Country‐, firm‐, and director‐level risk and responsibilities and independent director compensation

• Published date: 01 May 2021
• Author: Andrea Melis,Luigi Rombi
• Date: 01 May 2021
• DOI: http://doi.org/10.1111/corg.12357

EDITOR'S PICK

Country-, firm-, and director-level risk and responsibilities and

independent director compensation

Andrea Melis | Luigi Rombi

Department of Scienze Economiche ed

Aziendali, University of Cagliari, Cagliari, Italy

Correspondence

Andrea Melis, University of Cagliari, Cagliari,

Italy.

Email: melisa@unica.it

Funding information

Fondazione di Sardegna

Abstract

Research Question/Issue: This study investigates how and to what extent country-

level institutional characteristics and firm- and independent director-level risk and

responsibilities are related to independent director compensation, in terms of amount

and design.

Research Findings/Insights: Using an international sample of 5,220 independent

directors on 727 non-financial listed firms in 16 countries, this study revealed that

both country-level institutional characteristics and firm- and director-level agency

account for the variation of independent director compensation amount. Firm-level

ESG-related reputational risk and director-level observable responsibilities on the

board are strongly related to independent director compensation amount. These

agency relationships vary in the different institutional settings. Country-level director

liability substitutes for firm-level and director-level monitoring. Firms conform to

institutional pressures for independent director compensation design. Institutional

embeddedness comes from the firm's primary institutional environment and its expo-

sure to foreign financial markets.

Theoretical/Academic Implications: This study develops a multilevel theory of the

antecedents of independent director compensation. Firm- and director-level agency

issues are nested in, and interact with, the institutional context in which the agency

relationship between shareholders and independent directors is embedded.

Practitioner/Policy Implications: This study helps practitioners to understand how

director liability regulations, a firm's ESG-related reputational risk and the specific

responsibilities on the board are related to independent director compensation. It

helps firms explain to shareholders (and stakeholders) how independent director

compensation is determined. Firms should consider that the consequences of their

ESG practices extend beyond direct costs. Policymakers can find our results useful

when regulating on director liability and developing best practices.

KEYWORDS

Corporate governance, corporate governance codes, comparative corporate governance,

director compensation

Received: 1 August 2019 Revised: 17 December 2020 Accepted: 21 December 2020

DOI: 10.1111/corg.12357

222 © 2021 John Wiley & Sons Ltd Corp Govern Int Rev. 2021;29:222–251.wileyonlinelibrary.com/journal/corg

1|INTRODUCTION

The presence of independent non-executive directors (hereafter

INEDs) on corporate boardrooms is a recommended corporate gover-

nance practice worldwide (e.g., Cuomo et al., 2016) as these directors

are expected to monitor and advise executives on behalf of share-

holders (Fama & Jensen, 1983).

Although individuals could be attracted to INED positions for

non-pecuniary reasons (Fama & Jensen, 1983; Lorsch & Young, 1990;

Mace, 1971), recent empirical evidence documented that compensa-

tion is an essential factor for INEDs (e.g., Adams & Ferreira, 2008;

Masulis & Mobbs, 2014). INED compensation also started to raise

interest among media, such as Fortune (Hodgson, 2015) and the

New York Times (Solomon, 2015). It also began to raise concerns

among shareholders. In June 2014, for example, a shareholder filed a

lawsuit against Facebook over an equity incentive plan for INEDs. In

January 2016, Facebook agreed to implement the shareholder meet-

ing approval of INED compensation (Court of Chancery of the State

of Delaware, 2014, 2016).

