Journal of Financial Economics 00 (2002) 000-000

Who is in whose pocket? Director compensation, board independence, and barriers to

effective monitoring

Harley E. Ryan, Jr.*, Roy A. Wiggins, III

*E. J. Ourso College of Business Administration, Louisiana State University,

Baton Rouge, LA 70803, USA Department of Finance, Bentley College, Waltham, MA 02452, USA

(Received 8 October 2003; accepted 18 November 2003)

Abstract We use a bargaining framework to examine empirically the relations between director compensation and board-of-director independence. Our evidence suggests that independent directors have a bargaining advantage over the CEO that results in compensation more closely aligned with shareholders’ objectives. Firms with more outsiders on their boards award directors more equity-based compensation. When the CEO’s power over the board increases, compensation provides weaker incentives to monitor. Firms with more inside directors and with entrenched CEOs use less equity-based pay. Furthermore, firms with entrenched CEOs and CEOs who also chair the board are less likely to replace cash pay with equity. JEL classification: G30; G34; G38 Keywords: Board of Directors, Compensation, Bargaining Power, Agency Theory, Regulation

We thank Tom Arnold, George Baker, Lucian Bebchuk, Alex Butler, Sudip Datta, Mai Iskandar-Datta,

Melissa Frye, Stuart Gillan, Shane Johnson, Jayant Kale, April Klein, Adam Lei, Lalatendu Misra, Brooke Stanley, Lori Walsh, Mike Weisbach, an anonymous referee, and the participants at the NBER Universities Conference on Corporate Governance for helpful comments. We acknowledge the excellent research assistance of Pingshun Huang, Mauricia Nagujja, and Kyojik Song. Ryan acknowledges financial support from the LSU Council on Research Summer Stipend Program and Wiggins acknowledges support from a Bentley College summer research grant. The authors assume responsibility for any errors.

*Author contact information: Department of Finance, E. J. Ourso College of Business, Louisiana State

University, Baton Rouge, LA 70803, USA. Tel.: +1-225-578-6258; fax: +1-225-578-6366. Email: cryan@lsu.edu (H. E. Ryan)

0304-405X/02/ $ see front matter © 2002 Published by Elsevier Science S.A.

1. Introduction

The general consensus in both the popular press and the academic literature is that an

independent board of directors results in more effective corporate governance. Researchers and

practitioners suggest that inside board members, large boards, CEOs who also chair the board,

and entrenched CEOs result in less independent and less effective boards of directors. Although

such characteristics constitute barriers to effective governance, contracting theory suggests that

they could be counteracted by the incentive compensation contracts that directors receive. In this

paper, we examine the relations between the structure of outside-director compensation and

board-of-director independence. We seek to shed light on the following question: Does the

structure of director compensation mitigate or reinforce barriers to effective governance?

The extant financial literature has typically examined compensation decisions from the

perspective of a board of directors that wishes to establish an optimal contract in order to

mitigate agency conflicts. Recent research, however, suggests that the process of determining

compensation is better described as a negotiation between the board and the CEO. For instance,

Hermalin and Weisbach (1998) model a bargaining game in which the selection of directors and

the CEO’s compensation are negotiated between the two parties. Bebchuk, Fried, and Walker

(2002) argue that the CEO’s managerial power over the board of directors distorts optimal

compensation contracts. Moreover, they suggest that the existing empirical evidence better

supports the bargaining model than an optimal contracting paradigm.

We extend this notion to suggest that directors explicitly or implicitly negotiate their own

pay. We expect the party with the bargaining advantage, either the directors or the CEO, to

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influence the size and the structure of the compensation package in its own interest.1 Following

Hermalin and Weisbach (1998), we base our analysis on the principles that (i) board

independence is a consequence of the directors’ bargaining advantage with the CEO and (ii)

independent boards are more willing to monitor the CEO, whose ability to impose costs on them

declines with their independence. For instance, the CEO has less influence over the directors’

opportunity to continue to serve on the board or to serve on other boards if the board has greater

independence.

We recognize that board independence, managerial power, and compensation, like most

observed outcomes in corporate finance, are determined over time in an endogenous process.

However, the board’s characteristics are predetermined when they set compensation policy.

Thus, the relation between the structure of compensation for board members and board of

director characteristics represents an equilibrium outcome. This equilibrium provides an

opportunity to test economic hypotheses about effective corporate governance. We also analyze

changes in this equilibrium, allowing us to shed some light on the endogeneity issue.

An opportunity for a major change in director compensation occurred in 1996, when the

Securities and Exchange Commission liberalized Rule 16b-3. This change allows companies

more discretion to grant stock options and stock awards. The liberalization of Rule 16b-3

eliminates the need to obtain shareholder approval of director compensation plans and formula

grants, and effectively gives directors and CEOs more influence over their compensation plans.

We can test whether this new flexibility leads to plans that provide incentives to engage in

greater oversight, or whether agency conflicts undermine corporate governance by the board of

1 Although they formally model bargaining over the CEO’s wage and the selection of directors, Hermalin and Weisbach (1998) suggest that the two parties negotiate a variety of considerations that relate to board independence, one of which they argue is the compensation of the directors.

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directors. Our findings could also be useful to regulators since recent proposals by the boards of

both the New York and the NASDAQ stock exchanges limit director influence over

compensation and require shareholder approval for all equity-based and stock-option

compensation plans. To gain insight into this issue, we study director compensation in 1997, the

year following the rule revision, as well as the change in compensation from 1995 (the year

preceding the liberalization of Rule 16b-3) to 1997.

Examining 1,018 firms in 1997, we find that board-of-director compensation schemes

vary systematically with barriers to effective monitoring, but generally not in a manner that

encourages directors to increase their monitoring efforts when faced with these barriers.

Directors of firms with entrenched managers (those with longer tenures) receive significantly

smaller compensation packages. More important, they receive a significantly smaller proportion

of compensation in the form of equity-based awards. Directors for firms with entrenched CEOs

are also less likely to receive any equity-based compensation, as are directors on boards with

more insiders. Directors on boards with more insiders and on larger boards also receive less

equity-based pay as a percentage of their total compensation. All of these results are robust to a

number of tests that analyze CEO influence by industry characteristics, growth opportunities,

firm size, and CEO and board demographics.

When we examine the CEO’s compensation, relative to that of the directors, we find that

our proxies for board independence and managerial power also explain deviations in the CEO’s

compensation structure from a projected structure based on industry and director compensation.

Entrenched CEOs and CEOs whose boards lack independence receive less equity-based pay.

Thus, our results suggest that powerful managers use their positions to influence the directors’

compensation to provide fewer incentives to monitor and simultaneously make their own

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compensation less sensitive to stock price performance.

Examining changes in compensation for the boards of a sample of 600 firms from 1995

(the year before the liberalization of SEC Rule 16b-3) to 1997 (the year after), we find that total

director compensation increases by 64% on average. As a percentage of 1995 compensation,

cash compensation increases by 6% and equity-based compensation increases by 58%. This

increase in equity-based compensation does not merely result from higher stock prices. We find

that nearly 45% of the firms increase the number of shares in stock and stock options from 1995

to 1997, and that nearly 18% of the firms increase equity-based pay and simultaneously decrease

cash payments. With respect to our research question, we find that firms with more insiders on

the board, firms with entrenched CEOs, and firms with CEOs who also chair the board are less

likely to increase the percentage of equity awards or replace cash pay with equity-based

compensation. These results suggest a direct relation between board independence and the

change in director compensation after the modification to the SEC rule.

Our results imply that weak boards and powerful executives result in inefficient director

compensation policies. The independence of the board and the power of the CEO influence both

the size and the structure of director compensation. Although directors will always have

incentives that diverge from those of shareholders, the evidence suggests that directors on

independent boards receive compensation packages that are more closely tied to stock price

performance. Our results support the generally accepted premise that board of director

independence enhances shareholder welfare since board independence results in compensation

contracts that provide directors with stronger incentives to monitor. They also suggest that

entrenched managers have significant influence over director compensation, which results in

contracts that provide directors with weaker incentives to act in the interests of shareholders.

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The remainder of this article is organized as follows. Section 2 discusses background

material and the extant literature. Section 3 describes our data and sample selection. Section 4

contains the univariate and multivariate results of our analysis of the relation between the

structure of director compensation and board and CEO characteristics. Section 5 analyzes the

relations between director compensation and the CEO’s compensation structure, and Section 6

examines the change in director compensation from 1995 to 1997. Section 7 concludes the

article.

2. Background material and extant literature

The board of directors should monitor the firm’s managers to mitigate the agency

conflicts that result from the separation of ownership and control (Fama and Jensen, 1983).

