Academic journal article Financial Management

Further Evidence on Compensation Committee Composition as a Determinant of CEO Compensation

Academic journal article Financial Management

Further Evidence on Compensation Committee Composition as a Determinant of CEO Compensation

Article excerpt

I use more than 1,500 firm-year observations for 271 US firms between 1991-1997 to examine the relation between insider membership in compensation committees and CEO pay. I find a steady decline in the number of committees with insider participation during the sample period, and uncover some opportunism by insiders in setting pay prior to the compensation disclosure and tax reforms. Finally, I document changes in pay practices that would be consistent with the intent of these reforms. Based on this evidence, however, I cannot definitively conclude whether the reforms were efficient.

**********

Recent regulatory reforms by the Securities and Exchange Commission (SEC Releases 33-6940 and 33-6962) and the Internal Revenue Service (Section 162(m) of the IRC) illuminate the executive compensation committee as the core decision-making body responsible for setting and monitoring executive pay. Although not explicitly stated, compensation reform measures appear to be motivated, at least in part, by concerns over the inefficient design of executive pay contracts (Perry and Zenner, 2001). One of the concerns implicitly conveyed by these reform measures is that insider participation in compensation committees compromises committee independence, resulting in contracts that are skewed in management's favor.

Motivated by concerns over committee independence, the IRS regulations disallow tax deductibility of executive compensation in cases where insiders participate in the compensation committee. (1) Similarly, the 1992 SEC compensation disclosure rules require a detailed compensation report, signed by compensation committee members and disclosed in the annual proxy statement, that discusses the criteria used in making the compensation decisions. (2) Implicit in these reform measures is the concern that if insiders act opportunistically in the pay process, then CEOs in firms with insiders in the compensation committee will receive higher pay levels than CEOs in firms with independent committees. Further, the rules also imply that the interests of managers and shareholders diverge more in firms with insider-dominated committees (insider-firms) as signified by a weaker link between CEO pay and corporate performance. If compensation reform measures are effective in reducing opportunistic behavior by insider-dominated compensation committees, then executive pay practices will converge toward shareholder preferences after the reform: After insiders are removed from the committee, the benefits to shareholders from incentive alignment should outweigh the costs of reform.

An opposing view is that insiders are more motivated to exercise effective decision control, because their reputation as decision-makers depends on the quality of their pay decisions. Further, insiders have an informational advantage over outsiders in understanding the firm's environment and strategy (see Baysinger and Hoskisson, 1990). Therefore, insiders might be better able to design optimal CEO compensation contracts. This line of argument questions the benefits of the compensation reform measures that limit the flexibility of firms to write optimal contracts. In sum, although there is concern over the role of insiders in compensation committees, some arguments exist in favor of insider participation in committees and against the related compensation reforms.

This article provides new evidence on the impact of insider-dominated compensation committees on CEO pay structures, and on changes in compensation committee composition surrounding recent regulatory reforms. My tests examine three distinct, but related research questions. First, what is the relation between insider participation in compensation committees and CEO pay levels? Second, what is the relation between insider participation in compensation committees and the pay-for-performance sensitivity? Third, how do CEO pay structures and the composition of the compensation committee change following the reforms? …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.