Chief Executive Pay and Remuneration Committee Independence*

Publication Date01 Aug 2012
AuthorIan Gregory‐Smith
©Blackwell Publishing Ltd and the Department of Economics, University of Oxford, 2011. Published by Blackwell Publishing Ltd,
9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.
doi: 10.1111/j.1468-0084.2011.00660.x
Chief Executive Pay and Remuneration Committee
Ian Gregory-Smith
University of Edinburgh Business School, Edinburgh, EH8 9JS, UK
This article tests the impact of remuneration committee independence on Chief Executive
(CEO) pay. FTSE350 companies between 1996 and 2008 are used to assess whether re-
muneration committees facilitate optimal contracting or whether CEOs capture the pay-
setting process and inate their own remuneration. This panel has a number of advantages
over prior samples and, in particular, contains a more comprehensive assessment of non-
executive directors’ independence. No evidence of a relationship between CEO pay and
director independence is found, challenging the theory of managerial power and the re-
ceived wisdom of institutional guidance.
I. Introduction
There is widespread concern that the CEO pay-setting process is broken. With the onset of
spectacular corporate failures, particularly in the nancial services industry where aggres-
sive bonus schemes are commonplace, the public disquiet with executive remuneration
has reached new heights.1Yet,orthodox economic theory (optimal contracting) posits that
CEO pay is set by the board on behalf of shareholders, attracting and motivating directors
of the desired calibre without paying more than is necessary (Holmstrom, 1979; Prender-
gast, 1999). In light of recent events2alternative theories of pay determination warrant
Lucian Bebchuk has developed a theory (referred to here as managerial power3) that
is consistent with the popular perception of executive remuneration, (Bebchuk, Fried and
ÅThe author thanks Martin Conyon, Alistair Bruce, SarahWilson, Guy Callaghan (Manifest Information Services
Ltd), the anonymous referee, and participants at EARIE 2007 for helpful comments. The author is indebted to Steve
Thompson and Peter Wrightfor their numerous contributions and for the generous guidance they continue to provide.
JEL Classication numbers: G30, J30.
1Public outrage became violent when the house of Sir Fred Goodwin, the former CEO of Royal Bank of Scotland
(RBS), was attacked after it emerged RBS posted a record loss of £40,667m and Sir Fred would receive a pension of
£700,000 per annum. This was later reduced to a lump sum of £2.8m and £342,500 per annum.
2For example, the apparent disconnect between shareholder returns and CEO pay in high prole companies such
as RBS, Shell and Bellway and the possibility that bonuses arrangements might actually have contributed to the
present nancial crisis by generating myopic incentives and encouraging excessive risk taking (Treasury Committee,
2009), see
3Also known as rent extraction, or board capture theory.
Chief executive pay and remuneration committee independence 511
Walker, 2002; Bebchuk and Fried, 2003, 2004). Following earlier work by Kays and
Silberston (1995), and Bertrand and Mullainathan (2001), Bebchuk and his co-authors
have documented a broken system producing inefcient, ineffective and extremely gener-
ous compensation arrangements. Their central tenet is that the system is broken because of
unresolved agency problems which stem from powerful managers who are able to capture
the pay-setting process. Thus, the CEO effectively sets their own pay constrained only by
an aversion to the outrage their contract generates.
Regulators are aware of the potential conict of interest. In the UK, best practice ini-
tiatives since the Cadbury Report (1992) have sought to limit executive inuence over the
pay-setting process and strengthen the role of non-executive directors (Greenbury Report,
1995; Higgs, 2003; Combined Code, 2009). In particular, members serving on the remuner-
ation committee, the sub-committee of the board that determines CEO pay, are supposed
to be independent in character and judgement so that they are able to resist capture by the
CEO and curtail inated pay outcomes.4The recent Walkerreview (2009) revisits the idea
that a lack of remuneration committee independence contributed to failings in the nancial
service sector. An empirical investigation of the impact of independence on CEO pay is
very timely for policymakers.
The optimal contracting model predicts that CEO pay will not vary in any consistent
direction with the level of independence in the pay-setting process (Core, Holtausen and
Larcker, 1999). It is not that the composition of the board is irrelevant, only that share-
holders control elections to the board and the remuneration committee who will produce
the optimal contract. In direct contrast, the managerial power hypothesis implies the more
inuence the CEO has over the remuneration committee, the more they will distort their
pay above the optimal level. Thus a truly independent remuneration committee is vital to
avoid inated pay outcomes under the managerial power hypothesis, but not of central
concern under standard contracting theory.
In contrast to the voluminous coverage in the business press5the impact of indepen-
dence on pay negotiations been subject to little formal empirical investigation. There is
not consensus on the simple question of whether more independence diminishes CEO
excess. Prior work has been hindered by limited data arising from incomplete and opaque
company disclosures. Even as companies have become more forthcoming with their dis-
closures6prior studies have lacked a comprehensive impartial measure of independence.
This article exploits a dataset with several novel elements including an objective indepen-
dence assessment covering 40,455 director-years. The sample permits detailed scrutiny of
the notion of independence and its impact on CEO pay by identifying individual CEOs
with full remuneration data and precise service dates. This enables the estimation of a
dynamic pay equation that controls for unobservable individual effects. No evidence of an
independence effect is found, presenting a challenge to the managerial power perspective.
This result is robust to several econometric specications.
4Such provisions do not form part of UK company law.Rather, the adopted approach is one of ‘comply or explain’;
that is companies quoted on the London Stock Exchange are required by law to either comply with the provisions or
disclose any non-compliance to shareholders. See Solomon (2007) for a review.
5See for example Guardian Special Reports.
6Due to pressure from best practice in the 1990s and formal disclosures rules post 2002.
©Blackwell Publishing Ltd and the Department of Economics, University of Oxford 2011

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