However, barriers to monitoring can lead to a breakdown of the governance mechanism. Both

information problems and incentive alignment problems can create barriers to monitoring.

Hirshleifer and Thakor (1994) show that incentive alignment, noisy information, and external

disciplining mechanisms, such as takeovers, interact to influence the quality of board

performance. Maug (1997) shows that compensating directors with either shares or options

mitigates such barriers and improves directors’ incentives to maximize shareholder wealth.

Hermalin and Weisbach (1998) show that board efficacy declines over time as the CEO

gains power over the board. In their model, directors will retain a CEO only if he or she is

valuable to them. However, the CEO’s value to the directors increases his or her bargaining

power. Over time, the CEO nominates new directors who are indebted for their appointments,

which erodes board independence. In fact, Hermalin and Weisbach (1988) find that the

proportion of outside directors decreases over a CEO’s career, and Shivdasani and Yermack

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(1999) find that firms choose fewer outside directors and more gray directors (non-insiders with

business ties to the firm or interlocking relationship with the CEO) when the CEO is involved in

the selection process. They also find that the stock price reaction to director appointments is

lower when the CEO is involved.

Lipton and Lorsch (1992) and Jensen (1993) propose that as boards of directors become

larger, they are less capable of holding frank discussions and are less effective as monitors.

These arguments imply that the CEO’s power increases with the number of directors on the

board. Supporting this premise, Yermack (1996) finds a negative relation between Tobin’s Q

and board size. Eisenberg, Sundgren and Wells (1998) find a similar negative relation between

earnings and board size. Other researchers present evidence that board composition significantly

influences governance. Weisbach (1988) finds a positive relation between CEO turnover

following poor performance and the fraction of outside directors. Rosenstein and Wyatt (1990,

1997) find a positive stock price reaction to the election of outside directors, and a negative

(positive) reaction to the election of inside directors when their stock ownership is low (high).

Others propose that the board of directors cannot objectively monitor a CEO who also

chairs the board. Supporting this hypothesis, Pi and Timme (1993) document a weak negative

relation between ownership and CEO duality for commercial banks. In contrast, Brickley, Coles,

and Jarrell (1997) find that CEOs who chair the board hold substantially more stock than CEOs

who do not chair the board. They argue that CEO duality naturally follows if a new CEO serves

a probationary period under the chairman and is subsequently rewarded with both titles (see

Vancil, 1987). Dahya, McConnell, and Travlos (2002) find higher CEO turnover following

poor firm performance for firms that comply with the Cadbury Committee’s recommendation to

have separate CEOs and board chairs and to have at least three outside directors. They also find

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that operating and stock price performance improves for these firms.

Researchers have recently turned their attention to board of director compensation. Perry

(2000) finds a positive relation between CEO turnover following poor firm performance and

incentive compensation to outside board members. Brick, Palmon, and Wald (2002) report a

relation between firm underperformance and “excessive” compensation for managers and

directors. They interpret their findings as evidence of cronyism between CEOs and directors.

Yermack (2002) examines a broad range of incentives, one of which is director compensation,

that are available to outside directors during their first five years. Becher, Campbell, and Frye

(2003) find that banks increase equity-based compensation for directors following deregulation.

They argue that this increase in the use of equity-based compensation results from the need for

improved internal monitoring in a deregulated environment. We are not aware of any study that

examines the relation between director compensation and board independence.

3. Data and sample selection

3.1. Sources of data

We obtain board compensation data for 1995 and 1997 from the Standard & Poor’s

ExecuComp database, which provides information on firms in the S&P 500, the Midcap 400, and

the Smallcap 600. We collect data on the annual cash retainer paid to each director, the fee paid

for each meeting attended, the number of stock grants, and the number of stock option grants.

We value the stock grants, which include restricted and unrestricted shares, by multiplying the

number of shares by the closing stock price from the previous fiscal year. We use the modified

Black-Scholes model, assuming firms issue option grants at the money and with a ten-year

maturity, to value stock options.

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Firms that offer their directors equity-based compensation generally award stock and

stock option grants on a regular annual schedule. Some firms make additional awards on an

irregular schedule. We identify two firms in our sample that do not pay any annual

compensation, but that make a one-time award of options or restricted stock when a director

joins the board. ExecuComp combines additional and one-time awards and presents these data

separately from the annual grants. We include these additional awards since we do not wish to

ignore a source of incentive compensation that aligns the interests of directors and shareholders.

However, as we present later in a robustness section, we repeat our analysis on a sample based

only on annual awards with results similar to those reported in the tables.

We collect information from the firms’ proxy statements on board size and composition,

director affiliations, the CEO’s tenure, and whether the CEO also chairs the board. We define

directors who are also officers of the firm as insiders. Directors who work for service firms can

obtain fee income from the firm, which creates an incentive conflict. We classify non-insiders

who work for a financial service firm, consulting firm, accounting firm, or legal firm as “gray”

directors. We classify all other directors as outsiders. Financial and accounting data come from

the Standard & Poor’s Research Insight database. To control for the firm’s past performance, we

use the three-year cash-flow return on assets and the three-year stock return for the firm. The

choice of return horizon is a tradeoff between losing observations and choosing a reasonable

performance window; other windows (five, seven) yield similar results. We adjust both

measures by taking the difference between the returns for our sample firm and the returns for a

size- and industry-matched (three-digit SIC code) control firm.

To be included in the sample, compensation data must be available from ExecuComp,

board and CEO data must be available from proxy statements, and financial data must be

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available from Research Insight. The final sample comprises 1,018 firms.

3.2. Summary statistics

We present summary statistics on board of director compensation in Table 1. On

average, directors receive a cash retainer of $18,540 for serving as a director and an additional

$1,030 in cash for each meeting attended. Assuming directors attend all meetings, the total

average (median) cash payment is $25,664 ($25,000) and equals 49.95% (48.6%) of total

compensation. The highest cash compensation is $85,000 (all in the form of a retainer) and the

lowest is zero. The average value of stock grants awarded to directors is $9,588 and the average

value of stock option grants is $75,742. Altogether, the average (median) equity-based

compensation is $85,330 ($28,234), or 50.05% (51.44%) of total compensation. Total director

compensation ranges from a low of $500 to a high of $2,947,780, which was all in the form of

stock options. Total compensation averages $110,995. Approximately 3.5% of the firms provide

additional compensation to corporate executives who serve as directors. Roughly 80% of the

firms pay additional fees to directors who attend board meetings, and 74.4% pay for attending

committee meetings. Nearly 32% of the firms in the sample award stock shares to directors,

63% award options, and 81% award shares or options.

[Insert Table 1 about here]

Additional awards of stock grants and stock options influence the summary statistics

presented above, particularly the maximum and average values. In results not reported in tables,

we find that the average (median) value of annual stock option awards is $35,334 ($9,512) with a

maximum value of $969,000. Annual stock grants average $6,069 and top out at $124,000.

Based only on the annual awards, the average (median) total compensation is $67,145 ($47,483),

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of which approximately 42% comes from equity-based awards. The maximum annual

compensation totals $1,019,600 and includes both cash and equity-based components.

Table 2 presents summary statistics on firm, board, and CEO characteristics. The mean

(median) asset size is approximately $4.1 billion ($916 million). The mean (median) market-to-

book asset ratio is 2.10 (1.51) with a maximum of 45.17 (the biotechnology firm Organogenesis)

and a low of 0.28 (Smith Corona). Mean past performance measures are –0.20% for three-year

stock returns and 1.99% for three-year cash-flow return on assets.

[Insert Table 2 about here]

Board size in our sample averages 9.23 directors. The median board has nine directors.

The largest board consists of 22 directors (Gulfstream Aerospace) and the two smallest consist of

three directors (Tricord Systems and UCAR International). On average, boards have nearly 48%

outside directors and range from no outside directors to almost 92% outsiders. Gray directors

make up 24.8% of the boards on average, and insiders make up 27.3%. No board consists of

entirely outside, gray, or inside directors. The mean (median) CEO tenure is nine years (six

years). The longest tenure is 59 years (William Dillard, of Dillard’s, Inc.) and the shortest is less

than one year (ten CEOs). Approximately 69% of the CEOs in our sample also chair the board

of directors (duals), while almost 18% are from the firm’s founding family.

4. Empirical results

4.1. Univariate analysis of director compensation

In this section, we use difference-in-means tests to analyze the level and the structure of

outside board compensation and four characteristics of board independence: board size, board

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composition, CEO tenure, and CEO/chair duality. An analysis of medians yields similar

inferences, but to be brief we present only results based on means. We define large boards as

those with more directors than the sample median. We define an outside board as one in which

outside directors (excluding gray directors) make up more than 50% of total board membership.

