Are optimal contracting and managerial power competing or complementary views? Evidence from the compensation of statutory auditors in Italy

• DOI: http://doi.org/10.1111/corg.12231
• Author: Andrea Melis,Luigi Rombi
• Date: 01 May 2018
• Published date: 01 May 2018

ORIGINAL ARTICLE

Are optimal contracting and managerial power competing or

complementary views? Evidence from the compensation of

statutory auditors in Italy

Andrea Melis |Luigi Rombi

Department of Business and Economics,

University of Cagliari, Italy

Correspondence

Andrea Melis, Department of Business and

Economics, University of Cagliari, Italy

Email: melisa@unica.it

Funding information

Fondazione di Sardegna

Abstract

Manuscript Type: Empirical

Research Question/Issue: This study examines whether and to what extent the compensa-

tion of independent monitors at the board level is the outcome of an optimal contract between

independent parties or the result of involvement with corporate insiders.

Research Findings/Insights: By using a hierarchical linear regression model with a sample

of 559 statutory auditors, whose main task is to monitor the acts and the decision‐making pro-

cess of the board of directors, this study provides evidence that statutory auditors' compensation

is mainly based upon the effort and responsibilities that are observable by shareholders. How-

ever, our findings highlight that the additional, poorly disclosed, compensation that a statutory

auditor may receive, unrelated to his/her role, is associated with his/her involvement with corpo-

rate insiders.

Theoretical/Academic Implications: By analyzing a de facto three‐tier hierarchical agency

model, this study gives insights into how and to what extent the optimal contracting and mana-

gerial power perspectives provide complementary, rather than competing, explanations to the

basis and design of compensation at the board level. Not only do these perspectives of agency

theory co‐exist at an aggregate level, but also seem to be complementary at both the firm level

and individual level.

Practitioner/Policy Implications: This study offers insights to policymakers by questioning

the current regulation that allows threats to the de facto independence of a formally independent

corporate governance mechanism. We recommend further disclosure about the criteria and the

rationales of the additional compensation received by statutory auditors. In addition, we suggest

investors and other stakeholders, who may rely on the work of the board of statutory auditors as

independent monitor, to be careful about the way statutory auditors are paid.

KEYWORDS

Corporate GovernanceTheories, Board of Director Mechanisms,Director Compensation, Italy,

Agency Theory

1|INTRODUCTION

The compensation of individuals who operate at board level, with or

without an executive role, represents a controversial topic in corporate

governance (e.g., Adams & Ferreira, 2008; Boyd, 1996; Brick, Palmon,

& Wald, 2006; Conyon, 2006; Cordeiro, Veliyath, & Eramus, 2000;

Fernandes, Ferreira, Matos, & Murphy, 2013; Hahn & Lasfer, 2011;

Mallin, Melis, & Gaia, 2015; Murphy, 2002). The underlying idea is that

the structure and determinants of the compensation of these individ-

uals can be a proxy for the quality and effectiveness of their role per-

formed at board level (e.g., Adams & Ferreira, 2008; Boyd, 1996;

Cordeiro et al., 2000; Mallin et al., 2015). On the one hand, high levels

Received: 2 November 2016 Revised: 18 October 2017 Accepted: 23 November 2017

DOI: 10.1111/corg.12231

Corp Govern Int Rev. 2018;26:197–218. © 2018 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/corg 197

of compensation could reflect the high levels of effort, responsibilities,

and reputational risk that accompany the role (e.g., Adams & Ferreira,

2008; Mallin et al., 2015). On the other hand, they might also reveal

lack of efficiency because of the potential reciprocity and collusion

among corporate insiders (Bebchuk, Fried, & Walker, 2002; Brick

et al., 2006; Mallin et al., 2015).

One of the questions that has been widely investigated, but which

is still of great potential interest as prior studies have not provided a

definitive answer, is whether compensation at board level is the out-

come of managerial power, rather than being the result of an optimal

contract between independent parties (Bebchuk et al., 2002; Bebchuk

& Fried, 2003; Murphy, 2002; Van Essen, Otten, & Carberry, 2015).

Most prior literature has focused on executive compensation, in partic-

ular on the highest paid executive, the CEO (Brick et al., 2006;

Fernandes et al., 2013; Murphy & Zábojník, 2004; Van Essen et al.,

2015). Despite its theoretical and practical relevance, the compensa-

tion of the independent corporate governance institutions that

monitor the board of directors' decisions has received relatively little

attention so far and their structure and determinants have been

referred to as an “enigma”(Hahn & Lasfer, 2011; Magnan, St‐Onge,

& Gélinas, 2010; Shen, 2005). This limited research stream focused

on independent non‐executive directors (e.g., Adams & Ferreira,

2008; Brick et al., 2006; Farrell, Friesen, & Hersch, 2008; Goh & Gupta,

2016; Hahn & Lasfer, 2011; Hempel & Fay, 1994; Mallin et al., 2015;

