Board Independence and Ceo Pay

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The Effect of Board Independence on CEO Compensation

by

Shu Li

University of Groningen
Faculty of Economics and Business

June 2012

Spieghelstraat 10
9721JW Groningen
0614398093
S.Li.9@student.rug.nl
S2181045

ABSTRACT

In order to investigate the effects of board independence on total CEO compensation, I collected data from 256 UK listed firms. At the beginning, I assume the CEO compensation is lower with higher degree of board independence. However, I get totally different result. My finding is that the CEO compensation is high when the board independence is high. To answer the reason, I analyze the structure of the CEO compensation, and I found that the high compensation is because of high stock-based compensation for the reason that the CEOs performs well when the board is more independent.

Key words:Board independence, outside directors, CEO compensation, agency theory, board structure, corporate governance, CEO pay structure, incentive pay

Seminar supervisor: Dr. Bo Qin

INTRODUCTION

In recent years, the CEO compensation increases a lot than before especially in public corporations. The decision-making about how to compensate CEO is delegated to the board of directors, and there are a lot of arguments about the criteria to compensate CEO. The source of these arguments can be derived from the agency problem, which is a really common but difficult problem for a lot of firms. For most corporations, the ownership and the control are separated and this might result in the different interests between the principal and agent. In order to keep their wealth, shareholders intend to use the board of directors to supervise and evaluate CEO’s performance. If the performance of CEO is well and this firm earns more profits, the board of directors would honor the CEO with high compensation which might be high salary or bonus or stock based compensation; otherwise, they would choose to decrease the CEO compensation or even fire the CEO. For shareholders, this is an ideal situation, which is not too often existing in real world. Crystal (1991) argues that corporate directors might be ineffective in setting appropriate levels of compensation because if the directors are hired by the CEOs they will be under the control of and can be manipulated by the CEOs, and the CEOs can remove them from their boards anytime. If that is the case, the CEOs can easily control the board and get what they want such as high salary without good performance. What will shareholders do to solve this kind of problems?

Many people believe that some rules should be set to strengthen the corporate governance practices. Chhaochharia & Grinstein (2009) come up with four main rules to strengthen the board: (1) the majority of board members should be independent, (2) members of compensation, audit, and nominating committees need to be independent, (3) separate meetings should be conducted by directors who are not employed by the company, and (4) some specific written procedures have be used to evaluate CEOs performance and the election of new board members. To be concluded, the directors of the board have to be independent and independent director is someone who holds a seat on the board but not hired by the firm. Normally, when there are more independent board members, the CEO’s control for the board will be weakened and the CEOs have to concentrate on improving performance. This research paper is going to analyze the relationship between the board independence and CEO compensation. Does the CEO compensated lower when the board is more independent?

This study belongs to a number of studies that research at the effects of the board structures on executive compensation. Those studies tell a lot about the determinants of executive compensation and complex relationships among board structures and executive compensation. However, the difference between this paper and other studies is that I am only concentrating on a narrow...
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