Paying by Donating: Corporate Donations Affiliated with Independent Directors

The monitoring role of independent directors on corporate boards has long been a topic of interest in the corporate governance literature. Stock-exchange rules establishing directors’ independence are typically based on transaction-based financial ties, and most empirical research classifies independent directors according to this limited assessment. However, independent directors may have other ties to top executives that interfere with their exercise of independent judgment in carrying out director responsibilities.

In our forthcoming paper in the Review of Financial Studies, Paying by Donating: Corporate Donations Affiliated with Independent Directors, we investigate a new determinant of director independence: material relationships between independent directors and top executives via corporate charitable contributions to tax-exempt organizations affiliated with independent directors (affiliated donations). Corporate donations help fulfill directors’ fundraising obligations at their affiliated charities, creating a potential conflict of interest that increases directors’ disutility in carrying out monitoring responsibilities. Because corporate charitable contributions are rarely disclosed in companies’ filings with the Securities and Exchange Commission (SEC), they have been largely overlooked in corporate governance research until very recently.

In this study, we test whether CEOs gain leverage over independent directors by channeling corporate donations to directors’ affiliated charities. We examine the determinants of affiliated donations and their effect on board monitoring. We find that firms with weaker board oversight and shareholder monitoring are more likely to make affiliated donations, and such donations are larger. Moreover, long-tenured directors and directors affiliated with more charities are more likely to receive corporate donations. Interestingly, affiliated donations typically begin after an independent director’s appointment to the board that connects the firm and the charity, and they end after his or her exogenous departure that severs the connection. This indicates that affiliated donations target independent directors rather than particular charitable causes.

To examine the effects of affiliated donations, we focus primarily on CEO compensation practices; we also study CEO replacement decisions and firm performance. Greater CEO compensation and retention of a poorly performing CEO are often signs of governance failures. We find that firms making affiliated donations pay their CEOs 9.4% more on average than firms not making affiliated donations, after controlling for common determinants of CEO compensation. To identify the channel by which affiliated donations affect CEO compensation, we contrast donations made to charities affiliated with independent directors serving on the compensation committee with donations made to charities involving other independent directors. We show that the positive association between affiliated donations and the level of CEO compensation is significant only when affiliated donations involve compensation committee members. On average, at firms that donate to charities affiliated with the compensation committee chair, CEO compensation is 15.6% higher than it is at firms that do not make affiliated donations.

Endogeneity is an important concern in studies on corporate governance. One potential problem is that the positive association between affiliated donations and CEO compensation may be driven by omitted variables beyond the firm, CEO, and governance characteristics included in our analyses. We conduct a battery of tests to address such concerns: examining changes in CEO compensation around the initiation and termination of affiliated donations; including firm fixed effects, firm-by-CEO fixed effects, and director fixed effects in the analysis; and using the propensity score matching (PSM) approach. We further control for alternative channels such as unaffiliated donations, CEO-affiliated donations, inside director–affiliated donations, CEO-director ties at affiliated charities, and free cash flow. The positive correlation between affiliated donations and CEO compensation continues to hold in all the tests.

Because it is impossible to exhaust all omitted variables that may drive the positive correlation between affiliated donations and CEO compensation, we construct an instrumental variable based on an exogenous shock to the demand for affiliated donations. More specifically, we identify forced turnovers of college basketball and football head coaches. We focus on these events because over 40% of affiliated donations go to educational institutions, and forced turnovers of head coaches are very common. Firing a coach for poor performance and revamping the team can cost millions of dollars (see, for example, Texas A&M football). Head coach terminations tend to happen after a prolonged period of poor performance, when advertisement revenue and alumni donations are below expectations. Under pressure to fundraise, independent directors who are affiliated with the universities greatly appreciate CEOs’ understanding and corporate contributions at these critical moments, and this appreciation may weaken their monitoring incentive. Importantly, college coach replacement is unlikely to be related to CEO compensation. It affects CEO compensation only via a firm’s decision to make affiliated donations in response to the increased demand for funding. Our instrumental variable regression shows that CEO compensation increases with affiliated donations predicted by forced turnovers of college coaches. This result helps us establish a causal effect of affiliated donations on CEO compensation.

In addition to their effect on CEO compensation, we examine how affiliated donations affect CEO replacement decisions, another important monitoring task performed by boards. Poor firm performance is often used as a proxy for low CEO ability. Retaining a low-ability CEO can be costly to shareholders. We show that affiliated donations attenuate the link between forced CEO turnover and firm performance: a CEO is unlikely to be replaced for poor performance if the firm donates to charities affiliated with a large fraction of the board or if the firm makes large affiliated donations. Lastly, if affiliated donations weaken board monitoring effectiveness, we expect firm performance and shareholder value to be negatively affected. We test this prediction using various measures of stock and accounting performance and show that this is indeed the case.

Our research shows that affiliated donations weaken independent directors’ monitoring incentives at the expense of taxpayers and shareholders. We suggest that regulators should mandate disclosure of affiliated donations in SEC filings (e.g., in firms’ proxy statements) that are easily accessible to investors. Such disclosure would help inform shareholders of independent directors’ potential conflicts of interest, leading to a more accurate definition of director independence.

The complete paper is available here.