Compensation of Outside Directors:

An Empirical Analysis of Economic Determinants

Stephen Bryan

Babcock Graduate School of Management

Wake Forest University

Lee-Seok Hwang

Zicklin School of Business

Baruch College, CUNY

April Klein

Stern School of Business

New York University

and

Steven Lilien^*

Zicklin School of Business

Baruch College, CUNY

September 2000

^*Please send all correspondence to:

Professor Steven Lilien

Stan Ross Department of Accountancy

Zicklin School of Business

Baruch College, CUNY

17 Lexington Avenue, Box E-0725

New York, NY 10010

Phone: 212) 802-6420

Fax: 212) 802-6423

E-mail:

Compensation of Outside Directors:

An Empirical Analysis of Economic Determinants

Abstract

Little is known about the economic environments and determinants of the compensation arrangements for outside board members.  In their roles as delegated monitors of corporate management, board members act as shareholders’ agents.  Thus, a potential for misaligned interests exits, requiring, in turn, incentive arrangements that are incentive-compatible and individually rational.  We study the economic determinants of both the levels and mixes of compensation for outside board members.  We also examine the effects of the existence of a director pension plan on the relation between director compensation and the hypothesized determinants.  In sum, and contrary to some criticisms that the board of directors is often a passive, ineffective entity that dislikes conflict with the incumbent management, we find that board compensation is structured to mitigate agency problems inherent in firms whose management control is separated from ownership.

JEL classification: J33, D82, D23

Key Words: Director compensation, outside directors, director pension plan, incentive contracts, agency theory

Compensation of Outside Directors:

An Empirical Analysis of Economic Determinants

1. Introduction

            While board member characteristics and board composition have attracted significant attention from both financial economists and practitioners, compensation paid to outside directors has escaped similar scrutiny. One conjecture for the paucity of studies (compared to the extensive line of research on CEO compensation) is that, relative to CEOs whose contributions and decisions critically affect firm performance and value, the board of directors’ role as a corporate monitor appears of reduced importance, except for the extreme scenarios where the board’s intervention is warranted.[1]  However, outside board members serve as shareholders’ agents.  Therefore, a potential for misaligned interests exists, requiring in turn, incentive arrangements that are incentive-compatible and individually rational for board members.

            Anecdotal evidence suggests that outside board members are paid increasingly in a manner to mitigate such agency problems.  Over the past five years, remuneration for outside directors has increased by 70%, largely due to the growth of stock-based compensation (stock grants and stock options) [Oppermann, 1997, Schellhardt, 1999, Perry, 1999].   Hambrick and Jackson, 2000, find that outside directors of 40 high-performing firms between 1987-1996 held 1.3% of stock in the company in 1987 compared to 0.1% of stock held by outside directors for a matched-industry sample of poorly-performing firms over the same time period.  Perry, 1999, finds that firms with independent boards whose outside directors receive stock options are more likely to dismiss the CEO of poorly-performing firms.

            This study fills the research void and scrutinizes anecdotal evidence by comprehensively analyzing the economic determinants behind both the levels of compensation paid to outside directors and the mixes of incentive-based compensation in the total board compensation package.  The drivers we consider are agency-theory-based; that is, we propose that outside director compensation packages are constructed to alleviate potentially misaligned shareholder-board member interests.  We examine cash compensation, stock option awards, and stock grants. We also examine the determinants behind the presence of outside director pension plans and ask whether the existence of such a plan affects our results.[2]

            Using a sample of more than 1,700 U.S. firms over the 1992-1997 period, we provide strong, overall support for the hypothesized determinants.  We find that the level of outside director stock option awards is positively related to the firm’s growth opportunities, institutional stock holdings, and the threat of takeover, and negatively associated with firm size, the number of lines of business, managerial stock ownership, and regulation.  Conversely, the level of director stock grants is negatively related to the firm’s growth opportunities and takeover threat.  We find that the mix of stock option compensation to cash compensation is positively related to the firm’s growth opportunities, institutional stock holdings, and negatively associated with managerial stock ownership, firm leverage, effective tax costs, free cash flow, firm size, number of  business segments, and regulation.  We find that the mix of stock grants to cash compensation is negatively related to growth opportunities and positively related to firm leverage, liquidity, firm size, and the number of segments.  Finally, we find that director pension plans have a set of economic determinants similar to that for director cash compensation and that the existence of a director pension affects the relation between director compensation and the hypothesized determinants.

            In summary, we conclude that outside board compensation packages are designed largely around agency-cost reduction, arising from management oversight and control that is separate from ownership.  Thus, it appears that compensation packages paid to outside directors are designed to resemble compensation packages paid to the CEO.  This conclusion is in stark contrast to criticisms that board members are often passive and ineffective, shunning conflict with incumbent management [Crystal, 1991; Jensen, 1993].  Our findings and conclusions, to our knowledge, represent the first comprehensive study on the relation between a set of firm characteristics and outside director compensation.

            The rest of the study is organized as follows.  Section 2 develops our research hypotheses, and section 3 describes the research design and the sample.  Section 4 provides descriptive statistics on our samples and section 5 provides our empirical findings.  Section 6 provides evidence on robustness checks and contains the results on pension plans. Section 7 concludes the study.

