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Does the compensation level of outside director depend on its personal profile? Some evidence from UK

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Abstract

Combining human capital theory and equity theory, we developed and tested a model in which the outside directors’ total cash compensation is related to the outsider’s profile, as well as to the board and firm characteristics. Consistent with our model, characteristics of the outsider’s profile, in terms of his/her role and responsibility, meeting activities and length of service, are relevant. Only the director’s popularity, as a part of his/her human capital, has a significant effect on his/her compensation. Our empirical results confirm the necessity to create a stronger link between the remuneration policies of the outsider directors and their contribution in a board, in terms of human capital. The remuneration policies adopted by firms should be linked to practices on corporate governance useful for helping outsiders contribute confidently to their work of the board and receive ongoing support and information so they can develop their understanding of the total environment within they work. Then, we suggest having recourse to qualifications and professional skills as well as to specific training or board induction programmes defined by firms themselves. Finally, the Combined Code should promote the adoption and spreading of such practices on market.

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Notes

  1. Lasfer (2006) found a steady proportion of non-executive directors on the board, from 42.7% in 1990 to 43.13% in 1996. Moreover, Udueni (1999) and Peasnell et al. (2003) found only a few of non-executives were really independent. Following a study of Protiviti (2005), an independent risk consulting company, on the profile of Italian independent directors, Santella et al. (2006) investigated about this topic with reference to the Italian case and found Italian listed companies didn’t really apply the independence standards (required by the Preda Code, 2002, and the EC Recommendation, 2005) they declared they followed. In particular, they studied the 40 Italian Blue Chips in 2003 and found compliance with the Preda Code standards for only 5 out of the 284 directors formally identified as independent by their companies, and for only 4 directors with respect to the EC standards. These results suggest that in almost all cases company disclosure either contradicts alleged director independence or doesn’t allow verifying it. Then, the same authors (see Santella et al. 2007) expanded their previous analysis and found a general low level of compliance with independence requirements for both financial and non-financial companies. In particular, they found that: “Financial companies show a lower level of compliance than non-financial ones, and are connected with each other and with a few non-financial companies through networks of cross-directorships: two directors (one independent and one executive) who also sit at the same time on another company board” (Santella et al. 2007).

    In addition, they found those non-financial companies with a relatively fragmented shareholder structure tended to be characterized by higher levels of compliance and disclosure than tightly-controlled non-financial ones. While financial companies with fragmented shareholder structure tended to be characterized by low disclosure levels, although such companies were also subject to strong financial supervision.

  2. Many economic reasons explain the existence of independent directors, as in particular the ownership structure. In fact, the separation between ownership and control, analyzed by Berle and Means in 1930s, is a point of reference for further studies yet. According to authors, as long as ownership and control are in one’s hand, the personal interest coincides with company’s one, but when there is a very fragmented shareholding (and a consequent separation between ownership and control) some conflicts of interest could appear and they could be reduced and/or eliminated by a certain number of independent directors on the board. See also Fama and Jensen (1983b), according to which an optimal structure of board requires the presence of both inside directors and outside directors, and outsiders just protect shareholders from potential conflicts of interest between principal and agent.

  3. A review about theoretical studies and empirical results on outsiders role in general, without distinguish between affiliated and independent is in Fields and Keys (2003).

  4. All the CG codes include a section for independent directors, but the definition of independence and proportion of outsiders on the board vary across the countries, while nomination procedures and roles of independent directors are quite standardized.

  5. For example, after observing that independent directors were responsible for the protection and promotion of small shareholders interests, Byrd and Hickman (1992) found a better performance in firms with a greater proportion (at least 45%) of independent outsiders on their boards, because the board’s independency influenced market’s behaviours. But, they also found this relation became negative when the proportion of independent outsiders increased over 60%.

  6. But when outsiders decide to dismiss the CEO because of a poor corporate performance, they also could be dismissed. But they are rewarded by market for their decision. See Farrell and Whidbee (2000).

  7. In particular, Petra (2007) found that, even if a high proportion of independent directors involved a better corporate performance, that wasn't worth when there were a separation of CEO and Chairman roles and entirely independent committees. Numerous authors (such as, for the Japanese companies Kang and Shivdasani 1995; for the US companies Borokhovich et al. 1996; and for the UK companies Dahya and McConnell 2005) found a positive relationship between the proportion of outsiders on the board and the appointment of an external CEO, and that improved corporate performance.

  8. According to Fernandes (2007), there are some doubts about the real effectiveness of outsiders to align interests between managers and shareholders. He found, in fact, Portuguese companies (as one-tier system) with most of non-executives paid higher fees to their top-managers than companies without outsiders. This is a problem of un-real independency of outsiders, as Shivdasani and Yermack (1999), Carretta et al. (2006) and Santella et al. (2006, 2007) observed.

  9. For example, as we previously mentioned, Protiviti (2005) and Schwizer and Netti (2006) analyzed the Italian case. For the Italian listed companies, see also Assonime—Emittenti Titoli SpA (2007). For the US companies see Agrawal and Knoeber (2001), who found also politics influenced the board’s composition because outsiders with a political and legal experience played a key role in those companies where politics was relevant, while that wasn’t worth if there were female directors.

  10. The Companies Act has received the dispositions for the remuneration of the boards as introduced in “The Directors’ Remunerative Report Regulations 2002”, Statutory Instrument 2002 No. 1986, available at: http://www.opsi.gov.uk/si/si2002.20021986.htm.

  11. In certain cases, even the regressor is expressed on a logarithmic scale resulting in a log–log type model. In yet other cases, it takes on a binary form, while in the others a continuous one.

  12. In the case of the directors’ total compensation is reported in American dollars, the 2005 average rate USD/GBP is used to convert the director compensation in GBP.

  13. In this profile, the author makes all the outsiders who belong to the sample with an academic or political role that has professional experience in a field different from those of the company being served.

  14. The evaluation of popularity of individuals is usually used in political circles in order to determine the potential of the candidature in winning the political elections in a Country. See Mueller (1970) for example.

  15. We calculated Blau’s Index (B) as:

    \( B = \left( {1 - \sum {p_{i} } } \right)^{2} \) where B is the heterogeneity measure and p i is the percentage of board members in the i-th group (i.e. nationality, education, gender). The higher the value of B, the greater is the heterogeneity on a particular variable, Ruigrok et al. (2006, p. 133).

  16. To simplify the analysis and the comment of the results, in certain cases the six industrial sectors have been grouped into the following three: banking and financial services, hi-tech (made up of companies in the aerospace, technology hardware and technology software areas), pharma & biotech.

  17. To homogenize and complete the survey, the profile of the outsider includes all non-executive directors (independent, senior non-executive directors as well as non-executive chairmen) present within the board of the firms belonging to the sample.

  18. In the case of multiple directorships detected in the sampling, the director appears only once in the sample, in the first company on which the consensus has been specimen.

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Acknowledgements

The authors would like to express their gratitude to Dr. Yener Althunbas (University of Wales) and to three anonymous referees for their helpful comments on a previous draft of the paper.

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    Pietro Marchetti & Valeria Stefanelli

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Correspondence to Valeria Stefanelli.

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This paper is the result of a co-operation between the authors. In particular, Pietro Marchetti has contributed to the Sects. 1, 2 and 7 while Valeria Stefanelli has contributed to the Sects. 3, 4, 5 and 6.

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Marchetti, P., Stefanelli, V. Does the compensation level of outside director depend on its personal profile? Some evidence from UK. J Manag Gov 13, 325–354 (2009). https://doi.org/10.1007/s10997-009-9086-9

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