How Common Directors on Board Committees Play a Positive Role in Monitoring and Incentive Alignment

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Author Information : Pamela Brandes (Whitman School of Management, Syracuse University)
Ravi Dharwadkar (Whitman School of Management, Syracuse University)
Sanghyun Suh (Manning School of Business, University of Massachusetts Lowell)

Year of Publication : Strategic Management Journal (2015)

Summary of Findings : Increasing regulatory pressures have created specialization within boards, with more requirements and responsibilities being refocused to the committee level. Using data from S&P 1,500 firms, we find that board committee overlap associated with linking pin directors (i.e., those serving simultaneously on the audit and compensation committees) is an important conduit for knowledge transfer between boards' monitoring and incentive alignment functions. These directors are associated with lower executive compensation and influence pay mix. In studying the dynamics behind this process, we find that newly created linking pins improve monitoring effectiveness whereas recently dissolved linking pins decrease it. We also find that linking pins are all the more important when managers make less conservative accounting

Research Questions : Is the problem of increasing CEO compensation partially resolved by the audit and compensation committees having a common director (linking pin)?

What we know : Regulators, scholars, the popular business press and even directors of professional associations, such as the National Association of Corporate Directors, have been concerned about high levels of CEO compensation. According to an Economic Policy Institute report, while the average CEO made nearly 30 times as much as the average worker’s compensation in 1978, CEOs in 2013 made 296 times the average worker. The same report found that even when one compares inflation-adjusted stock market returns based on the Standard and Poor’s 500 index of the Dow Jones index over the same time period, CEO compensation growth has handsomely exceeded the growth of both these indices.

Consequently, demands of directors to both improve corporate governance and reign in executive compensation at publicly traded companies have increased both in the public and the regulatory domains. However, these demands have created specialization within boards, with more requirements and responsibilities being refocused to the committee level, such as the creation of audit and compensation committees. While these role specializations enable directors to better cope with two of the most important problems they face—limited time and complexity of information—time constraints prevent the efficient transfers of information between the committees. This may have enabled the increases in CEO compensation, especially as compensation committee members often lack the information, ability and expertise to understand financial and accounting implications associated with CEO pay, according to the 2009 Public Company Governance Survey by the National Association of Corporate Directors.

Novel Findings : Our paper examines whether the problem of increasing CEO compensation is partially resolved by the audit and compensation committees having a common director (a linking pin) who can seamlessly move information between them.  We find that such “linking pin” directors are an essential mechanism for transferring information about firm performance and risk factors between board committees than just regular full board meetings and committee reports, as the audit committee is more knowledgeable about them then the compensation committee, and can better use this information in setting pay. Using data from S&P 1500 firms from 1998-2009, we find that board committee overlaps associated with such linking pin directors is an important conduit for knowledge transfer between boards’ audit and compensation setting functions. These directors are associated with lower CEO compensation and influence pay mix. In studying the dynamics behind this process, we find that newly created linking pins improve monitoring effectiveness whereas recently dissolved linking pins decrease it. We conclude that linking pin directors facilitate intra-board information transfers that have implications for the CEO compensation setting process. In the absence of linking pin directors, such information transfers could be assisted by having more interaction between the audit and compensation committees or holding joint meetings, leading to improved board vigilance in the compensation setting process at little or no cost.

Implications for Practice : Ernst and Young’s recent report on leading practices of audit committees suggests that: “the audit and compensation committees should coordinate with each other,” “the audit committee can help assess how certain financial metrics are employed in the company’s compensation plans,” “the audit committee, in conjunction with the compensation committee, consider the appropriateness of the incentive structure and whether it contributes to increased fraud risk.” Our research findings highlight one particular mechanism for doing this.

Full Citations : Brandes, P., Dharwadkar, R. and Suh, S. (2015), I know something you don't know!: The role of linking pin directors in monitoring and incentive alignment. Strat. Mgmt. J.. doi: 10.1002/smj.2353

Abstract : Regulators, scholars, the popular business press and even directors of professional associations, such as the National Association of Corporate Directors, have been concerned about high levels of CEO compensation. According to an Economic Policy Institute report, while the average CEO made nearly 30 times as much as the average worker’s compensation in 1978, CEOs in 2013 made 296 times the average worker. The same report found that even when one compares inflation-adjusted stock market returns based on the Standard and Poor’s 500 index of the Dow Jones index over the same time period, CEO compensation growth has handsomely exceeded the growth of both these indices.

Consequently, demands of directors to both improve corporate governance and reign in executive compensation at publicly traded companies have increased both in the public and the regulatory domains. However, these demands have created specialization within boards, with more requirements and responsibilities being refocused to the committee level, such as the creation of audit and compensation committees. While these role specializations enable directors to better cope with two of the most important problems they face—limited time and complexity of information—time constraints prevent the efficient transfers of information between the committees. This may have enabled the increases in CEO compensation, especially as compensation committee members often lack the information, ability and expertise to understand financial and accounting implications associated with CEO pay, according to the 2009 Public Company Governance Survey by the National Association of Corporate Directors.

Our paper examines whether the problem of increasing CEO compensation is partially resolved by the audit and compensation committees having a common director (a linking pin) who can seamlessly move information between them.  We find that such “linking pin” directors are an essential mechanism for transferring information about firm performance and risk factors between board committees than just regular full board meetings and committee reports, as the audit committee is more knowledgeable about them then the compensation committee, and can better use this information in setting pay. Using data from S&P 1500 firms from 1998-2009, we find that board committee overlaps associated with such linking pin directors is an important conduit for knowledge transfer between boards’ audit and compensation setting functions. These directors are associated with lower CEO compensation and influence pay mix. In studying the dynamics behind this process, we find that newly created linking pins improve monitoring effectiveness whereas recently dissolved linking pins decrease it. We conclude that linking pin directors facilitate intra-board information transfers that have implications for the CEO compensation setting process. In the absence of linking pin directors, such information transfers could be assisted by having more interaction between the audit and compensation committees or holding joint meetings, leading to improved board vigilance in the compensation setting process at little or no cost.

In fact, Ernst and Young’s recent report on leading practices of audit committees suggests that: “the audit and compensation committees should coordinate with each other,” “the audit committee can help assess how certain financial metrics are employed in the company’s compensation plans,” “the audit committee, in conjunction with the compensation committee, consider the appropriateness of the incentive structure and whether it contributes to increased fraud risk.” Our research findings highlight one particular mechanism for doing this.

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This study finds board committee overlap associated with linking pin directors is an important conduit for knowledge transfer between boards’ monitoring and incentive alignment functions.

Pamela Brandes

Pamela Brandes

Professor Brandes is an associate professor of management. Her research interests are in the areas of executive compensation, corporate governance, and employee attitudes.
Pamela Brandes
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