Understanding more about INED compensation is also important

from an academic perspective. Within an optimal contracting perspec-

tive of agency theory, an INED is expected to act as an agent for

shareholders (Fama & Jensen, 1983). However, INEDs, like executives,

are potentially self-interested and opportunistic (e.g., Andreas

et al., 2012; Certo et al., 2008). INED work and performance are

hardly observable outside the boardroom, that is, from a shareholders'

perspective. Specifically, shareholders who are not corporate insiders

are unlikely to have either the information and/or the expertise to

express a professional judgment upon INED performance (e.g., Mallin

et al., 2015). Hence, whether an INED will work in the shareholders'

interest is questionable. Prior literature within an optimal contracting

perspective of agency theory pointed out that the combination of

opportunism and information asymmetry creates the potential for an

agency problem between INEDs and shareholders. INED compensa-

tion is assumed to be the outcome of a contract that takes into

account risk and other economic factors with the intent of minimizing

agency costs by aligning the interests between shareholders and

INEDs (e.g., Andreas et al., 2012; Cordeiro et al., 2000; Mallin

et al., 2015).

Despite the theoretical and practical importance of INEDs and

their compensation, INED compensation has been defined as an

“enigma,”regarding both the amount and design (Brown, 2007;

Hahn & Lasfer, 2011; Magnan et al., 2010). The debate mainly

focused on the consequences of INED's performance-based compen-

sation (e.g., Cullinan et al., 2010; Sengupta & Zhang, 2015). The lim-

ited empirical literature on the antecedents of INED compensation

mainly examined firm- and, more recently, director-specific determi-

nants in a single institutional setting (e.g., Boyd, 1996; Cordeiro

et al., 2000; Goh & Gupta, 2016). However, these studies generally

neglected the role of institutional characteristics. Hence, it remains

unclear whether their findings are generalizable to other institutional

settings and how, and to what extent, country-, firm-, and director-

level factors shape INED compensation, in terms of amount and

design. These important limitations have been explicitly acknowl-

edged in the scant cross-country literature on INED compensation

(Mallin et al., 2015).

In this study, we contr ibute to filling thes e lacunas by exam-

ining the compensati on of 5,220 INEDs who ser ved on the board

of 727 non-financial listed firms headqu artered in 16 countr ies.

This study investiga tes whether, how, and to w hat extent

country-, firm-, a nd independent dire ctor-level observa ble risk and

responsibilities a re related to the amount of IN ED compensation.

It also investigates h ow, and to what extent, c ountry-level corp o-

rate governance bes t practices shape the c ontroversial issu e con-

cerning the adoption of p erformance-based co mpensations for

INEDs.

Our study seeks to make two contributions to the corporate

governance literature. First, this study helps to shed light on the

outstanding question (e.g., Aguilera et al., 2015; Kumar &

Zattoni, 2013) on how and to what extent country-level and firm-

and director-level agency characteristics interact shaping INED com-

pensation and, more in general, corporate governance practices. Our

results revealed that they all account for the variation in the amount

paid to INEDs. Among agency factors, an important variation in the

amount paid to INEDs lies between firms in the same country, while

a more modest, yet material, variation lies between INEDs in the

same board. Specifically, firm-level environmental, social, and gover-

nance (hereafter ESG) reputational risk and director-level observable

responsibilities on the board are strongly related to the amount paid

to an INED. Importantly, these agency relationships vary in the dif-

ferent institutional settings, with the director liability regime serving

as moderator. Country-level director liability substitutes for external

firm-level and internal director-level monitoring mechanisms so that

the positive relationship between these monitoring mechanisms and

independent director compensation is strengthened when director

liability is relatively lower. Second, this study provides new insights

on the controversial issue concerning performance-based compensa-

tion for INEDs (e.g., Hamdani & Kraakman, 2007; Sengupta &

Zhang, 2015; Zattoni & Cuomo, 2010). It documented that firms

strongly conform to institutional pressures for the design of INED

compensation. Only a relatively moderate variation lies between

firms in the same country, while no material variation lies between

INEDs in the same board. Institutional embeddedness does not

come only from the firm's primary institutional environment but also

from the exposure to foreign financial markets where the adoption

of performance-based compensation for INEDs is considered as a

best practice.

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

section covers the literature review, conceptual framework, and the

hypotheses' development. In Section 3, we outline our research

design. Findings are reported in Section 4. In Section 5, we present

our discussion and conclusion.

MELIS AND ROMBI 223