Otherwise, we classify the board as an inside board. CEOs are considered entrenched if their

tenure as CEO is greater than the sample median. If the CEO chairs the board, we classify the

firm as dual CEO/chairs. For family-controlled firms, we cannot judge the degree of

involvement in the firm of “outside” family members, which complicates the interpretation of the

results. Additionally, a CEO from the founding family has a different relationship with board

members than do CEOs in typical firms. Thus, we identify firms with a CEO from the founding

family and repeat our tests on a sample that excludes these firms. Table 3 presents the results

from our analysis of means. Panel A presents the results for the entire sample and Panel B

presents the results for the subset of firms that are not family controlled.

[Insert Table 3 about here]

4.1.1. Board size and director compensation

If larger boards have greater coordination problems, we expect the CEO to have more

power over the board. In this case, we expect directors to receive more cash and less equity-

based compensation. Supporting this premise, we find that directors on large boards receive

$30,965 (55.4% of total compensation) in cash compensation compared to $22,219 (46%)

received by their counterparts on small boards (significantly different at the 0.01 level).

Directors on small boards receive significantly more equity-based compensation at $101,450

(54% of total compensation) compared to $60,521 (45% of total compensation), significantly

different at the 0.01 level. Consistent with a bargaining outcome, small boards receive larger

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total compensation ($123,670 compared to $91,487 significantly different at the 0.01 level).

However, large boards are more likely to be awarded equity-based compensation (84.5%

compared to 79%). This latter result could be due to relations between compensation structure

and firm size, which we examine later in the paper. We find a similar pattern in Panel B when

we exclude family-controlled firms.

4.1.2. Board composition and director compensation

The univariate evidence from our examination of board composition and director

compensation provides modest support for the agency hypothesis. Outside-dominated boards

receive more cash compensation in dollar terms ($27,975 compared to $23,974, significantly

different at the 0.01 level), but the percentage of total compensation arising from cash is

essentially the same for the two groups. Although total compensation and equity-based

compensation are not statistically different across the two groups, outside-dominated boards are

more likely to receive equity-based compensation (85.58% of the firms with outside-dominated

boards compared to 78% of the firms with inside boards). Thus, outside directors on boards

dominated by inside and gray directors are less likely to receive incentives to monitor.

Again, we find a similar pattern when we exclude family-controlled firms from the

sample. These comparable results suggest that any misclassifications in board composition (e.g.,

classifying a family director who is not employed by the firm as an “outsider”) are minimal.

When we combine these results with our results for board size, we conclude that family control

does not influence the relation between board characteristics and outside director compensation.

However, we note that the overall use of equity-based compensation increases when we include

family-controlled firms in the sample. To confirm this observation, we compare the percentage

of equity-based compensation paid to directors in 183 family-controlled firms to the other 835

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firms in our sample. In results not reported in a table, we find that equity-based compensation in

family-controlled firms averages 58% of total compensation compared to 48% for the other

firms. These percentages are significantly different at a p-value of 0.01.

4.1.3. CEO tenure and director compensation

Following Hermalin and Weisbach (1998), we expect that as a CEO’s tenure increases,

he or she becomes entrenched, influences the selection of new directors, and gains greater

managerial power over the board of directors. These CEOs can use their power to negotiate a

director compensation package that discourages board scrutiny of management. Our results

support the notion that the ability of the CEO to influence the board increases with his tenure.

On a dollar basis, board members for firms with entrenched CEOs receive smaller cash

retainers (significant at the 0.10 level), less cash from attending meetings (significant at the 0.01

level), and less total cash compensation (significant at the 0.01 level) than do directors of firms

with short-tenured CEOs. However, as a percentage of total compensation, the directors of firms

with entrenched CEOs receive a larger share of their compensation from cash (52% vs. 48%,

significant at the 0.10 level). Furthermore, directors of firms in which the CEOs are not

entrenched are more likely to receive equity-based grants (86.4% of firms compared to 75.7% of

firms), significant at the 0.01 level. These results suggest that director compensation in firms

with entrenched managers provides weaker incentives to monitor management.

The results in Panel B strengthen our conclusion that firms with entrenched managers

provide directors with weaker incentives to monitor. Without the family-controlled firms, we

find a significant difference between the amounts of equity-based compensation ($62,853 for

long-tenure CEOs compared to $86,926 for newer CEOs significant at the 0.05 level) and

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stronger results for the percentage of equity-based compensation (44.79% compared to 50.92%

significant at the 0.01 level). Additionally, the total compensation for directors is smaller when

the CEO has a longer tenure ($88,788 compared to $114, 280 significant at the 0.05 level).

4.1.4. CEO/board chair duality and director compensation

Directors of firms with dual CEO/Chairs receive more cash compensation ($26,840

compared to $23,075 significant at the 0.01 level). However, the compensation structure does

not significantly differ across the two groups. We find no difference in the fraction of firms that

use equity-based compensation. Thus, the evidence on the relation between CEO/chair duality

and board compensation for the full sample weakly supports, at best, the idea that dual

CEO/chairs use their positions to weaken the directors’ incentives to monitor.

The results are stronger when we exclude family-controlled firms. The percentage cash

retainer for dual CEO/chairs is greater than for separate chairs (significant at the 0.05 level), and

the value of equity-based compensation is considerably less ($65,951 compared to $99,612

significant at the 0.05 level). Total compensation for directors is also less when the CEO chairs

the board ($94,083 compared to $123,380 significant at the 0.10 level), consistent with the

bargaining power prediction. Altogether, the results on duality moderately support the agency

hypothesis when we exclude family-controlled firms. Combined with the results for CEO

tenure, they underscore the influence of family control on the relationship between the CEO and

the board of directors and suggest the need to control for connections between the CEO and the

founding family in multivariate tests.

4.2. Multivariate analysis of the director compensation

To further analyze the relations between board independence and director compensation

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and to control for other factors that might influence compensation packages, we estimate an

ordinary least squares (OLS) regression for total director compensation, a Tobit regression for

the percentage of equity-based compensation, and a probit model for the likelihood that firms

give directors any equity-based awards. In each case, our explanatory variables include the size

and composition of the board of directors, the CEO’s tenure, an indicator variable for CEO/chair

duality, and control variables for firm size, investment opportunities, family control, and firm

performance. To mitigate the inordinate influence of extreme values, we winsorize the adjusted

performance measures at the 1% and 99% values. Following Servaes and Zenner (1996), we set

missing data to the mean for the sample.

The sum of the percentages of insiders, outsiders, and gray directors equals one, which

creates extreme multicollinearity with the intercept if we include two of the proxies in the same

specification. Thus, we estimate three models according to board member classification (inside,

outside, or gray).2 We present only the results for the inside directors in the tables. In results not

reported in the tables, we find statistically significant relations for outside directors that are

opposite in sign to those reported for inside directors. We do not find any significant relations

with the percentage of gray directors. Since industry characteristics are potentially correlated

with board characteristics, we also control for industry effects with two-digit SIC code industry

dummy variables. Table 4 presents these results.

[Insert Table 4 about here]

2 For completeness, we also include the percentage of both insiders and outsiders in our regressions. Despite the multicollinearity, the signs confirm those reported in the tables. Standard errors are large and the coefficients are not statistically significant. The signs and significance of all other coefficients are similar to those reported.

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4.2.1. Regression analysis of total director compensation

The first two columns of Table 4 contain the results of our regressions for total director

compensation. If the CEO has managerial power over the board or if the board lacks

independence, the bargaining advantage shifts to the CEO and directors will receive less total

compensation since the CEO has the incentive to limit the equity-based portion, which

encourages monitoring. Supporting this prediction, the results indicate a negative relation

between total compensation and board size (significant at least at the 0.05 level) and CEO tenure

(significant at the 0.01 level). We also find that larger firms, firms with more investment

opportunities, and family-controlled firms pay directors more compensation. Firms with lower

historical accounting returns pay directors less total compensation.

4.2.2. Tobit analysis of director compensation

Next, we use Tobit to analyze equity-based compensation as a percentage of total

compensation. We regress equity-based compensation measure against the four characteristics

of board independence and our control variables using a specification that controls for censoring

at both zero and 100%. As a robustness check, we also estimate these regressions for the

guaranteed cash retainer and for the total cash compensation assuming directors attend all

meetings and draw similar inferences to those based on Table 4. The two middle columns of

Table 4 contain the results of these regressions. We find that the percentage of equity-based

compensation is negatively related to the number of directors on the board, the fraction of inside

directors, and CEO tenure. These relations are significant at least at the 0.01 level. We find no

relation between the percentage of equity-based compensation and CEO/chair duality. As in

studies of CEO compensation (e.g., Smith and Watts, 1992), we find that directors’ equity-based

compensation is positively related to market-to-book assets at the 0.01 significance level.

