Does board independence mediate the impact of CEO power on the use of equity-based compensation?

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Does board independence mediate the impact of CEO

power on the use of equity-based compensation?

Master Thesis Accountancy & Controlling Reiny Haijtema

S2720035 University of Groningen Faculty of Economics and Business

Jozef Israëlsstraat 73a 9718GG Groningen r.a.haijtema@student.rug.nl

ABSTRACT: This study investigates whether CEOs influence the use of equity-based compensation directly, or via board composition. A panel data regression is performed on S&P 500 firms in the U.S. in the period 2010-2016. Findings suggest that CEOs use their power to affect the compensation package in such a way that it will contain less equity-based compensation. Surprisingly, the findings are suggesting that board independence increases when CEO power increases. The results of this study imply that, beside the increased regulation on board independence (e.g. SOX and listing requirements) and increasing independence to curb increasing CEO power, a CEO is still able to exert his/her power in such a way that compensation package is shaped in a way which is more favorable for the CEO.

Keywords: Corporate governance; CEO power; board independence; equity-based compensation

JEL Classifications: G34; J33

Supervisor: N. J. B. Mangin Co-assessor: dr. R.A. Minnaar

Word count: 7598

Acknowledgment: First of all I want to thank my supervisor mr. Mangin for guiding me through this process and providing me with useful feedback to write my master thesis. Besides mr. Mangin I would also like to thank PwC for providing the opportunity to write my thesis during an internship. Via this, I received extra support writing my thesis and became familiar with PwC and their people. Lastly, I would like to thank my friends and family for their mental support.

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1. INTRODUCTION

Shareholders are increasingly dissatisfied with the current compensation packages received by top executives of U.S. firms. As suggested by a decrease in the amount of votes which accept the compensation packages received by the executives.1_{In 2013, 68.9% of the votes of shareholders were}

in favor of the compensation plan; in 2017 this was only 48.1%.2_{This growing dissatisfaction with}

executive compensation may call into question the effectiveness of the board of directors which is supposed to protect the interests of the shareholders (Jensen & Murphy, 1990).

From the perspective of agency theory, shareholders and executives have different interests. Shareholders (principals), are interested in the growth of stock returns, while CEOs (agents) are more interested in maximizing their own returns (Jensen & Murphy, 1990). CEOs which continue their own goals to pursue private benefits are defined by Combs, Ketchen, Perryman, and Donahue (2017) as powerful CEOs. Nyberg, Fulmer, Gerhart, and Carpenter, (2010) and Garg and Eisenhardt (2017) describe two mechanisms to control for the described agency problem namely, (1) the monitoring role of the board of directors and (2) the use of financial incentives for the CEO of a firm

Monitoring consists in observing the behaviour of the CEO and intervening when CEOs display opportunistic behaviour (Martin, Wiseman, & Gomez-Mejia, 2016). According to Boivie, Bednar, Aguilera, and Andrus (2016), effective monitoring occurs when board members are able to gather and process information, and thereafter share this with those who need the information. Fama and Jensen (1983), predict that a board is more effective in performing this monitoring role when board members are more independent, i.e. outsiders of the firm (Armstrong, Core, & Guay, 2014). By obtaining a board which consists mainly of independent directors, monitoring is supposed to become more effective, which in turn leads to a decrease in the ability for a CEO to take actions which are self-interested (Fama & Jensen, 1983).

From the perspective of agency theory, the setting of a compensation plan is based on optimal contracting in which the board acts as the representatives of the shareholder, and negotiate with CEOs who try to get their own best deal (Core, Guay, & Verrecchia, 2003). Agency theory predicts that by aligning CEO compensation with shareholder returns, the CEO has incentives to act in line with the interest of the shareholders. For example, include equity-based compensation as a type of compensation for the CEO (Jensen & Murphy, 1990). Equity-based compensation is a way to reward the performance of a CEO, by aligning CEO compensation directly to the stock price of the firm (Seo & Sharma, 2018).

1_{The Dodd-Frank Wall Street Reform and Consumer Protection Act comprises a so called say-on-pay provision.}

This provision provides shareholders, of public companies within the U.S., with the right to give an advisory vote on the compensation package of the top 5 executives within the firm (Collins, Marquardt, & Niu, 2017).

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However, empirical evidence suggests that setting a compensation plan is not always based on optimal contracting (Van Essen, Otten, & Carberry, 2015). Bebchuk and Fried (2006) argue that, based on managerial power theory, a CEO can leverage his/her power to negotiate towards a more advantageous compensation package. According to Combs et al., (2017), directors are responsible for controlling the power of a CEO. When directors don’t do this in a proper way, the CEO is able to take self-serving actions, and in turn, decrease shareholder wealth. Such self-serving actions includes to ‘engineer a large fixed salary’, resulting in a compensation plan that contains less equity-based compensation but more cash compensation and short-term compensation (Walsh & Seward, 1990: 432, Morse, Nanda & Seru, 2011). By adopting such a strategy, the CEO maximizes his/her own wealth, instead of maximizing shareholder value.

According to Hill and Phan (1991), there are reasons to believe that a CEO seizes power over time to dominate the board of directors in such a way that the compensation plan will change, so that it reflects the interests of the CEO more than those of the shareholders. Zajac and Westphal (1996), suggest that a CEO can exert his/her power by affecting the board composition in a way which is favourable for him/her. This could be a board with familiar directors, thus adding more insiders than outsiders in the board, and thereby decreasing board independence. Other studies like Bebchuk, Fried, and Walker (2002) argue that a CEO uses his/her power to influence both outside as well as inside directors, thereby affecting the attitude of board members towards the CEO. A CEO is in charge of shaping the agenda for board meetings, and therefore able to control discussions within the boardroom, and most importantly, the CEO decides what kind of information is received by directors. If power is exerted via board composition discussed by Zajac and Westphal (1996), regulations on board independence may serve as a solution. When power is exerted by affecting the attitude of board members discussed by Bebchuk et al. (2002), regulations on board independence are not the optimal solutions and further research has to be done to study how this power can be mitigated.