2.  Hypothesized determinants

            Boards of directors are the elected agents of shareholders. Their role is to “manage” the “business and affairs” of the corporation (e.g., see Delaware General Corporation Law (DGCL) §141(a)).  However, for large publicly-traded firms with many shareholders, internal management (e.g., the officers of the firm) run the day-to-day operations, with the board playing a crucial oversight role on behalf of shareholders.  The existence of agency problems between shareholders and internal management and the resulting value loss has been well-documented [Berle and Means, 1932; Jensen and Meckling, 1976].  However, agency problems exist between shareholders and outside directors as well [Williamson, 1984; Fama and Jensen, 1983].

Following Fama and Jensen (1983) and Jensen and Meckling (1976), we define agency costs as the costs of structuring, monitoring, and bonding a set of contracts among agents with conflicting interests and the value of output lost because the costs of full enforcement of contracts exceed the benefits.  One way to alleviate the agency problems between shareholders and outside directors is to provide outside directors with compensation packages that directly align the interests of both parties.  Types of compensation include cash (e.g., annual cash retainer, fee per board meeting, and fee for chairing a committee), stock option awards, restricted stock grants, and pension plans.  Each award has its benefits and drawbacks in motivating directors to act in the best interests of their shareholders.  These benefits and detriments, in turn, depend on the characteristics of each firm.

In the following subsections, we describe the various hypothesized attributes that are related to the levels and mix of outside director compensation.  When there is a clear-signed hypothesis, we present it.  Otherwise, we discuss the rationales behind conflicting predictions.

2.1. Investment opportunities

            High growth firms tend to include stock option awards and stock grants in upper management compensation packages.[3]  The reliance on stock-based compensation is due, in part, to the low level of liquidity and to the high level of information asymmetry that are typical of high growth firms. Since stock-based compensation captures future as well as present cash flows, it has been argued that it dominates cash as a form of compensation for investment-rich firms [Smith and Watts, 1992].

            We predict that firms with rich investment opportunities are likely to rely heavily on stock-based compensation. Thus, both the level of stock-based compensation and mix of stock-based compensation to cash are predicted to be positively related to the firm’s growth opportunities.  However, the incentives attached to stock option awards are not equivalent to stock grants.   Stock option awards provide a convex payoff schedule, which more likely induces the risk-taking that is critical for high growth firms [Bryan, Hwang, and Lilien, 2000].  By comparison, stock grants, because of their linear payoff schedule, may contribute to the under-investment problem [Smith and Stulz, 1985] as board members forego risky, yet value-increasing, projects. Thus, we predict that high growth firms will use stock option awards more heavily than stock grants in outside directors’ compensation packages.

            To measure investment opportunities, we use the market-to-book ratio and, alternatively, in our robustness checks, research and development expenditures scaled by the market value of the firm, consistent with prior studies [e.g., Gaver and Gaver, 1993; Baber, Janakiraman, and Kang, 1996].

2.2. Inside stock ownership

            It has been argued that firms whose managers hold a large fraction of equity have a reduced demand for additional incentive or monitoring mechanisms [Jensen and Meckling, 1976].  Therefore, for these firms, we predict that outside directors’ compensation packages will contain a lower mix of stock-based compensation.  In addition, we expect the equilibrium levels of board compensation to be inversely related to managerial stock holdings.

            However, at high managerial shareholdings, two forces potentially counterbalance the substitution of managerial ownership for incentive based board compensation.  First, at sufficiently high levels of stock ownership, managerial entrenchment problems arise since outside monitoring forces such as takeover threats and proxy fights are unlikely to be effective [Stulz, 1988; Morck, Shleifer, and Vishny, 1988; McConell and Servaes, 1990; Hermalin and Weisbach, 1991].  Second, managers typically are unable to diversify away the risk associated with their wealth, since their personal capital is largely invested in a single position of employment [Smith and Watts, 1992].  At significantly high levels of stock ownership, managers may become overly risk-averse, thereby under-investing in value-increasing, yet risky, projects.  Therefore, as managerial stock holdings increase above an “optimal” level, the equilibrium level of outside director compensation and the mix of stock-based board compensation may become positively associated with managerial stock holdings.  We examine this potential non-linear relation between managerial stock holdings and board compensation by including a quadratic form of managerial stock ownership as a separate independent variable in the regressions, patterned after prior studies [Stulz, 1988; McConell and Servaes, 1990; Himmelberg, Hubbard, and Palia, 1999].

2.3. Institutional stock ownership

            The direction between institutional stock ownership and the level and mix of outside board compensation is unclear. 

The large stock holdings and sophistication of institutional investors facilitate effective monitoring.  This ensures that managers undertake value-maximizing investment projects [Graves, 1988; Hansen and Hill, 1991; Bushee, 1998].  Institutional investors have fewer free rider problems relative to fragmented individual shareholders.  This provides them with strong incentives to engage in continuous information gathering of corporate affairs [Shleifer and Vishny, 1986].  Both lines of reasoning suggest a substitution effect between institutional shareholdings and the level (and mix) of stock-based compensation awarded to the outside board members.

            However, managerial myopia (the focus on short-term performance) is often attributed to the primacy of “transient” institutional investors (i.e., those who trade actively on short-term earnings) in the market [Porter, 1992].  To counterbalance this effect, incentive-based compensation for outside directors may be required.  In addition, large institutional investors have the clout to nominate board members of their own choice and transfer the monitoring role to the board itself.  These arguments lead to a positive relation between institutional ownership and the equilibrium level of compensation and the use of incentive-sensitive stock-based compensation.