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We find that equity-based compensation is negatively related to past accounting

performance, but that it is unrelated to stock price performance. This result indicates that

directors of firms in which the CEO achieves superior accounting performance are given fewer

incentives to monitor. Our finding compares to previous findings (e.g., Weisbach, 1988) that

poor accounting performance predicts CEO turnover better than stock price performance. In

fact, Hermalin and Weisbach (1998) argue that accounting performance should explain CEO

turnover better than stock price performance. They reason that accounting performance results

strictly from the current CEO’s efforts, whereas stock-price performance reflects the impact of

the current CEO, the expected productivity of future CEOs, and market factors outside of the

CEO’s control.

In the spirit of the Hermalin and Weisbach (1998) framework, we propose two possible

interpretations for our finding of a negative relation between accounting performance and equity-

based compensation. CEOs who achieve superior operating performance require less oversight,

so directors optimally are given fewer incentives to monitor. However, these CEOs become

entrenched and thus can use their power to influence director compensation to provide fewer

incentives to monitor. These two interpretations need not be mutually exclusive. To shed more

light on this issue, we look at the correlations between CEO tenure and performance

variables. We find no correlation between CEO tenure and stock price performance, but we find

a positive correlation of 0.12 (p-value equals 0.01) between tenure and accounting performance.

Our Tobit results suggest that compensation schemes reduce the incentives of directors to

monitor when the CEO is entrenched and when there is a higher percentage of insiders on the

board of directors. These findings support the premise that boards lose independence and that

agency problems become more severe when the CEO is entrenched, when there are more

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insiders on the board, or when boards are larger. Our results suggest that compensation packages

reflect the self-interest of both CEOs and directors, but that these packages encourage greater

scrutiny and shareholder maximization only when directors remain independent.

4.2.3. Probit analysis of equity-based compensation choice

We also use probit models to estimate the incidence of option awards and/or stock grants

as a function of the same set of explanatory variables. The last two columns of Table 4 contain

the results of our probit estimates. CEO tenure negatively influences the likelihood that a firm

uses equity-based compensation (significant at the 0.01 level). This relation confirms the Tobit

results and suggests that entrenched CEOs use their influence to reduce monitoring incentives.

Also, firms with a larger percentage of inside directors on the board are less likely to receive

equity-based awards (significant at the 0.01 level). Firms with a CEO from the founding family

are more likely to include equity components in board compensation schemes. We find no

statistically significant relations between the likelihood that a firm provides equity-based

compensation to directors and board size or CEO duality.

The results from the probit analysis reinforce those from the Tobit analysis. We find that

the likelihood of equity-based compensation decreases with the percentage of inside directors

and CEO tenure. These results imply an equilibrium outcome based on board independence. As

board independence decreases, or as barriers to monitoring increase, directors are less likely to

receive compensation incentives that encourage them to monitor on behalf of shareholders. This

decreased likelihood of receiving equity-based incentives exacerbates the monitoring problem

and leads to less effective corporate governance.

19

4.3. Robustness tests

In this section, we discuss the results of robustness tests to ensure that our findings do not

represent spurious relations between firm and board characteristics. We also check to make sure

that extremely long CEO tenures or our method of dealing with missing performance data do not

overly affect our results. We find that our results are robust to severe restrictions on the data, to

the removal of extreme CEO tenure observations, to our method of controlling for missing

performance data, to the omission of family-controlled firms, and to the exclusion of additional

equity-based grants.

4.3.1. Firm size

In our sample, the correlation between firm size and the number of directors on the board

is 0.57. To control for potential spurious relations with size, we include in our regression

dummy variables for observations in the first, second, and third size quartiles. We find similar

qualitative and statistical results to those reported in the tables. For instance, the coefficients (t-

statistics are in parentheses) for the percentage equity-based compensation regression are

% Equity-based comp = 1.11 - 0.03*Q1 - 0.09*Q2 - 0.00*Q3 + 0.00*log(assets) (5.12) (-0.33) (-1.38) (-0.09) (0.21) + 0.03*Market/Book - 0.23*log(No. dir.) - 0.27*(% inside directors) (5.86) (-4.68) (-2.89) - 0.07*log(CEO tenure) - 0.02*CEO/Chair duality + 0.14*(Family Firm) (-4.54) (-0.77) (4.19) - 0.00*(3-yr stock return) - 0.26*(3-year CFROA). (-0.08) (-2.39)

As an additional test, we eliminate the smallest and largest 25% (by assets) of the firms,

which results in a more homogeneous sample of 509 firms. In this subsample, the correlation

between firm size and board size is only 0.26. We estimate our tests on this smaller sample and

20

again find similar qualitative and statistical results to those reported.

4.3.2. Growth opportunities

The market-to-book asset ratio does not highly correlate with our board characteristics on

a pair-wise basis. The largest correlation is –0.14 (with board size). However, growth

opportunities might interact with our measures in complicated and unknown ways. To control

for potential spurious relations with growth opportunities, we follow a similar procedure to the

one described above and include in our regression dummy variables for observations in the first,

second, and third quartiles by the market-to-book ratio. We also eliminate the 25% of firms with

the highest and lowest market-to-book asset ratios, to get a subsample of 509 firms. In this

subsample, the market-to-book ratio ranges from 1.05 to 2.36, compared to a range of 0.28 to

45.17 in the complete sample. In both cases, we find similar qualitative and statistical results to

those reported for the full sample. For instance, the coefficients (t-statistics are in parentheses)

for the percentage equity-based compensation regression with the quartile dummy variables are

% Equity-based comp = 1.17 - 0.22*Q1 - 0.18*Q2 - 0.14*Q3 + 0.02*log(assets) (9.79) (-3.87) (-3.38) (-2.90) (1.66) + 0.01*Market/Book - 0.22*log(No. dir.) - 0.29*(% inside directors) (1.91) (-4.58) (-3.09) - 0.08*log(CEO tenure) - 0.00*CEO/Chair duality + 0.13*(Family Firm) (-4.82) (0.31) (4.07) - 0.01*(3-yr stock return) - 0.32*(3-year CFROA). (-0.34) (-2.95)

4.3.3. CEO tenure

The maximum CEO tenure (59 years) is more than double the 95th percentile (28 years).

Additionally, we code all CEOs who have held their position less than one year as having zero

tenure. To control for a possible inordinate influence by these extreme values, we winsorize our

sample at the fifth (tenure equals one year) and 95th (tenure equals 28 years) percentiles. We also

21

eliminate these observations and estimate the regression on a trimmed sample with similar

results. The results suggest that relations with CEO tenure do not result from extreme values.

For instance, the coefficients (t-statistics are in parentheses) for the percentage equity-based

compensation regression on the winsorized sample are

% Equity-based comp = 0.99 + 0.02*log(assets) + 0.03*Market/Book - 0.22*log(No. dir.) (9.02) (1.56) (6.22) (-4.60) - 0.28*(% inside directors) - 0.07*log(CEO tenure) - 0.01*CEO/Chair duality (-3.01) (-4.68) (-0.55) + 0.14*(Family Firm) - 0.01*(3-yr stock return) - 0.24*(3-year CFROA). (4.21) (-0.12) (-2.23)

4.3.4. Prior performance

If missing data do not allow us to calculate adjusted performance measures for the three-

year period prior to 1997, we set the values to the sample means to avoid losing observations.

