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

Pablo Ruiz-Verdú is Associate Professor of Management at the Department of Business Administration at Carlos III University; Ravi Singh is Managing Partner at Higher Moment Capital. This post is based on their recent paper, forthcoming in the Journal of Finance. Related research from the Program on Corporate Governance includes Stealth Compensation Via Retirement Benefits by Lucian Bebchuk and Jesse Fried.

Boards of directors set CEO pay. Understanding how directors’ incentives affect compensation contracts is therefore essential for understanding executive pay. In a recent paper, we contribute to this goal by proposing a model in which we analyze CEO pay explicitly as a board decision determined by director independence and by directors’ reputational concerns.  In the paper, 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.

Reputational concerns are widely regarded as a key determinant of director incentives and play a central role in our analysis. In our model reputational 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, for example, 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.

Compensation decisions are a particularly important indicator of director independence as there is a clear conflict between shareholder and management interests when it comes to the appropriate level of executive pay. Indeed, compensation decisions are commonly viewed as the “acid test” of corporate governance (as Warren Buffett put it). It is for this reason that we focus on the signaling role of compensation 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 camouflage pay. Second, the value to the manager of hidden forms of compensation 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 prevalence of camouflaged forms of executive pay such as opaque perks, projects that yield private benefits for managers, poorly disclosed pension plans, backdated options, strategically timed option grants, or manipulated performance measures. The fact that boards appear to hide pay suggests that they care about the information that their compensation decisions convey to shareholders.  The reputational concerns of directors are thus likely the primary motivation for boards adopting hidden forms of pay, as in our model.

The model yields several novel results. We show that independent boards signal their independence to investors by reducing CEO pay. Lower CEO pay is a credible signal of director independence because reducing CEO pay has a greater private cost for manager-friendly boards. Therefore, 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 necessary 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, leading to weaker managerial incentives.

Although the use of hidden pay or inefficient compensation structures is often attributed to a lack of independence, we show that independent boards are more likely than manager-friendly boards to engage in these practices. Hidden 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 caution is due when interpreting the compensation 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 exacerbates the effects of reputational concerns by making it less costly for manager-friendly boards to imitate independent boards, thus forcing independent boards to distort compensation contracts to an even greater extent to signal their independence. The availability of hidden pay can thus lead to inefficiencies, even if boards do not use hidden pay in equilibrium, by inducing independent boards to choose inefficient disclosed contracts. In fact, the availability 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 distort incentives the most when the low cost of hiding pay makes it cheap for manager-friendly boards to imitate independent boards.

We derive several empirical implications from the model that shed light on the potential impact of recent regulatory changes and corporate governance trends towards greater transparency and board accountability. Disclosure requirements that aim to make executive compensation more transparent or greater scrutiny of compensation packages by external monitors will generally have the intended effect of discouraging the use of hidden pay. However, by making it more costly for manager-friendly boards to imitate the pay policies of independent boards, greater transparency reduces the pressure on independent boards to reduce CEO pay to signal their independence and thus can lead to higher managerial pay and lower profits. Indeed, we show that transparency is likely to be beneficial only up to a certain threshold, beyond which the increase in disclosed pay outweighs the benefit of reducing hidden pay and inefficient contract distortions, so that some pay opacity is optimal for shareholders. Our model thus shows that although stricter disclosure requirements may have beneficial effects, there is a limit to how far mandated disclosure can go before it is value-decreasing.

We also show that corporate governance changes that increase the value of a reputation for independence, such as an increase in institutional ownership, the adoption of voting rules that increase investor influence over the election of  directors, or an increase in the influence of proxy advisory firms, will generally lead to lower executive compensation but may also have the unintended effects of  increasing the use of inefficient hidden pay or inefficiently reducing the strength of CEOs’ incentives. As in the case of transparency, there is generally a threshold level beyond which the distortions created by increased reputational pressure outweigh the benefit for shareholders of lower CEO pay.

The complete paper is available for download here.

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