Board Effectiveness and CEO Pay: Board Information Processing Capacity, Monitoring Complexity, and CEO Pay‐for‐Performance Sensitivity

• Author: Jeongil Seo
• DOI: http://doi.org/10.1002/hrm.21769
• Date: 01 May 2017
• Published date: 01 May 2017

Human Resource Management, May–June 2017, Vol. 56, No. 3. Pp. 373–388

© 2015 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).

DOI:10.1002/hrm.21769

Correspondence to: Jeongil Seo, Associate Professor, Sogang Business School, Sogang University, Sinsu-dong,

Mapo-gu, Seoul, 121-742 Korea, Phone: 82-2-705-7990, Fax: 82-2-705-8519, E-mail: jeongil@sogang.ac.kr.

BOARD EFFECTIVENESS AND

CEO PAY: BOARD INFORMATION

PROCESSING CAPACITY,

MONITORING COMPLEXITY,

ANDCEO PAY-FOR-PERFORMANCE

SENSITIVITY

JEONGIL SEO

We have developed an information processing theory of board effectiveness to

examine board-chief executive offi cers (CEOs) pay relations. We theorize that CEO

pay refl ects the information processing context of boards. Boards have limited

information processing capacity and therefore prefer to use outcome-based CEO

pay when they have diffi culty in processing information for monitoring their CEOs.

Using a longitudinal sample of Standard and Poor’s (S&P’s) large-, medium-, and

small-cap manufacturing fi rms in the United States from 1998 through 2005, we

found support for our theory. Large boards and boards in less complex monitor-

ing contexts tend to link CEO pay less tightly to fi rm performance by providing

less stock-based incentives, and the tendency of large boards to decrease out-

come-based CEO pay is even greater when boards are not busy or when boards

are in less complex monitoring contexts. ©2015Wiley Periodicals, Inc.

Keywords: board information processing capacity; board size; board busyness;

monitoring complexity; CEO pay-for-performance sensitivity

One of the main tenets in corporate gov-

ernance research drawing on agency

theory (Fama & Jensen, 1983) is that the

role of the board is to safeguard share-

holder interests, typically indicated by

high firm performance; yet the evidence linking

boards to firm performance is inconsistent and

ambiguous at best (for a review, see Finegold,

Benson, & Hecht, 2007). For example, Dalton and

colleagues conducted a series of meta-analyses. In

one study, Dalton, Daily, Ellstrand, and Johnson

(1998) found no direct relationship between

board features such as board composition or

board leadership structure, and financial profit-

ability. In another study, Dalton, Daily, Johnson,

and Ellstrand (1999) found a positive relation-

ship between board size and firm performance;

however, it may be overly simplistic to expect

firm performance to be a reflection of board char-

acteristics because boards only indirectly affect

374 HUMAN RESOURCE MANAGEMENT, MAY–JUNE 2017

Human Resource Management DOI: 10.1002/hrm

We adopt an

information

processing

perspective to

predict how board-

level information

processing capacity

will affect boards’

decisions about CEO

pay, particularly

decisions on how

tightly CEO pay

is linked to firm

performance.

outcome-based CEO incentive pay. That is, out-

come-based CEO pay has the potential to mitigate

agency problems between CEO and shareholders

by aligning CEO interests with shareholder inter-

ests. However, a growing body of research docu-

ments that outcome-based CEO pay has many

detrimental effects as well as beneficial effects

because outcome-based CEO pay may induce

undesirable behaviors (e.g., earnings manipula-

tion) from CEO or help grant excessive pay to

CEO (see Devers, Cannella, Reilly, & Yoder, 2007,

for a review). Thus, shareholders may have het-

erogeneous preferences for the use of outcome-

based CEO pay (Shin & Seo, 2011). Nonetheless,

prior research has assumed outcome-based CEO

incentive pay as the first-best solution to the

agency problems and argued that optimal level

of board monitoring of CEO behaviors should

be based on how effectively outcome-based CEO

pay is designed (Beatty & Zajac, 1994, p. 317).

Accordingly, these studies examined how the

use of outcome-based CEO pay affects the use of

board monitoring (Beatty & Zajac, 1994; Zajac

& Westphal, 1994). The possibilities that boards

may vary in their capacity to monitor and that

the boards’ varying degree of monitoring capac-

ity may affect their relative use of outcome-

based CEO pay have not been examined. Given

that governance scholars have long insisted that

cognitively limited directors cannot be effective

monitors (e.g., Fich & Shivdasani, 2006; Forbes

& Milliken, 1999; Main, O’Reilly, & Wade, 1995)

it is surprising that the board-CEO pay relation-

ship has not been examined from the informa-

tion processing perspective. Our study intends to

make an important contribution to both board

research and CEO pay research by resolving the

ambiguity about the relationship between board

and CEO pay (Core, Holthausen, & Larcker, 1999).

Our information processing theory proposes

that better understanding of the board-CEO pay

relationship can be achieved when we examine

board effectiveness from an integrated agency/

information processing perspective.

Theory and Hypotheses

Information processing theory posits that organi-

zations are more effective when they match their

information processing capacity to the informa-

tion processing demands of their environment

(Tushman & Nadler, 1978). While prior research

has viewed CEO pay from an information process-

ing perspective (e.g., Henderson & Fredrickson,

1996; Sanders & Carpenter, 1998), board effective-

ness in CEO pay has not been examined through

this lens. Moreover, prior research has not consid-

ered board information processing capacity as a

firm actions through the incentive and monitor-

ing they provide to their chief executive officer

(CEO). Thus, one critical role played by boards is

in the setting and administering of CEO compen-

sation. Specifically, the board is responsible, by

review and ratification of its compensation com-

mittee’s recommendations, for how well or poorly

CEO pay is tied to firm performance.

Prior research on the role of boards in CEO

pay, drawing on agency theory, has viewed CEO

pay as an outcome of the sociopolitical process

between CEOs and boards. Accordingly, prior

studies have focused on the independence of

boards from their CEOs, suggesting that inde-

pendent boards will be most effective in tightly

linking CEO pay to firm performance (Bebchuk &

Fried, 2004). Research, however, has

failed to identify a meaningful rela-

tionship between CEO pay and firm

performance and boards are not

considered effective in using CEO

pay as a primary device to mitigate

agency problems between CEOs and

shareholders (Barkema & Gomez-

Mejia, 1998; Devers, Cannella,

Reilly, & Yoder, 2007; Finkelstein,

Hambrick, & Cannella, 2009; Jensen

& Murphy, 1990; Tosi, Werner, Katz,

& Gomez-Mejia, 2000).

This study goes beyond the

board independence theme and

suggests another condition under

which boards may show varying

degrees of effectiveness in using

CEO pay to ensure that CEOs

behave in the best interests of share-

holders. Specifically, we adopt an

information processing perspective

to predict how board-level informa-

tion processing capacity will affect

boards’ decisions about CEO pay,

particularly decisions on how tightly

CEO pay is linked to firm performance. According

to agency theory, more independent boards will

link CEO pay more tightly to firm performance

than less independent boards will (Mizruchi,

1983; Fama & Jensen, 1983; Jensen, 1993); how-

ever, board-CEO pay relationship is more com-

plicated than agency theory predicts. That is, the

sensitivity of CEO pay to firm performance may

reflect other aspects of board effectiveness than its

independence.

Boards can use both incentive mechanisms

(i.e., outcome-based controls) and monitor-

ing mechanisms (i.e., behavior-based controls)

to control CEO behaviors. Research based on

agency theory points to the beneficial aspects of