Compensation Committee Quality: Analysis of Determinants and Implications
Incentive programs have always occupied the attention of academics and practitioners, mainly because of their function to align shareholder and managerial interests and thus to provide a solution to the principal-agent conflict, which every company faces. The financial crisis of 2008, however, exemplified how damaging suboptimal incentive systems could be for a corporation and even for the whole economy.
Cases of excessive CEO compensation raised public scrutiny and gave reason for regulatory intervention. As main representatives of shareholder interests, boards were held accountable for being unable to protect investors. The responsibility for setting and implementing executive compensation, however, often lies not within the board as a whole, but within compensation committee duties. Interestingly enough, researchers have mainly focused their attention on the relationship between board composition and CEO compensation. Although compensation committee composition and effectiveness were awarded some consideration, scholars have primarily examined the influence of director independency and its consequences for the committee. Based on a proposition made by Sun et al. (2009), this paper is interested in the question whether the governance quality of independent compensation committees can vary across companies.
Consistent with this proposition, the aim of this paper is twofold – first to examine what determines compensation committee quality and second to analyze what implications compensation committee quality may have for companies. For this purpose, the paper compares a number of empirical studies on the matter.
The paper begins with a classification of the concept compensation committee quality in the corporate governance context. First, it introduces the board of directors and the compensation committee as internal governance mechanisms, following which it focuses on the concept of quality. The discussion continues with a shift in perspective – the role compensation committees play in the practical context. The focus lies on the United States (U.S.) exchange regulation on committee composition and independence. The viewpoint changes once again to analyze the topic from a theoretical perspective. Two fundamental opposing theories are presented in the light of compensation committee quality – optimal contracting and managerial power theory.
The central discussion in this paper focuses on the determinants and implications of compensation committee quality. Based on the benchmark study of Sun et al. (2009) this paper differentiates between the following six determinants – CEO appointed directors, director’s tenure, CEO directors, busy directors, director’s ownership, and compensation committee size. The paper pursues with an examination of two major implications of compensation committee quality. For the first implication -the effect of compensation committee quality on CEO pay- three empirical studies are presented and discussed. The second implication is based on the benchmark study of Sun et al. (2009) and examines the relationship between CEO stock option grants and future firm performance.
At the end the paper compares and critically reviews the methodology used in the three studies on CEO pay. A discussion on the limitations of empirical studies in this field of research and suggestions for future research follow. To conclude, the paper summarizes the present discussion and reviews its contribution to research on compensation committee quality.
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