2.4. Firm leverage

            Debt can play a disciplinary role by limiting overinvestment [Grossman and Hart, 1982; Jensen, 1986; Stulz, 1990].  In addition, debtholders demand premiums for increased firm risk, which can occur if incentive plans attempt to align the interests of managers, directors, and stockholders at the expense of debtholders [John and John, 1993; Yermack, 1995].  Both propositions suggest an inverse relation between debt and both the equilibrium level and mix of board compensation.  We measure leverage as the sum of short-term and long-term debt scaled by the market value of the firm.

2.5. Liquidity constraints

            Firms with low liquidity are more likely to compensate outside directors with stock-based compensation, rather than with cash compensation, since stock-based compensation conserves cash.  Thus, we predict a negative relation between the mix of stock-based compensation to cash compensation and free cash flow.  We measure liquidity as free cash flow, defined as cash flows from operating activities less cash outflows for investing activities, scaled by firm value, consistent with Matsunaga (1995) and Dechow, Hutton, and Sloan (1996).

2.6. Tax costs

            Stock option awards provide either no tax deduction (for “incentive” stock options) or a tax deduction that is deferred until the options are exercised (for “non-qualified” stock options).  Restricted stock awards offer a deferred tax deduction only when the restrictions lapse. Cash compensation, by contrast, is immediately deductible.[4]  Therefore, the opportunity costs of losing the tax benefits by using stock-based awards increase with firms’ marginal tax rates [Scholes and Wolfson, 1992; Matsunaga, 1995].  Consequently, we expect firms with high marginal tax rates to shift the mix of director pay away from stock-based compensation and toward cash compensation.  As a proxy for the firm’s marginal tax rates, we use net loss carryforwards scaled by market value of the firm [Matsunaga, 1995; Yermack, 1995].  Since firms with a balance of loss carryforwards are likely to incur reduced tax payments than firms without such a balance, the higher the net loss carryforward amount, the lower the marginal tax rates.

2.7. Firm size and the number of lines of business

            The directions between firm size, the number of lines of business and the levels and mixes of outside director compensation are ambiguous.  On one hand, the complexities of investing and operating decisions for large diversified firms make the boards’ monitoring function extremely difficulty [Eaton and Rosen, 1983].  Complex firms may also have more risky investment outcomes.  Under these arguments, larger, multifaceted firms will be associated with higher outside director compensation levels and more stock options. In contrast, as firms grow, they invest resources to establish effective internal control mechanisms, accounting systems, budgeting processes, and performance evaluation systems.  If such planning and control systems provide timely information to the board on managerial performance, then the demand for incentive sensitive board compensation is likely to be reduced.

            We use the natural logarithm of market value of the firm as a proxy for firm size, where market value of the firm is estimated as the sum of market value common stock and total book liabilities.  As a proxy for the number of segments, we use the natural logarithm of the number of lines of business reported by Compustat’s Business Segment File.

2.8. Regulation

            Direct monitoring and oversight by regulatory authorities reduce information asymmetries in regulated firms.  With executives’ actions more observable, regulated firms have reduced needs for incentive-sensitive compensation plans for outside directors [Demsetz and Lehn, 1985; Smith and Watts, 1992].  Regulated firms also tend to have limited investment opportunities due to constraints that the regulators impose [Joskow, Rose, and Shepard, 1993].

            We use an indicator variable that takes the value of one for firms in the electric utility, banking, and insurance industries, and 0 otherwise, consistent with Smith and Watts (1992).

2.9. Threat of takeover

            The demand for incentive-sensitive board compensation is likely to be low if active markets for corporate control discipline management and reduce agency costs [Jensen and Ruback, 1983; Fama and Jensen, 1983].  This implies a negative relation between the threat of takeover and compensation levels and mix.   Conversely, since firms with mismatches between growth opportunities and financial resources are likely targets [Palepu, 1986], outside directors of firms that may be taken over may be accused of poor management of corporate resources, and, consequently are likely to be replaced [Gilson, 1990].  If the threat of takeover imposes added risk on outside board members, then compensation would increase.

            Consistent with Agrawal and Knoeber (1998), we estimate the threat of takeover by measuring the incidence of takeovers in a firm’s two-digit SIC industry during the preceding three years.[5]

3. Board compensation measures and research design

3.1. Outside director cash compensation, stock option awards, and stock awards

            Directors have the legal authority, within limitations, to determine their own compensation packages [DGCL §141(h); New York Business Corporation Law (NYBCL) §713(e)].   The amount and types of authorized shares available limit stock options and stock grants and shareholders must vote to amend the articles of incorporation if there is a change in stock (e.g., DGCL §242).  Many states’ corporate laws specifically allow the board of directors to create stock option plans for its directors.  For example, Delaware gives this right exclusively to the board (DGCL §157).  New York gives the right to the board (NYBCL §202(13)) but requires majority shareholder approval (NYBCL §505(d)).[6]  The NASDAQ stock market listing requirements mandates shareholder approval for the establishment of a stock option plan for officers or directors [Sec. 4310(c)(25)(i)(a)].

We use four outside director compensation components: cash compensation, stock option awards, stock grants, and pension plans.  Each metric is for one outside director.

(1)        Cash compensation  =  Annual cash retainer + (no. of board meetings * fee per meeting).   

