Friendly compensation committees and pay‐for‐luck asymmetry: Evidence from Taiwan

• Author: Hunghua Pan,Chia‐Wei Hsu,Yi‐Ping Liao
• DOI: http://doi.org/10.1111/corg.12311
• Published date: 01 March 2020
• Date: 01 March 2020

ORIGINAL ARTICLE

Friendly compensation committees and pay-for-luck

asymmetry: Evidence from Taiwan

Hunghua Pan

1

| Yi-Ping Liao

2

| Chia-Wei Hsu

3

1

Department of Quantitative Finance, National

Tsing Hua University and Center for Research

in Econometric Theory and Applications,

National Taiwan University

2

Department of Accounting, Fu Jen Catholic

University and Center for Research in

Econometric Theory and Applications,

National Taiwan University

3

Deloitte, Taiwan

Correspondence

Yi-Ping Liao, Department of Accounting, Fu

Jen Catholic University and Center for

Research in Econometric Theory and

Applications, National Taiwan University, No.

510 Zhongzheng Rd, Xinzhuang Dist., New

Taipei City, 24205. Taiwan (R.O.C).

Email: d93722002@gmail.com

Funding information

Ministry of Education in Taiwan, Grant/Award

Number: 108 L900202; Ministry of Science

and Technology in Taiwan, Grant/Award

Number: MOST 108-3017-F-002-003

Abstract

Research Question/Issue: The study examines whether the presence of social ties

between compensation committee members and executives explains pay-for-luck

asymmetry in compensation, which means that the compensation contracts reward

executives with higher pay for good luck but minimally penalize them with lower pay

for bad luck.

Research Findings/Insights: We find that half of our sample firms have a friendly

compensation committee, defined as the majority of the committee members having

at least two social ties with executives. For firms with a friendly compensation com-

mittee, executives tend to be rewarded for good luck but not be penalized for bad

luck, which indicates the presence of pay-for-luck asymmetry. For firms without a

friendly compensation committee, their executive compensation is not associated

with good luck or bad luck.

Theoretical/Academic Implications: The higher homophily due to social ties between

compensation committee members and executives induces the committee to be

more mentally close to or loosen the monitoring intensity over executives, and to be

less likely to make an unfavorable design of compensation toward executives in the

presence of bad luck. We complement existing studies by clearly demonstrating the

channel through which executives influence the committee members. We also high-

light the decisive role of the compensation committee in examining pay-for-luck

asymmetry research issues.

Practitioner/Policy Implications: Our findings inform practitioners that social ties

between compensation committee members and executives may impair the monitor-

ing intensity of the committee, and hence, regulators should take measures to man-

date or at least encourage firms to provide social ties information.

https://www.youtube.com/watch?v=UL9iGjERnRo&feature=youtu.be

KEYWORDS

Corporate governance, compensation committee, executive compensation, pay-for-luck

asymmetry, social ties

1|INTRODUCTION

Principal-agent theory suggests that tying executives' compensation

to a firm's performance is the most common compensation design to

induce executives' efforts in maximizing firm values (Grossman &

Hart, 1983; Harris & Raviv, 1979; Holmstrom, 1979). While firm per-

formance can be affected by executives' efforts, it also relates to out-

side factors that are beyond executives' control (Calvet & Rahman,

Received: 22 August 2018 Revised: 9 December 2019 Accepted: 10 December 2019

DOI: 10.1111/corg.12311

Corp Govern Int Rev. 2020;28:141–156. wileyonlinelibrary.com/journal/corg © 2020 John Wiley & Sons Ltd 141

2006; Holmstrom, 1979, 1982). The most widely known example is

provided by Bertrand and Mullainathan (2001). They mention that for

the oil industry, large movements in oil prices affect firm performance

on a regular basis, and they term the comovement between execu-

tives' compensation and oil prices “pay-for-luck,”because oil prices

are apparently out of managerial control. They empirically use mean

industry returns to measure the overall economic fortune of a sector

(i.e., the luck component of the firm performance), and find that CEO

compensation responds significantly to luck. Subsequently, Garvey

and Milbourn (2006) demonstrate evidence that penalties for bad luck

are significantly smaller than rewards for good luck, and such asym-

metry is usually referred to as pay-for-luck asymmetry (Campbell &

Thompson, 2015; Skantz, 2012).

Pay-for-luck asymmetry received academics' and practitioners'

attention because the design of executive compensation directly

affects executives' efforts, and consequently shareholders' wealth.

