Board Characteristics and Firmss Choice of Using Non-Financial Performance Measures: An Empirical Analysis

Abstract

This study investigates whether and how board characteristics influence firms’ choice of incorporating non-financial performance measures (NFPM) in CEO compensation. The board of directors (BOD) is responsible for designing executive compensation. Outside directors of BOD can provide more objective monitoring considering their independent status (Fama and Jensen 1983), while inside directors have better access to inside information (Klein 1998; Adams and Ferreira 2007). The effectiveness of corporate governance can be a key factor in the choice of NFPM in CEO compensation contracts. Using two proxies, the percentage of director ownership and the value of director ownership, we find that firms with a higher proportion of outside board members are more likely to adopt NFPM. We also find a concave relation between the percentage of inside director shares and the use of NFPM. Specifically, boards with both a low and a high level of inside director ownership are more likely to recommend the use of NFPM. In addition, the probability of using NFPM is negatively associated with the value of inside director shares. This evidence suggests that entrenchment issues are a plausible disadvantage of offering equity incentives to board members. That is, directors become entrenched as their own wealth becomes increasingly tied to the firm and they begin to make decisions that may not be in the best interest of shareholders. The results of this study shed light on how the composition and remuneration of the BOD affects the design of firm compensation and the use of NFPM in particular.