Board Independence, CEO Ownership, and Compensation

• Author: Kose John,Hae Jin Chung
• Date: 01 August 2017
• DOI: http://doi.org/10.1111/ajfs.12179
• Published date: 01 August 2017

Board Independence, CEO Ownership, and

Compensation*

Hae Jin Chung**

Korea Advanced Institute of Science and Technology, Republic of Korea

Kose John

New York University and Temple University, United States

Received 3 August 2016; Accepted 28 March 2017

Abstract

Using the percentage of outside directors as a proxy for board monitoring, we find empiri-

cal evidence that board monitoring and CEO pay–performance sensitivity (PPS) are substi-

tutes. In 2002, major US exchanges began to require that the boards of listed firms have

more than 50% outside directors. In the case of firms affected by this requirement, their

CEO PPS decreased significantly because of a reduction of CEO ownership relative to the

control group, especially in the case of firms in which outside directors are better

informed. We find that this substitution in governance mechanisms did not change overall

firm value.

Keywords Board independence; Board regulation; Corporate governance; Managerial com-

pensation; Managerial ownership

JEL Classification: G34, G38, K22

*We thank Jennifer N. Carpenter, Jaewon Choi, Andre de Souza, Ran Duchin, Koren Jo,

Jihay Ellie Kwack, Craig M. Lewis, Sadi Ozelge, Enrichetta Ravina, Anjolein Schmeits, Rik

Sen, Lemma Senbet, Rene Stulz, Daniel Wolfenzon, David Yermack, and seminar participants

at the 2008 FMA Doctoral Consortium, the 2009 FMA Meetings, Korea Advanced Institute

of Science and Technology, Nanyang Technological University, New York University, Seoul

National University, Sungkyunkwan University, University of Amsterdam, Vrije University

Amsterdam for helpful comments. We thank Induck Hwang for excellent data collection and

research assistance. This is a revised version of a paper previously circulated as “Board Inde-

pendence and CEO Incentives.”

**Corresponding author: Hae Jin Chung, Korea Advanced Institute of Science and Technol-

ogy (KAIST), College of Business, 85 Hoegiro Dongdaemoon-Gu, Seoul 02455, Korea. Tel:

+82-2-958-3625, Fax: +82-2-958-3620, email: hjchung@business.kaist.ac.kr.

Asia-Pacific Journal of Financial Studies (2017) 46, 558–582 doi:10.1111/ajfs.12179

558 ©2017 Korean Securities Association

1. Introduction

An efficient contracting view of the firm suggests that firms choose an optimal mix of

corporate governance mechanisms that align managers’ interests with shareholders’

interests so that a manager maximizes firm value. One way of achieving this goal is by

monitoring, and shareholders delegate the monitoring role to the corporate board. Cor-

porate boards give advice regarding important corporate strategies like mergers and

acquisitions, auditing financial statements, setting pay for executives, and even deciding

whether to fire a CEO. Therefore, a main focus of corporate governance reforms has

been constructing boards with greater outsider representation as the reformers believe

this would enhance the monitoring function of boards. There is empirical evidence sup-

porting that boards with greater outsider representation do indeed have better moni-

toring and that this increases firm value (see, e.g., Weisbach,1988).

Another way of aligning top executives and shareholders is by increasing pay–per-

formance sensitivity (PPS). PPS, though defined in various ways empirically, is a mea-

sure of the degree of alignment of shareholder wealth change and CEO wealth change.

It provides monetary incentives to CEOs to act on behalf of shareholders. Firms do

not suffer from an agency problem if the CEO owns 100% of the firm or, equivalently,

if his PPS is one (Jensen and Meckling, 1976). Without any monitoring, a CEO will

choose an action that maximizes the firm’s value for his own interest. In modern cor-

porations in which ownership and management are separated, CEO compensation

contracts, especially stock and option grants, are designed to supplement the low own-

ership of CEOs by boosting the PPS of CEOs. Since Jensen and Murphy (1990) ques-

tioned the low PPS of US CEOs, the higher PPS of CEOs has been another measure of

good corporate governance (Yermack, 1996; Hartzell and Starks, 2003).

This paper investigates whether two representative internal governance mecha-

nisms, board independence and CEO incentives, are substitutes or complements

using an exogenous shock on the board independence.

1

Empirically, the negative

relationship between the two has been documented in the cross-section. However,

most of the studies investigated an alternative hypothesis arguing reverse causality

that CEO ownership determines board independence (Boone et al., 2007; Linck

et al., 2008) or common factors that determine a firm’s simultaneous choice of the

CEO PPS and board independence (Cai et al., 2015).

We use the adoption of the majority board independence requirement by major

exchanges in the United States in 2002 as a natural experiment to investigate how

exogenous shocks to board independence affected CEO incentives. Following a differ-

ence-in-differences approach, this paper finds a decrease in CEO PPS as a

1

An exogenous shock on board structure may influence other monitoring mechanisms such

as monitoring by debt holders, institutional holdings, large outside shareholders, or prospec-

tive acquirers, and PPS could be indirectly affected by a change in these other monitoring

mechanisms. We control for CEO–firm fixed effects and year effects, but the interaction

among a general set of governance mechanisms is beyond the scope of this paper. See Agra-

wal and Knoeber (1996) for the relationship among governance mechanisms.

Board, CEO Ownership, Compensation

©2017 Korean Securities Association 559