An Empirical Analysis of the Relation between Inside Director’s Excess Compensation and Firm’s Future Performance: Implicit Contract Perspective
Date Issued
2012
Date
2012
Author(s)
Tai, Yi-Hui
Abstract
The purpose of this paper is to investigate the relation between inside director’s excess compensation and firm’s future performance. This paper takes the "inside director" as the research subject due to the following concerns. Firstly, the compensation of the outside director is usually only travel allowances and his chance to collude with the manager is lower. Moreover, comparing to simply taking the high-level manager as the research subject, we can learn more due to the duality of inside director. Finally, few prior papers study the relation between inside director’s excess compensation and firm’s future performance. Therefore, the firm’s future performance is expressed as a function of the two excess compensations as derived from the inside director’s respective roles of director and executive. Besides that, this paper also tests the relation between total excess compensation and firm’s future performance.
The excess compensation’s relation to the firm’s future performance has been explained in the literature based on the two perspectives: cronyism versus implicit contract theory. According to cronyism, it views the excess compensation as an agency problem that the agent exploits from the information asymmetry between principal and agent. To the contrary, implicit contract theory argues that if corporate boards optimally use both observable and unobservable measures of performance and the unobservable measures are correlated with firm future performance, then unexplained variation in current compensation should predict future variation in firm performance. In addition, even if there exists excess compensation paid to inside director and no significant growth of firm future performance, it could be due to other factors than cronyism. Therefore, this study chooses implicit contract theory as the basis to develop hypotheses.
This study defines excess compensation as the compensation unexplained by current observable financial and market performance measures. In other words, the excess compensation means the compensation explained by unobservable performance measures and is the difference between the actual pay and the reasonable pay. The latter is determined by the outsiders who use public information to derive their view on inside director’s reasonable pay and this paper use agency theory to define the combination of reasonable pay. Firstly, the compensation for an agent shall be in accordance with the performance. Also, the weight allocated to the performance measures should have a negative correlation with the level of uncertainty, and this paper divided the uncertainty involved into two dimensions: complexity and risk. Here we defined reasonable compensation as the function with the following factor: (1) performance, (2) complexity, and (3) risk.
Empirical evidence shows that the inside director’s total excess compensation and the inside director’s excess compensation from director’s role are both positively related to the firm’s future performance as measured by the Tobin’s q of the first or second succeeding period. This result supports the view base on implicit contract theory. Also, the prior empirical result is supported by non-electronics companies. Nevertheless, empirical evidence shows that the inside director’s excess compensation from executive role is unrelated to the firm’s future performance as measured by the Tobin’s q of the first or second succeeding period or ROA of the succeeding period. Lastly, the inside director’s excess compensation from director’s role is not negatively related to the firm’s future performance in the firm with CEO duality.
Subjects
Inside director
Excess compensation
Firm performance
Implicit contract
CEO Duality
Type
thesis
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