To check that this method does not distort our inferences, we estimate our regressions on a

smaller sample of 830 firms for which we can calculate operating performance measures. We

find similar results to those reported in the tables. For instance, the coefficients (t-statistics are in

parentheses) for the percentage equity-based compensation regression are

% Equity-based comp = 1.00 + 0.03*log(assets) + 0.04*Market/Book - 0.30*log(No. dir.) (8.10) (2.70) (5.74) (-5.34) - 0.29*(% inside directors) - 0.05*log(CEO tenure) - 0.05*CEO/Chair duality (-2.74) (-2.56) (-1.45) 0.13*(Family Firm) - 0.01*(3-yr stock return) - 0.25*(3-year CFROA). (-3.34) (-0.24) (-2.34)

We also estimate our regressions on the full sample of 1,018 firms, but omit the prior

performance control variables. Our results on the board-structure variables are similar to those

reported for the full model. For instance, the coefficients (t-statistics are in parentheses) for the

percentage equity-based compensation regression are

22

% Equity-based comp = 1.00 + 0.02*log(assets) + 0.03*Market/Book - 0.23*log(No. dir.) (9.04 ) (1.64) (6.11) (-4.64) - 0.29*(% inside directors) - 0.08*log(CEO tenure) - 0.01*CEO/Chair duality (-3.11) (-4.87) (-0.41) + 0.14*(Family Firm). (4.21)

4.3.5. Family control

The relationship between the board of directors and the CEO is clearly different when the

CEO is from the founding family. Family control also poses additional problems in classifying

directors as insiders, outsiders, or gray. Thus, we estimate our regressions without the family-

CEO dummy variable on a sample of 835 firms that excludes the family-controlled firms. Our

results are qualitatively and statistically similar to those for the full sample. The results for the

percentage equity-based compensation regression are

% Equity-based comp = 0.88 + 0.01*log(assets) + 0.03*Market/Book - 0.19*log(No. dir.) (7.38) (1.38) (5.85) (-3.45) - 0.24*(% inside directors) - 0.06*log(CEO tenure) - 0.02*CEO/Chair duality (-2.28) (-3.37) (-0.80) + 0.00*(3-yr stock return) - 0.35*(3-year CFROA). (0.06) (-2.88)

4.3.6. Annual awards only

As explained previously, many companies augment annual equity-based awards with

additional awards. Some companies do not pay any annual compensation, but make periodic

equity based awards that ExecuComp classifies as additional awards. To exclude these awards

ignores a source of incentive compensation that aligns the interests of directors and shareholders,

but to include them creates some large values in a given year that are not present on an annual

basis. Thus, we repeat all of our analysis for the sample of 1,016 firms using compensation that

consists only of annual awards and find similar qualitative and statistical results to those

23

presented in the tables. As an example, we present a regression for the equity-based

compensation below:

% Equity-based comp = 0.92 + 0.02*log(assets) + 0.03*Market/Book - 0.26*log(No. dir.) (8.20) (2.28) (5.90) (-5.23) - 0.35*(% inside directors) - 0.06*log(CEO tenure) + 0.00*CEO/Chair duality (-3.59) (-3.94) (0.04) + 0.14*(Family Firm) + 0.01*(3-yr stock return) - 0.23*(3-year CFROA). (3.91) (0.29) (-2.14)

5. Analysis of the CEO’s compensation structure compared to director compensation

We expect the compensation structures of the CEOs and the directors to be positively

correlated since the same firm-specific characteristics influence both. However, the two

structures should be different since directors and CEOs perform different jobs. The bargaining

hypothesis suggests that a CEO with significant power over the board of directors would

influence both CEO and director compensation. This influence should be present in both the

portions of CEO compensation that can and cannot be explained by director compensation. To

test this hypothesis, we project the equity proportion of the CEO’s pay onto the equity proportion

of the directors’ compensation with the following regression:

.~%% µββ ++∑= DirectorIndustryIndustryCEO nCompenatioEquityDonCompensatiEquity

The residual from this regression,µ~ , represents the portion of the CEO’s compensation structure

that cannot be explained by director compensation and industry effects. We regress this residual

against the same vector of variables that we use to explain director compensation. If the

bargaining hypothesis is true, we expect negative relations with proxies for managerial power

and positive relations with proxies for board independence. Table 5 presents the results of this

test.

24

We find that the CEO’s residual equity-based compensation is negatively related to both

board size and CEO tenure, each at the 0.01 significance level. When the CEO is entrenched or

boards are larger and more susceptible to coordination problems, the CEO’s compensation

contains a smaller proportion of equity. This reduction in the percentage of equity-based

compensation reduces the sensitivity of the CEO’s overall compensation package to changes in

the firm’s stock price. Although the signs for board composition and CEO duality are consistent

with the bargaining hypothesis, we do not find any significant relations with these other

governance proxies. We do find positive relations with the market-to-book asset ratio and firm

size (both significant at the 0.01 level). Again, our results suggest that managerial power and

weak governance create agency problems that distort optimal contracting outcomes.

[Insert Table 5 about here]

6. Analysis of the change in the structure of director compensation from 1995 to 1997

The liberalization of SEC Rule 16b-3 provides directors and CEOs greater flexibility to

adopt compensation plans without shareholder approval. To gain additional insight into the

process by which director compensation is determined, we compare compensation in 1995, the

year before the implementation of SEC Rule 16b-3, to compensation in 1997. These tests also

allow us to shed light on the endogeneity issue and provide insight into causality since we relate

the change in compensation (after the removal of a barrier) to preexisting firm, board, and CEO

characteristics. For this test we lose firms that are not in the ExecuComp database for 1995, and

we eliminate firms that change CEOs during this time period. The sample for this examination

comprises 600 firms.

25

6.1. Descriptive statistics

Table 6 presents mean (median) amounts and percentage changes in compensation from

1995 to 1997 and compares the corporate governance structures across these two years. Panel A

presents the compensation data. We find that average (median) total director compensation

increases by 64.16% (21.96%) during this time period, the bulk of which comes from changes in

stock-based compensation. In dollar terms, total average (median) compensation rises from

$70,064 ($39,501) to $89,354 ($53,611), while cash compensation changes from $26,140

($25,000) to $27,267 ($26,550). Total mean (median) equity-based compensation increases from

$42,978 ($9,634) in 1995 to $64,331 ($23,163) in 1997. As a percentage of total 1995

compensation, average (median) cash compensation increases by 6.02% (0.8%) and equity-based

compensation increases by 58.35% (12.59%), all significant at the 0.01 level.

[Insert Table 6 about here]

We also look at the change in component compensation as a percentage of the change in

total compensation for 570 of the 600 firms where there was in fact a change in total director

compensation from 1995 to 1997. On average, the total cash compensation as a percentage of

the change in total compensation decreases by 20%, and equity compensation increases by nearly

78% (median changes equal 3.08% and 79.8% for cash and equity, respectively). The average

decline in cash compensation as a percentage of the change in total compensation results from

firms that reduce cash compensation and is not significantly different from zero. All other

changes are significant at the 0.01 level. Almost 18% of the firms increase the percentage of

equity and simultaneously reduce the amount of cash. To verify that increases in equity

compensation are not simply a function of rising stock prices, we also examine the shares

26

underlying stock and stock option grants. We find that 44.7% of the firms increase the number

of shares in stock and stock options from 1995 to 1997. We also find that 12.2% award options,

12% award stock grants, and 13.7% award some combination of equity-based incentives in 1997

but not 1995. Thus, the data point to a substantial change in both the level and type of equity-

based incentives in director compensation.

Our results indicate that liberalizing Rule 16b-3 results in a significant increase in the use

of equity-based awards. Following the arguments in Bebchuk et al. (2002), this finding suggests

that external restrictions influence the negotiations between directors and CEOs and, moreover,

that shareholder approval of compensation plans is not carte blanche. This observation should

be useful to policymakers who seek to vest control over compensation plans with shareholders.

Panel B presents summary data on boards of directors and CEOs. We note that CEO

tenure is longer in 1997 by definition since for this test we focus on CEOs who were in place in

1995. When we compare 1995 to 1997, we observe that the percentage of insider directors

decreases from about 31.5% on average in 1995 to 26.5% in 1997, and that the percentage of

gray directors increases from 20.5% to 24.5%. These changes are significantly different from

zero at the 0.01 level and, assuming that gray directors are more independent than insiders,

suggest that on average boards became slightly more independent from 1995 to 1997. Board

size, the percentage of outside directors, and CEO/chair duality do not significantly change.

We also examine the changes in board composition and board size for relations with the

compensation structure and CEO characteristics. In unreported results, we do not find any

relations between changes in the board and the preexisting compensation structure, but we do

find significant relations between changes in board composition and CEO characteristics. The

27

decrease in inside directors is smaller when the CEO is entrenched than otherwise (-3%

compared to -6.6%, p-value equals 0.00). Both groups tend to replace the insiders with gray

directors. When the CEO does not chair the board, firms decrease the percentage of insiders by a

greater margin than do firms with dual CEO/chairs (-7.7% compared to -4%, p-value equals

0.00). The firms with separate CEOs and board chairs replace most of these insiders with

outsiders (+6.14% compared to –0.7%, p-value equals 0.00), but firms with dual CEO/chairs add

more gray directors (1.6% for separate CEO/chair compared to 4.8% for dual CEO/chair, p-value

equals 0.04). The results are robust to cross-sectional regression analysis. Supporting the

managerial power hypothesis, these results suggest that the boards of firms with entrenched

CEOs or dual CEO/chairs became relatively less independent from 1995 to 1997.

6.2. Tobit analysis of the change in director compensation from 1995 to 1997

Next, we model the change in equity-based compensation paid to directors as a function

of the same control variables used in our previous regression analyses. We use two measures of

the change in equity compensation from 1995 to 1997 as our dependent variable. In both

measures, the numerator equals the change in equity compensation. The denominator is the 1995

total compensation for the first measure and the change in total compensation for the second

measure. This test isolates the influence of board independence on changes in director

compensation following the change in SEC Rule 16b-3.

