Independent director compensation, corruption, and monitoring

• Author: John K. Wald,Natasha Burns,Anna Kapalczynski
• DOI: http://doi.org/10.1111/fire.12232
• Date: 01 February 2021
• Published date: 01 February 2021

DOI: 10.1111/fire.12232

ORIGINAL ARTICLE

Independent director compensation, corruption,

and monitoring

Natasha Burns1Anna Kapalczynski2John K. Wald1

1Department of Finance, University of Texasat

San Antonio, San Antonio, Texas,USA

2School of Business and Leadership,University of

Puget Sound, Tacoma,Washington, USA

Correspondence

JohnK. Wald, Department of Finance, UTSA, One

UTSACircle, San Antonio, TX 78249, USA.

Email:john.wald@utsa.edu

Abstract

We find that independent directors in more corrupt countries

receive greater pay. This relation could reflect outside directors

in corrupt countries expropriating firm value, or it could reflect

higher compensation for the additional effort required to lessen the

negative effects of corruption. Acquirer acquisition announcement

returns are lower in more corrupt countries, and this relation is miti-

gated by higher director pay. Higher director pay is also associated

with greater sensitivity of CEO turnover to firm performance and

moderates the negative effects of country-level corruption on firm

value. This evidence is consistent with higher director pay in corrupt

countries incentivizing effort.

KEYWORDS

Compensation, corporate governance,corruption, director

JEL CLASSIFICATION

G34

1INTRODUCTION

Opportunities to self-deal and incentives to monitor vary with the institutional environment. Corruption, along with

laws and institutions regarding minority shareholder protection and transparency,is an important element of this envi-

ronment. For example, Svensson (2005) states that corruption is “areflection of a country’s legal, economic, cultural

and political institutions,” while Becker and Stigler (1974) describe that corruption is an “extreme manifestation of

apparently poor enforcement.” We consider corruption as an important measure of the quality of institutions and cul-

ture which can result in a need for more monitoring by independent directors.1

The responsibilities of directors include advising as well as monitoring managers in order to mitigate the problems

associated with the separation of ownership and control, and directors are compensated for these efforts. Beckerand

1One outcome of corruption is tunneling, that is, the expropriationor theft of firms’ resources by insiders (Shleifer & Vishny, 1997). The tunneling literature

largely follows fromthe w orkof Johnson, La Porta,Lopez-de-Silanes, and Shleifer (2000). Mironov and Zhuravskaya (2016) use Transparency International’s

corruption index to show that more tunneling occurs in more corrupt jurisdictions, and that this results in inefficient allocation of procurement contracts.

Additionally,Atanasov, Black, Ciccotello, and Gyoshev (2010) show that legal rules can help mitigate tunneling.

Financial Review.2021;56:5–28. wileyonlinelibrary.com/journal/fire c

2020 The Eastern Finance Association 5

6BURNS ET AL.

Stigler (1974) provide a model in which higher pay for monitors mitigates some of the negative effects of corruption.

Alternatively, Bebchuck and Fried (2003) argue that high compensation can reflect agency problems and can be a

means of expropriation. Given this background, we consider how director compensation is related to corruption and

other measures of the legal environment. We focus on independent directors because they havebeen shown to have

an important monitoring role.2In particular, we examine whether director payin countries with higher corruption is

better explained by directorsexpropriating value or by directors expending greater effort to monitor so as to mitigate

the negative effects of corruption.

We first explore the relation between independent director compensation and the institutional environmentusing

data on 10,510 firms from 27 countries. Corruption reflects various country institutions, and we primarily focus on

corruption while controlling for other country institutions. Our primary measure of institutional corruption is the cor-

ruption indexfrom the World Bank. The other measures of the institutional environment include an anti-director rights

index (La Porta, Lopez-de-Silanes, Shleifer, & Vishny, 1998; Spamann, 2010), an index of director liability (La Porta,

Lopez-de-Silanes, & Shleifer, 2006), a measure of accounting disclosure requirements (Bushman, Piotroski, & Smith,

2004), whether employees participate on the board (OECD,2004), and whether the firm is cross-listed (Coffee, 1999;

Stulz, 1999). Importantly,we find a strong positive relation between corruption and independent director compensa-

tion even when controlling for other institutional characteristics. A one standard deviation increase in corruption is

associated with an economically significant 38% increase in the median-independent director’s pay. In comparison, a

one standard deviation increase in firm size leads to a 71% increase in compensation. This finding is consistent with

either directors receiving greater pay for monitoring effort, or with directors extracting rents in the form of higher

compensation in more corrupt countries. In this latter case, higher director would pay primarily reflect self-dealing

(Bebchuck & Fried, 2003).

With respect to the other institutional measures, we find that director compensation is not related to anti-director

rights in the full sample of countries. Director liability and disclosure are positively associated with director pay in

developedcounties, but not in emerging countries. These findings are consistent with liability and disclosure laws being

applied more effectively in developed countries, and this leads to more effort from directors and higher director com-

pensation. In addition to these country level characteristics, we examineemployee board participation and find that it

is negatively associated with director pay,suggesting that perceptions of fairness from working closely with lower paid

employees affects the payof directors (Akerlof & Yellen, 1990).

To test whether the relation between director pay and corruption is better explainedby efficiently incentivizing

directors for effort or whether it is better explained as a form of expropriation, we explorethree contexts frequently

considered by researchers as evidence of monitoring—performance around acquisitions, CEO turnover-performance

sensitivity,and firm value. As described by Masulis, Wang, and Xie (2007) and Chen, Harford, and Li (2007), acquirer’s

returns provide a potential test of effective monitoring. If directors’ pay primarily reflects monitoring as opposed to

self-dealing, then we expect CEO turnoverto be more strongly related to poor performance when director pay is high.

If higher director pay is a form of self-dealing, then we expecthigh director pay to be associated with lower firm value.

Wefirst analyze how corruption and independent director compensation are associated with acquisition announce-

ment returns. Our results show that acquirer returns around the announcement of an acquisition are lower for firms

in more corrupt countries. Higher director pay is also, on average,associated with lower acquisition returns, but higher

director pay mitigates the negative effects of corruption. This finding is not consistent with greater director pay pri-

marily reflecting self-dealing, but it is consistent with greater compensation to independent directors for providing

better monitoring in more corrupt jurisdictions.

Second, we examinethe relation between director compensation and CEO turnover.Empirically, our results show a

significantly stronger association between CEO turnover and performance when director compensation is higher.This

result is consistent with higher director payreflecting compensation for better monitoring, which requires more effort.

This result is also consistent with the predictions of the relative power model of Hermalin and Weisbach (1998) which

2See,for instance, Hermalin and Weisbach (2003) and Guo and Masulis (2015), or Adams (2017) for a review of the literature.