Board Independence and CEO Incentives

Abstract

Contrary to a commonly-held view in the corporate governance literature, I argue theoretically that the optimal pay-performance sensitivity (PPS) should be smaller in the presence of board monitoring for a risk-averse CEO. My model is based on a simple adaptation of Holmstrom and Milgrom (Econometrica 1987). I show that board monitoring and PPS should be substitutes and the relative weights placed on board monitoring and PPS should depend on firm transparency (ease of monitoring). It is a prediction of my model that if firms that were relying on incentives (PPS) are mandated to strengthen monitoring, their constrained optimal PPS would be smaller. Using the percentage of outside directors as a proxy for board monitoring, I find empirical evidences consistent with these predictions. In 2002, following the adoption of the Sarbanes-Oxley Act of 2002, major U.S. exchanges began to require the boards of listed firms to have more than 50% of outside directors. In the case of firms affected by this requirement, their CEO pay-performance sensitivity decreased significantly relative to the control group, especially in the case of large firms which are more transparent and thus easier to monitor than small firms. The decrease was a result of the CEOs aggressively selling their stock while the boards allowed the option sensitivity to remain the same.