How Firms Use Director Networks in Setting CEO Pay

Published date01 August 2019
Date01 August 2019
The Financial Review 54 (2019) 501–540
How Firms Use Director Networks
in Setting CEO Pay
Ian Cherryand Vladimir A. Gatchev
University of Central Florida
We examine how firms use the network of overlapping directorships to determine chief
executiveofficer (CEO) compensation. We contribute to related work by empirically exploring
two competing hypotheses. In the first hypothesis, networks propagate relevant information
used to establish good pay practices. In the second hypothesis, director networks are used
opportunistically to benefit the CEO. The empirical findings are generally consistent with
the first hypothesis. Yet, the importance of director networks is reduced when the CEO is
entrenched and when management hires a compensation consultant. The latter finding is
especially pronounced when director networks predict a reduction in CEO pay.
Keywords: executive compensation, director networks, corporate governance
JEL Classifications: G34, G38, J33, M12
Corresponding author: College of Business Administration, University of Central Florida, Orlando, FL
32816-1400; Phone: (407) 823-2977; Fax: (407) 823-6676; E-mail:
The authors are grateful to the Editor Richard S. Warr and two anonymous referees, whose insightful
comments have greatly improved the paper.For comments and suggestions on an earlier draft, we would
like to also thank Vladimir Atanasov, Honghui Chen, Melissa Frye, Daniel Green, Charles Schnitzlein,
Stephan Shipe, Ajai Singh, Geoffrey Turnbull, Qinghai Wang, and seminar participants at the University
of Central Florida, Boise State University, Loyola Marymount University, University of South Florida,
the 2014 Florida Finance Conference, the 2014 Financial Management Association annual meetings, the
2015 Midwest Finance Association annual meetings, and the 2015 Southwestern Finance Association
annual meetings. We thank Lalitha Naveenfor making available the CEO delta and vega data. We remain
responsible for any errors.
C2019 The Eastern Finance Association 501
502 I. Cherry and V.A. Gatchev/ The Financial Review 54 (2019) 501–540
1. Introduction
The interaction of overlapping directors forms a social network of influence
through which various corporate policies propagate. Research has established the
importance of director networks for firm policies such as options backdating (Bizjak,
Lemmon and Whitby, 2009), earnings management (Chiu, Teoh and Tian, 2013),
various measures of corporate governance practices (Bouwman, 2011), tax avoidance
strategies (Brown and Drake, 2014), board compensation (Boivie,Bednar and Barker,
2015), and the composition of executive compensation and incentives(Wong, Gygax
and Wang, 2015; Gallani, 2016).
To provide new insights in the role played by director networks, this paper per-
forms a detailed empirical analysis of how the chief executive officer (CEO) pay in
one firm is related to the CEO pay in other firms sharing its directors, which we label
networked CEO pay. Our interest in CEO pay is, in part, motivated by the ongoing
debate about what drives executive compensation.1We explore two competing hy-
potheses. The first hypothesis is derived under the optimal contracting view, which
argues that the board determines CEO pay in the best interest of shareholders. Accord-
ing to this view, director networks propagate relevant information used to establish
good pay practices. The second hypothesis is derived under the view that the board is
largely under the control of the CEO, and CEOs use their influence to set their own
pay and extract rents (e.g., Bebchuk, Fried and Walker, 2002; Bebchuk and Fried,
2003, 2004). According to this view, director networks are used opportunistically for
the benefit of the CEO.
We examine how CEO pay depends on networked CEO pay. Controlling for
year and industry effects and for other relevant firm, CEO, and board characteristics,
we find that CEO pay increases by 5.4% for a one-standard-deviation increase in
networked CEO pay.We then test whether boards take into account the characteristics
of firms in the director network when propagating CEO pay practices. To that end,
we estimate a predictive model and decompose networked CEO pay into a predicted
component and a residual component. The predicted component is CEO pay predicted
by firm, CEO, and board characteristics, and the residual component is the residual
from the model. We find CEO pay is more sensitive to the residual component than
to the predicted component of networked CEO pay.Further analysis suggests that the
significance of the predicted component of networked CEO pay is due to latent firm
characteristics rather than an actual influence on CEO pay.
Toensure our findings are robust to endogeneity concerns, all analyses control for
the endogenous selection of directors to boards using a Heckman approach (Heckman,
1979). We further verify the importance of director networks while focusing on
directors with ongoing directorships at the firm of interest and new directorships at
1For a review of this extensive literature, see, for example, Frydman and Jenter (2010). A press paper
by Steven Clifford provides further anecdotal evidence on how companies decide to pay their CEOs:
I. Cherry and V.A. Gatchev/ The Financial Review 54 (2019) 501–540 503
other firms. In such cases, the appointment at new firms is not under the control
of the firm of interest and so endogeneity concerns should be mitigated. As another
approach to handle endogeneity, we confirmthat our findings are robust to geography
fixed effects, firm fixed effects, and CEO fixed effects.
The relevance of director networks is relatively stable over time, even though
the past 20 years have experienced significant changes in governance practices such
as the Sarbanes-Oxley Act (SOX) of 2002, the accompanying changes in NYSE and
NASDAQ-listing requirements for board independence, and the Dodd-Frank Wall
Street Reform and Consumer Protection Act of 2010 (Dodd-Frank). To examine
whether our findings capture a mechanical link due to broadly rising pay levels, we
estimate both the importance of direct links and indirect links between firms. A direct
link exists when two firms share a director, while an indirect link exists when two
firms do not share a director but have directors who jointly serve on the boards of
other firm(s). Direct links should provide astronger communications channel between
firms (Larcker, Richardson, Seary and Tuna,2005). Indeed, we find (1) indirect links
do not have a significant effect on CEO pay, and (2) the importance of direct links is
not diminished if we control for indirect links.
Further analyses produce several new findings, which contribute to the under-
standing of how firms use director networks to set CEO pay. First, we find CEO pay
responds significantly to residual networked CEO pay both when residual networked
CEO pay is negative (i.e., belowaverage) and when it is positive (i.e., above average).
In some specifications, the response to positive shocks is twice as large as that to
negativeshocks, but this difference is not statistically significant. Second, we find that
director networks have a more pronounced effect on CEO pay for firmswith stronger
corporate governance than for firms with weaker governance. Notably, the CEO pay
of firms with weaker governance is not sensitive to negative shocks in networked
CEO pay. Third, we explore how the use of compensation consultants changes the
role of director networks in determining CEO pay. We find that when management
hires consultants, CEO pay is sensitive to networked CEO pay only when networked
CEO pay is relatively high but not when it is relatively low, and that management is
more likely to hire a compensation consultant when networked CEO pay is relatively
A potential concern is that our findings may be affected by the use of compen-
sation peers.2While the benefits of using compensation peers are still debated, it is
widely accepted that peer groups are significant in explaining CEO pay practices.
Faulkender and Yang (2010), Bizjak, Lemmon and Nguyen (2011), and Elson and
Ferrere (2013) find that firms tend to select highly paid peers, creating a natural
2This concern is somewhat mitigated by findingsin Cremers and Grinstein (2014) that CEO talent markets
do not span across industry lines, so industry effects should capture some of the peer effects. Moreover,
due to antitrust laws (e.g., Section 8 of the Clayton Act), most directors who serve on multiple boards also
serve on boards across different industries, so director network effects should be largely independent of
industry peer effects.

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