As before, we estimate the model separately for the percentage of inside, gray, and

outside directors both with and without industry controls. Both sets of regressions yield similar

results, but we only present the results for the specifications that include the percentage of inside

directors and industry controls. Our proxies for the change in equity-based compensation create

28

extreme values that result in a skewed distribution. To mitigate this problem, we winsorize the

dependent variables at the 10% and 90% levels, respectively. Regressions on the raw data

produce similar inferences for our test variables, but also large coefficients and a poor fit as

evidenced by the pseudo R2. Regressions on a trimmed sample of 480 observations, which omit

the bottom and top deciles, produce results that are similar to those from the regressions on the

winsorized sample. The first two columns of Table 7 show the results of the regression analysis

for the winsorized sample.

In support of the managerial power hypothesis, we find a negative relation between CEO

tenure and the change in equity-based compensation, significant at the 0.01 level for both

dependent variables. The relation between the change in equity-based compensation and the

percentage of insiders on the board is negative, significant at the 0.05 level for the change as a

percentage of total compensation. The change to Rule 16b-3 removes an external restriction on

director compensation, which allows greater freedom for internal negotiations. Our results

suggest that independent boards use this freedom to negotiate compensation packages that

provide stronger incentives to monitor. Both firm size and investment opportunities are positive

(significant at the 0.01 level for size and at least the 0.05 level for the market-to-book ratio).

[Insert Table 7 about here]

These results, combined with those presented earlier in the paper, suggest the potential

for an “old-boy” familiarity between entrenched managers and their directors. To further

analyze this relationship, we calculate the average tenure of all members on the board and

compare these board tenures by CEO entrenchment. We find that the mean (median) board

tenure is 9.3 (8.6) years for directors of firms with entrenched managers (CEO tenure greater

29

than the sample median of six years) compared to 7.0 (6.6) years for those working with more

recently hired CEOs, significantly different at the 0.01 level. Additionally, the tenures of the

CEO and the board of directors have a positive correlation of 0.41.

We also look at the number of meetings held by the board. Vafeas (1999) argues that

boards that meet more frequently have a better opportunity to monitor than boards that meet less

frequently. The average (median) number of meetings is 6.5 (6) for firms where the CEO has

been in place longer than the sample median compared to 7.4 (7) meetings when the CEO has

shorter tenure, significantly different at the 0.01 level, which suggests that the board monitors

less frequently as the CEO becomes entrenched. These comparisons support the notion of

cronyism between an entrenched CEO and the board resulting in less board independence and

therefore greater agency problems.

Taken together, these results confirm our earlier findings and suggest that entrenched

CEOs use their position to influence board of director compensation to consist more of cash than

of equity-based awards, which reduces the incentives for directors to monitor the CEO’s actions.

These results also shed light on the endogenous relations between governance characteristics and

director compensation. In fact, they suggest a direct relation between CEO entrenchment and

changes in director compensation.

6.3. Probit analysis of the change in director compensation from 1995 to 1997

Better governance should produce superior performance. If so, the relations that we

document could result from increases in equity values and not from policy changes. To examine

this issue, we estimate two separate probit models to analyze how equity-based compensation

changes from 1995 to 1997. In the first model, the dependent variable equals one if the firm

30

increases the number of shares underlying stock and stock option grants and zero otherwise. In

the second model, the dependent variable equals one if the firm increases equity-based

compensation and concurrently decreases cash compensation. The last two columns of Table 7

contain the results.

The relation between changes in board compensation and CEO tenure are again negative

and significant at the 0.01 level. These relations indicate that firms are less likely to increase

equity shares and are also less likely to replace cash with equity in the structure of director

compensation when their CEOs are entrenched. Larger firms are more likely to both increase

equity shares and replace cash with equity (significant at the 0.01 level). We also find that for

our sample firms are less likely to decrease cash and increase equity when the CEO also chairs

the board (significant at the 0.10 level). Firms with a greater percentage of insiders on their

boards are less likely to increase equity-based incentives (significant at the 0.05 level). The

results from these two tests confirm our previous results. Firms with more independent boards

are more likely to increase equity-based compensation. Firms with boards that consist of a larger

percentage of inside directors, firms with entrenched CEOs, and firms with CEOs who also chair

the board are less likely to either increase the percentage of equity awards or replace cash with

equity. Additionally, the results from these two tests suggest that the relations between the

change in compensation and our governance characteristics result from actual changes in

compensation policy and do not arise spuriously from increases in stock prices.

7. Conclusion

We examine the relation between director compensation and four proposed

characteristics of board independence: board size, board composition, CEO entrenchment, and

31

CEO/chair duality. Our findings support the premise that shareholders’ economic interests are

best served when the board remains independent. To the degree that the board remains

independent, director compensation provides incentives more closely aligned with those of the

shareholders. To the extent that the CEO has power over the board, the compensation structure

provides weaker incentives to monitor.

We find that board of director compensation varies across different types of monitoring

barriers in a way that suggests self-selection in terms of monitoring effectiveness. Specifically,

we find that boards lose independence as the CEO’s tenure increases, or when insiders control

the board or boards are large. The likelihood of using equity-based incentives decreases with the

percentage of insiders on the board and the CEO’s time in office. That is, directors facing more

severe monitoring impediments and who are charged with governing more powerful CEOs

receive fewer incentives to exert effort to overcome those impediments. These results highlight

inefficiencies in board of director compensation and suggest implicit or explicit bargaining

between CEOs and directors.

Our results imply that director compensation is a reinforcing mechanism. Independent

boards, which are generally associated with good corporate governance, receive compensation

packages that are more closely aligned with shareholder wealth maximization. When the CEO

has greater bargaining power, the board loses independence and director compensation

exacerbates agency problems in these firms. Thus, we agree with Hermalin and Weisbach

(1998), that “[s]trong, independent boards will beget stronger, more independent boards than will

weak ones” (p. 107).

From the shareholders’ perspective, the directors of firms where the CEO has a long

32

tenure and is probably entrenched receive compensation that is least aligned with wealth

maximization goals. Furthermore, following the implementation of SEC Rule 16b-3, firms with

long-tenured managers increased stock compensation less than did firms with short-tenured

managers. In general, we find that firms are less likely to increase equity-based incentives for

their directors or replace cash with equity when the CEO is entrenched or chairs the board, or

when insiders make up a larger percentage of the board. Our results also indicate that the boards

of firms that have entrenched managers receive the least financial compensation and suggest that

these directors have long-term relationships with the CEO. In fact, our results suggest a direct

relation between CEO entrenchment and changes in director compensation. Entrenched CEOs

also appear to use their positions to influence their own compensation, compared to that of the

directors, to be relatively less sensitive to stock price performance. In sum, our findings indicate

significant agency problems in board governance when the CEO is entrenched and the board of

directors loses its independence.

33

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Table 1 Descriptive statistics on board of director compensation for 1,018 firms in 1997 Annual cash retainer equals the guaranteed cash payment to each director, fee paid per meeting equals the additional fee received for each meeting attended, and total cash compensation is the cash compensation received if a director attends all meetings. We calculate the value of stock grants by multiplying the number of shares granted times the closing stock price from the previous fiscal year. We value option grants with the modified Black-Scholes model assuming grants are at the money with a ten-year maturity. Total compensation equals the sum of cash, stock, and stock option pay assuming the director attends all meetings.