Therefore, the aim of this study is to understand how a CEO uses his/her power to influence the structure of a compensation package which is received by a CEO. More precisely, how CEO power can influence the compensation package in such a way that it is less aligned with shareholders’ interest, as evidence by the use of equity-based compensation. Is this via re-shaping the board, i.e. decreasing independence of the board, or is a CEO able to exert his/her power, no matter whether the board is independent or not? This leads to the following research question:

“Does board independence mediate the impact of CEO power on the use of equity- based compensation?”

This study is performed on S&P 500 firms located in the U.S. with a sample of 1469 firm-years observations from the period 2010-2016. Empirical evidence is found for the decrease in equity-based compensation when CEO power increases. However, there is no evidence that board independence

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mediates this relation. I observe, on the contrary that board independence increases when CEO power increases. A possible explanation could be that shareholders use board independence as a mechanism to counteract CEOs increase in power over time.

This study will contribute to previous studies in several ways. First, findings indicate that a CEO exerts its power through private information and setting the agenda to reduce equity-based compensation as stated by Bebchuk et al, (2002), and not through the composition of the board as stated by Zajac and Westphal (1996). This implies that increasing board regulation on board independence is not sufficient to mitigate the power of the CEO, since CEOs are still able to pursue their own interest. Second, to my best knowledge, this is the first study which found that board independence increases together with CEO power. A reason for this could be that shareholders demand more board independence when CEO power increases as a way to curb CEO power (Lewellyn & Muller-Kahle, 2012). This implies that board independence is used to compensate for the increase in CEO power over time.

The remainder of this paper is structured as follows. Chapter two consists of the theory section. Chapter three includes the development of the hypotheses. Chapter four explains the research method. In chapter five, the results of this study are provided. Last, chapter six contains the discussion of the results of this study, possible limitations, and implications for further research.

2. THEORETICAL BACKGROUND

2.1. CEO compensation

Corporate scandals like Enron and Worldcom, have cast doubt on the effectiveness of corporate governance mechanisms, especially the board of directors. This attracted attention and caused a large public debate about corporate governance, and especially, CEO compensation (Bebchuk & Fried, 2006; Cianci, Fernando & Werner, 2011). Jensen and Meckling (1976) state that contracts are formed between the principals, and the agent of the firm, in which the shareholders, the owners of the firm, agree on delegating the authority of decision making to the management. Eisenhardt (1989) describes two agency problems, arising in the principal-agent relationship. The first problem arises when the goals of the principal and agent are not aligned. And due to the fact that for the principal it is hard to measure the actions and effort performed by the agent in such a way that it is possible to link a justified reward to those actions. The second problem is concerned with different attitudes towards risk. The principal is assumed to be risk-neutral because he/she is able to diversify the investment portfolio. On the contrary, the agent is not able to diversify its risk and is therefore assumed to be risk averse. Both conflicts arise because the parties are maximizing their own utility, therefore management may not always act in the best interest of the shareholders (Jensen & Meckling, 1976).

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Two mechanisms are used to address the described agency problem, monitoring and incentive alignment (Jensen & Meckling 1976). The main purpose of incentive alignment, by the use of an incentive scheme, is to provide management with a financial reward for their performed actions, which resulted in an increase in shareholder wealth. Equity-based compensation is a way to align the interest of the CEO and the shareholders, by aligning CEO compensation directly to the stock price of the firm (Petra & Dorata, 2008; Seo & Sharma, 2018). Now, the definition of an incentive scheme is different in optimal contracting theory and managerial power theory (Bechuk et al., 2002)

2.2. Optimal contracting theory

The first view to address the link between the agency problem and CEO compensation is optimal contracting theory (OCT). Bebchuk and Fried (2006:5) describe, from the view of OCT, the setting of a compensation plan as a “product of arm’s-length contracting”. In which boards are trying to get a favorable deal for shareholders, and CEOs try to set a favorable deal for themselves. According to the OCT, a properly constructed compensation package for CEOs can be a strong instrument by which performance of the CEO can be enhanced, and in turn the solution to (partially)3_{solve the agency}

problem (Bebchuk & Fried, 2003; Schneider, 2013; Cho, Huang & Padmanabhan, 2014; Ntim, Lindop, Thomas, Abdou & Opong, 2017). The OCT view caused a huge call from economists, for boards, to create a compensation package where a strong link between pay and performance exists. Thereby, creating an increase in the amount of equity-based compensation which is received by the CEO as a way to mitigate the agency problem (Weisbach, 2007).

