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Does Independent Advice to the Board Affect CEO Compensation?

Published online by Cambridge University Press:  02 December 2019

Tor-Erik Bakke  and
Hamed Mahmudi Open the ORCID record for Hamed Mahmudi [Opens in a new window]
Tor-Erik Bakke
Affiliation:
Bakke, tbakke@uic.edu, University of Illinois at Chicago College of Business Administration
Hamed Mahmudi*
Affiliation:
Mahmudi, hmahmudi@udel.edu, University of Delaware Lerner College of Business and Economics
*
Mahmudi (corresponding author), hmahmudi@udel.edu
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Abstract

This article investigates the role external advice plays in the board’s determination of chief executive officer (CEO) compensation. We show that CEO incentive pay increases with the degree of compensation consultant independence using a quasi-natural experiment provided by the creation of an independent consultant after separation from an affiliated consultant. Specifically, switching to an independent consultant significantly increases the pay–performance sensitivity and relative performance evaluation of CEO contracts. Despite the benefits of independent advice, independent consultants may not be hired due to the influence of powerful CEOs or because boards already possess adequate expertise.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 56 , Issue 2 , March 2021 , pp. 693 - 744
Copyright
© Michael G. Foster School of Business, University of Washington 2019

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Footnotes

Mahmudi thanks Alexander Dyck (chair), Craig Doidge, and Jan Mahrt-Smith for their supervision and invaluable comments. We thank the following compensation consultants and chairs of compensation committees for insightful discussions: David Beatty, Paul Gryglewicz, Ken Hugessen, Ira Kay, Georges Soare, and Dale Stanway. We also thank Chris Armstrong (the referee), Laurence Booth, Ing-Haw Cheng, Susan Christoffersen, Sergei Davydenko, Gus De Franco, José Miguel Gaspar, Richard Green, Denis Gromb, Dirk Jenter (Western Finance Association (WFA) discussant), Kevin Murphy, Chris Parsons, Lukasz Pomorski, Aazam Virani, Kent Womack, and Jun Yang and seminar participants at the University of Oklahoma, ESSEC, the University of Toronto, the Bank of Canada, the 2011 Financial Management Association (FMA) Doctoral Student Consortium, the 2012 Northern Finance Association (NFA) Meetings, the 2013 Corporate Governance Conference at Drexel University, and the 2013 WFA Meetings for their helpful comments and suggestions. This article is the recipient of the Best Paper Award sponsored by the Bank of Canada at the NFA Meetings. Mahmudi acknowledges the financial support from the Canadian Foundation for Governance Research (CFGR). We thank Matt Fullbrook from the Clarkson Centre for Business Ethics and Board Effectiveness at the University of Toronto for sharing the Canadian corporate governance data. All errors are solely the authors’ responsibility.

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