Does the Composition of the Compensation Committee Influence CEO Compensation Practices?

Financial Management (Financial Management Association), Autumn, 1999 by Harry A. Newman, Haim A. Mozes

This paper examines whether compensation committee composition affects CEO compensation practices. We find that CEOs receive preferential treatment (at shareholders' expense) when insiders are members of the compensation committee. We do not find that CEO compensation is greater in firms that have insiders on the compensation committee than it is in firms that do not. However, we show that the relation between CEO compensation and performance is more favorable toward the CEO (i.e., biased in the CEO's favor at shareholder expense) among the firms that have insiders on the compensation committee.

Congress, the National Association of Corporate Directors, directors, and others have criticized the appropriateness of having insider directors on the compensation committee of the board of directors. For example, the National Association of Corporate Directors (1993) advocates compensation committees that are truly independent. In a poll of directors of Fortune 1000 firms, 84% of respondents believed that compensation committees should be composed entirely of outside board members (Directors Publications, 1992). Even the US tax code reflects concern with insiders serving on compensation committees. A 1993 amendment to the Internal Revenue Code of 1986 (Section 162(m)) disallows a tax deduction for compensation in excess of $1,000,000 for certain top executives if performance goals are determined by a compensation committee that includes even a single insider director.

These concerns and regulations could reflect the perception that compensation practices are more preferential toward the CEO, and at shareholder expense, when the compensation committee includes insiders. Although there has been much discussion on this topic, there is almost no empirical research that tests for a relation between the composition of the compensation committee and CEO compensation decisions. This research begins to fill this void. We explore and examine whether the composition of compensation committees of boards of directors influences CEO compensation.

The results of our study address the concerns of interested parties, and provide support for calls for public policy initiatives regarding the appointment of insiders to compensation committees.

Recent evidence suggests that cross-sectional differences in stock-option grants are inconsistent with optimal contracting (e.g., Yermack, 1995). Our results indicate that stock-option grants following firm-specific price declines are more consistent with managerial self-dealing than with optimal contracting. Further, our results indicate that Saly's (1994) finding, that additional stock-option grants are made when options go deeply out of the money due to a market-wide downturn, is more likely to be consistent with managerial self-dealing than with optimal contracting.

Several papers find that the composition of the full board of directors, in terms of insiders and outsiders, influences firm value either directly or indirectly (e.g., Brickley, Coles, and Terry, 1994; Byrd and Hickman, 1992; Rosenstein and Wyatt, 1990; Weisbach, 1988; and Brickley and James, 1987). Weisbach finds that a greater proportion of outsiders on the board of directors is associated with an increased likelihood that the board will replace the CEO after a period of poor corporate performance. Brickley and James credit board outsiders with reduced managerial consumption of perquisites. [1] This paper provides evidence that the composition of the compensation committee, a committee appointed by the board of directors, influences CEO compensation practices, and hence the value of the firm.

The paper is organized as follows. We describe our hypotheses in Section I. We discuss the methodology used to test our hypotheses in Section II. Section III presents the test results. Section IV provides a summary, conclusions, and recommends several public policy initiatives.

I. Hypotheses

The compensation committee of the board of directors plays an important role in the CEO compensation decision. The compensation committee's role in the executive compensation decision process is to either determine executive compensation or make recommendations to the full board of directors. The board expects to adopt the compensation committee's recommendations with possible modest modifications. The importance of the compensation committee in CEO compensation decisions is supported empirically (e.g., Belliveau, O'Reilly, and Wade, 1996; and O'Reilly, Main, and Crystal, 1988).

The managing director of William M. Mercer Inc., a compensation and benefit consultant organization, stated, "The compensation committee has a difficult job: it is charged with overseeing the company's pay programs for officers (salary, incentive, stock perquisites), and often the pay programs of other employees as well (pension, profit sharing, etc.)" (McMillan, 1992).

For example, the 1992 proxy statement of American Cyanamid describes the function of the compensation committee as:

The Compensation Committee, which held five meetings in 1991, determines the salaries of the Company's officers, administers several compensation plans and makes recommendations thereunder, and passes on all forms of remuneration affecting the Company's senior management.