Since equity-based compensation enhances shareholder wealth due to rewarding a CEO for actions that increase firm value, and thus shareholder value, it became an important aspect in the compensation package of the CEO (Schneider, 2013). The inclusion of equity-based compensation creates incentives for a CEO to take actions which maximize stock value (Martin, Gomez-Mejia & Wiseman, 2013). An important notion has to be made that only using equity-based compensation is not a good idea. The behavioral agency model of Wiseman and Gomez-Mejia (1998) states that including too much equity-based compensation creates an extremely risk-averse CEO, due to huge risk bearing. Where shareholders are able to diversify their risk across their portfolio, a CEO is not able to diversify its risk, therefore the CEO has great risk bearing and will become risk-averse and conservative in making decisions, which in turn will affect the firm (Cordeiro & Valiyath, 2003). This suggests that there is an optimal level of equity-based compensation, which varies with the idiosyncratic risk of the

3_{The OCT recognizes that it is impossible to create a contract which causes a perfect alignment between the}

interest of the principal and the agent, so when talking about an optimal contract, we mean the contract that reduces the agency costs as much as possible (Bechuk, Fried, & Walker, 2002).

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firm. This view can be seen as the prevailing theory which is used before the financial crisis in 2008 (Schneider, 2013).

2.3. Managerial power theory

While the OCT states that CEO compensation is an effective remedy to (partially) solve the agency problem, the managerial power theory (MPT) focusses on a view in which the compensation of a CEO can even exacerbate the agency problem. Powerful CEOs can have a significant influence on the definition of incentive contract. They may therefore exert this influence to serve their own best interest, subverting incentive compensation away from its intended purpose (Bebchuk & Fried, 2003; Vo & Canil, 2016). As Van Essen et al., (2015) state, the MPT does not counter the agency theory, but instead expand it by showing that a CEO can have a significant influence on his/her compensation in such a way that the theory of optimal contracting doesn’t seem to work in reality. Advocates of the MPT state that this view is more consistent with the reality in which the board and the CEO within an organization try to negotiate on a compensation contract (Schneider, 2013).

There are two ways in which this power can be exerted. Indirect influence via board composition (Zajac & Westphal, 1996). Or direct by controlling the private information and setting the agenda’s for board meetings (Bebchuk et al., 2002). The actions which needs to be taken to mitigate CEO power, depends on which path prevails. When power is exerted via affecting board composition, more regulation on board independence might be an optimal solution. However, when the direct path seems more prevailing, another way to mitigate CEO power needs to be found.

3. HYPOTHESIS DEVELOPMENT

3.1. CEO power and equity-based compensation

Several researchers argue that a CEO, who has significant influence on his/her compensation package, will try to engineer a compensation package in which pay is more fixed and not depending on other factors, for example a compensation package which exists mainly out of cash compensation (Bebchuk & Fried, 2004; Ryan & Wiggins, 2004).

Bebchuk and Fried (2004) provide several reasons why directors might approve such a compensation package which is in favor of the CEO, instead of acting in the best interest of shareholder, when the CEO tries to exert his/her power. First, the power of the CEO has an impact on psychological and structural mechanisms, which impact the process of decision-making within the board (O’Reilly & Main, 2010). Second, CEOs can provide directors with more remuneration as directors act more in the interest of the CEO (Bebchuk & Fried, 2006). And third, a CEO has a significant power on the director nomination process. It is important for directors to keep their seat within the board as this is closely

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related with their connection, status and of course their income. All of this leading to lower incentives for board members to create compensation packages which are more aligned with the interest of the shareholders of the firm, instead providing incentives to choose the side of the CEO in the negotiation on compensation (Bebchuk & Fried, 2006).

Empirical results also show that the influence of CEO power has resulted in compensation packages which contain to a less incentives for CEOs to take actions that lead to an increase in shareholder value (Schneider, 2013). Therefore I argue that a CEO uses his/her power in such a way that it will lead to a compensation package which consists of less equity-based compensation, leading to the following hypothesis:

H1: CEO power has a negative effect on the proportion of CEO compensation based on equity.

3.2. Board independence and equity-based compensation

The board of directors serve an important role in both mechanisms which are used to reduce the agency problem. On behalf of the shareholders, they are held responsible for creating a compensation plan that is efficient and cause alignment between interest of shareholder and CEO (Fama & Jensen, 1983; Petra & Dorata, 2008). Bechuk and Fried (2004) argue that boards should consist of a reasonable number of outside (independent) directors, which are not sensitive to influence from powerful insiders, like for example the CEO. Board independence is of high importance because insiders are seen as a ‘pawn’ of the CEO, who have a great impact on their pay and career within the firm (Lok, 2010; Shipilov, Greve, & Rowley, 2010; Westphal & Graebner, 2010). Petra and Dorota (2008) showed in their research that various board characteristics have an impact on compensation packages. One of the main findings is that board independence strengthens the corporate governance mechanism which in turn will result in a more aligned compensation package. Therefore, I argue that a board with more independent directors4_{is better able to create a compensation package which is aligned}

with the interest of shareholders, and thus with more equity-based compensation, leading to the following hypothesis:

H2a: Board independence has a positive effect on the proportion of CEO compensation based on equity.

3.3. CEO power and board independence

Another manifestation of CEO power can be found in the research of Albuquerque & Miao (2013), who argue that a CEO can use his/her power to change the design of the governance mechanisms within the firm in such a way that the effectiveness of the monitoring role of the governance mechanisms decrease. Lynall, Golden and Hillman (2003) found empirical evidence for this by showing that an increase in CEO power, causes a greater likelihood for the CEO to exercise this power in a way that it

4_{Independent directors are directors who do not work at the company at the moment of nomination nor did this}

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has an impact on the composition and the structure of the board. As stated above, the board of directors is an important mechanism to control for the agency problem, and their independence results in a more effective board. A powerful CEO, trying to change his/her compensation plan, will benefit more from a less independent board, since independency will temper the power. Therefore I argue that it is likely that a CEO will use his power in such a way, to decrease the independency of the board, leading to the following hypotheses:

H2b: CEO power has a negative effect on board independence.