The number of board meetings is reported in the company’s proxy statements and the fee per meeting attended usually is paid in cash.[7]

            The cash compensation metric potentially suffers from two measurement errors. First, it does not include a fee for chairing a standing committee, since not every outside director serves in that capacity.  This fee is paid only once a year and is usually smaller than the combined fees paid for committee meetings.  Second, and more significantly, cash compensation includes fees per board meetings. Thus, firms with more annual board meetings will register higher cash compensation per director.  In addition, the number of board meetings appears to be correlated with firm characteristics such as past firm performance and inside shareholdings (Vafeas, 1999).  This suggests that cash compensation as well the coefficients in our models may be unduly influenced firms having abnormally high or low board meetings.  We perform sensitivity analyses in Section 6 to address this issue.

(2)        Stock option compensation  =  (per share option value * number of options awarded). 

            Per share option value is an ex-ante value using the Black-Scholes (1973) model.  The metric contains measurement error to the extent that Black-Scholes does not incorporate unique characteristics of stock options, such as non-transferability of stock options and directors’ limited ability to hedge their wealth [Huddart, 1994; Cuny and Jorion, 1995; Carpenter, 1998].  The metric also does not include one-time stock options that are often granted to outside directors upon their nomination.  If this one-time option grant reduces the need for further annual option grants, then our measure understates the incentive effects derived from stock options.

(3)        Stock grants  =  (number of shares granted * average stock price),

where average stock price is the average of beginning and end of the year stock prices.    

(4)        Mix of stock option awards to cash compensation = (stock option awards ÷ cash compensation), and

(5)        Mix of stock grants to cash compensation  =  (stock grants ÷ cash compensation).

            In addition, firms often provide outside directors with pension plans for a certain number of years after retirement.  We use an indicator variable to determine whether an outside director pension plan exists.

3.2.  Regression Specifications

            Since stock options and/or stock grants are not granted every year to outside directors, these variables have a preponderance of left-censored (at zero) values.  To accommodate for the highly-right-skewed distributions used in the levels regressions, we add the value of one to stock option compensation and stock grant values before log-transformation, an approach similar to Lewellen, Loderer, and Martin (1987).  For the mixes, we use a Tobit model because even though the distribution is left-censored, the overall distribution is more normal than lognormal.[8] We also take natural logs of firm size, number of segments, percentage of inside stock ownership, and percentage of institutional stock ownership to mitigate potential concerns arising from these skewed distributions. 

We include controls for firm performance and firm risk in the levels regressions, since cash compensation (e.g., see Vafeas (1999)) and stock values may be related to these characteristics.  We use yearly stock returns for firm performance beta, estimated from a one-factor market model using a maximum of 60 monthly stock returns ending at fiscal year-end, for firm risk.

For all regression results, we present the summary year-by-year regression coefficients to mitigate potential serial correlations that may arise if we used the pooled data set.  One advantage to this approach is that the summary of yearly regression coefficients is free from heteroscedasticity.  The major disadvantage of this approach is the loss of information relating to year-to-year variation, potentially leading to reduced power of the empirical tests.

4. Sample and descriptive statistics

4.1.  Sample

            All required data on outside director compensation is taken from Standard & Poor’s (S&P) ExecuComp database for the 1992-1997 period.  ExecuComp covers companies from the S&P 500, S&P 400 mid-cap, and S&P 600 small-cap indices.  Firms changing their fiscal year-ends are dropped for that year to ensure that board compensation relates to the whole year.  The sample firms must also have data on the determinants and on the parameters of the Black-Scholes option pricing model available from Compustat and CRSP databases.  The data on inside stock ownership and institutional stock ownership are from Compact Disclosure.  Compustat’s Business Segment Files provide the number of segments.

            Table 1 presents the distribution of the sample firms by industry and stock exchange.  The distributions of the sample companies by one-digit SIC code (panel A) and by stock exchange[9] (panel B) indicate that our sample firms are from a wide range of industries, market capitalizations, and stock exchanges, reducing the concern with sample clustering.

4.2. Descriptive statistics

            Panel A of Table 2 provides several interesting findings.  Consistent with anecdotal evidence [e.g., Schellhardt, 1999], average level cash compensation increased only 11%, from $23,960 in 1992 to $26,550 in 1997, whereas stock option levels increased 170%, from $13,840 in 1992 to $37,290 in 1997.  Further, although the value of stock grants rose significantly from 1992 to 1997 (from $2,200 to $6,610), the increase in total outside director compensation over the period was attributable largely to the dramatic increase in stock option awards.

            Examination of the time trends of the mixes between stock (option)-based and cash compensation tells the same story.  The mixes of stock option awards and stock grants relative to cash compensation increased from 0.66 and 0.08 in 1992 to 1.60 and 0.25 in 1997, respectively.  The percentages of sample firms issuing stock options (stock grants) increased from approximately 29% (15%) in 1992 to 56% (31%) in 1997.  As a result, over 75% of the sample firms granted either stock options or stock to the board of directors in 1997, compared to 43% in 1992. 

            Finally, we note a steep drop in the percentage of firms offering a pension plan for outside directors.  This decrease, from about 35% in 1992 to 16.75% in 1997, became visible in 1996.  One possible explanation, offered by Oppermann [1997] is that firm increasingly are replacing director pension plans with stock options or stock grants.

