Two Minds on CEO Pay

Smaller and independent boards are more likely to get executive compensation right

The essentials

  • In setting executive compensation, Board directors have a delicate balance between gathering valuable private information on CEO performance and using the information to reward or punish CEO actions.
  • In a study, smaller and more independent boards and boards with CEOs as the chair relied more heavily on private performance measures than larger boards.
  • Independent boards may weaken their ability to gather private information but are more likely to properly use what intelligence they do glean to reward or punish the CEO accordingly.
  • Shareholders wanting to understand executive compensation decisions should push corporations for more useful disclosure, such as compensation and shareholder value over time.

There is a predictable cycle of shock, indignation, and ridicule that greets news of many executive compensation packages. The most egregious example is former Volkswagen chief Martin Winterkorn being awarded $7 million in performance-related pay in 2015, the year in which an emissions-fixing scandal erased more than $40 billion off the value of the company. The usual reaction is: What were they thinking?

“They” are the members of compensation committees of publicly-traded companies, the people who should be in the best position to assess the relationship between executive and corporate performance. They have access to the same corporate indicators as the rest of us but also private information about CEOs that may not be reflected in annual reports.

“We all know that numbers like stock market prices are very noisy and don’t perfectly reflect the efforts of CEOs,” says Serena Wu, assistant professor at Smith School of Business. “Board directors are insiders and have more intimate knowledge, so they can compensate for those noisy measures by using some information on CEOs that they gathered from private channels.”

The extent of private information being used to shape compensation decisions in a public firm has to do largely with how board members view their two, sometimes conflicting, roles, says Wu. The first is the information role — gathering precise intelligence on CEO actions and judgment. The second is the monitoring role — leveraging the information to reward or punish the CEO in line with shareholders’ interests.

The first requires close relations with the CEO. The second requires the courage to sometimes act against the CEO’s personal interests.

“There is this tension between the information and the monitoring roles,” says Wu. “If you want to stress the monitoring role of the board, you want to make sure the board has some distance from the CEO. In that case, the information role may be less effective because the CEOs would communicate less with a tough board. But if you stress the information role, the monitoring role might be weakened.”

How Tough Should a Board Be?

Wu teamed up with Kin Lo of Sauder School of Business to devise a novel study that examines the trade-off between these two functions. They examined a sample of publicly-traded firms in the U.S. from 1996 to 2010. That period straddles the passage of the Sarbanes-Oxley (SOX) Act, which regulated the structure of boards of directors and toughened their responsibilities. That allowed Wu and Lo to observe directors’ behaviour in two regulatory environments.

As Wu notes, the private intelligence on CEOs that the board has access to cannot be observed by researchers, so they needed to infer it from observable information. Using a regression analysis of CEO compensation packages, they separated out public performance measures such as stock price and related financial data. They were left with what they called “residual” compensation, which Wu and Lo used as a proxy for the boards’ private information.

They then took that residual compensation and related it to future firm performance. “Our assumption is that if the residual really represents private information used by the board, then it should reflect future performance,” she says. That’s because board members would be aware of strategic decisions behind the scenes, such as a merger or acquisition, that would have an effect on the firm’s long-term value but not show up in public filings.

Independent boards may weaken their ability to gather information but are more likely to properly use what intelligence they do glean to reward or punish the CEO accordingly

Wu and Lo made a number of findings. Smaller and more independent boards and boards with CEOs as the chair relied more heavily on private performance measures than larger boards, though these effects disappeared after the passage of SOX. This makes sense: on larger boards, there tends to be weaker communications between CEO and directors, and directors are more likely to rely on corporate officers for information on CEO actions rather than take matters into their own hands.

By playing a stronger monitoring role, independent boards may weaken their ability to gather private information, Wu says, yet they are more likely to properly use what intelligence they do glean to reward or punish the CEO accordingly.

Many observers figure that having a CEO act as board chair would water down the board’s monitoring role. Wu, however, says communication between the CEO and board is strengthened and thus richer private information becomes available for the board to use in setting a compensation package.

Two-Way Traffic

A healthy board “should have a channel for the CEO to communicate to the board, and the board should also be diligent enough to gain more intimate knowledge of the CEO’s effort. It should be two-way traffic,” she says.

There are lessons in these findings for regulators and shareholders, Wu says. Regulators should realize that “that monitoring or the independence of a board should not be everything and that information acquisition is as important if not more important for a board to be effective in compensation decisions.”

And shareholders wanting to understand executive compensation decisions should push corporations for more useful disclosure, such as compensation over a period of time with shareholder value over a period of time as a benchmark. That might help them understand why a CEO received a big bonus one year for a strategic decision that yielded benefits two years later.

Alan Morantz

Smith School of Business
Goodes Hall, Queen's University
Kingston, Ontario
Canada K7L 3N6

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