3.4. The (partially) mediating role of board independence

To determine how CEO power is exerted, the indirect relation between CEO power and the proportion of equity-based compensation needs to be tested. As Zajac and Wetphal (1996) state a CEO tries to exert his/her power by affecting the composition of the board. By doing this a CEO will try to ‘engineer’ a favourable compensation package (Morse et al., 2011). Therefore, I argue that board independence plays a mediating role in the relation between CEO power and equity-based compensation, leading to the following hypothesis:

H3: The negative impact of CEO power on CEO compensation based on equity is (partially) mediated by a decrease in board independence.

4. METHOD SECTION

4.1. Sample and data collection

The initial sample of this study consists of Standard & Poor’s 500 (S&P 500) firms. The S&P 500 firms are the largest listed firms in the US listed on the New York Stock Exchange (NYSE) or NASDAQ. Because of the implementation of new regulation regarding CEO compensation in the U.S. (e.g. Dod-Frank Act in 2010) panel data is used from 2010 to 2016. The inclusion of a say-on-pay provision for shareholders caused a change in the structure of compensation packages, in order to receive enough votes in favor of the compensation packages proposed (Larcker, McCall & Ormazabal, 2012; Ertimur, Ferri & Oesch, 2013). In addition, excessive risk-taking behavior of the CEO has been viewed as a major cause of the financial crisis of 2007-2009. So, after the crisis both dismissed many CEOs and adjusted their compensation package to reduce this excessive risk-taking (Gabaix, Landier & Sauvagnat, 2014). Excluding observations prior to 2010 limits the risk of attributing the change in CEO power to consequences of both financial crisis and greater transparency in compensation.

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Data regarding CEO compensation, CEO power and board characteristics can be conducted from BoardEx5_{, which provides specified information for each director in a firm year concerning his/her}

position, tenure and compensation. COMPUSTAT provides a firm’s financial information, which is also used in many other studies (e.g. Brick, Palmon, & Wald, 2006; Ai & Li, 2015).

The initial sample consisted of 3342 firm-years of which 1088 are excluded due to missing data in BoardEx or Compustat. Consistent with previous studies, regulatory sectors (SIC 4400 – 4900) utilities (SIC 4900-4949) financial sectors (SIC 6000-6999) are excluded from the sample due to the impact of regulation and limitations on compensation packages of firms within the named industries (e.g. De Cesari & Ozkan, 2015; Huang, Jiang, Lie, & Que, 2017). The final sample consists of 1469 firm-years.

Table 1

Sample selection criteria

Sample Initial firm-years in BoardEx for S&P 500 firms between 2010-2016 3342 Less:

Missing data concerning CEO Power in BoardEx 114

Missing data concerning Equity-based compensation BoardEx 680

Missing data from Compustat,and BoardEx regarding control variables 294

Excluding regulatory sectors (SIC 4400-4900) 134

Excluding utilities (SIC 4900-4949) 163

Excluding financial sectors (SIC 6000-6999) 488

Final sample 1469

4.2. Variables and measures

4.2.1. Dependent variable: Equity-based compensation

To measure the amount of equity-based compensation, I focus on the long-term pay mix in compensation plans: amount of stock options, restricted stock, and long-term incentive plans and this was calculated as long-term compensation divided by total compensation (Sanders & Carpenter, 1998:166; Balkin, Markman, & Gomez-Mejia, 2000; Bergstresser & Philippon 2006). In this study, we make use of equity-linked compensation divided by total compensation. Equity-linked compensation (EQUITYCOMP) is the sum of shares, options, and long-term incentive plans awarded in that period. Total compensation is the equity-linked compensation added by the direct compensation in that period, which contains all cash-based compensation received by a CEO.

5_{For a better comparability with other studies concerning CEO compensation in the U.S., it would be better to}

use data from ExecuComp, however Fernandes, Ferreira, Matos, and Murphy, (2009) showed in their study that that it doesn’t alter their main findings using BoardEx for CEO compensation.

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4.2.2. Independent variable: CEO power

CEO power may come from multiple sources and has a subjective nature; therefore, different proxies are used in the literature to capture CEO power (Finkelstein, 1992). Power can increase due to duality (when the CEO is also the chairperson of the board), the number of directors who are appointed after the CEO is appointed increase and, when the tenure of a CEO increases (Hill & Phan, 1991; Haynes & Hillman, 2010; Chen, 2014 and Sauerwald, Zin & Peng, 2016). As tenure is closely related to obtaining power (both as a cause and a consequence), this proxy is used in this study. Tenure is important since a CEO is able to build on good relationships with the company and board members and increase knowledge of the firm over time (Walsh & Seward, 1990; Hou, Priem, & Goranova, 2017). CEO tenure can be seen as a cause of CEO power because when tenure increases a CEO becomes more entrenched within the firm and is therefore able to pursue his/her own interest above the interest of the shareholders. As a consequence of gaining power CEOs are also less likely to be dismissed because they have shaped the directors to become loyal and as a result, those loyal directors shall not fire the CEO and thus tenure will increase (Hill & Phan, 1991; Boling, Pieper, & Covin, 2016). Tenure (CEOPOWER) is measured by the number of years that a CEO is in his/her position as a CEO of the firm.

4.2.3. Mediator: Board independence

A director is marked as independent when he/she is not an employee of the firm or affiliated with the firm in another way6_{. Board independence (BOARDIND) is measured by the ratio of}

independent directors. In this study, we divide the number of independent, non-executive directors, by the total number of directors in the board.