Mean Median Maximum Minimum Standard deviation

Panel A. Board of director compensation

Annual cash retainer $18,540 35.60%

$19,100 32.39%

$85,000 100%

$0 0%

$11,880 27.83%

Fee paid/meeting $1030 $1,000 $6,000 $0 $775

Number of meetings 6.94 6 24 1 2.78

Cash from meetings $7,124 14.35%

$6,000 11.19%

$52,000 100%

$0 0%

$5,884 16.22%

Total cash compensation $25,664 49.95%

$25,000 48.56%

$85,000 100%

$0 0%

$13,118 33.10%

Value of stock grants $9,588 11.45%

$0 0%

$745,000 100%

$0 0%

$34,314 20.89%

Value of option grants $75,742 38.61%

$16,467 34.27%

$2,947,780 100%

$0 0%

$202,339 36.35%

Total equity-based compensation $85,330 50.05%

$28,234 51.44%

$2,947,780 100%

$0 0%

$202,874 33.10%

Total compensation $110,995 $56,194 $2,947,780 $500 $202,324

Panel B. Board of director compensation characteristics

Company executives who are also directors are paid director compensation 3.44%

Fees paid for board meetings 80.16%

Fees paid for committee meetings 74.36%

Firm offers a director pension/retirement plan 13.16%

Firm awards stock to directors 31.34%

Firm awards options to directors 63.16%

Firm awards stock or options 81.14%

Table 2 Firm, CEO, and board of director characteristics for 1,018 firms in 1997 Market-to-book assets is the market value of equity plus the book value of debt divided by the book value of equity plus the book value of debt. We calculate adjusted performance measures by matching each sample firm to the firm in the same three-digit SIC code industry that is closest in size. We present the adjusted three-year stock return and the adjusted three-year cash flow return on assets for the three fiscal years preceding the fiscal year 1997. We classify directors as insiders if they are also employed by the firm or recently retired from the firm, ‘gray’ if they work for a financial service, consulting, or law firm, and outside otherwise. We define CEO tenure as the number of years the CEO has held that position, CEOs that also chair the board of directors as dual CEO/chairs, and CEOs from the founding family in family-controlled firms as founding family CEOs

Mean Median Maximum Minimum Standard deviation

Total Assets ($1000s) 4,081,730 916,242 304,012,00 13,780 16,388,650

Market-to-book assets 2.10 1.51 45.17 0.28 2.24

Adjusted three-year stock returns -0.20% -0.24% 95.96% -140.43% 25.57%

Adjusted three-year cash flow return on assets 1.99% 1.96% 39.92% -44.68% 11.47%

Number of directors 9.23 9 22 3 2.80

Outside directors 47.92% 50.00% 91.67% 0% 19.70%

‘Gray’ directors 24.82% 22.22% 85.71% 0% 16.98%

Inside directors 27.26% 25.00% 81.82% 0% 14.05%

CEO tenure (years) 9.11 6 59 0 8.84

Dual CEO/board chair 68.76%

Founding family CEO 17.98%

Table 3 Comparison of board compensation by board and CEO characteristics This table presents mean compensation components in dollar terms and as a percentage of the total compensation for 1,018 total firms and 835 firms not under family control in 1997. Annual cash retainer equals the guaranteed cash payment to each director, fee paid per meeting equals the additional fee received for each meeting attended, and total cash compensation is the cash compensation received if a director attends all meetings. We value stock grants by multiplying the number of shares granted times the closing stock price from the previous fiscal year, and stock options with the modified Black-Scholes model assuming at-the-money grants with a ten-year maturity. Total compensation includes total cash compensation and the value of stock and stock option grants. We classify a board as large if it has more than nine directors (the sample median) and small otherwise. Outside boards consist of a majority of outside directors, defined as directors who have no other relationship with the firm and do not work for a professional services firm. We classify CEOs whose time in position exceeds the sample median of six years as having long tenures, which we consider more likely to be entrenched. Otherwise the CEO has a short tenure. We label CEOs that also chair the board of directors as dual CEO/chairs. We use t-tests to determine significant differences.

Panel A. Entire sample

Board characteristics CEO characteristics

Large board (N=401)

Small board (N=617)

Inside board (N=588)

Outside board (N=430)

Long tenure (N=497)

Short tenure (N=521)

CEO/Chair (N=700)

Separate Chair (N=318)

Cash retainer $23,274 41.24%

$15,464*** 31.93%***

$17,334 35.67%

$20,189*** 35.50%

$17,874 37.10%

$19,176* 34.16%*

$19,725 36.61%

$15,932*** 33.37%*

Cash from meetings $7,691 14.19%

$6,755** 14.46%

$6,640 14.05%

$7,786*** 14.77%

$6,556 14.72%

$7,666*** 14.00%

$7,115 14.17%

$7,143 14.75%

Total cash compensation $30,965 55.42%

$22,219*** 46.39%***

$23,974 49.71%

$27,975*** 50.26%

$24,430 51.82%

$26,842*** 48.16%*

$26,840 50.77%

$23,075*** 48.13%

Total equity-based compensation

$60,521 44.58%

$101,450*** 53.61%***

$92,174 50.29%

$75,972 49.74%

$81,274 48.18%

$89,200 51.84%*

$77,669 49.23%

$102,200 51.87%

Total compensation

$91,487 $123,670*** $116,150 $103,950 $105,700 $116,040 $104,510 $125,270

Awards equity-based compensation 84.54% 78.93%** 77.89% 85.58%*** 75.65% 86.37%*** 81.20% 80.82%

Panel B. Excludes family-controlled firms

Board characteristics CEO characteristics

Large board (N=361)

Small board (N=474)

Inside board (N=442)

Outside board (N=393)

Long tenure (N=357)

Short tenure (N=478)

CEO/chair (N=570)

Separate chair (N=265)

Cash retainer $23,889 41.50%

$16,193*** 33.82%***

$18,586 38.06%

$20,571** 36.11%

$19,468 40.42%

$19,560 34.69%***

$20.963 38.52%

$16,418*** 34.16%**

Cash from meetings $7,556 13.76%

$6,973 15.18%

$6,715 14.66%

$7,799*** 14.46%

$6,467 14.79%

$7,791*** 14.40%

$7,169 14.20%

$7,345 15.35%

Total cash compensation $31,445 55.26%

$23,166*** 48.99%***

$25,301 52.71%

$28,370*** 50.56%

$25,935 55.21%

$27,351 49.08%***

$28,132 52.72%

$23,763*** 49.51%

Total equity-based compensation

$57,903 44.74%

$90,899*** 51.01%***

$80,576 47.29%

$72,200 49.44%

$62,853 44.79%

$86,926** 50.92%****

$65,951 47.28%

$99,612** 50.49%

Total compensation $89,348 $114,070** $105,880 $100,570 $88,788 $114,280** $94,083 $123,380*

Awards equity-based compensation 85.60% 78.48%** 77.38% 86.26%*** 74.79% 86.61%*** 81.75% 81.13%

*** Significantly different at the 0.01 level ** Significantly different at the 0.05 level

* Significantly different at the 0.10 level

Table 4 Regression analysis of the compensation paid to board members This table presents our analysis of compensation paid to outside directors by 1,018 firms in 1997. Total compensation equals the sum of total cash compensation, the value of stock option grants, and the value of stock grants. We value stock grants by multiplying the number of shares granted times the closing stock price from the previous fiscal year, and stock options with the modified Black-Scholes model assuming at-the-money grants with a ten-year maturity. We calculate adjusted performance measures by matching each sample firm to the firm in the same three-digit SIC code industry that is closest in size. We include both the adjusted three-year stock return and the adjusted three-year cash flow return on assets (CFROA) for the three fiscal years preceding the fiscal year 1997 in the specification. We classify directors as insiders if they are employed by the firm or recently retired from the firm. We define CEO tenure as the number of years the CEO has held that position, CEOs that also chair the board of directors as dual CEO/chairs, and CEOs from the founding family in family-controlled firms as founding family CEOs. We control for industry effects by including industry dummy variables determined at the two-digit SIC code level. We present t-statistics in parentheses.

OLS Tobit Probit

Dependent variable: Logarithm of total compensation

Total equity-based compensation divided by total compensation

One if directors receive equity-based compensation and zero otherwise

Industry dummy variables No Yes No Yes No Yes

Intercept 4.1115*** (13.74)

4.2607*** (11.49)

0.9922***(9.02)

1.1042***(7.12)

1.514*** (3.49)

8.2330 (0.00)

Ln (assets) 0.1925*** (8.39)

0.1945*** (8.63)

0.0155 (1.56)

0.0169* (1.68)

0.1091*** (2.68)

0.1302***(3.01)

Market-to-book assets 0.1236*** (3.55)

0.1034*** (3.38)

0.0343***(6.22)

0.0278***(4.89)

0.0551* (1.89)

0.0436 (1.41)

Ln (number of directors) -0.4987*** (-3.63)

-0.3011** (-2.22)

-0.2264***(-4.60)

-0.1628***(-3.21)

-0.2572 (-1.37)

-0.1526 (-0.75)

Percentage inside directors -0.4459* (-1.75)

-0.2966 (-1.20)

-0.2847***(-3.01)

-0.2539***(-2.68)

-1.1882*** (-3.35)

-1.2261***(-3.27)

Ln (CEO tenure) -0.1829*** (-5.10)

-0.1802*** (-4.94)

-0.0745***(-4.68)

-0.0714***(-4.46)

-0.3107*** (-4.98)

-0.3136***(-4.76)

Dual CEO/chair (0/1) -0.0464 (-0.67)

0.0037 (0.06)

-0.0151 (-0.55)

0.0015 (0.05)

0.0212 (0.20)

0.0634 (0.57)

Founding family CEO (0/1) 0.2882***(3.04)

0.2481***(2.81)

0.1441***(4.21)

0.1317***(3.91)

0.2671** (2.03)

0.2873** (2.10)