Marchetti & Stefanelli, 2009) and, to a lesser extent, on the members

of the supervisory council (Andreas, Rapp, & Wolff, 2012). Given the

fact that prior literature focused on corporate governance actors

who are expected to monitor and advise executives (e.g., Andreas

et al., 2012; Fama & Jensen, 1983; Goh & Gupta, 2016), this choice

has not allowed prior studies to disentangle the effect on pay of the

advisory role from the monitoring role (Goh & Gupta, 2016; Hahn &

Lasfer, 2011; Mallin et al., 2015). This gap is important as these effects

differ depending on the individual's role (and tasks) at the board level

(e.g., Courteau, Di Pietra, Giudici, & Melis, 2017; Schöndube‐

Pirchegger & Schöndube, 2010). By using a unique hand‐collected

dataset of 559 individuals who operate exclusively as monitors

at board level in 181 Italian non‐financial listed firms, this study is

able to isolate the monitoring function from the advisory one and

address this gap.

This study aims to understand whether, and to what extent,

optimal contracting and managerial power represent alternative or

complementary views on the compensation of board‐level monitoring.

The members of the board of statutory auditors, a corporate gover-

nance institution that is typical of the board structure of Italian firms,

are expected to provide reassurance to shareholders that corporate

directors are monitored. They should oversee the internal control

system of the firm similarly to the independent non‐executive direc-

tors in an audit committee. However, in contrast to independent

directors, statutory auditors are expected to act as independent mon-

itors of the board of directors' decision‐making process on behalf of

shareholders. They also take part in the board of directors' meetings,

without having any advisory role in the decision taken (Melis, 2004).

For this reason, the analysis of the basis and amount of their compen-

sation provides an ideal setting to examine the compensation of

individual members who are expected to serve exclusively as

independent monitors at board level. Therefore, our study contributes

to understanding how monitoring responsibilities at board level are

rewarded.

The paper makes a number of key contributions to the corporate

governance literature. First, this study provides new insights on how,

and to what extent, optimal contracting and managerial power per-

spectives provide complementary, rather than competing, explanations

of statutory auditors' compensation, within the different contracting

arrangements covered by agency theory. Second, to the best of our

knowledge, this is the first archival‐based effort that examines the

criteria of the compensation of the members of a formally independent

corporate governance institution that acts exclusively as a monitor of

the decisions of boards of directors. By exploiting the uniqueness of

the activity performed by the board of statutory auditors in Italy, this

study addresses one of the main limitations of prior literature, which

could not fully disentangle the effect on pay of the advisory role from

the monitoring role (Goh & Gupta, 2016; Hahn & Lasfer, 2011; Mallin

et al., 2015). The focus on this corporate governance institution also

allows us to conduct the empirical analysis in an institutional context

(Italy) in which the risk of collusion between corporate insiders and

supposedly independent monitors is potentially high (e.g., La Porta,

Lopez‐de‐Silanes, Shleifer, & Vishny, 1997; Melis, 2000, 2005; Volpin,

2002; Zattoni, 1999; 2015). This is an important corporate governance

issue given the potential for agency problems (Jensen & Meckling,

1976) between different types of principals (controlling and minority

shareholders) and the members of a board appointed by them to exer-

cise independent monitoring on corporate insiders and the board of

directors (Andreas et al., 2012; Bebchuk et al., 2002; Mallin et al.,

2015). Given the institutional characteristics of Italy (e.g., prevailing

principal–principal agency problem, concentrated ownership and

control structure, high risk of collusion at the board level, etc.—see

the next section), our findings are potentially highly generalizable to

the great majority of firms listed around the world. These firms, possi-

bly with the exclusion of those headquartered in some important

Anglo‐American countries, generally cope with similar agency prob-

lems (e.g., Djankov, La Porta, Lopez‐de‐Silanes, & Shleifer, 2008;

Volpin, 2002).

Our study also offers important insights to policymakers. First, it

questions the formally strict regulation on de jure independence which

seems to allow threats to statutory auditors' de facto independence.

Secondly, it suggests improvements in the disclosure of the criteria

for the compensation of individuals who are expected to serve as inde-

pendent monitors at the board level in the interest of all shareholders.

In addition, this study also cautions investors and other stakeholders,

who may rely on the work of internal independent monitors (such as

the board of statutory auditors), to be careful about the way these

monitors are paid.

The remainder of the article is structured as follows. The next sec-

tion provides some background on the institutional setting, describing

the agency problem that characterizes Italian listed firms and the role

of the board of statutory auditors within the Italian corporate gover-

nance regulatory framework. The third section covers the literature

review, the conceptual framework and the development of the

hypotheses. In the fourth section, we outline our research methodol-

ogy, followed by the data analysis. The empirical findings are reported

198 MELIS AND ROMBI