Managerial Bargaining Power and Board Independence

Abstract

This paper considers how a Chief Executive Officer (CEO) designs a bargaining process for the determination of his or her own compensation by selecting the level of independence of board members in order to influence the compensation determination process within the board and the monitoring ability of the board. The formulation is consistent with the rent extraction view, which regards the compensation contract as an instrument for the CEO to extract rents, and also with the view that the CEO forces the owners of the firm to pay high compensation by influencing some parameters in the agency problem. The CEO may design his or her bargaining power so as to set a high level of compensation and a low possibility of being fired. However, he or she cannot neglect the role of independent outside directors because their monitoring function can increase the CEO's expected compensation by raising the expected outcome of the firm. The independence level of board members, which is determined by the CEO prior to the compensation bargaining, indicates the board's pre-commitment level of monitoring. Hence, the CEO needs to allow the board to be an effective monitor to some extent, even though he or she can freely choose the composition of the board. Nevertheless, the fraction of independent outside directors on the board must be less than or equal to (1/2), which is lower than that obtained by the CEO and shareholders' joint surplus maximization problem. The model predicts several testable implications for the optimal composition of board members.