Public Thrift, Private Perks: Signaling Board Independence with Executive Pay

• DOI: http://doi.org/10.1111/jofi.12989
• Published date: 01 April 2021
• Date: 01 April 2021

THE JOURNAL OF FINANCE •VOL. LXXVI, NO. 2 •APRIL 2021

Public Thrift, Private Perks: Signaling Board

Independence with Executive Pay

PABLO RUIZ-VERDÚ and RAVI SINGH∗

ABSTRACT

We analyze how boards’ reputational concerns inf‌luence executive compensation and

the use of hidden pay. Independent boards reduce disclosed pay to signal their in-

dependence, but are more likely than manager-friendly boards to use hidden pay

or to distort incentive contracts. Stronger reputational pressures lead to lower dis-

closed pay, weaker managerial incentives, and higher hidden pay, whereas greater

transparency of executive compensation has the opposite effects. Although reputa-

tional concerns can induce boards to choose compensation contracts more favorable to

shareholders, we show that there is a threshold beyond which stronger reputational

concerns harm shareholders. Similarly,excessive pay transparency can harm share-

holders.

BOARDS OF DIRECTORS SET CEO pay. Understanding how directors’ incen-

tives affect compensation contracts is therefore essential for understanding

executive pay. In this paper, we model CEO pay explicitly as a board deci-

sion determined by the extent of director independence and by directors’ rep-

utational concerns. We show that a key consequence of directors’ reputational

concerns is the use of camouf‌laged or hidden forms of pay, which are otherwise

diff‌icult to rationalize in optimal contracting models.1

∗Pablo Ruiz-Verdú is with the Department of Business Administration, Universidad Carlos III

de Madrid. Ravi Singh is with Higher Moment Capital, LP. A previous version of this paper was

circulated under the title “Board Independence, CEO Pay, and Camouf‌laged Compensation.” The

authors are grateful to Philip Bond (the Editor), an anonymous Associate Editor, and two anony-

mous referees for their valuable feedback and suggestions. Pablo Ruiz-Verdú acknowledges the

f‌inancial support of Spain’s Ministry of Science, Innovation and Universities, the State Research

Agency, and FEDER (through grant PGC2018-097187-B-I00), Madrid’s Autonomous Community

(through grant EARLYFIN-CM, #S2015/HUM-3353), and Spain’s Ministry of Economy and Com-

petitiveness (through grant ECO2015-69615-R). We have read The Journal of Finance disclosure

policy and have no conf‌licts of interest to disclose.

Correspondence: Pablo Ruiz-Verdú, Universidad Carlos III de Madrid, Department of Business

Administration, Calle Madrid, 126, Getafe 28903, Madrid, Spain; e-mail: pablo.ruiz@uc3m.es

1Indeed, recent reviews of the literature on CEO compensation argue that “the widespread

use of ‘stealth’ compensation is diff‌icult to explain if compensation were simply the eff‌icient out-

come of an optimal contract” (Frydman and Jenter (2010, p. 91)), and that “The use of ‘stealth’

compensation is a challenge for the shareholder value view” (Edmans, Gabaix, and Jenter (2017,

p. 468).

DOI: 10.1111/jof‌i.12989

© 2020 the American Finance Association

845

846 The Journal of Finance®

In our model, directors account for the effect of their compensation decisions

on their reputation for independence. Boards signal their independence to in-

vestors by reducing the level of compensation that is disclosed to investors.

However, boards offset part of this reduction by compensating CEOs in cam-

ouf‌laged ways. Moreover, while the reduction in disclosed pay in and of itself

is benef‌icial to shareholders, this signaling is potentially ineff‌icient because

the reduction in CEO pay can lead to suboptimal managerial incentives and

because hidden pay is more costly to the f‌irm than disclosed pay (i.e., hid-

den forms of pay result in a deadweight loss). A key result is that indepen-

dent boards are more likely to distort incentives and use hidden pay than are

manager-friendly boards. Our analysis thus explains the use of hidden forms of

pay as a by-product of independent boards’ effort to signal their independence

to investors.

Reputational concerns are widely regarded as a key determinant of direc-

tor incentives and play a central role in our analysis.2In our model, repu-

tational concerns arise because we assume that shareholders do not observe

directors’ true independence from management and must infer the degree of

independence from directors’ actions. Of course, shareholders observe formal

measures of director independence (such as, e.g., whether a director is a former

employee of the f‌irm). However, shareholders may be unaware of undisclosed

ties between directors and the f‌irm or the CEO, or of other attributes, such as

personality traits that inf‌luence the willingness of a director to confront the

CEO.3

Compensation decisions are a particularly important indicator of director

independence as there is a clear conf‌lict between shareholder and manage-

ment interests when it comes to the appropriate level of executive pay. Indeed,

compensation decisions are commonly viewed as the “acid test” of corporate

governance.4It is for this reason that we focus on the signaling role of compen-

sation decisions.