4.2.4. Control variables

Starting with board size, when board size increases this goes along with an increase in independent directors (Guest, 2009) and greater diversity when it comes to experience and skills for example (Ntim, Opong, & Danbolt, 2015). As Linck, Netter, and Yang (2008) and Seo (2017) find, the performance of the board increases when size increases. Board size (BOARDSIZE) is measured as the total number of directors within the board. Second board tenure, a long-tenured director is more committed to the firm and has more expertise to guide the firm in the right direction, instead when a director tenure becomes too high this may be detrimental for shareholders. Vafeas (2003) found that board tenure is U-shaped when it comes to performance of the board. Board tenure (BOARDTEN) is measured as the average tenure of the members within the board. Third board experience, a board is better able to monitor and perform when there are more experienced directors within the board. Kroll,

6_{BoardEx states: Affiliated directors are those who have family connections with an employee of the firm,}

customers, suppliers, former employees and members of professional services firms who provide services to the firm.

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Walters and Wright (2008) found empirical evidence for this. Board experience (BOARDEXP) is measured by the number of boards on which the director has served over her/his lifetime.

Beside the use of board characteristics, also some firm characteristics are used as control variables. Starting with the market-to-book ratio. When the market-to-book ratio is high, it will imply that a major part of the assets are intangible, resulting is less informative information coming from the accounting information and in turn more information asymmetry (Lev & Zarowin, 1999). Monitoring is less likely to be effective in such situations where market-to-book ratio is high, since it is hard to observe the effort of a CEO by looking at the accounting information. This uncertainty induces the board to choose for an output-based contract to guide the CEO in the right direction instead of use monitoring, e.g. make us of interest alignment (Prendergast, 2000; Demougin & Fluet, 2001). So, in situations where monitoring doesn’t work well, equity-based compensation is needed to align interests. Supporting empirical evidence comes from Smith and Watts (1992) who state that firms where market-to-book ratio is high, thus high-growth firms, equity-based compensation is more likely to be used, since CEO effort is less observable. Market-to-book ratio (MTB) is defined as the market value divided by the book value of the firm.

Firm risk Based on the agency theory, CEOs are risk averse. Using variable pay increases

simultaneously risk and incentives. Therefore, when CEO compensation is tied to equity, a CEO will take risks in order to maximize stock value (Martin et al., 2013). On the other hand the behavioral agency model of Wiseman and Gomez-Mejia (1998) suggests that beyond a threshold, equity-based compensation may on the contrary cause excessive risk-aversion of CEOs due to the huge risk bearing. Where shareholders are able to diversify their risk across their portfolio, a CEO is not able to diversify its risk, therefore the CEO has great risk bearing and will become risk-averse in making decisions, which in turn will affect the firm (Cordeiro & Valiyath, 2003). So less equity-based compensation will be used in firms with high risk, since this will negatively affect the shareholders’ value. John, Mehran and Qian (2010) find evidence that leverage has an impact on performance linked compensation. This may be due to the fact that firms with high leverage experience greater agency problems (Jensen & Meckling, 1976). Leverage (LEV) is measured by dividing total debt by total assets.

Firm size Pay-for-performance sensitivity is assumed to increase when the size of the firm

increases. Schaefer (1998) finds evidence for this. Firm size (SIZE) is measured as the log of the book value of the assets. A description of the variables used in this study can be found in table 1, appendix A.

4.3. Model specification

Hypothesis 1: For the first hypothesis, a panel data regression is used, as it is for the other

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EQUITYCOMP = 𝛼 + 𝛽1 ∗ (CEOPOWER)it + 𝛽2 ∗ (BOARDSIZE)it + 𝛽3 ∗

(BOARDTEN)it + 𝛽4 ∗ (BOARDEXP)it + 𝛽5 ∗ (MTB)it + 𝛽6 ∗

(LEV) it + 𝛽7 ∗ (SIZE) it ∗

𝜀

𝑖𝑡

Where i comprises the firm and t the year.

Hypothesis 2a: Test whether the mediator BOARDIND affects the dependent variable

EQUITYCOMP. In this equation, it is not sufficient to take only the mediator and the dependent variable in the equation, because the correlation between the mediator and the dependent variable may exist due to the effect of the independent variable on both the mediator and the dependent variable. The model is specified as follows:

EQUITYCOMP = 𝛼 + 𝛽1 ∗ (CEOPOWER)it + 𝛽2 ∗ (BOARDIND)it + 𝛽3 ∗

(BOARDSIZE)it + 𝛽4 ∗ (BOARDTEN)it + 𝛽5 ∗ (BOARDEXP)it +

𝛽6 ∗ (MTB)it + 𝛽7 ∗ (LEV) it + 𝛽8 ∗ (SIZE) it ∗

𝜀

𝑖𝑡

Hypothesis 2b: Test the correlation between the independent variable CEOPOWER on the

mediator BOARDIND. This step treats the mediator as an outcome variable. The model is specified as follows:

BOARDIND = 𝛼 + 𝛽1 ∗ (CEOPOWER)it + 𝛽2 ∗ (BOARDSIZE)it + 𝛽3 ∗ (BOARDTEN)it

+ 𝛽4 ∗ (BOARDEXP)it + 𝛽5 ∗ (MTB)it + 𝛽6 ∗ (LEV) it + 𝛽7 ∗

(SIZE) it ∗

𝜀

𝑖𝑡

Hypothesis 3: The last step is to test whether there is a partial or full mediation. A full mediation

occurs when the effect of the independent variable CEOPOWER on EQUITYCOMP while controlling for BOARDIND is tested. The mediation is measured based on previous literature (e.g. Judd & Kenny, 1981; James & Brett, 1984; Baron & Kenny, 1986 and Frazier, Tix & Barron, 2004).

