Board Independence and the Design of Executive Compensation

Executive compensation serves as a metric by which investors measure the quality of a firm's governance. In this paper, I explore how the signaling role of executive compensation impacts the compensation decisions of boards. I show that reputational concerns often cause boards to adopt pay packages that are inefficient. For example, boards may offer contracts that provide excessive incentives to signal that their firms are well-governed. Moreover, to avoid investor criticism, certain boards opt to transfer rents to executives in opaque and costly ways. Although the model predicts that captured boards compensate their executives more than independent boards, it is not the most captured and entrenched boards that are prone to choose inefficient forms of pay as commonly argued. Rather, it is those boards most responsive to investor pressure that signal their independence in a costly manner