In my review of Lucian Bebchuk and Jesse Fried's book Pay Without Performance, I noted their argument that outside directors fail to act as an effective constraint on management:
According to Bebchuk and Fried, boards of directors -- even those nominally independent of management -- have strong incentives to acquiesce in executive compensation that pays managers rents (i.e., amounts in excess of the compensation management would receive if the board had bargained with them at arms'-length). Among these are: Directors often are chosen de facto by the CEO. Once a director is on the board, pay and other incentives give the director a strong interest in being reelected; in turn, due to the CEO's considerable influence over selection of the board slate, this gives directors an incentive to stay on the CEO's good side. Directors who work closely with top management develop feelings of loyalty and affection for those managers, as well as becoming inculcated with norms of collegiality and team spirit, which induce directors to "go along" with bloated pay packages. Finally, Bebchuk and Fried argue that those few directors who resist these incentives and seek to put shareholder interests first face a number of obstacles in both the law and practice of corporate governance.
I rejected this argument, pointing out that outside directors have countervailing incentives that encourage them to effectively oversee management. A new research paper on Director Compensation and Board Effectiveness lends considerable support to my argument:
The increase in director incentive compensation in recent years has potentially created greater alignment between directors and owners. Focusing on corporate financing and dividend policies, this paper examines the effect of compensation structure of outside directors on the reliability of financial information; managers' overinvestment and entrenchment behavior; CEO influence on the board and the riskiness of the investment strategy. The results suggest that director stock options not only align the interests of directors and shareholders that manifest in improving the reliability of financial information and monitoring of management but also align their risk preferences that result in adopting riskier investment strategies. In addition, the paper argues that, whereas CEO stock options are used along side other control mechanisms to reduce the agency problem between managers and owners, director stock options are used as substitutes for these other mechanisms. Overall, the results are consistent with the argument that incentive compensation to outside directors promotes board effectiveness and inconsistent with the claim that boards are inactive monitoring institutions.
It may not be "Game. Set. Match.," but you can definitely score one for my side of this debate.
