Optimal Contracting or Managerial Power : Evidence from the Role of Independent Directors in Adjusting CEO Inside Debt

Whether executive compensation practices reflect optimal contracting or managerial power is one of the most fundamental and controversial topics in compensation and governance research. We shed light on this central issue by being the first to study the role of independent directors in adjusting the inside debt of the Chief Executive Officer (CEO). Consistent with the optimal contracting view, we find that firms with more independent directors adjust CEO inside debt more quickly toward the optimum. Our results are stronger in financially unconstrained firms, growth firms, under-levered firms, and firms led by more powerful CEOs or overconfident CEOs. We also find that when the agency cost of CEO inside debt is low, board independence is associated with a slower adjustment speed. Our results have policy implications since executive compensation continues to grow in importance and our evidence suggests that independent directors make intricate tradeoff decisions when adjusting it