            Panel B provides descriptive statistics for the compensation variables and determinants used in the analyses for the pooled sample.  Since the sample firms are from different industries, size groups, and exchange listings, considerable cross-sectional variations are found in the levels

4.3. Comparisons of board compensation and hypothesized determinants across stock exchanges

            To highlight the cross-sectional variation in our data set, we test for differences in means across stock exchanges. We report the results in Table 3. Consistent with a common belief, NASD companies, on average, exhibit higher growth opportunities, are smaller, have fewer segments, and are riskier than NYSE firms.  Also relative to NYSE firms, NASD firms have higher levels of managerial stock ownership, lower institutional stock holdings, lower leverage, lower free cash flow, higher net operating loss, and higher incidences of takeover in their industries.  Similar differences are found between NYSE and AMEX firms.

            Stock options levels are highest for NASD firms while stock grant values are greatest for NYSE firms.  More interestingly, the mean of the ratio of stock option awards to cash compensation is 0.73 for NYSE firms’ directors, compared to 2.26 for NASD firms’ directors.  This finding is consistent with the prediction that stock options provide a more efficient incentive to directors of high growth firms to mitigate value loss from under-investment.

5.  Empirical Evidence

5.1. Regression results for the levels of outside director compensation

            We begin by presenting the results for the regressions on the levels of outside director compensation components. Table 4 reports average yearly coefficients and our t-statistics are based on standard errors using yearly regression coefficients.  Column (4) examines total compensation.  Columns (1)-(3) looks at the cash, stock option awards, and stock grant components of total compensation.

In column (4), the coefficient on the market-to-book ratio is significantly positive, consistent with the hypothesis that total compensation is positively associated with the firm’s growth opportunities.  However, this result is driven solely by the significantly positive coefficient for the regression on stock option awards (column (2)).  In contrast, the coefficients are significantly negative for the regressions on cash compensation and stock grants (columns (1) and (3), respectively).  In tandem, these findings support the prediction that, relative to stock grants and cash, stock option awards are a more efficient means of providing desired incentives to outside directors of firms with a rich investment opportunity set.

            For all four regressions, the coefficients on the percentages of managerial stockholdings are statistically negative. These results are consistent with the substitution hypothesis, that is,  high ownership aligns otherwise divergent interests, reducing the demand for other incentive mechanisms [Jensen and Meckling, 1976].  When we include a quadratic form of managerial stock ownership as a separate independent variable (to test for a potential non-linear relation between managerial stock holdings and board compensation), we find significant positive coefficients for all dependent variables.  This suggests that as managerial stock ownership goes beyond optimal levels, managers likely become either overly risk-averse or entrenched, prompting shareholders to respond with adequate monetary incentives to mitigate any potential value loss.

            The coefficients on institutional ownership are all significantly positive, suggesting that high institutional ownership complements, rather than substitutes for, outside director compensation. 

The coefficient on leverage is significant only for the regression on stock option awards. Thus, heavily leveraged firms have fewer stock option awards, in board compensation.  One possible explanation is that for the value loss from increased agency costs of debt exceeds incentive effects of stock options.  An alternative explanation based on debt’s disciplinary role does not appear to be plausible, since we find no evidence of a negative relation between leverage and director cash compensation or stock grants.

            Director cash compensation and stock grants are positively related to both firm size and the number of lines of business, consistent with the view that as the complexity of the firm’s operations increases, the equilibrium level of cash compensation increases.  However, the level of board’s stock option awards is negatively related to firm size and number of segments, suggesting that well-established internal monitoring mechanisms reduce the need for stock option awards.

The coefficients on regulation are significantly negative, supporting the prediction that regulated firms have less need for monitoring by outside directors.

            Finally, the threat of takeover appears to have two opposing effects on board compensation. While the coefficient on takeover threat is significantly positive when the dependent variable is stock option awards, it is significantly negative when the dependent variable is either cash compensation or stock awards.  An explanation for this result is the down-side risk protection on directors’ wealth (due to the convexity of the option payoff function).  Conversely, stock grants can exacerbate the risk due to the linear payoff schedule.

            The coefficients on the two control variables, stock returns and beta, have the expected signs overall.  As firm performance improves, directors’ stock option awards and total compensation increase.  As systematic risk increases, stock option awards increase to compensate for the increased risk.  It is possible, however, that the positive relation is mechanically induced, since systematic risk is positively related to volatility of stock returns, which in turn increases the estimate of the fair value of stock options.  Interestingly, the relation between stock grants and beta is negative, suggesting that as firm risk increases, stock grants become less efficient in providing desired incentives to outside directors possibly due to the linear payoff function.

5.2.  Tobit results on the mix of board compensation

            Table 5 presents the summary results of year-by-year Tobit regressions of the relation between the mix of board compensation and the hypothesized determinants.  Column (3) has the results for the ratio of all stock-based compensation over cash.  Columns (1) and (2) show the results for the mixes of stock option awards and stock grants, respectively.

            The coefficients on the market-to-book ratio, managerial shareholdings, institutional ownership, leverage, firm size, the number of segments, and regulation are consistent with those reported in Table 4 and will not be elaborated upon.  One exception we note is that unlike the results reported for compensation levels, we do not find a significant positive coefficient for the quadratic term of managerial stock ownership for the mix regressions.

            The coefficient on free cash flows is significantly negative for the mix of stock option awards, suggesting that liquidity constraints lead to heavy reliance on stock option awards relative to cash compensation.  However, the liquidity constraint appears to have the opposite association with the mix of stock grants, contrary to prediction, and the explanation is not readily apparent.

