Katherine Guthrie, Jan Sokolowsky, and Kam-Ming Wan
CEO compensation and board structure revisited
Journal of Finance | Volume 67, Issue 3 (Jun 2012), 1149–1169

Contrary to a well-publicized JF study by Vidhi Chhaochharia of the University of Miami and Yaniv Grinstein of Cornell University, we find that the director independence requirements imposed by the major stock exchanges in 2003 did not help rein in CEO pay. In a nutshell, the original results are largely driven by the pay of the late Steve Jobs at Apple and Kosta Kartsotis at Fossil, and neither case fits the story of board structure affecting CEO pay.

The promise of board independence

To better convey the practical importance of our finding, let us provide some context. Shareholders delegate the tasks of monitoring and advising management to corporate directors. So it was only natural to point the finger at boards in the wake of the many accounting scandals and run-away executive compensation that caught the public's attention in the early 2000s. Exactly why boards failed their monitoring responsibilities is not well understood and remains a hotly debated topic.

One compelling explanation is the story of captured directors: directors with ties to the company (e.g., current executives, recent employees, major business partners) cannot be expected to be effective monitors, lest they suffer the wrath of the powerful CEOs they are supposed to oversee. In fact, this story was so compelling that the ensuing regulatory reforms focused heavily on director independence requirements. The Sarbanes-Oxley Act (SOX) of 2002 required audit committees to be comprised solely of independent directors. The NYSE and NASDAQ followed suit and expanded the requirement to nominating and compensation committees, and they mandated that the majority of directors on a board be independent.

Regulators and investors hoped that greater director independence would significantly improve corporate governance, but the independence mandates also risked interfering with firm's value-maximizing governance choices, such as impeding boards' role as advisors and reducing competition for the CEO position. Given these potential costs, at least some evidence of their purported benefits in the provision of corporate governance is needed.

If run-away CEO pay was a symptom of poor board oversight and director independence was the cure, as many believed at the time, then one would expect CEO pay to decline in firms that were not previously compliant with the new independence requirements relative to those that were already compliant. This is precisely what Chhaochharia-Grinstein (JF 2009) find. Specifically, in a sample of 865 large, publicly traded firms in the U.S., they estimate that board independence leads to a 17.5% reduction in CEO pay. This result confirms that independent directors are effective at preventing managers from using their influence to increase their pay.

Chhaochharia and Grinstein's study proved highly influential, in part due to its empirical design. Comparing changes in pay between firms that were already compliant with the mandatory independence requirement and firms that were not compliant strengthens one's confidence in attributing the change in compensation to board independence. The effect of independence on pay does not merely reflect (i) permanent differences between compliant and noncompliant firms, (ii) other factors that might have induced firms to voluntarily adopt board independence, or (iii) common time trends in CEO pay.

Taking a closer look at the data

However, in our JF paper we show that Chhaochharia and Grinstein's results are misleading. Using those authors' data and methodology, we identify two noncompliant firms whose CEOs experienced unusually large decreases in their compensation around the board independence mandate: Apple's Steve Jobs and Fossil's Kosta Kartsotis. In other words, the causal effect of board independence on CEO pay identified by Chhaochharia and Grinstein reflects extraordinary events at two companies, but is not generalizable to other large publicly traded firms.

The outliers' influence on the average change in CEO pay becomes apparent in Figure 1. The histogram captures changes in CEO pay from the pre-event period (average over fiscal years 2000–2002) to the post-event period (2003–2005) among firms that had to make changes to their boards to be in compliance with the new regulations (hereafter,“noncompliant firm”).

1: Logged compensation changes
Kosta Kartsotis (Fossil) and Steve Jobs (Apple) were extreme outliers. This had a large influence on the results in Chhaochharia and Grinstein.

Table 1 shows the compensation for Kosta Kartsotis and Steve Jobs from 1998–2011. Neither Kartsotis' nor Jobs' reduction in pay can be attributed to greater board independence. Motivated by Fossil's poor stock performance in the preceding year, Kosta Kartsotis urged his board to eliminate his $255,000 salary in 2005 (his total compensation dropped to $180 in life insurance premiums paid for by the company). At the time, Kosta and his brother Tom—founder of Fossil, former CEO, and chairman of the board in 2005—held about 30% of the firm's shares.

1: CEO Pay at Fossil and Apple, 1998–2011
Year Kosta Kartsotis Steve Jobs
1998–1999 $255,035 $1
2000 $255,035 $600,347,351
2001 $255,021 $83,996,129
2002 $255,017 $93,016,179
2003 $255,324 $74,750,001
2004 $255,220 $1
2005 $180 $1
2006–2011 $0–$4,266 $1
In the second half of the sample, Kosta Kartsotis and Steve Jobs were compensated very differently from how they were compensated in the first half of the sample.

