with important growth potential, need for external financing, aggravated agency costs of free cash, or suffering from adverse events. In addition, board leaders, such as the lead directors or committee chairs, typically receive additional compensation for their more significant and laborious roles. Well-connected directors are intrinsically motivated to be diligent because of the aggravated cost of reputation loss due to greater social capital. Thus, these directors are likely to provide better monitoring and advising services which could be reflected in their holding more leadership roles on a board as well as sitting on a greater number of boards.

Our empirical findings demonstrate that boardroom social capital matters. That is, on average, a one standard deviation increase in boardroom social capital increases overall board compensation by about 57%, which in dollar value terms is more than a $380,000 increase in total compensation. This association between boardroom connectedness and compensation is stronger for specific “important” connections. Specifically, within-industry boardroom social capital as well as social connections with large firms are the most valuable. In addition, firms isolated from their industry peers pay a premium for well-connected boards. The pay-for-connection premium is also increased when potential agency problems from free cash flow are more severe. Social capital effects are more pronounced for firms with a high growth option and need for external financing. Finally, firms that have suffered adverse events, such as bad mergers, performance declines, or dividend cuts, are in greater need of more well-connected boards to help re-establish their business and repair their credibility. Hence, these firms pay a premium for well-connected boards. A potential issue with our empirical evidence is that the results could be driven by endogeneity. We have deployed a battery of tests to address it. Our results of examining the moderating effects of various firm-level financial and network variables are consistent with the a priori predictions alleviating the concern that the main findings are driven by omitted variables. In addition, we address director skill concern directly by controlling the skill level of directors using an experience index as well as using university fixed effects. We also apply an instrumental variable estimation method using a number of instruments, including death of network ties. Our results are invariant to these various controls for endogeneity suggesting robust association between social capital and boardroom compensation.

The complete paper is available for download here.

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