RFS Advance Access originally published online on March 3, 2008
Review of Financial Studies 2008 21(3):1371-1401; doi:10.1093/rfs/hhn010
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Who Monitors the Monitor? The Effect of Board Independence on Executive Compensation and Firm Value
University of Houston
Address correspondence to Praveen Kumar, University of Houston, C.T. Bauer College of Business, Houston, TX 77204-2016; telephone: (713) 743-4770; fax: (713) 743-4789; e-mail: pkumar{at}uh.edu
JEL Classification: G31, G34, D82
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Abstract |
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Recent corporate governance reforms focus on the board's independence and encourage equity ownership by directors. We analyze the efficacy of these reforms in a model in which both adverse selection and moral hazard exist at the level of the firm's management. Delegating governance to the board improves monitoring but creates another agency problem because directors themselves avoid effort and are dependent on the CEO. We show that as directors become less dependent on the CEO, their monitoring efficiency may decrease even as they improve the incentive efficiency of executive compensation contracts. Therefore, a board composed of directors that are more independent may actually perform worse. Moreover, higher equity incentives for the board may increase equity-based compensation awards to management.
We thank the editor, Bob McDonald, and an anonymous referee for very helpful comments. We also thank Sandeep Baglia, Bala Balchandran, Joel Demski, Douglas Gale, Ed Green, Steve Huddart, Kose John, Sok-Hyon Kang, Paul MacAvoy, Todd Milbourn, Dilip Mookherjee, John O'Brien, Madhav Rajan, Stefan Reichelstein, Susan Spring, Shyam Sunder, Jean Tirole, Donna Zerwitz, and participants at the 2003 Summer Econometric Society meetings and the 2004 CMU Accounting Conference for comments and discussions on issues addressed in the paper.