5. RESULTS

5.1. Descriptive statistics

In table 3, the descriptive statistics of this study are provided for each variable. Since the control variables, MTB, LEV, and SIZE had some major outliers they are all three winsorized at a the 5% level. The descriptive statistics of the dependent variable shows that, on average, 88,6% of the total compensation received by a CEO consists of equity-based compensation, which is consistent with previous research of Otto (2014). Statistics of BOARDIND shows that independence within U.S. corporate boards is relatively high, 84,1%, with a low standard deviation of 0,098, showing that boards are mainly composed of independent directors. The average tenure of a CEO is 5 years, varying from 0 to 34,5 years.

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Table 3

Descriptive statistics full sample n=1469

Variable Min Max Mean Std.

Deviation Median Skew EQUITYCOMP 0 1 0,886 0,096 0,910 -3,869 BOARDIND 0,167 0,944 0,841 0,098 0,875 -1,957 CEOPOWER 0 34,5 5,054 4,655 3.7 1,678 BOARDSIZE -1.673 1.734 0,931 0,631 1,114 -0.792 BOARDTEN 0.1 22.925 9,006 3,368 8,67 0,711 BOARDEXP -1.429 3.245 0,524 0,693 0,464 0,434 MTB 0,977 15,068 4,367 3,483 3,226 0,178 LEV 0 3,648 0,810 0,898 0,541 5,153 SIZE 3,372 5,013 4,093 0,457 4,023 0,545 5.2. Multicollinearity

In table 4, a Pearson correlation matrix is presented, which shows the correlations between the variables used in this study, to rule out the threat of multicollinearity. The highest correlation between two variables is r=0.402, p<0,001 (LEV x MTB). Since this is only a moderate correlation between 2 control variables, multicollinearity doesn’t play a major role in this study. As an additional check, the variance inflation factor of each variable is presented in table 5. Those results support the Pearson correlation matrix, since there is no value above 10 present in the table.

Table 4

Pearson correlation matrix

Variable EQUITY COMP BOARD IND CEO POWER BOARD SIZE BOARD TEN BOARD

EXP MTB LEV SIZE

EQUITYCOMP 1 BOARDIND .133*** 1 CEOPOWER -.077*** -.055* 1 BOARDSIZE .077*** .129*** -.201*** 1 BOARDTEN -.046* -.086*** .324*** -.051* 1 BOARDEXP .056** .195*** -.106*** .178*** -.075*** 1 MTB .143*** -.013 .099*** -.083*** .024*** .010 1 LEV .033 .157*** -.074*** .146*** -.069*** .100*** .439*** 1 SIZE .052** .196*** -.158*** .401*** -.186*** .196*** -.215*** .138*** 1 Significance levels: *** p<0.01; ** p<0.05; * p <0.1

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Table 5

5.3. Regression results

Table 5 provides the results of the regressions performed in this study. A Hausman test was performed to decide whether a random- or fixed-effects model is appropriate for this regression. Based on this test, the hypothesis is accepted (χ2_{=12.71, p=0.012), therefore a fixed-effects model is used in}

this study. Table 6

Regression results EQUITYCOMP

Model 1 Model 2 Model 3

Independent variable CEO POWER -.002*** -.002** Mediator BOARDIND .099** Control variables BOARDSIZE .013* .013* .011* BOARDTEN .017* .017** .023** BOARDEXP .016* .016** .016* MTB .005*** .005*** .005*** LEV -.013** -.013*** -.014*** SIZE .075*** .075*** .070*** Constant .513*** .519** .448*** Observations 1469 1469 1469 F-test 5.53*** 5.54*** 5.42*** R² .035 .042 .046 Significance levels: *** p<0.01; ** p<0.05; * p <0.1

The coefficients associated with board characteristics are consistent with previous literature. As with the increase of BOARDSIZE, BOARDTEN and BOARDEXP the amount of equity-based compensation increases, respectively (β=.013, p=0.100; β=.017, p=.011; β=.016, p=.045). The coefficients associated with firm characteristics are also consistent with what was expected from previous literature. Starting with MTB, when the market-to-book ratio increases there is a higher need for incentive alignment in the form of equity-based compensation. The findings (β=.005, p=.000)

Variance inflation factor

Variable VIF BOARDIND 1.09 CEOPOWER 1.18 BOARDSIZE 1.25 BOARDTEN 1.15 BOARDEXP 1.09 MTB 1.39 LEV 1.38 SIZE 1.37 MEAN VIF 1.24

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support this idea. Second LEV, when leverage is high, a firm is exposed to more risk and should make less use of equity-based compensation to make the CEO less risk-averse, findings (β=-.013, p=.006) support this idea. Third SIZE, it is expected that the pay-for-performance sensitivity increases when firm size increases, findings (β=.072, p=.001) are consistent with this expectation.

Based on the managerial power theory (MPT), a powerful CEO is able to exert his/her power in such a way that it affects the compensation package, which in the end will result in a package with less equity-based compensation. Therefore, hypothesis 1 states that CEO power has a negative effect on the proportion of CEO compensation based on equity. Model 2 in table 6, provides empirical evidence consistent with this expectation (β=-.002, p=.005). The amount of equity-based compensation decreases when CEO power increases, supporting hypothesis 17_.

