Board Independence and CEO Pay Disparity

Abstract

This paper analyzes how board independence affects a board's monitoring intensity and the CEO pay disparity. We consider a corporate tournament model with a novel feature that the board of directors may lack independence. This has significant implications for a board's monitoring and rewarding policies. Our results provide several empirical implications, including: (i) the CEO pay disparity increases with the board's equity holding; (ii) the CEO pay disparity can decrease with the board's monitoring intensity; (iii) the board's monitoring intensity increases with the level of board independence; and (iv) the CEO pay disparity can increase or decrease with the level of board independence, depending on the relative sizes of the contracting effect and the monitoring effect defined in the current paper. These implications are robust to limited liability concerns, alternative definitions of board dependence, biases in tournaments, and external recruitment threats. Overall, our results suggest that the trends of CEO pay disparity can be partly explained by the trends in the nature of board independence.For robustness checks, we show that: (iv) the CEO pay disparity becomes smaller when the required minimum pay rises; (v) the CEO pay disparity is higher in a biased tournament than in an unbiased tournament; (vi) the threat of external recruitment reduces the resource input level and can widen (shrink) the CEO pay disparity if the uncertainty of internal performance measure is great (weak) relative to the uncertainty of the external contestant's ability; and (vii) if the board appoints an external CEO, the CEO pay disparity (defined as the pay gap between the external CEO and the winner of corporate tournament) increases with the performance and the mean ability level of the external contestant, whereas it decreases with the ability level of internal contestants and the cost of hiring an external CEO (which may be caused by the inexperience of the external CEO, the disincentives of internal staff, and the loss of the benefits from diverted company resources by internal contestants), which implies that the less independent the board, the smaller the CEO pay disparity.