            The coefficients for the firm’s net operating loss carryforward are significantly positive, consistent with the prediction that as implicit tax costs of stock options awards and stock grants decrease, firms are more likely to use stock-based compensation, relative to cash compensation.

6. Cash Pension Plans and Sensitivity Analyses

            In this section, we test whether our results are sensitive to the number of board meetings and to alternative proxies for the firm’s growth opportunities, log-transformations of certain variables, and industry clustering of the sample firms.  We also examine cash pension plans for outside directors.  We propose that these pension plans are deferred cash compensation and test whether the economic determinants behind the existence of the plans are similar to those behind the levels of cash compensation.  We then examine the robustness of the results reported in Table 5 to the inclusion of whether a pension plan exists.  The rationale behind this test is that if pensions are deferred cash compensation to directors then the mix of stock grants (options) to cash compensation will be upwardly biased for those firms with pensions.

6.1. Number of board meetings and cash compensation

            Cash compensation paid to directors increases with the number of board meetings since it includes fees per board meeting. As we showed in Table 2, the average number of board meetings over the 1992-1997 period remained fairly constant at around 7.20.  However, the actual number of board meetings varies from 2 through 34. This suggests that the levels regression on cash compensation and the Tobit models on mixes should be related to the number of board meetings.  In addition, Vafeas (1999) shows that the number of board meetings is related to firm specific attributes, such as past firm performance and managerial shareholdings.  Thus, it is possible that our independent variables may be correlated with the number of board meetings, producing ambiguous interpretations of the reported results.

            To examine these issues, we perform three sensitivity analyses.  First, we add the log of the number of board meetings as an independent variable to levels and mixes regressions. Tables 6A and 6B present the results.  As expected, the coefficient on the number of board meetings is significantly positive for the cash compensation regression (the value is 0.34; t-value = 24.10).  The coefficients on the mixes models are all significantly positive (the values vary between 0.33 and 0.96; the t-statistics are between 4.89 and 5.83).  More importantly, the coefficients and statistical significance levels of the other independent variables are virtually identical to those reported in Tables 4 and 5.  The one exception is that leverage becomes significantly negative at the .05 level for the levels regressions on cash compensation and total compensation.

            Second, we delete from the final sample those firm-year observations that have an “abnormally” high number of board meetings during a year compared to other firm-years.[10]  We define an abnormal level of board meetings as one with an absolute change of more than 100% in the number of meetings for the same company over two adjacent years.[11] This screening process eliminates 98 firm-year observations, or 1.2% from the sample.  Our results on the levels of components of director compensation and the mix of stock-based compensation remain almost unchanged after deleting firm-year observations classified as having unusually high number of board meetings.

            Finally, we eliminate firm-year observations that fall in either the bottom 5% (4 meetings per year) or the top 5% (13 meetings) of the distribution of the number of board meetings, assuming that it is unusual to have less than four meetings or more than 13 meetings during a year.  Since this cutoff is rather arbitrary, we also use a 10% threshold to truncate the extreme observations.  We continue to have similar results after removing from the sample those extreme firm-year observations.

6.2. Variable Definitions

            As an alternative proxy for the firm’s growth opportunities, we use research and development (R&D) expenditures scaled by firm value [e.g., Baber, Janakiraman, and Kang, 1996].  The coefficients on R&D have the same signs as those reported above using the market-to-book ratio and the statistical significance remains qualitatively the same.

            The regressions use log-transformed variables for the levels of board compensation and also for certain independent variables to mitigate concern over non-normal distributions.  Since we estimate statistical significance of the independent variables using annual regression coefficients only, the benefit of using the log-transformed variables is likely small.   When we use raw variables in regressions, we obtain similar results.

            It is unlikely that industry clustering causes a serious bias in estimating regressions since as table 1 shows, the sample firms are from a variety of industries without any particular industries dominating the sample.  Nonetheless, we estimate the regressions for each two-digit SIC industry and aggregate the regression coefficients only across these industries and obtain qualitatively similar results.

6.3. Sensitivity to the presence of a director cash  pension plan

            Thus far, the paper has examined determinants behind cash compensation, stock grants, and stock options.  A fourth type of director compensation, a cash pension plan upon retirement from board activities, is also prevalent.[12]  In this section, we provide some preliminary evidence on the determinants of the presence of a pension plan for outside directors, and we examine whether the presence of a pension plan for outside directors affects our inferences on the relation between the mix of stock-based compensation and the hypothesized economic determinants.

            Directors’ retirement plans typically are defined benefit plans equal to the last annual retainer that the outside director received prior to retiring from the board.  A “vesting” period of three to ten years of service as a board member is usual.  Payments are received upon retirement or a specified age (65 or 70 the most common).  Many plans include survival benefits for a remaining spouse.

            As we showed in Table 2, the percentage of firms offering cash retirement plans for outside directors has diminished dramatically over time.  In 1992, 34.78% of our sample firms offered these plans.  By 1997, the percentage declined to 16.75%.  Perusal of several proxy statements indicate that the predominant stated reason for firms discontinuing cash pension plans is that they do not align the interests of directors with shareholders.  This is because cash pension plans act as deferred cash compensation whereas deferred stock plans are more akin to stock options.  Thus, we hypothesize that the coefficients behind the determinants of pension plans will behave most similarly to the cash compensation variables as shown in Table 4. 

