The Joint Impact of Executive Pay Disparity and Corporate Governance on Corporate Performance
Pissaris, Seema, Jeffus, Wendy, Gleason, Kimberly C., Journal of Managerial Issues
CEO compensation is at historically high levels and as a result is receiving unprecedented levels of attention from multiple stakeholders including the academic, regulatory, business, and political comnmnities. An important by-product of escalating CEO compensation is the disparity in pay with other employees of the firm and particularly with other executives of the firm who work alongside the CEO. That gap in pay has been steadily rising, with CEOs now earning up to six times the compensation of their closest lieutenants (Pissaris and Golden, 2008), taking up a larger and larger slice of the firm's resources (Bebchuk et al., 2008).
The rising disparity or gap in pay between the CEO and other executives is commensurate with the number of studies devoted to this subject. There has been a veritable explosion of empirical and theoretical research aimed towards understanding the relationship between the relative difference in executive pay and its impact on firm performance (Boschen and Smith, 1995; Barkema and Gomez-Mejia, 1998) including the development of tournament theory (Lazear and Rozen, 1981; Lawler, 1981). Interest in executive pay has seeped beyond academia and corporate boardrooms. It is now raising eyebrows at the highest levels of government prompting debates aimed at improving corporate governance through additional regulations to better protect shareholders.
The bridge between CEO compensation and corporate governance can best be anchored in agency theory (Jensen and Meckling, 1976; Fama and Jensen, 1983) which views firms as a nexus of contracts between participants such as owners, managers, employees, creditors, suppliers, and others. The contracts, either express or implicit, are agreements for contributions to the organization in exchange for payment (Stinchcombe, 1965; Eisenhardt, 1985, 1989; White, 1985; Mitnick, 1986). Owners or principals contract with the manager or agent and the terms specify each party's obligations to the other (Fama and Jensen, 1983). The CEO's compensation package represents one such contract where the firm agrees to certain rewards in exchange for leadership and management of the firm. In order to effectively manage the organization, the CEO is also conferred control of organizational resources which may give rise to conflict of interest known as agency conflict. The costs of monitoring the CEO (agent) and ensuring that organizational resources are utilized to maximize shareholder (principal) interests while minimizing the potential risk of losses from the agent's self-interested behavior are known as agency costs.
Traditionally, corporate governance has relied on both internal and external monitors to align the goals of management with the goals of shareholders. External governance imposed on companies in the U.S. includes the 2002 Corporate Oversight Bill and the NYSE/Nasdaq/AMEX corporate governance rules. The U.S. functions under a market-based system with various monitors including institutional investors, board of directors, and management compensation. Market-based responses to shareholder dissatisfaction include disposal of shares, lawsuits, management change, and takeover threats. CEO rewards and the corresponding pay disparity are an internal governance mechanism that falls under the broad category of management compensation. Additional internal governance mechanisms include ownership concentration and issues related to the board of directors.
This study brings forward existing knowledge by empirically investigating in parallel the role of pay disparity and other corporate governance measures and their combined effects on firm performance. It examines four separate areas of corporate governance, assesses their interaction with pay disparity, and determines whether and how governance moderates the impact of executive pay disparity on performance. This relationship is viewed through longitudinal lenses in order to establish the combined role of governance and pay disparity on current and subsequent period performance. …