Garvey and Milbourn (2006) postulate that the degree of pay-for-luck

asymmetry varies with firm governance. Nevertheless, we are

unaware of any research that examines how oversight by the com-

pensation committee influences pay-for-luck asymmetry, which is sur-

prising because the committee plays a decisive role in determining the

appropriate design of reward structures for management and aligning

management and shareholders' interests (Conyon & Peck, 1998; Fal-

eye, Hoitash, & Hoitash, 2011; Jensen & Meckling, 1976). The present

study seeks to fill this research gap. As prior studies focus on the

potential of executives to influence the compensation setting process

(Bertrand & Mullainathan, 2001; Garvey & Milbourn, 2006) without

specifying the channel through which such influence takes place, we

focus on how the friendliness between executives and the compensa-

tion committee affects pay-for-luck asymmetry.

We capture the friendliness between executives and the compen-

sation committee based on the extent to which the committee mem-

bers are socially tied to executives (Hwang & Kim, 2009). Social ties

between the compensation committee members and executives usu-

ally indicate higher homophily (McPherson, Smith-Lovin, & Cook,

2001), which may lead to a higher sense of trust (Uzzi, 1996), familiar-

ity bias (Coval & Moskowitz, 1999; French & Poterba, 1991), and

groupthink (Janis, 1982). Consequently, a friendly compensation com-

mittee would be more mentally close to or loosen their monitoring

intensity over executives, and be less likely to make an unfavorable

compensation package for executives in the presence of “bad luck,”

which results in pay-for-luck asymmetry. In sum, we expect that a

friendly compensation committee positively relates to pay-for-luck

asymmetry in executive compensation.

Notably, unlike Hwang and Kim (2009) who focus on whether

friendly boards would reward executives with more compensation,

we examine the impact of a friendly compensation committee on the

design of executive compensation contracts. Specifically, we differ

from Hwang and Kim (2009) because we focus on “how to pay”

instead of “how much to pay.”Jensen and Murphy (1990) indicate

that it is more essential to focus on how to pay more than on how

much to pay. In other words, finding CEOs in firms with a friendly

compensation committee being paid more does not mean that they

are not paid according to the firm's performance. Hence, using pay-

for-luck asymmetry as the focus of our study is insightful from this

perspective. Additionally, Hwang and Kim (2009) focus on social ties

between board members and executives, while we are concerned

about social ties between the compensation committee members and

executives. As the research issue of interest is related to executive

compensation, focusing on social ties between compensation commit-

tee members and executives should be more straightforward and

close to the real world context.

Our sample includes all listed firms in Taiwan from 2011 to 2013.

We document the following evidence. First, our empirical analysis

indicates that for our sample, more than 50% of the compensation

committees are friendly towards executives. Second, the most com-

mon social tie between committee members and executives is that

they work in the same industry. More than 70% of committee mem-

bers and the executives were colleagues two years ago. Third, the

regression analysis indicates the presence of pay-for-luck asymmetry

only when the compensation committee is friendly. We conduct sev-

eral robustness tests, including using different definitions of friendly

compensation committees and applying instrumental variables (IV) to

mitigate endogeneity, and find consistent results.

This study contributes to executive compensation and board liter-

ature in the following ways. First, we embrace a wide range of board

literature, including organization theory, sociology, and finance litera-

ture to explore the effect of social ties on the design of compensation

contracts. Specifically, we elaborate on why social ties cause compen-

sation committees to loosen their monitoring intensity over execu-

tives. Second, we uncover the missing link between the pay structure

of executive compensation and a friendly compensation committee,

while prior studies suggest the potential presence of such a link but

fail to address whether it empirically exists (e.g., Bertrand & Mul-

lainathan, 2001; Hwang & Kim, 2009).

Our study also offers policy implications. The committee mem-

bers subject to executive influence may be more likely to align them-

selves with executives rather than shareholders. While our study

shows that social ties between committee members and executives

are prevalent and their background information is publicly accessible,

it is still less likely for general investors to identify the social ties

between them. To improve transparency about the relationships

between committee members and executives, the regulator may take

some measures to mandate or at least encourage firms to disclose

their social ties. This will not only benefit investors but also signal that

such firms have sound corporate governance.

Our findings provide valuable insights for the effectiveness of

corporate governance mechanisms. While corporate governance in

many markets has evolved by emulating practices in developed coun-

tries, this emulation does not necessarily solve the problem (Chen &

Huang, 2014; Chou, Hamill, & Yeh, 2018; Solomon, Lin, Norton, & Sol-

omon, 2003). The prevalence of social ties between committee mem-

bers and executives implies that firms may respond to the regulation

by recruiting committee members in a perfunctory manner. Hence, as

Larcker, Ormazabal, and Taylor (2011) indicate, because the existing

governance choices are the result of value-maximizing contracts

PAN ET AL.

142