A board of directors is responsible for the compensation package of a CEO. Since a more independent board is more likely to act in the best interest of the shareholders and thus to generate a compensation package, which aligns the interest of the shareholders and the CEO, hypothesis 2a states that board independence has a positive effect on the proportion of CEO compensation based on equity. Table 6, model 3 provides empirical evidence which is consistent with what is expected (β=.099, p=.032). So, the amount of equity-based compensation increases when board independence increases, supporting hypothesis 2a.

Table 7

Regression results BOARDIND

Model 1 Model 2 Independent variable CEO POWER .001* Control variables BOARDSIZE -.006 -.006 BOARDTEN .024*** .211*** BOARDEXP .011** .010** MTB .001 .001 LEV .002 .002 SIZE .018 .019 Constant .708*** .706*** Observations 1469 1469 F-test 17.23*** 17.27*** R² .028 .303 Significance levels: *** p<0.01; ** p<0.05; * p <0.1

7_{As an additional, unreported test, CEO board tenure is used as a proxy for CEO power since Combs and Skill}

(2003) report that a CEO is already able to build good relationships with other board members in his/her time as a manager, prior to his/her position as a CEO. Those findings are consistent with the findings in table 6, model 2 with (β=-.002, p=.000).

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Hypothesis 2b states CEO power has a negative effect on board independence. The findings in table 7, model 2 show a positive and significant coefficient (β=.001, p=.073), which is contrary to my expectation. Therefore, there is no support for hypothesis 2b. Because of this, there is no need to test the mediation relation of hypothesis 3 anymore.

5.4. Additional analysis

Although CEO tenure is a common used proxy for CEO power, other studies also focus on the number of directors who are appointed after the CEO (e.g. Haynes & Hillman, 2010; Chen, 2014 & Sauerwald, Zin & Peng, 2016). As this studies assume that a CEO gains more power when more directors are appointed after him/her. This proxy for CEO power (CEOPOWER) is measured by adding up the number of directors on the board who are appointed after the CEO and dividing it by the total number of directors. Results are presented in table 8, model 2 and show not significant results (β=-.012, p=.284), therefore, using this proxy for CEOPOWER, no support for hypothesis 1 is found.

Table 8

Regression results EQUITYCOMP - additional

Model 1 Model 2 Independent variable CEO POWER -.012 Control variables BOARDSIZE .013* .013* BOARDTEN .017* .017* BOARDEXP .016* .016* MTB .005*** .005*** LEV -.013*** -.014*** SIZE .074** .074*** Constant .513*** .519*** Observations 1469 1469 F-test 7.12*** 6.27*** R² .035 .036 Significance levels: *** p<0.01; ** p<0.05; * p <0.1

Due to the low variance in board independence, gender diversity is used as mediator in the second additional analysis. A board which contains more gender diversity is able to make better decisions about the design of CEO compensation plans which are more in line with the interest of the shareholders (Benkraiem, Hamrouni, Lakhal, & Toumi 2017). This is because female directors are not within the “old boys network”, and are therefore more independent (Kang, Cheng, & Gray 2007:196). Board diversity (BOARDDIV) is measured as the amount of female directors who have a seat in the board. Results are presented in table 9, model 2 and show not significant results (β=-.005, p=.634). The direction of the coefficient is consistent with what was expected, however it is not significant so there is no support for the relation between board diversity and CEO power.

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Table 9

Regression results BOARDDIV - additional

Model 1 Model 2 Independent variable CEO POWER -.005 Control variables BOARDSIZE .741*** .735*** BOARDTEN -.057 -.042 BOARDEXP .055 .054 MTB .028* .029* LEV -.002 -.003 SIZE .317*** .317*** YEARNUM .075*** .075*** Constant -.387*** -.390*** Observations 1469 1469 F-test 33.39*** 29.16*** R² .272 .272 Significance levels: *** p<0.01; ** p<0.05; * p <0.1

6. DISCUSSION

Despite increased regulation in the U.S. on board independence (Dah, Frye, & Hurst, 2014), it seems that a CEO is still able to exert his/her power to affect the compensation package, seen the increasing dissatisfaction amongst shareholders who vote against it. Therefore, from a regulatory perspective, on corporate governance, it is important to study whether and how board independence plays a role in the power-compensation relationship. I rely on two theories to formulate my hypotheses. Starting with the optimal contracting theory (OCT), which describes the setting of a compensation plan for a CEO as a “product of arm’s-length contracting” in which boards try to get a favorable deal for shareholders, and CEOs try to pursue their own interests in it (Bebchuk & Fried 2006:5). Instead, the managerial power theory (MPT) states that it is not about arm’s-length contracting at all, because of the significant influence of a CEO in the setting of a compensation plan (Bebchuk & Fried, 2003; Vo & Canil, 2016). Therefore, I expect that CEO power has a negative effect on the proportion of CEO compensation based on equity. This power can be exerted indirectly, via shaping the board as stated by Zajac and Westphal (1996), or directly by controlling the information which is received by directors and shaping the agenda of board meetings as stated by Bebchuk et al., (2002).

To test these hypotheses, I rely on a sample of 1469 firms-year observations taken from S&P 500 firms located in the U.S. for the period 2010-2016. The findings suggest that CEOs indeed exercise their power over time to engineer the compensation package in such a way that it will contain less equity-based compensation. This finding is consistent with prior literature, and more specifically the observations of Schneider (2013). Second, findings suggest that a more independent board is associated

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with more equity-based compensation, which is consistent with the findings of Fama and Jensen (1983) and Petra and Dorata (2008). However, contrary with what was expected, evidence is found of a positive relation between CEO power and board independence. In the additional analysis a regression is performed using the number of directors who are appointed after the CEO as a proxy for CEO power. The additional analysis does not support the initial findings, and therefore do not support hypothesis 1. Still this proxy for CEO power causes an increase in board independence, consistent with the initial findings. The second additional analysis, uses gender diversity as a mediator. Findings are not significant, and therefore do not change the initial findings.