In addition to the pay that is disclosed to shareholders, we assume that the

board can pay the manager in hidden ways. We further assume that hiding

compensation is costly for two reasons. First, resources are diverted to camou-

f‌lage pay. Second, the value to the manager of hidden forms of compensation

2The optimal contracting view of executive compensation builds on the implicit assumption

that directors’ reputational concerns align their incentives with those of shareholders (see, e.g.,

Fama a nd Je nse n (1983)), so that boards choose compensation contracts that maximize share-

holder value. At the other extreme, the rent extraction view of executive compensation holds that

reputational concerns induce directors to camouf‌lage managerial rent extraction (Bertrand and

Mullainathan (2000), Bebchuk and Fried (2004)).

3The NYSE’s Listed Company Manual states that “It is not possible to anticipate, or explicitly

to provide for, all circumstances that might signal potential conf‌licts of interest, or that might

bear on the materiality of a director’s relationship to a listed company.” (NYSE (2010), section

303.A.02). In fact, the NYSE considers satisfying the NYSE independence tests a necessary but

not suff‌icient condition for independence. See Lochner (2009) for a discussion of the limitations of

formal independence tests.

4Warren Buffett, Chairman and CEO of Berkshire Hathaway, famously described executive

compensation as the acid test of corporate governance (see, e.g., Buffet (2002)).

Public Thrift, Private Perks 847

is likely to be lower than their cost to the f‌irm. For example, a manager is

likely to prefer 100,000 dollars in cash over a perk that costs 100,000 dollars

to the f‌irm.

Our motivation for incorporating hidden pay into the model is the preva-

lence of camouf‌laged forms of executive pay such as perks that are diff‌icult

to observe, projects that yield private benef‌its for managers, poorly disclosed

pension plans, backdated options, strategically timed option grants, or manipu-

lated performance measures. The fact that boards appear to hide pay suggests

that they care about the information that their compensation decisions con-

vey to shareholders. The reputational concerns of directors are thus likely the

primary motivation for boards adopting hidden forms of pay, as in our model.

As outlined above, the model yields several novel results. We show that inde-

pendent boards signal their independence to investors by reducing CEO pay.

Lower CEO pay is a credible signal of director independence because reduc-

ing CEO pay has a greater private cost for manager-friendly boards. There-

fore, the benef‌it to shareholders of directors’ reputational concerns is that they

generally lead to lower managerial pay. However, reputational concerns also

have a dark side: independent boards may compensate the manager in costly

undisclosed ways to make up for the reduction in disclosed pay that is neces-

sary to signal their independence. In addition, reputational concerns can lead

independent boards to choose ineff‌iciently structured incentive compensation

contracts. In particular, when reducing the CEO’s base pay is not suff‌icient to

signal independence, independent boards may also reduce incentive pay, lead-

ing to weaker managerial incentives.5

Although the use of hidden pay or ineff‌icient compensation structures is of-

ten attributed to a lack of independence, we show that independent boards are

more likely than manager-friendly boards to engage in these practices. Hid-

den pay or other ineff‌icient compensation structures are not a vehicle used by

manager-friendly boards to deceive shareholders, but rather are a consequence

of independent boards attempting to signal their independence to investors.

Thus, the model suggests that caution is due when interpreting the compensa-

tion structures of boards perceived to be independent as def‌ining standards of

good practice.

Another key result of the paper is that the availability of hidden pay ex-

acerbates the effects of reputational concerns by making it less costly for

manager-friendly boards to imitate independent boards, thus forcing indepen-

dent boards to distort compensation contracts to an even greater extent to

signal their independence. The availability of hidden pay can thus lead to in-

eff‌iciencies, even if boards do not use hidden pay in equilibrium, by inducing

independent boards to choose ineff‌icient disclosed contracts. In fact, the avail-

ability of hidden pay can lead to a signif‌icant deadweight loss precisely when

the cost of hiding pay is negligible because independent boards are forced to

5These results are in line with Jensen and Murphy’s (1990) conjecture that “political forces”

together with disclosure requirements create distortions in the structure of compensation schemes.