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E-MailLily Fang is a Professor of Finance at INSEAD and Sterling Huang is an Associate Professor of Accounting at Singapore Management University. This post is based on their recent article forthcoming in the Journal of Financial Economics.
Despite an extensive literature on CEO and executive compensation spurred by public concerns about corporate governance and excess compensation, director compensation has received limited research attention. One reason could be that for decades before the 1990s, director compensation showed little variation over time and across firms, predominantly comprising a fixed retainer with additional fees allocated for specific roles on board committees (Yermack, 2004). The staid nature of director compensation prompted Fama and Jensen (1983) to suggest that the primary incentive for outside directors stemmed from their intent to cultivate a reputation as judicious decision makers. They further argued that such reputational signals would bear credibility when “the direct payments to outside directors are small, but there is a substantial devaluation of human capital when internal decision control breaks down….” (p. 315).
However, director compensation has undergone significant shifts over the past two decades. Notably, the average total compensation for directors at U.S.-listed entities surged from $133,930 in 2000 to $342,030 in 2020, surpassing both inflation rates and the growth in CEO compensation. Considering that outside directorship is not a full-time role and many directors serve on multiple boards, such compensation levels are high both in relative and absolute terms. Furthermore, equity-linked compensation (options and restricted stocks) has emerged as the dominant component of the compensation package, accounting for about 66% in our sample. We observe a notable shift from options to restricted stock units. By 2020, option compensation is just 6% of the equity component, down from 62% in 2000. Meanwhile, directors’ cash salaries rise by 217% from $29,440 in 2000 to $93,370 in 2020, with significant growth observed between 2003 and 2007, a period marked by increased regulatory demands and heightened compliance costs (Adams and Ferreira, 2008). This shift suggests that contemporary director compensation packages offer tangible and substantial financial incentives, challenging Fama and Jensen’s (1983) propositions based on compensation practices of an earlier era. Given the pivotal role boards of directors play in corporate governance, the implications of their compensation structure extend to broader corporate governance considerations.
From a governance perspective, the setting of directors’ compensation is unique. Per Section 8.11 of the Model Business Corporation Act, the board of directors holds the authority to determine their own compensation unless otherwise specified in the articles of incorporation. This stipulation potentially paves the way for “director self-dealing,” where directors might award substantial compensation to themselves, irrespective of company performance. Equally noteworthy is that the same board sets the compensation structure for CEOs and other executives. Thus, apprehensions associated with excessive CEO or executive compensation should inherently extend to director compensation.
We argue and document that in the context of self-dealing, legal standards function as an effective governance mechanism for director remuneration. Generally, two legal standards apply to decisions made by corporate directors in the event of shareholder litigation: the “business judgment” standard and the “entire fairness” standard. The business judgment standard is more director-friendly and shelters director decisions from ex-post litigation risk based on the presumption that they have exercised reasonable business judgment. However, safe harbor granted by the business judgment standard does not automatically extend to self-dealing transactions, such as director compensation. Board decisions regarding directors’ own compensation inherently involve self-dealing because a director who receives a financial benefit from the transaction stands on both sides of the transaction (i.e., setting and receiving the compensation). As a result, board members could bear the burden of proving that the compensation they pay themselves is “entirely fair” to the company. This entire fairness standard imposes a tougher burden of proof in that directors must establish fair dealing and fair price when transactions are challenged in court.
Before 2012, director compensation was generally exempt from the entire fairness standard as long as the compensation plan had been ratified by shareholder vote, a legal argument known as the “shareholder ratification defense.” However, in a surprise landmark ruling in Seinfeld v. Slager (2012), the Delaware Court of Chancery defied legal tradition by ruling that the shareholder-approved director compensation plan of the plaintiff (Republic Service Inc.) was subject to the entire fairness standard due to the absence of meaningful compensation limits imposed in stockholder-approved plans.
Exploiting this ruling and using a difference-in-differences framework, we find that relative to firms incorporated elsewhere, Delaware-incorporated firms significantly reduce compensation to their directors after the ruling. Directors of Delaware-incorporated firms that previously awarded higher-than-average compensation before the ruling exhibit larger-than-average reductions in compensation after the ruling. These changes are accompanied by positive, non-transient stock market reactions. Collectively, our evidence indicates that legal frameworks function as governance mechanisms for self-dealing transactions, such as director compensation, and that proper governance of director compensation is value-enhancing.
The full paper is available for download here.
