Private Information in Executive Compensation: The Information Role vs. The Monitoring Role of the Board

• Published date: 01 January 2016
• Author: Kin Lo,Serena Shuo Wu
• Date: 01 January 2016
• DOI: http://doi.org/10.1111/corg.12122

Private Information in Executive Compensation:

The Information Role vs. The Monitoring Role of

the Board

Kin Lo and Serena Shuo Wu*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paperexamines the effect of boards of directors’characteristicson the use of private information

in executive compensation.

Research Findings/Insights: We predict and f‌ind that boards’competence both in information acquisition and in monitoring

inf‌luences the extentto which boards use private performance measures in CEO compensation. Specif‌ically, smaller and more

independent boards with their CEOs as the board chair are found to rely more heavily on private performance measures. The

documented effects of board characteristics disappear after the passage of SOX, likely due to the homogenized composition of

boards and compensation committees brought by the legislated changes.

Theoretical/Academic Implications: The paper extends theliterature on the board’s rolein executive compensation. Although

prior evidenceis abundant on how boards affect thealignment of CEO compensation withpublic performance measures,little

is known about boards’use of private information to compensate CEOs. It also extends the literature on the role of corporate

boards by examining both their monitoring and information roles.

Practitioner/Policy Implications: This study offers insightsto regulators regardingthe role of boards of directors in monitoring

and their rolein private informationacquisition. It highlightsthe importance of consideringthe tradeoff between thesetwo roles

when regulating corporate governance rules.

Keywords: Corporate Governance, Executive Compensation, Private Performance Measures, Board of Directors

INTRODUCTION

Recent researchf‌inds evidence that boardsuse their private

informationaboutCEOs as an additionalinput in compen-

sation contracts (Gibbs, Merchant, Van der Stede, & Vargus,

2004; Hayes & Schaefer, 2000).This practice can improve com-

pensationeff‌iciencyby mitigatingmanagement’smyopicfocus

on current performance and by reducing the noise in perfor-

mance measures. Building on this result, we explore some of

the determinant s that inf‌luence the extentto which boards use

private information in executive compensation. The purpose

of this analysisis to extend the literature on theboard’s role in

executive compensation; there is little existing evidence on

boards’useof private information,in contrast to a large volume

of researchon their use of public information.

Executive compensation is one of the most important tasks

for boards of directors. As insiders who work closely with ex-

ecutives, directors have a more complete view of managers’

work than outsiders. Specif‌ically, directors possess private

knowledge about certain CEO actions, such as strategic plan-

ning and innovativedevelopments, which impact f‌irms in the

long run but are not captured by current observable perfor-

mance measures. In setting CEO compensation, the role of

boards of directors with respect to information has two dis-

tinct components. The f‌irst is the acquisition of precise infor-

mation about CEO actions, which we call the “information

role.”The second component is the use of that information

in performanceevaluation and compensation;we call this sec-

ond component the “monitoring role”in the sense that direc-

tors can use the information they acquired to reward or

punish CEOs and induce a set of actions that conform to

shareholders’interests.

1

Recent theoretical work highlights

the importance of information acquisition in board effective-

ness; examples include Adams and Ferreira (2007), Harris

and Raviv (2008), Kumar and Sivaramakrishnan (2008), and

Raheja (2005). In contrast, the information role of the board

is often neglected in empirical compensation research.

Existing literature has examined the relation between board

attributes and indicators of compensation eff‌iciency, such as

the level of CEO compensation (Core, Holthausen, & Larcker,

1999; Cyert, Kang & Kumar, 2002; Grinstein & Hribar, 2004),

*Address for correspondence: Serena Shuo Wu, Queen’s School of Business, Queen’s

University, 143 Union Street, Kingston, ON, Canada, K7L 3N6; E-mail: swu@business.

queensu.ca

© 2015 JohnWiley & Sons Ltd

doi:10.1111/corg.12122

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Corporate Governance: An International Review, 2016, 24(1): 5–23

pay-performance sensitivities (Yermack, 1996), and replacing

management forpoor performance (Weisbach, 1988). Priorre-

search emphasizes the monitoring role of the board, examin-

ing to what extent the CEO is rewarded/published in

accordance withthe publicly observable measures such as ac-

counting performance or stock returns (i.e,, no private infor-

mation is involved). However, in the context of private

performancemeasures, which is the focus ofthis paper, the in-

formation roleof the board becomes crucialbecause the board

must acquire the private information before using it in com-

pensation decisions.

2

Therefore, a distinct feature of this re-

search is that we examine the tradeoff between the

information role and the monitoring role.

