Who Monitors the Monitor? The Effect of Board Independence on Executive Compensation and Firm Value

Abstract:     
Recent corporate governance reforms focus on board independence and encourage equity ownership by directors. We analyze the efficacy of these reforms in a model where both adverse selection and moral hazard are present 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 the board's dependence on the CEO increases, its monitoring efficiency may increase even as incentive efficiency deteriorates with respect to compensation contracts awarded to the managers. This endogenous tension implies - contrary to the assumptions underlying recent reforms - that outside shareholders' value can indeed decrease (increase) as board independence increases (falls). Moreover, and again contrary to the general presumption in the literature, higher equity incentives for the board sometimes may increase (equity-based) compensation awards to management.

Keywords: Corporate governance, Board of directors, Monitoring, Director independence, Equity incentives, Executive compensation

JEL Classifications: G31, G34, D82

Working Paper Series