This study provides additional support to previous studies on CEO compensation by showing that despite the increased regulation, in the U.S., on board independence, which should control for CEO power, a CEO is still able to influence his/her compensation package in a way that it is less aligned with shareholders interest. Findings indicate that increased independence is of importance for boards to perform well in the process of arm’s length-contracting, as more independence results in more aligned compensation. However, less equity-based compensation is not obtained by affecting the composition of the board as stated by Zajac and Westphal (1996), as findings surprisingly indicate that board independence increases when a CEO has more power. Several studies mention board independence as a way to curb CEO power (e.g. Lewellyn & Muller-Kahle, 2012). They assume that, when the proportion of independent director’s increases, the board is better able to mitigate CEO power. As Adams and Ferreira (2007) state that an independent board is better able to pursue the interests of the shareholders. Therefore, it could be hypothesized that shareholders use board independence as a mechanism to counteract CEOs increase in power over time. This would explain the positive relationship between CEO power and board independence. Beside this successful way to curb CEO power, a CEO is still able to affect the compensation package. These findings could stimulate the corporate governance discussion around CEO compensation and focus on the way in which CEO power is involved in this.

This study has some limitations. Starting with the internal validity of the measurement of CEO power, since there is no direct measure for this, several studies use different proxies. In this study I used CEO tenure, however when another proxy is used, namely the amount of directors who are appointed after the CEO, the initial findings do not hold. As previous studies (e.g. Hill & Phan, 1991) showed, a CEO becomes more powerful when tenure increases. However, Ferreira, Raisch and Klarner (2014) find that tenure is not only about power, but also success and performance of the CEO, and it is likely that this is also taken into account when setting a compensation plan. Although performance is controlled for in this study, it is only about recent performance of the CEO, while the performance of his/her whole career, is important for gaining power. Second is the issue of external validity. As shown in appendix B, board independence differs a lot across countries, with the highest percentage of independence in the U.S.. CEOs ability to affect board composition might be more difficult in the U.S.,

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because of regulations and institutional development. Therefore, it cannot be assumed that board independence is used as a way to curb CEO power in other countries as well. It might be possible that a CEO is able to affect the independence of the board in other countries, due to other regulations and institutional factors. Third, the increase in board independence might also be explained by a greater scrutiny. After the occurrence of several corporate scandals, regulation on board independence increased (Dah et al., 2014), and thus received increased attention and importance. Therefore, the increase of board independence might result from CEOs trying to avoid scrutiny from the public by influencing the composition of the board in a way that it will consist of more independent directors.

There are also new avenues opened for further research. Starting with the measurement of CEO power. Findings of this study are not consistent when using different proxies for CEO power. Further investigation of how those proxies of power elaborate itself within a firm would be an interesting avenue. Second, as the findings show, a CEO is still able to exert his/her power, despite high board independence, to weaken the amount of equity-based compensation. Additional research can be done on investigating how a CEO does this and which issues in corporate governance could possibly mitigate this. For example, Tosi, Werner, Katz, and Gomez-Mejia (2000) state that ownership structure might curb CEO power as large investors have more influence within the firm, and due to their greater investment stakes are more reliant on firm performance. Also institutional ownership might curb CEO power, as institutional investors are often seen as better monitors then other investors (Hartzell & Starks, 2003). Lastly, as shown in appendix B, board independence is the highest in the U.S., therefore it would be interesting to perform the same study in other countries with lower board independence to test whether board independence does play a mediating role in those countries. This difference in independence across countries might be caused by different definitions and requirements on board independence in those jurisdictions. Some countries do not have minimum requirements on board independence, other countries use the word ‘sufficient independent directors’ in their requirements on board independence, and lastly there are countries which have quantitative requirements on board independence (International Organization of Securities Commissions, 2007).8_{Therefore, in countries}

with less guidelines on board independence, or bad enforcement of it, a CEO is more able to exert his/her power to affect the independence.

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APPENDIX A

Table 1

Description of the dependent, mediator, independent and control variables

Label Variable Measurement

EQUITYCOMP Equity-based compensation The amount of equity-based compensation divided by the total amount of compensation received by a CEO. BoardEx

BOARDIND Board independence The amount of independent

directors dividend by the total amount of directors of the board. BoardEx

CEOPOWER CEO power The number of directors who

are appointed after the CEO was appointed. BoardEx

BOARDSIZE Board size The amount of directors within

the board. BoardEx

BOARDTEN Board tenure The average tenure of the

directors within the board.

BoardEx

BOARDEXP Board experience The average number of boards

on which the directors have served. BoardEx.

MTB Market-to-book ratio Market value of the firm

divided by the book value of the firm at fiscal year end.

Compustat

LEV Financial leverage ratio Total equity divided by total

debt. Compustat

SIZE Firm size The logarithm of the book value

of the total assets. Compustat

TENURE CEO tenure The number of years the current

CEO has been appointed as CEO of the firm. BoardEx

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APPENDIX B

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Chile Japan Turkey Brazil Peru Russia Hong Kong Spain Belgium Poland Italy Germany UK Singapore India France Sweden Norway Denmark Canada Switerzerland Netherlands Finland U.S.

Board independence (%) in 2017

Does board independence mediate the impact of CEO power on the use of equity-based compensation?