Is Board Compensation Excessive?

In our article, Is Board Compensation Excessive? (forthcoming in the Journal of Corporate Finance), we examine whether board members are overpaid. We also consider whether excessive compensation of directors affects their ability to monitor. We address these issues by carefully constructing a model to predict director compensation. We then identify the presence and magnitude of over- and undercompensation and examine whether superfluous director compensation affects the directors’ monitoring incentives.

While executive pay has been researched extensively, the issue of excessive director compensation is emerging as a new focus of media attention. The interest seems to have been sparked by a lawsuit filed against Facebook, claiming that the directors voted to pay themselves excessive levels of compensation. While the Facebook lawsuit was recently settled, it certainly raises the issue of reasonable pay for directors and calls attention to the fact that directors establish their own compensation.

Prior literature suggests that excess executive compensation is not beneficial to shareholders; however, relatively little is known about excess director compensation. We follow prior academic studies in defining excess compensation as the difference between the observed compensation levels and expected compensation levels after controlling for firm characteristics. We develop motivation for our determinants of director compensation based on the idea that director pay should be determined by firm complexity and the need for monitoring. We examine total director pay as well as the equity and cash components. Our results support the idea that more complex firms that require more monitoring pay higher levels of director compensation, especially equity-based compensation. For example, Tobin’s Q is often used as a proxy for investment opportunities. Firms with high Q ratios are perceived to need more monitoring. We find that total and equity compensation are positively related to Q. Larger firms and firms with higher levels of R&D may be more complex and have a greater need for monitoring. These are both positively related to director compensation.

While our predicted model is based on firm characteristics, we recognize board compensation is determined by the directors themselves. Thus, we consider that the governance structure may alter the directors’ ability to extract excess compensation. To capture the influence of governance on director compensation, we use our measures of excess compensation based on firm and economic conditions and then examine whether the firm’s governance characteristics allow directors to extract greater rents. Larger boards are associated with coordination problems. We find that larger boards use less total and equity-based compensation. Our findings may suggest that firms do in some sense consider aggregate board pay. If the board is larger, less excess compensation per director may be paid. Older directors may be more knowledgeable about the firm but also more risk averse. We find older directors pay themselves greater levels of cash based compensation; however, director tenure is generally associated with lower excess compensation. Recent research points to a shortage in qualified directors coupled with an increased workload. Our results imply that newer directors receive greater excess compensation. Interlocked directors are also able to extract greater excess pay and equity based compensation. Firms with entrenched management, proxied by the Entrenchment Index, are more likely to extract greater cash compensation. Finally, having a CEO that also serves as the chair, leads to less rent extraction by directors. Given that duality is a proxy for CEO power, this suggests that the board’s position is weakened.

We also examine how director excess compensation affects the firm’s internal monitoring. Overcompensation may act as an incentive for board members to exert more effort and, thus, improve the soundness of the firm’s governance structure. Essentially, it is possible that excess compensation leads to more monitoring as directors may feel beholden to shareholders to work hard and retain their high pay. Alternatively, the surplus in director compensation might indicate that directors are entrenched and not effective monitors. Directors may be hesitant to destabilize the status quo and jeopardize their positions and compensation. To explore how excess director compensation affects monitoring, we examine CEO turnover-performance sensitivity, CEO compensation, and CEO pay-for-performance sensitivity.

Our results are consistent with excess director compensation exacerbating agency problems. Given that over- and undercompensated directors may have significantly different monitoring incentives, we divide our sample based on whether director excess compensation is positive or negative. For the firms that overcompensate their directors, we find that CEO turnover-performance sensitivity is lower. Thus, the overpayment of board members provides the CEO with additional immunity and job security. For the undercompensated directors, we generally find no significant effect of excess compensation on turnover-performance sensitivity. In addition, we find evidence consistent with cronyism between directors and CEOs. Specifically, we show that excess director compensation is positively related to CEO total compensation. Finally, supporting the notion that overcompensation leads to less monitoring, we find that excess compensation for overcompensated directors reduces CEO pay-for-performance sensitivity.

Overall, our findings suggest that director excess compensation may be a sign of board entrenchment where overcompensated directors are not necessarily focused on protecting shareholder interests. Our results imply that even a relatively small corporate expenditure has significant monitoring implications. To illustrate, during 1997-2012, firms in our sample have approximately eight non-inside directors receiving excess compensation of approximately $17,187 each. However, the additional $137,496 from the firm’s perspective leads to significantly lower monitoring of CEO performance and less pay-for-performance sensitivity. If we focus only on those directors that are overcompensated, the average excess pay per director is about $63,342 or about $506,736 per average board. While still small at the firm level, the $63,342 appears to be significant to the individual directors.

The complete article is available for download here.