Adjusted 3-year stock return 0.0431 (0.31)

0.0723 (0.54)

-0.0059 (-0.12)

0.0009 (0.02)

-0.0745 (-0.39)

-0.0785 (-0.39)

Adjusted 3-year CFROA -0.6192** (-2.26)

-0.5422** (-2.06)

-0.2384** (-2.23)

-0.2147** (-2.01)

-0.7114 (-1.64)

-0.7460 (-1.63)

Adjusted R2/Pseudo R2 0.1465 0.1902 0.0840 0.1343 0.3681 0.5379

*** Significant at the 0.01 level ** Significant at the 0.05 level * Significant at the 0.10 level

Table 5 Tobit analysis of the residual equity-based compensation paid to CEOs This table presents our Tobit analysis of the residual percentage equity-based compensation paid to CEOs in 1997. Three of our sample firms have non-paid chief executives who are significant stockholders in a controlling holding company. Thus, we use a sample of 1,015 firms for this test. The dependent variable is the residual from a Tobit regression of the CEO’s equity-based compensation as a percentage of total compensation on the percentage equity-based compensation for directors and two-digit SIC code industry dummy variables. Total compensation includes total cash compensation and the value of stock and stock option grants. We value stock grants by multiplying the number of shares granted times the closing stock price from the previous fiscal year, and stock options with the modified Black-Scholes model assuming at-the-money grants with a ten-year maturity. We calculate adjusted performance measures by matching each sample firm to the firm in the same three-digit SIC code industry that is closest in size. We include both the adjusted three-year stock return and the adjusted three-year cash flow return on assets (CFROA) for the three fiscal years preceding the fiscal year 1997 in the specification. We classify directors as insiders if they are employed by the firm or recently retired from the firm. We define CEO tenure as the number of years the CEO has held that position, CEOs that also chair the board of directors as dual CEO/chairs, and CEOs from the founding family in family-controlled firms as founding family CEOs. We present t-statistics in parentheses.

Intercept 0.0072 (0.09)

Ln (assets) 0.0462*** (6.40)

Market-to-book assets 0.0222*** (5.90)

Ln (number of directors) -0.1126*** (-3.16)

Percentage inside directors -0.0349 (-0.51)

Ln (CEO tenure) -0.0471*** (-4.14)

Dual CEO/chair (0/1) -0.0098 (-0.50)

Founding family CEO (0/1) -0.0060 (-0.24)

Adjusted 3-year stock return 0.0126 (0.37)

Adjusted 3-year CFROA 0.0054 (0.07)

Pseudo R2 0.1128

*** Significant at the 0.01 level ** Significant at the 0.05 level * Significant at the 0.10 level

Table 6 Changes in director compensation and governance characteristics from 1995 to 1997 This table presents the mean (median) changes in compensation and governance characteristics from 1997 for 600 firms. We express the change as a percentage of the total 1995 compensation. Total compensation is the sum of all cash and equity-based compensation if the director attends all meetings. Total cash compensation is the cash compensation received if a director attends all meetings. Total compensation is the sum of total cash compensation and the value of stock and stock option grants. We value stock grants by multiplying the number of shares granted times the closing stock price from the previous fiscal year, and stock options with the modified Black-Scholes model assuming at-the-money grants with a ten-year maturity. We classify directors as insiders if they are current or retired officers of the firm, ‘gray’ if they work for a financial service, consulting, or law firm, and outside otherwise. We define CEO tenure as the number of years the CEO has held that position, CEOs that also chair the board of directors as dual CEO/chairs, and CEOs from the founding family in family-controlled firms as founding family CEOs. We base significance tests on t-test for means and Wilcoxon tests for medians.

Panel A. Compensation data

1997 Compensation

1995 Compensation

Change as a percentage of 1995 total compensation

Change as a percentage of the change in total

compensation from 1995 to 1997a

Annual cash retainer $20,052 ($20,000)

$19,252 ($20,000)

2.99%*** (0%)***

0.11%*** (0%)***

Total cash compensation $27,267 ($26,550)

$26,140 ($25,000)

6.02%*** (0.83%)***

-20.00% (3.08%)***

Total equity-based compensation $64,331 ($23,163)

$42,978 ($9,634)

58.35%*** (12.59%)***

77.55%*** (79.82%)***

Total compensation $89,354 ($53,611)

$70,064 ($39,501)

64.16%*** (21.96%)***

Percentage of firms that increase shares in stock and stock option grants from 1995 to 1997 44.67%

Percentage of firms that increase equity-based compensation and decrease cash compensation 17.83%

Percentage of firms that award stock options in 1997 but not in 1995 12.17%

Percentage of firms that award stock grants in 1997 but not in 1995 12.00%

Percentage of firms that award any type of equity-based compensation in 1997 but not in 1995 13.67%

Panel B. Governance characteristics 1997 1995 t-statistic (Wilcoxon)

Number of directors 9.64 (9)

9.71 (9)

1.03 (0.70)

Outside directors 49.00% (50.00%)

47.96% (50.00%)

1.41 (0.55)

‘Gray’ directors 24.48% (22.22%)

20.52% (20.00%)

5.55*** (3.91)***

Inside directors 26.52% (23.30%)

31.47% (28.57%)

9.28*** (5.72)***

CEO tenure (years) 10.70 (8.00)

8.70 (6.00) N/A

Dual CEO/board chair (% of firms) 73.83% 74.17% 0.19

aThirty firms do not change total compensation from 1995 to 1997, which results in a sample of 570 firms.

*** Significant at the 0.01 level ** Significant at the 0.05 level * Significant at the 0.10 level

Table 7 Analysis of the change in equity-based compensation paid to board members This table presents our analysis of the change from 1995 to 1997 of the equity-based compensation paid to board members. Total compensation includes total cash compensation and the value of stock and stock option grants. We value stock grants by multiplying the number of shares granted times the closing stock price from the previous fiscal year, and stock options with the modified Black-Scholes model assuming at-the-money grants with a ten-year maturity. We calculate adjusted stock and accounting performance measures for the three fiscal years preceding 1997 by matching each sample firm to the firm in the same three-digit SIC code industry that is closest in size. We include both the adjusted three-year stock return and the adjusted three-year cash flow return on assets (CFROA) for the three fiscal years preceding the fiscal year 1997 in the specification. We classify directors as insiders if they are current or retired officers of the firm. We measure the CEO’s tenure by the number of years as the top officer. CEOs that also chair the board of directors are dual CEO/chairs, and CEOs from the founding family in family-controlled firms are founding-family CEOs. Dummy variables based on the firm’s two-digit SIC code control for industry effects. We present t-statistics in parentheses.

Tobit Probit

Dependent variable:

The change in equity-based compensation as a fraction of 1995 total compensation

The change in equity-based compensation divided by the change in total compensation

One if the firm increases shares underlying stock and stock option grants from 1995 to 1997 and zero otherwise

One if the firm increases equity-based compensation and also decreases cash compensation from 1995 to 1997 and zero otherwise

Industry dummy variables Yes Yes Yes Yes

Intercept -0.4469 (-1.09)

0.0180 (0.04)

-2.9165*** (-3.99)

-2.5643*** (-3.85)

Ln (assets) 0.0801*** (3.54)

0.1284*** (5.24)

0.1926*** (4.06)

0.1758*** (3.26)

Market-to-book assets 0.0783*** (3.78)

0.0572** (2.49)

0.0516 (1.18)

0.0635 (1.30)

Ln (number of directors) -0.0270 (-0.24)

0.0007 (0.01)

0.1749 (0.76)

0.2364 (0.88)

Percentage inside directors -0.2733 (-1.42)

-0.5143** (-2.45)

-0.7648** (-1.95)

-0.4477 (-0.95)

Ln (CEO tenure) -0.0928*** (-3.04)

-0.1046*** (-3.14)

-0.1806*** (-2.89)

-0.1943*** (-2.68)

Dual CEO/chair (0/1) 0.0215 (0.74)

-0.0390 (-0.55)

0.0704 (0.53)

-0.2794* (-1.83)

Founding Family CEO (0/1) -0.0605 (-0.75)

0.0050 (0.06)

-0.0668 (-0.41)

0.2237 (1.16)

Adjusted 3-year stock return 0.1460 (1.31)

0.1643 (1.37)

-0.1254 (-0.57)

0.0258 (0.10)

Adjusted 3-year CFROA -0.0831 (-0.34)

-0.2205 (-0.83)

-0.4017 (-0.79)

-0.3918 (-0.65)

Pseudo R2 0.0947 0.0947 0.4743 0.3902 Number of Observations 600 570 600 600

*** Significant at the 0.01 level ** Significant at the 0.05 level * Significant at the 0.10 level