The private information that the board has access to cannot

be observed by researchers; rather, it needs to be inferredfrom

public information. If CEO compensation is based on both

publicly and privately observed performance measures, a re-

gression of CEO compensation on currentpublic performance

measures produces residuals (later referred to as ‘residual

compensation’) that serve as a proxy for private information

of the board.However, this proxyis noisy because the residual

potentially contains both private information regarding CEO

actions and other factors driving compensation but orthogo-

nal to current performance.

We examine the relation between future f‌irm performance

and current residual compensation, similar to the design de-

veloped in Hayes andSchaefer (2000). Since the private infor-

mation received by the board can reveal the impact of CEO

actions on long-term f‌irm value, it should therefore have a

positive association with future f‌irm performance. If no pri-

vate information is used in CEO compensation, the residual

term would be unrelated to future f‌irm performance on aver-

age. As the private information component is afforded larger

weight, a strongerrelation should be observedbetween future

performance and residual compensation.

The evidence prior to the Sarbanes-Oxley Act (SOX)

shows that board characteristics have signif‌icant impact

on the use of private information in compensation. Specif-

ically, the relation between future performance and resid-

ual compensation is found to be stronger for f‌irms with

smaller and more independent boards and for f‌irms with

their CEOs as the board chair. Consistent with prior liter-

ature, the f‌indings of this study support the view that

smaller boards are better able to obtain information for

making decisions. The results on board independence,

combined with evidence from prior studies, suggest that

the monitoring role is important for mitigating agency

costs. On the other hand, the dual arrangement of the

CEO being the Chair of the Board (CEO/COB)

strengthens the information role of the board, presumably

through more direct communication between the CEO and

the other directors; therefore, private information of higher

quality can be obtained and incorporated into the com-

pensation contract.

The passage of SOX has introduced sweeping changes to

the landscape of corporate governance,including the compo-

sition of corporate boards and the compensation committee.

Our analyses that compare the pre- and post-SOX periods

lead to an interestingf‌inding that the effects of the boardchar-

acteristics found in the pre-SOX period disappear after SOX,

suggesting that the more stringent corporate governance

requirements following the reforms have regulated the board

structure to theextent that the structure becomes irrelevant to

board effectiveness.

This paper has three contributions. First, it extends the liter-

ature on the board’s role in executive compensation. Specif‌i-

cally, this paper examines the board’sroleinanother

dimensionof compensation: the use of privatelyobserved per-

formance. Although prior evidence is abundant on how

boards affectthe alignment of CEO compensationwith public

performance measures (e.g., pay-performance sensitivity,

turnover-performance sensitivity, etc.), little is known about

boards’use of private information to compensate CEOs. In

comparisonto these studies, the use of privately observedper-

formance measures is less likely to be confounded by other

motives forusing such information. Boardsdo not have incen-

tives to window dress for public relations purposes (e.g., set

high pay-performance sensitivities), because how compensa-

tion is contracted on private performance measures cannot

be observed by outsiders. Neither do boards have incentives

to put a higher-than-optimal weight on private performance

measures, as public pressure makes it costly to compensate

CEOs based on what is unobservable and diff‌icult for the

board to justify.

Second, this paper extends the literature on the role of cor-

porate boards by examining both their monitoring and infor-

mation roles. Prior research largely emphasizes the

monitoring role of the board, arguing that board members

should be independent from corporate executives to improve

governance, enhance f‌irm value, and achieve optimal com-

pensation contracts (Brickley, Coles, & Terry, 1994; Core

et al., 1999; Fama, 1980; Fama & Jensen, 1983). However, re-

cent work by Adams and Ferreira (2007) suggests that it is

as important, if not more important, for the board to obtain

high quality information about the f‌irm, and that stressing

the monitoring role alone is not ideal, as the quality of infor-

mation receivedby the board would be sacrif‌iced. In addition,

Harris and Raviv (2008) and Kumar and Sivaramakrishnan

(2008) model the importance of information acquisition and

how boards’characteristics interact with their private infor-

mation efforts. We provide empirical evidence that builds on

this body of theoretical work, and offer insights to academia

and regulators by highlighting the importance of considering

the tradeoff between information and monitoring roles when

regulating corporate governance rules.

Third, this paper provides evidence on the eff‌icacy of SOX.

Variation in board characterist ics explains the use of priva te

information pre-SOX but not post-SOX, suggesting that SOX

had the intended effect of increasing the uniformity of board

structure and the composition of compensation committees.

The remainder of this paper is organized as follows: The

next section reviews the prior literature and developstestable

hypotheses. This is followed by a section that details the re-

search design and describes the data. The empirical results

and robustnesscheck are then discussed. The paperthen ends

with a summary of conclusions.

LITERATURE AND HYPOTHESES

Compensation committee reports contained in f‌irms’proxy

statements often indicate that bonuses awarded to managers

6CORPORATE GOVERNANCE

© 2015 JohnWiley & Sons LtdVolume 24 Number 1 January 2016