Table 7 provides the summary of year-by-year results on the relation between the presence a pension plan for outside directors and the economic determinants. In contrast to Table 4, we are unable to calculate a dollar value for pensions; therefore, the dependent variable takes on the value of one if the firm has an outside cash pension plan and zero otherwise.  In column (1), we use a logit model to calculate the coefficients.  In column (2), we present OLS results so that the reader can compare the coefficients from the cash compensation regressions in Table 4 with the pension results.  The OLS estimators are unbiased but are not efficient due to the heteroskedastic nature of the disturbance.  In addition, since a binary dependent variable produces error terms that are not normally distributed, classical tests of significance on the estimators cannot be done.

As column (1) shows, the existence of a pension plan is negatively associated with the firm’s growth opportunities, managerial stock holdings, the likelihood of a takeover threat, and systematic risk of the firm, and is positively associated with institutional shareholdings, firm size, and the number of segments.  From column (2), we note that the coefficients on these independent variables are similar to those found for director cash compensation (shown in column (3)).   Thus, with the exception of the sign and significance level on the regulation, it appears that current cash compensation and deferred cash compensation (pensions) have similar determinants.  To our knowledge, this is the first evidence on the potential drivers of pension plans for outside directors.

            Tables 8A and 8B examine the degree to which the presence of an outside director  pension plan affects the results reported in Tables 4 and 5.  For instance, pension benefits may provide outside directors with incentives to adopt a long-term decision horizon and consequently replace, at least partially, stock-based compensation.  In Table 8A, we find that cash compensation is significantly positively related to the existence of a pension plan.  In contrast, the level of stock options grants is significantly negatively related to the presence of such a plan.  These findings suggest that pension plans supplement (substitute) for cash (incentive-based) compensation.  The results for the Tobit mixes models in Table 8B provide similar results and interpretations.  While this paper does not explore this issue more fully, we believe that it is a topic that future researchers may want to examine.  For this study, however, we note the coefficients and significance levels of the other variables in the analyses do not differ much from those presented in Tables 4 and 5.  The two exceptions are the coefficients beta in the cash compensation regression and institutional ownership in the stock compensation regression which, in Table 8A, are not significantly different from zero.  Hence, we conclude that our earlier results are not influenced unduly by the presence or absence of an outside director pension plan.

7.  Conclusions and Future Research

            This study tests hypothesized determinants of compensation for members of the board of directors.  Using a large sample of U.S. firms over the 1992-1997 period, we find that the level of director stock option awards is positively related to the firm’s growth opportunities, institutional stock holdings, and the threat of takeover, and negatively associated with firm size, the number of lines of business, managerial stock ownership, and regulation.  Conversely, the level of stock grants is negatively related to the firm’s growth opportunities and takeover threat.  We find that the mix of stock-based compensation relative to cash compensation is positively related to firm’s growth opportunities, institutional stock holdings, and negatively associated with managerial stock ownership, firm leverage, effective tax costs, level of free cash flow, firm size, the number of segments, and regulation.  Further, the mix of stock grants relative to cash compensation is negatively related to growth opportunities and positively related to firm leverage, liquidity, firm size, and the number of segments.  The documented differences between stock options and stock are attributable to their respective payoff functions.  Since stock option awards create a convex payoff schedule, they appear to be more efficient in providing desired incentives to outside directors when firms have abundant investment opportunities and a high likelihood of takeover threat, relative to stock grants, which have a linear payoff function in stock price.

            We also examine the determinants and effects of an outside director pension plan.  We find that director cash compensation and the presence of a pension plan have a similar set of economic determinants.  In addition, the existence of a pension plan appears to influence the amount of cash compensation and stock options given to outside directors.  We believe this is an interesting, yet preliminary result,  and are intending to address it in more detail in a later paper.

            In sum, and contrary to some criticisms that the board of directors are often a passive, ineffective entity that dislikes conflict with the incumbent management [Crystal, 1991; Jensen, 1993], we find that board compensation is structured to mitigate agency problems inherent in firms whose management control is separated from ownership.

            Future research can extend our study by incorporating the possible endogenous aspects of board stock option grants and stock awards.  Prior studies show that the adoption and existence of executives’ incentive contracts not only reflect the firm- and industry-specific characteristics underlying the firm’s contracting and economic environment, but they also affect the executives’ operating, investing, or financing decisions [Larcker, 1983; Lambert, Lanen, and Larcker, 1989; Holthausen, Larcker and Sloan, 1995; Guay, 1999].

            The distinction between “dedicated” institutional investors and “transient” institutional investors appears to be another fruitful area in future compensation studies.  Namely, do the different types of institutional investors affect agency relations of the firm?  Recent studies begin to provide some guidance on this issue [e.g., Bushee, 1998].

            Our understanding of board compensation could be further enhanced by investigating the composition of the board to determine the nature of the relation between board composition and board compensation. Perry, 1999, does presents some interesting work in this area. In order to gain additional insights into efficient board contracting, more work on this line appears warranted.

            Further, we consider only the effect of the “flow” of stock options (i.e., stock options awarded in the current year) and exclude the “stock” of options that are granted in prior years.  Since executive stock options granted in prior years are on average in-the-money [Guay, 1999] and in-the-money stock options have greater sensitivity to stock price than at-the-money stock options, future research can examine the incentive effects of both the “flow” and the “stock” of stock options.