Similarly, after rejoining Apple in 1997 Jobs insisted that Apple's board routinely pay him $1. However, his total compensation rose to over $600 million in 2000 and fell back to the symbolic $1 in 2004. The temporary spike in Jobs' compensation in 2000–2004 reflects the reestablishment of his ownership stake in Apple—the company he co-founded, was forced to leave, and rejoined as savior in 1997—and an aircraft he was awarded in 1999 for his successful performance as interim-CEO.

Particularly noteworthy, Apple did not need to replace or add any directors to become compliant by 2003. Continuing director Millard Drexler turned “independent” in 2003, because his and Jobs' interlocking relationship ended (Drexler resigned as CEO of Gap Inc. in 2002 and Jobs quit his directorship a few days later). Consequently, Apple should not have been classified as a noncompliant firm and changes in Jobs' pay should not be attributed to the imposed independence requirement.

Table 2 shows just how sensitive the estimated effect of board independence on CEO pay is to removing the outliers (the estimates are imputed from multivariate regressions that account for differential changes in firm performance, as reflected in revenues, profitability, and stock returns, as well as industry effects). Columns 1 and 2 show that excluding the observations of Apple and Fossil (i.e., 12 out of 5,190 firm-year observations) reduces the estimated magnitude of the effect of board independence on CEO pay from –17.5% to –4.6%, which translates into pay cuts of $362,000 and $95,000, respectively, for a typical noncompliant firm's CEO. In other words, Jobs' and Kartsotis' compensation arrangements are responsible for three quarters of the originally reported effect of board independence on CEO pay. Removing them from the sample renders the estimate economically insignificant and statistically indistinguishable from zero.

2: The effect of board independence on executive pay
CG's published results Excluding Apple & Fossil Non-CEO top executives
–17.5% –4.6% –3.1%

If mandating director independence really strengthened directors' bargaining positions vis-à-vis top executives, then we would also expect non-CEO executives' pay to decrease in noncompliant firms. After all, the same directors who negotiate CEOs' compensation packages are also responsible for the pay of other top executives. Column 3 shows that the independence effect on non-CEO executives' pay is an immaterial –3.1% (which is also statistically indistinguishable from zero).

Removing the outliers further reveals that executive pay rose in firms with noncompliant compensation committees relative to those with compliant committees. Two implications of these findings are worth emphasizing. First, our evidence suggests that decisions are reached at the committee level rather than the board level. Second, requiring independence improves executives' bargaining position.

Concluding remarks

What accounts for the rise in executive pay among those noncompliant firms? One potential explanation is that non-independent directors differ from independent directors in other dimensions that make them more effective monitors. For example, we find that only 3.2% of independent directors, but 35.6% of non-independent directors have voting rights of 1% or more in their firms. It is also plausible that the additional workload imposed by SOX and the exchange listing requirements pushed compensation issues down on the priority list, especially among noncompliant firms. Between 2001 and 2004, the meeting frequencies of audit and nominating committees almost doubled and quadrupled, whereas the meeting frequency of compensation committees remained just about unchanged. Even after satisfying the independence mandate, previously noncompliant firms have a lower representation of independent directors on their boards (58% on average in our sample) than compliant firms (77%). Their independent directors are more likely to be spread thin, as there are fewer of them to fulfill the committees' responsibilities.

In sum, having more independent directors on corporate boards does not seem to lead to lower CEO pay. Perhaps director independence is not the silver bullet to corporate governance problems it was thought to be. Perhaps the new independence requirements were not stringent enough. Or perhaps there was nothing to fix in executive compensation. Determining which of these interpretations is correct remains an open and pertinent research question.

Kobayashi Kiyochika (1847–1915): Sumida River by Night. Japan, 1881.. The Smithsonian describes this serene painting as follows: “On September 3, 1868, the city called Edo ceased to exist. Renamed Tokyo (“Eastern Capital”) by Japan's new rulers, the city became the primary experiment in a national drive toward modernization. Kobayashi Kiyochika, a minor retainer of the recently-deposed shogun, followed his master into exile. When he returned to his birthplace in 1874, Kiyochika found Tokyo filled with railroads, steamships, gaslights, telegraph lines, and large brick buildings—never-before-seen entities that were now ingrained in the cityscape. Self-trained as an artist, Kiyochika set out to record his views of Tokyo.”   Kiyochika's use of light and shadows—as opposed to the usual colorful cityscape—represents a new way of seeing, a new visual vocabulary. Kiyochika's prints experienced a revival in the 20th century as the symbol of a critique of modernity. This painting is part of the Robert Muller Collection at the Smithsonian, which has the most comprehensive collection of 20th-century Japanese prints.