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 Table 1

Distribution of the sample firms by one-digit Standard Industry Code (SIC) and exchange listing

            Panel A: The distribution by one-digit SIC code

            Panel B: Exchange listings

Final sample firms satisfy the following requirements:

  (i)       The annual data on the board of directors’ stock option awards, stock grants, and cash compensation (annual retainer and fees paid for committee meetings) are available from the Standard & Poor’s ExecuComp database for at least one year over the period 1992-1997;

(iii)       The firm maintains the same fiscal year-end from one year to the next;

(iv)       The data on the parameters for the Black-Scholes option valuation model and the hypothesized determinants of the board of directors’ compensation are available from Compustat’s 1998 Primary, Secondary, and Tertiary, Full Coverage, Research Annual file, or the Center for Research in Stock Prices (CRSP) database.

Table 2

Descriptive statistics on the board of directors’ compensation and hypothesized determinants

Panel A: Trends in the board’s cash compensation, stock option awards, stock grants, and pension plan over the 1992-1997 period

Table 2 (Continued)

Panel B: Descriptive statistics on the board of directors’ compensation variables and hypothesized determinants for the pooled sample

The variables are defined as follows:

Cash compensation                        =            annual director retainer plus the number of board meetings times fees paid per director meeting;

Stock option awards                        =            annual stock option compensation measured as per share Black-Scholes option value times the number of stock options granted;

Stock grants                              =            annual stock compensation measured as the number of shares granted times the average stock price;

Stock option plus stock awards            =            stock option awards plus stock awards;

Mix of stock option awards to             =            the ratio of stock option awards to cash compensation;

  cash compensation                       

Mix of stock grants to                         =            the ratio of stock grants to cash compensation;

  cash compensation           

Mix of stock option plus stock             =            the ratio of stock option awards plus stock awards to cash

  grants to cash compensation                        compensation;

Market-to-book ratio                        =            the ratio of market value of the firm to book value of total assets, where market value of the firm is measured as the sum of market value of equity and book value of total liabilities;

Inside ownership                        =            proportion of shares held by insiders who consist of officers, directors, beneficial owners, and principal stockholders owning ten percent or more of the company stock.  Officers, directors, and beneficial ownership are only included if they hold at least 1,000 shares;

Institutional ownership                        =            proportion of shares held by all institutions filling a 13-F form with the SEC, i.e., organizations, companies, universities and other groups that have greater than $100 million in equity assets;

Leverage                                  =            short-term debt plus long-term liabilities scaled by firm market value;

Free cash flow                          =            free cash flow scaled by firm market value, where free cash flow is measured as cash inflows from operating activities plus cash outflows to investing activities;

Net operating loss                        =            net operating loss carryforward scaled by firm market value;

Firm value                                =            market value of the firm;

No. of segments                        =            the number of separately reported business segments; estimated over 60 months ending at the end of fiscal year, where the market return is proxied by value-weighted market return;

Regulation dummy                        =            an indicator variable for regulated firms which equals 1 for firms in the electric utility industry (two-digit SIC of 49) or financial industries  (SIC of 60, 62, 64 through 67) and 0 otherwise;

Takeover threat                                                 =          the incidence of takeovers in the firm’s two-digit SIC industry during the preceding three years;

Return                                      =            stock rates of returns during the fiscal year; and

Beta                                         =            the systematic risk measured using a one-factor market model using a maximum of 60 monthly returns ending at fiscal year-end.

Table 3

Comparison of mean values of the board of director compensation variables

and hypothesized determinants across stock exchange listing

^aPlease refer to Table 2 for variable definitions.

^bTests for differences are in relation to the NYSE sample.

^cNon-parametric Wilcoxon rank-sum z-statistics.

^***(^**,^*) Statistically significant at the 1% (5%, 10%) level, two-tailed.

Table 4

Summary of year-by-year ordinary least squares regression results for the association between the level of the board of directors’ compensation components and the hypothesized economic determinants (Reported coefficients are inter-temporal means and t-statistics are based on yearly regression coefficients)

^aPlease refer to Table 2 for variable definitions.

^bThe dependent variable takes the value of 1 if a firm has a pension plan for outside directors and 0 otherwise.

^***(^**,^*) Statistically significant at the 1% (5%, 10%) level, two-tailed.

Table 5

Summary of year-by-year Tobit regression results for the association between the mix of the board of directors’ compensation components and the hypothesized economic determinants (Reported coefficients are inter-temporal means and t-statistics are based on yearly regression coefficients)

^aPlease refer to Table 2 for variable definitions.

^***(^**,^*) Statistically significant at the 1% (5%, 10%) level, two-tailed.

Table 6

Comparison of components of director compensation between the sample of firms a with director pension plan and the sample of firms without a director pension plan

^aPlease refer to Table 2 for variable definitions.

^bTests for differences are in relation to the NYSE sample.

^cNon-parametric Wilcoxon rank-sum z-statistics.

Table 7

Separate summary of year-by-year Tobit regression results for the sample of firms with a director pension plan and the sample of firms without a director pension plan for the association between the mix of the board of directors’ compensation components and the hypothesized economic determinants (Reported coefficients are inter-temporal means and t-statistics are based on yearly regression coefficients)

^aPlease refer to Table 2 for variable definitions.

^***(^**,^*) Statistically significant at the 1% (5%, 10%) level, two-tailed.